Oil prices explained: Putting a dollar value on a barrel of crude
- Crude oil and petroleum products are globally traded commodities, whose prices are largely governed by supply and demand fundamentals. But global currencies, availability of money flow and market sentiment also play an important role.
- Advances in technology, such as horizontal drilling and hydraulic fracturing, have fundamentally shifted the supply side of the curve. Advancements in vehicle fuel efficiency standards have the potential to dramatically alter the demand side of the equation.
- Global demand is arguably the most important driver of crude prices, particularly demand from emerging markets. However, demand can only continue to expand when oil prices remain relatively low. High crude prices can be particularly bad for GDP growth, since most of the world's largest economies are net energy importers.
- Crude pricing tends to follow a seasonality pattern, rising through the spring and declining through the fall. Most significant oil price bottoms occur in the dead of winter, between December and February.
- The US dollar has a profound effect on the price of crude, particularly when the dollar is weak. Sharp declines in the dollar are always accompanied by significant increases in oil prices. However, prices tend to bottom-out when the dollar gains strength, becoming rather unresponsive to changes in the currency.
- Steep oil price declines that occurred through the late 1990s and 2008 were caused by a lack of liquidity in global financial markets, where an absence of buyers caused prices to fall through the floor. Quantitative easing was introduced after 2009, injecting liquidity back into the system and temporarily re-inflating the price of crude.
- Futures markets provide much needed liquidity, always ensuring a buyer for every seller. But most contracts are purchased by traders who have no interest in receiving delivery of the crude. Market speculators can artificially inflate demand for oil, particularly during a bull run, causing prices to overshoot on the way up and overcorrect on the way down.
Several hundred streams of marketable crude are produced around the world every day. No two streams are exactly alike. Variances in grade and quality affect the selling price of every barrel. More importantly, oil prices reflect a specific point of sale, which has an even greater impact on its market value.
Most crude streams are priced in reference to a major benchmark, adjusted for grade, quality and market access.
PRICING A BENCHMARK
The two most commonly quoted benchmarks are West Texas Intermediate (WTI) and North Sea Brent:
- WTI is priced out of the Cushing, Oklahoma storage hub and represents the North American benchmark for light, sweet crude.
- Brent is the international benchmark, a light/sweet seaborne crude priced out of Sullom Voe, Scotland.
HISTORICAL BENCHMARK OIL PRICES|
Nominal USD/bbl data by CME Group
Both Brent and WTI trade on the Chicago Mercantile Exchange (now part of the CME Group). There are a number of other popular crude benchmarks that also trade on the CME, including Dubai Crude, Russia's Urals and Canada's Western Canadian Select.
About two thirds of the world's internationally traded crudes are priced in reference to Brent, largely outside of North America and outside of OPEC. About one-fifth of the world's oil supply, particularly from China and the Middle East, does not trade on open markets. Instead, prices are negotiated between buyers and sellers. It is not uncommon for state-owned oil producers to offer discounts or incentives to entice buyers from a specific region to gain market share.
Oil prices are underpinned by supply/demand fundamentals but can also be greatly impacted by market sentiment, global currencies and availability of money flow in financial markets.
VARIABLE 1: SUPPLY
Supply is arguably the more complex half of the supply/demand curve and the only variable producers can directly control. Some factors are temporary in nature (such as weather events), causing a short-term boost in oil prices. Other variables such as technological shifts and adjustments in capital spending can have a more prolonged effect.
There are three types of oil suppliers in the world:
- Public and private companies owned by shareholders, investment firms or pension funds, such as BP, Shell, Chevron and ExxonMobil.
- National companies owned and operated by the state, such as Mexico's Pemex, Malaysia's Petronas and Saudi Aramco.
- Quasi-national oil companies, where some of the shares are publicly traded but part of the company (usually a majority) is owned by the government. Examples include Brazil's PetroBras, China's CNOOC, Norway's Statoil and Russia's Rosneft.
There are some very important differences between national and public/private producers:
- Public/private companies are corporations driven to maximize profits, which generally means increasing production and reducing operating costs. They have a limited amount of capital available, generated through internal cash flow, equity or debt markets.
- National oil companies have more fuzzy objectives. They lack competition and transparency, putting profitability lower on the priority list. They tend to be less innovative but have the ability to dip into taxpayer funds. State-owned entities have a reputation for being less efficient, often managed by friends of senior ranking government officials, who don't always understand the oil business or technical aspects of crude production.
Now that the "easy" oil has been tapped, national oil companies have been increasingly interested in joint-ventures for large projects, pairing up with more experienced public oil companies who trade technology and expertise for barrels of reserves. This has been far more prevalent since the 2008 oil price crash, which left many state-owned oil producers short on cash.
