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Crude Oil And Gas Prices
BY NICK K. LIOUDIS
When the price of
gas rises, it impacts how people travel, how goods are shipped, and how people
formulate their budgets.
When home heating
prices climb, people have to decide whether or not they can afford to turn up
their thermostats.
When various goods
have become more expensive because their components also cost more, people have
to make difficult choices on what to buy.
One reason for
these and other price fluctuations is the price of oil. The price
of oil affects individual spending choices. It forces companies to make
difficult decisions. It can even change relations between countries.
Oil is perhaps the
world's most important natural resource and impact the daily lives of people
worldwide.
Crude Oil Origins
No one knows
exactly how oil was created. But there are two theories that explain how the
substance may have originated.
The first theory
suggests that oil is a fossil fuel, meaning it is composed of dead
plants and animals that lived hundreds of millions of years ago. After
decomposing over the eons, the chemical compounds of the remains broke down and
formed what we now call oil.
Twentieth-century
Russian scientists proposed another, "abiotic" theory, which states
that oil comes from near the earth's core, where it eventually flows, much like
lava, into puddles underneath the earth's crust.
Finding Crude Oil
Oil can be found on
all of the earth's continents.
Some places, like
Australia, have very little, but countries that have large reservoirs of oil
are key players on the world stage. After all, they are sitting on top of pools
of one of the most important global resources.
Oil is
traditionally measured in barrels, and 1 barrel equals 42 gallons.
Experts say that
there are about 1.5 trillion barrels of oil reserves left in the ground. If you've
ever read anything about the Middle East, then you certainly know that it is
the center of the world's oil supply.
The region sits on
top of a liquid gold mine; experts estimate the region holds more than 1.2
trillion barrels of oil in its various fields and reserves or roughly 49% of
all the world's resources.
The nation that has
some of the most oil — not just the Middle East but the entire world — is Saudi
Arabia. The kingdom, also the spiritual home of Islam, reportedly has more than
267 billion barrels of oil reserves, second only to Venezuela’s 300 billion.
The other Middle
Eastern nations, all with sizable quantities, have about one-half of what Saudi
Arabia has in reserves.
These nations
include Iraq, Iran, Kuwait and the United Arab Emirates. In total, the region's
vast supplies of oil make them an integral part of the world economy.
Canada, which has
close to 172 billion barrels within its borders, has the third-largest amount
of proven oil reserves in the world.
However, much of
these reserves are located in Alberta's "sand pits," a terrain
that makes the oil harder to extract from the earth than it is in other
countries.
However,
technological innovations are expected to make extracting oil located in this
kind of terrain easier.
Other nations with
large reservoirs of oil include Russia, Libya, United States, Nigeria, and
Kazakhstan.
Refining Crude Oil
Before oil can be
used, it has to be broken down in a process known as "refining."
After being purchased, oil is shipped to various refineries around the world.
In America, many
(but certainly not all) of the oil refineries are located in the Gulf Coast
region. This is a reason why oil costs tend to fluctuate during storm season. A
large hurricane, for example, puts oil supplied at the refineries at risk of
destruction.
Refining oil works
in a relatively easy way. Crude oil is put into a boiler and turned
into a vapor. From there, the vapor moves into a distillation chamber, where it
is turned back into a liquid.
Different types of
oil are formed depending upon the temperature they were distilled at.
Gasoline, for
example, is distilled at cooler temperatures than residual oils that are used
to make products, such as asphalt and tar.
After the many
substances made from oil are processed, they arrive in various products to do a
little bit of everything, from heating homes to powering cars.
Oil Uses
It makes sense that
the world's biggest economies would use the most oil.
America, which has
the world's biggest gross domestic
product (GDP), also consumes more oil than any other nation. The
U.S. uses almost 25% of the estimated 80 million barrels of oil produced around
the world every day.
The phrase
"America's dependence on foreign oil" is mentioned often in the
media, particularly in reference to American imports from the Middle East.
