Brent Crude Oil Analysis

1. Crude Oil Dynamics

Crude oil, the most actively traded global commodity, is being traded both on the physical and futures market thus simultaneously mirroring current and expected economic fundamentals conditions. The largest crude oil markets, both in the physical and financial sense, are in London, New York and Singapore.

The crude oil market consists of 161 different crude oils which vary in quality, characteristics and market penetration. What is specific about the crude oil market is the high diversity in quality (differences in grades and variety) among the crudes depending on their place of extraction. To simplify the market, oil benchmarks (also known as markers) are used, with Brent being recognized as the global reference point for two-thirds of the world’s internationally traded crude oil supplies[1]. Hence, the most quoted price worldwide is that of a barrel of Brent blend crude oil from the North Sea sold at the ICE Futures Exchange (previously known as the International Petroleum Exchange (IPE)). The three key world crude oil benchmarks are WTI, Dated Brent and Dubai-Oman. Another important benchmark is the OPEC Reference Basket (ORB) which is a weighted average of heavier than Brent Crude and WTI petroleum blends manufactured by OPEC countries.

1.1 Product characteristics

An analysis of Brent Crude product characteristics will be done both from a physical and from a producer’s point of view.

Crude oil has two main characteristics – density and sulphur. Lower density and low sulphur correspond to sweet crudes (Brent Crude), while higher density and high sulphur define sour crudes (America’s Crude Marker). The crude oil assa is a chemical evaluation of crude oil done by testing laboratories; it provides hydrocarbon analysis for refiners, oil producers and oil traders.

Brent Crude is a sweet light crude oil sourced from the North Sea, typically refined in northwest Europe, the Mediterranean, and the East Coast or Gulf Coast (U.S.A.). The Brent crude is a combination of crude oils sourced from 15 oil fields in the Brent and Ninian systems with Brent Blend, Forties, Oseberg and Ekofisk crudes being the major ones. The Brent benchmark refers to a high-quality light crude oil[2] used as a benchmark for Brent Blend, London Brent and Brent Petroleum. Even though it is priced above WTI, it is not as light as the latter[3]. The oil is appropriate for the production of middle distillates, such as kerosene, diesel, and petrol. Its API gravity [4] is 38.06 and specific density[5] equals 0.835 (International Energy Agency).

Another classification of the characteristics of crude oil is from a producer’s perspective. The most important ones from this point of view are global crude oil stockpiles, proven and unproven oil reserves (especially global strategic petroleum reserves[6]), spare production capacity and others[7].

Strategic petroleum reserves (SPR), readily available stocks of crude oil, are used as a response in an economically threatening[8] disruption in oil supplies. In the case of private oil companies, stockpiling is done either to profit from selling oil in the future or to maintain access to oil in times of physical shortages.

Another major characteristic, excess production capacity, has tightened with time. It is used to absorb a significant oil disruption. Even though not officially reported, it is considered that non OPEC countries have minimal to none, while OPEC countries have significant slack capacity. As is the case with Saudi Arabia, due to past and expected investments in expanding their production capacity, the country has a slack capacity of approximately 1.5 – 2 mbpd: hence OPEC’s influence on crude oil prices.

1.2 Nature and forms of trading

Crude oil can be traded along the entire petroleum value chain. However, the first ‘liquid market’ is upstream, close to the production point. Crude oils are traded through different contract types (including ‘spot’ transactions) which serve to transfer the physical ownership of crude oil from supplier to buyer and to manage the commodity’s financial risks.

The physical oil market is solely used for receiving and delivering crude oil. Non-standard, spot contracts are used and the title and risk are transferred at a specific time and venue.

