oil physical and financial markets: economics, engineering, pricing, and regulations
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Oil Physical & Financial Markets: Economics, Engineering, Pricing, and Regulations
Created By Kevin P. Kane
Background
Oil Futures Fundamentals
Oil Physical Fundamentals
Speculation Debate
New CFTC Rules
I
III
II
IV
V
CONTENT
Conclusion
VI
Derivatives
VII
Background
Oil PricesA
I
Jan-80
Feb-81
Mar-82
Apr-83
May-84
Jun-85Jul-8
6
Aug-87
Sep-88
Oct-89
Nov-90
Dec-91
Jan-93
Feb-94
Mar-95
Apr-96
May-97
Jun-98Jul-9
9
Aug-00
Sep-01
Oct-02
Nov-03
Dec-04
Jan-06
Feb-07
Mar-08
Apr-09
May-100.00
20.00
40.00
60.00
80.00
100.00
120.00
140.00Real Oil Price (2008)WTI
Background
Oil PricesA
I
O p
P o
1
2
3
4
S 2D 1 D 2D3
(1998) $20
(2008) $100
(2009) $50
Oil Supply and Demand Shifts: 1998 -2008Av
erag
e A
nnua
l Rea
l Pric
e
S 1
60% of all new oil discoveries are offshore
Oil Supply Concerns
09-2008 drop in price largely reflected drop in demand
Expected 2030 Demand Creates Uncertainties in Supply
$70 per barrel to receive same profit as $30 per barrel several years ago
Excess Capacity Almost Exceeded in 2008. New Production Growth Slow
Inexpensive Recoverable Oil Gone. Capital Intensive Oil Remaining
Crude Quality Decreasing (API & Sulfur) – Refinery Margin Decreasing
Optimists and Pessimists Politicize Oil Price Debate
이연희
Oil Physical FundamentalsII
BACKGROUND
Three Aspects Reviewed
Firm LevelPrice Discovery: Firms, Fundamentals, & Distortions
Economic LevelDemand• World GDP• Inventory vs.
Reserve• Short Term
Inelasticity• Expected DemandSupply• Production• Excess Capacity• Proved vs. Probable• Offshore vs. Onshore• InelasticityInterest and Ex Rates• ∆R → ↑ or ↓Op
• ↓$→↑$ex →↑Cf→↑Odw
• ↓$ →↓O-Expp→↑Scut
Distortion Level
Supply Side• Concerted
Production• CollusionDemand Side• Subsidies• Price Ceiling• MS ExpansionUncertainty – Politics• Supply Disruption• Nationalization • Transit Monopolies
E&P Firm Costs• Exploration • Development• Production Upstream Factors• Geology• Drive Mechanism• Recovery Factor• Reserve
Classification• R/q Ratio Downstream Factors• Refinery Capacity• Refinery Margin• API – Sulfur Content
Oil Physical FundamentalsII
Proved Reserves (≥ 90)
Probable Reserves (> 50%)
Possible Reserves (< 50%)
Reserves which on the available evidence are 90% certain to be technically and economically producible
Reserves which are not yet proven but which are estimated to havegreater than 50% chance of being technically & economically producible
Reserves which at present cannot be regarded as probable but which aresignificant but less than 50% chance of being technically producible
Oil Physical FundamentalsII
Seismic Survey & Soil Sample
Firm Level – Understanding Definitions
Seismic Survey & No Soil Sample
Seismic Survey & Soil Sample
Q
Q = Liquid Hydrocarbons Produced
Time
QEL = Economic Limit where if one goes below this line they do not sell enough to cover their operating costs
Est. QEL
Example of Remaining Oil Reserves if Produced to this point
30% to 90% of Oil in Place (OIP) is Left in the Ground
Unrecovered Oil
Reserves Are NOT SUPPLY – Expected Incremental SupplyOil Physical FundamentalsII
Firm Level - Reservoir EconomicsR/q Critical Ratio (15-10) equally important as MC & S&D in Determining Production Levels
Oil Natural Gas
Oil Expansion 2 to 5
Gas Expansion 70 to 95
Solution Gas 10 to 30
Gas Cap 20 to 50
Gravity Segregation 30 to 70
Water Drive 20 to 50 45 to 70Pay Zone
WaterGas Cap
SurfaceDerrick
Oil Physical FundamentalsII
Saudi Arabia Conspiracies Debunked: Water Drive and Conning
Firm Level - Natural Drive / Recovery
Natural Drive Type Recovery Percentage
Recovery Estimation MethodsOil Physical FundamentalsII
Recovery of Oil: Delicate Business
Oil in Place
Volumetric MethodMaterial Balance
Estimation is not an exact science and is subject to potential abrupt changes in expected recovery and production levels: changes in pressure, water entry, et al.
