Oil for beginners: why oil prices move up and down

Our head of equity strategy provides an insight into some of the drivers influencing global oil markets.

Prices for almost everything we buy and sell are dictated by supply and demand. Put simply, when supply exceeds demand, prices go down, and when demand exceeds supply, prices go up. 

It is no different on the oil markets, but prices there are heavily influenced by an oil cartel called Opec (Organisation of the Petroleum Exporting Countries). As at April 2020, it had 13 member states, including Saudi Arabia, Kuwait, Venezuela, Iran and Nigeria.

Part of its “mission” is to ensure stable oil markets to secure an “efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital for those investing in the petroleum industry".

You will also hear reference to Opec+, which includes 10 non-Opec countries, among them Azerbaijan, Bahrain, Brunei, Kazakhstan, Mexico, Russia and Sudan.

Of all the oil producers, Saudi Arabia is the largest, and is often referred to as a “swing producer”, meaning it can heavily influence the price of oil by effectively increasing supply if it thinks the oil price is too high, or decreasing supply if it wants prices to rise. 

More often than not, powerful oil producers are able to agree levels of output that generate stable oil prices. But global economic and political events can have a dramatic influence on supply and demand. When this happens, producers must agree to either increase or decrease output to achieve stability. If they do not, oil prices can fall dramatically.

The two main benchmark oil contracts are West Texas Intermediate (WTI), produced in the US, and Brent Crude from the North Sea. They are priced separately and can behave differently in certain circumstances. 

Negative oil prices explained

The situation in April 2020 is a classic example of oil markets being overtaken by geopolitical events.

A global lockdown in response to the coronavirus pandemic has taken millions of cars off the roads, seen most of the world’s fleet of aircraft grounded, and forced the closure of factories, including the two largest economies of America and China. This caused a massive decline in demand for oil products.

Oil prices were fragile even before the Covid-19 outbreak took hold in February 2020. In early January, the WTI contract was trading above $65 a barrel, but weak demand caused prices to drift.

Then, in early March, a disagreement between Saudi Arabia and Russia triggered an oil ‘price war’, during which the Saudis increased production to force prices lower. Within two weeks, the price of oil had halved.  

An agreement to end the price war and cut global oil supply by 10% was signed in April, but the impact of coronavirus on demand is estimated to exceed 10%, which means more oil is still being produced than is needed.

The oil that is being used must be kept somewhere, and global storage facilities have filled up quickly.

This extreme supply/demand imbalance and lack of storage capacity is the reason why we saw a negative oil price for the first time ever overnight on 20-21 April.

No one wants the oil, so energy companies were effectively being told they must pay to get rid of the oil they had produced. The price fell as low as -$40 per barrel.

On this occasion, the problem was exacerbated by the expiry of the contract for delivery of WTI crude oil in May. It is important to understand that oil is traded on futures exchanges.

The WTI contract is traded on the New York Mercantile Exchange. 

So-called 'futures' contracts are priced individually for delivery of oil in each month. Market participants will use these contracts for different reasons, but mainly by oil companies to hedge exposure to price fluctuations, and by others to take physical delivery of the oil.

When a monthly contract expires, anyone still owning it will take physical delivery. So-called ‘front-month’ contracts – the month that will expire next - are typically the most volatile.

What appears to have happened this month, is that storage capacity at the major US oil hub in Cushing, Oklahoma has been in short supply.

Those owning the May oil contract about to expire would have had nowhere to store it, so chose to sell.

It is worth noting that the WTI contract for June delivery is currently trading at about $17 a barrel, at almost $24 for July delivery, and $26 for August delivery, implying that the negative oil price was a short-term issue caused by a confluence of events.

It is also worth noting that Brent Crude did not fall as far as WTI because it is not suffering the same storage issues. However, oversupply and lack of demand have forced the price below $20 a barrel to an 18-year low. 

Further cuts in global oil production will ease some of the pressure on prices and storage, at least until levels of demand increase.