The Myth: Sudden increases in prices are caused by a) the major oil companies, b) the government, and/or c) the Organization of Petroleum Exporting Companies (OPEC).

Oil price graph: July 5, 2006 - July 17, 2007

The Evidence: Figure 1 shows the daily price of crude oil from July 5 to July 17, 2007. The short run changes you observe are determined by the same forces that determine the price of all goods and services in market economies: the balance of supply and demand. When the demand for oil products such as motor gasoline, home heating oil and jet fuel exceeds the available supply, prices rise. The demand for oil fluctuates over time in predictable ways, e.g., seasonal patterns of driving and weather, but also in unpredictable ways, e.g., unseasonably warm or cool weather, swings in economic activity, and so on.

In the short run, there is a relatively fixed supply of oil–the amount of refined product immediately available to retailers, and the amount of crude oil that can be converted to refined product in short period of time. That is, crude oil held in storage tanks, pipelines, and tankers. For example, a surge in driving that increases the demand for motor gasoline beyond what refiners can immediately supply will put upward pressure on prices. An unusually warm winter will lead to a build up home heating inventory that puts downward pressure on oil prices.

Day-to-day oil prices are formed in places New York Mercantile Exchange (NYMEX) the world’s largest physical commodity futures exchange and trading forum for energy. Here the expectations of energy traders play an important role in determining oil prices, just as they do in other exchanges such as the Hong Kong or New York Stock Exchange. Energy traders consider the short run supply and demand forces described above, as well as other political, economic, strategic and technological forces. A strike in the Venezuelan refining industry, civil unrest in Nigerian oil fields, or conflict in the Middle East will cause concern about possible future shortages in supply, and result in traders bidding up the price of oil. Conversely, news about a major new discovery, or economic forecasts for a slowdown in economic growth will push oil prices down.

Offshore Oil Platform: An offshore oil platform damaged by Hurricane Katrina in 2005

“Acts of God” also play a role in oil price formation. In 2005, Hurricane Katrina damaged or otherwise idled a lot of production and refining capacity in the Gulf of Mexico region, a loss that caused supply to decline relative to demand. Prices rose. The hurricane also sent a tremor through the oil markets, causing traders to bid up the price of oil due their fears of what the hurricane damage would do to future supply.

There is very little that a major oil company—or even the collusion of several companies—can do to affect the price of oil. The reason is simple: a single company does not control enough of the world’s total oil supply to be able to affect prices by restraining or expanding supply. This is true at the both production and refining stages.

Governments can and do influence oil prices through two mechanisms: taxation and policy. Government taxes constitute an important part of he price consumers pay for motor gasoline—about 20% of the pump price in the U.S., and a much larger fraction in Europe and parts of Asia. But changes in tax policy occur tend to be relatively infrequent and thus are longer run determinants of oil prices. Governments have in the past instituted policy that actually control energy prices, typically to moderate the level of prices. But this again tends to be a longer run force and cannot explain short run swings in prices. In addition, the trend almost everywhere in the world outside of OPEC is towards less government influence in the energy industry.

The eleven nations that comprise OPEC do affect oil prices. In the past, OPEC held great sway over prices because they controlled a large fraction of global production, and because they had a lot of spare production capacity. That is, OPEC had the ability to quickly increase production without having to find new oil or drill new wells. This control over the market contributed to the sharp energy prices increases in the 1970s and 1980s. However, OPEC’s ability to decisively swing prices at will has diminished considerably. The principal reason is that OPEC no longer has large amounts of spare capacity at its fingertips, and the lion’s share of spare capacity rests with Saudi Arabia, a relatively “moderate” member of OPEC. Other members of OPEC are producing close to full capacity in large part because they need the revenue. The net result of all this is that OPEC nations collude on production levels in an attempt to keep oil prices within a given range acceptable to them, but OPEC cannot set and maintain a specific price.

OPEC Sign

The Verdict:

• False in the case of oil companies.
• False in the case of governments.
• Plausible in the case of OPEC, with the important caveats discussed above.

Sources

• OPEC web site
• Energy Information Administration, U.S. Department of Energy, A Primer on Gasoline Prices
• Kaufmann, R.K, S. Dees, P. Karadeloglou, and M. Sanchez, 2004, Does OPEC matter? an econometric analysis of oil prices. The Energy Journal 25(4):67-90.