Three Phases of the World Oil Market

Figure 10A.1: Three phases of the world oil market.

S. Blumsack © Penn State is licensed under CC BY-NC-SA 4.0

As shown in Figure 10A.1, the development of our current globalized oil market can be broken down into a few different stages. The first phase was marked largely by intra-company transactions, with occasional inter-company "spot" sales. The second was defined by the emergence of OPEC and its attempts to influence an increasingly global oil trade for political ends. The third is defined by the commoditization of oil markets, with regional prices linked by inter-regional trade and the development of sophisticated financial instruments such as futures and option contracts, which we'll discuss in more detail below.

Regional Pricing of Crude Oil

While the market for oil is global in reach, trade has clustered itself into several primary regions. This has happened despite shipping costs that are generally low (only a few dollars per barrel) and the ease with which oil cargoes can be directed and redirected towards the highest-priced buyers (in financial terms, oil is "fungible"). Nevertheless, prices in these regions tend to move in tandem.

One reason for regional pricing of crude oil is that it is a heterogeneous commodity - not all crude oils are alike. Some oil can be extracted at a cost of a few dollars per barrel, and flows like water (it would look like Coca-Cola coming out of the ground). Other oil requires sophisticated equipment, techniques and processing to extract, and is thick as tar, requiring special methods to transport it to the refinery (and to refine into saleable petroleum products). In general, oil with a low viscosity is referred to as "light," while thicker, higher-viscosity crude oils are referred to as "heavy." Light oils are generally valued higher than heavy oils. The viscosity of crude oil is measured on a scale known as the API gravity (API stands for "American Petroleum Institute"). The API gravity scale measures how heavy or light a crude oil is, relative to water (thus the terms heavy and light oil). The API gravity of a crude oil is measured by taking its specific gravity (density relative to water), and calculating:

$\text{ API Gravity }=(141.5÷\text{ Specific Gravity) }-131.5$

Sulfur content is another important determinant of value; the lower the sulfur content the better. So-called "sweet" oils are low in sulfur, while "sour" oils have a higher sulfur content. There are some differences in crude oil quality among the major trading regions. Pricing of heterogeneous commodities often involves establishing a benchmark or "marker" price that is used to track general price movements. Pricing in any particular transaction is based on the marker price, with adjustments for location and quality. Below are some brief descriptions of some of the major global benchmark oil streams, and the Energy Information Administration has a very nice article on the most important global marker prices [1]. The first two, West Texas Intermediate (WTI) and Brent, are the most important benchmark oil prices in the world.

• West Texas Intermediate (WTI) is a light crude oil that is primarily representative of the U.S. market. It is a "light sweet" oil, meaning that it has low density (high API gravity of around 40) and a low sulfur content.
• Brent is a blend of light sweet crude oils from the North Sea, off the coast of the United Kingdom. Its API gravity is around 38 and it has a somewhat higher sulfur content than WTI. Still, in terms of quality, WTI and Brent are largely comparable.
• Fateh is a crude oil stream from the emirate of Dubai (which is why it is sometimes simply called "Dubai Crude"). Fateh has an API gravity of around 31, making it a denser crude oil than either WTI or Brent. Fateh is also classified as a "sour" oil for having a higher sulfur content than WTI or Brent. The importance of Fateh as a benchmark oil price is that it is representative of crude oil shipments from the Middle East to Asia.
• Bonny Light is a light sweet crude oil stream from Nigeria. It serves as a benchmark for African crude oils because its low density and sulfur content make it comparable to WTI and Brent (and, indeed, the major source of demand for Bonny Light has historically been refineries in Europe and the U.S.).
• Urals is a heavy (low API gravity) and sour crude oil blend from Russia. It serves as a benchmark for oil exports from Russia.

