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Understanding Oil Prices

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Understanding Oil Prices

A Guide to What Drives the Price of Oil

in Today’s Markets

Salvatore Carollo

A John Wiley & Sons, Ltd., Publicatio

This edition ﬁrst published 2012

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Library of Congress Cataloging-in-Publication Data

Carollo, Salvatore.

Understanding oil prices : a guide to what drives the price of oil in today’s markets / Salvatore

Carollo.

p. cm.—(The wiley ﬁnance series)

Includes bibliographical references and index.

ISBN 978-1-119-96272-4 (hardback)

1. Petroleum products—Prices. 2. Petroleum industry and trade—History. I. Title.

HD9560.4.C37 2012

338.23282—dc23

2011039266

A catalogue record for this book is available from the British Library.

ISBN 978-1-119-96272-4 (hardback) ISBN 978-1-119-96289-2 (ebk)

ISBN 978-1-119-96290-8 (ebk) ISBN 978-1-119-96291-5 (ebk)

Set in 11/13pt Times by Aptara Inc., New Delhi, India

Printed in Great Britain by TJ International Ltd, Padstow, Cornwall, UK

A Soﬁa e Riccardo

Parmi d’aver per lunghe esperienze osservato

tale essere la condizione umana

intorno alle cose intellettuali,

che quanto altri meno ne intende e ne sa,

tanto pi`

u risolutamente voglia discorrerne;

e che, all’incontro, la moltitudine delle cose conosciute ed intese

renda pi`

u lento e irresoluto al sentenziare circa qualche novit`

It seems to me, after long experience

in observing the human condition

as regards intellectual matters,

that some persons, the less they understand and know,

all the more forcibly wish to hold forth;

and that, when we encounter something new,

the myriad things known and understood

make any judgement regarding it slower and less conclusive.

Galileo Galilei

Contents

Foreword xiii

Preface xv

Quick Reference Guide xix

List of Figures xxiii

List of Tables xxvii

List of Boxes xxix

1 The World Crude Oil Paradoxes 1

2 The Market Events from 2008 to 2011 7

World Energy Policy 8

The Financial Crisis and the Oil Market 10

Fundamentals or Financial Speculation? 17

Demand/Supply of Gasoline and Gasoil 21

WTI – Brent Differential 24

3 Evolution of the Price of Crude Oil from the 1960s

up to 1999 29

1960–1980: The Oil Monopoly and the Two Crises

in the 1970s 30

The 1980s: The Gradual Disappearance of OPEC 33

The Price War 35

x Contents

1985–2000: From the Introduction of Brent as an

International Benchmark to the Clean Air Act 37

The Suicide of OPEC 40

The Start of the Free Market 41

The Consequences of the Environmental Turnaround 44

4 Changes in the Market for Automotive Fuels 45

Evolution of Environmental Demand 45

Gasoline and its Components 50

Reforming 51

Cracking 52

Alkylation 53

Isomerization 53

Reﬁners Walk the Tightrope 53

The Fiscal Policy of the Industrialized Countries

Regarding Fuels 55

5 World Oil Flow 63

Transformations in the Downstream 66

World Supply Structure 70

6 The Classical Model of the International Oil Market 73

7 The Short-term Model of the International

Oil Market 81

8 The Brent Market 89

The Sale and Purchase Contract 90

The Forward Market for Brent (15 day Brent Contract) 94

The IPE Brent Market 100

The Divorce Between Oil Price and Oil 102

9 Principal Uses of the Forward and Futures Markets 105

Tax Spinning 105

Benchmarking 105

Hedging the Price Risks 106

Speculations on Operational Flexibilities at Loading 114

Market Structure: Contango and Backwardation 117

Procedures at the Loading Terminals 119

Contents xi

10 Problems of the Brent Forward Market 123

11 The European Reﬁnery Crisis 131

12 Conclusions: We are Ourselves OPEC 155

Bibliography 163

Index 165

Foreword

This book was conceived after a critical re-reading of the lectures I gave

at the Eni Corporate University (ECU) for the Master MEDEA and for

the Annual Seminar on oil marketing.

It is therefore the result not only of my elaborations and market models

developed over the years to interpret the international oil market, but

also of the discussions in the lecture hall with the students of the Master

MEDEA and with the representatives of those producing countries who

have taken part in the various editions of the Annual Seminar.

My thanks are due above all to these persons.

I also wish to thank Prof. Enzo Di Giulio, president of ECU, who

desired to be present in these lectures and encouraged me to put the

content of my presentations in book form.

Finally, I owe particular thanks to Dr Caterina Marmorato who, apart

from helping me with notable professional commitment in the delivery

of the lectures for the Master course, dedicated a good part of her free

time for several months in preparing the technical annexes and in the

task of editing.

Preface

The title of the book you are holding – Understanding Oil Prices: A

Guide to What Drives Oil Prices in Today’s Markets – brings to mind

the telling of a story. Now, we know that for a story to be a good story

it should meet three conditions: a) there are certain events to relate;

b) these events run in order, that is, their sequence has some sense and,

if possible, succeeds in holding the attention of the reader; c) there

is a voice that narrates the story effectively and clearly. We feel that

Salvatore Carollo’s book satisﬁes all three of these conditions, and it

tells a story of great interest to all of us.

The world of oil seems to be cloaked by a form of disparity in

comprehension. Without oil, our entire existence – as we know it today –

would not be possible. Despite the countless discussions regarding the

oil peak and the end of the oil era, this fuel still represents, by far, the

primary energy source. According to the last World Energy Outlook

of the IEA, the proportion of oil as a source of energy stands at 34%

against the 26% of coal and 21% of gas. According to the IMF’s World

Economic Outlook (WEO) reference scenario, in 2030 it will still be

the primary source: 30% as against the 29% of coal and 22% of gas.

Oil has, and continues to have, a profound inﬂuence on the lives of

westerners and perhaps even more so on that of the peoples of the east.

Certainly, it is a non-renewable source and this means that its days, in

the long term, are numbered. But that is not the point here: the heart of

the matter is that we are dealing with a material that shapes, changes,

models, directs and conﬁgures the history of the world. And this is

destined to carry on for a long time – true even when the lusty ﬂames

of oil, ephemeral like all the things in this world, fade away in the great

emptiness of time. Just as the Hellenistic or Roman worlds still inﬂuence

xvi Preface

our lives despite their decline – consider for a moment our language –

in the same way, oil has given the world a development and geopolitical

model, which is destined to last for the coming centuries. But this is

the future. Today, rather, we are in the midst of the oil era. And yet,

as we said earlier, there is a depressingly inadequate awareness of the

signiﬁcance of this essential source. This very book has come to your

hands, reader, thanks to oil. Here we are not talking about a technical

knowledge of the complex work of exploration, or oilﬁeld production,

or of the transport of crude oil across the oceans of the globe. Rather,

we refer to those three words that millions, if not billions, of times

stand out in the media: the ‘price of oil’. This expression, the content

of which has such a powerful inﬂuence on our lives, is the synthesis of

immense forces – costs, decisions regarding investments and expenses,

use of reserves, operations to cover risks, speculations, transactions, the

policies of contracting companies, the policies of nations, oil companies

and so on – that interact to form it. At the same time, from the price

itself stem innumerable chains of actions that inﬂuence variables of

fundamental importance for the entire economy: the quotations of the

dollar and the euro, the balance of payments, the price of gasoline and

gasoil, the cost of electricity, the rate of inﬂation, employment and so on.

Thus, the price of oil has a vast and forceful impact on our existence.

And despite all this, the issue is not adequately discussed. Rather, it

is mentioned, hinted at and at times journalists try to explain it; but

beyond the inner circle of specialists no one talks much about it. And

this circle, to tell the truth, is very restricted. This is a destiny that oil

shares, unfortunately, with all the sources of energy. Just reﬂect on the

scarce availability of courses in energy economics in universities across

the world. A similar reﬂection applies to books on energy economics

that are a rara avis on this planet, particularly if we compare them

with the plethora of texts on environmental economics. Paradoxically,

energy – which represents perhaps the central axle around which the

entire economy rotates – is almost never an issue to dissect in our degree

courses, in particular those regarding economics. Thus, tethered within

the strict boundaries of a territory for specialists, the price of oil remains

an abstruse, esoteric matter. When an attempt is made to pass from the

esoteric to the exoteric, it is often done in a misguided, amateurish way.

The media advances information that evokes horriﬁc scenarios – until

last year some were predicting a price of around $200 per barrel – they

talk of an oil peak and the end of oil. Alternatively, OPEC is indicted as

Preface xvii

being responsible for the high prices, inﬂating its role disproportionately.

In this way, public opinion tends to form biased opinions based on

explanations that draw attention to just one main force, as the only one

responsible for what happens.

This book by Salvatore Carollo speaks of all this. It tells a story, as

we said, and it does so starting from the end, namely the crude oil price

collapse of last year from almost $150 to under $40 per barrel. Why did

this happen? To what extent can the fundamentals explain it? Starting

from these questions, the book offers an examination of the phenomenon

that takes us nimbly through the essential phases of the evolution of crude

oil price. The volume deals with relevant aspects – some quite technical –

such as purchase contracts, the structure of world supply, the evolution of

environmental regulations and, naturally, the reﬁning process for crude

oil. But at its core remains the key question of the price and its formation.

The various issues discussed serve as fodder for the exploration of the

primary question, as if they were pieces of a jigsaw to be completed.

Certainly, as regards the role of the various forces that drive prices up

or down, the book offers a very clear explanation. In one sense, it tracks

down some of those guilty. We will not reveal them here, so as not to

deprive the readers of the pleasure of discovering them in due course.

We will only declare that the text materializes from the vast experiences

of the author. As we read, we hear the voice of a professional, namely a

man who works in the oil arena and whose main task is, for his part, to

contribute towards the formation of prices, and not explain them. And

yet, the author belongs to that class of professionals that master, thanks

to their deliberation, whatever they do, in this way succeeding to unify

thought with action. Unfortunately, their class is very rare: it is hard to

say whether it is more or less rare than that of the academic who follows

the inverse route, passing from theory to practice. What is certain is

that the marriage of practice and reﬂection has produced a stimulating

and enjoyable book. Some readers will appreciate its structure, which

alternates the narration with the technical aspects, others the voice, still

others will ﬁnd it an interesting and nimble introduction to the world

of oil, and others, ﬁnally, may see it as a sort of text book. Some will

agree with its propositions, others not: we can be certain of that. But the

function of a book is precisely this: to stimulate reﬂection and nurture

knowledge with thought. To quote the celebrated words of a troubled

writer of the 1900s, Franz Kafka – as troubled as the oil market! – ‘a

book must be a pickaxe for the frozen sea that resides within us’. And the

xviii Preface

frozen sea is not only the existential and interior one as navigated by the

writer from Prague. Often, the ice on the sea is created by prejudices, the

knowledge fossilized inside us and never seen again, by the ready-made

explanations, by their nebulosity which is never questioned. This book

has the honour and duty to be a robust pickaxe.

Enzo Di Giulio

President, Scuola Enrico Mattei

Quick Reference Guide

To assist the reader a glossary of the technical terms that have been only

brieﬂy considered in the text has been added. Other terms have been

described in some detail in the pertinent chapters.

rASSESSMENT: this term is used in the text to mean estimate and/or

valuation.

rAUTHOR’S SOURCE: when this reference is indicated, the source

of data and graphs should be intended as a personal elaboration of

data available in the market and from public sources.

rBENCHMARK: in the crude oil sector, a benchmark provides a

reference parameter based on which other crudes are evaluated or

priced. Some benchmarks are localized in speciﬁc geographic areas

(e.g. Dubai in the Middle East or Tapis in the Asia-Paciﬁc area) while

others have global application, e.g. Brent Dated.

rBLENDING of GASOLINES: ﬁnal operations in a reﬁnery for mix-

ing semi-ﬁnished products arriving from various plants. Actually, with

very few exceptions, for technical/economic reasons, gasoline as a ﬁn-

ished product is not directly obtained in a reﬁnery from one sole plant,

but usually through mixing various components.

rDOWNSTREAM/UPSTREAM: downstream is the part of the oil

cycle that embraces transport, reﬁning and marketing. The preceding

operations, i.e. exploration and production of crude, represent the

upstream.

rDRIVING SEASON: this term indicates the season for gasoline in

America. Normally this phase starts in late May and continues for the

entire summer season; in other words, as a result of summer travel, it

is the period of greatest gasoline consumption in the USA.

xx Quick Reference Guide

rICE: acronym for the Intercontinental Exchange, previously known

as the International Petroleum Exchange (IPE), one of the major

exchange markets for physical products and their derivates. The con-

tracts dealt with on ICE include the following products: exchange

rates, stocks and shares, crude and reﬁned products, natural gas, cof-

fee, cotton, sugar and so on. When reference is made to ICE futures,

this signiﬁes the futures contract for ICE Brent, dealt with in Europe

on the London Exchange.

rIEA: Acronym for the International Energy Agency, an international

organization founded by the Organization for Economic Cooperation

and Development (OECD) with headquarters in Paris.

rJET-FUEL or JET-KERO: aviation fuel.

rJOINT VENTURE: a contract between organizations for the imple-

mentation of a project that involves notable technical and ﬁnancial

risks. The obligations and responsibilities of each partner are shared

proportionately on the basis of each partner’s participation quota in

the project. Joint ventures between oil companies occur frequently

in the exploration and exploitation of oilﬁelds (in particular offshore

ones).

rOCTANE NUMBER: the index of resistance to detonation of a fuel.

If the octane number is too low the speed of combustion of the gasoline

is too high and this causes shock waves in the combustion chamber

of the engine (‘pinking’) and dispersion of energy.

rNYMEX: acronym for the New York Mercantile Exchange, one of

the biggest commodity markets. Founded in 1872 for trading eggs,

butter and cheese, it is now the reference bourse for oil. When the text

refers to NYMEX futures this means the WTI futures contract.

rOPEC: acronym for the Organization of the Petroleum Exporting

Countries.

rOPEN INTEREST/OPEN POSITIONS: in the futures market, this

indicates the aggregate of the purchase and sale operations that have

not been closed by operations in the opposite side.

rTERMINAL OPERATOR: the body that manages and administers

a production terminal for crude oil (loading tankers, administration of

production data, allocation of barrels). Normally this body coincides

with the partner that has a majority shareholding in the project.

rOSP: Acronym for Ofﬁcial Selling Price. This provides one of the

many ways for determining crude prices. The OSPs are normally ﬁxed

unilaterally and published by the producing countries.

Quick Reference Guide xxi

rSPARE CAPACITY: in general, this refers to the unused capacity

of a reﬁnery (namely the capacity to produce greater quantities of

reﬁned products as compared with those already in production), or

the unused production capacity of an oilﬁeld (namely the capacity to

produce greater quantities of crude oil as compared with those already

in production).

rSWING PRODUCER: a producing country or association of such

countries likely to adjust its offer of crude to the demand so as to

control price movements.

rARMS-LENGTH TRANSACTIONS: those between related par-

ties but whose contractual terms reﬂect market conditions between

independent and unrelated parties.

rWTI: acronym for West Texas Intermediate, also called Texas Light

Sweet. This crude is used as a benchmark throughout America. The

WTI derived contract is traded on the NYMEX.

List of Figures

Figure 1.1 Brent Dated 1970–2010 and main historical events 2

Figure 1.2 OPEC production versus Brent 4

Figure 1.3 Complexity and interdependence in the oil market 4

Figure 1.4 World oil demand (average in 2005–2010),

million barrels per day 6

Figure 2.1 World oil demand versus supply 8

Figure 2.2 NYMEX WTI crude oil futures open interest:

non-commercial versus total traders 14

Figure 2.3 Comparison between volumes of NYMEX and

Brent traded in the futures and physical markets 15

Figure 2.4 Futures: daily trades in 2008–2010 18

Figure 2.5 Provisional and ﬁnal assessments of stock

changes versus Brent prices 21

Figure 2.6 Price movements during the winter months 25

Figure 2.7 WTI NYMEX–ICE Brent differential 26

Figure 2.8 Brent and inter-monthly volatility (1988–2011) 27

Figure 3.1 Crude oil prices (1970–2011) 30

Figure 3.2 The price of crude with reference to the

benchmark 31

Figure 4.1 USA crude demand by sector (2009) 46

Figure 4.2 Evolution of gasoil speciﬁcations 47

Figure 4.3 Evolution of oil demand in the USA, Europe and

Asia-Paciﬁc (1985–2020) 49

Figure 4.4 Per capita oil demand in the USA, Europe and

Asia-Paciﬁc (1985–2010) 49

Figure 4.5 Gasoline and reﬁning plants 51

xxiv List of Figures

Figure 4.6 USA imports: gasoline versus blending

components 54

Figure 4.7 Simpliﬁed reﬁnery scheme 56

Figure 4.8 Gasoline prices in the world 60

Figure 4.9 Price (excluding taxes) of gasoline in Europe

and the USA 60

Figure 4.10 Tax burden on diesel fuel in 2010 (Europe

and the USA) 61

Figure 5.1 World oil ﬂow 64

Figure 5.2 Number of reﬁneries versus average reﬁning

capacity 68

Figure 5.3 Reﬁning capacity versus rate of

utilization (USA) 69

Figure 5.4 Destinations guaranteed and destinations

dependent on the price 71

Figure 5.5 Destination of crude (%) 71

Figure 6.1 Variation of stocks versus variation in the

Brent price 75

Figure 6.2 The classical model of demand/supply 76

Figure 6.3 The modern supply/demand model 77

Figure 6.4 The vicious circle in the classical

demand/supply model 78

Figure 6.5 Adjustments to the estimate of the yearly

imbalance between demand and supply 79

Figure 7.1 The classical industrial model 82

Figure 7.2 Reﬁning cycle for a heavy crude to produce

1 tonne of gasoline 84

Figure 7.3 The modern oil industrial cycle 85

Figure 7.4 Relative prices of gasoline, gasoil, jet fuel

and fuel oil 86

Figure 7.5 Relative prices of products in 2008 86

Figure 9.1 Example of price-lock hedging 107

Figure 9.2 Example of integrated price-lock hedging 112

Figure 9.3 Example of operational ﬂexibility effects 115

Figure 10.1 Distorted Brent Dated quotations 125

Figure 10.2 Movement of the benchmark before and after

July 2002 127

Figure 10.3 Relationship between demand and supply of

regional crudes 129

List of Figures xxv

Figure 11.1 USA: number of reﬁneries versus average

reﬁning capacity 133

Figure 11.2 Europe: number of reﬁneries versus distillation

and conversion reﬁning capacity 133

Figure 11.3 NWE and MED reﬁnery margins:

cracking plants 134

Figure 11.4 EUROPE: surplus/deﬁcit in capacity, reﬁning

margins and demand 136

Figure 11.5 EUROPE and USA: surplus/deﬁcit in capacity,

reﬁning capacity and demand 137

Figure 11.6 US import: gasoline and blending components

from Europe 138

Figure 11.7 Alkylate premium to gasoline 139

Figure 11.8 Brent and products prices 2004 143

Figure 11.9 Brent and products prices 2010 144

Figure 11.10 Brent and products prices 2004 (base:

1 January =100) 145

Figure 11.11 Brent and products prices 2010 (base:

1 January =100) 145

Figure 11.12 Gasoline/Brent prices ratio 146

Figure 11.13 Gas oil/Brent prices ratio 147

Figure 11.14 Comparison between a ﬁnancial reﬁnery and a

real reﬁnery (MED, January 2011) 148

Figure 11.15 NWE: reﬁnery margins (cracking plant)

versus crack spread (seasonal 3–2–1) 149

Figure 11.16 MED: reﬁnery margins (cracking plant)

versus crack spread 149

Figure 11.17 Agricultural and oil demand and prices 150

Figure 11.18 GDP per capita and open interest 151

Figure 11.19 Agricultural and oil futures open interest

on NYMEX 153

List of Tables

Table 2.1 Comparative analysis of the value of NYMEX and

Brent in the ﬁnancial and physical markets 16

Table 2.2 Total production costs by region 19

Table 2.3 Demand of oil products in OECD Europe and

in the USA 22

Table 4.1 Evolution of gasoline speciﬁcations 46

Table 4.2 Evolution of gasoil speciﬁcations 47

Table 4.3 World crude oil demand 47

Table 4.4 Gasoline in Europe and the USA: list price and price

at the pump 58

Table 4.5 Price of gasoline and diesel fuel in some

European countries 59

Table 5.1 Italian reﬁneries 67

Table 6.1 Global oil demand and supply 74

Table 9.1 Correlation index between Brent and other

international crudes 106

Table 11.1 EUROPE: surplus/deﬁcit in capacity, reﬁning

margins and demand 135

Table 11.2 USA: surplus/deﬁcit in capacity, reﬁning

margins and demand 137

List of Boxes

Box 2.1 Cost of the Marginal Barrel 18

Box 2.2 Jet Fuel and Gasoil Market 24

Box 3.1 The Netback Value System 36

Box 6.1 Variations in Estimated IEA Stocks 79

Box 8.1 The Principal Clauses in a Sale and

Purchase Contract 90

Box 8.2 The Daisy Chain 95

Box 8.3 15 day Brent Contract 96

Box 8.4 The Price Risk in the 15 day Brent Contract 98

Box 9.1 First Example of Hedging 107

Box 9.2 Second Example of Hedging 110

Box 9.3 Example of Synergies Between Operational

Flexibilities and Hedging 114

Box 9.4 Floating Storages 117

Box 10.1 Market Squeeze 124

Box 10.2 Assessment of Brent Dated (Platts’ Methodology) 128

Box 11.1 Trends in Agricultural Products and Oil Prices 150

The World Crude Oil Paradoxes

For some years now, the price of oil has been out of control. None of the

great names of the industry, the production cycle or the oil market is able

to intervene to decide its level or guide its progress. The oil companies,

the OPEC producing countries as well as the non-OPEC, the consuming

countries, the consumers: not one of these has this capability.

The price of oil, in the imagination of western consumers, is still

linked to the equilibrium developed during the 1970s and 1980s, with

the emerging of the Persian Gulf countries and the OPEC nations.

It is still a popular belief that the cartel of the largest oil producing

countries in the world is capable of regulating the volume of production

and using this key raw material to achieve political aims.

Even today, when the price of oil rises beyond any level considered

critical, the vast majority of the oil market analysts turn their eyes

towards Vienna, where the oil ministers of the OPEC countries meet,

imagining, hoping for and analysing decisions which either will not be

taken or, if taken, will turn out to be completely ineffective. Lately, in

some market reports, more sophisticated analyses are merely focused

on the availability of OPEC countries’ spare capacity; linking to this

factor the dynamics of the oil price. When we look at the graph of the

price of crude oil in Figure 1.1 we do not see the result of market forces,

but rather a design traced by the hand of a powerful invisible architect

who, following his own purposes, has established a course along which

the price of oil should travel.

Since the end of 1998 analysts, oil companies and producing countries

have mistaken every forecast of the price of oil, clearly showing not only

that they no longer control the fundamental market mechanisms, but that

they are not even able to comprehend its real dynamics – it is as if the

invisible architect had lost his pencil.

If we take our memory back to December 1998, when the price of

crude oil fell to $9 per barrel, all the respected names of the oil industry,

bar none, forecast that the price would stay for at least one or two decades

under $15 per barrel. It is enough to glance at the investment budgets

of all the oil companies or the ﬁnancial programmes of the producing

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

2 Understanding Oil Prices

100

120

140

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

$/bbl

Yom Kippur

War

Iraq/Iran

War

Gulf War

Iraq War

Price War

Financial

Crisis

Clean Air

Act

Brent as International

Benchmark

2011 Unrest in

Middle East and

Earthquake in

Japan

Figure 1.1 Brent Dated 1970–2010 and main historical events

countries to conﬁrm that only the most optimistic among them estimated

maximum price levels between $14 and $15 per barrel in the long run.

Some oil companies, based on this view, hedged their production at

this level of prices and went bankrupt. Yet only a few months later,

in the summer of 2000, the price had already reached $35 per barrel,

taking everyone – market analysts, oil companies, producing countries,

economists, politicians and consumers – by surprise. Rivers of ink were

consumed to explain the nature of this event through analysis where the

causes were sought in transient factors; a sudden storm, nervousness

between two OPEC countries, political uncertainties and so on.

The years of the energy crises were far away and deeply buried in

the collective subconscious. The reappearance of such a thorny question

was regarded, before it raised any anxiety, as almost a nuisance. Still

today, after a decade of price hikes for crude from $9 to more than $140

and then down to $37 and once again above $120 per barrel, most people

limit themselves to reciting a series of clich´

es to try to ﬁnd justiﬁcations

for an incomprehensible phenomenon:

rLimited supply from the producing countries, apparently inadequate

to satisfy the growing demand for oil.

rUnexpected growth in the demand for oil by China and India, appar-

ently upsetting the stability of the oil market.

The World Crude Oil Paradoxes 3

rTensions in the Middle East.

rThe prospect of a decrease in the crude reserves/crude production

ratio and therefore the availability of spare capacity.

rThe excessive taxes on petroleum products (gasoline, diesel, LPG

etc.) imposed by European governments.

This type of analysis has the advantage of being simple and easily

presentable to the public at large, without, however, explaining what

has really happened or is happening. Nevertheless, this approach has

enabled some commentators to exaggerate on the contentious issues

regarding the excessive power of the OPEC countries and the ways to

bring them to reason.

The problem which all serious analysts have to face up to is actually

quite simple. The essence is to explain oil price movements by use of

the classic model of economics, which assumes that price is a function

of the relationship between demand and supply:

Price =f (demand, supply)

This principle of economics seems too valid to allow any space

for querying it. Notwithstanding this, the fundamental classic method

applied tout-court to the oil market does not work. Yes, it is correct to

say that the price is linked to the supply and demand balance, but of

which good? We need to ﬁnd out the merchandise or commodity whose

supply and demand is determining the dynamics of oil price. For sure,

it is not the physical crude oil.

OPEC has programmed and put into effect increases or cuts in pro-

duction on numerous occasions, but always with scarce results. To every

public announcement of increased production by the OPEC countries,

the markets have responded with an increase in the crude oil price by at

least a couple of dollars per barrel – and vice versa, when they announced

cuts (Figure 1.2).

It is therefore reasonable to question whether the economic model

utilized really works or if it is applied in an incorrect way to the oil

market. Or, rather, that the technological complexity of this market does

not allow it to be modelled on the simple relationship between demand

and supply at a global level. The internal dynamics of this particular

market require a much more detailed and complex model, capable of

describing some of the fundamental dynamics of the system.

Unfortunately, the majority of analysts in this ﬁeld have exclusively

economic backgrounds and tend to apply general or econometric mod-

els to the crude oil, which are suitable for other commodities (coffee,

4 Understanding Oil Prices

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

Jan-07

May-07

Sep-07

Jan-08

May-08

Sep-08

Jan-09

May-09

Sep-09

Jan-10

May-10

Sep-10

million bbl/day

110

130

$/bbl

Total OPEC production

Brent Quotation

Figure 1.2 OPEC production versus Brent

Source: International Energy Agency

copper, gold etc.), where the production and technological transforma-

tion processes are less complex.

One starting point should be the recognition that what is commonly

called the oil market is actually the conjunction and interaction of

different markets which operate separately and independently but

which are linked by certain complex forms of correlation and dynamics

(Figure 1.3).

Producing Countries

and Oil Companies

Crude Oil

Market

Financial

Institutions

Trading

Companies

Refineries Final Product

Market

Consumers

ICE/NYMEX

Brent/WTI

Financial

Market

Physical

Market

Figure 1.3 Complexity and interdependence in the oil market

The World Crude Oil Paradoxes 5

We refer now to the crude oil market (raw material), to the ﬁnished

products market (gasoline, diesel, jet fuel, fuel oil, chemical feedstocks,

lubricants) and to the ﬁnancial market for crude and ﬁnished products

(futures). We should always remember that in our cars and in airplanes

we do not use crude oil, but ﬁnished products, which are increasingly

difﬁcult to produce. We cannot also neglect the dramatic developments

of the futures market and its predominant role in the world economy.

Each and all these markets respond to different behavioural patterns

and they are operated by bodies with differing interests, culture and

business objectives. A model that does not take into account the inter-

relations between these markets and their individual dynamics is inca-

pable of describing what happens to oil prices.

When the analyst is confronted by the unequivocal event of a price

variation, and having only the classic model of the global demand/

supply, he can only create a scenario of probable events (input to the

model), which, when processed, might generate the variation in price

which actually took place. If the price rises it is clear that there must have

been an increase in demand or a reduction in supply. Therefore, one looks

for all the clues which might prove that something like this has taken

place. In the absence of reliable and prompt information there is more

than enough space for these concoctions. It is thus very easy to reach

the mistaken conclusion that China and India (the distant enemy, the

invisible tartars) are becoming the critical factors for our planet. And that

certainly OPEC (the conﬂict of civilizations) is yet again, for political

and ideological reasons, not producing enough crude. Unquestionably

there is no need to verify the production data of Venezuela under Chavez,

or Iran under Ahmadinejad. It seems highly likely that both would wish

to create problems for the west by raising prices.

The economic and strategic importance of the themes related to the

price of crude oil would require a far more detailed technical analysis.

In this discussion we shall ﬁrstly try to examine the structural changes

in the oil industry in recent decades, to see what has changed to make

these dramatic and uncontrollable variations in price possible. And

above all we shall try to understand why, in the space of a few short

weeks (August–November 2008), without having seen even a small vari-

ation in the physical crude oil demand/supply situation the price tumbled

from $144 to $37 per barrel. Then, in a couple of months it climbed

back to $70–80 per barrel, exceeding again $120 per barrel in 2011.

These events have silenced many analysts, who have not been able to

provide consistent answers to the following questions. First of all, why

did the price drop in 2008? What happened in those few weeks? Did the

6 Understanding Oil Prices

Others

34.4

India

3.0

China

7.8

Japan

5.0

Europe

15.5

USA 50

19.9

[million barrels per day]

Figure 1.4 World oil demand (average in 2005–2010), million barrels per day

Source: International Energy Agency

demands of China and India dry up or did the tensions in the Middle

East calm down? Was OPEC ﬂooding the markets with crude?

The truth is that OPEC cut production, the data regarding world

demand for oil (see Figure 1.4) showed no reduction in global con-

sumption, and – in the previous weeks – the Middle East lived through

one of the most dramatic crises in recent history. In all this turmoil, the

oil price plunged by almost $110 per barrel.

What is the factor that then pushed the price up again above $120 per

barrel, during a worldwide dramatic economic crisis and stagnation of

oil consumption?

Is there an economic model that can explain these recent events? A

description will be attempted in the following pages.

The Market Events from

2008 to 2011

This conversation starts by taking a quick look at what happened in the

international oil market during 2008. Actually, 2008 was the year when

all the contradictions brewing in the previous decade surfaced. Events

as dramatic as the collapse of crude oil to under $40 per barrel after a

surge to more than $140 per barrel had never been seen before in the

history of the oil industry. Not even the impressive crises of 1973 and

1979 were able to cause price swings of this size and speed.

It has already been mentioned that in the last decade, despite the

available supply constantly exceeding the demand, we have witnessed

the continual growth of the crude price.

The upward trend in prices underwent a brisk acceleration in spring

2008 and went on to touch a peak of $144 per barrel in summer (see

Figure 2.1). After this we saw a spectacular nosedive of almost $110 per

barrel. Analysts, economists and commentators have tried in all possi-

ble ways to provide explanations (sometimes far-fetched) for this phe-

nomenon which apparently seemed unexplainable. In fact from the data

available to all, we can safely say that in the passage from the phase of

price increases to the phase of their fall, nothing changed in the physical

oil market. On the contrary, in that very moment there was a seasonal

increase in global demand of around 2 million barrels per day and a

reduction in crude production of about the same amount. These changes

should have worked in the opposite way, that is, an increasing price.

The classic explanations (India, China, Middle East, crude oil reserves

etc.) used by the analysts to explain the upward trend of the market

became obsolete instantaneously and proved insufﬁcient to account for

the subsequent price tumble. The textbook explanations are unable to

pinpoint the real causes behind everything.

Only recently some ﬁnancial analysts have tried to link the fall of

the price in November 2008 with the lack of ﬁnancial capacity to open

letters of credit of some traders, when trading their cargoes of oil. It

is true that some banks had problems in issuing a letter of credit for

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

8 Understanding Oil Prices

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

million bbl/day

WORLD OIL DEMAND

WORLD OIL SUPPLY

Figure 2.1 World oil demand versus supply

Source: International Energy Agency

some traders, but it was just a very marginal phenomenon relative only

to very few cargoes in the market. The oil kept moving from the loading

terminals to the end users, from the producers to the consumers. No

interruption or excess of supply occurred at all and, therefore, nothing

justiﬁed the fall of $110 per barrel.

It is not even comparable with the apparently similar events of 1986

and 1988 when the forward Brent market collapsed to $9 per barrel. At

that time the oversupply of OPEC crude oil was real and the level of

stocks evident.

WORLD ENERGY POLICY

It is important to clarify from the beginning that a short cut is not being

sought by using a simplistic model where the ﬁnancial speculation

is soley responsible for all the chaos in the oil market. The ﬁnancial

investments are likely just taking advantage of the existing paradoxes

and bottlenecks in the oil industry and in the energy policy worldwide.

The stability will eventually come only when and if these structural

problems are solved.

For the time being we are just observing further additional elements

of crisis arriving and making the scenario even worse. The North Africa

The Market Events from 2008 to 2011 9

crisis (Libya in particular) and the Fukushima nuclear accident are

referred to.

These two events will amplify the structural crisis of the oil market,

accelerating all the processes already in progress since the Chernobyl

accident.

We have already experienced in all the industrialized countries the

lack of an energy policy that is capable of harmonizing the growing

energy demand with the new respect for the environment. The develop-

ment of environmental regulations in the last two decades has created

burdensome (but unchallengeable) limits for the energy and oil com-

panies in particular, but has not driven the bodies concerned to make

the investments necessary to create ‘compliant’ energy and products.

The result of these divergent processes has been the net reduction of

availability of ﬁnished products marketable in the western industrial-

ized countries. There is now a shortage of clean gasoline and gasoil.

In total the shortfall in the USA amounts to about 50 million tonnes

per year of gasoline, and about 40 million tonnes per year of gasoil

in Europe. To bridge these gaps it is necessary to import from other

geographical areas, which obviously deprives local consumers of these

products or forces them to pay the higher prices that consumers in the

strong countries can pay to get their hands on the missing products. It is

a real competition where the winners are always the ones who can pay

more.

A glance at the newspapers is enough to discover the limitations

imposed on motorists in Middle Eastern countries (Iran, Egypt etc.) or

all of West Africa.

The deﬁcit of these high-quality ﬁnished products has bolstered the

rise in crude oil prices, particularly the light varieties such as those from

the North Sea or North Africa. Somewhat similar to what would happen

if, for some strange reason, a rule were introduced to allow the sale of

only choice cuts of meat (ﬁllet steak, entrecˆ

ote, silverside): the price of

these would rise but so would the price of the cow.

This potential shortage of ﬁnished products has spread the feeling

in the trading market that something is at risk and, on a daily basis,

somebody may not be able to get the product he or she is looking for.

The oil market has become nervous and very transient, with the same

level of volatility experienced during the Gulf wars (when the risk of a

shortage of supply was evident).

The recent dramatic events (Fukushima and Libya) will deﬁnitely

amplify the already existing concerns and tensions and will spread the

10 Understanding Oil Prices

sensitivity about the environmental issues worldwide and accelerate the

increase of the demand for clean products.

We cannot forget that the only decision taken at the global political

level in one of the G20 meetings, to reduce the impact on the economy

of the increasing price of oil, was to encourage the construction of new

nuclear plants for producing electricity. This decision was inadequate

already when it was taken (less than 10% of the oil is used to produce

electricity) but today, after Fukushima, it appears to be almost obsolete.

We can say without any doubt that there is a lack of energy policy

worldwide, but especially in the industrialized countries; only China

and India are building what they need, despite the apparent general

market indication.

