BL Oil & Gas History, Economics and Geopolitics OENA8433: Topic 4, Lecture 2: Oil Pricing

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CRICOS Provider No. 00126G copyright © The University of Western Australia
BL Oil & Gas History, Economics and Geopolitics OENA8433

Topic 4, Lecture 2: Oil Pricing
Dr. Karin Oerlemans
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Unit Overview
Topic 1: Introduction – The Founders
Topic 2: The Global Struggle
Topic 3: War and Strategy
Topic 4: Oil and Gas Economics
Lecture 1: Fundamentals of Oil and Gas Economics
Lecture 2: Oil Pricing
Lecture 3: Natural Gas Markets & LNG pricing
Lecture 4: Government Revenues and taxation
Lecture 5: OPEC - Oligopoly & Oil Shocks
Topic 5: Oil and Gas Technology in context
Topic 6: The Energy Industry Today
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Lecture Outcomes
Upon successful completion of this lecture you should be able to:
Describe how oil is priced
Describe some of the factors affecting crude oil pricing
Understand that prices of crude oil markers are affected by
many factors which can change over time
Comprehend that in order to provide adequate control for
producers and consumers and still allow the market to set
prices both physical and financial markets are required
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Recommended Reading
Any text on Economics would be suitable:
Gwartney, J. D., Stroup, R. L. & Stobel, R. S. (2000). Economics:
Private and public choice. Fort Worth, Tx: Dryden Press.
Sloman, J. (2006). Economics (6th edn.) Pearson Education.
Hannesson, R. (1998). Petroleum Economics. Westport,

Connecticut: Quorum Books.
http://www.turtletrader.com/beginners_report.pdf
http://www nymex com/media/energyhedge pdf
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Lecture Outline
Historical perspective
Crude Oil Pricing
Marker Crudes
Hotelling
Spot vs. Futures Price
How Spot Markets Work
How Futures Markets Work
Conclusions
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Historical Prices
http://www.exxonmobil.com/files/corporate/hjlslide6.pdf
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Crude Oil Pricing

Crude oil sold:
Physical Contracts
Spot markets
Futures markets
Affected by:
Demand/Supply
Cost of
exploration
extraction
production
dismantling production installations
freight rates
competition in the crude markets
competition in the regional and domestic markets for petroleum products
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Marker Crudes
West Texas Intermediate (WTI – NYMEX, NY, USA)
Futures trading – Contract size 1,000bbls Contracts/day 431,000
Brent (International Petroleum Exchange, London, UK)
Spot and forward trading
Limited futures trading – Contract size 1,000bbls Contracts/day
232,000
Price two thirds of the world's internationally traded crude oil
supplies
Dubai and Oman (Middle East)
Limited physical trading
Tapis (in Asia)
Independent panel
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NYMEX
New York Mercantile Exchange offers futures and options
contracts for:
Light sweet crude oil
Heating oil
New York Harbour gasoline
Natural gas
Electricity
Platinum
Futures for propane
Palladium
Sour crude oil
Gulf Coast unleaded gasoline
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Pricing of Physical Crude Oil Trades
Price Differentials
Formula approach :
Marker crude is used as the base
+/- a quality differential
+/- a demand/supply (premium/discount)
Tight supply will drag up the Marker crude price
Surplus supply will drag down the Marker crude price
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Hotelling
Price Theory and Non Hotelling Assumptions
Renewable Resources Fixed known resource stock
Constant technology
Hotelling’s rule Certainty and perfect foresight
Will future generations have non Competitive minerals market
renewable resources? Net price=rent=market price
Treat a mineral as an asset less extraction cost
All assets must earn the
prevailing rate of return
Assets not earning the
prevailing rate are converted
from mineral capital to financial
capital
Extraction today increases
scarcity and future values
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Hotelling
Outcomes Dead end!
Maximum return to resource Resource supply is not fixed
owners when the same net Technology changes
price (in present value terms) is Risky environment
charged in each period
This means the net price (in
dollars of the day) must rise by But the idea of a backstop
the rate of discount in each technology is good – limits
period extent of resource depletion
Treating resources as an asset
means there must be a return or
the asset is liquidated
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Spot vs. Futures Price

