Crude Oil Pricing Primer

14 September 2016


 

Good Morning Everyone. 

Whenever I view the 7 o’clock news on the local TV channels, the news presenter on each station will mention the day’s oil price. But, on any given day you will realise that each price mentioned is different. I suspect some viewers may not understand why the prices reported are not the same.  So this piece attempts to explain why they are different.
 
Have a good week everyone!
Firstline Team

Crude Oil Pricing Primer

Crude Oil Pricing 101

Image result for crude oil liquid

The “markets action” segments of the 7:00 pm news on the local channels TV6 CCN, CNC3 and CTV each presents a crude oil price and each value is different from the other! Ever wonder why? Which is correct? Do the viewership understand why each is different? How many crude oil prices are there really?

Let’s attempt to bring some clarity here.

The reality is at any one point in time there literally are hundreds of crude oil prices.

The crude oil market has a “physical‟ dimension and a “financial” dimension to it.

Physical Dimension

The physical dimension should anchor prices in oil market fundamentals: crude oil is produced, consumed and stored at various locations worldwide; vary in chemical nature and widely traded with millions of barrels being bought and sold every day at prices agreed by transacting parties. These prices, referred to as spot prices, should reflect existing supply-demand and quality considerations.

Crude oil is not a homogenous commodity; each one has its own characteristic chemical composition. So to price each, market participants have since 1988 adopted the market-related pricing approach. The pricing system permits crude oil with different qualities and characteristics, which have a bearing on refining yields derived from such, to be priced usually at a discount or at a premium to marker or reference prices, often referred to as benchmarks.

These differentials are adjusted periodically to reflect differences in the quality of crudes as well as the relative demand and supply of the various types of crudes.

At the heart of formulae pricing is the identification of the price of key “physical‟ benchmarks, such as West Texas Intermediate (WTI), Dated Brent and Dubai-Oman. The benchmark crudes are a central feature of the oil pricing system and are used by oil companies and traders to price cargoes under long term contracts or in spot market transactions; by futures exchanges for the settlement of their financial contracts; by banks and companies for the settlement of derivative instruments such as swap contracts; and by governments for taxation purposes.

These physical benchmarks with relatively low volumes of production such as WTI, Brent, and Dubai set the price for markets with higher volumes of production elsewhere in the world.

Financial Dimension
Image result for crude oil
In the last two decades or so, many financial layers (paper markets) have emerged around crude oil benchmarks. They include the futures, options, swaps and forward market (in WTI, Brent and Dubai). Some of the instruments such as futures and options are traded on regulated exchanges such as ICE and CME Group while other instruments, such as swaps, options and forward contracts, are traded bilaterally over the counter (OTC). Nevertheless, these financial layers are highly interlinked. Over the years, these markets have grown in terms of size, liquidity, sophistication and have attracted a diverse set of players both physical and financial. These markets have become central for market participants wishing to hedge their risk and to bet on oil price movements. Equally important, these financial layers have become central to the oil price process.

Futures Primer

A futures contract is a legal agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument for a price agreed upon today (the forward price) with delivery and payment occurring at a future point, the delivery date.

Futures contract trades in months before the contract expires. No contracts exist when trading begins and no contracts would exist if no one was interested in trading. But as soon as a buyer finds a seller, a contract is created. All the buyer and seller recognise is that a commodity will be available at some time in the future and they want to agree on a price now. Amazingly though, the process of contract creation can go on indefinitely as long as buyers find sellers and vice versa. In fact the number of contracts can often be larger than the actual supply of the commodity that exists. Buying a futures (going long) involves the possibility of accepting delivery. Selling a futures (going short) involves either the possibility of making a delivery or liquidating a long position.

The obvious question is: if there is only so much of a commodity to go around and if the number of contracts exceeds the available commodity supply, how are the contracts filled? Interesting, as the delivery month nears (first nearby, delivery or prompt contract), the number of contracts tend to decrease naturally. The speculators will be offsetting, leaving the physical commodity traders to deal.

Those contracts remaining in the prompt month at expiry will be settled either through delivery or through offset. Since a contract is eliminated either when a delivery is actually made, when a long is liquidated, or when a short covered, all contracts are eliminated, one way or the other, when trading in the delivery month ceases.

At contract expiry the physical and futures prices converge. One finds if the supply of the commodity is greater than the amount totalled up in all the contracts, that the prices tend to drop because supply exceeds demand. Speculative longs’ will be aggressively selling (offsetting) positions to avoid the risk of taking delivery.

On the other hand, if the physical commodity supply is in short supply and the amount available is less than that totalled up in all contracts, prices will tend to rise as speculative shorts’ are aggressively buying (covering) to exit their short position to avoid the risk of buy back from the longs at prices higher than anticipated..

As of today’s date September 12th, the prompt NYMEX WTI crude oil contract being traded is for October delivery. This contract will expire on September 20th and thereafter the contract for November 2016 delivery, which is the 2nd nearby, becomes the prompt, 1st nearby or front month contract.

Some specifics of NYMEX WTI Crude Oil Contracts

  1. Contract volume –  1,000 barrels WTI crude oil
  2. Price quotes –  US $ and cents per barrel
  3. Listed Contracts – Crude oil futures are listed 9 years forward using the following listing schedule: consecutive months are listed for the current year and the next five years; in addition, the June and December contract months are listed beyond the sixth year.
  4. Front Month Settlement Methodology –  The front month settles to the weighted average price of all trades that are executed between 14:28:00 and 14:30:00 ET, the settlement period, rounded to the nearest cent.

So which Crude Oil Prices the local TV Stations present nightly?

CCN TV6 – Presents the previous day’s WTI prompt (1st nearby) futures settlement price;

CNC 3 – Presents the day’s prompt WTI futures settlement price; and

CTV – Presents the day’s Brent prompt futures settlement price

Closing thoughts – time to consider your investing strategies

Firstline Securities Limited offers comprehensive coverage of local and international markets with a bias for the energy sector. Firstline offers a number of unique opportunities to put surplus cash to work either as your asset manager or investment advisor. Please contact us for more details at info@nullfirstlinesecurities.com or at 868.628.1175, we can discuss your investment needs in detail and craft a portfolio that makes sense for you. We look forward to hearing from you.

Mr. Phillip Lewis
Executive Manager – Business Development
Firstline Securities Limited


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