Understanding Crude Oil: A Beginner’s Guide to the World’s Most Traded Commodity

What is Crude Oil?

Imagine you’ve struck black gold—no, not a treasure chest filled with ancient coins, but something even better (for the modern world at least): crude oil! This thick, sticky, and slightly smelly substance is a crucial resource for our global economy. Extracted from deep underground, crude oil along with a bit of heating and refining, transforms into everything from the gasoline in your car to the plastic in your smartphone case.

A Brief History of Oil

The importance of oil dates back to ancient times when it was used in its raw form for waterproofing and medicine. However, its true value became apparent in the mid-19th century when it was discovered that crude oil could be refined into kerosene for lighting, which marked the beginning of the modern oil industry. The development of the internal combustion engine in the late 19th century, particularly for cars, further established oil’s role as a critical energy source. Companies like Standard Oil, led by John D. Rockefeller (who made a fortune), revolutionized the industry by controlling every aspect of oil production, from drilling to distribution, making oil widely available and indispensable. And just like that, oil went from a stinky nuisance to the most important global commodity.

The Composition of Crude Oil

Crude oil is composed of a mixture of hydrocarbons (compound of hydrogen and carbon) and its composition can vary depending on its origin. The main differences in the oils are based on these factors:

Density: Crude oil can be light, medium or heavy. Light crude oil has a low density and can flow easily. On the other hand, heavy crude oil is very viscous, which is a lot thicker and stickier, making it harder to refine.

Sulphur Content: Crude oil is also categorised into “sweet” and “sour” variants. Sweet crude oil is based on low sulphur content and sour crude oil has a high sulphur content. In general, sweet crude oil is more desirable since its easier to refine.

The Refining Process: From Crude to Cool Stuff

So, how do we turn this sticky, smelly goo into useful products? Enter fractional distillation, which sounds fancy but is basically like giving crude oil a spa day and if you want to be technical than it’s the process of separating a mixture of hydrocarbons into different components or fractions based on their boiling points (shout out to my chemistry teacher). Here’s how it works: crude oil is heated up in a distillation column until it starts to break down—kind of like when you’ve had enough of exams week. As it vaporizes, the different parts of the oil (called fractions) separate based on how hot they get.

• Light fractions (like gasoline and naphtha) are the early birds—they rise to the top.
• Heavy fractions (like diesel and jet fuel) like to take their time, so they settle lower down.
• Residues (like bitumen and bunker fuel) are the procrastinators of the bunch—they hang out at the bottom.

The result? A whole bunch of useful products, each ready to power your car, your plane, or even pave your roads. Typically light sweet crude is more desirable since it yields a higher proportion of high value products like gasoline and diesel.

Understanding Oil Pricing: The Role of Exchanges and Derivatives

Now that we’ve got our shiny new products, how do we figure out what they’re worth? Enter the exchanges, where traders gather (these days, mostly online) to buy and sell oil and its derivatives. Think of these exchanges like the world’s most intense auction house, where the prices of oil are determined by a mix of supply, demand, and, of course, a little bit of luck.

What Are Exchanges and Why Are They Important?

Exchanges like the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE) are where the magic happens. They ensure that everyone plays by the rules and that the prices we see are fair and square (mostly). Without them, trading oil would be like trying to sell a used car without a price tag—chaos!

As of today there are 3 main benchmarks in the world for crude oil:

WTI (West Texas Intermediate) in the US traded on CME’s NYMEX

Brent (reference for crude in the North Sea) traded on ICE Futures Europe

Dubai which the benchmark for the Middle East and Far East traded on the DME.

So, what contracts do traders use to trade?

Well, if you’re a producer/user of oil than ideally you would want to lock in a price for oil to buy or sell. Why? Because the oil markets are quite volatile, i.e. price movements can occur quite fast, leaving lots of money to be made and lost.  In term of risk management market participants would like to be as ‘protected’ as much as possible from these price fluctuations.  In come, derivative contracts. These contracts are an agreement between two or more parties that has a value derived from the underlying market.  The most common derivative contracts are futures, options and swaps.

Futures Contracts: Is the agreement to buy or sell an asset at a predetermined date and price. The buyer is obligated to buy at the price specified in the contract and the seller is obligated to sell/deliver.

Option Contracts: Are similar to futures contracts, except the buyer has the option to activate the contract and is not obligated to do so. I.e. If I bought an options contract for a strike price of $100 and at the end of the contract, I see the market is currently at $50. Then I wouldn’t activate my options contract to buy at $100, since the contract is worthless (expires out of the money) and I can buy at $50 in the underlying market.

 So here are main reasons why derivatives are used:

• Hedging: Think of it as insurance. If you’re an airline, you don’t want to be at the mercy of wild price swings, so you use derivatives to lock in prices.
• Speculation: Some traders just like to roll the dice. They bet on future price movements, hoping to strike it rich (or at least avoid striking out).
• Risk Management: Derivatives help companies avoid nasty surprises by managing the risks associated with unpredictable oil prices. For example, a refiner may use a futures/options contract to ensure they can buy oil at a certain price even if the market price skyrockets.

What Influences Oil Prices?

So, what makes oil prices go up or down? It’s a bit like trying to predict the weather—sometimes it’s obvious, and sometimes you’re caught in a surprise storm. Here are the main reasons:

• Supply and Demand: When more people want oil (like when everyone’s driving to the beach in summer), prices go up. When demand drops, prices do too.
• Geopolitical Events: Nothing sends oil prices on a rollercoaster ride like a good old-fashioned international crisis. Conflict in oil-rich regions? Prices shoot up. Peace talks? They might come back down.
• Economic Indicators: If the global economy is booming, demand for oil increases, pushing prices up. During economic downturns, prices typically fall as demand shrinks.
• Market Speculation: Traders can be a jittery bunch. If they think prices are going to rise, they start buying, which ironically can cause prices to rise—even if nothing has actually happened yet.
• OPEC Decisions: The Organization of the Petroleum Exporting Countries (OPEC) is like the ultimate oil cartel. When they decide to cut production, prices can skyrocket. If they increase production, prices might drop.

The Journey of Oil: From Drilling to Your Driveway

1. Exploration and Drilling: It all starts with a treasure hunt. Geologists search for promising oil fields, and when they find one, the drilling begins. Companies like ExxonMobil, Saudi Aramco, Royal Dutch Shell and BP are the pros at this.
2. Transportation: Once oil is extracted, it needs a lift. Whether by pipeline, tanker, or even rail, companies like Enbridge and Euronav make sure the oil gets to where it’s needed.
3. Refining: Next up, the oil heads to the refinery, where it gets the full makeover treatment—fractional distillation and all. Companies like Valero Energy and Phillips 66 are masters of this transformation. ExxonMobil and Shell also have significant refining operations.
4. Distribution: Now that the oil’s all dolled up, it’s time to hit the road. Trucks, pipelines, and ships carry the refined products to gas stations, airports, and factories.
5. End-User Consumption: Finally, the oil reaches you, the end-user. Whether you’re filling up your car, flying across the country, or using a plastic product, oil’s got your back.

Conclusion

So hopefully that gave you a brief overview of the oil markets, in the next posts all be giving weekly updates on the oil markets and a deeper dive into derivative contracts.

Stay tuned for more in-depth analyses, market updates, and educational content on crude oil and other energy commodities. If you have any questions or topics you’d like to see covered, feel free to leave a comment below!