Oil market and price

Summary: Oil prices are formed on oil markets. Although markets have diminished the threat of physical supply shortages, they are accompanied by worries about rising and more volatile oil prices.

The price of oil is probably the most cited, commented upon, and observed price in the world. However, while reference to the “oil price” suggests a homogeneous price and a single market, neither of these actually exists: There are a variety of different crude oils and there are several ways of trading oil—for example, by making long-term contracts on the global oil market. In the oil trade, these global markets have gained great importance over the decades. There are spot, forward, and future markets. Oil markets have eased worries about energy security in the Western world. They provide the opportunity to obtain petroleum in a flexible and timely manner. On the other hand, the growing importance of oil markets has led to new vulnerabilities; the risks of rising and volatile prices have, to a great extent, replaced the risk of physical shortages.

Instead of only one oil price, there are many prices in the oil trade. The term crude oil refers to a variety of fossil, mineral liquid hydrocarbons. According to the Energy Charter Secretariat (based on the 1991 Energy Charter Agreement, which established a multilateral framework for energy trade), there are 130 crude grades worldwide. When traded, the prices of these oils are usually strongly related to the prices of particular benchmark crudes. Since the 1980s, three major benchmarks have emerged: Brent for North Sea oil, West Texas Intermediate (WTI) in North America, and Dubai crude in the Middle East. Given the functional similarity of different crudes, price differences between crudes appear to be relatively small compared to their shared overall price developments. Despite the great variety of crude oils in practice, it might therefore be legitimate to talk about the “oil price” not as a concrete price but as a broad category.

It took several decades of international oil trade before this market emerged. The initial years of international oil trade were dominated by the North American and European oil companies that started to develop and exploit petroleum resources in various regions of the world. These major companies, often referred to as the Seven Sisters, dominated oil trade until the producing states began to nationalize domestic production sites and determine the conditions of oil sales, particularly during the early 1970s. With nationalization, pricing power shifted from the companies toward producing countries. In 1973, Middle Eastern oil producers raised the oil prices unilaterally for the first time. During 1970s, crude oil from the Organization of Petroleum Exporting Countries (OPEC) was then sold at an official price determined by OPEC. Under both the dominance of the Western companies as well as producing states, oil was commonly sold on the basis of long-term contracts.

The spot market for oil emerged slowly. Before the events of the early 1970s, less than 5 percent of global oil was traded on this market. However, in response to the first oil crisis of 1973, Western oil companies started to develop oil resources in countries that were not OPEC members. Most of that oil was subsequently traded on the spot market, and by the mid-1970s up to 15 percent of global oil trade was processed on that market. The price pressure from this additional oil forced OPEC to cut production levels significantly to sustain its selling price. Saudi Arabia alone cut production volumes from 10 million to only 3.5 million barrels per day. In 1986, Saudi Arabia suspended production restrictions and introduced the netback pricing system to sell its crude oil. This system determined the price of crude oil by considering the spot price of refined products and subtracting a fixed refining margin and transportation costs. As a consequence, oil prices plunged, and the OPEC pricing system collapsed. In 1988, OPEC stopped determining prices and introduced a more refined system of contracts. Roughly 30 to 50 percent of all oil is traded on this market. Most of the remaining volume, particularly crude from the Middle East, is traded in the form of long-term contracts. However, contracts no longer involve a fixed price but instead contain a mathematical formula to determine the actual selling price of oil. This formula is normally closely tied to the spot price of one or several crude oils. Therefore, spot prices determine the value of crude oil far beyond the actual market volume.

The oil market is by no means a perfect market. OPEC is still a production cartel and a powerful player on the market. According to the International Energy Agency (IEA), about 44 percent of global crude oil supply comes from OPEC countries. The IEA predicted this share would rise 52 percent between 2010 and 2030. The pricing power held by OPEC tends to be greatest in times of tight markets. Nevertheless, it is unclear how great this power actually is. A defense against potential OPEC ambitions to cut the amount of oil available to specific consumers was organized by IEA members after the first oil crisis in the early 1970s. These states committed themselves to establish strategic petroleum reserves and facilitate a coordinated response to oil crises through the IEA. These reserves amount to at least 90 days of the state’s net oil imports. Moreover, OPEC states themselves have long been interested in a stable oil market.

The global oil market has substantially lessened the risk of serious physical supply shortages. If a producer—whether intentionally or as a consequence of natural disasters, accidents, or a terrorist attack—cuts production, customers can avoid physical shortfalls by turning to other producers. Instead of a physical shortage, the shifting balance between (constant) demand and (decreasing) supply would then lead to rising oil prices, which would in turn reduce demand and thus lead to a new market equilibrium. This way, physical shortages are translated into rising prices, the consequences of which are borne by all consumers on the market. To hedge against the resulting price risks, future and forward oil markets have coevolved with spot markets. On these markets, consumers can buy options or future contracts to sell or buy oil at a time in the future at a price fixed when the contract is made.

The current energy security challenges on the oil market are therefore related to high, volatile, and erratically fluctuating prices. The issue of price stability has drawn much attention in recent years, as oil prices at one point shot up to more than $140 per barrel and then plunged to less than $40 per barrel. Uncertainty about future prices negatively affects investment decisions and thereby impedes economic growth. Moreover, uncertain future prospects about oil prices negatively affect investment into oil exploration and production itself. This might lead to even greater future price hikes due to insufficient supply. There are two major positions regarding the causes of price volatility. Some experts hold market fundamentals, such as a rapidly growing demand and a lack of spare production capacity, responsible. Others point to increasing speculation in the oil markets; financial investors, they argue, exacerbate or even cause fluctuating prices. The first of these analyses calls for investing more in production infrastructure; the latter calls for stricter regulations of investors in oil markets. Internationally, these issues are continuously addressed in the context of the International Energy Forum, an international group of energy ministers from 87 of the world’s largest oil- and gas-producing nations.

In modern times, a range of factors affect oil prices. Supply, policy changes, global events, politics, and consumer demand are among the most common. For example, the COVID-19 pandemic occurred during 2020. Travel decreased significantly, and the world experienced an economic slowdown. Consequently, crude prices fell into negative territory.

Bibliography

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Energy Charter Secretariat. Putting a Price on Energy: International Pricing Mechanisms for Oil and Gas. Brussels: Energy Charter Secretariat, 2007.

Fattouh, Bassam. “OPEC Pricing Power: The Need for a New Perspective.” In The New Energy Paradigm, edited by Dieter Helm. New York: Oxford University Press, 2007.

International Energy Agency. World Energy Outlook 2011. Paris: International Energy Agency, 2011.