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What determines the prices of Crude Oil?

It is a widely acknowledged fact that crude oil, also known as black gold, is one of the most important commodities out there as it is the primary source of energy over which multiple crucial industries rely upon. As crude oil is an important commodity, it is paramount to understand what drives its price as any changes in the price tend to impact the economic outlook of the world at almost every level. In this article, we will understand what determines the prices of crude oil.

Oil price is in a constant state of flux, due to oil being such a crucial commodity. There are multiple factors which can influence oil prices and we will be going through a few of them, namely: the demand side, the supply side which is mainly governed by OPEC, the impact of events like regional conflicts and wars, weather and natural disasters, and the impact of upcoming alternative sources of energy.

Impact of supply and demand on crude oil prices

Firstly, let’s understand how the traditional market forces of supply and demand influence the prices of crude oil.

The supply side is largely governed by OPEC, and it can be said that OPEC has a major influence over the prices of crude oil. The acronym OPEC stands for the Organization of Petroleum Exporting Countries. As of 2021, it is a consortium of 13 countries which as a whole control almost 40% of the world’s crude oil reserves. The main objective of the participant countries of OPEC is to regulate the supply of oil to meet global demand levels and leadingly, exert control over oil prices.

Coming to the demand side of the equation, it has been generally observed that economic growth is strongly correlated with oil consumption. The reason for that is explained by higher power generation demands, increased demand for transportation and increased infrastructure building activities, particularly road building as roads require bitumen, which is a derivative of oil. All these factors then translate to a higher demand of crude oil and expectations of robust economic growth can potentially result in higher oil prices as speculators may anticipate a higher demand for crude oil.

Let’s try to understand the impact of demand on oil prices through an example. If large importers of oil, like India and China start going through an economic slump, then it is likely that their demand for oil will drop as well. Due to these countries being one of the largest consumers of oil, a drop in demand from their side holds the potential to majorly reduce oil prices globally.

Impact of wars, conflicts and natural disasters on crude oil prices

Let’s now come to the impact of events like wars, conflicts, and natural disasters on oil prices. Wars, conflicts, and political instability, at least in the Middle East can cause major fluctuations in oil prices. Historically speaking, events like the Iranian revolution, The Second Gulf War, Iraqi invasion of Kuwait and the Arab spring have impacted oil prices globally. Since the middle east has control over a major share of oil production and if incidents like the ones mentioned previously start impacting infrastructure critical to oil production, then it is highly likely that oil prices all around the world may witness a spike.

Let’s now come to how weather and natural disasters impact oil prices through the help of an example. Back in the year 2005, when Hurricane Katrina hit the East coast of America, it caused extensive damage to oil rigs and supply lines, causing an oil crisis in America. Due to the leading disruption in oil supply, an increase in oil prices was observed. Extreme weather conditions hold the possibility of impacting oil prices due to the increased demand, with the objective of managing favourable weather conditions.

Impact of renewable energy sources on crude oil prices

Other than these factors, due to the pace at which renewable energy sources are becoming prominent and upcoming innovations which optimize fuel consumption in vehicles, there exists a possibility of a reduction in oil demand in the future.

All of us must be familiar with companies like Tesla, Rivian and some Indian companies like Ather Energy and Ola Electric, whose objective is to introduce electric vehicles for mass-adoption by the public. As we know that the transport sector is one of the biggest consumers of oil, the hegemony of petrol and diesel operated vehicles stands to be challenged due to advent of electric vehicles, which will hurt oil demand and eventually its price in the future.

Due to the pollution inducing nature of machines operating on petrol and diesel and also due to the environmentally concerning practice of oil drilling, climate agreements are also rolling out in multiple countries, with these countries pledging to reduce their reliance on fossil fuel driven technologies by gradually replacing them with cleaner alternatives within a stipulated time frame.

Multiple governments are also framing targets to reduce the production of vehicles running on fossil fuels and incentivising the production and adoption of vehicles driven by sustainable and non-polluting sources of energy. Countries are also aiming to reduce reliance on fossil fuels for power generation and shift to environmentally favourable practices like solar, wind or tidal energy. The position of oil in the global energy markets may stand to be displaced soon by alternative sources of energy, which will most likely impact demand and consequently the prices of oil as well.

Also Read: Different Types of Crude Oil and their Relevance

Conclusion

To conclude, other than the generic supply-demand variations which impact oil prices, the adoption of renewable sources of energy and agreements like the Paris Climate Accord may act as possible causes of the subsequent decline in the utility and consequently, the demand of oil, thereby impacting oil prices.

Disclaimer: ICICI Securities Ltd. (I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100. I-Sec is a Member of National Stock Exchange of India Ltd (Member Code :07730), BSE Ltd (Member Code :103) and Member of Multi Commodity Exchange of India Ltd. (Member Code: 56250) and having SEBI registration no. INZ000183631. Name of the Compliance officer (broking): Mr. Anoop Goyal, Contact number: 022-40701000, E-mail address: complianceofficer@icicisecurities.com. Investment in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investors should consult their financial advisers whether the product is suitable for them before taking any decision. The contents herein mentioned are solely for informational and educational purpose.

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