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Oil is one of the most important commodities at the heart of the global economy. In addition to powering the transportation sector worldwide, it is also used in heating, cooking and generating electricity. Therefore its supply is always a matter of national security. Continue reading to learn more about what affects oil prices and its impact on global markets.
Its importance remains intact despite continued efforts to try and reduce its use as the focus shifts to alternative green energy sources. Additionally, oil is one of the most traded instruments in the financial markets. It attracts a huge amount of traded volume on any given day as traders and countries respond varyingly to the forces of supply and demand.
Because the world economy is highly dependent on crude oil, its price is closely followed. Its fluctuations significantly impact the transportation, chemical and manufacturing industries where petroleum products are heavily used.
Oil prices in the markets are constantly fluctuating. The fluctuations are never random but a factor of various developments and events.
The factors that drive oil prices in the markets are:
Supply is one of the most important aspects of oil price determination. The Organization of Petroleum Exporting Countries OPEC is a cartel that regulates 40% of the total supply, all in an effort to control prices. Given that the cartel comprises the biggest oil-producing nations, its actions influence prices greatly.
For instance, whenever OPEC cuts supply, there is usually a shortage in the oil markets, which often causes prices to increase significantly on high demand. Likewise, whenever the cartel cannot agree on production cuts, supply remains at elevated levels, something that causes oil prices to drop.
OPEC's power to influence oil prices was significantly undermined as the US embarked on aggressive shale production. However, its growing alliance with Russia, a key oil exporter, has reinforced the cartel's power in determining oil prices.
While OPEC tries to speak in one voice, geopolitical developments in member countries are often a big factor. Political events in major producers such as Libya, Saudi Arabia and Russia recently have significantly affected supply in the past, resulting in higher oil prices.
For example 2003, oil prices soared as the US invaded Iraq, one of the world's largest oil producers. Oil prices also skyrocketed at the start of the Russian invasion of Ukraine in early 2022 as the move impacted supplies from Russia to Europe.
Technological developments have also had a significant impact, therefore, influencing prices. For instance, developments in Hydraulic fracturing led to increased oil production from rocks in the so-called shale oil, making the US a net exporter of black gold. The US being a net exporter has made it a key force in oil price determination. Furthermore, increased production from the US often leads to a glut in supply, consequently pushing prices lower.
Demand is also an important factor that influences oil prices. For example, during periods of robust economic development characterized by increased industrial production, demand for oil products is always high.
During periods of high oil demand, oil prices tick higher as suppliers maintain oil production or cut to cause a shortage. In other periods of economic slowdown, industrial activity tends to decline significantly. As economic activities slow down, demand for industrial goods slows, resulting in reduced demand for the commodity.
With supply remaining at elevated levels, oil prices tend to decline, given the glut in supply. At the height of the COVID-19 pandemic, oil prices fell to record lows below the $20 a barrel level due to increased supply amid low demand. The plunge came as the global transportation industry reached a standstill with lockdowns in play. Additionally, industrial activities came to a halt.
Market sentiments are another important aspect influencing the price action in the oil market. It entails the buying and selling of oil futures contracts on the floor of a commodity exchange. Trading activities at the Chicago and the New York Mercantile Exchanges have influenced oil prices for the longest time. In the two markets, traders fall into Hedgers and Speculators.
Hedgers include representatives of companies that produce and consume the commodity. In hedging, traders enter into agreements, thus setting the price for buying and selling oil. For instance, an airline that expects oil prices to increase significantly over the next few months would enter into a futures agreement, thus purchasing large amounts of oil at the prevailing price. Should the price increase, the airline would have saved a lot on paying the lower prices. On the other hand, should oil prices decrease, the airline would incur a loss on taking delivery at the agreed price.
Likewise, an oil producer that expects oil prices to decline over the next few months can enter into a futures agreement, selling huge amounts of oil at the prevailing prices. Therefore, even if oil prices were to drop significantly, the producer could still sell at the agreed much higher price.
The actions undertaken by producers and consumers influence oil prices, given the size of the contracts traded in the market.
Speculators are the other players driving oil prices by trying to profit from oil price differences. Therefore, whenever a good number of traders place buy orders in the market, the prospect of higher oil prices is usually high, especially when large institutions place millions of dollars worth of buy orders. Likewise, whenever market participants place millions or even billions of dollars worth of sell orders in the market, the risk of oil price plunging is usually high.
