Image © Press Association ImagesWe can’t really live without oil, but how much do you really know about the slick liquid that powers most of our lives? Not only does it fuel our cars it is also found in plastics and even some types of make-up. But it is important to all of us in another way since it is also one commodity the world tends to fight over.
The latest oil-related spat is between Iran, and, well, the rest of the world. Europe and the US have threatened to stop buying Iranian oil until Tehran ditches its nuclear ambitions. In retaliation Iran has threatened to block the Straits of Hormuz, a major artery where oil flows from the Middle East to Europe and beyond, which the US has called an “act of war” if it were to go ahead.
So oil is not only necessary to power our lives but it also determines our geopolitical safety, isn’t it time that we learnt how this market works?
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Why barrels?
One of the most basic questions to ask is why oil is measured in barrels and why is it priced in US dollars? No one actually buys a barrel of oil; it’s not even transported in barrels. The main reason is that the US measures it in barrels (one barrel is the equivalent of 42 gallons) and that has become the “normal” way that oil is talked about.
To understand its origins we need to look back to the 1860’s early oil fields in Pennsylvania USA. The first oil that was pumped wasn’t stored in barrels. In fact it was stored in any type of vessel or jar that could be found, which made it extremely difficult to judge what quantity you bought or sold it in if every jar was a different size.
As the oil industry grew during the 19th Century explorers needed to find a way to transport it around the country. Inspiration came from the whiskey industry. It transported the golden liquid in wooden barrels of a standard size, 40 gallons.
Rather than re-invent the wheel, the oil producers took the idea for themselves and so the 40 gallon barrel was created - plus the extra 2 gallons that were added to oil barrels to cover spillages on route to their destinations.
This was revolutionary since it allowed the purchasers of oil to know exactly how much of the stuff they were buying at one time, which was pivotal to the development of the industry that we know today. However, these days pumping crude into 40 gallon vessels would not be efficient or economical so it’s generally pumped straight into tankers or cargo ships, but the concept of the barrel has stuck.
But why is oil quoted at $100 per bbl? Let’s take the bbl bit first. It actually stands for Blue Barrel – hence the double B used in the acronym. The Blue Barrel originated with the Standard Oil Company owned by the Rockefeller family, who used blue barrels to transport their crude. However, its origins aren’t clear and some believe that the BB originates from the two extra gallons included in each barrel to cover any spills or evaporation. Either way bbl has stuck.
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Why dollars?
But why is oil quoted in dollars and not in the native currency of the user? Some say that it’s because the dollar is the world’s reserve currency and so the most traded currency in the world. Along with that it is traditionally associated with political stability and might. In other words, since oil trade is big business you need the Daddy of the FX world to pay for it.
Another reason is that oil could be pumped in Azerbaijan, get transported to Sweden and then onto France where it is sold to the end user. The complex life-cycle of a barrel of oil (or BBL of oil) means that trading it in one currency is easier for everyone involved.
Otherwise using the example above, the currency exposure of trading the oil would be: Swedish exporter changing krone to Azerbaijani manat, then transferring Azerbaijani manat to euro and back to krone again. If the whole transaction process is completed in dollars then it cuts out a lot of the risk of fluctuating exchange rates out for all involved.
There are plenty of conspiracy theories out there too. Some argue that it benefits the US. If the dollar wasn’t so important to global trade flows then the US could not get away with dollar debasement, which has boosted US trade for decades.
However, while the majority of oil trade is done in dollars, there is some completed in other currencies, for example, the US and Europe are making it hard for Iran to settle trade done in dollars, so Tehran has set up a deal to provide India with oil in return for rupees, thus taking out the dollar-part of the transaction altogether.
So the next time you look at the price of oil and wonder what the hell it actually means, now you know. And you might find it comes in handy for pub quiz some time, unless you actually want to trade the stuff one day.
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