Crude oil is a naturally occurring, unrefined petroleum product composed of hydrocarbon deposits and other organic materials. A type of fossil fuel, crude oil can be refined to produce usable products such as gasoline, diesel, and various other forms of petrochemicals. It is a nonrenewable resource, which means that it can’t be replaced naturally at the rate we consume it and is, therefore, a limited resource.
Understanding Crude Oil
Crude oil is typically obtained through drilling, where it is usually found alongside other resources, such as natural gas (which is lighter and therefore sits above the crude oil) and saline water (which is denser and sinks below). It is then refined and processed into a variety of forms, such as gasoline, kerosene, and asphalt, and sold to consumers.
Although it is often called black gold, crude oil has ranging viscosity and can vary in color from black to yellow depending on its hydrocarbon composition. Distillation, the process by which oil is heated and separated in different components, is the first stage in refining.
A History of Crude Oil Usage
Although fossil fuels like coal have been harvested in one way or another for centuries, crude oil was first discovered and developed during the Industrial Revolution, and its industrial uses were first developed in the 19th century. Newly invented machines revolutionized the way we do work, and they depended on these resources to run. Today, the world’s economy is largely dependent on fossil fuels such as crude oil, and the demand for these resources often spark political unrest, as a small number of countries control the largest reservoirs. Like any industry, supply and demand heavily affect the prices and profitability of crude oil. The United States, Saudi Arabia, and Russia are the leading producers of oil in the world.
In the late 19th and early 20th centuries, however, the United States was one of the world’s leading oil producers, and U.S. companies developed the technology to make oil into useful products like gasoline. During the middle and last decades of the 20th century, however, U.S. oil production fell dramatically, and the U.S. became an energy importer. Its major supplier was the Organization of the Petroleum Exporting Countries (OPEC), founded in 1960, which consists of the world’s largest (by volume) holders of crude oil and natural gas, reserves. As such, the OPEC nations had a lot of economic leverage in determining supply, and therefore the price, of oil in the late 1900s.
In the early 21st century, the development of new technology, particularly hydro-fracturing, has created a second U.S. energy boom, largely decreasing OPEC’s importance and influence.
Adverse Effects of Relying on Oil
Heavy reliance on fossil fuels is cited as one of the main causes of global warming, a topic that has gained traction in the past 20 years. Risks surrounding oil drilling include oil spills and ocean acidification, which damage the ecosystem. Many manufacturers have begun creating products that rely on alternative sources of energy, such as cars run by electricity, homes powered by solar panels, and communities powered by wind turbines.
Investing in Oil
Investors may purchase two types of oil contracts: futures contracts and spot contracts.
The price of the spot contract reflects the current market price for oil, whereas the futures price reflects the price buyers are willing to pay for oil on a delivery date set at some point in the future. The futures price is no guarantee that oil will actually hit that price in the current market when that date comes; it is just the price that, at the time of the contract, purchasers of oil are anticipating. The actual price of oil on that date depends on many factors.
Commodity contracts bought and sold on the spot markets take effect immediately: Money is exchanged, and the purchaser accepts delivery of the goods. In the case of oil, the demand for immediate delivery versus future delivery is small, because in no small part of the logistics of transporting oil to users. Investors, of course, don’t intend to take delivery at all (although there have been situations where an investor’s error has resulted in this), so futures contracts are more common, among both end-users and investors.
An oil futures contract is an agreement to buy or sell a certain number of barrels set amount of oil at a predetermined price, on a predetermined date. When futures are purchased, a contract is signed between buyer and seller and secured with a margin payment that covers a percentage of the total value of the contract. End-users of oil purchase on the futures market to lock in a price; investors buy futures to essentially gamble on what the price will actually be down the road, and profit by guessing correctly. Typically, they will liquidate or roll over their futures holdings before they would have to take delivery.
