Digging deeper into oil prices and how they work

ROCHESTER, Minn. (KTTC) – We’re all aware that oil prices have been greatly impacted by the ongoing war in Iran, but it’s not just one part of the world that impacts the price at the pump.

Many factors go into the final price for petroleum-based products, but it’s not always immediately clear how those factors impact it. Here’s your guide to how oil prices work.

NOT ALL OIL IS THE SAME

The value of extracted oil is derived from two main factors: oil density (or API gravity) and sulfur content.

OIL DENSITY:

• Light crude – Has a higher API gravity and flows more easily.
• Medium crude – Doesn’t flow as easily as light crude but is easier than heavy crude to refine.
• Heavy crude – The hardest type of oil to work with and often requires more complex refining methods.

SULFUR CONTENT:

• Sweet – Crude oil with less than 1% sulfur content and tends to be easier and cheaper to refine
• Sour – Contains more than 1% sulfur content and yields more sulfur byproducts, which can be harder to refine

Light, sweet crude is typically priced higher than heavy, sour crude. Light crudes are easier to refine into high demand products like gasoline and jet fuel because the density is closer to the density of those fuels. Sweet crudes are easier to refine into low-sulfur fuels that meet air-quality standards.

This doesn’t include the price for transporting said crude from its extraction site to processing plants elsewhere in the world.

WHAT PUSHES THE PRICE AROUND

At least five major factors impact the price of crude oil:

1. Conflict: Wars, sanctions and global politics in major producing regions can greatly impact prices since it directly impacts global supply.
2. OPEC: The Organization of the Petroleum Exporting Countries, which consists for more than a dozen member countries, will directly control supply and exports to affect global prices; whether that be through controlling production levels to keep prices high or flooding the market to drive out competitors with higher operating costs.
3. Global economic health: Strong economies generally have higher demand for petroleum-based products while struggling economies tend to restrict consumption.
4. Oil market participants: Hedgers and speculators can affect prices through their trading practices, along with general market sentiment.
5. Extreme weather: Natural disasters can impact supply and production like hurricanes or cold snaps.

Benchmarks set the starting price for financial markets across the globe.

There are a few major benchmarks used:

• Brent – The most-used global reference for prices, it refers to the North Sea benchmark price and is widely used for oil trade through Europe, Africa, and the Middle East. It’s largely futures-settled (ICE Brent) with a broader “Brent Complex” influencing physical price.
• WTI – The West Texas Intermediate is the primary U.S. benchmark price for oil extracted in the states (specifically crude delivered at Cushing, Oklahoma).

Both benchmarks track light, sweet-ish crudes but there can be discrepancies between the two. One of the reasons they differ is due to the way prices are originated:

• Spot price – This is the price that buyers pay for physical crude delivered now or soon, usually a cargo or pipeline delivery.
• Future price – This is a standardized exchange contract to buy/sell crude at a set price for a future delivery month.

Brent and WTI are benchmark reference points. Spot prices reflect physical barrels delivered right now and can be higher or lower than futures depending on whether the global market is tight or looser on any given day.

Most headlines people see online will use the front-month futures contract, a.k.a. paper trading, but is still tightly linked to physical markets.

Differences between all of these prices come from supply and demand. If the U.S. has too much supply inland, then the WTI can be cheaper than Brent. If global supply is tight (like the closure of the Strait of Hormuz), the Brent price can rise.

Oil market participants can affect prices as well, with Hedgers buying futures to secure against potential price hikes later and speculators guessing what the price might do and betting against it.

According to the Chicago Mercantile Exchange, less than 3% of futures contracts purchased by speculators result in the buyer taking physical delivery of the oil.

According to Investopedia, market sentiment, or the belief around how oil prices will change, can also impact market prices, manifested through their trading practices.

Sources:

U.S. Energy Information Administration – Crude oils have different quality characteristics – U.S. Energy Information Administration (EIA)

Stanford Energy – Understand Crude Oil | Understand Energy Learning Hub

Investopedia – What Determines Oil Prices?

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