The world oil market is already in the middle of these tensions, but we

have not yet seen the worst. The forthcoming summers will offer some

anticipation of the future developments we can expect in the near future,

with a shortage of supply of high-quality gasoline and clean gasoil and

a signiﬁcant increase of the price differential between light and heavy

crude oils.

Later the combined impact of the reduction of the sweet light crude

oils (like the ones produced by Libya) and the shortage of clean products

will be examined with more technical detail and analysis. An under-

standing will be gained as to why Saudi Arabia was ready to increase

the production to compensate the reduction of supply from Libya, but,

after a couple of weeks had to stop producing additional barrels of oil.

The quality (more than the quantity) of the crude oils offered to the

market is today a crucial factor for meeting the demand of products

worldwide. With the existing quality of the raw materials, it takes new

technologies and massive investments in the reﬁnery industry. We are

far away from implementing such solutions worldwide.

It is evident that the structural problems for the oil industry will remain

as they are in the next decade and they will keep providing grounds for

ﬁnancial speculation and therefore for the increase of prices, as has

happened in the last ten years.

THE FINANCIAL CRISIS AND THE OIL MARKET

In December 1988, OPEC decided to adopt as reference for the price of

crude oil (rather than the value of the Arabian light, the Saudi crude of

light quality) the value of the Brent.

The Market Events from 2008 to 2011 11

At that time, everyone thought that this was the value of the crude

produced in the North Sea, the name of which was indeed Brent. No-one

realized that this was a misunderstanding, a case of a homonym. The

Brent in question was not a crude oil, but a ﬁnancial commodity.

Let us imagine, for a moment and as a game, which OPEC had decided

to adopt, as a reference for ﬁxing the price of oil, the value of a particular

type of cherry tomato, to which the creator and biggest producer gave

the name of ‘Brent’. The reason for the choice could have been the high

energy consumption needed to produce the new ‘Brent’ cherry tomato.

Once the decision was taken, it would become obvious that the price

of oil would depend, almost exclusively, on the supply and demand of

Brent tomatoes on the international market. A plentiful harvest would

equal low prices and a difﬁcult year, high prices. Cherry tomatoes in

fashion means high prices; and so on.

No-one would dream of looking, to analyse the movements of the

price or to make predictions of the future, at the supply and demand of

the physical crude oil.

We have taken the above example as a joke, but one capable, although

with the differentiation needed and analyses concerned, of giving us a

description that is fairly close to reality. These dynamics of the oil market

are slowly beginning to become clear and understandable to the principal

subjects in the oil market, producing countries and oil companies.

What is in fact the Brent market, the true one that deﬁnes the price

of oil?

This is a huge game like the ‘Panini football stickers’, those carrying

the picture of football players. The stickers, once printed and sold, create

an exchange market between the children or fans that look for them, and

their value varies according to the demand. Those of the famous and

popular players will go for more than those of unknown or less well-

known players.

Let us imagine that one day, for some reason, the football teams of the

world, with the agreement of UEFA and FIFA, decide that the market

value of the various players is that of the respective stickers or that they

are indexed to that reference.

A double market would be created, that of the football market where

against real money a club recruits a player in ﬂesh and blood, and the

other where everyone can buy or sell stickers without ever becoming

owners of a player. If the market of the stickers should develop massively,

thanks to the ease with which it is possible to buy and sell (online for

example), it could at a certain point become a form of investment in

12 Understanding Oil Prices

itself, with participants that have never been interested in football and

even less in stickers.

If an international bank, for various reasons, should invest signiﬁcant

amounts of capital in the stickers of a particular player, this would cause

an increase in value, regardless of the performance of the player and the

policy of the club to which the player belongs.

We would say that the football market has slipped through the hands

of the operators of that sport and has become an instrument of ﬁnancial

speculation with positive and negative effects also for the world of

football (proﬁts or losses for the bodies that ‘own’ the players whose

stickers are the subject of speculation).

Something similar has taken place in the world of oil. In the eighties

a sticker market was created, that of the futures contracts, which is just

like plastic cards (or stickers) on which a barrel of crude is depicted.

Whoever buys these plastic cards buys the drawing of a barrel, but

does not have any possibility of exchanging a plastic card with a real

barrel. The market of the oil stickers is a market that is almost totally

independent from the real oil market, with bodies operating there and

dominating it (controlling it and manipulating it) that normally have no

relationship with or interest in the oil industry.

In December 1988, the OPEC countries decided that the price of

their crude oils would be ﬁxed on the basis of the value of the ‘oil

stickers’. This was an almost unnoticed change of a geo-political nature

that transferred control and management of the international oil market

out of the hands of the OPEC countries into those of the City of London

and, slightly less so, Wall Street. This was the event that overturned

the balance of the power that had been established since the crisis

of 1973.

For years the constant expansion of this parallel market supported

the real market. The value of the ‘drawing of the barrel’ was almost

always higher than the one the physical market would have guaranteed,

bringing beneﬁts to those who invest in this sector and to the various

producing countries. Yes, it is a crazy game, but with a useful purpose.

In the autumn of 2008, the bankruptcy of the principal banks, which

owned massive quantities of oil stickers, obliged them to sell the oil

stickers and therefore cause a slump in the value of such stickers and

hence in the price of oil, the reference value of which derives from these.

From that moment there began talks about the need to review the

mechanism used to set the price of oil, but quietly and without haste.

The Market Events from 2008 to 2011 13

During 2009, the oil price, thanks to the recovery of what we called

the sticker market (where the banks have placed a signiﬁcant share of

the money received from the governments), started to increase again.

The attitude of the producing countries became: let us discuss,

examine and wait. Any action will eventually be taken if and when

the banks ﬁnd more proﬁtable ways to invest their money, not in the

Panini stickers anymore but maybe in the real economy. For now, we

carry on this way.

So we have to resign ourselves to seeing the price of oil go up and

down, avoiding having to pretend to be able to explain the correlations

between these ﬂuctuations and the fundamentals of the oil industry or

the non-existing policies of OPEC.

For most of 2009 and 2010, we saw the price ﬂuctuating, in the range

of $70–80 per barrel. Everybody started to announce the new kind

of ideal range of the price of oil, considered sacred by the main OPEC

ofﬁcial representatives. As usual the market, a few months later, deviated

from all these guidelines given by the gurus and by the authorities. We

can say, then, that since December 1988 the global reference for the

price of crude has lost its direct relationship with the physical market.

Initially, the oil futures market had in common with the oil market,

apart from the name Brent, the historic fact that it was born to support

the trading operations of the oil companies, as a ﬁnancial instrument to

provide risk hedging against oscillations in crude oil prices.

At the start of the year 2000, the oil futures market detached itself

almost completely from its original nature, becoming a market purely

for ﬁnancial purposes. International banks entered this business without

having any involment in the oil business, just as an opportunity to make

proﬁt, but some oil companies and almost all the oil trading organizations

also started to consider the futures market as an independent business

beyond the hedging purposes. All those analysts who tried to explain

the movements of the crude oil price on the basis of the evolution of the

relationship between demand and supply of physical crude have failed,

simply because the link between the ﬁnancial market and the crude oil

market has become increasing ephemeral or even non-existent.

The graph in Figure 2.2 clearly shows how the volume of business on

the crude oil futures market has risen tenfold in the last 10 years, closely

following the entry of the great ﬁnancial institutions in this ﬁeld and the

change in the attitude of the traditional oil players. This has caused the

complete disruption of the internal dynamics of the oil market.

14 Understanding Oil Prices

200

400

600

800

1000

1200

1400

1600

1800

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

1000 contracts

NonReportables Average positions

Non-commercial Average positions

Commercial Average positions

Figure 2.2 NYMEX WTI crude oil futures open interest: non-commercial versus

total traders

Source: NYMEX

Brent (on paper, ﬁnancial) is now traded on the market simply for

investment purposes or ﬁnancial speculation, to protect capital by park-

ing it in a safe place for a certain period of time (even just for a few

minutes), to proﬁt from a momentary wave of speculation, or to manip-

ulate a market which otherwise would be stable.

To understand better the size of the phenomenon, let us glance at the

numbers of this business (see Figure 2.3), which is almost unknown to

those who complain about the price of gasoline.

During 2008–2010, with world crude production around 86 million

barrels per day, only about 20 million barrels per day were marketed.

The remainder, about 65 million barrels per day, was not put on the

international markets because it was consumed directly by the produc-

ing countries.

If we refer to a valuation made in the period January 2008–December

2010, with an average price for Brent of $80 per barrel, we can easily cal-

culate that the value of the mass of money in movement due to purchases

and sales of physical crude as traded amounts to around $1,900 billion.

If we further assume that all the crude produced (86 million barrels per

day) was traded at market price, the mass of money in play, in the same

period from January 2008 to December 2010, would have been around

$7,600 billion. The balance between demand and supply of physical

crude at world level ﬂuctuates within these values.

The Market Events from 2008 to 2011 15

Jan/08

Mar/08

May/08

Jul/08

Sep/08

Nov/08

Jan/09

Mar/09

May/09

Jul/09

Sep/09

Nov/09

Jan/10

Mar/10

May/10

Jul/10

Sep/10

Nov/10

Jan/11

Mar/11

billion barrels/month

100

120

140

160

$/bbl

ICE + NYMEX Volume of Transactions World Crude Oil Production

Physical Crude Oil Sales Brent ICE price [right axis]

Figure 2.3 Comparison between volumes of NYMEX and Brent traded in the futures

and physical markets

Sources: NYMEX and International Energy Agency

Now we can look at the volumes traded on the Exchange to dis-

cover that we have a totally different picture and with degrees of mag-

nitude enormously higher. During 2008–2010, about $51,000 billion

were traded on the futures market, that is to say, 27 times more than the

value traded on the physical market and about six to seven times more

than the entire world production of crude.

Table 2.1 shows a situation with daily trades of about $46 billion

(about $4 billion per working hour), just as if on the crude market about

580 million barrels per day were traded on the crude market and not the

20 million actually commercialized or the 86 produced. What are these

580 million barrels per day on paper, which have nothing to do with the

oil market and the demand and supply of oil for energy consumption,

and what inﬂuence do they have on the pricing system for petroleum

products? What effect do they have on the price of gasoline for the

poor motorist?

In theory the futures market for Brent was created to stabilize crude

prices after the epic oil crises of the 1970s and 1980s. The daily quotation

for Brent was supposed to permit greater transparency in the transactions

and thus a stabilization of prices in the short and medium term. In the

early years this was the case; the volumes of crude traded on the futures

16 Understanding Oil Prices

Table 2.1 Comparative analysis of the value of NYMEX and Brent in the ﬁnancial

and physical markets

January 2008–December 2010

Production

of Physical

Crude Oil

Transactions

of Physical

Crude Oil

Transaction of

equivalent oil

in the ﬁnancial

market

Ratio

Futures/

Physical

Ratio

Physical/

Futures

Volume

(billion barrels) 93.7 23.4 623.1 27 3.8%

Value (billion $) 7,594 1,899 50,806 27 3.7%

Sources: NYMEX and International Energy Agency

market never exceeded the physical quantities produced and sold. This

can only mean that the oil companies operated on the paper market to

stabilize the price of their crudes with hedging operations. Today we

see 580 million barrels of oil equivalent arriving on the market – which

strangely enough we continue to call an oil market – and they are behind

the real dynamics that move the quotation for Brent, which is still called,

for no good reason, the price of crude oil.

Let us give an even more concrete example. At the end of June

2008 the price of Brent touched levels above $140 per barrel. Rivers

of ink ﬂowed to try to explain the reasons behind this increase. There

was discussion of the threats from China and India, the fall in world

oil reserves, geopolitical scenarios, stock variances and so on. But a

simple, crude and dramatic truth was overlooked. The level of prices

above the $140 per barrel number, which in June was used to trade the

commodity called oil, does not derive from the market for this particular

commodity and is not the result of the demand and supply balance of this

merchandise. It has nothing to do with oil. Going back to our previous

example, the crisis was in the cherry tomato (called Brent) market, not

in the market of the crude oil (called also Brent).

Thus, to try to explain its dynamics using models related to the market

for consumption and production of energy will be an exercise carried

out in vain.

During the whole month of June, about 700 million barrels of crude

(the physical kind that dirties your hands if you touch it) were traded.

In the same month on the paper market for Brent up to 20,000 million

equivalent barrels were traded, in other words nearly 30 times more than

the physical market.

The Market Events from 2008 to 2011 17

In the course of 2008, just when the wind seemed to be blow-

ing the prices towards $144 per barrel, the long-awaited event took

place, namely the crash of the banks and the main international

ﬁnancial institutions, which also burst the oil bubble. Following the

bankruptcy of some banks and the much-reduced liquidity of many

ﬁnancial institutions, transactions in the Petroleum Exchange quickly

nosedived, at the same time bringing down the price of Brent to under

$40 per barrel.

In this context OPEC, aware of a dramatic curtailment in the revenues

of various member countries, tried to keep up appearances and show a

minimum level of action, announcing and trying to implement cuts in

production to bolster up the crude price which was in free-fall (from

the $144 per barrel of July to the $40 per barrel of December). Such

a collapse had never been seen in the history of the oil industry. As

usual, the result of the cuts announced was the continuation of the fall

in prices, conﬁrming the completely insigniﬁcant inﬂuence of OPEC on

the dynamics of crude oil prices.

From the data we have seen, it follows that OPEC represents 30% of

a segment of 4% of the business that we call the oil market. This being

so, how can it have a signiﬁcant inﬂuence on price trends?

The great ﬁnancial crisis has, however, highlighted some important

novelties in the international oil market scenario. In the year 2008, we

saw the downturn in the ﬁnancial activity on the futures market (see

Figure 2.4). Daily trades of oil contracts on the ﬁnancial markets fell

from levels of almost $282 billion per day in June to around $75 billion

per day at year-end: a nosedive of almost 4 times.

Fundamentals or ﬁnancial speculation?

During the second part of 2008 the exclusively ﬁnancial activities of

the banks disappeared progressively from the crude oil futures market,

leaving mainly the oil companies and the physical market professionals

to operate for the sole purpose of covering the risk of price ﬂuctuations:

in other words, we digressed back to a market structure closer to that

of the late 1990s. The players of the oil market, although for a very

limited period of time, were once again the physical producers, oil

producers and oil companies. The price of crude, although still linked to

the movements of the crude markets of London and New York, during

the last quarter of 2008 and the ﬁrst one of 2009 seemed more closely

correlated to the balance of demand and supply in the physical market,

18 Understanding Oil Prices

100

150

200

250

300

Jan/08

Mar/08

May/08

Jul/08

Sep/08

Nov/08

Jan/09

Mar/09

May/09

Jul/09

Sep/09

Nov/09

Jan/10

Mar/10

May/10

Jul/10

Sep/10

Nov/10

BILLION $

100

125

150

$/bbl

ICE+NYMEX Open Interest [left axis]

Physical Oil Sales [left axis]

ICE Brent Price, 1st position, $/bbl [right axis]

Figure 2.4 Futures: daily trades in 2008–2010

Source: NYMEX

moving in the range of $40–50 per barrel, which, at that time, seemed

to represent a reasonable and long-lasting point of balance.

Box 2.1 Cost of the Marginal Barrel

The crisis of November 2008 conﬁrmed an important indication about

what price level crude oil would have reached if driven exclusively by

physical balances in the demand and supply of gasoline and gasoil.

Everyone remembers that until the 1990s, whenever there was a crisis

of excess supply in the market, the crude price quickly fell below $10

per barrel. This price represented the production cost in the marginal

ﬁelds at that time, namely offshore wells in the North Sea or the

Texas Gulf.

Holding the price at those levels removed the production of part

of such crudes from the market and thus contributed to realigning

supply and demand, or at least it triggered actions on the international

market (or international political decisions), which created stability.

Today the marginal ﬁelds are the producing wells borderline from

the technological point of view, such as the tar sands of Canada or

Venezuela, or certain offshore ﬁelds in ultra deep waters.

Production costs in these ﬁelds are over $40 per barrel. This is,

therefore, the new lower limit to the crude price. Below this there

would be a drastic stoppage in the ﬂow of energy to fundamental

The Market Events from 2008 to 2011 19

areas of the industrialized countries, with severe consequences for

the economy.

Table 2.2 Total production costs by region

2003–2005 2004–2006 Delta

Region $/boe $/boe %

USA

Onshore 14.00 19.46 39

Offshore 50.56 69.75 38

Total USA 16.70 23.16 39

Canada 23.84 26.59 12

Europe 16.43 29.79 81

Africa 22.26 32.13 44

Middle East 9.78 14.31 46

Others

Eastern Hemisphere 14.98 18.76 25

Western Hemisphere 31.06 47.63 53

Worldwide 17.45 24.29 39

Source: International Energy Agency

We therefore have always suggested abandoning scenarios which

contemplate further falls in price down to the levels of the past

and to be realistic with regard to the possibility of increases in the

near future.

During 2009, as it is well known, all the major international banks,

which were saved by the governments, re-started to invest the money

received again in the ﬁnancial market and in particular in the oil

futures (back to the stickers market). The result has been the increase

of the price of oil during the period of lower consumption. Then, at

the end of 2010 the price of crude reached a level of $90 per barrel

with an average of $10 per barrel above the value of 2009, and in

2011 (the time of writing) is already above $120 per barrel. The

imaginary new equilibrium value, established in the range of $70–80

per barrel, does not exist anymore. It has just gone. This increase of

about $50 per barrel in two years, above the ideal range, was once

again beyond any expectations.

The recent events, after 2009, in the oil market have reopened the dis-

cussion about the real reason for the price uptrend. Many analysts have

concluded that the new trend is ﬁrmly supported by strong fundamentals

and the ﬁnancial ‘investments’ are just following suit.

20 Understanding Oil Prices

Despite some positive signs in the evolution of the oil demand, we do

not think that what has happened in the last three years and the recent

increase of the oil price can be explained simply through the evolution

of the fundamentals.

The analysis of the dynamics of the market has currently become

complex and the distinction between the effects due to the pure ﬁnancial

activity (speculation) or due to the fundamentals is not so clear.

First of all, we should try to take into account the deep change in the

organization and in the attitude of the ﬁnancial institutions playing in

the oil futures market.

The ﬁnancial institutions in the last few years have invested in hiring

experts and traders from the physical oil markets. They normally don’t

move a drop of oil, but they plan their ﬁnancial operations following

closely the evolution of the fundamentals and every single rumour about

the life of the oil industry. They move their money based on these

elements of information. We have already seen the dimension of the

impact of the movement of this amount of money, which is so massive

to overcome the ‘natural’ dynamics of the physical market. There are

always overreactions due to the enormous ﬂow of money and number of

transactions on the futures market. What in the past would have caused

a price ﬂuctuation of a few cents per barrel, nowadays can produce a

price change of many dollars per barrel.

Sometimes the direction of the ﬁnancial operations are in line with

the fundamentals, but there are moments where the money is moved to

or from the oil futures market because of the evolution of other com-

modities and with no relationship at all to the dynamics of the oil world.

It looks like the new alignments between ﬁnance and fundamentals

materialize in the mind of ﬁnancial traders.

In Figure 2.5 we can see how fragile is the link between the funda-

mentals and the price of oil, taking also into account that the actual data

of the supply and demand become available (and reliable) with delays

of months, when the price is already history.

Of course, the ﬁnancial analysts are very proud to afﬁrm that all

the ﬁnancial investments are made only on the basis of the oil market

fundamentals. And the investors seem to trust them.

It seems, however, evident that the real alignment between the funda-

mentals and the ﬁnancial activity takes place in the minds of the ﬁnancial

traders.

For this reason it is useful to have a look at the real physical market

since the ﬁnancial crisis also became an economic crisis. Let’s have a

The Market Events from 2008 to 2011 21

Δ Stock Vs Brent

[provisional and final data]

-2000

-1500

-1000

-500

500

1000

1500

2000

Jan-07

Mar-07

May-07

Jul-07

Sep-07

Nov-07

Jan-08

Mar-08

May-08

Jul-08

Sep-08

Nov-08

Jan-09

Mar-09

May-09

Jul-09

Sep-09

Nov-09

Jan-10

Mar-10

May-10

Jul-10

Sep-10

Nov-10

Jan-11

Mar-11

Thousand bbl/day

100

120

140

$/bbl

Δ Stock (PROVISIONAL)

Δ Stock (FINAL)

Brent Dated

Figure 2.5 Provisional and ﬁnal assessments of stock changes versus Brent prices

Source: International Energy Agency

look at some relevant phenomena which have affected the evolution of

the prices, and let’s try to understand better the role of the ﬁnancial

speculation.

DEMAND/SUPPLY OF GASOLINE AND GASOIL

Looking at the actual data, in Table 2.3, about oil consumption in Europe

and the USA, it is evident that we are still facing a downward trend in

oil consumptions in the main western consuming countries, with some

substantial differences between Europe and the USA. During 2010 we

still had a declining trend in Europe, but a quite positive reaction in

the USA.

However, the main element of the analysis is not the direction of the

global consumption in these main market areas, but the evolution of

some critical products.

When the Brent price was at its peak, some signs of the economic

crisis started to show up and all the analysts were looking for a possible

fall in US gasoline demand, a fall considered responsible for triggering

a sort of domino effect inside the world oil market (crash in the demand

Table 2.3 Demand of oil products in OECD Europe and in the USA

OECD Europe [kbbl/day] 2007 2008 2009 2010 2011 2008–2007 2009–2008 2010–2009

LPG and Ethane 993 1,016 924 924 921 23 −92 0

Naphtha 1,283 1,157 1,108 1,208 1,220 −126 −49 100

Motor Gasoline 2,481 2,360 2,287 2,195 2,128 −121 −73 −92

Jet and Kerosene 1,303 1,323 1,267 1,270 1,297 20 −56 3

Gas/Diesel Oil 6,117 6,269 6,021 6,138 6,155 152 −248 117

Diesel 4,273 4,290 4,228 4,334 4,416 17 −62 106

Other Gasoils 1,844 1,979 1,793 1,804 1,739 135 −186 11

Residual Fuels 1,725 1,661 1,434 1,290 1,214 −64 −227 −144

Other Products 1,552 1,572 1,451 1,405 1,451 20 −121 −46

Total Products 15,453 15,357 14,493 14,431 14,387 −96 −864 −62

United States [kbbl/day] 2007 2008 2009 2010 2011 2008–2007 2009–2008 2010–2009

LPG and Ethane 2,091 1,959 2,056 2,113 2,104 −132 97 57

Naphtha 294 248 246 263 241 −46 −217

Motor Gasoline 9,355 9,047 9,055 9,129 9,169 −308 8 74

Jet and Kerosene 1,696 1,587 1,446 1,493 1,526 −109 −141 47

Gas/Diesel Oil 4,277 4,013 3,700 3,852 3,889 −264 −313 152

Diesel 3,520 3,484 3,221 3,345 3,401 −36 −263 124

Other Gasoils 757 529 478 507 489 −228 −51 29

Residual Fuels 818 702 591 642 610 −116 −111 51

Other Products 2,498 2,233 1,971 2,059 2,068 −265 −262 88

Total Products 21,028 19,789 19,065 19,551 19,606 −1,239 −724 486

Source: International Energy Agency

The Market Events from 2008 to 2011 23

for US gasoline, interruption of gasoline imports from Europe, fall in

prices in Europe and, thus, a nosedive in crude prices).

Now we know that the real market evolution was quite different.

Actually, the crude price did fall to around $40 per barrel but the gasoline

demand in the USA did not vary signiﬁcantly. In fact, in the course

of 2008 there was a reduction of only 3% in gasoline consumption,

far below the level required to signiﬁcantly reduce the ﬂow of high-

octane components imported from Europe and South America. After

this slowdown of the demand in 2008 the gasoline consumption already

gradually started to rise again in 2009.

There is a structural element in the USA market, too often overlooked

by many analysts, which can keep the price of gasoline at a very high

level, despite any weakness on the demand side.

As we will examine later in detail, the US environmental legislation

has churned out some monstrosities, such as the possibility for each

State to request gasoline speciﬁcations differing from the national stan-

dards. About 40 different types of gasoline are thus on sale, distributed

in the various States and counties of the nation, creating immense dif-

ﬁculties for the productive system to face. Each marketer is forced to

import, or swap with other reﬁners in neighbouring States, the compo-

nents for blending gasolines (as we will examine later, gasoline is not

a product but a mixture of products and semi-ﬁnished products which

together guarantee certain characteristics: octane number, density, a lim-

ited presence of aromatics, olephines etc.) to formulate a product which

is marketable in the particular area.

As of today, the volume of high-octane components imported into the

USA remains close to 1 million barrels per day, keeping a certain level

of tension in the international market, which serves to prop up the crude

prices (remember the example of the price of ﬁllet steak and the cow).

The decrease of the demand was more drastic in Europe both in terms

of gasoline and gasoil, but, because of the ﬂow of the export of gasoline

to the traditional USA market and to other new destinations (Middle

East, West Africa), there was not a dramatic impact on the price system.

This structural strength of the fundamentals, once again, has given

a new progressive conﬁdence to the ﬁnancial operators that the oil

business was still worth investing in and was still the most reliable and

liquid market among all the other commodities.

A similar phenomenon happened for the gasoil market, where the

decline of the demand has been balanced by the introduction of more

severe quality speciﬁcations in the European market (January 2008).

24 Understanding Oil Prices

WTI – BRENT DIFFERENTIAL

A further example of how the ﬁnancial speculation can thrive on the

basis of some structural constraints of the oil industry is useful here.

Brent and WTI are the two main crude oils used in the futures market:

Brent in London (ICE) and WTI in New York (NYMEX). WTI is a

crude of better quality than Brent and its price has always been higher,

in the range of $1–4 per barrel. In the last years, we have seen the price

of WTI being lower than Brent by up to $18 less per barrel.

Looking at all the crude oils of the worse quality, none of them

is priced with such a discount to Brent. This unbelievable event has

engaged all the analysts in a debate. Analyses and interpretations have

been given, trying to link the dynamics of the prices with the fundamen-

tals of the US market.

Of course, it is very hard to explain why a bottle of high-quality

champagne should be sold at the price of a low-quality carton of red

wine.

Box 2.2 Jet Fuel and Gasoil Market

The only sector that was really hit by the crisis was that of aviation.

The consumption of jet fuel in the USA fell by over 10% and was

accompanied by cuts in the ﬂights of all the main airlines (Continental

reduced its ﬂights by almost 15%). These were the only data that

measured a change of habits in the USA, in both the business and

the private worlds. Obviously, since this is a variation in a limited

segment of US oil demand (jet fuel represents less than 10% of the

total demand), it is not a key factor in determining a change in the

crude price levels. The reduction of jet fuel consumption, however,

had an impact in the evolution of the winter gasoil market. In fact,

kerosene (from which jet fuel is obtained) is also used for mixing

with gasoil to improve its quality.

Both the USA and Europe need to import huge quantities of gasoil

during the winter season. The countries that can supply gasoil in

excess, in relation to their own domestic consumption, are Russia and

the Persian Gulf nations. Unfortunately the quality of the products

from these sources is not in line with the environmental speciﬁcations

in the west (excessive sulphur contents) and they, therefore, have to

be processed in reﬁnery desulphurization plants or blended with

semi-ﬁnished products of higher quality. Kerosene is one of these.

The Market Events from 2008 to 2011 25

This was the key element that affected price movements during

the winter months of 2008–2009: the supply capacity of the western

reﬁning system for clean, high-quality gasoil (see Figure 2.6). If the

winter had been mild, as it was in the 2006–2007 season, the demand

of heating gasoil would have been limited and the production would

have been easily capable of supplying the system without putting any

pressure on the prices.

-10

-5

Sep-2008 Oct-2008 Nov-2008 Dec-2008 Jan-2009

1.2

1.3

1.4

1.5

1.6

Germany Min Temperatures [left axis]

Gas Oil/Brent [right axis]

Figure 2.6 Price movements during the winter months

The fact that the winter was colder than any in the previous decade,

once again showed the bottlenecks in the production system, just

as they did in the past, which had powerful effects on both the

gasoil and the crude oil price, giving ground and conﬁdence to the

ﬁnancial investors putting their money in the oil futures market again.

From November 2008 until March 2009, the thermometer decided

the crude oil price in the major areas of consumption (USA, Europe).

All the other factors (OPEC policy, macro-economic and geopolitical

scenarios etc.) continued to act purely as aesthetic embellishments to

the scenario.

This is a typical example where, unless we take into consideration

the combined action of the ﬁnancial speculation with the industry con-

straints, we are not be able to understand the dynamic of that anomalous

event.

26 Understanding Oil Prices

-20

-15

-10

-5

2004

2005

2006

2007

2008

2009

2010

2011

$/bbl

Figure 2.7 WTI NYMEX–ICE Brent differential

Source: NYMEX

All the crude oils produced in the south of the USA are collected

in Cushing, Oklahoma and then sent, via pipelines, to the north. All

the pipelines have one direction, south to north. The opposite direction

has never been considered, because it would have been meaningless.

However, it is a matter of fact that it is not possible to move the WTI

from Cushing to the reﬁneries on the east coast of the USA. Based on

this fact, the ﬁnancial investors started to sell WTI on NYMEX and buy

Brent on ICE, inverting and widening the price spread between the two

crude oils, with WTI becoming cheaper and cheaper (see Figure 2.7).

In order to re-balance the market anomaly it would have been nec-

essary to move WTI to the east coast, where the price of Brent was

$18 per barrel higher, but, as we have seen, there are no pipelines able

to transport the crude in that direction. In other words, we are in the

situation where the market is unable to guarantee any feedback to create

the condition for the re-adjustment of the previous equilibrium. It has

become impossible to limit the action of the ﬁnancial speculation.

Actually, one of the investors in this speciﬁc business, hired all the

railways capacity from Cushing to the Atlantic coast, in advance and

started to transport some WTI, making a lot of proﬁt on the spread

The Market Events from 2008 to 2011 27

artiﬁcially created. Just to prove that the event was planned in the ﬁ-

nancial environment many months in advance. Once again, the ﬁnancial

speculation (or ﬁnancial investment) operates and thrives on the existing

industry constraints and structural problems of the market. Very often

this massive activity doesn’t allow the market to activate the physiolog-

ical feedbacks to overcome or accelerate the solution of the problems,

which become heavier and therefore encourage an increasing level of

speculation.

It is instructive to observe the graph in Figure 2.8, which shows the

movement of the volatility of the price of Brent from 1988 to 2011.

To simplify, the volatility has been deﬁned as the difference between

the highest and lowest value recorded during the same month. One

can see clearly that historically the volatility index of the crude price

remained between $1 and $2 per barrel until the end of the 1990s. The

only exception was seen in 1981 at the time of the ﬁrst Gulf War when

the volatility index touched $15 per barrel. These dramatic changes in

price evidently reﬂected the uncertainty in the market and the continual

changes in the expectations of the trading world. Starting from the

early 2000s, we note that volatility indices over $10 per barrel became a

constant feature in the market, even in the absence of factors engendering

tension in the market comparable to those of times of war in the Persian

Gulf area; as if we were continuously facing a situation of potential

short supply. This graph also tells us that there is a date in the evolution

100

120

140

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

$/bbl

Brent [left axis]

Volatility [right axis]

Figure 2.8 Brent and inter-monthly volatility (1988–2011)

28 Understanding Oil Prices

of the dynamics of the oil market after which the break with the past

takes shape. We believe that a study of the evolution of the price of

crude oil must start out from this observation and try to understand what

happened at the beginning of the year 2000.

The economic crisis may have appeared, in some moments, to have

lessened the impact of the structural bottlenecks of the oil industry

but certainly not to have removed them. The North Africa crisis and

the Fukushima nuclear accident are here to remind us that there is a

structural energy crisis that we shall have to face up to and how large the

lack of awareness is in the political leadership of the main industrialized

countries.

In the following pages we shall try to reconstruct the processes which

have led to the growing divergence between the physical crude oil market

and the dynamics of the crude oil price. In particular we shall consider:

rThe effects deriving from certain historical decisions by the OPEC

producing countries, such as the indexing of the price of their crudes

to the ﬁnancial market of Brent crude.

rThe distortions created by the new environmental laws, in the context

of the lack of adequate investments in the world reﬁning sector.

These phenomena could have been described in a different order.

However, this one was chosen for its ability to enable the reader to

follow, in a more linear way, the creation of the puzzle, even if the tie-

up between the various aspects is such that only in the end the overall

reasoning will become intelligible, together with the model with which

today the evolution of the oil market can be interpreted.

Evolution of the Price of Crude

Oil from the 1960s up to 1999

The structural characteristics of the oil industry that have supported the

rising trend of prices in the past decade have already been mentioned.

They do not explain, however, why the world of ﬁnance has managed

to grasp almost complete control of this oil market and the system that

ﬁxes the price of crude, pushing aside producing countries as well as the

oil companies. The process and the mechanisms that have made this

transformation possible will be examined. For this purpose and against

this background we have to revisit the main events in oil history in

the last decades and particularly the suicidal decisions of the OPEC

countries, as well as to analyse the technical mechanisms in the Brent

market (forward and its futures).

Obviously it is not the author’s intention to describe the history of oil,

already told in detail by many prestigious writers, but only to provide a

way of looking at the events just as a plain professional in this ﬁeld would

have done, living through them and interpreting them, but to whom the

descriptions made by others did not seem convincing and coherent

with what he or she observed day by day in the market. Avoidance is

intentional of a purely political view of the various events – for which

valuable studies and analyses exist – by limiting ourselves to the search

for the appropriate economic model within which the oil market has

moved, in its different historic situations.

The aim is to understand whether prices have evolved in an oligopoly

or in a free market situation. And in this latter case, what has kept it at

price levels higher than the laws of the market would seem to permit?

In particular, the aim is to be able to reply to the question that was put

forth at the start of this story and which comes to mind spontaneously

when we look at Figure 3.1 showing the historical evolution of the price

of crude: is the curve which traces the movements in price a sequence of

values that mark a posteriori the free dynamics of the market, namely

the result of the interaction between demand and supply, or is it the

design that an invisible hand has traced day after day for decades?

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

30 Understanding Oil Prices

100

120

140

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

$/bbl

Figure 3.1 Crude oil prices (1970–2011)

1960–1980: THE OIL MONOPOLY AND THE TWO

CRISES IN THE 1970s

We could start our tale by saying: ‘once upon a time there was the

price of crude oil’. Actually, the price of crude oil has existed for many

years and it was the amount of money with which one could purchase

a physical cargo of crude to put on a ship and take it to a reﬁnery to

transform it into gasoline, gasoil and other products. Today, however,

when we speak of the price of Brent, it is not clear what we are talking

about; above all it is not clear what we can buy with that amount of

money. But let us take things in order.

In the 1960s and up to 1973, the price of crude was a number, more

or less ﬁxed, established unilaterally by the big US oil companies, who

had a monopoly in the market. The experts in the energy sectors in

charge of forecasting the price of crude oil for the current year used

to describe the model employed for the forecast with the following,

colourful but effective, phrase: ‘take the price used by Exxon, add it

to that used by Shell and divide the sum by two’. Until 1973, there

was no way to mistake the price forecast, it was just a simple average.

The price that was ofﬁcially ﬁxed and published was one alone, that of

the benchmark (reference price), namely Arabian Light crude, the main

Evolution of the Price of Crude Oil from the 1960s up to 1999 31

Crude Oil

Price Benchmark Price Differential= +/–

Figure 3.2 The price of crude with reference to the benchmark

crude of medium–high-quality produced in Saudi Arabia. The prices of

all the other crudes were established by referring to the benchmark and

ﬁxing a price differential that took account of their price, quality and

marketability (see Figure 3.2).

This was a classic situation of monopoly/oligopoly, featuring perfect

control of the supply by the producers. The prices were completely

stable, since the producers were able to regulate supply according to

any ﬂuctuation in demand.

OPEC (Organization of Petroleum Exporting Countries) was formed

in 1960, with the main objective being to create some form of control in

the oil market by establishing co-ordination between the various coun-

tries regarding the structure of the mineral contracts. However, control

of the price of crude remained ﬁrmly in the hands of the multinational

companies until 1973. In fact, only the majors were able to control the

production of crude together with the ﬂow of purchases by the reﬁneries

(almost all of them owned by the same companies).

