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The past year or so has been a time of constant flux for the price of gasoline, diesel fuel and many other commonly used fuels derived from petroleum. I am sure that most readers have at some point turned on the news to hear that the price of oil went up or down rather dramatically. Then the news media attempts to explain how and why the price of a barrel of oil has changed by bringing an economist on the air who then spews out a slew of terms that make absolutely no sense to the rest of us. In this piece, it is my hope to explain exactly how the price of oil works and how it relates to those of us who do not have a PhD in economics.
Market Basics
In its natural form just out of the ground, crude oil is “packaged” into barrels (U.S. 42 gallons, the world standard) and shipped to the nearest refinery to be converted into various forms of usable fuel. Crude oil has many grades, but as discussed below, the most prized is light sweet crude. Organizations such as Brent set world benchmarks on the quality of oil, which in turn sets a range of prices.
What the average Joe needs to understand is that prices the consumer eventually pays for converted fuel is highly dependent upon what futures traders are paying per barrel. Futures traders are somewhat similar to stock traders, except they deal in futures contracts. A futures contract is not like stock in that the contract has an expiration date, while stock does not. That is to say, you can hold onto stock for as long as you want, while futures traders have to sell the contract when it is set to expire.
Put simplistically, a futures contract is originally held by a seller, whom in this case, typically has X amount of barrels of oil for sale within the contract. A buyer then comes along and agrees to purchase the contact for a fixed price when the contract expires. You must be asking yourself, “Where is the profit if the price is fixed?” The profit (or loss) is incurred by the seller of the contract, as market forces, such as The Organization of the Petroleum Exporting Countries (OPEC), are still in control of quantity and price (to a degree).
For example, if the seller has sold the contract for a fixed price, he or she is now hoping that oil exporters raise the price that they charge for oil so they can incur a profit on the contract that they are about to sell. Say I purchase a contract at a fixed price of $110 a barrel and there are 5000 barrels in that contract. I will pay $550,000 (US) for the contract when it expires. However, the seller makes a profit if OPEC decides to raise certain rates that drive the price to $130 a barrel, which in this case, nets the contract owner a $100,000 profit.
Market Basics Related To Oil And The Effect On Your Wallet
To keep this as simple as possible, I will shy away from clearing houses, long and short hedging, option writing and other various processes, as explaining those terms would constitute writing a small book! In sticking with my previous example, I now own a contract for 5000 barrels or 210,000 gallons of oil. I now need to find someone that needs 210,000 gallons of oil, which in this case, would be a large oil corporation who has the facilities to refine the crude oil. I also need to incur a profit to get back my $550,000 and then some. While in the possession of my contract, I would have hired a brokerage firm to handle the sale or potentially resell the contract for a profit. In this case, my firm has found a buyer in the form of a large oil corporation who agrees to pay me $700,000 for the 210,000 gallons.
From here on, oil is no different from other commodities that we purchase in stores. The large oil corporation needs to send the oil off to be refined, transported to a gas station and sold (the gas station owner also needs to incur a profit). Besides the point of sale, all of this costs money and there are hidden costs that are also passed onto the consumer (for example, the extra $150,000 the oil company paid to buy my 210,000 gallons). That, ladies and gentlemen, is, in a nutshell, how the price of oil works in relation to what we pay for it at the pump.
Stay Informed
For those of you who are interested in keeping an eye on the price of a barrel of oil, check out the New York Mercantile Exchange (www.nymex.com) and search for ‘CL’. Crude oil is not traded on the ever so familiar New York Stock Exchange (NYSE), which houses the DOW Jones Industrial companies. Instead, NYMEX handles the trading of energy related materials and precious metals. CL is the symbol for the above-mentioned light sweet crude oil (it is called sweet if there is less than .5 per cent sulfur). There individuals can view a variety of free charts and graphs concerning the present and future prices of oil. For those who want more information on oil and other sources of energy, check out Canada’s Centre of Energy website at (www.centreofenergy.com) or the U.S. Department of Energy’s Information Administration (www.eia.doe.gov).
Sources:
news.bbc.co.uk
tfc-charts.w2d.com
www.nymex.com
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