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How World Oil Markets Work

Crude Oil Types

Crude oil is arguably the world's most important and actively-traded commodity. Oil trades in a world market, and every barrel of crude oil is bought and sold in relation to global prices. Because there are many different varieties and grades of crude oil, buyers and sellers have found it easier to refer to a limited number of reference, or benchmark, crude oils. Other varieties are then priced at a discount or premium, according to their quality. The type of crude oil that is used as a benchmark in North America is West Texas Intermediate (WTI) oil, which is a light, sweet (low sulphur) crude. This is the price that is usually quoted in newspaper articles. Light sweet crudes sell at higher prices than heavy sour crudes, which are more difficult and expensive to refine and yield less of the more valuable oil products such as gasoline and jet fuel.

The Oil Producers

The largest oil producers in the world are state-owned national oil companies (NOCs) and large integrated private sector energy companies. Eight of the ten largest oil producers in the world are NOCs. Furthermore, nine of the ten biggest oil reserve holders in the world are NOCs. Many of these were formerly private sector companies that were nationalized in the 1970s. There is a great deal of corporate concentration in the world oil industry: just ten companies control 68 percent of the world's proven oil reserves.

In September 1960 four Persian Gulf nations (Iran, Iraq, Kuwait, and Saudi Arabia) and Venezuela formed the Organization of Petroleum Exporting Countries (OPEC) with an eye to obtaining stable prices for crude oil. By 1973, eight other major oil producing nations had joined OPEC. In 2004, OPEC produced about 33 million barrels per day (MMB/D) of crude oil and NGLs (natural gas liquids) or about 40 percent of the world's supply of oil. Most of the world's proven oil reserves are controlled by OPEC member countries (69.3 percent).

World Oil Production and Consumption

In 2004, world oil production was 83.1 MMB/D with about 48.1 MMB/D of this oil exported to various countries around the world. Exports are transported to the market using a variety of means including tankers, pipelines, trains, trucks and barges. When the crude oil reaches its destination it is processed and refined into petroleum products such as gasoline, heating oil and jet fuel. The price of crude oil is reflected in the price of these refined products. However, oil product prices are also affected by other factors, such as refining and marketing operating margins, taxes, transportation costs and local/regional market conditions and competition. In turn, oil product prices and pressures feed back into crude oil prices.

The main consumers of oil continue to be the industrialized countries of the Organization for Economic Cooperation and Development (OECD), particularly the US, Europe and Japan, which together consume about half of the world's annual oil output. However, consumption in emerging market regions is expanding at a faster pace (especially in China and India) as these countries grow rapidly and their use of energy in transportation, industry and residential sectors expands. The transportation sector accounts for about two-thirds of the oil consumed in the United States and around half of the oil used in the world.

Crude Oil Prices

The price of oil is set in the global marketplace. The two key oil commodity markets in the world are in New York and London. Prices are determined every day at the NYMEX (New York Mercantile Exchange), based on contracts between buyers and sellers of oil. In the NYMEX and London's IPE (International Petroleum Exchange) about 200 million paper barrels of oil are traded per day. This is more than twice the world's actual production. It is possible to trade more oil on petroleum exchanges than actually exists in the world because these "paper transactions" are settled with cash long before the delivery dates. About 95 percent of oil traded on the NYMEX never shows up as physical product. Most contracts in the futures market are for near-terms months. This means that prices reflect expectations about future supplies and their potential impact on prices.

In the futures market, the buyers and sellers can be real producers and users of oil, or commodity traders who buy oil as a long-term investment or a short-term bet. Commercial traders are producers and users (refiners, airlines) of oil who use the futures market to guarantee steady revenue and cost certainty, and protect against fluctuating prices. In contrast, speculators or non-commercial traders are neither producers nor users of oil and include investment banks, hedge funds and other financial investors in the stock market who use the oil paper market to spread risks and diversify their investments.

In the last two years the price of WTI crude oil has doubled from US$30 in the third quarter of 2003 to over $60 in the third quarter of 2005. Commercial oil traders have been concerned with a variety of issues like OPEC spare capacity levels, strong demand growth in China, refining capacity levels, and hurricane and terrorist activity. Speculation, pessimism and geopolitical concerns about major oil producers like Saudi Arabia, Iraq, Iran, Nigeria, Russia and Venezuela have also contributed to the rise in prices. A large increase in speculative paper trades has corresponded with the rising price of oil (but whether in leading or following it is impossible to tell). It is fair to say that geopolitical concerns and speculation have had a role in upward pressure on oil prices.

No one knows if $60 oil represents a bubble or a new price paradigm. But oil markets and prices have always been cyclical, and today's risk premium could disappear if global uncertainty in the oil market eased. On the other hand, prices could remain higher than the 1985-2001 range of around $20 per barrel since oil demand and global economic growth, while much lower in 2005 than in 2004, have remained relatively strong despite higher oil prices.