How Are Oil Prices Determined?

Commodity traders are responsible for oil prices by bidding on oil futures contracts. These contracts are basically agreements to buy or sell oil at a specific date in the future for an agreed-upon price. These futures contracts are executed on the floor of a commodity exchange by traders who are registered with the Commodities Futures Trading Commission. Commodities have been traded for more than 100 years, and have been regulated by the CFTC since the 1920s. 

Commodities traders fall into two categories. Most are representatives of companies who actually use oil. They buy oil for delivery at a future date at the fixed price. That way, they know the price of the oil, can plan for it financially, and therefore reduce (or hedge) the risk to their corporations. Traders in the second category are actual speculators. Their only motive is to make money from changes in the price of oil.

What Factors Do Traders Use To Determine Oil Prices?

There are many factors that commodities traders look at when developing the bids that create oil prices:

• Current supply in terms of output, especially the production quota set by OPEC. If traders believe supply will decline, they bid the price up. If they believe supply will increase, they willing to pay as much for oil, and the price falls.

• Oil reserves, including what is available in U.S. refineries and what is stored at theStrategic Petroleum Reserves. These reserves can be accessed very easily, and can add to the oil supply if prices get too high. Saudi Arabia also has a large reserve capacity. If it promises to tap those reserves, traders allow oil prices to fall.

• Oil demand, particularly from the U.S. These estimates are provided monthly by the Energy Information Agency . Demand usually rises during the summer vacation driving season. To predict summer-time demand, forecasts for travel from AAA are used to determine potential gasoline use. During the winter, weather forecasts are used to determine potential home heating oil use.

The Effect of World Crises on the Price of Oil

Of course, potential world crises in oil-producing countries can also dramatically increase oil prices. That's usually because traders anticipate the crisis will limit supply. This happened in January 2012, after inspectors found more proof that Iran was closer to building nuclear weapons capabilities. The U.S. and European Union began financial sanctions, which escalated to Iran threatening to close the Straits of Hormuz. The U.S. responded with a promise to reopen the Strait with military force if necessary. The possibility of an Israeli strike was also a concern.

As a result, oil prices bounced around $95-$100 a barrel from November through January. In mid-February, oil broke above $100 a barrel and stayed there. Gas prices also went to $3.50 a gallon.

Forecasts were that gas would be at least $4.00 a gallon through the summer driving season. (Source: New York Times, Iran News; Energy Information Administration, Cushing WTI Spot Price)
World unrest also caused oil prices to rise in the spring of 2011. In March 2011, investors became concerned about unrest in Libya, Egypt and Tunisia in what became known as the Arab Spring. Oil prices rose above $100 a barrel in early March, reaching its peak of $113 a barrel in late April.

The Arab Spring revolts lasted through the summer, and resulted in an overturn of dictators in those countries. At first, commodities traders were worried that the Arab Spring would disrupt oil supplies. However, as that didn't happen, the price of oil returned to below $100 a barrel by mid-June.

Oil prices also increased $10 a barrel in July 2006 when the Israel-Lebanon war raised fears of a potential threat of war with Iran. Oil rose from its target of $70 a barrel in May to record-high of $77 a barrel by late July.

Effect of Disasters on Oil Prices

Natural and man-made disasters can drive up oil prices if they are dramatic enough. Hurricane Katrina caused oil prices to rise $3 a barrel, and gas prices to reach $5 a gallon in 2005. Katrina affected 19% of the nation's oil production. It came on the heels of Hurricane Rita. Between the two, 113 offshore oil and gas platforms were destroyed, and 457 oil and gas pipelines were damaged.
In May 2011, the Mississippi River flooding caused gas prices to rise to $3.98 a gallon. Traders were concerned the flooding would damage oil refineries.

On the other hand, the Exxon-Valdez oil spill did not cause oil prices to rise. One reason was because oil prices in 1989 were only around $20 a barrel. The other was that only 250,000 barrels were spilled. Although this had a devastating impact on the Alaskan coastline, it didn't really threaten world supply.

The BP oil spill spewed more than 18 times the oil than did the Exxon Valdez. Yet, oil and gas prices barely budged as a result. Why? For one thing, global demand was down thanks to a slow recovery from the 2008 financial crisis and recession. Second, even though 174 million gallons of oil was spilled, it was over a long period of time, and it wasn't a large percentage of total oil used by the U.S. In fact, it was only about 9 days worth of oil. The U.S. consumed 6.99 billion barrels in 2010, according to the U.S. Energy Information Administration. That's a little over 19 million barrels per day. 

(Article updated February 22, 2012)

Source : about.com