Generally, the market price of something is the result of two things: the supply of a product and the demand for it.
But in the oil market, it's not so simple. On Friday, for example, the variety of oil that traders follow most closely was selling for about $114 a barrel — up about $18 from the price at the beginning of the year.
That price reflects more than just current supply and current demand, because buyers and sellers are making deals now for future oil deliveries. And that requires them to make judgments about where world events are headed: whether there will be wars or revolutions or something else that might bring about a halt in oil production.
"In times like these, traders have to put on their geopolitical hats, you know, instead of their supply-and-demand hats," says Michael Wittner, global director of oil research for the French investment bank Societe General.
If oil traders are to have a sense of what a barrel of oil is really worth right now, he says, they have to think about where the situation in the Middle East and North Africa is headed. They have to follow the news.
"The bottom line is, you know, the market has to make some sort of judgment or assumption about the risk of disruptions and ... unrest at some point in the future," he says.
'Geopolitical Risk Premium'
If the price of oil today reflected just current supply and demand, it would be about $20 less than what it is. That extra $20 is what traders call the "geopolitical risk premium."
It's a very precise indicator of how worried oil traders are, from one day to the next, about what's likely to happen to oil production.
"Our knowledge of the world, our views of the future change every day, and the price of oil immediately reflects changes in the news, changes in our perceptions," says Jim Burkhard, managing director for global oil at IHS Cambridge Energy Research Associates. "It reflects our expectations, our beliefs on that particular day."
Three Scenarios
At Societe General, Wittner has identified three scenarios for oil production in the Middle East and North Africa. One is a continued shutdown of production in Libya. The second is a shutdown in a second medium-sized producer. And the third is a shutdown in Saudi Arabia, the region's largest producer.
Each scenario is associated with a particular oil price. Scenario 1 means a price range of $110 to $125 a barrel. That's exactly where things stand today.
"The market is assuming that the Libyan shutdown will last a while," Wittner says.
But the oil price — even for future deliveries — is nowhere near Wittner's estimate of where it would be if traders thought the second or third scenario were likely.
"The market is not assuming another shutdown in a medium-sized producer or a big producer like Saudi Arabia," he says. "The market is talking about that and thinking about it and worrying about it, but that's not actually what's in prices."
Of course, the price could change overnight. Analysts suggest different scenarios because it helps buyers and sellers make decisions about how much risk they're facing.
Burkhard of IHS Cambridge Energy thinks of them as alternative stories about the future that his clients should ponder.
"Since the future is so full of surprises, it can be quite risky to make that bet, taking into account just one vision of that future," he says.
Say you're wrong in thinking the troubles in the Middle East will be limited to Libya. These analysts can tell you how much it is likely to cost you: roughly an additional $30 a barrel.
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