Types of Transactions

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 London, oil is traded literally by open outcry.  Offers to buy and sell are given vocally, and by hand signals; in this "recognition trading," the buyer and the seller each acknowledge the completion of the transaction by recognizing the other party across the physical trading area.  The exchange records the pairings of buyers and sellers, and reports the transaction prices.  Electronic services then report these prices with minimal lag.  Furthermore, prices are available throughout the day from the exchanges via the Internet, are published in specialty trade publications and daily newspapers throughout the country, and are reported on a weekly basis by the Energy Information Administration.  The ready availability of the reported prices has enhanced "price transparency" -- the ability of any market participant to assess the prevailing price level.

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.

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