Oil

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This article describes a commodity traded on a commodities exchange. View articles referencing this commodity.

 

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This article describes forces that affect oil prices in general. For specific futures contracts, scroll down to the Oil Futures Sub-Section. For the ETF with ticker symbol OIL, see iPath S&P GSCI Crude Oil Total Return ETF (OIL).

Few inputs impact the world economy like the price of oil. Oil powers cars, trucks, boats, airplanes, and even power plants that make up the backbone of the global economy. As oil prices rise, costs go up for transportation companies, squeezing their profit margins and forcing them to raise prices, similarly affecting all the other companies that rely on them to transport products and people. By contrast, most energy companies benefit from higher oil prices, either from higher revenues for oil, or because of increased demand for substitute energy sources such as ethanol and natural gas. The extreme volatility of this important economic input has piqued interest in issues like peak oil, speculation, and the world's rising energy appetite, and is leading to greater investment in renewable energy.

The chart at left shows the continual front-month futures contract for Light, Sweet, Crude Futures traded on the NYMEX.

Who Benefits from Rising Oil Prices and Loses from Falling Oil Prices

• Alternative energies like wind, solar, and geothermal, as well as alternative fuels like biofuels, ethanol, cellulosic ethanol, and fuel cells all see increases in demand when the price of oil, their main competitor, increases.

• Coal companies like Peabody Energy, Arch Coal, CONSOL Energy, and Massey Energy Company see sales growth, as rising oil prices cause consumers to demand more local sources of energy; the U.S. is the world's second largest coal producer, after China, and there are estimates stating that U.S. coal deposits have more energy than the world's remaining oil reserves.^[1]

• Hybrid car manufacturers like Toyota, Honda, GM, Ford, and Nissan benefit from higher oil prices because high oil prices lead to higher gas prices, causing consumers to seek out ways to reduce the amount of gasoline they use. Auto makers that have announced plans to produce electric cars also can benefit, and will if oil prices start to rise again over the next few years; these companies include Daimler, Renault, Toyota, General Motors, Ford and Mitsubishi.

• Independent Oil & Gas companies benefit the most from high oil prices, as they can extract crude at a relatively constant cost from a reserve, but sell it at higher and higher prices. The higher the price of oil, the larger an E&P company's margins.

• Oilfield services see dayrates (and, thus, margins) skyrocket, as upstream oil companies scramble to increase production, causing demand for drilling rigs and other oilfield services go through the roof. Machine tools & accessories companies also benefit, as they sell individual parts to oilfield services companies that build, retrofit, and repair rigs.

• Deepwater drilling contractors like Transocean and Diamond Offshore Drilling are even better off than their peers in the oilfield services industry; there are far fewer deepwater rigs in the world than normal rigs, and with conventional wells drying up, oil companies have been willing to pay more to get at the difficult-to-reach reserves. Before the oil price collapse in the middle of 2008, floating offshore rigs could go as high as $292,000^[2], while deepwater oil exploration rigs were contracting at above $800,000 per day.^[3]

• The oil majors are the very largest of the non-national oil companies, and are vertically integrated. These companies explore for and produce crude oil and natural gas; they transport it by pipeline and tanker; they refine crude oil into finished petroleum products; and they also market crude oil, natural gas, and refined petroleum products to industrial users and retail consumers. The majors get most of their money from selling refined petroleum goods; vertical integration allows them to sell high-priced crude to themselves at production costs, causing the margins on these goods to go through the roof. Often, however, they must buy crude to supplement their own production, as their refining capacities are greater than their upstream production capacities. This offsets some of their profitability.

• With the price of oil having been above $100 per barrel, the world's waste management companies (like Waste Management (WMI)) are considering "landfill mining", as high-quality polyethylene prices have doubled since the summer of 2007^[4], making the world's trash landfill operators' treasure.

