Module 8 Currency, Commodity, and Government Securities

Chapter 11

Crude Oil (Part 2), the crude oil eco system

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11.1 – Mapping companies

I’m hoping that the previous chapter gave you some insight into the current situation of the crude oil fundamentals. Some of you may also be interested in learning how crude oil is extracted from the ground and supplied to various stakeholders such as the refineries. The ‘Oil and Gas videos’ channel on YouTube, has done a stellar job in putting up short animated videos on this topic. If not all the videos, I’d encourage you to at least watch this one.

This animated video gives a beautiful, high level understanding of how oil is extracted from the ground and ocean beds. You will also understand what ‘oil rigs’ are in this video. They are those huge pad-like things, floating in the ocean, with flames spewing out of the exhaust. Companies such as Aban Offshore, Selan Exploration, Cairn India etc., are involved in setting this infrastructure up. I know a lot of traders and even investors investing in these asset heavy companies, without knowing the operational core of such companies. Personally, I think this is not a great idea; one should always know what they are dealing with. Given this, and the relevance of crude oil on many listed companies, I would like to briefly discuss how the oil industry is structured.

11.2 – Upstream, Downstream, and Midstream

A note of warning here – I’m no oil and gas expert; my knowledge is limited to just the basics. As a crude oil trader, I do think it is extremely important to know the industry dynamics simply because the trading opportunities may not always be presented to you directly. For example there could be some fundamental change brewing in crude oil, it may not manifest into a trade in crude oil directly, but instead a trade opportunity may come about in the downstream companies. For you to benefit from this, it becomes imperative to know the layout of the industry and identify areas of opportunity. My objective here is to familiarize you with the industry layout and help you map companies and how they fit into the overall oil and gas ecosystem.

So let us get started.

The oil and gas industry can be segregated into three sections –

  1. The upstream industry
  2. The downstream industry
  3. The midstream industry

Let us briefly discuss each one of the starting from the upstream companies.

m8-c11-cartoon1

Upstream companies

The upstream companies are the ones that do the dirty work – they take on geological surveys, dig up bore wells to get a sense of what’s in the ground underneath, and if they find oil reserves, they then begin the drilling and extraction of crude oil. It takes many years for upstream companies to identify an asset (potential oil well) and convert it into a fully functional, profitable oil well. Upstream companies manufacture and store crude oil in barrels (millions of barrels are produced everyday). These companies do R&D and engineering, and are asset heavy. Therefore, they end up spending a lot of money (read as capital expenditure) to extract oil.

However, the price at which they can sell this oil in the open market is not really in their control. The price is determined by the markets in which market participants like you and I participate and influence the international oil price. Every upstream company has a breakeven point – defined as the cost of producing one barrel of oil. The breakeven point is also referred to as the ‘full cycle cost’. Naturally, these companies would strive hard to keep their costs low and bring down the full cycle cost.

Companies such as ONGC, Carin India, Reliance Industries, Oil India are some of the Indian upstream companies. Internationally companies such as Shell, BP, Chevron etc., fall in this category.

The key point to note here is that low oil prices do not really favor upstream companies in general, especially the ones which have high economies of scale (the ones which have high full cost cycle). Obviously, higher oil price is good for these companies as their efforts to extract oil remain the same, but margins improve drastically.

m8-c11-cartoon2

Downstream companies

We will talk about the downstream industry first, and then discuss the mid stream industry. Generally speaking, the job of the upstream companies ends at producing crude oil. ‘Crude oil’ as you realize is produced in its raw form. If we have to use it as petrol or diesel, then the crude oil has to be refined. This is where the downstream industry comes into the picture. These companies purchase the crude oil from upstream companies and refine the crude oil to various forms such as – petrol, diesel, aviation fuel, marine oil, kerosene, lubricants, waxes, asphalts, liquefied petroleum gas etc.,.

Companies in this sector also go the extent of distributing these products across the value chain, right from business to business (B2B distribution) to business to consumer (B2C) distribution. In fact, petrol bunks are a good example of this phenomenon. Petrol bunks are nothing but a retail outlet, retailing petroleum products and owned by downstream companies.

