In this book the principal author, Liz Bossley, and her colleagues share with the reader many years of experience of crude oil trading. The aim of the book is to provide an understanding of both the theory and practice of buying and selling crude oil and the management and protection of the value of sales realisations using hedging techniques.
The book seeks to serve the needs of new entrants to the trading community as well as the much wider audience of professionals in industry, finance and the regulatory sectors who need an overview of trading operations. They may need this oversight because they work in organisations with trading activities and have a direct or indirect responsibility for them, or simply because they wish to know how the world’s largest commodity is bought and sold. The analysis offered is a realistic and business-like view of oil trading activities, avoiding polemic. While the book aims at utility to the widest possible readership, as Executive Chairman I happily own up to a special fondness for the international independent oil exploration & production sector.
The recent history of technical progress in both exploration and oil field development in the sector is one of almost continual growth and improvement in efficiency. There has indeed also been rapid development of the price management trading tools available to the industry. But it is highly questionable if progress in risk management techniques has been embraced with similar enthusiasm. We do not hear company management reporting as confidently or authoritatively about their new abilities to manage price risk on behalf of owners, as we do about their ability to deploy new exploration and production techniques.
At a conference 10 years or so ago in Houston I had the pleasure of listening to a senior colleague in the industry talk – with numbers – about the successful struggle by an asset team he led to reduce the full cycle costs of a field development by a dollar and fifty cents a barrel. His enthusiasm for the task and the effort that delivery had cost him and his people was manifestly apparent in his face. As a former CEO, I could not help but respect and share his satisfaction with the achievement. Unfortunately, as both a former CEO and CFO with a budgeting background, neither could I prevent myself having two less worthy private thoughts: first, to what extent, if any, would his economies come back to haunt him, or his successor, toward the back end of field life; secondly, what, if anything, had he done to assure the actual realisation of his long run sales price assumptions. I had plenty of room for conjecture on this second matter, for although there had been much discussion on unit cost control and technical innovation, there had not been a single comment about price risk management.
It was thinking about this widespread, though to be fair not universal, disparity in the amount of consideration given to the technical and cost issues compared to the time spent on price management issues that led indirectly to the formation of our consultancy, Consilience, and ultimately to the writing of this book. Why should this disparity exist? There is a curious industry fatalism about price realisations stemming from a perfectly correct view that you cannot forecast the long run price of oil. But there is world of difference between frankly admitting, as I do, that I cannot forecast long run oil prices and being a wholly passive price taker.
Examples of current issues discussed include the role of international benchmark, or marker, crude oils in the price formation process. In particular we analyse the position of the Brent marker, made up of a number of North Sea blends, which play an exceptionally significant role in pricing and hedging crude contracts. Some estimates suggest that Brent is used as the marker crude for pricing up to two thirds of the world physical oil sales of approximately 88 million barrels per day. Even more impressively, conservative estimates indicate that Brent is used as the price marker for at least 200 billion barrels of oil per year, both physical and derivative, for hedging and speculation.
Separately there is a discussion of strategic issues for management and Boards concerning price forecasting and investment policy, including the potential role of hedging and its limitations. It is sometimes not wholly understood that the major benefit of hedging is not unit price maximisation, but the provision of certainty and the creation of a secure framework for investment. As discussed later in the book, in this particular context the only “bad” hedge is one that produces a surprise.
The current Dodd Frank and Volcker regulation (soon to be implemented, subject to the provision of detailed regulations that are currently under discussion), welcome in many quarters as a necessary corrective control of derivative activities, has the unfortunate potential for the oil business, particularly the independent sector, of throwing the financing baby out with the bath water. There is no evidence in the oil sector of a general, or structural, misuse of derivatives, or any evidence at this stage that their use has skewed oil prices. But if the anticipated legislation is passed without any exception for the oil industry Dodd Frank will require that many of the current over-the-counter (OTC), i.e. private, unregulated hedging transactions between company and provider, migrate to regulated exchanges and be subject to a regime of margin calls. This will be substantially damaging to corporate cash management.
In a similar fashion the anticipated Volcker rule will limit the ability of organisations to simultaneously make markets, i.e. quote two-way prices, and trade on a proprietary basis. This will initially hit the large investment banks that have provided the hedges necessary to underpin oil field development loans in the independent sector. Sadly, if this comes to pass I suspect the banks will find a faster use for their new spare capacity than the independent oil sector will find new sources of finance – unless new foreign banks move to fill the gap very quickly.
