Economics of Crude Oil - Black Gold or Not?

Introduction

The Year 2020, or the 'Year of the Rat' as they call in People's Republic of China (PRC) brought forward myriad unexpected lows in the global scenario. Of all the wild, unprecented swings in the financial markets since the Covid-19 pandemic broke out, none has been more jaw dropping since the collapse in WTI (West Texas Intermediate) crude oil prices on April 20, which is a key segment in the US oil trading.

Fundamentals

We will, through this write-up primarily discuss about the recent WTI oil price crash. But before we begin that, we will briefly talk about the fundamentals of crude oil – facts and figures. We will skip the origin, extraction, distillation and distribution of crude oil. It is important to understand a few basic properties of crude oil, the key raw material processed in a refinery. They vary across colour, composition and consistency and are classified as light or heavy, and sweet or sour. A chemical compound is a mixture of two or more elements, and thus, like water, crude oil is not a chemical compound. It is rather a hydrocarbon i.e it exclusively consists of hydrogen and carbon atoms. Each of the compounds in the crude oil boils at its own boiling temperature. The higher the carbon component in the compound – the higher the boiling temperature, which is why crude oil is refined into several products, some of which are: asphalt, gasoline, kerosene, lubricants, feedstocks etc. which are further refined.

Now how to determine which crude oil is light, sweet and which is heavy, sour? The popular approach in the oil industry is to use the API Gravity. The higher the API Gravity, the lighter the oil and vice-versa. Crude oils with less than 0.5% sulphur are referred to as light, sweet oil, whereas those greater than 2.5% are referred to as heavy, sour oil, the ones between these values are considered intermediate. Crude oil is measured in barrels with each barrel equalling 42 gallons. 1 gallon is equal to approximately equal to 3.8 litres. The oil is extracted out of oil wells using drilling rigs into an underground or a subsurface reservoir. The oil is pumped out using pumps and it is transported to distributing stations using pipelines or oil tankers.

How is the Pricing of Crude Oil Determined?

The pricing of oil is determined on several factors, from producers' side, from buyers' side and others. We shall discuss them in brief.

Producers Side Pricing

Extraction of Oil: There are commonly two ways of extraction of crude oil:

1. Convention Extraction: Here, the pipe is drilled straight into the oil well deposit and it is pumped out and pulled to the surface. The costs of cement, acids, pumps, trucks, labour, solvents, power are expended to extract the oil. Saudi Arabia is mostly able to pump the oil cheaply, sometimes under $10 per barrel. The Middle East and North Africa (MENA) regions have a break-even cost around $20 per barrel while it is $30 to $40 per barrel worldwide.

2. Unconventional Extraction: Fracking is an unconventional way of extraction where the rocks are fractured to collect oil. The costs are higher because the productivity of the oil wells is very low. The barrel of oil produced per pressure drop is very low and the reservoirs are low of energy. The other costs in conventional oil drilling also applies here and thus, the break-even costs go up to $40 per barrel, which can run up to $60 per barrel.

Geopolitical Reasons: It is common knowledge that USA, Russia and OPEC are the largest producers of oil around the world. The constant demand to offset the balance between pricing of crude oil and capture of market share has always been the constant endeavour of the crude oil producers. While the oil companies of America are totally owned by the private players, the companies in OPEC and Russia are owned either by the Government or private or collaboration ownership. The oil producing corporates enter into deals with each other to regulate the production of oil by either increasing it or decreasing it.

Consumers Side Pricing

Demand: Government Policies and weather changes influence the demand of the prices. Summer seasons typically witnesses high pricing in oil and due to spike in demand and conversely, the demand in winter season falls. The rise in demand of heating oil still does not manage to offset the fall in demand for other products, most typically being gasoline.

Other Reasons

War and Terrorism: War and terrorism pushes the prices of crude oil higher from the usual. The reason being, refineries spike the demand of crude oil as the refining process needs to continue to serve the local demand. The traders also hike the prices knowing that the refineries will be ready to buy the crude oil in case of destruction of oil wells thereby resulting in a sharp decline in the supply.

Dollar Depreciation: Another important reason is the depreciation of dollar. The American dollar is the global currency and the transactions in crude oil are done through the American dollar. The increase in dollar makes the prices of crude oil rise, thus cutting the margins of refineries. However, there have been attempts among countries to peg the crude oil with other forms of currency, with little success.

