How World Oil Markets Work

Summary

Several key factors influence the global oil market, including the types of crude oil, the players in the oil market, supply and demand for crude oil, and the price of oil. All have a direct impact on the prices consumers pay for gasoline, diesel fuel and other oil-based products.

Crude Oil Types

Crude oil is arguably the world's most important and actively-traded commodity. Oil trades in a world market, and 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 how their quality compares to that of the benchmark. 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 crude oils sell at higher prices than heavy sour (high sulphur) 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 Players

Oil Producers

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

Since 1960 the world oil market has been significantly influenced by the Organization of Petroleum Exporting Countries (OPEC). The goal of OPEC is to stabilize oil prices by adjusting their production levels and influencing the world's oil supply and demand balance. There are currently eleven members of OPEC, most of which are located in the Middle East and Africa. OPEC countries control close to 70 percent of the world's proven oil reserves and in 2005 accounted for about 41 percent of the world's supply of oil.

Canada holds the second largest oil reserves in the world, with over 178 billion barrels of oil. Over the next decade, Canada's importance as a leading oil producer is expected to increase, as oil sands production is projected to triple. Other key non-OPEC producers include: Russia, the United States, Mexico, China and Norway.

Oil Consumers

Oil refineries are the primary users of oil. They convert crude oil into useable petroleum products such as gasoline, diesel, jet fuel and home heating oil. The refining industry's need for crude oil is driven by the demand for these products. The main consumers of oil continue to be the industrialized countries of the Organization for Economic Cooperation and Development (OECD), particularly the United States, 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) as these markets 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 used in the world and for about half of the oil consumed in the United States.

Oil Traders

Oil is a commodity that is widely traded around the world. Similar to other commodities, like coffee and soybeans, oil attracts investors who see an opportunity to make money by speculating on its price volatility. These traders are not generally involved in the actual production or use of oil - they buy and sell paper contracts, not actual oil - but can often have a significant influence on market prices.

Oil Supply and Demand

The price of oil has traditionally been determined by how closely supply and demand match each other. When there is more supply than consumers want, they can shop around for the best price leading to lower prices. If demand is higher than the amount available, consumers will compete with each other, bidding for the supplies they need driving prices up.

However, it is not only the current supply/demand balance that determines market prices. Buyers and sellers also factor in what they expect will happen to prices in the future. If buyers think that supply might be lower in a few weeks or months and the price could go up, they will want to stockpile some oil now and might even be willing to pay a premium today to protect against a higher price in the future. Similarly, if buyers think that the supply of oil will increase in the future or that the price can be expected to decline soon, they will delay their purchases as long as possible or demand a discount on the price.

Crude Oil Prices

The price of oil is set in the global marketplace. Oil is traded widely all around the world and can move from one market to another easily by ship, pipeline or barge. Therefore, the market is worldwide and the supply/demand balance determines the price for crude oil all around the world. If there is a shortage of oil in one part of the world, prices will rise in that market to attract supplies from other markets until supply and demand are in balance. If there is a surplus in a region and the price drops, buyers will soon be drawn to that market. This explains why crude oil prices are similar all around the world. Prices vary only to reflect the cost of transporting crude oil to that market and the quality differences between the various types of oil. The global nature of the market also explains why events anywhere in the world will affect oil prices in every market.

In addition to all of the actual barrels of oil that are traded, there is a second market that trades in "paper" barrels. This simply indicates that oil is traded on "paper" based on a perceived monetary value of oil and there is not usually a physical exchange of the product. The two key markets where paper barrels of oil are bought and sold are in New York, on the NYMEX (New York Mercantile Exchange), and in London on the IPE (International Petroleum Exchange). In these futures markets, paper contracts for oil are bought and sold based on the expected market conditions in the coming months, or even years.

There are two types of buyers and sellers in the futures market: those that are actual producers or users of crude oil and those who buy futures contracts as an investment, without any intention of ever taking possession of the actual crude oil. The first group use the futures market to protect themselves from price volatility by locking in either their costs or their revenue. The second group are investors who can make money by correctly guessing whether prices will increase or decrease in the future.

In the spot market, oil is bought and sold for cash and delivered immediately. The current spot price for oil is influenced by the futures market price because the futures price represents the market's collective view, at a given point in time, of where prices may be headed.

The media most often quotes the futures market price in the nearest month as representative of the current price of oil.