Over the last 20 years oil has become the biggest commodity market in the world. During this period, oil trading has evolved from primarily physical activity into a sophisticated financial market. In the process it has attracted the interest of a wide range of participants who now include banks and fund managers as well as the traditional oil majors, independents and physical oil traders.
As well as being the largest commodity market in the world, oil is also the most complicated. The physical oil market trades many different types of crude oil and refined products, and the relative value of each grade is continually shifting in response to changes in the supply and demand on both global and local scale. The industry has therefore developed a complex set of interlocking markets not only to establish prices across the entire spectrum of crude and product qualities, but also to enable buyers and sellers to accommodate changes in relative prices wherever they might occur. Oil has a number of important trading characteristics that also help to distinguish it from other commodities:
First there are many different types of crude oil and refined products and the relative value of each of these is constantly changing. As a result, the oil market suffers from considerable relative price volatility as well as absolute price volatility.
Although other commodity markets also cover a range of grade or qualities, the scale of price risks involved is typically smaller.
Secondly, oil products are manufactured in a refinery and, although refiners have some flexibility to vary the yield of each product derived from a barrel of crude, they cannot always match supply to demand across the spectrum. As a result, the price of any one type of refined product cannot be determined independently of the rest of the market since changes in the supply or demand for other products must also be taken into account. While joint production is not unique to oil, the factors determining the price relationship between the different refinery products are potentially much more complicated.
Thirdly, neither demand nor supplies are particularly responsive to changes in price in the short-run. On the demand side, consumers cannot easily switch to some other source of energy if the price of oil rises since this usually requires investments in new equipment. In addition, there are some uses, such as transport, for which oil still has no effective substitute. On the supply side, the operating costs of existing capacity are substantially lower than the capital costs of installing new capacity. As a result, oil prices can fall to quite low levels without shutting production. In the longer run, it is a different story since both consumers and producers will eventually respond to price changes.
Finally, oil is a highly political commodity. It still provides nearly half of the world's primary energy and is essential to the functioning of any developed economy. However, two-thirds of the world's oil productions is in the Middle East, which remains a potentially unstable area. With most of the world's largest consuming countries heavily dependent on imports for their supply, the threat of supply disruption remains very real and political events often play a significant role in the oil market.