SEB Commodity
Research
Bjarne Schieldrop
Head of SEB Commodities Research
[email protected]
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FICC Oslo
+47 9248 9230
Setting the price of crude oil
May 2013
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Crude oil - Not one commodity but more than 300!
Thus not one price, but many! Huge variety qualities, locations, regulations,…
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FICC Oslo
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1940 to 1970 - The Seven Sisters period
Oligopol pricing, no free market, no OPEC power. The Concession market
 Seven Sisters dominated
 Total control of crude oil supply
 The Concession system
 Posted prices a fiscal instrument
 No link between price and market
 No functioning spot market
 Transfer prices – tax
minimization
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FICC Oslo
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1965 to 1973 – The end of the Concession system
Seven sisters looses control and OPEC is formed in a soft spot of prices
 Late 1950s - independent oil companies were
able to gain access to upstream crude oil
 Libya, Venezuela, Iran and Saudi Arabia granting
concessions to non-majors
 Increasing competitive pressure led the majors to
cut the posted prices in 1959 and 1960
 1960 - OPEC formed to counter decline in prices.
 Strong demand growth from 1965 to 1973. OPEC
increased production from 14 mb/d to 30 mb/d
 1970 – Libya pushed for better deals and soon all
OPEC members pushed for same deals.
 1973 – Demand for revision of Teheran deal with
large increase in posted price. Majors said no.
 1973, October 16 – OPEC unilaterally announces
an increase in posted price for Arab Light from
$3.65/b to $5.1/b and then to $11.65/b
OPEC combines oil production with geopolitics and announces
a 5% production reduction per month until Israeli forces are out of Arab territory
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FICC Oslo
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1970 to 1975 – The Buy-back Pricing System
The first steps of a new pricing regime, but highly confusing and inefficient
 Along with increasing negotiation power from
the mid 1960s host countries were able to
negotiate increasing equity shares in oil
 Iran, Iraq and Kuwait opted for
nationalization of their oil production
activities
 Need for host countries to sell its oil to third
parties led to Official Selling Prices (OSP)
and Government Selling Price (GSP)
 Limited marketing experience and inability to
integrate into the downstream market led host
countries to mostly sell its equity share of oil
back to the operating oil companies
 1970 to 1975 – The Buy-back system. Highly
inefficient pricing system with several different
prices: Posted prices, Official selling prices
and Buyback prices. No mechanism for
convergence. Buyers could buy at different
prices.
 The system broke down in 1975
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OPEC conference in Vienna in 1974
FICC Oslo
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1974 to 1986 – OPEC Administered Pricing System
De-integration of market as majors lost access to oil. Strong rise in spot deals
 A complete shift in pricing power to OPEC
 New system centered around Marker price
 Saudi Arabia’s Arab Light the elected marker
 OPEC continued to publish OSPs but now as the
differential to the marker price
 Differentials was a result of the different crude
qualities which gave different refining economics
 Setting of differentials were very flexible which
made setting the marker price very difficult
 1979 – Iranian crisis. The new Iranian regime
canceled all agreements with oil companies
 OPEC became marketer of its own oil and the
majors became buyers like any other
 Majors lost access to huge amounts of oil. Forced
into the market as buyers. De-integration of
market. Rapid development of competitive
market. Strong rise in spot transactions.
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FICC Oslo
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1979 to 1986 - End of OPECs administered pricing
Declining demand and increasing non-OPEC production
 Iranian revolution 1979 -> oil price up 2 to 3 times by 1981 ->
Global recession and oil demand decline.
 Increasing non-OPEC oil production in mid 1980s amid
recession
 Non-OPEC producers with exess oil undercut OPECs prices
 A high Marker price -> loss of market share for Saudi Arabia
while it was good with a high marker price for the other OPEC
members who sold at a differential
 OPEC dissagreement started to emerge
 OPEC market share: 51% in 1973 and 28% in 1985
 Demand for Saudi Arabian oil fell from 10.2 mb/d in 1980 to only
3.6 mb/d in 1985!
