Like most commodities, long-term oil and gas prices are determined by the sorts of supply and demand factors we’ve discussed. And these can be visualized through the chart commonly known as a “cost curve”.

A cost curve shows how much output different suppliers produce at a given cost per unit. In other words, it displays a commodity’s available supply in increasing order of cost. The width of the bars indicate supply quantity, and the height shows cost per unit. The market price of the commodity, meanwhile, is found at the point where the quantity demanded intersects the cost curve. An example is shown below.

Source: McKinsey

We can use a theoretical oil example to explain this further. Let’s say OPEC can produce 10 barrels of oil at a cost of $30 a barrel, US shale drillers can cough up 5 barrels at $40, and UK offshore rigs can churn out 4 barrels at $50. If oil demand is 15 barrels, then you only need OPEC (10 barrels) and US shale (5 barrels) to produce all their oil to fully meet that demand. Producers of a commodity are generally willing to supply it as long as the price exceeds their cost of production; otherwise they’ll make a loss. In this case, US shale producers need a price of at least $40 a barrel in order to produce enough to meet demand – and so the market price of oil will be around $40. If oil demand increased to 17 barrels, meanwhile, we’d need to turn to UK offshore supply – but they’ll only supply oil at $50+ a barrel. In that case, the market price would go up to $50.

Natural gas is a bit different in that it’s considered an “island commodity”. Because it’s much harder to transport unstable gas from one region to another than it is liquid oil, you can get big regional differences in the gas price based on local supply and demand dynamics. But the growing liquefied natural gas (LNG) trade – which allows cooled gas to be shipped globally – is beginning to more closely link prices around the world. If natural gas is cheap in the US and expensive in Asia, then Asian energy companies will now look to import US LNG. The increased demand for US gas will lead to higher prices there, while increased supply in Asia will reduce prices there – converging the two.

Besides supply and demand, however, there are short-term factors that influence oil and gas prices. Seasonal trends, for example: natural gas prices are usually higher in the winter when heating demand is at its highest, while oil prices tend to be higher in the summer as more people travel.

Another important short-term factor is inventory: the amount of oil or gas in storage. With natural gas, production is relatively stable throughout the year: one does not simply turn off a gas well. But to balance the mismatch of seasonal demand, natural gas is injected into the ground for storage during the summer and withdrawn when it’s needed in winter. If storage levels are too low, natural gas prices go up, incentivizing greater production – but also lower usage. These two factors combined should eventually bring inventory and prices back to normal levels.

Speculators can also influence oil and gas prices. These traders buy and sell oil and gas futures with the goal of making money from price changes – sometimes with little regard to the underlying supply and demand factors. For example, some hedge funds use a “momentum” strategy to invest in commodities: buying commodities that have gone up recently in the expectation of future price increases. So if oil has done well over the past few months, speculators will likely start buying oil futures, driving up prices.

Lastly, one of the most important short-run factors influencing oil and gas prices is geopolitics. OPEC, as mentioned, supplies almost a third of the world’s oil, and its members are mainly found in the Middle East and Africa. When tensions are simmering in the region – for example, between Saudi Arabia and Iran – both speculators and firms that actually need oil may buy oil futures for fear of future supply disruptions. A prime example of this came in September 2019, when an attack on Saudi Arabian infrastructure caused the price of oil to shoot up over 20%.

The takeaway: Oil and gas prices are determined by supply and demand factors in the long run – but seasonal trends, inventory levels, speculators' actions, and geopolitics all influence short-term prices.