How the Crude Oil Market Works


An Indonesian worker walks on barrels of oil at a distribution station of the state-owned oil company Pertamina in Jakarta, Indonesia, on June 24, 2005. See more oil field pictures.
AP Photo/Tatan Syuflana

Unless you're an oil company executive or the ruler of a petroleum-exporting Middle Eastern nation, hearing "The price of a barrel of oil went up today…" on the news is rarely a good thing. Most of us know what that kind of news means: higher gasoline prices.

But how does a barrel of oil from Saudi Arabia or Iran determine how expensive our gasoline is? That's because the barrel is a part of the crude oil market, which has a major effect on gas prices. Crude oil is the "black stuff" that comes out of the ground, also known as petroleum. It's made up of a variety of elements like carbon, hydrogen and sulfur, and originates from the remains of animals and plants that existed millions of years ago -- hence the term "fossil fuel."

However, crude oil in its purest form is of little use to anyone. People must refine it in order to produce energy, a process that creates gasoline, diesel fuel, kerosene and other products. The completed petroleum products later end up in places like gas stations and factories all over the world.

But what causes the price of oil to go up and down? Why doesn't the cost of gasoline stay at a constant level? That's because crude oil is a "commodity," a product that is generally the same no matter who or what produces it. Other commodities include corn, coffee beans and raw materials like gold and copper.

The prices of commodities are always in flux because they depend on worldwide supply and demand. When ethanol fuel started becoming a popular alternative fuel option in vehicles, the price of corn -- from which ethanol can be produced -- spiked. As another example, you may hear on the news about an oil refinery explosion where a supply of crude oil is compromised. This will cause the price of oil to increase.

There's also the international commodities market, where investors hedge bets on how much they think the price of oil will increase or decrease down the road. Speculating over the price of oil also has a lot to do with how much it costs.

Sound confusing? It can be, since the truth is there are many, many factors that determine how much a barrel of liquefied dinosaur bones will cost when it ends up in your car.

In this article, we'll take a look at the crude oil market -- where the supply comes from, who prices it, and how that translates into what we pay at the pump.

Crude Oil Pricing

Gas pumps at a Mobil gas station in New Haven, Conn., on May 20, 2008, reflect soaring gas prices.
Gas pumps at a Mobil gas station in New Haven, Conn., on May 20, 2008, reflect soaring gas prices.
AP Photo/Jennifer Graylock

When U.S. gas prices hit their peak in 2008, and everyone was paying around $4 per gallon (about $1.05 per liter) at the pump, the price of a barrel of oil spiked to $145. Yet by fall of 2009, it had lowered to around $69 [source: Murphy]. But what exactly is a barrel of crude oil, anyway, and what does it really mean for gas prices?

There are 42 gallons (159 liters) of oil in a barrel. And roughly 1 gallon (about 3.8 liters) of crude oil can be made into between .47 and .67 gallons (1.78 and 2.54 liters) of gasoline, depending on the refiner and the quality of the crude oil, among other factors [source: Suermann]. While the contents and size of a barrel of oil remain constant, the price it commands on the international market can change quite often.

Four major factors help determine the price of oil: supply, consumption, financial markets and government policies [source: Murphy].

Basic economics teaches us that a high supply of oil means demand is low, which means that the prices will be low, too; the inverse, that a low supply increases demand and raises prices, is also true. However, oil pricing goes far beyond just supply and demand -- if only it were that simple!

The way oil is traded on the financial market has a massive influence on its price. Speculators invest in oil futures, essentially bets on how much oil will cost at a later date, and this in turn affects how other people think oil should be priced. It also affects how much oil the petroleum companies will release to the market. We'll discuss more on oil futures later.

Government regulation also has a big effect on oil prices. Recently passed rules on sulfur content could raise the demand for sweet crude oil -- a type of crude oil with less sulfur -- but sweet crude oil is less common than other types of oil. And laws aimed at preventing climate change will likely raise the price of energy, too [source: Murphy]. Taxes on gasoline can also affect prices.

