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Oil Market Prices

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This article tries to explain how the oil market works in a simple and brief manner.
However the reader should be aware that the oil market is quite complex, no one statement can cover all the cases and instances of oil trading. With crude oil and gasoline prices rising to record levels in 2008 and the potential for new records to be set in the future, it is reasonable to assume that questions arise as to how crude and product prices are ultimately established.

Crude Oil Market
Worldwide crude oil production is approximately 85 million barrels per day with just over 30 million barrels per day produced by OPEC member countries. Crude oil production in the United States is approximately 5.8 million barrels per day.
The US, with a population of 313 million, consumes about 19 million barrels per day of oil products. China, with a population of 1.33 billion, consumes about one-half of that amount; roughly 9.5 million barrels per day. A 2.5% growth rate in US demand is currently equivalent to about a 5.0% growth rate in Chinese oil demand. Total world oil demand is over 89 million barrels per day.
Crude oil quality varies significantly. There are hundreds of different types of crudes produced around the world. West Texas Intermediate (WTI) crude is low sulfur, approximately 0.4 weight percent. Crudes from Nigeria have even lower sulfur of around 0.1 weight percent or less. Meanwhile crude produced from Saudi Arabia has sulfur
levels in excess of 2% while crude out of Iraq has a sulfur level of nearly 3%. This is but one aspect of quality.
Another aspect of quality is whether it is light or heavy. Light crude is easier to refine because it contains more material such as naphtha that can be refined into gasoline while also containing significant amounts of jet fuel and diesel fuel. Heavier crudes contain what is know as vacuum gas oil and residual fuel which must be further processed into lighter transportation fuels in several refining process units.

Read also Crude Oil Contracts

Refiners then value each of these different crudes based on the yields of those products mentioned in the previous paragraph, the cost of refining into a finished product, and the ultimate value of those products. The value of each is different to every refiner and the cost of these different types of crude varies.
This naturally leads to the question “How is the price of crude oil determined?”
There are three benchmark crudes in the world. Dubai is the benchmark for crude in the Middle East, Brent crude is the North Sea crude marker, and West Texas Intermediate (WTI crude) is the marker crude for Western Hemisphere crude oils. WTI, or light sweet crude is the crude one hears about daily. When you hear a crude oil price of $100 per barrel, or $70 per barrel, this is the crude that is being referred to. What is not so clear is what this $100 per barrel means to the rest of the crude oil market.
Light Sweet crude oil contracts, also known as WTI crude is traded on the New York Mercantile Exchange Futures Market. When one hears a price, it refers to a specific quality—WTI, for a specific timing, say March Delivery, at a specific location—namely Cushing Oklahoma. Clearly one can see that this means nothing to a refiner in Philadelphia, Los Angeles, Brazil or Canada. Over the years, the NYMEX has allowed foreign crudes to be delivered against the contracts with a deemed quality differential. This increases the liquidity of the contract.
Every day hundreds of millions of barrels of WTI are traded, and at the end of the day a settlement price is announced. As mentioned before, each crude oil has distinctive qualities, and therefore it has a market value higher or lower than that of WTI. The different types of crude oil bought and sold around the world are priced at discounts or premiums to the benchmark crudes. For example, Arab Heavy crude from Saudi Arabia, which is heavier and higher sulfur than WTI, is being offered by Aramco at a price of WTI minus about $3 per barrel loading in February 2012 at a port in Saudi Arabia.

Read also Crude Oil Trading

Specifically, when you load your oil tanker, you create a bill of lading date, and the price is calculated based on the average of five trading days where one would take the NYMEX settlement price and subtract 3 dollars. The price of WTI crude can fluctuate on a daily basis, but in this example, the buyer would always pay 3 dollars less.
This type of process is repeated throughout the trading world, although some Asian crudes price a bit differently. In addition, some domestic crude oils are priced on a posting basis, but these postings fluctuate daily with the NYMEX. To reiterate: Crude oil is priced on a differential basis to the benchmark crudes. When the benchmark moves, the final purchase price moves. OPEC sets production rates that impact supply which in turn affects the price determined by the market.
That leads to the question, “Who is setting the benchmark crude price?” The answer is oil traders, refiners, producers, hedge funds, pension funds, speculators, doctors, lawyers and individuals who all are taking a position on NYMEX Crude. (A similar parallel can be drawn with Brent and to a lesser extent Dubai). If the market hears a story about a supply interruption in Nigerian oil supply, the market is bid up. If the market hears about potential sanctions on Iran, price is bid up. When inventories of crude oil and oil products rise, or demand goes down, the price falls. These moves affect the price of crude oil that has been purchased or sold by oil companies on a differential basis.
When crude oil prices rise, oil producers around the world benefit. OPEC, state owned oil companies, and large integrated oil companies with oil reserves are the winners. (Note that Indonesia, an OPEC member, is actually a loser in this scenario as they import more finished products than their crude oil exports.) The consumer is not. The supply/demand balance throughout the world is much tighter, so the market has been bid up accordingly.
The spare production capacity that OPEC has is virtually gone, while refineries are operating at nearly full capacity limiting product supply. Add to that the geopolitical issues, and we have a volatile market with an upside bias.

