Factors Affecting the Prices of Oil and Gas

Factors Affecting the Prices of Oil and Gas

Oil and gas remain the most traded and consumed commodities in the world. The global economy remains dependent on these fossil fuels to generate the electricity needed for end-use consumption and business activities, power different modes of transportation, and provide heating during the winter season. The pace of growth of specific economies and the progress of communities are also heavily influenced by access to these commodities.

There are ongoing attempts to reduce dependence on these fossil fuels and switch to alternative energy sources as part of addressing the ongoing climate emergency and improving global energy security. But a complete transition to alternative sources would take a couple more years and even decades. This is the reason the prices of oil and gas have notable impacts transpiring at macroeconomic and microeconomic levels.

An upward trend in price increases the costs of doing business in a particular industry. Households and individual consumers would also be affected through higher electricity bills, gasoline expenses, and even pricier consumer goods. Even the stock markets respond to the trends and developments in their prices. But what exactly are the factors affecting the prices of oil and gas both in the global and local markets?

Understanding the Factors Affecting the Prices of Oil and Gas

Quantity of Supply and Quantity of Demand

The supply and demand model postulates that the price of a traded item will vary until it settles at a point in which the quantity demanded at the current price will equal the quantity supply at the current price—granted that all else is equal.

Note that the law of supply also holds that a higher price will induce producers or suppliers to supply higher in the market while the law of demand states the quantity purchases or the quantity of demand varies inversely with prices.

Both the law of supply and the law of demand would work together to reach an equilibrium between the quantity of supply and quantity of demand to result in price stability. The prices of oil and gas are fundamentally influenced by the availability of their supply and demand.

Note that the COVID-19 pandemic perfectly illustrates how the demand and supply for oil and gas affect their prices. To be specific, due to the slowdown of economic activities around the world, the demand for oil decreased, thus resulting in an abundance of supply.

Oil and gas producers responded to the current market trend by cutting down the volume of their production output. This situation is a real-world demonstration of one of the examples of supply shifters or factors influencing the shifts in the supply curve.

The prices of oil and gas both in the global and local markets hit notable lows from the second quarter of 2020 to the second quarter of 2021. However, following the reopening of economies beginning in the middle part of 2021, the prices went up.

Note that the demand for fossil fuels increased due to the revitalization of economic activities ranging from manufacturing to transportation. This situation demonstrates one of the examples of demand shifters or factors influencing the shifts in the demand curve.

It is important to note that the prices of oil and gas do not readily respond to supply and demand. Specifically, the supply and demand for fossil fuels are relatively inelastic because they are slow to respond to price signals and require bigger price moves.

Sentiments and Speculations in the Futures Market

A futures exchange or futures market is a centralized financial exchange in which people trade futures and options contracts or standardized legal agreements to buy and sell something at a predetermined price at a specific time in the future.

The market is fundamentally an auction market. Sellers offer commodities represented by contracts to buyers for a particular price and delivery on a specific date in the future. Examples of these commodities are corn and oil.

More people and organizations are buying and selling oil and gas not in their physical or actual form but rather through futures and options contracts. Examples of buyers are businesses or governments. They buy these contracts to hedge against price volatility.

Airliners are a more specific example. These businesses normally buy fuel kerosene in the form of contracts. The price of these contracts is based on the current market price. Doing so would allow them to save costs in case the price of kerosene increases in the future.

However, apart from these buyers, speculators also participate in the futures market. These individuals and organizations use futures and options contracts not for direct consumption of the commodities attached to them but as securities.

The goal of these speculators is to profit. For example, when a particular speculator buys 100 barrels of crude oil at USD 80.00 per barrel through the futures market, it is possible for them to earn a profit if the price of this commodity increases in the future.

Of course, as observed in different markets for securities, market sentiments affect current price trends. A strong belief that the prices of oil and gas will increase in the future compel hedgers and speculators to buy oil and gas futures and options contracts.

High demand for these contracts can dramatically increase current prices. A belief that the prices will go down results in a decrease in current prices due to contract holders liquidating these securities. This phenomenon is called speculation.

Hydrocarbon Industry Operations and Investments

The supply and demand model has explained price trends in most commodities. It is also the fundamental factor determining the price movements in the oil and gas industry. But the entire is complex. The model alone is not sufficient to understand trends in the market.

Remember that oil and gas prices are volatile because the supply and demand are relatively inelastic. Consumers are slow to change their consumption in response to price changes and producers are slow to adjust their production in response to similar changes.

Of course, remember that the postulations of the law of supply and law of demand highlight that all things should be equal. The reality is that the hydrocarbon industry can be complicated. There are factors affecting their production capacity and output.

The United States managed to increase its in-house production of oil due to advances in hydraulic fracking that extracted crude from rock to unearth so-called shale oil. The country even become a net exporter of crude oil for the first time in 2018 since the 1940s.

Note that the U.S. had a surplus of extracted but unprocessed oil in 2019. Fields in North Dakota and Alberta were very productive. However, although the production was high, refinery and distribution in the country were not able to keep up.

There are around 130 oil refineries operating on American soil. The Americans have only built an average of one refinery per decade. It was not able to effectively increase the supply of end-use petroleum products due to the limitation of its hydrocarbon industry.

It is also interesting to note that the COVID-19 pandemic has also dampened interests in investing in the hydrocarbon industry. Investors were limiting their investment activities either due to a brewing financial crisis or as a result of low demand.

The result of the dampened investment activity in the global oil and gas industry was reduced production output that affected the global oil and gas supply. Hence, once the economies rebounded in the middle of 2021, prices went up because of high demand.

International Relations and Global Events

The decisions of international actors are also an important factor affecting the prices of oil and gas. The Organization of Petroleum Exporting Countries or OPEC is one of these actors that have a considerable influence over global market price trends.

Note that OPEC draws its power from consensus. It represents the decisions of its members surrounding oil and gas production. These members collectively agree to either limit or increase the supply in the global market by reducing or increasing their production output.

Governments can also influence market prices through their localized decisions or foreign policy. Social and political unrests in hydrocarbon-producing countries have dramatically increased oil and gas prices in the global market.

One notable example is the Arab Spring. Investors began concerned with the events in countries such as Egypt, Libya, and Tunisia beginning March 2011. The result was crude oil prices reaching above USD 100.00 per barrel and peaking at USD 113.00.

International relations and geopolitics have long been a factor in the prices of oil and gas. The supply of oil decreased in 1991 following the Gulf War. The invasion of Iraq by U.S. and NATO forces in 2013 resulted in sharp increases in crude oil prices.

Another notable example is the Russia-Ukraine conflict that began in 2014. Vladimir Putin specifically ordered the Russian Armed Forces to invade Ukraine in February 2022. Western countries such as the United States responded with economic sanctions.

The Biden administration banned the importation of Russian oil. The European Union announced that it would reduce its imports while the United Kingdom noted its plan to remove Russian oil and gas from its energy mix by the end of 2022.

Oil and gas prices were already inflated before the invasion of Ukraine due to the global economic rebound from the COVID-19 pandemic. But the situation worsened after Putin made a move. Russia is one of the largest producers and importers of hydrocarbons.

Other global events influencing the oil and gas market are economic crises. The Asian Crisis of 1998 and 2007-2008 Financial Crisis affected the demand for oil and gas due to a slowdown in business activities and dampened investment interests.

Another example of natural and human-made disasters. Remember that the COVID-19 pandemic has been repeatedly cited as a specific factor for influencing oil and gas prices in 2020 and 2021. Oil spills can also temporarily lower supply over a short period.