How Prices are Determined

How Petroleum Product Prices are Determined

Price is the equalizer than ensures supply always meets demand. If demand exceeds supply, prices will rise until either new supplies are attracted to the market or demand is dampened so that equilibrium is achieved. If supply exceeds demand, prices will drop until the market is in balance.

From a refiner´s perspective, the price of petroleum products is measured at the refinery gate. The price at which a refiner can sell product at the loading rack is called the rack price. It is rack prices that determine refinery viability in terms of revenue generated from the refining process.

Because of the ability to move product to the market where the highest price is found, most petroleum product prices are similar from market to market. For example, if the rack price for gasoline was lower in Toronto than it was in Buffalo, refiners in Toronto would choose to ship their product to Buffalo to sell at the higher price, as long as the cost of transporting it to Buffalo was less than the price difference. This would increase the supply in Buffalo and lead to a price decrease until the two markets were in balance. The same would apply in reverse if the Toronto price were higher. Generally, the difference in wholesale prices between two markets can be attributed to the cost of transportation between those two markets.

As a result of the integrated nature of North American petroleum product markets, Canadian refiners are price takers and must price their products to compete with the price of imported product delivered to Canada. Even if no products are in fact actually imported, the existence of the import option imposes a certain pricing discipline on local refiners.

The price that the consumer pays for a petroleum product depends on the product and how the product will be used. With the exception of automotive fuels, most petroleum products are sold at the wholesale level directly to the consumer of the fuel, usually under contract. The terms of the contracts are considered commercially sensitive and not generally made public. As a result, the prices of these products are less transparent and more difficult to track.

Wholesale prices for petroleum products react to a broad range of factors unique to their individual markets. Product prices are influenced by the supply and demand balances as well as the prices of alternative products with which they compete. For example, propane can be used for heating, as an automotive fuel or for agricultural uses like crop drying. A late wet harvesting season in the prairies can overlap with an early cold winter that result in a surge in demand and short-term price spikes.

The demand for diesel fuel is directly related to economic activity, which is manifested in increased truck traffic to move goods and services in a robust economy. Diesel oil is also an automotive fuel and can be easily converted to furnace oil for home heating. When all of these uses compete for supply, prices will rise.

Automotive fuels are distributed to consumers through retail outlets. The retail price, therefore, includes distribution costs as well as a number of federal and provincial consumption taxes. Retail price can also be used as a tool to attract market share. This kind of competition in the market can lead to significant price wars with some low and volatile consumer prices.

When all the factors that can influence prices - supply/demand, crude oil costs, distribution costs, federal and provincial taxes and local market conditions - all come together, retail prices, and to a lesser degree wholesale prices, can vary significantly between markets.




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How Retail Gasoline Prices are Determined

Gasoline prices can be difficult to understand because they do not behave like the prices of many of the other goods that consumers buy every week. Gasoline is a commodity, like gold or pork bellies, and its wholesale price reacts to a number of factors. The most obvious ones are supply and demand. When there is more demand (in summer when everyone drives more), there is more pressure to ensure that there is sufficient supply to meet demand, so the price goes up. When there is less demand, such as during the winter months, supply and demand are better balanced and prices are generally lower.

Over the longer term, demand has been growing each year as drivers choose bigger and bigger vehicles and drive greater distances. This puts pressure on the supply and can also lead to higher prices.

Another factor that has the greatest influence on gasoline prices over time is the cost of crude oil, the raw material from which gasoline is made. The supply and demand for crude oil are balanced in a worldwide market, so that every refiner around the world has to pay the world price for oil. When events like the war in Iraq cause concerns over possible supply disruptions, some buyers are willing to pay more for oil to ensure they have adequate supply for their refineries. This pushes up the price for everyone.

Both gasoline and crude oil prices also react to commodity markets. Speculators who want to make money buying and selling contracts for oil or gasoline can influence prices with their buying patterns.

Recently, the combination of all of these factors has lead to some of the highest prices for crude oil and gasoline in the last 10 years. They have also led to frequent changes in the price that consumers pay at the pump.

However, the overriding factor is always the local market. Every gas station owner wants consumers to buy gasoline from them. They will try to attract business by lowering their prices by a small amount. The other stations watch their competitors very closely and will match the lower price almost immediately. This can lead to price wars where prices drop by small amounts over a few days until they reach levels where suppliers are selling gasoline for less than the price that they paid for it. When this happens, one of the suppliers may decide to go back to the original price, which can often be five or ten cents per litre higher. Usually the other stations will follow soon afterward to return to a price that provides some profit. This is called a price restoration. Some markets, where competition is fierce, have one or more price wars every week so prices appear to be constantly changing. Consumers can benefit from price wars because the price they pay is often lower than it would be
in a market with less competition.




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How Crude Oil Prices are Determined

The price of oil is set in the global marketplace. Oil is traded widely all around the world and can move from one market to another easily by ship, pipeline or barge. Therefore, the market is worldwide and the supply/demand balance determines the price for crude oil all around the world. If there is a shortage of oil in one part of the world, prices will rise in that market to attract supplies from other markets until supply and demand are in balance. If there is a surplus in a region and the price drops, buyers will soon be drawn to that market. This explains why crude oil prices are similar all around the world. Prices vary only to reflect the cost of transporting crude oil to that market and the quality differences between the various types of oil. The global nature of the market also explains why events anywhere in the world will affect oil prices in every market.

In addition to all of the actual barrels of oil that are traded, there is a second market that trades in "paper" barrels. This simply indicates that oil is traded on "paper" based on a perceived monetary value of oil and there is not usually a physical exchange of the product. The two key markets where paper barrels of oil are bought and sold are in New York, on the NYMEX (New York Mercantile Exchange), and in London on the IPE (International Petroleum Exchange). In these futures markets, paper contracts for oil are bought and sold based on the expected market conditions in the coming months, or even years.

There are two types of buyers and sellers in the futures market: those that are actual producers or users of crude oil and those who buy futures contracts as an investment, without any intention of ever taking possession of the actual crude oil. The first group use the futures market to protect themselves from price volatility by locking in either their costs or their revenue. The second group are investors who can make money by correctly guessing whether prices will increase or decrease in the future.

In the spot market, oil is bought and sold for cash and delivered immediately. The current spot price for oil is influenced by the futures market price because the futures price represents the market's collective view, at a given point in time, of where prices may be headed.

The media most often quotes the futures market price in the nearest month as representative of the current price of oil.