Evaluating Crude Oil Prices – A Review of the Basics
Having been in the physical trading of commodities on and off for over a decade now, I am stunned to see how many people – mostly brokers – who claim to trade oil derivatives know so very little if any about how crude oil prices are evaluated.
So for the sake of clarifying it all for everyone concerned, I thought of sharing this blog with all our readers in the hope they become more educated brokers and traders alike.
For all of those of you who still don’t know, there have been successive price regimes since the beginnings of the 20th Century.
- Between 1930 and 1970, it was the so-called “seven sisters pricing regime”, where the prices where controlled and posted by oil companies.
- Then, until 1985, the prices were controlled by the producing countries, a period is known as the OPEC pricing regime.
- After a short period of netback pricing regime (crude oil price was tied to the price of refined products), the reference pricing regime was adopted. This is the system that we still use today.
In this system, only a very small proportion of crude oil is freely traded and serves as a benchmark, while the price of the crude oil which is not freely traded is tied by some formula to these benchmarks, hence the “reference” pricing regime.
Depending on the quality of each type of crude oil, its price would be higher or lower in comparison with the benchmark. Those formulas are adapted from time to time but are generally stable.
There are two mains benchmarks, the WTI and the Brent, which are traded on several layers, building a quite complicated market. For the Brent market, for example, there is a spot market, a physical forward market and a futures market.
- The spot market is a non-standardized market (different quantities of oil are traded), the transactions are bilateral and “over the counter”.
- The forward market (also called the 21-day Brent), is a standardized market (a standard parcel is 600,000 barrels), where the seller will make the oil available on an unspecified day of the relevant month (the loading date must be announced 21 days in advance to the buyer).
- The futures market is also a standardized market (contract on 1,000 barrels), but it is not a “physical market”, which means that the contracts are based on cash settlement and not on physical delivery, those barrels are thus named “paper barrels”. You can buy “call options” that give you the right to buy the underlying futures contract of “put options” that give you the right to sell the contracts. The idea here is that the producers and the consumers can manage risks. A producer can sell futures or buy put options to ensure a certain level of prices; a large consumer can buy futures or call options to limit the risks of very high prices. Buying and selling Brent futures and options make sense only because the other crude prices follow the evolution of Brent.
The benchmark spot oil price is purely supply/demand driven. These prices are heavily influenced by paper trading (which includes refineries’ price hedging efforts, not just speculators) and are entirely market-driven for hypothetical deliveries of non-existent oil of the benchmark type. Specific oils contracted for actual delivery are then priced on a discount or premium to the benchmark based on each refinery’s capabilities. There isn’t really a generic formula that works across the entire market, just rules of thumb. Each buyer has a different ability to process oil into refined products, so some oil shipments are worth more or less to particular people. Each refinery has its own internal pricing formulas based on the crude assay and the refinery’s configuration. Buyers usually try to set up long-term production contracts with a specific source that has favorable characteristics for the refinery’s equipment.
On a superficial level, two factors differentiate crude: “Weight” and sulfur content. The most desirable type is light sweet crude, because it has little sulfur and requires less processing to turn into gasoline. The worst type is heavy sour oil, which really more of a horrible smelly tar than something you’d recognize as oil. Sulfur poisons the catalysts used in processing and must be removed to meet environmental standards. So oil containing it requires more energy & equipment to process.
In practice oils are sold by region because a particular exploration basin tends to have somewhat consistent geology and oil quality. (Also it’s just simpler than comparing chemical assays.) Prices are set by benchmarks to West Texas Intermediate in the US and Brent (from the North Sea) in the rest of the world. These specific oils are a pretty small portion of what’s traded but are used as known standards when comparing quality. If you have a higher quality crude than the benchmark such as Nigerian Bonny Light, it will sell for a few dollars above the benchmark. A low quality crude like Venezuela’s Orinoco heavy oil will sell for a discount — fewer refineries can process it.
The “weight” in reality is determined by the mix of hydrocarbon compounds. The more carbon atoms per molecule, the higher the viscosity and density of the crude. 1 carbon plus associated hydrogen is methane (natural gas), 3 carbons is propane, 4 carbons is butane, and gasoline is a mix averaging 7-8 carbons but ranges from 5 to 12 or so. Crude oil can contain a mix of everything from C1 to C100 (and up) in various ratios.
Refining separates the mix into fractions differentiated by volatility and weight. The most valuable fraction of a barrel of crude is the light liquids, C5 to C10 or so. Different mixes of all those molecules affect the volatility, energy content, viscosity, toxicity, and general suitability for producing gasoline.
Then there is the shape of the molecules. For a molecule with just 6 carbon atoms, you could have straight-chain n-hexane, several different iso-hexanes with branched chains, a ring of cyclohexane, or an aromatic ring of benzene. The first two are good for gasoline, and cyclohexane is a useful solvent (for example decaffeinating coffee), but benzene is toxic and heavily regulated. The shape of the molecules matters.
Really big carbon molecules create wax if they’re straight chains (parrafins), or tar/asphalt if they’re in webs/sheets, or coke if they’re in giant messy clumps with minimal hydrogen. These all cause problems for pipelines and refineries. Tar and coke molecules contain plenty of room for sulfur and heavy metals to get attached to the carbon, making it difficult to extract these toxins.
So in a nutshell, different crudes are ranked by how easy it is to get gasoline & diesel out (the two highest value products) and how little toxic sludge has to be separated out during refining.
Sulfur content always reduces crude value. I am not aware of any exceptions to this.
Broadly speaking, lighter crudes are worth more, because they produce more gasoline. That usually implies crude with lower density (which is equivalent to higher API gravity). The most valuable part of the barrel of crude is the C5-C12 range (Cn meaning the count of carbon atoms in the hydrocarbon molecules). However, a light oil can be less valuable if it contains too much of the smog-causing components like benzene (C6) that evaporate easily and contribute to air pollution. The type of hydrocarbon molecules matters just as much as the size.
In some countries, diesel is used more than gasoline so refiners will prefer a slightly heavier oil than in gasoline-focused regions. The gasoline/diesel ratio can be adjusted somewhat via processing equipment, but it’s always easier to start with the best oil for the target output.
So the light/heavy scale is really an oversimplification. The refining value of a crude oil cannot be determined from a few simple parameters — you really do need a full chemical assay (crude oil assay), which includes at minimum the distilled fractions, vapor pressure (Reid Vapor Pressure), sulfur content, metal content, and so forth.
Hope this clarifies all and sets the record straight
Please share your thoughts.