WHO SETS THE PRICE OF OIL?

Renewed controversy over oil prices has revived a question not heard in a while: Who sets the price of oil?

Mar 3rd, 2000

Renewed controversy over oil prices has revived a question not heard in a while: Who sets the price of oil?

Since last April, members of the Organization of Petroleum Exporting Countries have successfully limited production to cure chronic oversupply. Now that the world export crude price has pierced the $30/bbl ceiling for the first time since the Persian Gulf war, the group receives credit-or blame-for setting the price.

The fact, however, is that if OPEC were able to set the price in any durable way, the $30/bbl ceiling would been pierced long ago and never seen again.

To be sure, the exporters' group strongly influences the price of crude. Most of the time, however, its greatest influence is downward.

Most of the time, the world has all the oil it needs, plus a little extra. And to the extent of their unused capacity to produce, producers wield potential mainly to push unneeded crude oil into the market and drive the price down.

Most unused production capacity in the world at any given time belongs to members of OPEC, who usually consider the deliberate wrecking of prices a bad idea.

There are times, fairly infrequent times, when consumption would be higher if only more oil were available. At those times, holders of idle production capacity bear unusual price influence through their reluctance to produce the oil that the market would readily absorb.

First-quarter 2000 is one of those times. Consumers would use more oil if OPEC members with idle capacity made it available. Until OPEC members do so, consumers must aggressively compete for available quantities, and prices levitate.

For the time being, therefore, OPEC might be said to be setting the price of crude. What it really is doing is propping up the price by withholding supply and intensifying competition at the margins of consumption. Such influence cannot last.

Basic economic theory and history both warn of what will happen. In response to elevated price, consumption will shrink, and supply will emerge from outside of OPEC, members of which will then lose market share.

And the price of crude will subside, along with notions that OPEC sets the price.

It is easy to forget that for nearly 2 years before present circumstances, consumers had as much to say about the price of oil as OPEC does now.

Consumption sagged following the Asian financial collapse of mid-1997, and there was too much oil relative to demand. An oil buyer not liking one supplier's price had plenty of willing sellers with which to conduct business. The competition hammered inflation-adjusted oil prices down to their lowest levels in decades.

But that condition was as extreme on the high end of oil supply as current conditions are at the low end.

When conditions aren't extreme, which is most of the time, no one can be said to set the price because everybody does. Under normal conditions, the price reflects the amalgamated decisions of buyers and sellers all along the chain of hydrocarbon value, from production all the way to the service station pump.

Under normal conditions, the price of oil is high enough to allow producers, refiners, and retailers to make money but low enough not to strain consumers. Normal conditions allow supplies to flow and markets to grow.

Normal conditions make everybody reasonably happy. For that reason, they dissipate the urge to blame somebody for setting the price oil, a practice that nature and the laws of economics simply will not allow.

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