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7/29/2019 Anatomy of Crude Pricing
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AnatomyofCrudePricingandHedgingStrategiesforCorda
Corporation
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GregorMaxGeorgSchlederer
Auditorsby:Prof.Dr.BerndGussmann,Prof.Dr.RalphKriechbaum
BachelorThesis
CourseofStudies:BusinessAdministration
FachhochschuleRosenheimUniversityofAppliedSciences
Dallas,TX,Jun2012
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LISTOFABBREVIATIONS ..................................................................................................... 4
ABSTRACT.......................................................................................................................... 5
CORDACORPORATION ....................................................................................................... 5
OVERVIEWOFTHEOILMARKET .......................................................................................... 7
BRIEFHISTORYOFTHEOILMARKET ........................................................................................... 7CRUDEBENCHMARKS........................................................................................................... 12
World-BrentCrude ..................................................................................................... 13
American-WTICrude .................................................................................................. 13BottleneckWTI .................................................................................................................................... 15
IMPACTSONOILPRICES ................................................................................................... 20
SUPPLYANDDEMAND.......................................................................................................... 20
Risingdemand............................................................................................................ 20
Tightersupply............................................................................................................. 22
Inventories ................................................................................................................. 24
SpareCapacity............................................................................................................ 25GeopoliticalUncertainty.............................................................................................. 27
WeatherUncertainty................................................................................................... 29
EXCHANGERATES ............................................................................................................... 29
INTERESTRATES ................................................................................................................. 30
SCARCITYRENT-MODELOFHOTELLING ..................................................................................... 30
Changesintheextractioncosts.................................................................................... 32NewcrudeDiscoveries................................................................................................. 32
Backstoptechnology................................................................................................... 33
Impactsofamonopoly................................................................................................ 34
PRICE-INELASTICINTHESHORTTERM........................................................................................ 35PRICEVOLATILITY ............................................................................................................... 35RestructuringofCordaCorp .................................................................................................................. 38
INTRODUCTIONTODERIVATIVEOILPRODUCTS ................................................................. 38
OTCDERIVATIVE ................................................................................................................ 39
PriceReportingAgencies.............................................................................................. 40
FUTUREMARKET ................................................................................................................ 41
SpecificationsofLightSweetCrudeandBrent................................................................ 42FuturecurvesandPricing............................................................................................. 42
SPECULATIONIMPACTSONCRUDEMARKETS .............................................................................. 46
Partiesonthefuturemarket........................................................................................ 47
CALCULATINGCRUDEPRICE ................................................................................................... 50
CASESTUDY ..................................................................................................................... 53
RISKSOFHEDGING .............................................................................................................. 54AIMSOFHEDGING .............................................................................................................. 55CORDACORPORATOIN2011 ................................................................................................. 57
FUTURESTRATEGY .............................................................................................................. 58
COLLARSTRATEGY .............................................................................................................. 62
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CONCLUSION ................................................................................................................ 65
LISTOFREFERENCE........................................................................................................... 66
DECLARATIONOFAUTHENTICITY ...................................................................................... 68
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LISTOFABBREVIATIONS
API AmericanPetroleumInstitutegravity
ASCI ArgusSourCrudeIndex
bbl Barrel/158liter
BFOE BrentBlend,Forties,Oseberg,Ekofisk
EIA U.S.EnergyInformationAdministration
IEA InternationalEnergyAgency
IOC InternationalOilCompanies
IOSCO InternationalOrganizationofSecuritiesCommissions
NOC NationalizedOilCompany
OPEC OrganizationofPetroleumExportingCountries
OTC Overthecounter
PADD PetroleumAllocationforDefenseDistricts
PRA PriceReporting Agency
TRC TexasRailroadCommissionWTI WestTexasIntermediate
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ABSTRACT
ExplorationandproductioncompanieslikeCordaCorporationhavetofaceavarietyofrisks.
Theoriginoftheseuncertaintiesarisefromthecomplexityoftheindustry.Ingeneral,these
riskscanbedividedintotwogroups:
Element/technicalrisks:containingconstruction,operation,financing,andrevenue
generationrisk
Global/marketrisk:lastingfrompolitical,legal,commercialandenvironmentalrisk,to
crudepricesrisk
Crudeproducerscanswaythetechnicalrisks,sincetheycaninfluencethevolumeoftheir
production.Independentexplorationandproductioncompaniesareinacompetitivemarket,
therefore,theycannotinfluencemarketrisksandhavetofindwaystorollovermarketrisks.1
TheaimofthispaperistoprovidedifferentcrudepricehedgingstrategiesforCorda
Corporation.Inordertounderstandthespecialtiesofthemarket,Iwillstartwithabroad
historyandoverview.Iwillthendeterminefactorsthatimpactcrudepricingandwillpayspecial
attentiontothescarcityrentthatisdescribedbytheHotellingrule.Iwillultimatelyshowthe
needforhedgingstrategiesforcrudeprices.Iwillthenintroducederivativeinstrumentsthat
helptohedgecrudeprices.Finally,IwillapplythesemethodstoacasestudyonCorda
Corporation.
CORDACORPORATION
PaulDeClevaJr.foundedCordaCorporationin1982.CordaCorporationisanoilandgas
explorationcorporationwithanexecutiveofficeinDallas,TXandaproductionofficeinWichita
Falls,TX.CordaCorporationruns56producingwellsinandaroundTexas.
Hisfather,Mr.PaulDeClevaSr.,camefromHungarytoAmericaaftertheSecondWorldWar,wherehefulfilledthe"AmericanDream."Hedrilledover850wellsandsetthecourseforhis
1 On the State's Choice of Oil Company: Risk Management and the Frontier of
the Petroleum Industry, Peter A. Nolan and Mark C. Thurber, Program on Energy
and Sustainable Development, 12-2010 (S 7)
Theplayersintheoilbusinesscanbedividedinto3categories:
Upstream Explorationandproduction
Midstream Transportationofhydrocarbons
Downstream Refining,distribution,andretailing
CordaCorporationisoneoftheExploration&Productioncompanies.
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son.Eventhoughheis97yearsold,heisstillintheofficeeveryday.PaulDeClevaSr.hasfour
children,allofwhomhaveaninterestinthebusiness;hissonPaulDeClevaJr.runsthebusiness.
Becauseitsafamilybusiness,theCordaCorporationsstrategyisconservativeandaimsfor
long-termsuccess.Toretaincontroloverthedevelopment,CordaCorporationprefersoperating
onitsownproperties,whilealsofinancingitsprojectswithacombinationofitsowncapitaland
externalprivateequity.Further,themanagementseekstoincreaseoil,gasreservesand
productionthroughacombinationofnewexploratorydrillingandtakesadvantageof
techniquesforthedevelopmentofexistingwells.CordaCorporationisconcentratingontheir
corebusiness:theexplorationanddevelopmentofverticalwellsintheFortWorthBasinin
Texas.
CordaCorporationoutsourcedthedrillingrigsinthe1980sandbooksthedrillingasaservice
fromadrillingrigcontractor.Inthesection"ConsequencesofOilPriceVolatility,"Iwilltakea
closerlookatthereasonsforthisdecision.
HighoilpricesmadethepastyearextraordinaryforCordaCorporation.Theaveragepricefor
theWTIcrudewas$92.37,andCordaCorporation'sgrossoilandgasrevenuefromoperated
propertieswere$9,436,249in2011.AminorpartofCordaCorporationsincomeisduetogas
sales.ThewellsofCordaCorporationareproducingamixtureofoilandgas.However,gasprices
aretumblingatalowpricelevel.Thispaperisgoingtofocusentirelyonoil,asitplaysthe
leadingroleforCordaCorporation
TheFortWorthBasinisfamousforitsunconventionalenergysourcesofshalegasandshale
oil.Theoilandgasiscapturedintightformations.Theseunconventionalsourcesbecame
availablethroughnewtechnologieslikehorizontaldrilling.Horizontaldrillingisanexpensive
andriskydrillingmethodforindependentfirms.Thecostsfordrillingahorizontalwellare
threetimeshigherthanacomparableverticalwell.Duetothehighcapitalintensityofhorizontaldrilling,anindependentexplorationandproductionfirmwouldhavetoshoulder
ahigherriskcomparedtomajorcompanies,sincetheycoulddrilllesswells,resultingina
lowerdiversification.Asaresult,horizontalwellsaremostlyoperatedbymajororsecond-
tierintegratedcompaniesratherthanbyindependentexplorationandproduction
companies.However,theFortWorthBasincontainsothertypesoflayerswithhydrocarbons
thatcanbereachedthroughtheclassicalverticaldrilling.
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OVERVIEWOFTHEOILMARKET
BRIEFHISTORYOFTHEOILMARKET
ControlofSpareCapacity Pricesetting
1870-
1911StandardOilCompany StandardOilCompany
1931-
1971TRC SevenSisters/netbackpricing
1971-
1973OPEC
OPEC-SevenSisters/postedpricingandbuyback
pricing
1974-
1975OPEC
OPEC/administeredoil-pricingregime
1984-
1986OPEC Marketpricing-finishedproduct
1986-
2012OPEC Marketpricingcrude
Inordertounderstandthecurrentoilpricesystem,itisimportanttotakeacloserlookat
previousoilpricingsystemsandtheirmajorchanges.Thischapterdiscussesthemainalterations
intheoilmarket.2
Thehistoryofthemodernoilmarketbeginsin1870inAmericawithJohnD.Rockefellerforming
"TheStandardOilCompany."Rockefellercontrolled90%oftheAmericanoilmarket,andthus
wasfrighteningtheAmericanpublicandgovernment.In1911TheStandardOilCompanywas
splitinto34companies.Someoftodaysmajoroilcompanies,likeExxonMobil,Chevron,and
ConocoPhillips,havetheirorigininTheStandardOilCompany.
Thenexterabeganin1931whenmassiveoilfieldswerediscoveredinTexas.TheUS
governmentimposedproductionrestrictionsthroughtheTexasRailroadCommission(TRC)in
ordertosupporttheoilindustry.AtthattimetheTRCwasincontrolofthecrudesparecapacity
andthuscontrolledtheglobalcrudepricing.ThiswasthetimeoftheInternationalOil
Corporations(IOC),alsocalledtheSevenSisters.TheSevenSisterscontrolledtheupstream,
midstream,andthedownstream.Furthermore,theycontrolledtherateofsupplythrough
concessionsthattheyreceivedfrommajoroilproducingcountries.Theprofitsweresplit50/50
betweentheforeigngovernmentandtheIOC.
2 The history is based on four books: The Prize: The Epic Quest for Oil, Money, &
Power, Daniel Yergin, ISBN 978-0671799328, 2011 / The Quest - Energy, Security,
and the Remaking of the Modern World; Daniel Yergin, ISBN 978-1-59420-283-4,
2011 / Understanding Oil Prices - A Guide to What Drives the Price of Oil in
Today's Markets, Salvatore Carollo, ISBN 978-119-96272-4, 2012/ and the history
part of Oil 101, Morgan Downey, ISBN 978-0-09820392-0-5, 2009
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Theoilmajorssetthepostedpriceovernetbackpricing.Netbackpricinglinkedthecrudeina
foreigncountrytothetransparentUSgulfpriceanddiscounteditbythefreightingcoststothe
USgulfcoast.Theresultwasanunderdevelopedspotmarketwherethepostedpricedidnot
respondtotheactualdemandandsupplyonthemarket.Basically,ithadnofunctionof
allocation.Instead,theSevenSisterssetthepostedpriceandcontrolledtherevenuesoftheoil
exportingcountries.
