Oil Physical and Financial Markets: Economics, Engineering, Pricing, And Regulations

1. Oil Physical & Financial Markets:
Economics, Engineering, Pricing, and Regulations
Created By Kevin P. Kane

2. Background
Oil Futures Fundamentals
Oil Physical Fundamentals
Speculation Debate
New CFTC Rules
I
III
II
IV
V
CONTENT
Conclusion
VI
Derivatives
VII

3. Background
Oil PricesA
I
0.00
20.00
40.00
60.00
80.00
100.00
120.00
140.00
Jan-80
Feb-81
Mar-82
Apr-83
May-84
Jun-85
Jul-86
Aug-87
Sep-88
Oct-89
Nov-90
Dec-91
Jan-93
Feb-94
Mar-95
Apr-96
May-97
Jun-98
Jul-99
Aug-00
Sep-01
Oct-02
Nov-03
Dec-04
Jan-06
Feb-07
Mar-08
Apr-09
May-10
Real Oil Price (2008)WTI

4. Background
Oil PricesA
I
Op
Po
1
2
3
4
S2D1
D2D3
(1998) $20
(2008) $100
(2009) $50
S1

5. 60% of all new oil discoveries are offshore
Oil Supply Concerns
09-2008 drop in price largely reflected drop in demand
Expected 2030 Demand Creates Uncertainties in Supply
$70 per barrel to receive same profit as $30 per barrel several years ago
Excess Capacity Almost Exceeded in 2008. New Production Growth Slow
Inexpensive Recoverable Oil Gone. Capital Intensive Oil Remaining
Crude Quality Decreasing (API & Sulfur) – Refinery Margin Decreasing
Optimists and Pessimists Politicize Oil Price Debate
이연희
Oil Physical FundamentalsII
BACKGROUND

6. Three Aspects Reviewed
Firm Level
Price Discovery: Firms, Fundamentals, & Distortions
Economic Level
Demand
•World GDP
•Inventory vs. Reserve
•Short Term Inelasticity
•Expected Demand
Supply
•Production
•Excess Capacity
•Proved vs. Probable
•Offshore vs. Onshore
•Inelasticity
Interest and Ex Rates
•∆R → ↑ or ↓Op
•↓$→↑$ex →↑Cf→↑Odw
•↓$ →↓O-Expp→↑Scut
Distortion Level
Supply Side
•Concerted Production
•Collusion
Demand Side
•Subsidies
•Price Ceiling
•MS Expansion
Uncertainty – Politics
•Supply Disruption
•Nationalization
•Transit Monopolies
E&P Firm Costs
•Exploration
•Development
•Production
Upstream Factors
•Geology
•Drive Mechanism
•Recovery Factor
•Reserve Classification
•R/q Ratio
Downstream Factors
•Refinery Capacity
•Refinery Margin
•API – Sulfur Content
Oil Physical FundamentalsII

7. Proved Reserves (≥ 90)
Probable Reserves (> 50%)
Possible Reserves (< 50%)
Reserves which on the available evidence are 90% certain to be
technically and economically producible
Reserves which are not yet proven but which are estimated to have
greater than 50% chance of being technically & economically producible
Reserves which at present cannot be regarded as probable but which are
significant but less than 50% chance of being technically producible
Oil Physical FundamentalsII
Firm Level – Understanding Definitions

8. Q
Q = Liquid Hydrocarbons Produced
Time
QEL = Economic Limit where if one goes below this line they
do not sell enough to cover their operating costs
Est. QEL
Example of Remaining Oil
Reserves if Produced to this point
30% to 90% of Oil in Place (OIP) is Left in the Ground
Unrecovered Oil
Reserves Are NOT SUPPLY – Expected Incremental Supply
Oil Physical FundamentalsII
Firm Level - Reservoir Economics
R/q Critical Ratio (15-10) equally important as MC & S&D in Determining Production Levels

