oil markets

8/2/2019 Oil Markets

1/6

Te Structure o Global Oil Markets

June 2010

B A C K G R O U N D E ROIL


2/6

2 | The Structure o Global Oil Markets

BACKGROUNDER: ThE STRUCTURE Of GLOBAL OIL MARKETS

WhAT ARE ThE VARIOUS OIL TRADING STRUCTURES?

Total world production o crude oil is around 85 millionbarrels per day. The crude oil eeds a network o reneriesat key locations located close to consuming centers ornext to pipelines or shipping acilities. The crude oil is

processed at the reneries and transormed into nishedoil products.

Some companies are ully integrated, rening their owncrude oil production and then eeding their retail networkswith the oil products produced. But or the most partproduction and rening are not ully integrated and renersengage in trade to secure supplies or their acilities or todispose o surpluses.

This oil is primarily secured via term contracts as renersare typically loath to rely too heavily on spot supplies asthese may be unreliable and exhibit high price volatility.End users (airlines, manuacturers, etc.) operate similarly.An airline, or instance, usually secures supplies at airportsrom term suppliers rather than entering the spot market touel its feets.

Hence, the bulk o the crude oil and oil products is soldthrough term contracts, where a volume is agreed with aspecied tolerance over a dened period. The tolerance isbuilt in to provide fexibility to either buyer or seller to loadmore or less than the contracted amount.

Estimates vary but typically industry sources concur that

90-95% o all crude oil and oil products are sold under termcontracts. The mechanisms or pricing crude and productsvary by market sector and geographical region but aresummarized under (Q3).

The balance, 5-10%, is sold on the spot market. A spotdeal is usually dened as a one-o deal between willingcounterparties or a physical commodity. Becausethe deals are on a one-o basis, the spot market isrepresentative o the marginal barrel in terms o supply anddemand.

Typically, spot sales are surpluses or amounts that aproducer has not committed to sell on a term basis oramounts that do not t scheduled sales. Buyers may alsohave under- or over-estimated their consumption and mayhave oil surpluses to sell or shortages to cover.

A variety o derivatives instruments are available that allowpeople to lock in or hedge a price or oil deliveries in theuture. These include orwards, utures, options and swaps.These markets may overlap.

Where they have become highly commoditized, cargoesor partial cargoes o crude oil and oil products may tradeas orwards, usually in hal-monthly, monthly or quarterlyblocks. These markets are oten termed the cashmarkets to distinguish them rom instruments such asswaps which do not involve a physical delivery o oil,

and thereore are reerred to as paper instruments.Examples o orward cash markets include cash Dubaiand open spec naphtha C+F Japan. They are distinct romutures because they are always physically deliverableand they are bilaterally traded between counterpartiesin the over-the-counter (OTC) market. The term OTC is abilateral market in which deals are negotiated betweencounterparties, usually over the telephone. There is nocentral organization o such markets, although third-party bodies such as the International Swaps DealersAssociation may lend expertise on structures aecting thevalue o derivative contracts.

Futures are also used to lock in prices or orward delivery,but they are dierent rom orwards in that they tradeunder standardized terms on a utures exchange. Dealsare agreed bilaterally, either electronically on screensor through open outcry in a trading pit, but are executedwith the exchange through a process known as novation.In novation, a deal is split into two legs, a purchaseand sale, and each leg is executed with the exchangeas counterparty. Futures deals may or may not involvephysical delivery o a commodity, depending on theunderlying contract terms. In oil, the New York MercantileExchange (NYMEX) and IntercontinentalExchange (ICE) arethe key utures exchanges.

Options are most visibly traded on the same exchangesas utures, but they may also be traded on an OTC basis.Options give the buyer or seller the right to take delivery orgive delivery o oil. A put is the right, but not the obligationto sell; a call is the right but not the obligation to buy.Market participants can buy or sell puts or calls.

In swaps, there is never a physical delivery, and as theswap matures there is simply an exchange o cash fows.

So the swaps are purely nancial instruments. Swapsare usually traded OTC and can be tailor-made, althoughcommoditized instruments are also traded on exchangessuch as ICE. Swaps are xed or foating deals:

A sells to B xed price and B agrees to sell back to A at aspecied time at whatever the market rate is at the time.

The foating leg is settled against the market price or thephysical commodity during the settlement period.


