Oil & Gas

From exploration to distribution

Week 1 V02 Energy commodity markets
Sidney Lambert-Lalitte

W1V2 Energy commodity markets p. 1

IFPEN - IFP School 2015 / TOTAL SA 2015 / IFP Training 2015

Introduction
You have already seen with Arash the global energy scene and the main areas of production
and consumption throughout the world. Now, in this session, we will see together how oil
and gas, extracted from reservoirs, are priced and traded in international energy markets.

Oil price formation history

Let us start by looking at how the price of crude oil has evolved from the beginning. Just
after the first discovery of oil by Colonel Drake and the Oil rush in North America, the
Rockefeller empire was established as a monopolistic entity. John D. Rockefeller controlled
the oil pricing system by using the posted price of oil, that he set himself every morning, at
the gate of his refineries. This was the pricing regime until 1911, which ended with the
dissolution of his empire: the Standard Oil Company.
Later on, crude oil was fairly stable as oil supply was somehow controlled by big private
market players, known as the Seven Sisters. This stability continued with the foundation of
the Organization of the Petroleum Exporting Countries in 1960, controlling approximately
half of the world oil supply.
Suddenly, due to unpredicted geopolitical events (political tensions, revolutions, wars) this
stability left the floor to pure chaos and two consecutive Oil Shocks in 1973 and 1979.
Since then, there is a consensus among experts that market forces, both physical and
financial, are the main drivers behind the crude oil price formation.

W1V2 Energy commodity markets p. 2

IFPEN - IFP School 2015 / TOTAL SA 2015 / IFP Training 2015

Oil pricing fundamentals & markers

In the market, there is not a single crude oil price, simply because there are many qualities of
oil, due to different densities, sulfur contents, and other technical properties that we will
discuss in detail in the next sessions. At the moment, just bear in mind that the lighter and
the sweeter the crude, the higher the price.

As a matter of fact, practitioners apply some sort of benchmarking system that not only
takes into account these quality differences, but also the transport arbitration, resulting
from the multiple locations of crude sources.
Oil markers are the benchmarks that are used for pricing crude oil from different regions of
the world.

W1V2 Energy commodity markets p. 3

IFPEN - IFP School 2015 / TOTAL SA 2015 / IFP Training 2015

WTI, Oman-Dubai and Brent are the most famous examples, respectively used in North
America, Asia and Europe and even beyond.
To become a reliable marker, both physical and financial infrastructures are needed, which
means enough reserves, considerable production, proper geographical location, solid
financial liquidity, and of course geopolitical stability.

Natural gas pricing

Pricing efficiently natural gas is slightly more challenging, due to transportation constraints,
as gas can only be brought to the final consumer through gas pipelines. However, in the last
decade, the development of the liquefied natural gas chain has opened new maritime supply
routes for international trade.
There are two main pricing systems for natural gas: oil indexation and gas-to-gas
competition. As the name indicates, in the oil indexation system, the price of natural gas is
linked to the crude oil price in the targeted market. The Asian market is a very good example
of this pricing regime.

W1V2 Energy commodity markets p. 4

IFPEN - IFP School 2015 / TOTAL SA 2015 / IFP Training 2015

In the second pricing system, I mean gas-to-gas competition, we use gas hubs as a reference.
These hubs are somehow comparable to oil markers. Henry hub in the United States, and
the National Balancing Point (NBP) in the United Kingdom are the two most active ones.
As for oil markers, natural gas hubs must also have solid properties both in terms of physical
and financial infrastructure, so as to be considered as a reliable reference point for both
producers and consumers.

W1V2 Energy commodity markets p. 5

IFPEN - IFP School 2015 / TOTAL SA 2015 / IFP Training 2015

Physical & Financial markets

Since the 1980s, there has been a growing need for price stability and visibility. Markets
have developed as the most efficient tool responding to this end.
In this context, physical markets have emerged, enabling market players to trade energy
commodities. When the exchange happens in real time and with a physical delivery, we call
it a spot transaction. But suppliers and consumers can also secure a future delivery for a
given price by contracting forward transactions.
In parallel to this physical market, there is also the financial market, which enables market
players to trade financial contracts or assets without any physical delivery at the term of the
contract. Futures contracts are one of the most famous and traded products in this market.
The main purpose of this market is to provide market players with some sort of standardized
financial product so as to be able to cover themselves against risks associated with price
volatility.

Lets take the example of an airline company that needs to supply its aircraft fleet with jet
fuel. This company will want to hedge itself against a future price increase of fuel. To do so,
it can buy oil products under forward contracts in the physical market for the coming
months. Now, imagine at the delivery date agreed in the contract, the price of fuel is far
below the one previously set between the two contractors. So, in some sense, the airline
company will lose money as it is buying fuel at a higher price than what is being announced
on the spot market.
In order to prevent this loss, the company could have covered itself by taking an opposite
position on the financial market. By this, I mean to make a financial deal with another
counter-party in which the airline company bets on the price decrease. In other words, the
airline company will get paid if the price of fuel decreases in the future. And this can
compensate the former loss already produced in the previous physical contract.
Through this example, we have talked only about futures contracts on the financial markets.
But there are also more financial products such as swaps, options and other derivatives that
can help market players in their hedging strategies against future price variation.
Roughly speaking, for market players, better hedging strategy brings more certainty and
stability in terms of the future price of the commodity and hence future income.
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IFPEN - IFP School 2015 / TOTAL SA 2015 / IFP Training 2015

Conclusion
Since the emergence and the gradual development of financial markets, more and more
liquidity and financial security has been brought into the energy commodity markets. These
phenomena have both pros and cons: pros in the sense that they have provided the market
players with many trading and risk management tools to hedge against price instability. On
the other hand, these financial markets have also encouraged the arrival of speculators,
who are pure financial gamblers without any hedging strategy.
Nowadays, trading on financial markets is the predominant type of transaction for
exchanging commodities. But what really matter, in the long term, are the physical market
fundamentals: in simple words, the balance between supply and demand remains the main
driver for determining the price of crude oil and energy commodities in general. And the
current sharp fall in oil prices is a striking example to observe.

W1V2 Energy commodity markets p. 7

IFPEN - IFP School 2015 / TOTAL SA 2015 / IFP Training 2015