Spot prices – commodity sold at the market locations for
immediate delivery
Futures price – current market opinion of what commodity will

be worth in the future
Futures price = present spot price + “carry charges”
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How Spot Markets work
Are volatile
Only include real buyers and
sellers
Transactions usually made on a
one-time basis
Spot prices
At the short end of the market
type spectrum
Fixed by supply and demand at
the time of sale
Product is bought and sold with
near term physical delivery
Work on basis of electronic
trading with offers to buy and
sell displayed in the open
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Futures Markets
Organised exchanges in which standard contracts are bought and
sold for the future delivery of a commodity but delivery rarely occurs
The contract is settle financially
NYMEX (West Texas), IPE (Brent)
The financial transaction is a hedge against volatility in the spot
market
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How Forward Financial Markets Reduce Risk and Add
Value:
Significant, sometimes abrupt, changes in supply, demand, and
pricing are affected by:
International politics
War
Changing economic patterns
Structural changes
This creates considerable uncertainty as to the future direction of
market conditions
Uncertainty, in turn, leads to market volatility, and the need for an
effective means to reduce the risk of adverse price exposure
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Private and institutional investors who seek to profit by:
Assuming the risks that the underlying industries seek to avoid
In exchange for the possibility of rewards
Futures lend themselves to widely diverse participation and

efficient price discovery
To do this effectively, the underlying market must meet three

broad criteria:
The prices of the underlying commodities must be volatile
there must be a diverse, large number of buyers and sellers
the underlying physical products must be fungible, that is,
products are interchangeable for purposes of shipment or storage
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Futures contracts are firm commitments to make or accept
delivery of a specified quantity and quality of a commodity
during a specific month in the future at a price agreed upon at
the time the commitment is made
Eg 1000bbls of WTI oil in 90 days time
The buyer, known as the long, agrees to take delivery of the oil
The seller, known as the short, agrees to make delivery
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Only a small number of contracts traded each year result in
delivery of the underlying commodity (1%)
Instead, traders generally offset (a buyer will liquidate by

selling the contract, the seller will liquidate by buying back the
contract) their futures positions before their contracts mature
The difference between the initial purchase or sale price and

the price of the offsetting transaction represents the realised
profit or loss
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Futures Contango vs Backwardation Markets
Contango
Upward trend to the prices of distant contract months due to carry
charges
Backwardation
A nearby month trades at a higher price relative to the outer months
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Hedging
Establish a position in the
futures or options market that is
equal and opposite to a position
at risk in the physical market
The principle behind

establishing equal and opposite
positions in the spot and
futures or options (financial)
markets is that a loss in one
market should be offset by a
gain in the other market
Hedges work because spot

prices and futures prices tend
to move in tandem, converging
as each delivery month contract
reaches expiration
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Hedging Example
Receives $37/bbl Physical
Pays $37/bbl in
in Physical
Market Physical Market
Market
Month B Spot
Market Price
$37/bbl
Pays $6 to Receives $6
the Financial from
Supplier Market Financial Consumer
Market
Contract to sell Contract to

purchase 1000bbl
$ $
1000bbl at
Financial at $31/bbl Month A
$31/bbl in Month
A for Month B Market for delivery
supply in Month B
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Outcry Auction
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Outcry Auction
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Options
The purchase or sale of a right to buy or sell a commodity at a
given price
Traded in organised markets or
Over the counter (OTC)
Put option
The purchase of a right to sell a commodity (but not the obligation to
do so) at a given price before a given date but if the option is
exercised the buyer must buy
Call option
The purchase of a right to buy a commodity (but not the obligation
to do so) at a given price before a given date but if the option is
exercised the seller must sell
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Example: Crude Oil Producer Options
Producer agrees to sell 30,000 barrels a month for each of six
months at the Spot Market prices prevailing at delivery
When the Producer agrees to the deal, Spot Market prices are
$20.50 a barrel, but market conditions appear to be weakening
How can the Producer protect revenues against a decline?
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Crude Oil Producer Not Hedging

Relatively high spot prices case:
Spot Sales Spot Sales Unhedged

Date Volume Sold Price Received Price Required Sales Revenue
Jan 1st 30,000 $ 21.00 $ 20.00 $ 630,000.00
Feb 1st 30,000 $ 20.50 $ 20.00 $ 615,000.00
March 1st 30,000 $ 20.00 $ 20.00 $ 600,000.00
Apr 1st 30,000 $ 19.50 $ 20.00 $ -
May 1st 30,000 $ 19.50 $ 20.00 $ -
Jun 1st 30,000 $ 20.00 $ 20.00 $ 600,000.00
Unhedged
Sales Revenue $ 2,445,000.00
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Crude Oil Producer Not Hedging
Relatively low spot prices case:
Spot Sales Spot Sales Unhedged

Date Volume Sold Price Received Price Required Sales Revenue
Jan 1st 30,000 $ 20.00 $ 19.00 $ 600,000.00
Feb 1st 30,000 $ 19.50 $ 19.00 $ 585,000.00
March 1st 30,000 $ 19.00 $ 19.00 $ 570,000.00
Apr 1st 30,000 $ 18.50 $ 19.00 $ -
May 1st 30,000 $ 18.50 $ 19.00 $ -
Jun 1st 30,000 $ 19.00 $ 19.00 $ 570,000.00
Unhedged
Sales Revenue $ 2,325,000.00
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Crude Oil Producer Hedging

