Crude Oil (Part 2)
I hope the previous chapter provided an understanding of the underlying crude oil fundamentals. Additionally, if you’d like to learn more about how it’s extracted from the earth and distributed to users like refineries, then viewing the ‘Oil and Gas videos’ on YouTube is a great source of information. These short animations give a comprehensive overview of this process.
This animated video provides an insightful look into the process of extracting oil from the ground and seas. Furthermore, it gives viewers an insight into what ‘oil rigs’ are. They’re those large platforms with flames shooting out of the exhaust located in oceans around the world. Companies such as Aban Offshore, Selan Exploration and Cairn India specialize in constructing this infrastructure. Many traders and even investors invest in these asset-heavy firms without any knowledge of their operational aspects. While I understand this can be financially rewarding, I don’t think it is a wise approach. For this reason, as well as for its effect on many listed organizations, I would like to discuss how the oil industry works in brief.
I should issue a disclaimer here – I am not an expert in the oil and gas sector, just a basic understanding. Being a crude oil trader does, though, mean it is important for me to be aware of the industry. In some cases, such as if there is a significant change occurring in crude oil, you may get a trading opportunity from one of the downstream companies rather than directly from the crude oil market. Knowing your way around the industry and recognising potential money-making opportunities will be invaluable to you; this is where I come in, introducing you to how everything works and helping you put together an energy landscape roadmap.
So let us get started.
The oil and gas industry can be segregated into three sections –
Let us briefly discuss each one of them starting from the upstream companies.
Upstream companies are responsible for the majority of the hard work in oil extraction. This means conducting geological surveys, digging bore wells to determine what is under the ground, and then drilling and extracting crude oil if reserves are found. It can take several years from discovering an asset (potential oil well) to making it a fully operational resource that produces income. They also produce and store large amounts of crude oil in barrels every day (millions!) so research and development as well as engineering are integral parts of their operations. As a result, substantial capital expenditure is necessary for successful extraction.
The price which upstream companies are able to get for the oil they produce is not always within their control due to market forces. This full-cycle cost, or breakeven point, is essentially the amount of money they need in order to produce a single barrel of oil. As such, these companies strive to reduce costs so that this full-cycle cost is more economical.
Indian upstream companies include entities such as ONGC, Carin India, Reliance Industries, Oil India. Globally, Shell, BP and Chevron are some of the prominent names belonging to this domain.
It’s important to bear in mind that not all upstream companies will benefit from lower oil prices. Companies with high economies of scale, known as high full cost cycle, are particularly affected. Higher oil prices on the other hand will bring about an increase in margins for these companies, as their effort to extract oil stays unchanged.
We will begin with the downstream industry, followed by the midstream. Generally, when upstream companies have finished producing crude oil, it needs to be refined before it can be used as petrol or diesel. This is where the downstream industry plays their part; they purchase the raw crude oil and refine it into products like petrol, diesel, aviation fuel, marine oil, kerosene, lubricants, waxes, asphalt and liquefied petroleum gas.
In this sector, products are spread across the value chain, from business to business (B2B) to retail outlets that reach consumers directly. Petrol bunks make a good example of this – these are shops that belong to downstream companies and specialize in petroleum products.
Downstream companies in the Indian context include BPCL, HPCL and IOC. Some firms attempt to span the whole value chain by performing both upstream and downstream operations, which are colloquially known as ‘Super Major’. An example of this is Exxon Mobil Corp, based in the United States. It produces around 4 million barrels of oil a day and has 40 refineries across 21 countries. Managing an operation of this size is an immense undertaking; certainly not for everyone.
If the oil prices decrease, it does not bode well for upstream companies as their production efforts remain constant. However, in places like the US and UK, this benefit is swiftly transferred to consumers like you and me.
Anyway, here is what you need to remember at this stage –
o Upstream and downstream companies share a see-saw relationship.
o Low oil prices are bad for the upstream boys but suitable for the downstream fellows.
o Higher oil price is right for upstream fellows but bad for downstream boys.
If oil costs are declining, don’t leap to bet against ONGC or BPCL. Spend a moment to grasp their upstream or downstream status and consider the effect of new prices on their performance.
