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What drives the oil price?

Oil prices have a big influence in everything that happens in the financial world. Even though it may not be that obvious, oil price fluctuations dictate monetary policies around the world, influence economies growth and offer power to the one that knows the reason for these fluctuations.

Brokers are offering oil as a commodity to be traded. Like any commodity, it is heavily influenced by the balance between supply and demand.

What drives the oil price?

Oil is the reason for inflation to appear or disappear, as oil prices are a determinant factor in inflation's calculation. In fact, central banks are considering oil prices when setting the monetary policy for the period ahead.

As a rule of thumb, a rise in oil prices creates inflation, while a drop in oil prices has the opposite effect on inflation. Any central bank in the world has a mandate, and this is tied to a specific inflation level.

Typically, central banks are targeting a 2% inflation level as being normal for a healthy growth of an economy. To make sure they measure this inflation level correctly, oil effects are not being considered.

Therefore, when you see the CPI (Consumer Price Index) being released, don't go for the headline number, but look at the "core" inflation. This is not considering the effects of oil and energy prices on inflation.

If oil is so important, what makes the oil market so volatile? What are the reasons why oil prices are moving?

OPEC Meetings

OPEC (Organization of Petroleum Exporting Countries) meetings are subject to extreme speculation. These meetings are known in advance and the discussions and decisions being made are influencing the way oil prices are moving.

OPEC was founded on the idea to fight oil companies controlling prices and it ended up setting the price of oil on its own. Supply and demand are key here, and if OPEC decides to cut production levels, oil prices spike higher. The opposite is true when production levels are raised.

Recent technologies allow companies to extract oil from various places and this, in turn, diminished the market share the OPEC members represent. It is being estimated that around forty percent of the whole oil market is OPEC related, with the rest being in the hands of other countries.

United States, Russia, and Canada are one of the world's big oil producers, without being OPEC members. The general oil price is subject to a constant fight over power between these countries and changes in supply and demand are relevant.

Geological Discoveries

Oil discoveries are still being made around the world even these days and this changes the balance of power between the countries and the regions where these geological discoveries are being made.

It is not only about an oil discovery, but the quality of the oil discovered as well. Some oil fields require a different process to produce oil, either more costly or cheaper, and this has a value in the overall oil supply and demand balance.

The technology used also plays an important role in evaluating the value of an oil field. For example, a huge oil discovery at the Arctic will have little influence on the current oil prices as the extraction process is extremely expensive and few companies, if any, will go for such an investment.

Current oil prices are the reason for research and development budgets to be changed. If oil prices are moving to the downside, like it was the case in 2015 when oil prices fell from over $100/barrel to around $30/barrel, companies are cutting new projects until prices recover.

Oil and its derivate products have always been influenced by new discoveries and changed the way the world evolved. A general belief is that oil is used only to fuel cars and general transportation, and now that the car industry is going electric oil prices should drop as there will be less demand.

This cannot be further from the truth. Oil is used in maritime transportation, and that is not going to change anytime soon. The aviation industry is heavily dependent on oil prices as the kerosene used to fuel jets is a big driver in pricing tickets and future expansion plans.

Inventory Levels

Because supply and demand are key in pricing oil, inventory levels are crucial. These are changing constantly and traders and speculators are monitoring them constantly.

The EIA (Energy Information Administration) is releasing the Crude Oil Inventories on a weekly basis, four days after the week ends. While this is a U.S. based indicator, it gives a general idea about the state of the overall industry as the United States is one of the biggest oil producer and consumer as well.

A sudden rise or drop in the inventory levels is having a major effect on the oil prices and volatility is suddenly rising. This indicator shows the change in the number of barrels of crude oil held in inventory by commercial firms in the past week.

There are various ways to store oil, and, when demand is weak, a good idea about the oil glut can be formed by looking at the number of oil tankers filled with oil. Totaling that number with the capacity carried is a good estimate of the barrels to be delivered or waiting to be delivered.

Traders care about oil prices because a sudden change in petroleum products influence inflation levels and this, in turn, influences the monetary policy a central bank is setting for the period ahead. Moreover, oil prices impact growth as a lot of industries and countries use oil to produce goods.

This will be seen in the overall GDP (Gross Domestic Product) of those countries. Therefore, it is safe to say that oil prices fluctuations are seen in our everyday lives and oil is influencing all aspects of an economy.

Although the changes in oil prices are attributed to supply and demand imbalances, there are commentators that argue that changes in oil prices are due to speculation and to futures market changes. While this is true to some extent, only looking at the overall picture will result in having a correct view of the oil market.

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