How Oil Prices Are Determined

Date Thursday, September 18th, 2008

Oil prices today are determined by many factors. As a commodity, oil is of course priced by market forces: supply versus demand. However, oil is subject to several distorting factors which can lead to vast swings in price.

Oil requires a lot of processing to turn it into a useful form. Crude oil is a complex soup of different molecules, and must pass through a refining process to split it out into kerosene, gasoline, diesel and other products. Anything which affects refining capacity (such as a hurricane striking the concentration of refineries around the coast of the Gulf of Mexico) tends to drive up the price of oil, even though the crude oil itself may be coming out of the ground as quickly as ever.

As petroleum products are most heavily consumed in the northern hemisphere, and usage of these products is very seasonal (lots of use of heating oil in winter, lots of use of gasoline for the summer driving season), the price of oil is also partially determined by the season in the northern hemisphere. Demand for oil also increases when the economies of northern hemisphere countries are strong, and drops off when economic activity declines.

Although cost and availability of refining and northern hemisphere season and economy are important factors determining the price of oil, many of the most important influences are on the supply side. Although oil fields exist almost everywhere in the world, the most economically available of these are restricted to a relatively few nations. This uneven distribution of inexpensive petroleum means oil prices are overwhelmingly determined by regional stability (or the lack thereof) and the OPEC oil cartel.

The easiest oil to extract with the least expensive investment in capital and labor is found on the Arabian peninsula and areas around it in the Middle East. The nations of this area vary greatly in their stability, and any major change can lead to wild fluctuations in oil price. The Iraqi invasion of Kuwait in August of 1990 led to an immediate increase in the price of crude oil as the market anticipated that supply would drop. The American invasion of Iraq in 2003 also drove prices up, again because the market was able to predict that Iraqi oil production would be disrupted, and the conflict in the region would reinforce the impression that the oil-exporting countries were unstable. Even relatively benign events like a democratic change of government in Venezuela can lead to market jitters.

The OPEC organization is composed of 12 nations which among them possess over 60% of world proven reserves of crude and over 40% of annual crude production. The purpose of the organization is to influence oil prices with the twin goals of price stability and maximum profit for OPEC members. Technological and political changes since the 1970’s have diminished the power of the cartel, as Russian oilfields are developed and Canadian oil sands technology becomes economical. However, the cartel is still the only organization capable of rapidly decreasing production when there is a glut in the market, or of quickly ramping production up when crude is in high demand, and thus retains a great deal of influence over the price of oil.

The many factors influencing the price of oil explain why prices can vary so widely. When the Asian economic crisis coincided with an increase of Iraqi oil production in 1999, the price dropped sharply. When Saudi Arabia was victim to terrorist attack at the same time as U.S.-Iran relations were deteriorating, the price rose. As long as northern hemisphere nations continue to be so reliant on a scarce resource supplied overwhelmingly by a few countries, the price of oil will remain volatile.

Leave a Reply