The Oil Industry and the Factors that influence Oil Prices – Chapter 2: Oil Prices Determinants

This is chapter number 2 out of 10. Read the rest:

Read The Oil Industry and the Factors that influence Oil Prices – Chapter 1: History of the Oil Industry

Because Petroleum is such a highly demanded and critical commodity in the global economy, it is a forgone conclusion that any strong fluctuations in its price will have a big economic shock to the world’s economy. Two major reasons that caused the fluctuations of oil prices are:

1. Its demand and supply
2. The sentiment of the petroleum market.

 

Demand and supply are fairly simple and straightforward economic theory. The laws of demand and supply stipulate that if the prices of any commodity go up, its demand will fall. The same effect will also prevail if supply is decreased. Likewise, the demand for a commodity will increase if its price falls. The price of a commodity will also fall if its supply is increased to the market.

However, things in real life are not as simple. The price of petroleum is actually determined in the oil Futures market. Oil Futures contracts are contractual binding agreements which give buyers the “rights” to purchase the petroleum at a specific price at a specific date in the future. At the specific date in the future, both parties to the Futures contract are obligated to fulfill their transactional role. The Futures market is actually dominated by either hedgers or speculators.

Although the Futures market has developed a reputation of being an extremely risky speculative market, it also an important component of risk management for many companies. Without Futures contracts, oil prices will be extremely volatile.

The hedgers in the Futures market are companies that deal directly in the commodities. They can be producers like farmers, oil drilling companies and forest harvesters. They also comprise of users like oil refineries, mills and manufacturers. The key thing to note between these two groups of hedgers is that producers sell the Futures contracts while users buy the Futures contract. The purpose of these Futures contracts is for them to “hedge” their risk against price fluctuations that will affect their profitability.

The other category of traders in the Futures market are the speculators. These are neither users nor producers of the commodities.  They are in the Futures market purely to make money. The majority of these speculators trade in Futures contracts which can accord them the highest level of returns. In essence, what they are trying to do is to bet on the fluctuation of the price.

They make money when the Futures contracts they bought could be sold for a higher price. Profits are also made by the speculators when the Futures contracts could be sold for a higher price and then bought back at a lower price. In the pursuit of above average profits, speculators are also subjected to higher level of risk. They are undertaking the very risk which hedgers are trying to eliminate. The trading done by speculators actually forms the bulk of the trading volume as only around 3% of Futures contracts are actually taken possession off. 

Read The Oil Industry and the Factors that influence Oil Prices – Chapter 3: The Sentiment of the Market
Read The Oil Industry and the Factors that influence Oil Prices – Chapter 4: The Origin of Oil and its Composition
Read The Oil Industry and the Factors that influence Oil Prices – Chapter 5: The Drilling & Production of Oil
Read The Oil Industry and the Factors that influence Oil Prices – Chapter 6: Comprehending Price Fluctuations
Read The Oil Industry and the Factors that influence Oil Prices – Chapter 7: The Supply of Crude Oil and Its Prices
Read The Oil Industry and the Factors that influence Oil Prices – Chapter 8: The Components of Gasoline’s Retail Price
Read The Oil Industry and the Factors that influence Oil Prices – Chapter 9: When Supply and Demand isn’t the answer
Read The Oil Industry and the Factors that influence Oil Prices – Chapter 10: Conclusion