What Does And Doesn’t Drive Oil Prices

The internet is abuzz with arguments for why oil prices should rise or fall in the coming months, with a range of explanations including the weakness of the dollar, the projected oil surplus, high gold prices, the near-disappearance of OPEC surplus capacity and the possibility that sanctions against one or more oil exporters will be strengthened or weakened. A step back to consider the typical drivers of prices seems warranted.

One important consideration is the periodicity of oil price moves. Specifically, there is a huge difference between how prices move over years and decades as opposed to the hourly and daily fluctuations. For the latter, it is a truism that economics can’t explain price fluctuations but an economist did. Specifically, John Maynard Keynes, who had large gains and losses speculating on the stock market, realized that the economics of an asset don’t determine its price, but the traders’ views of the economics of the assets do. In the long run, the two generally converge but they can diverge spectacularly in the short run, such as during bubbles or crashes. It should hopefully be clear the degree to which different factors discussed in this post have short-term versus long-term effects.

It’s the age of conspiracy theories but this is hardly new to the oil industry. People have long complained about the setting of prices by actors such as the oil companies, OPEC, the American president and pretty much everybody but the Illuminati. Partly, this reflects the real-world experience of seeing gasoline prices change: somebody is obviously changing them. But it also stems from the historical record, where the Standard Oil Trust set prices for years and afterwards the Texas Railroad Commission and the major oil companies known as the Seven Sisters used a system of quotas for decades to stabilize prices at levels above the marginal cost of production.

That was then and this is now. The Texas Railroad Commission’s power effectively vanished when the state’s oil producers ran out of surplus capacity in the late 1960s, and the Seven Sisters lost the ability to set prices after they cut payments to oil exporting nations once too many times. Some of those countries responded by creating OPEC, which successfully resisted the 1959 price cut, but the group didn’t achieve price-setting ability until after the second Arab Oil Embargo in 1973. For over a decade, the prices it announced determined the market price.

But after demand for OPEC oil dropped by 15 million barrels a day from 1980 to 1985, the group effectively gave up setting prices and instead settled for production quotas to manage them. The group later established a price range in the late 1990s; production quota changes were to be triggered automatically when prices fell outside this range. This effort quickly failed when tight markets after 2000 sent prices far beyond the high end, especially given the production losses from the second Gulf War and unrest in Venezuela.

Where does that leave us? The factors thought to affect oil prices include: political motives, exporters’ financial needs, industry economics and the market fundamentals. As with many medical questions, the industry ecosphere is complex to the point that the precise impact of any given element is hard to parse from the many other constantly changing factors. Some things, however, are more clear than others.

Politics: In the years leading up to and after the 1973/74 oil crisis, some like James Akins argued that the status of the Arab-Israeli conflict would determine the willingness of Arab oil exporters to invest in production and/or sell their oil. The first and second Arab Oil Embargoes (1967 and 1973) certainly supported this notion but the reality was that prices were not raised as part of the embargoes: a group of oil exporters were meeting with industry officials in October 1973 demanding an increase in the posted price of oil when the 1973 Arab-Israeli War broke out.

When the Embargo and production cuts were announced sending spot prices soaring, the industry had little option but to yield to the price demands issued in the Vienna group. But those exporters—including Iran, who did not participation in the embargo—were raising prices before the War because soaring demand suggested the commodity was undervalued. Without the 1973/74 Oil Crisis, prices would have risen anyway, although presumably more slowly. Oil exporters didn’t want higher prices because of the Arab-Israeli conflict, they wanted higher prices because they felt they deserved them.

There is also a popular notion that the Saudis crashed the oil price in 1985/86 in response to a request from President Reagan, who was seeking to hurt the Soviet economy. Peter Schweizer made this argument in his book Victory, apparently based on Administration missives to the Saudis asking them to reduce oil prices.

The reality is more prosaic: demand for OPEC oil collapsed after the two price spikes in the 1970s, dropping by 50% from 1980 to 1985. The Saudis reduced production by 75% in an effort to maintain the price after 1980 but abandoned the effort in late 1985 when their exports were dwindling to almost nothing. That the Reagan Administration asked for lower prices appears coincidental—pretty much every U.S. administration since 1973 has asked OPEC and/or the Saudis to cut oil prices.

