The oil market

Crude oil can come from almost any part of the world and the oil market, unlike gas
and power, can be described as a truly global market. The principal production
regions can be generally grouped into the following: North Sea (the most notable
grade being Brent), West Africa, Mediterranean, Persian Gulf (notably Dubai), Asia,
USA (notably WTI), Canada and Latin America. Each region will have a number of
quality grades and specifications within it, in particular, depending on their API
gravity2 and sulfur content.

In Europe the benchmark crude product is North Sea Brent while in the USA it is
often quoted as WTI. WTI is the principal product meeting the NYMEX sweet crude
specifications for delivery at Cushing (a number of other qualities can also be
deliverable, although many non-US crudes receive a discount to the quoted settlement
price). The other major crude product is Dubai, representing the product
shipped from the Persian Gulf.
Each of these three products will trade in close relation to each other, generally
reflecting their slightly different qualities and the transport cost from end-user
markets, all three markets reflecting the overall real or perceived supply/demand
balance in the world market. Other crude specifications and delivery points will then
trade some ‘basis’ from these benchmark prices.
As well as the three crude products noted above, the oil market encompasses the
refined products from crude oil. While thousands of different qualities and delivery
points world-wide will ultimately result in hundreds of thousands of different prices,
in Europe and North America these can generally be linked back to a number of
relatively strong trading hubs that exist, notably:
Product type Principal hubs
Crude Brent/Cushing/Dubai
Unleaded NWE3/New York/Gulf Coast
Gas Oil/No. 2 Oil NWE/New York Harbor
Heavy Fuel Oil/No. 6 Oil NWE/New York Harbor/Far East
In addition, the rest of the barrel, propane, butane, naphtha and kerosene trade
actively, but are more limited in terms of their relevance to the energy complex.
Within the various product ranges prices are quoted for particular standard grades.
For instance, No. 6 oil (also known as HFO or residual oil) can be segmented to 1%,
2.2%, 3% and 3.5% sulfur specifications. Each have their own forward curves and
active trading occurs both on the individual product and between the products. The
market has developed to the point where NYMEX lists not only option prices but also
Crack Spread Options (the option on the spread between the products).4
Like its other energy counterparts most of the trading is done in the OTC ‘brokered’
market that supports most of the commonly traded options, swaps and other
derivative structures seen in the financial markets. Derivatives are particularly useful
in oil compared to other energy products given the international nature of the product
and the relationship between the overall oil complex. For instance, if we take an
airline company, this needs a jet fuel hedge that reflects the weighted average cost
of its physical spot fuel price purchases in different parts of the world. At the same
time it would like to avoid any competitive loss it might experience from hedging out
at high prices. This would be complex (and unnecessary) to achieve physically, but
relatively straightforward to hedge using a combination of different swaps and
average price options, which can be easily linked to currency hedges.
Another common swap is the front-to-back spread, or synthetic storage. This
allows the current spot price to be swapped for a specified forward month. It should
be noted that this relationship may be positive or negative, depending on market
expectations. Locational swaps are also very common, providing a synthetic transport
cost. Such swap providers in this market (and all energy markets), however, need to
be very aware of both the physical logistics and the spot market volatility.
Crack spreads and Crack spread options are used to create synthetic refineries.

The 3:2:1 crack spread that is traded in NYMEX is a standard example of this linking
the prices of crude, heating oil and gasoline.
In oil, the majority of swap transactions are carried out against Platt’s indices that
cover most products and locations, although a number of other credible indices exist
in different locations. For instance, CFD’s (Contracts for Differences) are commonly
traded against ‘dated’ Brent, the price for physical cargoes loading shortly and a
forward Brent price approximately three months away.
While such derivatives are easy to construct and transact against the liquid hubs
they have their dangers when using them to hedge physical product at a specific
delivery point. Specific supply/demand factors can cause spreads between locations
and the hubs to change dramatically for short periods of time before they move back
into equilibrium. For example, extreme weather conditions can lead to significant
shortages in specific locations where imports are not possible leading to a complete
breakdown of the correlation between the physical product and the index being used
to hedge. In other words you lose your hedge exactly when you need it. A risk
manager must look carefully at the spreads during such events and the impact on
the correlations used in VaR and Stress tests. They should also understand the
underlying supply/demand conditions and how they could react during such extreme
events.
It should also be noted that oil products are often heavily taxed and regulated on
a state and national basis which can lead to a number of legal, settlement and
logistical complexities. Going hand in hand with this is the environmental risks
associated with storage and delivery, where insurance costs can be very substantial.
Ever-changing refinery economics, storage and transportation costs associated
with the physical delivery of oil are thus a significant factor in pricing which results
in the forward curve dynamics being more complex than those seen in the financial
markets. As a result the term structure is unpredictable in nature and can vary
significantly over time. Both backwardation5 and contago6 structures are seen within
the curve, as is a mean reversion component. Two components are commonly used
to describe the term structure of the oil forward curve: the price term structure,
notably the cost of financing and carry until the maturity date, and the convenience
yield. The convenience yield can be described as the ‘fudge factor’ capturing the
market expectations of future prices that are not captured in the arbitrage models.
This would include seasonal and trend factors.
Given the convenience yield captures the ‘unpredictable’ component of the curve,
much of the modeling of oil prices has focused on describing this convenience yield
which is significantly more complex than those seen in the financial markets. For
instance, under normal conditions (if there is such a thing), given the benefit of
having the physical commodity rather than a paper hedge, the convenience yield is
often higher than the cost of carry driving the market towards backwardation.
Fitting a complex array of price data to a consistent forward curve is a major
challenge and most energy companies have developed proprietary models based on
approaches such as HJM to solve this problem. Such models require underlying
assumptions on the shape of the curve fitting discrete data points and rigorous
testing of these assumptions is required on an ongoing basis.
Assumptions about the shape of the forward market can be very dangerous as MG
discovered. In their case they provided long-term hedges to customers and hedged
them using a rolling program of short-term future positions. As such they were
exposed to the spread or basis risk of the differential between the front end of the
market (approximately three-month hedges) and the long-term sales (up to ten years).
When oil prices in 1993 fell dramatically they had to pay out almost a billion dollars
or margin calls in their short-term positions but saw no offsetting benefit from their
long-term sales. In total they were reported to have lost a total of $1.3 billion by
misunderstanding the volatility of this spread.
Particularly in the case of heating oil, significant seasonality can exists. Given the
variation in demand throughout the year and storage economics, the convenience
yield will vary with these future demand expectations. This has the characteristic of
pronounced trends, high in winter when heating oil is used, low in summer and a
large random element given the underlying randomness of weather conditions.
The oil market also exhibits mean reversion characteristics. This makes sense,
since production economics show a relatively flat cost curve (on a worldwide basis
the market can respond to over- and under-supply and that weather conditions (and
thus the demand parameters) will return to normal after some period.
In addition, expected supply conditions will vary unpredictably from time to time.
Examples of this include the OPEC and Gulf War impacts on perceived supply risks.
Such events severely disrupt the pricing at any point leading to a ‘jump’ among the
random elements and disrupting both the spot prices and the entire dynamics of the
convenience yield. I will return to the problem of ‘jumps’ and ‘spikes’ later in this
chapter. 529