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How the Crude Oil Market Works


Crude Oil Futures
Traders work on the crude oil options pit at the New York Mercantile Exchange on March 11, 2009.
Traders work on the crude oil options pit at the New York Mercantile Exchange on March 11, 2009.
AP Photo/Mary Altaffer

Similar to the stock market, which involves trading investments in various companies, people also trade in commodities at financial markets.

They purchase "futures" -- a sort of bet on whether a commodity will increase in price at a later date. Once locked into a futures contract, the buyer will get his or her commodity at that price, regardless of whether the market price has changed or not later down the line. These futures are traded in the New York Mercantile Exchange (or NYMEX), as well as the International Petroleum Exchange.

Commodity trading has been getting bigger than ever in recent years as a response to the dot-com crash of the early 2000s. Some financial analysts say it's more of a certainty than trading in the price of the dollar or gold. However, as result, speculation has come to shape the price of commodities like oil more than ever before.

Commodity futures have a surprising effect on crude oil prices -- speculators who buy large amounts of futures can swing the price one way or another. Here's an example: A speculator who buys oil futures at higher than the current market price can cause oil producers to horde their oil supply so they can sell it later at the new, higher "future" price. This cuts the current supply of oil on the market and drives up both present and future prices.

While it may seem unfair that speculators have so much sway over the oil market, keep in mind that speculation is a part of any financial system, and stock investments are an act of speculation in and of itself. When you buy stock, you're speculating on a company's future [source: Murphy].

Also, government regulation comes into play, keeping the speculators from going completely out of control. In the U.S., the Commodity Futures Trading Commission (CFTC) was established during the 1970s oil crises to head off speculation that artificially drove up the price of oil.

Over the past few decades, however, the CFTC lost most of its regulatory power -- especially during the economic boom of the 1990s. But as oil prices spike higher and higher, Congress has shown more interest in allowing the commission to have increased oversight over oil prices.

For more information about the crude oil market and other related topics, follow the links on the next page.