Trading of paper barrels, such as oil futures and oil derivatives, characterise today's oil and gas markets and add further volatility to oil prices. Th e trillions of dollars that are found in hedge funds operated by commodity traders and speculators often follow a herd mentality. This magnifies the effects of geopolitical unrest or natural disasters by creating panic buying or selling situations. Hedge funds and speculators need prices to oscillate to make profit – buy low, sell high and buy low1.

Nature's Best

You don't have to trade commodities to know the simple rule: the best quality fetches the highest prices. Just go down to a coff ee shop; the best beans command a premium. Oil is no exception to the quality rule, yet the prevailing stereotype is that a group of oil barons in Dallas or oil sheiks in Dubai control prices behind closed doors. Th ankfully, the reality is somewhat more transparent with petroleum prices being determined by market forces, quality and trading.

Pricing Is Complex

Th e pricing of petroleum is highly complex. Making comparisons between producers regarding what is a fair price for oil and gas is a tough call. Th is is because it would involve selecting countries that match each other's profiles in terms of oil and gas exports and imports. Almost all petroleum exporters import petroleum either for derivative needs or to maintain refi ning blends for national refi neries. Even then, the comparison would be invalid due to diff ering circumstances such as:

  • Fiscal arrangements
  • Production agreements
  • Royalties
  • Tax breaks
  • Seasonal adjustments and their aff ect on West Texas Intermediate (WTI) crude (which does not necessarily apply to Brent crude)
  • Discounts and sunk costs for a certain type of refi nery confi guration for a certain basket of crudes
  • Per barrel fi nding costs, and
  • Th e sweetness and density of the crudes being imported and exported2.

Th e following example is instructive. Consider that sweet WTI crude trades at US $X on a given day. WTI Sour would trade at a lower rate between US $3.75 to $5.00; therefore, WTI Sour would trade at approx. $X-$3.75 to $X-$5.00. A sliding scale operates that knocks down the price according to sourness. A 50° API sour would trade at approx US $68.25 per barrel although the marker WTI would trade parallel at US $90 – a price diff erential of nearly US $22. Additionally, crude that is below 25° API, would fetch lower prices. Roughly speaking, 20 cents is deducted for each API degree below the benchmark. For crude below 20° API, 70 cents would be deducted for each API degree3. This gap is likely to increase in the future due to the shortage of sour and heavy refneries.

Petroleum pricing is further complicated due to variations in the type of oil company, its internal marketing channels, the age of refi neries involved as well as their confi guration, effi ciency, ownership, economies of scale and sunk costs4.

Oil and Gas

The split between oil and gas production is always important because oil and gas are priced according to their nature and utility. Gas pricing is different to crude oil pricing mainly due to the long-term contracts which can be as long as 20 years, a situation which is unthinkable in oil futures. Even the most progressive and forward thinking oil companies or oil traders will not likely contract beyond a few years. Th is leads us to the second fact: differences exist in oil contracts between oil companies and traders and oil contracts 'off -thetrading- fl oor'. Th e latter are not hushed up for secrecy purposes, but for more mundane reasons – getting the right blend for refi ning5.

Trading

Every day billions of dollars worth of petroleum contracts are traded at exchanges around the world. Th e most famous are those of the New York Mercantile Exchange To see the trends clearly, consider that by the end of 2008 the Organisation of the Petroleum Exporting Countries (OPEC) had promised a production cut of two MMbbl/d – the largest cut in its history. Yet, this had minimal impact on the downward trend. To contrast, in early 2005 in certain European markets, some fi nance houses profi ted from rising oil prices by chartering oil tankers and storage facilities to hoard oil; however, they were profi ting from an upward trend not creating one and were able to access capital easily.

Even the powerhouse of OPEC, which supplies roughly the equivalent of 40% of the world's crude oil, is unable to determine prices. Of course, OPEC and its constituent state companies infl uence the market by increasing or decreasing production. Th ey cannot, however, reverse or start a trend that is already underway9,10,11.

But what if suppliers increased production in an upward-market? In theory, this should send prices spiralling downwards due to excess supply. In reality, however, the supply-demand equation is so tightly reckoned that insuffi cient spare capacity exists that could actually pump more oil or gas, let alone refi ne, market and distribute it. What if the suppliers reduced production in an upward-market? Of course, this would increase prices. In the normal course of business, however, this is not likely as producers want to make the most of high prices.

