World oil market
Jan Osička
W. Nordhaus: The „Bathtub“ view of the World oil market
The idea:
• Taps: Saudi Arabia, Russia, and other producers that introduce oil into the inventory
• Sinks: the United States,
China, and other consumers
drawing oil from the tub
Assumptions:
• Oil is fungible
• Bilateral ties are irrelevant
• Single price regardless the source
The commodity
What is (traded) oil?
Oil crudes actually vary...
Oil benchmarks
Benchmark crude
• Specific crude oil
• Widely and actively bought and sold
• To which other types of crude oil can be compared to determine a price by an agreed-upon differential
Oil benchmarks
Brent
• The most widely used global crude oil benchmark
• Include four North Sea streams:
• Brent and Forties (offshore the United Kingdom)
• Ekofisk and Oseberg (offshore Norway)
• 1 % of global production in 2013 (0.86 bpd)
• Benchmark for approx. 2/3 of global oil
• Light and sweet crude oil
that is produced and traded in:
• Europe
• the Mediterranean and Africa
• Australia
• Asia (selectively)
Original source streams of Brent
West Texas Intermediate
• Light, sweet crude oil produced in the United States
• Priced at Cushing, Oklahoma
• Benchmark for other types of crude oil produced in the United States, such as:
• Mars, a medium, sour crude produced in the Gulf of Mexico
• Bakken, a light, sweet crude produced in North Dakota.
• WTI is also used as a benchmark for imported crude oil that is produced in:
• Canada
• Mexico
• South America
Dubai/Oman
•Average price of Dubai and Oman crude, both of which are medium
and sour
•Benchmark for crude oil produced in the Middle East (incl. Saudi
Aramco) and exported to Asian markets.
•Dubai: steady decline in production down to 0.034 mbd (2013)
=> Omani oil (0.94 mbd in 2013) used to continue the benchmark
Differentials
... A benchmark is a type of crude oil to which other types of crude oil can be compared to determine a price by an agreed-upon
differential...
Differentials are determined by:
• Quality characteristics (API gravity or sulfur content).
• Transportation costs from production areas to refineries.
• Regional and global supply and demand conditions.
Oilquality
Oilquality
Oil quality
Refineries
• Calibrated to process a particular type of oil (sweet/sour, light/heavy)
• Processing different oil possible but at reduced efficiency => noncompetitiveness
• Re-calibration possible but at significant costs
Transportation costs
P2
P1
Transportation costs
Onshore-produced and otherwise poorly accessible crudes tend to be cheaper than offshore and easily accessible onshore
crudes
Transportation costs
Onshore-produced and otherwise poorly accessible crudes tend to be cheaper than offshore and easily accessible onshore
crudes
• To compensate for additional costs of transportation
• Transportation bottleneck foster „micro“ oil-to-oil competition
Regional supply/demand
Regional supply/demand
Regional supply/demand
How a specific crude becomes benchmark?
• Stable and ample production.
• Transparent, liquid market located in a geopolitically and financially stable region to encourage price discovery.
• Adequate storage to encourage market development.
• Delivery points at locations that allow arbitrage opportunities in world markets so that prices reflect global supply and
demand.
An oil bathtub?
• Individual crudes are interchangeable only at significant costs/loss of competitiveness
• Individual crudes are feedstock for production of the same products
• World oil market = set of very closely correlated benchmark/regional markets
The oil market: actors and structure
Market structure and actors
MARKET
EQUILIBRIUM
UNCERTAINTY
Weather
Politics
Security
DEMAND
Economic
growth
Technology
Price
REGULATION
Business
Environmental
SUPPLY
Non-OPEC
production
OPEC strategy
Technology
Price
Other market
participants
Consumers
Governments
International
organizations
IOCs
NOCs
27
Market fundamentals: what defines the oil market?
