Common Factors That Affect Oil and Gas Prices

Oil and gas play a key role in running our world, from powering homes and businesses to keeping the transportation infrastructure running. Our lives wouldn’t be the same without oil and gas.

gas pump

That reliance on petroleum makes price fluctuations in the oil and gas industry easy to spot for consumers. We see it at the gas pump every time we fill the tank. We see it on our utility bills when heating oil prices fluctuate. Those pricing changes may seem arbitrary, but several factors actually influence increases and decreases in oil and gas pricing. Oil and gas pricing relates to much more than simple supply and demand.

If you’re considering investing in crude oil drilling, understanding the factors that affect oil and gas prices gives you a solid foundation for your investing activities.

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Oil Barrel Prices Versus End User Prices

When you look at pricing overall, it’s important to understand that crude oil pricing is different than the final end-user gasoline pricing. Crude oil is the natural state of the oil when it comes from the ground. That crude oil then goes into refineries, where companies process the oil into various types of fuels, lubricants and sources for petroleum-based products.

The price of gasoline, heating oil and other end-user products tends to shift with the price per barrel of crude oil. When crude oil costs more, it naturally costs more to produce those other products. However, other factors can come into play during the refining process that influence end-user pricing of oil-based products. This includes outages at the refinery, market demands for a particular petroleum product and seasonal variations.

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Current Crude Oil Supply

As with any commodity, the supply influences the price of oil and gas. An ample supply means the price per barrel drops. When supply is low, the price per barrel increases. The supply levels vary depending on current production and current demand.

The Organization of Petroleum Exporting Countries accounts for about 40 percent of all crude oil production in the world. OPEC exports about 60 percent of all internationally traded petroleum. With such a large share of the global oil output, OPEC has a strong impact on the current supply. The organization can restrict or increase the supply to affect global pricing.

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Individual countries that are part of OPEC can also have an impact on supply. OPEC establishes production targets, but participating countries may be unwilling or unable to meet those quotas, thus influencing the oil prices.

While OPEC does have a strong influence on the supply, the United States has stepped up production in recent years by doubling its shale oil production from 2011 to 2014. The increased supply makes the price per barrel drop. OPEC nations stopped limiting production in July of 2014, largely in response to that increased production in the U.S. and similar increased production in Canada. This decreased the cost of oil even more, due to the increased supply in the global market.

Quality of Crude Oil Supply

Supply relates to not only the amount of crude oil available, but also to the quality of that oil. All crude oil gets a grade based on viscosity and impurities. The viscosity rating ranges from light to heavy. The impurity level of crude oil gets labeled from sweet to sour, with sweet oil having few impurities and sour oil having lots of impurities.

Crude oil pricing typically represents the light/sweet oil that is light and low in impurities, making it much easier to process. While ideal because of the easier refining process, crude oil graded as light/sweet is becoming more difficult to find. The decreasing availability of light/sweet crude oil means the price for that specific grade goes up.

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Heavy/sour crude oil requires more processing, which in turn requires more capital upfront. The lower quality crude oil often comes with a much lower price tag than the light/sweet crude oil, making the investment profitable.

Demand for Oil

Like other industries, the demand for crude oil affects overall pricing. Demand for oil continues to grow globally, particularly for transportation needs. China, India and other countries are seeing increasing numbers of vehicles on the road due to an expanding middle class. More vehicles on the road means those countries will consume more gasoline, which increases demands for crude oil.

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Despite increasing costs due to the rising demand for oil and gas, most consumers don’t change their habits. While the demand may decrease slightly when gas prices increase, most people continue using petroleum products, keeping the overall demand relatively high. Alternative fuels, fuel-efficient vehicles and other methods of decreasing fuel consumption are typically slow to affect change and have minimal impact on the overall demand for oil. Even when individuals lower fuel consumption with these methods, the increased number of consumers using gasoline prevents a decrease in demand.

train carrying oil

Certain times of the year see a temporary increase in demand, which drives up the price per barrel. Those increased periods of demand typically correlate to certain activities or events.

Cold winter months may force an increase in gas and oil prices due to the increased consumption of heating oil for homes and businesses. During the summer months, more people tend to travel, which causes an increase in demand for transportation fuels.

Oil Futures Market

The oil futures market throws a twist into the traditional supply and demand flow of crude oil pricing. A futures contract essentially locks in the price of oil at a future date. The buyer of a futures contract is guaranteed that price at the predetermined date, regardless of the actual pricing at that time.

This futures market requires speculation to determine the potential future pricing of crude oil. That speculation can actually influence the pricing of gasoline. When one large investor or several smaller investors buy futures at a higher price, those futures purchases may actually cause the speculated increase. Oil producers may stockpile supplies to hold until that higher futures price goes into effect. Not only does the future supply go up, but the current pricing may also increase because of a decreased current oil supply.