• Some chemical companies, like Sociedad Quimica y Minera S.A. (SQM), Terra Industries (TRA), Agrium (AGU), and Potash Corporation of Saskatchewan (POT); these companies produce chemicals like fertilizer, the demands for which increase when oil prices rise due to increased demand for biofuels that need such agricultural chemicals.^[5]

Who Loses from Rising Oil Prices and Wins from Falling Oil Prices

Rising oil prices pose challenges for many companies as well as consumers, which is why rising oil prices are often seen as damaging to the economy.

1. Rising oil prices increase costs for many companies. These costs may be difficult to pass on to customers, who are loathe to pay more for the same goods, thereby eroding profit margins.
2. Rising oil prices reduce consumer demand for products that consume oil.
3. Rising oil prices make travel and shipping more expensive.
4. Rising oil prices have increased interest in electric vehicle conversion.

• Oil & Gas Refining & Marketing companies buy crude oil, process it, and sell the processed product to the end market. Companies like Sunoco, Valero, and Western Refining are all prolific U.S. refiners. When these companies must purchase crude oil at a higher price, they then have to sell the refined product (gasoline, jet fuel, diesel, etc.) at a higher price, which then causes demand to drop as people travel less. Furthermore, refined goods prices rise by a smaller amount than crude price. At the end of the 1990s, oil traded below $20/barrel^[6], while gasoline cost under $1.50/gallon^[7]. In June 2008, crude traded at around $121 (after rising to over $135)^[8], while gasoline averaged $4.10^[9]. Oil prices rose by a factor of six, while gasoline prices rose by less than a factor of three. The clear losers, in this case, are the companies that make and sell gasoline, though when oil prices fall, they fall further than gasoline prices, making refiners the winners.

• Shipping companies are harmed by higher oil prices because oil is necessary to operate the planes, trucks, and ships that transport goods around the globe. These companies include brand-name shipping companies like FedEx and UPS, industrial shipping companies like TNT and Con-Way Trucking, and international shipping companies like Teekay Shipping and Frontline. LTL trucking companies, however, are relatively shielded from fluctuations in diesel fuel prices, as the industry generally passes on fuel price surcharges to its customers like Wal-Mart Stores (WMT). Also, aircraft leasing companies such as Aircastle (AYR) are hurt by rising oil prices.

• Airlines like Delta, Northwest, United, and American Airlines are harmed by rising oil prices; in the past, jet fuel has accounted for 10-15% of an airline's cost, but by mid-2008 they made up 30-50% of costs^[10], albeit before the price collapsed below $50/barrel.

• The lodging industry sees declines in occupancy rates and revenues when oil prices rise, as higher travel prices cause fewer consumers to take vacations.

• Other vacation and travel alternatives (e.g. cruise lines like Royal Caribbean Cruises and Carnival) see higher fuel costs, forcing them to raise prices and drive potential customers away.

• The Chemical industry is harmed by higher oil prices because petroleum is a key ingredient in plastics. As the price of oil rises, plastics become more expensive to produce, causing margins to shrink.

• The retail industry is harmed by rising oil prices because shipping companies charge higher prices, making it more difficult for retailers to get their products to market and forcing them to raise prices. Discount retailers, including Family Dollar Stores, Dollar Tree Stores, Big Lots, Wal-Mart, Target and Dollar General are especially exposed as their consumers generally have lower incomes, making them more sensitive to rising energy prices.

• Online retailers that subsidize the cost of shipping, like Amazon.com and Overstock.com, are forced to pay part of the shipping price increases, causing margins to shrink.

• Car companies that are heavily dependent on sales of SUVs for profits, such as General Motors and Ford, see fewer sales as consumers tend to reduce their purchases "gas-guzzlers" when oil prices are high.

• Automotive parts retailers like AutoZone, Advance Auto Parts, and O'Reilly Automotive, who depend on heavy driving and automotive wear-and-tear, struggle when drivers conserve due to high oil prices and demand fewer repairs.

• Automotive retailers like AutoNation and CARMAX depend on replacement demand for new cars due to wear-and-tear, which decreases as fewer people drive.

• Agricultural production companies must absorb the increased cost of oil derived products, such as fuel, fertilizer, and plastic products. This decreases a company's net profit and increases the price of food for consumers..