9. Oil Natural Gas
Oil Expansion 2 to 5
Gas Expansion 70 to 95
Solution Gas 10 to 30
Gas Cap 20 to 50
Gravity Segregation 30 to 70
Water Drive 20 to 50 45 to 70
Pay Zone
Water
Gas Cap
Surface
Derrick
Oil Physical FundamentalsII
Saudi Arabia Conspiracies Debunked: Water Drive and Conning
Firm Level - Natural Drive / Recovery
Natural Drive Type Recovery Percentage

10. Recovery Estimation Methods
Oil Physical FundamentalsII
Recovery of Oil: Delicate Business
Oil in Place
Volumetric Method
Material Balance
Estimation is not an exact science and is subject to potential abrupt changes in
expected recovery and production levels: changes in pressure, water entry, et al.
Total hydrocarbon content in an oil reservoir, referred to as Stock Tank Original Oil In Place (STOOIP)
= Bulk (rock) volume (acre-feet or cubic meters)
= Fluid-filled porosity of the rock (fraction)
= Water saturation - water-filled portion of this porosity (fraction)
= Formation volume factor (dimensionless factor for the change in volume between reservoir
and standard surface conditions)
Decline Curve Analysis

11. Oil Physical FundamentalsII
Primary Recovery – Sucking & Pulling
Sucker Rod Pumps, Plunger Lift Pumps, Hydraulic Lift Pumping, Progressing Cavity
Pumps, Gas Lift Pumps, Electric Submersible Pumps (ESPs)
Water Flooding (Most Common), Gas Reinjection
Create Fractures (Permeability) & Pumping Inert Gas (Displacing Oil) & Lowering
Viscosity
Hydraulic Fracturing, Acid Fracturing, Miscible Fracturing, Thermal Recovery,
Chemical Flooding, In-Situ Combustion, Microbial EOR
Secondary Recovery – Increase Reservoir Pressure
Enhanced Oil Recovery (EOR)– Tertiary Production
Firm Level - Natural Drive – Recovery Factor

12. Measure of the relative Density of Oil (Higher Figure = Better)
Tell us how much Sulfur will need to be separated from the oil
API Gravity (Specific Gravity
Sulfur Content
Two Factors
Firm Level – Changing Oil
Oil Physical FundamentalsII

13. Oil Physical FundamentalsII
1.05
1.1
1.15
1.2
1.25
1.3
1.35
1.4
1.45
1.5
29.5
30
30.5
31
31.5
32
1/1/1995
8/1/1995
3/1/1996
10/1/1996
5/1/1997
12/1/1997
7/1/1998
2/1/1999
9/1/1999
4/1/2000
11/1/2000
6/1/2001
1/1/2002
8/1/2002
3/1/2003
10/1/2003
5/1/2004
12/1/2004
7/1/2005
2/1/2006
9/1/2006
4/1/2007
11/1/2007
6/1/2008
SulfurContent
API-24to34=MediumCrude
U.S. Weighted Avg Crude Import Quality
API Sulfur
Firm Level: Crude Quality & Yields

14. CRUDE TYPES CHARATERISTICS YIELDS US REFINERY
MEDIUM
SOUR CRUDE
(Mars, Basrah,
Arab Medium)
HEAVY SOUR
CRUDE
(Maya, Ratawi,
Venezuela)
SWEET CRUDE
(Bonnie Light)
34 + API
<0.5% Sulfur
Inexpensive to Refine
and Sold at a High
Price
24 - 34 API
> 1.0 % Sulfur
More expensive than
“Sweet” to refine and
sold for less
< 24 API
> 1.0 % Sulfur
Least Ideal
8% Propane/Butane
49% Gasoline:
Conventional,
CARB, Premium
32% Distillate: Jet
Fuel, Diesel,
Heating
11% Heavy Fuel Oil
& Other
Oil Physical FundamentalsII
Firm Level: Refinery Crude Yields

15. Oil Physical FundamentalsII
0.00
5,000.00
10,000.00
15,000.00
20,000.00
25,000.00
30,000.00
35,000.00
40,000.00
2005 2006 2007 2008
Millions
Long Term Investment-Financial Statements
XOM Chevron Shell Total S.A. BP
Economic Level: Investment Trends