Total hydrocarbon content in an oil reservoir, referred to as Stock Tank Original Oil In Place (STOOIP) = Bulk (rock) volume (acre-feet or cubic meters) = Fluid-filled porosity of the rock (fraction) = Water saturation - water-filled portion of this porosity (fraction) = Formation volume factor (dimensionless factor for the change in volume between reservoir
and standard surface conditions)
Decline Curve Analysis
Oil Physical FundamentalsII
Primary Recovery – Sucking & Pulling
Sucker Rod Pumps, Plunger Lift Pumps, Hydraulic Lift Pumping, Progressing Cavity Pumps, Gas Lift Pumps, Electric Submersible Pumps (ESPs)
Water Flooding (Most Common), Gas Reinjection
Create Fractures (Permeability) & Pumping Inert Gas (Displacing Oil) & Lowering Viscosity
Hydraulic Fracturing, Acid Fracturing, Miscible Fracturing, Thermal Recovery, Chemical Flooding, In-Situ Combustion, Microbial EOR
Secondary Recovery – Increase Reservoir Pressure
Enhanced Oil Recovery (EOR)– Tertiary Production
Firm Level - Natural Drive – Recovery Factor
Measure of the relative Density of Oil (Higher Figure = Better)
Tell us how much Sulfur will need to be separated from the oil
API Gravity (Specific Gravity
Sulfur Content
Two Factors
Firm Level – Changing Oil
Oil Physical FundamentalsII
Oil Physical FundamentalsII
1/1/1
995
8/1/1
995
3/1/1
996
10/1/1
996
5/1/1
997
12/1/1
997
7/1/1
998
2/1/1
999
9/1/1
999
4/1/2
000
11/1/2
000
6/1/2
001
1/1/2
002
8/1/2
002
3/1/2
003
10/1/2
003
5/1/2
004
12/1/2
004
7/1/2
005
2/1/2
006
9/1/2
006
4/1/2
007
11/1/2
007
6/1/2
00829.5
30
30.5
31
31.5
32
1.05
1.1
1.15
1.2
1.25
1.3
1.35
1.4
1.45
1.5U.S. Weighted Avg Crude Import Quality
API Sulfur
API
- 24
to 3
4 =
Med
ium
Cru
de
Sulfu
r Con
tent
Decreasing Quality Decreasing Quality
Firm Level: Crude Quality & Yields
CRUDE TYPES CHARATERISTICS YIELDS US REFINERY
MEDIUM SOUR CRUDE
(Mars, Basrah, Arab Medium)
HEAVY SOUR CRUDE
(Maya, Ratawi, Venezuela)
SWEET CRUDE(Bonnie Light)
34 + API<0.5% Sulfur
Inexpensive to Refine and Sold at a High
Price
24 - 34 API> 1.0 % Sulfur
More expensive than “Sweet” to refine and
sold for less
< 24 API> 1.0 % Sulfur
Least Ideal
33%
34%30%3%
50%
26%22%3%
63%
22%14%1%
8% Propane/Butane
49% Gasoline: Conventional,
CARB, Premium
32% Distillate: Jet Fuel, Diesel,
Heating
11% Heavy Fuel Oil & Other
Oil Physical FundamentalsII
Firm Level: Refinery Crude Yields
Oil Physical FundamentalsII
2005 2006 2007 20080.00
5,000.00
10,000.00
15,000.00
20,000.00
25,000.00
30,000.00
35,000.00
40,000.00Long Term Investment-Financial Statements
XOM Chevron Shell Total S.A. BP
Mill
ions
Economic Level: Investment Trends
Oil Physical FundamentalsI