 The net-back pricing system. A desperate measure that failed.
In order to hold on to its market share Saudi Arabia guaranteed
refineries a margin. Rest of OPEC followed suite. Refineries ran
flat out and floded the market with oil products. Crude prices
chased product prices lower.
 In 1986/87 Saudi Arabia gave up on the adminstered pricing
system and joined the more flexible market related pricing
system that many oil exporting countries had gradually
developed.
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FICC Oslo
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1986 – A market based pricing system
A complex structure of interlinked markets with dealing at arm’s length
Consumers
Swing producers - OPEC
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FICC Oslo
Refiners
Non-OPEC producers
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Physical market  Contractual dealing
The contractual dealing is strongly shaped by the market’s physical characteristics
 A rise of independent crude buyers and sellers along with increasing non-OPEC production
 A rise in arm’s length dealing
 Spot crud transactions, an element of “forwardness”, as much as 45 to 60 days
 Price fixing at the date of agreement or loading?
 Long-term contracts - OTC
 A series of shipments over one to two years
 Contracts specify: Volumes, delivery schedule, default clauses and not least the price
calculating methodology to be applied
 The pricing methodology links the price of the cargo in the contract to a crude oil spot price
 The Gross Products Worth (GPW) – Different crude oils have different values
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FICC Oslo
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Formula pricing – the heart of today’s oil market
Applies to both spot, forward and long term contracts
 Today most crude oils are priced as a differential D to a few benchmark crudes.
 P_x = P_b + - D
 The differential D is often set at the time of agreement. The benchmark P_b left floating
 Differentials for different crudes are usually set
 Independently by each of the oil producing countries or by
 Price Reporting Agencies
 Competing crudes have competing differentials (Saudi Arabia Light and Iranian Light)
 Buyers market: CIF
 Sellers market: FOB
 Advantage of formula pricing
 Pricing set close to delivery
 Price discovery in differentials and a few benchmarks
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FICC Oslo
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Benchmark prices – The heart of pricing formulas
A few key crude oil benchmarks sets the price level – the rest set by differentials
 Gulf of Mexico:
WTI – US, Cushing Oklahoma
 The Gulf:
ASCI – Argus Sour Crude Index
 The Gulf:
Oman, Dubai – Gulf crude oil index
 North Sea:
Dated Brent / Dated North Sea Light / North Sea Dated / Dated BFOE
 North Sea:
BWAVE – The weighted average price of Brent futures trades during a day
 Formula prices may be based on the “physical” benchmarks such as Dated Brent or on the financial
layers surrounding these benchmarks such as BWAVE
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FICC Oslo
May-13
Mar-13
Jan-13
Nov-12
Sep-12
Jul-12
May-12
Mar-12
Jan-12
Nov-11
Sep-11
Jul-11
May-11
Mar-11
Jan-11
Nov-10
Sep-10
Jul-10
May-10
Mar-10
Jan-10
Nov-09
Sep-09
Jul-09
May-09
Mar-09
Jan-09
Nov-08
Sep-08
Jul-08
May-08
Mar-08
Brent crude minus US WTI
Jan-08
USD/b diff
 Choice of Benchmark is extremely important for revenue and pricing
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Choice of benchmark depends on export destination
..,but Brent crude is gaining ground as the global benchmark
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Why do we need Price Reporting Agencies?