Good examples of downstream companies in the Indian context are – BPCL, HPCL, IOC etc. Some companies try and integrate and operate across the value chain i.e., they try and do both upstream and downstream operations. Companies that successfully combine these operations are often referred to as the ‘Super Major’. Classic example of this is the US based ‘Exxon Mobil Corp’. They produce close to 4 million oil barrels per day and operate around 40 oil refineries across 21 countries. An operation of this scale is a mammoth management and operational undertaking; clearly not everybody’s cup of tea.

So, if the oil prices cool off, then it implies that the downstream companies can buy oil at cheaper prices from the upstream company (which is not so good for upstream boys as their efforts to produce oil is still the same). However, the benefit of lower oil price is not passed on to the end user i.e. you and me, but in developed countries like US and UK, this benefit is passed on to the end users quite quickly.

Anyway, here is what you need to remember at this stage –

  • Upstream and downstream companies share a see-saw relationship
  • Low oil prices is bad for the upstream boys but good for the downstream fellows
  • Higher oil price is good for upstream fellows but bad for downstream boys.

So the next time you see oil prices going down, don’t be in a hurry to short ONGC or BPCL. Take a minute to understand weather the company is downstream or upstream company, and analyze the impact of oil prices on the company.

m8-c11-cartoon3

Midstream companies

We will quickly discuss the midstream companies before looking into other aspects.

In very loose terms, midstream companies are the ones act as a courier between the upstream and downstream companies. They are responsible for the transport of oil from the oil well to the refineries. They do this via pipelines, road transportation (oil takers), and by ocean shipments. Consider them as the wholesalers of crude oil. Some midstream companies try to deliver more on the value chain by refining the crude oil to some extent, hence their operations sometimes overlap with downstream companies. Since midstream companies deal with both up and downstream companies, they are kind of caught in the middle, they neither want oil prices to increase or decrease, but seek stability in oil prices. If oil price decreases, then upstream companies are affected, this is not good for them. Likewise, if the prices increase downstream companies are affected, this is again not so great for them.

Some of the top players in this segment are TransCanada, Spectra Energy, Willams and Company etc.

Here is a snapshot which gives you a quick overview of all the three industries –

m8-c11-diagram

11.2 – Difference between WTI Crude and Brent

Many people tend to speak about ‘Crude Oil’ like as if it is a single uniform entity, something like Gold. However, this is not true. Did you know there are many varieties of crude oil which can be extracted from the ground below? The difference comes in mainly from the geographic variation and its unique characteristics. The impact of geography is so much that the characteristics of crude oil, right from thickness, color (light yellow, golden yellow, deep black), viscosity, sulfur content, volatility etc., change drastically.

Given this, naturally, there are many different types of Crude oil. I’ll not get into details of the many different types of oil – not that I don’t want to, it’s simply because I don’t know them myself J. I know the basic difference between to West Texas Intermediate (WTI) and Brent Blend, which is what matters to most of the crude oil traders and hence we will stick to it.

Before we get into the difference between the two, let us touch upon two distinct characteristics of crude oil, which basically define the variation of crude.

API Gravity – API here stands for ‘American Petroleum Institute’, which is essentially a metric to compare the lightness of crude oil with that of water. If the ‘API Gravity’ of a particular variety of oil is higher than 10, it simply indicates that the oil is lighter than water, therefore the oil can float on water. API gravity less than 10 indicates that the oil is heavier than water; hence the oil will sink in water.

Sweetness – Crude oil of any form will naturally contain sulfur. The lesser the content (I was told sub 0.5%) the ‘sweeter’ the oil is considered. Higher the content of sulfur, then the oil is not considered ‘not so sweet’.

The difference between WTI and Brent mainly comes from the API Gravity and its sweetness.