Crude oil futures contract began trading on the NYMEX exchange in 1983 and until now, the NYMEX Division light sweet crude oil futures contract is the most liquid and largest in volume (as it comes to physical commodities) platform for oil trading. Brent crude oil was initially traded on the IPE (International Petroleum Exchange) in London, which was transformed into ICE (Intercontinental Exchange) in 2005. Futures contracts for crude oil are also traded at Dubai Mercantile Exchange (DME), Multi Commodity Exchange (MCX), India’s National Commodity and Derivatives Exchange (NCDEX) and the Tokyo Commodity Exchange (TOCOM). A typical crude oil futures contract is paid daily, traded on regulated exchanges, has a minimum purchase of 1,000 U.S. barrels and is quoted in U.S. dollars.

Counter intuitively, the futures market volumes are much larger than physical trading ones. Different types of trading that occur within the crude oil market include arbitrage, spread trading, refinery trading and physical outright (long/short) trading.

1.3 Market participants

The main activities associated with the physical movement of crude oil include:

• Production (done by a producer)

Locating, extracting and transporting crude oil

• Refining (refiner, distiller)

Crude oil is processed and refined into naphtha, gasoline, heating oil etc.

• Distribution and marketing (traders, brokers, marketer)

Moving end products to consumers

A massive physical infrastructure maintained by an international financial market supports those processes and connects buyers and sellers worldwide. It is comprises the following physical assets: drilling rigs, pipelines, ports, tankers, trucks, warehouses, refineries, product terminals, retail storage tanks and gasoline pumps.

Down the pipeline from extraction through refinement to distribution and consumption, the crude oil market players can be divided into producers (platform, wellhead), oil refiners, marketers, brokers, oil traders and consumers which buy and sell physical volumes of crude oil and petroleum products (Marketing and Trading of Crude Oil)

Since the international crude oil market also comprises futures and other financial contracts futures trading distinguishes the following categories of actors:

• Hedgers

Market participants who have a direct interest in physical oil production, consumption or trade purchase crude oil futures to hedge against rising crude oil prices.

• Speculators

Participants in the futures market who do not want to trade physical oil take risky positions with the intention of profiting from short- or medium-term crude oil price fluctuations.

• Arbitragers

Arbitragers take advantage of the sporadic disparities between the prices of the same assets in different markets. This is possible due to logistical constraints that are not feasible on the commodity futures market.

1.4 Crude Oil Pricing System: PRAs, price identification and formulae pricing

Price Reporting Agencies (PRA) are essential in identifying the prices of oil market crudes. Platts, Argus Media, ICIS London Oil Report and APPI are the most prominent of these. Although their price assessments are close to one another, their data reporting methodologies differ considerably. Platts and Argus, the most internationally recognized of the four, utilize a mix of judgement and mechanistic analysis. What is important about the agencies is that they act as reflectors of the trade and do have a substantial influence on key-decision makers within the industry. Also, the difference between different agencies impacts crude oil revenues, flows and exporters. (IEA, IEF, OPEC and IOSCO, 2011)

Crude oil prices are simultaneously determined by a mix of variables. Those can be found within the physical layer that consists of the so called differentials, timing, location and crude oil quality, and the financial layer that is comprised of futures, forwards, swaps etc. The price of a particular crude oil is established at a discount or a premium to a market or reference price. What is typical of crude oil prices is that they are closely related and the price difference between different benchmarks is limited.

Their main functions are:The main factors to play a role in crude oil price formation include global demand growth, financial speculation and obliging monetary policy. Formulae pricing is the price identification of the three crude oil markers that are the key components of the oil pricing system – WTI, Brent and Dubai-Oman.

