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How Is The Price Of A Barrel Of Oil Determined?

University Of The South

March 15, 2022

I thought this was a useful article.

But here’s what I really want to know — how much “new” oil needs to come into production to reduce the price of oil to the level it was say on average last year? All of the articles I’ve read would get an F at Darden. The articles say the US needs to produce more but they don’t say how much we need to drive the prices down. Perhaps we can’t produce enough more to decrease the price substantially even if there were no regulatory bottlenecks.

The article: Crude oil prices are determined by global supply and demand. Economic growth is one of the biggest factors affecting petroleum product—and therefore crude oil—demand. Growing economies increase demand for energy in general and especially for transporting goods and materials from producers to consumers. The world’s transportation sector is almost totally dependent on petroleum products such as gasoline and diesel fuel. Many countries also rely heavily on petroleum fuels for heating, cooking, or generating electricity. Petroleum products made from crude oil and other hydrocarbon liquids account for about a third of total world energy consumption.

OPEC can influence world oil supplies and prices

The Organization of the Petroleum Exporting Countries (OPEC)can have a significant influence on oil prices by setting production targets for its members. OPEC includes countries with some of the world's largest oil reserves. At the beginning of 2020, OPEC members controlled about 71% of total world proved crude oil reserves (plus lease condensate), and they accounted for 36% of total world crude oil production in 2020.

OPEC attempts to manage oil production of its member countries by setting crude oil production targets, or quotas, for its members. Compliance of OPEC members with OPEC quotas is mixed because production decisions are ultimately in the hands of the individual members.

In general, the main factors determining OPEC's effectiveness in influencing oil prices include:

  • The extent to which OPEC members actually comply with production quotas

  • The ability or willingness of consumers to reduce petroleum consumption

  • The competitiveness of non-OPEC producers when oil prices change

  • The efficiency of OPEC producers to supply oil compared with non-OPEC producers

The difference between oil market demand and supply from non-OPEC sources is often referred to as the call on OPEC because OPEC members maintain the world's entire spare crude oil production capacity. Saudi Arabia, the largest OPEC oil producer and one of the world's largest oil exporters, historically has had the largest share of the world's spare oil production capacity. Developing and maintaining idle spare production capacity is generally not cost-effective for international oil companies (IOC) because the IOC business model maximizes revenue by producing oil as long as the price of selling the oil is higher than the cost of supplying an additional barrel of oil to market. OPEC spare capacity provides an indicator of the world oil market's ability to respond to real and potential disruptions in world oil supplies.

The U.S. Energy Information Administration (EIA) defines spare capacity as the volume of oil production that can be brought online within 30 days and sustained for at least 90 days. Spare capacity can also be thought of as the difference between a country's current oil production and its maximum oil production capacity. If a supply disruption occurs, oil producers can use spare capacity to moderate increases in world oil prices by boosting production to offset reduced oil supplies.

Causes of world crude oil prices and supply disruptions

Geopolitical events and severe weather that disrupt the supply of crude oil and petroleum products to market can affect crude oil and petroleum product prices. These events may create uncertainty about future supply or demand, which can lead to higher volatility in prices. The volatility of oil prices is tied to the low responsiveness, or inelasticity, of supply and demand to price changes in the short term. Crude oil production capacity and the equipment that uses petroleum products as its main source of energy are relatively fixed in the near term. It takes time to develop new supply sources or to vary production, and when prices rise, switching to other fuels or increasing equipment fuel efficiency in the near term is challenging for consumers to do. These conditions may require a large price change to rebalance physical supply and demand.

Most of the crude oil reserves in the world are located in regions that have been prone to political upheaval or in regions that have had oil production disruptions because of political events. Several major oil price shocks have occurred at the same time that political events caused supply disruptions, most notably the Arab Oil Embargo in 1973–74, the Iranian revolution, the Iran-Iraq war in the 1980s, and the Persian Gulf War in 1990–91. In recent years, conflicts and political events in the Middle East, the Persian Gulf, Libya, and Venezuela have contributed to world oil supply disruptions and increases in oil prices.

Given the history of oil supply disruptions caused by political events, market participants constantly assess the possibility of future disruptions. In addition to the size and duration of a potential disruption, market participants also consider the availability of crude oil stocks and the ability of other producers to offset a potential supply loss. When spare capacity and inventories are low, a potential supply disruption may have a greater impact on prices than might be expected if only current demand and supply were considered.

Weather also plays a significant role in the supply of crude oil. Hurricanes in the Gulf of Mexico can affect oil production and refinery operations in the Gulf region. As a result, U.S. petroleum product prices may increase sharply as supplies from the Gulf to other regions drop. Severe cold weather can also strain product markets as producers attempt to supply enough product, such as heating oil, to consumers in a short amount of time. This seasonal demand can also result in higher prices.

