SPE October Meeting Presentation 2006 Copyright Dalton H. Garis 2006 1.

SPE October Meeting SPE October Meeting Presentation 2006Presentation 2006 Copyright Dalton H. Garis 2006Copyright Dalton H. Garis 2006 11


“Where’s My Benchmark?”

Oil Price Formation, Benchmarks, and the Upper Zakum Stream

“Where’s My Benchmark?”

Oil Price Formation, Benchmarks, and the Upper Zakum Stream


Crude Crude Price Price

FormationFormation

Crude Crude Price Price

FormationFormation


. . . How most think crude oil . . . How most think crude oil prices are formed . . .prices are formed . . .

. . . How most think crude oil . . . How most think crude oil prices are formed . . .prices are formed . . .


AreAre theythey rightright ??AreAre theythey rightright ??


For producers, what is For producers, what is essential to know is that essential to know is that the the crude oil price is crude oil price is demand-drivendemand-driven..

• Price = Marginal CostPrice = Marginal Cost is not is not used; used; Marginal Price = Marginal Price = Marginal benefitMarginal benefit is used. is used.

• Price therefore based on Price therefore based on ““willingness to paywillingness to pay”” and not and not on on ““willingness to supplywillingness to supply..””


For producers, what is For producers, what is essential to know is that essential to know is that the the crude oil price is crude oil price is demand-drivendemand-driven..

• There is no surplus supply There is no surplus supply capacity as existed before.capacity as existed before.

• Price therefore follows fear of Price therefore follows fear of shortages in the presence of shortages in the presence of persistent demand increases.persistent demand increases.


In the Long Run, crude prices based on supply and demand Fundamentals.

In the Long Run, crude prices based on supply and demand Fundamentals.• Daily Oil Balance (EIA) tells the story

and is watched carefully.• Daily Oil Balance (EIA) tells the story

and is watched carefully.• Production is watched (news events).Production is watched (news events).• And, demand is watched (GDP).And, demand is watched (GDP).

•USA biggest consumer, but China steals the show for analysts

• Production is watched (news events).Production is watched (news events).• And, demand is watched (GDP).And, demand is watched (GDP).

•USA biggest consumer, but China steals the show for analysts


But in the Short Run, crude prices But in the Short Run, crude prices are based on future price are based on future price expectations for buyers and sellers.expectations for buyers and sellers.

• Trading itself forms prices, which Trading itself forms prices, which subsequently induce more trading.subsequently induce more trading.

• Traders act and react in anticipation of Traders act and react in anticipation of what other traders likely to do.what other traders likely to do.

• And news drives fear and greed in the And news drives fear and greed in the markets.markets.


““Economic models differ Economic models differ from models in the from models in the physical sciences in that physical sciences in that agents are supposed to agents are supposed to anticipate the future.anticipate the future.”” - Didier Sornette, U-Cal Professor - Didier Sornette, U-Cal Professor of Geophysics (2003)of Geophysics (2003)

OUTLIERS ARE THE OUTLIERS ARE THE NORMNORM!!


A price-auction market is A price-auction market is

characterized bycharacterized by qualitatively qualitatively hierarchical behaviorhierarchical behavior—imitation, —imitation, herding, contrarianism—in the herding, contrarianism—in the presence ofpresence of endogenously endogenously generated singularitiesgenerated singularities (critical (critical

points) triggered by points) triggered by exogenous exogenous information cascadesinformation cascades..

This dynamical system exhibits This dynamical system exhibits self-organization about chaotic self-organization about chaotic bifurcationsbifurcations——boundedly rational boundedly rational responses to extreme eventsresponses to extreme events..


It is It is ““computationally irreduciblcomputationally irreduciblee”” and therefore unpredictable. and therefore unpredictable. But we see extreme events But we see extreme events constantly generated by imitation constantly generated by imitation between traders which cause between traders which cause local—and eventually global—local—and eventually global—self reinforcement. self reinforcement. ----Sornette 2003Sornette 2003Probabilistic models of markets Probabilistic models of markets exhibit fat tails—numerous exhibit fat tails—numerous outliers.outliers.


