The Correlation Between Physical and Financial Crude Oil Markets

Using the Example of the Price Developments in the Past 10 Years


Seminar Paper, 2012
26 Pages, Grade: 1,6

Excerpt

List of contents

List of figures

1 Introduction

2 World Oil Market
2.1 Physical and economic characteristics of crude oil
2.2 Value chain

3 Physical and Financial Oil Trade
3.1 Players on the physical and financial oil market
3.2 Physical oil trading: Spot and forward transactions
3.3 Commercial trading with „paper oil“: Futures trading

4 Cause Analysis of Crude Oil Increase in the last Decade
4.1 The influence of fundamental data on oil price development
4.2 The influence of the financial markets on the oil price development

5 Conclusion

Annex: Conventional crude oil reserves and oil production 2010

List of literature

List of figures

Graphic 1. Crude Oil Prices, USD/Barell, 2000-2010 (Average yearly)

Graphic 2. Production, Consumption and Refinery Capacities (Total World), 2000- 2010

Graphic 3. The Price-Convenience Yield Relationship 1988-2011, Crude Oil.

Graphic 4. The Price-Convenience Yield Relationship 1988-2011, Soybean.

Graphic 5. The Price-Convenience Yield Relationship 1988-2011, Copper.

Graphic 6. The Price-Convenience Yield Relationship 1988-2011, Live Cattle.

Graphic 7. Foreign Exchange Rate and Commodity Prices.

1 Introduction

Crude oil is currently the most important source of energy in the world. Thanks to advanced production and extraction methods, and due to new discoveries, the available reserves have grown over the last ten years. During this period of time, oil prices rose considerably. These increases in price are associated with the increasing energy demands of growing economies across the planet and a shifting of weight between the physical and financial oil market.

The goal of this work is to examine the correlation between physical and financial crude oil markets as well as establish an explanation for the drastic increase in crude oil price in the past decade.

The work is organized as follows: To begin, the characteristics of crude oil as well as its value chain are presented and examined. This is followed by an explanation of the physical and financial oil trade. To conclude, the fundamentals of the world oil market and the financial oil trade are examined to determine the relevance of causation with respect to the recent price increase.

2 World Oil Market

2.1 Physical and economic characteristics of crude oil

In conjunction with the "large" oil drilling site in Pennsylvania (USA) in 1859, the oil industry came to enjoy its first major boom. By the end of the 19th century, the development of the automotive industry had established gasoline as the second most important source of energy in the world, allowing this market to grow rapidly.1 In 2009, the crude oil share of the total primary energy supply in the world amounted to 33%, while the share of total final consumption amounted to 41.3%2.

"Crude oil is a mineral oil consisting of a mixture of hydrocarbons of natural origin and associated impurities, such as sulphur. It exists in the liquid phase under normal surface temperatures and pressure and its physical characteristics (density, viscosity, etc.) are highly variable."3

The most important economical characteristics of crude oil are its exhaustibility (extremely long development period), low demand, supply of price elasticity (due to weak substitutability) and heterogeneity (depending on the genesis of different chemical characteristics in terms of density and sulfur content).4

As a result of the conundrum of its exhaustibility, one can indeed question the optimal inter-temporal allocation of crude oil (i.e. when which amount should be consumed in what period of time). The approach of the optimal inter-temporal allocation of exhaustible resources was initially developed by Hotelling (1931). Hotelling ’ s Law states that the profit from the sale of a non-renewable resource is maximized when the scarcity rent (i.e. the periodically discounted payments of this scarcity rent) is the same for each period.5 In this case, the scarcity rent consists of the opportunity costs of the sale of an additional unit of resource.6 In other words, in a perfect market, the difference between the market price and marginal cost grows from period to period with the interest rate and therefore, the price of the exhaustible resource must increase over time, assuming that the marginal costs are constant.7 Thus, the exhaustion tends to lead to a cost increase for crude oil products, which can however be somewhat offset by improved recovery and production methods.8