3/6

The Structure o Global Oil Markets | 3

A common mechanism or settlement o a monthly swap isto settle against Platts monthly averages or the physicalcommodities underlying the swap, but there are a numbero price publishers that are used to settle derivatives.

hOW IS ThE PhYSICAL OIL MARKET STRUCTURED?

Platts assesses thousands o individual physical oilcommodities across the oil spectrum on every tradingday. Platts coverage o the petroleum sector includeseverything rom crude oils to nished oil products to highlyspecialized petrochemicals.

These can be classied as upstream, which reers tothe production o the raw materials, to downstream,which reers to the consumption o nished products. Theterminology is, however, used relatively.

Broadly, crude oil and condensates are upstream; oilproducts ranging rom gasoline to jet uel to bitumen aredownstream. The oil value chain is extremely complexand some oil products such as naphtha may be processedurther to make petrochemicals.

There are more than 300 separate grades o crude oil soldaround the world.

Oil is produced rom widely diering geographical areas,on land in which case the oil is called onshore and

at sea in which case the oil is known as oshore. Examples o oshore oilelds include Statjord and

Gullaks rom the Norwegian North Sea.

Onshore elds range rom the biggest to the smallest.The giant Ghawar eld in Saudi Arabia, the worldsbiggest, stretches or hundreds o miles along easternSaudi Arabia, and seepages rom it stain the sands onthe desert surace.

But at the other extreme, tiny elds like that atKimmeridge in Dorset, England, pump only around 200barrels per day (b/d). The average production per well inthe US is only about 10 b/d.

The crude oils that are sold in the market are oten blends

o oils rom individual oilelds which have been gatheredand pumped to a single location either at land or in the seaFor instance, North Sea Brent Blend is actually a blend odozens o oilelds that have been gathered and pumpedto the Sullom Voe oil terminal in the North Sea, rom whichthey are transported by tanker. The major Saudi Arabianand Russian export crude oils are all blends o manydierent streams o oil. These are blended and sold as abrand, or instance Arab Light or Urals.

The crude oils are rened to make oil products. Thebasic rening process is that o distillation. The crude

oil is heated, and oil products bubble o at dierenttemperatures, the lightest at the lowest temperatures andthe heaviest at the highest temperatures. These productsare typically treated urther to make nished oil productssuch as gasoline that we use in everyday lie. A varietyo upgrading processes such as cracking, coking andhydrotreating allow reners to maximize the yield o high-value nished products manuactured rom crude oil.

WhAT ARE ThE DIffERENT TYPES Of OIL AND WhAT AREThEIR CLASSIfICATIONS?

Finished oil products are those most amiliar to the public:automotive gasoline, known also as gas in the US andpetrol in the UK; kerosene, which is used in the airlinesector as commercial aviation uel or in the householdsector or illumination and heating; diesel or use in truckingand agricultural machinery; and heating oil, used byhomeowners and industrial companies or space heating.

The dierent grades o crude oils are dierentiated by theirdistillation characteristics and the qualities o the productsproduced rom distillation.

They are classied as light or heavy, and sweet or sour.Light crude oils contain more light products such asgasoline whereas heavy crude oils contain more heavyresidues such as uel oil. The lighter a product, the lessdense it is. Density is measured using either specicgravity or API gravity (e.g. the density o water is 1;anything below that foats, anything above it sinks.)

Sweet and sour reers to the level o sulur, an undesirableimpurity that is dangerous and pollutive. Sweet crude oils

TRADING

Derivatives trading

Futures Options Swaps

Physical trading

Spot (5-10%) Term (90-95%)


4/6

4 | The Structure o Global Oil Markets

BACKGROUNDER: ThE STRUCTURE Of GLOBAL OIL MARKETS

contain less sulur; sour crude oils contain more sulur.Prospectors used to taste the oils they ound and coulddetermine the approximate level o sulur rom the taste,hence the sweet/sour terminology.

Because these are physical liquids, they have non-

standard parameters o quality, delivery, timing, locationand lot size. For instance, in dening a uel oil or use by autility, dozens o quality parameters are specied, and thetesting regime or each parameter is also dened.

hOW IS PhYSICAL OIL, AND hOW ARE OIL DERIVATIVES,BOUGhT AND SOLD?

Because the volumes o oil sold each day are so large,oil companies typically sell or buy most o their oil underlong-term agreements, usually annual contracts that getrenewed each year. The balance, also reerred to as the

marginal barrel, is bought or sold on the spot market.Critically, the marginal short or long barrel is the unit thatsets the price, and is ully responsive to standard economicprinciples o supply and demand. This is in line with time-tested standard economic principles.