West Texas Intermediate (WTI) – This is considered a very superior quality of crude, hence the final refined products are also meant to be of superior quality. The API gravity is 39.6 (recall higher than 10, then it’s lighter than water) therefore WTI is considered super light. Further, the sulfur content is just 0.26 percent, making it a very sweet crude oil

Brent Blend – Much like blended scotch, crude oil can also be blended to create variants with certain properties. Apparently, the Brent blend is created by blending oil from over 15 oil wells. Brent has a sulfur content of 0.37%, which makes it sweet, but not as sweet as WTI. The API gravity is around 38.06, which makes Brent quite ‘light’.

Clearly, due to the variation in the characteristics, the two are traded at different prices. Have a look at the price quote for these two variants –

image-2_brent-and-wti

Source: Bloomberg

Brent crude is priced higher compared to WTI. Most importantly, you need to know that crude oil traded on MCX follows the Brent crude and not WTI. In fact, Brent crude is the benchmark for International crude oil pricing.

11.3 – Crude oil inventory levels

Supply-demand effects crude oil prices and therefore the profitability of many companies linked at various points in the oil and gas eco-system. This makes tracking the inventory levels of crude oil prices important on several counts. You can use this information to trade not just crude at MCX, but also set up trades on companies such as BPCL, HPCL, IOC, ONGC etc.

There are two organizations which put out the inventory details –

  1. US Energy Information Administration (US EIA) – They report the inventory levels on a weekly basis. You can track the information here. Remember inventories tend to increase when the demand is low or there is an oversupply, either which way, it is bad for oil prices, and hence the upstream companies. Likewise lower inventories mean either there is a lot of demand or there is a cut in production, both ways it’s good for crude prices and upstream companies.
  2. OECD Crude Oil inventory – OECD stands for ‘Organization of Economic Co operation and Development’. OECD also gives out crude oil inventory (but not at a weekly forecast like EIA). You can track the inventory position on OECD’s website.

11.4 – The relationship between US Dollar and Crude Oil

The crude oil and US Dollar share an inverse relationship with each other. A strengthening US Dollar tends to drive the price of crude oil down. Likewise, weakening USD tends to drive the prices of crude oil higher. At this point it is very important to note that both these assets have their own supply demand dynamics influencing their price movement; however, they are also somewhat linked to one another.

If you do an image search for ‘Crude Oil versus Dollar’, you will find many charts which display this inverse relationship. Here is one for example –

image-3_crude-vs-oil

The interesting thing to note here is, the dollar used in these charts is not the “USD Dollar Spot” but instead the ‘Dollar index’, which is a representation of dollar against major world currencies. This makes absolute sense as crude oil is an international currency priced in dollars, therefore irrespective of who is buying crude oil, payments happen in US dollars.

Given this, if the Dollar increases (for whatever reasons), then countries tend to purchase more oil for the same level of dollar (more oil can be purchased for the same dollar level). This leads to quicker depletion of inventory levels, therefore the price of oil increases.

The argument above is generally true over long time periods. However, please do remember that both these assets have their own fundamental dynamics playing. So there could be instances where both of them may break their inverse correlation and head in same direction.

Also, remember the inverse correlation only suggests that the two assets move in opposite direction but does not say anything in magnitude. So for example if the dollar declines 10%, this does not imply that the Crude oil will increase 10%.

In the next chapter, we will discuss the contract specification of Crude oil on MCX.


Key takeaways from this chapter

  1. It is important to understand the Oil & Gas eco system and map how companies are mapped under this ecosystem.
  2. Upstream companies are asset heavy, and are involved in extracting oil from ground.
  3. Increase in oil price is good for upstream companies while a decrease is not.
  4. Downstream companies mainly consist of refineries. Higher oil price is not good for them while lower oil prices are good (as their margins tend to increase).
  5. Midstream companies are involved in the oil and gas logistics. They prefer stability in oil prices as they do business with both upstream and downstream companies.
  6. WTI and Brent are two variants of crude oil varying mostly in terms of API gravity and sweetness.
  7. Brent Crude is the international benchmark.
  8. Keeping track of inventory levels is critical. Increase in inventory tends to decrease the crude oil price and drop inventory tends to increase the prices of crude oil.
  9. The USD index and crude oil share an inverse correlation over longer periods. However, this relationship may break over short time frames owing to their own supply demand dynamics.