In the following scenarios, the oil producer initially establishes
hedges on December 1st for February, March, April, May, June,
and July (against January, February, March, April, May, and
June production)
Near-month futures positions are liquidated after a price

posting is established (normally on the first day of the calendar
month) Eg On December 1st near month is January 1st
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Relatively high posted and futures prices case:
Futures Result =
Spot Sales Futures Futures (Futures Contract - Net Price
Date Volume Sold Price Received Contract Buyback Futures Buyback) Received
Jan 1st 30,000 $ 21.00 $ 20.00 $ 20.50 -0.50 $ 20.50
Feb 1st 30,000 $ 20.50 $ 19.75 $ 19.75 0.00 $ 20.50
March 1st 30,000 $ 20.00 $ 19.50 $ 19.00 0.50 $ 20.50
Apr 1st 30,000 $ 19.50 $ 19.50 $ 18.50 1.00 $ 20.50
May 1st 30,000 $ 19.50 $ 19.25 $ 18.75 0.50 $ 20.00
Jun 1st 30,000 $ 20.00 $ 19.00 $ 19.50 -0.50 $ 19.50
180,000 $ 20.08 Average $ 20.25 Average
Unhedged Hedged Sales

$3,615,000.00 Sales Revenue $3,645,000.00 Revenue
Hedging Benefit: $30,000
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Relatively low posted and futures prices case:
Futures Result =
Spot Sales Futures Futures (Futures Contract - Net Price
Date Volume Sold Price Received Contract Buyback Futures Buyback) Received
Jan 1st 30,000 $ 20.00 $ 20.00 $ 19.50 0.50 $ 20.50
Feb 1st 30,000 $ 19.50 $ 19.75 $ 18.75 1.00 $ 20.50
March 1st 30,000 $ 19.00 $ 19.50 $ 18.00 1.50 $ 20.50
Apr 1st 30,000 $ 18.50 $ 19.50 $ 17.50 2.00 $ 20.50
May 1st 30,000 $ 18.50 $ 19.25 $ 17.75 1.50 $ 20.00
Jun 1st 30,000 $ 19.00 $ 19.00 $ 18.50 0.50 $ 19.50
180,000 $ 19.08 Average $ 20.25 Average
Unhedged Hedged Sales

$3,435,000.00 Sales Revenue $3,645,000.00 Revenue
Hedging Benefit: $ 210,000
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Summary:
Not Hedging
Relatively high spot prices case: $2,445,000.00
Relatively high spot prices case: $2,325,000.00
Hedging
Relatively high posted and futures prices case: $3,645,000.00
Relatively low posted and futures prices case: $3,645,000.00
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Summary:
Producer revenue is protected from the full brunt of a declining
market because in a surplus crude market spot prices generally
fall faster than postings
NB. When spot prices are lower than the minimum economic
level for the field the producer may withhold production
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In Summary
Prices of crude oil markers are affected by many factors which
can change over time
In order to provide adequate control for producers and
consumers and still allow the market to set prices both
physical and financial markets are required
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Lecture Conclusion
This is the end of lecture 2, topic 4
You may now progress to Lecture 3, Topic 4
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CRICOS Provider No. 00126G copyright © The University of Western Australia

BL Oil & Gas History, Economics and Geopolitics OENA8433

Dr. Karin Oerlemans

CRICOS Provider No. 00126G copyright © The University of Western Australia

 Hannesson, R. (1998). Petroleum Economics. Westport,

Crude Oil Pricing

Spot vs. Futures Price

 Futures price – current market opinion of what commodity will

 Futures price = present spot price + “carry charges”

How Futures Markets Work

 Futures lend themselves to widely diverse participation and

 To do this effectively, the underlying market must meet three

 The seller, known as the short, agrees to make delivery

How Futures Markets Work

 Instead, traders generally offset (a buyer will liquidate by

 The difference between the initial purchase or sale price and

 The principle behind

 Hedges work because spot

Contract to sell Contract to

 How can the Producer protect revenues against a decline?

Crude Oil Producer Not Hedging

Spot Sales Spot Sales Unhedged

Spot Sales Spot Sales Unhedged

Crude Oil Producer Hedging

 Near-month futures positions are liquidated after a price

Unhedged Hedged Sales

Hedging Benefit: $30,000

Crude Oil Producer Hedging

Unhedged Hedged Sales

Hedging Benefit: $ 210,000

Crude Oil Producer Hedging

Anda mungkin juga menyukai

Hannesson, R. (1998). Petroleum Economics. Westport,

Futures price – current market opinion of what commodity will

Futures price = present spot price + “carry charges”

Futures lend themselves to widely diverse participation and

To do this effectively, the underlying market must meet three

The seller, known as the short, agrees to make delivery

Instead, traders generally offset (a buyer will liquidate by

The difference between the initial purchase or sale price and

The principle behind

Hedges work because spot

How can the Producer protect revenues against a decline?

Near-month futures positions are liquidated after a price