Oil is sold under a variety of contract arrangements and in spot
transactions. Oil is also traded in futures markets, a mechanism designed
to distribute risk among participants on different sides (or with different
expectations) of the market, but not generally to supply physical volumes of
oil. Both spot markets and futures markets provide critical price
information for contract markets, and so they are discussed first.
A spot transaction is an agreement to sell or buy one shipment of oil
under a price agreed-upon at the time of the arrangement. In a sense, a
consumer's purchase of gasoline is a kind of spot transaction -- the consumer
needed supply, found the price acceptable, and made no promise to make
additional purchases. More traditionally, however, the oil industry uses
the spot market to balance supply and demand. When a company temporarily
has too much supply for its own needs, it will offer some for sale in the spot
market. Likewise, if it needs additional volumes to meet a demand spike,
or because supply is unexpectedly curtailed, it will purchase oil on a
cargo-by-cargo, shipment-by-shipment basis. In recent years, the growth of
"merchant refiners" has depended on viable spot markets. These
independent refiners manufacture products not to fill their own marketing
networks, but to sell the oil in third-party transactions to the highest bidder.
Prices in spot markets send a clear signal about the supply/demand
balance. Rising prices indicate that more supply is needed,
and falling prices indicate that there is too much supply for the prevailing
demand level. There are "spot markets" for different commodities and
qualities (crude oil, for instance, as distinct from gasoline or heating oil,
and low sulfur crude oil as distinct from high sulfur crude oil), and for
different regions (Rotterdam/Northwest Europe, New York Harbor/U.S. Northeast,
Chicago/U.S. Midwest, Singapore/South East Asia, and the U.S. Gulf Coast,
for instance). The evolution of a regional market into a pricing center has its
foundation in logistics. These markets have a ready supply, transportation
choices, storage facilities, and many buyers and sellers.
Spot prices are reported for transactions in these different markets
and prices in spot markets are relatively "transparent" -- they are reported by
a number of sources and widely available in a variety of media. While some
of the most active spot markets offer deals on supplies that will be available
in the future (a "forward" physical market), most focus on "prompt" delivery of
readily available volumes.
The price paid on future markets further enhance the availability of
price information to all aspects of the oil market. While spot
markets involve the trade of physical barrels of oil, futures markets are
designed as a financial mechanism. While everyone in the market wishes to
buy at a low price and sell at a high price, buyers and sellers are on opposite
sides of the transaction and their risks are inherently different.
Different market participants may also have varying appetite for risk, and
speculators may wish to gamble that the price will move one way or another.
The futures market, a zero-sum game where there is a buyer for every seller,
distributes the risk among market participants according to their positions and
appetites.
A futures contract is a promise to deliver a given quantity of a
standardized commodity at a specified place, price and time in the future.
In practice, oil is seldom actually delivered under a futures contract. At
futures exchanges such as the New York Stock Exchange or International Petroleum
Exchange in
Existence of the futures market also allows any participant to "lock
in" the prevailing price for future deliveries, such as heating oil prices for
the winter heating season. Such a strategy, called a hedge, involves a
series of transactions, offsetting profits or losses on a futures transaction
against losses or profits on the physical purchase or sale of oil. By
limiting the uncertainty over future costs, the hedge allows companies or
consumers to make other choices. A marketer, for instance, can offer fixed
price arrangements to customers, or a consumer (primarily a bulk consumer) can
budget with confidence.
The fact that futures contracts are traded for each month for 18 months
in the future provides a forward price curve -- a picture of expected prices in
the future. (It is important to note that trade volumes are extremely low
for more distant months.) Thus, the futures market also allows a
mechanism for companies to profit from changes in market prices by holding
nearly risk-free inventories in a rising market. Furthermore,
options and other well-developed over-the-counter financial mechanisms allow
participants to limit their risk without eliminating their benefit in the event
of higher or lower than expected prices. The mechanisms together have
allowed companies to offer "price cap" and/or fixed price deals to their
customers.
Contract arrangements in the oil market in fact cover most oil that
changes hands. In earlier decades, contracts covered almost all oil, with
terms that were infrequently readjusted. Even the pricing term of the
contract was only seldom re-examined. Prices at all levels of the oil
market were relatively stable. Pricing power was more dominantly in the
hands of the seller, because oil availability was the paramount issue for
purchasers. After the very high prices of the early 1980's, demand
declined and supply increased, leading to significant price declines. At
the same time, additional players (both countries and companies) entered the oil
market. Worries over supply faded. It became apparent that the old
constant price called for in most contracts was too high -- higher than the
purchaser would pay in the abundantly-supplied open market. Purchasers
rebelled, with many abandoning contracts and relying instead on the spot market.
To coax them back, suppliers granted pricing terms tied to a market indicator --
the spot market, for instance, or the futures market. Thus while most oil
flows under contract, its price varies with spot markets. Contract
arrangements for different products are discussed below.
Most of the crude oil that flows in international trade is priced by
formula: a base price, usually based on a market indicator, plus or minus a
quality adjustment. A common pricing term sets a base of a spot price
published by a particular source or publication. For crude oil sold into
the U.S. Gulf Coast, for instance, the base would commonly be the price of West
Texas Intermediate crude oil. This high quality crude oil indigenous to
the U.S. Southwest is an informal benchmark for the region.
Analogously, crude oil sold into Northwest Europe is often tied to the spot
price for the North Sea's Brent Blend, and crude sold into Singapore or other
South East Asian locations is often tied to Dubai. The base price is then
adjusted for quality. The value of a crude oil is based on the ease with
which it can be refined into high value products. Thus, denser crude oils
with higher sulfur content are worth less than lighter, low sulfur ones.)
Finally, the credit terms affect the realized price.
In the United States, some domestically-produced crude oil is sold at a posted
price. Named for the sheet that was literally posted in a producing field,
posted prices are established by the buyers, usually refiners, but sometimes
firms that aggregate supply, "gatherers." Posted prices generally apply to
a crude oil "stream" -- a crude oil or blend of oils of standardized quality
(West Texas Intermediate, Louisiana Light Sweet), with quality adjustments where
the oil varies from the standard. In decades past, posted prices remained
relatively stable even while spot prices fluctuated. Today, they more
commonly reflect market conditions quickly. Companies may also add a
temporary premium to a posted price ("Posting Plus") to account for transient
market conditions.
Contracts for products between suppliers and resellers and/or bulk consumers are
often priced in a similar way to international crude oil: a base price
tied to a market indicator, then adjusted for other factors such as volume,
delivery terms, etc. Bulk consumers may also be able to convince their
suppliers to provide fixed prices, or may be able to enter into the types of
offsetting financial transactions that will have the same effect.