Future Supply and Reserves

The current supply and output aren’t the only ways countries introduce oil into the economy. Many countries, including the United States, hold reserves of crude oil for times when oil prices increase dramatically. Just like an investor might buy when prices are low, the government stockpiles crude oil when the barrel prices are low. If the price spikes, the country pulls from the reserves to help minimize the impact of increasing oil prices.

The reserves in non-OPEC countries aren’t enough to control pricing like OPEC is able to do. Instead, those reserves give the countries a way to respond to market fluctuations caused by other factors.

Oil Supply Location

The source of the oil often affects pricing. When the United States relies heavily on foreign oil supplies, the country must deal with pricing set by those countries and the events and conditions taking place there. This can cause greater fluctuations in the cost of crude oil, which translates into greater fluctuations in consumer products containing oil.

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Drilling for oil in our own country takes some of the instability out of the equation. While OPEC can still influence pricing by adjusting its supply, having our own sources for oil gives us more independence when it comes to a commodity that is essential to the modern way of life.

Natural Disasters and World Crises

Gas and oil prices increase when something interferes with production. Those natural disasters often interrupt or damage production facilities, temporarily decreasing or halting production in that location. Disasters may also damage or interrupt the pipelines that form the distribution infrastructure.

In other cases, just the risk of an interruption is enough to affect crude oil pricing. When a natural disaster or world crisis is a potential threat to the oil supply or distribution process, the event creates uncertainty about the future of oil supply and demand. This uncertainty often causes volatility in pricing.

Hurricane Katrina is one of the most notable natural disasters to affect the price of crude oil. The catastrophic hurricane of 2005 rocked gas and oil prices due to the number of platforms and pipelines that were destroyed during the storm. This decreased production, which lowered the available supply from the affected area.

Political Policies and Upheaval

Governments around the world have a strong impact on oil reserves and production. For this reason, political influences often cause gas prices to increase or decrease.

Taxes are one way that governments affect the pricing of oil. Another impact comes in the form of energy policies. The government might restrict or ban certain activities related to oil drilling and production. For example, a government might ban oil exploration in a particular area, even if the area is proven to have an oil supply. If those restrictions are lifted, then that oil supply could potentially lower the crude oil and gas pricing.

Political instability in a large oil-producing area can also drive up crude oil pricing. A large portion of the crude oil available in the world lies in areas with a history of political instability. Many of these regions have already experienced interruptions in oil production due to those political activities.

Examples of those politically-caused disruptions in oil production include:

  • Arab Oil Embargo (1973): Arab nations participating in OPEC instituted an embargo after the U.S. resupplied the Israeli military during the Arab-Israeli War. The countries also decreased production. These events caused a huge jump in oil prices, with effects felt around the world.

  • Iranian Revolution (1978): Political upheaval during the Iranian Revolution caused a major decrease in oil production. Iranian oil production dropped by 4.8 million barrels of oil each day. At the time, that equaled 7 percent of the world’s oil production. The likelihood of further disruptions likely caused a bigger impact in oil price increases than the decreased production itself.

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  • Iran-Iraq War (1980):While still recovering from the effects of the revolution, Iran received another blow when Iraq invaded. Oil production in both countries dropped significantly, with oil prices more than doubling during this period.

  • Persian Gulf War (1990):Iraq’s invasion of Kuwait in 1990 caused a sudden and sharp increase in crude oil prices. The United Nations imposed an embargo on crude oil and products coming from those two countries, which caused fear of a shortage, thus increasing prices further.

  • September 11 Attacks (2001):After the September 11, 2001 terrorist attacks on U.S. soil, oil prices temporarily shot up. That increase was due to the fear that crude oil imports from the Middle East would stop. The increase was short-lived, and prices quickly returned to normal for the time.

These past political events caused uncertainty for the future. Assessing the risk for future political disruptions becomes part of the job for market participants.

Weather Interruptions and Influences on Demand

Weather disasters such as Hurricane Katrina are not the other weather-related influences on oil and gas pricing. Seasonal changes influence the demand, which can increase or lower the prices. This is particularly evident with heating oil, which experiences season fluctuation.

When cold weather strikes, demand for heating oil increases. In some cases, the fast consumption during cold months makes it difficult for refineries to keep up with the demands. That need for more oil can cause a temporary increase in price. The worry that the supply won’t cover the demand can also increase oil prices.

snow covered mountain

Unseasonably cold temperatures or a huge snowstorm can cause a severe and unexpected spike in demand for heating oil. If the supplier is not prepared for an unusual weather event, the increased demand has an even bigger impact.

