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PUTTING A PRICE ON

ENERGY
From A Book Entitled Putting a Price on Energy: Oil
Pricing Update by Energy Charter Secretariat (2011).
BY
Dr. BHAWANISINGH G. DESAI

GLOBAL OIL TRADE

INTRODUCTION
Oil is the most important energy source, accounting
for more than a third of the world primary energy mix.
Crude oil is a global commodity.
It has been traded internationally since soon after the
modern oil industry started in Pennsylvania, the US, in
the 1860s.
Oil trading has come a long way from
the stable, controlled system of the Majors, which ended in
the late 1960s,
OPECs quota system in the 1970s and the first half of the
1980s,
market mechanism starting in the mid-1980s.

INTRODUCTION
There are over 130 crude grades around the world.
However, crude oil itself has almost no direct end use.
Crude oil needs to be refined into petroleum products (gasoline
(petrol), heating oil and other) to be consumed.
It is the total value of the products processed from crude (called
gross product worth or GPW) that determines the crude value.
This does not mean that product prices set crude prices. The
two are interactive.
From the refiners viewpoint, GPW defines the upper limit of
crude price.

Introduction Contd.
FOB (Free on Board) is a price for crude or
products at the loading port.
while CIF (Cost, Insurance and Freight) is a price
for crude or product at the destination.
Buyers have to pay the additional costs of
transport when buying crude or products at a
FOB price,
while In CIF prices include costs of transportation.
Furthermore, the timing of the pricing is different.
FOB prices are taken on the loading date
CIF prices on the unloading date.
It is more common for crude to be traded at a
FOB price and for products at a CIF price.

Oil Trading - Evolution


Pre OPEC

Not much trading


Domination by seven sisters
Integration across supply Chain
Stable oil prices

Formation of OPEC

Post OPEC

Large imbalances
between consuming
Split in control of producing assets
Split in refining & marketing assets
and producing
Trading evolved in big way
regions - huge
Volatility in oil market
trading potential

OPEC
What is OPEC?
The Organisation of Petroleum Exporting
Countries (OPEC) is a voluntary Organisation
with objective to
Co-ordinate and unify petroleum policies
among Member Countries, in order to
secure fair & stable prices for producers
regular supply of petroleum to consuming
nations;
fair return on capital to those investing in
the industry.

Why was it formed?


Cheap oil flowing from Russia.
Western companies having oil fields in Middle
East, etc. cut oil prices affecting revenues of
those countries.

Algeria 1.36

Ecuador 0.52 OPEC

MEMBERS AND
PRODUCTION
QUOTA (MMBPD)

Indonesia 0.87
Iran

3.82

Kuwait

2.53

OPEC

Libya

1.71

Nigeria

2.16

Qatar

1 Saudi
Arabia

0.83

Saudi Arabia
UAE

Founder members

8.94

2. Iran

2.57

Venezuela

3. Iraq

2.47

4. Kuwait

Iraq
Angola

1.90

Source : IEA

5. Venezuela

Classification of Oil Trade


EXCHANGES

PAPER

OTC
OIL TRADE

PHYSICALS

th physicals and paper market trades important in price discove

Over-the-counter (OTC) or off-exchange trading is done


directly between two parties, without any supervision of
an exchange. It is contrasted with exchange trading,
which occurs via these facilities. An exchange has the
benefit of facilitating liquidity, mitigates all credit risk
concerning the default of one party in the transaction,
provides transparency, and maintains the current market
price. In an OTC trade, the price is not necessarily made
public information

Benchmark Crude
A benchmark crude grade serves as the reference for other crude grades of similar
qualities and locations.
Arabian Light with its 5 MBD production volume, was the benchmark crude
under OPECs official selling price system.
WTI was selected as the reference grade when the New York Mercantile
Exchange (NYMEX) launched the crude oil futures trading in 1983.
Dubai displaced Arabian Light as the Middle East bench marker in the spot
market in the late 1980s.
Dubai now faces a problem of declining physical production.
As a result, Oman plays an increasingly important role in the region and Oman in
combination with Dubai is linked to other Middle East crude.
Crude from various fields in Russia and the former Soviet republics is mingled when
transported by Transnefts pipeline system and becomes the Urals grade.

There are other regional benchmark grades, such as Tapis (Malaysia), Minas (Indonesia) and Bonny Light
(Nigeria). The Tapis field off Malaysia is operated by Exxon, and Malaysias state-owned Petronas is a
regular seller of spot Tapis.
Indonesian Minas is also traded regularly in the spot market.