If oil prices become too high, this will induce infl ation and restrict global growth, reducing consumption and bringing prices downwards. Th e oil producers seek stability; they are highly dependent on oil and gas revenues. If supply was shut off completely, that would send economic shockwaves worldwide as in the 1970s. While it may be possible, this is not likely to happen in the normal course of business12.

On the demand side, as long as world economies continued to grow (even at very low rates, i.e. 0.25% per annum), oil demand does not falter and oil prices maintain their high levels. However, as soon it was clear that world economies were going to falter in late 2008, demand dropped so fast that by early 2009 the oil price was US $40 per barrel. Th is was a drop of more than US $ 100 within less than six months.

Consumers and Producers Dance Together

Consumers and producers are locked in a complex and inescapable equation that continually attempts to balance trillions of supply and demand transactions.

(NYMEX), Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE) London. Th ese exchanges act as trading venues by bringing buyers and sellers together. Th ese exchanges do not control price, nor can they intervene to stimulate demand or supply. What they off er is the certainty and anonymity of a regulated trading place. Today's corporate governance and anti-trust laws make price fi xing and monopolies a historic relic. Regulated contracts are generally either here-and-now (spot) contracts or set at a predetermined date (futures). Th ese contracts allow buyers and sellers to hedge against future risk, oil price increases or reductions. Hedging or speculative investments are unregulated fi nancial instruments where traders look for a 'margin' between market value and real value. Th eir profi ts are made when the values differ6,7,8.

Auto-Pilot

Bright blazers, frenzied fi nger signs, shouting and paper strips littering the fl oor – the unmistakable scene of open pit trading. In 2005, London's open-pit petroleum exchange became completely e-based. Buyers and sellers instruct brokers who set e-tag alarms at given bid-tobuy or off er-to-sell levels. This has removed much of the human element in petroleum trading making it almost automatic execution. Although this removes an element of panic, prices are still infl uenced by volume transactions or the 'herd' mentality. Th e NYMEX still maintains open pit trading, but it is only a matter of time before this too becomes automated.

Control or Influence?

No single body, organisation or even nation state is capable of controlling oil prices without infl icting major harm on itself. If a trend for oil prices has been established, and is achieved by all the world's producers and consumers, this trend can only be undone by the same combination. Of course, certain institutions may be able to infl uence the trend, but the underlying trend is far too diverse and powerful to be broken. Not even the world's fi nancial muscle can control oil prices. Banks and billionaires can clearly infl uence prices by buying and hoarding physical oil stocks. They can suddenly offload oil at high prices, and buy it back at a lower price; however, the daily volumes involved just to make a diff erence would be huge (one million barrels a day [MMbbl/d] would cost many millions of dollars). Considering, the severity of the current banking crisis, it is hardly likely either banks or billionaires will want to hold substantial volumes of oil.

To comprehend this, we need to look beyond politics and realise that producers and consumers are mutually dependent. Although certain countries hold the world's long term oil and gas reserves, those reserves are only ever of real value if they are marketed.

Giant consumers such as the US, Europe and China need to meet demand for heating, cooling, lighting and mobility. Other consumers such as Brazil and India are growing demand. As demand is so heavily dependent on economic health, any change in consumption will aff ect producer decisions regarding production output, exploration spending, etc. Th at much seems clear.

What is not clear is the time delay between a growth or fall in consumption and the reactions of producers. Not only is this delay so protracted that it goes unnoticed, it is also deadly. Why are we consistently unable to spot the dangers of 'boom and bust' cycles? Since biblical times, and the seven years of feast followed by seven years of famine, why is it that we always get hit?

Just like the Titanic and the iceberg, it seems as if the cycle has suddenly come from nowhere. Bang. By the time we get hit, it is too late to change course. But is our fate the same as that of the Titanic13?

Large economic swings leading to excess production or consumption are not in the interests of producers and consumers. Th ey can lead to recession and even depression; therefore, it is in the interests of both groups to maintain stability. Ultimately, however, the market balances the uncertainties of economic growth and oil price. But how does this aff ect the oil and gas industry?

Cycles

Clearly, the major determinant of oil company profi ts and share prices is the oil price. As such, it is a crucial factor in pacing industry activity. It dictates budgets and investment throughout the industry from E & P spending, rig activity, wells, facilities, refi neries and pipelines. It is relatively easy to see where the industry is in a given cycle by looking at oil prices. If they are low, so are share prices, capital expenditures, rig levels, drilling and activity in general. When oil prices rise, the opposite applies14.

