In the first eight months of 2004, crude oil has soared 44 percent to never-before-seen levels, with analysts predicting that $50 a barrel is now possible - even likely. These prices are determined in the global oil market, which matches supplies and demand through a complex trading structure.
The world’s big oil companies do not totally control their own oil from the well to the petrol pump. So, companies need places where they can sell the oil they have and buy the oil they need. The two most important ones are the New York Mercantile Exchange – called “the Merc” – and the International Petroleum Exchange in London.
Traders have two markets to work with – the “spot” market, where oil can be bought for immediate use, and the “futures” market, where oil is purchased for delivery and use some time in the future. Ben Brockwell, with New Jersey-based Oil Price Information Service, explains the vital role played by the spot market. “We have a spot market" he says "because it augments the world’s supply of fuel. It helps the markets to stay in balance.” Simply put, a refiner running short on crude oil can buy more on the spot market. Conversely, a supplier with too much oil can unload it there.
The other market is for futures – oil needed tomorrow, not today. Oil trader Steve Bellino, Senior VP at FIMAT USA, says futures exist as a means of controlling costs and ensuring that oil will be available. He tells VOA “People buy and sell futures based on their need and their perception of what prices are going to be down the road.”
Ben Brockwell at OPIS provides an example of how one end user of oil buys and then sells futures contracts to control both present and tomorrow’s costs. “Southwest Airlines locked in the price of their crude oil on the futures contract four years in advance at an average cost of $25 a barrel," adding "So, now they’re able to convert those contracts at $45 a barrel, take the $20 profit, and pay for the more expensive jet fuel that they’re now facing in the marketplace.”
Oil industry analyst Philip Verleger says when futures prices go up, those selling on the spot market believe their oil is also worth more. Mr. Verleger commented “(A)buyer’s worry about the price of oil to be delivered in ’06 is actually raising the price today.”
Also, news developments affect the oil market. For instance, news about changes in OPEC production, about a pipeline or refinery explosion, or new discoveries cause prices to go up or down.
The U.S. dollar is yet another factor impacting the oil market. Oil is sold worldwide in dollars, and so long as that currency remains stable, it by itself does not impact prices. But when the dollar’s value falls, as it has in recent years, oil producers want to retain a level value for what they pump out of the ground and subsequently demand higher prices.
To complicate matters even more, the oil market is not just for oil producers and end users. A great deal of activity at the New York Merc and the London Exchange comes from speculators and hedge fund managers who are buying and selling oil purely for profit. American Petroleum Institute chief economist John Felmy says the impact of these players is significant. “These participants are very large." He also asserts "They have a huge amount of financial resources to be able to participate in the market, and they can clearly move the market up or down dramatically.”
In fact, analysts say that in futures contracts, only about two percent of the activity actually results in the delivery of oil. The rest are only paper contracts bought and sold on a speculative basis, much the same as gold or wheat.
While the oil market has been surging upwards for more than a year and a half, history has shown that prices also go down, such as in the aftermath of the 1991 Gulf War. Oil trader Steve Bellino describes a simple economic rule that could reverse the market’s present course. In his opinion, “The one thing to stop high prices is high prices. It’ll get to the point where it will start slowing down economic growth around the world. And then these speculators will realize that demand is waning, that prices can’t remain at these lofty levels, and they will exit. And, you’ll probably see a good selloff. But from what level is the question."
So, the global oil market indeed has a number of components constantly interacting to determine the present and future price of oil. Ultimately, however, it’s subject to the basic law of economics regarding supply and demand. And, while a surging market enriches producers at the expense of end users, a falling market triggered by recession hurts everyone. It’s a delicate balance.