Crude oil classification


API Gravity Measure of the
gravity of oil
API gravity = 141.5/(SG at 60 deg F)
-131.5
Based on API gravity a crude oil is
called light, medium or heavy

Sulphur content
Low Sulphur (referred to as sweet in
trade circles)
High Sulphur (referred to as sour in
trade circles)

CRUDE OIL TRADING


MECHANISM

Types of Crude Transactions


Barter Deal
Barter deals remain important. The transactions typically involve trading of
crude oil or petroleum products in exchange for goods, services or finances.
E.g. : Middle East

Cargo Transaction
Spot and forward contracts are based on cargo-by-cargo transactions
Forward transactions: 1 to 3 months
Spot transactions: 15 days to Maximum 1 month

Long/Short-Term Contract
OPEC developed long-term contracts in crude trading
OPEC countries in the Middle East sell their crude exclusively to refiners
through long-term contracts.
long-term contracts guarantee market access for their crude
A party assumes a long position in the futures market when it agrees to
buy an underlying asset on a certain future date for a certain specified
price.
Conversely, when a party agrees to sell an underlying asset on a certain
future date for a certain specified price, the position it assumes is called
short

CRUDE OIL TRADE


OIL TRADE

TERM
CONTRACTS

TENDERS/SPOT
MARKET

TERM

MONTHLY

Indian Crude Oil Basket


Comprises three marker crude oil
grades:
Dubai (Sour grade)
Oman(Sour grade)
Brent Dated (Sweet grade)

Indian Basket

Dubai & Oman


Average 62.3%

Brent (dated)
37.7%

Oil Trading Market


Structure
O w n e r s h ip

N O C s
G o v t. o w n e d

O il M a jo r s /
S u p e r -m a jo r s

In d e p e n d e n t
O il C o m p a n ie s
U S te m in o lo g y

O il P r o d u c e r s
O x y , C o n o c o , e tc

O il R e fin e r ie s

T r a d in g c o m p a n ie s
L ittle o r n o p h y s ic a l
a s s e ts

Global Crude Oil Markets


SOUTH
AMERICA

MIDDLE
EAST

NORTH
SEA

FAR EAST

CRUDE OIL
MARKETS

US
MARKET

CIS

W AFRICA

CENTRAL
AMERICA

Oil Exports Market Structure


Implications for trading
Middle east:
Dominated by National Oil
Companies viz. Saudi Aramco,
ADNOC, NIOC, KPC, SOMO, etc.
Crude oil usually sold on term
contracts only.

Europe
UK/Norway large exporters Statoil, NOC of Norway, a key
player. UK producers are private
companies

Oil Exports Market Structure


Implications for trading
West Africa:
Usually a 50/50 JV between National
Oil Companies & MNCs
Crude oil finds its way into spot
market

South & Central America:


Venezuela & Mexico major exporters NOCs of respective country play a
major role in exports
Sold on term as well as spot basis.

North America:

Risk Profile Major Oil


Exporters
High

Iraq
Yemen

Medium
High
Medium
Medium
Low

Indonesia

Angola
Russia Nigeria

Vietnam

Algeria

Iran

Libya

Venezuela

Malaysia
S.Arabia
Egypt
Kuwait

Columbia

Oman

UAE
Qatar

Mexico

Low
UK

Distance from India

Norway

Canada

there is an inherent tendency for oil and for gas markets to move towards
more competitive structures (with contractual structures and pricing
mechanisms corresponding to the particular stage of market development).

INTERNATIONAL OIL
PRICES

Prices are market determined the


prices are transparently decided in
the market.
INFLUENCING FACTORS..
Supply and demand fundamentals
OPEC policies
Political/economic developments
in the exporting / consuming
countries
Weather conditions
Alternative fuels (natural gas)
Freight markets (environmental
considerations - double hull)

Recent developments in international market

Geopolitical Factors
Irans tussle with western West over its
nuclear projects
Threat of attack on US embassies in Gulf
countries
Civil unrest in Nigeria causing production
stoppage.
Unrest in Iraq

Spectacular demand growth


Oil demand growth rate peaked at 3.7% in
2004 and grew further 1.4 % in 2005 and 1.0%
in 2006. (CAGR 1.5% in last 20 years)
Strong demand from US, China, India and other

Recent developments in
international market
Tight refinery capacity
Globally refineries struggling to
cope with rising product demand
No new refinery in US after 70s

Other factors
Increased activities of speculators
at NYMEX and IPE
No production growth in Non OPEC
oil producing countries.

