What Is Crude Oil?
Crude oil is a naturally occurring petroleum product composed of hydrocarbon deposits and other organic materials. A type of fossil fuel, crude oil is refined to produce usable products including 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).
After its extraction, crude oil is refined and processed into a variety of forms, such as gasoline, kerosene, and asphalt, for sale to consumers.
Although it is often called "black gold," crude oil has a range of 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 into different components, is the first stage in refining.
Although fossil fuels like coal have been harvested for centuries, crude oil was first discovered and developed during the Industrial Revolution, and its industrial uses were 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 sparks 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, 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, 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 great deal 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, created a second U.S. energy boom, largely decreasing OPEC's importance and influence.
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 several decades. Risks surrounding oil drilling include oil spills and ocean acidification, which damage the ecosystem. In the 21st century, 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. To the individual investor, oil can be a speculative asset, a portfolio diversifier, or a hedge against related positions.
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.
Most commodity contracts that are 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, in no small part due to the logistics of transporting oil.
Investors, of course, don't intend to take delivery of commodities at all (although there have been cases of investor errors that have resulted in unexpected deliveries), so futures contracts are more commonly used by traders and investors.
An oil futures contract is an agreement to buy or sell a certain number of barrels 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 in order to lock in a price; investors buy futures essentially as a gamble on what the price will actually be down the road, and they profit if they guess correctly. Typically, they will liquidate or roll over their futures holdings before they would have to take delivery.
There are two major oil contracts that are closely watched by oil market participants. 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 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.
How Does One Invest in Crude Oil?
To an investor, crude oil can be a speculative asset, a portfolio diversifier, or a hedge against related positions. There are two ways to invest in crude oil: 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.
Most commodity contracts that are bought and sold on the spot markets take effect immediately—money is exchanged, and the purchaser accepts delivery of the goods. A futures contract is an agreement to buy or sell a certain number of barrels of oil at a predetermined price, on a predetermined date.