Friday, October 3, 2014

The Pricing of Crude Oil

The Reserve Bank has an interesting analysis of how crude oil is priced in world markets - The Pricing of Crude Oil.
Arguably no commodity is more important for the modern economy than oil. This is true in terms of both production and financial market activity. Yet its pricing is relatively complex. In part this reflects the fact that there are actually more than 300 types of crude oil, the characteristics of which can vary quite markedly. This article describes some of the key features of the oil market and then discusses the pricing of oil, highlighting the important role of the futures market. It also notes some related issues for the oil market. ...

The crude oil market is significantly larger than that for any other commodity, both in terms of physical production and financial market activity (Table 1).

The value of crude oil production is more than twice that of coal and natural gas, 10 times that of iron ore and almost 20 times that of copper. Crude oil is the most widely used source of fuel, supplying around one-third of the world’s energy needs. It is also used to produce a variety of other products including plastics, synthetic fibres and bitumen. Accordingly, changes in the price of crude oil have far-reaching effects.

The pricing mechanism underlying crude oil is, however, not as straightforward as it might appear. Almost all crude oil sold internationally is traded in the ‘over-the-counter’ (OTC) market, where the transaction details are not readily observable. Instead, private sector firms known as price reporting agencies (PRAs) play a central role in establishing and reporting the price of oil – the two most significant PRAs being Platts and Argus Media. ...

While physical crude oil can be purchased from organised exchanges by entering into a futures contract, only around 1 per cent of these contracts are in fact settled in terms of the physical commodity. Futures contracts are standardised contracts traded on organised exchanges, specifying a set quantity (usually 1 000 barrels) of a set type of crude oil for future delivery. The two key oil futures contracts are the New York Mercantile Exchange (NYMEX) WTI light sweet crude and the Intercontinental Exchange (ICE) Brent contracts. ...

With so many different grades of oil, there is actually no specific individual market price for most crude oils. Instead, prices are determined with reference to a few benchmark oil prices, notably Brent and West Texas Intermediate (WTI) (Graph  3). Brent is produced in the North Sea and is used as a reference price for roughly two-thirds of the global physical trade in oil, although it only accounts for around 1 per cent of world crude oil production (Table 3). WTI is produced in the United States and has traditionally dominated the futures market, accounting for around two-thirds of futures trading activity. However, futures market trading in Brent has increased significantly in recent years to be now close to that for WTI, reinforcing Brent’s role as the key global benchmark (Graph 4). As discussed below, Brent’s dominance as a benchmark has benefited from the fact that it is a seaborne crude and, unlike WTI (which is a landlocked pipeline crude), can readily be shipped around the world.

These benchmarks form the basis for the pricing of most contracts used to trade oil in the physical (and financial futures) markets. For oil transactions undertaken in the spot market, or negotiated via term contracts between buyers and sellers, contracts specify the pricing mechanism that will be used to calculate the price of the shipment. So-called ‘formula’ pricing is the most common mechanism, and it anchors the price of a contracted cargo to a benchmark price, with various price differentials then added or subtracted. These price differentials relate to factors such as the difference in quality between the contracted and benchmark crude oils, transportation costs and the difference in the refinery’s return from refining the contracted and benchmark crudes into the various petroleum products. For example, a barrel of Brent is generally worth more than a barrel of Dubai (a  medium sour crude oil) because Brent will yield more high-value gasoline, diesel and jet fuel than Dubai without the need for intensive refining. However, the actual magnitude of the Brent-Dubai spread will depend on the relative prices of these petroleum products at the time when the oil is sold to the refineries, along with the location and the spare capacity in those refineries that can easily convert lower-quality crude oil into higher-yielding petroleum products. Reflecting changes in these fundamental determinants, the Brent-Dubai spread has fluctuated within a range of around US$0–15 per barrel. These benchmark prices used in formula pricing are usually based on either (i) ‘spot’ prices determined by PRAs (for example, a ‘spot’ price published by Platts called Dated Brent); or (ii) prices determined in futures markets (for example, the assessed WTI price published by the PRAs).

Oil companies often reference more than one benchmark price depending on the final destination; for example, Saudi Aramco typically employs the Brent benchmark to price oil exports to Europe, Dubai-Oman for exports to Asia and the Argus Sour Crude Index for exports to the United States. These particular crudes emerged as benchmarks due to several distinctive characteristics. Brent developed as a benchmark owing to favourable tax regulations for oil producers in the United Kingdom, in addition to the benefits of stable legal and political institutions (Fattouh 2011). Ownership of Brent crude oil is well diversified, with more than 15 different companies producing it, which helps to reduce individual producers’ pricing power.