Price Trends : Marker Crude Oils


(Annual Average Prices)

(Figs in $/bbl)

Prices rose following


introduction of price
band production cut
by OPEC

Demand surge,
limited spare
capacity with OPEC,
Geopolitical tension,
increasing activities
of speculators pulled
up prices

Prices fell
following South
East Asian
financial crisis
Prices
remained
strong on
speculative
inflow

2008: Average till 13th Oct 08

Oil Pricing Mechanism

PRICING
In the oil market, trades are
usually done on a variable
market related pricing basis
The price of the product being
imported is not known at the
time of purchase but is based on
the price prevailing at the time
of loading.

Oil Pricing
Three dimensions
Physical spot market activity
Forward market activity with physical deliveries
Exchange/Swap markets

Impact of variable market related pricing The


entire sale of physical oil in the international oil
market is priced based on the last barrel of oil
traded in the market.
Eg: If the last cargo of a grade of crude oil is traded
at a premium or discount, the same gets reflected
in the sale/purchase price of the entire volume of
crude oil. Term or spot purchases are same from
the price perspective

Oil Pricing
Price discovery mechanism is the key
In the market today, Platts is the
dominant and influential price
publishing agency.
In Asia Pacific market, Platts arrives at
pricing of crude oil and petroleum
products using:
Market On Close method viz. trades at
market close are reckoned for assessing
the price.
Trades done in their Trading Window are
only considered

Other agencies like Petroleum Argus,


etc. publish their price assessments
based on full day trades. However,

PRICE
Price signals are visible to both producers and consumers.
Both sides follow them with their decisions on production (output) and consumption to
optimise their profit or overall benefit.
Price is a signal from the market.
It represents scarcity of the commodity in the market.
When the price rises, demand is reduced to a level where supply matches demand (&
vice versa).
It also indicates a foresight of supply and demand, as expectations are factored in both
supply and demand curves.
Price is also a key signal for an efficient allocation of capital.
A higher price relative to cost signals the need for new investment in production
capacity, as the price signals a potential reward to investors.
A low price discourages investment. It is worth noting that the oil and gas sector

What governs the Oil and Gas pricing? A philosophy


Oil and gas have many characteristics that distinguish them from other
commodities,
such as:
1) the high uncertainty linked to resource development and the high
specificity of investment
all along the energy chain from production to consumption,
2) the character of a natural resource,
3) the finiteness of the resource, exacerbated by the high concentration of
reserves in about a
dozen countries,
4) the involvement of two decision makers on the production side: producing
company and
resource owner,
5) the often highly inelastic demand for energy and its interaction with
concentration and
capacity restrictions on the supply side, and

CRUDE OIL TRADE - PRICING BASIS


PRICING BASIS FOR THE CRUDE OIL
CONTAINS THE FOLLOWING ELEMENTS:
LINKAGE TO A MARKER CRUDE OIL VIZ WTI,
BRENT, DUBAI/OMAN, TAPIS, ETC
PRICE OUT PERIOD VIZ. NO. OF QUOTES TO
BE TAKEN AROUND/AFTER BILL OF LADING
PUBLICATIONS TO BE CONSIDERED FOR THE
PRICING BASIS.
PREMIUM/DISCOUNT TO REFLECT QUALITY,
LOCATION, ETC.

Irrespective of term or spot imports, the prices are finalised


on variable market related viz. price prevailing around time
of loading will apply.

Oil Pricing- Spot market


Platts
methodology(Singapore)
Trading Window open from 4.00pm
to 4.30 pm Singapore time.
Trading lot is kept small (25000
barrels) called partials
Markers like Dubai and Oman are
traded. Minas & Tapis have been
started recently
Platts only considers deals finalised
or firm bid/ask prices on offer during
this window. Deals outside this

Crude Oil Pricing Challenges


Grades
similar
but not
identica
l

GPW

Marker

Hundre
ds of
grades

Little
use
directly

Needs
Refinin
g

Few
grades
traded
activel
y

Characteristics of a
Marker
Significant
Production
volumes

Versatile, good
quality & desired
by Refineries

Actively Traded in
the Paper Market

Diversity of
ownership

MARK
ER
CRUD
E OIL

Export in
shippable cargo
lots

Free of destination
restrictions

Marker crude oils


North/South American Region

North Sea, Nigerian, Angolan, Libyan


Grades etc

Middle East countries like Saudi Arabia,


Kuwait, Iraq
Malaysian, Indonesian, Australian Grades

WTI
BRENT
DUBAI
/OMAN
TAPIS

VALUATION OF CRUDE OIL

Crude oils may be


similar but no two
crude oils are identical
in all their physical and
chemical
characteristics
How are crude oils

Futures markets have grown considerably since the mid-1980s.