In 2007 and 2008, contrary to the popular belief that the spike in crude oil from $70 per barrel to $160 per barrel was caused due to shortage in production, the spike in demand in diesel and airplane turbine fuel in Europe fuelled the rise. It flew so high; it was forecasted that the price of crude oil will touch as high as $200 per barrel. However, the global financial crisis of 2008 eventually caused the crude oil prices to plunge from a historic high of $140 per barrel to $50 per barrel. Geopolitical tensions have caused the price to rise at $130 per barrel but ever since then, it has remained steady at $70 per barrel.

Bench Mark System of Pricing

A benchmark crude is a crude oil that serves as a reference price for buyers and sellers of crude oil. There are three primary benchmarks, West Texas Intermediate (WTI), Brent Blend, and Dubai Crude. Other well-known blends include the OPEC Reference Basket used by OPEC, Tapis Crude which is traded in Singapore, Bonny Light used in Nigeria, Urals oil used in Russia and Mexico's Isthmus.

Benchmarks are used because there are many different varieties and grades of crude oil. Using benchmarks makes referencing types of oil easier for sellers and buyers.

There is always a spread between WTI, Brent and other blends due to the relative volatility (high API gravity is more valuable), sweetness / sourness (low sulphur is more valuable) and transportation cost. This is the price that controls world oil market price.

Where Does India Gets its Crude Oil?

India imports most of its crude from the Middle East. Brent is mainly found in the North Sea where the Brent crude is used as a global benchmark for pricing of crude oil. However, for India, Brent will be too expensive to import. India uses mostly Dubai crude or the Indian basket crude from the Middle East. WTI is mainly found in America and is more expensive than Middle Eastern oil due to the costs of transportation. Thus, India already purchases the cheap crude. Also, Brent and WTI are sweet in comparison to Middle East oil, which means they have less sulphur and other chemicals. Indian refineries are designed such that they purify Middle Eastern grade crude and produce by products, and the usage of other grade of crude may hamper the production of the by-products and the operation of refineries will be less profitable.

Few years back India had a $31 billion trade deficit with USA and Donald Trump insisted India to fill the gap. It was subsequently filled with the purchases of crude oil and advanced weapon systems.

India also imported a small percentage of crude oil from Venezuela. The purchases went smooth until President Nicolás Maduro of Venezuela lost favour of Donald Trump for his socialist policies. The Venezuelan Government is under sanctions from America and thus dollar payments cannot be made. Thus, in 2018, Venezuela offered India to buy oil at a 30% discount, provided the payments are made in cryptocurrency. Venezuela developed its own cryptocurrency named 'Petro' and it entered into a cryptocurrency exchange based in Delhi named 'Coinsecure' where the cryptos will be transacted.

Since the RBI was wary of cryptocurrency because of reasons obvious to it, India was not comfortable to buy oil from the Latin American nation in exchange of crypto. Also, the Venezuelan oil is extremely sour and heavy and only the Reliance refinery in Jamnagar had the capacity to refine it.

The Capital Markets of Oil

Unlike the corporate bonds and equities which do not have a tangible form, but are traded from demat to demat among traders and investors, crude oil as a commodity does not behave that way. There are 2 kinds of players in the oil markets- the traders and the buyers (corporates for refineries).

The traders do not buy the actual crude oil commodities. They buy and sell the commodity futures. An oil futures contract is an agreement to buy or sell a certain number of barrels set amount of oil at a predetermined price, on a predetermined date. When futures are purchased, a contract is signed between buyer and seller and secured with a margin payment that covers a percentage of the total value of the contract. End-users of oil purchase on the futures market to lock in a price; investors buy futures to essentially gamble on what the price will actually be down the road, and profit by guessing correctly. Typically, they will liquidate or roll over their futures holdings before they would have to take physical delivery.

The price of the spot contract reflects the current market price for oil, whereas the futures price reflects the price buyers are willing to pay for oil on a delivery date set at some point in the future. The futures price is no guarantee that oil will actually hit that price in the current market when that date comes; it is just the price that, at the time of the contract, purchasers of oil are anticipating. The actual price of oil on that date depends on many factors.

The corporates purchase the crude oil for refining in their refineries through a process called fractional distillation. The processed components of oil are then sold to various companies.

The traders mainly buy and sell oil for speculation, but the corporates are the actual users of the commodity. On the expiry of the contract, the corporate refineries purchase the physical commodities from the producers.