In 1973, with the Yom Kippur war, we witnessed the ﬁrst historic over-

turn in the world oil market. The Arab countries, following the Israeli–

Palestine conﬂict, declared an oil embargo on those countries that

supported Israel, particularly the USA and Holland. OPEC took control

of crude prices and started to publish a price list each year, always based

on Arabian Light as the benchmark. Saudi Arabia, being the principal

producing country, but above all being the producer of the benchmark,

took on the leadership of OPEC. From that moment it became the task

of Saudi Arabia to ﬁne-tune the supply of Arabian Light on the market

to stabilize its price around the value published by OPEC.

Under the control of the OPEC countries, and thanks to the scare

sparked off by the Middle East crisis, the crude price rose from the

$2 per barrel level to $12–15 per barrel. This was the ﬁrst great oil

crisis that citizens of the main consuming countries witnessed; going

on foot or by bicycle during their weekends and holidays. It was in

this extremely emotional context, characterized by a strong sense of

participation and awareness, that debate was opened concerning the need

for diversiﬁcation of energy sources; massive investment programmes

32 Understanding Oil Prices

were tabled for the construction of nuclear and mixed-fuel power stations

(oil and gas). The highest level of consensus was reached regarding

development and use of public transport in towns, especially in Europe.

This historic phase was to last 10–15 years and it brought with it pro-

found changes in the world of energy. During this same period, however,

certain events took place, which at the time had little relevance but nev-

ertheless triggered important transformations in the following decades.

In 1974 the International Energy Agency (IEA) was created; an asso-

ciation between the main oil consuming countries with two fundamen-

tal purposes:

rTo mutually assist one another in the case of an embargo (for political

reasons) by the cartel of crude producing countries. No one wished

to see the affair of 1973 repeated.

rTo exchange all possible information regarding national oil data

(demand, supply, stocks, transport etc.), excluding those of a com-

mercial nature (prices, trading activity etc.).

Having overcome the crisis of 1973, the IEA took the general role

of a research bureau for energy issues unprecedented levels with its

headquarters in Paris, countering the similar research bureau of OPEC

headquartered in Vienna. It took some years before the work carried out

proved to be of some use. The collection process for pertinent data from

different countries took time and it was difﬁcult to organize the infor-

mation on efﬁcient databases capable of updating in reasonable times.

Some years later, a new oilﬁeld in the North Sea, named Brent, started

production on 11 November 1976. On the following 13 December the

ﬁrst oil tanker left the terminal with a cargo of this crude, which would

soon upset the balance of the world oil market.

And so we arrive at the events of 1979 characterized by the seizure

of power by Saddam Hussein in Iraq, the revolution in Iran and the

break-out of the Iran–Iraq war in September 1980. These events, and

their subsequent consequences, mark the history of the oil market in the

two following decades.

The start of the revolution in Iran was immediately seen as a seri-

ous threat to the geopolitical stability of the Persian Gulf area and a

worrisome element of risk for the ﬂow of crude exports towards the

consumer countries.

Almost on tiptoes, all the oil companies in the world began to raise

the level of their stocks in their storage and reﬁneries, thus creating

increased demand for crude precisely at the moment when production

Evolution of the Price of Crude Oil from the 1960s up to 1999 33

difﬁculties were felt in Iran. In this way a vicious circle was created

which artiﬁcially raised the demand (to boost the stocks) and triggered

a rise in prices. When the Iran–Iraq war broke out, in September 1980,

it unleashed a true race for oil. All the bodies involved, among them oil

companies, governments of consumer countries, industries and condo-

miniums, pushed the level of stocks to the highest possible amounts. At

the end of this rush the level of oil stocks in the western consumer coun-

tries had risen from the normal level, that is, what was needed to cover

around 30–50 days’ consumption, to that for 180 days, in other words

ﬁve or six times greater than was necessary. One had even gone beyond

the physical storage capacity on land. In the main ports supertankers

were anchored and used as ﬂoating storage while waiting for tankage

to become available onshore. Crude prices spiralled upwards, reaching

levels of $40 per barrel for the lightest qualities.

The producing nations pushed their output up to unprecedented

levels. Saudi Arabia reached the level of 11 million barrels per day,

a record unrepeated thereafter. During the months of crisis some new

mechanisms to protect the consumer countries were put into effect.

The IEA, although having no reason to intervene operationally, by

activating the assistance mechanism for countries in difﬁculty (there

was no embargo or physical limitation on the supplies towards any of

the member countries, but only a generalized rise in prices), began to

make an essential contribution to governments and oil companies. The

collection and examination of the statistical data showed clearly that

the dramatic rise in prices was due to the simultaneous action in the

same direction, without any coordination, of all those involved, causing

a dramatic increase in the level of stocks of crude. Faced with the data

that showed that the production system could function for 180 days

using its stocks, even in the case of a total interruption of crude supplies,

it was clear to everyone that the enormous costs incurred to maintain the

stocks (logistic costs, ﬁnance charges) were completely unjustiﬁed and

disproportionate. Further, the Iran–Iraq war had stalled and become by

then a regional war, which could in no way affect the ﬂow of oil supplies.

THE 1980s: THE GRADUAL DISAPPEARANCE OF OPEC

During 1982, all the oil companies in the world had drastically cut

down their purchases of crude from the producing nations, particularly

the OPEC ones, which continued to propose very aggressive prices. A

new phase of the market opened up from this point. That phase, begun in

34 Understanding Oil Prices

1973 with the rise of OPEC to leadership of the world oil market, came

to an end and a new one of creeping crisis began: this, throughout the

1980s, led up to the loss of any role for OPEC and its member countries.

Faced with the facts that proved the dramatic excess of stocks, the

OPEC countries were unable to ﬁnd a common strategy to adjust pro-

duction to the demand. At ﬁrst they tried to force their customers to

honour the current contracts, obliging them to take the same quantity

of crude as in previous years, and then they began to use every kind of

cunning to try to maintain the maximum levels of production of 1981.

All the crude not purchased by the oil companies at the ofﬁcial prices

(OSP) set by the OPEC conference was sold spot to independent traders

at discounted market prices.

After several months of such practice, two parallel markets were

actually created, one based on ofﬁcial prices and the other on spot prices.

Thus, for the same type of crude there could be two prices, differing by

as much as $10 per barrel. To remedy this situation, an extraordinary

meeting was convened by OPEC, which resolved to reduce the ofﬁcial

price of Arabian Light from $34 to $29 per barrel and to re-establish

lower production quotas for its members. This decision was reached

after furious discussions betweens the hawks (Iran at their head, who

wanted to keep the price high) and the doves (headed by Saudi Arabia,

who wanted to align with the real market).

The three following years were marked by a continuous weakening

of crude prices, due to a combination of factors. After the crisis of 1973

the ﬁrst effects of energy diversiﬁcation began to become apparent with:

rThe start-up of the new nuclear power stations, which began to cause

a visible and progressive reduction in the consumption of fuel oil

burned in the thermo-electric power stations, triggering a structural

crisis in the reﬁning system, particularly in Europe.

rAn increase in the supplies of natural gas for electricity production as

well as for domestic heating.

Reﬁning capacity underwent a process of radical re-conversion and

restructuring. The reﬁneries found themselves at a crossroads: should

they build cracking plants to transform fuel oil into gasoline and diesel

fuel (thus improving reﬁning margins), or shut down.

The production of the non-OPEC nations, historically marginal, began

to become relevant and competitive on the international market. In

particular, production in the North Sea began to play a key role in

the political and economic balance in the oil world. These were the

Evolution of the Price of Crude Oil from the 1960s up to 1999 35

years when the prime minister of the United Kingdom was Margaret

Thatcher, who wanted to deal a powerful blow on the excessive power

of the OPEC countries. Thatcher’s government refused any form of

dialogue or cooperation with the OPEC countries tending to regulate

crude prices by adjusting production. Together with the government

of the USA, whose President was then Ronald Reagan, Mrs Thatcher

wanted to reach the objective of having a crude oil price that was the

result of free market transactions and without any political control by

the OPEC cartel.

Finally it was the OPEC countries that, after the euphoria of the rise

in prices during the previous decade, were not aware of the changes in

the global energy and political scenario and continued to pump more

oil into the market than the demand required, obviously violating the

agreements within OPEC and fuelling the spot markets, parallel to the

ofﬁcial ones.

THE PRICE WAR

The sole defence of the dignity of OPEC and the price level of the bench-

mark (Arabian Light) remained in the hands of Saudi Arabia, which in

these years was forced to cut production from a rate of 11 million barrels

per day in 1981 to scarcely 2.5 million in July 1985. A level so low as

not to allow production of the gas associated, which, in turn, fed the

structures of the producing plants. This sort of Babel continued until the

summer of 1985.

One morning in late August 1985, Sheikh Yamani, the historic min-

ister of Saudi Arabia, issued a declaration in which he claimed a fair

market quota for his country, namely a production rate in line with the

ofﬁcial OPEC agreement of about 5–6 million barrels per day. Yamani

declared publicly and ofﬁcially that the various OPEC countries were

producing about 3 million barrels per day more to the detriment of

Saudi Arabia and urged a return to a cartel regime. To make his message

politically less explosive, two weeks later during a conference in Oxford

regarding the oil market, he tried to draw attention towards the activ-

ities of the non-OPEC countries, particularly in the North Sea. These

countries had hitherto refused any form of coordination of production

levels, although in the meantime they had beneﬁted from the high prices

resulting from the Saudi sacriﬁces.

Yamani then announced a crude oil price war against the non-OPEC

countries, even if it was clear that the main target was the OPEC countries

36 Understanding Oil Prices

that continued to ﬂout the production quotas. To ﬁght this war, Yamani

informed the oil world that Saudi Arabia would, from that moment,

adopt the following measures:

rCessation of its role as swing producer to protect the benchmark price,

that of Arabian Light.

rRenunciation by Saudi Arabia of the ofﬁcial price system (OSP) and

refusal to publish or agree the price of Arabian Light.

rAdoption of a new price system for all Saudi crudes, based on their

netback value.

This was a real upset in modern oil history, which illustrated all the

hypocrisies that had allowed hitherto the maintenance of the unstable

balance of the market.

Box 3.1 The Netback Value System

Let’s make matters clear. What was the new netback value system

adopted by Yamani?

It was a very simple way of increasing market share by destabiliz-

ing the price system and based on a very simple principle. A Saudi

customer who signed the contract did not know the purchase price at

the time he took away a cargo of crude. The price was established at

the end of the customer’s production and marketing cycle, after he

had sold in the market the ﬁnished products obtained from reﬁning

the Saudi crude. The price to pay the Saudis was established with a

calculation of this type:

a. Revenue obtained from sale of ﬁnished products 100

b. Costs incurred for transport of crude 5

c. Costs incurred for reﬁning crude 5

d. Finance and other charges 4

e. Guaranteed margin for customer 10

Price to pay for crude (P =a−b−c−d−e) 76

A mechanism was set up by which every purchaser of Saudi crude

who had an integrated downstream system (reﬁning and sale of ﬁn-

ished products) earned a guaranteed ﬁxed margin on every barrel of

crude purchased, apart from the proﬁts derived from the optimum

management of his operations. Thus, the more barrels he managed

to obtain from the producing country, the greater were his proﬁts.

Evolution of the Price of Crude Oil from the 1960s up to 1999 37

No great analysis is needed to understand that, when this mecha-

nism was announced, sales of Saudi crudes increased and a queue of

customers lined up to sign the new contracts.

What about the other producing countries? The OPEC countries

waited just to understand the new mechanism before competing with

the Saudis. Hence, they began to sell their crude with the same pricing

mechanism, perhaps increasing the guaranteed margin for the purchaser.

A situation of total liberty from the production restrictions of OPEC

and the defence of the price level occurred. The euphoria of the petrodol-

lars obscured any powers of analysis and comprehension of the collec-

tive interests of the producing countries. Monopoly conditions no longer

existed in the oil market. The free market had begun to operate in a con-

text of full competition between OPEC and non-OPEC producers. The

market dynamics changed from the so-called oligopoly model, which

obeyed the classical law that links price to supply and quickly, and a

competitive free market was created.

1985–2000: FROM THE INTRODUCTION OF BRENT

AS AN INTERNATIONAL BENCHMARK TO THE

CLEAN AIR ACT

The inevitable arrived unexpectedly quickly. Actually, the process trig-

gered had very precise and inexorable features. Yamani, in his unleashed

war of prices, had brought to his side all the producing countries and

all the reﬁners in the world, who, unknowingly and in a climate of col-

lective folly, continued to pump crude and ﬁnished products into the

market as fast as possible.

The crisis of the mechanism began when the market, ﬂooded with

ﬁnished products, was no longer able to absorb further quantities. The

price of these products therefore began to fall and dragged the price

of crude down with it, mathematically linked to that of the prod-

ucts, engendering a climate of confusion and frenetic activity by the

oil professionals.

Right at that time and in that mood of conﬂict, an alternative solution

for ﬁxing the price of crude in a free market context came from the

North Sea. In July 1986, one year after Yamani’s declaration, Shell UK

published the ‘15 day Brent contract’ (later we shall give a detailed

description of this new market mechanism). For the ﬁrst time the price

of crude, Brent, was anchored to a sort of petroleum exchange, where

a selected number of professionals (about 100) could operate, helping

to deﬁne, day by day, the price level. It was not yet a world reference

38 Understanding Oil Prices

point, only regional and very limited to the north European sphere.

However, in a very short time it became the reference tool in the London

marketplace, where all the oil trading companies, linked to the big oil

companies or independent operators, had their headquarters and carried

out their business activities.

In this complex scenario, each single world event, any form of tension

in the Middle East and any decision by the OPEC countries in the

London atmosphere kindled the expectations of the market and pushed

Brent upwards or downwards, inﬂuencing positively or negatively the

crude price levels of the OPEC countries. Speciﬁcally, the movements

of the Brent market became very critical for the price levels of Nigerian

crudes, that is, those of the highest quality among the crudes of the

OPEC nations and very similar to Brent. The Nigerian crudes were

caught between two ﬁres:

ron one side the need to keep the price differential vis-`

a-vis Arabian

Light at least $4–5 per barrel higher; and

ron the other, to compete with Brent which was priced at least $1–

2 per barrel lower.

For a country like Nigeria, already saddled with a serious ﬁnan-

cial crisis and exposed to massive immigration from the neighbouring

countries, the direct competition with the North Sea was disastrous.

Especially because the two types of crude were competing for the same

proﬁtable US market.

Putting the 15 day Brent contract on the market could not have come

at a worse moment. In fact, it took place when the effects of the price

war unleashed by Yamani were at their most devastating pitch. The

tidal wave of over-full storage tanks was rising from consumer level

(condominiums, industries) to distributor level and ﬁnally the reﬁners;

everyone was convinced to ﬁll up at ultra-convenient prices. When these

levels began to jeopardize the operations and logistics of the reﬁneries,

the crash became inevitable.

At a speed hitherto unknown, prices began to tumble week after week

and then day after day from the level of $30 per barrel down to $11 per

barrel. This was the oil counter-shock. It was too much for everyone

and especially for the heroic supporters of the free market for crude.

As long as there was OPEC to hold the crude price level at around

$28–30 per barrel, to speak of a free market only meant a free ﬂuctuation

of the daily oscillations of a few dollars per barrel on stock markets. But

now the picture was different and dramatic. In London they spoke of a

Evolution of the Price of Crude Oil from the 1960s up to 1999 39

‘blood bath’. Many traders who had bought cargoes of crude only a few

days earlier at prices considered good at the time were forced to sell these

cargoes at $10 or $20 per barrel under the purchase price, with massive

losses in consequence. The big companies honoured commitments in

any case, but many independent traders preferred to declare bankruptcy

and disappeared from the market.

The producing countries witnessed for the ﬁrst time after more than

a decade the crash of oil revenues and were forced to make drastic cuts

in their investment and expense budgets. The effect of these cuts made

itself felt in the economies of the industrialized countries, who found

themselves missing, from one day to another, contracts and tenders that

were ﬁnalized. The oil companies were forced to block their develop-

ment investments in areas where the production costs would have been

higher than the new level of crude prices. Production in a series of

marginal ﬁelds had to stop since they were no longer proﬁtable.

In the USA about 2 million barrels per day of crude production

coming from the so-called strippers, those tiny ﬁelds in the back garden

that we see in ﬁlms of that period, disappeared from the national oil

balance sheet.

The North Sea suffered a severe cutback in the development of the

existing ﬁelds and a freeze-up of research projects.

In Nigeria the crisis was such as to cause an exodus of biblical dimen-

sions: over 20 million persons returned to the neighbouring countries

they had come from 20 years earlier.

One thing was clear to everyone: the price of crude, left free to move

only on the basis of the laws of the free market, had fallen to a level that

allowed the supply to vary in line with the demand, in other words, to

a level so low as to eliminate all the marginal ﬁelds, whose production

cost was higher than the going price. This price level, however, was not

compatible with the equilibrium of the world economy and politics, and

it was also not compatible with the guarantees for future supplies. The

free market was not compatible with the oil market. A solution had to

be found – quickly.

During 1987 meetings were held at various levels between the play-

ers involved, OPEC and non-OPEC countries, governments of consumer

countries and producing countries. Everything pointed in one direction

only, a return to a protected system for crude prices, with OPEC guar-

anteeing stability.

In December 1987, Saudi Arabia agreed to sign the new agreement

between the OPEC countries that envisaged the return to the system

40 Understanding Oil Prices

of ofﬁcial prices with Arabian Light in the role of benchmark, which

was ﬁxed at $28 per barrel. In the space of around three months the

market stabilized and the crude price returned to the levels programmed

by the OPEC countries. Encouraged by this political result and the new

cohesion shown by its member countries, OPEC required that even the

non-OPEC countries should indicate their willingness to make some

contribution towards modulating supply. However, during the meetings

that followed in 1987 and 1988, no signiﬁcant results were achieved.

On the contrary, a further step was taken in the process of transforming

the physical market for Brent into a purely ﬁnancial market. The price

crash in 1986 had created a climate of panic in the London petroleum

and ﬁnancial circles. The 15 day contract had proved not to be fully

adequate to guarantee the economic and ﬁnancial system and had caused

the bankruptcy of dozens of trading companies declared insolvent. The

biggest companies producing Brent Blend (Shell, Exxon, Chevron and

BP) had had to re-purchase the cargoes of Brent not collected and

abandoned by the traders who were wiped out. The costs of the crisis

turned out to be enormous for the economic and ﬁnancial system of the

City. The intention had been to create a purely ﬁnancial Brent market,

in which there was no longer any obligation for the participants to buy

a physical cargo of crude, but only to handle ﬁnancial paper.

In July 1988, the IPE (International Petroleum Exchange) launched

the Brent Futures contract. The event was hailed as the long-sought

solution ﬁnally found, the new frontier of the free oil market vis-`

a-vis

the archaic solutions proposed by OPEC (the return to the system of

ofﬁcial prices).

THE SUICIDE OF OPEC

The lack of agreement on production control and the propaganda at the

point of provocation regarding the unsophisticated economic vision of

the OPEC countries caused a new serious and irreversible crisis in the

government of the international oil market.

In December 1988 OPEC, guided by Saudi Arabia, decided to

accept the challenge of modernity and the free oil market that everyone

desired, abandoning yet again the OSP system and adopting as the new

benchmark Brent itself.

All the crudes produced by the OPEC nations were from that time

to be priced with reference to Brent. The various countries would

limit themselves to setting the price differential to apply to each crude

Evolution of the Price of Crude Oil from the 1960s up to 1999 41

vis-`

a-vis the market value of Brent. For a pure question of national pride,

what was commonly called the price differential vis-`

a-vis the benchmark

was re-named OSP by the OPEC countries, although it was quite clear

that the crude price was no longer published, but only its adjustment vis-

a-vis the benchmark, in other words a more or less negligible fraction

of the price of a particular crude.

The event was hailed positively by all the commentators and the mar-

ket operators. It seemed the end of a sort of Middle Ages and a step

towards a much-desired new world. However, all the upsets and imme-

diate consequences that the change would bring were not appreciated.

Neither was it understood, in the euphoria and the desire to proclaim a

political victory, that in fact the OPEC countries had tried to start a new

price war using the Brent market as a tool (leaving aside the net-back

used in 1986).

The OPEC, in turn, did not understand that, having started this war

in the political climate of those times, it did not have great hopes of

victory and in fact its decision turned out to be a real act of suicide.

From that time, OPEC lost any reason to exist. It was transformed into

a cooperative study bureau between the member countries, prestigious

but with no other operational role: a sort of rival project to the IEA.

The truth was that since all the producing nations in the OPEC and

non-OPEC world used the same benchmark, actually they were all

part of the same non-existent cartel. But since this ghostly cartel had

no agreement for regulating supply, there was no way to discipline or

control the prices. The market had become absolutely free, just as Mrs

Thatcher and the City of London had so much desired.

THE START OF THE FREE MARKET

The sequence of market events quickly showed the inconsistency of the

analyses that had convinced the majority to celebrate the OPEC decision.

In the absence of any agreement between the producers, everyone felt

free to produce as much as they could and to try to sell their crude

in competition with the others, simply varying the price differential

vis-`

a-vis Brent (thus, the concept of variable discount was born). What

happened seemed an exact replica of 1986 events. The price of the new

benchmark, Brent, dropped quickly to around $9 per barrel.

It is interesting to read again the remarks of the most important

commentators of the time; after preaching modernity and acceptance of

the principles of the free market by OPEC, after the price crashed down

42 Understanding Oil Prices

to $9 per barrel, they began to criticize the lack of cohesion between

the OPEC countries and their incapacity to control production levels. It

became clear that an oil market only apparently free was desired, but

actually supported by voluntary production cuts by OPEC (which had

committed suicide in December 1988).

The acceleration of the crisis was also aggravated by the end of the

Iran–Iraq war, which took place at this time. The two ex-belligerents,

both in a profound ﬁnancial crisis, had dire need to increase their produc-

tion and crude oil revenues to reconstruct their countries. They asked

the other Gulf countries to give back their market outlets which had

been taken up during the war by Kuwait, the Emirates, Saudi Arabia

and Venezuela in particular. The reply from the countries concerned

was totally negative (we should not forget the new general context of

the market when this happened), with the result that the newly increased

production from Iran and Iraq contributed to ﬂood the markets.

It was absolutely necessary to reduce world crude production and

therefore to ﬁnd a swing producer. All attempts to ﬁnd one, who would

come forward willingly, either as an individual country (as Saudi Arabia

had done between 1982 and 1985) or as a collective entity (OPEC), had

failed. OPEC in fact no longer existed after December 1988, when it had

adopted Brent as benchmark. Political history and the military events in

the Persian Gulf area took charge from that time and for over a decade

chose the swing producer of the international oil market.

This historic phase began in August 1989 with the invasion of Kuwait

by Iraq. Rivers of ink have been used to describe this event and its

aftermath lasting over two decades. This war is still loaded with political

consequences and is far from receiving a historic judgement that is not

interpreted as politically biased. As it affects our tale, let’s show how

the price model worked in that context.

Formally we were, in fact, in a free market system, with the distinc-

tion that reduction of supply was the task of a swing producer imposed

by a real situation and not by the decision of a political–economic cartel.

Above all, it was clear that the nomination of a swing producer was not

made with the agreement of the nominee. The result, from the techni-

cal and economic standpoint, was, however, to lessen the pressure of

supply on the market, allowing prices to be stabilized in the region of

$15–20 per barrel. The ﬁrst candidate for the role of swing producer was

Kuwait, who, for almost two or three years was no longer able to pro-

duce, thus removing from the market over 2 million barrels per day.

Evolution of the Price of Crude Oil from the 1960s up to 1999 43

We should repeat that from the economic point of view the market had

remained a free market, with an outside limit (stoppage of production

from Kuwait) not programmed by any cartel, and not imposed (even if

not unwelcome) by market forces.

The ﬁrst Gulf War triggered the next baton change. Kuwait passed

the relay baton to Iraq, which became the swing producer, obliged and

ofﬁcial, of the oil world for almost a decade. During the change of baton,

before the outbreak of the Gulf War, the price reached $40 per barrel. It

was a short-lived peak, more an exchange speculation of the emotional

sort that had no real effect on crude movements, almost a celebration

of the event itself. The same night that the bombardment of Baghdad

began, the price tumbled from $40 to the usual $16–20 per barrel.

The UN embargo on Iraq had the result that the re-start of production

in Kuwait was compensated by the stoppage of exports from Iraq, with

a substantial balancing of the volumes. This equilibrium lasted till 1996,

when growth of demand and the aftermath of the Chernobyl accident

began to nudge the crude price over the $20 per barrel range, ﬁnally

touching and exceeding $25 per barrel.

It was right at this moment that the debate over the humanitarian

aspect in Iraq heated up and began to gather a global consensus in the

media. In this new climate, the Security Council of the United Nations

(UN) approved a resolution that permitted Iraq to sell limited quantities

of crude to purchase food and essential goods, the so-called oil for food

programme. The resolution envisaged a duration of six months, with

eventual renewals to decide duration and amount of crude to export.

Without going into the political merit of the matter, we have to note

that – always from the technical and economic standpoints – the ﬂow of

Iraq crude into the market had the effect of maintaining price stability

in the desired range of $16–20 per barrel.

In 1998 there was disagreement between Iraq and the UN inspectors,

who left the country. Iraq declared it was no longer open for dialogue

with the UN unless the cycle of inspections and the sanctions were

terminated. At the same time it began to boost to the maximum possible

(for the state of the plants and the pipeline network) the production and

export of crude, favouring certain marketing channels outside the ofﬁcial

control of the UN. The arrival of these extra barrels came at a critical

time for the market, right at the time when the increased production

from non-OPEC countries (North Sea, Angola and Kazakhstan) and

other OPEC countries (Nigeria, Venezuela, Algeria etc.) was being felt.

44 Understanding Oil Prices

Once again the conditions were created for a fall in the crude price, this

time faster than in the past, bearing in mind that the ﬁnancial markets

had assumed the role of accelerator to this course of action.

In 1999 the price of Brent stood at $9 per barrel, the lowest in the

last 20 years. This level, however, was no longer considered by all

the analysts, oil companies and producing countries, as a temporary

event or the fruit of a crisis easy to overcome, but rather as a structural

reality, due, in a free market situation, to the constant excess of supply

over demand.

All the budgets of producer nations and oil companies are drawn up

in the shadow of cuts in costs and investments. In this scenario, many

oil companies adopted dramatic rationalization programmes that also

involved mergers with their competitors. The most overt cases were

Exxon-Mobil, Total-Fina-Elf, BP-Amoco-Arco and Chevron-Texaco.

Actually, all these analyses and forecasts, even if they have been

glaringly contradicted by history (only a few months afterwards), were

apparently correct. We were in conditions of an excess of crude supply

over demand for at least two decades and in the absence of any cartel

whatsoever, which might have regulated the offer. The price, therefore,

could only stay low.

THE CONSEQUENCES OF THE

ENVIRONMENTAL TURNAROUND

Nobody foresaw the small (yet big) revolution that the implementation

of the Clean Air Act in the USA, enacted during 1999 to take effect from

1 January 2000, would have sparked off in all the world oil markets. This

measure tore from the hand of the mystical and mysterious architect the

pencil that from the 1960s until then had enabled him to trace the graph

of the price of crude.

Changes in the Market for

Automotive Fuels

EVOLUTION OF ENVIRONMENTAL DEMAND

The most notable effect of the Chernobyl accident on 26 April 1986 was

the halt in construction programmes for nuclear power stations across

the entire world. There were, however, other effects deriving from the

emotions aroused by that dramatic event, which were not discussed at

any length but which caused, in the course of time, enormous modiﬁca-

tions in the world energy conﬁguration.

The debate over environmental problems had actually been venti-

lated some time ago in certain countries. We might remember the

success of Rachel Carson’s 1962 book Silent Spring, which revealed

the global effects of the inconsiderate use of DDT (dichlorodiphenyl-

trichloroethane) and the ﬁrst Earth Day organized in the USA on

22 April 1970.

The primary emotional effect, subsequently removed, was the silence

which fell on the word energy. This word became a sort of taboo in every

political speech and in the programmes of the various governments

of the industrialized nations, and it was completely replaced by the

word environment. The total separation between the two problems has

produced results that we are paying dearly for today. Actually, a sort

of conception has grown up in which the objective of improving the

environment seems to be just a cultural choice desired or rejected for

ideological reasons, independently of technology and economics.

The day after Chernobyl set in motion, among other actions, a legisla-

tive process which imposed on all the industrialized nations, apart from

the nuclear moratorium, a change in fuel speciﬁcations, in particular for

automotive fuels.

No measure, however, bothered to check how, if and at what costs the

industry would be able to make an adequate response to the new quality

requirements of the market. No-one raised the problem of how to encour-

age the investments needed and how to make the industry an informed

and motivated protagonist of the environmental changes suggested.

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

46 Understanding Oil Prices

Residential &

Commercial;

Electric Power;

Industrial;

22%

Transportation;

72%

Figure 4.1 USA crude demand by sector (2009)

Source: U.S. Energy Information Administration

Figure 4.1 shows crude demand in the USA by sector.

The aftermath of Chernobyl highlighted certain trends in the oil sector

(see Tables 4.1 and 4.2 and Figure 4.2), in particular:

rA massive increase in world oil consumption.

rA tightening of environmental speciﬁcations for all fuels, with dire

effects on those for the automotive sector.

rA growing inadequacy of the world reﬁning system vis-`

a-vis the

changes that had taken place.

We shall examine each of these aspects in depth, to grasp how they

are behind the current international energy crisis.

Some 25 years after Chernobyl, the world oil balance has undergone

the transformations shown in Table 4.3.

Table 4.1 Evolution of gasoline speciﬁcations

Aromatics Olephines Benzene Sulphur

Europe USA Europe USA Europe USA Europe USA

%%%%%%ppmppm

1995 5 1000/500 320

2000 42 45 18 18 1 4 150 150

2005 35 35 18 1 1 50(10) 30

2010 35 25 18 6 1 1 10 10

Changes in the Market for Automotive Fuels 47

Table 4.2 Evolution of gasoil speciﬁcations

Poliaromatics Sulphur Density

Europe USA Europe USA Europe USA

% % ppm ppm kg/m3kg/m3

1995 2000/500 5000 820–860

2000 11 11 350 500 820–845

2005 11 11 50/10 15/50 820–845

2010 8(6) 10 15 820–845

500

350

150

100

200

300

400

500

600

Gasoline Diesel

ppm

Euro 2 Euro 3 Euro 4 Euro 5

Figure 4.2 Evolution of gasoil speciﬁcations

Table 4.3 World crude oil demand

1986 2010 2010−1986

World Oil Demand (million bbl/day) 60.0 87.7 27.7

Of which:

North America 15.7 23.9 8.2

Europe 12.6 14.4 1.8

Asia Paciﬁc 10.4 27.4 17.0

Source: International Energy Agency

48 Understanding Oil Prices

Oil demand has grown by 27.7 million barrels per day, of which

17 million serve to cover the growth of the Asiatic countries, under

2 million for the European nations and 8.2 million for the USA. Table 4.3

shows this distribution in the course of almost 25 years. It can be seen

that while Europe has to some extent stabilized its oil demand, the USA

and the Asian countries continue their process of growth and capture of

the oil reserves available. Moreover the USA must face up to another

structural emergency, namely the continual fall in domestic production

of crude, which has gone from 8.9 to 5.1 million barrels per day, for a net

reduction of 3.8 million barrels per day. It is as if the USA had cut down

its productive capacity by an amount equal to the production of Iran, the

second OPEC producing nation. These data appear to show the extent

of the leadership crisis which has dogged America in the past decade.

There is a mixture of lack of awareness of the data of the problem and

a sort of subjection to the petroleum lobby, which has taken some kind of

revenge against the European countries, free to expand their activities

in areas of the world forbidden to the US companies (e.g. Iran, Iraq,

Libya). In this context few have understood the need to exploit the new

frontiers of technology for both production and consumption of energy.

And so, with these changes, the internal structure of consumption in the

various areas of the world has marked up an incomprehensible growth

in per capita consumption in the USA from 24 to almost 26 barrels per

year in 2007 then brought down to 23 merely due to the contingent

economic crises, while in Europe it has remained steady at the 1985

level at 9.6 barrels per year. The Asian countries are light-years away,

although they have gone from 1.12 to 1.72 barrels per year. Perhaps one

day, in 10 years perhaps, China and India will become a problem for

their competition on the energy and oil market, but today the situation

is very different (and there is plenty of time to get suitably organized).

Analysis of the data in Figures 4.3 and 4.4 is fundamental to

understand the internal dynamics of the oil market and the impact of the

changes in environmental legislation enacted after Chernobyl.

The ﬁrst actions regarding fossil fuels were taken in almost all the

industrialized nations (including Japan), with the banning of leaded

gasolines (an additive for raising the octane number, but very poi-

sonous and pollutant) and proceeding to the reduction of the sulphur

content. The real jump forward in quality came in 1990 with the

approval in the USA of the Clean Air Act, which introduced a revolution

in the composition of gasolines, with the so-called reformulated types.

Changes in the Market for Automotive Fuels 49

1985 1990 1995 2000 2005 2010 2015 2020

million bbl/day

USA Europe Far East

Figure 4.3 Evolution of oil demand in the USA, Europe and Asia-Paciﬁc (1985–2020)

Source: International Energy Agency

Actually, two types of decisions were taken regarding the quality of

automotive fuels:

rTo continue with the limitation and elimination of contaminant sub-

stances (total banning of lead, continual reduction of sulphur content

and oxygenated compounds).

rTo intervene regarding the molecular composition of the hydrocar-

bons used in fuels, setting the maximum content of those types of

hydrocarbons considered to be health risks.

1985 1990 1995 2000 2002 2003 2004 2005 2006 2007 2008 2009 2010

bbl/year per capita

USA EU ASIA-PACIFIC

Figure 4.4 Per capita oil demand in the USA, Europe and Asia-Paciﬁc (1985–2010)

Sources: International Energy Agency, United Nations

50 Understanding Oil Prices

The revolution inherent in these decisions was not immediately

grasped by the industry and the authorities themselves that had pro-

posed them. In fact, the date for implementation of the law was ﬁxed

as from January 1996, giving six years of grace to the operators to

organize themselves. However, the lack of perception of the future

impact on the oil industry gave no clue that powerful incentives would

be required to motivate the companies to invest in the transformation of

their plants. Without incentives and without the start of any industrial

re-conversion process, it became clear that after the six years leading up

to 1996, the American reﬁning industry was not able to respond to the

new speciﬁcations imposed by the Clean Air Act; it was therefore neces-

sary to postpone the implementation for a further four years, namely to

January 2000.

In 1999, in the middle of the American presidential election campaign

(Gore versus Bush), the problem was re-proposed in exactly the same

terms as in 1996: that is, American industry was not ready to respond to

the market changes which would derive from application of the new law.

This time, however, the political conditions were not such as to allow

a further postponement. The Greens exerted pressure and furthermore

one independent Green politician from Florida was a candidate for the

Presidency and seemed capable of ﬁlching some important votes from

Gore, the democratic candidate who was challenging Bush. A deferment

of the Clean Air Act, passed by the Clinton administration, would have

been fatal for Gore. Thus, the American administration conﬁrmed the

implementation of the new law from the starting date envisaged of 1

January 2000.

The impact on the US and world oil markets was dramatic. A rise in

prices began, which didn’t stop until the ﬁnancial crisis of autumn 2008.

Actually, a situation arose in which crude prices broke away from the

control of any organ whatever (OPEC, oil companies, nations).

But what made application of the new law impracticable or difﬁcult?

And why was its introduction so momentous for the evolution of crude

oil prices?

To make an adequate reply we have to consider some technical aspects

of the problem in depth.

