The New Era of Petroleum Trading Public Disclosure Authorized Spot Oil, Spot-Related Contracts, and Futures Markets

WORLD BANK TECHNICAL PAPER NUMBER 96 WTP-96

Hossein Razavi Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized RECENT WORLD BANK TECHNICAL PAPERS

No. 50. Turtiainen and Von Pischke, Investment and Finance in Agricultural Service Cooperatives No. 51. Shuval and others, Wastewater Irrigation in Developing Countries: Health Effects and Technical Solutions No. 52. Armstrong-Wright, Urban Transit Systems: Guidelines for Examining Options (also in Spanish, 52S) No. 53. Bamberger and Hewitt, Monitoring and Evaluating Urban Development Programs: A Handbook for Program Managers and Researchers (also in French, 53F) No. 54. Bamberger and Hewitt, A Manager's Guide to "Monitoring and Evaluating Urban Development Programs: A Handbook for Program Managers and Researchers" (also in French, 53F; Spanish, 53S; and Chinese, 53C) No. 55. Technica, Ltd., Techniques for Assessing Industrial Hazards: A Manual No. 56. Silverman, Kettering, and Schmidt, Action-Planning Workshops for Development Management: Guidelines No. 57. Obeng and Wright, The Co-composting of Domestic Solid and Human Wastes No. 58. Levitsky and Prasad, Credit Guarantee Schemes for Small and Medium Enterprises No. 59. Sheldrick, World Nitrogen Survey No. 60. Okun and Ernst, Community Piped Water Supply Systems in Developing Countries: A Planning Manual No. 61. Gorse and Steeds, Desertification in the Sahelian and Sudanian Zones of West Africa No. 62. Goodland and Webb, The Management of Cultural Property in World Bank-Assisted Projects:Archaeological, Historical, Religious, and Natural Unique Sites No. 63. Mould, Financial Information for Management of a Development Finance Institution: Some Guidelines No. 64. Hillel, The Efficient Use of Water in Irrigation: Principles and Practices for Improving Irrigation in Arid and Semiarid Regions No. 65. Hegstad and Newport, Manaigement Contracts: Main Features and Design Issues No. 66F. Godin, Preparation of Land Development Projects in Urban Areas (in French) No. 67. Leach and Gowen, Household Energy Handbook: An Interim Guide and Reference Manual (also in French, 67F) No. 68. Armstrong-Wright and Thiriez, Bus Services: Reducing Costs, Raising Standards No. 69. Prevost, Corrosion Protection of Pipelines Conveying Water and Wastewater: Guidelines No. 70. Falloux and Mukendi, Desertification Control and Renewable Resource Management in the Sahelian and Sudanian Zones of West Africa (also in French, 70F) No. 71. Mahmood, Reservoir Sedimentation: Impact, Extent, and Mitigation No. 72. Jeffcoate and Saravanapavan, The Reduction and Control of Unaccounted-for Water: Working Guidelines No. 73. Palange and Zavala, Water Pollution Control: Guidelines for Project Planning and Financing No. 74. Hoban, Evaluating Traffic Capacity and Improvements to Road Geometry No. 75. Noetstaller, Small-Scale Mining: A Review of the Issues No. 76. Noetstaller, Industrial Minerals: A Technical Review

(List continues on the inside back cover) WORLD BANK TECHNICAL PAPER NUMBER 96

The New Eraof Petroleum Trading Spot Oil, Spot-Related Contracts, and Futures Markets

Hossein Razavi

Technical Papers are not formal publications of the World Bank, and are circulated to encourage discussion and comment and to communicate the results of the Bank's work quickly to the development community; citation and the use of these papers should take account of their provisional character. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. Any maps that accompany the text have been prepared solely for the convenience of readers; the designations and presentation of material in them do not imply the expression of any opinion whatsoever on the part of the World Bank, its affiliates, or its Board or member countries conceming the legal status of any country, territory, city, or area or of the authorities thereof or concerning the delimitation of its boundaries or its national affiliation. Because of the informality and to present the results of research with the least possible delay, the typescript has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to Director, Publications Department at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to photocopy portions for classroom use is not required, though notification of such use having been made will be appreciated. The complete backlist of publications from the World Bank is shown in the annual Index of Publications,which contains an alphabetical title list and indexes of subjects, authors, and countries and regions; it is of value principally to libraries and institutional purchasers. The latest edition of each of these is available free of charge from the Publications Sales Unit, Department F, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or from Publications, The World Bank, 66, avenue d'Iena, 75116 Paris, France.

