World oil market
Jan Osička
Lecture outline
•Introduction: World oil market as a bathtub
•The commodity: What is it that is being traded?
•Market structure
•Actors
W. Nordhaus: The „Bathtub“ view of the
World oil market
• Spigots: Saudi Arabia, Russia, and other producers that introduce oil
into the inventory
• Drains: the United States,
China, and other consumers
drawing oil from the tub
• Oil is fungible
• Bilateral ties are irrelevant
• Single price regardless the source
The commodity
What is (traded) oil?
Oil crudes actually vary...
Oil benchmarks
Benchmark crude
• Specific crude oil
• Widely and actively bought and sold
• To which other types of crude oil can be compared to determine a
price by an agreed-upon differential
Oil benchmarks
Brent
• The most widely used global crude oil benchmark
• Include four North Sea streams:
• Brent and Forties (offshore the United Kingdom)
• Ekofisk and Oseberg (offshore Norway)
• 1 % of global production in 2013 (0.86 bpd)
• Benchmark for approx. 2/3 of global oil
• Light and sweet crude oil
that is produced and traded in:
• Europe
• the Mediterranean and Africa
• Australia
• Asia (selectively)
Original source streams of Brent
West Texas Intermediate
• Light, sweet crude oil produced in the United States
• Priced at Cushing, Oklahoma
• Benchmark for other types of crude oil produced in the United
States, such as:
• Mars, a medium, sour crude produced in the Gulf of Mexico
• Bakken, a light, sweet crude produced in North Dakota.
• WTI is also used as a benchmark for imported crude oil that is
produced in:
• Canada
• Mexico
• South America
Dubai/Oman
•Average price of Dubai and Oman crude, both of
which are medium and sour
•Benchmark for crude oil produced in the Middle
East (incl. Saudi Aramco) and exported to Asian
markets.
•Dubai: steady decline in production down to 0.034
mbd (2013)
=> Omani oil (0.94 mbd in 2013) used to continue
the benchmark
Differentials
... A benchmark is a type of crude oil to which other types of crude oil
can be compared to determine a price by an agreed-upon differential...
Differentials are determined by:
• Quality characteristics (API gravity or sulfur content).
• Transportation costs from production areas to refineries.
• Regional and global supply and demand conditions.
Oilquality
Oilquality
Oil quality
Refineries
• Calibrated to process a particular type of oil (sweet/sour, light/heavy)
• Processing different oil possible but at reduced efficiency =>
noncompetitiveness
• Re-calibration possible but at significant costs
Transportation costs
P2
P1
Transportation costs
• Onshore-produced and otherwise poorly accessible crudes tend to
be cheaper than offshore and easy accessible onshore crudes
Transportation costs
Onshore-produced and otherwise poorly accessible crudes tend to be
cheaper than offshore and easily accessible onshore crudes
• To compensate for additional costs of transportation
• Transportation bottleneck foster „micro“ oil-to-oil competition
Regional supply/demand
Regional supply/demand
Regional supply/demand
How a specific crude becomes benchmark?
• Stable and ample production.
• Transparent, liquid market located in a geopolitically and financially
stable region to encourage price discovery.
• Adequate storage to encourage market development.
• Delivery points at locations that allow arbitrage opportunities in
world markets so that prices reflect global supply and demand.
An oil bathtub?
• Individual crudes are interchangeable only at significant costs/loss of
competitiveness
• Individual crudes are feedstock for production of the same products
• World oil market = set of very closely correlated benchmark/regional
markets
Market structure
Market characteristics: elasticity
Limited elasticity of both supply and demand
• Supply (non-OPEC)
• Production requires huge up front investment
• Variable costs are a small component of total costs
• As long as variable costs are paid, producers are best off maximizing
production
• Supply (OPEC)
• Quotas
• Demand
• Oil satisfies essential needs
• Higher per capita income
• Concentration in transportation
• Taxes isolate consumers from the impact of price changes.
=> Demand is influenced primarily by macro trends (income effect) and the
weather.
Long term: boom and bust
• Demand and (less so) supply are price elastic.
• Consumers will make the investment required to reduce fuel
consumption or switch to a different fuel.