AftertheoilfieldsintheMiddleEastweredevelopedwiththehelpoftheIOC,theforeignoil
producingcountrieshadnoneedfortheIOC.Someoftheforeignproducingcountriesbeganto
nationalizetheiroilsectors.Atthebeginningofthenationalizationprocess,theoilproducing
countriesgainedcontrolovertheoilcompanieswithequityparticipations.Theseparticipations
increasedovertime,finallyresultinginacompletenationalization,likeinKuwaitin1980orin
Iraqin1972.
ThiswasnottheonlyproblemfortheIOCbetween1960and1970.Thecompetitioninthe
explorationandproductionsectorwasincreasing,andmoreandmoreindependentoil
companieswereappearing.Theseindependentoilcompanieswereenteringtheupstream
marketandwereassuringconcessionincountrieslikeVenezuela,Libya,Iran,andSaudiArabia.
Furthermore,theindependentcompaniesstartedtoproducehugevolumesofcrude,forcing
themajorstolowerthepostedprices.
Themajoroil-producingcountriesformedasupplycartel:OrganizationofPetroleumExporting
Countries(OPEC).ThemainideaofOPECwastoorganizethedifferentnationaloilcompanies.
Furthermore,theOPECwasformedasacorrespondenttotheSevenSistersinordertofight
againstthedecliningpostedprices.3
In1971,sixOPECGulfmembers:AbuDhabi,Iran,Iraq,SaudiArabia,Qatar,andKuwait,formed
theMinisterialCommittee.TheMinisterialCommitteewasempoweredbytheSaudiArabianOil
minister.TheSaudiArabianOilministershouldnegotiatethepostedpriceswiththeoilcompaniesandcollectivelyfortheotherOPECmember.
Thesechangesledtoashiftinthebalanceofpower,fromtheIOCtoOPEC.Now,OPEC
membersgainedcontrolovertheoilpricingsystem,andtheywouldchangeitinitsfoundations.
InsteadofthepostedpricebeingsetbytheIOC,OPECpublishedanofficialsellingprice.This
pricewasnotonlypublishedbytheIOC,butalso,OPECtriedtoselltheircrudetotheirrising
competitorsinordertobemoreindependent.However,thegovernmentswereunableto
marketalloftheircrudetothirdpartybuyers,sotheysoldtheircrudetothemajoroil
companiesforthebuybackprice.Ontheothersideofthings,theoilcompanieswerestill
holdingontheiroldpricesystemandthuswerealsopostingtheirprices.
Thissystemwascomplexandhighlyinefficient,becausethepurchasercouldchoosebetween
threedifferentprices.Thispricingsystemwasdiscardedbytheadministeredoil-pricingregime,
rulingfrom1974to1975.Inthispricingsystem,theSaudiArabianLightcrudewaschosenasthe
3 Oil Politics: A Modern History of Petroleum, Parra, London: IB Tauris, 2004,
(Page1-10)
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referencecrude.ThedifferentcrudesoftheOPECcountriesweresetinrelationtothemarket
price,andtheywereadjusteddependingoncrudequality.Thiswasthefinalpowerexchange,
withOPECsettingtheoilprices.
Between1965and1973globalcrudedemandwassharplyincreasing.Theincreasingdemand
wasmainlymetbyhigherproductionratesfromOPECcountries.OPECincreaseditsshareinthe
globalproductionfrom44%in1965to51%in1973. 4Duringthe1980s,theUSoilproduction
peaked.NowtheOPECcontrolledoverthespareproductioncapacity,andOPECwassettingthe
oilpricesinatimeofrisingdemand.
ItwasthefirsttimethatOPEChadsetthepostedpriceinaunilateralrole.Before,OPEChad
onlybeenabletopreventoilcompaniesfromreducingtheprice.In1973,someoftheOPEC
membersimposedanoilembargoontheUSandtheNetherlandsforaperiodofsixmonths.
ThereasonbeingthattheUSsupportedIsraelwithitsmilitary.Theembargoresultedina5%to
10%cutincrudesupplyandapriceincreaseintodaysterms,from$14.00to$50.00.Thiswas
thefirsttimethatoilwasusedasaweapon,andthisledtothefirstoilcrisis.
Shortlyafterthefirstoilshock,thesecondoilshockcameduringtheperiod1978-1981.ThistimeitwascausedbyastrikeofIranianoilworkersandwasfollowedbytheIran-IraqWar.The
pricewasrisingtonewheights,reachingpricelevelsof$90.00intodaysterms.
Duringthistime,thegeneralpublicinthedevelopingcountriesbegantorealizehowdependent
theywereoncrudeoilandespeciallyhowdependenttheywereonOPECcountries.Inaddition,
anewenvironmentalmovementcamealong,resultingintechnologicalimprovementsand
higherfuelefficiency.Thisledtoasinkingdemandofcrudeoil.
Duringthesecondoilcrisis,thecrudespotpriceswererisingfasterthantheofficialsellingprice.
TheofficialsellingpricewaslinkedtothereferencepriceofSaudiArabianLightcrude.The
problemfortheOPECcountrieswasthattheyhadlong-termcontractswiththeoilcompanies
basedontheofficialsellingprice.Theoilcompanycouldmakeprofitsbysellingthedifferential
betweenspotandofficialsellingprice.Asaresult,OPECproducercountrieswereabandoning
theirlong-termcontractsandstartingtoselllargevolumesofcrudetotheplayersinthespot
market.
Duringthistime,themajoroilcompanieshadlostlargepercentagesoftheiroilreserves
throughequityparticipationandnationalization.Thus,theyweresearchingfornewreserves
outsidetheOPEC.5ThesereserveswerefoundinCanadaandtheGulfofMexico.However,it
wouldtakeuntiltheearly1980stobringthesereservoirstotheoilmarket.Inaddition,small
independentmarketplayers,piquedbyhighoilprices,wereenteringthemarketandexploring
4 An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute
for Energy Studies, 01-2011 (Page 15)
5 On the State's Choice of Oil Company: Risk Management and the Frontier of
the Petroleum Industry, Peter A. Nolan and Mark C. Thurber, Program on Energy
and Sustainable Development, 12-2010 (S26)
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newfields.Inthemid1980s,oildemandwasdeclining,whereassupplywasrising.Furthermore,
thesenewsupplierswereundercuttingtheoilpricessetbytheOPECinthespotmarket.Asa
result,OPECmarketsharesintheworldoilproductionweresharplydroppingfrom51%in1973
to28%in1985.DisagreementsstartedtoarisebetweentheOPECcountriesabouthowtoset
theoilpriceseffectively.Itbecameclearveryquickly:independentproducerscouldalwayssell
theircrudeatadiscounttotheofficialprice,andthispricingsystemisthereforeunlikelytohold.
6
In1984thepowerofsettingthecrudepriceschangedandsetupanewchapterinthehistoryof
oilpricing.Theoilpricewasfirstsetbymultinationaloilcompanies,thenbytheOPEC,andthis
timebythemarketsinthefutureexchangemarketplaces.Thesystemiscalledamarket-related
pricingsystem.
Atthebeginningcrudeswerelinkedtothefinishedproducts.Therefinerypaidtheproducerthe
differencebetweenthesellingpricesoftheirfinishedproductandsubtractedthefixedrefinery
margin.Inthispricingsystem,refinerieshadanincentivetorunathighcapacityand
oversuppliedthemarketswiththeirproducts.Thisresultedinlowerproductandcrudeprices.
Thecrudepricessharplydecreasedfrom$26.70perbarrelinJuly1985to$9.15perbarrelin
July1986.
Source:Database-refiningcrudeoilfromIEA
DuringthistimethereweresparerefinerycapacityandOPECcrudeoilproducersreplacedthe
refiningmarginnetbackpricingwiththecrudeoilformulanetbackpricingsystem.OPECproducerswouldsettheircrudepriceinrelationshiptoacrudebenchmark,alsoknownasa
6 Risk Management at Apache, Lisa Meulbroek, Harvard Business School, 08-27-
2001(Page 4)
Theyields(finished-products)ofonebarrel(42-gallons)ofcrudearedependentonthetype
ofrefineryandthecharacteristicsofthecrude.ThesefiguresshowtheaverageyieldofUS
refineries:
FinishedProduct Gallons
Gasoline 19.3
DistillateFuelOil(HomeHeatingandDiesel) 9.83
Kerosene(JetFuel) 4.45
ResidualFuel 2.1
PetroleumCoke 2.1
OtherProducts 6.68
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pricemarker,plusorminusadifferential.Themarket-relatedpricingsystembecamestandardin
1988andisstillthemainmethodusedtoday;allmarketparticipantsarenowsettingtheoil
prices.
Duringtheyear1990,thepriceforcrudespikedagain,doublingwithinaweek.Thistimeitwas
aresultofuncertaintiesrelatedtotheIraqinvasionofKuwait.SaudiArabiaandothercountries
wereincreasingtheirproduction,andthecrudepriceswererisingandfallingveryquicklyin
succession.
Inlate1998thecrudepricesplummetedduetoanoversupplyofalmost$11.00.Theoversupply
happenedbecauseoftheAsianfinancialcrisisandtheUnitedNation"oil-for-food"programfor
Iraq.
Source:Database-spotpricesWTIfromIEA
Inthebeginningofthe21stcentury,demandwassoaring,andtheAsianeconomiesrecovered.
Inaddition,itwasthebeginningoftheInternetbubble,atimeofgreatworldGDPgrowthrates.
Thepriceswerealmosttripling-evensharperthanduringtheIranrevolution.Atthebeginning
of2006theoilpricesdippedslightly,followedbyatimeofrisingprices,lastinguntilthefinancial
crisisof2008.7Therearethreemainreasonsfortherapidpriceincrease,resultinginacrude
pricebubblefrommid2006untiltheworldfinancialcrisisin2008:first,Chinasrapidlygrowing
economy;second,therisingimpactsoffinancialspeculationonthecrudemarkets,andthird,
thethreatthattheworldproductionhadpasseditspeak.Furthermore,itseemedthatthe
marketshadbecomeverysensitivetosmallshocksandnews,resultinginhighvolatility.
7 Understanding Oil Prices - A Guide to What Drives the Price of Oil in Today's
Markets, Salvatore Carollo, ISBN 978-119-96272-4, 2012 (Page 10-17)
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Thefinancialcrisisof2008ledtoacollapseoftheoilprices.Asfastasthepricescollapsedin
2008,theywererisingagaininthemiddleof2010.Inthisperiod,thedailyoilpricestendedto
walkrandom,withanupwardtrend.8Thehistoryofthelasttwodecadesespeciallyshowsthe
greatvolatilityofcrudeprices.Further,itmakesclearthatthepricingsystemisnotalways
underlinedbyrationaldecisions.9
CRUDEBENCHMARKS
Nowadays,thereareavarietyofdifferentindicatorsfordeterminingcrudeprices.However,
therearethreemajorinternationalbenchmarks.Twoofthemaremainlyusedforthewestern
countries:WTIintheUS,DatedBrentinEurope,andDubaicrudefortheAsianregion.60-70%
oftheinternationaloiltradesaredirectlyorindirectlybasedontheBrentBenchmark.Dubai
crude,alsoknownasFateh,isusedwithOmancrudeasthebenchmarkforcountriesfromthe
MiddleEast.Thereisanewfourthindexarisingalso:theArgusSourCrudeIndex(ASCI).The
ASCIbenchmarkisseenasanadditiontoWTI.