Hossein Razavi is a senior energy economist in the Asia Regional Office of the World Bank.

Library of Congress Cataloging-in-Publication Data Razavi, Hossein. The new era of petroleum trading spot oil, spot-related contracts, and futures markets ! Hossein Razavi. p. cm. -- (World Bank technical paper, ISSN 0253-7494 ; no. 96) Bibliography: p. ISBN 0-8213-1199-9 1. Petroleum industry and trade. I. Title. II. Series. HD9560.5.R39 1989 332.64'422282--dc2O 89-5791 CIP ABSTRACT

Until as recentlyas the early 1970s,the main channelfor oil supplywas the integratedsystem of the major oil companies.Each companyhad its own sourceof crude oil supplyas well as the capacityto refineit. Petroleum productsoutside this closedsystem, either released from it due to imbal- ances betweenrefinery output and marketdemand, or refinedindependently of it, constitutedthe basis for spot trading. The volumeof spot trading was limitedto around5% of the totaloil trade,while the remaining95% was based on contractsspecifying prices and quantitiesover relativelylong periodsof time. Even that limitedamount of spot tradingwas conductedin a very simplemanner. Most of the trade was in the form of uninvoiced exchangesand basedon personaltrust, characterizing an era that many oil companyexecutives remember as the "goodold days."

Today,spot and spot-relatedtrades comprise some 80% to 85% of the internationallytraded petroleum. Petroleumtrading not only has developedinto one of the largestworldwide commodity markets but has turned into an increasinglycomplex business. A spot trade involvesmillions of dollars and is carriedout by sale and purchaseagreements containing numerous safeguardmeasures. A cargo of oil may be bought and sold more than 30 times beforereaching its final destination.Still, each selleror buyer may utilize"petroleum futures," "options on futures,"and other financial instrumentsto hedge againstthe risk of possibleprice fluctuations.The interlinkagesamong spot trading,futures markets and contractsales have changedthe natureof the petroleumbusiness from its traditionalstraight- forwardproduction-oriented approach to a complex portfoliomanagement environment.

Althoughthe use of new trade instrumentsbegan in the early 1980s and almost all market participantsare still learning,petroleum traders of developingcountries have laggedbehind those in the developedcountries. This lag has resultedin the inabilityof thesecountries to procuretheir petroleumrequirements at the lowestpossible cost. While an individual entityresponsible for petroleumdistribution may be able to pass the cost to final consumers,the countryas a whole would lose by not takingad- vantageof marketinstruments which are designedto lowerthe price or the risk associatedwith the price. In particular,since petroleumcosts in most developingcountries constitute a largecomponent of the total import bill, the potentialto benefitfrom the use of moderntrading instruments is substantial.

Developmentof modern tradingskills, like that of any other know-how, requiresan action plan to build the needed institutionsand train the

(ii) concernedstaff. Before preparingan action plan, however,the staff, planners,and policymakersinvolved in petroleumsupply need to acquirea fundamentalunderstanding of the workingsand the issuesinvolved in the new era of petroleumtrading. This reportis intendedto providesuch an understanding. It providesa detaileddescription of petroleumspot markets, futuresand optionstrading and their interlinkageswith contractsales.