There are four categories of supply shifts that affect energy markets:
1. Geopolitical events
2. OPEC policy
3. Technological advancements
4. Capital investment
1. GEOPOLITICAL EVENTS: WAR, STRIFE AND CONFLICT
Geopolitical events, such as war, sanctions or global conflicts, can affect supply or stability of supply. Although oil output may not be directly affected, oil markets can be jolted if supply is perceived to be at risk. This is especially true for conflicts among Middle-Eastern nations, which still represent one-third of the world's oil output.
CONFLICTS AND GEOPOLICAL EVENTS|
Real WTI price 2017 USD/bbl
Although conflicts can cause oil prices to rise, meaningful declines in oil prices can also lead to political upheaval. Oil production still accounts for a big chunk of government revenues in places like Venezuela, Russia, the Middle-East and parts of Africa. When oil prices are low, the economy contracts sharply, government handouts get reduced and military spending is often curtailed. This can sometimes fuel anti-government sentiment, initiating cycles of civil unrest. This was evident during the Arab spring uprising, collapse of Venezuela's economy and the rise of terrorist activity in Nigeria. Deep political issues may have existed prior to the 2008 oil price drop, but the subsequent collapse in oil revenues only added more fuel to the fire.
2. OPEC: THE ONE AND ONLY SWING PRODUCER
The Organization of Petroleum Exporting Countries (OPEC) accounts for about 40% of the world's oil production, largely from state-owned oil fields. OPEC was founded in the early 1960s with the goal of coordinating its members' petroleum policies and stabilizing oil markets. As state producers, OPEC members are not directly accountable to shareholders, allowing them to throttle output and control the supply side of the curve.
There have been several coordinated OPEC production cuts over the past few decades, each intended to limit supply while demand is temporarily low, such as in the case of global recessions or excessive production. OPEC quotas are generally successful in boosting oil prices, at least in the short term. However, OPEC's ability to shift the supply curve in the long run is debatable.
OPEC PRODUCTION CHANGES|
Real WTI price 2017 USD/bbl
3. TECHNOLOGICAL SHIFTS AND INNOVATION
Step-changes in technology can have a profound effect on supply and certainty of supply. This has been painfully evident in recent decades, making it difficult to forecast future oil production.
Less than 10 years ago, forecasters were convinced the world was running out of oil. The Peak Oil Theory combined with rapid economic growth in emerging markets caused oil prices to spike to all-time highs. High oil prices and dwindling "easy" supply encouraged oil producers to go where no man (or woman) has gone before.
Exploring for oil is no longer a shot in the dark. Advancements in marine-seismic technology enable explorers to pinpoint with much greater certainty where the oil deposits lie. Improvements in drilling technology, advanced materials and automation has made ultra-deepwater exploration at depths greater than 1,500 meters not only technically feasible, but rather common.
Perhaps the greatest example of a technology shift is the unlocking of production from unconventional shale deposits. The US shale boom took oil markets by surprise, now accounting for over 5 million bbl/day of production. More importantly, the technology now exists for exploiting oil from massive unconventional shale reserves around the world.
US SHALE PRODUCTION|
thousand bbl/day data by EIA
Low oil prices can also spur big gains in productivity. Horizontal drilling technology combined with fracking now allows operators to cover up to 3,000 meters of rock, versus a previous norm of a few hundred meters, greatly reducing the number of wells that need to be drilled. Advancements in seismic imaging allows drillers to adjust to where the oil deposit lies, greatly improving productivity per well. As producers learn to do more with less, breakeven prices come down, allowing for supply expansion despite unfavourable economic conditions.
US tight oil is a classic example of this phenomenon. Productivity has risen dramatically, with each new well producing 40% more per rig in both 2015 and 2016. Rigs in the Permian Basin have fallen over 75% from the highs of 2014, but output has continued to grow.
Total crude production & rig counts data by EIA
4. CAPITAL INVESTMENT: A LAGGING INDICATOR
Capital investment, or lack thereof, can have a profound effect on future oil supply. However, there is a considerable time lag between when the capital is deployed and when first oil is produced.
When oil prices suddenly collapse, production doesn't dry up instantly. Large multi-billion dollar projects take years to construct and eventually come online, regardless of the price of crude. That's why production often keeps growing as oil prices initially begin to fall. Conversely, when prices recover, it can take a long time for production to recover, even if more capital is deployed. This is especially true for oil sands mining projects and massive deepwater drilling platforms.
