Wednesday, September 10, 2008

How Oil Prices are Determined

I have friends who talk about gas prices as if oil and gas companies participate in price fixing to set the price as they wish. This is a false concept. History and economics tell us a different story.

Who are the stakeholders in this equation of oil prices? Producers, traders, and consumers all play a key role in determining the price of oil and gas.

Oil producers like Exxon Mobil, Chevron, and governments of other countries control the supply of oil based on economics. When oil prices go up, producers seek out more oil to bring to the market. When oil prices go down, producers slow down production. This is driven by a profit motive known as the law of supply.

Commodity traders help determine oil prices by bidding on oil futures contracts. They make their bids based on factors such as current supply in terms of output, oil reserves, and demand for oil.

Consumers determine price by providing demand for the product. As the price increases the demand falls and as the price decreases the demand increases. This is normally shown through what is known as a demand curve. During the rise to $4.00/gallon gasoline, many factors contributed to the rapid price increases. One factor was China importing extra oil products for the Olympics causing an artificial rise in demand. After the Olympics, China's government realized they had extra reserves and decided to cease importing oil until more of the reserves are depleted. You may have noticed how the price of gas dropped around $.50 per gallon in some places after the Olympics. The market is normalizing and prices should continue to drop barring any unforeseen crisis.

When someone starts to complain about oil prices, remember the stakeholders and forget the "evil oil company" propaganda.

No comments: