University of Zakho

College of Engineering
Petroleum Engineering Department

Petroleum Economic
Oil prices and Economic Fundamental of oil pricing

Prepared by : Ahmed Amir Ali

Supervised by: Mrs. Lulaf Mufti

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 List of content

Subject Nu. Of
Page

1. Oil Prices ………………………………………………….……. 2

2. Economic Fundamental of oil pricing ………………………

o Market (Supplay and Demand ……………………………..3-5

o Location ………………………………………………........6
o Transportation ………………………………………...……6-7

3. The Value of Crude Oil as Raw Material ……………………...…7

4. Crude Oil Characteristic………………………………………......7-9

5. World Oil Prices………………..………………………………….9-

10

6. Reference ………………………………………………………….11

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Introduction to oil prices
The price of crude oil, from which petroleum products such as gasoline are
derived, is influenced by a number of factors beyond the traditional movements of
supply and demand, notably geopolitics. Some of the lowest cost reserves are
located in sensitive areas of the world. There is not one price for crude oil but
many. World crude oil prices are established in relation to three market traded
benchmarks (West Texas Intermediate [WTI], Brent, Dubai), and are quoted at
premiums or discounts to these prices.

Crude oil import prices come from the Crude Oil Import Register. Information is
collected according to type of crude and average prices are obtained by dividing
value by volume as recorded by customs administrations for each tariff position.
Values are recorded at the time of import and include cost, insurance and freight
(CIF) but exclude import duties.

With each passing year, oil seems to play an even greater role in the global
economy. In the early days, finding oil during a drill was considered somewhat of
a nuisance as the intended treasures were normally water or salt. It wasn't until
1847 that the first commercial oil well was drilled in Azerbaijan. The U.S.
petroleum industry was born 12 years later with an intentional drilling near
Titusville, Pa.

While much of the early demand for oil was for kerosene and oil lamps, it wasn't
until 1901 that the first commercial well capable of mass production was drilled at
a site known as Spindle top in southeastern Texas. This site produced more than
100,000 barrels of oil in one day, more than all the other oil-producing wells in the
United States combined. Many would argue that the modern oil era was born that
day in 1901, as oil was soon to replace coal as the world's primary fuel source.

Oil's use in fuels continues to be the primary factor in making it a high-

demand commodity around the globe.

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Economic Fundamentals of Oil Pricing
The petroleum industry has very complex historical, political and economic
factors. Over the past five years, we have seen the oil price react to both political
and non-political events such as decisions by OPEC, trade agreements or even the
coronavirus affecting demand. However, this Tip of the Month discusses the
fundamental economic factors that determine the price of oil in the long term and
the global standards for crude oil valuation.

Politics and global events determine oil price in the short term; economics
determines oil price in the long term.

In our industry there are three primary economic factors that determine the price of
crude oil:

Primary factors:
1. MARKET (SUPPLY/DEMAND
2. LOCATION (TRANSPORTATION)
3. QUALITY (REFINING COST AND YIELD) 

These factors currently have the greatest effect on crude oil price. Supply and
demand must include both crude oil and petroleum products made from it.
Location will determine the transportation cost to move crude oil and/or petroleum
products from the point of production/refining to the customer. Lastly, crude oil
quality reflects the products that can be refined from a particular crude oil and the
cost to the refiner to do so.
 
1. MARKET (SUPPLY/DEMAND)
It should be realized that supply/price/demand are tied together as a package. It is
impossible to change any one of these three without affecting one or both others.
The relationship between supply and demand effects the price paid for oil and gas.
Conversely a significant change in price will affect both supply and demand. At
times it is all quite cyclical. For example, a major price increase commonly leads
to an increase in supply as the result of additional drilling. The same price increase

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frequently reduces demand as various conservation measures are taken. The result
is an imbalance of supply and demand, which may lead to a lower price.

