Crude oil is actually a variable commodity. Most of us working in the industry never see it, simply pumping different types of petrol or gasoline into our cars.
The quality varies considerably, however, and determines what it can be converted into – higher-value products such as petrol/gasoline and aviation fuel and lower-value products such as fuel oil and mazut.
Oil refineries are configured to maximise the yields from whatever crudes they are supplied with. The lighter crudes are much more valuable than the heavier ones because they can produce higher fractions of the more valuable products.
The oil industry has developed a very sophisticated pricing system based on a few marker or reference crudes. Prices of oil from all other fields throughout the world are set by relationships with the marker crudes. They sell above or below the marker prices depending on the actual, or anticipated, yields from the refineries.
The best known of these is West Texas Intermediate (WTI) because the US has long been the largest oil market in the world. In the North Sea, Brent crude has long been accepted as the benchmark. Opec uses a basket of crudes to give an average price.
Oil has traditionally been priced in US dollars. When the “greenback” was stable against other currencies, that was widely accepted, but recent fluctuations have caused problems.
WTI prices are usually a few dollars higher than Brent because of the additional costs of transporting oil to the US from the Middle East and elsewhere. The Opec average is usually a few dollars lower because it includes some heavy crudes.
WTI has long been regarded as the key indicator of oil prices. Some days, more than 300billion barrels of WTI are traded on the New York Mercantile Exchange (Nymex), which is more than three times the world’s daily oil consumption.
WTI’s reputation has been shredded in recent weeks, however. The price has fluctuated erratically for reasons largely unconnected with world supply and demand.
Daily production of West Texas is actually less than 300,000 barrels. Brent oil production, per se, is now only about 6,500 barrels per day, which is less than 0.5% of UK oil output.
WTI is delivered to a pipeline hub in Cushing, Oklahoma, and serves only refineries in the Midwest. It is landlocked and not traded elsewhere, which is bizarre for a marker crude.
In recent weeks, the price of WTI crude collapsed to as low as $33, trading at a discount of nearly $12 to Brent. The local refineries had large stocks and the storage tanks in Cushing were full.
Perhaps influenced by this, Platts has launched a new Americas Marker Crude (AMC) which it hopes will replace WTI. This is based on US Gulf of Mexico production. The ACM assessment each day will reflect the most competitively priced crude oil among four US Gulf Coast pipeline sour crudes: Mars, Poseidon, Southern Green Canyon and Thunder Horse. The combined production of these crudes is more than 800,000bpd.
About two-thirds of world oil production is now priced in relationship to Brent, and I expect that proportion to increase because of the problems with WTI. Nevertheless, I doubt that many people in the industry know that the Brent field is now producing only about 6,500bpd.
Traded Brent is a blend and actually includes other similar light, low-sulphur crudes from the North Sea, such as Ekofisk and Forties, whose combined output is about 1.5million bpd. Thus, although Brent production itself has fallen dramatically, the Brent price has proved to be a reliable benchmark.
World oil prices have fluctuated between about $145 and $40 per barrel over the last year (the low $30s for WTI) – as market watchers and the North Sea industry know all too well.
Sterling has fallen from $2 to about $1.45 over the same period. If oil were $50 per barrel, at an exchange rate of $2, the sterling price would be £25. At $1.45, it would be £35.
Thus, exchange-rate fluctuations can make huge differences. The dollar has, in fact, fallen against most other currencies because of the financial crises in the US and the very low interest rates. That has caused great concern among many oil producers, notably in the Middle East.
However, I see no alternative to pricing in US dollars for the foreseeable future. What is more likely to happen is a widening of the differentials between Brent and other crudes, particularly in Asia and the Middle East. Sometime soon, the Brent field must cease production, but the Brent price looks certain to continue.
Tony Mackay is MD of Mackay Consultants
