Overview of Oil Trading

-Sonal Gupta
11/14/2019 Overview of Oil trading
 Agenda
 Introduction

 Fundamentals of Physical Trading

 Functioning of Energy Derivatives

 Risk Management

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 Introduction – Setting the context
1
2 Fundamentals of physical Trading

Functioning of Derivative Markets 3

4 Risk Management

Overview of Oil trading

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 What is Oil
• “Petroleum" = Latin words Petra, or rock, and oleum, oil.
• Largest Single Commodity in International Trade – Volume / Value
• Oil is found in reservoirs in sedimentary rock

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 The Oil Story
• 1859 – Colonel Drake Strikes oil near Titusville, Pennsylvania
• 1870 – John d. Rockefeller started acquiring Kerosene refineries and strong position
with railroad to feed Europe/USSR. Formed Standard Oil Company
• 1879 – First crude oil trunkline called Tidewater was built, Standard oil acquired half of
tidewater and was busily laying pipelines to Buffalo, Philadelphia, Cleveland and New
York
• 1880 – Oil was discovered near the Russian sea town of Baku. Over 20 refineries sprang
up in the region, but logistics was key; Enterprising Marcus Samuel developed the first
organized Kerosene shipping enterprise to compete with Rockfeller and send kerosene
to Europe and Far east
• 1901 – Oil discoveries in Ohio, Oklahoma, Kansas, and the first true gusher at
Spindletop, TX flowed 110Kbd
• 1912 – Anti Trust litigation formed by energetic young president, Theodore Roosevelt,
challenged the Standard Oil Trust and Standard oil dissolved; Seven Sisters formed (
seven regional oil companies – Exxon/ Mobil/BP/ Conocophilips/ Chevron/Texaco/Shell
)
• Late 1940’s – Rise of Middle East Production with seven sister dominance
• Late 1950’s – Russia, significant player in Oil
• 1960 – Rise of new force -- OPEC
New Seven Sisters (Non OECD) – Saudi Aramco ( Saudi); JSC Gazprom (Russia);CNPC (China);NIOC ( Iran); PDVSA (
Venezuela); Petrobras ( Brazil) and Petronas ( Malaysia)

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11/14/2019 Overview of Oil trading
 What do we need to know about oil?
What is Oil?
• It is a naturally occurring bituminous liquid composed of various organic
chemicals
• An “average” crude oil contains about 84% carbon, 14% hydrogen, 0.1 to 5%
percent sulphur and less than 1% each of nitrogen, oxygen, metals and salts.

What do we get from oil?

• High Speed Diesel (HSD)
• Motor Spirit (MS)
• Liquefied Petroleum Gas (LPG)
• Kerosene (SKO)
• Aviation Turbine Fuel (ATF)
• Furnace Oil (FO)
• Bitumen
• Naphtha
• Lubes

7
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The Oil and Gas Chain
 Refining Process

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 World consumption patterns(mtoe)

World primary energy consumption grew by 2.5% in 2011, less than half the growth rate experienced in
2010 but close to the historical average. Oil remains the world's leading fuel, accounting for 33.1% of
global energy consumption, but this figure is the lowest share on record. Coal's market share of 30.3%
was the highest since 1969.
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Source : BPSR
 Proved oil reserves

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OPEC controls 73% (1196 mb) of the Global Oil Reserve
Overview of Oil trading
Source : BPSR
 What next???????

The life of proven oil reserves is estimated to be 41 years

What then????

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 Organisation of Petroleum Exporting
Countries ( OPEC)
 OPEC founded in Baghdad, Iraq, in September 1960
 To protest pressure by major oil companies (mostly
owned by U.S., British, and Dutch nationals) to reduce
oil prices and payments to producers
 Objective to unify and coordinate members'
petroleum policies.
 Original OPEC members include Iran, Iraq, Kuwait,
Saudi Arabia, and Venezuela
 OPEC members' national oil ministers meet regularly
to discuss prices and, since 1982, to set crude oil
production quotas.
 Between 1960 and 1975, the organization expanded
to include Qatar (1961), Indonesia (1962), Libya
(1962), the United Arab Emirates (1967), Algeria
(1969), and Nigeria (1971); Angola and
Eucador(2007). Indonesia suspended its membership
effective January 2009.
 EIA estimates that the current twelve OPEC members
account for about 40% of world oil production, and
about 2/3 of the world's proven oil reserves. Exports
55% of the oil traded internationally.
 Iran, Iraq, Kuwait, Saudi Arabia, Venezuela,
Qatar, Libya , the United Arab Emirates ,Algeria
,Nigeria ,Ecuador and Angola.