The April 20, 2020 Oil Price Crash

For particularly WTI crude oil, what happened on April 20 was, due to corona virus, there was no demand and consumption of crude oil and thus there were active storage capacities present with the refineries. The oil was continuing to be produced. The refineries were not buying the contracts as there is a huge storage cost and transportation cost involved to store the oil as well. The price ultimately plunged to -$37 per barrel and the producers and traders were literally paying the buyers for taking the oil away as there was no room to store the crude oil. The WTI crude is landlocked and thus there is a huge logistics cost to transport the oil from the oil wells to the ports and other distributing station.

The global oil consumption is roughly 100 million barrels per day and the supply generally stays in line with that. The consumption is down 30% globally and the cuts in production are far less. A record 60 million barrels of oil is sitting in tankers around the world.

The price drop in global markets was caused due the following two major reasons:

1. Demand Side - Covid-19 Virus: Due to the outbreak of the corona virus, several governments have imposed lock-downs in their respective nations. Due to lock-down, the industries and logistics both have shut down, causing a sudden plunge in the demand of vehicular fuel. The creeping rise in electric vehicles are also contributing to the shift away from gasoline, although that caused a very small dent to the crude oil consumption owing the increasing consumption.

In basic economics, when demand side push causes an inflationary rise in price of commodities, a general withdrawal of demand will cause a reverse effect. Due to the closure of industries, logistics and ports, India is also not able to consume oil, and there is no demand being created. This has taken suit in a lot of countries across the globe.

Also, there has been an evaporation in the consumption of ATF since the airplanes were all grounded post lock-down.

2. Supply Side – Breakdown of Saudi Arabia and Russia Deal: In 2018, OPEC (Organization of Petroleum Exporting Countries; a group of 14 nations) leader Saudi Arabia and Russia agreed to a deal to cut the production of crude oil. To facilitate the deal, OPEC formed OPEC+ which included non-OPEC nations like Russia and Azerbaijan (a nation under good Russian influence). However, due to corona virus outbreak, the demand of crude oil fell which led to a fall in prices and thus Saudi Arabia wanted deeper production cuts to maintain the supply level to match the demand level to put price into equilibrium. Russia denied this stance and thus, it broke away from the oil deal. Russian Government Oil Company - Rosneft, did not want to help American shale companies and thus disagreed to further production cuts with a view to steadily make the oil prices fall. OPEC saw it as a way to capture customers from the market. Plus, the American shale oil companies, who were producing high grade sweet light crude were gaining customers at the expense of Russia. It also wanted to test how long can the American companies test the low prices before becoming unviable and ultimately turning bankrupt.

To punish Russia, Saudi Arabia opened fire and started the price war. It started offering deep discounts to the customers and hiked the production of crude oil, the consensus of which was brought into by the rest of the OPEC members. American shale companies are privately owned corporations unlike Russian oil companies and OPEC oil companies. It is almost impossible to put a quota on shale oil production. Thus, there is a trade-off between price earnings and market share. There is no national American company to regulate oil production. This resulted into a loss of at least $100 million per day for Russia since they also had their own break-even price level. This would mean disastrous for a country already reeling under the sanctions of so-called illegal annexation of Crimea.

A question would arise – if the OPEC is bringing the price down to hurt Russia, won't it hurt itself as well? The answer is in affirmative. But then, they have two break-even prices, which includes one for lifting the crude oil. They are issuing bonds to the consumers to cover the deficit in the budget. It means, if the crude oil prices will remain low for far too long, it will mean disastrous for the Middle East as well.

For India, this was a goldmine opportunity because a drop in oil price would mean huge savings on the import bills despite the depreciating Indian Rupee. India is the world's third largest crude oil customer. Last year, it imported 85% of the crude oil which it consumed. Crude oil is bought and sold in American dollars in the international markets. When we are paying dollars for crude oil, that invariably pushes the demand towards the dollar against the rupee.

The crude oil stockpiles at Cushing, Oklahoma - America's key storage hub and delivery point of the West Texas Intermediate contract - have jumped 48% to almost 55 million barrels since the end of February. The hub had working storage capacity of 76 million as of September 30, according to the Energy Information Administration of USA.

Why Did the Oil Price Plunge Did NOT Affect India?