Oil companies and traders as well as financial institutions use the futures
markets for hedging against the risk of price fluctuations.
Meanwhile, a spot contract is an
A futures contract is an agreement
between two parties to buy or sell an agreement to buy or sell an asset
today.
asset at a certain future time for a
certain price.
A futures contract is a derivative.
(A derivative is defined as a financial instrument whose
value derives from the values of underlying assets. )

A futures contract is traded in the


exchange.
Less than 5% of futures contracts
result in physical delivery. A futures
holder normally has the opposite
position in the market, so that the
two contracts cancel out

Like a futures contract, a forward


contract is a derivative, too.
A forward contract is traded in the
OTC market.

QUALITY DIFFERENTIAL
BRENT (Low Sulphur) VS DUBAI (High Sulphur)
(LAST 5 YRS)

No discernable trend witnessed in quality differential between high


sulphur and low sulphur. Factors like regional supply/demand,
tightness in HS crude availability etc have resulted in fluctuating
differentials.

CRUDE PURCHASE - ILLUSTRATION


Item

African

Far East

Crude price

85.0

83.0

Freight

2.5

2.3

Refining Costs

0.5

0.4

88.0

85.7

Total costs

VALUATION OF CRUDE OIL


REFINING MARGIN
GROSS PRODUCT WORTH(GPW)
MINUS
CRUDE OIL LANDED COST AT REFINERY
MINUS
VARIABLE OPERATING COSTS OF
REFINERY
=
REFINING MARGIN.

Netback Pricing
The netback pricing formula was:
Crude oil price (FOB) =
GPW in the spot market - fixed refining margin - transportation
costs*
* from the terminal in the oil-exporting country to the refinery in
the oil-importing country)

GPW - AN ILLUSTRATION
African crude Yield(%wt) Product price (Landed)
VALUE
($/MT)
($)
LPG
3.5
730
3.5 x 730 2555.0
NAPH/MS
20.0
800
20 x 800 16000.0
SKO
10.0
820
10 x 820 8200.0
HSD
51.0
810
51 x 810
41310.0
LSHS 10.0
500
10 x 500 5000.0
F& L
5.5
TOTAL
100.0
73065.0
GPW OF CRUDE
GPW ($/bbl)
$/BBL

= 73065.0 /100 = 730.65 $/MT


=
730.65 /7.38 = 99.00

CRUDE PURCHASE ILLUSTRATION


AFRICAN AND FAR EAST CRUDE OILS
ARE AVAILABLE FOR IMPORT
YIELD

AFRICAN FAR EAST Landed cost


of products
LPG
3.5
3.7
730
SRN/MS
20.0
15.0
800
KERO
10.0
10.0
820
HSD
51.0
49.0
810
LSHS
10.0
17.0
500
F&L
5.5
5.3
TOTAL
100.0
100.0
GPW($/bbl) 99.00
96.33

CRUDE PURCHASE - ILLUSTRATION


Item

African

Far East

Crude price

85.0

83.0

Freight

2.5

2.3

Refining Costs

0.5

0.4

Total costs (A)

88.0

85.7

GPW (B)

99.0

96.3

Ref Margin (B-A)

11.0

10.6

Each stage of development of the world oil market has added new
contractual structures to the
previously existing ones: new structures appeared in addition to and not
instead of previous

Price Formula
Prior to 1979-80, long-term contracts accounted for most international trade.
In the 1970s, crude was sold at official selling prices, which were set
according to differentials to Arabian Light.
The differentials were based on physical properties of the grades and
distances to the markets.
Saudi Arabia abandoned the official prices and established a netback pricing
system in late 1985 to defend its market share.
The netback pricing system tied the value of crude oil to the spot market
prices of refined
Products
If a price formula is only linked to one benchmark crude, the particular
characteristic and special
market circumstances of the referred crude can have large effects.
To avoid this, the use of crude baskets involving more than one benchmark is
common. For instance, common formulas for crude sales of Arabian Light to
the Asia-Pacific market (eastbound sales) are linked to the Dubai and Oman
grades.
While, those for Europe and North America (westbound sales) refer to ICE

Hedging and Speculation


Hedging means reducing a risk of loss in the business, resulting from an
unexpected change in the value or cost of a product
Companies hedge and fix unknown variables in order to concentrate on their
main activities.
The best way to understand hedging is to think of it as insurance.
When people decide to hedge, they are insuring themselves against a
negative event. This doesn't prevent a negative event from happening, but if
it does happen and you're properly hedged, the impact of the event is
reduced. So, hedging occurs almost everywhere, and we see it everyday.

