oil physical and financial markets: economics, engineering, pricing, and regulations

Oil Physical & Financial Markets: Economics, Engineering, Pricing, and Regulations

Created By Kevin P. Kane

http://www.quotationspage.com/quote/32966.html

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


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


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


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


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



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


Firm Level: Refinery Crude Yields


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




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


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


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)


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”


Economic Level: Inelastic Demand


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


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


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?

oil physical and financial markets: economics, engineering, pricing, and regulations

Documents

2008investment

price discovery

oil prices

futures market

month contracts

swap dealers

cumulative

monthly limits