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 OPEC Crude Production…

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 Global Oil Production by Area
Russia, Saudi Arabia
and US are top three
oil producers

World oil production increased by 1.1 million b/d in 2011,with OPEC (42%)accounting for nearly all
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of Overview of Oil
the increase despite a 1.2 million b/d reduction in trading
Libyan production.
Source : BPSR
 Global Oil Consumption by Area
US; China and Japan
are top three oil
consumers

World oil consumption increased by roughly 600,000 b/d. All of the net growth came from emerging economies
in Asia, South & Central America, and the Middle East, offsetting declines in Europe and North America.
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Source : BPSR
 Top Global Oil Exporters…
Region Crude Exports(mt)
Middle East 879.4
Former Soviet Union 319.3
West Africa 224.1
S. & Cent. America 139.0
Canada 111.7
North Africa 72.3
Mexico 67.5
East & Southern Africa 16.6
Australasia 14.2
Europe 12.9

OPEC remains Dominant Player

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Source : PIRA
 Major Oil Trade Movement…(Middle East,
Europe and US)

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Source : BPSR
 Choke points

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 Evolution of Crude oil prices since 1861

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Source: BP
 Introduction – Setting the context 1

2 Fundamentals of physical Trading

Functioning of Derivative Markets 3

4 Risk Management

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 International petroleum markets
Contracts
Type of Players Term Major Players
Hedgers Spot National Oil Comp.
Speculators Fixed/Floating (NOCs)
Arbitrageurs Cartels (OPEC)
Multinationals
Traders

Pricing Agencies Oil

Platt's Pricing
Argus Benchmarks
(WTI, Brent, Dubai/Oman Avg.,
Tapis)
Premiums or discounts for –
quality variation
regional supply/demand variations….
Value Chain
Upstream
Market Type
Refiners
Physical
Downstream
Derivatives
Shippers
- OTC
- Commodity Exchanges
(NYMEX/IPE/NCDEX…)
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• Physical Market
Market Type
Physical oil is sold and bought and the actual seller and actual buyer meet and enter
into a contract to deliver and accept the cargo at a price.

In economic sense, price is what a buyer pays for the utility of the goods that he buys.
In that sense, the price of Crude Oil is the market price in the physical market.

Prices of Crude are generally quoted ‘free on board’ (FOB) at their loading port.

• Paper market
Derivative market which is a logical extension of Physical market.

Derivatives are instruments such as futures, swaps, Options which derive their value
from an underlying commodity.

Delivery can be enforced ( but usually not)

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 Factors influencing Crude Oil Prices..
• Quality of the Crude Oil

• Demand Supply Fundamentals

• OPEC Policies

• Geopolitical Reasons

• Inventory; Reserves

• Weather

• Currency movement

• Other Markets

Conflicting market forces can induce extreme

market volatility
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 Quality of Crude …

The API density or viscosity

And why are these

characteristics so
important?

Sulphur content

-- Less than 0.5%  Sweet

– More than 0.5%  Sour

Of course, the price of crude depends on these factors. The lighter the crude and sweeter it is
the higher is the price

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 Evaluation of Crude Oil…
Arab Heavy Bonny Light

API 27.8 35.1

Density 0.88 0.8495
Sulphur wt% 2.78 0.15
Visc @ 100F 18.5 5.21

Which Crude is worth More ??

……..

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 Kingpin Dollar

Currency Movement ..

US Dollar is the currency of choice in global crude oil trade

Oil producing countries receive their oil revenues in US dollar

Consumers use local currencies to buy petroleum products

Dollar depreciation reduces activities in upstream due to

increased cost, higher inflation, lower PP, lower ROI

Depreciation in USD increases the demand for gasoline as US

citizens spend their vacations driving

……..

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 Inventory…..

• Inventories are needed to match supply & demand

for economic optimization and uncertainty over
 Absolute price levels and the magnitude of the
price changes (volatility) depends on how far apart
demand moves away from supply
 Changes in inventory levels can be used to reduce
the difference between supply and demand, thus
and limit the magnitude or price change

……..

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 Trading Characteristics of Oil

• Transportation
– Ships or pipelines
– Sizes involved in crude and product transportation

• Processing
– Different types of crude and their relative values
– Refinery configuration

• Storage
– Specialised storage tank at every point in supply chain

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 Global Crude Benchmarks

WTI and
brent
Brent
Zone
Dubai/Oman

Tapis/Minas
Zone

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 Benchmark crude oils

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 Market Terms
Long (Buy):
…….
• If the market goes up, money is made
If the market goes down, money is lost

Short (Sell):
• If the market goes up, money is lost
If the market goes down, money is made

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 Energy Trading
• Why ……
• How
• What ……
• When
• Where
• Who

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 Why We Trade ?
Why Trade

Supply Balancing Hedging Speculation

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 What instruments are traded?
Instruments

Physical Derivatives

OTC Exchange

Spot Forwad
Options

Forward Swaps Options Future

……

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 Who trades

Market Players

Producers Consumers Speculators Market Maker

Crude Oil Producers - Oil Refiners - Day Traders -Energy Companies

Refiners ( Product) - Power Station ( gas) - Position Traders -Utility Companies
Gas Producers - Airlines - Arbitrageurs
-Trading Companies
Power Station
-Arbitrageurs

24 Nov 2008 Overview of energy trading

 Introduction – Setting the context 1

2 Fundamentals of physical Trading

Risk Management
3
4 Functioning of Derivative Markets

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 There is More Risk than may appear at first Glance …

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 What is Risk?