Month Last Chg Volume OpenInt Date

Dec '06 60.75 0.39 90464 318724 10/27/2006 Jan '07 62.53 0.54 8875 124382 10/27/2006 Mar '07 64.61 0.66 234 41882 10/27/2006 May '07 65.91 0.69 5 29898 10/27/2006 Jun '07 66.41 0.7 126 68343 10/27/2006 Aug '07 67.23 0.72 1 13626 10/27/2006 Oct '07 67.83 0.74 2414 16948 10/27/2006

Dec '07 68.28 0.77 328 117889 10/27/2006 Jan '08 68.45 0.78 3065 13957 10/27/2006 Feb '08 68.58 0.77 650 9963 10/27/2006 Mar '08 68.68 0.76 2469 13109 10/27/2006 Apr '08 68.76 0.75 75 5892 10/27/2006

May '08 68.83 0.75 750 4379 10/27/2006 Jun '08 68.88 0.75 5 22163 10/27/2006 Jul '08 68.9 0.75 100 4515 10/27/2006

Aug '08 68.91 0.75 650 2930 10/27/2006 Sep '08 68.9 0.75 325 12749 10/27/2006 Oct '08 68.88 0.75 70 2540 10/27/2006 Nov '08 68.86 0.75 100 2620 10/27/2006

Dec '08 68.83 0.75 10 52187 10/27/2006 Dec '09 67.7 0.64 300 30497 10/27/2006 Dec '10 66.35 0.54 2 36557 10/27/2006 Dec '11 65.1 0.47 35 17344 10/27/2006 Dec '12 63.88 0.42 29 11060 10/27/2006

Crude Light Oil Comp. - nymexData retrieved at Oct 29 03:21:59 GMT • All quotes are in Greenwich Mean Time • Data


Expectations for future demand:

Expectations for future demand:

•We have enough oil now . . .We have enough oil now . . .

•BUT MARKETS DONBUT MARKETS DON’’T CARE.T CARE.

• NOW THEY ARE MORE NEGATIVE NOW THEY ARE MORE NEGATIVE

ON THE L.R. FUTURE.ON THE L.R. FUTURE.

• No one wants to be the last to hold aNo one wants to be the last to hold a big and highly leveraged position.big and highly leveraged position.


Expectations for excess Expectations for excess production capacity:production capacity:

• Prices rise when excess production Prices rise when excess production

capacity falls below 1-1.4 mbd. Based capacity falls below 1-1.4 mbd. Based

on risk.on risk.

• If OPEC cuts supply to support prices . . If OPEC cuts supply to support prices . .

..

•It increases excess capacityIt increases excess capacity

•And erodes risk premium.And erodes risk premium.


Value and Price are like Love and Marriage!Value and Price are like Love and Marriage!

•Fundamentals say Fundamentals say ““lots of oil.lots of oil.””

More now than when $28.00/bbl.More now than when $28.00/bbl.

•2003 balance was less, but so was price.2003 balance was less, but so was price.•2004-5 balance larger, and so2004-5 balance larger, and so

was crude price. was crude price. •2006 even higher: little daily surplus and 2006 even higher: little daily surplus and even less excess production capacity.even less excess production capacity.


Real change is in price Real change is in price stability, not volatility, stability, not volatility, which has remained which has remained largely unchanged.largely unchanged.

• Price gaps more common.Price gaps more common.

• Extremely news sensitive.Extremely news sensitive.

• Strong contrarian thinking.Strong contrarian thinking.


BenchmarksBenchmarks&&

PricesPrices


What is a Benchmark Crude?What is a Benchmark Crude?A Crude standard against which other crudes in a market can be priced.

Atlantic Basin: Atlantic Basin: BrentBrent. North America: . North America: WTIWTI. For Pacific-Asia: . For Pacific-Asia: Dubai-Oman.Dubai-Oman.

http://legacy.futuresource.com/ifs/quotes.asp?cID=WSJ&symbols=CLZ07&options=CLZ07&root=CL&title=Light%20Crude%20Oil

http://legacy.futuresource.com/ifs/quotes.asp?cID=WSJ&symbols=CLM08&options=CLM08&root=CL&title=Light%20Crude%20Oil





What makes a good Benchmark crude? What makes a good Benchmark crude?

