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Relationships in the crude oil market
There is no need to convince anyone that it is difficult to predict how oil prices will change. This is not due to a lack of knowledge about the mechanisms that shape oil and fuel prices, but to the occurrence of unpredictable events that change the relationship between supply and demand.
The global network of connections between regional oil and fuel markets and economies is causing a butterfly effect.
The symbolic undercooked bat from Wuhan made oil barrel sellers in Cushing, USA pay a lot to get rid of oil on April 20, 2020. Since then a number of publications have appeared that seek to explain the rules prevailing in this specific market. The thing is, the devil is in the details, which are worth knowing.
Spot prices for WTI and Brent crude are set differently.
The spot price is the price on the physical market with a short delivery date, i.e. it is the price of a transaction at a specific place and time when the oil changes owner with typical market trading dynamics.
Spot means “at the place” where the price is quoted. For WTI, spot is Cushing, Oklahoma. That’s where physical transactions are still made with on-site sales/receipts (the seller and buyer must have space in the warehouse).
For Brent, the spot, or trading place, is in the North Sea, because oil is constantly loaded onto ships and the cargo changes ownership frequently. The spot price is estimated by Platts and Argus, among other agencies, based on a lot of information that comes from both the physical and paper markets (more on that in a moment). Platts estimates the spot price of oil called Dated Brent. This is a comparative assessment of the physical price of North Sea oil from a basket of five grades (Brent, Forties, Oseberg, Ekofisk and Troll). The term “Dated Brent” refers to physical cargoes of crude oil in the North Sea that have been assigned specific delivery dates. Each dated cargo of crude oil is often traded more than once as it makes its way to refineries. Platts’ analysis of commercial transactions culminates in the publication of the Platts Dated Brent quotes, a daily assessment of the price of Dated Brent in the North Sea crude market.
Until recently, spot prices and prices in futures contracts for the first month were virtually identical. Why are there such big differences between these prices now?
Normally, spot prices and prices on commodity exchanges for front-month (first-month) futures are very similar, but not identical.
Sometimes there are more obvious differences – usually during severe turmoil in oil markets, because the physical market and paper markets respond to signals at different rates. Usually, the reason for this includes discrepancies in the assessment of storage costs (expected at the time of contract issuance and delivery). The angle of the forward curve is also critical here. As this angle grows (colloquially we call it curve steepening), the differences between spot prices and futures prices increase. This phenomenon occurs when there is a significant increase in supply on the spot market, which needs to be stored quickly. It is the steepening of the curve that triggers the incentive to increase the amount of stocks. This happens due to a correspondingly deep drop in spot prices. The price of WTI crude oil is more exposed to differences in spot and futures prices due to the existence of a single physical price quotation point (in Cushing) and the need to physically take over crude oil after the contract maturity date, which is associated with additional storage costs, especially for traders who are not prepared for such eventuality.
In the case of Brent crude oil, there is no obligation to physically take delivery, it is possible to withdraw financially from contracts.
On 21 April the price of WTI crude oil in the physical market dropped below zero. How did this happen?
Financial dealers are not ready to physically take over barrels of oil. They avoid taking positions in the physical market by selling futures contracts to physical dealers before their due date. Not all have been successful in doing so. Those who would have had to physically take oil in May would have had to incur additional costs of storing it, the scale of which is difficult to predict in a situation when there is no buyer for it (oil changes hands while in storage). They preferred to dispose of it at a known cost (negative price - paying buyers to take back the oil).
How does oil futures trading work?
Futures markets provide liquidity in the physical oil market. Thanks to futures contracts, the oil market can easily absorb surpluses (the structure of prices for various dates encourages storage) and get rid of them. The possibility of hedging against the variable oil prices has a stabilizing effect on the profitability of extraction and the profitability of fuel production. Contracts are issued by clearing houses. A sale contract is a financial product that contains a standardized volume of crude oil. The price of oil in the contract is set by the market. The buyer acquires the contract at the market price and undertakes to take a specific volume of crude oil within the specified period. Before the contract maturity date, this obligation is an option that can be disposed of by selling the contract. On the contract maturity date, this option expires and the contract owner is obliged to take over the physical delivery of crude oil, which will be delivered to it in the first (second, third) month after the contract maturity.
How vulnerable is crude oil to speculation? Is it sometimes the case that the market price deviates from the real value?
Transactions in oil futures markets are called speculation in economic slang. The price of oil is not immune to speculation, because financial dealers discount in contract prices any emerging information that may affect or change the conditions of supply and demand, and ultimately the price of oil.
The time through which one looks at the market and the price of oil is important. Financial dealers and physical traders constantly monitor the markets and react immediately to any new information. In contrast, the crude oil extraction industry and fuel producers (refineries) look at oil prices through a monthly, quarterly and annual window. During these windows, prices are less susceptible to change and more dependent on fundamental factors such as real demand, extraction and inventory changes. We learn about real changes in these factors with a lag, sometimes after several months (GDP, changes in global inventories).
Research shows that speculation only amplify oil price movements resulting from the evaluation of fundamental factors. In other words, speculators do not change trends based on fundamentals, such as extraction volumes, extraction costs, consumption volumes, inventory levels, etc.
The market price of oil oscillates around its real value – on a day-to-day basis it is higher and lower, but on average it must be such as to ensure the profitability of extraction at the level of future consumption. If it is too low, there will be a shortage of supply and the price will skyrocket (as was the case in 2005-2010). When it is too high, new technologies will emerge to increase extraction potential, there will be too much oil and the price will go down (as was the case from mid-2014 to 2017).
Adam B. Czyżewski, Ph.D., has been the Chief Economist at PKN ORLEN since 2007. He specialises in the changes of the global energy sector that are driven by economic policies and revolutionary innovations.
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- Relationships in the crude oil market