16. Oil Physical FundamentalsI
0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
80.00
90.00
0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
80.0
90.0
100.0
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
OilPrice(2008)
BillionsInvested
FRS Worldwide Expenditure E-D-P
Exploration Development Production 2008 WTI
If we considerExpected
Demand and Need for Future
Supply, Price is too Low at
$20 to $40 per barrel
Declining either
because of E&P
ROI from 1990s,
or increasing
MC from
offshore
Economic Level: Investment Trends

17. Oil Physical FundamentalsI
Economic Level: Investment Trends
Op
1
2
3
4
S2D1
D2D3
(1998)
$20
(2008)
$100
(2009)
$50
(1999)(2010)(2009)
S1

18. -0.06
-0.04
-0.02
0.00
0.02
0.04
0.06
0.08
2/1/1982
11/1/1982
8/1/1983
5/1/1984
2/1/1985
11/1/1985
8/1/1986
5/1/1987
2/1/1988
11/1/1988
8/1/1989
5/1/1990
2/1/1991
11/1/1991
8/1/1992
5/1/1993
2/1/1994
11/1/1994
8/1/1995
5/1/1996
2/1/1997
11/1/1997
8/1/1998
5/1/1999
2/1/2000
11/1/2000
8/1/2001
5/1/2002
2/1/2003
11/1/2003
8/1/2004
5/1/2005
2/1/2006
11/1/2006
8/1/2007
5/1/2008
ProductionPercentageChange
Production Changes Compared: Canada to OPEC
Prod_Canada Prod_Opec
Oil Physical FundamentalsII
Cutting Production when price falls is natural economic behavior
due to marginal costs—something not specific to only OPEC
Economic Level: Production & Marginal Costs

19. 이연희
0
1
2
3
4
5
Mb/d
OPEC Spare Capacity
Algeria Angola Ecuador Iran Iraq Kuwait Libya Nigeria Qatar Saudi Arabia United Arab Emirates
Oil Physical FundamentalsII
Critical & Unique Period
for Low Spare Capacity
due to Expected Demand
Economic Level: Spare (Excess) Capacity

20. 2200.0
2400.0
2600.0
2800.0
3000.0
3200.0
3400.0
3600.0
3800.0
4000.0
4200.0
0.00
10,000.00
20,000.00
30,000.00
40,000.00
50,000.00
60,000.00
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
(WorldOilProductionTonnes
(Millions)
WorldGDP(2008)Billions
World GDP = Oil Production
World GDP Billions World Production Tonnes
Oil Physical FundamentalsII
Economic Level: Supply & Demand

21. 165000000
215000000
265000000
315000000
365000000
0.0
200000000.0
400000000.0
600000000.0
800000000.0
1000000000.0
1200000000.0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
TonnesofOilChina
TonnesofOilConsumed
Oil Consumption
NA Total Europe & Eurasia China
China’s anti-free market subsidy policies may have caused the 2004 to
2008 Price Spike. Without Subsidies, China’s consumption and GDP would
have slowed, reducing demand, and moving equilibrium down more
smoothly.
More Inelastic
Why?
China’s Fuel
Subsidies are 1%
of GDP, “Morgan
Stanley”
Oil Physical FundamentalsII
Economic Level: Inelastic Demand

22. Oil Physical FundamentalsI
0
2
4
6
8
10
12
14
16
0
20
40
60
80
100
120
140
1/1/1982
2/1/1983
3/1/1984
4/1/1985
5/1/1986
6/1/1987
7/1/1988
8/1/1989
9/1/1990
10/1/1991
11/1/1992
12/1/1993
1/1/1995
2/1/1996
3/1/1997
4/1/1998
5/1/1999
6/1/2000
7/1/2001
8/1/2002
9/1/2003
10/1/2004
11/1/2005
12/1/2006
1/1/2008
FederalFundsRate
RealOilPriceWTI(2008)
Federal Funds Rate & Oil Price
Real Oil Price WTI (2008) Federal Funds Rate
Economic Level: Oil Priced in Dollars

