Fundamentals of Crude Oil Pricing: Part III
Posted on: October 31, 2008 - Email Article - Printable Version
If you have not read parts earlier parts of this article please visit Part One and Part Two.
Shortages, Stockpiles, and Decline Rates
Often one of the most important short-term pricing factors in regards to crude oil are shortages and stockpiles. These dynamics work in ways that are mysterious to most investors and misunderstood by many others. It is easy to understand that reports or rumors of any shortages will cause the market to price in future 
shifts in supply that in turn, will tighten the supply. This conceptual logic also applies to decline rates. Decline rates are the rates at which oil or gas fields and wells “shrink” in terms of production. This number is generally quoted in a year-over-year metric and is a great measure when projecting and modeling future production. Decline rates are generally only issued after a well has surpassed its peak production phase, under most circumstances 2-6 years after the well has started producing oil. Obviously, different types of wells from different geographical locations have different average decline rates. Because there is a wealth of historical information available on decline rates, the market has priced in expected future supply of oil. The shifts in the price of crude oil occur when the decline rates are either greater or smaller than expected. Obviously smaller than expected decline rates will cause future supply predictions to increase, and greater than expected decline rates will cause future supply predictions to decrease.
This same scenario is reflected when investors are looking at crude oil stockpiles. The Energy Information Agency (EIA) produces a report that is released at 10:35 AM EST on Wednesday of every week that collects data on the amount of crude that is currently in storage. Every week analysts predict numbers for barrels of crude oil, gasoline, heating distillate, and the refinery utilization rates. If these reports come out and are either above or below analyst expectations, it is likely that the price of crude oil will fluctuate. (As a side note, the EIA also produces a natural gas inventory report that is released on the Thursday of every week at 10:35 AM EST.)
Discoveries
Just as shortages have an effect on the pricing of crude oil, so do new discoveries. New discoveries generally bring down the price of crude oil because investors will predict new supply coming online in future years after the new resources are tapped. Great examples of this are the new discovery announcements that have recently come out of Brazil. Petroleo Brazileiro [PBR: 46.37, -0.73 (-1.55%)], Brazil’s largest oil company which is partially state-owned, announced the discovery of the Tupi field in 2006 and the Jupiter field in 2008. These are two pre-salt layer petroleum fields that contain a vast number of reserves. Current estimates are that the Jupiter field contains 5-8 billion barrels of oil and that the Tupi field contains 7-30 billion barrels of oil. When these announcements were made, the price of oil came down because of the expectation for increased supply not only from these two fields, but also from the speculation that other reserves may be found in the pre-salt layer crust level of the Earth. Conventional discoveries have been slowing down in terms of number and magnitude as the world’s population uses all of the easily accessible oil. It is very likely that in the future, discovery announcements will come in the form of unconventional sources of oil, such as oil sands, rock basins, and other sources deep under the Earth’s surface.
An excellent way to keep up with announcements of discoveries is to reference the Wikipedia Oil Megaprojects page. This website lists all of the new megaprojects, their location, their production, and their time frame. From all of my research, I believe it is the most comprehensive and user friendly compilation of discoveries and megaprojects information on the internet. The link for the website can be found below:
http://en.wikipedia.org/wiki/Oil_Megaprojects
Currency
Probably the most under appreciated determinant of crude oil prices is currency. Many investors forget that the foreign exchange markets sometimes are the entire reason for a move up or down in oil. Crude oil around the world on almost all exchanges is denominated in U.S. Dollars and a change in the base currency of an asset will cause the assets value to fluctuate in terms of other currencies. As you can imagine, the recent volatility in the foreign exchange market, especially in regards to the U.S. Dollar, have only compounded the complexity and volatility within the crude oil markets. Obviously, there is no way to measure what effect a change in the U.S. Dollar against any basket of currencies has on crude oil, because there is no way to isolate currency as the only variable within crude oil pricing. Many experts currently believe that roughly a 1% gain or loss for the U.S. Dollar Index will represent approximately a $3.00 gain or loss in the price of crude oil respectively. During this current liquidity and credit crisis it is not uncommon to see the U.S. Dollar Index move up or down 2% in one day, which would help to explain why there have been giant record setting moves up and down in crude over the last six months. This theory also happens to perfectly coincide with the rise of oil to $147 when the Dollar was appreciating and the subsequent fall back down as the Dollar appreciated heavily against the Euro and British Pound over the last month or two.
During volatile times, especially currently during the massive market panic, crude oil has not traded in lock step with the United States Dollar. This is a special circumstance where multiple negatively correlated assets can trade in a correlated manner for a small period of time. In this example it would be the United States Dollar and crude oil depreciating simultaneously. The events of the last two weeks in respect to the currency and crude oil markets are aberrations and are extremely unlikely to occur again unless another similar situation arises in the distant future.
Please join me for part four of this article that will be released on Sunday, November 2nd. Part Four can be found here and Part Five can be found here.
- Charles W. Petredis
Disclosure: COP owns a stake in LUKOIL and the mutual fund the author manages as well as the author’s family is long COP. The author’s family is also long PBR.
The Following Stocks Were Mentioned In This Article: COP, PBR
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- Commodities » Fundamentals of Crude Oil Pricing: Part III
- What Determines Crude Oil Pricing I | Bullish Bankers
- What Determines Crude Oil Pricing II | Bullish Bankers
- What Determines Crude Oil Pricing IV | Bullish Bankers
- What Determines Crude Oil Pricing V | Bullish Bankers
- Tuesday's Market Recap (12/9/2008) | Bullish Bankers
I am still looking for: When crude oil was (say) $125 per bbl., how much of that went to the Saudis?
In Texas, where my parents owned some oil property, their original deal was 1/16 of the going price per bbl. Why so little? The normal rate, if you own all the mineral rights on your land was 1/8 (in the late 1940’s). They sold half their mineral rights to pay for the land. In Texas, the oil company that buys the oil sets the price, not the seller!
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