Conversely, an unseasonably warm winter means the consumption of heating oil is lower than normal. This can cause a surplus of oil, since the demands are satisfied with lower quantities.

Issues With the Refineries or Pipelines

Weather isn't the only potential cause of disruptions at the refinery or with pipelines. An outage at an oil refinery temporarily disrupts the flow of oil through the facility. This causes a temporary decrease in supply, while the demand remains the same. Depending on the cause and length of the outage, it can cause prices to increase temporarily.

The same effect happens when any problem occurs somewhere along the pipeline. Since pipelines serve as the main distribution method from the refinery, any issue that slows or stops the flow of oil through the pipelines can affect supply and increase prices.

Consumer Location Pricing Influences

Another influence on end-user gas and oil pricing is the consumer’s location. Pricing isn’t the same throughout the world or throughout the United States. Pricing for petroleum products varies significantly from one state to the next, and even from one city to the next, within the same state.

Here are some ways location affects the end pricing:

  • Proximity to Refinery or Supply Area: People who live near a refinery or an area where fuel is held often see lower pricing. This is due to the shorter distance the oil or gas needs to travel to get to the end user. The transportation costs increase significantly the farther the oil has to travel to get to its end destination. That cost gets built in to the pricing on the petroleum products the consumers purchase. People who live in remote areas often pay more because of the difficulty in reaching those areas and the distance the oil travels to get there.

  • Competition: Consumers see a shift in pricing when multiple companies service an area. For example, if a homeowner has multiple options for heating oil suppliers, that competition will likely drive down the pricing. People who live in areas with only one supplier are likely to pay more. The same holds true for gasoline. In an area with lots of gas stations, competitive pricing may drive down the cost per gallon. In remote areas with only a few gas stations, the per-gallon price is likely higher.

  • Climate: The climate of a particular location often drives the pricing. Areas with more severe weather or cold temperatures may see higher pricing.

  • Taxes and Fees: State and local governments often add fees, taxes and other charges on gasoline, heating oil and other petroleum-based products. That difference in tax rates and fees means the consumer’s overall cost varies by location.

Production Costs and Taxes

The cost to refine and distribute products comes into play for the final pricing on the actual petroleum products when they hit the market. The specific breakdown depends on the exact product and the specific location.

Gasoline is a good reference to explore the breakdown of pricing, since most consumers use it. In 2015, the average cost per gallon for regular-grade gasoline was $2.42. Here is a breakdown of where that money went according to the U.S. Energy Information Administration:

  • Crude oil: 48 percent
  • Federal and state taxes: 19 percent
  • Refining costs and profits: 19 percent
  • Distribution and marketing costs: 14 percent

The largest chunk of the cost went to the crude oil itself. For this reason, the cost of crude oil per barrel has the largest impact on the cost of a gallon of gasoline. That percentage sometimes shifts to account for a larger portion of the gasoline price. For example, in years prior to 2015, the crude oil cost accounted for an average of 63 percent of the cost.

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A gallon of gasoline includes federal, state and local taxes. Gasoline in all states includes a federal excise tax of 18.34 cents per gallon, plus a 1-cent Leaking Underground Storage Tank fee. State taxes go on top of the federal taxes and vary by location. Some cities and counties add more taxes or fees, making location a factor in the end pricing. On average, those state and local taxes and fees add 26.49 cents to each gallon of gasoline.

The influence of the refining process includes both the costs associated with the process and the profits of the company. Those costs and profits depend largely on the seasonal demands and the regional requirements for refining. Some regions require different formulations to meet air pollution standards, for example.

Getting the gasoline to the consumer and the costs of running the businesses that consumers purchase from are also factors in the final pricing of petroleum-based products. Retailers in some areas face higher business costs for things like wages, benefits, leases, insurance and business taxes and fees. Those costs go into the final cost of a gallon of gasoline.

Temporary Price Fluctuations

Despite the vast number of influences on the pricing for gas and oil, the good news is the overall balanced price of oil. Weather, political disturbances, supply problems — these factors may increase or decrease pricing for a short time, but then usually rebounds. Once the oil reaches the normal supply and demand levels, the pricing levels out. The length of time it takes to rebound depends on the cause and how long it takes to correct the problem that affected pricing.

Investing in Oil and Gas Drilling

Crude oil investing comes with a certain amount of risk, but it also comes with the potential for high returns on your investment. Drilling for oil closer to home provides the U.S. with a more stable oil supply without the risk of fluctuations often accompanying foreign oil sources. By seeking legitimate oil investment options, you support those American oil-drilling efforts.

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