23. DERIVATIVESIII
Derivatives: Futures & OTC
Hedge Risk Contracts For Future Price:
Futures, Credit Default Swaps, Interest Rates, Exchange Rates, OTC, et al.
Derivatives Traded Between 2 Parties Outside of “Transparent, Organized Market
Structures” such as NYMEX—a central exchange or trading venue.
Over-The-Counter (OTC) Derivatives
Calls, Puts, Premium: $300 Trillion Dollar Market
Commodity Swap Dealers offer tailored swap contracts to client OTC
Markets. Limiting unmatchable contract exposure requires futures markets
Clearing Houses
Clear the agreement to accept a future delivery of oil through a futures contract
Often settled in cash rather than physical delivery. 03–08 only 2% physical delivery
Hedging Risk

24. Oil Futures FundamentalsIV
Oil Futures
Price Discovery
Short & Long Term
Trader Classifications
Position Limit
CFTC

25. Price Discovery
Information Sharing and Equilibrium – one world oil price
One countries oil supply gain, is everyone’s gain
Oil Futures FundamentalsIV
Futures Market – NYMEX (DCM), ICE (ECM)
A Contract to Receive Delivery of a Commodity at a Future Date:
Paper Oil – less than 1% Physical
A Forward Curve
Contango versus Backwardation
Intermonth Spread (Switch) – Full Carry + Forward Curve (In Contango)
Primary Functions
Economics of Futures
Oil Futures Market
“In first 10 months of 2009, more than 114 million (114 billion barrels at $1.6 Trillion
dollars) WTI contracts were traded on CFTC-regulated exchanges.” Gary Geisler

26. Oil Futures FundamentalsIII
$78.00
$79.00
$80.00
$81.00
$82.00
$83.00
$84.00
$85.00
$86.00
$87.00 Mar-10
Apr-10
May-10
Jun-10
Jul-10
Aug-10
Sep-10
Oct-10
Nov-10
Dec-10
Jan-11
Feb-11
Mar-11
Apr-11
May-11
Jun-11
Jul-11
Aug-11
Sep-11
Oct-11
Nov-11
Dec-11
OilFuturesin$
WTI Crude Futures - Contango
WTI Crude Futures -…
Back of the Curve
Front of the Curve
Forward Curve - Term Structure
Intermonth Spread
Months ForwardToday - Cash
Oil Futures Market

27. Speculator 1: Scalpers or Market Makers
Operate Shortest Horizon, sometimes trading within seconds. Do not trade with a
view of where prices are going. CFTC Interim Report
Oil Futures FundamentalsIV
Speculator 2: View of Long Term
Anticipate prices in minutes, hours, days, weeks, or months = make price discovery
Hedgers
Commercial Interests. If one holds physical inventory but does not hedge by going
short, will with hold downward pressure on prices
Commercial Traders
Non-Commercial Traders
Oil Futures Market

28. COT Report
CFTC Publishes every Friday at 3:30 PM Eastern Time. 90% of all Open Interests!
Contains a summary of traders’ positions as of the close of business on previous
Tuesday for each market in which 20 or more traders hold positions equal to or
above the large trader reporting levels established by the CFTC
Oil Futures FundamentalsIII
CFTC: Commodity Futures TRADING Commission
Regulating Certain Markets for Risk Management Contracts (Derivatives)
REGULATORS
Oil Futures Market

29. Speculation DebateV
WTI Average Open Interest by Non-Commerical Participants, 2003-2008
Investment Banks & Speculation