57 comments

  1. RITUKANT MAURYA says:

    Very well and concise information about Crude Oil. Eagerly waiting for next chapter on Crude Oil Trading.

  2. mukul agarwal says:

    Sir I just read option module. last comments there were from 2015 so i thought of asking a doubt here. Can you please explain the drop in premium of put calls.
    – ashok leyland otm puts will expire after 30 days, underlying price moved down. then why did some premium fall. was that because of drop in volatility. if that is so, then why there was increase in premium around(both for more and less strike) and only that premium fall particularly? can I attach a photo of option chain here?

    • Karthik Rangappa says:

      Mukhul, I respond to queries everyday based on where it appears. Nothing else apart from Volatility and liquidity can explain this. I’d suspect its because of drop in both.

  3. subrat kumar sahoo says:

    it’s a great job sir

  4. Raj Pawar says:

    if WTI is Superior quality oil then why its trading at low price compare to Brent?

  5. deepak says:

    If crude oil price increase internationally. Does that means ONGC or Cairn India Indian upstream companies will also sell at higher price to Indian down stream companies ? What I want to know is that oil prices is determined internationally only or domestic angle could be their ? some thing like involvement of govt. as after all ONGC and BPCL both are govt. companies .

    • Karthik Rangappa says:

      There are several layers here – if the oil prices increase, then upstream companies can sell them at higher prices. Therefore, their margins increase. Downstream companies have to buy it higher prices…internationally this increase in price is directly passed on to end customers. However, in India petroleum prices are regulated by the govt, hence customers are kind of insulated to these shocks….but not entirely. Another angle to note here is that increase in oil prices will increase Govt’s import bills..and this tends to increase the fiscal deficit.

  6. Deepak says:

    Is it okay to say inverse relationship b/w upstream and downstream companies share price ? If bpcl or hpcl increases ,ONGC should go down . But last 1 year data says both companies share price effectively gone up.
    last 1 year :
    ONGC 235 -> 287
    HPCL 282 ->481

  7. Khyati verdhan says:

    Sir, on 30 th Nov I made a bullish opec bet on crude oil and gains good profit. Thanks for your teaching.

  8. Saurabh Rendale says:

    Hi Karthik,

    I have a question, suppose I am trading only in one metal or say crude oil multiple times a day or say 3 times a day, (like a scalper) buying- selling, buying -selling , at the end of the day will the points made be averaged out or i will get the total points?, I mean as an eg. if for the first trade, i buy at 10 and sell it at 20 and then second time I sell it at 20 and buy it at 14, and for the third time, I buy it at 10 and sell it at 17, will the total point be 10+6+7=23 (not counting brokerage here), or the price would be taken as an average of three trades?

    Thank you,
    Saurabh

  9. PR1743 says:

    Does the crude prices on MCX really follow the Brent prices?doesnt MCX have a Brent crude future which is hardly traded….great tutorials btw…..have been learning a lot thru varsity….keep up the good work

  10. DEEPESH KUMAR says:

    Can you please suggest some books, periodicals, newsletters which a commodity trader should read?

    • Karthik Rangappa says:

      There arent any good ones that I;ve come across. However, I do glance through Hindu Businessline’s commodity section. I find it quite useful.

  11. mukilan says:

    Karthik, you guys are doing awesome job.
    I am new to trading and i think this the best platform for beginner like me to learn about markets.
    Is there any fundamentals that will affect the price of commodity? While i notice TA works only 40% to 50% of trades and lots of whipsaws.

    • Karthik Rangappa says:

      Thanks for the kind words 🙂

      Yes, fundamentals do affect commodities, however, since most of the trades on commodities are short term, tracking fundamentals may not help much. But yeah, good to be aware of whats generally happening on the fundamentals side.

  12. banibrata says:

    how to check inventory immediately at 8 pm in wednesday ?

    • Karthik Rangappa says:

      Not sure about this. I guess we will have to wait for the inventory data to be relayed across.

