18 - Is Oil Price Really Determined by Supply & Demand?
Updated: Aug 30, 2018
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:
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:
new oil discoveries,
natural disasters, and
The US Dollar
US Dollar is the currency with which oil is traded, primarily because
the US Dollar is the dominant reserve-currency worldwide
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.
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.
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
growth rate of other energy sectors such as solar, wind, and hydro
change in US Dollar interest rates
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