How the Crude Oil Market Works

Crude Oil Pricing

Gas pumps at a Mobil gas station in New Haven, Conn., on May 20, 2008, reflect soaring gas prices.
Gas pumps at a Mobil gas station in New Haven, Conn., on May 20, 2008, reflect soaring gas prices.
AP Photo/Jennifer Graylock

When U.S. gas prices hit their peak in 2008, and everyone was paying around $4 per gallon (about $1.05 per liter) at the pump, the price of a barrel of oil spiked to $145. Yet by fall of 2009, it had lowered to around $69 [source: Murphy]. But what exactly is a barrel of crude oil, anyway, and what does it really mean for gas prices?

There are 42 gallons (159 liters) of oil in a barrel. And roughly 1 gallon (about 3.8 liters) of crude oil can be made into between .47 and .67 gallons (1.78 and 2.54 liters) of gasoline, depending on the refiner and the quality of the crude oil, among other factors [source: Suermann]. While the contents and size of a barrel of oil remain constant, the price it commands on the international market can change quite often.

Four major factors help determine the price of oil: supply, consumption, financial markets and government policies [source: Murphy].

Basic economics teaches us that a high supply of oil means demand is low, which means that the prices will be low, too; the inverse, that a low supply increases demand and raises prices, is also true. However, oil pricing goes far beyond just supply and demand -- if only it were that simple!

The way oil is traded on the financial market has a massive influence on its price. Speculators invest in oil futures, essentially bets on how much oil will cost at a later date, and this in turn affects how other people think oil should be priced. It also affects how much oil the petroleum companies will release to the market. We'll discuss more on oil futures later.

Government regulation also has a big effect on oil prices. Recently passed rules on sulfur content could raise the demand for sweet crude oil -- a type of crude oil with less sulfur -- but sweet crude oil is less common than other types of oil. And laws aimed at preventing climate change will likely raise the price of energy, too [source: Murphy]. Taxes on gasoline can also affect prices.

At the same time, the government continues to find ways for people to switch to power sources like wind and solar energy -- and drive more fuel efficient cars -- so it's possible that the demand for oil will go down, simply because we won't need it as much anymore. Most analysts believe that's a long way off, however.

In the next section, we'll look at where the world's supply of crude oil comes from, and how wars in the Middle East affect the cost of your commute to work.