Products Markets
After purchasing crude, refiners make all sorts of transportation fuels as well as chemical plant feedstocks. The following discussion will be limited to gasoline in the United States.
Like crude oil, not all gasoline is created equal. When the consumer pulls up to the gasoline pump, he or she only decides whether to buy regular, mid grade or premium. But the refiner must meet additional quality specifications for different geographic regions in the country. Simply put, gasoline specifications in Los Angeles are different than those in New York, which again are different than those in Florida. The octane rating is just one of the many quality specifications that refiners must meet.
Gasoline futures are traded on the New York Mercantile Exchange, and this gasoline contract is for a specific quality, with a specified timing, for example March, and at a specific location—namely New York Harbor. Again this does not do much good for a buyer in Bismarck, North Dakota or Seattle, Washington who may need product of a different quality sooner. However like crude, each of these locations can and do trade at a differential to the NYMEX gasoline futures contract. It is that differential that is negotiated. The final price can then be invoiced against the NYMEX price on a particular settlement date. These prices are then passed down to the wholesale level at the terminal racks and then on to the consumer at the retail outlet.
Again like crude oil, the price of gasoline on the NYMEX is influenced by refiners, traders, importers, blenders, wholesalers, retailers, consumers, hedge funds, pension funds, doctors, lawyers and individuals all buying and selling. When the market hears of a refining problem or supply interruption, prices are bid up. If demand goes down or inventories rise, prices fall.
When gasoline prices rise faster than crude oil prices, refiners are the beneficiary, since refiners make money based on the difference of their raw material cost namely crude oil and their finished products namely gasoline and diesel fuel. When demand falls, product prices fall, the consumer benefits, and the refiners often see their margins shrink.
The hurricanes of 2005 and 2008 severely impacted supply and resulted in a market where the price of gasoline was bid up substantially. With the loss of approximately 15% of the US refining capacity the effect was felt nationwide. Those refiners whose operations were NOT impacted made a lot of money. Refiners in Europe and Asia who
were able to supply imports also reaped the rewards of higher prices in US markets. The market redirected supply into the highest priced geographic locations.
One can debate whether the market treated everyone fairly or not, but prices rose to the point where demand was reduced and the remaining supply was distributed throughout the country with a limited amount of shortages. The market, in effect, rationed the gasoline supply. Many refiners saw increased profits. Note that during the course of these price increases, some marketers did not pass on the increased wholesale price to their customers, since they either would not or could not increase the price at the pump due to other competition.
The old adage, “A rising tide lifts all boats” applies. A problem in one part of the world affects prices throughout, consequently oil producers and refiners may benefit during periods of supply shortages.

Looking to the Future
Geopolitical factors such as Nigeria, Iran and other Middle East politics still weigh heavily on the minds of traders. Increasing demand from China and India also puts upward pressure on oil prices.
The United States has implemented new sulfur limits on gasoline and diesel fuel over the past few years. New York State will require low sulfur heating oil beginning July 2012.This means more refining units must properly operate to ensure that the final product meets specifications. Tighter specifications will also limit some of the imports
that previously had entered the US market. We can look forward to another year of price volatility.

References:
1. How the Oil Market Prices Work-A Brief Explanation - Lipow Oil Associates, LLC.
2. Crude Oil Trading - Hedge Strategy.
3. What Drives Crude Oil Prices - EIA.

Crude Oil Trading

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Oil market overview
This article gives an overview of the oil market and its dynamics. Furthermore, analyzes the types of oils, their characteristics and the factors that can influence the supply and demand and thus the price of the oil in the market.