• On the supply side, companies’ cash flow improves, investment
increases, new fields are developed.
• However, higher prices may also encourage resource nationalism
and slow down investment/production
Market structure: the big picture
MARKET
EQUILIBRIUM
UNCERNTAINTY:
- geopolitics
- security
- weather
DEMAND:
- GWP
development
- USD exchange
rate
- Taxation
FINANCIAL
MARKETS
- hedging
- speculations
SUPPLY:
- reserves
- OPEC strategy
- non-OPEC
productino
- technology
30
Actors
• International oil companies(IOCs).
• National oil companies (NOCs).
• International energy organizations: OPEC, IEA (IOs).
• Investors, traders.
32
OPEC
Founded in 1960 in Baghdad,
founding members Venezuela,
Saudi Arabia, Iraq, Iran, Kuwait.
Holds 80% of proven reservers,
44% production, and practically
all spare production capacity.
33
Spare capacity
OPEC
Regulates the supply via two
means:
• Production quotas.
• Investments into new production
capacities.
35
How a cartel works? A coordination game
Imagine following situation:
• Overall demand for oil is 6-14 barrels per day
• The price varies according to scarcity of oil:
• At 6 bpd the price is high (20 USD/b)
• At 14 bpd the price is low (4 USD/b)
• There are (only) two producers (P1 and P2)
• Similar production and delivery costs
• Wishing to maximize profits
=> adjusting production according to the price
How a cartel works? A coordination game
37
Barrels USD/b P1‘s income P2‘s income Total income
6 20 3*20=60 3*20=60 120
7 18 4*18=72 3*18=54 126
8 16 4*16=64 4*16=64 128
9 14 5*14=70 4*14=56 126
10 12 5*12=60 5*12=60 120
11 10 6*10=60 5*10=50 110
12 8 6*8=48 6*8=48 96
13 6 7*6=42 6*6=36 78
14 4 7*4=28 7*4=28 56
How a cartel works? A coordination game
38
Barrels USD/b P1‘s income P2‘s income Total income
6 20 3*20=60 3*20=60 120
7 18 4*18=72 3*18=54 126
8 16 4*16=64 4*16=64 128 (cartel equilibrium)
9 14 5*14=70 4*14=56 126
10 12 5*12=60 5*12=60 120 (Nash equilibrium)
11 10 6*10=60 5*10=50 110
12 8 6*8=48 6*8=48 96
13 6 7*6=42 6*6=36 78
14 4 7*4=28 7*4=28 56
The freeriding issue: prisoners‘ dilema
39
"Mr. President, we are rapidly approaching a moment of truth
both for ourselves as human beings and for the life of our nation.
Now, truth is not always a pleasant thing. But it is necessary now
to make a choice, to choose between two admittedly regrettable,
but nevertheless *distinguishable*, postwar environments: one
where you got twenty million people killed, and the other where
you got a hundred and fifty million people killed.“
General Buck Turgidson, (Dr. Strangelove)
http://www.youtube.com/watch?v=HgyjlqhiTV8
The freeriding issue: prisoners‘ dilema
40
P2
Does not
increase
Increases
P1
Does not
increase
64/64 56/70
Increases 70/56 60/60
Freeriding: the case of Venezuela
41
Buying oil
•Physical oil
•Financial derivatives (futures, options, ...)
•Speculation
•Hedging
What is the ratio between daily traded physical and financial (paper)
barrels?
Physical deliveries
Over-the-counter (bilateral agreements)
• Term contracts of mostly one year
• Price set according to spot
• 90-95% physically traded volume
Spot market (hub trading, exchange trading)
• Balancing needs (surplus or missing barrels)
• Sets the price („marginal barrels“)
• 5-10% of volume
Financial deliveries
• Futures
• Options
• Swaps
• Forwards
Futures
Futures
A financial contract obligating the buyer to purchase an asset (or the
seller to sell an asset), such as a physical commodity or a financial
instrument, at a predetermined future date and price.