0.0
20.0
40.0
60.0
80.0
100.0
120.0
140.0
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
Consumption (mbd) Price (USD2018/b)
The Troll A platform A typical oilfield production diagram World oil consumption and price (since 1965)
Price elasticity
Long time horizonts
Long time horizonts
Ula (Norway) Prudhoe Bay (Alaska) Jones Creek (Nigeria)
Cost structure
Marginal costs
~15-120 $/b
Operational costs
~4-40 $/b
Long term: boom and bust
• Cost structure and long time horizons: maximizing revenues = maximizing production
• Correction: demand and (less so) supply are price elastic in the long run:
• Demand: adjusted fuel consumption or switching to a different fuel
• Supply: companies’ cash flow improves/deteriorates, investment increases/decreases, new
fields are/are not developed
Time
Price
OPEC
Founded in 1960 in Baghdad,
founding members Venezuela,
Saudi Arabia, Iraq, Iran, Kuwait
• 80% of proven reservers
• 44% production
• Practically all spare production capacity
34
Spare capacity
OPEC
Regulates the supply via two means:
• Production quotas.
• Investments into new production
capacities.
36
How cartels work? A coordination game
Imagine the following situation:
• Overall demand for oil is 6-14 barrels per day
• The price varies according to scarcity of oil:
• At 6 bpd the price is high (20 USD/b)
• At 14 bpd the price is low (4 USD/b)
• There are (only) two producers (P1 and P2)
• Similar production and delivery costs
• Wishing to maximize profits
=> adjusting production according to the price
How cartels work? A coordination game
38
Barrels USD/b P1‘s income P2‘s income Total income
6 20 3*20=60 3*20=60 120
7 18 4*18=72 3*18=54 126
8 16 4*16=64 4*16=64 128
9 14 5*14=70 4*14=56 126
10 12 5*12=60 5*12=60 120
11 10 6*10=60 5*10=50 110
12 8 6*8=48 6*8=48 96
13 6 7*6=42 6*6=36 78
14 4 7*4=28 7*4=28 56
How cartels work? A coordination game
39
Barrels USD/b P1‘s income P2‘s income Total income
6 20 3*20=60 3*20=60 120
7 18 4*18=72 3*18=54 126
8 16 4*16=64 4*16=64 128 (cartel equilibrium)
9 14 5*14=70 4*14=56 126
10 12 5*12=60 5*12=60 120 (Nash equilibrium)
11 10 6*10=60 5*10=50 110
12 8 6*8=48 6*8=48 96
13 6 7*6=42 6*6=36 78
14 4 7*4=28 7*4=28 56
The freeriding issue: prisoners‘ dilema
"Mr. President, we are rapidly approaching a moment of truth both for ourselves as
human beings and for the life of our nation. Now, truth is not always a pleasant
thing. But it is necessary now to make a choice, to choose between two admittedly
regrettable, but nevertheless *distinguishable*, postwar environments: one where
you got twenty million people killed, and the other where you got a hundred and
fifty million people killed.“
General Buck Turgidson, (Dr. Strangelove)
http://www.youtube.com/watch?v=HgyjlqhiTV8
40
The freeriding issue: prisoners‘ dilema
41
P2
Does not
increase
Increases
P1
Does not
increase
64/64 56/70
Increases 70/56 60/60
Trading oil
Market structure and actors
MARKET
EQUILIBRIUM
UNCERTAINTY
Weather
Politics
Security
DEMAND
Economic
growth
Technology
Price
REGULATION
Business
Environmental
SUPPLY
Non-OPEC
production
OPEC strategy
Technology
Price
Other market
participants
Consumers
Governments
International
organizations
IOCs
NOCs
Trading oil
Physical delivery
  $
Financial delivery
$  $ ()
What is the ratio between daily traded physical and financial (paper) barrels?
Physical deliveries Financial deliveries
Bilateral agreements (Over-the-counter)
• Term contracts of mostly one year
• Price set according to spot
• 90-95% physically traded volume
Spot market (hub trading, exchange trading)
• Balancing needs (surplus or missing barrels)
• Sets the price („marginal barrels“)
• 5-10% of volume
Bilateral agreements
• Term contracts of different lengths
• Price: spot +/- expectations
• Used for speculation and hedging
Types vary according to contract characteristics
• Futures
• Options
• Swaps
• Forwards
Financial deliveries
Futures
Futures
A financial contract obligating the buyer to purchase an asset (or the seller to sell
an asset), such as a physical commodity or a financial instrument, at a
predetermined future date and price.