More importantly, capital investment is a function of cash flow and therefore follows the oil price (not vice versa). A good example is onshore producers, who are far more nimble than mega-project operators, quickly switching production off when prices fall and restarting operation when prices recover. The effect is clearly evident in US crude production, where the number of oil rigs in service lags the price of WTI by about 4 to 5 months.
RIG COUNTS VS OIL PRICES|
2017 USD/bbl WTI data by EIA
VARIABLE 2: DEMAND
While the supply side of the equation is relatively easy to measure and control, crude demand is fickle, unpredictable and far more difficult to adjust. Oil still accounts for one-third of the world's energy demand, making it very susceptible to global economic trends. About two-thirds of world's crude is used for transportation of people and goods - planes, trains, ships and automobiles - which can also be greatly affected by advancements in technology.When examining oil demand in recent history, there are four categories of events that can shift the demand side of the curve:
1. Economic cycles and recessions
2. Global GDP growth and emerging markets
3. US gasoline consumption and automotive trends
1. ECONOMIC CYCLES AND RECESSIONS
All commodities, including energy, tend to follow periodic cycles of expansion and contraction:
- As the economy expands, demand for energy increases, causing prices to rise.
- As prices rise, producers will try to increase output, expanding the supply.
- Rising oil prices creep into all corners of the economy, sparking inflation.
- Consumers then start to feel the pinch in their wallets, sometimes causing a change in spending patterns and eventually leading to economic contraction.
- Since demand is elastic, oil consumption starts to drop-off, creating an oversupply in the market. And that eventually causes the oil price to drop.
Prolonged weakness in oil prices eventually incentivizes producers to cut back on output, shrinking the supply. Then the cycle begins again.
Spikes in oil prices have long been a harbinger of upcoming recessions. In fact, since 1946, 9-out-of-10 major oil price spikes have ended in recession, where the oil price continues to fall during periods of economic contraction.
RECESSIONS VS OIL PRICES|
Real WTI price 2017 USD/bbl
2. GLOBAL GDP GROWTH AND EMERGING MARKETS
Outside of the Middle-East, Russia, Canada, Venezuela and Norway, most of the world's largest economies are net energy importers, the largest being the US, Europe, China, India and Japan. A low oil price is therefore key to their economic growth.
Since 2005, most of the world's GDP growth has come from emerging markets, predominantly China, India and Southeast Asia. In fact, petroleum consumption in non-OECD countries exceeded OECD countries for the first time in 2014. Although recent global GDP data has been soft, it's being dragged lower by developed countries, where demand for oil is relatively stagnant.
GLOBAL OIL DEMAND VS OIL PRICES|
Avg WTI annual price 2017 USD/bbl
The relationship between oil prices and global demand is non-linear. Although a low oil price is generally good for most economies, it increases demand, which puts upward pressure on oil prices. However, if prices get too high, global markets can easily tip into recession, curbing demand for crude. Global economic growth, particular in non-OECD countries, is therefore a key variable in projecting where oil prices are headed.
WORLD OIL DEMAND VS GLOBAL GDP|
Million bbl/day data by EIA
3. GASOLINE CONSUMPTION: WHY AMERICAN DRIVERS STILL MATTER - A LOT
Fuel consumption remains one of the largest drivers of oil demand, particularly in the US. Despite growth in emerging markets around the world, American drivers still guzzle about 10 million bbl/day of gasoline and diesel, accounting for more than 10% of the world's crude demand.
Since Saudi Arabia's 1974 oil embargo, the US has been collecting data on vehicle fleet efficiency and regulating fuel standards for automakers. As the world's largest buyer of vehicles, American drivers also drive trends in the automotive industry.
As gas prices began rising through the late 1970s and early 1980s, fuel economy standards tightened considerably, encouraging automakers to lighten up their fleet. The sale of Japanese cars doubled from 1980 to the year 2000, as Americans shifted from muscle cars to Toyota Corollas. Gas prices then dropped precipitously through the late 1980s, causing demand to rise. The introduction of biofuel blending standards in 2005 displaced several million barrels of demand.
FUEL EFFICIENCY STANDARDS VS GASOLINE DEMAND|
million bbl/day data by EIA
As oil prices began to accelerate rapidly post-2005, high gasoline prices drove up demand for smaller vehicles and newly-introduced hybrids. However, as gas prices began sinking fast in 2009, US consumers rekindled their love for SUVs and trucks, causing domestic fuel demand to rise once again. Demand is therefore a lagging indicator, and will improve prior to increases in oil prices.
During the oil price shock of 2007, President Bush set a fuel mandate target of 35 miles per gallon (mpg) by 2020, up from 27.5 mpg at the time. The Obama Administration struck a deal with automakers to raise that number to 54.5 mpg by 2025. If total miles driven remains unchanged, that would displace about 3 million bbl/day from 2009 levels. Fuel efficiency standards are projected to rise by another 50% by 2040.