Price assessments are needed in opaque and illiquid markets
 Physical benchmarks are not trading in real time
 Illiquid, opaque with a few large chunky transactions
 Sometimes no transactions at all, only bids and offers
 No obligations to report physical transactions
 Platts and Argus: Assess the price level
 Assessment methodology vary from market to market
 Actual transactions – the highest form of proof
 Often have to settle for second best – bids and offers
 Assessments are always an interpretation
 Methodologies change over time due
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Some basic features of Benchmark crudes
Large differences between benchmarks
 Global base of physical
benchmarks
 3 mb/d or 3.5% of global
prod
 Financial layers have
developed around these
benchmarks: OTC: Forwards
and swaps. Exchanges:
Futures and options
 Financial layers have grown
in size and sophistication and
has now in them selves
become part of the oil price
identification process
Note: In the table it should say “KBPD” and not “MBPD”
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Brent crude – Contract in constant change
Declining production demanded a constant refill of new crudes
 1980s – Dated Brent spot market and an informal physical forward market. It was a mixture of crudes produced at different fields,
collected through main pipelines and transported to terminal Sullom Voe. Physical base was 885 kb/d in mid 1980s
 1990 – Name changed to Brent Blend. Brent production at 366 kb/d. Ninian North Sea crude added (total prod: 856 kb/d)
 2002 – Name changed to BFO. Brent Blend production down to 400 kb/d being only 20 cargoes per month. Fortis (UK North) and
Oseberg (Norway) added to Platts definition and were thus deliverable into the Brent forward contract. Fortis is a mixture of fields
delivered to Hound point UK and Oseberg is a mixture of fields delivered to Sture terminal. This created the Brent – Fortis – Oseberg
or BFO benchmark.
 Distribution of cargoes across a wider range of companies. Non with a dominant position. Volume 1200 kb/d (63 cargoes/mth)
 2007 – BFO volume down to less than 1000 kb/d (48 cargoes/mth). Ekofisk was added to the physical spot market: BFOE, 1.5 mb/d
 Ekofisk crude is a mixture of fields delivered to the Teesside terminal UK
 BFOE production has fallen from 1.5 mb/d in 2007 to less than 1 mb/d in 2012
 The BFOE contract is likely to be enlarged in the future as physical volumes decline further
Brent: Sullom Voe Shetland
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FICC Oslo
Fortis: Hound Point, Scotland
Oseberg: Sture terminal, Bergen
Ekofisk: Teesside UK
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Brent Forwards – the first layer – 21 day BFOE
Trading of oil cargoes with known delivery month, but unknown delivery date
 Started for tax spinning purposes
 Physical crude oil loading structure - Example
 By early June the latest all producers nominate preferred loading dates for July
 By June 10 all producers are allocated individual 3 day slot times for loading in July
 => producers get a minimum 21 day notice for loading date
 Once the 21 day notice day expires the cargo starts to trade as a Dated Brent cargo
 Physical cargoes (600 kb) often bought and sold many times in the Forward market (known month)
 The Chain of buyers and sellers
 Then the cargoes are often bought and sold many times as Dated Brent cargoes (know dates)
 Dated Brent cargoes rarely trade less than 10 days ahead of delivery
 Dated Brent Index or Dated BFO Spot Index
 The average of all traded Dated Brent cargoes over a day with delivery dates 10 to 21 days ahead
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FICC Oslo
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Brent crude futures market
 Launched on IPE in 1988. Trades today at ICE
 The December contract expires the 15th of November if it is a business day
 It is cash settled, but with an option for physical delivery through (EFP)
 In 2010 the daily average traded ICE Brent volume exceeded 400 mb (5x global demand)
 ICE Brent is settled against the ICE Brent Futures Index – The Brent Index
 The Brent Index is calculated on the basis of transaction in the Brent Forward market
 ICE Brent is thus settled against a forward market and not a pure physical spot
 EFP - Exchange For Physical - OTC
 An EFP contract switches a futures position to a 21 day BFOE Forward contract
 EFP’s are usually quoted as a differential to Brent futures
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FICC Oslo
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Price level for Brent crude is set in the Futures market
Everything else is set by differentials.
BWAVE
Brent Futures
EFP
CFD
Forwards 21d BFOE
Dated Brent
Dated Brent Index
Dated Brent Index
Forward 21d BFOE (July) = Brent Future (July) + EFP (July)
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