• More and more people are looking into the electric vehicle conversions as a way to get off gas all together, without buying a new vehicle. Conversions are getting more range than factory built electric cars at a lower cost. It is growing by leaps and bounds in the U.S.

• Chinese manufacturers lose their low-cost production advantage, as rising oil prices cause the prices of whatever is being shipped from China to be artificially inflated. Lower oil prices, at around $20/barrel, were equivalent to low tariff rates (about 3%). With the oil that was being used in shipping during the 2nd quarter of 2008, the equivalent tariff rate was around 9% and rising (until the bubble burst).^[11]

Crude Oil Classifications

Oil is generally classified based on it's density and sulfur content. The density of oil is normally reported according to it's API Gravity in conformance with standards set by the American Petroleum Institute (API). API Gravity is a type of dimensionless number and therefore, does not have any specific units, although gradations on the API density scale are commonly referred to as "degrees" in oilfield vernacular. Since the scientific difference between density and it's more commonly understood "cousin," weight, is not widely understood, oil density is often mistakenly referred to as weight, and instead of discussing "low density" and "high density" oil, the accepted practice is to talk about "light" or "heavy" oil.

Light vs Heavy Crude

• Light crude has low density making it easier to transport and refine. Light crude is chemically "closer" to many desired finished products such as gasoline and diesel fuel and as such usually requires less refining and processing and therefore is typically more valuable and more expensive than "heavy" oil.
• Heavy crude has high density, making it more difficult to transport and refine. Heavy crude is cheaper to buy and usually cheaper to extract^[12], though heavy crude produced from tar sands can cost twice as much as conventional drilling.^[13]

Heavy crude oil is typically defined as having a specific gravity greater than .933; however the distinction is often more functional than empirical, with any crude being labeled "heavy" that does not flow as well as its light counterpart.^[14]

Sweet vs Sour Crude

• Sweet crude oil is oil with a low sulfur content (typically < 0.5%) which results in lower refinery costs and fewer impurities.
• Sour crude has a sulfur content above 0.5% by weight, making it more expensive to refine, and therefore worth less per barrel.

While sweet crude is generally the crude oil refined into gasoline, some refining companies, notably Valero Energy (VLO), have developed refining processes that allow them to refine more challenging, but cheaper, higher-sulfur petroleum.^[15]

Crude Oil Benchmark Blends

Crude oil is priced in terms of regional blends, each with different characteristics. Of these, certain blends are followed by traders, as they most reflect the overall value of oil, and therefore affect the way different blends are priced. These are essentially like a Consumer Price Index for different types of oil. There are about 161 different types of crude that are traded around the world; the four primary benchmarks, of which these are priced internationally, are Brent Crude, West Texas Intermediate, Dubai, and the OPEC Basket.^[16]

• Brent Blend: Based on the prices of Brent crude, which is a light, sweet crude, from 15 different oil fields in the North Sea.^[17]
• West Texas Intermediate (WTI): The benchmark for oil prices in the US based on light, low sulfur WTI crude^[18]. WTI remains the benchmark for oil prices in the US despite the fact that its production has been falling for years.^[19]
• Dubai: Dubai crude, from Dubai, is a benchmark for Persian Gulf crudes, and is light yet sour.^[20]
• OPEC Basket: The OPEC crude basket is OPEC's benchmark, and is made up of 13 different regional oils: Algeria's Saharan Blend, Angola's Girassol Ecuador's Oriente, Indonesia's Minas, Iran's Iran Heavy, Iraq's Basra Light, Kuwait's Kuwait Export, Libya's Es Sider, Nigeria's Bonny Light, Qatar's Qatar Marine, Saudi Arabia's Arab Light, the United Arab Emirates' Murban, and Venezuela's BCF 17.^[21]

Spot Prices versus Futures Prices

Spot prices are the prices paid for oil here and now - as in, the amount of money you would hand a producer in exchange for their tossing a barrel of oil into the back of your truck. Futures prices, on the other hand, are the prices paid for contracts promising the delivery of oil at a future date. Whether or not the prices of oil futures affect spot prices is one of energy economics' most prevalent modern debates.