GASOLINE AND ITS COMPONENTS

What is commonly called gasoline is a mixture of several components,

obtained through the reﬁning process of crude oil. These components,

Changes in the Market for Automotive Fuels 51

Gasoline Components

Octane Number 85–95 (+)

Sulphur < 30 ppm

Aromatics < 35%

Olephines < 6%

Benzene < 1%

Density 720–770 kg/m3

Cracking

Olephines: 40%

Sulphur: 400 ppm

Topping

Naphtha

Butane

Reforming

Octane Number: 98

Aromatics: 58%

Benzene: 4.5%

Alkylation

Octane Number: 96

Aromatics: 0%

Benzene: 0%

Additives

MTBE: 118

Ethanol: 130

Isomerization

Aromatics: 0%

Benzene: 0%

Octane Number: 87

Figure 4.5 Gasoline and reﬁning plants

and their quality, vary as a function of the complexity of the techno-

logical cycle and the size of the reﬁnery producing them, as well as the

crude oils (the raw material) available for processing.

This problem will be examined later in more detail. At this stage,

however, we shall conﬁne ourselves to listing the reﬁnery plants dedi-

cated to gasoline production and the characteristics of the components

obtained from each plant (see Figure 4.5).

In the annexed sketch we give an example of a reﬁnery, quite complex,

but more or less in line with the medium–high standards of the oil

industry at present. We see clearly that the components for blending

gasolines come from ﬁve separate plants, each one producing a different

component with different characteristics.

Reforming

Reforming is the key plant for producing gasoline and it is present in all

reﬁneries, even the most simple and traditional ones. Its function is to

52 Understanding Oil Prices

transform the molecules of linear hydrocarbons into molecules of more

complex, cyclical form to increase the octane number, which at the end

of the treatment exceeds the limit of 85–95 required for commercial

gasoline. The component produced is called reformed gasoline. The

chemical–physical reactions which permit the increase in octane number

have the undesired effect of increasing the amounts of benzenes and

aromatics well beyond the acceptable limits of the new norms. Thus,

gasoline obtained in a reﬁnery having only this plant could not be

marketed, because although satisfactory as regards octane number it

would contain too much benzene and aromatics.

This is an example where the new norms have made it almost

impossible for a traditional reﬁnery to produce gasoline on speciﬁ-

cation. To formulate an acceptable gasoline these reﬁneries would have

to buy component products elsewhere, to be able to mix them with

the reformed gasoline; alternatively they could focus their purchases of

crude on those types which allow creation of semi-ﬁnished products

which permit formulation of acceptable gasoline. This option, however,

is not easy, since it is obvious that all reﬁneries with such problems are

continually trying to get their hands on these crudes, whose availability

is limited and whose prices are very high.

Cracking

Cracking is the plant which enables a signiﬁcant increase in the volume

of gasoline produced, through a process which converts heavy fractions

of petroleum into light products (gasoline, gasoil). Development of such

plants was accelerated in the 1980s, when the demand for fuel oil from

the power stations was greatly reduced, following the construction of

nuclear power stations and the transformation of oil-burning power

stations into stations burning natural gas (methane). With the reﬁn-

ing systems then in use, about 50% of heavy fuel oil was obtained

from crude oil. When demand for this fell, it became essential to equip

reﬁneries with plants to transform it into other light products, demand

for which was, on the contrary, rising fast. Thus, a series of cracking

plants (with various technologies) were devised, all aimed at increasing

the production of gasoline and gasoil by transforming heavy fuel oil.

Needless to say, these plants are those which guarantee the highest prof-

itability within a reﬁnery. In fact the price ratio between the products

obtained (gasoline and gasoil) and the feedstocks used (heavy fuel oil)

is on average three to one, but it can also reach higher levels.

Changes in the Market for Automotive Fuels 53

Yet, even in this case, there is a problem of quality. These gasolines

have high olephines content (unstable products, therefore dangerous,

obtained by splitting heavy molecules). The new norms limit this content

quite drastically to a maximum of 6%. This puts a strict limit on the

reﬁning process cycle as it has been structured in the last decades.

Alkylation

Obviously, there is a technological answer to this problem. This is the

construction of an alkylation plant downstream of the cracking unit.

Actually, this plant produces, starting from the waste oleﬁnic gases

from the cracking unit, a gasoline of very high quality, with a high

octane number, without benzenes, without sulphur, without aromatics.

This is a costly and dangerous plant. It operates at a pressure of over

40 atmospheres and it is full of sulphuric acid. Any accident could

be fatal. To obtain a permit to insert it in existing reﬁneries, perhaps

close to inhabited centres, is certainly not easy. During the gasoline sea-

son (April–August), the price of alkylate gasoline reaches unbelievable

levels ($100–200 per tonne) above those for reformed gasoline.

Isomerization

Another minor production process is isomerization, which contributes

towards the slight increase in the octane number of the light virgin

naphtha produced by the topping unit. This is, however, a marginal con-

tribution both in quantity and in quality. The octane number of the iso-

merate gasoline is in fact close to the minimum required for marketing.

The plant enables the light virgin naphtha to be used up, particularly

if the amount produced is limited and cannot be commercialized for

other uses (in petrochemicals). On the other hand it does not raise the

octane number enough to ‘absorb’ other products of lower quality in the

mixture of gasolines.

REFINERS WALK THE TIGHTROPE

On the basis of what we have seen so far, we can understand that the

quantity of components for gasoline produced every day in a reﬁnery can

(with difﬁculty) be mixed together and automatically create a gasoline

ready for sale on the ﬁnal market (US or European). In fact, the overall

resulting quality is compatible with the technical characteristics required

54 Understanding Oil Prices

by the engines (octane number, density) and by environmental norms

(sulphur, aromatics, benzenes and olephines).

Many of the problems in balancing quality were and still are solved by

adding to the mixture certain so-called oxygenated compounds, namely

MTBE (Methyl tert-butyl ether) or other similar products. In the USA,

inclusion of MTBE in gasoline has been prohibited since 2006, making

the life of reﬁners harder still.

Let us now imagine that a US reﬁnery, with this technology available

and with the environmental norms operative, must be able to supply its

hinterland with a variety of about 40 different types of gasoline, each one

formulated to speciﬁcations among the strangest and restrictive possible.

The task becomes a nightmare, which can be faced only through a

frenetic purchase activity for speciﬁc components imported from other

international markets (e.g. Europe, South America). Obviously the price

of these components becomes sky-high during the gasoline season and

causes a reduced availability of high-quality product in the markets of

those areas that produce but also export these components. This is why

the price of gasoline in Europe is practically in line with that in the USA

(net of taxes), instead of being much lower, the market having a big

surplus of product (see Figure 4.6).

100

200

300

400

500

600

700

800

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

(1000 bbl/day)

Gasoline Import

Gasoline Blending Components Import

Figure 4.6 USA imports: gasoline versus blending components

Source: U.S. Energy Information Administration

Changes in the Market for Automotive Fuels 55

This mechanism, previously described, might appear to be an irrele-

vant technical detail for the experts concerned. On the contrary, however,

it represents the crux of the problem of understanding today’s dynam-

ics of the international oil market. The need to restock the biggest and

richest world oil market with marginal products creates competition at

global level, a sort of continuous but invisible auction, in which the

product is assigned to the highest bidder, to the person or ﬁrm able to

pay the highest price. But with the result that the price of the last barrel

of product sold becomes the market price of that day for the whole

world. The proof of this phenomenon is before our eyes:

rThe gasoline price in the European countries, producers of surplus

gasoline and exporters to the US markets, turns out to be in line with

the very high price in the USA (net of taxes). All the investments made

in the reﬁning sector and the price paid in terms of industrial pollution

do not generate any economic beneﬁt for European consumers.

rThe poorer countries of Africa and the Middle East (often important

crude producing countries but without a signiﬁcant reﬁning activity)

ﬁnd themselves, during the US gasoline season, very short of product

and with consequential social problems (e.g. Iran, Nigeria, Egypt,

Angola).

rA dual gasoline market has thus developed a US market and a Euro-

pean market, comprising high-quality gasoline and low-quality gaso-

line made by blending low-speciﬁcation components not saleable in

industrialized countries.

This is a precarious balance which has been maintained with great dif-

ﬁculty and which has already shown the potential disasters that ﬁnancial

speculation can create (starting from this). Action in the reﬁning sector

has now become urgent and inevitable, but unfortunately, as we shall see

later, it will not be taken for some time yet (Figure 4.7 shows a simpli-

ﬁed reﬁnery scheme). We shall, therefore, have to learn how to consider

the oil price with a completely different mental model and leave the

producing countries in peace when things do not work as we would like.

THE FISCAL POLICY OF THE INDUSTRIALIZED

COUNTRIES REGARDING FUELS

It is important to note that, when faced with the structural problems

that we have just mentioned, the governments of the industrialized

56 Understanding Oil Prices

Topping

(Atmospheric Distillation)

Crude Oil

Heavy

Virgin Naphtha

Light

Virgin Naphtha

Desulfurization

Isomerization

Reforming

Alkylation

Cracking

Vacuum

Gasoline

Mid Distillate (gas

oil, jet kero,...)

Fuel Oil and

Bitumen

Isomerate

Alkylate

Reformate

Fuel Oil

Figure 4.7 Simpliﬁed reﬁnery scheme

countries, instead of focusing on the quest for a stable and integrated

solution using policies of incentives for industrial investments and

research projects, have in fact contributed towards amplifying the effect

of the crisis through taxation on fuels so punitive as to justify our saying

that effectively the real automotive fuel is composed of taxes.

This matter is deeply felt by consumers of oil, in particular the

motorists of the various countries who suffer the effects and costs of the

phenomena just examined. It is true that the reactions of the public are

often emotional and based on the well-worn clich´

es, usually for igno-

rance of the real mechanisms that affect the prices of crude and ﬁnished

products, and even more regarding the taxation of petroleum products

imposed by the governments of the consumer countries. This in fact con-

stitutes one of the fundamental variables for determining the true cost

afﬂicting the consumers and the economies of the industrialized nations.

The tax burden is often much greater than the sum of the costs of the

raw material, its transformation and distribution as ﬁnished products.

The OPEC countries have always strongly criticized the governments

of the industrialized nations for their ﬁscal policies, seen as ampli-

ﬁers and accelerators of the processes that have made crude oil prices

Changes in the Market for Automotive Fuels 57

completely irrational. And the fact that the reactions of the consumer

are often the result of unawareness of the real mechanisms is important.

The taxation of petroleum products imposed by the governments of the

consumer nations is one of the fundamental variables for determining

the true cost afﬂicting the consumers and the economies of the industri-

alized nations. We may well say that the ﬁnal consumers have no real

perception of the cost of crude oil, since the major charge affecting them

is the taxation on ﬁnished products, which, being a ﬁxed percentage of

their industrial cost, is greatly magniﬁed with every increase in the crude

oil price.

Regarding this issue even the producing nations accuse the govern-

ments of the industrialized countries of adopting a tax policy on oil so

punitive as to make the effective price level of the raw material com-

pletely immaterial. The system of continually putting the blame on the

producing nations is considered unacceptable, when the greater part of

the price increases at the retail level is due in fact to taxation. Perhaps

a better knowledge of the taxation mechanisms on gasoline and diesel,

with a clear statement of the amounts and their effect on consumption,

would avoid concentrating the blame on the producing countries and

the oil companies, but without keeping the governments responsible for

such tax policies out of the picture.

Perhaps it will be useful to give some consideration to the concrete

data in Table 4.4 regarding the oil sector, comparing two different real-

ities – the European and the American – which historically have used

two different philosophies concerning the taxation of automotive fuels.

It is interesting to comment on some of the data which emerge.

The average list price applied by the oil companies in Europe is

higher than that in the USA. This is in clear contrast with the fact that

a signiﬁcant proportion of US gasoline is imported from Europe. It is

well known that European structure produces excess gasoline, while the

US market has a deﬁcit of over a million barrels per day. Based on

the laws of economics it would be reasonable to expect that gasoline

in the USA would cost more than that in Europe, at least to compen-

sate for the transport cost from the Mediterranean/North Europe to the

Atlantic coast of the USA. Surprisingly, the contrary happens. It is just

as if the price of lemons were higher in Sicily and Spain than in Norway

and Sweden.

The taxation on gasoline in Europe represents around 60% of the

price at the pump and about 136% of the market price, while in the USA

it is only 13% of the price at the pump and 15% of the market price.

Table 4.4 Gasoline in Europe and the USA: list price and price at the pump

Retail premium gasoline prices Retail premium gasoline taxes Retail premium gasoline prices

UE USA UE USA UE USA

(€/liter) %(€/liter) %(€/liter) %(€/liter) %(€/liter) %(€/liter) %

2000 0.35 0.34 0.77 0.13 1.12 0.48

2001 0.32 −9% 0.34 −1% 0.76 −1% 0.14 3% 1.08 −3% 0.48 0%

2002 0.30 −7% 0.30 −12% 0.77 1% 0.13 −5% 1.06 −1% 0.43 −10%

2003 0.30 1% 0.30 1% 0.77 0% 0.11 −17% 1.06 0% 0.41 −4%

2004 0.34 14% 0.33 12% 0.80 4% 0.10 −9% 1.14 7% 0.43 6%

2005 0.42 23% 0.42 27% 0.82 3% 0.10 2% 1.24 9% 0.52 21%

2006 0.48 13% 0.49 15% 0.83 1% 0.10 −3% 1.31 5% 0.59 12%

2007 0.49 4% 0.49 0% 0.85 2% 0.09 −8% 1.34 3% 0.58 −1%

2008 0.57 15% 0.55 12% 0.85 0% 0.09 −4% 1.42 6% 0.64 10%

2009 0.41 −27% 0.37 −32% 0.82 −4% 0.12 38% 1.24 −13% 0.49 −23%

2010 0.53 28% 0.51 37% 0.86 5% 0.09 −22% 1.39 13% 0.60 23%

Source: U.S. Energy Information Administration

Changes in the Market for Automotive Fuels 59

Table 4.5 Price of gasoline and diesel fuel in some European countries

Prices

(excluding taxes) Taxes Pump prices

€/liter

Jan 10–Sept 10 Gasoline Diesel Gasoline Diesel Gasoline Diesel

UK 0.36 0.44 0.87 0.87 1.36 1.38

Netherlands 0.56 0.56 0.96 0.62 1.52 1.18

Italy 0.55 0.57 0.79 0.61 1.34 1.18

France 0.52 0.55 0.84 0.62 1.36 1.17

Germany 0.54 0.56 0.89 0.66 1.42 1.22

Belgium 0.55 0.56 0.85 0.57 1.40 1.13

Luxembourg 0.54 0.54 0.62 0.44 1.15 0.98

Spain 0.55 0.56 0.59 0.50 1.14 1.06

Ireland 0.52 0.55 0.78 0.66 1.31 1.21

Average 0.52 0.54 0.80 0.62 1.33 1.17

Source: UK Petroleum Industry Association Ltd.

The consequence of these two different situations is that the retail

price of gasoline in Europe is on average between two and three times

higher than in the USA.

In Europe there is a heavier tax burden than in the USA, but with

signiﬁcant differences between one country and another (see Table 4.5).

In 2010, the list price applied by the companies (net of taxes) varied

widely between each country: from €0.36 per litre in the UK to €0.56

per litre in the Netherlands.

In Italy the oil companies applied prices somewhat higher than the

European average, €0.55 against €0.52 per litre, with the tax component

in line with the European average and, thus, with the price at the pump

slightly higher than the average in Europe.

It is not easy to obtain up-to-date and homogeneous data for all the

countries in the world. However, the IEA has provided some important

information regarding the main consuming countries for 2010.

The data shown in Figures 4.8 and 4.9, substantially in line with those

from Europe in 2010, conﬁrm some evident structural facts:

rThe market price of gasoline is lower in the USA, Australia and the

UK, countries which are net importers of ﬁnished products and where

competition between the various operators is strong. We may note

the situation in Australia, where, although there is no national oil

company of importance, there is a very competitive system between

the distributors, a high degree of transparency in the markets and a

widespread institutional antitrust culture.

60 Understanding Oil Prices

Mexico

United States

Canada

Australia

Poland

Japan

Spain

Switzerland

Austria

Hungary

Ireland

France

Sweden

United Kingdom

Italy

Germany

Belgium

Netherlands

Norway

Turkey

$/gallon

price without taxes total tax

Figure 4.8 Gasoline prices in the world

Source: International Energy Agency

rIn Italy, the most important reﬁning country in the Mediterranean and

a gasoline exporter, the consumer pays more for his or her gasoline

than in all the other countries (apart from Norway, Turkey and Hol-

land). Obviously the fragmentation of the distribution system and the

high related costs play their part.

0.0

0.2

0.4

0.6

0.8

1.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

[euro/liter]

Platts: gasoline FOB NWE

Platts: gasoline FOB Med

Italy

USA

Figure 4.9 Price (excluding taxes) of gasoline in Europe and the USA

Sources: U.S. Energy Information Administration and European Commission

Changes in the Market for Automotive Fuels 61

rThe high taxation level in Europe means that the price of the industrial

product (pre-tax) is low compared with the ﬁnal price on the market,

making less transparent and, thus, negligible the dynamics of the

industry prices as well as competition between the operators. This

phenomenon tends to worsen in countries where a culture rooted in

transparency and effective antitrust control bodies is lacking.

rIn the USA the gasoline price is closely aligned with the international

market and responds quickly to the demand/supply balance. In 2008

we saw some cooling-off of the price (distance from the international

market), while the price of the companies in Europe stayed at higher

levels. The fall in the dollar/euro exchange rate should have caused

the opposite effect, but actually it provided an additional beneﬁt for

the distributors and the Inland Revenue.

The same analysis can be made for gasoil with results quite similar

to those of gasoline.

It is worthwhile examining the meaning of these differences in tax-

ation policies for automotive fuels (see Figure 4.10). Transport policy

in the USA has always privileged private transport. Not by chance do

nearly 300 million inhabitants consume around 50% of the gasoline

produced in the world. Putting gasoline and gasoil together, the quantity

Europe USA

($/gallon)

Ta x e s

Diesel Net Price

Figure 4.10 Tax burden on diesel fuel in 2010 (Europe and the USA)

Sources: U.S. Energy Information Administration, European Commission

62 Understanding Oil Prices

reaches nearly 735 billion litres per year. Taxation on fuels provides the

State with around $100 billion a year. This is clearly a political choice,

based on certain principles typical of US culture, which has given posi-

tive results, in economic terms, during the years of low oil prices but is

now showing its weaknesses.

Europe, on the other hand, has always assisted public transport in the

cities as well as outside (e.g. metros, trains, ferries, buses etc.), demoting,

generally speaking, the automobile to residual transport chores, tourism

or individual comfort. The idea of taxing in punitive fashion individual

transport by car started out from here.

In the various European countries, however, taxation on the auto-

mobile – and hence on fuels – is in some way aimed at supply of services

of a certain level for the motoring citizen: a very efﬁcient road network;

well-maintained and safe roads; free, well-policed motorways; and car

parks that are easy to use and with spaces available. Bicycle paths are

also an integral part of the road system.

In certain European countries taxation on vehicles and fuels function

as an additional component, but not openly declared as ordinary taxation.

For example, in Italy, the revenue deriving from taxation on gasoline

and diesel is around €35 billion per year, compared to the value of the

goods taxed of about €20–25 billion. If we also add the taxes on other

petroleum products, apart from gasoline and diesel fuel, the number

arrives at €50 billion per year. This amount is updated continually since

it is linked to the industrial price. As the oil companies’ price list rises,

the taxes increase automatically.

Just to give an idea of the size of this phenomenon in the European

context, we may remember that while the volume of gasoline consumed

in the USA is about 30 times greater than that in Italy, the tax revenue in

America derived from automotive fuels is about three times lower than

that in Italy. Obviously the situation is not very different in the other

European countries.

Let us hope that a signiﬁcant part of this sum will be used for invest-

ments for a more efﬁcient transport policy.

World Oil Flow

Many of the distortions existing today in the world oil market stem from

the loss of control of the processes started in past times to respond to a

vision of economic rationalization.

When we note that the USA, while consuming over 22 million bar-

rels per day of petroleum products, have created a reﬁning capacity that

can produce in continuous regime only about 14–15 million barrels per

day, we can conclude that they decided to depend structurally on pro-

curement of reﬁned products coming from other geographic areas. The

dependence of many industrialized nations on procurement of raw mate-

rial (crude oil) from producing countries is often a necessity imposed by

nature (oil is not found everywhere). However, dependence for ﬁnished

products on other reﬁning countries is an economic and strategic choice

that provides beneﬁts if well managed and monitored as time goes by,

but that can also become a heavy burden if it slips out of control and

becomes a strategic limitation. One often has the sensation that many

choices in the oil ﬁeld were made with a purely economic vision and,

being based only on company ends, thus, short term by necessity. It is

hard to discern any guidelines programmed by national authorities in a

sector so strategic and decisive for the economy of a country.

To understand better what is happening today, we can look at some

historic decisions made in the 1950s and 1960s by the leading US oil

companies. We have to go back to a time when the price of crude at the

origin, at the loading terminals in the various producing countries, was

effectively ﬁxed by the US multi-nationals (the famous Seven Sisters

that Enrico Mattei talked about), and it was so low that the price at the

ﬁnal destination represented over 50% of the cost of transport. Reduction

of transport costs was therefore a fundamental factor in the economic

strategies of the US companies.

If we look at the movements of oil at that time (see Figure 5.1), we

can clearly see that about 80% of the crude came from the Persian Gulf

and reached the Atlantic basin via the Suez canal. The crude needed

for the growing consumption in the USA, therefore, had to arrive ﬁrst

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

1. From Gulf to West

2. From N. Sea to the USA

3. From Gulf to F. East

4. From W. Africa to the USA

5. From W. Africa to F. East

6. From Caspian to F. East

7. From Caspian to the USA

Figure 5.1 World oil ﬂow

World Oil Flow 65

in the Mediterranean and proceed accross the Atlantic, with very high

transport costs.

Let us remember yet again that the USA did not require all the

reﬁned products obtainable from crude, but essentially just gasoline.

Construction of further reﬁneries to produce gasoline would have pro-

duced an excess of other products (gasoils, fuels) which would have to be

exported and, thus, be re-transported with high additional costs.

Europe too was going through a phase of economic boom due to post-

war reconstruction and the industrialization of new areas. Europe needed

fuels and electricity. It was possible to satisfy the needs of the two sides

of the Atlantic with an integrated industrial plan, aiming to optimize

everything; by building reﬁneries in Europe that the US market needed,

thus it became able:

rto produce and export gasoline to a privileged market, with good

economic returns, providing availability of hard currency needed to

pay for the raw material;

rto produce at marginal costs the fuel oil for the power stations being

built, to provide energy for the expanding industrial system; and

rto develop the technology for diesel engines (little used in the USA)

to use the gasoil produced and maximize export of gasoline.

This design made sense and offered secure economic returns. There-

fore, the plan took shape and saw the massive construction of reﬁneries

in Italy (at the centre of the Mediterranean) and at Rotterdam, the key

point for supply of gasoil to Germany. Furthermore it was essential to

heavily promote the construction of power stations fed exclusively with

fuel oil (a product considered as reﬁnery waste), if possible located near

the reﬁneries. The newspapers of the time also tell us of the pressure

exerted by the oil industry on the political world to reach its objectives.

This model worked perfectly until the end of the 1960s, but it was met

with many difﬁculties that worsened with the ﬁrst oil crises. Firstly, the

closure of the Suez canal in June 1967. All the tankers from the Persian

Gulf were forced to circumnavigate Africa to reach the Mediterranean,

where the reﬁneries were found. Clearly the economies on the transport

costs completely disappeared. To take the crude, after the long circum-

navigation of Africa, into the Mediterranean or to North Europe and

then depart from there to take the gasoline to the USA, added extra

costs as compared with the alternative voyage direct from the Persian

Gulf towards the USA.

66 Understanding Oil Prices

The system managed to resist, thanks to some adjustments to the

transport element. The tankers that carried 60,000–80,000 tonnes of

crude were replaced by supertankers carrying up to 350,000 tonnes. In

this way the unit cost of transport was kept down and all continued as

before. Furthermore, in the meantime, from 1973, OPEC took control of

the prices and imposed a signiﬁcant increase of around $10 per barrel.

This took the transport cost to an acceptable fraction of the cost of crude

at ﬁnal destination.

Starting from 1973, two parallel processes got under way:

rEnergy diversiﬁcation in all the industrialized countries, tending

essentially towards the production of electricity in an alternative way

to that of the oil-ﬁred power stations. In Europe, in the following

decade, the demand for fuel oil fell to about 20% of the total oil

demand.

rConstruction of reﬁneries in the producing countries, with the clear

intention of shifting margins of the oil cycle from the companies

towards the producing countries. These reﬁneries were obviously ori-

ented towards the export of ﬁnished products to international markets

and they were built in those countries with huge ﬁnancial resources

(petrodollars) and with only a modest internal demand for petroleum

products (Saudi Arabia, Kuwait).

TRANSFORMATIONS IN THE DOWNSTREAM

The result of all this was to create a very competitive market for ﬁnished

products (the prices applied by the producing countries can be lower) and

consequently, a reduction of the reﬁning margins in all the plants with

a relatively simple technological cycle; oriented towards production of

fuels for power stations (no longer necessary) and marginal quantities

of gasoline for export to the USA. A dramatic process of restructuring

the reﬁning system in the countries on both sides of the Atlantic started

in the 1980s. All the reﬁneries with a simple cycle that did not have a

local pool of consumption (including adjacent power stations) were shut

down. Those more modern and better located to supply the city outskirts

or export gasoline to the USA were restructured with the installation

of conversion plants. To illustrate this, Table 5.1 lists the closures in

Italy, the European country necessarily most affected by this process,

and in the USA, where the liberalization laws introduced by the Reagan

administration accelerated the rationalization process.

World Oil Flow 67

Table 5.1 Italian reﬁneries

Company Location

Technology

complexity Status

Capacity

1973 [1000

bbl/day]

Capacity

2010 [1000

bbl/day]

AGIP

Rafﬁnazione

La Spezia low Closed 85 −

AGIP

Rafﬁnazione

Rho high Closed 80 −

ALMA Ravenna low 4 −

API Falconara mid 80 −

Aquila Trieste low Closed 50 78

Arcola Petr. La Spezia low Closed 20 −

ENI Livorno high 104 −

ENI Porto

Marghera

mid 90 108

ENI Sannazaro high 120 221

ENI Taranto mid 84 118

ERG Genova low Closed 130 −

ERG Melilli mid −255

ERG Priolo high 300 250

Esso Augusta high 182 196

Gaeta IP Gaeta low Closed 80 −

Italiana energia &

servizi

Mantova high 65 58

IPLOM Busalla low 32 38

Kuwait

Petroleum

Naples mid Closed 130 −

Lombarda Petroli Villasanta low Closed 22 −

Milazzo Milazzo high 400 280

Gela Gela high 90 129

Rome Pantano low 86 86

San Quirico San Quirico low Closed 30 −

Saras Sarroch high 360 355

Sardoil Porto Torres low Closed 90 −

Sarni Bertonico low Closed 80 −

Sarom Ravenne low Closed 140 −

Sarpom Trecate high 260 180

Tamoil Cremona mid 80 100

Volpiano Volpiano low Closed 80 −

In the USA an even more extensive and drastic process took effect in

two directions:

rReduction of reﬁning capacity with closure of uneconomic plants and

concentration of ownership in the hands of fewer proprietors (Figure

5.2).

rIncrease of the rate of utilization of existing capacity (higher opera-

tional efﬁciency) (Figure 5.3).

68 Understanding Oil Prices

100

120

140

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

1000 bbl/day

100

150

200

250

300

350

Number of refineries

USA Average Refinery Capacity [left axis]

Number of operable refineries in USA [right axis]

Figure 5.2 Number of reﬁneries versus average reﬁning capacity

Source: U.S. Energy Information Administration

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

million bbl/day

USA Refineries Capacity USA refinery runs (1000 bbl/day)

Figure 5.3 Reﬁning capacity versus rate of utilization (USA)

Source: U.S. Energy Information Administration

World Oil Flow 69

In this context whatever plan there was for construction of new re-

ﬁneries was shelved. The last new reﬁnery built in the USA dates back

to 1976. In Italy too, the last reﬁnery built was at Melilli (Siracusa) in

1976: since then, only upgrading work has been carried out on some

existing plants.

All the tables of reference and the strategic lines of the past were wiped

out and the oil industry began to live from one day to the next, incapable

of making any overall plan to face the challenges of the future decades. In

a situation of low prices and reﬁning margins at the limits of survival, the

companies limited themselves to closing each year with more or less pos-

itive results rather than make bets on the future. The continuation of this

situation for over two decades created a survival culture in the oil down-

stream, which from that time has remained captive of a business philoso-

phy tied to day-by-day dynamics; without realizing that the famous mole

in the story was burrowing underground tunnels that would have pro-

voked a crisis of capacity and lack of technology in the following decade.

This background explains the variations in the ﬂow of crude supplies

starting from the 1990s. To the prevalent direction of ﬂow from East to

West (Persian Gulf towards Europe and the Americas) an increasingly

important ﬂow towards the Far East was added. At the beginning this was

low-quality, cheaper crude (the environment was not yet a relevant theme

in the Far East), then the demand for light, low-sulphur crudes grew

slowly. Reﬁners in the Far East turned their gaze on higher-quality crudes

from the Gulf as well as from West Africa, triggering a commercial

conﬂict with the US market, which hitherto had used them exclusively.

The arrival of Far Eastern operators in West Africa coincided with the

rekindling of civil wars in many of the countries either already producing

crude or with the potential to. This was obviously not an automatic

coincidence, but certainly it would appear to be not unconnected with

the events.

The history of the 2000s to date conﬁrms that the consolidation of the

processes of the previous decade and the new conﬂicts taking shape con-

tributed towards directing world crude movements to the west or to the

east. West Africa showed it was an area of bitter conﬂict and competition,

where the game for control of crude oil was played on several fronts:

rpolitical and military support in the local conﬂicts;

rmassive assistance in building civil works, payment for which was

expected to be made in crude oil in the future;

rpartnerships for interventions in various business areas which could

provide the country with some development also outside the oil sector.

70 Understanding Oil Prices

Then the confrontation, perhaps even more bitter, in the Caspian Sea

area came to the forefront. This area seems to have a potential for

development comparable to that of the Persian Gulf. The area belongs

to a series of member states of the ex-USSR and Iran. After the frag-

mentation of the USSR, the major oil companies raced to obtain mineral

concessions in the area, with some clear-cut successes. From some years

ago, however, the situation seems to have become a little more compli-

cated because of the limitation of the export routes from the Caspian

area towards the international markets, involving the need to resolve the

following problems:

rCrossing Russian or Iranian territory.

rReaching the Mediterranean without disturbing maritime trafﬁc in the

Dardanelles.

rEquipping the Mediterranean, historically an area importing oil, to

export a mass of light crudes to more remunerative markets.

On this front the political, and sometimes military, reports inform

us of growing tensions in the areas of transit, today or tomorrow, of

the pipelines. The stakes in this game are very high and of strategic

consequence: certainly beyond the scope of our present tale.

WORLD SUPPLY STRUCTURE

Another aspect of oil movements concerns the pinpointing of canals via

which the crude, produced in various nations, reaches its ﬁnal markets

and how much of this crude contributes to support the dynamics of the

oil market through commercial transactions. In the ﬁrst place we should

split world production into two distinct segments:

rthat of the guaranteed ﬂows, namely the part of world production that,

every day, independently of the price level, is able to reach its ﬁnal

destination. This part represents about 88% of the production; and

rthat of the ﬂows dependent on the price, namely that part of the

production that reaches any ﬁnal market whatsoever only if its price

is adequate and competitive. This part represents about 12% of the

production.

It is interesting to look into the two segments deﬁned above and shown

in Figure 5.4, especially the one of the guaranteed ﬂows, to understand

the level of fragility of the physical markets for crude, where only a tiny

fraction of the production is exchanged every day.

World Oil Flow 71

88%

12%

Destination guaranteed Destination dependent on price

Figure 5.4 Destinations guaranteed and destinations dependent on the price

Therefore, in the oil market a gigantic space for manipulation is

created. By moving only marginal quantities an enormous pressure can

be exerted on the balance of the world market (such as the phenomenon

of the squeeze on Brent).

In greater detail (as shown in Figure 5.5), we may note that:

rAbout 55% of the crude extracted by the producing countries is used

in their internal reﬁning system to cover their domestic needs. A small

percentage of reﬁned products (under 10%), in excess of the domestic

requirement, is exported to other markets.

100

Local refinery

54.8

Foreign network

7.5

Oil companies’

equity

9.8

Strategic sale and

purchase

15.9

Destination price

dependent

Refinery system of the

oil companies and

producing countries

77.4

Spot market

22.6

Figure 5.5 Destination of crude (%)

72 Understanding Oil Prices

rAbout 7–8% of the crude is transferred to reﬁning and distribution

circuits that some producing countries own in the main areas of con-

sumption (e.g. Saudi Arabia, Venezuela, Kuwait, Libya).

rAbout 10% represents the crude due to the oil companies for the

repayment of their investments (the so-called equity quota) and which

is sent either to their reﬁning system or sold in the international

markets.

rSome 15–16% of the production, historically, is destined by many

countries to repay works and goods of strategic nature (e.g.

major civil works, infrastructures and means of transport, military

expenses).

Only 12% of world production is linked every day to spot or short-

term sales contracts. This segment, plus other fractions of crude from

the preceding segments, for a total never greater than 25%, constitutes

the base of what we call the physical oil market. Out of a production of

around 88 million barrels per day, the crude responding to commercial

transactions does not exceed 20–25 million barrels per day.

From these data it is easy to see how the market forces do not affect

the overall mass of demand and world oil supply but only a very limited

segment in the hands of just a few operators. This fragile and critical

balance is rocked today by the power of speculative ﬁnance which

upsets the precarious equilibrium of what was formerly the international

oil market.

The Classical Model of the

International Oil Market

When analysts speak of the price of oil they are normally referring to

the classical model of demand and supply. There is, however, a speciﬁc

complexity in the technological model of the oil market, which when

the model is applied tout-court leads to completely mistaken and para-

doxical results. Not only are we unable to ﬁnd an instrument that allows

us to forecast the evolution of the price of oil (which any respectable

model should do, at least in terms of revealing overall tendencies), but

we cannot even manage to give a logical interpretation of events past and

present. Many analysts in veneration of the model they use are forced to

make far-fetched readings of the input data, so as to make them coherent

with the facts of the market.

In the oil market there is only one incontrovertible fact, namely the

evolution of the price of oil. Every day purchases and sales are completed

on the basis of a price accepted by the buyer and the seller. On the basis

of this ﬁgure physical transactions and payments take place. Price is

therefore an incontrovertible fact. The price used one day differs from

that of the day before or the day after. The reason for these variations is

the mystery we need to unravel. The dynamics of demand and supply

applied in the classical way are of little use. Let us try to see why.

When we examine the data regarding world oil demand and supply

we normally refer to the International Energy Agency (IEA).

Table 6.1 is nothing more than the materialization of an interpretative

model in which a forcible comparison of two dissimilar sets of data

is made as if they were homogeneous and related to the same market

dynamics we wish to understand. Actually, the comparison is made

between:

rthe world oil supply from the producing countries (OPEC and non-

OPEC); and

roil demand as the aggregate of ﬁnished products (e.g. gasoline, gasoil,

fuel oil etc.).

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

Table 6.1 Global oil demand and supply

Global Oil Supply and Demand (MB/D)

2010 2011

Source: IEA 18/01/2011 1 Q 2 Q 3 Q 4 Q 2010 1 Q 2 Q 3 Q 4 Q 2011

World Oil Demand 86.3 86.9 88.6 88.9 87.7 88.6 88.4 89.8 89.7 89.1

OECD 45.9 45.2 46.6 46.7 46.1 46.3 45.0 46.1 46.3 45.9

Non OECD 40.4 41.7 42.0 42.2 41.6 42.3 43.4 43.7 43.4 43.2

of Which ex FSU 4.2 4.1 4.4 4.3 4.3 4.4 4.2 4.5 4.4 4.4

World Oil Supply 86.5 87.1 87.4 88.2 87.3 88.3 88.4 88.9 89.4 88.7

Non OPEC Supply 52.4 52.8 52.8 53.3 52.8 53.1 53.1 53.5 53.9 53.4

OPEC Crude (X) 29.1 29.1 29.3 29.5 29.2 29.5 29.5 29.5 29.5 29.5

OPEC NGLs 5.1 5.2 5.4 5.5 5.3 5.7 5.8 5.9 6.0 5.8

Stock Change 0.2 0.2 −1.2 −0.7 −0.4 −0.3 0.0 −0.9 −0.3 −0.4

Source: International Energy Agency

The Classical Model of the International Oil Market 75

From the ﬁgures we can deduce, at various times, the level of relative

imbalance, namely, the excess or deﬁcit of supply vis-`

a-vis demand.

