Basis Pricing and Spot Markets:

Market governance and crude oil pricing

Basis Pricing: benchmarks

Benchmark markets: used to price all oil› Brent› WTI› Dubai-Oman (Not always recognized)

Access to multiple demand centers› Brent represents international conditions› WTI represents S&D in the US› Dubai-Oman – Asian demand (sour)

Basis Pricing: benchmarks

Several markets constructed around the physical base› Variation in size, timing, physicality,

exclusivity, transparency, etc. Prices in financial markets closely

connected to related physical markets› Brent futures expiry› WTI futures delivery› EFPs

Basis Pricing: benchmarks

Prices of the benchmarks are highly correlated› financial markets increase speed of

correction Basis price serves as price

administered to the international market › normalizes the price of oil internationally

Stabilizes physical crude flows

Basis Pricing: benchmarks

Forward looking› Somewhat resistant to temporary market

hiccups› Driven by expectations

Seasonal Circumstances associated with the calendar

month Current conditions are also an influential

factor

benchmark prices

Trade month averages smooth over peaks and troughs

WTI Futures November 2014 Trade month› 23 September – 21 October

WTI November 2014 Deliveries› 1 November – 30 November

November prices› Associated with expectations in the

present related to conditions in November

Basis Pricing: differentials

Crude X = benchmark +/– differential› The relative value – relates the benchmark

to a specific market› Quality› Location, location, location…› Market signal› Negotiations

Traditionally a minor portion of price› Enables the system - flexibility

Spot pricing

Spot markets› Sped the decline of OPEC administered

prices Tax spinning Independent producers Trading Houses

› Tiny portion of total market› Forward looking › Independent CPs

Spot Pricing

The role of the spot market› Differentials in spot markets determine those in

contract markets› Eliminates price competition b/t the markets› Monthly prices: smoother

Why participate?› Engage in price determination› Enables greater flexibility

Daily price can be volatile› Not marked by desperation› NOT MARGINAL PRICING

Spot pricing: PRAs

Price Reporting Agencies (PRA)› Transparency

Recall futures price is the only transparent price

› Neutrality› Structure: define markets and acceptable

info Structure also implemented in new markets

› Deal exclusively with spot markets› Prices written in contracts› Differentials written in swaps

Crude oil pricing

Producer discretion› Spot market participation› Differential to the differential› Constructed basis price

Speculation

The speculation debate related exclusively to the daily futures market price

Ignores the physical connections Ignores differentials Ignores the fundamentals of the time

Speculation

Physical market participants knew of the tension› Higher demand› Falling spare capacity, especially in high demand

seasons› Worsening crude quality› Increasingly stringent environmental standards› Oil sands and hydraulic fracturing – structural

break› Ascent to $145/bl related to dollar-hedging› Crash related to major recession and credit market

collapse

SPEC

ULA

TIO

N

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

FEDFUNDS Nymex WTI month 1

› Final ascent to $145/bl related to dollar-hedging› Crash related to major recession and credit markets

Speculation

Speculator view conveniently argued financial participants were to blame› Great scrutiny over price manipulation› Avoidance of blame points to successful

pricing method Structural break required higher prices

› Speculation now curtailed and oil price still higher

› Prices are mean-reverting: likely to hit $50-$55/bl prior to recovery to $80-$85/bl

Higher production from shale

Jan-

1960

Aug-1

961

Mar-1

963

Oct-1

964

May-1

966

Dec-1

967

Jul-1

969

Feb-

1971

Sep-

1972

Apr-1

974

Nov-1

975

Jun-

1977

Jan-

1979

Aug-1

980

Mar-1

982

Oct-1

983

May-1

985

Dec-1

986

Jul-1

988

Feb-

1990

Sep-

1991

Apr-1

993

Nov-1

994

Jun-

1996

Jan-

1998

Aug-1

999

Mar-2

001

Oct-2

002

May-2

004

Dec-2

005

Jul-2

007

Feb-

2009

Sep-

2010

Apr-2

012

Nov-2

013

3500

4500

5500

6500

7500

8500

9500

10500

US Field Production of Crude Oil ‘000 b/d