There are two major oil contracts in which oil market participants are most interested. In North America, the benchmark for oil futures is West Texas Intermediate (WTI) crude, which trades on the New York Mercantile Exchange (NYMEX). In Europe, Africa, and the Middle East, the benchmark is North Sea Brent crude, which trades on the Intercontinental Exchange (ICE). While the two contracts move somewhat in unison, WTI is more sensitive to American economic developments, and Brent responds more to those overseas.
While there are multiple futures contracts open at once, most trading revolves around the front-month contract (the nearest futures contract); for this reason, it’s is known as the most active contract.
Spot vs. Future Oil Prices
Futures prices for crude oil can be higher, lower or equal to spot prices. The price difference between the spot market and the futures market says something about the overall state of the oil market and expectations for it. If the futures prices are higher than the spot prices, this usually means that purchasers anticipate the market will improve, so they are willing to pay a premium for oil to be delivered at a future date. If the futures prices are lower than the spot prices, this means that buyers expect the market to deteriorate.
Backwardation and Contango are two terms used to describe the relationship between expected future spot prices and actual futures prices. When a market is in contango, the futures price is above the expected spot price. When a market is in normal backwardation, the futures price is below the expected future spot price.
The prices of different futures contracts can also vary depending on their projected delivery dates.
Forecasting Oil Prices
Economists and experts are hard-pressed to predict the path of crude oil prices, which are volatile and depend on various situations. They use a range of forecasting tools and depend on time to confirm or disprove their predictions. The five models used most often are:
~ Oil futures prices
~ Regression-based structural models
~ Time-series analysis
~ Bayesian autoregressive models
~ Dynamic stochastic general equilibrium graphs
Oil Futures Prices
Central banks and the International Monetary Fund (IMF) mainly use oil futures contract prices as their gauge. Traders in crude oil futures set prices by two factors: supply and demand and market sentiment. However, futures prices can be a poor predictor, because they tend to add too much variance to the current price of oil.
Regression-Based Structural Models
Statistical computer programming calculates the probabilities of certain behaviors on the price of oil. For instance, mathematicians may consider forces such as behavior among OPEC members, inventory levels, production costs, or consumption levels. Regression-based models have strong predictive power, but scientists may fail to include one or more factors, or unexpected variables may step in to cause these regression-based models to fail.
Bayesian Vector Autoregressive Model
One way to improve upon the standard regression-based model is by adding calculations to gauge the probability of the impact of certain predicted events on oil. Most contemporary economists like to use the Bayesian vector autoregressive (BVAR) model for predicting oil prices, although a 2015 International Monetary Fund working paper noted these models work best when used on a maximum 18-month horizon and when a smaller number of predictive variables are inserted. BVAR models accurately predicted the price of oil during the years 2008-2009 and 2014-2015.
Some economists use time-series models, such as exponential smoothing models and autoregressive models, which include the categories of ARIMA and the ARCH/GARCH, to correct for the limitations of oil futures prices. These models analyze the history of oil at various points in time to extract meaningful statistics and predict future values based on previously observed values. Time-series analysis sometimes errs, but usually produces more accurate results when economists apply it to shorter time spans.
Dynamic Stochastic General Equilibrium (DSGE) Model
Dynamic stochastic general equilibrium (DSGE) models use macroeconomic principles to explain complex economic phenomena; in this case, prices of oil. DSGE models sometimes work, but their success depends on events and policies remaining unchanged since DSGE calculations are based on historical observations.
Combining the Models
Each mathematical model is time-dependent, and some models work better at one time than another. Since no one model alone offers a reliably accurate prediction, economists often use a weighted combination of them all to get the most accurate answer. In 2014, for instance, the European Central Bank (ECB) used a four-model combination to predict the course of oil prices to generate a more accurate forecast. There have been times, however, when the ECB has used fewer or more models to capture the best results. Even so, unforeseen factors like natural disasters, political events or social upheavals may derail the most careful of calculations.
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