How is Oil Price Really Determined?

Throughout the history, oil prices have had a roller-coaster ride and the trends do not make sense all the time. The current downturn has once again brought into focus the complex dynamics behind this crucial commodity. This article covers the very starting point in this story – the determinants of oil price. The rate of crude oil is impacted by the demand-supply dynamics, but contrary to popular belief, it is primarily set by the derivatives market.

Demand and Supply
The availability of oil in the global market vis-à-vis the current and future requirement, influences the broad market sentiments. Following are some of the key factors:

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The prices we see in the international markets are set on the basis of crude oil futures. Different grades of crude oil are differentiated by their sulfur content. Brent Crude and West Texas Intermediate (WTI), both low sulfur grades, are the two international benchmarks denominated in USD per barrel. The above demand/supply factors influence traders’ views on potential future price movements and the market activity is directed accordingly. However, not all futures trades are hedging transactions. Since the market is largely controlled by big banks and hedge funds, industry watchers believe that the bigger portion of it is speculation.


Extracted in the North Sea, Brent Crude is used as a pricing base by most countries. It usually leads WTI and OPEC basket price, though the gap has narrowed significantly over years. Before 2005, Brent was traded on the International Petroleum Exchange, London through an open-outcry floor. These days it trades electronically on Intercontinental Exchange (ICE), also in London.

West Texas Intermediate

WTI is the benchmark for U.S. oil prices. Though it is lighter than Brent, it is extracted from land sites and therefore more expensive to transport. WTI is traded on New York Mercantile Exchange (NYMEX) in Manhattan, which converted to electronic trading in 2006.

The Real-World Prices

When the near-term demand shows a potential to increase, the big traders begin taking long (buy) positions in expectation of future price increases, pushing the futures prices higher. As discussed above, these prices are used to set the current rates. Therefore, any expected change in the demand and supply has a magnified impact on the market, which is far from what is warranted. Major institutions and oil producers, including OPEC, have admitted that speculation is playing havoc with oil rates. The hedge funds and banks are happier when volatility increases because that is how they book profits. According to OPEC, “The stability that OPEC and other energy stakeholders seek is of no help to them and severely limits their scope for gain.” An IMF Working Paper, Oil Price Volatility and the Role of Speculation (2014), estimates that speculative demand increase oil volatility by 10-35% in the short-term

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