It’s hard to go more than a few days without seeing something in the news about oil. For better or worse, crude oil underlies the entire global economy. It powers our cars, it’s used to pave our roads, and even the waste product of oil refining (petroleum coke) is used in aluminum smelting.
A recent AP report shows that the “price of oil extended losses below $99 per barrel” on Tuesday, October 22nd. What’s misleading about that number is that oil is much like wine, with many “flavors” and “qualities.” As such, having one number describe the price of oil is unsatisfying. Let’s unpack what the pundits mean when they talk about “the price of oil” and then we’ll examine why there has been a recent decline.
The popular oil price that is tracked by all major news organizations in the U.S. is actually a contract for future delivery of a very specific type of crude oil. This “futures” contract is for 1,000 barrels of West Texas Intermediate (WTI) crude oil. The reason why it is always that specific volume of that specific product is because it is traded on the New York Mercantile Exchange (NYMEX). If a contract is openly traded on an exchange, it has to be totally “fungible” or exactly the same every time. Most of the activity on the NYMEX is not between companies that actually plan to “take delivery” of the oil in the contract. It’s more often the case that companies settle the contract (by taking an equal and opposite position) or they sell it to a company that actually needs 1,000 barrels of physical oil.
However, because the WTI contract is very close to the market, it is used in many large oil deals as the pricing benchmark. For example, let’s say Company A plans to buy one million barrels of oil from Company B. Rather than simply setting a fixed price (say $50 per barrel), Company B would write a contract for one million barrels at WTI + $x per barrel on the day the product changed hands.
Now you’ll know that when someone talks about the price of oil, they are referring to a very specific entity.
Supply and Demand
During the Nixon administration, there was an oil crisis because the Organization of Arab Petroleum Exporting Countries (OAPEC) launched an embargo against the U.S. for its support of Israel during the Yom Kippur War. There was another large oil price fluctuation in 1979 in the wake of the Iranian Hostage Crisis: this time there was no embargo, but Iranian oil exports plummeted during the period. In both cases, kinks in the availability of oil caused the price of oil to skyrocket. These events, along with countless other examples, lead us to the reason why oil prices fluctuate: supply and demand.
Although global oil inventories don’t fluctuate daily like the WTI price, violent market fluctuations often reflect the future outlook of oil availability. The most recent downward swing in the price of oil is the result of two large factors.
First, after furloughed government employees returned to work this week, a report was released that showed the U.S. supply of crude rose by 4 million barrels in the week ending October 11 (supply up). Incidentally, this is the highest inventory level in October since 1930. Second, we are coming into the winter season when gasoline demand from U.S. motorists is traditionally lower than in summer months. Furthermore, this is the time when refineries in the U.S. typically close down for maintenance, lowering crude demand even further.
This article was written by Roger Sard. He likes to stay current on the oil industry prices and enjoys sharing this information with his readers. Click here for more information on the oil business.