Editorial Comment

	Vol. 226 No. 12
PERRY A. FISCHER, EDITOR

How are crude oil prices set? That’s a question I’m often asked. Of course, the question itself is rather vague, because I’m certain that in a general, long-term sense, supply and demand determines prices. But in any given month or day, the effect of paper-only traders, spot prices, futures, the timing and type of data sources – I honestly don’t know the finer details, or how it all works. I ran across the following commentary by George Clemen, someone that I’ve enjoyed reading for several years. George has 29 years’ experience in analyzing oil markets; a brief biography follows this column. So, with the usual caveats from management about opinions, here’s how he answers the question.

You can’t pin this one on Saudi Arabia, or OPEC – they are simply beneficiaries of a very complex international market. In general, like all other commodities, the price is based on supply and demand. If the only players were oil producers and refiners, the market would be well-behaved and would be far more responsive to consumer demand. It used to be that prices would be determined by a balance between spot prices (shipments of crude oil that are on the way to refiners but, for whatever reason, become available for sale), and the price refiners can get for their total product slate on the wholesale market. Spot prices would be determined by looking at the recent prices paid for shipments as reported in a couple of industry newsletters, such as Platts Oilgram or Argus reports.

The introduction and recent popularity of trading crude oil and refined product futures changed the market. Here, traders who have no possible way of receiving or refining crude oil purchase contracts and hold them to trade on price fluctuations, at a profit, and before delivery. In theory, the futures market provides a trading ground where a willing buyer and seller agree on a price and the price is instantly public, thereby setting a marker for the industry. Unfortunately, this market was simply overlaid on top of an already functional market with well-entrenched pricing practices. It is the duplication of systems that provides fertile ground for speculative games.

First, speculation in this market is very expensive, because oil is traded in 1,000-bbl contracts. It is a game fit only for investors with lots of money and willing to take large risks, primarily wealthy traders and those operating high-risk investment and hedge funds. As it turns out, several players of this ilk entered the energy market during the brief Enron era, where they learned the tricks of the trade.

The California energy crises provided a special training ground for savvy energy commodities traders who quickly learned how to work the information system. Specifically, they learned that they could drive up natural gas prices incrementally by purchasing one natural gas spot market contract and submitting the trade to one of the journals that collects and publishes market trade prices. At the time, there was no method of validation, so the trade price was published. In the meantime, the same investors could be holding several natural gas futures contracts. The price of the futures would increase on the report of the spot trade price that was reported.

Since it was only one contract, the investor could then sell the spot contract at market value, even at a loss, not report the sale and reap the benefit of the rise in the futures market resulting from the report. The utilities that purchase natural gas depended on the prices for spot trades reported in the journals to accurately reflect what others (utilities) were paying for natural gas. In fact, it was common to write contracts between suppliers and utilities to reference certain prices in reputable journals as benchmarks for contract valuation on a day-by-day basis. Using this system, futures prices could be driven to lofty heights in a very short period. The opportunity to pull off a similar run up in prices still exists in the all too trusting oil markets.

In this situation, there is no reason for oil companies, or foreign producers, to get involved in driving prices up. All they have to do is sit back and sell oil at the prices created by investors. For months now, major oil companies and even OPEC members have pointed out that prices are being set in the futures markets by speculators. However, producers should note that the entire process described above can be reversed, and the speculators can make money on puts as they drive prices down, leaving producers holding the bag.

There are producers and refiners out there selling and buying crude oil, in part, based on prices set by speculators in the futures market. Each time a trade is made in that market, refiners and producers note the price, up or down. This becomes the price against which spot pricing is weighed, i.e., a buyer in the spot market looks at the current price in the futures market and reasons “if I have to purchase oil today at market price, the futures price is the amount established in the current market,” and weighs this price against the most recently reported spot price in the preferred journal. Thus, the futures price and spot price are used as a measure to begin negotiations for a spot market delivery.

The big refiners use complex models to determine the optimum price to pay for various types of crude, depending on sulfur content, API gravity, transportation costs, and many other factors, including the most recent futures price, and the price someone with a real tank of oil is asking.

With the addition of new equipment to US refineries since the 1980s, most refineries can refine a wide range of crude, although it is still less expensive to process light sweet crude. However, environmental permits for sulfur emissions limit capacity to process sour crude. This change in refining capacity pushed prices for various types of crude oil closer, but there is still a range based on quality.

Of course, there are probably few, if any, speculators in the petroleum futures market who buy and sell crude oil based on real demand, because they lack sufficient information to know what crude oil refiners need at any point in time. It is this problem that distinguishes crude oil futures from all other commodities.

If an investor buys pork bellies, and ends up taking delivery, he can probably figure out a way to sell them. In contrast, if an investor tries to take delivery of a crude oil contract, he will find that there is no storage available, and would have to find a refinery that wants the crude and a way to transport it. Most likely, an investor who takes delivery would own a large quantity of crude that has no market value because, in truth, there is no market for crude oil sold on the futures market.

Speculators in the futures markets have driven the price up and, generally, there is no counter-balancing purchaser to drag the prices back down in the interest of consumers. Competition among refiners in the US for market shares used to force refiners to shop for the least expensive crude oil. But the advent of boutique fuels in US cities (in response to EPA air quality goals) created isolated markets, making gasoline a less fungible product and preventing competition from product imports. Internally, the US government killed competition among refiners by creating markets for products that are so small that one or two refiners who have no interest in competing can supply them.

Finally, the US made this whole system worse by implementing today’s system of purchasing oil for the SPR. While the amount of oil purchased to fill the SPR, in itself, is almost insignificant, each purchase establishes a price between a willing seller and a willing buyer. And the current system creates a buyer (a contractor for the US) who has no incentive to bargain for a lower price. Thus, when filling the SPR, the US government may be an unsuspecting player in the run-up of crude prices if the price of these sales is reported to the journals.

(SPR filling: The US takes it’s royalties in oil production from US federal waters “in-kind,” because it does not want offshore-quality oil in the SPR. Offshore production is shipped to a US refiner on the Gulf Coast, and then a contractor for the US (awarded annually to an oil company) goes into the international market and uses the equivalent dollar value of the production delivered to the refiners to purchase a quantity of higher-quality oil to deliver to the SPR. In this way, the US contractor serves as a market participant, helping to establish the market price of crude oil.)

Overall, there is no simple answer to how prices for crude oil are set. But it appears the system could use some tightening, so that each trade in either the real petroleum business, or in the paper market, represents a valid trade and sets a valid price between a willing seller and a willing buyer. 

George Clemen has 29 years’ experience in analyzing oil markets, beginning with exceptional training in the oil movements and economics department of a major oil company. Degrees he has earned include a BA in communications from Eckerd College, a BS in petroleum engineering from Louisiana Tech University., an MS in Engineering from LaSalle University, and a JD (emphasis in international law) from UOP McGeorge School of Law. He also owns the website: http://oil-gasoline.typepad.com.