Inthelongrunthereisanequilibriumrelationshipbetweenthesebenchmarkswheretheworldmarketisunifiedandhomogenous.Thereisanimpulseresponsefunctionbetweenthemarkets
whereWTIcrudeleadsBrentandtheASCI;BrentleadsDubaiandOmancrude.10
Mostofthecrudepricesarelinkedtobenchmarkpricesplusorminusadifferential,which
representaspecialtypeofcrudeinaspecificarea.However,thesebenchmarksrepresenta
relativelylowvolumeofproduction,whiletheysetthepriceforahighvolumeofcrudes.The
problembecomesevenmoreseriouswhenthebenchmarkmarketsgettighter,andproduction
ratesaredeclining.Inthinmarkets,thepricediscoveryprocessbecomesmoredifficult,andthe
dangerofmarketplayersmanipulatingandsqueezingthebenchmarkrises.11
Squeezingoccurswhenapartygoeslongintheforward/futuremarketwithavolumethat
exceedsthephysicalmarket.Itisonlypossibletosqueezeamarketifthepartieshave
anonymityandifthepartiesaretradingrelativelyhugevolumes.Theresultsarepricesthatare
notreflectingactualmarketconditionsandhighervolatility.
8 Empirical Evidence of Some Stylized Facts in International Crude Oil Markets,
Ling-Yun He, College of Economics and Management, Chinese Agricultural
University,2008 (Page 2)9 Probability Distribution of Return and Volatility in Crude Oil Market, Tung-Li Shinih,
Hai-Chin Yu, MingoDao University Taiwan, 2009 (Page1-4)
10 Lead-Lag Relationship between World Crude Oil Benchmarks: Evidence from
WTI, Brent, Dubai and Oman; Mohammad S. AlMadi, Baosheng Zhang, China
Petroleum University Beijing, 2011 (Page 1-5)
11 An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute
for Energy Studies, 01-2011 (Page 7)
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Infuturemarketsthepartiesareanonymous,however,thesemarketsareveryliquid,soitis
hardforonepartytoaccumulatesignificantpercentagesinthevolumeinordertoinfluencethe
market.Thephysicalmarketisthereforemucheasiertosqueeze,eventhoughtheparties
evolvedareknown.
WORLD-BRENTCRUDE
Now,IwilltakeacloserlookattheBrentmarket,asitisoneofthemostimportantbenchmarks
fortheinternationalcrudemarket.
ThereisnosimpleexplanationfortheriseofBrentcrudetothemostimportantinternationaloil
benchmark.OnecontributingfactormaybethegeographiclocationoftheBrentcrude,asitis
neartheEuropeanrefineries.Also,itisinanareacontrolledbytheUK.TheUKhasastable
governmentcomparedtomostOPECcountrieslikeMexicoandRussia.
Yet,themostimportantfactorfortheriseofBrentisthatitsownershipishighlydiversified.This
diversificationcanbeseenintheexchangemarketratherthanintheBrentOTCmarket.The
Brentmarketdevelopedintoacomplexbenchmark.Marketscanonlyworkeffectivelyifthey
areopentoabroadrangeofparties.12Anoligopoly-structuredormonopoly-structuredmarket
couldeasilybemanipulated,andoutstandingpartieswouldbereluctanttoenterthemarket.As
aresult,thesemarketswouldnotdevelopsuchavarietyoffinanciallayers.Crudemarketsin
thepasthavebeeninsuchpositions,withtheSevenSistersortheOPECcartel.
Further,acertaincrudeproductionvolumeisimportantforanoilbenchmarkasitassuresa
liquidmarket.NowadaysBrentproductionvolumescannotcompetewithcrudefieldlikeinthe
GulfofMexicoortheMiddleEast.DuringthehightimesofBrentinthe1980s,thedailytrading
volumewasaround30cargoscomparedtotodaystradevolumeoflessthanonecargo.Inorder
toaddvolumetotheBrentfieldproduction,newstreamswereadded:in1992theNinian
system,in2002theFortiesandOsenbergsystem,andin2007theEkofisksystem.Thesecrudes
arenowformingtheBFOEbenchmark(BrentBlend,Forties,Oseberg,Ekofisk).13
AMERICAN-WTICRUDE
TheWTIcrudehasfinanciallayers,likefuturesandoptioncontractsandOTCderivatives.But
theselayersarefewercomparedtothecomplexBrentmarket.IntheUS,theWTIplaysthe
leadingrole.WTIplaysasignificantroleintheglobalcrudemarket,astheUSisanimportant
marketforoilconsuming,producing,andimporting.TheUSmarketconsumedmorethan21%
oftheglobalworldconsumptionin2011.14Theyproduce10%oftheglobalcrudeproduction.
12 An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute
for Energy Studies, 01-2011 (Page 36)
13 An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute
for Energy Studies, 01-2011 (Page 7)
14 Database: EIA Total Petroleum Consumption/Production 2011
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AllofCordaCorporation'sproductionissomehowlinkedtotheWTIbenchmark,andchangesin
WTIdirectlyaffecttherevenues.
Source:basedonTodayinEnergyFeb07.2012IEA
Source:Database-IEAPADDProduction2011
InordertounderstandtheUSoilmarket,itisimportanttogettheoverviewovertheallocation
ofcrudesintheUS.TheEIAdividestheUSintofive"PetroleumAllocationforDefenseDistricts"(PADDs);thesePADDsweredefinedintheSecondWorldWar.
ThemostimportantPADDfortheUScrudeproductionisPADDIII,asithaslargevolumesof
crudeproductionandrefiningcapacities.PADDIIreceivesaspecialimportancefortheoil
market,asPADDIIhaslargecrudestoragefacilitiesandrefineries.PADDIIcanbedividedinto
twosubregions:MidcontinentwithhugestoragefacilitiesandMidwestwithrefineries.The
MidcontinentregionistheheartofthestoragefacilitiesintheUSandisgatheringthecrude
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fromOklahomatoTexas.Cushing,asmallcitynearOklahomaCity,isthedeliverypointforWTI
crudefuturecontracts.ThestoragecapacityofCushingexceeds45millionbarrels.
Acronym Name Type API Location/Composition
Benchma
rk WTI WestTexasIntermediate Lightsweetcrude 39.6 Cushing,Oklahoma
ASCI ArgusSourCrudeIndex Mediumsourcrude 38 Mars,Poseidon,SGC
Po
pularCrudeTypes
LLS LightLouisiana Lightsweetcrude 37 OffshoreUSGulfCoast
HLS HeavyLouisiana Heavysweetcrude 31 OffshoreUSGulfCoast
Mars Deep-waterMars Sourandmediumcrude 30 OffshoreUSGulfCoast
Poseidon Poseidon Sourandmediumcrude 29.1 OffshoreLouisiana
WTS WestTexasSour Mediumsourcrude 33 Midland,Texas
SGC SouthernGreenCanyon Heavysourcrude 28.2 OffshoreUSGulfCoast
Asitisshowninthetableabove,thereareavarietyofimportantcrudesintheUS.However,
mostoftheseindicescouldnotestablishthemselvesasaleadingbenchmark.Thesecrudesare
definedbytheirphysicalcharacteristicsandtheirproductionlocation.Thesepopularcrudesare
mostlytradedovertheOTCmarketandmeasuredbyPRAinordertodetermineprice
differentialstotheunderlyingbenchmarks.
EventhoughtheUShasavarietyofcrudes,WTIisthepredominatebenchmark.TheWTIcrude
isproducedinTexas,NewMexico,Oklahoma,andKansas.Themaindifferencebetweenthe
WTIandBrentcrudeisthatBrentisawaterbornecrude,whereasWTIisapipelinecrude.PipelinecrudeslikeWTIhavetheadvantageofahigherdiversificationinthephysicalmarket.As
mentionedabove,diversificationplaysakeyroleinthesuccessofabenchmark.IntheUSthe
typicaltradingvolumeforapipelinecrudeovertheOTCmarketisaround30.000barrel,a
fractionwhencomparedtothe600.000-barrelshipcargostradedontheBrentmarket.
BOTTLENECKWTI
However,theinfrastructureofWTIcannothandlethetradedvolumesresultinginaphysical
bottleneckandinhighpricevolatiles.Pipelinecrudeshavelogistic-andstorage-problemsand
arelessflexiblethanwaterbornecrudes.Cushingisnotaccessiblebytankersorships.Inhistory,
theproblemwastogetenoughoilintoCushing,resultinginadislocationoftheWTIpriceabove
internationalbenchmarks.Nowadays,thisproblemhasbeensolvedandtheproblemhasshifted
ingettingthecrudeoutofCushingtotherefininghubslocatedintheGulfofMexico.The
refineriesaroundCushinghaveahighutilization,andwhilesupplyisgrowing,refineriesand
pipelinesarenot.
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16
Source:Database-spotpricefromCME/ICE
Year Correlation(WTItoBrent)
2006 0.960956621
2007 0.973611742
2008 0.99438944
2009 0.983931855
2010 0.936289999
2011 0.65571719
BrentistradingatapremiumtoWTI,asWTIhashighertransportationandstoragecosts.The
signsofthischangebeganinmid2007.Asitcanbeseeninthegraphabove,WTIlostforashort
timeperiodthecorrelationtoBrentbeginninginJanuary2007toJuly2007.Atthattime,the
explanationwasthatthisshiftwouldbetemporary,causedbytheimpactsofthefinancial
markets.Itwasnotconsideredthatthesedifferencesweretheresultofthephysicallimitations
ofCushing.Besides,atthistimeimports,especiallyfromCanada,werefloodingthemarket,
whereasNorthSeaproductionwassteadilydeclining.Inaddition,thecrudeproductionin
MidwestPADDIIwasrisingduetothedevelopmentofshaleoilandgas,whichbecameavailable
throughnewtechnologieslikehorizontaldrillingandmoreefficientwaysoffracking.15Asnewcrudereservesbecameavailable,thescarcityrentofcrudedeclined,whichresultedinalower
15 What's the real price of oil?, Joachim Azria, Credit Suisse Fixed Income
Research, 02-17-2012 (1-8)
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worldcrudeprice.However,thesecrudeswerenotabletoreachtheworldmarketssince
pipelinefacilitiesweremissing(compareHotellingrule).
Thetableaboveshowsthatthecorrelation(Brent,WTI)intheyearsfrom2006to2009was
alwaysabove0.95.Thischangesin2010,yetstillthereisastrongrelationshipbetweenWTIand
Brent.Itcanbeseenthattherelationshiphasbeguntoweaken.In2011thisrelationship
changesfromastrongrelationshiptoamoderaterelationship:0.65.Thisismainlyduetothe
hugediscountsonWTIoverBrent.
Source:Database-CrudeImportsReportFeb.2012fromEIA
Source:Database-CrudeproductionbycountryfromEIA
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Source:modifiedfromCanadianAssociationofPetroleumProducts,CrudeOilForecastJune2011
Source:Database-Petroleumandotherliquids,stocksfromEIA
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InthefollowingIwanttoshowtheimpactsofCanadiancrudeimportsontheWTImarket.In
2011,almost30%ofcrudeimportscamefromCanada.Enbridge,aCanadianpipelinecompany,
boughtimportantpipelinesintheUS,likethe190-kbdSpearheadpipelinefromCushingto
Chicago(redlinein"CanadianandUSPipeline").Thispipelinesystemwaspumpingcrudefrom
thestoragefacilitiesofCushingtotherefineriesinChicago.MostoftheCanadiancrudeimports
arepumpedtowardsChicagoandthentoCushing.EnbridgechangedtheflowoftheSpearheadpipeline.Nowadays,CanadiancrudesaretransportedfromChicagotoCushingoverthe190-k
bdSpearheadpipeline,resultinginahighercrudesupplyinCushing.16Itseemsthatthistrend
willextendintothefuture,asEnbridgehasnewprojects,liketheexpansionoftheFlanagan
SouthPipeline,whichwillsupplyCushingwithmorecrude.Thesteadyriseofthesupplycanbe
seenintheriseofstockinventoriesatCushing,whichareplottedinthegraphabove.Ifthe
supplyinCushingisrising,thecostsforthestoragearerisingtoo.17
OnepossibilityoftransportingtheoversupplyoutofCushingwouldbetotransportitbyrailway
ortruckstotheUSGulfCoast.However,thesewaysoftransportationarelimitedintheir
volumeandonlyoccurifthearbitragebetweenWTIandBrentissignificantenoughtoequalize
thehighertransportationcosts.UntiltherearenosolutionsfoundtodebottlenecktheoversupplyinCushing,theWTIcrudewilllikelyhaveaveryvolatilediscountedrelationshipto
Brent.Thus,investorswillmovetheirinterestfromWTI,towardsBrentorASCI.Additionally,
thisshiftissupportedbythenegativerollyieldsintheshort-termofWTI.