However, this
statement doesn't accurately tell who supplies the U.S. About 34% of all of the
oil America uses comes from reserves found in the 50 states.
The country that
exports the most oil to America is Canada, with Saudi Arabia second.
The European Union (EU) also uses a large
percentage of the world's reserves, going through approximately 14.5 million
barrels daily.
Other nations who
have large, established economies — Japan, Canada and South Korea rank high on
the list of the world's biggest oil consumers.
China is one
country that may play the biggest role in world oil consumption. China
currently ranks as the third-biggest oil consumer on the planet.
But with its
dynamic and fast-growing economy, China's usage of oil is forecasted to grow
exponentially. Analysts have said
that China's demand for oil grows by approximately 7.5% a year.
This increased
demand — along with the growing energy needs of countries like India and Brazil
— has been a contributing factor in the rise of oil prices over the past few
years. These countries act as the demand for the world's oil supplies. However,
the way oil is priced does not reflect that of the free market.
OPEC's Impact on Oil
One body has great
influence over the worldwide price of oil.
The Organization of
Petroleum Exporting Countries, more commonly known as OPEC, is
a cartel made up of 12
of the world's biggest oil-producing nations, including all of the major Middle
Eastern states, Venezuela and Nigeria.
According to OPEC,
this cartel controls 78% of the world's known oil reserves. The major oil
producers not in OPEC include Russia, Canada, and the U.S.
Since the OPEC
nations produce so much of the world's oil supply, they can manipulate the
price per barrel depending upon how many barrels per day the group
will sell on the world oil market.
If the group wants
the price to rise in order to make more money, they can reduce the amount of
oil contributed to the world market.
And if they want
the price to dip — high energy prices drive down demand from OPEC's consumers —
they can release more barrels to the market.
While Canada,
Russia, America, and other producers can also increase supply, they cannot
affect world prices nearly as much as OPEC.
Types of Oil and Pricing
One might assume
there is only one type of oil, but that's far from the truth: There are 161
different types, each with its own consistency, chemical breakdown, and
potential for use.
Even though there
are so many forms of oil, we typically only cite only one price for a barrel.
This is because oil traders have selected
the most widely used types of oil to determine the price per barrel.
For instance, one
common type of oil found and used in America is called West Texas Intermediate (WTI).
West Texas
Intermediate's popularity is due to it being a "light and sweet" oil, which is easy to break down in the refining
process. Since this oil is purchased quite frequently, it is used as an
industry standard.
Other price benchmarks are used globally. Most
European nations use the Brent Blend, found in the North Sea, as their
benchmark price.
Another heavily
used benchmark is the OPEC basket, which combines the prices of
several other popular types of oil from around the world into a
"price basket."
And while oil can
be purchased directly (in what is called the spot market), the commonly cited price per
barrel does not reflect what a customer pays. Instead, the price bandied about
has been sold on the futures market.
In America, WTI
crude-oil futures are traded through the New York Mercantile
Exchange (NYMEX).
European oil
futures are sold through Intercontinental Exchange's London branch.
Globex is another
popular commodities market where oil futures change hands.
Oil and Gas Correlation
There is a limited
positive correlation between crude oil and natural gas prices.
It seems logical
there would be a positive correlation between the commodities, especially since
natural gas is often a byproduct of drilling for crude oil.
While at times
crude oil and natural gas have had a positive correlation, the markets for each
commodity are substantially different and subject to different fundamental
forces.
Statistical
analysis shows there are periods of positive correlation, but generally, the
two have limited correlation.
Natural Gas & Oil Correlation
The correlation coefficient is a statistical measure of the
extent to which the price of natural gas and crude oil move together. It is
also a measure of the degree to which the prices move together.
The correlation
coefficient is measured on a scale of -1 to +1.
A measure of +1
indicates a perfect positive correlation between two asset prices, meaning the
prices of the assets move together in the same direction to the same degree
proportionally all of the time.
