How Does the Crude Oil Market Work?

Most likely, the nearest any of us get to understanding fluctuations in the crude oil market is when we notice a price hike at the local petrol station or when the man on the news reports the rising cost of oil barrels. But what is crude oil, and how exactly does the market work?

The ABCs of crude oil formation

The petrol, gasoline or diesel which we use to power our vehicles began its life as crude oil; or, more accurately, it began its life as millions of tiny organisms – both plant and animal – which lived millions of years ago.

Time, working hand in hand with the natural forces of the Earth, served to heat and pressurise these organisms into crude oil, which today we harvest and transform into a variety of commodities. Because this process took millions of years, the shortage of oil supplies today is a serious business; we can’t exactly wait around for another million years while more is formed, so when it’s gone, it’s gone.

For more information on this fascinating process, see the article: How Is Crude Oil Formed?

The crude oil market

As with any market, the crude oil industry is driven by the opposing forces of supply and demand. When supply outweighs demand, those in possession of the oil have an excess of it and so are likely to let it go at cheaper prices. Contrastingly, when there is not enough supply to satisfy demand, prices will spike as consumers clamour to obtain it and the owners can basically set whatever price they see fit.

However, it’s not quite as simple as that. Firstly, there are a variety of factors which dictate how big both supply and demand are. As aforementioned, oil reserves are running out; so inevitably, prices will rise as the supply ebbs away. However, pursuing other avenues of energy production may alleviate this stranglehold on supply and diminish the demand, as people become more environmentally aware.

In fact, increasingly, governments are imposing regulations on their countries and the companies who operate in them in a bid to encourage renewable energy, such as wind, wave and solar power.

Also, politics can play a part in the price of crude oil. For example, the Organisation of the Petroleum Exporting Countries (OPEC) can wreak havoc on the world’s economy and energy capabilities, as they showed in 1973. Western support of Israel in the Yom Kippur War against Egypt and Syria was punished by the Arab members of OPEC, led by Saudi Arabia, who enforced an oil embargo against the United States and sent oil prices spiralling out of control.

Speculation leads to distortion

Meanwhile, speculators who invest in the future of such commodities as crude oil can have a significant effect on its price, as well. Crude oil speculation is much like other forms of investment; - the speculators are basically “betting” on whether they believe the price of the commodity will rise in the future.

If a speculator buys oil reserves at an artificially-inflated price (i.e. higher than its current market worth) this will cause the producers to desist trading with other buyers, in the hopes of selling their oil at a similar price in the future. In this manner, the prices can be artificially driven up.

Therefore, there are a variety of factors which go into determining the fluctuations in the prices of crude oil, and as a direct result, of petrol and diesel. This article, How Much Will Petrol Cost in the Future?, looks at what could happen to the future of the industry; though with so many variables, it’s difficult to accurately say. One thing’s for sure – crude oil is running out - so simple logic dictates that the market (by which I mean the consumer, not the producer) will suffer. However, the reality does not coincide with the hypothesis. Recently, prices have been dropping. Why? You can find out in: Why Are Oil Prices Dropping?