Transportation fuels still account for 40% of the world's total energy needs, but that number is expected to decline over the next few decades. Although only 1% of the world's vehicle fleet is fully electric, many have suggested the internal combustion engine will eventually become extinct, potentially cause the next technology shift in energy demand.
4. SEASONALITY: BLAME IT ON THE WEATHER
Oil prices tend to follow a seasonality pattern. These patterns stem from both supply and demand changes that occur during the different seasons, but are predominantly a demand story.
Gasoline demand is very cyclical and weather dependent. Peak demand occurs during summer months, spanning from late May to Labour Day weekend in early September. Demand then starts to decline during the fall and through the winter months.
SEASONALITY AND GASOLINE DEMAND|
Million bbl/day data from EIA
US refineries plan their maintenance shutdowns around the "slow" fall/winter period, reducing throughput and demand for crude. Stockpiles generally rise through the winter, causing oil prices to fall and usually bottom-out in December or January. It's not uncommon for oil prices to bottom in the dead of winter.
OIL PRICE BOTTOMS|
Nominal Brent price USD/bbl (log scale)
Once the summer driving season kicks-in at the end of May, refineries crank throughput, lowering crude stockpiles and causing oil prices to rise. Oil prices tend to peak in summer months, just before the cycle begins again.
AVERAGE OIL PRICE BY MONTH VS GASOLINE DEMAND|
1976 to 2016 data Real 2017 USD/bbl
Hurricanes can also play a factor, although the impact tends to be a lot more short-lived.
The Gulf of Mexico has traditionally been a huge source of crude production for both the US and Mexico, accounting for almost 4 million bbl/day of production and almost 10 million bbl/day of refining capacity. The area is also home to major import/export terminals for both crude oil and refined products.
Oil prices generally tend to get a small boost during severe weather events. Hurricanes and tropical storms can force the evacuation of offshore oil platforms and temporarily suspend production in the prolific Eagle Ford basin. However, price spikes tend be very short lived and quickly return to "normal."
Although hurricanes can dent supply, they have a more important effect on demand, as travel plans are disrupted and refineries are taken offline. This drop in demand can put downward pressure on oil prices and negate any effects of production losses.
MAJOR HURRICANES IN THE GULF COAST|
Real WTI price 2017 USD/bbl
VARIABLE 3: THE US DOLLAR
Like all globally-traded commodities, crude oil is denominated in US dollars. Commodity prices are therefore inversely correlated to the greenback, generally rising when the dollar weakens and falling as the dollar gains strength.
US DOLLAR INDEX VS OIL PRICES|
Real WTI price 2017 USD/bbl
There are a couple of theories behind this trend:
1. The foreign demand effect
2. The trade balance factor
1. THE FOREIGN DEMAND EFFECT
As the US dollar declines, foreign currencies strengthen, causing oil prices to weaken globally (ex-USA). That increases global demand, causing oil prices to rise.
Inversely, as the US dollar rises, foreign currencies fall, making global oil producers more profitable in their local currency (ex-USA). This encourages more oil production, increasing supply and lowers the oil price.
This theory would suggest that oil prices follow the US dollar, trading in the opposite direction.
2. THE TRADE BALANCE FACTOR
The US is still the world's largest consumer of oil, and largest consumer of goods in general. Since the country imports 8 million bbl/day of crude, the price of crude has a profound effect on its trade deficit.
IMPACT OF CRUDE TRADE ON US TRADE BALANCE|
data from FRED
A country's currency generally reflects its trade balance - more specifically, total value of goods exported subtracted from the value of goods imported. When the price of oil is high, the total value of imports increases, creating a more negative trade balance, pushing the dollar lower. However, when oil prices are low, the value of imports diminishes, narrowing the trade deficit, causing the dollar to rise. This theory would suggest that oil prices move the currency, not the other way around.
US CRUDE TRADE VS OIL PRICES|
Real (2017) billion USD/mo data from FRED
Interestingly, the correlation between oil prices and the US dollar is definitely not a linear one. When the dollar is weak, oil prices are very sensitive to changes in the greenback. This was painfully evident in 2008/2009, where both the US dollar and crude prices swung from record highs to record lows, trading in inverse correlation to each other.
However, when the dollar is high, oil prices tend to "bottom out" and becomes far less sensitive to changes in the currency. This was evident between 2000 and 2002, when the US Dollar Index was relatively strong (trading above 100 and as high as 120), but oil prices remained stuck in the US$35 to US$45 range.