From an investor's perspective, ExxonMobil, BP, Royal Dutch Shell and ChevronTexaco all enjoyed an increase in absolute values in line with high oil prices and record corporate profi ts. Independents and service-company stocks had a similar story. Anadarko, Burlington, Baker Hughes, Halliburton, Schlumberger, Smith

and Weatherford experienced relatively large gains. Both majors and services, however, had tremendous fl uctuations in unison with cycle movements thus wiping off billions in market share values as oil prices dropped in late 2008.

Down Cycle

But how does that aff ect the industry? It's no secret that markets are ruthless. Since the 1970s, the boom and bust cycles have seen oil prices and drilling activity crash three times – twice due to the wider recession in the world economy and once due to the Arab-Israeli war. Two clear patterns emerge from these cycles. First, just like the market traders, the upstream industry is dominated by a herd mentality too. Despite bust markets off ering less expensive stocks, rigs and labour, drilling levels never rise; they fall. Second, the industry is regulated as if it were a tap. Despite experience reminding us that cycles do not last forever, the tap is opened or closed, and the flow that follows always compounds the boom or bust 15.

To illustrate this, since the US $10 oil price in 1998, basket crude prices doubled to above US $20/bbl by 2000, doubled again to US $40 by 2004 and nearly doubled again reaching US $78.40 in 2006. By July 2008, they had reached a peak of US $147. Although oil prices have more than doubled three times since 1998, exploration spending has only increased marginally in comparison.

Despite lower E & P budgets relative to the increase in oil price, most rig contractors and oilfield service companies have all recorded record profits and high utilisation levels. Th e reason is that demand for equipment and services has been very high and technological forces have also been at play.

We have seen that fewer wells are being drilled, but they are far more eff ective at drainage and production is increased. Better technology such as sub-salt imaging is helping to discover fi elds such as Tupi in Brazil, while directional drilling techniques can access and enable multiple reservoir completions. Yet, once again faced with uncertain economic conditions, the industry is faced with cost-cutting16,17.

Big Crew Change

Arguably the industry's most valuable resource, upstream labour, suff ers the most when the tap closes. Th e 'big crew change' refers to an ageing population that is creating a labour defi cit across all skills and capacities, but is largest in technical areas. Many people who are laid off exit the industry and potential new entrants remain wary. Today, nearly half of all oil and gas industry workers are over the age of 50. Only 15 percent are in the age range of 20s to mid-30s. University enrolment in petroleum engineering is down from 11,000 students in 1993 to 1700 today. The number of universities with petroleum engineering degrees has fallen from 34 to 17. Companies searching for their future leaders are fast realising they are going to have to do things diff erently; there are lots of intellectual gaps. We're seeing more outsourcing, greater dependence on suppliers to solve problems and higher demand for consultants18.

Oil – Profits or Profiteering?

Rocketing oil and gas prices and record corporate profi ts are almost always accompanied by the pockets of consumer's hurting. Th is leads to greater scrutiny of oil and gas companies, yet what are the issues surrounding petroleum prices and corporate profits19?

Nobody wants oil or gas. What people want is the progressive lifestyle that oil and gas provides. It's all about comfort, freedom and consumption. We want the 'climate-comfort' that comes from heating or cooling our homes, our workplaces and malls. We want the freedom that comes from driving our cars or from fl ying anywhere. We want derived goods such as aspirin, plastics and cosmetics. No other commodity touches us so completely or underpins modernity as petroleum. Undeniably, we are 'petroleum people'.

As the desire for modernity spreads, lifestyles that were once confi ned to wealthy classes in wealthy countries are now found up and down social classes and across the globe—not just China, India, Russia and Brazil but the wealthy states of the Middle East. Together, this relentless social mobility has contributed to oil becoming in many ways the world's most desired commodity 20.

Petroleum Generation

Emotions run high because everyone wants a better lifestyle or at least a more comfortable one, and oil and gas can make this happen. It's that simple. If we strip away our needs from our wants, however, it becomes clear that we do not need everything we want. Linked to this, we can also use energy more efficiently.

Of course, no one is suggesting that air-conditioning in the tropics (gas power generation) is unnecessary or that heating (gas fi red) in cold countries is a luxury. What is important here is that we don't need to drive everywhere, but we want to. It just seems easier to get to the shops, to work and to the gym. Our language is telling; often our fi rst car is a little 'runabout' for local journeys21.