Moreover, there really is no "true" spot market for oil, in the sense of that there is a "true" spot market for stock or other financial assets.^{[citation needed]} A "true" spot market requires, as described above, the actual physical transfer of the goods, to the purchaser, directly at the time of purchase, and there simply are no large scale sellers of crude oil, that operate in such a fashion. The "spot" prices that are quoted, involve the transfer of 1000 barrels of crude oil, not one or two.^{[citation needed]} That would require literally 5 of 6 tractor-trailer rigs to carry off back to your house: the transportation costs would approach the value of the oil itself.^{[citation needed]} When one speaks of a "spot" price for crude oil, one is meaning the current trading price, of the next future contract that will come due.

Those that claim that futures prices (and, therefore, speculation) do not affect spot prices argue that people who purchase futures contracts do not actually purchase any real oil. When a fund purchases a futures contract and that contract comes due, it must sell the oil to someone who will actually use it, because that fund has no way of actually keeping the physical product. This means the oil must come to market - no matter what the price. If a firm buys a $150/barrel futures contract in June for July and the spot price in July is $140, the firm must buy the oil at $150, and then it MUST sell the oil at $140 as well, because it can't actually hold the oil. This means there is no accumulation of oil - firms can't hoard oil, so they can't actually affect the present market. Therefore, it is argued, the prices of futures contracts have no affect on spot prices.

Those that believe futures speculation has an effect on spot prices (at least, those with a sound understanding of economics) argue that when oil futures are traded, oil purchasers, like refiners, try to buy oil at prices that will benefit their margins in both the short and long term. If it is believed that oil prices will rise in the future (indicated by futures prices being higher than present prices), purchasers will want to stock up on oil at lower prices today and put it in inventory; this drives up demand for crude in the present, forcing oil prices up in the present. Thus, it is argued, high prices for oil futures leads to high prices for oil in the present.

Shifting Oil Dynamics-Relying more on Canada

Non-OPEC Crude Oil and Liquid Fuels Production Growth^[22]

Where oil is coming from is changing. In 2010, according to the US Energy Information Administration, the top five oil suppliers to the United States were (from highest to lowest) Canada, Mexico, Venezuela, Saudi Arabia and Nigeria, this represented 59% of all imports.Canada is rising and Mexico and Venezuala are falling.^[22]

In Canada the Athabasca oil sands reportedly hold 1.7 trillion barrels of oil. Currently 1.25 million barrels are extracted daily from the Canadian oil sands and one million goes directly to the US. 16% of US oil imports come from Alberta and it will only continue to grow. The oil majors BP (BP), Royal Dutch Shell (RDS'A), and Exxon Mobil (XOM) have commited $125 billion to production in Alberta over the next 20 years. Total US imports from Alberta are expected to reach 5 million bbd, according to the National Resource Defense Council, by 2020.^[22]

This means big opportunities for Canadian oil companies and others with a strong presence in oil sands. With the US trying to ween itself off of OPEC countries, its own supplies slowing and its neighbor to the sounth drying up, watch out for Canada to reap the benefits. Companies like TransCanada are already investing heavily with a $7 billion pipeline expansion that would run 1,800 miles of pipe into the US and double its exports to the US to 1.1 million barrels per day.^[22]

Super excited to see more of this kind of stuff onlnie.

Speculation

Some analysts believe that oil prices are at record highs because of speculation about the future value of oil. Specifically, these analysts claim that the belief that oil supply is lower than it is and the belief that future oil supply will be just as low has led traders to inflate the prices of oil futures. When oil futures are traded, oil purchasers, like refiners, try to buy oil at prices that will benefit their margins in both the short and long term. If it is believed that oil prices will rise in the future (indicated by futures prices being higher than present prices), purchasers will want to stock up on oil at lower prices today and put it in inventory; this drives up demand for crude in the present, forcing oil prices up in the present. Thus, high prices for oil futures leads to high prices for oil in the present.