In many industries, crude oil cannot be replaced in the short to medium term, or can only be done so at very high costs. In particular, for the fuels in the transportation sector (gasoline and diesel), oil products play an enormously important role. The conversion of the entire infrastructure for the widespread use of alternative fuels (conversion of filling stations, vehicle conversion, etc.) is a short-to-medium term perspective combined with prohibitively high investments. One consequence of this dependence on crude oil products is the low short-term price elasticity demand: The consumers react weakly and with delay when it comes to the price change of goods.9

The heterogeneity of crude oil plays a very important role in the oil trade. Raw oils featuring a high density are to be referred to as "heavy" and those with lower density are "light". Raw oils featuring high sulfur contents are considered” sour crude” while those with lower sulfur contents are referred to as “sweet crude”. The more dense and sour raw oil is, the higher the costs of its processing. Therefore, the lighter raw oil (light crude oil) featuring low sulfur contents is more expensive than its counterpart. Worldwide, there are nearly 190 raw oil assortments from different regions that differ in terms of quality.10 The international trade is however concentrated on certain assortments, so-called “marker crudes “. Every important production region has a reference oil. The most important mixtures are those of the US American value orientation West Texas Intermediate (WTI) and the value orientation Brent - which come from 15 oil fields in the North Sea. Via the so-called formula pricing, the reference raw oil assortments determine the prices for all other dealt with raw oil assortments. The pricing of all other raw oil types is established through bonuses and discounts, depending on the quality and geographic location of the occurrence deposit.11 As such, only but a few marker crudes determine the market value of about 80% of worldwide trade in raw oil amounts.12

2.2 Value chain

In particular, the slow and cyclical adjustment in the value chain depends not only on the physical exhaustion of crude oil, but also the physical crude oil markets and builds the basis for many of the specifics in the oil trades.13

The individual links of the crude oil value chain are exploration, production, transportation, processing and distribution. These are examined separately below.

a) Exploration and crude oil reserves

Exploration is usually understood as the general development and extraction of deposits and raw materials in the earth’s crust. The totality of all deposits is formed by the supplies or resources. Reserves are the portion of the resources - in this case, the entire amount of crude oil - that is potentially available to society. They are defined as resources that are all proven and can be commercially usable with recognized technology. In making a reserve estimation, one must contemplate geologic, technical and economical factors. As such, the reserves are practically enlarged in the case of increasing crude oil and constant production costs (or with decreasing costs and the same price). The crude oil and the productions costs are, in turn, always influenced by many factors. These factors include technological advances, new usage opportunities and crude oil substitutes as well as demand growth, government regulations, war and changed market power. This indicates that no reserves can be regarded as a stock variable.14

Due to the exhaustion of crude oil, the question arises as to how much time sufficient crude oil reserves still have. Using the Peak Oil Theory, an attempt is made to predict the point in time of the maximum global crude oil extraction.15 Assuming the technical proposal is restricted - and according to the thesis - the maximum production of crude oil is reached when about half of the existing deposits have been extracted (depletion midpoint). This means that the world oil extraction initially develops with increasing amounts, but later - after exceeding the depletion midpoint - with declining margins.16

In order to avoid negative consequences for the global economy, alternative sources of energy must be available in a sufficient quantity at the point in time of the peak production.17

The theory takes neither the possibility of a substitution for crude oil nor technical progress into account.18 As such, the extraction decline in the USA predicted by Hubbert (1956) could, for example, be offset by new production techniques (deep offshore) and development extraction areas (Alaska). The development of unconventional crude oil deposits in Canada as well as the globally strongly expanding production of biogenic fuels point out that innovative solutions can be developed to ensure the supply of liquid sources of energy in the mid-term.19

The world's proven oil reserves20 currently amount to approximately 1‘400 billion barrels21, whereas the total unconventional world oil reserves are estimated to be approximately 2‘000-3‘000 billion barrels.22 In 2010, 30 billion barrels23 of crude oil were produced worldwide. The statistical range as the ratio of proven reserves and the current annual production was 40 years in recent decades (even 46.7 years in 2010). This suggests that the expansion of proven reserves took place in at least the same scale as the expansion of crude has oil production. With that, the geological restriction loses a large percentage of its importance if, through technological advances and increasing prices, some new, previously non-rentable deposits can be developed.24 That is, the reserves are increased as long as the value of a reserve unit is higher than its replacement costs.25

