Lecture 2: International Crude Oil Pricing PDF

Lecture 2: International Crude Oil Pricing Dr. Jonathan Atuquaye Quaye Department of Petroleum Engineering College of Engineering KNUST, Kumasi. Email: [email protected]  Crude Oil Pricing  In general, crude oil is sold through a variety of contract arrangements and...

Lecture 2: International Crude Oil Pricing Dr. Jonathan Atuquaye Quaye Department of Petroleum Engineering College of Engineering KNUST, Kumasi. Email: [email protected]  Crude Oil Pricing  In general, crude oil is sold through a variety of contract arrangements and in spot transactions (immediate delivery of crude for exchange of cash).  Oil is also traded on futures markets (delivery of crude at a future date) but not generally to supply physical volumes of oil, more as a mechanism to distribute risk.  These mechanisms play an important role in providing pricing information to markets.  In fact, the pricing of crude oils has become increasingly transparent from the 1990s onwards through the use of marker crudes such as:  Crude Oil Pricing  West Texas Intermediate (WTI – USA) – primary  Brent (Europe and Africa) - primary  Dubai and Oman (Middle East) - primary QUESTIONS: How would you define a benchmark crude? Which other benchmark crudes are there; where are they traded?  The main criteria for a marker crude is for it to be sold in sufficient volumes to provide liquidity (many buyers and sellers) in the physical  market as well as having similar physical qualities of alternative crudes. In addition, the marker crude should provide pricing information.  Crude Oil Pricing  A futures contract for crude oil is a promise to deliver a given quantity of crude oil but this rarely occurs as participants are more interested in taking a position on the price of the crude oil.  Futures markets are a financial instrument to distribute risk among participants with the side effect of providing transparency on the pricing of crude oil.  Crude Oil Pricing  Pricing of Physical Crude Oil Trades  Generally this is based on a formula approach where a marker crude is used as the base and then a quality differential (premium/discount)  as well as a demand/supply (premium/discount) is added depending on the crude being purchased.  Thus in times of tight supply this premium will rise and gradually drag up the Marker crude price,  whilst in times of surplus supply, a reduced premium or even a discount will drag down the Marker crude price.  Crude Oil Pricing  Of course big changes, announcement or events that can significantly influence crude supply levels will sometimes result a large step change in the prices of crude oil (e.g. OPEC announcements, civil unrest or wars, hurricane activity, major refinery shutdowns or outages etc.).  That is, crude oils being purchased do not always slavishly follow marker crudes.  Marker crudes are indicators of what is happening in regional markets. QUESTION: What are premiums and discounts in crude oil pricing?  Crude Oil Pricing  Crude Oil as an Input Cost to Refiners  It is true to say that the cost of crude oil is the major input cost for refiners.  However, the relationship between such a cost and the final price for a petroleum product produced from that crude, such as petrol or diesel, is  not as direct as one would think. There are, for instance, additional petroleum product markers which give a guide to prices.  That is, prices are not just a function of cost-push, but are also strongly influenced by demand-pull. There are also a number of other variables  Crude Oil Pricing  Which affect the price of products such as petrol.  In addition the perception of the purchasers and sellers in the market as to the price risk over time can also add or subtract premiums to the  product marker price. Prices of crude oil markers and petroleum product markers are affected by a myriad of factors including:  a. overall supply/demand for crude  b. supply/demand for petroleum products  c. freight rates  Crude Oil Pricing  d. competition in the crude markets  e. competition in the regional and domestic markets for petroleum products.  They all have a role in determining the final price charged to consumers and the role that each of these elements plays can change over time. DISCUSS: It would be prudent for Ghana to buy Dubai & Oman marker crude instead of Brent marker crude because it is 10 % cheaper.  Crude Oil Pricing  Gas Price  Gas prices are match more complex to predict.  The nature of gas requires that there is a market for it before the field is developed and produced.  The price of the gas is determined by contract. However this contract value could be linked to the price of oil.  In that case the price of the gas will track (follow) that of the oil.  International Oil Pricing System  The Era of the Posted Price  Until the late 1950s, the international oil industry outside the United States, Canada, the USSR and China was characterized by the dominant  position of the large multinational oil companies known as the Seven Sisters or the majors.  