Crude Oil Price Formation

Prof. Dr. H.Z. Harraz Presentation
Crude Oil Price Formation
Hassan Z. Harraz
hharraz2006@yahoo.com
2015- 2016
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Please see hharraz2006@yahoo.com for contact details.

Lecture # 11
Crude Oil Price Formation
The Functioning of the International Oil & Gas Markets
© Hassan Harraz 2016

1) INTRODUCTION
2) WHO'S WHO IN GLOBAL OIL MARKETS.. !
3) FUNDAMENTAL FACTORS AFFECTING ON CRUDE OIL PRICES
4) CRUDE OIL PRICES UPS and DOWNS
4.1) Rising Oil Prices
4.1.1) Cost inflation dampens investment impact
4.1.2) Rising Costs Hamper Projects
4.2) Falling Oil Prices
5) CRUDE OIL PRICES
5.1) A Short History of the Rise (and Fall) of Oil Prices
5.2) So When will Crude Oil Prices Rise Again?
Outline of Lecture :

 Oil is the world economy’s most important source of energy and is therefore critical to
economic growth. Its value is driven by demand for refined petroleum products,
particularly in the transportation sector.
 Petroleum products power virtually all motor vehicles, aircraft, marine vessels, and
trains around the globe. In total, products derived from oil, such as motor gasoline, jet
fuel, diesel fuel, and heating oil, supply 33% of all the energy consumed by
households, businesses, and manufacturers worldwide. By way of comparison,
natural gas and coal supply 22% and 28%, respectively, of the world’s energy needs.
 The principal activities, as illustrated in Figure 4, involved in moving crude oil from its
source to the ultimate consumer are:
 Production, which involves finding, extracting, and transporting crude oil;
 Refining, the process by which crude oil is turned into products such as
gasoline; and
 Distribution and marketing, which focus on moving those products to final
consumers.
 These activities occur within a global marketplace—an extensive physical
infrastructure that connects buyers and sellers worldwide, all supported by an
international financial market. The physical infrastructure encompasses a vast array
of capital, including drilling rigs, pipelines, ports, tankers, barges, trucks, crude oil
storage facilities, refineries, product terminals—right down to retail storage tanks and
gasoline pumps.
1) INTRODUCTION
© Hassan Harraz 2016 4

Who's who in Global
Oil Markets.. !

Oil Prices: a increasingly complex market
constellation
No single cause of high prices…!

OECD/IEA - 2007
Oil prices relate to many uncertain factors

3) MANY FACTORS INFLUENCE THE FORMATION OF
OIL PRICES AND OTHER ENERGY PRICES
Oil Barrel Politics:
Running on Volatility

3.1) Supply and Demand
• Domestic demand and global demand both effect on crude oil price.
• Over the last decade, emerging markets like China and India have increased demand for crude oil
and so this led many speculators to suggest that demand would outpace supply.
• On the domestic side, the regular reports from the EIA on refining activity and crude oil supply
have direct impact on crude oil price and also crude oil futures price volatility.
• Released weekly, EIA reports and API reports are often key fundamental influences on crude oil
futures markets.
3.2) OPEC Output
 OPEC ; from its name, we all can be sure that its activities will have strong effect on oil market.
 OPEC production levels and promises for production can also add volatility to crude oil prices.
 Even a scheduled OPEC meeting and speculation about increases or cuts to oil production can
impact crude oil futures markets.
3.3) Weather
• That sounds strange that weather can affect oil price, but it will.
• Storms in the Gulf region of the United States as well as the North Sea can halt production of crude
oil both on drilling platforms as well as refineries which may be shut down anticipating the arrival
of a bad storm.
• Events like Hurricane Katrina stand as strong examples of how weather may have a direct impact
on crude oil price.
• You have just viewed some fundamentals that affect on crude oil prices. There are some more but I
can’t list out here for you because of the limited spaces. Just discover more from the resource. By
the way, keep up with the oil and other futures market prices for your investments!

