How Does Crude Oil Affect Gas Prices?

By Gregory Gethard AAA

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.

The reason for the above price fluctuations is 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. But what makes it so important? Why is it constantly in the headlines? And why is the price of oil constantly in flux? In this article we'll take a look at where oil comes from.

How Oil Was Made
No one knows exactly how oil was created. But there are two theories that explain how the substance may have originated.

  1. 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. (Read more about alternatives to fossil fuels in The Biofuels Debate Heats Up.)
  2. Some scientists believe in another theory. Twentieth-century Russian scientists proposed the "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.

Where is Oil Found?
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 find themselves as key players on the world stage. After all, they are sitting on top of pools of one of the most important resources in the world.

Oil is traditionally measured in barrels, and 1 barrel = 42 gallons. Experts say that there are about 1.3 trillion barrels of oil. 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 700 billion barrels of oil in its various fields and reserves, or roughly 56% of all the world's resources.

The nation that has the most oil - in not just the Middle East, but the entire world - is Saudi Arabia. The kingdom, also the spiritual home of Islam, reportedly has more than 250 billion barrels. The other Middle Eastern nations with sizable quantities all have about one-half of Saudi Arabia's reserves. They 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. (Learn more about OPEC and oil supply in A Guide To Investing In Oil Markets.)

It may shock you to learn which country has the second-largest amount of proven oil reserves in the world. The answer is Canada, which has close to 200 billion barrels within its borders. 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, over time, to make extracting oil located in this kind of terrain easier. (Learn more about the relationship between Canada and oil in Commodity Prices And Currency Movements.)

Other nations with large reservoirs of oil include:

  • Libya
  • Venezuela
  • Nigeria
  • Mexico
  • Indonesia
  • the EU nations
  • Brazil
  • China

Refining
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 GulfCoast 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. (Oil companies are often synonymous with environmental problems in many people's minds. Read about oil producers that have attempted to mislead the public in The Green Marketing Machine.)

Refining oil works in an 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 our homes to powering our cars.

Who Uses Oil?
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 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 United States. 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.

But the one country that may play the biggest role in world oil consumption is China. 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 forecast to grow exponentially. Chinese analysts have said that China's demand for oil grows by 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. (For more on China's role in the oil and gas markets, read What Determines Gas Prices?)

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. (To learn about the most common way goods' prices are determined, see our Economics Basics tutorial.)

OPEC
One body has great influence over the worldwide price of oil. The Organization of Petroleum Exporting Countries (OPEC), more commonly known as OPEC, is a cartel comprising 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 United States.

Since OPEC's 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 can and does. (For more on how oil prices end up as your price at the pump, see Why You Can't Influence Gas Prices.)

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. But since there are so many forms of oil, why does the media give 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. (For more, read What Determines Oil Prices?)

Other price benchmarks are used in other parts of the world. 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 IntercontinentalExchange's London branch. Globex is another popular commodities market where oil futures change hands. (Get an education on how futures work at Futures Fundamentals, and learn about the oil futures market in Become An Oil And Gas Futures Detective.)

Conclusion
Oil is one of the world's most important commodities, and 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 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 in the media. All in all, the oil market is quite complex, and a better understanding of how the oil gets from the ground to you, in all its forms, will help you to understand and deal with fluctuating prices.

For further reading, check out Getting A Grip On The Cost Of Gas.

comments powered by Disqus
Related Articles
  1. Not All Oil Economies Are Created Equal
    Investing Basics

    Not All Oil Economies Are Created Equal

  2. Oil Price Analysis: The Impact Of Supply ...
    Economics

    Oil Price Analysis: The Impact Of Supply ...

  3. Interested In Investing In Africa? Here's ...
    Fundamental Analysis

    Interested In Investing In Africa? Here's ...

  4. How To Buy Oil Options
    Options & Futures

    How To Buy Oil Options

  5. Can Investors Trust Official Statistics?
    Economics

    Can Investors Trust Official Statistics?

Trading Center