To edge against market volatility large buyers often strike deals with individual oil producing countries, at a price different from the market.

What sets Oil Prices?

Did you ever wonder what makes the price of oil move and why movements in the price of oil don't always feed through to the gas station's prices? Who decides the price of oil and how do all the oil businesses in the world hedge against sudden movements in the price? Although there are well known oil price indices in the world, the mechanism that sets their levels involves a range of factors from politics to transport networks. Buyers of oil for physical delivery rarely pay the price listed on the WTI index or the Brent crude index. In this article, we take a look at how crude oil prices are calculated and why gasoline prices are not always linked to the price of crude oil.

Crude Oil

The price of oil as discussed in the news is the price of a commodity different from the gasoline you fill your car with; it is in fact crude oil. Crude oil is the base product that gets processed into gasoline at oil refineries. So, if the price of oil goes up, the price of gas goes up. However, there are a number of other factors affecting the price of gasoline and that's why the gas price doesn't always fall with the price of oil. Refining capacity can rise and fall. If a major refinery develops problems and has to shut down, then the amount of gasoline that can be produced falls. The price of gasoline rises because of shortages, but the price of crude oil will fall because of gluts.

Transport costs can also affect both the price of crude oil and the price of gas as the oil needs to be taken to the refineries and then the gas needs to be distributed from the refineries to gas stations. So if the price of transport rises significantly on any stage of this supply chain, the pump price of gas will increase irrespective of what the price of crude is doing.

The USA consumes much more oil than it produces, so if some major oil producing countries unexpectedly withdraw their oil from the market as happened during the 1973 oil crisis, the economies of the USA and the developed world can suffer long-term damage. For this reason, the Federal government created a vast oil storage facility called the Strategic Petroleum Reserve, or SPR. The President can take the decision to release oil from this reserve to balance out any sudden drop in the supply of reasonably priced oil. Thus, the nation has a mechanism to protect against sudden spikes in the price of oil. To limit consumption, state and Federal governments can increase the price of gas by imposing taxes and levies on oil companies, refineries and gas stations.

Oil Barrel

Oil refineries buy their crude oil by the barrel. Let's say a refinery buys 1,000 barrels of oil for delivery and a set of trucks filled up with oil drums starts rolling in its direction. Surprisingly these trucks will not be carrying 1,000 drums of oil because the volume of a (standard) oil drum differs from the volume of an oil barrel: 55 gallons for an oil drum versus 42 gallons for an oil barrel. Hence the trucks will be carrying 763 drums of oil (same volume as 1,000 barrels of oil, just fewer drums). Think of a barrel more as a unit of measure, like a gallon or a litre rather than as a container. When you hear talk of the price of oil, that price is given per barrel, which is abbreviated to "bbl." A barrel of oil is the equivalent of 42 gallons, or 159 litres. Thus, if you read that the price of oil is $104 that means for 42 gallons of crude oil.

Indices

Anyone can strike a deal and there is no law dictating the price. However, whenever you buy something, you want to know what the going rate for that item is, and the oil industry is no different. There are a number of published indices around the world that the oil industry uses. The first of these is the West Texas Intermediate price set at the New York Mercantile Exchange. The second is the Brent Crude Index, which is set at the Intercontinental Exchange in London and the third is the OPEC Basket, which is an average of the prices achieved in all OPEC countries and is managed from OPEC's headquarters in Vienna.

Each index rises and falls depending on how many people want to buy oil on that particular day. Many of the people who invest in oil at these exchanges never actually intend to take delivery. These people just want to buy a contract at a low price and then sell it on at a higher price. When speculation enters a market then many new factors enter the pricing structure. Political uncertainty in some part of the world could disrupt supply and so the price goes up. Trade figures of a major manufacturing nation, like China, might show that country is slipping into recession. That would reduce demand for oil, thus the price would fall on all the indices in the world.

Countries that produce more oil than they consume, like Saudi Arabia and Russia, like the price of oil to go up. Countries that produce little oil, like Japan and Italy, like the price of oil to go down. In the US, it would be in the general economy's interests for oil prices to be low, but a low oil price would damage large American corporations that have influence with national politicians through election fund contribution and targeted job creation. Thus, some countries may try to drag the price of oil down, while others may try to force the price up. Politics, then, plays a major role in the price of oil registered on these indices.

Other investor-related factors may also influence the price of crude oil. The banking crisis of 2008 saw savers looking for places to store their money when it looked like banks might go bust, so they poured money into commodities, including oil. Thus, the price of oil rose despite a general collapse in demand. Speculators like volatility because they then don't have to wait too long before they can sell on their investments at a higher price. Speculators, and the information providers that support them, over-react to world news to try to force dips and peaks so they can buy and sell. Thus, there are many non-oil related factors that can influence the price of oil set on the three main indices.

Contracts

Buyers of oil for delivery rarely pay the index price. However, the price of a particular index is a factor in the contract price mechanism. Not all oil in the world is the same. Some oil is quicker and cheaper to refine than others. Thus, you would likely pay more for oil that is easy to process, than for oil that is expensive to process. The location of the oil and transport capacity is also a factor. A contract to buy oil in Saudi Arabia would carry a lower price than a contract to buy a tanker load of oil that is just off the coast from a refinery. Therefore, the two factors of oil properties and location influence the price paid on contracts for delivery regardless of what the price of WTI or Brent crude is.

Oil companies understand the short-termism of speculators and so oil price contracts tend to work on the average price over a certain period. Rather than striking a price at the Brent Crude Index price on the day of delivery minus $3, a contract is more likely to take the price from the index averaged across the week of delivery and then apply a premium or a discount. This avoids a buyer being hit by bad news on the day of delivery jacking up the Index for a few days.

Although the WTI index is based in America, the Brent Crude Index is based in Europe and the OPEC Basket is based mainly on oil prices in Arabia, contracts for oil do not have to rely on the price of the closest Index. Thus, American buyers may strike a price based on the Brent crude index, even though they are buying oil from Arabia.

All these factors boil down to oil price indices operating as "benchmarks" for the oil industry rather than a common price. The relative movements of the indices do affect the price oil companies charge for oil, but the actual price is a matter of individual contracts accounting for many different factors rather than a global standard price.

Conclusion

The index prices of crude oil are important throughout the oil industry. However, if you are interested in how much buyers actually pay, do research the contract terms arrived at for individual deals. For example, the China National Petroleum Corporation recently signed a joint venture with the UAE's Abu Dhabi National Oil Company. This deal would undoubtedly grant cheaper oil prices to China than those listed for the OPEC Basket, of which Abu Dhabi's oil market is a constituent. Taxes, politics, transport networks, geography, economic expansion and the weather all play a part in the complex calculation of setting the level of oil price indices. However, deal-making, contract conditions, side benefits and commercial interests override all other factors when setting the price for individual oil supply contracts.