The Complex World of Oil Markets and Trading
In this issue, we introduce some fundamental concepts in oil trading to allow us to further explore this industry sector in future articles. We also look into operating expenditure modeling issues, which tend to be overlooked at project appraisal stages.—Kristine Petrosyan, Deputy Editor-in-Chief, TWA, Editor, Economist’s Corner
Oil trading is a broad term, incorporating the exchange of physical oil cargoes and trading of paper instruments, which does not necessarily result in physical delivery of oil. It is a complex mechanism composed of several markets—spot, over-the-counter, and futures markets.
In the 1960s and partly in the 1970s, oil trading was mostly limited to direct deals between producers and consumers, whereas the price of oil was fixed by the producer. Following the first oil shock in 1973, refiners were eager to get oil from a wider variety of sources. This initiated spot oil trading, also called physical markets. The oversupplied market in the early 1980s led to more competition and more barrels in the spot market, which eliminated the price control by the producer and gave more power to consumers. The emergence of spot markets also attracted a large number of intermediary parties—trading companies and, recently, hedge funds—which increased liquidity in the market.
Due to a large number of different grades based on quality and location, which are sold and bought in the spot market, it is difficult to determine the absolute price of each single grade. Therefore, the market chose several grades and endowed them with a benchmark status. The rest of the grades are priced at a differential (premium or discount) to one of those markers. Currently, there are several important crude-oil markers: West Texas Intermediate (WTI) in the US; Brent, Forties, Oseberg, and Ekofisk in Europe; and Dubai and Oman in the Middle East. These grades have to fulfill a number of requirements for a benchmark, such as sufficient production volumes, a stable market, representative quality, and absence of resale restrictions. Benchmarks are also indicators for interregional crude movements, called arbitrage.
Although active spot trading increases competition in the market, it leads unavoidably to more-volatile pricing and growing risk for all participating parties—especially for those at the start and the end of the supply chain. In addition, there are significant time gaps between the deal conclusion, loading date, and delivery date. This led to the emergence of hedging techniques, helping to protect physical barrels from price volatility. By fixing a certain price level, it is possible to secure more-stable cash flows. This is done by using derivatives. A derivative is a traded paper instrument, and its value depends on the underlying commodity. Typical examples of derivatives are forward contracts, swaps, and futures.
There are two different types of paper markets—over-the-counter markets and futures exchanges. Over-the-counter markets are “organized” around a limited number of participants, normally large players such as oil majors. Although generally flexible, these markets have developed a number of standardized contracts—i.e., forward contracts (where physical delivery of the oil is required) and swaps (where only cash is exchanged). The over-the-counter market, similar to the spot market, is rather opaque, which means that the scale of real trading activity remains unknown. The obscured trading activity resulted in a need for price discovery and the services of price-reporting agencies, which assess prices of different grades after collecting trading information from the market.
Unlike over-the-counter contracts, futures contracts are standardized and can neither be changed nor adapted by market participants. There are two major futures exchanges—the New York Mercantile Exchange (Nymex) and the InterContinental Exchange (ICE) in London—with two major crude-oil futures contracts, ICE Brent and Nymex light, sweet crude (called Nymex WTI). While the former is cash settled at the expiration, the latter is physically deliverable. Due to high liquidity and the large number of participants, futures markets are considered price setters, while over-the-counter and spot markets are seen as price takers.
Public exchanges are the most active and liquid oil markets, with trading volumes of more than 500 million B/D. (Compare this with the actual oil-production level of about 84 million B/D). Due to lower market barriers, public exchanges are attractive for a large number of participants. These exchanges are an ideal market for financial institutions such as banks and hedge funds, which can profit from price volatility (speculative trading) while avoiding physical delivery.
Oil trading remains a turbulent segment, with few novelties emerging on the horizon. Recently, an important new exchange appeared—the Dubai Mercantile Exchange, inaugurating the Omani futures contract. At the same time, ICE launched the new Middle Eastern Sour Crude Oil futures contract. They are both competing for the status of the new benchmark in the Middle East. At the same time, several benchmarks are struggling with different problems—mostly inadequate production volumes, illiquid markets, and unstable quality, which resulted in a number of improvements to the trading mechanism.
Oil trading mechanisms will still have scope to develop and expand, as the dislocation of supply (producing areas) and demand (refineries and consuming areas) remains. Oil trading is expected to increase significantly in the future.
Johannes Benigni is managing director and senior partner of PVM Oil Associates in Vienna, Austria. He founded this company in the early 1990s with PVM, an independent oil brokerage group.
Benigni specializes in pricing mechanisms and strategies and in supply and demand analyses. He has completed commercial, risk, benchmarking, and pricing audits in the energy industry; has set up trading and risk management operations; and has supported integrated oil companies in optimizing their downstream operations. In energy policy issues, Benigni guides the migration of energy companies and supports governments moving toward liberalized markets.
Benigni is a regular speaker at several international conferences. A graduate of the Vienna University of Economics and Business Administration, he is also visiting professor of International Trade at the Prague University of Economics.
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04 September 2019
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16 September 2019