Itisinterestingtotakeacloserlookatthestockinventoryduringthefinancialcrisis.Beforethe
worldfinancialcrisisof2008,crudeinventoriesinCushingweredecreasing,whileduringthe
financialcrisis,crudestocksweresharplyrisingasthedemandwassinking.Thisunderlinesa
positivecorrelationbetweentheGDPgrowthrateandthestockstorageinCushing.
IftheWTIpriceisaffectedbylocalsupplyanddemandinCushing,WTIpricesarenotreflecting
thesupplyanddemandbalanceoftheUSortheworldmarket.TheWTIpriceinsuchacase
woulddecouplefromtheBrentmarket.Further,thebottleneckofWTIdirectlyimpactstherevenuesofCordaCorporation.TheindicesthatareunderlyingforCordaCorporationscrude
productionarealldirectlylinkedtoWTIandhaveahighpositivecorrelation.
AsareactiontotheWTIpricevolatilitiesin2008,SaudiAramco(NOCofSaudiArabia),oneof
theleadingexporterstotheUS,droppedWTIastheirmainbenchmarkinfavoroftheArgus
SourCrudeIndex(ASCI).Thisindexwaspublishedbytheprice-reportingagency(PRA)Argusand
isbasedonthreetypesofUScrudes:Mars,Poseidon,andSouthernGreenCanyon.Thecrudes
fromtheASCIaremostlylocatedontheGulfofMexico,andthustheyhavenotthelogistical
problemsofapipelinecrude.TheimportanceoftheASCIasthebenchmarkfortheUScrude
marketisrisingonbehalfoftheWTIbenchmark.
16 What's the real price of oil?, Joachim Azria, Credit Suisse Fixed Income
Research, 02-17-2012 (Page 5)
17 Canadian Enbridge to expand pipeline into Oklahoma, Tulsa World, 03-28-2012
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IMPACTSONOILPRICES
Inordertoreducethenegativeimpactofoilpricefluctuationsitisimportanttounderstand
whatdeterminestheoilprice.Thereisnodemandforcrudeoilfromtheendconsumer.The
demandforcrudeisdeductedfromitsrefinedproducts.
Further,crudeisnotahomogenouscommodity;insteadtherearevariousdifferentkindsof
crude.Thespecificcrudepriceislinkedtotherefinedproductsthatcanbeproducedoutofit.18
AnimportantkeymeasurementforthephysicalcomponentsofcrudeoilistheAmerican
PetroleumInstitutegravity(API).TheAPIgravitycalculatesthedensityofcrude.Water,for
example,hasanAPIgravityof10,WTIof39,Brentof38,andDubaiof31.Thus,Dubaicrudeisa
heaviercrudewithhigherasulfurcontent.
Heaviercrudeshavetobecrackedorcockedandhave,ingeneral,highersulfurcontent.Crudes
withhighsulfurcontentarereferredtoassourcrudes,andrefinerieshavehigherexpenditures
inremovingthesulfur.Refineriescangainmoregasandgasolineoutoflightercrudes.Since
crudepricesarelinkedtotheyieldsofthefinalproducts,lightcrudesachieveapremiumover
theheavycrudes.
SUPPLYANDDEMAND
Thereareavarietyofexplanationsforthesharpswinginoilpricesduringthepastdecade.
Someoftheseexplanationsarebasedonthetighteningdemandandrisingsupplyside.
RISINGDEMAND
18 An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute
for Energy Studies, 01-2011 (Page 11)
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Source:Database-fromWorldBankWorldDevelopmentIndicators,InternationalFinancialStatisticsoftheIMF
Thekeydriverforthedemandofcrudeoilistheglobaleconomicgrowth.19Forexample,during
thefinancialcrisisfrom2008-2009,orduringthedot-comcrisis,theglobaldemandfor
petroleumfellslightly.Still,thedemandforpetroleumhadbeengrowingrapidlyby12.6%over
thelast10years.Asitcanbeseeninthegraphabove,thegrowthrateofcrudeproduction
couldnotmeasureupwiththeGDPworldgrowthrate.(Rememberthegraph-Cushing,stocks
ofcrudeandproductsandtheimpactsofthefinancialcrisis)20
Source:Database-CrudeDemand2012fromEIA
Theriseofthedemandsideislargelydrivenbynon-OECDandemergingmarketswithhighGDP
growthrates.TheshiftofoilflowingtoAsiaisremarkable.TheseeconomieshaveahighGDP
19 Interim Report on Crude Oil Interagency Task Force of Commodity Markets,
Commodity Future Trading Commission, 06-2008 (Page 8)
20 Understanding Oil Prices - A Guide to What Drives the Price of Oil in Today's
Markets, Salvatore Carollo, ISBN 978-119-96272-4, 2012 (Page 21-24)
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growth,whilesimultaneouslytheireconomiesareshiftingfrombeinglabor-intensivetowards
oil-intensive.
Additionally,manyoftheemergingmarkets,likeIndonesiaandIndia,aresupportingtheir
economybypricesubsidiesonfueloil.Duetosubsidies,theoilpriceinsomeemerging
economiesissetbelowtheglobaloilprice,andthedemandisnotadequatelyrespondingto
pricesignals,resultinginahigherdemandforcrudeoil. 21
TIGHTERSUPPLY
Source:Database-April2012MonthlyEnergyReviewfromEIA
Ontheotherside,crudesupplyhasnotkeptupwiththecrudedemand.Ifcrudepricesare
rising,oilreserves,whichwerenoteconomicalintimesoflowcrudeprices,willbecomeavailable,andthecrudesupplywillrise.In2011thenon-OPECcrudeproductioncountedfor
57.12%,withnearly1/4ofthiscomingfromRussia.Thegraphaboveshowsthechangeinthe
productionvolumesin2011comparedto2000.Whileglobaldemandandcrudepriceswere
rising,thenon-OPECcountries,exceptRussia,couldntkeeptheirproductioninbalancewiththe
risingdemand.ThereasonwhytheRussianproductionissharplyrisingisduetoprivate
investmentsmadeafterthefalloftheSovietUnion.However,thegraphshowsthatnon-OPEC
countrieshavepassedthepeakproduction,andthattheyarenotabletoholdtheproduction
levelsfrompastdecades,evenwithhighercrudeprices.OPECproducingcountriesandRussia
areequalizingthisimbalanceofsupplyanddemand.
Inordertosupplythegrowingdemand,OPEChasincreasedtheirproductionfrom2000to2011
by2.71millionbarrelsperday.However,the"callonOPEC,"whichisdefinedastheworld
21 Oil Subsidies: Costly and Rising, Benedict Clemens, David Coady, John
Piotrowiski, International Monetary Fund, 06-2010
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consumption,subtractedbythenon-OPECproduction,hasincreasedoverthesameperiodto
over7.07millionbarrelsperday.Thisimbalanceresultsintightermarkets.22
However,asitisgettingmoredifficulttoexploreconventionalcrudes,OPECproductiongrowth
ratesareslowingdown.Andinordertoreplacetheproductionofconventionalcrudes,
unconventionalcrudeshavetobeexplored.Unconventionalcrudesaredifficulttoexploreand
arecausinghigherproductioncosts.
Expectationsplayamajorroleinthefinancialmarketandinthecrudemarket.Thecurrent
crudespotpriceshouldbebasedonexpectationsinthefuture,makingchangesintheprice
hardtopredict.23Inthecrudemarkettherearealotofuncertaintiesaboutthefutureinoil
supplyanddemand.Theseuncertaintiesleadtoariskpremiumandincreasedemand,asthe
partiesinvolvedaregatheringcrudesandstoringitforuncertaintimes.Asaresult,theoilprice
infuturemarketscandifferfromitstrueunderlyingvalueandmaycauseacrudebubblelikein
2008.24
Theresultisanimbalanceinrisingdemandsanddecliningsupply.Thisimbalanceislikelytorise
inthefutureandisthemainreasonforlargeandrapidpriceincreasesinordertoreestablish
theequilibriumbetweensupplyanddemand.
22Database: IEA Short Term Outlook May 2012
23 Interim Report on Crude Oil Interagency Task Force of Commodity Markets,
Commodity Future Trading Commission, 06-2008 (Page4)
24 Price of Oil: Manipulation? Bubble? Supply/Demand?, Natural Resources, 06-
06-2008 (Page 2-3)
Unconventional crudes are all the crudes not produced from a classical
wellhead. According to the IEA, unconventional crudes can have the
following sources:
Oil sands (i.e. Alaska)
Oil shale (i.e. Forth-Worth Basin in Texas)
Coal based liquid (i.e. German production in the Second World War)
Biomass based liquids (i.e. Brazil)
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INVENTORIES
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TimePeriod CorrelationbetweenWTI-PriceandUS-CrudeStocks
1992-1996 -0.527304116
1997-2001 0.389332895
2002-2006 0.8459272
2007-2011 -0.261635432
Source:Database-USStockhistoryfromEIAWTIpricingfromNYMEXspot
Oneindicatorthatisusedbycrudemarketexpertstopredictfuturepricedevelopmentsisthe
US-Stockinventory.Inordertodetermineifthereisanycorrelationbetweencrudestocksand
crudeprices,IplottedtheWTIcrudepricesfromdifferenttimeperiodstothecrudeoil
inventoriesintheUS.AftertheHotellingtheory,crudeoilpricesandinventoriesshouldhave
hadanegativecorrelation.Thismeansifcrudeinventoriesarerising,crudepricesshouldbe
decreasing,andtheotherwayaround,everythingelseequal.Theplotaboveshowsthatthereis
littlesystematicrelationshipbetweenoilinventoriesandoilprices,especiallyinthelasttimeperiodfrom2006to2011.Furthermore,thecorrelationofthedifferenttimeperiodsseemsto
vary.Inthefirstperiod,from1992to1996,thereisamoderatenegativecorrelation,which
changesinthenextfive-yearperiodtoaweakpositivecorrelation.Thispositivecorrelation
cannotbeexplainedbytheory.Furthermore,intheperiodof20022006,thecorrelationis
highpositive,whereasinthelastperiod,thecorrelationchangesagaintoaweaknegative
covariance.Therelationshipbetweencrudeinventoriesandcrudepricingisnotclear,and
therefore,UScrudeinventoriesfailifusedforfuturepricepredictions.25
Thisplotdiagrammayshowsomeevidencethatspeculationhasanincreasingimpactoncrude
pricing.Inthelastperiod,from2006to2011itseemsthatthereisalmostnocorrelation
betweenrisingoilpricesandUSstockinventories.Inpastperiods,thedotsinthegraphwereclosertogether.Throughexcessivespeculation,thefuturepricewouldbeabovethe
equilibrium.Thiswouldresultinhigherstocks,asproductionwouldriseanddemandwouldfall.