Fig 1. Basic Supply and Demand Economic Model

 
The oil industry has experienced several of these cycles over the past 35 years.
There are also marked seasonal cycles of consumption—heavy gasoline demand
for summer driving and heavy home heating loads in winter—which must be
anticipated in planning refinery runs months ahead of time. The gas industry
experiences a semiannual cycle with peak loads in summer and winter and low
demand in spring and fall.
The unprecedented price volatility which has occurred since the “price shocks” of
the 1970s, and more particularly since crude oil began to trade as a commodity in
the 1980s, has had a dramatic impact on the industry. The results have severely
affected oil company profits, the revenues of oil exporting countries, and the
availability of investment funds. This, in turn, has led to great ingenuity by the
industry and the financial community in their efforts to manage price risk. Some
examples are diversifying product and investment portfolios, investing heavily in
R&D and integrating new technologies into processes such as the use of IoT.
The timing of available crude oil supply can be an important pricing factor.
Imported oil may take more than a month enroute on the high seas, even more if
the owners of the cargo choose to “slow steam” to conserve ship’s fuel, and

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perhaps to wait for an improved price at the receiving end of the voyage. The
inverse can also occur in a declining market. This has led to extensive use of
options and futures for price hedging for the longer haul crudes.

 
Longer range timing of available supply is also a principal factor in regard to the
industry’s exploration program. High prices make funds available for new
exploration. When prices plummet exploration is the first activity to be curtailed in
order to preserve oil company profits under the western world’s system of
accounting. The long lead times, five to ten years, between exploration and
discovery and actual production imposes another almost irreversible cyclic factor
into the equation. High prices beget increased exploration, and supply, which can
easily exceed overall demand.

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2. LOCATION (TRANSPORTATION)
Since crude oil production and local consumer demand are generally far removed
from one another, transportation is also a factor in setting the demand for certain
crudes. Crude oil has been moved from the oilfield to refineries by wagon, truck,
rail car, pipeline, barge, and tankship. Transportation costs vary with the means of
transport and volumes. Political jurisdictions, and sometimes the physical
characteristics of the crude oil, can also have an effect on its transportation. If there
is sufficient daily volume over land pipelines are the cheapest method. Crude oil
that can be moved in sufficient volume by pipeline will out-compete those crudes
which have to be moved overland by other methods.
Pipelines require large investments, and once installed must be kept full, in order to
realize their low throughput costs. In North America pipelines are probably subject
to more governmental regulation than are the other forms of crude oil
transportation due in large part to their having to cross so many tracts of
individually owned land. In other parts of the world operating pipelines have
sometimes been permanently shut down due to political problems.
The question is often asked, “Who pays the transportation cost for oil?” The
obvious answer is the ultimate consumer of petroleum products as they pay all
costs. But the more important question is “Who bears the burden of oil
transportation costs?” The answer to that question is the oil producer. Because the
price of oil into a refinery is determined by the quality of the crude and
supply/demand conditions, not where it is produced. The wellhead price for oil is
the refinery gate price minus the cost to transport it there. Houston, Texas is still
generally considered the central location for worldwide pricing of crude oil.
 
3. QUALITY (REFINING COST AND YIELD) 
Crude oil quality reflects the products that can be refined from a particular crude
oil and the cost to the refiner to do so.
A barrel of crude oil of itself is relatively worthless even though it will burn with a
low smokey yellow flame. As a raw material, crude oil’s mixture of hydrocarbons,
of greatly varying molecular weights, has great commercial value. The refining of
crude oil into the hundreds of industrial and consumer products is hardly a cottage
industry. Petroleum refining has to be done in sufficiently large industrial plants

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(called refineries) so that even the smallest product volumes can have sufficient
economy of scale to permit the whole refining process to be economically feasible.
In the larger oil companies the internal value of each individual type of crude oil as
a raw material is subject to intense study and computation by a group of experts.
On the basis of laboratory distillations and statistical calculations these refinery
engineers determine the optimum volumes and values of all the fractions of a
specific crude oil, including, for example, such attributes as the octane number of
its gasoline fraction and the pour point of its diesel fuel component.
 
