Assumptions about the price of oil strongly influence forecasts of oil demand and supply such as Oil & Gas Journal's Midyear Forecast (p. 30). But what influences the price of oil?
The US Energy Information Administration addresses that question in its Energy and Financial Markets Initiative. Its answers are varied and complex.
EIA's analysis covers not only physical fundamentals such as energy consumption, production, inventories, and geopolitical risks but also financial markets, including futures trading, commodity investment, currency-exchange rates, and equity values.
Divergent objectives
EIA points out that oil trading involves a range of participants with divergent objectives.
"Commercial investors", such as oil producers and airlines with large exposure to oil-price changes, seek to hedge their risks by trading energy derivatives. Banks, hedge funds, and money managers are "noncommercial investors" with no interests in physical oil but with hope for profiting from oil-price changes.
Energy and other commodities have been used as alternatives to equity and bond investments for the sake of portfolio diversification or as hedges against inflation risks.
Noncommercial investors can add liquidity to futures and derivative markets by taking sides of transactions opposite those of commercial participants. However, active noncommercial trading may amplify oil-price fluctuations.
Investors in growing numbers favor index funds, which are market instruments usually with shares of various energy and other commodities.
"Exchange-traded funds (ETFs)-which can be bought and sold throughout the day like individual common stocks-are an increasingly popular means for investors, including individuals, to gain exposure to commodities as an asset class," EIA notes.
While this gives rise to a higher correlation between crude oil and other commodities, relationships between crude oil prices and other asset values remain unclear.
Prices of stocks and oil tend to move together as both of them are strongly influenced by macroeconomic conditions or expectations.
"Over the past decade, crude oil has shown similar risk-return characteristics to stocks," EIA says. "As a result, during periods where risks were rising significantly (during the financial crisis) and then abating (during recovery), stocks and prices for crude oil and other commodities could tend to move in the same direction."
Bonds are less volatile and less risky than stocks and oil. US Treasury bonds, in fact, are usually considered riskless investments. Bond prices and crude oil prices tend to move in opposite directions. When economic uncertainty rises and investors worry about future returns on high-risk assets, such as stocks and oil, they tend to invest in less-risky bonds.
Currencies and oil
An inverse relationship can be observed between dollar-denominated crude oil prices and the exchange value of the dollar and other currencies. Several explanations for the relationship have been suggested, EIA notes.
According to one explanation, depreciation of the dollar decreases the effective oil price outside the US. This might raise non-US demand, boosting oil prices.
Another explanation noted by EIA is that dollar depreciation lowers the profits of major oil-producing countries converting dollars from oil sales into home currencies. The effect encourages the countries to seek higher oil prices.
Dollar depreciation also trims returns on dollar-denominated assets measured in foreign currencies and hence increases the attractiveness of foreign investment in commodities like oil. A further attraction to commodity investment might be expectations of inflation resulting from dollar depreciation.
And a rise in oil prices expands the US trade imbalance, which can add downward pressures on the dollar.
Despite these possible explanations, "the actual correlation between oil prices and exchange rates has not been stable over time, and was close to zero for more than half of the last decade," EIA says.
EIA's analysis makes clear that oil prices change for a complex set of reasons that vary over time in their degrees of influence and are neither fully understood nor predictable.
What's certain about oil prices is that they're important to future oil demand and supply and that their unpredictability makes forecasting demand and supply very interesting.
