Traditional Factors Driving Oil Prices
October 2010
The traditional factors driving oil prices have always been the fundamentals - factors or events which affect oil supply and demand10. Changes to factors such as weather, world oil supply and demand, OPEC spare capacity levels, the marginal cost of oil production, crude oil inventory levels, and technological changes have for decades played a significant role in determining the oil price. The effect of these factors is discussed below.
Seasonal Weather
Seasonal weather influences oil prices. In summer, gasoline use increases during the travel season, increasing demand for oil, leading to an increase in prices. Cold winters can result in higher heating fuel demand, causing oil prices to increase. A relatively mild winter can cause oil prices to fall.
Severe weather events
Hurricanes can have a significant influence on oil prices. In 2005, two severe hurricanes (Katrina and Rita) caused extensive damage to Gulf of Mexico offshore oil and natural gas rigs, pipelines and onshore oil refineries. U.S. gasoline prices jumped more than 40% in the immediate aftermath of hurricane Katrina.
Oil Supply or Demand Changes
Changes in oil supply levels have traditionally had an impact on oil prices. Unexpectedly low supply/high demand raises prices, and high supply/low demand causes price weakness.
U.S.Commercial Crude Oil Inventory Levels
U.S. commercial crude oil inventories are reported every Wednesday by the U.S. Department of Energy, and these reports have a significant effect on the crude oil price. Low crude oil inventories cause uncertainty about the ability of the market to meet demand, which supports higher prices. Conversely, high crude oil inventory levels support lower oil prices.
OPEC Production Decisions
Announcements by OPEC, particularly changes to production quotas, price targets, or production investments, can have immediate impacts on oil prices.
OPEC Spare Capacity Levels
OPEC spare oil production capacity gives the market comfort that supply can be maintained, and demand can be met. Accordingly, high levels of OPEC spare production capacity typically are correlated with falling or low oil prices, and vice-versa.
Marginal Cost of Production
Rising marginal costs of producing oil have an upward effect on oil prices, and vice-versa for falling marginal costs. It is generally recognized, particularly in the western hemisphere, that the marginal cost of producing oil has risen significantly, due to rapidly increasing costs for steel pipes, drilling rigs, services, labour and other input costs associated with oil production, and this has impacted the price of oil. In addition, offshore oil producers could face higher costs, if regulations are tightened in light of the April 2010 Gulf of Mexico oil spill.
According to the U.S. Energy Information Agency (EIA), between 2003 and 2007, the average worldwide cost of barrel-of-oil-equivalent production rose by 50%11. In the future, the marginal cost of oil production could continue to rise as the world turns to more expensive, more remote, and more challenging oil resources to meet its energy needs - including offshore and unconventional oil supplies such as Canada's oil sands.
The Impact of Technological Changes on Oil Prices
Fifty years ago, technology such as oil sands production and offshore drilling were not commercially developed and this technology has been instrumental in increasing the world's oil reserves. Technological improvements act in only one direction - to increase oil field recovery rates and output, reduce production costs, and contribute to lower oil prices.
Refinery Infrastructure
Globally, aging and increasingly complex refinery infrastructure makes refineries more vulnerable to disruptions, which can cause a temporary loss of petroleum product supply to markets. While usually product markets (e.g. gasoline and diesel) track crude prices, in the case of a refinery outage, product prices can rise while crude declines. Crude prices decline in such a scenario, since only refineries can "use" crude oil, and a refinery outage causes a loss of crude oil demand. As the world's supply of conventional (light, sweet) crude oil declines, many of the existing refineries will have to make modifications to their facilities in order to be able to process more readily available heavy crude oil. Changes to refineries' ability to process crude oil have obvious implications for crude oil prices.