30. Speculation DebateV
WTI Average Open Interest by Commercial Participants, 2003-2008
Investment Banks & Speculation

31. Speculation DebateV
0
20
40
60
80
100
120
140
160
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
2005.03.15
2005.04.26
2005.06.07
2005.07.19
2005.08.30
2005.10.11
2005.11.22
2006.01.03
2006.02.14
2006.03.28
2006.05.09
2006.06.20
2006.08.01
2006.09.12
2006.10.24
2006.12.05
2007.01.16
2007.02.27
2007.04.10
2007.05.22
2007.07.03
2007.08.14
2007.09.25
2007.11.06
2007.12.18
2008.01.29
2008.03.11
2008.04.22
2008.06.03
2008.07.15
2008.08.26
2008.10.07
2008.11.18
2008.12.30
2009.02.10
2009.03.24
2009.05.08
2009.06.16
2009.07.28
2009.09.08
2009.10.20
2009.12.01
WTIOil
CFTCData:NetBuyingW/Options
Total Positions With Options: Bias Result
WTI 선물 Net Buying Positions-O
Long Positions alone appear to move up before prices, but to be non-bias,
we must include short positions as well. A non-bias result with both short
and long positions is in the next slide. Short positions cancel out Long
Long Positions & Oil Prices

32. Speculation DebateV
0
20
40
60
80
100
120
140
160
0
50,000
100,000
150,000
200,000
250,000
2005.03.15
2005.05.17
2005.07.19
2005.09.20
2005.11.22
2006.01.24
2006.03.28
2006.05.30
2006.08.01
2006.10.03
2006.12.05
2007.02.06
2007.04.10
2007.06.12
2007.08.14
2007.10.16
2007.12.18
2008.02.19
2008.04.22
2008.06.24
2008.08.26
2008.10.28
2008.12.30
2009.03.03
2009.05.08
2009.07.07
2009.09.08
2009.11.09
WTIOil
CFTCData:NetBuyingW/Options
Net Buying With Options: Non-Bias Result
WTI 선물 Net Buying Positions-O
Long and Short Positions & Oil Prices

33. Speculation DebateV
Oil Price Schools of Thought & Primary Players
Oil Prices 04-08
Increase Arguments
Demand & Supply
Reserves/ Discovery Declining
Marginal Costs
Optimists Oil Peakers
Downstream
Lobbyists
Governments
SpeculatorsFundamentals
Distortions
Excess Capacity
US Fed Rate - $ Value
Speculation
Oil Peak
0
KEY
Accept Partially Accept Reject
US, JP, KR EU
Oil Prices, Bias, and Political Lenses

34. SPECULATION DEBATEV
INTERESTS
Where is the Absolute Answer to Oil Prices?
(1) Want to cover MC and generate
capital for investment.
(2) Want to avert demand destruction
(1) Long Term View of Oil & Energy
(2) Change Consumer Behavior
(3) Sustain Globalization
0
(1) Realize Low Prices
(2) Sustain Popularity
(3) Show people they are doing something
(1) Hedge Risk
(2) Price Discovery
(3) Speculators: Price Changes
Dishonest Governments Honest Governments
Oil Producers Oil Traders
Truth?

35. Jeffrey Harris, Chief Economist at the CFTC, quit his post in January after
finding no evidence that speculation played a role in driving up oil
prices.
SPECULATION DEBATEV
SPECULATION EVIDENCE
CFTC Chief Economist
Speculation
Evidence
Commodity Trading Regulation
Low Price Elasticity coupled with Insufficient Production Increases
caused the 2007 to 2008 price increases rather than speculation
James Hamilton, Economist
Speculation
Evidence
“We do not need to show excessive speculation is affecting prices in
order to approve the rule.”(Position Limits, et al.)
CFTC Officials
Speculation
Evidence

36. If a contact traded in an Exempt Commercial Market (ECM) is found to
influence price discovery, the ECM is subject to heightened regulation
and to comply with Futures Contract principles
New CFTC RulesVI
ENACTED REGULATIONS
Strengthen CFTC Authority over Futures Market
(H.R. 6124) Farm Bill, 2008
Enacted
Commodity Trading Regulation

37. (1) Wall Street Wide Spreads from Lack of Buyer-Seller transparency
(2) Concentrated with 6 to 15 Institutions worldwide
(3) want to control for potential risks from interconnectedness.
(4) Transparency To Public & Regulatory Body = Better Pricing
New CFTC RulesVI
PROPOSED REGULATIONS
Move To Standard OTC transactions into clearing houses
Over-The-Counter (OTC) Derivatives
Supporting
Argument
Option premium costs change with changes in underlying futures
prices rather than options being a part of price discovery
themselves. So option prices are derived from futures prices rather
than setting futures prices - hence options are called derivatives.”
Morgan Downey, Commodity Trader
Opposing
Argument
Fear vs. Empiricism