Historically, it has been difficult to attract external funding to both the fixed and working capital requirements of the industry through the various stages from exploration to first oil. This has led over time to the development of a suite of financing techniques developed by and funded within the industry itself, i.e. “industry finance”. The overriding objective of the arrangements is to split and spread the project risk amongst the participants best able bear it and to provide suitable rewards for the risks assumed. Examples of such arrangements include farm–outs, carried interest arrangements, overriding royalties and carved out production payments.
For example, where a joint venture group comprising smaller companies has made a discovery, larger companies may be invited into the group to offer balance sheet and technical strength to help the smaller partners participate in a discovery that might otherwise be a risk too far for a small outfits. However, the larger oil companies are acquirers and owners of oil equity, not third party lenders. So such assistance comes at the cost of a larger share in the field and usually with the right of the larger company to trade the smaller producer’s oil for it, when it is eventually able to lift.
The development of a banking sector that had oil reservoir engineering expertise and, in some banks, major balance sheet strength, injected external competition into industry finance. The banks also brought to the table a suite of two way tradable instruments that could reduce price risk significantly for the independent oil sector. This has given the independent companies much greater flexibility and the ability in many circumstances to preserve more of their equity in oil field developments. If anticipated financial regulation removes banks from this game it is the independent sector that will be the loser.
For a newcomer to the industry the scale of operation, the complexity of process and the necessary documentation of the physical sale and any insurance, i.e. hedging to protect anticipated cash revenues from the sale, may appear daunting. As ever apparent complexity can be resolved by keeping your eye on the ball.
First, track what is happening to the physical flow of oil; secondly follow the cash; and thirdly, at each stage ask, what would I do if this was my cargo and my cash? From this perspective most of the actions and documentation will fall into place.
Here are the key points to bear in mind:
- Your oil is probably produced into shared storage with joint venture partners in your field and a number of other fields. Everyone has to have a fair opportunity to lift their share and this means that there has to be a schedule that allocates cargoes to companies in time to let each organise a sale.
- That allocation happens typically 4-10 weeks in advance of loading, depending on the particular area of the world in which you are operating.
- A cargo has to be sold at least ten days before it loads to allow the organisation of a ship and to put credit facilities in place with the buyer.
- But regardless of when the cargo is sold the ultimate price you will receive depends on the loading date of the cargo that is allocated to you. Industry convention sells physical cargoes of oil using a formula price in the contract that calculates the price of a cargo by reference to prices published by industry reporting agencies such as Argus or Platts tied to its specific loading date.
- You can either accept the outcome of that price formula and take no further action. Or you can decide to manage it using financial hedging instruments.
If you decide to manage the price you can do so broadly at any time, but a year or more in advance is typical. This management can be achieved by hedging using forwards, futures, swaps or options, far in advance of the date when you know the date of the cargo in question. As the date of delivery gets closer and you know the exact shipping date of the cargo these broad hedges can be fine-tuned using the precision instrument of the CFD, “dated-to-paper” swap.
To assist the reader in getting to grips with these concepts the book uses the Consilience “A/T/G” analysis tool. This unbundles the oil price into three component parts; the absolute price of a benchmark grade (A); a time differential, the price attributed to oil being delivered on different specific loading dates (T); and, a grade differential (G), the difference in price between a benchmark grade and the grade of oil in question.
The construction of the price formula for a physical cargo and the management of the A and T components of that price formula using financial instruments are made clear. The grade differential, G, is explained in detail using assay analysis and by explaining how crude oil performs in the refinery to produce the finished products that the end-user wants.
The early chapters will lead the reader through these issues, but to summarise, the key point for consideration is that the seller or buyer will normally be tied in to a price for a physical cargo related to a price formula, reported by the price reporting agencies on or around the day of loading. However, to help circumvent that restriction and provide price management flexibility, the market offers a choice of tools that allow the hedger to control prices either on a cargo by cargo basis, or on a more strategic level over a longer time frame. Therefore the matter for resolution becomes what are your degrees of freedom to manage your price realisation and how, if at all, do you want to use them?
I hope that you enjoy reading our book and find that it serves its purpose of providing you with a clear and soundly based understanding of how crude oil is bought and sold in practice.
John Walmsley, Chairman