• Underlying asset (oil)
• Type: long (buying) x short (selling)
• Date of settlement
• Price
Long and short position
Long futures: buying futures with expectation of price increase
Short futures: selling futures with expectation of price decline
Futures: physical and financial delivery
 Physical delivery $ Financial delivery
Selling physical
barrels
 delivered: a barrel worth of P1 Selling financial
barrels
$ paid: P1
$ received: P0 $ received: P0
Buying physical
barrels
$ paid: P0 Buying financial
barrels
$ paid: P0
 received: a barrel worth of P1 $ received: P1
Note:
P0 = negotiated price
P1 = market price at the day of settlement
Speculation with futures
Example
• Time T0 (now), negotiated price P0 = $50
• 1,000 barrels financial futures bought at $50 with settlement next June (T1)
• Time T1 (next June), oil price P1 = $45
• Bought for $50 what is being now traded at $45 => lost $5 per barrel => lost 5,000 USD
• Time T1 (next June), oil price P1 = $55
• Bought for $50 what is being now traded at $55 => gained $5 per barrel => gained 5,000 USD
Hedging with futures
 Physical delivery $ Financial delivery
Selling physical
barrels
 delivered: a barrel worth of P1 Selling financial
barrels
$ paid: P1
$ received: P0 $ received: P0
Buying physical
barrels
$ paid: P0 Buying financial
barrels
$ paid: P0
 received: a barrel worth of P1 $ received: P1
What are the balances of green and blue traders if:
(1) P0 = 50; P1 = 70
(2) P0 = 50; P1 = 30
Hedging with futures
Imagine the following oil buyer:
• Has invested in business the profitability of which depends on price of oil (i.e. a
rafinery)
• Needs a stable oil price to plan the development of the business
=> Wishes to hedge against price fluctations, i.e. wishes the current (time T0)
prices (P0) to last.
Will need 1,000 barrels of oil about this time next year (time T1, oil price P1)
Hedging with futures
Today (time T0, negotiated price P0 = 50 USD/b):
• The buyer enters a contract in which agrees to buy 1,000 physical barrels at $50 (P0) with delivery
in time T1.
• At the same time sells 1,000 financial barrels at $50 (P0) with delivery in time T1
• In time T1, therefore, the buyer:
• Will pay for the physical delivery amount equal to 1,000 x P0
• Will get paid for financial delivery amount equal to 1,000 x P1
Hedging with futures
About this time next year (T1): The price went up to P1 = 70 USD/b
Settles the physical contract:
• Bought $70 worth barrels for $50 ... Balance: +20 x 1,000 = +20,000 USD
Settles the financial contract:
• Sold $70 worth barrels for $50 ... Balance: -20 x 1,000 = -20,000 USD
Total balance: 0 USD
=> The buyer got 1,000 barrels at $50 as desired.
Hedging with futures
About this time next year (T1): The price went down to P1 = 30 USD/b
Settles the physical contract:
• Bought $30 worth barrels for $50 ... Balance: -20 x 1,000 = -20,000 USD
Settles the financial contract:
• Sold $30 worth barrels for $50 ... Balance: +20 x 1,000 = +20,000 USD
Total balance: 0 USD
=> The buyer got 1,000 barrels at $50 as desired.
Hedging with futures
If the buyer was a seller:
T0: P0 = 50 USD/b
Agrees to deliver 1,000 physical barrels at 50 USD/b in T1
At 50 USD/b buys 1,000 financial barrels to receive what they are worth in T1 (P1)
T1: P1 = 70 USD/b
• Physical: Delivered $70 worth barrels at $50 ... Balance -20,000 USD
• Financial: Received $70 for what was bought for $50 ... Balance +20,000 USD
T1: P1 = 30 USD/b
• Physical: Delivered $30 worth barrels at $50 ... Balance +20,000 USD
• Financial: Received $30 for what was bought for $50 ... Balance -20,000 USD
Total balance: 0 USD
=> The seller sold 1,000 barrels at $50 as desired.
