| By

Written by Jan Spoerer, BSc 2017

 1 Overview

News reports about oil prices usually only cover one-time events that can help in understanding current price movements, but they fail to provide a deeper and more fundamental understanding of what constitutes oil prices. Therefore, we take a step back and discuss the most important and the most universally applicable drivers of oil prices.

1.1 Supply

1.1.1 Politics and the OPEC

As political events played a prominent role in oil pricing in the past, we start with this factor. Political events can affect both demand and supply of oil prices. For example, demand for oil is indirectly controlled by policy makers through bans or tax penalties for energy-inefficient vehicles and power stations or through subsidies of energy-efficient ones. More directly, it can be altered by taxing oil (in Germany: Energiesteuergesetz) or by limiting oil consumption (dramatic example: oil crisis from 1973). In contrast to demand, supply can be affected by political shocks very abruptly: Conflicts and sanctions can decrease oil supply within hours if important oil routes are cut by closing borders or if oil plants are occupied by armed forces. Politicians of oil-producing countries might want to increase oil supply if they want to become more economically independent from other countries’ supply or if they require higher revenues to keep public spending up. When the economic sanctions against Iran were lifted in January 2016, oil prices dropped to the lowest point since 2003. If similar sanctions are introduced again in Iran or another oil-exporting country, this could have quick and unforeseen consequences on oil supply and could lead to a reversal of the downside movement we observed recently. National policies, such as shale gas policies in the US, and international relations, such as the impending close of the Strait of Hormuz by Iran in 2011 – 2012, are factors that cause high uncertainty and might affect oil prices before supply and demand are actually changed.
Besides global trade restrictions and conflicts, the OPEC still plays a significant and only partially predictable role. This unpredictability was shown in 2014 when it became apparent that the OPEC will not be able keep its members’ oil output low. Saudi Arabia increased supply in order to push American shale gas out of the market and to maintain market share while Venezuela and Ecuador could not afford this
maneuver and opposed it. Nevertheless, the OPEC’s decisions are still one key element in determining oil prices.

1.2 Demand

1.2.1 Current and Expected Economic Strength

After having covered the key drivers of oil supply, we explore demand as the other part of the pricing mechanism. In recent decades, there was a strong correlation between global GDP and oil production. Although the correlation might be less clear in the future (due to substitutes of oil), it’s to be expected that this relationship continues to hold in the foreseeable future.

1.2.2 Current and Expected Availability of Substitutes

Fossil oil can be substituted by creating the final product, often petrol, from renewable sources or other fossil energy sources. Petrol can be produced by using grains or sugar cane as a raw product. Brazil serves as a great real-life example as it produces and consumes large amounts of bioethanol and manages to substitute fossil energy sources to a major degree. There are virtually no automobiles in Brazil that use common petrol. All over the world, many standard cars can be modified to run on bioethanol or on liquid natural gas, which is a non-renewable alternative to normal petrol and bioethanol.

1.2.3 Availability of Storage

With the beginning of the oil price plunge in 2014, many newspapers reported that there was more supply than demand. This wording is not entirely correct. Supply always matches demand unless pricing is politically restricted. But there is indeed a possibility for oil production and oil consumption to differ: storage. Supply and demand are always equal but not supply and consumption. Free storage capacity allows for a short-term increase in demand without increasing consumption; stocked oil, in contrast, makes a short-term increase in consumption possible without increasing demand. As a result, storage serves as a buffer and facilitates stable prices.
Since 2014, storage began to fill at an extraordinary pace. Oil tankers even slow their traveling speed when loaded to turn into moving oil reservoirs in order to prevent running out of stationary storage.

1.3 Elasticity of Demand and Supply

Oil demand is inelastic in the short run. The low elasticity of oil demand results
from the fact that oil consumption can only be significantly influenced by substituting
oil or by changing consumption and production patterns quite substantially.
Consumers’ and producers’ goal that results from using oil is usually mobility or electric
energy. Both mobility and electric energy cannot be replaced easily, nor are more
energy-efficient alternatives cheap. Either a substitute is needed or efficiency needs to
be improved, but both approaches take time. Hence, oil demand can best be changed in
the long run.
Oil supply is a bit more complex. Supply elasticity is not constant among the
price range because the maximum oil output is limited to about 100 million barrels per
day1 so that supply elasticity sharply decreases when production reaches levels close to
100 million barrels per day. At this level, growing demand quickly leads to sharply
increasing prices. Specifically, a change in oil demand of 1 million barrels per day might
cause a price change of USD 30 per barrel (Mearns, 2014; Hart, 2009).

1: The maximum oil output of 100 million barrels per day is subject to discussion but serves as a decent
estimate for this purpose.

References
Hart, P. (2009). The Economies of Volatile Oil Prices. Retrieved from
http://anz.theoildrum.com/node/5110l
Mearns, E. (2014). The 2014 Oil Price Crash Explained. Retrieved from
http://oilprice.com/Energy/Crude-Oil/The-2014-Oil-Price-Crash-Explained.html