India's entire crude basket represents oil from Dubai and Brent crude, not WTI. The prices that have made headlines for hitting -$37 are of WTI which is mostly relevant for the local US, Canada and Mexican markets.

Brent crude, which is what India buys has also seen a fall of about 5%, but prices are still hovering around $27 a barrel. It's not as cheap as the WTI, which is the benchmark for the US oil.

Even if India were to buy WTI oil, practically for free, considering the prices are negative, India does not have enough capacity to store the oil. India had targeted over 15 million tonnes of strategic oil reserves. However, the total capacity available for storage is just 5.33 million tonnes (enough to meet 9.7 days of requirement). The remaining capacity is not ready yet.

Ongoing coronavirus lockdown in India means there is no economic activity and no significant demand for oil from industries. Indian refiners already have existing stock because IOCL bought oil from Saudi Aramco at quite deep discounts.

The price of crude oil in January 2020 was $65.93 per barrel and in March 2020, it was $31.49 per barrel, which means more than a 50% crash. In New Delhi, the prices of petrol and diesel on January 1, 2020 was Rs. 75.14 per litre and Rs. 67.96 per litre respectively. However, the prices of petrol and diesel fell only to Rs. 70.14 per litre and Rs. 62.89 per litre. It was not even a 10% price drop.

On March 9, 2020, the crude oil price saw a huge single-day price plunge from $45 per barrel to $31.52 per barrel. If the price of oil stood remained at $50 per barrel for the rest of the year, India would save a whopping $22 billion in the financial year 2020-21. A price drop below $35 per barrel would provide India a benefit of $30 billion savings. That is tremendously huge for an importing nation with a constantly depreciating currency.

The Oil Refineries in India have imposed the force majeure clause to avoid contractual obligations. IOCL has also cut its production of around 30% due to a decrease in demand from the consumers due to lock-down imposed by the Government of India. The cost of Indian crude has come down from the levels of $56.43 and $69.88 per barrel in 2018 and 2019 respectively to $24 to $25 per barrel on March 27 due to the double whammy effect of excessive supply and lack of demand. Whenever there has been a sharp fall in crude, our stock market has also fallen. The possible reason for this could be that crude-oil prices also indicate economic expansion and contraction. Often oil prices rise due to economic expansion and fall when there is a slowdown.

In wake of record slump in the WTI, Multi Commodity Exchange Clearing Corporation (MCXCCL), a wholly owned subsidiary of the Multi Commodity Exchange (MCX) of India, settled April expiry at a -Rs. 2,884 per barrel, in an unprecedented move which was never seen in India's commodity derivatives history.

As a result, many retail traders with long positions in the April 2020 contract would now have to pay around Rs. 1 lakh for every lot of crude, i.e. 100 barrels, at the MCX quoted closing price of Rs. 965 on April 20, as per Moneycontrol report. This was calculated assuming the trader would have paid the full value of the contract.

In India, as per (Securities and Exchange Board of India), the settlement of futures contract in physical delivery or cash settlement can be done on agri-commodities or energy commodities. For bullions and base metals, SEBI mandates physical delivery. SEBI Considering that 11,000 oil futures contracts remained opened on Indian commodity exchange at the end of the day, the loss for all long positions have been pegged around Rs. 418 crores, the report said.

In a circular issued on Tuesday, MCXCCL said crude oil futures contracts expired on April 20 need to be settled at, while taking into account the price of the front month contract, i.e. May 2020 in this case, which was trading at a negative $37.63 per barrel (or negative Rs 2884 per barrel) around 11P.M.

So, Why India Does Not Buy WTI Crude Oil?

The simple reason why India does not buy the Crude Oil from America in abundance is, the WTI Crude is sweet, light oil and the usage of other grade of crude may hamper the production of the by-products and the operation of refineries will be less profitable.

Breakdown of Petrol Price in New Delhi (Prices Vary in Difference States due to Different State Taxes)

Now, evidently, as the price of crude oil falls, the proportionate tax collection by the Governments also fall. Thus, they resort to hike in tax on vehicle fuel as it is a high source of revenue for the governments. That is why, the government on hiked excise duty on petrol and diesel by a steep Rs. 3 per litre each to garner about Rs 39,000 crore additional revenue despite the slump in international oil prices.

Supply Chain Investments in Crude Oil

Regards to an oil company's position in the supply chain, they can be categorised into 3 kinds: upstream, downstream, and midstream. Some companies are considered to be 'integrated' because they combine the functions of two or three of the groups.