Gas Pricing
The physical properties of oil and the fact that it is relatively easy to
transport and to store facilitated the emergence of commodity pricing
mechanisms in the oil sector.
However, these considerations do not apply in the same way to natural gas.
Will Gas Follow Oil to Become a Global Commodity?
The situation with gas is more complicated.

The supply side


The indicator for liquidity is usually called churn. Churn is the ratio between
traded volumes and delivered volumes.
A churn of at least 15 is usually considered to be the threshold for a liquid
market.
The gas hubs in North America were created by industry at appropriate
places, with Henry Hub in Louisiana being the most prominent and important
of these.
Henry Hub has a churn of about 100, indicating high market liquidity.
For comparison: on the oil side the churn of WTI and Brent is about 500.
the National Balancing Point (NBP), a
notional point at which gas is traded
in the UK, was created by regulation.
The churn on the NBP rose to about
15 until 2004 and then dropped for
some
time to 10, placing the NBP at the
edge of being considered as a liquid
market.

The demand side


In all regions gas is used in the captive sectors, residential and commercial,
which not only have little price elasticity but also a demand that is strongly
dependent on weather conditions.
The hubs that have developed in Continental Europe (Zeebrugge, Bunde and
TTF in the Netherlands) all have a churn of clearly below 10, a sign of low
liquidity.
While Continental Europe has developed some hubs, Japan and Korea so far
have no hubs at all:
Korea only has one gas company, Japan has a maximum of two per region
(one gas, one power utility) and there is practically no pipeline connection
between the regions, although the companies do swap LNG cargoes with
each other in short-term lend / borrow arrangements.

The role of LNG


The fast growing trade in LNG is regarded by some as a factor that will lead
to the creation of a global gas market

Basic Element of Gas Tariff Design

FREIGHT MARKET

OIL TANKERS CLASSIFICATION


ULCC
3,20,000 & above
VLCC
160,000-319,999
LR II
80000-159999
LR1
45000-79999
VLCC= Very Large Crude
Carrier
ULCC= Ultra Large Crude

MR
25000-44999

All fig in DWT

CHARTER PARTY
Time Charter
Charterer pays loading, unloading,
bunkers, port charges, agency and
becomes disponent owner
Voyage Charter
Owner pays loading, unloading,
bunkers, port charges, agency

Freight market World Scale


Every year, World Scale Association (WS)
publishes freight rates for voyages between
various ports in the world.
Freight rate basis:
Vessel size: 75000 tons
Fixed hire: USD 12000/day
Bunker price: USD 328.75/mt (Oct06-Sep07)
Bunker fuel (steaming:@55mt/day; Others:100 T/Voyage;
5 tons/each port involved)

Freight rate is for one round voyage


Standard cost ($/MT) of particular journey is
given in world scale which is equivalent to WS

FREIGHT RATES(AFRA)

FREIGHT COSTS - ILLUSTRATION


Based on Ws 2008 rates

VOYAGE: RAS TANURA TO VADINAR


WORLD SCALE FRT RATE = $ 4.94/MT
AFRA(Aug08)
VLCC = 134.4
S.MAX
= 175.2

FREIGHT RATES:
VLCC = 4.94 x 134.4/100 = $6.64/MT
S.MAX = 4.94 x 175.2/100 = $8.65MT
Difference
= $2.02/MT

On 10 million tons import through VLCC, freight


savings are about $20.15 million or Rs. 87
Crores.

FREIGHT COSTS - ILLUSTRATION


(BASED ON WORLD SCALE 2008 RATES)

VOYAGE: AG TO HALDIA
WORLD SCALE FRT RATE = $9.91/MT
AFRA FOR Aug08
VLCC
LR-II

= 134.4
= 175.2

FREIGHT RATES:
VLCC = 9.91x 134.4/100
= $13.32/MT
LR-II = 9.91 x 175.2/100 = $17.368/MT
Difference
= $ 5.95/MT

On 10 million tonnes import, freight


savings are about $59 million. (Rs.
255 crore)

OIL IMPORTS

TERM
CONTRACTS

TENDERS

TERM

MONTHLY

Assignment: Group Discussion & Presentation


In Indonesian PSC Model the
investment credit offered by
Government really helpful to
Contractor?
Can a PSC Contractor in a Typical PSC
Makes a Profit out of Cost recovery?