The Straight Dope®

We're all taught in B-school that market prices are determined by supply and demand. I can't for one minute believe this is true of crude oil prices. Demand appears to be static (that is, static at a given moment, although steadily increasing with time) and not affected by price at all. China isn't going to buy incrementally less oil as the price goes up. So how is the market price actually determined? --Jason, Atlanta

Simple: ­it's whatever the market will bear. That's the high-level view, of course. The details are more complicated. Pull up a chair.

There are two ways to buy oil--first, by entering into a long-term contract to get regular deliveries, and second, by buying oil when you want it at the current price in the so-called spot market. Through the 1970s most oil on the international market was bought on long-term contracts, which meant prices didn't fluctuate much. Sure, you had that little adjustment following the 1973 oil embargo, but afterward prices remained stable, just higher. That changed following the Iran hostage crisis of 1979-'81. The price of oil more than doubled initially, then dropped when OPEC's stranglehold was broken by noncartel suppliers, such as those pumping crude from the North Sea. They could undercut existing long-term contract prices by selling on the spot market, which thereafter assumed much greater importance. Competition complicated life for bulk oil purchasers. It kept the price down, which they liked. They didn't like the resultant price fluctuations, because running a business is tough when you can't predict costs. Enter oil futures.

Oil futures are a mechanism purchasers use to protect themselves against short-term price swings. The basic idea is simple. Say in January you know you're going to need 1,000 barrels of oil in July. Producers look at their stockpiles and production and decide they'll sell you oil for future ( i.e., July) delivery at $70 a barrel. Come July, you get your 1,000 barrels at $70 per as expected. But what if the price of oil on the spot market at that point is only $50 a barrel? Then you overpaid $20,000 by buying early. You console yourself with the thought that in this crazy world the spot price could have gone to $100. In short, by purchasing oil on the futures market, you bought predictability. The parties who sold you the futures contracts, on the other hand, gambled that they could make money on the difference between the contract price and the spot price. The whole process is a game--everyone's trying to outguess each other and arrive at a comfortable balance of potential profit and risk.

Oil futures make up a large part of the oil markets, and oil is the world's most heavily traded commodity. Because of this, the price of oil is sensitive to how traders think the world will look one month, six months, or even years in the future. Bad news can send futures prices skyrocketing, especially if it involves Middle Eastern politics or natural disasters. Other factors, such as China's growing oil consumption, cause gradual increases in prices. Since the lifting cost (the cost to get the oil out of the ground and into a tanker) is typically less than four dollars per barrel for Middle Eastern crude, suppliers could be a lot more flexible with prices if they wanted, but why should they? Consumers are manifestly willing to pay, and besides, producers have R & D and exploration costs to cover.

Oil futures prices drive gasoline prices, but it's not a simple relationship. As of March 2006, the price of crude oil made up about 55 percent of the total price of gasoline, with refining, taxes, distribution, and marketing making up the rest. Even if the price of oil at the wellhead is flat, things like refinery costs, excise tax changes, and transportation problems (e.g., pits in the pipeline) can raise prices at the pump.

Chances are what's really bugging you is why pump prices go up or down so quickly after the price of oil changes, especially since the gas at the filling station is already sitting there. Part of it is price gouging, but less than you might think. The Federal Trade Commission figures that 85 percent of gasoline price variability is ultimately due to changes in crude oil prices rather than greed. Remember: there are lots of players in the oil business, they're all trying to make money, and margins for the little guys are thin­often less than ten cents a gallon. When the price of crude spikes, the filling-station owner knows the wholesale price he pays for gas will soon jump, so it's not unreasonable for him to salt away a couple bucks by hiking the pump price now.

Cold comfort, I know. Here's a thought to make you chillier still: gas prices a generation from now, maybe sooner, will make the cost of a fill-up today look amusingly cheap.


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