How Are Oil Prices Set?

How Are Oil Prices Set?

Today, when we talk about oil prices, we are usually talking about the price at which a barrel of oil is traded on the financial markets. But far from this world where speculation is often the rule, the setting of oil prices involves a multitude of players and is played out at various levels, from the most concrete to the least tangible.

Three types of market

Since the second half of the 1970s, oil transaction markets have gradually replaced the previous system of “producer prices” where a reference price was set by a dominant producer (or group of producers) who managed to impose it on other market players.

There are now three types of oil markets: a physical spot market, a physical forward market and a futures market.

On the first two markets, physical transactions are carried out, which means that deliveries of oil will actually take place at the end of the exchange. In the case of the physical spot market, delivery is immediate (or almost immediate given the delivery times), whereas in the case of the forward market, delivery is deferred from the time the transaction is concluded.

In the futures market, investors exchange intentions to buy or sell futures (which can range from a few months to several years in the future) at an immediately fixed price, but unlike physical markets, these transactions generally do not result in physical deliveries. Oil is therefore only sold “on paper”.

Various operators

The physical market essentially involves private and public producing companies (seller’s side), refiners (buyer’s side) and traders on both sides.

The futures market, on the other hand, involves two types of players: commercial and non-commercial. The former are operators, generally the same as on the physical markets, who seek above all, through the use of futures contracts, to protect their operations from variations in spot prices.

Non-commercial operators, on the other hand, use the futures market to make purely financial profits, disconnected from any physical transaction. They therefore engage in speculation.

Several qualities of crude oil

There are more than 160 different qualities of crude oil which will themselves determine different ranges of petroleum products obtained after refining and thus justify price differentials.

The quality of crude oil depends essentially on its density and its content of impurities (particularly sulphur) depending on the deposit from which it is extracted.

Of all these varieties of oil, crude oil transactions are based on the three main world trade references: Brent, a blend of crudes produced in the North Sea, which is the European reference listed in London, West Texas Intermediate (WTI) produced in North America and listed in New York, and finally Dubai Light, produced in the Persian Gulf.

The prices of the other crude oils are indexed to the prices of these three reference oils.

Supervised pricing

Oil prices are expressed in dollars per barrel, a unit of measurement that corresponds to 42 US gallons or 158.99 litres.

The physical prices of oil are set according to a very complex mechanism involving specialized agencies that are supposed to ensure the transparency of the process.

The historical reference agency in this area is the American Platts, which collects data daily from sellers and buyers – producers, consumers, traders and brokers – around the world to provide an estimate of the prices charged.

From there, Platts publishes daily around 100 indices of physical oil and refined products (varying according to mode of transport and destination) via its specialised journal, Platts Oilgram Price Reports.

Even if futures market prices do not exactly overlap with spot market prices, they remain intrinsically linked to the spot market through the virtual possibility for a forward buyer to demand delivery of the product. This dependency requires that the futures price converges at maturity to the spot price.