• Underlying asset (oil)
• Type: long (buying) x short (selling)
• Date of settlement
Long and short position
Long futures: buying futures with expectation of price increase
Short futures: selling futures with expectation of price decline
Speculation with futures
Example
• Time T0 (now), oil price P0 = $50
• 1,000 barrels financial futures bought at $60 with settlement next June (T1)
• Time T1 (next June), oil price P1 = $55
• Bought for $60 what is being now traded at $55 => lost $5 per barrel => lost
5,000 USD
• Time T1 (next June), oil price P1 = $65
• Bought for $60 what is being now traded at $65 => gained $5 per barrel =>
gained 5,000 USD
Hedging with futures
Imagine a following oil buyer:
• Has invested in business whose profitability depends on
price of oil (i.e. an airline)
• Needs a stable oil price to plan the development of the
business.
• => Wishes to hedge against price fluctations, i.e. wishes
the current (time T0) prices (P0) to last.
• Will need 1,000 barrels of oil about this time next year
(time T1, oil price P1)
Hedging with futures
Today (time T0, price P0 = 50 USD/b):
• The buyer enters a contract in which agrees to buy 1,000 physical barrels
at $50 (P0) with delivery in time T1.
• At the same time sells 1,000 financial barrels at $50 (P0) with delivery in
time T1
• In time T1, therefore, the buyer:
• Will pay for the physical delivery amount equal to 1,000 x P0.
• Will get paid for financial delivery amount equal to 1,000 x P1.
Hedging with futures
About this time next year (T1): The price went up to P1 = 70 USD/b
Settles the physical contract:
• Bought $70 worth barrels for $50 ... Balance: +20 x 1,000 = +20,000 USD
Settles the financial contract:
• Sold $70 worth barrels for $50 ... Balance: -20 x 1,000 = -20,000 USD
Total balance: 0 USD
=> The buyer got 1,000 barrels at $50 as desired.
Hedging with futures
About this time next year (T1): The price went down to P1 = 30 USD/b
Settles the physical contract:
• Bought $30 worth barrels for $50 ... Balance: -20 x 1,000 = -20,000 USD
Settles the financial contract:
• Sold $30 worth barrels for $50 ... Balance: +20 x 1,000 = +20,000 USD
Total balance: 0 USD
=> The buyer got 1,000 barrels at $50 as desired.
Hedging with futures
If buyer was a seller:
T0: P0 = 50 USD/b
Agrees to deliver 1,000 physical barrels at 50 USD/b in T1
At 50 USD/b buys 1,000 financial barrels to receive what they are worth in T1 (P1)
T1: P1 = 70 USD/b
• Physical: Delivered $70 worth barrels at $50 ... Balance -20,000 USD
• Financial: Received $70 for what was bought for $50 ... Balance +20,000 USD
T1: P1 = 30 USD/b
• Physical: Delivered $30 worth barrels at $50 ... Balance +20,000 USD
• Financial: Received $30 for what was bought for $50 ... Balance -20,000 USD
Total balance: 0 USD
=> The seller sold 1,000 barrels at $50 as desired.
Options
Options
A financial derivative that represents a contract sold by one party
(option writer) to another party (option holder). The contract offers
the buyer the right, but not the obligation, to buy (call) or sell (put) a
security or other financial asset at an agreed-upon price (the strike
price) during a certain period of time or on a specific date (exercise
date).