0
20
40
60
80
100
120
140
1970 1975 1980 1985 1990 1995 2000 2005 2010
Arab Oil
Embargo
Iranian
Revolution
Iran-Iraq
War
Saudi Arabia
abandons role as
swing producer
Iraq invades
Kuwait
Asian Financial Crisis
OPEC cuts quotas 1.7 MMbbl/d
9/11 attacks
Invasion of Iraq
Hurricanes Katrina
and Rita
Very low spare
capacity
Global economic crisis
OPEC cuts
production
targets by 4.2
MMbbl/d
3.4) Geopolitical and economic events have driven large
movements in world oil prices
Real (Dec 2009)
dollars per barrel
Source: EIA
Figure : Oil Crisis in relation to oil price

Chart of crude oil prices since 1861
Figure : Oil Crisis in relation to oil price

Crude Oil Prices: What Happened?
 Oil prices:
 Implications for supply and demand
 A dynamic equilibrium of factors
 The basic story: As long as supply far outstrips demand, oil prices will stay relatively low.
Ultimately, the supply and demand dynamic is the thing to keep an eye on. And expectations matter enormously here.
Whenever new data shows an unexpected boost in oil production or an unexpected drop in oil demand, prices tend to
go down.
Conversely, a surprise drop in supply or a surprise surge in demand will push prices back up.
As global production changed relative to demand, the world moved from a period of “Over Supply” (or peak oil) in 1998 to
one of “Under Supply” in 1999 and 2000.
Inventories are a good means of seeing the imbalance between petroleum production and demand.
For example, when production exceeds demand, inventories rise. A large over supply will put downward pressure on
prices, while under supply will cause prices to rise.
4) CRUDE OIL PRICES UPS AND DOWNS

4.1) Rising Oil Prices
en.wikipedia.org/wiki/Image: Oil_Prices_Medium_Term.png
$139 by June 2008
 Oil prices have been steadily rising
for several years and in June 2008
stand at a record high of $139 per
barrel.
Is the rise due to a squeeze in
availability (peak oil) or are other
political or economic factors to blame?

Oil price near $100, ……. but why?
 Tight crude and product fundamentals push oil near $100/bbl in late-November
 Resilient demand growth – driven by non-OECD regions
 Concern over inventory cover ahead of winter demand
 OPEC-10 production has fallen, despite rising oil prices
Crude Futures
Front Month Close
65
70
75
80
85
90
95
100
Aug 07 Sep 07 Oct 07 Nov 07 Dec 07
$/bbl
NYM EX WTI ICE Brent
Source: Platts
Source: IEA Oil Market Report

4.1.1) Cost inflation dampens investment impact
Source: Resources to Reserves, IEA, 2005
 Tight service sector causes further cost inflation - $35 to $55/barrel?
 Call option for speculators/OPEC?
 Marginal cost of non-OPEC production influential when OPEC producing flat out
 When spare capacity exists, price OPEC are willing to keep spare capacity off the market is the key
(long-term futures prices remain above $80)

4.1.2) Rising Costs Hamper Projects
Credit squeeze adds
further difficulty to
project finance
Fixed price tenders
increase risks for
contractors
Uncertainty reflected in
bids, pushing costs up
further
Rising costs pressure
project timeframes
Delays in awarding
contracts
Increased order times
delay projects further
Source: IEA Oil Market Report

5) CRUDE OIL PRICES
 Brent crude oil spot prices decreased by $7/b in January to a monthly average of $31/b, the lowest
monthly average price since December 2003. Ongoing growth in global oil inventories and uncertainty
over future global demand growth continued to put downward pressure on oil prices during January. After
growing by an estimated 1.8 million b/d in 2015, global oil inventories are forecast to grow by 1.4 million
b/d in the first quarter of 2016.
Daily changes in crude oil prices were highly correlated with daily changes in global equity indexes. The
increased co-movement and higher volatility likely reflect increased uncertainty about future global
economic growth. Changes in overall demand for risk assets, such as commodities and equities, by
investors and market participants may also be playing a larger role in price discovery across global
asset markets compared with previous months.
 With global oil inventory builds expected to continue in 2016, upward pressure on crude oil prices will be
limited. Forecast Brent prices will average $38/b in 2016, $3/b lower than forecast in last month's STEO.
The largest inventory builds occur in the first half of 2016, helping keep Brent prices below $40/b through
August.
 Brent prices are forecast to average $50/b in 2017, with upward price pressure concentrated later in that
year. At that point, the market is expected to experience small inventory draws, with the possibility of
further draws beyond the forecast period. Brent prices are forecast to average $56/b in the fourth quarter
of 2017.
 Forecast West Texas Intermediate (WTI) crude oil prices average the same as Brent crude oil prices
through the forecast period, compared with $2/b lower than Brent in 2016 and $3/b lower in 2017 in the
prior STEO. The price parity of WTI with Brent in the forecast period is based on the assumption of
competition between the two crudes in the U.S.
 The current values of futures and options contracts continue to suggest both heightened volatility and
high uncertainty in the price outlook. WTI futures contracts for May 2016 delivery, traded during the five-
day period ending February 4, averaged $35/b, while implied volatility averaged 57%. These levels
established the lower and upper limits of the 95% confidence interval for the market's expectations of
monthly average WTI prices in May 2016 at $21/b and $58/b, respectively. At this time last year, WTI for
May 2015 delivery averaged $52/b, and implied volatility averaged 52%. The corresponding lower and
upper limits of the 95% confidence interval were $33/b and $81/b.

