A commodity is a physical substance which is interchangeable with another product of the same type.  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, especially when it comes to oil.

‘Big Oil’

When you hear the words "big oil," companies like BP, Exxon-Mobil and Chevron usually come to mind. But everything about oil is big. A few numbers can justify that:

The value of oil production is:


  • 2x 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 vertical depths of 35,000 feet below sea level.

Oil comes in a variety of colours and, if the industrial terms were taken literally, tastes. In colour, oil ranges from nearly colourless to pitch black, with viscosity ranging from water-like to nearly solid.

In terms of price, the two most important physical characteristics are:


  • Viscosity
  • Sulfur content
The highest-value fractions of oil - gasoline, diesel and jet fuel - are 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).

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Benchmarks

 There is no single benchmark for 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 of 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.

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Oil companies often reference more than one benchmark price depending on the destination. In addition, the methods used by the Price Reporting Agencies to calculate WTI and Brent prices are different.

WTI – (West Texas Intermediat[img]../../../images/img/commodities-oil3-jpg1.png[/img]e)



Historically, the prices for West Texas Intermediate and Brent moved in tandem. That changed when oil volumes from Canada and North Dakota began to increase, leading to bottlenecks in the refining hub of Cushing, Oklahoma. The Cushing hub is asymmetric: more pipelines lead into Cushing than lead out. The closure of the McKee refinery has led to increased inventories in Cushing and significant downward pressure on WTI prices.

Pricing WTI

The pricing for West Texas Intermediate crude is 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 PRA (Price Reporting Agencies) 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; and this would be the price of a barrel of WTI.

Brent

 The Brent benchmark owes its existence to favourable 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).[YP2]

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 (159m3). 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 forfeited (which happened to the Malaysian-Tapis benchmark). The Brent benchmark now includes Brent, Forties, Oseberg and Ekofisk.

Production in thousands barrels per day

Pricing Brent

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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 [KTB3] [YP4] . 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 (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 grouping.

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 LCH no longer guarantees the settlement, and the contract does not 'cash settle' two days after trading ceases for such contracts.

Conclusion

As a working example of how oil prices can be affected, the reactions to the recent hurricane on the USA’s east coast can be considered. Traders bought oil futures as they believed that the post-Hurricane Sandy refinery shutdowns would put a premium on the price of oil because the near-term demand would not be met. In fact, the opposite occurred. The closing of the refineries increased the oil inventories, which resulted in oil prices to plummet. In addition to this, and despite the fact that the oil supply was reduced, oil prices continued to fall as the total miles driven were also reduced due to the damages and impact caused by the Hurricane.

There are many variables determining the price of a barrel of oil; supply, chemical composition, demand curves, geopolitical tension, refinery openings and closings, new pipelines, discoveries, depleted fields, official OPEC figures on proven reserves, analyst estimates on what those reserves may actually be, the weather, the liquidity of the Brent market, the price of natural gas, the survival of unstable regimes, the Cushing backlog, extraction technology, spill clean-up, and a host of other interlocking variables.

All will contribute to the amount of the price per barrel of the most important and provocative energy source on the planet.
Vincent Carbonare