Tuesday, November 24, 2009

Market Trend in Oil Trading

This article was first published on 8/31/2009.

Market Trend in Oil Trading

Introduction

There is not one person alive today that does not benefit, directly or indirectly, from products derived from crude oil. The most common, and logical, use of oil is fuel, that is, fuel for transportation, heating and the generation of electricity. Common uses derived from crude oil include plastics (from alkenes), lubricants, wax, tar and asphalt. Essentially, crude is the life blood of the modern developed society.

 Top Oil Producing Counties

In 2007, Saudi Arabia was the largest oil producer, extracting an average of 10,234,000 barrels per day. Russia and the United States follow with a production rate of 9,876,000 and 8,481,000 barrels per day respectively.

Oil consumption per capita 
Oil consumption per capita

The top three oil consumers are the United States, China and Japan with rates of consumption of 20,687,000, 7,201,000 and 5,197,000 barrels per day respectively. Immediately you will notices that the United States has a 10,000,000 barrel per day trade deficit. Or in other words, the United States currently consumes twice as much oil as Saudi Arabia is extracting from the ground.

Oil exports
Oil exports

Oil imports
Oil imports

It may not be surprising that Saudi Arabia and Russia are by far the largest exporters of crude oil at a rate of 8,651,000 and 6,565,000 barrels per day. Norway, Iran and the United Arab Emirates follow with approximately 2,500,000 barrels per day.

This paper will address the topic of crude oil trade, analyze recent price fluctuations and attempt to predict the short term price trend.

Trade

Crude oil is traded at both the New York Mercantile Exchange (NYMEX) and the Chicago Mercantile Exchange (or the “Merc”), both of which are owned by the CME Group. Both exchanges offer trading in commodities and commodity derivatives. In fact, the Merc is the world’s largest commodity trader. Both exchanges have pit floors where independent traders use the “open outcry” system of announcing, negotiating and agreeing to sales. Open outcry uses verbal calls and elaborate hand signals to communicate information. Today however, approximately 70% of all commodity trades at NYMEX and the Merc are conducted on Globex, an electronic around-the-clock trading system. This system allows almost anyone anywhere to trade commodities and commodity derivatives. During one day in 2004, Globex recorded more than one billion transactions.

Crude oil derivatives are also traded at the Tokyo Commodity Exchange (TOCOM) and the Multi Commodity Exchange (MCX) in India. Another organization that trades almost exclusively in energy commodities and derivatives is the Intercontinental Exchange (or ICE), an American firm based in Atlanta, Georgia. Unlike the other exchanges, ICE operates exclusively electronically.

Price

The price of petroleum is highly dependent on the grade of the fuel. Grades are measured by American Petroleum Institute gravity (or API gravity) which is essentially the density of crude relative to water. Fuel prices stated in the media are normally one of the following:

  1. West Texas Intermediate traded on the NYMEX for delivery at Crushing, Oklahoma, or
  2. Brent traded on the Intercontinental Exchange delivered at Sullom Voe, Scotland

 Brent monthly spot price
Historic oil prices

For most of the past decade, prices have been fairly consistent in the $30-$50 per barrel range. Obviously the past few years have been the exception but let’s first examine the slump that occurred almost a decade ago when the price fell to $16/barrel in January 1999. This drop has been attributed to the over production in Iraq and the fallout from the Asian Financial Crisis. The crisis caused an immediate drop in demand, leading to an oversupply and a global price decline.

The infamous (and financially painful) price spike in 2008 which culminated in the July 11 record price of $147.27 per barrel started in 2007. The exorbitant fuel prices can be attributed to a number of international events, such as:

  1. June, 2007:
    Changes in US Federal oil policies,
  2. September, 2007:
    OPEC announced lower than expected output,
    US stock prices fell lower than expected,
    Six oil pipelines in Mexico were attacked by leftist guerillas,
  3. October, 2007:
    Political tensions in Turkey,
    US dollar depreciates
  4. June, 2008:
    Libya threatens to cut output,
    OPEC’s president predicts a price surge to $170/barrel
  5. July, 2008:
    Iranian missile tests.

Price declines following the peak were significant, most notably following a statement by then Federal Reserve Chairman, Ben Bernanke, regarding what he termed “demand destruction”. Prices in 2008 continued to drop as the US dollar appreciated and the credit crisis worsened.

One somewhat controversial practice undertaken by some Wall Street firms like Morgan Stanley was the purchasing and storage of oil. Morgan Stanley leased storage silo filled with oil purchased at the current spot price and entered into future contracts. When prices escalated, they earned enormous returns without having to move a drop of oil as the contracts were settled. This practice is controversial because it can be argued that the stockpiling of crude oil may have contributed to the increased demand, or Morgan Stanley may have “manipulated the market”.

The speculation bubble was exasperated by financial reports from Goldman Sachs and Gazprom that prices could peak at $200 per barrel. Speculation in oil derivatives was only “fueled” by investors leaving a declining stock market. Earlier this year, the television current affairs show, 60 Minutes, profiled the apparent speculation in the oil market. The following quote demonstrates the amount of speculation.

“In a five year period, Masters said the amount of money institutional investors, hedge funds, and the big Wall Street banks had placed in the commodities markets went from $13 billion to $300 billion. Last year, 27 barrels of crude were being traded every day on the New York Mercantile Exchange for every one barrel of oil that was actually being consumed in the United States.”
(CBS News, 2009)

Sixty Minutes also proved that there was no economic justification for the price spike.

“A recent report out of MIT, analyzing world oil production and consumption, also concluded that the basic fundamentals of supply and demand could not have been responsible for last year's run-up in oil prices. And Michael Masters says the U.S. Department of Energy's own statistics show that if the markets had been working properly, the price of oil should have been going down, not up.”
(CBS News, 2009)

To combat alleged market manipulation, the US Commodity Future Trading Commission (CFTC) announced initiatives to prevent price manipulate in the oil futures market.

The Future

The current economic recession has substantially reduced the predicted annual growth of global oil consumption to 0.6% per year. It is anticipated that oil producing countries will respond by reducing supply and hence their stockpiles. Reduced stockpiles will have a profound effect on the volatility of world oil prices, for example.

“WTI futures for August rose $2.33 to $71.49, after an attack on a Royal Dutch Shell oil platform by Nigerian militants.”
(Hoyos, 2009)

Surprisingly, a report by Chen (2009), based on ten years of economic data stated that emerging economies like China have an insignificant effect on the international oil market.

After last year’s peak, the price dropped below $60 and is now $69.95. The current rise is due, primarily, to the depreciation of the US dollar. Most economic analysts predict the price of crude to fluctuate between $60 and $70 in the short term.

References

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