Brent price, the Rotterdam market, strategic reserves: as familiar as these expressions are to oil industry experts, the layperson can find them puzzling. There is an "exchange" for oil, just as there is for stocks. How does it work? Who sets the price of crude oil? A look inside.

Ever since the 1970s and the nationalization of crude oil production, crude has been sold by one state to another, by a state to an oil company under a contract, or by a state to traders, who buy and sell the oil on global markets.

Once it has been refined, the oil itself supplies the entire petrochemical sector, generating a multitude of commodities, or "white products", that go beyond simple sources of energy. Trading companies deal in these products as well. Between the crude producer, the intermediary and the final consumer, there is thus a complex global market for trading and exchange.

Who are the traders?

All large oil companies have trading subsidiaries. These companies supply crude oil to refineries, sell surplus oil on the market, and swap crude oil and derivatives with their colleagues to avoid unnecessary shipping costs. But there are also completely independent trading companies with purely financial objectives. Their traders buy oil cargos in advance and sell them as quickly as possible on global markets to buyers in enough of a hurry to agree to a higher price. Thus, a trader can buy a cargo of oil at a relatively low price and turn around and sell it at a profit if others need it more and are ready to pay the price. It is common for a crude oil cargo to change hands en route, sometimes several times. Trading can therefore generate large profits.

Spot markets, forward markets…how does it all work?

A large share of the oil produced is sold on the open market according to the law of supply and demand. This is the "spot market", where deals are negotiated on the physical quantity of oil to be shipped in the near future, or perhaps even already on its way. But it usually takes several months between the date the crude oil is purchased and the delivery of refined products from that cargo, and the price of crude can vary during that time. As insurance against this risk, a financial mechanism called a "hedge" is set up on a special "forward market".

In that case, oil companies enter into relatively long-term buy or sell contracts with producer countries and/or companies (3 months, 6 months, 1 year, etc.) for a certain quantity of oil, whose price is fixed when the contract is signed. Since the beginning of the 1980s, forward contracts on crude oil and petroleum products have become so prevalent that those contract prices are often used, directly or indirectly, as a reference in developing prices for physical deliveries. Traders make deals by telephone or over the Internet, just as for financial transactions. Prices are quoted 7 days a week, 24 hours a day. They are printed in the daily Platts Oilgram News published by Platts, which specializes in publishing energy prices for both the physical markets and forward markets. Most oil companies also subscribe to dispatches from Reuters and Petroleum Argus (another specialized company), which supply quotes based on data collected from dealers and other market players. In Europe, traders work with Asia in the morning and with the United States in the afternoon, once the New York market has opened. The oil trading system is similar to that of the capital markets.

Where are the exchanges located?

The international crude oil trade is centered in two markets, New York and London, as is trading of intermediate petroleum products and finished products. In New York, it's the New York Mercantile Exchange, or Nymex. In London, it's the International Petroleum Exchange, or IPE, which was founded in 1980 by a group of companies connected with the financial and energy sectors.

These exchanges have had competition recently from electronic exchanges. One of them, the Intercontinental Exchange based in Atlanta, Georgia (USA), hoisted itself onto the global market in April 2001 when it bought the IPE. Financed by large oil companies and financial institutions, this exchange combines the facility of an electronic portal with risk management software. Today, its trading volume for crude oil exceeds that of NYMEX.

Other strategic marketplaces for oil trading are Houston (the "capital" of U.S. oil), Singapore (an important area for transit and refining), Tokyo, and Rotterdam (the largest spot market in northern Europe). Geographically, they are located near regional refineries, but all of them go through the two main markets via the Internet.

What are reference prices?

Prices for crude oil are expressed in dollars per barrel and are fixed at the global level. Coming up with a price is a complex process, as there are almost 450 types of crude worldwide. Some of them are used as a standard to establish the average price of oil from a given region, such as Arabian Light (the reference crude from the Middle East), West Texas Intermediate (WTI, the U.S. standard) and especially Brent. Brent, whose name was taken from a petroleum field discovered in the North Sea in 1971, is the standard not only for the European market, but for the global market as well. The price for 60% of the oil pumped worldwide is determined by the price of Brent, even though its production is limited¹.

