18 - Is Oil Price Really Determined by Supply & Demand?

The Law of Supply & Demand states that the price of any good or service is determined by the quantity supplied and the quantity demanded in the market. While this law is widely used to explain Oil price, we must first understand that the law applies only to a Market Economy, which is theoretical and doesn't exist in today's world.

So what is a Market Economy, and what other economies do we have?

A market economy is an economic system where the production and consumption of goods and services are determined by market forces without the interference of any party other than businesses and consumers.

The other two main economies are:

• the Command Economy, where a central authority (usually the government) is responsible for the allocation of resources used for production and consumption. In such economy, businesses and consumers do not have a say neither on supply nor demand, they only produce and consume according to what the central authority allowed to.

• the Traditional Economy, where production is made just enough to sustain the living of a family, tribe or small community. It is usually observed in rural areas in developing countries, where communities live on fishing, hunting, or farming.

In today's world, countries are forming their economy using elements from all three systems (with varied weights). Such economy is called Mixed Economy.

Since We Operate In A Mixed Economy, Then What Determines Oil Price?

While the Law of Supply & Demand remains valid (as Mixed Economy includes elements of Market Economy), there are two other important factors that determine oil price:

Speculation

Oil is purchased in future contracts at the Futures Exchange (although occasionally on spot market). This means that the current agreed price of oil is for a delivery and a consumption at a date in the future.

This what makes oil price subject to speculation and market sentiments, where both are influenced by:

• geopolitical tension,

• new oil discoveries,

• natural disasters, and

• technological advancement.

The US Dollar

US Dollar is the currency with which oil is traded, primarily because

• the US Dollar is the dominant reserve-currency worldwide

• the largest Futures Exchange market for Oil Futures is the New York Mercantile Exchange (NYMEX) (owned and operated by CME Group of Chicago)

This strong tie to US Dollar makes oil price inversely correlated to the currency, causing the price to fluctuate as the US Dollar weakens or strengthens.

Infrastructure

When pipeline or railway transportation reaches its maximum capacity, oil price tend to go down as operators begin to offer incentives in return of securing a portion of the throughput.

Final Words

An increase or drop in oil price doesn't necessarily mean a change in supply or demand. It can be caused by numerous other reasons such as:

• threat of hurricanes hitting oil platforms

• political unrest in major oil producing countries

• swinger producers (such as OPEC, Oil Shale producers, and US Strategic Reserve) fluctuate production to manipulate oil price

• growth rate of other energy sectors such as solar, wind, and hydro

• change in US Dollar interest rates

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