(iv) Tableof Contents

Chapter1 - An Overviewof PresentTrading Practices 1 The UnderlyingForces Behind Development of Spot Markets 1 VariousStages of Developmentof PetroleumSpot Markets 2 Interactionswith ContractMarkets 5 Interactionswith FuturesMarkets 8

Chapter2 - Mechanicsof Spot Trading 11 How It Works 11 MarketParticipants 12 The RotterdamMarket 16 Other Spot Markets 18

Chapter3 - Spot-RelatedDeals 24 Introduction 24 Countertrading 24 Discountsand Premiums 27 Term Contractswith Spot Prices 29 NetbackPricing Contracts 31 Calculationof Netbacks 32 Consequencesof NetbackDeals 35

Chapter4 - The Role of PetroleumSpot Prices 38 Sourcesof Information 38 Uses of Spot Prices 39 Most FrequentComplaints 41 Is There an Alternative? 43 Emergenceof New MarkerCrudes 48

Chapter5 - The Mechanicsof FuturesTrading 51 How FuturesTrading Works 51 MarketParticipants 53 Why Some PeopleHedge and Some Speculate 56 InvestmentOpportunities 58

Chapter6 - Evolutionof FuturesMarkets 62 From ForwardContracts to FuturesTrading 62 FuturesTrading in the PetroleumMarket 65 StatisticalTrends 70 Oil IndustryParticipation 70

(v) Chapter7 - The Rules of the Game 74 Organizationof a CommodityExchange 74 The Clearinghouse 75 Characteristicsof FuturesContracts 77 Specificsof PetroleumContracts 82 PetroleumContracts Traded at the InternationalPetroleum Exchange 85 Introductionof Propaneand NaturalGas Contracts 88

Chapter8 - PetroleumOptions Trading 91 Introduction 91 Mechanicsof OptionTrading 92 What FactorsDetermine the Size of the Premium? 94 Participantsin PetroleumOption Trading 100 Examplesof Hedgingwith PetroleumOptions 102 Volumeof OptionTrading 108

Glossaryof Terms 110

Bibliography 114

(vi) CHAPTER1 AN OVERVIEWOF PRESENTTRADING PRACTICES

Crude oil and petroleumproducts are tradedin eitherof two categories: by contract(sometimes referred to as term sales)or by spot transactions. A contractsale, as the name indicates,commits the buyer and sellerto tradeoil over a set periodof time and often at fixedprices. In the past, this period could have been as far ahead as three years. More recently, both the contractperiod and the price have been much more flexible. Spot sales,on the other hand,refer to very short-termtrading, usually involv- ing one cargo of oil per deal,with each deal struck at an agreed price for prompt liftingor delivery. Spot tradingcan thus be definedas a process by which cargoesof petroleumare exchangedon a day-to-daybasis rather than under long-termcontracts.

Duringthe past four years,spot tradingin petroleumhas grown dramatic- ally, from 10-15%of total volumetraded in the internationalmarket to about 30-35%. In addition,a new wave of spot-relatedtransactions which link the contractprice to spot marketprice has emerged. These deals, which were virtuallynon-existent before the 1980s, now comprise an estimated50-55% of total trades.

This chapterbriefly reviews recent developments in the spotmarket and the interactionsof this marketwith contractsales and futurestrading.

The UnderlyingForces Behind Development of Spot Markets

Since the age of barter economies,the startingpoint of trade for all grainsand mineralshas been the spotmarket. In this sense,a spotmarket is the "natural"market and the contractmarket is a specialarrangement introducedat a laterstage to copewith certainproblems. The main problem with spottrading is that neitherthe producernor the consumercan predict the price and quantityand thus are unableto plan their business. The extentof this problemis, of course,different for variouscommodities dependingon the volatilityof the market and the lead time needed for investmentdecisions. The most difficulttrading situation, and the one typical of the oil industry,is that in which: (a) supplyof the commodity, and therebyits price,are subjectto manipulation;and (b) there is a long investment lead time for both producers and consumers, who may, in turn, use this commodity to produce other goods. Faced with the unpredictability of spot tradingand the problemsit poses for planning, both producers and consumerssearch for contractualarrangements that providepredictability in price and quantityover a specifiedperiod of time. Thus, the develop-

1 ment of a contractmarket is mainlya responseto the need for planningof businessactivities on the part of both the producerand the consumer.