We are therefore able to estimate the effect on the available level of

stocks among the sectors’ market players (e.g. producers, reﬁners, dis-

tributors and transporters). Subsequently, an indication of the move-

ment of the price of oil can be derived from the ﬂuctuation of stocks

levels. An increase of the stocks may project a fall in prices while a

fall in stocks may forecast a rise in prices. In practice, however, the

application of this model is of no help. The indications obtained are sys-

tematically contradicted by the market, which seems to obey other fac-

tors. The reason, apparently mysterious, does, on the contrary, follow a

rigorous logic.

In Figure 6.1, covering the same quarterly periods starting from 2003,

the variation in the level of stocks with the corresponding variation

in the price of Brent are depicted. It is clear that in about 50% of the

cases the formula

Price =f (supply −demand)

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q

2003 2004 2005 2006 2007 2008 2009 2010

million bbl/day

-70

-50

-30

-10

$/bbl

Supply/Demand (left axis)

Delta Brent Price (Quarter versus Quarter) (right axis)

Figure 6.1 Variation of stocks versus variation in the Brent price

Source: International Energy Agency

76 Understanding Oil Prices

SUPPLY

CRUDES

(Sweet/Light

and

Heavy Sour)

OIL DEMAND

(FINISHED

PRODUCTS)

UNLIMITED

AND

FLEXIBLE

REFINERY

SYSTEM

Spare capacity of

Sweet/sour crudes Spare capacity

Figure 6.2 The classical model of demand/supply

does not provide any assistance. The crosses indicate each instance

where the classical model of demand/supply is unable to explain the

market rules. In fact, it is often that a rise in price corresponds erro-

neously to an increase in supply, when – on the contrary – economic

theory tells us that the exact opposite should take place. The data for

stocks are the ﬁnal ones, published with around a year’s delay vis-`

a-vis

the market situation at the time. They are, thus, not inﬂuenced, as we

shall see later, by the margin of error that exists due to uncertainties in

the ﬂow of data. Using the available data in each speciﬁc period, the

correlation would be still unreliable.

The apparently mysterious reason for these results follows a simple

and strict logic.

It has just been mentioned that the global model in practice compares

two dissimilar elements, the supply of crude, that is, the raw material,

with the demand for ﬁnished products (obtained by the reﬁning process

of the raw material). This is assuming that the world reﬁning system is,

on a daily basis, capable of transforming the raw material produced and

sold by producing countries, into the array of ﬁnished products required

by the market.

Figure 6.2 outlines the classical model for interpreting the encounter

between demand and supply.

The classical model was amply justiﬁed and gave reasonable expla-

nations for the movement of the market, as long as it was possible to

make the following assumptions:

The Classical Model of the International Oil Market 77

rThe potential availability of raw material is always greater than the

level of demand for ﬁnished products. In other words, there is always

spare capacity in the productive system for processing high-quality

light crudes as well as low-quality heavy crudes.

rThe world reﬁning system is characterized by spare capacity for the

transforming units, whether they use simple or complex technology.

In actual fact, the structural changes in recent years have been such

that both these hypotheses are no longer valid. The model of the world

oil market has mutated into a new scheme (Figure 6.3) in which:

rthe unused availability of raw material is limited exclusively to the

availability of low-quality heavy crudes; and

rthe spare capacity in the reﬁning system has fallen drastically and is

limited to a few plants of simple technology (where the possibility of

obtaining high-quality gasoline from heavy crudes is very slender).

The change in productive systems has made it necessary to modify

the interpretative models of the oil market. To continue to try to explain

the market scene through the old models is simply useless. Even more

is any attempt to make price forecasts using these models.

Yet, it is still the continuous and widespread practice of the major

international analysts in using this model that, in the end, they are

forced to deform the model’s input data in a totally irrational way. To

LIMITED

AND

Not FLEXIBLE

REFINERY

SYSTEM

Spare capacity

sour crudes

SUPPLY

CRUDES

(Sweet/ Light

and

Heavy Sour)

OIL DEMAND

FINISHED

PRODUCTS

WITH NEW

SPECIFICATIONS

Shortage of

High-quality products

spare capacity

of sweet and

Figure 6.3 The modern supply/demand model

78 Understanding Oil Prices

obtain the evolution of prices, data considered deﬁnitive and not subject

to interpretation, as an output of the interpretative model, analysts are

obliged to work on the input data, that is, on the movements of demand

and supply. The unavailability of objective data in real time makes this

manipulation of subjective estimates by analysts possible and hard to

contest. It is, thus, possible to reconstruct the events of the recent past

and above all to describe the present in an arbitrary way, particularly in

such a way as to succeed in justifying, if used as an input of the model,

the movement of price levels. If, for example, the price of oil has risen,

on the basis of the model there can only have been a combination of a

reduction in supply or an increase in demand.

Analysts, in the absence of available information, are often forced

to derive their data through econometric models which allow them to

be inferred. These are models which often have as their fundamental

variable the sole irrefutable piece of data on the oil market, namely, the

price of crude oil itself. They are, therefore, models of the type:

Demand =f (P Brent)

Supply =f (P Brent)

It is not difﬁcult to imagine that such models can create vicious

circles that often circulate in the market (see Figure 6.4). Rising prices

generate forecasts of increasing demand and falling supply, and hence

expectations of further rise in prices. These mechanisms thrive for what

may be long periods, with sudden and unjustiﬁed collapses. But, above

all, the tendency of analysts who make use of this model is to envisage

the future as an exact copy of the present, with some insigniﬁcant

cosmetic touches.

Brent

Price

Supply

Deman

Brent

Price

Supply

Deman

Stocks

Estimation

Figure 6.4 The vicious circle in the classical demand/supply model

The Classical Model of the International Oil Market 79

Box 6.1 Variations in Estimated IEA Stocks

To illustrate this, Figure 6.5 shows an example of the adjustments

made to the estimate of the yearly imbalance between demand and

supply, concerning the same time period, in the course of the various

updates as the conﬁrmed data become available from time to time.

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

Dec 99 Jan 00 Mar 00 Apr 00 May 00 Jun 00 Aug 00 Sep 00 Dec 00 Feb 01

million bbl/day

1999

2000

Figure 6.5 Adjustments to the estimate of the yearly imbalance between demand

and supply

Source: International Energy Agency

It is important to spotlight these structural data, which are un-

fortunately still considered an irrelevant point of detail. Generally

speaking, the classic market model derives its indications regarding

the crude oil price trend on the basis of imbalances between demand

and supply: under one million barrels per day. Such data are often the

grounds for a violent debate on expectations for future months. But

the error contained in the data under debate is far greater, 4/5 million

barrels per day, than the stock imbalance, at most 1 million barrels

per day. This analysis is what forecasts are based on.

We can certainly conclude that the global analysis and forecasts based

on the classic models of demand and supply are only expressions of

subjective opinions propped up by partial items of information lacking

in objectivity. The problem of information in the oil market is very

80 Understanding Oil Prices

critical and features levels of transparency and availability that are very

different, depending on the nature of the data in question:

rHigh level of transparency and availability in real time of prices and

futures in the markets. The data can be accessed on line, minute by

minute, from the various specialized sources.

rPartial level of transparency of the prices of physical transactions in

crude oil. Much of this information, of a conﬁdential nature since

it concerns transactions between private parties, is estimated with

varying levels of reliability by the specialized sources using particular

criteria, accepted in oil industry practices.

rMedium level of reliability of the data concerning estimates of pro-

duction in the main producing countries. The trustworthiness of the

data is inversely proportional to the political control exercised over

the level of oil production.

rLow level of reliability of the data regarding demand, with particular

uncertainty between consumption and variation of the stocks of ﬁn-

ished products in the various market areas. The only data available are

those published monthly by the IEA, which itself either gathers them

from the member countries (with average delays of 6–9 months), or

estimates them for the non-member countries.

In particular, the uncertainties in estimates of demand and supply

levels may arrive at quantities of 4 or 5 million barrels per day, as much

as 5–7% of the total. We can certainly conclude that the analysis and

forecasts based on the classical models of demand and supply at the

global level are only expressions of subjective opinions propped up by

partial items of information lacking in objectivity.

The Short-term Model of the

International Oil Market

It is not easy to describe in detail how the oil market’s model should be

structured in such a way that it faithfully reﬂects the price dynamics as

they relate to the ﬂuctuations in the demand and supply balance. It is also

necessary to take into account some essential features of the technolog-

ical model of the oil industry together with the qualitative composition

of both demand and supply. A functional model for industrial use can

even contain over ﬁve thousand variables. In our case, we shall limit

ourselves to the bare essentials, always trying, however, to identify the

internal dynamics of the model and, thus, of the market itself.

For instructional purposes, we shall refer to the sketch of the model

shown in Figure 7.1.

The sketch revisits the themes examined in the previous chapters, but

describes in more detail – even if schematically – the segments of the

oil cycle. In particular, the following points are considered:

rThe supply of raw material, crude oil, is not just a homogeneous

quantity, which can ﬂuctuate with changes in production as decided

by producing countries, but an aggregate of different qualities of crude

extracted and put on the market. At least four families of crudes are

on offer:

– light crudes without sulphur (sweet light) – much sought after and

specialized for production of high-quality products, both gasoline

and gasoil;

– light crudes with sulphur (sour light) – always sought after but

which require additional reﬁning processes to eliminate the sulphur

(or other contaminating elements);

– heavy crudes without sulphur (sweet heavy) – very useful for cat-

alytic conversion processes (cracking plants); and

– heavy crudes with sulphur and metals (sour heavy) – namely, the

worst quality crudes that require vigorous reﬁning and transforming

processes to obtain marketable products.

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

82 Understanding Oil Prices

SWEET

Light

SOUR

Heavy

CONVERSION

HYDROSKIMMING

GASOLINE

GAS OIL

GASOLINE

FUEL OIL

GAS OIL

FUEL OIL

REFINERY

SYSTEM

CRUDE

SUPPLY

PRODUCTS

SUPPLY

PRODUCTS

DEMAND

STANDARD

FLOW

Hydroskimming

Market

Sweet

Light Conversion

UNLIMITED

SPARE

CAPACITY

Sour

heavy

Seasonal

product

Associated

Production Stocks

Figure 7.1 The classical industrial model

rThe world reﬁning system can be split into at least two large cate-

gories:

– reﬁneries with a high conversion level, where the hydrocarbon

molecules undergo profound transformations and light products

can be obtained even from the heavy fractions of the raw materials

available; and

– reﬁneries with a simple cycle (hydroskimming), where the crude is

subjected only to a distillation process, with treatment of the virgin

naphtha at the reforming unit for production of a minimum amount

of gasoline.

rThe reference markets of the model are two in number:

– the crude oil market, where reﬁners purchase crude from the pro-

ducing countries and the oil companies; and

– the ﬁnished products market, where the consumers (primary and

secondary, namely simple citizens or industrial organizations) buy

products from the reﬁners.

rIn the crude oil market the price is the outcome of exchanges

between producers and reﬁners, in the products market the price

derives from the dynamics of the exchanges between consumers and

reﬁners.

rThe reﬁners represent the linkage between the two markets. Through

the reﬁning system the alignment or divergence of the two markets

takes place. A model of the oil market which does not contain the

description of the dynamics of the reﬁning system is absolutely

The Short-term Model of the International Oil Market 83

inadequate for any representation, even the simplest one, of these

markets.

rFor a simpliﬁed representation we have considered the possibility

of producing and marketing the three fundamental products in the

marketplace, namely gasoline, gasoil and fuel oil.

We shall now see how the use of a model, even an extremely simpliﬁed

one, but one which contains descriptions of the minimum variables,

enables us to describe some of the phenomena regarding the distortions

of the market. This has been witnessed in the last decade.

Let us give an example – theoretical for its level of simpliﬁcation

but sufﬁciently close to the phenomenology of the market. Suppose we

are at the beginning of July, right in the middle of the gasoline season

(the so-called driving season). Referring to the model just described, we

have a situation in which:

rThe producers of light crudes will have already committed their pro-

ductive capacity and probably already sold their production of the

summer months (July and August). Thus, there is no longer any ad-

ditional availability of light crudes on the market.

rThe reﬁners, who have already bought the crudes most suitable for

gasoline production, have also programmed the maximum use of all

the conversion plants, to produce the greatest volume of gasoline ob-

tainable from those crudes in those plants. Thus, there is no additional

capacity available for sophisticated reﬁning.

Let us suppose that in this situation there is additional demand for

gasoline and hence a substantial increase in its price. What can a reﬁner

do to meet market needs and exploit a possibility to earn more? Certainly

he will try to act with all the means he has at hand, namely:

rThe reﬁner will go to the crude market to buy marginal additional

quantities. But, seeing that there is no longer any availability of

light crudes, he will be forced to buy volumes of heavy crudes, the

only ones with some spare capacity, normally from producers in the

Persian Gulf.

rHe will have to process these crudes in the only plants that are not

completely utilized in his reﬁnery (which is already working at 100%

with the most sophisticated plants to produce gasoline), namely the

technologically simple plants (hydroskimming).

rFrom processing the heavy crudes purchased in the simple reﬁning

plants the reﬁner will get around 10% of gasoline and around 90%

84 Understanding Oil Prices

10 TONNES

HEAVY CRUDE

SIMPLE

REFINERY

1 TONNE

GASOLINE

4 TONNES

GAS OIL

5 TONNES

FUEL OIL

MARKET

STOCK

Figure 7.2 Reﬁning cycle for a heavy crude to produce 1 tonne of gasoline

of other products (gasoil, fuel oil), which are high in sulphur content

and are of very poor quality.

This means that to obtain a tonne of gasoline with this marginal cycle,

our reﬁner has to buy and process about 10 tonnes of heavy crude, much

more than he really needs (see Figure 7.2).

What impact will this marginal activity have on the market? Let us

examine the main effects:

rThe market will notice an increase in the demand for crude oil (raw

material) nine times greater than the consumer market effectively

needs, concentrated in the heavy crudes segment, whose relative price

will rise in mid-summer (during the gasoline season), in total contra-

diction to the normal expectations of industry professionals. In this

season, one expects the light crudes to be the most expensive and

sought after.

rThe stocks of gas oil and fuel oil will increase (their production

is linked to the processing of heavy crudes for the additional pro-

duction of gasoline) and their price will fall. This will make the

increase in price of heavy crudes, rich in fuel oil and gas oil,

incomprehensible.

In conclusion, the market will have gasoline prices sky-high, gas oil

and fuel oil prices low, but the price of heavy crudes, the raw material for

production of fuel oil and gas oil, relatively higher. No classical model

can provide an explanation.

The Short-term Model of the International Oil Market 85

SWEET

Light

SOUR

Heavy

CONVERSION

HYDROSKIMMING

GASOLINE

GAS OIL

GASOLINE

FUEL OIL

GAS OIL

FUEL OIL

REFINERY

SYSTEM

CRUDE

SUPPLY

PRODUCTS

SUPPLY

PRODUCTS

DEMAND

STANDARD

FLOW

Hydroskimming

Market

Sweet

Light Conversion

UNLIMITED

SPARE

CAPACITY

Sour

Heavy

Seasonal

product

Associated

production Stocks

Figure 7.3 The modern oil industrial cycle

All this appears quite logical if we glance at the model illustrated

in Figure 7.2 adapting it to the system in question, that is, a market

without spare capacity for light crudes and without spare capacity for

high-conversion reﬁning plants (see Figure 7.3).

This type of model enables us to understand why the concept of

seasonality has gone haywire as regards prices of petroleum products

and qualities of crude.

The price peaks of the various products and the more specialized

crudes for their production no longer take place regularly in the tra-

ditional season of maximum consumption, but in the phase when the

productive system has the greatest difﬁculty to produce, for whatever

reason (peak demand, plant production problem), the marginal quantity

of an individual product.

Historically, the relative prices for petroleum products (formulated

as indices vis-`

a-vis the unit value of the crude price) ﬂuctuated in an

orderly way during the various seasons of the year (see Figure 7.4):

rGasoline started from winter levels of 1.2, to reach average levels of

1.4 in summer and fell to levels around 1.1 in late autumn.

rGas oil, starting from levels of 1.3 in winter (above those of gasoline),

could fall in late spring down to 1.0 (a level at which there was no

sense in producing it, the ﬁnished product price being equal to the

raw material price).

rSimilar progressions can be found for the other products.

86 Understanding Oil Prices

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Ratio versus Brent

Gasoline Gas Oil

Jet Kero Fuel Oil

Figure 7.4 Relative prices of gasoline, gasoil, jet fuel and fuel oil

If we look at what happened, for example, during 2008 (see Fig-

ure 7.5), it is clear that:

rthe price of jet fuel was continually above that of all other products;

rthe price of gas oil was always above that of gasoline and had its

relative maximum in May (1.28), well above the historic level of 1.0;

and

rthe gasoline price fell to its minimum level (1.07) both in July and

November, without any apparent market logic.

0.3

0.5

0.7

0.9

1.1

1.3

1.5

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Ratio versus Brent

Gasoline Gasoil Jet Fuel Fuel Oil

Figure 7.5 Relative prices of products in 2008

The Short-term Model of the International Oil Market 87

All this analysis demonstrates that in a market system in which the

limits of the reﬁning system create a decisive bottleneck, the price of

crude is linked to the ones of the products. This is just the opposite of

the assumption made in the classical model, where the fundamental role

is attributed to the entry of raw materials in the crude oil market.

The crisis in the technological reﬁning system has brought a new key

factor in determining the level of petroleum prices: this is no longer

a relationship between supply and demand of the raw material, but

between high-quality ﬁnished products made available by the produc-

tive system and the level of demand for these same products in the

various markets. The principle that the demand and supply relationship

determines the price is, therefore, always valid, but it has to be applied

to the correct relationship, namely to that regarding ﬁnished products.

It is at this point that we see the narrowing between demand and supply,

not at the raw material level. It is this technological aspect that usually

escapes those analysts with a purely economic background. This is why,

in the real world of the marketplace, the critical factors that determine

prices are:

rthe lack of US gasolines from March to August; and

rthe lack of gasoil in Europe from October to February.

The balance within the international oil market at the various moments

of the year hinges on these two variables. All the other factors are only

a consequence, sometimes with an aesthetic effect, while at other times

exercising a magnifying inﬂuence.

The role of ﬁnance has inﬁltrated these mechanisms and manipulated

them in an exaggerated and speculative manner. Financial analysts, for

their activities on the stock exchange, use algorithms based on statistic

functions and they are, therefore, able to detect the repetition of cyclic

phenomena, which every year, spanning a decade by now, are seen on

the oil market. We are talking about a speculation that, in a free market

regime, can in no way be stopped, at least until the current structural

gap between productive systems and the level of demand for clean fuels

is modiﬁed. Unfortunately, not only is there no plan for a solution on

the horizon, but there is no sign yet of any awareness of the size of

the problem.

Before ending this discussion on the structure of the current oil market

model, we should clarify a fundamental concept. It’s normal to afﬁrm

that speculative factors and unforeseen events in operational practice

may make the use of the classical model based on supply and demand

88 Understanding Oil Prices

difﬁcult, but that in the long run the dynamics of the fundamentals will

prevail. This afﬁrmation is certainly understandable making clear that

short term corresponds to a period of time in which the bottlenecks of

the industrial reﬁning system will be overcome. In our case, we have

seen that for nearly ten years we are in a systematic short-term context

with the reﬁning limits that we have already examined. Unfortunately,

it is unclear when they can be removed from the scenario.

The Brent Market

Brent and the market for Brent have been mentioned several times. The

features of this market will be outlined without going into technical

speciﬁcs which concern the professionals. It will be explained why the

adoption of Brent as a benchmark triggered a revolution that pushed

both the producing countries and the oil companies out of the game

regarding the control of the price of oil.

Brent is an offshore crude extracted off the Shetland Islands, part of

the UK. It was the centre of one of the ﬁrst oil strikes in the North Sea and

certainly the most important, historically and politically. Shell UK, the

ﬁeld operator together with Exxon, gave the crude the name of a typical

goose found in the region, namely the Brent goose. The discovery of

Brent dates back to July 1971 but it was only on 13 December 1976 that

the ﬁrst oil tanker sailed from the loading terminal with a cargo of Brent

crude. Initially, the production was exported from the offshore terminal

of Spar, and subsequently, since November 1979, from the terminal of

Sullum Voe. This terminal also receives, apart from Brent, Ninian, a

crude discovered and extracted by the BP/Chevron consortium. In this

way the exported crude became the Brent blend, which collected the

production of around 15 ﬁelds in the North Sea operated by the two

consortia, Shell UK-Exxon and BP-Chevron.

The Sullom Voe terminal, with its four jetties for export, allowed the

simultaneous loading of four tankers of each type for whatever tonnage

and size. It was the biggest and more ﬂexible oil terminal of the time. It

could handle whatever requirements of the customers, supplying wide

ﬂexibilities in loading dates. North European reﬁners could consider it

almost an extension of their storage capacity and dispose of a cargo of

Brent blend in 2–3 days.

Brent is considered a light sweet crude with its features of API (38

degrees) and sulphur content of 0.45%. The Blend crude is typically

reﬁned in North-West Europe and, by processing it, mainly gasoline

and medium distillates are obtained. It soon became clear that Brent had

no difﬁculties in competing with crudes of similar quality from OPEC

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

90 Understanding Oil Prices

countries like Nigeria, where the services are certainly poorer – so, for

the same quality and price one would choose Brent.

The winning move, however, came in July 1986, when Shell UK, as

the operator of Brent, decided to publish the 15 days Brent Contract. To

understand what ‘to publish a contract’ means, and speciﬁcally for crude,

some background information necessary to understand the mechanism

involved will be provided.

THE SALE AND PURCHASE CONTRACT

We ﬁrst have to explain what the structure of a purchase contract for a

cargo of crude is. From the technical, commercial, administrative and

legal standpoints, this is a very complicated document, and in order for it

to be ﬁnalized, it needs the work of qualiﬁed international professionals.

In fact, it is not enough to simply have ﬁnancial resources and business

acumen to enter the world of crude trading. A very speciﬁc professional

competence is required. For the purpose of illustrating the complexity

of the issues and hence the effects of the notable changes caused by

Shell UK’s introduction of the standard for Brent (15 days), we have

brieﬂy summarized the series of fundamental clauses that make up the

structure of a contract in Box 8.1.

Box 8.1 The Principal Clauses in a Sale and Purchase Contract

The main clauses of a purchase contract for a cargo of crude oil are

as follows:

1. Detail of the Parties: clear descriptions of the seller and the pur-

chaser (name, address, company details).

2. Grade: descriptions of the essential features of the crude oil/object

of the transaction, not to allow any ambiguity.

3. Quantity: the exact deﬁnition of the size of the cargo in terms of

barrels and indication of the ﬂexibility guaranteed at the moment

of loading, namely the possibility that the ship is loaded with

more or fewer barrels than the quantity envisaged in the contract.

Normally, the purchaser may request a variation of +/−5%, but

he can obtain this only if the terminal operator agrees.

4. Delivery: deﬁnes the conditions and manner with which the seller

delivers the crude to the purchaser (Incoterms), such as:

The Brent Market 91

rFOB (FREE ON BOARD): the purchaser receives the crude at

the terminal where he must present himself with his ship on the

agreed day, and he becomes immediately its owner. This deﬁnes

the classic purchase model for goods, when the purchaser enters

the seller’s shop, buys, pays, becomes owner and takes away the

goods purchased;

rCFR (COST AND FREIGHT): the seller arranges on behalf of

the purchaser the transport of the crude from the loading terminal

until the point of delivery, obviously passing on the pertinent

costs. The title of the goods transported is of the buyer. Here

too we may refer to the model of a shop, where the purchaser

buys, pays, becomes owner (for example, of a movable object)

and requests the seller to arrange the transport (paid apart) to

his own residence;

rCIF (COST, INSURANCE AND FREIGHT): as in the previous

case, but with the addition of the insurance for the value of the

cargo transported. We may refer to the previous example, where

an insurance policy is requested against damage suffered during

transport;

rDES (DELIVERED EX SHIP): the seller, whether he has not

yet found a buyer or whether he wants to wait before selling,

loads the crude on a ship and tries to sell it during the voyage.

Obviously, delivery takes place at destination, likewise for the

transfer of ownership. An example from everyday life could be

that of the itinerant salesman who travels around with his goods

which he owns, and meets the purchaser on his front doorstep.

5. Price: the formula for calculating the price of the cargo must be

described unequivocally, indicating:

rthe reference benchmark (Arabian light, Brent)

rthe days considered for calculating the average value of the

benchmark (the pricing period, that is the average of the month

of loading, 5 days around the loading date), the price difference

to apply to the benchmark (premium or discount) for the speciﬁc

crude/object of the contract, automatic price adjustments in case

of variation in the quality of the crude delivered vis-`

a-vis the

contractual standard.

6. Invoicing Quantity: the seller’s invoice must show the quantity

that will be advised by the operator in the ofﬁcial document that

accompanies the cargo, the so-called Bill of Lading (B/L). The

92 Understanding Oil Prices

purchaser will be required to effect payment on the basis of this

quantity. In case of dispute, the purchaser may complain but cannot

reduce the amount of the payment.

7. Payment: in the oil industry, this clause is sufﬁciently standardized

and envisages that the payment:

rmust correspond exactly with the clauses of price and quantity,

without any discount, deduction or compensation for any reason

whatsoever;

rit’s normally effected in USD;

rmust take place by telegraphic transfer available to the seller on

the same day;

rmust be effected within 30 days, as of the date of issue of the

Bill of Lading;

rafter the buyer receives a commercial invoice and the original

copy of the B/L or an LOI (Letter of Indemnity).

The clause also deﬁnes other aspects, such as:

rthe opening of a letter of credit (or other documents of credit)

by the purchaser, before loading;

rwhat to do if the day of payment falls on a day when the banking

system is closed (payment due the day before or after such

closure);

rhow to compensate the seller in case of delayed payment: nor-

mally payment of interest (at 2% above LIBOR) is required.

8. Property and Risk: as deﬁned in the delivery clause, the time and

place where the transfer of property takes place and consequently

every risk that is passed to the owner will be speciﬁed (loss of

cargo, pollution of the surrounding environment).

9. Independent Inspection: both contracting parties are entitled to

appoint an independent inspector who can superintend all the

loading operations and certify the quantity and quality of the

cargo. Normally the parties agree on the name of the inspector

and share the costs.

10. Tankship Nomination: the owner of the cargo (buyer or seller,

depending on the delivery conditions) must:

rarrange and ensure the arrival of a ship at the loading terminal at

the date envisaged for loading, advising in good time the name

of the ship;

radvise the terminal operator at least 72 hours before and sub-

sequently updating the estimate 48 hours and 24 hours before

The Brent Market 93

the date and hour of arrival of the ship at the terminal (ETA =

Expected Time of Arrival);

radvise the terminal operator who to contact regarding any

operational action to be taken;

rbe certain that the owner of the chartered ship is a member of the

ITOPF (International Tanker Owners Pollution Federation Ltd),

so as to give the terminal every guarantee in case of accident

and pollution, and ensure respect of all the international norms

regarding insurance, transport of alcohol and drugs, as well as

safety and maintenance.

In the absence of these requisites the access of the ship to the

terminal may be refused.

11. Conﬁdentiality: all the information contained in a commercial oil

contract is strictly conﬁdential between the parties and cannot be

divulged to anyone without the prior approval of the other party.

The only exceptions envisaged are:

rin cases of legal disputes and limited to that speciﬁc use;

rin cases of speciﬁc request by the tax authorities of the country

of the seller/producer of the crude.

12. Measurement and Claims: this clause sets out the rules in force at

the terminal, the measuring systems to be used and the procedures

to adopt in case of claims made by the purchaser in instances

of non-conformity with the standards prescribed by the contract,

including appeal to an independent inspector.

13. Laytime: this deﬁnes the number of hours available to the terminal

to load a ship of given size.

14. Demurrage: for any time exceeding that allowed for loading, the

compensation for the purchaser (who has to await the ship for

longer than planned) is established.

15. Governing Law and Jurisdiction: one of the key clauses in an

international contract is the deﬁnition of the jurisdiction to refer

to and the law to be applied. Normally in oil contracts reference

is made to English law.

It is also necessary to state whether, in case of dispute, arbi-

tration or the High Court will be submitted to, and to agree on

which one.

16. Force Majeure: this clause deﬁnes the list of all the exceptional

events deemed sufﬁcient to suspend the obligations of the con-

tracting parties (for example, interruption of production in the

94 Understanding Oil Prices

oilﬁeld and therefore the impossibility for the seller to deliver the

cargo, documented breakdown of the ship and impossibility to

reach the terminal in good time).

17. Letter of Indemnity: this states that in case of loss or delay of the

Bill of Lading, before payment, the buyer must receive the letter

of indemnity which can replace the original documents while they

are being searched for or re-issued.

18. Assignment: the parties can assign the ongoing contract to another

subject (afﬁliated or otherwise) who will assume all the obligations

and rights deriving from the contract itself.

19. Liability: this deﬁnes the terms and limits of criminal and civil

responsibility of the parties.

20. Other clauses.

21. Contact addresses of seller and buyer.

As can be clearly seen, to ﬁnalize a purchase contract for a cargo of

crude oil is a very delicate and complex matter requiring very speciﬁc

professional competences.

THE FORWARD MARKET FOR BRENT

(15 DAY BRENT CONTRACT)

The revolution introduced by Shell UK consisted of the total standard-

ization of the purchase and sale contract for a cargo of Brent crude. All

the clauses had already been deﬁned in detail and could not be either

re-negotiated or modiﬁed. Anyone who wanted to buy or sell a cargo

of Brent blend only had to use the standard contract, without getting

involved in any of the complicated legal and administrative aspects of

the commercial negotiation.

The only items to state in the contractual document were:

rnames of the contracting parties, seller and buyer; and

rpurchase price per barrel.

As already mentioned, for all the other clauses, reference was made

to the standard contract published by Shell UK. In particular, the stan-

dardizations concerned:

rthe quantity, ﬁxed at 500,000 barrels for each cargo; and

rthe acceptance date of the cargo by the buyer, namely 15 days before

the loading date, hence the name given to the contract: 15 days Brent.

The Brent Market 95

It was moreover to buy and sell cargoes of Brent which were to be

produced and delivered in the following six months. This simpliﬁcation

of the negotiating process immediately ampliﬁed the possibilities of

taking part in the business, even for those not strictly linked to the oil

and related markets. Anyone with ﬁnancial resources and a certain feel

for the oil market (perhaps with the help of a qualiﬁed consultant) could

enter the Brent market game. It was not yet the petroleum exchange and

the pure ﬁnancial market, but this was the ﬁrst splinter from the historic

conﬁnes of the petroleum elite.

Box 8.2 The Daisy Chain

Let us try to explain the mechanism of the 15 day Brent market with

an example.

Suppose we are in January with the Brent market rather weak (as

happened in 2009) and above all with prospects that are even more

negative. A trader (B) decides to bet on a market recovery in April.

He tries then, in January, to buy a cargo of Brent for the month of

April. He believes that, amid the general pessimism, he will be able

to buy in January the April cargo at a lower price than he would be

able to buy in the future. He goes into the marketplace and tries to

ﬁnd someone who will sell him an April cargo. Suppose the going

price for Brent on 18 January (the day when he entered the market)

was $45 per barrel and for an April cargo his seller (A) asks for a

price of $43 per barrel.

Suppose now that (A) and (B) close the deal in the morning of

18 January and that, later the same day, something happens (such as

a burst pipeline in the Middle East, new maintenance programmes

in the North Sea production ﬁelds) which causes an immediate rise

in prices. Trader (B) sees that the April cargo, which he had bought

at 10:00 a.m. for $43 per barrel, by mid-day, only two hours later,

is worth $47 per barrel and he thus decides to sell it to (C) who in

competition with others has already offered him as much as $47.50

per barrel. He has registered a proﬁt of $4.50 per barrel, just with two

phone calls (and a good understanding of the market).

These deals, which began on 18 January for a speciﬁc April cargo,

can continue almost to the inﬁnite, up to a certain date in March. We

are describing the creation of a chain of transactions inside which

hundreds of different subjects can participate. It may even happen

that the same cargo passes through the hands of the same subject

several times. If we try to draw on a sheet of paper the succession

96 Understanding Oil Prices

of transactions inside the same chain, with the passage of the cargo

into the hands of the same subject, then we shall see that the sketch

recalls the petals of a daisy. It is for this reason that the chains are

known as daisy chains in petroleum slang. Naturally we are referring

to what happens for one cargo, but every day the chains behind

these transactions are dozens and dozens for each of the six months

following the current one (in our example of January, all the cargoes

up to the month of July in the same year can be negotiated). It is clear

that every day, starting from a single physical cargo of Brent that will

be available on a certain date as yet unknown, a number of cargoes of

Brent will be bought and sold, simply on paper, with contracts that

will not give rise, almost certainly, to the physical delivery of all the

barrels effectively exchanged.

In our example, (B) has on the same day bought from (A) and

sold to (C), earning $4.50 per barrel, without receiving or delivering

any cargo of crude. The aggregate of the transactions can reach an

enormous amount. For this speciﬁc market of 15 days Brent, peaks of

dealings have reached around 50 million barrels per day, in contrast

with a physical production of Brent blend of 700,000 barrels per day

in the good times. Today the ﬁeld produces only 200,000 barrels

per day – 15 days Brent contract has a volume of business 70 times

greater than its physical production.

Now the strategic objectives of the creation of the 15 days Brent

contract become clearer:

rCreation of a benchmark whose apparent production, in terms of daily

trading volume, was by far greater than any other benchmark proposed

and applied by OPEC.

rMake available a benchmark beyond OPEC’s control, supervised and

regulated to a large extent by the oil companies that produced Brent.

Box 8.3 15 day Brent Contract

Let us return again to the previous example. The chain was formed

on 18 January and up to March had involved thousands of subjects

within itself.

It is clear that at a certain point, the April cargo, the subject of the

deals between all these traders, will materialize and someone will

have to take his ship to the terminal at Sullom Voe and collect the

The Brent Market 97

cargo. If the person who has to collect the cargo is a reﬁner, there

will be no problem. If, however, the cargo ﬁnishes up in the hands of

someone who entered the chain just to speculate, then there will be

a problem to resolve. This person will have to handle the placing of

the cargo in the market and ﬁnd a reﬁner who needs it (obviously at

a suitable price).

Let us see how the process of assigning a speciﬁc physical cargo

to a person in the chain operates. We refer to the historic procedure,

the one that gave origin to the name 15 days Brent. Recently some

changes have been introduced and we shall examine them later.

For clarity we refer to the April cargo. On 13 March, BP, the

terminal operator at Sullom Voe, will publish the programme of all

the cargoes to be lifted during the month of April. This means that

for each separate cargo (in all about 25 cargoes) the following are

made known:

rthe loading date; and

rthe name of the producer (BP, Shell UK, Exxon, Chevron), owner

of the cargo as a mineral right. Obviously each of these cargoes

has been sold to other purchasers through the 15 days contracts.

