Crude oil plays a large role in both the global economy and everyday life. Each year, the world consumes some 4.2 billion metric tons of crude oil. At the same time, trillions of dollars’ worth of futures contracts trade hands in an attempt to profit from the black commodity. The average U.S. household consumes a little over 1,000 gallons of gasoline per year, which means that every dollar increase or decrease in price translates to $1,000 per year in gains or losses.
Below, CommodityHQ.com takes a look at how crude oil is priced both in theory and in practice.
Economic Theory of Oil Prices
Crude oil prices are determined by the equilibrium between supply and demand. In other words, prices will increase or decrease until an equilibrium is reached between the amount of crude oil available for sale and the amount demanded by consumers and traders.
For example, crude oil supply reached all-time highs in 2016. Prices responded with a precipitous fall as inventories continued to build. Rising demand could help offset these lower prices by shifting the demand curve at a greater rate than the supply curve is moving.
The supply and demand of crude oil is influenced by a number of different factors:
- OPEC: The Organization of Petroleum Exporting Countries is a cartel that controls the bulk of the world’s supply of crude oil. By coordinating production, the cartel has historically been capable of influencing crude oil prices in the global market.
- Conflicts: Wars and other conflicts can influence crude oil prices by impacting supply in unexpected ways. For example, Nigerian rebels have rendered many oil facilities in that country unusable this year in an effort to stop corruption.
- Economy: The health of the global economy greatly influences the demand side of the equation. During economic booms, crude oil demand increases and prices tend to rise if supply remains stable, while the opposite is true during recessions or depressions.
- Technology: The U.S. became a significant crude oil producer with the development of hydraulic fracturing technologies that made it possible to extract oil from difficult rock formations. This helped lower prices in 2015 and 2016.
These factors contribute to the significant volatility that’s often seen in the crude oil market. Often times, OPEC’s decision-making can be unpredictable and conflicts may unexpectedly arise, sending supply sharply lower. Economic growth tends to be a lot more predictable, which makes the demand side of the equation much easier to model than the supply side.
Reality Check
Crude oil pricing may seem rather straightforward from an economic perspective, but there are some important factors that make it difficult to project.
A key difference between traditional economic theory and the actual crude oil market is the timing of purchases. The price of crude oil is actually set in the futures market, which enables traders to purchase the right to a barrel of oil at a predefined price and date in the future. For example, an airline might buy crude oil futures contracts in order to lock in prices and hedge against rising crude oil prices a year or two down the road.
In addition, the majority of crude oil buying and selling is done by short-term traders who never take delivery of oil from futures contracts. In fact, the Chicago Mercantile Exchange (CME) estimates that less than 3% of futures contracts actually result in the purchaser taking possession of the commodity being traded. This adds to the unpredictability and volatility of crude oil prices since they may reflect expectations rather than reality.
The existence of unpredictable factors such as OPEC makes these expectations a lot more volatile than they would be if they were simply based on supply and demand. For instance, the price of crude oil futures contracts tends to be quite volatile ahead of OPEC meetings since the cartel decides whether or not to increase or decrease supply at these meetings. The decision may have as much to do with budgets and politics as it does with actual supply and demand.
Contango & Backwardation
A final piece of the crude oil pricing puzzle is the impact of storage costs, financing costs, and convenience yields. These factors can influence supply and demand and ultimately define the shape of the futures curve.
Contango occurs when futures prices are higher than the expected future spot price. For example, a crude oil contract may be trading at $30 per barrel today, but the price for delivery in one year might be $50 per barrel. This is known as a contango market since the futures price is expected to be more expensive than the spot price for any number of reasons. It is a beneficial condition for traders and investors who are net long.
Backwardation occurs when the futures price is below the expected future spot price. For example, a crude oil contract may be trading at $30 per barrel today, but the price for delivery in three months might be $20 per barrel. This is known as a market in backwardation since the futures price is lower than the current price. This condition is preferred for traders who are net short in crude oil or looking for the commodity price to fall.
A futures contract is priced with the spot-forward parity equation:
Futures Price = Se^(r+y-q-u)T
Where:
- S = spot price
- r = interest rate
- y = storage cost
- q = dividends
- u = convenience yield
- T = time to delivery
The Bottom Line
Crude oil is a hugely important commodity in the global market for both investors and consumers. While prices are set by the economic theory of supply and demand, the picture becomes a bit more complicated when factoring in the influence of futures contracts, speculators, and artificial supply that’s influenced by OPEC. As such, the true price of oil trades much more on expectations for the future than on the current state of the global economy.