The well-established and economically recoverable conventional oil reserves are, geographically seen, distributed unequally. Approximately 2/3 of conventional crude oil reserves are located in the Middle East (Persian Gulf) and in Central Asia - a region in the world that has been referred to as the energy ellipse since the disintegration of the Soviet Union in 1991.26 That region nonetheless sees the extraction and development of around half of the global crude oil occurrence (see Attachment 1).27 Another asymmetry occurs in OECD countries: The relative share of crude oil extraction there (approximately 22%) is far above the world share of their oil reserves. This suggests that the crude oil extraction will continue to be concentrated in these countries of the future energy ellipse (particularly the OPEC countries of the Middle East), which is why the influence of these countries on the crude oil market continues to grow.28

b) Production of conventional crude oil and the market structure

When placed under pressure, conventional crude oil is located in the small pores of the source rock. Apart from crude oil, both natural gas and water are located in crude oil deposits. They are considered to be crude oil products. The natural gas is either transported per pipeline and sold, or simply torched. The crude oil extraction rate declines in the time lapse with the regression of pressure in the deposits.29

Differences in the world distribution of crude oil reserves are made recognizable through uneven production costs. Thus, the crude oil in the Persian Gulf can be produced at the marginal cost of 5 USD/barrel (without taking exploration costs into consideration), whereas the costs of other production regions could amount to up to 15 USD/barrel. However, the production marginal costs in 90% of production means (including offshore production) currently come in at an average of 8 USD/barrel.30

Since only one efficient production profile exists for each field, the crude oil extraction will only reorganize its production under strongly altered economic conditions. This points out the overall inflexibility and a sluggish adjustment structure for the extraction process and thus, indicates an inelasticity of the supply side.

A share of 15% of the world oil extraction is accounted for by private oil companies while 85% are owned by the state.31 Crude oil producers come in the form of international, national and independent companies. The international crude oil companies are indicated by a completely vertical integration from the well to the pump. This includes ExxonMobil, ChevronTexaco, British Petroleum, Royal Dutch Shell, Total and ConocoPhilips. These producers are not capable of extracting a sufficient amount of crude oil through the geographic restrictions so as to supply additional levels of the value chain and thus, must also purchase crude oil. Investments in the strategic fields of Saudi Arabia, Iran and the Russian Federation remain prohibited to these companies by the respective governments.32 National oil companies - including Saudi

Arabian Oil Co., Petroleos de Venezuela SA and National Iranian Oil Co. - produce much more than they can process and sell. Since these companies have over 90% of the global crude oil reserves, their production will continue to increase over the long-term.33 The third group - independent oil producers - consists of technical or regionally specialized oil companies such as Anadarko, Hess and Occidental Ameranda.

Amongst the largest oil-producing countries are no less than the Russian Federation (total share of 12.9%), Saudi-Arabia (12%), USA (8.7%), China and Iran (each 5.2%), Canada (4.2%), Mexico (3.7%), AED (3.3%), Venezuela (3.2%), as well as Iraq and Kuwait (each 3.1%). An amount of 2/3 of the world oil production takes place in these countries.34 The OPEC35 member states dispose of 40% of the worldwide crude oil production and over 3/4 of the crude oil reserves (see Attachment 1). Thus, OPEC still has a significant influence on the physical supply of oil on the world market.36 The production quote is lowered by the member states if the market price for crude oil is too low (from the viewpoint of these states). This artificial shortage of the supply leads to price increases. This condition leads to price distortions, where the pricing is affected by the free market forces.

c) Transportation and storing

A well-developed infrastructure is a prerequisite for a functioning world oil trade. Comparably low transport costs are offered by oil transportation per tankers on international waterways. Otherwise, the crude oil is directly transported to a refinery or to inventory storage via a pipeline. The crude oil products are usually transported in relatively small quantities to the places of consumption per ships, trucks or railways.

