Currency Market, Commodity Market, and Government Securities

Lesson -> The Crude Oil - Part 02

11.1 -  The Mapping companies

I hope that you found the last chapter helpful in understanding the current state of crude oil fundamentals. You may be interested in learning more about how crude oil is extracted and delivered to different stakeholders, such as the refineries. YouTube's 'Oil and Gas videos channel has done an excellent job of creating animated videos about this topic.

This animated video provides a high-level explanation of oil extraction from ocean beds and ground. This video will help you understand the meaning of 'oil-rigs. These are the important pad-like objects floating in the sea with exhaust fumes. This infrastructure is being built by companies such as Aban Offshore and Selan Exploration. Many traders and investors invest in these asset-heavy businesses without understanding the operational core. I know many of them. This is a bad idea. One should always be aware of what they are doing. This, along with the importance of crude oil for many listed companies, leads me to briefly discuss the structure of the oil industry.

11.2 - Upstream and downstream, as well as midstream

Note: I am not an oil and gas expert. My knowledge is limited to the basics. Because the trading opportunities might not always be available to you, it is important to understand the industry dynamics as a crude oil trader. One example is that there may be a fundamental shift in crude oil. While it might not result in a trade in crude oil right now, it could lead to a trade opportunity in downstream companies. It is important to understand the industry layout and identify opportunities in order to reap the benefits of this. This is my goal: to help you understand the industry and map out companies, and how they fit in the overall oil-and-gas ecosystem.

So let us get started.

There are three main sections to the oil and gas industry.

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

Let's briefly talk about each of them, starting with the upstream companies.

Companies upstream

The upstream companies they are the ones who do the hard work. They conduct geological surveys and dig bore wells to determine the depth of the ground. If they find oil reserves, then they begin drilling for crude oil. Upstream companies take many years to find a potential oil well and turn it into a profitable, functional oil well. Oil is stored in barrels by upstream companies, which produce millions of barrels every day. These companies are heavy on engineering and R&D. They end up spending large amounts of money (referred to as capital expenditure) in order to extract oil.

They have no control over the oil's price on the open market. The markets where market participants such as you and me participate in determining the price of oil are key to influencing the global price. Each upstream company has a breakeven price, which is the cost of producing one barrel oil. Also known as the 'full cycle cost', the breakeven point can also be called "full-cycle cost". These companies will do everything possible to lower their costs and reduce the full-cycle cost.

Some of India's upstream companies include ONGC and Carin India, Reliance Industries and Oil India. Companies such as Shell and BP, Chevron, etc., are included in this category internationally.

It is important to remember that low oil prices don't really favor upstream companies, especially those with high economies of scale and high full-cost cycles. These companies are able to make more money by extracting oil at a higher price, which is obviously good. However, their margins will improve dramatically.


Companies downstream

We'll talk about thedownstream industryThe midstream industry is first. The job of the upstream companies is to produce crude oil. Crude oil, as you know, is only produced in its raw form. The crude oil must be refined if we want to use it for petrol or diesel. The downstream industry is crucial here. These companies buy crude oil from the upstream companies and then refine it to different forms, such as petrol, diesel or aviation fuel, marine oils, kerosene and lubricants. They also make waxes, asphalt, liquefied petroleum gases, etc.

This sector has companies that distribute products throughout the value chain. This phenomenon is best illustrated by petrol bunks. Petroleum bunks can be described as a retail outlet that sells petroleum products. They are owned by downstream companies.

BPCL and HPCL are good examples of Indian downstream companies. Companies may try to integrate across the value chain. This means that they attempt to do both upstream as well downstream operations. These companies are called the "Super Majors". Exxon Mobil Corp, a US-based company, is a classic example. They produce approximately 4 million barrels of oil per day and have around 40 oil refineries in 21 countries. A large-scale operation like this requires a lot of management and operations. Not everyone is up for it.

If oil prices drop, it means that downstream companies will be able to buy oil at lower prices than the upstream company. This is bad news for the upstream boys, as their efforts to make oil are still being made. The end-user does not get the benefit of a lower oil price, however. You and I may not realize it, but developed countries such as the US and UK have this benefit quite quickly.

Here are some things to keep in mind at this stage.

  • There is a mutually beneficial relationship between upstream and downstream companies.
  • Low oil prices can be bad for upstream guys, but good for downstream folks.
  • A higher oil price is good for upstream guys, but not for downstream ones.

Don't rush to sell ONGC and BPCL if you see oil prices falling. Consider whether the company is an upstream or downstream company and how oil prices will impact the company.

Companies in the midstream

We'll quickly discuss theMidstream companiesBefore you look at other aspects.

Midstream companies act as a conduit between upstream and downstream companies.They transport oil from oil wells to refineries. They transport oil by pipelines, roads (oil takers), and ocean shipments. They can be thought of as wholesalers for crude oil. Some midstream companies attempt to increase the value chain by refining crude oil. Their operations often overlap with those of downstream companies. Midstream companies work with both upstream and downstream companies. They are in the middle of oil price fluctuations. This is bad news for upstream companies if the oil price drops. The same goes for downstream companies if prices rise. This is not good news.

