Useful Article on "The Pricing of Crude Oil"

The Reserve Bank of Australia provides a useful article on "The Pricing of Crude Oil," by Stephanie Dunn and James Holloway.

The article provides a basic introduction into how crude oil fits into the overall global commodities hierarchy, and into how crude oil prices are determined for the important benchmarks Brent and WTI. Intriguing hints as to how futures prices can sometimes affect spot prices in crude, are also provided. Worth a look:

Arguably no commodity is more important for the modern economy than oil. This is true in terms of both production and financial market activity. Yet its pricing is relatively complex. In part this reflects the fact that there are actually more than 300 types of crude oil, the characteristics of which can vary quite markedly. This article describes some of the key features of the oil market and then discusses the pricing of oil, highlighting the important role of the futures market. It also notes some related issues for the oil market.

Introduction

The crude oil market is significantly larger than that for any other commodity, both in terms of physical production and financial market activity (Table 1). The value of crude oil production is more than twice that of coal and natural gas, 10 times that of iron ore and almost 20 times that of copper. Crude oil is the most widely used source of fuel, supplying around one-third of the world's energy needs. It is also used to produce a variety of other products including plastics, synthetic fibres and bitumen. Accordingly, changes in the price of crude oil have far-reaching effects.

Table 1: Physical and Financial Market Size of Major Commodities
2011, US$ billion

	Physical market(a)		Financial market (exchange-traded)
	Annual production	Annual exports	Annual turnover	Open interest (b)
(a) RBA estimates based on volumes and indicative world prices (b) Open interest is the total dollar value of futures and options contracts outstanding that are held by market participants at the end of each month; averaged over the year (c) Physical market data are for 2011/12 US financial year (d) Includes exchange-traded swaps (e) Export data are for 2010 Sources: ABARES; Bloomberg; BP (2012); Bureau of Resource and Energy Economics; Commodity Futures Trading Commission; International Copper Study Group; RBA; United Nations Comtrade; United States Department of Agriculture
Oil	3,250	2,211	40,194	288
Natural gas	1,578	530	3,160	38
Coal	1,203	187	40	3
Iron ore	318	164	8(d)	1(d)
Rice(c)	285	22	58	1
Corn(c)	245	27	2,865	48
Wheat(c)	200	43	1,257	27
Copper	173	51(e)	13,726	93
Gold	139	156(e)	9,362	85
Soybeans(c)	119	45	6,540	70
Sugar(c)	93	32	3,614	28

The pricing mechanism underlying crude oil is, however, not as straightforward as it might appear. Almost all crude oil sold internationally is traded in the ‘over-the-counter’ (OTC) market, where the transaction details are not readily observable. Instead, private sector firms known as price reporting agencies (PRAs) play a central role in establishing and reporting the price of oil – the two most significant PRAs being Platts and Argus Media.

Much more at RBA

It is important to understand the ways in which oil prices reflect fundamentals of supply and demand -- and the ways in which oil prices can at times swing away from the basic fundamentals.

All mechanisms of pricing are subject to manipulation by persons of vested interest. While safeguards can certainly be built into systems to try to minimise such manipulation, even the safeguards on the safeguards are subject to manipulation and circumvention by sufficiently motivated and savvy groups and individuals.

Investors and interested observers must keep all of that in mind as they monitor the states of various markets.