The Pricing of Oil

The price of oil is no longer an important determinant of the economic health of the West. To create the same amount of economic output, manufacturers use much less oil than they used to.

Moreover, today, there are futures contracts, which allow one to fix the price of purchased oil well in advance. There are options contracts which can be used to limit one's risks as a result of trading in such futures contracts. 

So, why is the price of oil going through the roof?

Because oil has become a form of investment and a hedge against rising inflation. People plough their savings into oil and speculators drive the markets. As Saudi Arabia correctly observes, the price of oil is no longer determined merely by supply and demand.

Who decides on the domestic price of oil and its derivatives?

In some countries, prices are fixed entirely by market forces, supply and demand, usually through specialized exchanges (e.g., the Rotterdam Exchange). The market is completely deregulated: exports and imports are totally allowed and free.

In other countries, prices are fixed by a committee of representatives of the government, the oil industry, the biggest consumers of oil, and representatives of households and agricultural consumers.

In most countries, prices are changed every 3 or 6 months based on the cost of oil at a certain port of delivery. In Israel, for instance, the price of oil fluctuates every three months according to the price of oil delivered in certain Italian ports (where Israel gets most of its oil delivered). This is an AUTOMATIC adjustment.

In a few countries the prices are fixed by the competent Ministry in accordance to the ACTUAL costs of the oil (importing, processing and distribution) + a fixed percentage (usually 15%). This is called a COST PLUS basis pricing method.

The international price of oil is determined by the following factors:

1. The weather. Cold weather increases consumption. The world is getting hotter. The 14 hottest years in history have been in the last 25 years. The warmer the climate - the less oil is consumed for heating, but the more oil is consumed for air conditioning.

1. Economic growth - The stronger the growth, the more oil is consumed (mostly for industrial purposes). The incredible economic development of countries like China and India and the emergence of car-owning middle classes in many developing countries enhanced demand and contributed to the current crisis.

1. Wars increase oil consumption by all parties involved.

1. Oil exploration budgets are growing and new contracts have just been signed in the Gulf area (including Iraq), Brazil, and Canada. The more exploration, the more reserves are discovered and exploited, thereby increasing the supply side of the oil equation.

1. Lifting of sanctions on Iraq, Iran and Libya will increase the supply of oil.

1. Oil reserves throughout the world are low. This tends to enhance demand for newly produced oil.

1. When there is an economic crisis in certain oil producers (Russia, Nigeria, Venezuela, Iraq) it forces them to sell oil cheaply, sometimes in defiance of the OPEC quotas. This was the case in the late 1990s.

1. OPEC agreements to restrict or increase output and support price levels should be closely scrutinized. OPEC is not reliable and its members are notorious for reneging on their obligations. Moreover, OPEC members represent less than half the oil produced globally. Their influence is limited.

1. Ecological concerns and economic considerations lead to the development of alternative fuels and the enhanced consumption of LNG (gas) and coal, at oil's expense. Even nuclear energy is reviving as does solar energy.

1. New oil exploration technology and productivity gains allow producers to turn a profit even on cheaper oil. So, they are not likely to refrain from extracting and selling oil even if its price declines to 5 US dollars a barrel.

1. Privatization and deregulation of oil industries (mainly in Latin America and, much more hesitantly, in the Gulf) increases supply. Recent moves in countries like Venezuela, Russia, and Bolivia to re-nationalize their oil industries and unrest in countries like Nigeria raise global oil prices owing to uncertainty and increased political risk.

1. Price volatility induced by hedge funds and other derivatives has increased lately. But, as opposed to common opinion, financial players have no preference which way he price goes, so they are NEUTRAL.