Upstream oil production is conducted by companies who identify, extract, or produce raw materials. Downstream oil production companies are closer to the end user or consumer. Here's a look at upstream and downstream oil and gas production, their individual functions, and what role they play in the broader supply chain.

Upstream oil and gas production and operations identify deposits, drill wells, and recover raw materials from underground. They are also often called exploration and production companies. This sector also includes related services such as rig operations, feasibility studies, machinery rental, and extraction of chemical supply.

The closer an oil and gas company is to supplying consumers with petroleum products, the further downstream it is said to be in the industry. Downstream operations are oil and gas processes that occur after the production phase to the point of sale.

Why can't India Produce its own Crude Oil?

India produces around 36 million metric ton (MMT) of crude oil whereas, the requirement or consumption is around 200 MMT. Indian E&P Companies and Directorate General of Hydrocarbon (DGH) had been striving hard to explore in all the basins to strike black gold. A huge investment has been made in this sector, however the discovery of fields with fossil fuel had not been very encouraging.

Bombay High in Western Offshore, KG Basin in Eastern Offshore had given good results and the country is producing lion's share of crude oil and gas from these fields. Onshore fields in Assam, Gujarat and Andhra Pradesh have been contributing a bit for production of fossil fuel.

Having found oil and gas in Western Offshore, Eastern Offshore, Western and Eastern Onshore fields, the production continued to be in the range of 35-37 MMT in a year for over a long period. Reliance has explored several locations; however, the limited success was achieved in some of the field having water depth of around 1200 M. Deep-water locations of around 3000 M and so were not very productive.

The seismic results of shale gas fields looked very interesting and Geo-Scientists were very enthusiastic. They, however explored few locations, without much luck.

We can't produce Crude Oil, because so far it is not available in rocks in Indian boundaries. Oil Exploration is a gamble, who knows, we may strike some giant field one day?

Despite Having a Huge Production, Why does Canada Import Crude Oil?

Canada has the world's 3rd largest oil and gas reserves. The majority of oil extraction is performed in Alberta and the northwest territories. The primary form of oil present is heavy crude, which exists in the form of oil sands. This is opposed to sweet crude, which typically exists in the form of oil well deposits, and shale oil (shale can be either sweet or heavy crude in nature).

A majority of Canada's refinery capability is located in either Ontario or Quebec. This leads to a huge mix of problems. First off, heavy crude is painful to transport. It requires some pre-processing before it can be transported, as heavy crude is exceptionally thick after it's extracted. Even then, it costs more to pipeline heavy crude then it does to pipeline sweet crude, and it's by a noticeable margin. Heavy crude also requires additional processing during refinement, as the sand causes the oil to possess additional impurities that need to be filtered out. The vast majority of pipelines between Alberta and Ontario are built for sweet crude, rather than heavy crude. Even if we could reliably get heavy crude to Ontario, the refineries there can't process it. They are only built for refining of sweet crude.

Due to this reason, Canada ends up importing sweet crude for further refining. This could indeed be remedied, but it would require a massive amount of investment to be able to set up the infrastructure to pipeline and process the heavy crude into usable forms within Canada.

Disclaimer:

The information presented in the article has been written as per the relevant laws, market situations and condition. The aim of the write-up is to evoke an academic interest and discussion on the topic. This does not constitute in any way a recommendation and the author will not be liable for any actions taken by the readers on the same.

The author can also be reached at csrajatagrawal@gmail.com.

Bibliography:

• Bloomberg - Oil Crashes 31% in Worst Loss Since 1991 After Price War Erupts
• Business Standard - Venezuela Offers India 30% Discount on Crude but with Cryptocurrency Rider
• Business Today - Why India Can't Gain from US Oil Price Collapse?
• Business Today - WTI Crude Oil Price Drop Effect: MCX settles April Crude Oil Contract in Negative
• Economic Times - Excise Duty on Petrol and Diesel Hiked by Rs. 3 per litre, No Change in Oil Prices
• Energy Information Administration of USA
• Indian Oil Corporation Limited Annual Report 2018-19
• Indian Strategic Petroleum Reserves Limited; Official Website
• Oil Prices Website (https://oilprice.com/)
• OPEC Annual Reports and Monthly Oil Market Report
• Petroleum Planning and Analysis Cell of India