• Sufficient volume for physical trades.• Sufficient volume for physical trades.

•A representative crude in weight and sourness similar to extensively

traded crude streams.

•A representative crude in weight and sourness similar to extensively

traded crude streams.

•Reselling and derivative sales capabilities.•Reselling and derivative sales capabilities.


What will a good What will a good Benchmark Crude do?Benchmark Crude do?

• Reduce buyer and seller risks.Reduce buyer and seller risks.• Transparently discover prices.Transparently discover prices.

• Reduce price volatility.Reduce price volatility.

And . . .And . . . Correctly underpin Correctly underpin forward and retrospective forward and retrospective

crude sales.crude sales.


Hedging Is Big Hedging Is Big BusinessBusiness

““Derivative traders Derivative traders are competing are competing vigorously for vigorously for business, evidence business, evidence that risk is being that risk is being transferred to those transferred to those who profit from who profit from bearing it at bearing it at competitive rates.competitive rates.”” Energy Information AgencyEnergy Information Agency


NYMEXNYMEXCrudeCrudeAndAndProductProductFuturesFuturesContractsContracts


Contract Specifications:Contract Specifications:Light, Sweet Crude

Trading unit: Crude Oil Futures trade in units of 1,000 U.S. barrels (42,000 gallons).

Trading Months: Crude Oil Futures trade 30 consecutive months plus long-dated futures initially listed 36, 48, 60, 72, and 84 months prior to delivery. Additionally, trading can be executed at an average differential to the previous day’s settlement prices for periods of two to 30 consecutive months in a single transaction. These calendar strips are executed during open outcry trading hours. Options: 12 consecutive months, plus three long-dated options at 18, 24, and 36 months out on a June/December cycle.

Price Quotation: Crude Oil Futures are quoted in dollars and cents per barrel.


Contract Specifications (contd.):Contract Specifications (contd.):

Minimum Price Fluctuation: $0.01 (1¢) per barrel ($10 per contract).

Maximum Daily Price Fluctuation: Futures: Initial limits of $3.00 per barrel are in place in all but the first two months and rise to $6.00 per barrel if the previous day's settlement price in any back month is at the $3.00 limit. In the event of a $7.50 per barrel move in either of the first two contract months, limits on all months become $7.50 per barrel from the limit

in place in the direction of the move following a one-hour trading halt.

Last Trading Day: Crude Oil Futures: Trading terminates at the close of business on the third business day prior to the 25th calendar day of the month preceding the delivery month. If the 25th calendar day of the month is a non-business day, trading shall cease on the third business day prior to the last business day preceding the 25th calendar day.


Contract Specifications (contd.):Contract Specifications (contd.):

Delivery

F.O.B. seller's facility, Cushing, Oklahoma, at any pipeline or storage facility with pipeline access to TEPPCO, Cushing storage, or Equilon Pipeline Co., by in-tank transfer, in-line transfer, book-out, or inter-facility transfer (pumpover).

Delivery Period: All deliveries are rateable over the course of the month and must be initiated on or after the first calendar day and completed by the last calendar day of the delivery month.

Alternate Delivery Procedure (ADP): An Alternate Delivery Procedure is available to buyers and sellers who have been matched by the Exchange subsequent to the termination of trading in the spot month contract. If buyer and seller agree to consummate delivery under terms different from those prescribed in the contract specifications, they may proceed on that basis after submitting a notice of their intention to the Exchange.


Contract Specifications (contd.):Contract Specifications (contd.):Exchange of Futures for, or in Connection with, Physicals (EFP). The commercial buyer or seller may exchange a futures position for a physical position of equal quantity by submitting a notice to the Exchange. EFPs may be used to either initiate or liquidate a futures position.

Deliverable Grades: Specific domestic crudes with 0.42% sulfur by weight or less, not less than 37° API gravity nor more than 42° API gravity. The following domestic crude streams are deliverable: West Texas Intermediate, Low Sweet Mix, New Mexican Sweet, North Texas Sweet, Oklahoma Sweet, South Texas Sweet. Specific foreign crudes of not less than 34° API nor more than 42° API. The following foreign streams are deliverable: U.K. Brent and Forties, and Norwegian Oseberg Blend, for which the seller shall receive a 30¢-per-barrel discount below the final settlement price; Nigerian Bonny Light and Colombian Cusiana are delivered at 15¢ premiums; and Nigerian Qua Iboe is delivered at a 5¢ premium.