198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004200520062007
0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
80.0
90.0
100.0
0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
80.00
90.00
FRS Worldwide Expenditure E-D-P
Exploration Development Production 2008 WTI
Billi
ons
Inve
sted
Oil
Pric
e (2
008)
If we considerExpected De-mand and Need for Future Supply, Price is too Low at
$20 to $40 per barrel
Declining either because of E&P ROI from 1990s,
or increasing MC from offshore
Economic Level: Investment Trends
Oil Physical FundamentalsI
Economic Level: Investment Trends
O p
1
2
3
4
S 2D1
D 2D3
(1998) $20
(2008)$100
(2009)$50
Impact of Cross Oil Price Elasticity of Energy R&D Demand
P & D Investment, Exp?
(1999)
(2010)
(2009) Est. One + Year Lag
S 1
-0.06
-0.04
-0.02
0.00
0.02
0.04
0.06
0.08Production Changes Compared: Canada to OPEC
Prod_Canada Prod_Opec
Prod
uctio
n Pe
rcen
tage
Cha
nge
Oil Physical FundamentalsII
Cutting Production when price falls is natural economic behavior due to marginal costs—something not specific to only OPEC
Economic Level: Production & Marginal Costs
이연희
Jan-03
Apr-03
Jul-03
Oct-03
Jan-04
Apr-04
Jul-04
Oct-04
Jan-05
Apr-05
Jul-05
Oct-05
Jan-06
Apr-06
Jul-06
Oct-06
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Apr-08
Jul-08
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
0
1
2
3
4
5
OPEC Spare Capacity
Algeria Angola Ecuador Iran Iraq Kuwait Libya Nigeria Qatar Saudi Arabia United Arab Emirates
Mb/
d 2008-9 Financial Crisis
Oil Physical FundamentalsII
M
arginal Costs - Risk - W
orld GDP
Spare Capacity – Production – Reserve Discovery - Exchange Rates
Critical & Unique Period for Low Spare Capacity
due to Expected Demand
Economic Level: Spare (Excess) Capacity
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
0.00
10,000.00
20,000.00
30,000.00
40,000.00
50,000.00
60,000.00
2200.0
2400.0
2600.0
2800.0
3000.0
3200.0
3400.0
3600.0
3800.0
4000.0
4200.0World GDP = Oil Production
World GDP Billions World Production Tonnes
Wor
ld G
DP
(200
8) B
illio
ns
(Wor
ld O
il Pr
oduc
tion
Tonn
es (M
illio
ns)
Oil Physical FundamentalsII
Economic Level: Supply & Demand
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 20080.0
200000000.0
400000000.0
600000000.0
800000000.0
1000000000.0
1200000000.0
165000000
215000000
265000000
315000000
365000000
Oil Consumption
NA Total Europe & Eurasia China
Tonn
es o
f Oil
Cons
umed
Tonn
es o
f Oil
Chin
a
China’s anti-free market subsidy policies may have caused the 2004 to 2008 Price Spike. Without Subsidies, China’s consumption and GDP would have slowed, reducing demand, and moving equilibrium down more smoothly.
More InelasticWhy?
