Page last updated at 10:54 GMT, Friday, 5 June 2009 11:54 UK

Q&A: Volatile oil prices

Oil prices hit record highs above $147 a barrel in July 2008 - but as the global economic crisis began to bite, plummeted to around $30. They have now risen sharply again.

Why did oil prices soar to such high levels in 2008?

Economists will tell you that prices are set by supply and demand and, indeed, at the heart of the rise in oil prices are what are known as the fundamentals.

Demand for oil was indeed growing as Asia's power-house economies such as China and India fuelled their rapid economic expansion.

Barrels of oil
There are many factors that influence the price of oil

At the same time, there were all sorts of worries about the supply of oil.

A lot of the world's oil comes from somewhat unstable countries, so every time oil workers were attacked in Nigeria or Iraqi oil facilities were damaged, people became concerned about supplies.

So fundamentally, people were worried that demand was growing faster than supply, and oil is such an important commodity that when people are worried they are prepared to pay very high prices for it.

So what made it fall again so quickly?

All of a sudden, traders started getting worried about the state of the US economy.

There was a big change in sentiment in the oil market. When previously everyone had been looking for excuses to raise prices, now they were looking for reasons it would fall.

The central problem for oil-producing countries is that a US economy in recession uses much less oil.

Research showed that US motorists had cut their consumption of petrol by more than 5% in 2008.

It is not just the US that is affected. Many other western economies have been hit by the same credit crunch and there is a knock-on effect for their trading partners, including those power-house Asian economies that were supposed to be fuelling demand.

So oil prices rose when demand was rising and fell when demand was falling.

So the sharp rebound from those lows means that the economy is well on the way to recovery?

There does appear to be a lot more optimism about the economic outlook than there was - with any piece of positive news on jobs, retail sales or housing being seen as a glimmer of hope, and perhaps those much talked about "green shoots" of recovery.

But there is still considerable uncertainty about the trend in oil prices, as there is about the wider economy.

Some analysts fear that the oil market may be moving ahead of reality, and warn that prices could fall as investors face up to the glut of supplies and weak global demand.

Surely there is a simple way to establish what direction oil prices are heading?

Well, it would be if everybody had exact figures for the fundamentals that influence oil prices.

The problem is that nobody knows exactly how much oil there is in the ground, many producers are a bit cagey about admitting how much they have taken out and we do not know how much is in tankers being shipped around the world.

On top of that, we do not have reliable figures for how much oil most countries have squirreled away in case of emergencies or indeed exactly how much oil is being consumed.

So what determines prices is not the fundamentals but everybody's perceptions of the fundamentals.

That means that when proper figures, such as the weekly US inventories figures, are released, undue weight is placed on them because few countries are so transparent.

But other than that, it's just like any other commodity?

Unfortunately not.

First of all there is the Organisation of Petroleum Exporting Countries (Opec), which controls 55% of the world's oil exports.

The idea is that its members only raise or lower their production when all the other members do.

It does not always work, but it certainly means that oil is not a free market.

Also, there is a finite amount of oil in the world.

The oil that has been taken out of the ground first is the easiest, and therefore cheapest, to access.

As prices rise, it becomes financially viable to spend more to extract oil that is in trickier places to mine.

But as the available oil is depleted, the price will naturally rise because it is harder to find and more expensive to mine.

In addition, when there is talk about supply being threatened by unrest in the Middle East or storms in the Gulf of Mexico, how much of a problem these factors will actually be is generally a guess.

So what part do speculators have to play in all this?

Financial institutions trade oil as an investment like shares or currencies.

Rocket in North Korean parade
Should North Korean rocket testing really have affected oil prices?

They buy oil contracts in the hope that their value will go up before they sell them.

Alternatively, if they think the price will fall, they may sell oil contracts they do not have and buy them later, in time to settle the deal.

Even those who believe that the market is based on fundamentals accept that the participation of speculators has created greater volatility in the market.

Factors that in the past might have moved the price by a few cents could now move it by more than a dollar.

It has also given sudden relevance to factors that in the past would not have moved oil prices at all.

What sort of factors?

Events such as rocket testing in North Korea have been cited as reasons for the rising price of oil.

But it is hard to imagine how it could have any direct effect on its supply or demand.

In a market with such a serious shortage of reliable information, as long as enough people believe that a factor will affect the oil price, it will.



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