Once the lifting programme has been published, the owner of each

separate cargo must, 15 days before the estimated loading date, advise

the terminal operator that he accepts the obligations (nomination of

the cargo) and guarantees the dispatch of a ship in good time to collect

the cargo. As previously explained, the obligation to nominate the

cargo 15 days before the loading date has given this contract the

name of 15 days Brent. But who is the owner of the cargo of Brent

that will load, for example, on 5 April? Pinpointing the owner takes

place with a particular mechanism. The mineral partner, the ﬁrst

owner of the cargo (as published by the operator) will telephone the

person to whom the cargo was sold, passing on to him the obligation

to nominate the cargo to the operator. The telephone used must be

totally and exclusively dedicated to this service. It must never happen

that a participant in the chain does not answer a call. Moreover,

this telephone is connected to the services of British Telecom, who

records and informs the exact time of the calls.

Every person who receives a call must decide whether to accept

the nomination or pass it on to the next person in the chain. Clearly

98 Understanding Oil Prices

all those who entered the chain for speculative purposes will try to

exit quickly, passing the nomination along to their purchaser.

If we consider the number of those in the chain, the number of tele-

phone calls could go ahead ad inﬁnitum. But there is a limit set by the

conditions of the contract. The person who receives the nomination

by 17:00 hours London time and does not succeed in passing it on to

the successive trader or purchaser always before 17:00 hours London

time, is obliged to nominate the cargo. If this person has suffered

the nomination, in slang he is said to have been ‘ﬁve o’clocked’.

Once the physical cargo is assigned to a person in the chain, all the

other participants must, in any case, settle their commitments. This

means that the person who takes the physical cargo must, however,

purchase a paper cargo (of the same month) to deliver to the person

after him in the chain. The natural solution of the mechanism would

be for the physical cargo to go to the last person in the chain. But this

rarely happens.

The market in which the physical cargoes of Brent are traded, whose

loading date is already known, is called the Brent Dated Market. This

price, published by specialized sources, establishes on a daily basis, the

market reference since the time when Brent became used as benchmark.

Participation in the 15 day Brent therefore offers the risk that, statisti-

cally, one may become the owner of a physical cargo of crude that must

be handled, something that is certainly not easy for anyone who is not

a producing company or a consumer of crude.

Box 8.4 The Price Risk in the 15 day Brent Contract

The example we have seen, an April cargo bought in January, is useful

to comprehend the size of the potential risk for one who speculates

with this contract.

We supposed that (B) bought the April cargo at $43 per barrel

from (A) and sold it to (C) at $47.50 per barrel. Suppose now that

(B) is the ‘ﬁve o’clocked’ trader, obliged to nominate the cargo and

market it on the physical crude market. If for some reason the April

market has crashed to $20 per barrel, our trader (B) will be forced

to sell at $20 per barrel what he bought at $43 per barrel, risking an

enormous loss. Furthermore, he will be obliged to buy a paper cargo

for his purchaser (C).

The Brent Market 99

This is exactly what happened on the London market in 1987, with the

famous ‘blood bath’. Many traders, facing certain bankruptcy, preferred

to refuse the nominations and abandon the activity.

In these cases, the Brent producers (BP, Shell UK, Exxon and

Chevron) had to take the place of the traders who were missing in

the chain and take responsibility for the collection of the so-called dis-

tressed cargoes. These occurrences showed that Brent forward, another

name for 15 days Brent, was not a perfect ﬁnancial instrument, both

because it showed it was not able to censure the functioning of the

mechanism in cases of crisis with big falls in price levels, and because

it limited the number of participants to those who could:

rshoulder ﬁnancial commitments at least equal to the value of a cargo

of 500,000 barrels;

rguarantee the handling of a physical cargo should the need arise; and

rhonour their commitments in every market situation.

For these reasons, those participating in the Brent game, although

numerous, could be considered as qualiﬁed members of an exclusive

club. Structurally, however, it was regarded that the system’s fragility

was elevated at the moment when a forward contract for paper crude

became a physical contract for Brent crude. This step in the chain’s

mechanism could become ‘traumatic’ creating anomalies in the system

and substantially modifying price levels.

With some similarities to other markets, which we hope will not take

offence, one could assert that the 15 days Brent constituted a market

d’elite, a sort of high fashion atelier of the oil market, where:

revery contract was between two parties identiﬁed with names and

surnames;

rthe price was the outcome of free negotiations between these two

parties; and

ra high-level professional and ﬁnancial proﬁle was required of the

participants.

It became clear that the objective of a totally liquid and transparent

market, with a daily trading volume equal to at least the oil production

of the globe, had not been achieved. Yet, the creation of this benchmark

has, in terms of dimensions and ﬂexibility, outclassed the old Arabian

Light crude.

100 Understanding Oil Prices

THE IPE BRENT MARKET

What was needed was a mass-market Brent, a supermarket type Brent,

an off-the-peg for the oil market. With this intent, in 1988 a new Brent

market, purely ﬁnancial, of a stock exchange type was created – the

International Petroleum Exchange, IPE.

The features of this market were and continue to be:

rNominal cargo (lot) reduced to 1000 barrels (no longer 500,000 bar-

rels), a size which, at the prevailing prices, made it comparable to the

value of similar ﬁnancial operations on the stock exchange, such as

the purchase or sale of company shares. It is a much more popular

size, one that allowed the grocer or the barber (as one used to say)

to get involved in the dynamics of the oil market, to have an opinion

about OPEC and to feel him or herself adequately informed after

reading the news.

rNo delivery of physical oil was possible or envisaged (except for one

precise case, more theoretical than practical). In this way, the critical

and fragile passage, inherent in the 15 days Brent, was eliminated from

the paper contract at the nomination of the physical cargo. Anyone

could play around in this market without running the risk, one ﬁne

day at 5:00 p.m., of hearing that they had become the owner of a

physical cargo of crude which had to be handled.

rThe transactions no longer took place between single parties, a buyer

and a seller, but between any party whatsoever and a clearing house

(the Exchange). It was like going to the supermarket, a particular

supermarket where one could buy and sell products, but where the

price was not negotiated, but only read, made known on an electronic

screen second by second with the ﬂuctuation of purchases and sales.

rEvery trader could sell or buy short what he or she did not yet possess.

Every operation conducted on this market had to be closed within a

certain time, as with the stock market. One could buy a lot of crude on

day ﬁve, when the price was, for example, $50 per barrel, and resell

it on day seven, when the price had become $52 per barrel. Or vice

versa one could sell a cargo at $52 per barrel and re-buy it when the

price was lower.

It was precisely here that the revolution in the international oil market

took place. This market had no longer any connection with the phys-

ical crude oil market opening it up to the participation of any person

The Brent Market 101

capable of investing through normal banking channels, just as one does

in the stock market. It was initially the oil markets’ institutional bod-

ies, companies, trading houses and banks acting on their clients’ behalf

that turned their attention to this new ﬁnancial product. At a certain

point, particularly after the start of the 21st century, when the market’s

volatility reached very high levels, thus, allowing those who traded

in the market to make enormous proﬁts, the main protagonists then

became the banks and ﬁnancial institutions who together with various

US and international funds, started to operate the market as a pure

ﬁnancial venture, totally independent of the dynamics of the oil market.

Enormous movements of capital were seen, thousands of billions of

dollars were rapidly shifted from various commodities and from the

stock market towards the ﬁnancial market of Brent, causing the price

to rise, or fall, in the case of operations in the other direction. Price

variations of $2–5 per barrel in one day became normal. This in itself

became a big incentive for other parties to enter the business. So, at one

point, a kind of fever enveloped the banks to hire experts in oil trading

(poaching them from oil companies) to start and develop this business.

Quite clearly, we are talking about Brent, but we could extend all the

concepts discussed to the analogous NYMEX market, the petroleum

exchange of New York, where the WTI (West Texas Intermediate), the

other crude comparable to Brent, is traded.

OPEC’s decision to use Brent as a benchmark came soon after the

birth of this market, effectively handing over total control of the oil

price to international ﬁnance. Not everyone understood immediately

the extent and consequences of what happened in 1988. There were

many misunderstandings and perhaps the lack of a full perception of

the mechanics of the commodity and stock exchanges in the decision

adopted by OPEC. From the documents of the time and the declara-

tions of the main players, it stands out clearly that the wish of OPEC

was to link its crude prices to that of physical Brent crude in offshore

UK, thus, pressuring that government to force it to negotiate its level

of production.

One presumed a new edition of the price war that was declared two

years earlier by Sheikh Yamani. No-one understood that a ﬁnancial

indicator was being adopted as a benchmark, outside the control of the

UK government and the companies producing Brent. It was an easy

mistake to make as the chosen benchmark was the value of Brent Dated,

which ofﬁcially represented the price of physical cargoes of Brent whose

loading date was already known.

102 Understanding Oil Prices

The price of a physical cargo sold by one party in the chain (perhaps

forced by circumstances to nominate the cargo) to a reﬁner is normally

not known. Neither of the two parties that sign a contract for Brent wishes

to inform the market of the damage suffered or the advantage obtained

and, thus, the value published by the sources is simply estimated on the

basis of the indications coming from the parallel ﬁnancial market of that

day. Likewise, once the Brent IPE market was developed, it became a

fact that dealings on the 15 days Brent market were inﬂuenced by what

was read on the electronic screen of the Brent exchange. It therefore

came about that the value of the ﬁnancial Brent IPE generated all the

other intermediate values that lead to the price of all the physical cargoes

of crude sold in the world. Brent IPE generates the Brent 15 days, from

which Brent Dated is derived, which in its turn is the basis for setting

the price for all the crudes of the world.

THE DIVORCE BETWEEN OIL PRICE AND OIL

This bond was made ofﬁcial and duly sanctiﬁed by the decisions taken

in 2002 by Saudi Arabia and Iran not to refer to the value of Brent Dated

to set the price for their crudes, but rather to directly use the Brent IPE.

They wanted to eliminate the intermediate step in the assessment of the

value of Brent Dated by the specialized sources, whom they accused of

being insufﬁciently neutral. It was in this new context that the divorce

between the oil price and oil itself came about.

Let us suppose that on one ﬁne day, because of ﬁnancial operations

by hedge funds, there was a massive purchase in the exchange of Brent

contracts and that its price went up several dollars per barrel. That same

day, the price variation would be reﬂected along the entire chain of

the various types of Brent; the Brent 15 days and the Brent Dated.

Consequently, this would have an impact on all crudes sold which

use it as benchmark. If an analyst tried to relate the variation in the

Brent price on that particular day to changes in the dynamics of offer

and supply of crude, he would need a ﬂight of fantasy to imagine

events and their impossible and illusory correlations. The only link

remaining between the ﬁnancial markets of Brent and the physical one

for crude is that of a certain sharing between ﬁnancial professionals and

oil traders of the market analyses as published by specialized ﬁrms. It

should be noted that the studies and analyses published by the research

departments of various international banks involved in this business

have become predominant in recent times. The remarkable rise in the

The Brent Market 103

price of Brent to $147 per barrel in July 2008 was preceded by a series of

analyses published by Merrill Lynch and other banks, which predicted

(inﬂuencing the market?) an escalation of the price up to $250 per barrel.

As from May 2000, the ICE platform (Intercontinental Exchange) was

created, and this subsequently assimilated the IPE and other institutions

present in the sector. The scope was to create a sole platform that would

allow professionals all over the world the opportunity to operate online

in the oil futures markets, 24 hours a day.

Principal Uses of the Forward

and Futures Markets

The two markets, 15 days Brent and the ﬁnancial ICE, have continued

to co-exist, simultaneously working in the price setting process, whilst

still responding to the different needs of traders.

TAX SPINNING

The ﬁrst activity of the crude oil producers of the United Kingdom was

to optimize the taxation burden (tax spinning). The taxes due to the

department of Inland Revenue were set as a ﬁxed percentage (40–50%)

of the value of each single cargo. The lower the price, the lower the

taxes to be paid. The price had to be advised by each producer within

48 hours from completion of loading. This allowed the producing com-

panies, in the two days following the loading, to intensify their trad-

ing operations on physical cargoes, and to attribute the lowest of the

prices obtained to the cargo just taken and to declare it to the Inland

Revenue with evident and sizeable tax advantages. This practice was

tolerated by the British authorities, as a form of incentive to invest in

offshore activities. Recent years have, however, seen limitations and

restrictions being gradually imposed on this tax ﬂexibility, forcing com-

panies operating in the UK to pay taxes corresponding to the prices

actually obtained.

BENCHMARKING

Brent Dated has been and continues to be used as the benchmark for

more than 60% of the crudes sold worldwide (look back to Figure 3.2

which shows the price of crude with reference to the benchmark). All the

crudes linked directly to Brent were valued by establishing a differential

vis-`

a-vis the assessment as published in Platts on a given day.

For example, on 20 July a cargo of Bonny Light (a Nigerian crude) is

valued on the market as Dated Brent +$1.50 per barrel. The valuation

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

106 Understanding Oil Prices

Table 9.1 Correlation index between Brent and other

international crudes

Crude Origin Correlation

Es Sider Libya 1.000

Suez Egypt 0.995

Escravos Nigeria 0.998

Ekoﬁsk North Sea 0.995

Ural Khazakstan 0.997

Kirkuk Iraq 0.995

Cabinda Angola 0.996

Iranian Light SK Iran 0.986

Source: eprm

of the crude for that day, 20 July, will reﬂect the value of Brent of that

day plus $1.50 per barrel. That is, if Brent stands at $75.00, the value of

the cargo of Bonny Light will be $76.50 per barrel.

Table 9.1 shows the index of correlation between Brent and crudes

from around the world since 1990.

One can understand how the assessment process affected by the spe-

cialized sources may represent a critical element in deﬁning the value

of a crude and, thus, the oil revenues of each single producing country.

The main sources of information, Platts, Argus, LOR and Reuters, are

continuously criticized by the producing countries for their activities

being slanted towards protecting the interests of the oil companies. To

avoid repeated discussions on the matter, in deﬁning the value of Brent

it is often preferred to cite the average of the values published by the

various sources, so as to depend less on the personal views of the analyst

who made that assessment.

HEDGING THE PRICE RISKS

A separate chapter is dedicated to describing the main activity that was

made possible by the introduction of the Brent market, and which turned

out to be the Trojan horse of the ﬁnancial world to take, by storm, the

oil market and break the power of the historical leaders, the producing

countries and oil companies. This is the so-called hedging, in other

words coverage of price risks.

After the international events that took place towards the end of the

1970s, we have seen how price volatility created conditions of total

uncertainty for oil company operations, both in the short (procurement

Principal Uses of the Forward and Futures Markets 107

for the reﬁning system, level of stocks) and long term (investments

in the borderline areas whose production costs are higher). The Brent

market, already in its ﬁrst form, the 15 days Brent, but certainly much

more so with its purely ﬁnancial form as in Brent ICE, offered and

continues to offer a way to eliminate or signiﬁcantly limit the risks of

oil professionals. The ﬁnancial managers of these activities presented

themselves, at quite acceptable costs, to their oil company contacts as

insurers against the risk of price ﬂuctuations. They were very successful

in this role, building up a colossal business, which in the long run has

completely inverted the roles played by everyone. Finance has become

the fundamental business, the core business, with oil becoming a non-

essential marginal incident.

A few examples will be given, quite simple and straightforward, to

allow the reader who is not familiar with these operations to dip his or

her toes into the world of ﬁnancial hedging and the speculative activities

linked to this sector.

Box 9.1 First Example of Hedging

As a ﬁrst example let us take the case illustrated in Figure 9.1 below:

20.00

16.00

5 Feb 15 Mar

Brent

($/bbl)

Brent Sale

(Hedging)

Brent Purchase

(Hedging)

Lock of the

Differential

Physical

Sale

Figure 9.1 Example of price-lock hedging

108 Understanding Oil Prices

Let us suppose that on 5 February an oil company, producer of

a certain quality of Nigerian crude (e.g. Nigerian Brass River), is

informed by the export terminal operator, that it must lift a cargo of

1 million barrels of Brass River on the coming 15 March. Obviously,

since the company in question is a partner in the joint venture that

produces the Brass River crude, the delivery of this cargo corresponds

to its production quota, so that it can recover its investments in that

month. The company must therefore lift the crude at the terminal

and try to sell it in the market at the highest possible price so as

to maximize its proﬁt. As soon as he is contacted by the terminal

operator, the commercial manager of the oil company puts his sales

strategy into effect. Referring to our example, in order to make his

decisions, he will make two assumptions:

rThe crude price on 5 February is $20 per barrel.

rMarket sentiment for the following weeks is very negative and

there may be a signiﬁcant fall in prices. Therefore, there is a real

risk that the price on 15 March (estimated loading date) will be

lower than that of 5 February.

The commercial manager will, therefore, try to sell his cargo of

crude as soon as possible, perhaps trying to freeze today’s price.

Obviously the potential buyer has the same information and will

hence try to do the exact opposite. Moreover, it is common prac-

tice in the oil industry that the price of a cargo is established on

the basis of the market values on the day of loading, therefore, in

our example, on the basis of the value ruling on 15 March. In the

end, the cargo will be sold at the standard market conditions and

accepted by the purchaser, namely at the price of Brent Dated ruling

on 15 March, which no one knows. The negotiation is concluded

(deal done).

But our commercial manager does not resign himself to suffering

the uncertainties of the market for the more than 30 days wait until

the loading date. He decides to enter the paper Brent market.

The same day, 5 February, in which he has sold his cargo of

1 million barrels of Brass River, he also sells 1 million barrels of

Brent futures (short, he does not have them yet). Please note that

in order to simplify the example, we assumed the hedging costs to

be nil.

Principal Uses of the Forward and Futures Markets 109

In practice, in the same day he has effected two commercial

operations:

1. He has taken a contractual commitment to sell one cargo of Brass

River which will load on 15 March, at the price of Brent ruling in

the market on 15 March.

2. He has effectively sold (on the petroleum exchange) 1 million

barrels equivalent of Brent at the price ruling on 5 February.

At this point he can only await the market outcome.

Let us suppose that, for once, the market forecasts are correct and,

therefore, the crude price falls in the following weeks to reach $16

per barrel on 15 March. That same day the purchaser’s ship presents

itself at the terminal and loads 1 million barrels of Brass River.

Obviously, the purchaser has paid the agreed price, that is, that of

Brent at 15 March, namely $16 per barrel, with an overall outlay of

$16 million. At the same time, our man decides to close his position

with the petroleum exchange, buying exactly 1 million barrels of

Brent today (the same quantity as that sold short on 5 February), at

today’s price of $16 per barrel. Having completed all his commercial

transactions built around this cargo of Brass River, the commercial

manager summarizes the situation:

million dollars

1. Sale of 1 million barrels of Brent ($20/b) +20

Hedging costs

2. Purchase of 1 million barrels of Brent ($16/b) −16

3. Sale of 1 million barrels of Brent ($16/b) +16

Overall result obtained +20

Our man, through the integrated deals done in the petroleum

exchange in the Brent market, has cashed in 20 million dollars from

the sale of 1 million barrels of Brass. He has succeeded in block-

ing the price of his cargo of Brass at the level of $20 per barrel

of 15 February. It is important to note that to obtain the result he

had to make two opposing deals on the same ﬁnancial market of

Brent. That is, he has doubled the volume of paper business vis-`

a-vis

the physical.

110 Understanding Oil Prices

In our absolutely straightforward and simpliﬁed example, we have

supposed that our man did nothing between 5 February and 15 March.

In practice, however, he will have followed the ﬂuctuations of the

market day by day, entering it with purchase and sale deals of

paper barrels, to take advantage of every opportunity to maximize

the proﬁts and reduce the losses.

For each physical transaction thousands of paper operations in the

Brent market may be associated, to the point that this market becomes

the most relevant and decisive to determine the mood of the market

and set the price of crude. It must be said here that to cover the price

risk, the strategy adopted by the various oil professionals is incredibly

diversiﬁed and has changed over the years. Some companies, right from

the start, have found in the risk hedging operations a fundamental way

to maximize proﬁts, to the point of making it an independent business

with the creation of organizational structures detached from the physical

trading of crude and petroleum products. They have, thus, created within

their organizations a sort of ﬁnancial group in competition with external

ﬁnancial institutions. Other companies have on the contrary tried to

reduce the hedging activities to the bare vital ones, introducing very

strict internal criteria for control and corporate governance.

Some companies that started out with the philosophy of the ﬁrst

group subsequently turned towards the second way of operating, often

after suffering signiﬁcant losses due to loss of control over the system

and the excessive enthusiasm of certain traders (no-one can forget the

historic banking houses that disappeared after the intemperance of some

over-creative rogue trader).

Box 9.2 Second Example of Hedging

Now we will look at a second example, of how a company can

implement strategies for hedging of its cargoes, cutting possible

recourse to the Brent market down to the minimum. For simplic-

ity, let us go back again to the example just elaborated and refer to

the same characters.

We turn back to 15 March, when our commercial manager has

concluded the operations regarding the cargo of Brass. Just at that

moment he receives fresh advice from the terminal operator that on

Principal Uses of the Forward and Futures Markets 111

29 March he must lift another cargo of 1 million barrels of Brass

River. Since the market scenario is still the same, namely depressed

and negative, he ﬁnds himself handling this second cargo, repeating

exactly the process just concluded. So on the same day 15 March:

rHe accepts the contractual commitment to sell a cargo of Brass

River that he will lift on 29 March, at the price of Brent ruling on

29 March.

rHe effectively sells (on the petroleum exchange) 1 million barrels

equivalent of Brent at the price of $16 per barrel on the day of

15 March.

On 29 March the price of Brent will turn out to be $14 per barrel

and he will complete, as in the previous case, the whole process by

effectively selling and cashing in the proceeds from his purchaser

of Brass (at $14 per barrel) and buying on the exchange (at $14 per

barrel) the million barrels to close the new operation opened on

15 March with the purchase of Brent. Overall, this time too the

balance of the situation is as follows:

million dollars

1. Sale of 1 million barrels of Brent ($16/b) +16

Hedging costs

2. Purchase of 1 million barrels of Brent ($14/b) −14

3. Sale of 1 million barrels of Brass River ($14/b) +14

Overall result obtained +16

This time too, the commercial manager has succeeded in blocking

the selling price at the level of the day when he concluded the deal

with the buyer, namely 15 March ($16 per barrel), thus avoiding

the lower price on 29 March ($14 per barrel). In the context of the

two physical sales, the paper market was used four times to carry

out the hedging operations. We said earlier that depending on the

commercial strategy of each company, these paper operations could

multiply ad inﬁnitum with daily actions on the oil exchange, such that

the hedging operations for the two physical cargoes become almost

a pretext.

In the case of a company that steers clear of ﬁnancial speculation,

is it possible to use the same technique of hedging of the two physical

112 Understanding Oil Prices

cargoes, reducing the number of the four operations executed in the

previous example?

20.00

16.00

5 Feb 15 Mar

Brent

($/bbl)

Brent Sale

(Hedging)

Physical Sale

Brent Sale

(Hedging)

Brent Purchase

(hedging)

Lock of the

Differential

10 Apr

14.00

Physical Sale

Lock of the

Differential Brent Purchase

(hedging)

Figure 9.2 Example of integrated price-lock hedging

Let us summarize all the operations carried out by our man in the

two cases:

millions dollars

5 February

1. Sale of 1 million barrels of Brent ($20/b) +20

Hedging costs

15 March

2. Sale of 1 million barrels of Brass River ($16/b) +16

Hedging costs

3. Purchase of 1 million barrels of Brent ($16/b) −16

4. Sale of 1 million barrels of Brent ($16/b) +16

29 March

5. Purchase of 1 million barrels of Brent ($14/b) −14

6. Sale of 1 million barrels of Brass River ($14/b) +14

Principal Uses of the Forward and Futures Markets 113

We have already seen the economic results obtained by the totality

of all these operations. Let us pause to examine only those actions

executed on 15 March and in particular the fact that on the same day,

and at the same price, the commercial manager has sold and bought

the same item (1 million barrels of Brent paper), dealing with the

same entity, the petroleum exchange. The ﬁrst time he did this was to

close his position regarding the ﬁrst Brass cargo and the second time

to open a new position for the second Brass cargo. From the economic

viewpoint the process makes no sense. He could simply avoid making

the two operations and still get the same result (saving the costs of

the operations, which we have not discussed, but which exist).

In practice, however, the fact that the overall result does not change,

even eliminating the two intermediate operations on the petroleum

exchange, signiﬁes that the hedging is anyway accomplished: but

with what hedging mechanism?

The lucky coincidence that the date of the second sale is precisely

that of the loading of the ﬁrst cargo ensures that the second cargo

acts as hedging for the ﬁrst.

It is preferable not to complicate still further the example by going

into real life where the complexity of the actual cases is obviously

more detailed and requires somewhat more sophisticated techniques

of application of the principles that have been illustrated. Let us limit

ourselves to noting that it is possible to obtain an acceptable level of

price risk reduction, and as such, a reasonable hedging effect, min-

imizing a recourse to the ﬁnancial market by means of appropriate

programming of:

rThe dates of lifting from the various export terminals.

rThe cargoes which are the property of a company or which have been

purchased.

rThe times in which to agree the sales’ details with the purchaser.

Obviously, the more cargoes a company handles in a month, the

greater are the possibilities of making this policy effective, that is, in

which a cargo bought or sold protects the other cargoes in the month and

is in turn protected by them. This technique is called portfolio hedging

and it is certainly the one that implies the lowest level of recourse to

the ﬁnancial market, minimizing traders’ temptation to speculate. To

114 Understanding Oil Prices

implement this hedging activity it is essential that a company is able to

programme actively and dynamically the physical operations of loading

at the various terminals, as well as the sales and purchases of outgoing

crudes. A command panel that is effectively under control can generate

enormous added value, often superior to what might be obtained through

sophisticated trading techniques.

SPECULATIONS ON OPERATIONAL

FLEXIBILITIES AT LOADING

At this point it is useful to give an example of how the paper market

can allow and make possible certain forms of speculation by oil profes-

sionals. This explains why the loss of control of the price system by the

producing countries and oil companies has not made many of them feel

like orphans.

Box 9.3 Example of Synergies Between Operational Flexibili-

ties and Hedging

We return again to a concrete example; on the famous starting day of

the previous examples, 5 February, when our commercial manager

is advised by the terminal operator of the date when he must lift his

March cargo. Suppose that this time the loading date is 30 March

(in the previous examples it was 15 March). When the manager goes

into the market to try to sell the cargo he ﬁnds two purchase offers

from his best client at these prices:

rthe price of Brent on the loading day (30 March) exactly as it is;

and

rthe arithmetic mean of the Brent quotations in the month of loading,

plus a premium of $1 per barrel.

He will have to decide which option to choose and then, eventually,

reﬂect on his hedging strategy. In view of the uncertainty regarding

the market in the following weeks (forecasts are always only fore-

casts), but considering a better price of $1 per barrel (which for a

cargo of 1 million barrels means 1 million dollars), the commercial

manager decides to accept the second offer and, thus, to sell the cargo

not at the price of the loading date but at the monthly average of Brent

quotations (see Figure 9.2).

Principal Uses of the Forward and Futures Markets 115

20.00

16.00

5 Feb 31 Mar

Brent

($/bbl)

1 Mar 30 Apr

Programmed

Date

Sale Options:

a.) Brent = 20.00

b.) Brent + 0.50 = 16.50

Figure 9.3 Example of operational ﬂexibility effects

Let us see whether the decision taken was the best option. Suppose

that once again the expectations for the Brent price are correct. Thus,

on 30 March the crude price will be $18 per barrel and the monthly

average for Brent until that day is $20 per barrel. Further, let us

suppose that projecting the trend for Brent into the following month,

it can be deduced that the April average will be around $16 per barrel.

With these facts in hand, the purchaser decides to play his own cards

to save $4 per barrel (meaning $4 million) on his deal. It is enough

for him to telephone the captain of the ship navigating towards the

terminal, to ask him to ‘take it easy’ and present himself at the berth

only in the afternoon of 31 March. The consequence will be that the

ship’s loading process will inevitably end after midnight of 31 March,

namely at the start of the month of April. Since the contract stated

that the price would be calculated based on the monthly average of

Brent in the ‘month of loading’, the purchaser will not pay $20 but

$16 per barrel.

But this is not all. Suppose that the buyer of the cargo is a reﬁn-

ing company of the same oil company that owns the cargo. On the

physical plane, the only effect will be a shift of income from one

department to another within the same company. If the two entities

116 Understanding Oil Prices

are in different countries with different tax regimes there could be

advantages or disadvantages deriving from a similar operation.

Now let us see what can happen if the physical operation in itself

is associated with a vigilant activity regarding the futures (dynamic

hedging). The seller as from 5 February knows that he has sold a cargo

of Brass at the monthly average for Brent in March (ﬁrst hypothesis).

In this case his hedging plan will be different. Starting from the ﬁrst

day of March, he will sell every day on the petroleum exchange a

quantity of Brent equalling 1/31 of 1 million barrels, thus striving

for a selling price for his cargo that is equal to the monthly average

($20 per barrel). When on 30 March he sees the situation, he decides,

together with his reﬁning company, to ‘shift’ the cargo from 30 March

to 1 April. That same day (30 March) he will close on the exchange

the positions opened during the month and buy 1 million barrels of

Brent at $18 per barrel (the day’s price), succeeding in selling at the

average price of the month ($20 per barrel) while having purchased

at $18 per barrel, earning $2 million on the exchange. Moreover, the

producing company will have to pay taxes on the cargo lifted based

on the average price of the month of loading, namely on $16 and not

on $20 per barrel. In addition, the sister reﬁning company will have

a cargo bought at $4 per barrel less, enhancing its reﬁning margins.

Thus an operation is concluded with three net results:

rEarning $2 million on the exchange.

rA net reduction of the taxation basis in the country of production.

rIncreasing the reﬁning margin by $4 million.

Some examples have been given at the academic level so as to allow

a glimpse of the complexities of the business that has developed with

the birth of the paper market of Brent, Forward and Futures, whose

interests have added to a business already exceptionally full of real

risks. It is sufﬁcient to reﬂect, just for a moment, on the size of the

interests that hang over the management of the loading terminals in the

various producing nations and how vital it is to ensure the transparency

of the information regarding the process of assigning the dates for lifting

the various cargoes.

In countries of unpredictable democracy and where the transparency

of these processes is lacking, we observe a frenetic activity by trading

companies that try to get their hands on crude supply contracts, although

Principal Uses of the Forward and Futures Markets 117

they do not have a reﬁning system behind them or an adequate trading

network. These ﬁrms try to acquire cargoes with especially favourable

conditions (particular dates) that they can sell off to other more solid

ﬁrms, sometimes earning a (huge) percentage of proﬁt. Obviously the

reality is much more complicated and those without adequate profes-

sional competences risk getting their ﬁngers badly burned. The list

of companies wiped out as a result of speculations that went awry is

very long.

MARKET STRUCTURE: CONTANGO

AND BACKWARDATION

In outlining the previous examples we made a series of simpliﬁed

assumptions to illustrate the basic concepts involved. The realities of the

market and industry practice today are obviously more complicated. Just

to hint at some of the complex factors we refer to the so-called market

structure. We have already seen how the 15 days Brent contract (even

in its new forms) allows, every day, the purchase of a cargo planned

for loading in the six months following the current one. The market

transactions concerning these cargoes generate, each day, the forward

quotations for the Brent price. Obviously, the forecast price for the future

months ﬂuctuates in line with market sentiments and the expectations

of the professionals.

Two market situations emerge:

rContango, where the Brent Dated price of today is lower than that

of the subsequent months. This is the classic situation where a price

increase is expected.

rBackwardation, where the Brent Dated price of today is higher than

that of the subsequent months. In this situation pessimism prevails

and the market expects a fall in prices.

Knowledge of the market structure allows and encourages many forms

of speculation.

Box 9.4 Floating Storages

As an example, we may mention what happened in end-2008 and

early-2009 – the speculation on whether crude cargoes were travelling

or held ﬂoating ‘on the water’.

118 Understanding Oil Prices

During the month of December, the so-called market structure of

Brent showed more or less this type of movement for the following

months:

Month Price, $ per barrel

December 43

January 48

February 50

March 52

April 54

May 56

This price structure offered the possibility for immense specula-

tions. Anyone who had bought a cargo of crude in December for

resale in December could have obtained a margin from the purchase

and sale of commercial operations limited only to price ﬂuctuations

between the moments of purchase and sale, both values around the

average price of $43 per barrel. If, however, he had succeeded in shift-

ing the moment of sale to a following month, seeing the quotations

of the following months, his margin would have become enormously

greater. In the example, for a shift between December and May it was

possible to arrive at $13 per barrel. For a cargo of 1 million barrels

this would mean $13 million of additional margin. With the typical

techniques of the futures markets it is possible to exchange (swap)

the price of one month with that of another, earning the difference

between the relative prices. Without entering into the technical details

of the operation, we will just say that to consolidate the economic

beneﬁt, the transfer of ownership of the physical cargo – on which

the speculation on the futures market is based – must pass from the

seller (who is speculating) to his buyer in the future month selected

as target for the price. It is easily appreciated that while the ﬁnancial

part of the operation on the futures market is relatively simple (it is

only a play on ﬁnancial transactions, stock exchange type), the phys-

ical part – maintaining ownership of the crude for months is not easy

to achieve. In fact the cost of the ship and the associated risks (envi-

ronmental and safety) must be taken into account. Since it is hard to

ﬁnd a buyer willing to accept these conditions of sale, the only way

to achieve the objective is generally to sell to oneself, or to a related

company. In practice, the tanker carrying the crude arrives normally

Principal Uses of the Forward and Futures Markets 119

at its destination. The crude is ofﬂoaded into the reﬁnery storage

tanks (rented by the seller), on behalf of the seller. The transfer of

ownership will take place between the two sister companies at the

most appropriate moment to maximize the margins of the operation.

The net margin will be that guaranteed by the ﬁnancial speculation

less the logistic costs incurred. With a potential of $13 per barrel

there is ample space to recover the costs.

PROCEDURES AT THE LOADING TERMINALS

From the examples we have just seen it is clear that the real value of

a cargo of crude is not given only by the price of Brent on the day

of loading, but by a series of factors that accompany the commercial

negotiation and the eventual trading operations also involved, namely:

rthe price differential agreed for that crude in that speciﬁc market

situation;

rthe hedging deals executed, to block the price at a level desired and

possible;

rthe eventual actions and operational ﬂexibility taken at the moment

of loading, with forward and backwards shifts of the loading date.

These are all actions that the birth of the Brent market has made

possible and that can have a decisive effect on the ﬁnal value of a

cargo. In particular, the most glaring effects can be derived, as we saw

in the previously elaborated, theoretical examples, from the combined

play of operational ﬂexibilities and oil futures. Many trading ﬁrms,

whose main scope is speculative, are present in the business of the

physical market for crude (buying and selling physical cargoes with

all the risks and work entailed) instead of limiting themselves just to

the game of speculation in the exchange, with the precise intention

of taking advantage to make enormous proﬁts inherent in combining

these transactions. Obviously, for these actions to be possible it is

necessary that rules exist at the various loading terminals which al-

low customers who present themselves with tank-ships to load crude

to be able to utilize and exercise some ﬂexibilities. It is furthermore

evident that the oil company that also acts as terminal operator there-

fore has detailed information regarding production, storage and size of

cargoes of the other partners and, with discretional powers over the

120 Understanding Oil Prices

ﬂexibilities permitted, can obtain the maximum advantage in placing

their own cargoes.

It is not unusual to observe within every joint venture bitter conﬂicts,

often difﬁcult to reconcile, when the so-called lifting procedures or

off-take agreements come up for discussion: these are the rules that

state how and when the various partners in a joint venture have the

right and obligation to lift the cargoes they are entitled to. Normally

the dispute regards certain fundamental matters. The ﬁrst concerns the

basic mechanism for the procedures, which may be of two types:

rThe mechanistic method, which on a given day in the same month

assigns the priority for lifting a cargo to the partner that on that day

has accumulated the most barrels in the terminal storage facility.

rThe nomination method, where the partners who in a certain month

have the right to lift a cargo of crude inform the terminal operator of

their desires regarding the loading date. The operator makes the ﬁnal

decision trying to satisfy the partners as far as possible.

Clearly the oil companies that act as operator (generally the majority

partner in a joint venture) will try to impose the second solution, while

the minority partners will try to defend themselves with the mechanical

method. The dollars in play can amount to an enormous sum and can

modify the degree of a partners’ investment recovery.