Similarly, other changes in production policies, and especially by the Saudis, have often been attributed to, variously, a wish to hurt another oil exporter (usually Iran) or in response to U.S. policies relating to Israel, Iran or Saudi Arabia itself. While producing government politics might sometimes coincide with production policies, in nearly all cases it appears that market conditions have determined changes in quotas and the political element was secondary at best.

Fiscal policy is another factor many believe drives production and pricing decisions, most notably oil exporters’ revenue needs. This has included one argument that exporters cut production in the 1970s not so much to support prices but because they were receiving far more money than they could absorb. The implication was that in the short term, a price spiral was created as higher prices lead to higher revenue which encouraged lower production causing higher prices and higher revenue, and so forth. Given that exporters had many opportunities to bank their excess funds, and that their revenue needs expanded rapidly, the model didn’t hold up for the long term.

But others have modified that model, arguing that producers try to set prices at levels that would allow them cover their budgets. Not surprisingly, no one has suggested that the price collapses in 1986, 1998 or 2014 were because oil exporting governments were running budget surpluses. Still, this view argues oil pricing policy was subservient to or influenced by a country’s budgetary needs, essentially, as if finance ministries sent a desired price to the relevant energy ministries.

That might happen, but there is little to suggest energy ministries do more than note the request. The price needed to cover an oil exporting government’s budget might suggest the price the government would like to achieve but it is more indicative of the fiscal balance that will occur rather than the market price the government will try to achieve. If fiscal needs determined prices, the period from 1986 to 2000 would have seen prices double or triple the actual levels.

The strength of the dollar is related to this model, in that oil prices and exporters’ revenues are generally set in dollars, while their budgets are in domestic currencies and their imports come from the global market: a strong dollar means their effective oil revenues are higher, a weak dollar means the reverse. Traders will thus sometimes send the oil price moving in the opposite direction from the dollar, but usually only in the very short term.

Certainly, oil exporting nations are aware of their revenue and import needs and presumably wish for an oil price to meet them, but the reality is that not only does each country has a different ‘target price’ but more important, few have run budget and/or trade surpluses over most of the past half century. Fiscal needs could be considered as providing clues to their aspirations and desires but do not predict actual prices.

Investing in oil as an asset is related to this. Such investments increased greatly when Exchange Traded Funds (ETFs) were created about two decades ago, resulting in a significant debate over whether speculation and/or investment in oil as an asset drove up the price beyond what the market balance would justify. This might be an effect in the short-term, but more likely traders would respond to elevated prices by selling, bringing prices back down.

Which isn’t to deny that financial market developments might move prices, particularly in the short- to medium-term. Aside from industry participants, there are investors seeking assets like gold and other precious metals as a hedge against inflation or other risks, but in theory, oil is less attractive as a safe haven than other commodities because markets are frequently affected by government decisions, most notably OPEC nation’s production policies.

Which isn’t to say that commodity values are completely unrelated to oil prices. An economic boom typically translates into higher commodity prices as supply struggles to meet surging demand. Oil price movements would be correlated in such a case, all else being equal. (The opposite holding true in a recession.) However, the correlation is far from perfect, as oil supply is heavily influenced by OPEC nations’ production policies; the availability of spare oil production capacity in some countries is something that doesn’t exist for agricultural or mineral commodities.

Economics: The marginal cost of production is often said to det the floor price for oil, that is, the price that allows sufficient investment to balance the market. When the price was over $100 a decade ago, that level was said to be the floor price on the grounds that the marginal barrel cost that much to produce, meaning meeting additional demand required at least that price. Conversely, if prices are above the marginal cost of production, then higher investment will moderate them eventually.

Several shortcomings make this a flawed indicator, however. Admittedly, the marginal cost of production sets the price over the long run—in a competitive market. However, oil has not been a competitive market except perhaps from 1859 to 1870 or from 1911 to 1922. Further, most making this argument assume the most expensive barrel is the marginal barrel, meaning the next barrel will be more expensive. As M.I.T.’s Adelman showed in 1989, the next barrel usually comes from the middle of the cost curve, not just in OPEC countries but many other producing nations where upstream investment is tightly regulated. New production is not from the next most expensive resource but comes from the areas that governments release for drilling.