We will quickly discuss the midstream companies before looking into other aspects.
Midstream companies act as couriers between the upstream and downstream producers. They transport oil products, most commonly via pipelines, trucks (oil tankers), or ocean vessels. Consider them as wholesalers of crude oil who are sometimes even involved in refining the product slightly. Even though this can lead to some operations overlapping with downstream businesses, these firms remain neutral when it comes to oil prices: not wanting either increases or decreases that would adversely affect upstream and downstream companies alike.
Some of the top players in this segment are TransCanada, Spectra Energy, Willams and Company etc.
Here is a snapshot which gives you a quick overview of all the three industries –
People often talk about Crude Oil as if it is one single homogenous resource, like Gold for example. However, this is not the case. Did you know that there are actually several varieties of oil that can be extracted from the ground? These variations stem primarily from the geographic area and its specific characteristics. Even geographical discrepancies have such a huge effect that appearance and other aspects of crude oil vary significantly – from thickness, to color (ranging from light yellow to deep black), viscosity, sulfur content, volatility, etc.
We should take a look at two distinct characteristics that define the variance of crude oil before we investigate the disparity between them.
API Gravity – API Gravity is a metric developed by the American Petroleum Institute to determine how light or heavy particular types of crude oil are relative to water. If it is above 10, the oil is lighter and will float on top. But if the gravity rating is below 10, then it’s heavier than water and will sink.
Sweetness – Crude oil of any form contains sulfur, the quantity determining its ‘sweetness’. Oil with sulfur content lower than 0.5% is considered ‘sweeter’ while higher concentrations are deemed ‘not so sweet’.
The difference between WTI and Brent is primarily attributed to their API Gravity as well as their sweetness.
West Texas Intermediate (WTI) – West Texas Intermediate (WTI) is a highly sought after grade of crude. Its API gravity of 39.6 – higher than 10, thus lighter than water – and sulfur content of 0.26 percent, ensure that the end product refined from it will also be of premium quality.
Brent Blend – Brent Blend is a type of crude crafted by combining oil from over 15 wells. It has a sulfur content of 0.37%, which makes it sweeter than WTI, yet comparatively less so. Furthermore, its API gravity of 38.06 gives it a light character. All in all, similar to blended scotch, this blend is also formulated to display specific features.
It is plain to see that these two differing models are traded at dissimilar prices. Let us take a peek at the quotes on offer for these variants –
It is critical to remember that on MCX, crude oil is based on the WTI index, not Brent.
Brent Crude offers an additional option on derivative contract expiration, with the ability to settle either physically or in cash. This can explain its higher price in comparison to WTI, which is physically settled.
The movements of the inventory levels of crude oil can highly influence its prices and the profits of many related businesses. It is essential to closely track these figures in order to gain an advantageous trading position. Knowing the supply and demand can help you transact not only crude at MCX, but also set up trades on companies like BPCL, HPCL, IOC and ONGC.
There are two organizations that put out the inventory details –
Crude oil and US Dollar prices exhibit an inverse relationship – as the American currency strengthens, the price of oil falls, and vice versa. It is important to bear in mind that although these two assets are partly connected, it is their own respective supply-demand dynamics which predominantly govern their rate movements.
Doing an image search for ‘Crude Oil versus Dollar’ yields numerous graphs depicting the inverse relationship between these two. To give you an example – here is a chart:
It is interesting to note that these charts are not measuring the “USD Dollar Spot”, but rather the ‘Dollar index’, which reflects its value against a basket of international currencies. It makes sense, as crude oil is an internationally priced commodity, so regardless of its purchasers, payment is always made in US dollars.
The appreciation of the Dollar leads to nations buying more oil for their money, causing inventory levels to be depleted at a faster rate and boosting oil prices.
It is generally correct over extended periods of time. However, it is important to bear in mind that both of these assets have their own distinct underlying forces at work. Therefore, there may be cases where they could break away from their inverse connection and move in the same direction.
What this inverse correlation also implies is that when the dollar decreases, it does not necessarily follow that oil will increase by the same amount; rather, it suggests that the two assets will move in opposite directions. Consequently, even though the dollar may weaken, there is no guarantee that crude oil will strengthen likewise.