Oil trading fundamentals. Module 1


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Konstantin Babourine seminar presentation on Oil trading, Hedging and Price Risk Management.

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Oil trading fundamentals. Module 1

  1. 1. Trading Fundamentals and Trading Terminology
  2. 2. Oil Markets Drivers • As any physical commodity oil prices are determined by availability of raw material, processing capacity and ability to deliver the final goods to the market • Consumer demand sets the trend for oil prices balanced by the supply at hands • Major misalignment of supply and demand causes significant price moves in the market
  3. 3. Oil Markets Drivers Seasonality “Technicals” Economic Growth Military Unrest PRICE Speculators Infrastructure Weather New Projects Politics
  4. 4. Oil Markets Drivers Processing • Crude oil markets operate between the producer and the refiner • Benchmarks are set for various crudes but the ultimate price is determined by what value each specific refinery sees in each type of crude • It is important to not only have high quality crude available but also have access to the market that values it the most • Product markets operate between the refiner and the blender or wholesaler • Very localized markets and depend on: • Local demand for each product (i.e. some country are more gasoline oriented than diesel) • Configuration of local refineries • Regional product quality requirements • One needs to be careful about refinery utilization as it varies by region (some regions may produce poor product specs and run at lower rate despite high demand for product in general)
  5. 5. Oil Markets Drivers Storage • Stock control is crucial in any demand driven market to avoid disruption of the product flow • In a normal course of business oil companies try to keep stocks to a minimum and avoid costly storage rental fees • Generally storage is used as an insurance instrument to protect from unforeseen supply disruptions but is also often used for speculative purposes if term structure permits
  6. 6. Oil Markets Drivers Transportation • Waterborne crude and products shipping • Crude oil is normally sold close to point of production and can be traded as transferred into the ship or/and already on the water • Refined products are traded closer to the market on various terms based on delivery arrangements and parcel sizes • Pipeline trading is mostly traded on a ratable basis and is sold free-in-pipeline at designated locations • Rail
  7. 7. Reasons for Open Arbitrage 30 % 25 % 22 17 % % 31 % 30 % 7% 10 % 12 9% % 5% 3% % of World Consumption % of World Production
  8. 8. Oil Supply Drivers • OPEC • Significantly increased influence from non-OPEC producing countries • New infrastructure project development • Political tensions in oil rich regions • Stocks • Forward Cover = Available stock / Consumption over the period • Strategic reserves (about 10%) • Minimum operating stocks of the companies (about 30% are in pipelines, tankers, tank bottoms and in refineries) • The rest is oil in transit
  9. 9. Cost of Production by Region Source: CERA
  10. 10. Oil Demand Drivers • The state of global economy especially in the industrialized countries • Seasonal consumption • Driving season • US Northeast heating season • Hurricane season • Construction season • Political tensions • Taxation (compare US vs. UK vs. low tax developing countries)
  11. 11. Introduction to Financial Markets and Derivatives Trading
  12. 12. What makes a Market • Materiality • Lack of state interference • Widespread ownership • Tax regime • Geographical locality • Quality and consistency of quality • Operating considerations
  13. 13. Energy Markets Participants Day Traders Investors Brokers Consumers Energy Producers Market Market Makers Arbitrageurs Refiners
  14. 14. The Market: Users • Producers – long reserves, strategic hedging, ROI management • Refiners – refining margin management • Aviation – jet fuel budget management • Commercial transport – operating cost coverage • Shipping – bunker fuel and freight management • Chemicals – feedstock price management • Second tier (lending) banks
  15. 15. Key Market Players Speculator: – Frequent in & out of the market looking for potential gain opportunities – View driven – Take a bet on the future direction of a market – Want price volatility to increase – Will enter into deals and set limits on when to exit
  16. 16. Key Market Players Hedger: – In & out of the market only when there is a (strategic) business – Reduce/eliminate the risk faced from potential future price movements – Business objective driven – Reduce/eliminate exposure to volatility of the business – Want certainty at the cost of sacrificing away potential upside – No surprise approach
  17. 17. Key Market Players Arbitrageur – Take offsetting positions in two or more instruments/markets to lock in profit – Exploit inefficiency in different markets/locations – Take advantage of mis-pricing of certain financial instruments – “Riskless” profit (from a price perspective)
