How Oil Prices Are Set

How benchmark crude prices, futures markets and stubborn demand combine to set the price of a barrel of oil.

Oil is not priced by one company or one government. Instead, its price is discovered every trading day in global markets, where buyers and sellers agree on the value of standard grades of crude called benchmark crudes. The best known are Brent, drawn from fields in the North Sea, and West Texas Intermediate, often shortened to WTI, delivered in the United States. Most of the world’s oil is priced as a small premium or discount to one of these benchmarks.

Why oil needs benchmarks

Crude oil is not a single product. Oil from different fields varies in how thick it is and how much sulphur it contains. Lighter, lower-sulphur crude is easier to turn into petrol and diesel, so refiners will pay more for it. Rather than negotiating a fresh price for every cargo from scratch, traders take a benchmark price and adjust it up or down for quality and for the cost of shipping it to where it is needed. Oil is usually quoted in dollars per barrel, and one barrel holds about 159 litres.

Spot prices and futures

The spot price is the price for oil delivered almost immediately. Much of the trading, though, happens through a futures contract, which is an agreement today to buy or sell a set amount of oil at a fixed price on a future date. Airlines, refiners and oil producers use futures to lock in prices and protect themselves from sudden swings. Investors and speculators trade them too, betting on where prices will go. Because futures markets react within seconds to news, such as a pipeline outage or a change in economic forecasts, the price you hear on the news is usually a futures price.

Why oil prices swing so sharply

In the short run, oil shows strong price inelasticity: the amount people buy barely changes when the price moves. Drivers still need to reach work, trucks still need to deliver food, and factories cannot switch fuels overnight. Supply is also slow to respond, because new oil fields can take years to develop. When both buyers and sellers react slowly, even a small shortage or surplus can push the price a long way before the market settles again.

When oil briefly cost less than nothing

In April 2020, as lockdowns sharply cut travel around the world, demand for oil collapsed while oil kept flowing out of the ground. Storage tanks in the United States filled up. For one day, a WTI futures contract that was about to require delivery traded at roughly minus 37 dollars a barrel. Traders who held those contracts had nowhere to store the oil, so they paid others to take it off their hands. The strange episode showed how a physical limit, like running out of tank space, can drive prices to extremes when demand cannot quickly adjust.

What moves the price over time

Over months and years, several forces push oil prices up or down. Global economic growth raises demand, especially in fast-growing economies. Decisions by major producers about how much to pump change supply. Conflicts and sanctions can threaten supply routes. Because oil is priced in dollars, a stronger dollar can make oil more expensive for buyers who hold other currencies, such as rupees or euros, which can gently reduce demand. Expectations matter as well: if traders believe a shortage is coming, they bid prices up before it arrives.

Assuming petrol prices simply follow crude prices

It is easy to assume that when crude oil falls by a tenth, petrol at the pump will fall by a tenth too. In reality, the pump price also includes refining costs, transport, retailer margins and, in many countries including India, large fuel taxes. Taxes and fixed costs can make up a big share of the final price, so pump prices usually move by a smaller percentage than crude, and often with a delay.

Key takeaways

Oil is priced against benchmark crudes such as Brent and WTI, adjusted for quality and location.
The spot price is for immediate delivery, while futures contracts lock in a price for a future date.
Short-run demand and supply both respond slowly, so small imbalances can cause big price swings.
Economic growth, producer decisions, conflict, the dollar and expectations all move prices over time.
Pump prices include taxes and other costs, so they do not move one for one with crude.