This chapter starts with a brief review of the price of internationally traded crude oil. The second section presents the economic theories of oil price determination, with a focus on the analysis of OPEC behaviour. The third section introduces a widely used two-factor model and a trend-cycle model for understanding the long- and short-run dynamics of oil prices. The fourth section gives a detailed account of the price formation mechanism in physical markets, while the final section briefly introduces energy derivatives, particularly futures markets.

A brief history of oil prices

From the birth of the industry to the Second World War

The modern oil industry is generally considered to date back to 1859, when Edwin Drake drilled the first commercially successful well in Titusville, Pennsylvania. Figure 7.1 shows the history of oil prices since 1861, measured both in 2017 dollars and the money of the day. There are several boom and bust cycles in the history of oil industry. Drake’s success prompted numerous entrepreneurs to enter the oil business in the 1860s, which can be understood from the perspective of the law of capture. Once oil is discovered, each landowner who is lucky enough to be sitting on the top of the reservoir has an incentive to drill into the “common pool” and produce as much as possible.

The early days of the industry were characterized by fierce competition and chaos (Stevens 2010a). In the ten years following the US Civil War the nominal price of crude oil declined sharply, from $8.04 per barrel in 1864 to $1.17 per barrel in 1874.

However, the subsequent rise of Standard Oil, which was accomplished largely by controlling refining and shipping, effectively consolidated the industry and stabilized the price. By 1904 Standard Oil controlled over 91 per cent of US refinery output and 85 per cent of final sales. Most of its output at the time was kerosene, 55 per cent of which was exported around the world. The United States was going through a period of rapid industrialization and fast population growth in the 1890s, eventually overtaking the United Kingdom as the world’s leading centre for manufacturing.