Oil, Oil, and More Oil...Part 1

This is Bradley again, reporting in from “Safe-at-home” in Southern California…(I needed a break from thesis writing). This week, I’m going to stay far away from COVID-19 news (because we definitely get enough of that) and talk about the global oil markets, and some recent “interesting” events.

We are all at least passingly familiar with oil. Oil is a mixture of chemicals (specifically hydrocarbons) that are derived from decay of organic remains of ancient organisms. In the past several centuries, humans have figured out how to separate oil into different useful parts (a process called refining) including fuels (gasoline, diesel, methane), feedstocks for the chemical industry (ingredients for plastics, perfumes, and pharmaceuticals), and building materials (asphalt and tar). As a result, oil production, trade, and refining has become an essential part of the global market.

Because of petroleum’s important uses, a global trade in petroleum has developed.  We’re probably all familiar with seeing pundits talking about the price of a “barrel” of oil. A barrel of oil is 42 gallons and is the primary trading unit in oil markets. There are many different kinds of oil that are traded in the global marketplace, but probably the two most common are Brent and WTI (West Texas Intermediate). Generally speaking, the differences between types of oil aren’t important financially (specifically they have different densities and quantities of sulfur) because they all produce fuels and other compounds after refining (that’s what we chemical engineers do). They generally move together in global markets, with Brent having a higher price than WTI.

Now, let’s finally talk about oil in the financial markets. Broadly speaking, oil prices move the same way as the economy. This is because when the economy is good, people buy more stuff (which often requires petroleum products to make and transport) and travel more (using more fuel), which increases the demand for petroleum products and thus the price. When the economy enters a recession, all things being equal, oil prices will decrease due to a decrease in aggregate demand.

However, the oil market is not a free market (at all), due to the presence of OPEC (organization of petroleum exporting countries) in the market. OPEC is a cartel made up of countries (and their state-owned petroleum companies) that produce much of the world’s oil, with the goal of maintaining high oil prices to maximize revenue.   Important members of OPEC include Saudi Arabia, Venezuela, Nigeria, Iraq, and Iran. Historically, OPEC has had a great deal of control over global oil prices.  However, recently due to technological advancements, the US (and to a lesser degree Canada) have diminished OPEC’s power due to development of shale oil resources. These resources significantly increased the supply of oil, resulting in lower prices and significant strife in OPEC which is no longer able to maintain their high prices.

Next up:  What has happened to oil prices in 2020 and why it matters to us