A measure of -1
indicates a perfect negative correlation. This means the asset prices move in
the opposite direction of each other in the same proportion all of the time.
If the correlation
coefficient is zero, it means there is no relationship between the two prices.
The correlation
coefficient is often used in the construction of portfolios by providing a
statistical measure of the diversification of the assets in the portfolio.
Oil and Gas Data Sources
The Energy Information Administration (EIA) provides
historical data for the daily correlation between commodities on a quarterly
basis.
This information
indicates the correlation between crude oil and natural gas is falling.
For example, in
2004, the average quarterly correlation between the two prices was around 0.45.
This is a moderate positive correlation.
In 2010, this
correlation average fell to -0.006, showing there was very little relationship
between the prices.
In 2014, the
average correlation was 0.075. This also indicates very little correlation.
However, the first two quarters of 2015 show an average correlation of 0.195,
which is slightly positive.
Prices for both
commodities generally fell during this period.
The highest
correlation was in the third quarter of 2005 with a measure of 0.699. The
lowest correlation was in the third quarter of 2010 with a negative correlation
of -0.21.
In general, the
correlation is falling. The EIA notes this is due to the increase in shale oil
natural gas production.
Gas Production and Oil
Natural gas oil production has increased
dramatically with the discovery of new shale drilling technologies.
Between 2007 and
2012, natural gas production from shale drilling rose by a whopping 417% and
overall production increased by around 20% during the same period.
Natural gas prices
have shown greater volatility historically than crude oil prices, while low
natural gas prices have led sectors such as the transportation industry to use
more natural gas over crude oil.
Natural gas usage
in the transportation sector grew by 22% from 2007 to 2012.
Prices and Oil Production
Shale drilling technologies have also led to
expanded crude oil production.
Daily crude oil
production increased from 5.35 million barrels per day in 2009 to 6.5 million
barrels in 2012.
Production in 2014
grew even more to 8.7 million barrels a day. Estimates for 2015 indicate this
number will likely grow even larger.
This increased
production is one of the reasons for the dramatic drop in oil prices from 2014
to 2015. Oil was trading at over $105 a barrel in June of 2014 and by late
January 2015, the price cratered to around $45 a barrel.
Supply was
outstripping demand and increased production combined with lower demand has
hurt prices.
Further, economic
uncertainty across the globe has called into question the strength of future
demand.
The Bottom Line
Oil is one of the
world's most important commodities. As a result, the nations that control the
bulk of the world's supply have (and exercise) a great deal of power over its
availability.
The supply of oil
in the world market has an impact on its price, and the fluctuations are passed
on to consumers, especially in nations that use a lot of oil, such as the U.S.
Oil prices are also
determined by the quality and ease of refining.
Investors have the
option of investing in oil futures, which themselves have an influence on the
price of oil that is reported.
The oil market is
quite complex, and a better understanding of how oil gets to you from the
ground in all its forms will help you to understand and deal with fluctuating
prices.
Nick
Lioudis
10+
years as a journalist for national publications including The Star Ledger and
amNY
Former
deputy editor of Financial Investment News, which offers a series of products
focused on institutional investors
Current content
manager at Chartbeat, a technology company that provides data and
analytics to global publishers.
Experience
Nick
Lioudis is a New Jersey-born, Brooklyn-based writer, multimedia
professional, and consultant whose work has appeared in national publications
such as amNY, Honeysuckle Magazine, The Star Ledger, Morristown Daily Record,
Nonprofit News, and Emerging Manager Monthly. He currently serves as content
manager for Chartbeat, a content intelligence platform for publishers,
empowers media companies to build loyal audiences with real-time and historical
editorial analytics across desktop, social, and mobile platforms. Nick was the
former content manager of Bread, a N.Y.-based fintech startup that offers
consumer lending solutions for retailers and consumers.
Education
Nick
received his Bachelor of Arts in journalism from Seton Hall University and he
earned his master's degree from the Milano School of Policy, Management, and
Environment at The New School.
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