The host governments did not participate in production or pricing of crude oil and acted only as competing sellers of licenses or oil concessions.  In return, host governments received a stream of income through royalties and income taxes.  International Oil Pricing System  Each of the Seven Sisters was vertically integrated and had control of both upstream operations and to a significant but lesser extent of downstream  operations. The oil pricing system associated with the concession system until the mid 1970s was centered on the concept of a “posted” price. QUESTION What is posted price of oil? The price at which oil companies offered to buy oil from oil-producing governments. This price was set by the oil companies and used to calculate the stream of revenues accruing to host governments.  International Oil Pricing System  Transfer prices used in transactions within the subsidiaries of an oil company did not reflect market conditions but were merely used by  multinational oil companies to minimize their worldwide tax liabilities by transferring profits from high-tax to low-tax jurisdictions.  The prices used in these contracts were never disclosed, with oil companies considering this information to be a commercial secret.  Oil-exporting countries were also not particularly keen on using contract prices as these were usually lower than posted prices.  International Oil Pricing System  Being a fiscal parameter, the posted price did not respond to the usual market forces of supply and demand and thus did not play any allocation function.  The multinational oil companies were comfortable with the system of posted prices because it maintained their oligopolistic position (?), and until the late 1960s OPEC countries were too weak to change the existing pricing system. Did you know? Oligopoly is an economic condition in which a small number of sellers exert control over the market of a commodity  International Oil Pricing System  OPEC Administered Pricing System  The oil industry witnessed a major transformation in the early 1970s when some OPEC governments stopped granting new concessions and started to  claim equity participation in their existing concessions, with a few of them opting for full nationalization.  OPEC’s six Gulf members (Abu Dhabi, Iran, Iraq, Saudi Arabia, Qatar, and Kuwait) agreed to negotiate the participation agreement with oil  companies collectively and empowered the Saudi oil Minister Zaki Yamani to negotiate in their name.  International Oil Pricing System  Equity participation gave OPEC governments a share of the oil produced which they had to sell to third- party buyers.  As owners of crude oil, governments had to set a price for third-party buyers. The concept of official selling price (OSP) or government selling  price (GSP) entered at this point and is still currently used by some oil exporters.  However, for reasons of convenience, lack of marketing experience and inability to integrate downwards into refining and marketing in oil  International Oil Pricing System  -importing countries, most of the governments’ share was sold back to the companies that held the concession and produced the crude oil in the first  place. These sales were made compulsory as part of equity participation agreements and used to be transacted at buyback prices (?). *The repurchase price of something previously sold.  The complex oil pricing system of the early 1970s centered on three different concepts of prices: the posted price, the official selling price, and the buyback price.  A new administered oil pricing regime emerged in 1974-75 after the short lived episode of the buyback system.  International Oil Pricing System  The new system was centered on the concept of reference or marker price with Saudi Arabia’s Arabian Light being the chosen marker crude.  In this administered pricing system, individual members retained the OSPs for their crudes, but these were now set in relation to the reference price.  Spot Markets, Long-Term Contracts and Formula Pricing  Physical delivery of crude oil is organized either through the spot (cash) market or through long-term contracts.  The spot market is used by transacting parties to buy and sell crude oil not covered by long- term contractual arrangements and applies often to one- off transactions.  Long-term contracts are negotiated bilaterally between buyers and sellers for the delivery of a series of oil shipments over a specified period of time,  usually one or two years. They specify, among other things, the volumes of crude oil to be delivered, the delivery schedule, the actions to be taken  Spot Markets, Long-Term Contracts and Formula Pricing  in case of default, and above all the method that should be used in calculating the price of an oil shipment.  Price agreements are usually concluded on the method of formula pricing which links the price of a cargo in long-term contracts to a market (spot) price.  Formula pricing has become the basis of the oil pricing system.  There are various types of internationally traded crude oil with different qualities and characteristics.  