Then there is another series of factors, apparently technical and

operational, which nevertheless have a fundamental inﬂuence on the

ﬁnal value of a cargo. Just to give one example, depending on the logis-

tics of the terminal, the standard size of the nominal cargo size that can

be lifted at the terminal must be decided, that is, the minimum amount

of crude that will be delivered to a ship arriving for loading. The major

partners will try to impose the highest possible size for the nominal

cargo, so as to increase the frequency of its own liftings and decrease

those of the minority partners. In fact, a partner with a 40% share will

accumulate more crude and quicker than one with only a 10% share.

The greater the size of the nominal cargo, the longer is the waiting time

for the minority partner to accumulate enough crude to allow him to lift

a nominal cargo. For this reason, and wishing to establish the conditions

of maximum operational ﬂexibility for all the partners and potential cus-

tomers at the Sullom Voe terminal, a nominal cargo of 500,000 barrels

was agreed to for Brent, the smallest possible load that nonetheless has

commercial value.

Principal Uses of the Forward and Futures Markets 121

Another bone of contention between partners is the clause regarding

the so-called pooling of rights, that is, the possibility of cooperation

between two or more minority partners, to lift the barrels due to them

and be considered as one sole partner having a participation equal to

the sum of their respective shares. It might, thus, be possible for a

new ‘synthetic’ partner to have a participation superior to that of the

partner with the relative majority and/or function of operator, and thus

be in a position to lift the collective cargoes with greater frequency

(with signiﬁcant advantages for a company’s cash ﬂow). Obviously,

the game involving the distribution of the privileges and ﬂexibilities

has to be discussed. This is the reason for tenacious opposition and

interminable discussions.

As mentioned previously, all this has a sharp impact on the value of

a cargo of crude. It is one thing to try to sell a crude that is loaded at a

terminal where all these ﬂexibilities can be brought into play together,

it is quite another to sell a crude to be loaded in a terminal where the

operator allows the buyer no ﬂexibilities whatsoever. The price can only

reﬂect these differences, independently of the benchmark quotations

on the day of loading. And often, for a standard cargo of a million

barrels, it is a question of differences that can ﬂuctuate around a sum of

$10 million. For a partner in a joint venture, for the same investments

made and costs incurred, the utilization of these operational ﬂexibilities

could seriously affect the time needed to recuperate such investments.

Problems of the Brent

Forward Market

A separate chapter is dedicated to the distortions that have been created

in the Brent 15 days market and the ways to remedy this. These are

quite technical matters, but it is important to describe them, at least in

general terms, to illustrate the dynamics that have permitted the creation

of today’s situation of almost total separation between the crude market

and the price of crude. The fact that Brent became the worldwide refer-

ence benchmark had the consequence that every case of speculation on

the Brent market translated automatically into a manipulation of the

price of all the other crudes in the world. We can, therefore, under-

stand the interest of Brent’s controllers (and of some trading companies

mainly operating in London circles) in wielding this tool and utilizing

the ﬂexibilities made possible, on the one hand, with the preoccupation

of most of the producing countries that saw the price of their crudes in

the hands of speculations perpetrated by a few operators. It is also for

this reason that Saudi Arabia and Iran decided to uncouple the price of

their crudes from Brent Dated, instead linking them directly to that of

Brent IPE/ICE, where these problems cannot arise.

The most typical of these speculations was the so-called Brent

squeeze. This was an operation for the temporary accumulation of

paper and physical cargoes of Brent, normally carried out by a trading

company, so as to remove them from the market, thus creating a short-

age (undersupply of Brent) and panic, forcing players in the chain of

15 days Brent to purchase cargoes to meet their commitments and forc-

ing many reﬁners to try to cover their requirements at any price. At the

same time, the creator of the squeeze would buy numerous ﬁnancial

parcels of Brent on the futures market, artiﬁcially increasing demand

expectations and consequently the price of Brent.

In the North Sea, given the short sea voyage (two to three days of

navigation) and continuous availability of supply, many reﬁners buy

their cargoes at the last moment. In the panic situation during the days

of the squeeze, the price could rise abruptly (and did so) by as much

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

124 Understanding Oil Prices

as $2–5 per barrel. Having achieved his objective of raising the price,

the trader who ran the operation came forward as the saviour of the

motherland, selling the cargoes hitherto hidden and for enormous proﬁts,

even on the ﬁnancial operations. Since all the crudes in the world are

indexed to Brent Dated, but not restricted to only this reason, proﬁts

could be made on crudes from other geographical areas sold to third

parties precisely during the days of the squeeze. We should not forget

that Brent represents the benchmark for over 60% of worldwide crude:

therefore, increasing the Brent price increases the price of all the crudes

linked to it.

Obviously, the success of a squeeze operation depends on the ability

to accumulate all the Brent cargoes in a minimum period (at least a

week). With the reduction of Brent’s production from 700,000 barrels

per day (with about 40–45 cargoes per month, say 10 a week) to 200,000

barrels per day (with 12–13 cargoes per month, say 3–4 a week), the risk

of a squeeze operation arose very frequently, making the value of Brent

Dated completely unreliable. To block three or four loadings within

one week became a feasible and frequently repeated operation for any

trading company.

Box 10.1 Market Squeeze

Given here is a concrete example of a squeeze, now widely known,

that was the proverbial straw that broke the camel’s back. In 2000,

a trading company (which we shall call Squeezer), with the help of

other companies, was able to raise the price of Brent by about $2 per

barrel for several days. Squeezer succeeded in making a market

squeeze by buying early the September forward ﬁnancial positions.

At the same time, companies allied to Squeezer bought the entire

physical market of Brent for the month of September, consisting of

a few cargoes.

Against this background, at the close of the open ﬁnancial posi-

tions, Squeezer requested the delivery of the cargoes bought in the

Brent chain, cargoes that did not exist on the market (because they had

been bought by its allies), and, therefore, obtained, as compensation,

a signiﬁcant monetary premium.

It was clear to everyone that the quotations of Brent Dated, under

a speculative course, were no longer correlated to market conditions,

but distorted upwards by actions orchestrated on the ﬁnancial and

Problems of the Brent Forward Market 125

physical markets. The graph in Figure 10.1 depicts what happened

in the market during this episode.

-3

-2

-1

Jan-00 Mar-00 May-00 Jul-00 Sep-00 Nov-00 Jan-01

$/bbl

Oseberg Differential

Forties Differential

Brent Assessments

Figure 10.1 Distorted Brent Dated quotations

We can see clearly that:

rThe North Sea market in September was obviously weak, as shown

by the movement of the differentials for Forties and Oseberg, two

crudes of higher quality than Brent, which became negative in

that period.

rIn contrast, the price of Brent Dated, parallel to the week of the

squeeze and contrary to all the other similar crudes from the North

Sea, registered a net and unjustiﬁed rise.

A US reﬁner, who right in that period had to buy some cargoes

of Brent, contested the fraudulent behaviour of Squeezer and was

awarded compensation by means of a lawsuit.

It is clear that an action of this type caused not only a rise of the

price of Brent, but rather a distortion of the value of all the activities

(ﬁnancial and physical) linked to Brent itself. A manoeuvre like that

made by Squeezer upset the entire market.

Something really had to be done to avoid such forms of specula-

tion. An advocate for ﬁnding a solution to the problem was Platts, a

McGraw-Hill owned specialized publisher of energy related periodicals

126 Understanding Oil Prices

that receives the support of industry professionals, analysts, traders, oil

companies, university professors and government ministers.

Starting from July 2002, the historic contract for 15 days Brent was

modiﬁed with the insertion of a series of new conditions and ﬂexibilities

of which the main ones are:

rthe standard cargo increased from 500 to 600 thousand barrels;

rthe delivery of the physical cargo could be accomplished by using two

alternative crudes of similar quality, Forties and Oseberg; not only of

Brent. The option to declare the type of crude was to be exercised two

days before loading;

rcargo nominations were to be made 21 days before loading and not

15 days. In practice, spurned by the need to comply with the lifting

rules at the terminals of the various crudes, the 15 day Brent became

the 21 day Brent.

In this manner, a new benchmark was artiﬁcially created and

expanded to comprise a basket of crudes, whose production permit-

ted around 90–100 cargoes per month (say 20–25 a week). A squeeze

would now require a ﬁnancial and organizational feat that would be

almost impossible for a trading company to instigate. The new market

should now be named the 21 days BFO (Brent, Forties, Oseberg), but in

industry parlance the old term, Brent contract, continued to be used. The

BFO assessment envisages the daily value of Brent Dated as assuming

the value of the most competitive crude among the crudes forming the

basket; Brent, Oseberg and Forties.

The effects of this modiﬁcation were clear from the start. The values

of Brent Dated returned to normal, that is, below the assessment levels

for Oseberg and Forties, and the squeeze problems disappeared.

The inclusion of Oseberg and Forties in the assessment also

allowed for:

ra reduction in the degree of concentration of ownership of the various

crudes, favouring greater transparency in the transactions;

ran expansion in the origin of the basket of crudes, which now included

Norwegian crudes – governed by a tax regime separate and different

from the UK tax system; and

rgreater diversiﬁcation of contract terms, since Brent cargoes respond

to the GTCs (General Terms and Conditions) of Shell, cargoes of

Oseberg respond to the GTCs of Statoil and those of Forties respond

to the BP GTCs.

Problems of the Brent Forward Market 127

-3

-2

-1

Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04

$/bbl

oseberg diff.l

forties diff.l

ekofisk diff.l

brent (right axis)

Figure 10.2 Movement of the benchmark before and after July 2002

As we can see in Figure 10.2, the benchmark, as from July 2002,

began to follow the market trends of the other North Sea crudes, no

longer presenting anomalous situations or unjustiﬁed price peaks.

We may, therefore, conclude that the passage to the BFO assessment

was advantageous for the market and its players. The emergence of two

new critical elements compelled a further adjustment to the BFO system

at the beginning of 2007. These factors were:

rA new trend towards reduced North Sea crude production particularly

in the crudes forming the benchmark (BFO).

rThe coming on stream of a new ﬁeld (Buzzard) inside the Forties

pipeline system. This was a heavy sour crude that worsened the quality

of Forties and hence the reference features of the BFO.

To compensate for the potential reduction in production and quality

of the BFO, the international community, supported yet again by the

forum of Platts, incorporated in the BFO basket the Norwegian crude

Ekoﬁsk. Ekoﬁsk is a light crude with 37.5 degrees API and a sulphur

content of 0.23%, thus transforming the BFO into 21 days BFOE. The

choice of Ekoﬁsk, together with Forties and Oseberg, had the purpose

of providing a safety valve should the value of Brent, normally the

128 Understanding Oil Prices

most competitive of the four, be manipulated for speculative purposes

(upward squeeze).

Expectedly, due to the introduction of crude from the Buzzard ﬁeld,

Platts had to insert quality standards regarding Forties. Cargoes of For-

ties included in the BFOE assessment must have a minimum API of

37 degrees and a maximum sulphur content of 0.60%. For each per-

centage increase over the 0.6% threshold, a sulphur de-escalation factor

applies in favour of the purchaser. If the sales contracts do not contain

these two clauses, the sales of the cargoes are not taken into considera-

tion for the purposes of estimating the BFOE.

The new assessment system was ﬁne-tuned further to take account of

the presence of the forward markets and the inﬂuence that they have in

the ﬁnal determination of the price of crude. Speciﬁcally, it was decided

to refer, in the so-called market structure, to the situation of contango

or backwardation.

Box 10.2 Assessment of Brent Dated (Platts’ Methodology)

One must note that the assessment of Brent Dated has never changed

name, either in its passage to BFO or when in 2007 it became the

BFOE assessment. Purely to complete the information we shall try to

summarize in a practical and concrete manner how the daily valuation

of Brent Dated takes place.

Being the specialized source most adopted internationally, Platts’

method will be utilized. In setting the daily valuation of the 21 day

cash BFOE, Platts uses a system called Market on Close (MOC).

MOC is none other than a system able to take account of all the val-

ues of the transactions effected within the 21 day BFOE contract at

the end of normal trading hours in London at 16:30. Platts only con-

siders arms-length (AL) sales, namely those negotiated openly in the

assessment window. As already mentioned, the BFOE methodology

envisages that the most competitive crude is the one that deﬁnes the

value of the benchmark. In normal market conditions, Brent has

always provided the benchmark. However, the introduction of

Buzzard into the Forties stream has resulted in Brent often no

longer being the most marginally competitive crude (see Figure 10.3).

Thanks to this procedure for deﬁning Brent Dated, the assessment

always remains related to the fundamentals of the North Sea market,

Problems of the Brent Forward Market 129

with the scope of reﬂecting the true relationship between demand

and supply of these regional crudes.

-2

-1

Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08

$/bbl

Ekofisk Statfjiord

Oseberg Forties

Linear (Oseberg) Linear (Forties)

Figure 10.3 Relationship between demand and supply of regional crudes

The following example will show how Platts makes, today, the

assessment of Brent Dated. Let us assume that on one particular day

Platts has news of two different market transactions:

ra Brent cargo with window 16–18 July sold at Brent for August +

$0.10 per barrel; and

ra Forties cargo with window 16–18 July sold at Brent Dated +

$0.15 per barrel.

To reﬂect the market structure Platts must determine:

rThe price of the Brent cargo on the basis of the value of August

Brent Forward (whose assessment will be made based on the infor-

mation available and the transparent movement of Brent ICE). If

we assume that the value of Brent for August is $75.00 per barrel,

then the price of the Brent cargo will be valued at $75.10 per barrel

($75.00 +$0.10).

rThe price of the Forties cargo will emerge from a slightly more

complex valuation. In fact, the value of Brent Dated will have

to be estimated in the period 16–18 July, using a method that

130 Understanding Oil Prices

refers to published data and is not subjective. Platts proceeds in

the following way, weighing:

– the value of Brent for August, which we have assumed to be $75

per barrel; and

– from the CFD market (contracts for difference), Platts deduces

the quotation of the value of the difference between Brent for

August and the value of Brent in the week 15–19 July, namely

the price paid by those operators who wish to modify a price

agreement transferring the calculation of the average for Brent

from one time reference to another (from the days 16–18 July

to the average in August). Let us assume that in this case the

market quotation for this type of exchange is 40.20 per barrel.

rThe premium agreed between the parties is $0.10 per barrel.

Based on these elements, the price of the Forties cargo turns out

to be $74.95 ($75.00 −$0.20 +$0.15).

It will, therefore, appear that on that day there were two transac-

tions regarding crudes in the Brent Dated (BFOE) basket that gave

rise to two values:

r$75.10 per barrel for the Brent cargo; and

r$74.95 per barrel for the Forties cargo.

Since the lower value is that of the Forties cargo, the value of

$74.95 per barrel will be published as the value of Brent Dated

BFOE on that day.

Obviously the same valuation process will have to be used for all

the other days in the time span of 10–21 days used for the assessment.

The method of calculation for the assessment of Brent Dated has

been modiﬁed over time, fundamentally to ensure the correct business

procedure and to make life difﬁcult for the cunning types who, to earn

easy proﬁts, could create enormous damage to the other operators by

upsetting the balance of the markets. There is still the fact that it remains

almost completely impossible to base price assessments on effective

market transactions and to have to rely on the estimates, based on the

behaviour of the futures market (ICE), made by the specialized sources.

Consequently, the last word regarding what we call the oil price is now

dictated by the ﬁnancial markets, since the physical markets align with

these without any possibility of reaction.

The European Reﬁnery Crisis

In the previous chapters we saw that there is a ﬁnancial oil market,

where oil purchase and sale contracts are exchanged every day that

do not involve the physical delivery of goods. There are purely paper

markets, controlled essentially by the biggest banks in the world, which

generate the number that we call the price of oil. Everyone assumes,

even if it is not true, that the exchange of these paper contracts

reﬂects in some way the dynamics between demand and supply of

the commodity called oil. If you talk to a ﬁnancial analyst he or she will

conﬁrm, believing it, that the movements in the price of Brent and the

exchanges of the relative futures contracts exclusively and rigorously

respect the fundamentals of the physical oil market. Since this high

level of transactions has contributed, as a collateral effect, to keeping

the price of oil at higher levels than that at which the physical market

would have held it, almost all the players involved (e.g. producing coun-

tries and oil companies, governments etc.) have let the ﬁnanciers play

their game.

Only the collapse in prices in autumn 2008 reopened the discussion

on the control of the price of oil. The rapid recovery of the prices in

the spring of 2009, however, deferred the discussion to the next crisis.

There is another collateral effect, unfortunately not made sufﬁciently

clear, that the ﬁnancial market is having on the oil industry and on the

energy world in general. This is the potential progressive erosion of

the margin of the reﬁner and hence of the future strategic position of the

reﬁnery industry.

The last reﬁneries built in Europe and the USA appeared in the mid-

seventies. From that time there have only been closures or upgrading

operations of the existing plants. If you enquire about satisfying the

oil consumption in the coming decades you will have to think about

the construction of new technically more developed plants, but with the

current low level of reﬁning margins, these would not be remunerative

investments. No private bodies could get involved in these activities,

faced with negative results.

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

132 Understanding Oil Prices

In the past decades reﬁnery experienced crises of different natures

and size. The most dramatic was at the start of the eighties when it had

to deal with:

rthe transformations of the energy market after the two oil shocks of

1973 and 1979; and

rthe entry of the producing countries into the world reﬁnery market.

The oil shocks have encouraged the growth and proliferation of

nuclear power stations and the progressive transformation of the thermal

power stations from fuel oil to gas, causing a collapse in the demand for

fuel oil.

At the same time, the need and desire of many producing countries

to expand their productive share and to recover increasing slices of

oil revenues, led them to invest in the downstream, both by investing

in reﬁning and by acquiring distribution networks in the main con-

sumer countries. Saudi Arabia, Kuwait, Venezuela and Libya are leading

these trends.

The markets in the ﬁnished products are inundated with marginal low

price products that will, however, become a new sort of benchmark for

the whole international market.

The reﬁners ﬁnd themselves in the situation of having to buy the

raw materials at ﬁrmly ﬁxed prices from the producing countries, and

having to sell the ﬁnished products at the discounted prices imposed on

the market by the marginal ﬂows coming from the same countries.

The collapse of the reﬁnery margins was inevitable. The sale of the

reﬁned products, at the new price levels, no longer allowed the raw

materials and the reﬁnery costs to be repaid.

Almost 50% of the reﬁneries in the Atlantic Basin (USA and Europe)

were unable to survive this transformation. This was a simple cycle for

most of the reﬁneries (those that were producing about 50% of the fuel

oil) that were swept away by the market.

Only the reﬁneries that either had already made investments to

improve the production cycle or were able to build new conversion

plants (those that transform fuel oil into gasoline and gasoil) survived.

However, still more reﬁneries survived, guaranteeing competition and

productivity, in fact by improving the export facilities were able to ex-

pand the market hinterland and to make the structural export of gasoline

to the US market (see Figures 11.1 and 11.2).

Following these dramatic transformations, the reﬁning situation

seemed to have stabilized in the second half of the nineties.

The European Reﬁnery Crisis 133

100

120

140

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

1000 bbl/day

100

150

200

250

300

350

Number of refineries

USA Average Refinery Capacity [left axis]

Number of operable refineries in the USA [right axis]

Figure 11.1 USA: number of reﬁneries versus average reﬁning capacity

Source: U.S. Energy Information Administration

Starting from 2000, the increase in the oil demand on the one hand,

but above all the introduction of the new environmental speciﬁcations

for vehicle fuels gave a new impetus to the reﬁnery margins. The lim-

ited industrial capacity (by the majority of the operators) to produce

reﬁned products of high quality, as required by the new standards, led to

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

million bbl/day

100

120

140

160

180

200

220

number of refineries

Distillation Capacity in Europe [left axis]

Conversion Capacity in Europe [left axis]

Number of Refineries [right axis]

[Parpinelli]

Figure 11.2 Europe: number of reﬁneries versus distillation and conversion reﬁning

capacity

134 Understanding Oil Prices

-5

2006 2007 2008 2009 2010 2011

$/bbl

NWE Margins (Brent)

MED Margins (Brent)

Margins Difference: NWE-MED

Figure 11.3 NWE and MED reﬁnery margins: cracking plants

higher prices for the ﬁnished products also making the reﬁnery margins

leap ahead.

The price of the raw materials, which is something always available

and potentially exceeding the demand, was in fact driven along by the

products level.

For about six years the reﬁners recorded decidedly positive economic

results. Slowly they began to talk about new investments and building

new plants.

Then unexpectedly in 2009 came the new crisis (see Figure 11.3).

This new collapse of the margins was fairly difﬁcult to understand

and analyse. At ﬁrst recourse was made to traditional models, citing:

rthe reduction in oil consumption, following the global economic cri-

sis; and

rthe emergence of a consequent excess of reﬁnery capacity, especially

in Europe.

Having accepted this analysis, some companies approached the crisis

by putting in place an exit strategy from the sector: partial or total

closure or sale of the plants to concerns more integrated into the oil

cycle (producing countries) capable of moving (or prepared to move)

margins from one segment of the oil cycle to another, essentially for

strategic, political or ﬁscal reasons.

The European Reﬁnery Crisis 135

Table 11.1 EUROPE: surplus/deﬁcit in capacity, reﬁning margins and demand

EUROPE

Capacity

Reﬁning Capacity Demand Surplus/Deﬁcit Reﬁning Margins

Year [kbbl/day] [kbbl/day] [kbbl/day] [$/bbl]

2000 17,072 15,222 1,850 2.874

2001 17,150 15,393 1,757 1.459

2002 17,186 15,344 1,842 0.521

2003 17,278 15,468 1,810 3.152

2004 17,352 15,535 1,817 4.515

2005 17,370 15,673 1,697 6.783

2006 17,349 15,688 1,661 4.560

2007 17,305 15,454 1,851 4.797

2008 17,243 15,360 1,884 8.012

2009 17,069 14,498 2,572 3.583

2010 16,744 14,435 2,310 2.466

There is no doubt that the crisis in European reﬁning, in a different

way from the global crisis, is serious, profound and structural.

On the basis of the data available, in Europe against an oil demand

of about 14.5 million barrels per day there is a reﬁnery capacity of

about 16.7 million barrels per day. There is therefore a nominal excess

capacity of about 2 million barrels/day (see Table 11.1).

Obviously the difference between reﬁning capacity and oil demand

is not per se a measure of a potential negative imbalance or necessarily

a cause of economic losses, for at least two reasons:

rDue to the historical trends in European reﬁning, about 1 million

barrels per day of products was exported to the US market.

rThe net excess capacity (spare capacity) in Europe of about 1 million

barrels per day means a lack of use of the existing plants of 6–7%,

or a usage factor of 93–94% that, based on the historic data of this

industrial sector, can be considered absolutely physiological.

In all the situations where it has been attempted to increase the usage

factor above these values a high risk was often encountered. The large

number of serious accidents occurring in American reﬁneries is often

due to the excessive increase in the usage factor.

Obviously, for a more effective analysis it is necessary to exam-

ine the distribution of the spare capacity according to the proprietary

control, territorial distribution and import/export infrastructures with

the network of the production system and the neighbouring markets.

136 Understanding Oil Prices

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

[million bbl/day]

[$/bbl]

Surplus/deficit in Capacity [left axis]

Refining Capacity [left axis]

Demand EU EIA [left axis]

Refining Margins Brent Cracking [right axis]

Figure 11.4 EUROPE: surplus/deﬁcit in capacity, reﬁning margins and demand

Sources: International Energy Agency and the author

Figure 11.4 clearly shows that the two curves of demand and reﬁning

capacity tend to follow one another.

There is a separation of the two curves in the years 2008–2010, when

against a fall in demand of about 800 thousand barrels per day, there

was a fall in reﬁning capacity of about 500 barrels per day.

This represents a change in the usage factor of about 1.5%, due to a

phase of economic crisis, which cannot on its own explain the collapse

in the margins of the operators.

If the trend of the margins is observed, it can be seen that even at

times of strongly positive values there is no surge in the usage factors

of the capacity, just being limited to ﬂuctuations of around 1%.

In the USA the situation is very different, even if it shows the constant

lack of capacity against the level of internal demand (see Table 11.2).

The interesting element to be observed results from the combined

analysis of the European and US reﬁnery structures in Figure 11.5.

It is easy to see how in 2009 there was an effective fall in the overall

oil demand of the Atlantic Basin of about 1 million barrels per day. This

is a key value in the crucial moment of the crisis, which has already

almost completely disappeared in 2010.

The persistence of heavily negative margins in 2010 cannot, therefore,

be explained just or principally by the excess of spare reﬁning capacity.

There is clearly something new and complex not seen in the past, which

The European Reﬁnery Crisis 137

Table 11.2 USA: surplus/deﬁcit in capacity, reﬁning margins and demand

USA

Capacity

Reﬁning Capacity Demand Surplus/Deﬁcit Reﬁning Margins

Year [kbbl/day] [kbbl/day] [kbbl/day] [$/bbl]

2000 16,525 19,996 −3,471 2.006

2001 16,582 19,995 −3,413 1.315

2002 16,744 20,099 −3,355 0.743

2003 16,748 20,399 −3,651 2.946

2004 16,974 21,104 −4,130 3.648

2005 17,196 21,164 −3,968 9.760

2006 17,385 21,050 −3,665 7.320

2007 17,450 21,031 −3,581 9.300

2008 17,607 19,788 −2,181 5.628

2009 17,678 19,065 −1,387 3.862

2010 17,590 19,548 −1,958 3.890

Source: U.S. Energy Information Administration and International Energy Agency

requires a more sophisticated capacity of operation. In fact if a number

of plants equal to the spare capacity (1 million barrels per day) were

closed, the problem should be considered resolved.

This should produce with immediate effect a return to decidedly

positive reﬁning margins and the start of massive investment to meet

-10

-5

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

[million bbl/day]

Demand

Capacity Surplus/Deficit

Refining Capacity

Figure 11.5 EUROPE and USA: surplus/deﬁcit in capacity, reﬁning capacity and

demand

Sources: U.S. Energy Information Administration, International Energy Agency and the author

138 Understanding Oil Prices

the technological challenges of the future, imposed by the qualitative

changes in oil demand. Apart from the management of some social

conﬂicts, if we were sure that this could be done, the problem could be

solved quickly without asking for important economic sacriﬁces from

the operators in the sector. Perhaps an in-depth analysis is worth while

starting from considerations of good sense.

The market in ﬁnished products continued, even during the periods

of collapsing margins, to be supplied without any form of interruption,

meaning that we are not looking at a homogeneous cross-section in

which all the operators ﬁnd themselves in the same situation. The aver-

age calculated reﬁning margins consider different situations especially

if reference is made to the various geographical areas (e.g. Rotterdam,

Mediterranean) and to the individual plants. Figure 11.6 shows how,

against the changes taking place in the market of US gasoline, the

reﬁners of Northern Europe have had a higher reaction capacity, pro-

ducing suitable ﬁnished products and expanding their market share in

the US market.

It is clear that these industrial and commercial policies have given

these reﬁners economic advantages that are not visible in the values of

the average standard reﬁning margins published by the various sources.

Just to give an example, which is signiﬁcant though not exclusive,

a reﬁner that was able to export alkylate gasoline, especially in certain

100

120

140

160

180

200

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

[kbbl/d]

from The Netherlands

from Italy

Italy + The Netherlands

Figure 11.6 US import: gasoline and blending components from Europe

Source: U.S. Energy Information Administration

The European Reﬁnery Crisis 139

100

200

300

400

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

$/mt

Premium to USGC Gasoline

Premium to NWE Gasoline

Premium to MED Gasoline

Figure 11.7 Alkylate premium to gasoline

periods of the year, should have been able to collect the extra margins

(of at least $100 per tonne) above the price of gasoline (see Figure 11.7).

Only those reﬁners that continue to operate in this market segment

have continued to obtain ‘good’ reﬁning margins, despite the crisis

factors. In particular, some differences can be explained in the perfor-

mances of the reﬁning markets in the two different areas of the European

market (negative in the Mediterranean, supportable in Rotterdam). The

different view of the market of the operators in the two areas has led

to different investment policies in the last decade. In the Mediterranean,

investment continued with the view of the eighties, namely sophisti-

cation of the plants to produce ever less fuel oil starting from heavy

low quality crude oils. Above all they were operated to make reﬁning

a regional industry able to cover the local consumption. The potential

hinterland of the market of the reﬁneries was restricted.

There was only marginal investment in the transport infrastructures

and export of ﬁnished products towards the more proﬁtable markets.

Some coastal reﬁneries, with a high potential for export infrastructures,

were closed or resized. In this context, Rotterdam has always been

and remains a reﬁnery base aimed at export. To get an idea of what

has happened at Rotterdam, just take a tour of the oil port, where the

reﬁneries are an integral part of the port infrastructures, with thousands

of tanks and loading wharfs for ships (and barges) of every size aimed

for all the European, US and even Asian markets. These infrastructures

140 Understanding Oil Prices

give ﬂexibility and, if managed with business sense, produce proﬁts

even in the difﬁcult times of the market.

Returning to the previous argument, if in this framework the marginal

operators who are no longer able to compete have to close the plants

(1–2 million barrels per day), we will ﬁnd ourselves in a situation that

is very different from the nineties, when the capacity was decidedly

greater than demand (almost double). In the context of the free market

that exists between the two banks of the Atlantic Basin today, Europe

ﬁnds itself in a similar situation to that of the USA, and should share

the consequences of the structural deﬁcit in the provision of ﬁnished

products of the USA.

In fact, having balanced the European reﬁning capacity at the level of

the regional demand, to prevent the export of petrol to the USA it would

be necessary either to establish duties (fairly improbable) or to be ready

for an escalation in the prices to compete with the US consumers. In

other words:

rThe USA would no longer have the guarantee of the ﬂows from ‘safe

and friendly’ Europe.

rEurope would no longer be autonomous in the provision of ﬁnished

products and could not count on a strategically reliable integrated

area of support (the USA will have Europe, but Europe will not have

another Europe for support).

So we are not able to face a dramatic collapse in the oil demand or

a quantitative transformation such as to require draconian reductions in

capacity. The problem is to adapt to the transformations in the quality

of the demand, of acquisition of ﬂexibility within the network of the

demand of the Atlantic Basin and of a structural change in the manage-

ment of the business in the face of the domain of ﬁnance in the control

of the price of the raw materials.

We are, therefore, talking about a complex business in which the long

term market view is important for making the appropriate investments as

is the capacity to gather business opportunities day by day. In this regard

we would like to add a basic consideration to the picture described up

to now. For simplicity of explanation we would like to ask ourselves

the following question: if a European reﬁner manages its plants in a

perfect way, plans its activities taking account of all the transformations

and evolutions of the international market and taking the opportunities

that present themselves day by day, would it be able to obtain a reﬁning

The European Reﬁnery Crisis 141

margin that was so remunerative as to enable it to make investments for

the total renovation of the plants: or, hopefully, to build a new reﬁnery?

The reply is very simple and it’s ‘no’, which means that, in the current

situation, European reﬁning is destined to remain an industry in slow

structural decline and at risk of progressive obsolescence.

Here we arrive at one of the most virtuous contradictions and anoma-

lies of the international oil market.

As we have already seen, the majority of the ﬁnancial business is

developed on the market of crude oil, namely the raw material. That of

the ﬁnished product is only marginally involved.

For years now there has been a different dynamic in the evolution

of the prices of these two markets. The price of crude is essentially

determined by the trends of the ﬁnancial exchanges in the stock mar-

ket, on the basis of the market expectations of the bank analysts and

operators, while that of the ﬁnished products continues to be fairly

closely connected to the movement in supply and demand of the physical

market.

The two trends are often divergent because of their nature and the

instruments with which the players in the two markets operate.

The crude market alone appears to be sufﬁciently integrated both in

the commercial dynamics and in the mechanisms that determine the

price, while the market of the products is deeply fragmented according

to product and geographical area.

The players in the physical market, the reﬁners, are used to operating

according to the laws of the physical markets in which they operate

and on which they place their products, seeking to identify the seasonal

nature of the demand and scaling the supply accordingly.

They also try to acquire the crude with a time-scale that enables them

to reduce their ﬁnancial costs and the risk of the price changing between

the purchase of the crude and the sale of the ﬁnished products. In the

past these dynamics were determined by ﬁxing the price of the crude

and the ﬁnished products.

Today the price of the raw material is detached from this reality

and depends on the expectations and dimensions of the business of the

ﬁnancial stock exchange.

The activity of the players in the virtual market is normally founded

on expectations based on the statistical trends of certain variables con-

sidered to be fundamental by the ﬁnancial analysts (spare capacity of

OPEC, limitations of the supply, reduction in global reserves etc.) and

on the technical analysis.

142 Understanding Oil Prices

Having had several years experience of the repeated seasonal peaks

of the price of US (and European) gasoline from April to August and

that of diesel oil from November to February, with the consequent

dragging of the price of crude, the ﬁnancial analysts memorized the

processes and changed their behaviour operating on the stock exchange

so as to anticipate the seasonal phenomena. The massive purchases of

crude (paper) take place at least one or two months before the expected

phenomenon of the physical market.

This results in an increase in the price of crude in advance of the

physical phenomenon and above the level that is only justiﬁed by the

dynamics of the physical market of the products.

In putting this strategy in place, the ﬁnancial operator is not taking

any particular risk, in that he never ﬁnds himself in the situation of

having to take possession of a single barrel of crude to be transformed

into products. His job will be to buy one day and resell when the price

has increased sufﬁciently. The provision in itself is just a pretext to

justify taking the initial position on the market. The ﬁnancial investor

can ‘escape’ in a few minutes from the market in which he entered.

The impact of his action is, on the other hand, real and has an effect

on the price of crude and the economics of the oil industry.

In our example, the reﬁner will have to buy the raw material at

the price inﬂated in advance by the ﬁnancial speculation but he will,

however, have to sell the ﬁnished products at the prices (decidedly

lower) imposed by the actual market. He will, therefore, ﬁnd himself in

the impossible situation of having to obtain satisfactory margins.

It seems to be a crazy mechanism without a way out that merits more

in-depth analysis.

We have analysed the differences between the market dynamics in

2004 and those of 2010, two years in which the reﬁning margins were

different.

We have already said that the various oil products have a particu-

lar seasonal nature, which obliges the reﬁner to plan the procurement

activities in a different way. In particular:

rGasoline, for which the peak demand is between May and June (in

preparation for the driving season). The necessary crude must be

bought starting from March.

rGasoil, for which the peak demand is in the winter months (being used

for domestic heating). The necessary crude must be bought starting

from the end of summer.

The European Reﬁnery Crisis 143

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

$/bbl

Brent

Gasoline

Gasoil

Figure 11.8 Brent and products prices 2004

Let us imagine evaluating the margin of a reﬁner operating in line

with these criteria. Obviously, in order not to get into complex technical

models, we will assume the extreme simpliﬁcation that one unit of crude

becomes one unit of ﬁnished product (gasoline or gasoil).

As our objective is to understand the dynamics and the mechanisms of

reciprocal inﬂuence between raw material and product, the simpliﬁca-

tions should not give us any problems. We have considered the ﬁctitious

margin of the reﬁner in 2004 (Figure 11.8) and 2010 (Figure 11.9),

particularly signiﬁcant years because they were less inﬂuenced by eco-

nomic crises and political events in the major oil producing countries.

From the two graphs above, it seems quite clear that a theoretical

reﬁner, who buys crude in March and sells gasoline in May, in 2004

earns $21.10 per barrel (gross of all costs, except that of the crude), that

is about 63% of the cost of the raw material. Just six years later, in 2010,

these earnings are reduced to $7.2 per barrel, that is (in the presence of

crude prices that are more than double) a thin 9%.

As far as the crude bought at the start of September to sell gasoil

in November is concerned, in 2004 our reﬁner earns $11.9 per barrel

(about 29% of the cost of the raw material), while in 2010 this margin

is $25.1 per barrel, that is about 33%.

Even if this data might seem comforting, we should remember that

2010 was a particularly cold year in Europe, so the demand for gasoil

was signiﬁcantly higher than expected.