Those making this argument typically are relying on a basic premise of non-renewable resource economics, namely that depletion starts with the best, least-expensive resource and gradually progresses to most expensive deposits. In the oil industry, this is referred to as looking for smaller, deeper fields. The implication is that the resource is gradually becoming more expensive, so prices should rise over the long term.

Except they don’t. Again, we can turn to an economist to explain the shortcomings of the economics. M.I.T.’s Adelman explained in 1986, “Diminishing returns are opposed by increasing knowledge, both of the earth’s crust and of methods of extraction and use. The price of oil, like that of any mineral, is the uncertain fluctuating result of the conflict.” In other words, depletion might drive up costs in a competitive market, but doesn’t necessarily do so.

It is true that prices can drop enough to affect production, and costs are the primary determinant of that. However, in the short-term the marginal cost of production is the operating cost, which is typically a fraction of the long-run marginal cost. Thus, in past price collapses, almost no production was shuttered. Instead, investment was reduced which eventually affected supply and rebalanced the market. As the old saying goes, the cure for low oil prices is low oil prices. (The reverse holds true as well.)

And the intersection of prices and long-run marginal costs is partly influenced by the level of prices before and after the decline. The 1998 oil price collapse was from a low level ($40/barrel adjusted for inflation), whereas in 1986 and 2014, the price dropped from a level that was far above the long-term mean, suggesting that there was still ample room for investment. Long-run marginal costs do not, without political intervention (more below), rise sharply. The rationale many gave for above $100 oil prices in 2006 to 2014 was that ‘the easy oil is gone,’ as if it had suddenly disappeared between 2001 and 2005.

Finally, market fundamentals are by far the strongest determinant of oil prices especially beyond the very short term (hours and days). The balance is typically measured and predicted by the International Energy Agency, OPEC, and the Energy Information Administration in their monthly market reports. However, while each of those nominally estimate the current balance and that for the coming year or more, the reality is that global oil demand and supply data is, at any given time, out of date by at least six weeks.

But there is of course a surrogate for the supply/demand balance: inventory changes. In the simplest form, supply minus demand equals the change inventory and inventories are reasonably well measured and reported, albeit it again with a lag. The U.S. weekly petroleum statistics report is the most important, being timely, fairly accurate and representing approximately one-fifth of the global market. A variety of sources also report oil movements in the major markets, especially the OECD nations but also China as well.

The other primary fundamental is surplus capacity, which these days rests entirely within OPEC and a few cooperating countries. But while influential, it is not determining. High levels of surplus capacity, as in the 1985-1990 period, suggest a ceiling on prices, as producers are easily able to respond to growing demand and especially because they are capable of cheating on quotas. This doesn’t mean they will, just that they can. Cohesion without OPEC acts as a major factor affecting whether high surplus capacity translates into oil price weakness.

On the other hand, low surplus capacity implies a floor price, as members are less able to over-produce and weaken the market. Their desires are effectively trumped by their ability. Again, this doesn’t mean that prices will rise, only that they are more likely to do so, especially if demand proves robust. Much of the 1990s saw surplus capacity in OPEC at relatively low levels without prices soaring, although 1996 saw a mini-price spike of about 25%.

So, when reading the many pundits (including this one) pontificating about the likely direction of oil prices bear in mind that they are the result of many variables interacting, not least the opinions of traders. But when reading confident assertions about the ratio of gold to oil prices, the level of surplus capacity in OPEC, or the financial plans of oil exporting governments, bear in mind the Roman logical fallacy of post hoc ergo prompter hoc, or correlation equals causality. This error is probably the most basic lesson of logic which is regularly ignored by all too many writing on this and other subjects, but investors and market participants would be well to heed it.

Source: https://www.forbes.com/sites/michaellynch/2025/11/06/what-does-and-doesnt-drive-oil-prices/