Spot Markets, Long-Term Contracts and Formula Pricing  The intrinsic properties of crude oil determine the mix of final petroleum products. The two most important properties are density and sulfur content.  Sulfur, a naturally occurring element in crude oil, is an undesirable property and refiners make heavy investments in order to remove it.  Crude oils with high sulfur are referred to as sour crudes while those with low sulfur content are referred to as sweet crudes.  The light/sweet crude grades usually command a premium over the heavy/sour crude grades.  Spot Markets, Long-Term Contracts and Formula Pricing  Given the large variety of crude oils, the price of a particular crude oil is usually set at a discount or at a premium to a marker or reference price.  These reference prices are often referred to as benchmarks.  The formula used in pricing oil in long-term contracts is straightforward. The formula pricing can be written as : Px = PR ± D  Where Px is the price of crude x; PR is the benchmark crude price; and D is the value of the price differential.  Spot Markets, Long-Term Contracts and Formula Pricing  The differential is often agreed at the time when the deal is concluded and could be set by an oil exporting country or assessed by price reporting  agencies. It is important to note that formula pricing may apply to all types of contractual arrangements, be they spot, forward or long term.  The differential to a benchmark is independently set by each of the oil- producing countries.  For many countries, it is usually set in the month preceding the loading month and is adjusted monthly or quarterly.  Spot Markets, Long-Term Contracts and Formula Pricing  In setting the differential, an oil-exporting country will not only consider the differential between its crude and the reference crude, but has also to  consider how its closest competitors are pricing their crude in relation to the reference crude.  This implies that the timing of setting the differential matters, especially in a slack market.  Oil-exporting countries that announce their differentials first are at the competitive disadvantage of being undercut by their closest competitors.  Benchmarks In Formulae Pricing  At the heart of formulae pricing is the identification of the price of key physical benchmarks, such as West Texas Intermediate (WTI), the ASCI price, Dated Brent and Dubai.  The prices of these benchmark crudes, often referred to as “spot market prices”, are central to the oil pricing system.  The prices of these benchmarks are used by oil companies and traders to price cargoes under long-term contracts or in spot market transactions;  Benchmarks In Formulae Pricing  by futures exchanges for the settlement of their financial contracts; by banks and companies for the settlement of derivative instruments such as  swap contracts; and by governments for taxation purposes. Given the  central role that benchmarking plays in the current oil pricing system,  it is important to highlight some of the main features of the most widely used benchmarks.  Benchmarks In Formulae Pricing  First, unlike the futures market where prices are observable in real time, the reported prices of physical benchmarks are identified or assessed  prices. These assessments are carried out by oil pricing reporting agencies. Assessments are needed in opaque markets such as oil where physical  transactions concluded between parties cannot be directly observed by market participants.  Assessments are also needed in illiquid markets where not enough representative deals or where no transactions take place.  Benchmarks In Formulae Pricing  Second, these agencies do not always produce the same price for the same benchmark as these pursue different methodologies in their price  assessments. Two price reporting services could publish different prices for the same crude because their price identification process and the deals  they include in the assessment could be different.  Third, the nature of these benchmarks tends to evolve over time. Although the general principle of benchmarking has remained more or  Benchmarks In Formulae Pricing  less the same over the last twenty-five years, the details of these benchmarks in terms of their liquidity and the type of crudes that are  included in the assessment process have changed dramatically over that period.  Finally, in the last two decades or so, many financial layers (paper markets) have emerged around these benchmarks.  These include the forward market (in Brent), swaps, futures, and options.  Benchmarks In Formulae Pricing  These markets have become central for market participants wishing to hedge their risk and to bet (or speculate) on oil price movements.  Equally important, these financial layers have become central to the oil price identification process.  ASSIGNMENTS Group 1 Benchmarks In Formulae Pricing Group 2 OPEC Administered Pricing System Group 3 Long-Term Contracts and Formula Pricing Group 4 Structure of the Oil & Gas Industry (E&P) Group 5 Structure of the Oil & Gas Industry (Refining) Group 6 Benchmark crudes Group 7 Spot & Futures Contracts Group 8 Hedging in the Oil & Gas Industry