Brent can also be used by a variety of buyers, given that it is a light sweet crude oil that requires relatively little processing. The physical infrastructure underlying Brent is also well developed. When the Brent benchmark was established in the mid 1980s, its production was initially reasonably large and stable, which is an important characteristic of a benchmark as it guarantees timely and reliable delivery. Although the volume of Brent crude oil produced has declined over time, three other North Sea crudes have been added to the Brent benchmark basket over the past decade, such that it now comprises Brent, Forties, Oseberg and Ekofisk (BFOE; Graph  5). The combination of these four alternatively deliverable grades has allowed the Brent benchmark to retain a reasonable volume of production. And while there are concerns about the adequacy of production volumes in the future, the depth and liquidity of the Brent futures market has nevertheless increased noticeably in recent years.

If alternative crude oils cannot be delivered against a benchmark, declining production volumes can weaken the status of that crude oil as a benchmark. This is because it becomes a less accurate barometer of current supply and demand as it becomes traded less frequently, and lower traded volumes enable individual market participants to influence the price more easily. Malaysian Tapis – which was previously a key benchmark for the Asia-Pacific region – is a case in point. Tapis’s benchmark status has faded away in recent years owing to declining production volumes; recently, only a single cargo of Tapis has typically been available for export each month, down from around 8 cargoes per month in previous years.

This compares with around 45 cargoes per month currently for the Brent benchmark. Declining production volumes, coupled with the absence of any alternative similar crude oils produced in the region, have seen refiners and producers shift to benchmark against other prices, predominantly Brent.

The emergence of WTI as a benchmark was also assisted by the presence of secure legal and regulatory regimes in the United States. WTI was established as a benchmark in 1983 and its status increased in prominence as the depth and liquidity of its futures contract expanded. Like Brent, WTI is a light sweet crude that is available from a broad range of producers. Similarly, several different types of crude can be delivered against the WTI contract, including sweet crudes from Oklahoma, New Mexico and Texas, as well as several foreign crude oils. WTI crudes are delivered via an extensive pipeline system (as well as by rail) to Cushing, Oklahoma.

Recently, however, the system has struggled to cope with the increasing volumes of crude oil flowing through Cushing. This has resulted in persistent inventory bottlenecks, owing to Cushing’s limited storage capacity and its landlocked location. These bottlenecks have weighed on the WTI price in recent years, to the point where it is now significantly influenced by local supply and demand conditions, in addition to those for the world as a whole (as indicated by the divergence between WTI and Brent oil prices shown in Graph 3). This has weakened WTI’s status as a global benchmark. ...

Given that oil prices are essentially jointly determined in both the physical and financial markets, it is no easy task to disentangle the effect of each market in the price discovery process with any precision. Nevertheless, futures markets appear to play an important role in the pricing of oil, perhaps more so than for other commodities. Indeed, there is a view that crude oil price levels are essentially determined in the futures market.

This is clearest for WTI where PRAs identify the ‘physical’ price directly from the deep and liquid futures market, and where there is no significant parallel OTC market. It is less obvious, however, for Brent. While Brent forward prices are typically used by the PRAs to derive the Dated Brent price, as noted above Brent forward and futures markets are directly linked via EFPs. Many large oil market players reportedly hold Brent forwards and futures in their portfolios, arbitraging between the two instruments, such that the prices of Brent futures and forwards typically converge.

The complexity of the oil pricing arrangements makes it difficult to demonstrate convincingly that benchmark oil prices fully reflect physical supply and demand conditions rather than the actions of uninformed financial speculators. Nevertheless, movements over time in the price differentials for the various benchmark crudes are broadly consistent with changes in demand and supply. The Brent-WTI spread provides a good example of the influence of such factors on oil price differentials (Graph 6). Prior to 2011, Brent and WTI prices generally moved in tandem, with the spread largely reflecting the costs of transporting Brent-referenced crude oils to the United States. In recent years, however, increased volumes of crude oil from North Dakota and Canada have flowed into Cushing, leading to a build-up in inventories. Most pipelines flow from the rest of North America into Cushing, making it difficult to move the extra crude oil out of Cushing. This has led to persistent inventory bottlenecks, which have weighed heavily on the price of WTI over the past 18 months, leading the Brent-WTI spread to widen to US$10–30 per barrel.

The recent widening of the Brent-WTI spread is also likely to reflect concerns about declining production volumes in the North Sea. More transparent information about oil reserves, daily production volumes and demand-driven factors could assist more efficient pricing in the oil market. Information about the demand for oil is often not known until well after the period for which it is reported. On the supply side, there is ongoing concern regarding the accuracy of various countries’ reported production volumes, while oil reserve estimates are subjective and depend on partial information and project feasibility. There have been steps towards greater transparency in the oil market; for example, the Joint Organisations Data Initiative (JODI) was established in 2001 to provide accurate and timely crude oil data on production, consumption, trade, refining and inventories. Nonetheless, there is still scope to increase country coverage and data quality

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