Most investors think of oil in terms of spot and futures price. Commodities, by definition, describe a class of goods for which there is demand, but no qualitative differentiation. Silver is silver and it costs what it costs, as do pork bellies, oranges, peanuts and gold. Of course, the reality is a little more complex than that.
And when it comes to the price of oil? It's a lot more complex than that.
When you hear the words "Big Oil," companies like Exxon-Mobil (XOM), BP (BP), and Chevron (CVX) usually come to mind. But everything about oil is big. The value of annual crude oil production is double that of natural gas and coal, 4.5x that of rice, wheat, and corn put together, and 23x that of gold.
In its natural state, oil is one of the most diverse products on the planet. More than 300 different types of crude are produced around the world. Oil can be found at every depth, from shallow pits only a few feet deep to over to a vertical depth of 35,000 feet below sea level. Oil comes in a variety of colors and - if the industrial terms were taken literally - tastes. In color, "black gold" runs the gamut from nearly colorless to pitch black, with viscosity ranging from that of water to nearly solid.
In terms of price, the two most important characteristics are viscosity and sulfur content. The highest-value fractions of oil - gasoline, diesel and jet fuel - are most cost-effectively derived from the low density ("light") and low sulfur content ("sweet") crude, and are usually more expensive than their heavy and sour counterparts, as sulfur is a harmful pollutant that must be extracted.
Fig. 1: Crude Oils By Density, Sulfur Content
There is no single benchmark of oil, and therefore, no one price for any barrel of oil. Instead, oil is priced via a method known as "formula pricing." Formula pricing works by first assigning a benchmark price - such as Brent or West Texas Intermediate (WTI) - to a contracted amount oil, then adding or subtracting a number of assorted price differentials according to a checklist of criteria ranging from quality and transportation costs, to things like refining costs. For example, a barrel of light, sweet WTI is usually worth more than a barrel of sour Dubai Crude. However, the actual spread in price depends upon the supply and demand dynamics of the oil market at the time, as well as the location, the spare capacity of the refineries, and whether the refineries are capable of processing lower quality oil into higher quality petroleum products.
Oil companies often reference more than one benchmark price depending on the destination. In addition, the methods used by the PRAs to calculate WTI and Brent prices are different.
Historically, the prices for Western Texas Intermediate and Brent moved in tandem. That changed when oil volumes from Canada and North Dakota began to pick up, leading to bottlenecks in the refining hub of Cushing, Oklahoma. Unfortunately, the Cushing hub is asymmetric: more pipelines lead into Cushing than lead out. The closing of Valero Energy Corp.'s (VLO) McKee refinery has led to increased inventories in Cushing and significant downward pressure on WTI prices. Cushing is the southernmost hub of the proposed Keystone pipeline.
The pricing for West Texas Intermediate crude is refreshingly simple when compared to Brent. WTI is priced using a single instrument: the NYMEX Light Sweet Oil futures contract.
The WTI futures contract allows for physical delivery when left open at expiry, specifying 1,000 barrels of WTI to be delivered to Cushing, Oklahoma - although it also allows for the delivery of several other domestic and foreign light sweet crudes against the futures contract. However, only a very small proportion of WTI futures contracts are actually physically settled.
Reflecting the absence of a significant forward market, the PRAs' assessed physical 'spot' price for WTI is determined differently to that for Dated Brent. The 'spot' price for WTI reported by the PRAs is typically the most recent and representative NYMEX WTI front-month. At contract expiry, the PRAs' reported price reflects the new front-month futures price plus the 'cash roll' - the cost of rolling a NYMEX futures contract forward into the next month without delivering on it. Ta-da! You now have the price of a barrel of WTI.
Now here's where it gets complicated.
The Brent benchmark owes its existence to favorable tax regulations for oil producers in the U.K. (The name "Brent" itself is the result of the naming policy of Shell UK Exploration and Production, which named all of its fields after birds.)
Brent was originally traded on the open outcry International Petroleum Exchange in London, but since 2005 has been traded on the electronic IntercontinentalExchange, or ICE. One contract equals 1,000 barrels (159 m3). Contracts are quoted in U.S. dollars. Each tick lost or gained equals $10.
Being a seaborne crude, the forward contract for Brent involves trading in large volumes of oil (a standard Brent shipment is 600,000 barrels), which is beyond the capability of most small traders; as a result, very few traders participate in this market, with between 4 and 12 traders participating each day. In contrast, WTI is a pipeline crude with much smaller trading lots and a correspondingly greater number of participants in the physical market.
The volume of Brent crude has declined over time, resulting in three other North Sea crudes being added to the benchmark over the past decade in order to replace lost volume. If enough volume is lost, the usefulness of the benchmark is forfeit. (Incidentally, this is what happened to the Malaysian-Tapis benchmark.) The Brent benchmark now includes Brent, Forties, Oseberg and Ekofisk.
