What is Crude Oil

Crude oil is a naturally occurring, unrefined petroleum product composed of hydrocarbon

deposits and other organic materials. A type of fossil fuel, crude oil can be refined to produce
usable products such as gasoline, diesel and various forms of petrochemicals. It is
a nonrenewable resource, which means that it can't be replaced naturally at the rate we
consume it and is therefore a limited resource.

BREAKING DOWN Crude Oil

Crude oil is typically obtained through drilling, where it is usually found alongside other
resources, such as natural gas (which is lighter, and therefore sits above the crude oil) and
saline water (which is denser, and sinks below). It is then refined and processed into a variety
of forms, such as gasoline, kerosene and asphalt, and sold to consumers.

Although it is often called "black gold," crude oil has ranging viscosity and can vary in color
from black and yellow depending on its hydrocarbon composition. Distillation, the process by
which oil is heated and separated in different components, is the the first stage in refining.

History of Crude Oil Usage

Although fossil fuels like coal have been harvested in one way or another for centuries, crude
oil was first discovered and developed during the Industrial Revolution, and its industrial uses
were first developed in the 19th century. Newly invented machines revolutionized the way
we do work, and they depended on these resources to run. Today, the world's economy is
largely dependent on fossil fuels such as crude oil, and the demand for these resources often
spark political unrest, since a small number of countries control the largest reservoirs. Like
any industry, supply and demand heavily affects the prices and profitability of crude oil. The
United States, Saudi Arabia, and Russia are the leading producers of oil in the world.

In the late 19th and early 20th centuries, however, the United States was one of the world's
leading oil producers, and U.S. companies developed the technology to make oil into useful
products like gasoline. During the middle and last decades of the 20th century, however, U.S.
oil production fell dramatically, and the U.S. became an energy importer. Its major supplier
was the Organization of the Petroleum Exporting Countries (OPEC), founded in 1960, which
consists of the world's largest (by volume) holders of crude oil and natural gas, reserves. As
such, the OPEC nations had a lot of economic leverage in determining supply, and therefore
the price, of oil in the late 1900s.

In the early 21st century, the development of new technology, particularly hydro-fracturing,
has created a second U.S. energy boom, largely decreasing the importance and influence of
OPEC. (For more, see How Does Crude Oil Affect Gas Prices?)

Adverse Effects of Reliance on Oil

Heavy reliance on fossil fuels is cited as one of the main causes of global warming, a topic
that has gained traction in the past 20 years. Risks surrounding oil drilling include oil spills
and ocean acidification, which damage the ecosystem. Many manufacturers have begun
creating products that rely on alternative sources of energy, such as cars run by electricity,
homes powered by solar panels, and communities powered by wind turbines.

Investing in Oil

Investors can purchase two types of oil contracts: futures contracts and spot contracts. The
price of the spot contract reflects the current market price for oil, while the futures price
reflects the price buyers are willing to pay for oil on a delivery date set at some point in the
future. The futures price is no guarantee that oil will actually hit that price in the current
market when that date comes; it is just the price that, at the time of the contract, purchasers of
oil are anticipating. The actual price of oil on that date depends on a multitude of factors.

Commodity contracts bought and sold on the spot markets take effect immediately: Money is
exchanged, and the purchaser accepts delivery of the goods. In the case of oil, the demand for
immediate delivery versus future delivery is small, due in no small part to the logistics of
transporting oil to users. Investors, of course, don't intend to take delivery at all (although
there have been situations where an investor’s error has resulted in this), so futures contracts
are more common, among both end users and investors.

Futures Contracts

An oil futures contract is an agreement to buy or sell a certain number of barrels set amount
of oil at a predetermined price, on a predetermined date. When futures are purchased, a
contract is signed between buyer and seller, and secured with a margin payment that covers a
percentage of the total value of the contract. End users of oil purchase on the futures market
to lock in a price; investors buy futures to essentially gamble on what the price will actually
be down the road, and profit by guessing correctly. Typically, they will liquidate or roll over
their futures holdings before they would have to take delivery.

There are two major oil contracts in which oil market participants are most interested. In
North America, the benchmark for oil futures is West Texas Intermediate (WTI) crude, which
trades on the New York Mercantile Exchange (NYMEX). In Europe, Africa and the Middle
East, the benchmark is North Sea Brent crude, which trades on the Intercontinental Exchange
(ICE). While the two contracts move somewhat in unison, WTI is more sensitive to American
economic developments, and Brent responds more to those overseas.

While there are multiple futures contracts open at once, most trading revolves around
the front-month contract (the nearest futures contract); for this reason, it's is known as
the most active contract.

