Crude oil is a natural petroleum product obtained from drilling in the Earth’s core. It is composed of organic matter and hydrocarbon, and used as a fossil fuel.
In a refinery, crude oil is distilled by heating it to break it up into different components. It is refined to produce products such as gasoline, diesel, kerosene, and petrochemicals that we use in society everyday.
Uses of Crude Oil
Crude oil is used in many products including:
1. Transportation Fuels
– Gasoline used in vehicles
– Diesel used in trucks, buses, trains, and factory & farm equipment
– Aviation fuels used in aircraft
2. Plastics
Crude oil is refined to produce plastics products, which we use everyday. Plastics are used in solar panels, food preservatives, eyeglasses, DVDs, toys, and tires.
3. Household Products
– Construction materials such as roofing, housing insulation, and paint
– Home decor products such as pillows, curtains, carpets, and house paint
– Kitchen products such as dishes, cups, pans, and dishwashing liquids
4. Clothing
Clothing and shoes are made from petroleum-based fibers including acrylic, rayon, leather, polyester, and nylon.
5. Electronics
Due to its insulating and heat-resistant properties, plastics and petroleum-based products are used in electronics such as smartphones, television sets, computers, and cameras.
6. Health and Beauty Products
Petroleum products are used in perfume, cosmetics, hand lotion, toothpaste, soap, deodorant, and shampoo.
7. Sporting Goods
Petroleum products are used in sporting goods such as basketballs, golf balls, helmets, and tennis rackets.
8. Medical Supplies
Plastics are used in medical devices and petrochemicals are used in pharmaceuticalssuch as aspirin, antihistamines, dentures, and hearing aids.
Oil and the Global Economy
Because of the large number of uses of crude oil, it is a critical part of the global economy.
A few countries hold, produce, and supply the majority of crude oil to the global economy. These producers include the United States, Saudi Arabia, Canada, Venezuela, and Russia, among many others.
In 1960, a collection of the world’s biggest holders of crude oil and natural gas reserves came together to form OPEC which stands for Organization of the Petroleum Exporting Countries.
OPEC controls oil output volume, and therefore, the price of oil, which we will discuss below.
Because of the ubiquity of petroleum products in everyday life around the world, oil prices affect the health of the global economy.
If oil prices rise, the cost of living rises as everyday products become more expensive. And the cost of fuel which is used to transport people and goods around the world also increases. Overall, life becomes more expensive for us all.
But what drives oil prices?
Oil Prices
In the early 1900s, crude oil replaced coal as the world’s main source of fuel. And fuel is still the primary use of oil in the global economy.
Like every other product, oil prices are driven by Supply and Demand, as well as Human Emotion.
Oil Futures Contract
There is a sophisticated market of traders (hedgers and speculators) that set the global oil price. They operate primarily in the oil futures market.
An oil futures contract is a binding agreement that gives a buyer the right to purchase oil by the barrel at a predetermined price at a predetermined date in the future. Thus, at the predetermined date, the seller must sell to the buyer at that agreed upon price regardless of what the market price is at that time.
The futures contract is signed between a buyer and seller and the buyer makes a margin payment of a percentage of the value of the contract to secure the contract.
The nearest-date futures contract or front-month contract is the most actively-traded type of contract.
Oil Spot Contract
The price in a futures contract details the price at which a buyer has agreed to pay for oil at a delivery date in the future.
On the other hand, a spot contract details the current market price of oil. This is today’s transaction. The buyer pays today and the seller initiates the delivery today.
As most traders are speculating on the price of oil in paper transactions, they do not take delivery of the actual physical product. Therefore, futures contracts are the more popular trading instrument of traders as traders can sell or roll over their futures contracts before the future delivery date.
Oil Market Benchmarks
Traders monitor two key benchmarks on global exchanges in order to make trading decisions.
North America – West Texas Intermediate (WTI) crude, which trades on the New York Mercantile Exchange (NYMEX) and is sensitive to the North American economy.
Europe, Africa, and the Middle East (EMEA) – North Sea Brent Crude, which trades on the Intercontinental Exchange (ICE) and is sensitive to the EMEA economy.
Futures Price versus Spot Price
If the futures contract price is higher than the spot price, this tells the trader that the market expects the oil price to increase in the future. This is called contango.
If the futures contract price is lower than the spot price, this tells the trader that the market expects the oil price to decrease in the future. This is called backwardation.
Hedger
Why would a trader agree to an oil price in advance of the date when he wants to pay for that oil?
This can be answered with an example. Imagine a commercial airline that regularly purchases aviation fuel for its aircraft. Because of the unpredictable nature of the price of oil, it is in the airline’s best interests to establish a fixed price for its oil so it can manage its fuel costs in a predictable manner. Or to buy a hedge against a future increase in the price of oil.
As such, the airline could buy oil futures to hedge against potential rising prices.
Speculator
Speculators provide a ton of liquidity in the market but do no actually sell or receive physical oil. They simply trade paper contracts that guess the price direction of oil.
Human Emotion
Commercial transactions are, of course, always driven by two key human emotions of Fear and Greed. Oil prices are are also driven by human emotion or market sentiment.
If the market feels that the price of oil will or should rise, then the market participants will rush in to buy futures contracts and the oil price will inevitably rise.
If the market feels that the price of oil will or should drop, then the market participants will rush to sell futures contracts and the oil price will inevitably drop.
Actual Supply versus Actual Demand
Because crude oil is a finite resource found in the Earth’s core, even if it is available, its supply is not always guaranteed or economical.
Crude oil is only useful if it can be extracted and refined. Therefore the number of refineries available to refine crude oil is as important to oil supply as the volume of crude oil available.
OPEC Oil Cartel
The oil industry is one of the few sectors where cartels are legally allowed to control and fix prices. The OPEC cartel effectively controls the price of oil regardless of the level of global demand for oil. OPEC controls the price of oil by controlling the supply of oil.
OPEC consists of 13 countries that control over 40% of the global oil supply. OPEC consists of Algeria, Angola, Congo, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Saudi Arabia, United Arab Emirates, and Venezuela.
OPEC can direct the oil output of its members and determine oil prices. It can restrict production and increase the oil price almost unilaterally.
OPEC aims to keep the price of oil at above $100 a barrel. But due to other market forces at play, and about 60% of global oil supply out of its control, OPEC cannot realistically achieve this objective whenever it wants.
There are large oil producers such as the United States, Canada, and Russia that are not members of OPEC who produce oil at their own supply levels without following OPEC guidelines.