How Is Oil Price Determined?

With each passing year, oil seems to play an even greater role in the global economy.

In the early days, finding oil during a drill was considered somewhat of a nuisance as the intended treasures were normally water or salt. It wasn't until 1857 that the first commercial oil well was drilled in Romania. The U.S. petroleum industry was born two years later with an intentional drilling in Titusville, Pa. ​

While much of the early demand for oil was for kerosene and oil lamps, it wasn't until 1901 that the first commercial well capable of mass production was drilled at a site known as Spindletop in southeastern Texas. This site produced more than 10,000 barrels of oil per day, more than all the other oil-producing wells in the U.S. combined. Many would argue that the modern oil era was born that day in 1901, as oil was soon to replace coal as the world's primary fuel source. Oil's use in fuels continues to be the primary factor in making it a high-demand commodity around the globe.

But how are prices determined?

With oil's stature as a high-demand global commodity comes the possibility that major fluctuations in price can have a significant economic impact. The two primary factors that impact the price of oil are:

  • Supply and Demand, and
  • Market Sentiment

The concept of supply and demand is fairly straightforward. As demand increases (or supply decreases) the price should go up. As demand decreases (or supply increases) the price should go down. Sound simple?

Not quite. The price of oil as we know it is actually set in the oil futures market. An oil futures contract is a binding agreement that gives one the right to purchase oil by the barrel at a predefined price on a predefined date in the future. Under a futures contract, both the buyer and the seller are obligated to fulfill their side of the transaction on the specified date.

There are a number of published indices around the world that the oil industry uses. The first of these is the West Texas Intermediate (WTI) price set at the New York Mercantile Exchange. The second is the Brent Crude Index (BCI), which is set at the Intercontinental Exchange in London and the third is the OPEC Basket, which is an average of the prices achieved in all OPEC countries and is managed from OPEC's headquarters in Vienna, Austria.

Each index rises and falls depending on how many people want to buy oil on that particular day. Many of the people who invest in oil at these exchanges never actually intend to take delivery. These people just want to buy a contract at a low price and then sell it on at a higher price. When speculation enters a market then many new factors enter the pricing structure.

Political uncertainty in some part of the world could disrupt supply and so the price goes up. Trade figures of a major manufacturing nation, like China, might show that country is slipping into recession. That would reduce demand for oil, thus the price would fall on all the indices in the world.

Countries that produce more oil than they consume, like Saudi Arabia and Russia, like the price of oil to go up. Countries that produce little oil, like Japan and Italy, like the price of oil to go down. In the US, it would be in the general economy's interests for oil prices to be low, but a low oil price would damage large American corporations that have influence with national politicians through election fund contribution and targeted job creation. Thus, some countries may try to drag the price of oil down, while others may try to force the price up. Politics, then, plays a major role in the price of oil registered on these indices.

Other investor-related factors may also influence the price of crude oil. The banking crisis of 2008 saw savers looking for places to store their money when it looked like banks might go bust, so they poured money into commodities, including oil. Thus, the price of oil rose despite a general collapse in demand. Speculators like volatility because they then don't have to wait too long before they can sell on their investments at a higher price. Speculators, and the information providers that support them, over-react to world news to try to force dips and peaks so they can buy and sell. Thus, there are many non-oil related factors that can influence the price of oil set on the three main indices.

All these factors boil down to oil price indices operating as "benchmarks" for the oil industry rather than a common price. The relative movements of the indices do affect the price oil companies charge for oil, but the actual price is a matter of individual contracts accounting for many different factors rather than a global standard price.

Taxes, politics, transport networks, geography, economic expansion and the weather, all play a part in the complex calculation of setting the level of oil price indices.

However, deal-making, contract conditions, side benefits and commercial interests override all other factors when setting the price for individual oil supply contracts.

 

~Eastern Union Energy