Spot vs. Future Oil Prices

Futures prices for crude oil can be higher, lower or equal to spot prices. The price difference
between the spot market and the futures market says something about the overall state of the
oil market and expectations for it. If the futures prices are higher than the spot prices, this
usually means that purchasers anticipate the market will improve, so they are willing to pay
a premium for oil to be delivered at a future date. If the futures prices are lower than the spot
prices, this means that buyers expect the market to deteriorate.

"Backwardation" and "contango" are two terms used to describe the relationship between
expected future spot prices and actual futures prices. When a market is in contango, the
futures price is above the expected spot price. When a market is in normal backwardation, the
futures price is below the expected future spot price.

The prices of different futures contracts can also vary depending on their projected delivery
dates.

Forecasting Oil Prices

Economists and experts are hard-pressed to predict the path of crude oil prices, which are
volatile and depend on various situations. They use a range offorecasting tools and depend on
time to confirm or disprove their predictions. The five models used most often are:

 oil futures prices

 regression-based structural models

 time-series analysis

 Bayesian autoregressive models

 dynamic stochastic general equilibrium graphs

Oil Futures Prices

Central banks and the International Monetary Fund (IMF) mainly use oil futures contract
prices as their gauge. Traders in crude oil futures set prices by two factors: supply and
demand and market sentiment. However, futures prices can be a poor predictor, because they
tend to add too much variance to the current price of oil.

Regression-Based Structural Models

Statistical computer programming calculates the probabilities of certain behaviors on the

price of oil. For instance, mathematicians may consider forces such as behavior among OPEC
members, inventory levels, production costs, or consumption levels. Regression-based
models have strong predictive power, but scientists may fail to include one or more factors,
or unexpected variables may step in to cause these regression-based models to fail.

Bayesian Vector Autoregressive Model

One way to improve upon the standard regression-based model is by adding calculations to
gauge the probability of the impact of certain predicted events on oil. Most contemporary
economists like to use the Bayesian vector autoregressive (BVAR) model for predicting oil
prices, although a 2015 International Monetary Fund working paper noted these models work
best when used on a maximum 18-month horizon and when a smaller number of predictive
variables are inserted. BVAR models accurately predicted the price of oil during the years
2008-2009 and 2014-2015.

Time-Series Models

Some economists use time-series models, such as exponential smoothing models

and autoregressive models, which include the categories of ARIMA and the ARCH/GARCH,
to correct for the limitations of oil futures prices. These models analyze the history of oil at
various points in time to extract meaningful statistics and predict future values based on
previously observed values. Time-series analysis sometimes errs, but usually produces more
accurate results when economists apply it to shorter time spans.

Dynamic Stochastic General Equilibrium Model

Dynamic stochastic general equilibrium (DSGE) models use macroeconomicprinciples to

explain complex economic phenomena; in this case, prices of oil. DSGE models sometimes
work, but their success depends on events and policies remaining unchanged, since DSGE
calculations are based on historical observations.

Combining the Models

Each mathematical model is time-dependent, and some models work better at one time than
another. Since no one model alone offers a reliably accurate prediction, economists often use
a weighted combination of them all to get the most accurate answer. In 2014, for instance,
the European Central Bank (ECB) used a four-model combination to predict the course of oil
prices to generate a more accurate forecast. There have been times, however, when the ECB
has used fewer or more models to capture best results. Even so, unforeseen factors like
natural disasters, political events or social upheavals may derail the most careful of
calculations.

Breaking News about Oil

Because the crude oil market is so liquid (no pun intended) – with positions and prices
changing by the second – staying on top of the industry (and events that might affect it, like
those mentioned above) is crucial for investors and traders. There are many websites that
report crude oil news, but only a few report breaking news and current prices. The following
three offer the most current information.

MarketWatch

MarketWatch provides "business news, personal finance information, real-time commentary,

investment tools and data." Due to this diversity, it might not necessarily stand out as
targeting oil, but it is always one of the first to break stories, putting out headlines as soon as
news hits. These headlines can be found at the top center of its home page under the tab
"Latest News." MarketWatch also provides details when necessary, posting stories,
sometimes only a paragraph or two, to elaborate on its headlines, and updating them
throughout the day.
The site provides current oil price information, stories detailing oil's price path –
including pre-market and closing bell commentary – and multiple feature articles. The
company has an active link on its landing page showing the price of WTI. Within most
articles, MarketWatch also includes an active link to the price of oil, so when you read an
article the price quote included is current.

In addition, MarketWatch offers a more in-depth analysis of the economic news driving oil
prices.

Reuters Commodities Page

Reuters has a commodity-specific portion of its website that releases breaking oil news,
background stories and current prices. It also offers more recent in-depth stories on, and
analysis of, the sector as a whole, including price-driving sector updates (it's superior to
MarketWatch in this regard) and is good at releasing any imperative news as it is made
public. Reuters also publishes frequent pieces detailing oil's price movements and factors
behind those movements.

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