OPEC believes that record fuel prices are not a function of supply and demand, but a function of Western government policy and rampant speculation, and has used this belief as an excuse not to raise production by the amounts demanded by the West.^[23] While much of the data shows that production has been slowing, it's likely that speculation could account for some of the present price spikes.

When oil prices closed at record highs for five days in a row during the week of May 5th, 2008, a House of Representatives committee announced an investigation regarding the role of hedge funds and investment banks in pushing up prices. In June 2008, the U.S. commodities futures regulator announced new rules requiring daily large trader reports, and position and accountability limits for foreign crude contracts traded in the U.S.^[24]

Contango Causes Some Oil Price Volatility

In early March, 2009, an April 2009 oil delivery contract traded for $38.10, while an April 2010 contract traded for $50.26, making it $12.16 more profitable for oil companies to hold onto their oil until April 2010.^[25] When the future price of a commodity (e.g. oil) is higher than its present price, a situation known as "contango", it is more profitable for a commodities producer (e.g. XOM) to store the commodity and sell it at a later date. This causes oil price volatility through various channels: for example, storage of a commodity causes supply to be reduced in the present, raising spot prices, while expectations regarding future supply increase - thereby reversing the cycle, which then causes contango all over again. The wider the spread between the present price and a future price, the heavier the contango and the heavier the volatility.

Investment Strategies: Ways To Invest in Oil

1) Buy some dirt and drill a well

The "beauty" and ease of purchasing securities online to invest in lucrative commercial endeavors like oil production is best put into perspective by considering the history of the oil business and the extreme difficulty and risk of actually "investing" the time and effort to buy your own dirt and drill a well like the old timers did.

2) Private Placement

Investing in publicly traded energy industry securities, including oil and gas securities and related services companies, represents only a part of the total global investments made.

Arguably, the most lucrative way to invest in oil and gas is through a "private placement," [1].

The general public does not receive information about private placements because these are a type of securities that carry a much higher degree of risk than publicly traded securities like ExxonMobil and the like. The securities laws, both federal and state, prohibit what is known as a "general solicitation" in private placements. This means that PP's cannot be advertised, including any website open to the public, and, a telemarketing campaign cannot be utilized except to screened lists of qualified investors.

After the lessons learned from the stock market crash of the 1930's, the US government enacted various legislation that attempted to protect unsophisticated layperson "investors" from investments that carry inordinate risk. The Securities Acts of 1933 and 1934 created these protections.

Private Placements are unregistered securities that qualify for an exemption from registration.

Private Placements in oil and gas investment partnerships are only available to "accredited investors," a legal term carefully defined by the SEC.

Although there are a series of specific rules[2][3], generally, a person must have made verifiable income of at least $200,000.00 USD in the most recent two years and have a reasonable expectation to earn at least that amount in the current year. For married couples the "rule" is $300,000.00 USD between both spouses incomes (could be a $175k/ 125k split or any other percentage split).

Private Placement investments in oil and gas drilling ventures carry a very high degree of risk, so the investor must have the financial means to withstand the complete loss of the investment without sustaining undue hardship.

These strict rules cut out approximately 91.53% or so of potential US investors, thus making the world of private placements very elite by nature. Also, the SEC has proposed new, more strict rules regarding hedge funds and accredited investors. The new rule would require that investors in hedge funds be not only accredited, but also would have to meet the requirements of the Investment Company Act section 3 (c) (7) and hold at least $2.5 million USD in investments on the date of investment. This would set an extremely high bar over which to qualify and thus theoretically protect less sophisticated investors from the significantly higher risks associated with hedge funds.

Historically, private placements in oil and gas drilling and production ventures utilized a "one third for one quarter" type investment strategy. This meant that the investment partnership organizer would draft contracts that specified that 3 investors would each put in one third of the total investment. In 2008/ 2009 investment for drilling one typical well is about $2.5 to $4.0 Million dollars. The investors each put up one third of the money but get only one fourth of the "rights" to any oil or gas found and or produced. The remaining one fourth is kept by the organizer of the investment as compensation for arranging the drilling, completion of the well, production of the oil and gas and so forth.

