One Hundred Dollar Oil

Oil “officially” traded above $100/barrel today for the first time ever (well, sort of). And by officially, I mean that the closing price of West Texas Intermediate in Cushing was $100.74/barrel. Oil has touched $100 a couple times recently though in intraday trading, but I’m fairly certain that this is the first time that it has closed at that level.

There are several different benchmark trading prices for oil, depending on the type of oil and the date of the transaction. For example, WTI is a common benchmark – it stands for West Texas Intermediate, which it is a “light, sweet” crude, with an API gravity of 39.6 and sulphur content of 0.24%. Its specific gravity is around 0.87 (hence the reason that it floats on water, like other oils). When someone talks about the “WTI price” they mean the price of WTI when it is in storage (or assumed to be in future storage) at the major U.S. distribution terminal in Cushing, Oklahoma. WTI is also the oil used for pricing when someone talks about the Nymex price, although under that pricing description, it is assumed that the oil is priced for storage or delivery through the New York Mercantile Exchange.

Other commonly used reference points for oil are Brent Crude (sourced from the North Sea, 0.37% sulphur, 38.1 API), Dubai Crude (sourced from the Middle East, 2.0% sulphur, 31.0 API), and the OPEC Reference Basket (a mix of eight or ten standard crudes from various Middle Eastern states).

The price of oil also depends whether it is a “spot” or “futures” price. A spot price means that a buyer and a seller are willing to trade the oil at a certain price at the time of the trade (ie. on-the-spot). A futures price means that the buyer and seller agree to transfer possession of the oil on a future date, usually measured as the first day of the month of the contract. Finally, a single “contract” means an amount equivalent to one thousand barrels of oil.

Getting confusing yet? It shouldn’t be. Let me give an example. Let’s say that a trader offers to buy 10 futures contracts of Nymex oil at $101.40 for June delivery, from another trader who is willing to sell under those conditions. Under those exact specifications, the buyer has just committed himself to buying 10,000 barrels of oil (on paper anyway, even though he may never physically take possession of the oil) on June 1st, for $101.40 per barrel. In other words, he just spent $1,014,000 – not a small amount. Now what happens if oil goes up in price/value over the next few months, so that on June 1st, the spot price on the Nymex is $103.50? Well, the buyer has already locked in the price with the previous transaction, so even though people are buying and selling for $103.50/barrel on the open (spot) market, the buyer still gets his oil for $101.40/barrel. The interesting thing is that the seller may never have even owned the oil in the first place. He might have been betting the prices would go down between now and June. However, in this example, he made a wrong guess. So the seller, if he didn’t actually have possession of 10,000 barrels of oil, would have to buy those on the open market (for $103.50/barrel) and then sell them right back to the buyer (for $101.40/barrel) at a loss, to meet his obligation, giving him an instant $21,000 loss.

Anyway, now that you know a bit about trading, let’s get back to the point: oil prices are continuing to rise. Oil has actually traded (briefly) above $100 a couple other times in the past year, but this is the first time that it closed trading for the day above the magic $100 mark. I think the first time that it traded for $100 was maybe back in late December? I can’t remember for sure, but I believe that it was a single contract traded, and the price immediately dropped back to $99.40 after that single $100.00 contract. So in other words, a trader probably did the trade for bragging rates. He bought a thousand barrels for $100.00 per barrel, and a minute later sold them for $99.40 per barrel, which would be a total loss of $600. Why would he do that? Either he was an idiot, or more likely, he did it for bragging rights: he probably figured it was worth $600 to him (pocket change for most big-time traders) to be able to brag to his grandkids someday and say, “Yes, I was the first person in the world to trade oil for $100.00/barrel.”

That’s a big psychological barrier. It was only a few years ago that people thought we would never, ever see oil priced that high. Before Katrina, the record high price for oil was around $60/barrel. However, I think $100.00 is still a drop in the bucket. Based on volume, that’s still cheaper than milk, and even cheaper than bottled water in a lot of places. There’s plenty of oil left in the world, although the cheap and easy-to-extract stuff is running out. Get ready for gas prices to continue to rise in the near future. The depressing thing however, which I’ve said before, is that “we haven’t seen anything yet.” I don’t think the real pressure on oil prices (due to worldwide demand exceeding available production capacity) will start causing major price spikes until 2010. Enjoy the party while you can.