Other events such as refinery outages or pipeline problems can also restrict the flow of crude oil and petroleum products to market. These events can lead to a temporary supply disruption that could increase prices.

The influence of any of these factors on crude oil prices tends to be relatively short lived. Once the supply disruption subsides, oil and product supply chains adjust, and prices usually return to their previous levels.

Buyers and sellers at a global auction

Crude oil and petroleum product prices are the result of thousands of transactions taking place simultaneously around the world at all levels of the supply chain, from the crude oil producer to the individual consumer. Oil markets are essentially a global auction—the highest bidder will win the available supply.

Like any auction, the bidder doesn't want to pay too much. When markets are tight (when demand is high and/or available supply is low), the bidder must be willing to pay a higher premium. When markets are loose (demand is low and/or available supply is high), a bidder may choose not to outbid competitors, waiting instead for lower-priced supplies.

Different types of oil market transactions are available

Contract arrangements in the oil market cover most crude oil that changes hands. Crude oil is traded in the futures markets. A futures contract is a standard contract to buy or sell a specific commodity of standardized quality at a certain date in the future. If oil producers want to sell oil in the future, they can lock in their desired price by selling a futures contract today. Alternatively, if consumers need to buy crude oil in the future, they can guarantee the price they will pay at a future date by buying a futures contract. In addition to oil producers and consumers, futures contracts are also bought and sold by market participants or speculators who do not produce or consume crude oil. These types of traders buy and sell futures contracts in anticipation of price changes, hoping to make a profit from those changes.

Crude oil is also sold in spot transactions—on the spotpurchases of a single shipment for prompt delivery at the current market price.

Changes in prices send signals to the market

Prices in spot markets send a clear signal about the balance of supply and demand. Rising prices indicate that additional supply is needed, and falling prices indicate there is too much supply for current demand. Futures markets also provide information about the physical supply and demand balance as well as the market's expectations.

The outlook for crude oil prices is uncertain

The large changes in world oil prices in the past decade demonstrate how all of these factors can influence oil prices, and they demonstrate the difficulty in making projections for oil prices. The U.S. Energy Information Administration projects crude oil prices in the

  • Short-Term Energy Outlook. See Table 2. Energy Prices

  • Annual Energy Outlook. See Table 12 Petroleum and Other Liquids Prices in the Reference case and in side cases

Last updated: February 25, 2022

The following article is from CNBC today. It’s useful in that it helps show that the price of oil can decrease even if the supply doesn’t change:

  • U.S. oil tumbled on Monday, breaking below $100 per barrel, amid talks between Russia and Ukraine as well as new Covid-19 lockdowns in China.

  • West Texas Intermediate crude futures, the U.S. oil benchmark, lost 8.75% to trade at $99.76 per barrel.

  • Even with the big decline both Brent crude, the international benchmark, and WTI are still up more than 30% for the year.

U.S. oil tumbled more than 8% on Monday, breaking below $100 per barrel, amid talks between Russia and Ukraine as well as new Covid-19 lockdowns in China — which could dent demand.

West Texas Intermediate crude futures, the U.S. oil benchmark, lost 8.75% to trade at $99.76 per barrel at the lows of the day. International benchmark Brent crude shed 8% to $103.68 per barrel.

In afternoon trading some of the losses were recovered. WTI settled 5.78% lower at $103.01 per barrel, with Brent finishing the day at $106.90 per barrel, for a loss of 5.1%.

Rebecca Babin, senior energy trader at CIBC Private Wealth U.S., attributed the declines to a mix of geopolitical and demand factors. Russia and Ukraine were slated to resume peace talks on Monday, while China's March demand is set to be revised lower due to new coronavirus lockdowns. Additionally, open interest in Brent futures has dropped, which means financial players are reducing risk.

"Today's action reflects a shift in sentiment in Russia/Ukraine causing sentiment traders to sell, fundamental concerns around demand coming from China's Covid lockdowns causing fundamental traders to take profits, and technical pressure as crude breaks" key levels, said Babin. Monday's sell-off builds on last week's decline, which saw WTI and Brent register their worst week since November.

Oil surged above $100 in late February as Russia invaded Ukraine, prompting fears that supply would be disrupted in what was already a tight market. It was the first time oil breached the triple-digit level since 2014.

And the climb didn't stop there. WTI traded as high as $130.50 last week, with Brent almost reaching $140.

The market has been whipsawing between gains and losses in what's been an especially volatile time for oil prices. The surge has sent the national average for a gallon of gas in the U.S. to the highest on record, unadjusted for inflation, which is adding to inflationary fears across the economy.

Even with Monday's big decline both Brent and WTI are still up more than 30% for the year. "We have a demand scare for the first time in a while," said John Kilduff, partner at Again Capital. "The Covid lockdown in China has spooked the market," he added, noting that high fuel prices around the world is also causing demand destruction.

A useful video:

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