Options
Options
A financial derivative that represents a contract sold by one party (option writer) to
another party (option holder). The contract offers the buyer the right, but not the
obligation, to buy (call) or sell (put) a security or other financial asset at an agreedupon
price (the strike price) during a certain period of time or on a specific date
(exercise date).
Option types
Call option Put option
Buyers Right to buy stock if exercised Right to sell stock if exercised
Sellers Obligation to sell stock if assigned Obligation to buy stock if assigned
• Underlying asset: oil
• Type: call (right to buy) x put (right to sell)
• Price: price of contract
• Strike price: oil price at which the right can be exercised
• Exercise date: when the contract expires
Hedging with options
Call option Put option
Buyers Right to buy stock if exercised Right to sell stock if exercised
Sellers Obligation to sell stock if assigned Obligation to buy stock if assigned
Example: oil purchasing hedging (oil purchaser = option buyer)
T0: oil price P0 = $50
• Buyer: bought call option for 1,000 barrels at $60 from Seller for 3 USD/b due to T1
T0.8 (between T0 and T1): oil price P1 = $70
• Buyer: exercises his right and gets $70 worth barrels for $60
... Balance: + 10,000 – 3,000 = + 7,000 USD
• Seller: sells $70 worth barrels for $60
... Balance: - 10,000 + 3,000 = - 7,000 USD
=> Hedging successful, major loss due to price spike prevented
Call option Put option
Buyers Right to buy stock if exercised Right to sell stock if exercised
Sellers Obligation to sell stock if assigned Obligation to buy stock if assigned
Example: oil purchasing hedging (oil purchaser = option buyer)
T0: oil price P0 = $50
• Buyer: bought call option for 1,000 barrels at strike price of $60 from Seller for 3 USD/b due
to T1
T1: oil price P1 = $58
• Buyer: does not exercise his right (would get $58 worth barrels for $60)
... Balance: - 3,000 USD
• Seller: gains $3 per each barrel for selling unexercised option at $3
... Balance: + 3,000 USD
=> Hedging successful, major loss due to price spike prevented
Call option Put option
Buyers Right to buy stock if exercised Right to sell stock if exercised
Sellers Obligation to sell stock if assigned Obligation to buy stock if assigned
Example: oil selling hedging (oil seller = option buyer)
T0: oil price P0 = $50
• Buyer: bought put option for 1,000 barrels at strike price of $40 from Seller for 3 USD/b
due to T1
T1: oil price P1 = $30
• Buyer: exercises his right and sells $30 for $40
... Balance: + 10,000 – 3,000 = + 7,000 USD
• Seller: buys $30 worth barrels for $40
... Balance: - 10,000 + 3,000 = - 7,000 USD
=> Hedging successful, major loss due to price decline prevented
Call option Put option
Buyers Right to buy stock if exercised Right to sell stock if exercised
Sellers Obligation to sell stock if assigned Obligation to buy stock if assigned
Example: oil selling hedging (oil seller = option buyer)
T0: oil price P0 = $50
• Buyer: bought put option for 1,000 barrels at strike price of $40 from Seller for 3 USD/b
due to T1
T1: oil price P1 = $45
• Buyer: does not exercise his right (would sell $45 worth barrels for $40)
... Balance: - 3,000 USD
• Seller: gains $3 per each barrel for selling unexercised option at $3
... Balance: + 3,000 USD
=> Hedging successful, major loss due to price spike prevented
What is the ratio between daily traded physical and financial (paper) barrels?
Physical to financial trading
• Physical barrels: approx. 92 mbd (2014, EIA)
• Financial barrels: more than 1,000 mbd
(2009, Congressional testimony by the commodities specialist Michael W. Masters)
=> At least 1:10