Anatomy of Crude Pricing

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)



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)




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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.





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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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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19

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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20

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




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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)




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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


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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25

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.



Nationalizedoilcompanies(NOC)havedifferentaimscomparedtotheprivateoil

companies.Themainaimintheprivatesectoristoyieldhighreturns,reachedthroughafull

andquickdevelopmentofoilprospects,withenhancedexpertsandtechnology.Ontheotherhand,nationalizedoilcompaniesaredrivenbypoliticalagendasandpublicinterests.

Therefore,privateoilcompanieswouldbemoreefficientinthesupplyofcrude.1This

phenomenonisdescribedbytheHotellingruleofamonopolysupply,whichwillbe

discussedlater.


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28

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)



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.



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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36

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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37

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


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)


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.






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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




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.



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?


Fattouh, Lutz Kilian, Lavan Mahadeva, Oxford Institute for Energy Studies, 03-18-

2012 (Page1)


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


Fattouh, Lutz Kilian, Lavan Mahadeva, Oxford Institute for Energy Studies, 03-18-2012 (Page 2-10)





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

Documents

Anatomy of Crude Pricing