38. (1) The CFTC Voted 4 to 1 (01-14-10) to put proposal out for 90
day public comment period to cap traders for all-monthly limits at
10% of the open interest of the first 2.5% open interest beyond
25,000. The single-month would limit 2/3 of the aggregate cap
cap traders for all-monthly limits.
(2) Caps Will covering individual exchanges, spot-month contracts,
all-month contracts, and would include a cumulative gap across U.S.
exchanges.
(3) Limits on Who is Exempt (Airliners Exempt) from position limits
New CFTC RulesVI
PROPOSED REGULATIONS
POSITION LIMITS
Proposed
A Punishment Without a Crime
•Individual exchanges: ICE and CME separately
•Spot month: the month nearest to expiry
•All Contract months: all months listed into the future on the futures exchange
•Cumulative gap across U.S. exchanges: CME and ICE together
•Position Limit: A limit is X futures contracts * 1000 barrels
Terms
Explained

39. (1) Removes Concentration in Futures Market away from a Few
Major Participants, Including Goldman Sachs.
(2) Curtails Momentum on Long Positions
New CFTC RulesVI
PROPOSED REGULATIONS
POSITION LIMITS
Supporting
Argument
No evidence concentration of a few players in the futures markets
influences momentum of price discovery into one direction, and
against market principles to suggest that it is inappropriate for a
someone to exercise their right to make money from price changes.
People should not have a natural entitlement to be free from
competition with successful banks. It is not the role of government to
prevent losers in the free market.
Opposing
Argument
Flawed Premise

40. (1) Under the aforementioned February Proposal, Swap Dealers will
No Longer Receive Confidential Hedge Exemptions. This proposal
targets 10 large traders across oil, natural gas, heating oil, and gasoline
markets, some of whom could qualify for exemptions.
(2) Swap Dealers would instead would need “risk management”
exemptions, that would be reviewed monthly by the commission and
made public after six months
New CFTC RulesVI
PROPOSED REGULATIONS
HEDGE DISCLOSURE EXEMPTIONS
Proposed
Market Intervention

41. (1) Increases Transparency & Reduces Market Information Deficit
for Price Discovery
(2) Increases Public Access to see Scope and Scale of Markets
(3) Eliminates Information Deficit for regulators, allowing them to
gather information necessary to police markets
New CFTC RulesVI
PROPOSED REGULATIONS
TRANSPARENCY
Supporting
Argument
(1) Since it may not be possible for the OTC market to influence price
discovery, and since their prices are determined by the Futures Market,
the effort will not achieve its insinuated aims. It is misleading to the
public.
(2) The public has no inalienable right to obtain market information
acquired by banks since they invested capital to obtain that information.
The belief that people are entitled to information is flawed.
Opposing
Argument
Immoral Entitlement

42. CONCLUSIONVII
Who is behind high oil prices?
(1) OPEC, Wall Street, Corrupt Banks? No!
(2) Oil Supply & Demand Fundamentals? Yes!
(3) Energy Price Ceilings & Control? Yes!
(4) The Average Consumer? Yes!
(5) Government Social Policies Promoting Demand? Yes!
Cure the Disease, not the Symptom!

43. CONCLUSIONVII
Oil Prices & Globalization
Banks, OPEC, Oil Companies, are not the source of oil price instability!
Prioritize Long Term Over Short Term
Educate Populations! Don’t prey on them for Votes!
Recognize that in a Financially and Economically Integrated World,
Energy Independence is Impossible!
Denationalize our View of Energy Security & Oil
Oil is Not a Public or National Good
If the intention of regulation speculators is to appease angry voters or to
suppress oil price, it is wrong, and could lead to a price spike at a later date!

44. CONCLUSIONVII
Drafted and Presented by Kevin P. Kane
QUESTIONS?