5.1) A Short History of the Rise (and Fall) of Oil Prices
 This wasn't always the case. Between 2010 and 2014, as you can see above, oil demand was soaring around the world, as
countries recovered from the financial crisis but global production was struggling to keep up. Many older oil fields were
stagnating. Conflicts in places like Libya and Iraq were restricting supply. Countries had to draw down their stockpiles, and
prices soared to around $100 per barrel.
 Those high prices, however, spurred drillers in the United States to use innovative hydraulic fracturing and horizontal
drilling techniques to unlock vast quantities of oil from shale formations in places like North Dakota and Texas. US crude
oil production has nearly doubled since 2010.
Eventually, supply caught up with demand — and then surpassed it. That's when the crash came.
 By mid-2014, global demand was starting to slow down. Europe was still reeling from the eurozone mess. China's economy
was starting to stumble. But the United States continued to produce more and more oil. Iraq and Libya were also starting to
bring more production back online. So prices began sliding, down to $70 per barrel.
 At that point, many people expected Saudi Arabia and other oil producers in OPEC to cut back on their own production to
prop up prices, as they have in the past.
 Surprisingly, that didn't happen. Saudi Arabia decided to increase production in order to maintain its market share, hoping
that the subsequent fall in oil prices would crush US frackers, who require higher prices to stay profitable.
 Ever since Saudi Arabia's decision to maintain output in late 2014, prices have kept tumbling and tumbling - to $50 per
barrel, then $40, then $30 - largely because supply has remained strong and demand has been weaker than expected.
 US drillers turned out to be far more adaptable to low oil prices than the Saudis thought, as companies cut costs and
boosted productivity in order to keep the oil flowing. Iraq has nearly doubled production since 2014 - to more than 4 million
barrels per day - as it recovers from conflict. Thanks to the nuclear deal with the US, Iran will start exporting more oil this
year as sanctions are lifted, offsetting declines elsewhere.
 In the meantime, major developing economies like China, Russia, and Brazil remain mired in a slump, putting a
damper on oil consumption. An unusually mild winter helped suppress demand for heating oil. And a stronger dollar
means that some countries now have to pay more for crude imports, which further limits consumption.
That's the basic story: As long as supply far outstrips demand, oil prices will stay relatively low.
 On the flip side, crude producers like Saudi Arabia, Russia, and Venezuela are struggling to balance their budgets and suffering
from a major revenue crunch. Oil companies in the United States and elsewhere are watching profits evaporate. Banks that financed
the US shale boom are reeling from a wave of defaults. Developing nations that previously relied on petrodollars for financing are
now hurting. It's a major disruption.

Figure : Present and future global oil and liquids supply cost curve

Note:
 Future Oil Prices will be determined by marginal cost of developing new oil rather
than OPEC interventions.
 North American Shale will out-complete many Oil sands and Arctic oil projects.
Figure : Cost of Supply Curve for Global Oil 2020

Figure : Overall cost to produce one barrel of crude oil
Sub -$20 oil

Sub -$20 oil seller Club

 For the last two years, global oil prices
have been in free fall, and no one
seems to know when the bungee cord
will catch.
 In June 2014 you had to plunk down
$110 to purchase a barrel of Brent
crude. By early 2015 that had dropped
to $60.
 Today it costs just $30 to buy that barrel
of oil - a level not seen since 2004. It's a
breathtaking decline.
Why crude oil prices keep falling and falling, in one simple chart
People are literally throwing barrels off a
plank. That's what it's come down to.
(archigraf/Shutterstock)
5.2) Falling Oil Prices

