What it means
Crude comes out of the ground in noticeably different qualities. "Light" crude flows easily and yields more high-value fuel per barrel, while "heavy" crude is thicker and more expensive to process, and "sweet" means low sulphur while "sour" means high sulphur.
Light sweet crude therefore commands a premium over heavy sour crude, and the gap between them is called the quality differential. Prices are quoted per barrel of 42 US gallons against a handful of benchmarks.
Brent, drawn from North Sea fields, is the reference for most internationally traded crude, West Texas Intermediate is the United States benchmark, and Dubai serves much of Asia. Other grades trade at a stated discount or premium to whichever benchmark best fits their quality and location.
The price moves on supply and demand like any other commodity, but both sides adjust unusually slowly. It takes years to bring a new field into production and drivers cannot suddenly stop driving, so small changes in the supply-demand balance can produce very large price swings.
That is why oil looks so volatile compared with most other traded goods. For an ordinary business, crude oil usually shows up indirectly rather than on the invoice.
Fuel, freight, packaging, chemicals and electricity all move with it, so a haulage firm, an airline or a plastics manufacturer can watch gross margin swing on a price nobody in the building controls. Many hedge with futures, options or fixed-price supply contracts simply to make budgeting possible.
Producers face the mirror image of the same problem. Their revenue moves directly with the price while their lifting costs stay broadly fixed, so margins expand and collapse dramatically across a cycle.
The break-even price per barrel is consequently the most watched single number in the sector.
In practice
Real-world examples.
Example
A regional haulage company burns about 4,000,000 litres of diesel a year and finds that fuel is its second largest cost after wages. It buys a fixed-price supply contract for 60% of expected volume each year, accepting that it will lose out if crude falls, in exchange for being able to quote customers firm rates for twelve months.
Example
An airline hedges roughly half its expected jet fuel consumption using a mix of swaps and call options tied to crude benchmarks. When prices spiked, the hedges cushioned about half the increase, and the finance director spent the results call explaining why the airline was still raising fares despite being hedged.
Example
A packaging manufacturer sees resin prices climb after a sustained rise in crude, since the resin is made from petroleum derivatives. Its supply contracts include a raw material escalator clause, so the increase passes to customers with a one-quarter lag, which temporarily squeezes margin before it recovers.
Formula
Calculation
Operating margin from production = (price per barrel - cash cost per barrel) x barrels produced
An independent producer lifts 12,000 barrels a day from a mature field. It sells at $78.00 per barrel and its cash lifting cost, including transport and royalties, is $32.00 per barrel.
Margin per barrel is $78.00 - $32.00 = $46.00. Daily operating margin is 12,000 x $46.00 = $552,000, and across a full year that is $552,000 x 365 = $201,480,000.
Now suppose the benchmark price falls $10 to $68.00. Margin per barrel drops to $68.00 - $32.00 = $36.00, daily margin to 12,000 x $36.00 = $432,000, and annual margin to $432,000 x 365 = $157,680,000. The fall is $201,480,000 - $157,680,000 = $43,800,000, which is simply 12,000 x $10.00 x 365. A price move of under 13% has wiped out almost 22% of the operating margin, and that gearing is the whole reason oil producers hedge.Case study
Seen in the real world.
Kestrel Energy Partners is an invented, illustrative independent producer operating a mature onshore field at 12,000 barrels a day, with a cash lifting cost of $32.00 per barrel. At $78.00 per barrel the field threw off an operating margin of about $201,000,000 a year, and the partners had grown used to planning around that figure.
Management had left the production unhedged, reasoning that hedging costs money and that prices had been stable for three years. When the benchmark fell to $68.00, annual operating margin dropped to roughly $158,000,000, a fall of nearly $44,000,000 on a price move of $10.00. The drilling programme for the following year, which had been sized against the higher figure, no longer fitted the cash flow.
The illustrative response was to hedge 50% of the next two years' production with swaps at around $70.00 per barrel. That capped the upside on half the barrels, and the partners disliked it, but it made the capital budget something the board could actually commit to rather than a forecast that moved every week.
Watch out
Common mistakes.
- Treating Brent and West Texas Intermediate as interchangeable. They are different grades delivered in different places, and the spread between them can move by several dollars a barrel, which matters a great deal on large volumes.
- Assuming a falling crude price flows straight through to the pump or the invoice. Taxes, refining margins, distribution costs and contract lags mean the pass-through is partial and usually slower on the way down than on the way up.
- Thinking only oil companies are exposed. Freight, packaging, chemicals, agriculture and electricity generation all carry oil sensitivity, so plenty of businesses with no direct fuel purchase are still exposed through their supply chain.
Questions
People also ask.
Why is a barrel 42 gallons?
It is a historical convention inherited from the early United States oil trade, and it has stuck as the global unit of quotation despite most of the world using litres for everything else.
Should a small business hedge its fuel cost?
Usually only through fixed-price supplier contracts rather than derivatives, since futures require margin, expertise and an appetite for basis risk that most small firms do not have.
What is the difference between spot and futures prices?
The spot price is for immediate delivery while a futures price is for delivery on a set future date, and the difference between them reflects storage, financing and market expectations.
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