At HEAT USA, a common question we receive from members and non-members alike is, “What’s the price of heating oil today?” As we always explain, the price of heating oil depends where you live, who your supplier is, whether or not you are a member of HEAT, and many other big-picture factors. What are those factors, and how do they lead to higher or lower retail prices for heating oil? It is a simple question with a complicated answer. We at HEAT This Week try to provide simple and straightforward explanations for why the price for a gallon of heating oil changes so rapidly. We have compiled a list of three factors that influence the price of heating oil in an attempt to help consumers understand how they could pay $2.90 a gallon one day and $3.10 the next.

Crude Oil. Also known as petroleum, crude oil is the main ingredient in heating oil (also know as number 2 fuel oil), as well as kerosene, jet fuel, and gasoline. Petroleum is also used to manufacture other essential materials, including lubricating oils, plastics, and asphalt. With so many uses, it’s no wonder that crude oil is the fuel of the world economy. Add the fact that crude oil is increasingly difficult to get out of the ground to consistently high demand for the product, and you’ve got one hot commodity! Crude oil is the most sought-after commodity on the New York Mercantile Exchange (NYMEX), and often affects the price of other commodities. So if the demand for crude oil suddenly increases because Americans start driving more or China purchases 100 new airplanes, the price increases. Generally, as goes the price of crude, so follows the price of heating oil.

Worldwide energy supply and demand. Since crude oil is a crucial part of nearly every energy source on the planet, its market price is very closely tied to the global market’s demand for energy. As explained in the October 17 edition of HEAT This Week (“The Stock Market, Heating Oil, and You”), the current economic slowdown affecting economies around the world has weighed down demand for energy everywhere. Americans are driving less and Chinese factories are manufacturing less, putting crude oil in low demand. When the stock market begins to perform more strongly (which some experts say will happen soon), it will be a signal of the global slowdown ending and energy demand returning. At that point, demand for crude oil will surge, lifting its market price and, in turn, lifting the price of heating oil as well.

Profit margins. As with every other good that is bought and sold, petroleum passes through many hands before it arrives at your home as heating oil.

Huge multinational corporations extract crude oil from the ground and ship it to refineries they own nearby to make heating oil. The heating oil is then shipped to local distribution centers called “racks.” At the racks, the heating oil is sold to local retailers, who fill up their tanker trucks and then deliver the oil to homeowners. The two transfers of ownership (multinational producers to retailers and retailers to consumers) include taking of profit from the sale of the oil. If the market value of heating oil is $2 a gallon on the day the retailer buys from the producer, the producer might charge $2.15 a gallon in order to make a profit. The retailer then adds on his own profit margin to the price he charges the consumer, making the retail price $2.50 a gallon. Profit margins are an important part of capitalism, so long as they are fair and justified by market forces. However, heating oil producers and retailers sometimes take advantage of customers and raise the price of the oil to prices that are disproportionate to the market value.

For example, heating oil retailers may raise their profit margins on heating oil during the winter, because they know consumers are more willing to pay higher prices when it’s cold outside. So in the winter, retailers often raise their prices, even if the market price for heating oil is going down. This allows retailers to maximize their profits during heating season so that they may continue to do business when demand is extremely low during the spring and summer. Retailers will argue that this is a fair practice, but some view it as exploiting heating oil consumers.

This tendency of retailers to maximize their profit margins led heating oil collectives like HEAT USA to provide price protection to their members, which compels retailers to agree to a specific number of cents per gallon in profit.

The three factors above are the basic forces that affect the price you pay for heating oil from the moment crude oil is pumped out of the ground to the moment the delivery truck fills up your tank. Crude oil availability and market price, worldwide demand for energy, and profit margins taken along the supply chain are all determined by hundreds of secondary factors that change every day, making the price for a gallon of heating oil change every day as well. With so many interrelated forces guiding the price of heating oil, along with the global economy’s first major crisis of this century, heating oil prices will continue to swing up and down. And whether the trend of the day or week is low or high, flat or sharp, the only thing heating oil consumers can surely bet on is uncertainty.

This article first appeared in the November 7, 2008 edition of the HEAT This Week email newsletter

HEAT USA president Andrew Heaney appeared in a story on BusinessWeek TV yesterday morning at 10 am on ABC.  Watch the full video here (3 min 50 seconds).