Crude oil is currently one of the most traded commodities in the globe.

In July 2008, the spot price of Europe Brent crude oil reached a peak of $143.95 per barrel. By December 2008 the price dropped to %33.73 per barrel. On the 8th September 2011 the price was $117.99 per barrel. (US Energy Information Administration, 2011) There are numerous factors that could have caused these changes in the price of crude oil. Before I can go into detail on these factors though, I have to first explain about the main components that cause changes in the prices of goods such as crude oil. Price is derived from the demand and supply of a product. The relationship between demand and price can be explained as such, when the price of a good rises, the quantity demanded will fall. This relationship is known as the law of demand. (John Sloman & Alison Wride, 2009) One reason for this is because the good has become more expensive and therefore decreased a persons purchasing power, which would mean that he or she would not be able to afford to buy as much as before. This is known as the income effect of a price rise. The other reason is due to other alternative goods also known as substitutes being cheaper. This would lead to a rise in consumers switching to these substitute goods. This is called the substitution effect of a price rise. Changes in the price of a good where other things remain equal (ceteris paribus) causes a movement in the demand curve. A change in a determinant however would cause a shift in the demand curve. On the supply hand, its relationship with price can be explained as such, when the price of a good rises, the quantity supplied will also rise. (John Sloman & Alison Wride, 2009) The first reason for this is that when firms increase their supply, costs for that good will increase more rapidly beyond a certain level of output. Therefore firms will need a higher price as an incentive to produce extra output. Another reason is that it will be more profitable to produce more the higher the price of the good. Lastly, high profits will encourage new firms to enter the market thus increasing market supply. Similar to the demand curve, movement in a supply curve is caused by a change in price whereas a shift in the supply curve is caused by a change in a determinant. The price of a good is the point of equilibrium where the demand curve and the supply curve intersects. A shift in either the demand or supply curve would form a new point of equilibrium which would cause a new price. One of the factors that may affect the demand of crude oil is global cyclical demand. Economic development has a strong link to the oil industry. This is because oil is an important commodity in most economies. Therefore in a growing economy, the demand for oil will increase. Another factor that that may influence oil demand is the change in climate. During the winter, demand for oil will rise for the use of household heating systems. The crude oil is used to fuel these heating systems. Thirdly, the price and availability of substitutes also affects the demand for crude oil. An example of a substitute for oil is gas. A fall in the price of gas would lead to a decrease in the demand for oil since consumers would switch to using gas. A lot of research and development is being done in crude oil substitutes due to the rising usage of crude oil and its limited supply. Lastly, market speculation also affects the demand of oil. There has always been a speculative demand for crude oil. In 2005, there was a substantial increase in oil
prices which was largely due to the high level of demand by hedge funds and other

investors pouring into the international petroleum exchanges to buy up any surplus oil futures contracts. They were expecting the price of oil to continue to increase whereby making a profit. (Geoff Riley, Eton College, 2006) In all these cases, the change in the demand of oil results in a shift in the demand curve either to the left or to the right. As illustrated in Diagram 1, when the demand for oil decreases, the curve D0 will shift to the left to D1. This will result in a new equilibrium point, e1 and a new lower price, P1. An increase in demand for oil will result in the demand curve shifting to the right from D0 to D2. This will in turn cause e0 to move to e2 which results in a higher price, P2.

Diagram 1 The other important factor that affects the price of crude oil is supply. A change in oil supply will cause a change in its price. The supply of oil can be divided into the short run and the long run. In the short run, capital is fixed which means that the technology used will remain constant. This would result in a limited amount of oil supply in a day and as a firm reaches its production capacity limit, the short run supply of oil becomes more inelastic. In the short run, supply is affected by the following factors. Firstly, supply is affected by spare capacity, which is the level of spare production capacity in the oil sector. If there isnt any spare capacity then the supply for crude oil will be limited. Second is the availability of crude oil inventory. This refers to the current level of crude oil stocks that can be immediately supplied from major firms if the need arises. By having a high level of inventory, extra supply of crude oil can be released into the market when demand fluctuates to prevent the price from rising too much. Another factor that affects supply is external shocks. This can be from war, terrorist attacks, as well as natural disasters such as hurricanes. These events would normally cause a disruption in production of crude oil which would cause a shortage of supply in crude oil since firms would be forced to stop production during these times. Oil supply is also affected by profit motives of firms which sometimes leads to cartels being formed. The Organization of Petroleum Exporting Countries (OPEC) cartel makes up a large percentage of the world supply of oil. This means that OPEC has a strong influence in the changes of oil prices. However, this will only work if the countries in the cartel work together to control production in order to balance the demand and supply of crude oil. OPEC sets quotas for how much crude oil they want to produce with the aim of stabilising the price at a target level. (Geoff Riley, Eton College, 2006) In the long run, it would be better to invest in finding and exploiting new oil reserves especially if oil prices are rising and expected to stay strong for the foreseeable future. Another factor that would affect oil supply in the long run is technological development. With new technology in oil extraction, production costs may be reduced thus increasing profitability which would mean a higher supply.

These changes in supply will cause a shift in the supply curve. As shown in Diagram 2, when supply decreases, the supply curve shifts to the left from S0 to S1. This will form a new equilibrium point, e1 and set a new higher price, P1. Similarly, when supply increases, the supply curve shifts to the right to S2 with new equilibrium point e2 and price P2.

Diagram 2 In conclusion, There are many price and non-price determinants of the quantity of oil supplied and demanded. However, as an inelastic commodity, gasoline tends to have consistent or increased demand, irrespective of price. On the supply side, there are a number of factors that can limit the quantity of oil available in the marketplace, many of which are independent of the price of oil per barrel. When analyzed in the context of worldwide requirements, limiting factors, and consistent demand, it is little wonder that this scarce and precious resource has such a high level of volatility, nor is it any surprise how much potential damage it can do to an economy.