Driving Forces Behind Crude Oil Prices

Crude oil prices are roaring louder, which is nudging 150 USD per barrel… I always wonder how world decides this price?

How transparent and fair are the driving forces behind sky rocketing pace of oil price rise??

1. A significant percentage of physical oil transactions occur outside the regulated market and beyond the view of analysts and traders.
2. The day’s spot price denotes the price at which a few origins of crude are sold.
3. As the market rarely has real-time knowledge of production and stocks, traders have to place their faith on the figures put out by a few agencies such as Platts.
4. Crude futures do not move exclusively in response to physical supply and demand conditions. They are determined by many factors such as-

• The positions taken by traders in many other assets (for example , bonds, equities, foreign exchange and other commodities)·
• Declining dollar
• Market speculation
• Refinery bottlenecks and geopolitical concerns.

The price of a barrel of oil depends on –

1- Grade (which is determined by factors such as specific gravity and sulphur content)

2- Location.

3- The lighter, sweeter crudes (low sulphur) are easier to refine than heavier, sourer crudes.

With the increase in crude oil prices, even refining heavier, sourer crudes has now become more profitable. Oil prices have risen, particularly for better quality crude oils, to bring supply and demand into balance.

Benchmarks for oil pricing system-

I- Brent - Almost all oil traded outside America and the Far East is priced using Brent as a benchmark.

II- West Texas Intermediate - is the main benchmark for pricing oil imports into the USA.

III- Dubai-Oman -is used as a benchmark for Gulf crudes (Saudi Arabia, Iran, Iraq, the UAE, Qatar and Kuwait) sold in the Asia-Pacific market.

In crude oil, spot contracts mean delivery over the coming month, e.g., a contract signed in June for delivery in July. The market consists of refiners, traders, producers , and transporters. Spot markets allow buyers and sellers, e.g., refiners and marketers, to adjust their supplies to reflect near-term supply and demand conditions. Till the late Eighties, the spot price of reference crude varieties was the accepted price of the day. But when the total production of the benchmark crudes began to drop and the volumes traded daily correspondingly fell, it became difficult to determine the correct price. Price assessing agencies came up with a few solutions. To make up for the drop in Brent production, for instance, in July 2002, Platts broadened its definition of Brent to include Forties (UK North Sea) and Oseberg (Norway). The new benchmark was called BFO.

The more lasting solution was shift to a futures market. Crude futures have two main advantages : one, they are not easily distorted by low spot market volumes. Two, futures price is determined by actual transactions in the futures exchanges and not on the basis of some assessed prices by oil reporting agencies. At any time, a seller or a buyer can look at the prevailing price and use it in spot and term contracts. The volume of daily transactions and open positions also helps investors gauge the liquidity of the market. Since most traders cancel their positions, futures transactions rarely lead to actual delivery.

Though crude futures prices are more transparently fixed than spot prices, not all contracts are successful. A crude oil contract becomes trustworthy only when its production is not controlled by a few companies and it has reasonably large volumes. If a few companies or even one company controls production, then the likelihood of price manipulation rises. Even if the oil pipelines and infrastructure are owned by a few, it increases the likelihood of manipulation.

(Source: ET)