Reference prices for crude in other markets vary, depending on the type of crude. For example, the Brent and WTI crudes mentioned above serve as a reference for the light and sweet crude category. For heavier crudes with a higher sulfur content, Dubai, West Texas Sour (WTS) and Alaska North Slope (ANS) are the standards. In the Persian Gulf, Dubai crude is used to fix prices for Asia, because it's one of the few Gulf crudes sold on a spot basis; most of the others are sold under forward contracts.

As the leading player in the oil market, OPEC also calculates a reference price called the "OPEC basket". Since June 2005, its reference basis includes 11 crude prices from its members (versus 7 in the past): Saharan Blend (Algeria), Minas (Indonesia), Iran Heavy (Iran), Basra Light (Iraq), Kuwait Export (Kuwait), Es Sider (Libya), Bonny Light (Nigeria), Qatar Marine (Qatar), Arabian Light (Saudi Arabia), Murban (United Arab Emirates) and BCF 17 from Venezuela. The price difference between Brent, WTI and the OPEC basket is minimal, at only a few percent.

The large spot markets

Petroleum products are also quoted on regional markets. There isn't a spot market for each type of crude, but there are seven key physical markets, each of which reflects prices for several types of crudes. The American market, for example, processes most of the oil produced in the United States, including West Texas Intermediate (WTI) and Alaska North Slope (ANS), along with a few others from Latin America. The North Sea market focuses mainly on oil from Norway and the United Kingdom, with Brent being the most common. Rotterdam is also a trading center for petroleum derivatives. The Mediterranean market deals in Russian, Libyan and Iranian crudes of highly variable quality. The Gulf market deals mostly in crudes from Oman and the United Arab Emirates; Saudi Arabian crudes are not often seen here. The Far Eastern market imports most of its crude oil from the Middle East. The West African market deals in some crude exports from Nigeria and Angola, but the majority of African crude is negotiated based on certain forward contract prices. Still, there is a strong correlation among all these markets, and they all experience generally the same trends with regard to trading prices.

How are crude prices set?

Since the mid-1990s, prices on the physical markets, which had up to then served as the reference, have increasingly been replaced by prices on forward markets. The final contract price is calculated using a formula based on one or more reference prices, to which a differential is added. This adjustment factor is tied to multiple variables. The difference in quality or different refining possibilities are first in importance.

The differences between crude prices therefore depend mostly on physical and chemical characteristics, which the original owner must disclose to the buyer. Put more simply, the lighter the crude – thus yielding a larger quantity of high value-added products after processing – the more expensive it is. Other factors also enter into the picture, such as sulfur content. Sweet crudes are the best, because they can be more easily refined. This is all the more true in that applicable environmental standards in many consumer countries require refined products to have low sulfur contents. Insurance, refining costs, refinery profits and, above all, transportation costs are also added to the base price. Oil tanker costs are based on an annually updated scale known as the New Worldwide Tanker Nominal Freight Scale – Worldscale for short – which gives freight costs for just about any sea route. Freight charges per tanker are calculated port to port, based on a standard ship in terms of size, age, speed, etc. Shipping costs are expressed as a percentage of the Worldscale cost. Last but not least, crude can be sold "Free on Board" (FOB) or with "Cost, Insurance and Freight" (CIF). In the first case, the buyer pays all expenses (ship chartering, cargo insurance); in the second case, the seller pays everything up front. The price of oil is therefore the result of a combination of many criteria. It varies constantly, influenced by many other factors that are much less foreseeable: overproduction or underproduction, political crisis in a country (not necessarily the producer country), bad weather, terrorism, war…

1. Platts as just modified its calculation formula slighty, and the term is now "Brent Forties Oserberg" (BFO).