    • VISHANT says:

      Banibrata go to forex factory website and look for news(event) calender. every wensday invotery resulst come and update same time 8pm in this size.
      happy trading

  13. krishna says:

    sir according to the example you gave above for the dollar and crude oil relationship then it should positive correlation between crude oil and dollar

  14. NIRAJ SINGH says:

    HELLO SIR,
    IN KEY TAKEAWAYS #8, YOU HAVE TOLD THAT INCREASE IN INVENTORY, PRICE DECREASES AND DECREASE IN INVENTORY PRICE INCREASES, BUT I HAVE BACKTESTED IT(FROM AROUND PREVIOUS 4 MONTHS) AND FOUND THAT 70 TO 80% OF POSITIVE INVENTORY DECREASED PRICE OF CRUDE AND NEGATIVE INVENTORY INCREASED THE PRICE. SO I REQUEST YOU TO PLEASE EXPLAIN SOMETHING ABOUT THIS IF POSSIBLE.

  15. james says:

    Respected Sir,
    As per the chapter, MCX follows Brent & it is international standard for oil price. This means when we say crude oil, we actually mean Brent Crude oil, right? But, as per my research work, I am getting flaws in my model when taking Brent crude price. Results are better when I take WTI prices.
    1) Does MCX really follow Brent? If yes, there may be error in my model. 🙁 If no, please correct the typo.
    2) Which crude oil price is standard for international oil price?
    3) When we say crude oil (a. nationally, b. internationally), which type are we referring to (in both case)?
    4) Which exchange is official/standard exchange for a. Brent (i guess UK branch of ICE) b. WTI (I guess NYSE for WTI) ??
    Please clarify all.
    Thanks & Regards
    james

    • Karthik Rangappa says:

      1) MCX has both Brent and WTI. India imports Brent so for any sort of fundamental analysis on BPCL, HPCL, ONGC etc, you are better off taking Brent. However, the world markets refer to WTI
      2) WTI
      3) WTI
      4) CME for both I suppose.

  16. Prajnesh jain says:

    Thank you so much
    Damn bingo

  17. Ayush Upadhyay says:

    Sir thank you for this information.
    I want to know how to do technical analysis for crude oil. I am unable to find the methods specific to crude oil.
    Is it the same as equities? I mean same indicators, signals and levels?

  18. PRASHANT VIG says:

    Dear Sir,

    I still have a doubt as i checked up on MCX Site, in the pdf there is a due date rate- which specifies taking NYMEX and RBI rate. So, on NYMEX it is WTI Crude Oil and thats why i am confused , maybe future instruments on MCX – CrudeOil and CrudeOil M follows WTI instead of Brent Oil ?

    link 2018 contracts

    https://www.mcxindia.com/docs/default-source/default-document-library/crude-oil-august-2018-contract-onwards.pdf?sfvrsn=0

  19. Arun says:

    As quoted in this chapter “””Given this, if the Dollar increases (for whatever reasons), then countries tend to purchase more oil for the same level of dollar (more oil can be purchased for the same dollar level). This leads to quicker depletion of inventory levels, therefore the price of oil increases.”””

    My qn is dollar increases means dollar is weakening against other currency??

  20. Pritam says:

    Hello Sir,

    Are you sure that the oil traded in MCX is Wti? Because in MCX website it says that
    “Due date rate shall be the settlement price, in India rupees, of the New York Mercantile Exchange’s(NYMEX) ”
    And NYMEX follows WTI crude.
    Kindly confirm. Would be helpful

    Thanks in advance.

  21. Ashwin says:

    Is it required to take physical delivery of crude oil or metals ? Or will it be settled in money?

  22. Sreepathi says:

    how crudeoilM margins calculate during buy / sell ?

  23. Aniruddhsinh Rathod says:

    Hello,

    In the comparison of usd and crude oil price,it is written that if dollar increases then crude oil price will also increase.what is the meaning of Dollar increases? If it means that Dollar strengthens then it should have positive correlation .

    THANKS

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