Further,risinginventoriescouldbeinterpretedinthatway,thatthemarketbelieves,thatthere
isarelativelylowscarcitytodayandthattherewillbeasupplyshortfallinthefuture.Otherwise,
themarketwouldhavenoneedtoholdcrudeinventories,asinventorieshavetocompensate
storagecostsandinterestcosts.
SPARECAPACITY
Thepartywhocontrolsthecrudesparecapacitysetsthecrudeprices.Thecontrollingpartycan
beasuperficialorganizationthatsetsquotasonoilliketheTRCandOPECoraprivatecompany,
25 The Role of Speculation in Oil Markets: What have we learned so far?, Bassam
Fattouh, Lutz Kilian, Lavan Mahadeva, Oxford Institute for Energy Studies, 03-18-
2012 (Page 13)
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liketheStandardOilCompany.However,thesepartiescanonlyinfluencetheoilsupplyaslong
astheyhavesparecapacityandaslongastheyaretakingontheroleofaswingproducer.
Source:Database-ShortTermOutlookMay2012fromEIA
Today,OPECcountriesstillserveasaswingproducerintheworldcrudemarket.Themajorityof
theworldcrudeproductioncomesfromNationalOilCompanies(NOC),likeSaudiAramco,a
memberoftheOPEC.26However,thereareconcernsthatOPECcountriesareproducingover
theoptimalproductionrateinordertostabilizethemarketsandthattheyarenotabletoserve
asaswingproducerinthelongrun.
Asseeninthegraphabove,OPECsurpluscapacitystayslow.Surpluscapacitiesweresharply
risingduetotheworldrecession.Thesecapacitiesareconsumedandwilldeclinetothelows
beforetherecession.Thesparecapacityof3.02MBPDin2011isequivalentto3.46%ofthe
worldcrudeconsumption.Thisputspressureonthesupplymarketandonthecrudeprice.Further,itisunclearwhowilltaketheroleoftheswingproducerinthefuture;theremaynotbe
one.Besides,thislowsurpluscapacityisalsoconcentratedinafewOPECcountries,withSaudi
Arabiaholdingthelargestshare,resultinginahighergeopoliticalrisk,becausethereisalower
diversification.
26 Database: Global Crude Oil and Liquid Fuels, IEA Short Term Outlook June 2012
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GEOPOLITICALUNCERTAINTY
Source:Database-InternationalEnergyStatistics;TotaloilSupplyfromEIA
Oilproductionishighlyconcentratedinafewcountries;thisresultsinahigherriskof
disruptions,asthereisalowerdiversification.Inaddition,in2011,sixofthetenlargestcrude-
producingcountrieswereeitherruledbycommunisticpartiesorhadnationalizedtheiroil
productionandthus,havelimitedaccesstoprivateinvestments.27
Geopoliticaldisruptionsfrequentlyappearinoil-supplyingcountries.Itseemsthatoil-supplying
countriesareaddictedtobeingunstable.Duringthelasttwoyearstherehavebeenovera
dozensupplydisruptions,lastingfromafewdaystoafewmonths.Thesedisruptionsmainly
occurredintheMiddleEast.
27 Interim Report on Crude Oil Interagency Task Force of Commodity Markets,
Commodity Future Trading Commission, 06-2008 (Page 13)
Nationalizedoilcompanies(NOC)havedifferentaimscomparedtotheprivateoil
companies.Themainaimintheprivatesectoristoyieldhighreturns,reachedthroughafull
andquickdevelopmentofoilprospects,withenhancedexpertsandtechnology.Ontheotherhand,nationalizedoilcompaniesaredrivenbypoliticalagendasandpublicinterests.
Therefore,privateoilcompanieswouldbemoreefficientinthesupplyofcrude.1This
phenomenonisdescribedbytheHotellingruleofamonopolysupply,whichwillbe
discussedlater.
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Source:unplannedproductiondisruptionsfromU.S.EnergyInformationAdministration
Inthefirstquarterof2012,fourcountrieswereresponsibleforthemainunplannedproduction
disruption:Canada,Libya,Sudan,andSouthSudan.In2011Libyawasholdinginalmosttheir
entireoilproductionofabout1.65mbbl/dayduetoacivilwar,resultinginacrudepricedrivein
theendof2011.However,thesituationinLibyagotundercontrol,andtheofflineproductionin
April2012wentdownto350mbbl/day.InJuly2011,SouthSudanbecameindependentfrom
Sudan.SudanandSouthSudanhadanargumentoverthepipelinetransitfee,andSouthSudanshutdowntheirentireproductionof460tbbl/d.
28ThedisruptioninCanadawascausedby
technicalupgradesintheAlbertaoilsandproductionfacilityinthemidofMarchandunplanned
repairfromFebruaryuntilMarchattheHorizonOilSandproductionfacility.
Theanalysisofthefirstquarterof2012showsthatdisruptionsoccurfrequentlyandrandomly.
Politicaldisruptionshavelong-termimpactsonthecrudesupplycomparedtoshort-term
technicaldisruptions.Thesesupplydisruptionsdirectlyaffectthephysicaloilmarketandleadto
ashortageinsupply.Throughthelimitedsparecapacity,geopoliticalproblemscannotalwaysbe
absorbedresultingincrudepricejumps.
28 Crude Oil: The Shifting of Global Supply Disruptions, Where Food comes from, 4-
18-2012
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WEATHERUNCERTAINTY
Inadditiontogeopoliticaluncertainties,thereareweatheruncertaintieswhichcanhavehuge
impactsonthesupplyside.Weatheruncertaintiesarerelativelysimilartogeopolitical
uncertainties,astheyoccurfrequentlyandrandomly.Theseuncertaintiesincludeflooding,
earthquakes,andhurricanes.Thesedisruptionsimpactthecrudeproduction,refineries,orthetransportationsystem.Onetypicalexampleofaweatheruncertaintyisthefrequentlyoccurring
disruptionsduringthehurricaneseasonintheGulfofMexicofromJunetoNovember.
EXCHANGERATES
Thecrudepriceandtheexchangeratesarebothvariablesthatgenerateasignificantimpacton
therealeconomy.Therelationshipbetweenthecrudeoilpriceandtheexchangeratesis
complex,andcausalitycanaffecteachother.29Crudeistypicallypricedindollars,anda
depreciationofthedollarleadstoariseintheoilprice;allotherfactorsareequal.Forexample,
ifthevalueofthedollardepreciatesagainstothercurrencies,itcouldboostforeigndemand.
Additionally,foreignoilexporterscouldsufferintheirpurchasingpoweroftheirearning.Thus,
theseexchangeratemovementsarecancelingeachotherout.
Source:Database:Yahoofinance(US.Dollarindex);IEA(WTISpotPrice)
29 Interim Report on Crude Oil Interagency Task Force of Commodity Markets,
Commodity Future Trading Commission, 06-2008 (Page 14)
TheUnitedStateshaschangedovertime,frombeinganetoilexportertoanetoilimporter,
andthiscountsnotonlyfortheiroilimports.TheUnitedStateshasasignificanttradedeficit,
resultinginincreasingconcernsaboutthesustainabilityoftheUSdollar,anditsetstheoil
priceagainstothercurrenciesunderpressure.
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TheabovegraphplotstheWTIspotpriceandtheU.S.dollarindexperformancesincethe
beginningofNovember2011.Itseemsthatthenegativecorrelationbetweenthedollarandthe
oilpriceislostoverthetimeperiodofMarchYEAR???tothebeginningofMay2012.Thelatest
tensionsbetweenIranandtheWesthaveresultedinariseoftheoilprices.WhiletheU.S.dollar
indexgainedastheEuropeancurrencystruggled,inMay2012thecorrelationsnappedbacktoa
normalnegativecorrelation.Thelatestdevelopmentshowsthatcrudepricedevelopmentsareunpredictableandthatlong-termrelationshipsandindicatorscanchangeintheshortrun.
30
INTERESTRATES
Theimpactofchangesintheinterestrates,setbytheFEDontheoilprice,isnotevident.There
aremanystudiesabouthowtheinterestrateinfluencestheoilprice,andtheirresultsdiffer.
However,adeclineintheinterestratestendstoleadtoaraiseintheoilprice,allotherfactors
equal.Oneexplanationforthephenomenaisthat,ifinterestratesaredeclining,costsforoil-
storinginventoryaresinking,andthus,thetemporarydemandisrising.Furthermore,oil
demandingeneralwillriseduetoahighereconomicactivity.Ofcoursethisphenomenawillnot
occurifthereasonforthedeclineintheinterestratesisduetoastrugglingeconomywherelow
interestratesboosttheeconomy.Inacrisis,theoildemandwilldecreaseandthustheoilprice
willdecrease.
Thefederalfundrateisstill0.25%almostfouryearsafterthefinancialcrisis.Nowadays,these
lowinterestratesmaynotbeimpactedasmuchfromthefinancialdownturnof2008andresult
inarisingoildemandandoilprice.
SCARCITYRENT-MODELOFHOTELLING
TheHotellingmodelisonemodelforthepredictionofprospectiveoilprices..In1931,Harold
HotellingdescribedinhisarticleTheEconomicsofExhaustibleResourcesthescarcityrentof
non-renewableresources.Mr.Hotellingexplainshownon-renewableresourceownersare
maximizingtheirpresentvalueuntilthecompletionoftheresource.TheHotellingmodelshould
beseenasageneralapproach.Itgivesthetheoreticalideaoffactorsthatareinfluencingtheoil
market.31
Economistsdefinenon-renewableresourcesasacommoditythatcannotbereplacedduringthe
timeperiodofdemand.Throughitslimitations,thepriceforanon-renewableresource
contains,besidestheproductioncosts,ascarcityrent.Hotellingassumesthattheoilmarketisa
competitivemarket,withoutbarrierspreventingrivalsfromenteringorleavingthemarket.
Anotherimportantcontext:themodelisbasedontheefficientmarkethypothesis,which
30 Ties That Bind Oil and Dollar Snap, Christian Berthelsen, The Wall Street Journal,
(03-07-2012)31 Nonrenewable Resource Scarcity, Jeffrey A. Krautkraemer, Journal of
Economic Literature, Dec. 1998 (Page 1-10)
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proposesthatstockpricesreflectallavailableinformation.Further,itassumesthatproducers
arepricetakersandcouldsellanyquantityatthemarketprice.
Inexhaustibleresource:
Pt=MCt
Exhaustibleresource:
Pt=MCt+P0(1+r)
Asoilisanon-renewablegood,theproducerhastheoptionofleavingthecrudeintheground
forfutureproductionorproducingthecrudetodayandreceivinginterest(r)ontheyields.The
producerwillholdtheoilasareserveifhebelievesthatthefuturepricewillbeabovethe
interestrate(r).