THE VALUE OF CRUDE OIL AS A RAW MATERIAL
There is no single benchmark pricing source for crude oil. The tremendous volume
of trading in crude oils has evolved several major price references. These are Saudi
Arabian Arab Light, West Texas Intermediate (WTI), Forties and Brent from the
U.K. waters of the North Sea, Fateh from Dubai, and more recently the Urals-
Mediterranean for the Russian production entering the western markets. Singapore
quotations are also increasingly employed as a reference for crude oil pricing in the
Far East.
The location of the production, its transportation requirements, and its eventual
market also affect the value of a particular crude oil. The lighter, fairly sweet
crudes of North America and the North Sea find favor in the American market
where gasoline motor fuels have large demand. The heavier Mid-East crudes fit
well into the Japanese product market mix.
Crude oil is considered a transportation fuel, because as much of 90% of it is used
to power vehicles; namely gasoline, diesel oil and jet fuel. Modern refineries can
make these products from almost any quality of oil, but the cost of doing so is
greater for low gravity high sulfur crudes. Thus, there is a definite linkage between
the price of crude oil, the cost of refining, and the price of transportation fuels.
 
CRUDE OIL CHARACTERISTICS
Although the geologist, geophysicist and petroleum engineer may tend to think of
all crude oils as alike, the refining engineer knows differently. No two crude oils
are physically identical. Table 2-1 summarizes some of these differences.
Consequently, the products that can be recovered and manufactured also differ
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significantly from one crude oil to another. Lighter (i.e., higher API gravity) such
as Norwegian North Sea Ekofisk tends to have more gasoline by volume than
heavy crudes such as Persian Gulf Dubai Fateh which has proportionately more
gas-oil (diesel) and residue cracking stock.
Table 1. Typical Reservoir Fluids Characteristics

Crude oils from different sources are categorized according to the API gravity (a
rule of thumb index of the proportion of straight run gasoline to be expected), and
the weight percent of sulfur incorporated in the crude. The sulfur imparts
undesirable odor to the refined products and also increases their corrosiveness. A
crude oil is classified as a “sweet” crude if it contains less than 0.5% by weight of
sulfur and as a “sour” crude if it contains a greater amount. The price for a sour
crude may be significantly less than that for a sweet crude of similar API gravity

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.
Fig 2. API Gravity Chart example

WORLD OIL PRICING

Prices for crude oil in international trade are universally quoted in U.S. dollars per
API barrel of 42 U.S. gallons at 60°F. The derivation of the 42 gallon measure
goes back to the earliest days of the industry in Pennsylvania when oil was
transported by wagon in used 50 gallon wine barrels. There was a good deal of
spillage and the pattern of the trade was to pay for only 42 gallons at the
destination without resort to further measurement. Producers soon learned to ship
that way as well.

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Some international statistics regarding production are quoted in metric tons. This
method of measurement derives from Europe, where most crude oil has been
received by oceangoing tanker, and weight (displacement) was an easier gauge.
Conversion of one measure to the other requires knowledge of the density, or API
gravity, of the specific crude oil. Actual monetary settlements are generally made
in currencies other than U.S. dollars.
More and more often in the present state of the world economy, and most
particularly in the developing world, settlements for crude oil imports may involve
barter arrangements for exportable goods from the purchasing country.
The term “world price” occurs frequently in economic discussions of the petroleum
business. This is a quite general term. In the eastern hemisphere it is often taken to
mean the per barrel price paid for spot, or unscheduled tanker load purchases of
crude oil in Rotterdam harbor. Elsewhere it may mean the OPEC posted price for
“reference” Saudi Arabian light crude. In several oil-importing industrialized
countries “world price” may refer to the actual, or historical cost of the average
imported barrel of crude oil into that country. For the first seventy-five years of the
industry, after the Drake well in Pennsylvania, the prices of domestic North
American and overseas crude oils each demonstrated a high degree of stability and
similarit

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Reference:
1. https://www.investopedia.com/articles/economics/08/determining-oil-

prices.asp.

2. https://www.petroskills.com/blog/entry/00_totm/feb20-sub-economic-

fundamentals-of-oil-pricing#.XuuVa0VvaM_

3. https://www.oecd.org/about/publishing/38413051.pdf

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