Option types
Call option Put option
Buyers Right to buy stock if exercised Right to sell stock if exercised
Sellers Obligation to sell stock if
assigned
Obligation to buy stock if assigned
• Underlying asset: oil
• Type: call (right to buy) x put (right to sell)
• Price: price of contract
• Strike price: oil price at which the right can be exercised
• Exercise date: when the contract expires
Hedging with options
Call option Put option
Buyers Right to buy stock if exercised Right to sell stock if exercised
Sellers Obligation to sell stock if assigned Obligation to buy stock if assigned
Example: oil purchasing hedging (oil purchaser = option buyer)
T0: oil price P0 = $50
• Buyer: bought call option for 1,000 barrels at $60 from Seller for 3
USD/b due to T1
T1: oil price P1 = $70
• Buyer: exercises his right and gets $70 worth barrels
for $60 ... Balance: + 10,000 – 3,000 = + 7,000 USD
• Seller: sells $70 worth barrels for $60
... Balance: - 10,000 + 3,000 = - 7,000 USD
=> Hedging successful, major loss due to price spike prevented
Call option Put option
Buyers Right to buy stock if exercised Right to sell stock if exercised
Sellers Obligation to sell stock if assigned Obligation to buy stock if assigned
Example: oil purchasing hedging (oil purchaser = option buyer)
T0: oil price P0 = $50
• Buyer: bought call option for 1,000 barrels at strike price of $60
from Seller for 3 USD/b due to T1
T1: oil price P1 = $58
• Buyer: does not exercise his right (would get $58 worth barrels for
$60) ... Balance: - 3,000 USD
• Seller: gains $3 per each barrel for selling unexercised option at $3
... Balance: + 3,000 USD
=> Hedging successful, major loss due to price spike prevented
Call option Put option
Buyers Right to buy stock if exercised Right to sell stock if exercised
Sellers Obligation to sell stock if assigned Obligation to buy stock if assigned
Example: oil selling hedging (oil seller = option buyer)
T0: oil price P0 = $50
• Buyer: bought put option for 1,000 barrels at strike price of $40
from Seller for 3 USD/b due to T1
T1: oil price P1 = $30
• Buyer: exercises his right and sells $30 for $40
... Balance: + 10,000 – 3,000 = + 7,000 USD
• Seller: buys $30 worth barrels for $40
... Balance: - 10,000 + 3,000 = - 7,000 USD
=> Hedging successful, major loss due to price decline prevented
Call option Put option
Buyers Right to buy stock if exercised Right to sell stock if exercised
Sellers Obligation to sell stock if assigned Obligation to buy stock if assigned
Example: oil selling hedging (oil seller = option buyer)
T0: oil price P0 = $50
• Buyer: bought put option for 1,000 barrels at strike price of $40
from Seller for 3 USD/b due to T1
T1: oil price P1 = $45
• Buyer: does not exercise his right (would sell $45 worth barrels for
$40) ... Balance: - 3,000 USD
• Seller: gains $3 per each barrel for selling unexercised option at $3
... Balance: + 3,000 USD
=> Hedging successful, major loss due to price spike prevented
What is the ratio between daily traded physical and financial (paper)
barrels?
Physical to financial trading
• Physical barrels: approx. 92 mbd (2014, EIA)
• Financial barrels: more than 1,000 mbd
(2009, Congressional testimony by the commodities specialist
Michael W. Masters)
=> At least 1:10
Market structure: the big picture
MARKET
EQUILIBRIUM
UNCERNTAINTY:
- geopolitics
- security
- weather
DEMAND:
- GWP
development
- USD exchange
rate
- Taxation
FINANCIAL
MARKETS
- hedging
- speculations
SUPPLY:
- reserves
- OPEC strategy
- non-OPEC
productino
- technology
65
The development of the World oil market
1910s - 1960s
• Establishment and dominance of vertically integrated IOCs – „Seven
sisters“ (1949: 88% of world oil trade)
• High barriers to entry (essentially building a whole new company)
• Support from Western governments
1960s
• New wave of globalization
• Economic prosperity
• Independence movements in colonies
• Nationalization of resources:
Russia (1918), Bolivia (1937), Mexico (1938), Argentina (1958),
Indonesia (1963), Algeria (1971), Libya (1971), Iraq (1972), Saudi
Arabia (1972), Kuwait (1972), Abu Dhabi, (1972), Iran (1973), and
Venezuela (1976).
=> Demand growth (115% between 1960 and 1970)
=> Emergence of an independent supply (up to 300 private and 50
state-owned companies)
1970s
• Independents leave trading oil through 7S and search for their own
low-cost reservers, offering better terms to local governments.
• 7S react by building non-OPEC reserves: North Sea oil discovered
1968 (on stream 1975), Alaska 1969 (1977).
• Less fortunate of the 7S start selling their down stream units
(expectations of decreased supply)
=> Origins of non-OPEC supply.
1970s oil shocks
Shocks facilitated the rise of independents
Before 70s:
• Buyers‘ market, where the IOCs, as the primary buyers of crude, had the
power to set prices they were willing to offer sellers (oil producing nations).
