Crude oil is the basis for many types of fuel. It is used in the production of gasoline, diesel and jet fuel. next to its usage as a fuel, crude oil is also used as a basis for motor oils, fertilizers, asphalt and many other uses. When trading oil, it will always be important to consider the major export countries and their political situation, to determine what risks are involved on the price. Because with oil a few nations have an enormous effect on the price.
Price Factors
The price of crude oil like any commodity is generally based on the balance between supply and demand. There are certain factors which can have an impact on this balance.
Reserves
The crude oil reserves of countries and companies have an impact on the prices of crude oil. Consider not only the reserves kept by countries, but also the amount of crude oil yet to be discovered and extracted. Due to this uncertainty about the reserves, many speculators on the market will drive the prices based on their expectations, without knowing the actual state of the current supplies.
Substitution
Due to the increasing demand for less polluting fuels and the more efficient production methods for alternative fuels, these are becoming an increasingly attractive substitute for crude oil. This increasing use of alternative fuels is affecting the demand for crude oil and thereby the price of crude oil. Alternative fuels are also encouraged by different countries, who give tax incentives to drivers of vehicles that have a less damaging effect on the environment. This way the demand for alternative fuels increases, resulting in a declining demand for crude oils.
Supply
Due to the limited number of locations where crude oil can be extracted, the number of suppliers is also limited. Therefore the supply can have a great impact on the price. For example the Middle East is a huge exporter of crude oil, but due to the unrest in this area the prices of their crude oil has risen. Because of their importance to the total supply, their declining production causes the supply and demand balance to move further apart. This results in a rising price. Apart from the extraction , the refining capacity of the different refineries plays an important role in meeting demands. When demands increase rapidly, refineries may not be able to meet these high demands. This will result in a rising price due to the limited supply.
Delivery Date and Location
The time and location of the delivery of crude oil can have an impact on the price. When using floating prices, the delivery date will affect the price, because the price is an average of the reference prices. These prices can change over time and thus influence the eventual price. The location has effect on the price due to the use of marker crudes, which depending on the location can differ. This results in a possible price difference. These factors will be explained in the following section.
Pricing Methods
There are various methods for pricing crude oil. Below are listed some of the more conventional pricing methods.
Marker Crudes
The marker crudes function as a benchmark for the price of crude oils and their futures contracts. These crudes can used as a benchmark for the global market, but can also apply to a specific area. However the usage of crudes is not mandatory. Prices of futures can be determined as a differential to marker crudes.
Fixed Price
A fixed price can be set in two ways. The first way is where a government sets a price for a period of time. This method can be used when the oil market of a country is nationalized. The second way is where to parties agree on a price for a period of time. This is a form of over the counter trade.
Floating Price
Here the price is not fixed but is determined upon delivery. Hereby an average of the oil price around the delivery time will be set as the eventual price. Specialized companies analyze the market and set so-called reference prices, which are averages of the price movement of a period. This way contracts can be easily settled by using these reference prices.
