The Pricing of Crude Oil
Stephanie Dunn and James Holloway*
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.
| 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.
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