144 Understanding Oil Prices

105

115

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

$/bbl

Brent

Gasoline

Gasoil

Figure 11.9 Brent and products prices 2010

It is also noted that both the products considered for 2004 are of

an inferior quality than those used in 2010, to reﬂect the change of

speciﬁcation laid down for both. Gasoil in fact went from 0.2% sulphur

content to 0.1 at the start of October 2007, and gasoline from 50 ppm of

sulphur content to 10 ppm at the start of January 2009.

For this reason we should have expected the margins to increase and

not substantially stay the same.

Now we will analyse the performance of Brent and products in our

two reference years, assuming a price of 100 on 1 January each year.

This operation enables us to analyse the variations for each commodity

better, and to evaluate the reactivity in the peak demand periods.

In 2004 (see Figure 11.10), it is fairly clear that the prices of the

products increase (with respect to their base value) at the moments of

greater demand by the ﬁnal consumers (mid-May for gasoline, towards

November for gasoil).

At the same time it is noted that the price of crude increases following

the greater demand on the part of the reﬁners, dragging the demand for

the ﬁnished products.

In 2010 (see Figure 11.11), however, the relative increase with respect

to the start of the year seems to be led by a much less marked seasonal

variation, both for the products and for the crude.

We can still see increases in the prices of products at the moments of

greater increase in demand, with the price of crude perfectly in line with

The European Reﬁnery Crisis 145

100

120

140

160

180

200

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Base: 1 January =100

Brent

Gasoline

Gasoil

Figure 11.10 Brent and products prices 2004 (base: 1 January = 100)

that of the products – a sign of a new ‘driver’ in the crude market that

slavishly follows or anticipates the movements in the product market.

Moreover, it seems that the prices of all three commodities are moving

in a perfectly aligned way during the course of the year: this means that

their percentage growth (with respect to the base value at the start of the

year) is equivalent.

The phenomenon seems to be even more apparent if we look at the

relationship between the prices of product and of crude.

100

120

140

160

180

200

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Base: 1 January =100

Brent

Gasoline

Gasoil

Figure 11.11 Brent and products prices 2010 (base: 1 January = 100)

146 Understanding Oil Prices

Even though the reﬁner is not as interested in the ratio between crude

and product as in the difference between the two (from the moment that

his remuneration is marginal), it is important to study the percentage

proﬁtability of the principal products obtained.

This evaluation can help the reﬁner to plan the reﬁning in a more

coherent way, turning towards the products with greater proﬁtability.

By analysing the ratio we can understand whether it is better to favour

a particular product at a certain time of the year, according to the logic

of supply and demand.

It seems clear that in 2004 there were increases in proﬁtability in

the periods of the year of greater demand, while this was no longer

happening in 2010. This consideration applies for both the products

analysed. The ratio for gasoline, that was very volatile in 2004, seems

to have levelled off six years later, and does not move substantially

from values of around 1.1; moreover, the seasonal effect is much

less evident.

This means that, while in 2004 the percentage proﬁtability of gasoline

varies considerably, and even reached 45% at the peak of the demand,

in 2010 it stayed below 20% (see Figure 11.12).

Gasoil was subject to a similar fate (see Figure 11.13): while in 2004 a

peak was noted in the ratio between November and December, reaching

about 40% proﬁtability at the peak of the demand, 2010 sees a much

less marked seasonal variation, with proﬁtability always less than 15%;

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2004

2010

Figure 11.12 Gasoline/Brent prices ratio

The European Reﬁnery Crisis 147

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2004

2010

Figure 11.13 Gas oil/Brent prices ratio

even in December, at a time of greater tension in the physical market,

the proﬁtability was only 10%.

Having seen the dynamics of the two markets of crude and of ﬁnished

products, it is clear that it was the crude market (ﬁnancial and extremely

ﬂexible) that adapted itself to that of the products, anticipating any

minimal variation and sweeping away the traditional possibility of the

reﬁner buying in advance in view of the seasonal nature of the demand

for the products. This led to the erosion in the earnings on products even

in the period of greater demand.

In practice, the new sophistication of the ﬁnancial markets conse-

quently led to the substantial transfer of most of the reﬁning margin

from the reﬁner to the ﬁnancial investor. We are facing a situation in

which the market is no longer able to generate reactions to correct the

mechanisms of exaggerated speculation.

It would be logical to expect, under normal conditions, that a reduction

in the margins would correspond to a reduction in the work on crude in

the reﬁneries and hence a reduction in the supply of ﬁnished products

with a consequent increase in the price of the products and ﬁnally a

rebalancing of the margins.

In our case, the ﬁnancial speculation has such a capacity to intervene

(due to its size and timing) as to neutralize these mechanisms of the phys-

iological reaction of the market. The increase in the ﬁnished products

that should allow the improvement of the margins is separate from the

148 Understanding Oil Prices

immediate rise in the prices of crude (paper), condemning the reﬁner to

a structural loss. It is the perverse effect of Uranus who ate his children.

What do you do in this absurd situation?

It would be hoped that the problems raised by this situation might

become the subject of the political and energy policy of the various

industrialized countries, but the individual operator cannot avoid looking

for his or her own survival strategy. In a world dominated by the ﬁnancial

mechanisms, the solution has to be sought in that very context with the

use of certain instruments offered by the world of ﬁnance.

It has created, as well as the crude market, a world of virtual reﬁning,

in which it is possible at any time to buy paper barrels, to process them

in a virtual reﬁnery and to sell the ﬁnished products obtained, achieving

a reﬁning margin. This margin is called the ‘crack spread’.

A reﬁner who operates in the real world of the oil industry can

associate his daily activity with certain operations in the virtual world

of ﬁnancial reﬁning, trying to combine the relative margins of the two

parallel activities. Obviously the technicalities of the market are complex

and varied. What is worthwhile emphasizing is how the virtual reﬁning

process, if suitably managed, enables higher margins to be achieved

than real ones (see Figure 11.14).

Figures 11.15 and 11.16 show how in the last two years the difference

between crack spread and real reﬁning margin registered a value of

$5–15 per barrel.

Therefore, a reﬁner who knows how to combine his or her activity in

the real market with the parallel and systematic activity on the ﬁnancial

market is in a position to achieve overall results that enable the margins

for the real activities to be improved in net terms. It is not the solution

to the problem, but a way of managing it.

1 paper barrel

of Brent Virtual Refinery Margin =

8.83 $/bbl

• 1/3 of a barrel of Gasoline

• 2/3 of a barrel of Gasoil

1 physical barrel

of Brent Real Refinery Margin =

-0.13 $/bbl

• 35% of Gasoline

• 45% of Gasoil

• 20% of Fuel Oil

Figure 11.14 Comparison between a ﬁnancial reﬁnery and a real reﬁnery (MED,

January 2011)

The European Reﬁnery Crisis 149

-5

Sep-05

Jan-06

May-06

Sep-06

Jan-07

May-07

Sep-07

Jan-08

May-08

Sep-08

Jan-09

May-09

Sep-09

Jan-10

May-10

Sep-10

Jan-11

$/bbl

Crack Spread

(seasonal 3-2-1)

Refining Margins

(Cracking - Brent)

Figure 11.15 NWE: reﬁnery margins (cracking plant) versus crack spread (seasonal

3–2–1)

We are, therefore, looking at an industrial problem that has complex

strategic implications, such as, for example:

rHistorical interdependence between American and European reﬁning.

rLevel of technological sophistication of the existing plants.

rCrisis and limitation of the import/export logistics.

rControl of the ﬁnancial oil markets.

-5

Sep-05

Jan-06

May-06

Sep-06

Jan-07

May-07

Sep-07

Jan-08

May-08

Sep-08

Jan-09

May-09

Sep-09

Jan-10

May-10

Sep-10

Jan-11

$/bbl

Crack Spread (3-1-1-1)

Refinery Margins (Cracking - Ural)

Figure 11.16 MED: reﬁnery margins (cracking plant) versus crack spread

150 Understanding Oil Prices

The problem lies in the future, in at least the next two decades,

in which we will still have a fundamental need of fuels for transport

(gasoline, gasoil, jet fuel).

There will need to be an industrial plan of European and US invest-

ment that enables security of supply to be achieved within this time

horizon. This will mean adopting decisions that are not too dissimilar

from those taken in face of the crisis in the automobile sector, hopefully

before the crisis blows up with very devastating impacts.

The worry is that nothing will be done, in that the size of the problem

still does not seem to be appreciated.

It is the author’s belief that, if similar considerations could be extended

to other sectors of the ﬁnancial markets (e.g. food), the reasons for the

difﬁculties and the enormous resistance that exist for any plan to reform

these markets and the international stock exchanges would be clearer.

Box 11.1 Trends in Agricultural Products and Oil Prices

The link between agricultural products and oil prices can be taken

into consideration to understand some of the aspects of the current

North Africa crisis.

Let’s start by looking at some data, in Figure 11.17, on the evolution

of the demand and the prices of oil and food products in the last

10 years.

Base year 2001 =100

130

180

230

280

330

380

430

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

[base year 2001 = 100]

WHEAT, CORN, SOYBEAN DEMAND OIL DEMAND ICE Brent Price Wheat Price Corn Price Soybean Price

Figure 11.17 Agricultural and oil demand and prices

The European Reﬁnery Crisis 151

From 2001 to 2010, the demand for oil, like that for the food

products, increased by 20–25%. In the same period the prices of

oil increased by about 350% and those for food products by up to

280%. We are looking at a price dynamic that is running on average

10 times above the level of demand, despite being in the presence

of a fairly balanced supply. The analysis of the data shows how

the increase in the price of food products has been relatively lower

than that of oil. The increase in the prices of food products becomes

signiﬁcant, among other things, only starting from 2006, while that

of oil is already evident from 2003. This means that, for the various

producing countries, the oil revenues have been higher than the costs

sustained for importing food products.

It would have been logical to expect that this difference between

oil revenues and costs of food products would transform itself into

an increase in the per capita income of the populations of the coun-

tries concerned. On the contrary, if we look at the published data

in Figure 11.18, we can see that (with the exception of Libya) the

level of the per capita income during the same period only increased

by 10–30%, in line with the increase in the actual demand for the

food products consumed. That is, the increase in income was not

even allowed, given the level of increase in the prices, to continue to

develop as in the past.

Base year 2001 =100

110

130

150

170

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

[base year 2001 = 100]

Egypt Algeria Libya Morocco Tunisia

Figure 11.18 GDP per capital and open interest

152 Understanding Oil Prices

So, two simple questions arise:

rHow have the rising oil revenues been used in the various countries

in the past 10 years?

rGiven the development of the effective demand for the various

goods, against a substantial stability in the supply (in some cases

even a supply surplus), what causes these enormous increases in

the prices of raw materials (oil and basic food products)?

The answer to the ﬁrst question is in all the papers and refers to

the scandal of the distribution of wealth in the various oil countries

where minority groups of the population, which gravitate around

the families of the various leaders, are able to accumulate enormous

fortunes, which are invested and spent in the most luxurious areas

of the major metropolises of the world. It would sufﬁce to draw up

the lists of the property assets in London, Paris and New York to get

the picture. Like the ﬂow into these countries of the most expensive

sports and luxury cars. It is astonishing to discover that in some cities

of the Middle East there are more Rolls-Royces than in the whole of

Europe.

The most alarming aspect of the gap between oil revenues and pro

capita income is the impoverishment of the middle classes. In the

past three to four years it turns out that even fairly high level state

ofﬁcials or state company employees are no longer in a position to

guarantee an acceptable standard of living. A real explosive cocktail

waiting for a detonator.

To answer the second question it is necessary to examine some

more data.

Figure 11.19 shows that starting from the mid 2000s an activity was

triggered on the parallel futures markets for oil and food products.

The exchanges of ‘paper’ contracts of grain are multiplied by more

than seven or eight times with increases of 400%, indicating a new

hunting ground for international ﬁnance. The food market became

another refuge for the monetary mass of the international banks. It

can also be seen how, once the moment of crisis of 2008–2009 had

passed, the activity in the futures on these raw materials restarted

with more strength than before.

The result of these activities on the virtual markets is the aggravated

increase in the prices of these goods on the physical markets and,

The European Reﬁnery Crisis 153

Figure 11.19 Agricultural and oil futures open interest on NYMEX

hence, an aggravation of the social problems of the poor part of

the population. Once again we are facing a case of the potential

disastrous effects that the ﬁnancial market can have on the physical

economy and the real word. The ﬁnancial speculation has penetrated

deep into the mechanisms of the production/physical systems and is

tending to deform its operations beyond the normal physiology of the

markets.

A realignment of the virtual markets with the real ones could have a

dramatic result for the banks in the short term, but perhaps this process

will be unavoidable at some point.

In the meantime, in the oil sector, this climate of expectation brings

concrete and immediate beneﬁts to the producers of the raw material

(producing countries and oil companies), but, as we have seen, is also

having dramatic effects for the reﬁnery industry.

The phenomenon is becoming dramatic in the western areas of con-

sumption, where the economy is strongly dominated by the ﬁnan-

cial markets. It is almost paradoxical to see that the only countries

that are investing in the reﬁning sector are China and India, where

the state intervention in the management of the real economy is still

determinant. They are the countries that are looking to the future,

beyond the contingent crises and the uncertainties of today’s market.

154 Understanding Oil Prices

In the west the false conviction often prevails that the liquidity of the

ﬁnancial markets corresponds to an excess of capacity of the production

systems. At this rate, if nothing is done, together with the tomatoes

coming from China we will begin to depend on the supply of oil products

from China and India. At that point, we will have to be ready to pay

very high prices, given the competition which we will have to face on a

global level.

Perhaps it would be more reasonable and advantageous, economically

and socially, to dig deep into our pocket and invest massively in the

reﬁnery technologies and plants. This is a much more important priority

than the construction of new nuclear power plants.

Conclusions: We are

Ourselves OPEC

In the recent past, following a big rise in oil prices, a debate took place

regarding two highly sensitive themes: the clash of civilizations and the

reactivation of a programme for the construction of nuclear power sta-

tions. These are two distinct themes, apparently unrelated to each other.

Yet it is singular that the discussion began and expanded in coincidence

with the materialization of the said initial event, the rise in oil prices.

Having reviewed these themes, no pretences are being made that there

are additional or resolute facts to add to those already circulated by the

world’s press. It is, however, important to relate the themes we have cov-

ered here to the basic model of reasoning which we have developed in

our discourse. It is certainly positive that a discussion regarding nuclear

energy goes ahead in a spirit that is critical, constructive and supported

by hard facts. By moving away from emotional responses to the oil price

alarm, we can move forward and adopt an approach based on economic,

technological, environmental and strategic terms.

In this sense we should clearly envision what we have already elab-

orated on in the preceding analyses. Today, the fundamental question

of the price of oil is linked to a lack of reﬁning capacity and ade-

quate transformation technologies for producing clean transport fuels

(gasoline, gasoil, jet fuel). This problem essentially concerns the

industrialized countries who have created growing and unchallenge-

able environmental legislations, but who have not provided sufﬁcient

investment incentives for the development of technologies and plants

(for production of cleaner products) in the reﬁning sector. Today the pro-

duction of electricity has no direct impact on the price of oil: the fuels

for power stations are residual products available in excess. The choice

of nuclear power for a country should be of an overall strategic nature:

that of being in one of the advanced technology sectors where scientiﬁc

research can be a fundamental and decisive factor for advancement in

other sectors. This was actually what many hoped would happen in Italy,

even after the 1987 referendum: to at least keep aﬂoat the existing plants

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

156 Understanding Oil Prices

to allow for the conservation of know-how and maintain participation

in worldwide scientiﬁc research. This brings to mind what happened in

Europe when the rich and powerful Italian marine republics refused to

ﬁnance the challenge proposed by Christopher Columbus. They were

not stimulated to expand their technological capacities to build ships

able to face the waves of the Atlantic. Countries like Holland and Por-

tugal, far behind Italy at the time, accepted the challenges of the ocean

and beneﬁted from remarkable developments. Perhaps they were helped

by the fact that their shores were washed by seas beyond the Columns

of Hercules; there was, thus, no debate on whether to pass through

them. Italy was destined to an inexorable decline and, locked within the

increasingly limited Mediterranean market and restricted by the cultural

climate of the counter-reform and the Council of Trent, was cut off from

all the scientiﬁc processes and technological research of those centuries.

One positive outcome of a debate over nuclear power would be if it

once again causes us to face up to the challenges of the technological

frontier. In this case, we will also have to get involved in the challenge

of research on automotive fuels that will enable us to overcome the

crisis of today (unfortunately the solution is not bio-fuels, too easy an

answer). Countries that for over 40 years have been the giants of the

world reﬁning industry cannot sidestep this challenge, of which full

awareness seems not to exist to date.

The environmental challenge has been, till now, a sort of problem

for the elites of the industrialized countries. Fuel laws have become

effective and strict in western countries, leaving emerging countries like

China and India, where the air in the cities has become unbreathable,

out of the picture. If we assume that in the space of a decade these

new consuming countries will move in the same direction as western

countries, the system will reach the point of collapse: there will not be

sufﬁcient clean fuels for everyone. The reﬁning systems which exist

today will be unable to produce clean fuels, starting from the crude oils

available. An economic commitment and a project for technological

research and industrial investments of enormous proportions will be

necessary, for which today’s downstream industry is not at all prepared

nor motivated. Is it conceivable to think of dedicating a part of the huge

amounts of tax paid on petroleum products to these projects?

Too often the debate over oil is concentrated on the size and duration

of the reserves. Certainly this aspect of the problem exists and has to

be considered, even if it is not the key issue that concerns the citizens

and inhabitants of planet Earth. And, above all, when it is invoked to

Conclusions: We are Ourselves OPEC 157

justify an increase in crude price, it is really out of place. The fuels we

need can be obtained using varying technologies starting from the most

disparate raw materials: from crude oil to natural gas, to coal, even up

to bio-components. There is ample availability of these. The problems

in production of clean, environmentally compatible fuels are related to

technology and costs. Let us just think about the development of GTL

(gas to liquid) technology, namely the production of extremely clean,

high-quality liquids, starting from gas. Not only do we know that there

is still enormous availability of natural gas, but that coal can also be

gasiﬁed, and from this gas clean liquids can be produced. There is no

need to remember that these are ancient technologies (to be re-studied

and improved) used, for example, in South Africa during the embargo

years. Implementation of these technologies will depend on investments

made in research, on overall production costs, but also on the ﬂexibilities

that the automobile industry will provide in the future. Engines designed

to function with liquids structured in a different way from the traditional

gasoline can make the use of these new products easier.

It is clear that, facing (and on the eve of) far-reaching changes that

can affect the world oil scenario, asking the reﬁners, who are the

most conservative and traditional members of the oil industry (at times

referred to as ‘petroleum peasants’), to expose themselves today to the

risk of heavy but ultimately excessively risky investments, would be a

pure illusion. The tensions we are facing up to tell us that the break-even

point for the use of different raw materials is now very close. If, when

analysing the future scenarios, the outcome of the environmental prob-

lem in the Far East were taken into serious consideration, the decisions

that would have to be taken would appear more linear and less exempt

from risk. Investments in downstream petroleum technologies should

be much greater and less tentative than they have been in the last three

decades. Within 10 years we could easily discover that someone else

has taken the situation seriously and is guiding the new technological

processes and the production of new fuels. Somewhat similar to what

happened to the Italian marine republics.

The obsession, almost exclusively focused on company share values

as examined by ﬁnancial analysts and presented to shareholders every

quarter or half-year after, increasingly risks locking companies into

policies that are targeting only short-term results. Without intervention

from national or supra-national institutions, this picture will not change

and there will be no move towards a solution on the basis of free

market forces.

158 Understanding Oil Prices

Discussion of these themes should have progressed in concrete and

scientiﬁc terms in the last 10 years, but unfortunately there have been

frequent attempts to sidestep the problem, taking refuge in pointless

exchanges. The most glaring example was the debate on the clash of

civilizations, or on religion, which produced a sort of metaphysical sub-

limation of the attempt to defend the status quo. The author has several

Nigerian friends with important jobs in the State administration, with

whom he has had the occasion to discuss the so-called religious con-

ﬂicts that have characterized Nigeria’s recent history. They explained,

in detail, how the tensions and conﬂicts were manipulated and ampliﬁed

to enable the heads of the various ethnic and social groups to demon-

strate their political weight in the mediations to develop in the centres

of power of the capital. No one had ever raised the problem of con-

testing the religious faith of other persons. And one ﬁnds an immediate

example of that when, travelling between villages, Christian churches

and Mosques of all types are seen, well distributed throughout the land.

However, from time to time, one cannot avoid seeing manifestations of

violence. The key problem is in the division of the oil revenues between

the poor regions (with a Christian majority) where the oil is produced,

and the richer regions (with an Islamic majority) where most of the rev-

enue arrives. With the increase or decrease in the ﬂow of petrodollars,

everyone feels entitled to renegotiate previous agreements with all the

tools at their disposal, including using an ideology of religious differ-

ences and the ensuing violent encounters. The author believes there is

not much difference between what happens in this country as charac-

terized by the historic co-existence between peoples of different reli-

gious creeds and what is happening around the globe. At the cusp of a

crucial crisis between availability of energy resources and prospects

of increased demand, the world is rediscovering that hydrocarbon

reserves are distributed across the globe in a very heterogeneous way and

are concentrated in certain speciﬁc regions of our planet, where Islam

is prevalent.

During the 1990s, the growth of crude production in the North Sea

and domestic production in the US allowed for the creation of a futures

market. The internal mechanisms of the ﬁnancial markets have created

a powerfully expansive trading game, where as a founding principle

the sensation of an unlimited supply, readily available everywhere, has

permitted the removal of the physical aspect of the market, namely

the authentic aspect. The basic principles of management of the oil

companies and the reﬁning organizations have been overturned. The

Conclusions: We are Ourselves OPEC 159

operational programming of the production cycle has become a sec-

ondary element vis-`

a-vis the achievement of the overall result. In some

organizations, the risk management department, which handles opera-

tions in the futures market, has become an autonomous business hub,

often the fulcrum of all the trading activities. All this has been strongly

supported by the tax legislation of some European and US states, where

trading activities have enjoyed important ﬁscal beneﬁts.

Financial instruments have become, as it were, a new religious faith,

whose sole priests are very young traders, fanatics and millionaires,

experts in market techniques. This explains the clamorous events in

which individual traders have triggered the fall or bankruptcy of ven-

erable world ﬁnancial institutions (see the much publicized case of the

Soci´

et´

en´

erale). This is a market that is becoming ever more self-

serving and controlled by the managers of world ﬁnance. The move-

ments of crude prices have proved to be linked more to the horizontal

operations of ﬁnance (shifts of funds from one asset to another) rather

than to the internal dynamics of the oil market, such as those of demand

and supply. Quiet reﬂection would be necessary, well away from the

fever of the ﬁnancial religion which has dominated these last few years.

Only in the last decade, the prevalence of the unﬂinching trust in ﬁnance

has brought us down a path that has resulted in the further deterioration

of the situation and taken us further away from a possible solution.

It is difﬁcult to ask the priests of these new religions, highly tech-

nological but also very fanatical, to formulate a logical, historical and

political approach to the problems of energy and oil. It is easier to

continue speaking about a west surrounded and attacked by another

religious universe that is also in control of the availability of crude.

This allows the world to postpone, still further, any concerted quest for

solutions to the problems at hand, instead permitting the ﬁnancial arena

to grab further proﬁts.

The author believes that a major part of the debate over the clash

of civilizations takes place at the abstract level, which does not get

to the root of the problems. Right from the start, the confrontation

between Islam and Christianity has been affected by the control of the

Mediterranean economy. Today, it has to take account of the control

of the energy market and distribution of the oil revenues. It may seem

trite to say this, but a true process of stabilization of peace can only

start from a reconsideration of the technology of private transport and

the replacement of the traditional service stations. We may conclude

our narrative by recalling a fable of Aesop, that of the horse, the boar

160 Understanding Oil Prices

and the man. The horse, accustomed to drinking at a fountain of fresh

crystalline water, one day sees a boar dirtying the spring water. To resolve

the problem, the horse decides to ask for the help of a hunter, who riding

the horse follows and captures the boar. With the task completed, the

man discovers the usefulness of the horse and decides to put a rope

round his neck so that he cannot escape. If we change the names of the

actors, putting the oil companies in place of the horse, the turbulence of

the market in place of the boar and the futures markets in place of the

man, we have a snapshot of what happened in the last two decades. All

the actors in the productive cycle of oil have delegated the management

of their company’s risk to the ﬁnancial fund managers, who at the end

have become the true masters of the business, dictating rules, limits and

perfecting the strategies. The lesson that the ﬁnancial crisis has given

us should make us understand that the links between ﬁnance and oil are

very tight and full of risks for the future.

The events that during the ﬁrst few months of 2011 upset the political

scenarios of North Africa and the energy markets of the Mediterranean

require an examination that goes beyond the possible future changes in

the control of power in the various countries.

We are therefore facing a crisis scenario in which it seems clear

that the power of ﬁnance, which in fact means that of no more than

a dozen banks in the world, is today boundless and devoid of any

political control.

There is nothing new in saying that the power of ﬁnance and the

banks is boundless, but it is new to see the new dimension of the

phenomenon on a global level, which can intervene in the political and

social equilibriums of entire regions in the world and of the development

of strategic sectors of the global economy. I remember learning from

the books at high school that the wars of the 16th century were decided

in Antwerp, the ﬁnancial capital at the time. In an era when armies

were not made up by national troops but by mercenaries, obtaining the

ﬁnancing from the banks was fundamental to equipping soldiers and

having the chance of winning. Indeed in order to keep Antwerp under

control, Charles V, the emperor of Spain and the Holy Roman Empire,

did not live in Madrid but in Brussels. There was, therefore, a form of

control of political power over international ﬁnance.

Today seeing this immense power devoid of control and causing

apparently devastating effects, leads us to ask how all this could be

possible. It is possible to fantasize about scenarios of the type described

by Orwell in 1984, with a Big Brother intent on using its ﬁnancial

Conclusions: We are Ourselves OPEC 161

power to achieve its objectives, but we know that the complexity of

the world does not permit these simpliﬁcations. So we need to look

at two possible alternatives. One is the existence of a neo-liberal and

monetarist economic target at a global level agreed by the majority of the

governments of the economically strongest countries, which, however,

is starting to break up and to cause unexpected and unwanted collateral

effects. The other is that there is no longer political leadership at a global

level able to call upon a capacity for governing these power centres.

The developments after the ﬁnancial crisis of 2008/2009 incline more

to the second. The banks were saved by the governments without any

attempt to at least change the rules of the ﬁnancial markets. When Obama

tried to open the Wall Street dossier he had to shut it again immediately.

There are no new Roosevelts, Churchills or De Gaulles around.

If we put together the messages that are coming from Japan with

the Fukushima disaster and from Libya with the shutdown in the pro-

duction of crude almost all of light quality (ideal for the production of

high-quality petrol), we see once again how the control of the market

in hydrocarbons continues to have a strategic bearing for all the indus-

trialized countries. In the next few months we will already be seeing

the effects of these events at the petrol pumps. So, despite the evidence

of this strategic impact of oil (as indeed that of food products) this

raw material will still be allowed to be subject to the most devastating

ﬁnancial speculation.

Karl Marx describes a world in which the owner of a factory and his

worker represent the two class enemies par excellence. Today they are

both like straws in the wind dragged along by a devastating current.

Perhaps we can continue to talk of the world with models that worked

up to a few years ago, but that no longer allow us to deal with events that

are taking place at a pace unknown before in the history of humanity.

In this framework politics seems too often to be inadequate, bewildered

and incapable of understanding and guiding the economic and social

processes. And we will continue to see the price of fuel increasing at

the service station, at least so long as we continue to produce it in

our reﬁneries.

Every time we stop at a service station to ﬁll up the car we should

be aware of the complex universe that is inside every drop of liquid

that the pump delivers. Above all, we should realize how precarious the

equilibrium is, which allows us, despite complaints about the prices we

have to pay, to receive a fuel that is sufﬁciently clean, readily available

everywhere, without having to queue or worry about the next ﬁll-up.

162 Understanding Oil Prices

This is not something to be taken for granted and this applies to anyone

who travels around the world. In too many countries this service is not

guaranteed and perhaps it will be even less so in the future, with the

resulting tensions that we can easily imagine. And these tensions foster

powerful ﬁnancial speculations.

All this can and must change, but it will require a radical cultural

transformation on the part of both consumers and producers. We might

say that it will take generations for this to happen, but we do not have

this time. Solutions are needed more quickly than our habits and lazi-

ness allow. Someone in the past decade has tried to coerce the global

equilibrium so as to guarantee the status quo of our way of life and

thinking, but with disastrous results.

The only way now is to force us to understand and ﬁnd the right

solutions. We cannot now put our faith in any OPEC, whether Christian

or Muslim. Now, we are OPEC.

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Speight, J.G. (1999) The Chemistry and Technology of Petroleum, Marcel Dekker.

Statistiche economiche energetiche e petrolifere (2008) Unione Petrolifera.

Van Der Linde, Coby (2000) The State and the International Oil Market: Competition

and the Changing Ownership of Crude Oil Assets, Springer.

World Oil and Gas Review 2008, Eni, 2008.

Yergin, Daniel (1991) The Prize: The Epic Quest for Oil, Money, & Power, Simon &

Schuster.

Index

Note: Page references in italics refer to Figures; those in bold refer to Tables.

agricultural products, link with oil prices

150–3

Ahmadinejad, Mahmoud 5

Algeria 43

alkylate gasoline 138–9, 139

alkylation 53

Angola 43

Arabian Light crude as benchmark 30–1, 31,

34, 35, 40

Asia-Paciﬁc, per capita oil demand 49

automotive fuels, taxation effect 61

backwardation 117, 128

benchmarking 105–6

BFO (Brent, Forties, Oseberg), 21 day

benchmark 126–7

bio-fuels 156

Bonny Light 105–6

BP 40

BP-Amoco-Arco 44

BP-Chevron 89

Brent 15 day contract 94–9, 117

mechanism 95–6

price risk 98

Brent 15 day market, problems of 123–30

Brent 21 day market 126

Brent Blend 40, 89

Brent Dated 101, 102

1970–2010 2

assessment 128–30

as benchmark 105–6

market 98

Brent IPE 102

Brent Oil

correlation index between international

crudes and 106, 106

discovery 89

features 89

Forward and Futures, paper market 116

Futures contract 40

inter-monthly volatility 27–8, 27

as international benchmark 37–40, 101

market 11–17, 89–103

creation and intention of 15–16

price collapse (1986–88) 8

IPE 100–2

versus NYMEX 14–15, 15,16

product prices

2004 143, 143, 144, 145

2010 143, 144, 144–6, 145

production 89

1976 32

sale and purchase contract 90–4

squeeze 123–5, 126

value, as reference for crude oil price

10–13

Bush, George 50

Carson, Rachel 45

Caspian Sea area, problems in 70

Chavez, Hugo 5

Chernobyl accident 9, 43, 45, 46

Chevron 40

Chevron-Texaco 44

China 48

classical industrial model 81–2, 82

Understanding Oil Prices: A Guide to What Drives the

Price of Oil in Today’s Markets

by Salvatore Carollo

166 Index

classical model of demand/supply 73, 76, 76

vicious circle in 78, 78

classical model of international oil market

73–80

Clinton, Bill, administration 50

component prices, impact of 53–5

contango 117, 128

Crack Spread 148

cracking 52–3

crude oil

destination of 71

heavy, reﬁning cycle 84, 84

marginal barrel, cost of18–19

market 5

link to physical market 17–18

monopoly and 1970s crises 30–3

prices 1970–2011 30

production

2008 7

2008–10 14

war 1970–2011 30

world demand 47

DDT 45

demand/supply of gasoline and gasoil 21–8

diesel fuel, tax burden 61

distressed cargoes 99

driving season 83

Earth Day 45

economic model 2, 3

Ekoﬁsk 127

electricity production 155

Emirates 42

energy diversiﬁcation 66

environmental demand, evolution of 45–50

equity quota 72

Europe

automobile taxation 62

construction of reﬁneries 65

gasoline prices 60

per capita oil demand 49

public transport 62

reﬁneries number versus distillation and

conversion reﬁning capacity 132, 133

reﬁnery crisis 131–54

surplus/deﬁcit in capacity, reﬁning margins

and demand 135–6, 135,136,137

taxation

on diesel fuel 59

on gasoline 57–9, 58,59,61

Exxon 30, 40, 89

Exxon-Mobil 44

ﬁnancial crisis and oil market 2008 10–17

ﬁnancial market for crude and ﬁnished

products 5

ﬁnancial reﬁnery versus real reﬁnery 148, 148

ﬁnished products market 5

ﬁscal policies 55–62

ﬂoating storages 117–19

ﬂows

dependent on price 70, 71

guaranteed 70, 71

Forties pipeline system 126, 127

free market, start of 41–4

Fukushima nuclear accident 9, 10, 28, 161

gasoil 61

demand/supply 21–8

Europe and USA 21–3, 22

in Europe 9

speciﬁcation, evolution of 47,47

US consumption 61–2

gasoil/Brent prices ratio 146, 147

gasoline

and components 50–3, 51

composition 23

consumption, US 61–2

demand/supply 21–8

Europe and USA 21–3, 22

price

US 61

world 60

shortfall in USA 9

speciﬁcations, evolution of 46

gasoline/Brent prices ratio 146, 146

Gore, Al 50

GTL (gas to liquid) technology 157

guaranteed ﬂows 70, 71

Gulf War 9, 43

hedging the price risks 106–14

examples 107–10, 110–13

Hussein, Saddam 32

hydrocarbons, molecular composition

hydroskimming 82, 83

India 48

Intercontinental Exchange (ICE) platform,

creation 103

Index 167

International Energy Agency (IEA) 32, 33, 73

variation in estimated stocks 79

International Petroleum Exchange (IPE) 40

Brent market 100–2

Iran 48

revolution in 32–3

Iran-Iraq war 32, 33, 42

Iraq 48

invasion of Kuwait 42

as swing producer 43

US embargo on 43

isomerization 53

Italy

automotive fuel taxation 62

gasoline prices 60

reﬁneries 69, 67

taxation on gasoline 59

Japan 48

jet fuel market 24–5

Kazakhstan 43

kerosene 24

Kuwait 42

invasion by Iraq 42

as swing producers 42–3

laws, fuel 156

US Clean Air Act (1999) 44, 48–50

lead, banning of 49

leaded gasolines, banning of 48

Libya 48, 161

crisis 9

sweet light crude production 10

lifting procedures 130

loading terminals procedures 119–21

market structure 117–19

Marx, Karl 161

Mattei, Enrico 63

mechanistic method 120

modern oil industrial cycle 85, 85

modern supply/demand model 77–8,

MTBE (methyl tert-butyl ether) 54

naphtha, light virgin 53

natural gas 157

netback value system 36

Nigeria 43

religious conﬂicts in 158

crudes, competition with Brent oil

crisis in 39

Ninian 89

nominal cargo size 120

nomination method 120

North Africa crisis 8–9, 28

North Sea 43

nuclear power 34, 156

NYMEX 14, 101

versus Brent 14–15, 15,16

Obama, Barack 161

off-take agreements 130

oil crisis 2008 7–8

oil for food programme 43

oil futures market 13

NYMEX 14

NYMEX versus Brent 14–15, 15,16

daily trades (2008–10) 18

oil market, correlation and dynamics in 4

oil price, divorce between oil and 102–3

oil shocks 132

oligopoly model 37

OPEC 162

formation of 31

inﬂuence on dynamics of crude prices 17

in 1980s 33–5

production v. Brent 3, 4,

suicide of 40–1

operational ﬂexibilities, hedging and 114–16

Oseberg 126

OSP 40, 41

petroleum peasants 157

Platts 125–6, 127, 128–30

pooling of rights 121

price crash 1986 40

price war 35–7

Reagan, Ronald 35

administration 66

reﬁneries

in Europe 65

in producing countries 66

(The Wiley Finance Series) Salvatore Carollo Understanding Oil Prices A Guide To What Drives The Pr

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