Open a newspaper and there’s a good chance you’ll find a news story about the price of oil going in one direction or the other. To the average consumer, it’s easy to get the impression that there’s a singular, worldwide market for this crucial energy source.
In reality, there are different types of crude oil – the thick, unprocessed liquid that drillers extract below the earth – and some are more desirable than others. For instance, it’s easier for refiners to make gasoline and diesel fuel out of low-sulfur or “sweet” crude than oil with high-sulfur concentrations. Low-density, or “light” crude is generally favorable to the high-density variety for the same reason.
Where the oil comes from also makes a difference if you’re a buyer. The less expensive it is to deliver the product, the cheaper it is for the consumer. From a transportation standpoint, oil extracted at sea has certain advantages over land-based supplies, which depend on the capacity of pipelines.
Because of these factors, buyers of crude oil – along with speculators – need an easy way to value the commodity based on its quality and location. Benchmarks such as Brent, WTI and Dubai/Oman serve this important purpose. When refiners purchase a Brent contract, they have a strong idea of how good the oil will be and where it will come from. Today, much of the global trading takes place on the futures market, with each contract tied to a certain category of oil.
Because of the dynamic nature of supply and demand, the value of each benchmark is continually changing. Over the long-term, a marker that sold at a premium to another index may suddenly become available at a discount.
Understanding Benchmark Oils
The Main Benchmarks
There are dozens of different oil benchmarks, with each one representing crude oil from a particular part of the globe. However, the price of most of them are pegged to one of the following three primary benchmarks:
Roughly two-thirds of all crude contracts around the world reference Brent Crude, making it the most widely used marker of all. These days, “Brent” actually refers to oil from four different fields in the North Sea: Brent, Forties, Oseberg, and Ekofisk. Crude from this region is light and sweet, making them ideal for the refining of diesel fuel, gasoline, and other high-demand products. And because the supply is waterborne, it’s easy to transport to distant locations.
West Texas Intermediate (WTI)
WTI refers to oil extracted from wells in the U.S. and sent via pipeline to Cushing, Oklahoma. The fact that supplies are land-locked is one of the drawbacks to West Texas crude as it’s relatively expensive to ship to certain parts of the globe. The product itself is very light and very sweet, making it ideal for gasoline refining, in particular. WTI continues to be the main benchmark for oil consumed in the United States.
This Middle Eastern crude is a useful reference for oil of a slightly lower grade than WTI or Brent. A “basket” product consisting of crude from Dubai, Oman or Abu Dhabi, it’s somewhat heavier and has higher sulfur content, putting it in the “sour” category. Dubai/Oman is the main reference for Persian Gulf oil delivered to the Asian market.
Brent is the reference for about two-thirds of the oil traded around the world, with WTI the dominant benchmark in the U.S. and Dubai/Oman influential in the Asian market.
Source: IntercontinentalExchange (ICE)
Importance of the Derivatives Market
There was once a time when buyers would primarily purchase crude oil on the “spot market” – that is, they’d pay the current price and accept delivery within a few weeks. But after the oil crisis of the late 1970s, refiners and government buyers began looking for a way to minimize the risk of sudden price increases.
The solution came in the form of crude oil futures, which are tied to a specific benchmark crude. With futures, buyers can lock in the price of a commodity several months, or even years, in advance. If the price of the reference crude rises significantly, the purchaser is better off with the futures contract. Many futures are settled in cash, although some allow for physical delivery of the commodity.
Different crude contracts trade on different exchanges. Brent futures are available on ICE Futures Europe, while WTI contracts are sold chiefly on the New York Mercantile Exchange, or NYMEX. The influential Oman Crude Oil Futures Contract (DME Oman) has been marketed on the Dubai Mercantile Exchange since 2007. These contracts stipulate not only where the oil is drilled, but also its quality.
In addition to futures, market participants can also invest in options that are linked to a particular crude benchmark. These derivatives are another important way to help mitigate price risk. Should the value of a certain crude marker skyrocket, the owner of a call option would have the right – though not the obligation – to buy a specific number of barrels at a pre-determined price.
However, not all futures or options tied to a crude benchmark are used for hedging purposes. Speculators are also major players in the market, betting that changes to supply or demand will drive the price of certain crude products higher or lower.
Investors can also gamble on what will happen to the difference, or spread, between two benchmarks. Participants typically analyze the fundamentals of a specific oil source and guess whether the gap between two markers will widen or close. Like traditional oil options, these “spread options” are available on major exchanges.
Trading tends to be particularly heavy when one of the two benchmarks undergoes unusual volatility. For example, WTI-Brent spread options on NYMEX experienced record trading volume from 2011 to 2013 after a glut in U.S. crude sent WTI prices in a tailspin relative to Brent.
The Bottom Line
The market for crude is incredibly diverse, with the quality and original location of the oil making a major impact on price. Because they’re relatively stable, most crude oil prices worldwide are pegged to the Brent, WTI or Dubai/Oman benchmarks.