Contract Specifications (contd.):Contract Specifications (contd.):Inspection:Inspection shall be conducted in accordance with pipeline practices. A buyer or seller may appoint an inspector to inspect the quality of oil delivered. However, the buyer or seller who requests the inspection will bear its costs and will notify the other party of the transaction that the inspection will occur.

Position Limits: Any one month/all months: 20,000 net futures, but not to exceed 1,000 in the last three days of trading in the spot month.

Margin Requirements: Margins are required for open futures or short options positions. The margin requirement for an options purchaser will never exceed the premium.

Trading Symbol: Futures: CL; Options: LO.


Brent, Dated Brent, and 21 Day Brent make up largest

Benchmark

Brent, Dated Brent, and 21 Day Brent make up largest

Benchmark•60% of world’s physically traded crude uses the Brent as marker.•60% of world’s physically traded crude uses the Brent as marker.

But Brent is lighter and But Brent is lighter and sweeter than most sweeter than most Middle East crudesMiddle East crudes

But Brent is lighter and But Brent is lighter and sweeter than most sweeter than most Middle East crudesMiddle East crudes


Most of the world’s crude reserves are in

the MENA region.

Most of the world’s crude reserves are in

the MENA region.

And most of world’s crude is heavy and becoming more sour.

And most of world’s crude is heavy and becoming more sour.


But where is the heavier sour marker crude?But where is the heavier sour marker crude?And where is the price for Middle East crudes benchmarked and discovered?

And where is the price for Middle East crudes benchmarked and discovered?

NOT IN THE NOT IN THE MIDDLE EASTMIDDLE EAST


the Upper ZakumBenchmark Crude

Alternative Proposal.

the Upper ZakumBenchmark Crude

Alternative Proposal.


What about Dubai-Oman?What about Dubai-Oman?

Production falling off.Dissimilar characteristics.

Faces thin-market problems.

Production falling off.Dissimilar characteristics.

Faces thin-market problems.


Platts has already moved to include Upper Zakum to support the Dubai-Oman contract. UZ as a benchmark is a superior solution

Platts has already moved to include Upper Zakum to support the Dubai-Oman contract. UZ as a benchmark is a superior solution


Can Upper Zakum be Can Upper Zakum be the Benchmark Crude?the Benchmark Crude?•Saudi Light is largest single stream …•Saudi Light is largest single stream …

•But KSA refuses to allow reselling.•But KSA refuses to allow reselling.

•UZ has the volume, UZ has the volume, physical characteristics physical characteristics and acceptability to work.and acceptability to work.


Contracting revenues would not be affected.Contracting revenues would not be affected.

•Assured price discovery – Less price drift and retrospective corrections.•Assured price discovery – Less price drift and retrospective corrections.

•Greater counterparty trust –Transparent process and timely pricing means no lags in pricing.

•Greater counterparty trust –Transparent process and timely pricing means no lags in pricing.


Additional benefits:Additional benefits:•Significant technology transfer into UAE: Local price discovery integration between producers, DME, and consumers.

•Significant technology transfer into UAE: Local price discovery integration between producers, DME, and consumers.

•Value additions to local and regional economy also large: New energy marketing and financing infrastructural establishment.

•Value additions to local and regional economy also large: New energy marketing and financing infrastructural establishment.


In Sum:• LR: Prices determined by fundamentals.•SR: Prices determined by the interplay of traders to news and their own actions.

•Reactions to production-consumption news.•Reactions to excess capacity news.

In Sum:• LR: Prices determined by fundamentals.•SR: Prices determined by the interplay of traders to news and their own actions.

•Reactions to production-consumption news.•Reactions to excess capacity news.

SPE October Meeting Presentation 2006 Copyright Dalton H. Garis 2006 1.

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Transcript of SPE October Meeting Presentation 2006 Copyright Dalton H. Garis 2006 1.