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: Singapore, Northwest Europe, and the U.S. Gulf Coast.  The crude oil price forms a baseline for product prices.   Products are manufactured and delivered to the main distribution centers, such as New York Harbor, or Chicago. Product supplies in these distribution centers would include output from area refineries, shipments from other regions (such as the Gulf Coast), and for some, product imports.  Product prices in these distribution centers establish a regional baseline.  Product is then re-distributed to ever more local markets, by barge, pipeline, and finally truck.  The fact the oil markets are physically inter-connected, with supply for a region coming from another region, means that of necessity even local gasoline prices feel the impact of prices abroad.

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 as discussed in the chapter on Stocks, 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.  See the example of re-adjustment in the Northeast.

Price spikes were an important feature of oil markets during 2000, including the Northeast's heating oil price runup in January and February, and the Midwest's gasoline price spike in May and June.  The Energy Information Administration has analyzed these market upheavals extensively, testifying before Congress, publishing reports, and providing routine updates on its website.

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.  The crude oil price increase was solely responsible for the increase in pump prices between the driving season of 1998 and the driving season of 1999, as shown in the illustration.  (The illustration also demonstrates that in the low price environment of July 1998, the gasoline and other excise taxes accounted for the largest share of the price of gasoline at the pump. Taxes are discussed in a separate section.)  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. 

This illustration is highly simplified.  Moving gasoline to the approximatelt 200,000 retail outlets throughout the United States has required the development of an intricate distribution infrastructure.  This complexity of the market structure is reflected in the "classes of trade" (different contract arrangements at different levels in the distribution chain) that are unique to the gasoline market.  There are other unique features in other oil product markets.  The Energy Information Administration has analyzed regional markets and price patterns in a number of publications.