• Long term contracts (2 years)
After 70s:
• NOCs become more and more important (IOCs share 73-83: 90 => 50%)
• Increased complexity (independent actors in upstream, downstream and
midstream).
• Price spikes motivate emerging traders (midstream)
• Basis of spot trading laid (independets + 7S compensating for upstream
outages incurring due to nationalization)
• Oil futures traded since 1983.
1980s
• Oil stocks at records high
• Conservation policies of developer states
• Inability of OPEC to limit production (cuts 20-65%)
• Freeriding incentive (increasing production above quotas)
• 1985: SA announces it would no longer play the role of a swing
producer
• Abandonment of production and pricing agreements, increase in
OPEC production by 25%
• Oil price down below 10 USD/b (in real terms lower than before
1973)
• OPEC unable to recover quotas until 1998.
1990s
• 1991: Gulf crisis (dispute over production levels mostly between Iraq
and Kuwait).
• Democratization, globalization
• 1998-2002 consolidation of supermajors
2000s+
2014 price decline
<= Supply/demand expectations
<= Receding geopolitical concerns
<= US dollar appreciation
<= Change in OPEC strategy
The 2014 price decline
Supply/demand
+ US shale oil
+ Biofuels
- Sluggish economic growth
- Demand corrections (between 7-12/14
alone the demand forecast for 2015 has
revised downwards by 0.8 mbd)
- Oil intensity of global GDP almost halved
since 1970s.
Geopolitics
• Production recovery by 0.5 mbd in Libya
• Iraq maintains output as ISIS expansion stalls
• Russian production unaffected by sanctions
US dollar
• Long term: negative correlation (terms of trade).
• Consumers (weak dollar  greater purchasing power  greater
consumption  oil price increase).
• Producers (weak dollar  lower purchasing power  lower
production  oil price increase).
• Long term: positive correlation (interest rates).
• Consumers (high oil prices  inflation/balance of payment issues 
increased interest rates/intervention  strong dollar).
• Producers (high oil prices accumulation of petrodollars  strong
dollar).
OPEC
• November 2014: OPEC fails to agree on production cuts.
• Revenue targeting displaced by maintaining market share.
• What was the motivation of Saudi Arabia, the cartel‘s swing
producer?
Saudi reaction
Why Saudi Arabia has not reacted to
the sharp fall in oil price in the
expected manner?
Does SA desire a lower price?
• Budget spending suggests otherwise
• Oil minister Ali Naimi:
‘One-hundred dollars is a fair price for
everybody - consumers, producers, oil
companies… it is a fair price. It is a good
price’ (Reuters, May 12, 2014).
SA able to cope with lower prices
• Large government assests
• Small debt relative to GDP
• Access to cheap loans
• Ability to adjust expenditures
Government assets
Billion USD % GDP
Nigeria 4.1 2.4
Russia 173.0 8.5
Saudi Arabia 446.9 58.1
Maintaining market share
• Stability of exports at around 7
mb/d
• Presence in key markets
• Building position for OPEC
negotiation
Competition in Asia?
Political goals
Russia and Iran among main
losers of low prices.
Reduce US production?
• In the past, SA has not reacted on any
new high-cost producer.
• US supply helps balancing outages and
provides price response feedback on
the upside
Reduce US production?
• Would low prices work in breakeven price
– diverse environment?
• How fast would the US producers react?
Enforcing discipline in OPEC?
• Lowering price to bring production
closer to quotas.
• Unilateral supply cuts unlikely:
‘We (Saudis) have learned our lesson.
Every time we go to quotas, who bears
the brunt? Us. We are no longer the
swing producer. Who needs quotas?’
(MEES, Dec 6, 2013 )
SA position: policy or pasivity?
• Could SA expect such price slide?
• Unilateral supply cuts are not adopted overnight.
• Lack of information on future demand => „wait and see“ strategy?
• Expectations that demand will pick up in Q4?
Consequences
Passivity or change in policy, either way:
=> Absence of feedback mechanism
=> Price left to market signals (marginal costs)
=> Deeper and more frequent price swings