Oil Price Analysis: The Impact of Supply and Demand

Oil is the crown jewel of commodities that is used in a multitude of ways in our lives, from plastics to asphalt to fuel. The oil industry is an economic powerhouse and the movements of oil prices are closely watched by investors and traders. Changes in oil prices can send shockwaves throughout the global economy. Every movement on the production and consumption side of oil is reflected in the price. Oil is not a diamond or caviar, luxury items of limited utility that most of us can live without. Oil is abundant and in great demand, making its price largely a function of market forces. (For more, see: What Determines Oil Prices?)

There are many variables that affect the price of oil, but let’s take a look at how one of the most basic economic theories, supply and demand, impacts this precious commodity. The law of supply and demand states that if supply goes up then prices will go down. If demand goes up then prices will go up. So the key question is, what affects the supply and demand of oil?

Simple Supply and Demand

The consumption side consists of hundreds of millions of us, who individually have limited power to influence prices, but collectively have plenty. The production side is a little trickier. Which nation is the world’s largest oil producer, day in and day out? The answer for 2019 is a little different than normal.

Typically, the United States has been the largest oil producer in the last few years, outpacing the country which most would think is the largest producer: Saudi Arabia. The U.S. surpassed Saudi Arabia as the world’s largest oil producer in 2013. The reason is due to shale fracking in Texas and North Dakota. However, in 2019, Saudi Arabia’s oil production was down for the year compared to normal levels due to attacks on its oil fields, which disrupted production.

In 2020, the U.S. produced approximately 11.3 million barrels of oil per day. Saudi Arabia produced approximately 9.3 million and Russia produced approximately 9.9 million barrels per day. No other country is producing even half as much oil as any of the top three. Canada is a very distant fourth at 4.2 million barrels per day.

Capacity and Reserves

If you’re curious as to why it seems that the nations that produce the most oil and the ones that are most commonly identified with an abundance of oil aren’t necessarily the same, you’re not imagining it. There is an important distinction between oil production and oil reserves. Oil reserves are oil in the ground that hasn’t been turned into supply.

As of 2019, Venezuela is the leader in that category, with reserves estimated at 304 billion barrels. However, most of their oil is offshore or deep underground, making it hard to reach. It is also dense oil, which makes it harder to refine into usable products, such as gasoline. Saudi Arabia has the second-largest reserves, with 298 billion barrels. This is 62 years’ worth of oil if you assume that production won’t increase or reserve estimates don’t change between now and 2082.

As for the United States, its proven reserves are less impressive than its current capacity. The U.S. has 69 billion barrels in reserve as of 2019, far behind Canada (170 billion), Iran (156 billion), Iraq (145 billion), and Kuwait (102 billion). The remaining countries ahead of the U.S. include some cordial ones (the United Arab Emirates, 98 billion), some antagonistic ones (Russia, 107 billion) and some whose friendliness is tentative (Libya, 48 billion.)

It is important to determine the number of oil reserves that are proven reserves (90%+ chance that the oil will be able to be extracted), probable reserves (50%+ chance that the oil will be able to be extracted), and possible reserves (extraction is less than 50%). Determining this information helps to determine where future supply will come from and the ability of future supply to meet demand.

From Well to Fumes

So what does a barrel of oil represent, let alone 13 million of them? It’s hard for people outside of the industry to visualize the production numbers, so let’s attempt to make sense of them. Most crude oil in the United States is used to make petroleum. Petroleum is used for fueling vehicles, providing electricity, heating buildings, making plastics, and many other goods. Current statistics for 2020 indicate that the U.S. consumed 18 million barrels per day, much higher than their own production levels.

In 2020, the breakdown in the use of petroleum was: 66% transportation, 28% industrial, 3% residential, 2% commercial, and 1% electric power. Consumption of motor gasoline was 8.0 million barrels a day, 44% of petroleum consumption. Gasoline is clearly the leader in terms of petroleum use (For more, see: What Determines Gas Prices?)

Pumping, Refining, and Distribution

Basic supply and demand theory states that the more of a product is produced, the more cheaply it should sell, all things being equal. It’s a symbiotic dance. The reason more was produced in the first place is because it became more economically efficient (or no less economically efficient) to do so. If someone were to invent a well stimulation technique that could double an oil field’s output for only a small incremental cost, then, with demand staying static, prices should fall.

Something similar has happened in recent years. Oil production in North America is at an all-time zenith, with fields in North Dakota and Alberta as fruitful as ever. As well as new supply from shale fracking. Since the internal combustion engine still predominates on our roads, and demand hasn’t kept up with supply, shouldn’t gas be selling for nickels a gallon?

One problem, and this is where theory butts up against practice; production is high, but distribution and refinement aren’t keeping up with it. They are still catching up with the boom. The United States does not build refineries often. Six refineries were built between 2014-2019, to keep up with production, but before 2014, the last refinery was built in 1998. Construction had slowed down to a trickle after the 1970s. A total of only two refineries were built in the 80s and three in the 90s, and these weren’t built for large capacity. There’s actually a net loss: the United States has fewer refineries than it did in years prior. As of January 2021, the U.S. has 129 refineries in operation. So even though there is a large supply of oil, the ability to refine it and get it to market is limited, affecting the actual supply that is available for consumption.

OPEC: Only So Much Influence

Then there’s the problem of cartels. The Organization of the Petroleum Exporting Countries (OPEC) was founded in the 1960s. Although the organization’s charter doesn’t state this explicitly, they fix prices. By restricting production, OPEC can force oil prices to rise, and thereby enjoy greater profits than if its member countries had each sold on the world market at the going rate. Throughout the 1970s and much of the 1980s, this was a sound if immoral strategy for OPEC.

To quote P.J. O’Rourke, the American journalist, “Certain people enter cartels because of greed; then, because of greed, they try to get out of the cartels.” According to the U.S. Energy Information Administration (EIA), OPEC member countries often exceed their quotas, selling a few million extra barrels and knowing that enforcers can’t really stop them from doing so. With Canada, China, Russia, and the United States as non-members, OPEC is limited in its ability to stabilize prices and supply.

Foreign Unrest

The oil industry is a global game and what happens in the world impacts the price of oil, especially since a large proportion of the world’s biggest oil producers are in unstable areas, mainly the Middle East. Saudi Arabia, Iraq, Iran, Kuwait, and Libya all fall in this region. Russia has been a nefarious player in global politics and suffered sanctions for being so, and Venezuela is in a political crisis. Terrorist attacks, sanctions, and other regional matters influence how these countries supply oil, which then determines how oil prices move. If these countries cannot supply oil because they are impeded from doing so, and demand remains constant, oil prices will go up.

2019 saw plenty of these regional impacts. The terrorist bombings on Saudi oil fields, renewed sanctions on Iran, Venezuela in turmoil, tanker bombings in the Gulf of Oman, and pipeline contaminations in Russia, are only some of the regional disasters beleaguering the oil industry.

The Bottom Line

The oil industry is a complex one with many different components and many different players. Natural laws of supply and demand come in to play, as with any free-market, but each is impacted by the components that make up the oil industry, such as refining capability, oil reserves, and foreign affairs.