Crude oil is a naturally occurring substance found in some rock formations in the earth that is refined and processed into a variety of valuable petroleum productions including gasoline, gas oil and fuel oil. Crude oil has immense value because it is a major source of energy; it is how we transport people and materials from place to place.
Without crude oil we would not be able to move goods across the world, we would not be able to fly in airplanes or drive. While there are other sources of energy available, so far these alternative and renewable energy sources have not been prevalent enough, reliable enough and/or affordable enough to overtake crude oil as the world’s primary source of energy. Also, it is unlikely that they will anytime soon.
Crude oil is the lifeblood of the global economy and it makes complete sense that it is the most widely traded commodity. There are a few different varieties of crude oil produced in different regions of the world with the two most popular being West Texas Intermediate Crude Oil (WTI) and Brent crude oil (Brent).
Facts About Crude Oil Production
One barrel of crude oil is the equivalent of 42 US gallons, and a barrel of oil, once refined, yields approximately twenty gallons of motor gasoline and 7 gallons of diesel plus an additional 17 gallons of petroleum byproducts. Note that there is a net gain of two gallons in the refining process.
West Texas Intermediate (US Oil)
West Texas Intermediate crude oil (WTI) is the underlying commodity of the New York Mercantile Exchange’s oil futures contract. WTI is the primary North American crude oil variety.
It is produced in different regions but refined mostly in Cushing, Oklahoma. Cushing is the major delivery point for crude contracts and the price settlement for WTI on the NYMEX. Inventories at Cushing are therefore a critical component of assessing the total supply and demand picture for WTI.
A bottleneck of WTI at Cushing can either signal weakening demand or transport challenges. Either is a negative for WTI prices. Low inventories at Cushing are a bullish point. Oil analysts are constantly assessing not only the total oil inventory picture in the US but also the inventory situation in Cushing. The best assessment of inventories are the weekly inventory report provided by the US Energy Information Administration, on Wednesday at 10:30 a.m. ET, except after long weekends when they are released on Thursday at 11:00 a.m. ET.
West Texas Intermediate crude oil is a low density low sulfur oil. It is actually the best quality crude oil, even better than its overseas counterpart Brent Crude.
Brent Crude is the other major oil benchmark, it is the overseas counterpart of WTI. Brent is a mixture of four types of crude oil from the North Sea. Brent is also light and sweet, or has low density and low sulfur content. Brent is the underlying oil future of the Intercontinental (ICE) Exchange.
Brent and WTI Relationship
Brent and WTI are compared to each other, with the price differential between the two major oil benchmarks the “Brent-WTI oil spread.” The prices are typically similar, but Brent can be at a premium or a discount to WTI.
If you look at quality alone, WTI should trade at a premium; however, Brent crude’s sea locale means transport is easier whereas WTI is landlocked and needs to be transported via pipeline and rail to refineries, and, if transported, to the coast. Furthermore, the North American continental transport system leaves something to be desired with inadequate pipelines forcing more and more oil to be transported via rail. This transport challenge can cause Brent to trade at a premium to WTI, Due to political and environmental challenges, WTI’s transport system is considered somewhat lacking.
Oil Price Drivers
There are numerous factors that control the price of oil, and of course each of the oil benchmarks has its own unique market fundamentals; here are the major factors.
Of course, like any commodity the normal factors of supply and demand dictate the market direction. However, speculation is also a major factor. With oil the world’s most traded commodity, there are many speculators buying and selling oil futures, hoping to cash in on the commodity’s price swings.
The Middle East used to be the only major player in terms of oil production, and they pretty much dictated the price of oil through OPEC, which coordinated oil production. While OPEC says it was created to level out the price of oil, the organization has been known to hold back production to boost prices.
Now, the fact is that OPEC is losing control of the industry due to rising oil production in North America. Thanks to technological advances, both the US and Canada have recently gone through oil booms.
In Canada, improving technology made oil sand production economical, and in the US, the shale boom brought more oil to the market. This increase in supply has pushed prices lower with OPEC, at the same time, unwilling to cut production, crude oil prices have fallen.
Nevertheless, the Middle East is still a major supplier of oil, and the challenge with that region of the world is it is prone to political upheaval. These political upheavals can threaten the supply chain and can, in turn, have a major impact on prices. Political turmoil in the region has in the past resulted in real supply disruptions, but the sentiment alone around the potential for political turmoil can have a major impact on prices.
The major demand for crude oil is fuel (gasoline). Now demand for fuel is related to economic health. When the world’s economy is doing well people are buying products and traveling — all these activities demand oil. When the economy stops then oil demand decreases. In the US there is also a seasonal component to oil demand. This is partly because Americans love their road trips, and there is a peak driving season that starts with the Memorial Day long weekend and lasts through the Labor Day weekend. Of course, demand during this period has a greater influence on WTI.
For Brent, in terms of overseas demand, China and the emerging markets are major players. As the emerging economies see their wealth increase, in turn, more people can afford vehicles and demand for oil improves.
The New Oil Market
The oil market has changed dramatically in recent years, mostly due to the increase in North American production. While supply diversity is good for markets over the long run, right now some major rebalancing is occurring.
When North American production increased, it flooded the market with new supplies while at the same time oil demand did not grow as hoped. This fact was the initial catalyst for the recent fall in oil prices, but what really exacerbated it was the Middle East’s unwillingness to cut back production. In fact, even as North America reined in its production, OPEC continued to ramp up its production, causing prices to crash. OPEC’s reasoning was that they did not want to decrease production and have that lost production picked up by a competitor.
Some people blame OPEC as trying to “bankrupt” North American oil production, but if this is their goal it will prove more challenging than OPEC probably hoped. While North American production used to be high-cost, technological advances have greatly reduced and will continue to reduce production costs. Whatever the reason for OPEC’s production decision, we are definitely in a time of change for the oil markets and we will see how this new market adjusts over the coming years.