Source:ONTHEECONOMICSOFNON-RENEWABLERESOURCES
Ifthecrudepriceweretoriseslowerthantheinterestrate,producerswouldsellofftheir
stocksinordertoreceivetheinterest.Ifthecrudepriceweretorisefaster,producerswould
holdtheirstocksforthefuture.Asseenintheleftgraphabove,themarketwouldgettighter
andpriceswouldriseexponentially.Furthermore,aspricesrise,theproductionrateswould
continuouslyfall,astheresourcestockgetsexhausted(leftgraph).32
Thedemand,ontheotherhand,wouldbecutoffatacertainpricelevelandinordertosell
crude,theproducerswouldhavetodecreasethecrudeprice.Inthismodel,thequantity
producedwouldbetheresultoftheequilibriumofthepricerisesincrudeandtheexponential
interest(r).Itmakesnodifferencebetweensellingabarreltodayoratafuturepoint.3334
32 Natural Resource Economics under the Rule of Hotelling, The Canadian Journal
of Economics, Vol 40, No 4., 11-2007 (Page 1043)
33 On the Economics of Non-Renewable Resources, Neha Khanna , Invited
contribution to Encyclopedia of Life and Social Sciences, UNESCO. Forthcoming,
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However,therearefourvariablesthatconfusethissteadydevelopment:
Fluctuationsindemand
Changesintheextractioncosts
Newcrudediscoveries
Alternativefuels(backstoptechnology)
CHANGESINTHEEXTRACTIONCOSTS
IntheHotellingmodel,achangeintheextractioncostshasnoimpactontheabsolutescarcity
rent.Theproductionscosts,theresourcepriceminusscarcityrent,willriseandfallwiththe
higherandlowermarginalextractioncosts.
Rt=Pt-MCt
Productioncostswoulddecreaseasnewtechnologies,likehorizontaldrillingoradvanced
frackingmethods,promiseahigherrecovery.Asaresultofdecreasingproductioncosts,net
pricescandecreaseintheshort-term,aslongassinkingproductioncostsareoutweighingthe
risingscarcityrent.Yet,afterallthis,thepriceswouldriseevenquicker,astheresourcewould
beexhaustedmorequickly.
Productioncostwouldrise,sinceitwouldbegettinghardertoproduceconventionalcrude.
Therearestillnewdiscoveriesofconventionalcrudes.However,thesediscoveriesareinremote
places,andtheproductionhastomovetolocationsofextremeconditions,liketotheoffshore
fieldsoftheGulfofMexicoortofieldsneartheArctic.Ifconventionalcrudeweredepleted,
expensiveunconventionalcruderesourceswouldhavetobeproduced.
NEWCRUDEDISCOVERIES
OneofthemostimportantvariablesintheHotellingmodelisthemeasurementofreserves.As
reservesarerising,thescarcityoftheresourceissinkingandthusthescarcityrentissinkingtoo.
Thereservesarebasedonestimatesandarecontinuouslychanging.Thebigcrudediscoveriesin
the1980sresultedinlowcrudeprices.Nowadays,newcrudediscoveries,liketheoffshore
discoveryofPetrobras,closetothecoastofRiodeJaneiro,arerelativelyrareandnotasbigas
historicaldiscoveries.35
Department of Economics and Environmental Studies Program Binghamton 01-30-2001 (Page 2-10)
34 Hotelling Revisited: Oil Prices and Endogenous Technological Progress, Cynthia
Lin, Haoying Meng, Tsz Yan Ngai, Natural Resources Research, 03-01-2009 (Page
1-10)
35 Petrobras finds new offshore oil reserves, Oil and Gas Technology, 03-13-2012
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BACKSTOPTECHNOLOGY
Abackstoptechnologyisasubstituteforthenon-renewableresource,likeethanolfromsugarin
ordertouseascrude.36Thisresourcecanbeproducedatanyquantityifthepricereachesa
certainlevel.Whenthepriceofcrudeishigherthanthepriceoftherenewableenergy,the
demandwillswitchtotherenewableenergysource.
Thisswitchcanbeseenintheoilmarket.Highvolatilityandrisingcrudepricesinthepastdecadehaveledtohigherinterestinnon-conventionaltransportationsfuels,likebiofuels,GTL
fuels,andCTLfuels.Asaresult,thecrudemarkethasrisingimpactsonthecornmarket,andthe
correlationbetweenthesemarketsisincreasing.
36 Crude Oil Price Forecasting: A Statistical Approach, Armando Lara, Michael
Leger, John Auers, National Petrochemical & Refiners Association, 03-18-2012
(Page 6)
Resources are the total amount of undiscovered and discovered oil. They
contain the produced oil as well as future predictions.
Reserves are a part of the resources and are the economically and
technically producible in the future.
OOIP OriginalOilinPlace TotalOil
URR UltimateRecoverableResources Resources
EUR EstimatedUltimatelyRecoverable Produced+Reserves
Reserves Proven 90%probability
Probable 50-89%probablity
Possible 10-49%probability
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Source:ONTHEECONOMICSOFNON-RENEWABLERESOURCES
IMPACTSOFAMONOPOLY
LetsassumeOPEChasamonopolymarketposition.Inthissituation,crudepriceswouldbe
higheringeneralandwouldrisemoreslowly,astheextractionwouldbeslower.Itisassumed
thatamonopolywouldnotcompletetheresourceasfastasitwouldinacompetitivemarket,
andthus,oilproductionwouldlastlonger.
Todayscrudemarketisfarfromamonopolymarketstructureandismorecharacterizedby
perfectcompetition.Onacountry-basedview,therearemonopolystructureswithNOC
controllingtheentirelocalproduction.37Thegovernmentsofthesecountrieswilladjusttheir
productionratestotheirpoliticalagendasandwillextracttheircrudereservesmoreslowlythanprivatecompanieswould.However,theyareactingindependentfromothergovernments
nationalizedoilcompanies.Thecrudemarketwas,withtheStandardOilCompany,amonopoly
market.OPECcountriesasawholeneverhadamonopolyposition,asthememberswerenot
actingasagroup.OPECmemberswereactingindependentlyfromthegroupdecision.
37 On the State's Choice of Oil Company: Risk Management and the Frontier of
the Petroleum Industry, Peter A. Nolan and Mark C. Thurber, Program on Energy
and Sustainable Development, 12-2010 (S4)
Thisphenomenonisalsoknownasthe"Prisoner'sDilemma:"everycountryisactinginits
bestinterest,soeverypartyhasanincentivetocheatontheirproductionquotas.
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PRICE-INELASTICINTHESHORTTERM
Intheshortrun,thedemandforfinishedproductsandthesupplyofcrudearerelativelyprice
inelastic.
Ittakeshugepriceincreasestolowerthedemandintheshort-term.Thepriceelasticityofthe
crudedemandislessthan1. 38Asaresult,theexpendituresforcrudeasapercentageofGDPare
risingwhenoilpricesarerising.Thepriceelasticityofcrudeoilisdifficulttocalculate,asthere
areavarietyofdifferentparametersinfluencingit.JamesHamiltoncalculatesthepriceelasticity
inhisNBERWorkingPaperNo.14492andfindsevidenceforthelowpriceelasticity.Itis
interestingthatthepriceelasticityforcrudeoilishigherinemergingmarketscomparedto
developingcountries.39
%Changeinoildemand
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Source:Database-spotWTIfromIEA
Thegraphaboveshowsthevolatilityofcrudepricesinthelastdecade.Mostofthepeaksare
duetoeconomicalboomsorrecessions.Theabnormalpeakin2009wascausedbytheworld
financialcrisis.However,itseemsthatthesepeaksaregettingbiggerovertime.
Count 843
Mean 0.0605
Median 0.1100
Max 7.6200
Min -8.9000StandardDeviation 1.7182
Skewness -0.2606Source:Database-spotWTIfromIEA
ThedailyreturnsofWTIcrudeoilareplottedinthegraphabove.Itcanbeseenthatthese
returnsarenotfollowinganormaldistribution.Thestandarddeviationisrelativelylow,which
meansthatthemajorityofreturnsareclusteredaroundthemedian.Furthermore,the
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distributionisleftskewed.Thisimpliesthatmostofthevaluesareconcentratedontherightof
themean,withextremevaluestotheleft.Theresultsfromthisgrapharecharacteristicfor
crudepricing.Itshowsthathugenegativefattailsdisruptthegeneraltrend.40
Inthelastperiodoflowoilpricesin1999,manyofthemajoroilcompaniesweremovingtheir
focusoutoftheUnitedStatesastherecoveringcostsweretoohigh.Forexample,thecostof
recoveringonebarrelofcrudeoutoftheGulfofMexicoisroughly$12,comparedtoOPEC
countries,thathaveproductioncostsoflessthan$2.41
Theoilbusinessingeneralisaveryvolatilebusiness,mostlydependingontheactualoilprice.
Oilandgasproducersaredrillingcircadian.Theyarespendingtoomuchmoneyfordrillingor
theacquisitionofnewplaysduringtimesofhighoilprices,resultinginashortcashflowduring
timeswithlowoilprices.Theseproducershavequestionablemethodsforreducingfixedcosts.
Duringperiodsoflowoilprices,itmaybeeconomicalto"shutin"awellandwaitforhigheroil
pricesinordertoeliminatethefixcostsforkeepingupthewellstructure.However,thereisthe
riskthatthereservoirisdamagedduringtheclosingtimeandhastobere-drilled.42Besides,the
explorationandproductioncompanymaynotbeabletoshutawellinforalongertimeperiod,asthecompanyhastopaybackthedrillingandcompletioncoststoinvestorsandbanks.
Anotherpossibilityofreducingfixcostsduringperiodsoflowoilpriceswouldbetolayoff
personallikeoilengineersandgeologistintimesoflowoilprices.Thisstrategyisusedbymany
majorsandsecondtierintegrated.Theyhavehugelayoffsandemployments,dependingonthe
oilprice.Ofcourse,circadianfireandhireemployeepoliticarenotsustainableandgreat
institutionalknowledgeisgettinglost.Institutionalknowledgeisacrucialfactorinthecompetitiveadvantageofanoilcompany.Intheoilbusiness,everyplayinaregionhasits
specialcharacteristicsi.e.theformationsorservicecompanies.
ThemanagementofCordaCorporationrealizedthatthesefiringandhiringcycleswere
extremelycostlyforthecompanyandmadeittotheiradvantage.Thecorporationisverylean
managedandhasonlyoneengineeringofficeinWichitaFalls.Thedirectoroftheengineering
officeinWichitaFalls,PaulLeming,followedthefootstepsofhisfather-in-lawandhasbeen
workingforCordaCorporationfor10years.Thushehasahugeexperienceinthelocaloilfields
40 World Crude Oil Markets: Monetary Policy and the Recent Oil Shock
,Noureddine Krichene , IMF Working Paper, 03-2006 (Page 10-20)
41 Database: FACTBOX-Oil production cost estimates by country, Reuters 07-2009
42 Risk Management at Apache, Lisa Meulbroek, Harvard Business School, 08-27-
2001(Page 4)
ThecostsfordrillinganonshoreverticalwellinTexasareroughlyabout$300,000andthe
costsforcompletionareabout$100,000Inordertorefinancetheseexpendituresitis
importanttohaveacontinuousreturnflow.
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andthelocalstructure.IftheworkloadreachesthecapacityofCordaCorporation,workis
outsourcedtolocalcompanies.
RESTRUCTURINGOFCORDACORP
Evenmoreaffectedbythepricechangesarethesuppliersoftheoilproducer,likeforexample
thedrillingrigs.QuotingMr.DeClevajunior:"Theoilservice43
industry,arethelastwhoarebenefitingfromhighoilpricesandthefirstwhogetoutofbusiness,ifthepricesgodown."As
explainedabove,mostoilE&Pfirmsnowadaysdonotownthedrillingrigs.Theseservicesare
outsourced.ThebusinessofdrillingrigcompaniesismorevolatilethantheE&Pbusiness.Ifthe
oilpricesarehigh,drillingrigsarebookedover12monthsinadvanced,whereasiftheprice
goesdown,manyoilplaysarenoteconomicalfordevelopment,leavingtherigstiedupatthe
docks.