China’s Fuel Subsidies are 1% of GDP, “Morgan
Stanley”
Oil Physical FundamentalsII
Economic Level: Inelastic Demand
Oil Physical FundamentalsI
1/1/1
982
1/1/1
983
1/1/1
984
1/1/1
985
1/1/1
986
1/1/1
987
1/1/1
988
1/1/1
989
1/1/1
990
1/1/1
991
1/1/1
992
1/1/1
993
1/1/1
994
1/1/1
995
1/1/1
996
1/1/1
997
1/1/1
998
1/1/1
999
1/1/2
000
1/1/2
001
1/1/2
002
1/1/2
003
1/1/2
004
1/1/2
005
1/1/2
006
1/1/2
007
1/1/2
0080
20
40
60
80
100
120
140
0
2
4
6
8
10
12
14
16Federal Funds Rate & Oil Price
Real Oil Price WTI (2008) Federal Funds Rate
Real
Oil
Pric
e W
TI (2
008)
Fede
ral F
unds
Rat
e
Economic Level: Oil Priced in Dollars
DERIVATIVESIII
Derivatives: Futures & OTCHedge Risk Contracts For Future Price: Futures, Credit Default Swaps, Interest Rates, Exchange Rates, OTC, et al.
Derivatives Traded Between 2 Parties Outside of “Transparent, Organized Market Structures” such as NYMEX—a central exchange or trading venue.
Over-The-Counter (OTC) Derivatives
Calls, Puts, Premium: $300 Trillion Dollar Market
Commodity Swap Dealers offer tailored swap contracts to client OTC Markets. Limiting unmatchable contract exposure requires futures markets
Clearing HousesClear the agreement to accept a future delivery of oil through a futures contractOften settled in cash rather than physical delivery. 03–08 only 2% physical delivery
Hedging Risk
Oil Futures FundamentalsIV
Oil Futures
Price Discovery
Short & Long Term
Trader Classifications
Position Limit
CFTC
Price DiscoveryInformation Sharing and Equilibrium – one world oil priceOne countries oil supply gain, is everyone’s gain
Oil Futures FundamentalsIV
Futures Market – NYMEX (DCM), ICE (ECM)A Contract to Receive Delivery of a Commodity at a Future Date: Paper Oil – less than 1% Physical
A Forward CurveContango versus Backwardation Intermonth Spread (Switch) – Full Carry + Forward Curve (In Contango)
Primary Functions
Economics of Futures
Oil Futures Market
“In first 10 months of 2009, more than 114 million (114 billion barrels at $1.6 Trillion dollars) WTI contracts were traded on CFTC-regulated exchanges.” Gary Geisler
Oil Futures FundamentalsIII
4023840269
4029940330
4036040391
4042240452
4048340513
4054440575
4060340634
4066440695
4072540756
4078740817
4084840878
$78.00
$79.00
$80.00
$81.00
$82.00
$83.00
$84.00
$85.00
$86.00
$87.00
WTI Crude Futures - Contango
WTI Crude Futures - C...