While contractsfacilitate the planningand managementof businesses,they take away flexibility.Term contractsare normallymade for long periods of time and at predeterminedprices. When businessconditions are relatively stable,the rigidityof these contractsis acceptable. But when markets become unstable,rigid contractscan hinder efficientbusiness operations. The attemptto balancethe benefitsand drawbacksof both systemshas resultedin two approachesto trading. In the shortand medium terms producersand consumersneed flexiblearrangements, combine spot and contracttrading in their portfoliosin order to keep some flexibility (throughspot trading)while preservingpredictability (through contract trading). The compositionof such a portfoliowill vary among business entitiesand over time. As a result,the industry'strade, at the macro level,will undergoperiodic shifts between spot and contracttrading. In the long run, the industrywill embark on a search for "more flexible contracts."This would includecontracts with flexiblepricing and delivery arrangementsas well as contractswhich can be sold to a thirdparty. There is, of course,a limitto this flexibility.If contractswere to becometoo flexible,they would no longerbe contracts.

The searchfor flexiblecontracts will eventuallylead to the introduction of futures markets. These markets will, indirectly,provide contract tradingwith price flexibilityand transferabilityoptions while allowing contractsto be basedon long-termdelivery and fixed-priceconditions.

Afterfutures markets are incorporatedinto overall trading practices, both buyersand sellersare betteroff to returnto long-termcontract trading, as this typeof tradingcan be combinedwith futuresmarket activity to keep the flexibilityneeded to cope with the changingbusiness environment. The extent of this return would depend on how fully futuresmarkets have developed. If they are worldwideand cover a sufficientlylong periodof time into the future,then there is littleincentive for spot trading. Under such circumstances,most sellersand buyersfind it advantageousto use contracttrading; the spot market'srole will then diminishto a residualor balancingmarket. However,in practice,there are limitations to the developmentof futuresmarkets in terms of geographicalcoverage, lead time, and productcoverage, and thus the returnto contracttrading will remainfar less than perfect.

VariousStages of Developmentof PetroleumSpot Markets

Spot transactionsin oil have been around for as long as the industry itself. However,today the spot marketis normallytaken to refer to spot

2 tradingin Rotterdam,New York Harbor,and a few other centers. These marketshave becomeestablished only in the past two decades. They have developedin four distinctstages:

STAGE1: THE SPOTMARKET FUNCTIONING AS THE RESIDUALMARKET:

Almostall oil companiesface the problemof matchingtheir refinery outputs with the market'scurrent demands for variousproducts. They have deficits of some productsand surplusesof others. The companymay balancethese deficitsand surplusesthrough the use of storageand/or shipment facilities. But quiteoften it is more economicalto balancethem by swappingor sellingand buyingsome products on the spotmarket. This was primarilythe functionthat the spot marketserved at its early stagesof developmentin the 1950sand 1960s.

The role of the spot market at this stage can be describedas a residual channelof oil trade. The main channelfor oil supplywas the integrated systemof the majoroil companies:each companyhad its own supplyof crude oil as well as the capacityto refineit. Petroleumproducts outside this closedsystem, either released from it due to imbalancesbetween refinery outputand marketdemand, or refinedindependently of it, constitutedthe basis for spot trading. The volumeof spot tradingwas limitedto around 5% of totaltrade, while the remaining95% was basedon contractsspecifying pricesand quantitiesover relativelylong periodsof time.

STAGE2: SHIFTFROM A RESIDUALTO A MARGINALMARKET:

After the 1973-74crisis, the spot marketbegan to play a marginalrole in petroleumtrading, that is, smallbut significanttrading as opposedto the small and insignificanttrading of the residualmarket. The significance is, of course,in termsof the impacton the main (contract)market. When the spotmarket serves a residualrole it basicallyfollows contract prices (usually with a discount or a premium) without significantly affecting these prices. But when the spot market serves a marginal role, it becomes an indicator of overall market conditions. As in any other business,when decisions are to be madein the petroleum industry, decisions are determined by marginal results. The cost and revenueof producingor processingthe marginal barrel constitute the basis of decision making in many planning areas--especiallyin refineryoperations.

