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Financial Markets and Crude Oil Prices

Source: API 5/1/2006, Location: North America

Over the last 25 years, the global oil industry has seen a transformation in the contractual structures used to purchase and sell crude oil. A market structure formerly based on rigid long-term, commercial arrangements has been replaced by a more efficient one that allows buyers and sellers greater flexibility in establishing commercial relationships that better meet their respective needs.

Whereas “spot” and “futures” markets have been longestablished institutional structures for many commodities, they are relatively new to the oil industry. Their uses, however, have grown rapidly and are now a well-developed part of the market. Today it is from the spot and futures markets that the global oil market – producers, refiners, marketers, traders, consumers, investment banks, hedge funds, and so forth – receives competitively determined market signals that inform buyers and sellers on current and future supply and demand conditions. In sum, the interactions of well-informed traders on spot and futures markets assure that the global price of crude properly reflects its market value.

Spot Markets versus Futures Transactions
The term “spot markets” is used to describe transactions which involve the near-term purchase and sale of a commodity, such as crude oil and refined products. In the crude oil market, “spot” contracts typically involve delivery of crude over the coming month, e.g., a contract signed in June for delivery in July. Spot markets are often referred to as the “physical market” since they entail the buying and selling of physical volumes. These markets consist of many buyers and sellers, including refiners, traders, producers, and transporters, transacting throughout the chain of supply – from the oil well right through to the refinery. These markets provide the benefit of allowing buyers and sellers, e.g., refiners and marketers, to more easily adjust their crude supplies to reflect near-term supply and demand conditions in both the product markets and the crude oil markets.

A futures contract, in contrast to a spot transaction, concerns the future purchase or sale of crude oil or petroleum products. Specifically, it is a contract that carries the obligation for delivery of a given quantity of crude in the future. The contract specifies the volume, type or grade of crude oil, the price, the future time in which the crude is bought or sold, and the particular location to which it is to be delivered. The buying and selling of futures contracts occurs on organized exchanges. Since the vast majority of traders “close out” their positions (i.e., cancel out a contract prior to the time it would require the trader to actually deliver or take delivery of the crude oil), futures transactions rarely entail the actual delivery. As a result, the futures market is often referred to as the “financial market.” The crudes underlying futures contracts are often called “marker” or “benchmark” crudes. A common example of a marker crude is West Texas Intermediate, which is the principal crude underlying the futures contract traded on the New York Mercantile Exchange, or NYMEX. These organized exchanges allow for the competitive interaction of thousands of independent traders, including both commercial as well as financial institutions. These interactions, in turn, give rise to publicly reported futures prices that reflect the market’s best estimate today of what future supply and demand conditions and, hence, prices will be. Prices of futures contracts are connected to prices in the physical market because futures positions that are not closed out will lead to either delivery or receipt. Thus, the closing “futures” price for any given month must equal the “physical” price at the time trading in the futures contract ends. With delivery, the futures price effectively becomes a physical price at the time the futures contract matures. So, for example, the closing “futures” price for delivery in June must equal the “spot” price for oil in June. If the prices differed, a trader would buy in the market in which the price is lower and immediately sell it into the market where the price is higher and earn a profit. No one wants to leave such profit opportunities on the table.

The prices in the spot market transactions described above are often tied to prices for crude oil on organized exchanges with, for example, price adjustments to account for differences in the quality of the crude oil being traded and the location of the spot market transaction. In fact, even OPEC countries often base their prices on the prices determined on organized exchanges, with appropriate quality and other differentials. The benefit of these arrangements is that the price of the physical crude oil will be set at the market level at the time of delivery. This protects buyers from dramatic price fluctuations that could occur while crude oil was in transit to its final markets.

Benefits of Futures Markets
Futures markets bring a number of benefits to the global oil market. First, crude oil futures markets provide information about future expectations regarding supply and demand conditions. Second, these expectations are made transparent, i.e., known to the market, in the form of a series of futures prices for crude to be delivered at different dates in the future. Finally, crude oil producers, marketers, refiners, and others are able to use the financial contracts on the exchanges to manage risk, facilitated, in part, by the increasing participation of the number of investors without a commercial interest in the petroleum industry (i.e., no capacity to produce, refine, store, or sell physical volumes of crude or petroleum products).

As described above, futures markets bring together valuable information about the market’s expectations about future supply and demand conditions in the physical market – conditions that will ultimately determine the price for oil. If, for example, the price today of an oil futures contract for the delivery of oil three months from now is $65 per barrel, that “futures” price represents thousands of buyers’ and sellers’ best estimate of what the price of oil will be for physical delivery three months hence. And, if in this hypothetical situation, the current (spot) price were $60 per barrel, the futures market would then be revealing the fact that it is the market’s current expectation that prices are expected to increase over the near future. That is, based on the information of thousands of commercial participants and sophisticated financial institutions, futures prices are telling producers and consumers alike that the crude oil market is likely to remain tight for the foreseeable future.

Of course, actual prices for crude in the future may be different than those implied by today’s future prices. Because it is the market’s best estimation today that oil will be $65 per barrel in three months does not necessarily imply that oil will, in three months, be $65 per barrel. As expectations about future supply and demand conditions change, e.g., due to colder than expected weather or unforeseen political events that could cause temporary supply disruptions, so too will current and future expected prices.

This trading process, i.e., the competition between various market players in the futures markets, is beneficial because it provides transparent price information to those who can respond to this information by, for example, putting additional oil in storage or taking steps to reduce their consumption in the future. To illustrate, when prices of futures contracts with early delivery dates exceed those with later delivery dates, the market consensus is for prices to fall in the future. This provides an economic incentive to draw down inventory today – thereby softening prices today. On the other hand, when prices of futures contracts with early delivery dates are lower than those with later delivery dates, the market consensus is for prices to rise in the future.? This provides the economic incentive to build inventories if the higher futures prices will cover the cost of storage. This saves supply for the future when prices say it is most needed. In short, futures market prices provide information about expected future supply and demand conditions that producers and consumers can act on today. The effect of these actions is to shift the supply of crude oil from periods of relatively lower prices to periods where crude oil prices are expected to be higher. These actions, in turn, tend to ameliorate price swings.

Finally, futures markets permit industry participants to manage the significant risks they bear in the production, refining, and transacting in crude oil and petroleum products.? They do so by making it possible, for example, for an oil producer to lock in prices for its future production on the futures market or to use other instruments to limit the price fluctuations it will realize. The fact that these financial markets are highly liquid, with thousands of traders, allows users to shed risk at the least possible cost and at prices that reflect all of the information brought to the market by those trading. Consumers benefit because holding down producers’ risks encourages investment in future supplies.

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