Oil consumption is at an all-time high. With the global demand for oil reaching nearly 94 million barrels per day at the end of 2014,1 the effects of large fluctuations in oil prices reverberate worldwide. Understanding how prices work in the international oil market is essential to understanding how energy resources and trade can impact countries’ energy security and, more broadly, national security.
Key Factors: Supply, Demand and Expectations
As in any market, supply and demand are the primary drivers behind oil prices. The more oil present in the global supply, the lower the price of crude oil. Factors that obstruct production raise the price of oil by reducing the overall supply. Countries’ attempts to ensure their secure access to affordable energy thus depend on the steady flow of oil into the market. Demand also plays a crucial role in price determination: When oil is in high demand, prices rise, but when demand is low, prices drop.
Expectations about changes in the market down the road impact prices as well. Buyers sign futures contracts in which they agree to purchase a certain amount of oil from sellers at a fixed price. If speculators begin buying sizeable futures at prices higher than the current spot price, it can signal to commercial producers that demand for crude oil will increase in the future, driving up prices. Should those producers start holding onto their oil supplies in the hope of getting more money for it in the future, global supplies will shrink, causing an actual rise in prices.
Industries: Upstream, Midstream and Downstream
Oil moves from the ground to the gas pump in three major stages:
- Upstream: Activities involved in the exploration for new oil reserves as well as the extraction and maintenance of current reserves;
- Midstream: The transportation of oil from fields to refineries;
- Downstream: The refinement of crude oil into finished products and the transportation of those products for commercial use.
Oil is fungible, which means that companies are price-takers; they cannot simply raise prices in response to higher input costs. Therefore, companies must consider factors affecting costs — and in turn, profits — at each stage of production. In the upstream sector, certain geological factors and above-ground obstacles can raise the cost of extracting oil. During the midstream phase, barriers to transportation drive up prices, and in the downstream sector, regulations and transportation impediments can increase costs.
When media outlets report on the price of oil, they are usually referring to one of few major benchmarks (Brent Crude, West Texas Intermediate and Dubai Crude) used to decide oil prices. Brent Crude, which originally referred to oil produced at the Brent Oil Platform in the North Sea, accounts for 60% of international trade. The most traded benchmarks refer to crude that is low in sulphur (sweet) and low density (light), making it easier to refine. Oil traders account for disparities in the quality of oil by selling oil at an agreed-upon differential to compensate for the extra costs of refinement.2 Price benchmarks based on crude oil produced in stable areas like the North Sea aids the integration of the oil market.