Price
Market balance for one product is also connected to the market balance
for another. These region-by-region and product-by-product supply and
demand patterns interact to establish the price level for crude oil and its
products. The interaction is constant and usually invisible to anyone not
directly involved in the oil industry. As a general rule, the thousands of
transactions that take place simultaneously are completed without fanfare.
The price fluctuations are small, and of interest only to the buyers and sellers
within the industry.
This steady-state stability can be -- and has been -- disrupted by a
number of factors, suddenly bringing oil prices to the headlines. Demand
surges, refinery outages, and supply cutbacks can all cause price run-ups.
Some, like refinery outages, logistics snags or demand surges in a cold snap,
cause a price spike -- prices shoot up initially and then recede again when the
supply and demand balance has been reestablished. Others, like the crude
oil price declines experienced during 1998 or the crude oil price increases
experienced during 2000, take longer to return to the underlying price trend.
Overview: Cost plus Market Conditions
Prices of oil, like those of other goods and services, reflect both the
product's underlying cost as well as market conditions at all stages of
production and distribution.
The
pre-tax price of gasoline (or any other refined oil product) reflects:
Its
raw material, crude oil.
Transportation from producing field to refinery.
Processing that raw material into refined products (refining).
Transportation from the refinery to the consuming market.
Transportation, storage and distribution between the market distribution center
and the retail outlet or consumer.
Market conditions at each stage along the way, and in the local market.
The price of crude oil, the raw material from which petroleum products
are made, is established by the supply and demand conditions in the global
market overall, and more particularly, in the main refining centers:
Oil prices are a result of thousands of transactions taking place
simultaneously around the world, at all levels of the distribution chain from
crude oil producer to individual consumer. Oil markets are essentially a
global auction -- the highest bidder will win the supply. Like any
auction, however, the bidder doesn't want to pay too much. When markets
are "strong" (when demand is high and/or supply is low), the bidder must be
willing to pay a higher premium to capture the supply. When markets are
"weak" (demand low and/or supply high), a bidder may choose not to outbid
competitors, waiting instead for later, possibly lower priced, supplies.
There are several different types of transactions that are common in
oil markets. Contract arrangements in the oil market in fact cover most
oil that changes hands. Oil is also sold in "spot transactions," that is,
cargo-by-cargo, transaction-by-transaction arrangements. In addition, oil
is traded in futures markets. Futures markets are a mechanism designed to
distribute risk among participants on different sides (such as buyers versus
sellers) or with different expectations of the market, but not generally to
supply physical volumes of oil. Both spot markets and futures markets
provide critical price information for contract markets.
Prices in spot markets -- cargo-by-cargo and transaction-by-transaction
-- send a clear signal about the supply/demand balance. Rising
prices indicate that more supply is needed, and falling prices indicate that
there is too much supply for the prevailing demand level. Furthermore,
while most oil flows under contract, its price varies with spot markets.
Futures markets also provide information about the physical supply/demand
balance as well as the market's expectations.
Seasonal swings are also an important underlying influence in the
supply/demand balance, and hence in price fluctuations. Other things being
equal, crude oil markets would tend to be stronger in the fourth quarter (the
high demand quarter on a global basis, where demand is boosted both by cold
weather and by stock building) and weaker in the late winter as global demand
falls with warmer weather. As a practical matter, however, crude oil
prices reflect more than just these seasonal factors; they are subject to a host
of other influences. Likewise, product prices tend to be highest relative
to crude as they move into their high demand season -- late spring for gasoline,
late autumn for heating oil. The seasonal pattern in actual product
prices, again, may be less obvious, because so many other factors are at work.
The overall supply picture is of course also influenced by the level of
inventories. When stocks in a given market are high, they represent incremental
supply immediately available, so prices tend to be weak. The opposite is
true in a low stock situation.
Price change patterns can vary between regions, depending on the
prevailing supply/demand conditions in the regional market, especially in the
short-term. Refinery outages or logistics problems in Chicago will
lead to rapid price increases in the Midwest without matching increases on the
East Coast. Both geography and the unique quality of the gasoline required
by the California Air Resources Board contribute to the volatility of gasoline
prices there. Sources for additional supply are limited and distant, so
any unusual increase in demand or reduction in supply gets a large price
response in the market.
That price response, and the differences in regional price movements,
are critical to the way the oil market redistributes products to re-balance
after an upheaval. The price increase in one area calls forward
additional supplies. These new supplies might come from other markets in
the United States, or from incremental imports. They may also be
augmented by increased output from refineries. The volume and source of
the relief supplies are interwoven. The farther away the necessary relief
supplies are, the higher and longer the likely price spike.
All other things being equal, cost differences are important factors in
regional prices. For instance, state excise taxes, product quality,
distance and ease of distribution are all important when comparing prices
between regions, states and even within states. These factors will lead to
higher prices (or lower) in a given area on a day-in, day-out basis.
(These differences are also important in comparing prices in the United States
with those abroad.
Ultimately, oil prices can only be as high as the market will bear.
They may be higher in areas with higher disposable income, where real estate
values, wages and other measures of economic activity indicate that the market
is more robust. If they rise higher than the market will bear, however,
consumers will seek substitutes or downsize their cars and make other
adjustments that reduce their consumption. If the local area offers
unusually high profits, competitors will quickly enter the market, finally
pushing prices down.
Gasoline Prices: An Example
On a pre-tax basis, crude oil prices are the most important determinant
of petroleum product prices, and often the most important factor in price
changes as well. Crude oil prices reflect an overall market balance --
when crude oil prices are low, reflecting an oversupply, product prices will
also be low; when crude oil prices are high, reflecting undersupply or high
demand, product prices will also be high. When the price of crude oil
moves up or down on a sustained basis, the change will be reflected in product
markets, all other things being equal. Crude oil prices were again the largest
factor in the increase between July 1999 and July 2000, accounting for about
two-thirds of the increase in the pump price. In contrast, the gross
retail margin -- the difference between a retail dealer's cost to purchase the
gasoline and the price at which the dealer can sell the gasoline -- actually
dropped by one-third between mid-1998 and mid-1999, righting itself again
between mid-1999 and mid-2000. The gross refining and distribution margin
stayed unchanged between mid-1998 and mid-1999, but increased between mid-1999
and mid-2000. Thus, it is useful to repeat that the price of petroleum
products to consumers reflects costs plus market conditions, and those market
conditions may augment or prevent a penny-for-penny passthrough of cost
increases at any stage of the market.