A Market Squeeze

A very interesting and entertaining thing happened in the crude oil market in April 2020, when the price of oil on the futures market went negative, trading at -$37.63 per barrel. This means that if you were a potential buyer of crude oil, someone would have paid you $37.63 for every barrel of oil you agreed to buy. I don't know about you, but no one has ever paid me to fill my car's gas tank. It usually works the other way around. What on earth happened here? This short blog post from RBN Energy [2] has a good explanation. The reason for this price craziness has to do a little bit with panic in the oil market because of the coronavirus pandemic and a little bit with how futures markets work. Basically, what happened was that there were a bunch of crude oil traders who had contracts to buy crude oil for delivery in May 2020. Those traders either had to take physical delivery of a bunch of barrels of crude oil in May, or find someone else to assume their contract (this is called "closing one's position" in commodity market parlance). Well, since the pandemic had hit and crude oil demand had collapsed, there was no one in the market who really wanted to buy crude oil from these traders. And, there was no place for these traders to physically put the crude oil that they were obligated to take in May 2020. So these traders got caught in a market squeeze and had to pay others to close their positions. It's crazy, and hasn't happened in the crude oil market before...but it makes perfect sense when you realize how this market actually works!

Regional Analysis of Petroleum Product Movements: Petroleum Administration for Defense Districts

Please read this short but informative background on the PADD system [3] from the Energy Information Administration:

Originally created during World War II for the purposes of regional rationing of gasoline supplies, the Petroleum Administration for Defense Districts (PADDs) are still utilized today to track regional movements of crude oil and (particularly) petroleum products in the United States. While the PADD system might seem a bit archaic, studying the movements of petroleum products between the PADD regions is useful for understanding how these markets are segmented in the United States. Figure 10A.2 shows a map of the PADDs with the locations of oil refineries. Note that the figure shows operable refinery locations and capacity volumes as of January 1, 2012 (a long time ago!). This is because the last full year for which data was published was 2010.  

Figure 10A.2: Petroleum Administration for Defense Districts and oil refineries in each (2012).
The Petroleum Administration for Defense Districts (PADDs) are geographic aggregations of the 50 States and the District of Columbia into five districts: PADD 1 is the East Coast, PADD 2 the Midwest, PADD 3 the Gulf Coast, PADD 4 the Rocky Mountain Region, and PADD 5 the West Coast. Due to its large population, PADD 1 is further divided into sub-PADDs, with PADD 1A as New England, PADD 1B the Central Atlantic States, and PADD 1C comprising the Lower Atlantic States. There are two additional PADDs (PADDs VI and VII) that encompass U.S. Territories (these are not pictured on the map).

Credit: EIA [4]

Figure 10A.3: Inter-PADD shipments of petroleum products.

Credit: EIA [4]

The description of the PADD system from the EIA includes some data on inter-PADD shipments of petroleum products (remember that most of these will be gasoline and the “distillates” – diesel fuel and heating oil). Figure 10A.3 shows this data in visual form, again using the PADD designation map from the EIA. The figure indicates that there is substantial inter-PADD trade between the eastern states, the Gulf Coast and the Midwest. The Rocky Mountain states and the U.S. West Coast, on the other hand, are largely isolated from the rest of the United States and even from one another. Because of a lack of refinery capacity and pipeline capacity, the U.S. West Coast, in particular, has a gasoline and diesel market that is largely separate from the rest of the country. (This is also due in part to California’s gasoline standards, which are more stringent than in the rest of the U.S.)

Petroleum product pipeline maps are not available in the public domain, but you can view an image online at the following websites.

• United States Pipelines map [5]
• United States Pipelines map information [6] (for an explanation of what you will see on the map)

Refinery Economics

Oil refineries produce value-added petroleum products from crude oil. Profitability is thus determined by several different variables:

• Feedstock costs (primarily crude oil)
• Fuel costs and other operational costs for the refinery itself
• Costs of complying with emissions regulations (particularly NO_x)
• Market prices for the products produced.