• to price cargoes under long-term contracts or in spot market transactions
• to settle financial contracts or derivative instruments
• for taxation purposes (Fattouh, 2011)

The process of price identification in the Brent Market begins with the identification of the price of the Brent Forwards, which is the value of the cargo for physical delivery within a month. PRAs use Exchange for Physicals markets (EFPs) to link the forward and futures prices − the oil price in the forward market is priced as a differential to the price of the Brent futures contract. That is followed by calculating the price of North Sea Dated or Dated Brent (spot market for Brent) as a differential to the forward market through the Contract for Differences Swap Market (CFDs). Due to the limited number of oil deals that the PRAs observe, it is through the value of differentials in the OTC Dubai/Brent swaps market that the value of Dubai is assessed. In conclusion, the discovery of the prices within the oil pricing system cannot be done without the inclusion of the financial layers as well. For each of the weeks the price of the Dated Brent swaps is reported based on the derived forward dated Brent curve – calculating the average of Forward Dated Brent (10-21 days). (Fattouh, 2011)

The Formula pricing for long-term contracts is the following:

with the price of crude (x) equal to the benchmark plus or minus the value of the price differential (price agreed at the time when the deal is concluded set by the oil exporting country and assessed by PRAs). (Fattouh, 2011)

1.6 Fundamentals and market factors

Shortages or oversupply cause crude oil prices to swing with the price cycle extending over several years. A rise in oil prices leads to a rise in the cost of production of goods and services, which in turn, influence inflation, consumer confidence and the financial markets. The countries most likely to be adversely affected by rising crude oil prices are those with high net imports of oil per GDP, large marginal propensities to consume and invest, small marginal propensity to import, where exports have a large share in GDP and those with a low level of exports to oil (Yanagisawa, 2012).

The departure of oil prices from the economic fundamentals of demand and supply are affected by geopolitical factors, persistent beliefs that oil is about to become a scarce commodity and future expectations. OPEC’s cartel behaviour also affects oil prices by the use of quotas and market power.

Aggregate demand growth in emerging markets, due to commodity-intensive industrialization, per capita income growth, increasing population and urbanization, reinforces the upward shift in aggregate commodity demand and thus influence oil prices.

As concerns production, constraints have the expected effect – increases in crude oil prices are closely associated with substantial slower output growth.

As for inflation, since crude oil is a major economy input,[9] products’ end prices follow the upward or downward movement of oil prices. However, there is a relatively recent detachment in the relationship that was even more apparent during the oil price run-up from 1999 to 2005, in which the annual average nominal price of oil rose from $16.56 to $50.04. During the same period, the CPI rose from 164.30 in January 1999 to 196.80 in December 2005 (Sedik, 2011) ( International Energy Agency, 2012).

1.7 The role of energy security

In the 1980s and 1990s energy security was understood as guaranteeing oil price stability, but with time its nature has transformed. During the 2008 economic and financial crisis it highlighted the supply and demand economic fundamentals and has recently focused on emerging market demand, diversification of energy sources and the use of hedging in limiting the influence of price volatility (International Energy Agency, 2012).

Rising energy prices, due to increases in extraction expenses, for example, have been one of the major threats to energy security. In the short term, this implies crude oil being physically accessible and economically viable to extract. Countering energy threats and securing the existence of readily available energy resources are the essence of energy security.

In a broader sense, energy security includes energy independence, energy efficiency and protection against energy supply disruptions which can be reiterated as availability, accessibility, affordability and acceptability both to society and the environment.

[1] According to IPE

[2] With a sulphur content of 0.37%, which is below the NYME benchmark for sweet oils that is less than 0.42% sulphur

[3] WTI is also a light sweet crude oil, but with a lower sulphur content than Brent – 0.24%.

[4] Measurement of heaviness as compared to water that determines whether the crude oil is a light one

[5] The ratio of the oil density compared to the density of water

[6] Crude oil stockpiles held by the government of a particular country, as well as private industry, for the purpose of providing economic and national security during an energy crises.

[7] Among them are crude oil field production, refinery production, imports, net receipts, days of supply, drawdown rate etc.

[8] As defined by IEA – one that blocks 7 % of daily world consumption

[9] 94% share in transport in 2011, also, since petroleum is heavily used in aircrafts, motor vehicles, marine vessels etc. transportation is the industry most heavily influenced by the volatility in oil prices.