The world crude oil market:
The oil industry is a global enterprise that employs millions of workers around the world and generates hundreds of millions of dollars. The oil sector, thus, is considered to be the largest in the world in terms of dollar value. In regions which house the major National Oil Companies, these corporations contribute significantly to the national GDP. The main products of the oil industry are constituted by fuel oil and gasoline (petroleum). Petroleum is one of the primary materials for the chemical industry: it is used for pharmaceutical products, plastics, solvents and fertilizers. Oil plays a key role in industrial production and therefore is a resource of critical importance for all the countries in the world. During the last decade, a growing negative sentiment against the oil industry has been emerging. Recent environmental disasters such as the BP oil spill (also referred to as the Deepwater Horizon Gulf Of Mexico Oil Spill) has given a negative spotlight on the whole oil industry. Moreover, the companies working in the oil and gas sector are being threatened by the increasing importance and attention given to renewable and alternative energies. Due to these phenomena, the government is putting pressure on these companies through increased legislations. Despite the increasing negative sentiment, the oil and gas industry is still extremely successful, and is experiencing a strong and rapid growth. It is estimated that the worldwide consumption of oil is 30 billion barrels per year, and this amount is mostly utilized by the developed countries. Moreover, oil also represents the major source of energy consumed around the globe and accounts for 32% in Europe, 35% in Asia, 40% in North America, 42% in Africa, and 51% in Middle East.

read also Crude Oil Price

Major oil futures exchanges Oil is one of the main commodities traded around the world. This section is focused on three among the major exchanges in which a large amount of oil futures contracts are traded.

CME:
The Chicago Mercantile Exchange (CME) was founded in 1895 in Chicago, Illinois, USA, and is one of the most important markets for derivate worldwide. Despite its importance, the CME is not the first American futures market as the Chicago Board of Trade ( CBOT ) was founded in 1848. In 2007 the CBOT was incorporated within the CME Group. In August 2008, the acquisition of the New York Mercantile Exchange (NYMEX) was completed. For a long time the only contracts traded on the CME had underlying assets as agricultural products such as grain, flour bacon etc. We have to wait until 1972 to witness the debut of the first “financial futures”. In that year, futures on seven currencies (British pound, Canadian dollar, German mark, French franc, Japanese yen, Mexican peso , Swiss franc) began to be traded. The development of financial markets in the following years led to an exponential growth of the tools available to operators. Between 1975 and 1977, the CBOT launched the first futures on interest rates. Particularly important was the debut of the contract on T- Bonds, the title of the US government, which quickly became the most traded futures in the world. The period between ’81 - ’82 was also crucial because the CME introduced the contract on Eurodollar deposits and then the first futures on a stock index , the S&P 500. In 1997, the CME opened its doors to private traders thanks to the invention of E-mini S&P 500 futures, contracts of smaller size than the standard, negotiated with margins also accessible to noninstitutional traders. Currently, the range of products traded at the CME Group ranges from futures and options on indices, currencies, interest rate, commodities and derivatives up to the economic indicators (e.g. inflation) and the evolvement of weather conditions. Exchanges at the CME take place in two ways. One being the classic system of “shouting”, in which specialized operators are physically present in the room for negotiation and exchange contracts through a set of codified hand gestures (impossible to do so by voice as this would be too chaotic).

This process was supplemented in 1992 with an online platform that allows traders to operate remotely via dedicated terminals .

ICE
The Intercontinental Exchange Group (ICE), is a complex network composed of clearing houses and exchanges created for financial and commodity markets. The group created in May 2000 is headquartered in Atlanta, Georgia and the ICE actually owns 23 exchanges and marketplaces all around the globe. This network, different from other marketplaces, operates completely as an electronic exchange, which connects firms and individuals looking to trade oil, electric-power, natural gas and general commodity derivatives. Moreover, the ICE also facilitates the exchange of emission (cap-and-trade) and OTC energy exchanges. In 2001 ICE acquired the International Petroleum Exchange (IPE), which is now called ICE Futures Europe. Furthermore, in 2007, the ICE also acquired the New York Board of Trade, that is now known as ICE Futures US.

NYMEX
The New York Mercantile Exchange (NYMEX) is arguably the largest market for the exchange of futures, as well as a major headquarters for the commercialization of energy and precious metals. Among other things, the exchange is also characterized by a major characteristic: the NYMEX stands out for its 135 years history of integrity and transparency in pricing. The transactions that take place here limit the risk of default by the counterparty. Trading relates to energy, metals, futures on environmental goods and some options relating to the system of e-commerce. The NYMEX refers to markets for the exchange of materials such as crude oil, diesel fuel, gasoline, natural gas, electricity, propane, uranium and other naturally occurring assets such as gold, silver, aluminum, platinum. Many varieties of options are available, including, options on the price differential between crude oil and its derived products (or so-called “crack spreads”), monthly futures contracts (better known in the U.S. as “calendar spreads”) and the European and Asian options . In essence the NYMEX offers products that ultimately aim to minimize the risk of default by the counterparty, as mentioned before . Usually, investors who choose to entrust their portfolio choices on the New York Mercantile Exchange are attracted by features such as excellent liquidity, the offering of stocks and bonds. The prices relative to prices in this market are often used as a reference by buyers from sellers who operate in the markets that exchange materials such as energy and precious metals.