The spot market'sshift from a residualto a marginalmarket occurredin 1975-78when low spot priceswere used as indicatorsof soft marketconditions by both the petroleumindustry and the governmentsof consuming countries (to set price control policies). The shift accelerated after 1979

3 when it was demonstratedthat the spot marketcould play this role in both tight and soft marketconditions.

STAGE 3: TURNINGINTO A MAJOR MARKET:

Despitethe significanceof spot transactionsto the industry'splanning and pricingpolicies, their volume remained small during the secondstage of marketdevelopment. It was only after 1983 that spot and spot-related trade startedto grow appreciably.By 1985,spot and spot-relatedtransactions were thoughtto accountfor 80-90%of internationallytraded oil. Several factors have contributedto this rapid growth. First, excess capacityin the refiningindustry has forcedrefiners to fight for their survival. Refinerswere forcedto use the most economicalway of procuring crudeoil. They increasedtheir refinery throughput to the pointwhere the priceof a marginalbarrel of productcovered the marginaloperating cost. Thisbrought about a shiftfrom term-contractarrangements to spot purchas- ing of crude to take advantage of flexible (declining) spot prices compared with rigid contract prices. It is also becoming a commonpractice to "refinefor the spot market." That is, despitea traditionof refiners' determiningtheir level of operationin the light of market demand and sellingonly surpluseson the spot market,excess capacity has now forced many refinersto refineand sell on the spot marketsas long as they can cover operatingcosts.

Second,as OPEC countriesbegan to losemarket share, they began to engage in so-called"spot-related" sales to recapturelost sales. These spot- relatedsales includedvariable price contracts,barter trade, netback pricingdeals, etc.

STAGE 4: PARALLELFUNCTION WITH FUTURESMARKETS:

Marketsin petroleumfutures developed in responseto instabilityin spot prices. The first-generationof petroleumfutures, including a crude oil contracton the New York CottonExchange and a BunkerC and gas oil contract on the New York MercantileExchange (NYMEX), were introducedin 1974.

Noneof the firstgeneration contracts attracted the petroleumindustry, and all faded into obscurity. The most importantreason for this failurewas thatpetroleum prices did not fluctuateas expected.The internationalspot price of crude oil stayedbetween $10.30 and $10.40a barrelduring the period from October 1974 to December1975. Price stabilitywas further reinforcedin the UnitedStates by the EnergyPolicy and ConservationAct (1975)which, by limitingthe annualincrease in the crude oil price,led to reasonablepredictability in petroleumprices.

4 The second-generationof petroleumfutures started with the introductionof a heatingoil and heavy fuel contracton NYMEX in November1978. The heatingoil contractwas a successbecause:

o fueloil had been exemptedfrom price controls in more than 40 U.S. statesin 1976;

o the internationalprice of oil becamevery volatile after 1978; and

o the completederegulation of the U.S. oil price by the Reagan administrationin February1981 forged a strongerlink between U.S. pricesand volatileinternational prices.

The successof the heatingoil contractencouraged NYMEX and otherexchanges (ChicagoBoard of Trade, ChicagoMercantile Exchange, and International PetroleumExchange of London)to introduceother petroleumfutures. Among them,the crudeoil contractintroduced on NYMEX in March 1983was the most significant:it expandedthe potentialfor tradingpetroleum futures and substantiallyintensified the interactionbetween the futures and spot markets. Indeed,it was after the introductionof this contractthat the petroleumindustry began to take futurestrading seriously. The significance of this contractwas in:

o its "cashmarket," i.e., the spot crude oil market,being one of the largestcommodity markets in the world;

o the complementaryrole of thiscontract in providingthe industry's requirementof a crude/productmix of contractsbefore effectively utilizingpetroleum futures for hedgingpurposes;

o the fact that it soondeveloped into a pricesignalling channel for the tradersof crude oil, especiallyin the UnitedStates.