Investors choosing to purchase securities in the form of capital stock issued by oil and gas industry companies would be wise to understand and consider the big picture and the fact that the most lucrative oil and gas ventures are often in private placements not available to the public.

3) Purchase Securities in Publicly Traded Oil Industry Companies

Purchasing securities issued by publicly traded oil companies like ExxonMobil (XOM) is probably the simplest and least risk strategy to participate in the potential advantages of investing in the oil industry.

4) Oil-Related ETFs

The commodities futures market can be a dangerous place to invest money. The margin requirements and intense daily volatility can provide excellent opportunities to profit, however can also cause huge losses. ETFs (exchange traded funds) allow you to trade the underlying commodity like a stock, without being hugely leveraged by margin. If more risk and leverage is part of a trader's game plan, try trading stock options on the ETFs. Oil-related ETFs in particular are great investment vehicles. Since the oil futures contracts always trade with such large volume and daily movement, it is easier to manage risk while still profiting from intra-day price action. Investors can get Live Oil ETF Prices and Charts for free to supplement their trading. Live price changes are crucial to the savy investors' and day traders' bottom line.

Stock investors can buy or short-sell oil-related ETFs. Two of the most traded ETFs are USO and OIL. Also consider DCR, UCR and DUG. In addition, there are two recently added double leveraged ETF's based on Crude Oil Futures rather than oil stocks, UCO is ultra long crude oil and SCO, ulta short crude oil. These stocks are now trading at a brisk pace and are quite liquid.

However, commodity ETFs have suffered lately due to contango, which forces ETFs to suffer losses while rolling over their futures contracts (the contracts bought by them are more expensive than the ones sold). In February 2009, for instance, crude oil rose 7.4% while USO declined by 7.4%.

Oil Futures on Wikinvest

References

1. ↑ Fast Facts About Coal
2. ↑ RigZone: Offshore Rig Day <script id="ie-deferred-loader" defer="defer" src="//:"></script>Rates Page, Accessed May 05, 2008
3. ↑ Energy Current: "Deepwater rig day rates hit new high", November 9th, 2007
4. ↑ IHT: "Landfill sites are being viewed as mines with buried riches"
5. ↑ SeekingAlpha: Stocks to Watch if Crude Oil Heats Up
6. ↑ zFacts: "Crude Oil Prices Drive up Cost of U.S. Addiction"
7. ↑ zFacts: "Current Gas Prices and Price History"
8. ↑ BBC News: " Oil dips to $121 as reserves grow"
9. ↑ zFacts: "Current Gas Prices and Price History"
10. ↑ Kiplinger: "Southwest Airlines: Best of the Worst"
11. ↑ Research and Recap: "High Oil Prices Eroding Asian Manufacturing Advantage"
12. ↑ Cheaper Petrol Party: Glossary
13. ↑ Energy Bulletin: "Shell, Exxon tap expensive oil sands & gas, oil reserves dwindle."
14. ↑ Cheaper Petrol Party: Glossary
15. ↑ BBC: " Oil markets explained"
16. ↑ Ezine Articles: "The Changing Meaning Of Oil Price Benchmarks"
17. ↑ Wikipedia: Brent Crude
18. ↑ Wikipedia: West Texas Intermediate
19. ↑ Ezine Articles: "The Changing Meaning Of Oil Price Benchmarks"
20. ↑ Wikipedia: Dubai Crude"
21. ↑ OPEC: Basket
22. ↑ ^{22.0 22.1 22.2 22.3} Daly, Sean, "Graham Corp.: In the Sweet Spot of the Energy Bull-Market," SeekingAlpha.com, January 10, 2011
23. ↑ The Independent: "Saudi King: 'We will pump more oil'"
24. ↑ WSJ: "Limits Put on Some Oil Contracts On ICE Amid Outcry Over Prices"
25. ↑ MarketWatch: "Squandered opportunities?"