CordaCorporationhadtomakethisexperienceinthe1980s.Besidestheexplorationand
productionriskCordaCorporationhadtomanagetherisksarrivingoutoftheoilservice
industry.Duringthe1980tstheoilindustrywasnearitsmarginofsubstance.Duetoamassive
oiloversupplyinthemid1980soilpricesweretumblingtonewlowsandsodidtheprofitsofmostoilbusinesses.Manyoilfirms,especiallymidandsmallsizedfirmshadtodeclare
bankruptcy.
CordaCorporationanditsaffiliateswererunningthreedrillingrigsandapayrollof30
employees,mostlyroughnecks,engineersandgeophysics.In1986,Cordaanditsaffiliatessold
itsdrillingrigsatasteepdiscount,therebyallowingittofocusexclusivelyonprospectivesand
exploration.RigserviceswereoutsourcedandCordaCorporationhadtoreducestaffand
overhead.CordaCorporationwentbacktoalong-termorientedviewwithleanstructures.This
policystilldictatestoday'sdecisionsandsetabasistothesuccessoftoday'sbusiness.
INTRODUCTIONTODERIVATIVEOILPRODUCTS
InthefollowingIwanttotakeacloserlookatthederivativemarketasitplaysamajorrolein
todayscrudepricingsystem.Therisinginfluenceofthepapermarketbecamepossiblethrough
thedevelopmentofthemarketpricingsystem.Thetwomainmarketsfortradingoilarethe
standardizedexchangemarketwithfutures,optionsandtheOTCmarketwithforwardsand
swaps.Thefirststandardizationappearedin1978whenheatingoilwastradedontheNYMEX.
In1983crudebecameavailableforfuturetrades.Atthebeginningofthefuturemarket,mostof
thecrudewasstillhedgedovertheOTCmarketwherethecounterpartiestradedwithoutathird
clearingparty.44Beginningin1988crudepriceswerelinkedtobenchmarks.
45Thisgavethe
43 Reservoir Digs: on energy investing and private equity, JP Morgan, 03-22-2012
(Page 1-2)
44 Risk Management at Apache, Lisa Meulbroek, Harvard Business School, 08-27-
2001(Page 5)
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producerandtheconsumersomekindofconfidencethatthecrudepricewasgroundedinthe
physicaldimensionofthemarketratherthansetbyoilmajorsorOPEC.Overtimethisledtothe
complexandinterlinkedstructurewiththespotmarket,futuresandoptions.Intodaysworld
thepriceofthebenchmarkscannotbeisolatedfromfinanciallayers.Spotcargos,forimmediate
deliveryofcrudearerare.46Throughthehighvolatilityofcrudepricesandtheirhugeimpacts
onthedailybusiness,theneedfortheproducerevolvestorollovertheriskstothemarket.Byusingderivativestheoilproducercanfocusontheirstrengthsandbuildouttheircomparative
advantagewhiletheydon'thavetoworryabouttheshort-termpricevolatility.
OTCDERIVATIVE
TheInternationalOrganizationofSecuritiesCommissions(IOSCO)reportedin2010that45%of
thetradesincrudeorpetroleumproductswereovertheOTCmarket;theremainingwastraded
overexchanges.IntheOTCmarketsingeneraltherearemorephysicaltraders,including
producers,refineries,downstreamconsumers,andphysicaltraders.Financialplayersaretrading
forthepurposeofspeculationandaremarginallypresentedintheOTCmarket.However,more
andmoreOTCdealsaretradedoverclearinghouses.TheOTCmarkethasshiftedfromamarket
wherepartieswerenegotiatingoverbrokersorface-to-facetoamarketoverelectronicOTCand
becamemoresimilartoexchangemarkets.TherearetwomainOTCderivativesforcrude:
forwardsandswaps.Iwillfocusespeciallyontheforwardmarket,astheforwardmarketsets
thepricedifferentials.
45 An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute
for Energy Studies, 01-2011 (Page 6)
46 An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute
for Energy Studies, 01-2011 (Page 7)
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47
PRICEREPORTINGAGENCIES
Theindicesforthephysicalmarketare,unlikeinthefuturemarket,wheretheyareinrealtime,
reportedorassessedprices.Assessedpricesareneededinellipticalorilliquidmarkets.48Pricing
reportingagencies(PRAs),likePlattsandArgus,areassessingpricesbyaskingasmanytrading
parties,aspossible,wheretheyseethemarket.PriceassessmentsfromOTCmarketsareusedtosetbillionsofdollarsworthdeals.
AroundthesePRAindicestherehaveemergedmanyfinanciallayerstradedintheOTCand
regulatedexchangemarket.Allkindsofforwards,swapsandfutureshaveevolvedusingphysical
indicesforspeculationandhedging.
ThedifferentindicespublishedbythePRAsdifferintheirmethodsofpriceassessmentandin
theformofvaluatingbids,offers,andobserveddeals.Ingeneralobserveddealsaremore
representativeforamarketthanbidsandoffers.Ifthephysicalmarketgetstoilliquid,thisisthe
onlywayforevaluatingapricelevel.Thetradingpartiesbehindthebidsareknown.ThePRAs
47 Understanding Oil Prices - A Guide to What Drives the Price of Oil in Today's
Markets, Salvatore Carollo, ISBN 978-119-96272-4, 2012 (Page 94-100)
48 An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute
for Energy Studies, 01-2011 (Page 7-31)
Onepopularforwardisthe21-dayBFOEcontract.Forexample,theproducerofaBrentfield
cansellontheforwardmarketonecargo,600.000barreloftheprojectedfieldproductionof
JulyinMay.Aftertheloadingscheduleisfinalizedthepurchaserreceivesatleast21days
beforetheactualloadingdate-anoticeoftheexactthree-dayloadingwindow.The
purchaserofthecargoofcrudemaynotwanttoreceiveaphysicalloadofcrudeandthushe
sellshiscontractbeforeexpirationandisbookinghispositionout.Thepurchaser,whoisholdingthe21daysBFOEbeyondtheexpirationdate,hastotakethephysicaldelivery.
Whenthedeliverydateisknown,the21-daysBFOEcargoturnsintoaDatedBrentcargo.
DatedBrent,DatedBFOE,DatedNorthSeaLight(Platts),orArgusNorthSeaDatedreferall
tothespotmarket,whereacargohasaspecificloadingdate.However,DatedBrent
contractsarenotdeliveredimmediatelyandstillhaveaforwardelementthatcanbetraded.
Infact,theDatedBrentpricepublishedreflectsthepriceofcrude,deliveredbetween10and
21daysahead.Forexample,theDatedBrentontheMayfirstrepresentsthepriceforcrude
deliveredonMay11untilMay22.
ThelinkagebetweentheforwardBrentmarketandtheDatedBrentmarketisthroughtheContractsforDifference(CFD)swapmarket.IntheCFDmarketbuyersandsellerscanswap
differencesbetweenpositionsoftheDatedBrentandforwardBrent.
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decidewhichinformationtheyareusing.Thus,physicalindiceshaveabigelementof
subjectivity.
Forinstance,ASCI,themainindexfromArgus,andanimportantbenchmarkforUSmarkets,is
mainlybasedonobserveddealsduringaday.ThePlatt'sindexhasthesameunderlyingdata,
howeverPlatt'smethoddiffersfromtheArgusmethod,asPlatt'sonlylooksatdealsinacertain
timewindow.Platt'swasusingavolume-weightedaveragepricingsystemuntil2001,whenit
changedtothemarket-on-close(MOC)methodology.Theproblemofthevolume-weighted
averagepricingsystemusedbyArgus,isthatitisalwaysrepresentingpricesinthepast,and
thusitislaggingbehind.Thisisespeciallyaprobleminhighvolatilemarkets.IntheMOCsystem,
thereisacertaintimewindowinwhichthemarketsareanalyzed.ThecriticismabouttheMOC
systemisthatinvolvedpartiesmaychangetheirtradingstrategyinordertoinfluencethe
benchmark,thusitwouldnotbeareliablesourceforthephysicalmarket.Thistimewindowwill
onlyrepresentafractionoftherealmarkettransactionsandtradingparties.Thetraderscould
forexample,accepthigherorloweroffersduringthePlatt'stimewindow.Thiswoulddistortthe
marketprice.Thelossesmadeduringthetimewindowcouldbeeasilycompensatedoverextern
derivativesasthepricedirectionisknown.
ThereareconcernsaboutthehugeinfluenceofthePRAontheoilcommoditymarket.In
November2010theinfluencesofthePRAswerediscussedbytheG20andanalyzesweredone
bytheInternationalOrganizationofSecuritiesCommissions(IOSCO).49TheresultisthatPRAs
areunderaspecialoversightoftheIOSCOandtheG20governmentshaveimposedmore
controlontheoilmarkets.PRAs,likeArgusorPlatts,areprivatecompanies,eachhavingtheir
ownmethodologyofassessingprices.ThedifferenceofonetoanotherPRAbenchmarkisover
timelessthanonedollar.However,onthedailytime,thedifferencesforthesamebenchmark
canbesignificantandhasimportantimplicationsontheexportearningrespectivelyonthe
financialflowsoftheinvolvedparties.50
FUTUREMARKET
Theadvantagesofstandardizedfuturesoverforwardsarethattheexchangematchesthe
partiesandtakesoverthecounterpartyriskresultinginahigherliquidmarket.
Ontheotherhand,forwardshavetheadvantagethattheyaremoreflexibleintheircontract
agreementslikelocation,price,ortime.Forexample,WTIcrudeispricedinCushing,Oklahoma.
Theenteringpartyinthefuturecontracthastotakeovertheresponsibilitiesofdeliveringthe
crudetoCushingevenifthecrudegoestoarefineryontheGulfCoast.
49 An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute
for Energy Studies, 01-2011 (Page 30)
50 Oil price agency Platts too powerful, regulator told, Reuters, 04-05-2012
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FutureandoptiontradingismostlydonethroughtheelectronicplatformGLOBEX.The
advantageofGLOBEXoveranopenoutcrysystemisthatGLOBEXprovidesaccesstoalarger
rangeofpeopleandisalmostaroundtheclock.
Itisimportanttolinkboth,theforwardandthefuturemarket,inordertoensuretheefficiency
ofthecrudemarket.TheoilpriceinaforwardmarketislinkedovertheExchangeforPhysicals
market(EFP)tofuturecontracts.
SPECIFICATIONSOFLIGHTSWEETCRUDEANDBRENT
InthefollowingIwilltakeacloserlookonthefuturespecificationsofWTIandBrent,astheyare
importantforthehedgingstrategyofCordaCorporation.WTIisunderlyingtheLightSweet
Crudefuturecontracts,tradedontheNYMEX.Thesecontractsaresomeofthelargesttraded
commoditiesintheworld.ThesettledpriceontheNYMEXhashugeimpactsonthephysical
market.Pricesare"discovered"onthefutureexchangesandaretakenasabenchmarkforthe
physicalmarket.ThesuccessoftheLightSweetOilfuturespushedWTIupintheglobal
understandingoftheoilpricing.Later,BrentfutureswereestablishedandtradedontheICEinLondon.ThesettlementofLightSweetCrudefuturesisthroughphysicaldeliverycomparedto
thecashsettledBrentfutures.
Crudefuturesarehighlystandardized.Forexample,theLightSweetCrudefuturehasdefined
characteristics,likeanAPIgravityof39.6andonecontract,1000barrelhastobedeliveredata
specificdatetoCushing.TheLightSweetCrudecontractallowsalsothedeliveryofsimilar
crudestoWTIlikeLowSweetMixandNewMexicanSweet.