Risk –the uncertainty associated with the possibility of a loss

Financial Markets

Potential for loss arising from unfavorable movements in interest rates, exchange
rates or commodity prices.

Financial Risk

Possibility of incurring a loss, or unfavorable outcome, arising from the future

movement of financial market variables (market risk), performance by
counterparties (credit risk), ability to fund operations or trade in financial markets
(liquidity risk), and/or operational failure (operational risk).

If a loss has already taken place or is certain – it is no longer a risk

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 Any oil company is exposed to a wide variety of risks. Listed below are key risks
that oil companies are typically exposed to

Market Credit Operational

 Commodity (e.g.  Counterparty defaults  Governance & controls
crude and product)  Technology
Components

prices  People
 Shipping rates  Geographical
 Exchange rates  Regulatory

 High crude prices  Third party suppliers do  System failures

 Refining margins not fulfill their obligations
 Mispriced contracts
squeezed - product  Counterparties go
 Rogue trading
Examples

prices did not move bankrupt

with crude price  Customers do not pay
 Vessel charter rates
may increase

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 Risk in the Energy World…

Crude Oil->

Producer Refiner

Products : Naphtha, Gas oil, Gasoline, Jet Fuel, Fuel Oil

Participants Price Risks
Oil producers Low crude oil price risk
Petroleum refiners and marketing High crude oil price;
companies

Low product price and

Thin margin
Large consumers High price
Consumer Large distribution companies
(Natural gas)
Unstable prices
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Airlines and Shippers High fuel price
 Introduction – Setting the context 1

2 Fundamentals of physical Trading

Risk Management 3

4 Functioning of Derivative Markets

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 Derivatives
• A financial instrument whose value is dependent upon or
derived from one or more basic variables. The derivative itself
is merely a contract between two or more parties.
• Value is determined by fluctuations in the underlying asset.
• Often the variables underlying derivatives are the prices of
traded assets.
• Are simply methods to manage ( hedge) risk.
• Futures, forwards, swaps, options
Derivative – Key Characteristics

• Finite time horizon (i.e. fixed expiry date)

• Requires at least two counterparties

• Represent a zero-sum game between the counterparties.

That is, a gain to one side is a loss to the other side.

• The Payoff is based on the value of the underlying.

 OTC Contract
• An over-the-counter contract is a bilateral contract
in which two parties agree on how a particular
trade or agreement is to be settled in the future.
• It is usually from an investment bank to its clients
directly.
• Forwards and swaps are prime examples of such
contracts. It is mostly done via the computer or the
telephone.
• For derivatives, these agreements are usually
governed by an International Swaps and
Derivatives Association agreement.
Forward Contracts
Forward contract is a non-standardized contract between two
parties to buy or sell an asset at a specified future time at a
price agreed upon today.

•Non-Standardized- It is custom made as per parties involved.

•Specified Future time- Any time in future when the delivery is to
be made.
•Price Agreed upon Today- Price is mutually decided at the time
of entering into the contract.
•Generally done in OTC market
 How Forwards works..

Forward Contract
31/01/13
A agree to Buy 1000 bbl of Crude @ $120/bbl from B on 31st March ,13

Cash Settlement (31/03/13)

Physical Settlement (31/03/13) OR
Suppose Crude Price as on 31/03/13 is
$110/barrel(Loss to buyer)
$120K
$10000
1000 bbl oil
$10000

Suppose Crude Price as on 31/03/13 is

$130/barrel(profit to buyer)
 Example(Normal forward contract)

• BP enters into a one month contract with its

customer to sell 1mmbtu of natural gas @
$5/mmbtu, to be delivered on 12th
August,2013.
• If price in exchange is $7/mmbtu on.
• Then there will be a loss of $2/mmbtu to BP
 Example(Hedging)
• BP now enters into a one month futures
contract with CME to buy 1mmbtu of natural
gas @ $5/mmbtu,to be delivered on 12th
August,2013.
• If price in exchange is $7/mmbtu on .
• Then there will be a profit of $2/mmbtu to
BP
• Net effect=0
 Futures
What is Futures Market?
A location where trading (buy-sell) in commodities is conducted in
accordance with specific rules, procedures, and guarantees.
 Futures (Contd.)
FUTURES CONTRACTS
A contractual agreement to buy /sell a particular commodity or
financial instrument at a predetermined price in the future.