Dropping? Why are Oil Prices
1) Increased Global Supply: Global supply of oil has surpassed the global demand,
which has resulted in the fall of prices.
2) US Oil Boom: Oil Production in the US has increased as Shale oil production has
gone up to 4 million barrels per day. As such, US import of oil from OPEC has
reduced by half.
3) Increased output from Libya: Because of the civil war in Libya, oil production had
decreased to 150,000 – 250,000 barrels per day. It now produces 1 million barrels a
day, which may go upto 1.2 million barrels a day by next year.
4) OPEC Infighting: There is a rivalry among OPEC members, who are trying to lower
prices to maintain their market share
5) Negative European Economic Outlook: A slowdown is expected in Eurozone
economies in 2015. The growth forecast has been cut down by IMF to 0.8% in 2014
and 1.3% in 2015.
6) Tepid Asian Demand: Countries in Asia are reducing oil subsidies, as a result of
which oil demand has fallen, which in turn has resulted in increased oil prices,
thereby, reducing demand.

Image Courtesy - http://money.cnn.com/2014/10/30/investing/cheap-oil-prices-hurt-iran-venezuela-saudi-arabia/
On November 27, a big meeting was held by the Cartel,
and countries, like Venezuela and Iran, proposed that
the Cartel (mainly Saudi Arabia) decreases oil
production in order to maintain stability in the oil prices.
1
Just to ensure it maintains its market share, Saudi
Arabia, the world's largest oil producer, did not agree to
reducing oil production and was willing to let prices
plummet.
2
OPEC's surprising response: Let prices keep falling

Russian budget
heavily relies on its
oil income
More than half of its
budget revenues
come from selling Oil
and Gas
The Russian
economy may go into
Recession if oil
prices keep falling
Effect of falling oil prices on Russia
Image Courtesy: http://www.kp24.fi/data/attachments/6488fd17-c93a-453c-b788-eedd292063d9_389541.jpg © Hassan Harraz 2016
28

High oil prices are one of the major factors affecting the Iranian economy.
Severe economic problems may result if oil prices keep falling.
Iran may decide to reach a nuclear deal with the US to ease economic sanctions.
Image Courtesy - http://www.timesofisrael.com/irans-supreme-leader-undergoes-prostate-surgery//
Effect of falling oil prices on Iran

This will translate into
accelerated economic
growth to a
forecasted 3.5% next
year.
Falling oil prices will
cause gas prices to
go down, which will
result in increased
consumer spending.
Effect of falling oil prices on US
Image Courtesy: http://www.ulkeajans.com/images/haberler/obama_uluslararasi_toplum_gazzede_ateskes_icin_calismali_h56636.jpg

Reduced OPEC’s global power
Benefit to Western and European
economies
Decline in oil and natural-gas
undertakings
Reduction in Commodity price
The devalue of Oman
Increase in global demand for
goods and services
Global Consequences of falling Oil Prices

Crux
1) Inflation increases
2) Govtement spending on subsidy increases
3) Foreign currency reserves reduce
4) Our export becomes weaker
5) GDP is affected negatively
6) Share market crumbles
7) Investment decreases
When Oil prices Moves UP ?

5.3) So when will oil prices rise again?
It's a guessing game, and there are lots of plausible guesses.
 No one knows for sure. Or, if they do, they're laying bets in the financial markets.
Some banks project oil prices to keep plummeting down to $20 per barrel this year.
Others expect a rebound to around $50 or $60 per barrel-by year's end as the US shale boom tapers
off and demand recovers.
 In January, the IEA pointed out that prices could easily slide lower this year… if Iran ramps up
production faster than expected:
 In a scenario whereby Iran adds 600 kb/d to the market by mid-year, and
 other members maintain current output, global oil supply could exceed demand by 1.5 mb/d in the
first half of 2016. …
So the answer to our question is an emphatic yes……. It could go lower.“
 Ultimately, the supply and demand dynamic is the thing to keep an eye on. And expectations matter
enormously here.
 Whenever new data shows an unexpected boost in oil production or an unexpected drop in oil
demand, prices tend to go down.
 Conversely, a surprise drop in supply or a surprise surge in demand will push prices back up.
 So if, say,……. the cold war between Saudi Arabia and Iran heats up and somehow leads to conflict that
crimps production, …………prices could rise. (So far, that hasn't happened.)
 If low prices are harder for the US shale industry to handle than anyone thought, that could also
cause prices to rise higher.
 If China's economy suddenly rebounds unexpectedly, that could have a similar effect.
 Or maybe Iran will do something that causes EU and US oil sanctions to snap back into place.
Alternatively, perhaps the supply glut — and hence low prices — will persist indefinitely.

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Crude Oil Price Formation

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