IntheLightSweetCrudefuturemarketthecurrentdeliverymonthexpiresonthethirdbusiness
daypriortothe25calendardaysoftheprecedingmonth.Forinstance,aJune2012WTIfuture
contract,expiresonMay22,2012.Aftertheexpirationittakesthreedaysforschedulingthe
pipelinedate,alsoknownastherollperiod.However,atNYMEXonlyabout0.4%ofthefutures
areactuallytakenasphysicaldelivery,therestareclosedoutoveroffsettingcontracts.
TheBrentfuturesaretradedontheInterContinentalExchange(ICE)inasizeof1000barrelper
trade.Thesecontractsarecashsettled.Inordertolinkthepapermarkettothephysicalmarket
thereistheoptionthroughphysicaldeliveryovertheExchangeFuturesforPhysical(EFP).The
EFPsaretradedoutsidetheexchangemarket.WherePartyAwantsphysicalcommoditiesand
swapstheirfuturestoPartyBinexchangeforaforwardagreement.
FUTURECURVESANDPRICING
Thebehaviorofthefuturecurveisimportanttothepricingofcrude.Thefuturepricerollsata
certaintimeintothespotprice.Unlikeothercommoditieslikegold,thefuturecurveofoilis
undernormalconditionsinbackwardation.Thismeansthatnearfuturecontractswillbetraded
atahigherprice,comparedtofuturecontracts,withexpirationdatesfurtheraway.In
conclusion,afuturepaperinbackwardationwilloutperformthespotmarket.
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Source:Database-CrudeProduction2011fromIEA
ThegraphaboveplotstheWTIandBrentfuturecurvefromtheviewofMay17,2012.ThestepsoftheBrentfuturecurveoccurduetodifferenttimeperiodsofWTIandBrent.Thesetwo
curvesdiffersignificantly.ThebottleneckofWTImentionedaboveandtheresultingstorage
problemschangedtheWTIfuturecurve.ThisiswhythefuturecurveofWTIcrudebeginswitha
contangoandthenchangesafterthreemonthstobackwardation.
Theformulafordeterminingthepriceofafutureis:
F0=S0e(r+u-y)^T
Where(F0)istodaysfutureprice,(S 0e)istodaysspotprice,(r)istherisklessrate,(u)thecosts
forstorage,(y)theconvenienceyields,and(T)thetimefromnowtotheexpirationdate.(r)and
(u)arealsoknownasthe"costsofcarry."Inorderthatthefuturepriceislowerthanthespot
price,(F0)
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Consuming,intheshortrun,ispriceinelastic
Thesupplyhasahighriskofdisruptions
Inventoriesforcrudeareexpensive
Crudehashighcostsofcarry,asithashighcostsforstorageandahighrisklessrate.Crudecan
beusedconditionalasasecurityandifonlywithanadvancepaymentresultinginahigher
risklessrate.Thiswouldfavorfuturepricecurvestobeincontango.Thehighcostsofcarry,
especiallyinthecommoditiesmarket,arethereasonwhymostcommodityfuturecurvesarein
contango.
Asmentionedabove,oilsupplyanddemandarefullofuncertainties.Thesupplysidehasto
guaranteethatthedemandforrefinedproductsisalwaysmet,independentfromsupply
disruptionsorhigherdemands.Assupplyhastobeguaranteedinordertofulfillcontracts,the
supplierscan'ttaketheriskofsellinginventoryandbuyingfuturecontracts.AccordingtoDr.
JohnHulltheconvenienceyieldofcrudefuturesreflectthemarketsexpectationsconcerning
thefutureavailabilityofthecommodity.Thegreaterthepossibilitythatshortageswilloccur
duringthelifeofthefuturescontract,thehighertheconvenienceyield.Therefore,
convenienceyieldsoccuroutoftheriskaversionofthesupplyingparty. 52
However,thisexplanationonlyappliestophysicalpartiesandnottothefinancialspeculatoron
thefuturemarket.Whatistheconvenienceyieldforthefinancialspeculatorincrude?One
explanationcomesfromJohnMaynardKeynes.Keynesarguesthatspeculatorsareactingoutof
thesameintentionofriskaversionasphysicalparties.Thephysicalpartiesareholdingcrude
inventoriesandaresellingfuturesoutofthepurposeofriskhedging.Speculatorsbuythese
futures,andtheyhavetocarrytherisk.Theriskwasrolledoverfromthephysicalpartiestothe
financialparties.
52 Commodity Futures Pricing- Contango and Backwardation, Jim Finnegan,
Chartered Financial Analyst
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Crudefuturecurvesarenotalwaysinbackwardation.However,duringthelastdecadethe
futurecurveshavebeenmostlyinbackwardation.Iffuturecurvesareinbackwardation,roll
yieldscanbemade,astheexpirationdatescomecloser,thefuturepriceisrises.Theyarethe
differencebetweenfuturepricesandspotprices.Thehistoricaldevelopmentofrollyieldscan
beseeninthegraphabove.
InNovember2008,duetothefinancialcrisis,thefuturecurveschangedandstayedincontango
untilOctober2011.Thecrudefuturecurvewasincontangoasthemarketbecamelesstightand
crudepricesfell.Theresultwasthatthecrudepricesandtheabsoluteconvenienceyieldssank,
whiletheabsolutecostsofcarrystayedthesame.But,therelativecarrycostsincreased
comparedtothecrudeprice.Thus,thecarrycostsoutweighedtheconvenienceyields,resulting
inacontangofuturecurve.
Source:DatabaseonIEAFuturepriceandCMEWTIcrudeSpotprice
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Inthetwographsabove,futurecurvesatdifferenttimesarecompared.Thedatawastakenon
May221987,andevery5yearsafterthat,untilMay222012.Contract1isinthenearestfuture
forthenextmonthinourexampleforJune,contract2isforJuly,andsoon.Thefuturecurves
changedduringthistimeperiodfrombackwardationin1987and1992toamorehorizontal
futurecurve.
SPECULATIONIMPACTSONCRUDEMARKETS
Itisawidespreadopinionamongmarketexpertsthattheincreaseinthecrudevolatilityisthe
resultofachangedmarketstructure.Crudescommoditiesacquirethecharacteristicsof
financialassets,ratherthanbeingactualphysicalcrude.Thefinancialplayersaremanipulating
thetruecrudepricethroughtheirinvestmentstrategies.Asaresult,commoditymarketsareno
longeradequatelyperformingtheirfunctionofthecrudepricediscovery.53
Inthepast,commoditieswereonlytradedbyphysicallyinvolvedpartiesorfinancialexperts.
Theshiftfromtheopenoutcrytoelectronictradingsystemsenabledawideraudienceto
participateintradingcommodities.Duetothegrowingaudience,thereisaneedforfinancialinnovations.
54Newfinancialproductshavebeendevelopedandtheunlimitedvarietyof
productsmakethemarketmorecomplex.
Speculatorsareusingthecommoditymarketforportfoliodiversification,sincethereisalowor
negativecorrelationbetweenstocksandcommodities.Commoditiesareseenasasafeharborin
timesofhighinflationandweakcurrencies.
Unlikethepurefinancialderivatives,oilislinkedtoaphysicalmarketwherecrudeisdemanded,
stored,andwidelytradedbythevariousparties.Thus,thepricesinthefinancialmarketsshould
adjustthemselvestothespotpricesinthephysicalcrudemarket.However,thecrudemarketis
morecomplex,anditisnotalwaysclearifthisrelationshipisaccurate.
Theoilpriceisunderlinedbythereferencepricesetonthefuturemarket.Theforwardmarkets
setthepricedifferential.ThePRAsareassessingthesepricedifferentialsandpublishthe
physicalbenchmarks.Thespotmarketwillusethefuturepricesasabarometerandseta
differentialbasedonbidsandoffersfromtheOTCmarket.Ifthefuturemarketbecomes
detachedfromtheunderlyingfundamentalsinthephysicalmarket,thedifferentialshallrise.
Thekeyquestionisthis:isthedifferentialstrongenoughtobalanceanunjustifiedchangeinthe
futuremarket?
53 The Role of Speculation in Oil Markets: What have we learned so far?, Bassam
Fattouh, Lutz Kilian, Lavan Mahadeva, Oxford Institute for Energy Studies, 03-18-
2012 (Page1)
54 An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute
for Energy Studies, 01-2011 (Page 6-20)
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PARTIESONTHEFUTUREMARKET
Partiesonthefuturemarketaretradingoutofdifferentintensions.Therearetwomaintypesof
parties:hedgersthathaveacommercialinterestandareconnectedtothephysicalmarket,and
speculators.TheHedgerspurposeonthefuturemarketismainlytorolloverriskstothe
market.
Speculation,inthepublicmind,isoftenviewedasnegativeandexcessive.Excessiveintheway
thatitharmssocietyandisonlybeneficialfortheprivateperson.55Theaimofaspeculatoristo
gainprofitsoutofapricechangeincrude.Thesearethefinancialplayers:swapdealers,pension
funds,hedgefunds,mutualfunds,technicaltraders,indexinvestors,andindividualswhoare
tradinginhighvolumes.Typically,theydonotwanttotakethephysicaldeliveryofcrude,and
thustheyareforexampleinaWTIfuturegoingshortbeforetheexpiringdate,orifitisBrentor
ASCIfuture,takethecashsettlement.56
Itisimportanttounderstandthedifferencebetweenthepricelevelandthepricedifferential.In
ourfinancialsystem,theactualoilprice,whichisfrighteningforconsumersandgovernments,is
notthemajorinterestforthespeculator.Partiescanonlymakeprofitsifthereisaspread.They
tradeonspreadsbetweencrudesofdifferentregions,times,andqualities.Thus,volatilityinthe
marketisnecessaryinordertomakeprofits.Thetrades,concernedwiththeoilpricelevel,
becomelessinteresting.57
55 The Role of Speculation in Oil Markets: What have we learned so far?, Bassam
Fattouh, Lutz Kilian, Lavan Mahadeva, Oxford Institute for Energy Studies, 03-18-2012 (Page 2-10)
56 Interim Report on Crude Oil Interagency Task Force of Commodity Markets,
Commodity Future Trading Commission, 06-2008 (Page 17)
57 An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute
for Energy Studies, 01-2011 (Page 9)
Speculatorscanbedistinguisheddependingontheirtimehorizoninwhichtheytrade.
Scalpersaretradingwithinsecondsinordertosellpositionataslightlyhigherpricethantheyboughtit.Theyarethemarketmakersandinsurethatthemarketstaysliquid.The
othertypeofspeculatorstake,dependingontheiropinionaboutthefutureoilprice,long
positionsinonemonthandsettlethemwithshortpositionsthenextmonth;theyare
importantforthepricediscovery.
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Source:MonthlyCrudeReportfromCTFTC(May-2012)
TheU.S.CommodityFutureTradingCommission(CFTC)publishestheCommitmentsofTraders
Reporteachweek.Inthisreportthepartiesinvolvedinthefuturemarketareanalyzedand
dividedintotwogroups:firstthecommercialparticipantsincludeproducersmanufacturersand
swapdealers.Thesepartiesareactingoutofthepurposeofhedgingandsecond,thenon-
commercialparties,includehedgefunds,floorbrokers,andtraders.Thesepartiesare
speculatingintheoilmarket.Thefirsttwographs,commercialopeninterestandnon-commercialopeninterest,showtheopeninterestinoilfutures.Inthesecondtwographs,the
netpositionsofthecommercialandnon-commercialpartiescanbeseen.Commercialparties
aregenerallyshort,whereasnon-commercialparticipantsarenetlong(seemutualfunds).Ifthe
developmentoftheopeninterestofbothpartiesiscompared,itbecomesclearthatthenon-
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commercialpartiesgainedonweightinthefuturepricing.Thus,thelongfuturesofthenon-
commercialpartiescoulddrivethefuturemarket.58
Asmentione
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