Determining profitability for a specific refinery is very difficult, since data on operational and environmental compliance costs are generally not available. A rough measure could be obtained by calculating the cost of crude-oil feedstock (though to do this with precision would require knowledge of the crude blends used in a specific refinery) and comparing that cost with the market value of the suite of products produced at the refinery. This still requires more information than might be publicly available for a typical refinery, and is subject to market conditions for the various products produced.

A useful but simplified measure of refinery profitability is the “crack spread.” The crack spread is the difference in the sales price of the refined product (gasoline and fuel oil distillates) and the price of crude oil. An average refinery would follow what is known as the 3-2-1 crack spread, meaning for every three barrels of oil, the refinery produces an equivalent of two barrels of gasoline and one barrel of distillate fuels (diesel and heating oil). This ratio of refined product output closely mirrors the composition in Figure 2.4, but remember that the crack spread is only a first-order approximation of how profitable a refinery would be at the margin! The higher the crack spread, the more money the refinery will make, so it will be utilizing as much capacity it has available. Inversely, at some lower crack spread prices, it actually may be in the refinery’s best interest, due to costs for the plant, to scale back the amount of capacity utilized. Please see the appendix for an example and further elucidation of the crack spread.

Calculating the 3-2-1 Crack Spread

Calculating the 3-2-1 crack spread typically uses published prices for crude oil, gasoline and distillates. These prices are typically taken from the New York Mercantile Exchange. The NYMEX has traded contracts for crude oil and gasoline, but no contract for diesel fuel (the most-produced of the distillate fuel oils). In calculating the 3-2-1 crack spread, prices for heating oil futures are typically used instead. Below is an example of how to calculate the crack spread, using data from 2012.

• Oil Price: $84.54/barrel
• Gasoline Price: $2.57/gallon
• Heating Oil Price: $2.79/gallon
• (remember that 42 gallons = 1 barrel)
• (2 barrels * 42 gallons/barrel * $2.57/gal of gas) +
  (1 barrel * 42 gallons/barrel * $2.79/gal of heating oil) -
  (3 barrels * $84.54/barrel of oil) =
  $79.44 profit / 3 barrels of oil.
• The crack spread would thus be $79.44 / 3 = $26.48/barrel of oil

The crack spread, of course, is not a perfect measure of refinery profitability. What it really measures is whether the refinery will make money at the margin – i.e., whether an additional barrel of crude oil purchased upstream will yield sufficient revenues from saleable products downstream. In reality, existing refineries must consider their refining costs in addition to just the cost of crude oil. These costs include labor (though that is generally a small part of refinery operations); chemical catalysts; utilities; and any short-term financial costs such as borrowing money to maintain refinery operations. These variable costs of refining may amount to perhaps $20 per barrel (depending on conditions in utility pricing and financial markets). In the example above, the true margin on refining would be $6.58 per barrel of crude oil – much lower than the simple crack spread would suggest.

The crack spread tends to be sensitive to the slate of products produced from the refinery. In the example above, we used gasoline and distillate fuel oil (heating oil) because those are two typically high-valued products, and U.S. refineries are generally engineered to maximize production of gasoline and fuel oil.

The crack spread is also sensitive to the selection of the oil price used. In the example above, we used the NYMEX futures price for crude oil, which recall is based on the West Texas Intermediate blend - a fairly light crude oil. Many U.S. refineries, however, are engineered to accept heavier crude oils as feedstocks. If there are systematic differences in the prices of heavy crude oils versus West Texas Intermediate, then the crack spread calculation (while illustrative) may not be sensible for a particular refinery.

The Energy Information Administration recently published a couple of good articles describing how the U.S. refinery fleet has been adjusting to changes in U.S. crude oil production. Not only has the quantity of crude oil produced in the U.S. been increasing rapidly, but the oil coming out of the large shale plays (like the Bakken in North Dakota) is much lighter than the crude oils typically accepted by U.S. refineries.

The first article, Regional Refinery Trends Continue to Evolve [7], published on 7 January 2015

The second article, Regional Refinery Trends Evolve to Accommodate Increased Domestic Crude Oil Production [8], published on 15 January 2015