CORRELATION BETWEEN US DOLLAR INDEX AND OIL PRICES|
Data from 1992 Real WTI price (2017 USD/bbl)
In more recent times, the US Dollar Index has been stuck in a relatively narrow range, from about 92 to 100, not too strong but definitely not weak. Oil prices have been hovering between US$40 and US$60 for much of that time, responding rather mutely to currency changes. Recent data would suggest a breakdown of the US dollar would be very good news for oil prices, likely causing prices to spike higher. Conversely, a further strengthening in the dollar would probably keep a lid on crude prices, but is unlikely to cause prices to sink much further from here.
If you believe in the trade balance theory, then recent US efforts to become energy independent has an important implication on oil prices. As the US imports less crude and exports more energy products, its trade deficit narrows and currency strengthens. That may help keep a lid on oil prices unless something shifts fundamentally in oil markets. Or at least until US oil consumption becomes a less important part of the global energy story.
VARIABLE 4: LIQUIDITY OF FINANCIAL MARKETS
Global market liquidity is a critical but far less advertised influencer of oil prices. The two most recent financial collapses, the Asian currency crisis of the late 1990s and the global meltdown in 2008, were prime examples of what happens when money flow dries up.
In both cases, financial markets seized up, stopping the normal flow of funds and ceasing all capital injection. Traders, investment banks and hedge funds then ran out of cash, forcing them to liquidate their positions. Stocks and hard assets, such as commodities and even real-estate, collapse in price due to a lack of buyers. The banks stop lending money, causing asset prices to over-correct on the downside.
Economies then enter a "death spiral", where demand drops off a cliff, companies declare bankruptcy, people lose their jobs and consumers close their wallets. Despite very attractive "bargain-basement" prices for stocks, commodities and real-estate, interested buyers are unable to raise funds, causing prices to fall through the floor.
Enter quantitative easing (QE), a lesson learned from the Great Depression of the 1920s. In 2009, central banks around the world pumped liquidity back into global markets. Cheap money flowed back into the economy in the form of interest-free loans made to banks, intended to trickle down to the general economy. Unfortunately, most of that "free money" gets pumps into treasuries, stock markets and global commodities, re-inflating asset prices. When QE stops, the money dries up again causing markets and commodity prices to correct.
LIQUIDITY OF FINANCIAL MARKETS VS OIL PRICES|
Real WTI price 2017 USD/bbl
VARIABLE 5: FUTURES MARKETS
Oil "spot" prices quoted on the evening news reflect delivery in the near term, within the coming months.
In contrast, a futures contract represents the price for future delivery of a specific volume, at a specific price and specific location. Futures contracts can be purchased by oil producers, traders and refineries, as well as non-commercial traders, such investment banks and hedge funds. The first crude oil futures contract began trading on the NYMEX in 1983.
Futures serve an important purpose for producers or refineries, enabling them to lock-in prices or hedge against a price increase or decrease. Producers can pay to store their oil and sell at a later date if they think the price will rise. Refineries can purchase crude futures to protect against rising oil prices. They can also lock-in gasoline futures to guarantee a specific refining margin.
Producers and refineries typically purchase contracts with the intent of delivering or receiving that crude once the contract expires. But the vast majority of traders, such as banks and investment firms, have no interest in the underlying commodity and would typically sell their contract before the expiry date, booking profits or losses.
As traders get more bullish, more futures contracts are purchased. This artificially increases demand, causing oil prices to rise without any underlying supply/demand reasons. This was especially evident during the 2008 boom.
When oil prices began to decline in the middle of 2008, traders who were long found themselves on the wrong side of the trade, forcing them to liquidate their positions. Other traders took advantage of the steep slide by taking a short position, pushing prices even lower. When coupled with a global economic contraction brought on by the financial crisis, oil prices collapsed from US$145 in July to just US$34 a barrel in December, a 76% decline in less than 6 months - a move most certainly not caused by underlying fundamentals.
WTI OPEN INTEREST CONTRACTS|
Real WTI price (2017 USD/bbl) data by CME Group
The Federal Reserve Bank of St. Louis estimates that global demand fundamentals account for only 40% of price increases in oil markets. Supply and inventory levels play and even smaller role. About 15% of price spikes are caused by speculators piling on to a momentum trade.
A healthy futures market provides much liquidity to the system, ensuring there is always a buyer and seller for every barrel of crude. That's good if you're a producer or refinery. Futures markets also provide insight into where traders think prices are headed (higher or lower), allowing companies to plan accordingly. But the increased popularity in futures trading and commodity derivatives has also added a lot of unwelcome volatility. That's the unfortunate trade-off of a highly liquid market.