At Stage 4, petroleumspot markets and futurestrading are both still growing and increasingtheir roles in the industry'sdecision-making process. At the same time, the two marketsinteract, compete, and comple- ment each other. As has been the case in the developmentof othercommodity markets,the coexistenceof spot and futurestrading is a sign of a maturing market.

Interactionswith ContractMarkets

In general, interactionsbetween contractmarkets and spot trading are numerous,complicated, and difficultto comprehend.However, in the case of petroleum,the traditionalstructure of the marketand, in particular,

5 the differentbehaviors of the independentcompanies and the majoroil companies,facilitate the analysisof theseinteractions. Although it may no longerbe the case,for almosttwo decadesthe pricingpolicy of the majorcompanies was associatedwith contract markets while the independent companiesfollowed spot market directives. Beginning in the early1970s, contractswere signed between the major companies and the governments of oil producingcountries which had takenover the production of crudeoil. The companieswould then refine the crudein theirown refineriesor resellit to thirdparty customers, including some independents and government-owned companiesin consumingcountries. Thus, the majorcompanies were the main channelof contracttrading in the petroleummarket. The independent companies,on the otherhand, bought some of theirrequirements from the largecompanies but reliedheavily on the spotmarket.

The flexibilityof the independentsin adjustingbetween sources of supply providedthem with an opportunityto gain from spot tradingunder soft marketconditions. They utilized this opportunity very effectively. For example,during the slackperiod (1975-78), independents were ableto buy cheap crudeand productson the spotmarket, and undersellthe majors' retailoutlets in mostof Europe.However, the spotmarket dependence made them also vulnerableto volatilitiesof spot pricesunder tight market conditions.This was experiencedin 1979when independents were forced to buy expensivesupplies on the spotmarket and resellthem at retailprices which,although they barely met thecost, were much higher than the majors' lowprices based on cheapercontract supplies.

The interfacebetween the majors and the independentsin the retailmarket providesa usefulexposition of theinteractions between the spot market and the contractmarket. These interactionsare based on two principles: (a)the relativepositions of the averageand marginalcost curves under softversus tight market conditions; and (b) the differencebetween the weightedaverage cost of suppliesto independentsand the majors. These principles,explained below, are the mainvehicles through which spot and contractprices interact to bringabout an equilibriumprice at the retail level. The retailprice will then work its way backto the crudelevel decisions(quantity or priceadjustments).

One of the basictenets in economictheory is thatin orderfor a producer to maximizeprofits, he shouldexpand or limitproduction to the pointat whichthe revenuefrom the sale of thelast unit (marginal revenue) is equal to the costof producingit (marginalcost). Althoughthe oil industry's long-termdecisions are guided by thisprinciple, its short-term decisions are much more constrained.An oil companyhas customersto serveand a marketshare to protect.Therefore, it cannotchange its supplylevel very freely. Yet the marginalcost of supplymay changeevery day and the

6 companyhas to do its best to cope with its marketobligations while trying to maximizeits profit. Figure1.1 showsthe relativepositions of average cost and marginalcost curves under soft and tightmarket conditions. Under soft marketconditions, the averagecost to each companyremains constant up to the levelof contractedsupplies. This is basicallythe traditional take-or-paycontract which obligesthe companyto buy a specifiedquantity of crude at a contractedprice. Beyondthe levelof contractsupply, the companycan go to the spotmarket and buy the additionalcrude at a cheaper price. Therefore,its marginalcost is below its averagecost. As it buys more on the spot,the averagecost of its crudesupplies will be reducedbut stillremain above the spot crude. Thus,an independentcompany, which has fewercontract obligations than a major,can acquireits crude supplyat a lower averagecost by dependingmore on spot supplies. Under tightmarket conditions,the oppositesituation would prevail: the marginalsupply of crude would be procuredon the spot market at a price higher than the contractprice.

Basedon its mix of spot and contractsupplies, and undercertain regulatory constraintsin most countries,an oil companyhas to set its retailprice high enoughto cover its costs and low enoughto competewith the retail outletsof other companies.This pricewould, on the cost side, dependon the weightedaverage cost of spot and contractsupplies. This is true for bothmajor companiesand independents.However, the weightis differentfor each group. The contractprice has a higherweight in the case of the majorswhile the spot price has a higherweight for the independents.This is the principalvehicle which bringsabout an equilibriumin the retail market.