Oil
Futu
res i
n $
Back of the Curve
Front of the Curve
Forward Curve - Term Structure
Intermonth Spread
Months ForwardToday - Cash
Oil Futures Market
Speculator 1: Scalpers or Market MakersOperate Shortest Horizon, sometimes trading within seconds. Do not trade with a
view of where prices are going. CFTC Interim Report
Oil Futures FundamentalsIV
Speculator 2: View of Long TermAnticipate prices in minutes, hours, days, weeks, or months = make price discovery
HedgersCommercial Interests. If one holds physical inventory but does not hedge by going short, will with hold downward pressure on prices
Commercial Traders
Non-Commercial Traders
Oil Futures Market
COT ReportCFTC Publishes every Friday at 3:30 PM Eastern Time. 90% of all Open Interests! Contains a summary of traders’ positions as of the close of business on previous Tuesday for each market in which 20 or more traders hold positions equal to or above the large trader reporting levels established by the CFTC
Oil Futures FundamentalsIII
CFTC: Commodity Futures TRADING Commission
Regulating Certain Markets for Risk Management Contracts (Derivatives)
REGULATORS
Oil Futures Market
Speculation DebateV
WTI Average Open Interest by Non-Commerical Participants, 2003-2008
Investment Banks & Speculation
Speculation DebateV
WTI Average Open Interest by Commercial Participants, 2003-2008
Investment Banks & Speculation
Speculation DebateV
2005.03.152005.08.162006.01.172006.06.202006.11.212007.04.242007.09.252008.02.262008.07.292008.12.302009.06.022009.11.030
50,000
100,000
150,000
200,000
250,000
300,000
350,000
0
2
4
6
8
10
12
Total Positions With Options: Bias Result
WTI 선물 Net Buying Positions-O
CFTC
Dat
a: N
et B
uyin
g W
/Opti
ons
WTI
Oil
Long Positions alone appear to move up before prices, but to be non-bias, we must include short positions as well. A non-bias result with both
short and long positions is in the next slide. Short positions cancel out Long
Long Positions & Oil Prices
Speculation DebateV
2005.03.152005.11.082006.07.032007.02.272007.10.232008.06.172009.02.102009.10.060
50,000
100,000
150,000
200,000
250,000
0
2
4
6
8
10
12
Net Buying With Options: Non-Bias Result
WTI 선물 Net Buying Positions-O
CFTC
Dat
a: N
et B
uyin
g W
/Opti
ons
WTI
Oil
Going Short by mid-
2007
No effect of Goldman Sachs March 2007 $200 Prediction. Reasonable prediction if a War with Iran broke out!
Long and Short Positions & Oil Prices
Speculation DebateV
Oil Price Schools of Thought & Primary PlayersOil Prices 04-08
Increase ArgumentsDemand & Supply
Reserves/ Discovery Declining
Marginal Costs
Optimists Oil Peakers Downstream LobbyistsGovernments
SpeculatorsFundamentals
Distortions
Excess Capacity
US Fed Rate - $ Value
Speculation
Oil Peak
0
KEY Accept Partially Accept Reject
US, JP, KR EU
Oil Prices, Bias, and Political Lenses
SPECULATION DEBATEV
INTERESTS
Where is the Absolute Answer to Oil Prices?
(1) Want to cover MC and generate capital for investment.(2) Want to avert demand destruction
(1) Long Term View of Oil & Energy(2) Change Consumer Behavior(3) Sustain Globalization0
(1) Realize Low Prices(2) Sustain Popularity(3) Show people they are doing something
(1) Hedge Risk(2) Price Discovery(3) Speculators: Price Changes
Dishonest Governments Honest Governments
Oil Producers Oil Traders
Truth?
Jeffrey Harris, Chief Economist at the CFTC, quit his post in January after finding no evidence that speculation played a role in driving up oil prices.
SPECULATION DEBATEV
SPECULATION EVIDENCECFTC Chief Economist
SpeculationEvidence
Commodity Trading Regulation
Low Price Elasticity coupled with Insufficient Production Increases caused the 2007 to 2008 price increases rather than speculation
James Hamilton, EconomistSpeculation
Evidence
“We do not need to show excessive speculation is affecting prices in order to approve the rule.”(Position Limits, et al.)