At the same time, the government continues to find ways for people to switch to power sources like wind and solar energy -- and drive more fuel efficient cars -- so it's possible that the demand for oil will go down, simply because we won't need it as much anymore. Most analysts believe that's a long way off, however.

In the next section, we'll look at where the world's supply of crude oil comes from, and how wars in the Middle East affect the cost of your commute to work.

Crude Oil Supply

On June 1, 1973, Leon Mill spray paints a sign outside his Phillips 66 station in Perkasie, Pa., to let his customers know he is out of gas.
On June 1, 1973, Leon Mill spray paints a sign outside his Phillips 66 station in Perkasie, Pa., to let his customers know he is out of gas.
AP Photo

We really depend on crude oil in modern society, but where exactly does it come from? Oil is made of compressed hydrocarbons, the remains of prehistoric animals and plants placed under extreme pressures and temperatures in the Earth's crust. Hydrocarbons take many forms, including coal, natural gas, crude oil and even diamonds [source: Energy Information Administration].

We can find oil supplies just about everywhere in the world, but some areas are more abundant than others. Countries in the Middle East, including Saudi Arabia, Iraq, Iran and others, have massive supplies of oil and are the world's leading oil exporters.

Other countries have strong supplies, including Russia, Venezuela and even the United States. The oil found in Texas in the early 20th century resulted in a significant economic boom for that region. In fact, North America is currently the world's second-largest oil producer [source: Energy Information Administration].

Groups like OPEC -- the Organization of the Petroleum Exporting Countries -- monitor their oil supply and can ration it out as they see fit, which sways the supply and price of oil. This is what led to the "gas crisis" of the 1970s: the Middle Eastern members of OPEC decided to "punish" Western nations for their support of Israel in the war in which the latter was attacked by Syria and Egypt. They imposed an oil embargo, and the result was a drastic upswing in oil prices. A severe recession ensued where gas prices in the U.S. rose from 30 cents per gallon (about 7 cents per liter) to about $1.20 per gallon (about 32 cents per liter) at the height of the crisis [source: Trumbore]. Geopolitical crisis', especially in volatile places like the Middle East, can have a big effect on gas prices in the United States.

Another thing to remember about crude oil and fossil fuels is that they are a non-renewable source of energy. This means that the world is slowly but surely running out of its supply of oil, and once it's gone, it's gone. After all, we can't wait around another few million years for animals to fossilize and become liquefied, can we?

While it's tough to know just how much oil is left in the world, more and more governments and businesses are looking into sources of renewable energy. This includes sources we can never really run out of, including wind, solar power and even heat from deep inside the Earth's core, just to name a few.

As our crude oil supplies dwindle, we know the short supply will make the demand increase -- and the cost will go along with it.

Up next, we'll examine how oil is traded in commodities markets, and how people make money by betting on its future price.

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.

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Sources

  • Energy Information Administration. "Supply." (Sept. 30, 2009) http://www.eia.doe.gov/pub/oil_gas/petroleum/analysis_publications /oil_market_basics/supply_text.htm
  • Energy Information Administration. "World Oil Reserves by Region." Jan. 1, 2005. (Sept. 30, 2009) http://www.eia.doe.gov/pub/oil_gas/petroleum/analysis_publications /oil_market_basics/sup_image_reserves.htm
  • Murphy, Cait. "Why Do Oil Prices Swing So Wildly?" CBS News. Sept. 1, 2009. (Sept. 30, 2009) http://www.cbsnews.com/blogs/2009/09/01/business/econwatch/entry5279365.shtml
  • Suermann, John. "Ask a Scientist." Newton. (Sept. 30, 2009) http://www.newton.dep.anl.gov/askasci/gen99/gen99675.htm
  • Trumbore, Brian. "The Arab Oil Embargo of 1973-74." BuyandHold.com. (Sept. 30, 2009) http://www.buyandhold.com/bh/en/education/history/2002/arab.html