Apr-2017

Crude oil sourcing: price and opportunity

Sourcing crudes for the best refining margin needs to be supported by a detailed procurement strategy.

MISHA GANGADHARAN, S D POHANEKAR and M D PAWDE
Hindustan Petroleum Corporation Limited

Article Summary

The world’s crude oil market includes not only spot markets featuring physical transactions but also highly developed paper markets, notably futures and forward delivery, thus forming a very composite market structure in which all these transactions are interrelated and reciprocally influential. The variation in prices between two grades can influence refinery margins significantly if corrective action is not taken at the appropriate time. Therefore identifying and procuring crude oil that results in maximum margins are the industry’s top priorities. In this article, various aspects relating to crude oil procurement for optimisation of refinery margins are outlined.

How the oil market works
The price of oil is set in the global marketplace. Oil is traded widely all around the world and can move from one market to another easily by ship, pipeline or barge. Therefore the market is worldwide and the supply/demand balance determines the price for crude oil all around the world. If there is a shortage of oil in one part of the world, prices will rise in that market to attract supplies from other markets until supply and demand are in balance. If there is a surplus in a region and the price drops, buyers will soon be drawn to that market. This explains why crude oil prices are similar all around the world. Prices vary only to reflect the cost of transporting crude oil to that market and the quality differences between the various types of oil. The global nature of the market also explains why events anywhere in the world affect oil prices in every market. Several key factors influence the oil price, however the four major factors that help in determining the price of oil are supply, consumption, financial markets and government policies.

As per the basic principles of economics, prices will be low if supply exceeds demand, and the reverse applies: an increase in consumption over supply will lead to an increase in prices. However, crude oil pricing goes far beyond just supply and demand. The way oil is traded on the financial markets has a massive influence on its price. Similar to the stock market, people also trade in crude oil as a commodity in financial markets. They purchase ‘futures’ –essentially bets on how much oil will cost at a later date – and this in turn affects how other people think oil should be priced. It also affects how much oil the petroleum companies will release to the market. Oil trading in financial markets has been growing bigger than ever in recent years. As a result, speculation has come to shape the price of crude oil more than ever before. Crude oil trading in financial markets has a surprising effect on crude oil prices – speculators who buy large amounts of futures can swing the price one way or another. Here is an example: a speculator who buys oil futures at a price higher than the current market price can cause oil producers to hoard their oil supply so they can sell it later at the new, higher ‘future’ price. This cuts the current supply of oil in the market and drives up both present and future prices.

Government regulation also has a big impact on oil prices. Rules and regulation on the sulphur content of fuel could raise demand for low sulphur crude oil. The incentive for fuel efficient cars, development of more efficient alternate modes of transport and so on will lead to demand for oil prices to go down, simply because the world will not need it as much. Thus selection of crude oil for processing at a refinery is always dynamic and crude oil that was most desirable from a margin point of view can be less attractive after a few months.

Pricing and marker crude oil grades
The price payable for crude oil is calculated based on the marker crude oil price plus or minus a price adjustment factor, which is set by the seller, or is mutually agreed between the buyer and the seller. While the marker crude oil price varies with events in international markets, including speculations, the adjustment factor is decided by the seller, taking various elements into account like quality difference with the marker crude, transportation cost difference with alternate grades, demand supply balance, competition from other suppliers/grades, and so on.

There are different crude oil markers, each one representing crude oil from a particular part of the globe. The marker crude oil is specific to the market and three major markers used in pricing of crude oil across the globe are WTI (Western Texas Intermediate) for the US market, Brent for the European/West African Market and Oman/Dubai for crude oil grades in the Persian Gulf for the Asian market. The applicability of marker crudes across the globe is shown in Figure 1. The details of each of the markers are:

Dubai/Oman: this Middle Eastern crude is a useful reference for oil of a slightly lower grade than WTI or Brent. It is heavier and has a higher sulphur content, putting it in the ‘sour’ category. Dubai/Oman is the main reference for Persian Gulf oil delivered to the Asian market.

Brent Blend: about two-thirds of all crude oil contracts around the world are marked to Brent Blend, making it the most widely used marker. ‘Brent’ actually refers to oil from four different fields in the North Sea: Brent, Forties, Oseberg and Ekofisk. Crude from this region is light and sweet, making it ideal for the refining of diesel fuel, gasoline and other high-demand products. The supply is waterborne and thus it is easy to transport to distant locations.

West Texas Intermediate (WTI): WTI refers to oil extracted from wells in the US and transported via pipelines. The crude is very light and very sweet, making it ideal for gasoline refining in particular. WTI continues to be the main benchmark for oil consumed in the US.  The characteristics of these marker crude oil grades are shown in Table 1.

Figure 2 indicates how price differentials between marker crude oil move for various reasons, swinging sourcing decisions for a refinery.

Determination of marker crude oil price
The determination of a marker crude oil price varies between suppliers, and the various ways of determining marker crude oil price are: bill of lading (B/L) month average, five days around B/L, nominated month average, or as agreed between buyer and seller. Thus while finalising the sourcing of marker crude oil, determination of its price must also be kept in mind. Table 2 indicates marker crude oil price determination methodologies followed by various national oil companies for supply to Asia, as well as the time of announcing the price adjustment factor.

Price adjustment factor, official selling price
The price adjustment factor for a crude oil grade is adjustment over the marker crude oil price. The adjustment factor is declared before the beginning of the month by many national oil companies and is called the official selling price (OSP), whereas if crude oil is purchased on the spot market the adjustment factor is as agreed between buyer and seller.

The adjustment factor plays an important role in crude selection as the relative economics (grade to be procured) changes based on the adjustment factors declared by the national oil company for their various grades. To be competitive, the national oil companies generally maintain the differentials of their grades with other, similar grades. Some national oil companies declare outright price for their grades after the completion of the month basis price is discovered under spot market conditions.

Figures 3 and 4 show how the price adjustment factors of grades similar to each other but from different suppliers closely track each other when the price adjustment factor is declared before the beginning of the month. However, the grades whose prices are declared after the end of the month (outright price) do not see any relationship with similar grades whose prices are declared before the beginning of the month (see Figures 5 and 6). 

Thus, the economics of a grade whose price is declared after the end of the month vis à vis a similar, alternative grade whose price is declared before the beginning of the month keep changing from month to month as the differential price between two grades varies significantly.