The actions of buyers and sellers at a global auction also influence how oil prices fluctuate. Unknown to most people is that crude prices result from thousands of transactions simultaneously worldwide. The transactions occur at various levels of the supply chain, from crude producers to large and individual consumers.
The highest bidder is accorded the right to take the available supply. However, like in any auction, no bidder wants to pay over the top, depending on the prevailing market situation. Therefore theirs is always intense bidding and haggling. Nevertheless, bidders must pay a higher premium for delivery whenever demand and supply are low.
Likewise, bidders tend to squeeze the producers to pay the lowest available price whenever the demand and supply are low. Additionally, bidders try to avoid outbidding competitors, therefore, wait for lower prices.
Oil trading offers one of the best ways of generating profits by speculating on the price of the underlying commodity. The process entails the buying and selling of different types of oil and oil-linked assets.
There are three ways of trading oil:
Oil spot presents an opportunity to buy and sell the commodity immediately on the spot and take delivery where necessary. With the help of financial instruments like a contract for differences, one can buy and sell a given amount of oil without taking delivery. In this case, a trader would speculate and profit from the price difference.
Futures contracts offer an opportunity to speculate on oil prices. Consequently, a trader or a company agrees to exchange an amount of oil at a set price on a set date in future. The futures contracts are traded on exchanges and reflect the demand for the different types of oil. One agrees to buy or sell with futures on a set expiry date.
Futures contracts are mostly used by big companies or consumers that seek to lock in advantageous prices. For instance, a company can buy a futures contract if it expects oil prices to increase over a given period. Therefore, they can lock in low prices should prices rise. Likewise, a major producer can use a Futures contract to lock in a higher price if they expect oil prices to drop.
Trading call options is similar to an oil futures contract. The only difference is that there is usually no obligation to trade at the expiry date. Instead, one can opt to incur the premium of the options. Call options give traders the right to buy or sell an agreed amount of oil at a set price on an expiry date. Nevertheless, there is no obligation to exercise the option.
Traders enter call options if they expect oil prices to increase. The profit is generated once the price increases above the strike price. Similarly, traders trigger the put option if oil prices drop below the strike price.
To trade oil using various instruments, a trader must clearly understand all the factors likely to influence price action in the long run. The process entails analyzing supply and demand dynamics at any given time as they affect prices immensely.
For example, oversupply amid shrinking demand is often a reason enough to try and profit from a possible decline in oil prices. Similarly, declining supply amid rising demand is enough reason to try and profit from a potential rise in oil prices.
In addition to supply and demand changes, a trader must be on the lookout for geopolitical developments likely to affect supply and demand dynamics. Likewise, one must clearly understand the global economy's health, which influences demand.
While trading the oil markets, a trader must pay close attention to the actions undertaken by big players. Professional traders, hedgers and big companies dominate the energy futures markets and have a big sway in the direction oil prices move. Industry players take positions to offset physical exposure while hedge funds speculate on oil price direction both in the long and short term.
Oil prices can be extremely volatile over a short period as market participants react to various developments likely to affect supply and demand. Therefore, any trader looking to trade the commodity actively must have a clear idea of how oil prices are moving.
A trader looking to speculate on oil prices should pay close attention to the long-term price chart to know the direction price is moving. If the chart is inclined to the upside, there is a higher chance that the price will move higher despite the short-term pullbacks. Likewise, if the price is tilted to the downside on a long-term price chart, there is a high probability prices will decline amid slight bounce-backs.
The three main factors affecting oil prices are current supply, future supply, and global demand. With OPEC members controlling 40% of the world's oil, their actions influence prices greatly. Other factors influencing oil prices include geopolitical developments, speculation and hedging in the oil markets.
Oil prices rose to the highest level of $147 a barrel in 2008. The increase came as the dollar lost its value amid economic turmoil. In addition, growing concerns about global supply disruptions amid flaring tensions in the Middle East supported the record-high prices.
At the height of the COVID-19 pandemic in 2020, oil prices fell below the $0 a barrel level, trading at record lows of -$40.32 a barrel. The plunge came on evaporation of demand as the world was left awash with lockdown restrictions to curtail transmission of the coronavirus. As a result, industries came to a halt, and the aviation industry collapsed, leading to record lows in demand.
Any person looking to speculate on oil prices must open an account with a brokerage account. Brokers offer various instruments traders can use to speculate on oil prices, such as contracts for difference. Additionally, one can invest in oil-producing company news to gain exposure to black gold.