•Detail the quality and quantity of the underlying asset.

•Standardized to facilitate trading on a futures exchange.
•Some futures contracts may call for physical delivery of the asset,
while others are settled in cash.
•No counter party Risk.
•CME,ICE,MCX,NCDEX
 Forwards vs Futures
Forwards Futures
Available to limited market Liquid market –wider market
participants participation
Lengthy and time consuming Standardized contracts
negotiations
Contract binding on both Positions can be squared off
parties
Counter party credit risk Counter party risk assumed by
exchange
 Contd..

Forwards Futures
Bilateral trades & negotiated Transparent price discovery
pricing mechanism
Inadequate dispute settlement Well defined dispute settlement
mechanism mechanism
Difficulty in reporting and The exchange is the central
regulating various trades reporting and regulating entity
 Options
• Options are traded both on exchanges and in the over-the-counter
market.
• Two basic types of options.
 A call option gives the holder the right to buy the underlying asset by a
certain date for a certain price.
 A put option gives the holder the right to sell the underlying asset by a
certain date for a certain price.
• The price in the contract is known as the exercise price or strike price.
• The date in the contract is known as the expiration date or maturity.
• American options can be exercised at any time up to the expiration
date.
• European options can be exercised only on the expiration date.
 Example
• Mr A buys a European call option with a strike price
of $5/mmbtu to purchase 1mmbtu of Natural gas,
the expiration date of the option is in one month,
the premium price is $1/mmbtu.
• If price in exchange is $8/mmbtu on the expiration
date.
• Mr A will have an option whether to execute the
contract.
• If he executes the contract there will be a profit of
$2/mmbtu.($8-$5-$1)
• If he doesn’t loss of $1(premium).
 Example
• Mr A bought an European put option with a strike price
of $5/mmbtu to sell 1mmbtu of Natural gas, the
expiration date of the option is in one month, the
premium price is $1/mmbtu.
• If price in exchange is $8/mmbtu on the expiration date.
• Mr A will have an option whether to execute the
contract.
• If he executes the contract there will be a loss of $2($8-
$5-$1).
• In case he doesn’t execute the contract there will be
loss of $1.
 Options – Basic Terminology
• Call Option The right to buy a specified amount of commodity
at a specified rate

• Put Option The right to sell .......

• Premium The price of the option

• Strike Price The rate at which the right can be exercised

• Expiry Date The date on which the right can be exercised

• Option holder Buys the option, has rights, has a long option position

• Option writer (seller) – Sells the option, has obligations, has a short option position
 Mechanics of options
Call Option

-- Buyer
Has the right to buy a futures contract at a predetermined price on or before a defined
date. Expectation: Rising prices

-- Seller
Grants right to buyer, so has obligation to sell futures at predeter- mined price at buyer's
discretion. Expectation: Neutral or falling prices

Put Option

-- Buyer
Has right to sell futures contract at a predetermined price on or before a defined
date. Expectation: Falling prices

-- Seller
Grants right to buyer, so has obligation to buy futures at a predetermined price at buyer's
discretion. Expectation: Neutral or rising prices
 Swaps
• “ Swap converts an unknown future price into current fixed price”
• A swap is a purely financial transaction designed to transfer price risk between the swap
purchaser and the swap provider.
• Plain vanilla OTC agreement
• Fixed for floating exchange of risk
• Purely a financial transaction – no delivery

• Settlement:
– If floating price lower than fixed (swap) price – swap provider pays swap buyer
– If floating price is higher than fixed (swap) price – buyer pays seller/provider.

Example – four month fix for Brent crude oil at $25.00 bbl:
Jan Feb March April
• Floating price ($/bbl) 24.50 24.75 25.40 26.80
• Quantity (bbls) 10,000 10,000 10,000 10,000
• Actual cost $ 245,000 247,500 254,000 268,000
• Swap seller pays 0 0 4,000 18,000
• Swap buyer pays (5,000) (2,500) 0 0
• Final cost to buyer 250,000 250,000 250,000 2,50,000
• Cost to buyer $/bbl 25.00 25.00 25.00 25.00
 Types of Traders
• Hedgers-reduce their risk by taking an opposite
position in the market to what they are trying to
hedge.
• Speculators- make bets or guesses on where they
believe the market is headed.
• Arbitrageurs- Attempts to profit from price
inefficiencies in the market by making simultaneous
trades that offset each other and capturing risk-free
profits.
 Example (Arbitrageurs)
• Price in CME is $100/barrel.
• Price in MCX is $101/barrel.
• Cost of transportation from US to India is
$.5/barrel
• In this case a traders will take long position in
US market and short position in Indian Market
thereby making a profit of $.5/barrel.
THANK YOU