  18. 18. Basic Trading Terminology • Position: Long/Short • Spot Vs Forward Curve • Bid / Offer Spread • Liquidity • Market Direction: Bullish/Bearish • Exposure • Market Structure • Spreads and Cracks • Arbitrage
  19. 19. Position: Long/Short LONG To net own a commodity in a market. A LONG position is taken in the expectation that prices will RISE. Think of something you own e.g. Your house. You are LONG one house and would prefer its value to increase SHORT To net owe a commodity in a market. You have an obligation to supply a commodity not currently owned to someone else. A SHORT position is taken in the expectation that prices will FALL In the oil industry, you may agree to supply a service station with gasoline at a certain price for an entire year. This makes you SHORT gasoline QUESTION 1: If you buy a car, is your position long or short?
  20. 20. Spot Price vs. Forward Price SPOT PRICE The spot price is the price for immediate payment and delivery FORWARD PRICE The forward price is established by a contract in which you set the price now, but delivery and payment occur at a future date FORWARD CURVE A graph of forward prices over different forward time periods
  21. 21. Forward Curve Explained Typical Forward Curve Shapes (Indexed At Spot) Contango vs. Backwardation • Due to the physical nature of oil and oil Price Contango products, the shapes of Backwardation these forward curves cannot be explained alone by the time value of money • Forward curve shapes 100% Price of the swap for a given month are primarily driven by in the future supply and demand expectations in the market Spot 3 6 9 12 15 18 21 24 Question 2: Which commodity forward curve is most likely to be in contango ?
  22. 22. Bid-Offer Spread BID PRICE The price at which you can sell OFFER PRICE The price at which you can buy BID-OFFER SPREAD The difference between the selling price and the purchase price QUESTION: Which price is normally higher? Always?
  23. 23. Liquidity • The ease with which something can be bought or sold (converted to cash) in the marketplace. • A large number of buyers and sellers and a high volume of trading activity are important components of liquidity. • Depth, or the ability of the market to absorb either a large buy or a large sell order without a significant price change in the underlying commodity, is also crucial to the liquidity of the market
  24. 24. Market Direction: Bullish/Bearish BULLISH Having the belief that prices will rise. A ‘Bull’ is someone who thinks market prices are going up A ‘Bull Market’ is when the price is rising BEARISH Having the belief that prices will fall. A ‘Bear’ is someone who thinks market prices are going down A ‘Bear Market’ is when the price is falling
  25. 25. Exposure PHYSICAL EXPOSURE You have bought a cargo of Crude, pricing on the average of next weeks Platts quotes. You are contracted to lift the cargo and hence have physical exposure, but the cargo will not price until next week, so you do not yet have a priced exposure PRICED EXPOSURE You have bought a cargo of Crude at $90/bbl. You have both physical exposure and price exposure (You are LONG 1 cargo). Similarly if you buy a cargo of crude oil which is pricing around loading date and will then take 45 days to arrive at your disport, you are carrying a priced exposure all the time the vessel is on the water (You are LONG 1 cargo). You may wish to hedge under these circumstances to give protection against adverse price movements
  26. 26. Types of trading Trading activity in energy markets may be grouped under the following broad headings: 1. Asset, commercial or industrial optimization: trading activity intended to balance real time needs in the operation of physical assets, commercial or industrial processes, buying additional supply or selling excess production when demand and production levels require, and making optimal choice of feedstocks to service the operations. 2. Hedging: trading activity intended to reduce the riskiness of a portfolio. 3. Arbitrage: trading activity resulting in a riskless profit, usually arising from participants exploiting inefficiencies in a market. The forces of supply and demand usually ensure these price mismatches subsequently disappear as a result of the trade being executed. 4. Speculation: taking risky positions in a market with the intention of exploiting market price movements. 5. Investment: investing cash through positions in energy markets, with the intention of earning returns on these positions.
  27. 27. Trading Strategies • Flat Price trading • Making a call on the commodity price in the future • Product Spread Trading • Making a call on relative price behavior between two markets • Geographical Spread Trading and/or Arbitrage • Crack Spread Trading • Calendar Spread Trading • Volatility Trading • Making a call on how volatile the market will be in the future