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 Structure of the oil industry
• The major oil producing entities have been state-owned since the mid-
1970s. Most belong to countries that are members of OPEC and depend
heavily on oil for revenues.

• OPEC, as a cartel, is tied into a policy of stabilising prices at fairly high levels
— largely for fiscal reasons. OPEC relies on output as its control tool; it was
not always thus.

• The largest sellers of oil products are privately owned companies. They sell
more oil than they produce, or refine.

• Term contracts predominate among the oil producing states, but the prices
of these contracts are set in the spot/futures markets. Some have
destination restrictions.

• Futures and derivatives markets have evolved to help the players handle
risk. The state-owned companies hardly ever participate in these markets.
 Oil price determination — a complex
story
• Economic theory tells us that prices are determined by the interaction
of supply and demand. This is true in an abstract, general sense;
however, in practice price determination is much more complex than
that.
• Spot oil prices are determined by what is known as stock
disequilibrium. Oil inventories change according to the following
identity.

• Change in Stocks = Oil Production less Oil Consumption

• The level of stocks is driven by these changes from a base level. At any
moment participants in the oil market wish to hold a certain level of
stocks, known as the ‘desired’ level.
 Oil price determination … continued
• The desired level of stocks depends on three key factors:
(a) the amount of oil needed to keep the business running,
usually expressed in days of forward cover;
(b) the amount needed as a contingency reserve for unforeseen
eventualities (e.g., supply disruptions);
(c) the amount wanted in order to gain from expected
movements in the price of oil (speculative demand).
• Oil prices are a function of the difference (so-called
disequilibrium) between the desired and actual level of
inventories (in practice, inventory cover).
 Refining

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Distribution of proved oil reserves

BP Statistical Review of World Energy

2012
© BP 2012
Oil production/consumption by region

BP Statistical Review of World Energy

2012
© BP 2012
Oil reserves-to-production (R/P) ratios

BP Statistical Review of World Energy

2012
© BP 2012
IEA Quarterly oil supply
Non-OPEC Supply
OPEC Supply
Oil production by area
Balance - inventories
US Reporting
Financial Markets
 Oil futures prices
• The prices we hear about on a daily basis (WTI and Brent) are actually
oil prices determined in the futures markets and refer to futures
contracts. These are contracts to buy and sell oil that is deliverable at
various times in the future, but at prices fixed today.
• There are two kinds of participants in the futures markets — hedgers
and speculators. Hedgers take particular positions in the oil futures
markets to offset their physical positions. Speculators have no desire
to offer or take delivery of physical oil in settlement; they buy and sell
contracts in the hope of reversing their deals at a profit sometime
before the expiry of the contract.
 Spot, term and futures prices
• Most of the oil sold by the main producers is on a term basis at prices
linked to spot/futures oil prices via formulae. Particular oil prices
apply depending on where the oil is heading (US, NW Europe or Far
East); for this reason destination restrictions usually apply.
• Spot prices interact closely with futures prices for the so-called front
month (the nearest futures contract) in a continuous arbitrage process
that prevents these two prices from straying too far from each other.
• Market fundamentals weigh heavily on spot prices, while hedging and
speculation drive futures prices. These forces come together where
spot and futures interact.
 Current Oil futures markets
Quality Location Quantity
US Markets
WTI Crude oil Cushing 1,000 bbl
Heating oil New York 42,000 US Gal
RBOB New York 42,000 US Gal
European markets
‘Brent’ crude oil North Sea* 1,000 bbl
Gasoil ARA 100 MT
Middle Eastern markets
Oman Oman 1,000 bbl

*‘Brent’ refers to a basket of North Sea crude oils that are cash settled, not physically delivered
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 CFTC Commitment of Trader report

Disaggregated Commitments of Traders-All Futures Combined Positions as of May 1, 2012

: Reportable Positions :
:------------------------------------------------------------------------------------------------------------- :
: Producer/Merchant : : : :
: Processor/User : Swap Dealers : Managed Money : Other Reportables :
: Long : Short : Long : Short :Spreading: Long : Short :Spreading: Long : Short :Spreading :
----------------------------------------------------------------------------------------------------------------
CRUDE OIL, LIGHT SWEET - NEW YORK MERCANTILE EXCHANGE (CONTRACTS OF 1,000 BARRELS) :
CFTC Code #067651 Open Interest is 1,602,007 :
: Positions :
: 249,344 323,478 156,819 334,148 219,626 225,381 39,280 292,390 149,156 108,614 216,954 :
: :
: Changes from: April 24, 2012 :
: 1,564 10,145 3,872 14,272 3,480 20,790 -789 9,053 -3,069 4,253 18,048 :
: :
: Percent of Open Interest Represented by Each Category of Trader :
: 15.6 20.2 9.8 20.9 13.7 14.1 2.5 18.3 9.3 6.8 13.5 :
: :
: Number of Traders in Each Category Total Traders: 342 :
: 50 56 21 30 41 78 35 69 55 47 80 :
Commitment of traders Report
Demand
 The demand for oil

To start with, oil is treated like any other good. Oil demand
depends on the nominal price of oil, the price of all other
goods and money income. Doubling the oil price, all other
prices and money income should leave the demand for oil
unchanged.
Oil thus becomes a function of the real price of oil and real
income - the classic hypothesis.
However, ...
 The demand for oil – (2)

• ...oil cannot be consumed without oil-burning equipment

(cars, ships, aeroplanes, boilers ...). The demand for oil thus
depends on the utilisation rate of the existing capital stock.
• The capital stock changes slowly over time in response to
economic and technological stimuli. The utilisation rate
changes much faster as people respond to variations in the
real oil price and real income — and the weather.
• The model of demand is thus more complex.
The impact of taxation:
Taxes as a percentage of the retail price

Gasoline Diesel
% %
USA 13 17
Germany 64 56
France 63 55
UK 66 65
Italy 59 52
Japan 42 30

Sources : IEA and CGES

Non-OECD Demand
OECD Demand
Refining
 Why high prices in 2008?
• Refiners were incapable of meeting the demand for low sulphur
diesel, following worldwide environmental regulatory changes,
except through
rationing by price

• Peak oil, speculation, political risk, OPEC cutbacks, long term

cycles, geopolitics, the dollar were not the reason for the price rise

• The price fall was because there was no longer a

constraint on the global refining system

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 Dominant Market Factors:
Increasing Chinese/Indian US Gasoline Stocks
Demand

Lack of upgrading
capacity

Instability in
producing areas Wrong type of crude

Rapid changes in the above have substantially affected prices

 What would change the situation?

• The price rise was going to continue until:

• Demand for low sulphur diesel stopped rising; and/or

• More refining capacity was built

 What would change the situation?

• The turning point was in the US – followed by Europe

– Demand in the US turned following the financial
crisis

• Sub-prime mortgage market

• Credit crunch

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Ridgeway Energy Consultancy Ltd
 Appendix

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 Final consumption

• Residential

• Commercial

• Industry

• Transport

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 Macroeconomic

• Growth projections reflects the interaction of many

economic variables and relationships.

– Short term

– Medium to long term

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 Short term

• Spending decisions (demand side) based on:

– Interest rates
– Prices
– Employment
– Income/wealth
– Fiscal and monetary policy

• It is the ability to produce goods and services (the

supply side) that ultimately determines the growth.

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 Medium to long term

• Economic growth depends on:

– Demographic trends
– Productivity trends
– Infrastructure
– Political stability

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 Medium to long term

• Impediments to economic growth:

• Europe, China, India

– Labour markets
– Products markets
– Social welfare
– State owned companies
– Banking systems

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