Oil: Pricing Determinants

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Oil is one of the most precious commodities in the world.  It is the lifeblood behind the growth of any economy, developing or mature.  Oil is the commodity that fuels our cars, heats our homes, and enables our communities and economies to remain mobile and growth-oriented.  Oil prices have always been volatile, but the world has been witness to a level of volatility in the last few months that has seldom been seen. As of October 26, 2004, a barrel of oil settled at a high of $55.17, a level not seen since the middle of the 1980s. However, since then, the price of oil has decreased by approximately 32%.  Regular unleaded gasoline, a key byproduct of oil, has only decreased around 9% in this same time period, and retail heating oil prices have witnessed a mere 5% drop.  Clearly, there are price factors at work that are independent of the production cost of a barrel of oil. 

Oil makes up about half the cost of gasoline. Consequently, as the price of a barrel of oil goes up or down, over time so does the price of gasoline.  While it is true that the price of products refined from oil go up faster than they come down, the surge in gasoline prices and their sustained highs can be attributed to a series of problems faced by refiners.  The greatest of these, according to the article “Family Finance: Why Pump Prices, Heating Bills Remain Lofty,” by Thaddeus Herrick, is the inability of refiners to keep up with the demand for gasoline.  Since 2003, the demand for gasoline has increased by 4.5 million barrels a day, whereas the capacity to refine gasoline from oil has only increased by 1 million barrels a day.  The availability of refineries, their location, their distribution method, their capacity, and local laws governing the formulation of gas play a role in the cost of gas.  Refining is another 15% of the cost of gas.  This has driven up capacity utilization to records never seen before, threatening the United States and the world with inflationary pressure. 

Heating oil inventories in the Northeast have also affected the price of oil in the United States.  Currently, heating oil inventories are 13% below last year’s levels.  Industry groups already expect heating oil expenses by families in the Northeast to be 34% higher than last year.   In the last few weeks, the Northeast has been witness to a short warm spell, driving up inventories of heating oil, and prices have stabilized at the lower end of the spectrum. However, continued cold weather (and the subsequent demand for heating oil) could drive heating oil prices back up to October levels. 

Another factor that will affect the price of consumer gasoline is the shift of petroleum refiners from winter stock to summer stock.  To do this, refineries have to run down their winter inventories and invest in time-consuming maintenance, both of which drive the price of gasoline up.  Compounding these inventory problems are the formulation of blends required by different states; the complexity involved with the different blends severely taxes the ability of refineries to manage and ship gasoline blends to various states.  In addition, American’s love of gas-guzzling Sports Utility Vehicles (SUVs) has accelerated the consumption of gasoline, adding demand pressure to the gasoline market.  

Nevertheless, gasoline tends to be somewhat of an inelastic commodity.  Irrespective of price, the demand will remain constant or grow.  If the price of oil doubles, there will not be a subsequent decrease in demand of gasoline by half.  Consequently, one cannot base any assumptions about the price of gas on demand.  To understand how oil is priced, one has to consider the supply side of the problem, not the demand side.

There are three major pain points that can disrupt the supply (and cost) of oil:

1.    Extraction - Oil must be extracted from the ground.  Price fluctuations can occur according to the costs associated with the cost per barrel of extraction.  Limitations to supply can be associated with extraction capacity, cost of drilling, cost of search, environmental factors associated with drilling, etc.  Demand can sometimes exceed output capacity, but typically prices rise when reserves drop (due to either demand or OPEC-induced cuts).  Typically, this constitutes about 40% of the cost of gas.

2.    Distribution - Once oil is extracted, it has to be shipped out to distribution ports or send via pipeline to distribution centers.  Supply can be limited by the availability of pipes, shipping infrastructure, weather, terrorist attacks, marketing, etc.  This constitutes about 15% of the price of gas

3.    Refining - once the crude oil reaches a destination, it has to be processed and refined for various uses, one of them being gasoline.  The availability of refineries, their location, their distribution method, their capacity, and local laws governing the formulation of gas play a role in the cost of gas.  Refining is another 15% of the cost of gas.

One other major factor that affects price:

1.    Taxes - This doesn't really affect the supply of oil, but plays a significant role in its price.  This factor tends to remain constant once adopted.  Taxes can be anywhere from 12% to 75% of the cost of gas, depending on the governing body.  In the US, the rate is 12.5%, which translates into about 30% the cost of gas.  However, since this is constant, it does not tend to affect the price fluctuations of gas.  However, it can play a significant role in the disparity of gas prices between nations and even states.

There are many price and non-price determinants of the quantity of oil supplied and demanded.  However, as an inelastic commodity, gasoline tends to have consistent or increased demand, irrespective of price.  On the supply side, there are a number of factors that can limit the quantity of oil available in the marketplace, many of which are independent of the price of oil per barrel.  When analyzed in the context of worldwide requirements, limiting factors, and consistent demand, it is little wonder that this scarce and precious resource has such a high level of volatility, nor is it any surprise how much potential damage it can do to an economy.