Inventory plays an important role in the oil trade. According to estimates by the US Energy Information Administration 37, there are 7-8 billion barrels of crude oil stored worldwide. It should however be noted that these estimates do not include the so-called floating inventory at sea and the inventory in Asian countries, since there is no sufficient information on these inventories. Only about 1/10 of the entire situation is made use of in the case of short-term need, but the majority is indeed retained for strategic reasons. The strategic crude oil inventory is held predominantly by crude oil companies that require the stored oil for their own purposes. These reserves should only although one would expect an increase in reserve. Thus, the adjustment of published reserves down by private firms can be explaned with the institutional and market conditions and not with the peak oil theory. Cf. Erdmann / Zweifel (2008), p. 178.

[...]


1 Cf. Pfaffenberger / Stroebele / Huterkes (2010), p. 7.

2 Cf. IEA Factsheet 2011.

3 IEA, Difinitions

4 Heuterkes (2008), p. 1 ff.

5 Cf. Hotelling (1931), p. 137 ff.

6 Cf. Minnitt (2007), p. 542.

7 Cf. Lin (2004), p. 1; Hotelling (1931), p. 137 ff.

8 Cf. Heutekers (2008), p. 2.

9 Cf. Mabro (2005); Gately / Huntington (2002) In: Heutekers (2008), p. 17.

10 Cf. Energy intelligence (2007) In: Hunt / Evans (2009), p. 421.

11 Cf. Heutekers (2008), p. 71 ff.; Geman (2005).

12 Cf. Rühl (2011), p. 40.

13 Cf. Heutekers (2008), p. 9.

14 Cf. McKelvey (1972); Simon (1996) In: Heuterkes (2008), p. 14 ff.

15 Cf. Williams, Bob (2003); Erdmann / Zweifel (2008), p. 177.

16 This is due to the decreasing pressure in the deposit. Erdmann / Zweifel (2008), p. 177 ff.

17 Cf. Campbell (2002), p. 195 ff.; Heuterkes (2008), p. 12.

18 Cf. Heuterkes (2008), p. 13.

19 Cf. Erdmann / Zweifel (2008), p. 177 f.

20 Proved reserves are reserves, whose develope probability is greater than 90 %. Cf. OGRC (2001), p. 20.

21 Cf. Ruehl (2011).

22 Cf. Williams (2003) In: Heuterkes (2008), p. 15.

23 Cf. BP (2011).

24 Cf. Adelman (1990), p 1 ff.

25 Cf. Heutekers (2008), p. 14-16.

26 The so-called "commodity and energy ellipse" includes the Middle East and countries of the Caucasian- Caspian region. Cf. BMBF.

27 Cf. Edmann / Zweifel (2008), p . 174.

28 Cf. Erdmann / Zweifel (2008), p. 174-176.

29 Cf. IEA.

30 Cf. Erdmann / Zweifel (2008), pp. 175-176.

31 Cf. MWV (2004), p. 12.

32 Cf. Fattouh (2007), p. 135 ff.. Many oil fields are on production sharing agreements (PSA) - a form of contract for oil & gas concessions - between the respective state and private companies operated. Here, private companies receive the share of oil production, which is sufficient to cover its investment costs plus a reasonable profit margin in terms of capital employed. With rising oil prices, this share drops as well as the reserve amount available for the private companies. This leads to a paradoxical situation in which private companies may need to downgrade its reserves when prices are rising,

33 Cf. Heuterkes (2008), p. 22.

34 Cf. BP (2011).

35 The organization has set with its foundation in 1960 the goal to secure the Member States against an oil price collapse (and thus the revenue slump in crude oil production) and to operate a common oil policy. Cf. OPEC.

36 Cf. MWV (2004), p. 15.

37 Cf. EIA.

Excerpt out of 26 pages

Details

Title
The Correlation Between Physical and Financial Crude Oil Markets
Subtitle
Using the Example of the Price Developments in the Past 10 Years
College
Humboldt-University of Berlin  (School of Business and Economics )
Course
Power Games in Energy Markets
Grade
1,6
Author
Year
2012
Pages
26
Catalog Number
V191197
ISBN (eBook)
9783656159513
ISBN (Book)
9783656159346
File size
634 KB
Language
English
Tags
Crude Oil, Commodity Trading, Physical Commodity Trading, Financial Commodity Trading, Crude Oil Trading
Quote paper
Johannes Sailer (Author), 2012, The Correlation Between Physical and Financial Crude Oil Markets, Munich, GRIN Verlag, https://www.grin.com/document/191197

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