Platts aim is to refect the value o the marginal unit, thespot price, and publish assessments o the spot price.

The proportion o term to spot varies by company and alsoover time. Many o the large Middle Eastern oil producershave traditionally sold their oil on a term basis. The largest,

Saudi Aramco, does not enter the spot market or allowurther resale o its oil in the spot market. Others, such asKuwait, may be more fexible, but by and large, producersworldwide sell their oil on a term basis.

Spot and term oil can be sold on a xed price basis or ona foating basis. Floating sales are overwhelmingly thenorm and buyers and sellers agree to link the price to aninstrument that rises and alls with the market. Buyersand sellers generally preer foating price deals to xedbecause it is less risky.

For instance, it takes about 40 days or a cargo o crudeoil rom a producer in the Middle East to reach a renerin the US Gul Coast.

I the rener bought the oil at xed price, he would ace apotentially large nancial loss i prices ell by the time theoil was delivered.

I the rener buys crude oil on a foating price basis tiedto the value o the oil when it is delivered to his reneryand sells the oil products also on a foating basis, theprice risk that he aces is reduced.

In general, foating price mechanisms allow companiesmore fexibility in risk management, and more fexibility inoptimizing purchases and sales.

Fixed price deals simply state a price at which a companywill trade. For instance, a seller may oer a Dated Brent

cargo o 600,000 barrels or loading May 5-7 at a xedprice o $80/bbl. I a deal is concluded, the price is $80/bblirrespective o what happens to the market between thedeal time and when the cargo is loaded on a tanker.

In a foating price deal, the counterparties agree tothe main terms o the deal but the price is set at a laterdate, usually when the cargo is loaded onto a tanker ordelivered into tanks at the delivery port. The mechanismor setting the price is agreed to at the time o deal. Thesemechanisms include the ollowing:

1) ones that reerence Platts or its competitors spotprice assessments, reerred to as Platts-related orquotesrelated deals.

2) ones that are linked to a utures exchange, usuallyreerred to as utures-related or EFP deals. Theterm EFP is used because such deals involve anexchange o utures or physical.

Such foating price deals can be term or spot.

Floating price mechanisms oten reerence Plattsassessments. A strong reason or using Platts, as opposed

to utures prices, is that utures may be disconnected romthe actual conditions in the physical markets as uturestrading is typically or a period ar away in the uture, whilethe physical market (which Platts assessments seek torefect) are reacting to the physical constraints aced in thevery near term. Hence a Platts assessment should be morein line with the actual physical markets in comparison to autures price.

It is important to emphasize that whatever the mechanism,physical oil is what changes hands. A trader may sell aphysical commodity at the utures value plus or minus

a dierential. But the existence o the dierentialemphasizes that physical and utures are dierent things,and that physical value is established by physical supplyand demand.

The mechanics o establishing a price and executing atrade, whether it uses xed price or foating price, aremaniold. A company may elect to trade at a posted price,in a tender or auction, through a negotiation model, with orwithout a broker, or by using a marketrelated benchmark.E-trading is simply one such mechanism.


5/6


6/6

About PlattsPlatts, a division o The McGraw-Hill Companies (NYSE: MHP), is the market leader or independent

real-time news, pricing, and data or the energy and metals markets. From our 17 worldwide oces, we

create market transparency and drive better decision-making or traders and investors in more than 150

countries. More inormation is available at www.platts.com.

For more inormation, please contact the Platts sales oce nearest you.

North America EMEA Latin America Asia-Pacic Russia www.platts.com+1-800-PLATTS8 (toll-ree) +44-(0)20-7176-6111 +54-11-4804-1890 +65-6530-6430 +7-495-783-4141 [email protected]+1-212-904-3070 (direct)

2010 Platts, a Division o The McGraw-Hill Companies, Inc.

Reproduction o this publication in any orm is prohibited except with the written permission o Platts. Because o the possibility o human or mechanical error by Platts

sources, Platts does not guarantee the accuracy, adequacy, completeness, or availability o any Platts inormation and is not responsible or any errors or omissions or

or the use o such Platts inormation. Platts gives no express or implied warranties, including, but not limited to, any implied warranties o merchantability or tness or

a particular purpose or use. In no event shall Platts be liable or any direct, indirect, special, or consequential damages in connection with subscribers or others use o

this publication.

OLBG002 0610

oil markets

Documents