As petroleum people, we drive everywhere – no matter how short the distance – and we fl y. Where past generations would have seen fl ying as a once in a lifetime experience, we think nothing of fl ying to visit people, go shopping or even to get a 'winter-tan'.

Lifestyle Price

It's fi ne that lifestyles come with a price. Th e logical question is at what price and who should pay. The logical tendency is that those that pollute should pay. What this means is that those people that live in Northern climates must get used to paying higher prices, especially during peak demand periods such as winter. Th ose that inhabit temperate climates will pay more for their energy, especially in summer. Everyone can expect higher gasoline prices. As students of economics will be quick to point out, this is demand and supply theory at work. In this context, what is a fair price for the lifestyle? All commodities can fl uctuate wildly according to seasonal production changes and non-scheduled events such as droughts or fl ooding. See the peaks and troughs of orange juice or coff ee futures; where crops are plentiful, prices fall. Th e reverse is also true. Without exception, oil and gas are commodities which are subject to price fluctuation22.

Cheap Oil

Getting it on the 'cheap' is a reality for only a handful of countries that 'enjoy' heavily subsidised oil such as Venezuela and several Arabian and central Asian states. Of course, the artifi cially low prices that these countries enjoy mean that part of oil revenues are transferred directly to consumers' pockets. Some commentators have decried this as distorting demand by allowing artifi cially low prices which lead to greater demand. Th at may be true, but the decision to remove taxes from gasoline sales in given countries is a sovereign decision and right. In some ways, it is an easy method of spreading the profi t.

It is clear that the oil price is determined globally by many buyers and sellers engaging in trillions of transactions: however, the time-delay before we can measure the diff erence is so long that it often catches us by surprise (who remembers the last bust cycle when it was a decade ago?) Th is is best characterised by the Texas car sticker—'Please Lord, give us one more boom. We promise we won't screw it up this time'.

In the long term, as long as economies and populations grow, demand will inevitably increase. On the supply side, three major world producers—Venezuela, Iraq and Nigeria – have had reduced production for four successive years. Add to this the spate of hurricanes and other non-scheduled events to use an analyst's term, it's hardly a surprise that oil and gas peaked recently.

But what is the trend for the future? Will renewables change the equation? What of global warming and climate change? Th e next chapter looks at these two points specifi cally. By understanding where renewables fit into the oil and gas equation, we will be better placed to understand which are the true exits from the Hydrocarbon Highway23.

References

1. Th e cycle can be self-fulfi lling and examples are the 'contango' situation in oil futures where spot prices are lower than long term futures or backwardation where spot prices are higher than futures.

2. Th e diff erence between imports and exports can make a huge diff erence to profi ts.

3. Th is is a guideline pricing diff erential for illustration only.

4. Planned maintenance is a growing problem as the refi nery stock ages.

5. With increased volumes of heavy and sour oil blending and purchasing is already becoming a complex trading task.

6. Th e New York Mercantile Exchange handles billions of dollars worth of energy products, metals, and other commodities being bought and sold on the trading fl oor and the overnight electronic trading computer systems. Th e prices quoted for transactions on the exchange are the basis for prices that people pay for various commodities throughout the world.

7. Th e Chicago Mercantile Exchange was formed in 1919. Initially, its members traded futures contracts on agricultural commodities via open outcry. This system of trading – which is still in use today – essentially involves hundreds of auctions going on at the same time albeit with today's electronic option available too.

8. ICE conducts its energy futures markets through ICE Futures Europe, its U.K. regulated Londonbased subsidiary, which offers the world's leading oil benchmarks and trades nearly half of the world's global crude futures in its markets.

9. Th e oil and gas markets are simply too large for any single group to control prices.

10. Th ere would be too many variables between OPEC and non-OPEC producers let alone considering consumer countries.

11. TTNRG Nature's Best.

12. Th is would hurt producers equally with the loss in revenues.

13. Th e Titanic sank for good; oil and gas markets go up and down.

14. Harts E & P Sept 2002 Drilling Column. 'Manage your tapped resources'. Discussion on industry cycles.

15. Idem.

16. Despite economic uncertainty certain deepwater projects are still going ahead.

17. See Yergins Prize 'Sweating'.

18. Th e Big Crew Change.

19. See 2005 US Senate Inquiries into Oil Prices.

20. Global economic growth has slowed down during the current recession but it will not disappear.

21. Th e comfort lifestyle.

22. See IMF commodity price charts.

23. Th is is the basis for substituting oil.

 

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