How the Price of Oil Is Determined

Keep in mind that I used a passbook savings account well into my twenties. So to say that I’m an authority when it comes to how the price of oil is determined would be a bit misleading. Thankfully, the process doesn’t always make sense, leaving the door open for people like me to chime in. Here goes.

 

The Absolute Basics

Oil, like other fossil fuels, comes from the ancient remains of plant and animal matter that, when covered by layers of inorganic matter, are deprived of oxygen and exposed to pressure and heat. The result is a substance that is rich in hydrogen and carbon (a hydrocarbon) and easily combustible, i.e. a great source of energy.

If we want to get a bit more technical, what actually comes out of the earth is usually called petroleum, often used interchangeably with the term crude oil. (Not all crude oil is exactly the same, but we can skip those details for the purposes of this article.) This concoction can then be refined into all sorts of stuff, with perhaps the most relatable example being the gasoline used to fuel vehicles. While human interaction with petroleum dates back thousands of years, its commercial value took off in the 1800s. In current times, it is traded in a global market.

 

A Few Additional Terms

To get the most out of what is to come, here’s a quick glossary.

Barrel

A common unit of crude oil production. One barrel is 42 US gallons, or about 159 liters.

Benchmark crude oil

The crude oil that serves as a pricing reference for buyers and sellers. Multiple such benchmarks exist—some of the most common are Brent Crude that reflects oil from the North Sea, West Texas Intermediate (WTI) that reflects oil from the US, and Dubai Crude. Prices are usually given in US dollars per barrel.

Futures contract

A contract that obligates you to buy or sell a commodity for a given price at a predetermined time.

Organization of the Petroleum Exporting Countries (OPEC)

A group of 13 oil-exporting countries that accounts for around 40 percent of global oil production and 80 percent of proven oil reserves. Included are Algeria, Angola, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, the Republic of Congo, Saudi Arabia, the United Arab Emirates, and Venezuela. The group’s control over the global supply of oil allows it to control pricing (see below). As non-OPEC nations such as the US have increased oil production, OPEC’s influence has probably diminished to a certain extent.

OPEC+

An extended group of oil-exporting countries that includes OPEC plus an additional 10, namely Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, Russia, South Sudan, and Sudan. This larger entity has helped OPEC maintain influence.

 

The Economics

The price of crude oil, as is the case for most commodities, is determined in part by simple supply and demand. If supply is high and/or demand is low, the price per barrel falls. Alternatively, if supply is low and/or demand is high, the price per barrel increases. Prices can fluctuate widely—since 2000, the average annual Brent Crude price has ranged from less than $25 per barrel to over $100 per barrel.

Anything that affects supply and/or demand is likely to affect the price of crude oil. For example, natural disasters that threaten supply are met with price increases, while the COVID-19 pandemic that rapidly dropped demand was initially met with price decreases. OPEC and OPEC+ carefully monitor world events to match supply with demand, theoretically assisting with price stabilization. Obviously, the groups err on the side of keeping prices high to optimize profits.

Here’s where it starts to get more confusing. Oil prices are not just dictated by what’s happening with supply and demand but rather what people think might happen regarding supply and demand. We’re referring to the futures market, where futures contracts are bought and sold. These contracts were designed to provide buyers and sellers of oil some degree of predictability in the face of volatility. In other words, oil producers can know how much they’ll receive for that oil several months into the future. Similarly, an industry reliant on oil would know how much to budget for that necessity.

It turns out, however, that the vast majority of traders of futures contracts really have no interest in the oil itself. They do, on the other hand, have an interest in making money off short-term price movements. And that’s where speculation kicks in. If traders expect the price of oil to increase, they might purchase futures contracts to lock in a favorable price and thus profit down the line. If they expect the price of oil to fall, they can sell futures contracts.

Of course, making such predictions involves…making predictions. Will a geopolitical conflict limit supply? Will a healthy economy induce demand? Will the proliferation of renewables diminish demand? And so on. The actions of these traders, when done en masse, end up affecting the price of oil (by altering the behavior of oil producers), whether or not the predictions that prompt the actions actually come to fruition.

 

Implications for the Regular Person

As mentioned above, perhaps the most recognizable manifestation of fluctuations in the price of crude oil can be found at the gas station. Over 50 percent of the price of gasoline is determined by the price of crude oil, with the rest being determined by taxes, distribution costs, etc. As such, the price of crude oil has a rather direct effect on household budgets.

Furthermore, given the ubiquitous nature of oil in our modern economy, an increase in oil prices drives up the cost of doing business across a wide range of industries. The result is that increased oil prices can contribute to inflation, something that also directly affects households.

 

Assuming you’re not an expert at trading futures contracts, I recommend the following approach. If the price of oil goes down, say nothing. If the price of oil goes up, start whining. And in the case of the latter, always make sure to blame a politician.