• Investment Management

Supply & Demand Aren't the Biggest Drivers of Oil Prices Anymore

Oil has become one more financial chip for investors to trade, susceptible to the vagaries of market dynamics and the outsized influence of central bank policies.

According to conventional wisdom, the laws of supply and demand—surging US oil supply and slumping Chinese demand—have brought sky-high oil prices down to earth.

Yet other forces just as strong, if not even stronger, have been at play. To understand the rise and fall of oil prices and where they may be headed next, it may be just as important to consider the financialization of commodities, in which oil has become one more financial chip for investors to trade rather than just a physical commodity.

The more oil behaves like a financial asset instead of a physical commodity, the less its price has to do with supply and demand—and the more its behavior mirrors the mentality of traders focused on future market conditions. As such, oil prices have come as much under the sway of central bank policies as other types of financial assets.

Fed Trigger

Consider: The oft cited supply and demand factors alone—more supply from shale oil production and slower economic growth in China—have been in place for several years, long before the spectacular collapse of oil prices since June, 2014. Another supply-side culprit, OPEC's announcement that it wouldn't cut production to prop up prices, came in October, 2014, when the rout in oil prices was well underway.

Another momentous event did occur last June: The US Federal Reserve signaled that it would wind down its quantitative easing (QE) stimulus program. For years, QE unleashed a torrent of easy money into the economy, allowing investors to borrow cheap and bet on financial products, including exchange-traded oil funds, and to finance the storage of oil.

When QE ended, that stream of cheap money began to dry up. Investors came face to face with the fundamentals—actual supply and demand. The steady inflow of money into the market (and the financial instruments of oil) suddenly reversed course.

Dollar Dynamics

The turnaround in currency markets has also factored in the fall of oil. When the Fed ended QE, which was effectively an expansion of the money supply, the dollar began to strengthen against other major currencies, such as the euro and yen. Because oil is priced in dollars, its value had to adjust as well, but downward. In fact, oil prices may not have collapsed so much as returned to reality.

Does that mean we are back in the old supply and demand dynamics of oil as a commodity? Certainly more so now than a year ago. But investors must keep in mind now that financial markets and central banks can move oil prices just as readily.

Get the full report, “The Straw That Broke Oil's Back," or explore more Ideas from Investment Management.

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