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
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There are two ways to buy oil–first, by entering into a long-term contract to get regular deliveries, and second, by buying it 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 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.
Art accompanying story in printed newspaper (not available in this archive): illustration/Slug Signorino.