Factors influencing the market
 The worldwide oil market is strongly affected by several factors, which can have a dramatic effect on the spot price. This section presents ten main variables that can influence the market.

Read Also Crude Oil Contracts

OPEC
 The Organization of the Petroleum Exporting Countries is a consortium composed of 13 nations: Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. This organization is the largest single entity that can affect, through its choices, the world’s oil supplies. OPEC is accountable for more than 40% of the world’s production of oil. OPEC decides the policy of the member countries in order to meet the global oil consumption. This entity can strongly affect the price of the crude oil, just by changing the production levels among its members.

Supply and Demand
The amount of oil present in the inventories balances the supply and demand. When the production exceeds the amount of the demand, the surplus can be stored. In the opposite way, if the consumption exceeds the demand, inventories can be exploited in order to cover the incremental demand: the strong relationship between oil inventories and oil prices makes corrections in each direction possible. Non-OPEC suppliers produce almost 60% of the global oil and thus outpace the OPEC countries in terms of production by 50%. Despite this difference in production levels the non-OPEC countries do not have sufficient reserves to control the price, and therefore they have only the ability to respond to market fluctuations.

Legislation
As already mentioned during the oil market overview, a vast part of the global oil reserves and production are controlled by companies strongly linked to the government. This means the world oil market is heavily affected by political decisions and so this market is far to be a competitive place. Moreover the variation in energy policy and taxation in oil-rich countries can also influence the world price of oil.

Political unrest
This is another factor that has always strongly affected the price of oil: if an oil-producing nation becomes politically unstable (e.g. Iranian Revolution in 1979), supplier markets react by increasing the prices of oil, so that the remaining supplies are still available to the highest bidder. The shortage in supply does not need be become real, only the perception of a possible decrease in production can drive the price up.

Production costs
Physical factors determine most of the costs of the oil production: from the location of reserves to the characteristics and the property of the oil found, and ultimately to the extraction procedures. Oil is a nonrenewable natural resource, therefore substantial investments are required for the discovery of new reserves and their development.

Financial markets
Oil brokers work as an intermediary to match buyers with sellers of crude oil, one of the major contracts traded are the futures contracts. Futures give the possibility to buyers and sellers to hedge their position against possible oil price fluctuations that could affect their profitability. Oil producers sell oil futures to lock their price for a determined amount of time while the counterpart purchases oil futures in order to receive a future delivery of oil at a predetermined price.

Weather
Being a commodity, the seasonal cycles in weather influences the demand of oil. During the winter, the amount of heating oil consumed increases, while in the summer people use a larger amount of gasoline to travel. Although markets expect those increased demand periods, the oil prices still raise and level out with the changes of the season every year. Beside the seasonality effect, extreme weather conditions can physically affect the production of oil by damaging infrastructures, interrupting supply, and therefore inducing pricing spikes.

Speculators
Speculators can influence the cost of crude oil by buying and selling futures contracts on the open market. This phenomena has a huge impact on the price due to particular requirements applied to these contracts. The speculator is not required to have the total sum required for the transaction, but just a small fraction of it (margin). These low margins requirements create a leverage effect. In recent years, it was believed that speculators were driving up the price of oil to the peak, in 2008, at more than $140/barrel. By the end of 2009, prices fell to $30/barrel as there was not a real demand supporting the inflated price level.

Exchange value of the dollar
Oil is bought and sold internationally using the US dollar currency. A depreciation of the dollar usually tends to raise the oil demand and increase the price of the oil. On the other hand, the appreciation of the dollar decreases the real income in consumer countries, therefore reducing the demand and the price of oil.

Non-OECD demand
While oil consumption in the Organization of Economic Cooperation and Development countries has declined during the last 10 years, the consumption in countries that are not part of the OECD has increased more than 40% during the same period. In particular the countries that registered the highest growth of consumption were China, India and Saudi Arabia.

References:
1. Technical analysis trading strategy - Masaryk University Faculty of Economics and Administration.
2. Oil Market Basics - Office of Oil and Gas, Energy Information Administration.