Fig. 3: Brent Production Volumes Over Time
Oil is priced according to both the financial and physical framework which surrounds it. Of the two crudes - Brent and WTI - Brent is by far the more difficult to price, which is one of the major reasons underpinning OPEC's preference for it. Pricing Brent crude involves multiple variables, including Dated Brent, ICE Brent futures and Brent forwards prices.
The matter is further complicated by the fact that Brent crude is priced differently, depending on the liquidity of the market.
Dated Brent - sometimes referred to as the 'spot' price for Brent - is the most commonly used reference price for the physical sale of oil by tanker. Dated Brent represents the price of a cargo of Brent crude oil that has been assigned a date, between 10-25 days ahead, for when it will be loaded and shipped to the purchaser.
Dated Brent pricing begins with the forward market. Brent forwards - known as 25-day BFOE - represent a physically deliverable over-the-counter contract, specifying the month (but not the actual date) in which the oil will be loaded onto a tanker for delivery. Buyers are notified of the loading date within 25 days of delivery. PRAs, like Platts, typically assess three Brent forward prices for a period of three months ahead. The PRAs then calculate the contract-for-difference, or CFD prices. The CFD price is a short-term swap between the floating price of Dated Brent on any given day and the fixed Brent forward price. By assessing weekly CFD values for eight weeks and combining the result with the second month Brent forward price, the PRAs construct a table of implied future Dated Brent prices for up to 8 weeks in the future. (i.e. Forward Dated Brent Curve)
Using this curve, the implied Dated Brent prices for the period 10 to 25 days ahead can be calculated - the average of which is known as the North Sea Dated Strip. Combining this with the grade differentials for each of the four crudes in the Brent basket gives an outright price for each of Brent, Forties, Oseberg and Ekofisk. The cheapest of which then becomes the final published daily quote for Dated Brent. This is typically Forties as it is the lowest quality of the four crudes in the Brent basket.
The linking of a Brent Futures contract with a Physical delivery converts the transaction to a 25 Day BFO Forward, which is an OTC settlement transaction. This 'conversion' is registered with the IPE and London Clearing House (LCH). After this registration the LCH no longer guarantees the settlement, and the contract does not 'cash settle' two days after trading ceases for such contracts.
Pricing Brent When Liquid
Pricing Brent When Illiquid
Occasionally, however, there is insufficient liquidity in the Brent forward market to use this as the starting point. In that case, the assessment instead starts in the futures market. As shown in Figure 2, a synthetic Brent forward price is derived by combining the ICE Brent futures prices with 'exchange of futures for physicals' (EFPs) values.
The ICE Brent futures contract specifies the delivery of 1,000 barrels of Brent crude oil at some determined future date. The contract is settled in cash, with an option for delivery via an EFP contract. Whereas futures contracts are highly standardized and traded on exchanges, EFPs are a more flexible contract that allow traders to convert a futures position into physical delivery, enabling traders to choose delivery location, grade type and trading partner. EFPs take place off-exchange, at a price agreed to by both parties.
Once a price for Brent forwards has been derived, the Dated Brent price can then be determined as before. While Dated Brent has traditionally been the most commonly used price in physical contracts, an increasing number of producers - including Saudi Arabia, Kuwait and Iran - have begun to adopt Brent futures prices as their preferred benchmark.
The most likely reason for this preference is the complexity of the Brent pricing system itself. By increasing the number of variables, a complex system invites uninformed speculators to mis-price the market, while the average movement over time of the price differentials allows OPEC to claim that the general trend is more or less consistent with physical supply/demand dynamics.
Many traders piled into oil futures recently on speculation that the post-Hurricane Sandy refinery shutdowns and increased uncertainty would put a premium on oil; in fact, the opposite occurred. The closing of the refineries increased oil inventories, which resulted in a plunge in the price of oil. In Sandy's case, the demand that oil traders were concerned about was that near term demand had taken a hit from the closure of the refineries. A refinery's demand for crude is not the same as consumer demand for fuel. There's even a "fuel crunch" in New York, but oil prices are still falling due to impact that all the damages caused by the Hurricane will reduce the amount the total miles driven.
Investors who are considering adding oil futures to their portfolio should make certain that they have a working understanding all the variables, pricing systems and methodologies involved in determining the price of a barrel of oil. Those variables include supply, chemical composition, demand curves, geopolitical tension, refinery closings, new pipelines being put in, new discoveries, depleted fields, "official" OPEC figures on proven reserves, analysts guesstimates on what those reserves may actually be, the weather, the liquidity of the Brent market, the price of Natural Gas, the survival or unstable regimes, the Cushing backlog, extraction technology, spill cleanup, and a host of other interlocking variables, all of which amount to the price per barrel of the most important and controversial energy source on the planet, without which the lights would go out, the V6 engines would lock up, hundreds of millions of people would starve or freeze, and civilization itself would grind to a sudden halt.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.