CFTC OfficialsSpeculation
Evidence
If a contact traded in an Exempt Commercial Market (ECM) is found to influence price discovery, the ECM is subject to heightened regulation and to comply with Futures Contract principles
New CFTC RulesVI
ENACTED REGULATIONS
Strengthen CFTC Authority over Futures Market(H.R. 6124) Farm Bill, 2008
Enacted
Commodity Trading Regulation
(1) Wall Street Wide Spreads from Lack of Buyer-Seller transparency (2) Concentrated with 6 to 15 Institutions worldwide(3) want to control for potential risks from interconnectedness.(4) Transparency To Public & Regulatory Body = Better Pricing
New CFTC RulesVI
PROPOSED REGULATIONS
Move To Standard OTC transactions into clearing housesOver-The-Counter (OTC) Derivatives
SupportingArgument
Option premium costs change with changes in underlying futuresprices rather than options being a part of price discovery themselves. So option prices are derived from futures prices rather than setting futures prices - hence options are called derivatives.”Morgan Downey, Commodity Trader
OpposingArgument
Fear vs. Empiricism
(1) The CFTC Voted 4 to 1 (01-14-10) to put proposal out for 90 day public comment period to cap traders for all-monthly limits at 10% of the open interest of the first 2.5% open interest beyond 25,000. The single-month would limit 2/3 of the aggregate capcap traders for all-monthly limits.(2) Caps Will covering individual exchanges, spot-month contracts, all-month contracts, and would include a cumulative gap across U.S. exchanges.(3) Limits on Who is Exempt (Airliners Exempt) from position limits
New CFTC RulesVI
PROPOSED REGULATIONSPOSITION LIMITS
Proposed
A Punishment Without a Crime
• Individual exchanges: ICE and CME separately• Spot month: the month nearest to expiry• All Contract months: all months listed into the future on the futures
exchange• Cumulative gap across U.S. exchanges: CME and ICE together• Position Limit: A limit is X futures contracts * 1000 barrels
Terms Explained
(1) Removes Concentration in Futures Market away from a Few Major Participants, Including Goldman Sachs.
(2) Curtails Momentum on Long Positions
New CFTC RulesVI
PROPOSED REGULATIONSPOSITION LIMITS
SupportingArgument
No evidence concentration of a few players in the futures markets influences momentum of price discovery into one direction, and against market principles to suggest that it is inappropriate for asomeone to exercise their right to make money from price changes. People should not have a natural entitlement to be free from competition with successful banks. It is not the role of government to prevent losers in the free market.
OpposingArgument
Flawed Premise
(1) Under the aforementioned February Proposal, Swap Dealers will No Longer Receive Confidential Hedge Exemptions. This proposal targets 10 large traders across oil, natural gas, heating oil, and gasoline markets, some of whom could qualify for exemptions. (2) Swap Dealers would instead would need “risk management” exemptions, that would be reviewed monthly by the commission and made public after six months
New CFTC RulesVI
PROPOSED REGULATIONSHEDGE DISCLOSURE EXEMPTIONS
Proposed
Market Intervention
(1) Increases Transparency & Reduces Market Information Deficitfor Price Discovery
(2) Increases Public Access to see Scope and Scale of Markets
(3) Eliminates Information Deficit for regulators, allowing them to gather information necessary to police markets
New CFTC RulesVI
PROPOSED REGULATIONSTRANSPARENCY
SupportingArgument
(1) Since it may not be possible for the OTC market to influence pricediscovery, and since their prices are determined by the Futures Market,the effort will not achieve its insinuated aims. It is misleading to thepublic.(2) The public has no inalienable right to obtain market information acquired by banks since they invested capital to obtain that information. The belief that people are entitled to information is flawed.
OpposingArgument
Immoral Entitlement
CONCLUSIONVII
Who is behind high oil prices?
(1) OPEC, Wall Street, Corrupt Banks? No! (2) Oil Supply & Demand Fundamentals? Yes!
(3) Energy Price Ceilings & Control? Yes!(4) The Average Consumer? Yes!
(5) Government Social Policies Promoting Demand? Yes!
Cure the Disease, not the Symptom!
CONCLUSIONVII
Oil Prices & Globalization
Banks, OPEC, Oil Companies, are not the source of oil price instability!
Prioritize Long Term Over Short TermEducate Populations! Don’t prey on them for Votes!
Recognize that in a Financially and Economically Integrated World,Energy Independence is Impossible!
Denationalize our View of Energy Security & OilOil is Not a Public or National Good
If the intention of regulation speculators is to appease angry voters or to suppress oil price, it is wrong, and could lead to a price spike at a later date!
CONCLUSIONVII
Drafted and Presented by Kevin P. Kane
QUESTIONS?
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