eThesis - School of Business electronic theses

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A review of factors determining crude oil prices.

This purpose of this thesis is to form a general understanding on price formation of crude oil in the short and the long run. It is motivated by the recent record increase and subsequent crash in crude oil prices. The impacts of the price changes were broad and altered industrial activity, consumer behavior and political power globally. Understanding the factors behind these changes is important for commercial investments and public policy making.

Academics, analysts and politicians seem to disagree on what is the main driver for the oil price development. Usual explanations are resource scarcity, cartel behavior, commodity speculation and market conditions. This paper examines these central arguments based on their theoretical background and observations on the oil market. It aims at explaining recent events and describing main drivers for future price development.

Economic theory on exhaustible resources provides a framework for long run price development based on increasing scarcity. While it does not explain recent crude oil price changes, it shows that prices of exhaustible resources are bound to rise even with perfect competition. Extensions to the theory provide possibilities for analyzing increasing costs and market power. More accurate models are however also much more complicated and thus not easily applicable to price analysis.

Recent high prices were often blamed on speculation, but physical and financial arbitrage constraints limit speculators’ possibility to drive prices. If the oil price was being driven higher than the market equilibrium, there should have been clear increase in oil inventories as supply was kept away from the market. When prices reached record highs, inventories were on unusually low levels, implying the contrary. Further studies on market participants’ behavior also do not support market manipulation. Recent price changes were most likely due to an initially booming and finally crashing demand, which was almost inelastic to prices because of the lack of substitutes. Demand reactions were further dampened by government subsidies and on the other hand taxes, which made the price changes seem smaller to consumers. Oil producers reacted by trying to pump as much oil as possible leading to higher costs. Supply limiting cartel behavior, which was common in the 20th century, was not observed in the past few years. While the market has now loosened, it is bound to tighten again as demand growth recovers and oil field investments have stalled due to low prices. If realistic substitutes do not emerge, there will be further market crunches ahead.