TransCanada, Spectra Energy and Willams and Company are some of the major players in this sector.

11.2 - Difference Between WTI Crude Oil and Brent

People tend to talk about Crude Oil as though it were a single entity, like Gold. This is false. There are many types of crude oil that can be extracted from the ground. Geographic variation and unique characteristics are the main factors that make each oil different. Geometry has a huge impact on the characteristics of crude oil. These include thickness, colour (light, dark, and golden), viscosity as well as sulfur content and volatility.

There are many types of Crude oil. I won't go into detail about the various types of fat, although I would like to.

Before we discuss the differences between the two, let's first mention two characteristics of crude oil that define the variety of crude.

API GravityAPI stands for American Petroleum Institute. This is an acronym that allows you to compare the lightness and weight of crude oil with water. The 'API Gravity of a particular oil variety is greater than 10 to indicate that it is lighter than water. The oil can therefore float on water. API gravity below 10 indicates that the oil weighs more than water and will therefore sink in water.

SweetnessSulfur is a natural component of crude oil in any form. I was told that the oil is considered'sweeter' if it has a lower sulfur content (which I believe to be sub 0.5%). The oil is considered to be 'not as sweet' if it has a higher sulfur content.

The API Gravity and its sweetness are the main factors that make Brent and WTI different.

West Texas Intermediate (WTI).This is a high-quality crude oil. The final products must be of a superior quality. WTI is classified as super-light because its API gravity is 39.6. If it is higher than 10, it is lighter than water. It is also a beautiful crude oil because it has a low sulfur content of 0.26 percent.

Brent Blend -Like blended Scotch, crude oil can be mixed to make certain variants. The Brent blend is made by mixing oil from more than 15 oil wells. Brent has a sulfur content around 0.37%. This makes it sweeter than WTI, but not as sweet. Brent is considered light due to its API gravity of 38.06.

Both are sold at different prices due to their differences in characteristics. Take a look at this price quote for the two variants.

Brent crude oil is more expensive than WTI. MCX crude oil trades on MCX follow the Brent crude, not WTI. This is important. Brent crude is actually the international benchmark for crude oil prices.

11.3 - Crude Oil Inventory Levels

Supply-demand affects crude oil prices, and thus the profitability of many companies that are connected at different points in the oil-and gas ecosystem. This makes it important to track the crude oil price inventories. This information can be used to trade crude oil at MCX as well as trades on companies like BPCL or HPCL.

Two organizations provide inventory details:

  1. US Energy Information Administration (US EIA)They provide weekly inventory reports. Keep in mind that inventories can increase when there is a shortage of demand. Also, lower inventories can indicate a lot more demand or a reduction in production. Both are good news for crude oil prices and upstream companies.
  2. OECD Crude Oil inventoryOECD stands to represent 'Organization of Economic Cooperation and Development'. OECD also provides crude oil inventory, but not at a weekly forecast as EIA.

11.4 - The relationship of the US Dollar to Crude Oil

The relationship between crude oil and the US Dollar is inverted. The price of crude oil will drop if the US Dollar is stronger. A weakening USD can also lead to higher prices for crude oil. It is important to remember that each of these assets has its own supply-demand dynamics, which influence their price movements; however, they can be somewhat linked to each other.

You will find many charts that show this inverse relationship if you search Google for "Crude Oil versus Dollar". Here's an example:

It is important to remember that these charts do not use the "USD Dollar Spot", but the "Dollar Index", which represents the dollar against other major currencies. This is logical, as crude oil is an international currency, and payments are made in US dollars regardless of who is purchasing it.

This means that countries will tend to buy more oil at the same price if the dollar rises (for whatever reason). More oil can be bought for the same amount of dollar. This causes a faster depletion in inventory and therefore, an increase in the oil price.

This argument holds true for long periods of time. Both assets have their fundamental dynamics. There could be situations where they may not have inverse correlation but move in the same direction.

Remember that the inverse correlation does not indicate that assets move in opposite directions but only indicates that they do so in the same direction. For example, a 10% drop in the dollar does not mean that Crude oil will rise by 10%.

The next chapter will be about the contract specification for Crude oil on MCX.

To Summarize

  1. It is crucial to fully understand the Oil & Gas Ecosystem and map the companies that are included within it.
  2. Companies involved in the extraction of oil from the ground are considered upstream and have a high asset count.
  3. Upstream companies benefit from an increase in oil prices, but not from a decrease.
  4. Refineries are the mainstay of downstream companies. They are not happy with a higher oil price, but they can benefit from lower oil prices (since their margins tends to increase).
  5. Oil and gas logistics are handled by midstream companies. They are more comfortable with stability in oil prices when doing business with upstream and downstream companies.
  6. WTI and Brent are crude oil variants that differ mainly in terms API gravity and sweetness.
  7. Brent Crude is an international benchmark.
  8. It is crucial to keep track of your inventory levels. An increase in inventory will decrease crude oil prices, while a decrease in inventory will cause crude oil prices to rise.
  9. Over longer periods, the USD index and crude oil have an inverted correlation. This relationship could break down over shorter time frames due to their supply-demand dynamics.