For example,if the contractprice is substantiallyabove the spot price (softmarket conditions),the independents'purchases of spot crude (and products)enable them to sell theirproducts at a lowerprice in the retail market. The majors'cost structurewould requireselling at a higherretail price,but they have to lowertheir price in orderto preservetheir market share. This interfacein the retailmarket would lead to an equilibrium priceat the retaillevel. The resultantretail price would yield a netback valueon the basisof whichthe companieshave to adjusttheir crude/product purchasepolicy. The processwould eventuallyaffect producers'supply decisionsin the form of a changein quantityand/or price.

In the past, the separationof the majors'and independents'channels of crude (andproducts) supplies allowed the spot/contractinteraction process to serve as a systemof checksand balances.When the gap betweencontract and spot priceswidens, costs to independentsand to the majorsbecome very different. The cost differenceis initiallyreflected in differentprices

7 on the retailmarket which would, over time,converge to an equilibrium price.

In future,the interaction process will remain essentially the same but the numberof players(or groups of players)will increase. Spot trading is no longerlimited to independentoil companies;many majors, state-owned oil companiesand OPECproducers are becoming involved in spotor spot-related trading. As a result,the marketis becomingmore fluid. The market disequilibriumsshow themselves rapidly and need to be takencare of equally quickly.That is, the contract/spot interaction mechanism is becomingmore efficientas a largernumber of entities(on both sides of the trade)are learninghow to use the spotmarket.

Interactionswith Futures Markets

Havingdeveloped into a majormarket, spot trading serves three important functionsfor the industry.First, it providesinformation about market clearingprices of crudeoil and petroleumproducts. This information is extensivelyused by producers,refiners and traders. The sourcesand reliabilityof this informationis discussedat some lengthin later chapters.At thisstage we needonly point out that this information is not basedon comprehensivesurveys or even representativesampling of trade activitiessince there is no formaladministrative body or a physical tradingfloor to registerspot transactions.

Second, the spot market functions as a mediumfor transferring or sharing the risk associated with price fluctuations. If a stockholder fears a drop in the valueof his inventoryfrom a declinein prices,he can sellpart of it on the spotmarket. The buyer will purchases the oil in anticipationof profitingfrom an increasein theprices. A significantportion of the spot transactionsof the late 1970sand early 1980swas due to speculative stockingand destockingof crudeand refinedproducts.

Third,as was discussedearlier, the spot marketis now an alternative channelof oiltrade. Thevolume of spottransactions, especially of crude oil,during the lastfew years increased very sharply. The disruptionand tight supply conditions of 1979 forced the purchasers of crude and refined products to learn to use the spot market. The reduceddemand of the 1980s, on the other hand,has forcedproducers to selltheir oil on the spot market. Thus,with both sides of the market trading in the spot market, a reversalof thepresent trend becomes unlikely. Further, there will always be an incentivefor one of the two sidesto tradeon the spot.

Petroleumfutures are likelyto take over two of the three important functionsof the spotmarket. These are the pricediscovery and risk

8 transferfunctions, both of which the futuresmarket can performmore effectivelythan the spotmarket. Regardingthe pricediscovery function, the petroleumspot market is geographicallyand organizationallydispersed, makingcollection of an accurateand representativesample of spot prices difficult,if not impossible.In addition,there are institutionallimits to processingand disseminatingthe data collected,which is treatedas privilegedinformation available only to thosewilling to pay for special- ized market services. The informationprovided by the spot market thus suffers from inherent statisticaldeficiencies. The futures market, however,is not so constrained.Unlike spot transactions, futures contracts are tradedon formallyorganized commodity exchanges. The transactiondata are compiledvery rapidlyand disseminatedalmost instantaneously; they are availableto the publicand there are no institutionalbarriers to their distribution.The futuresmarket is thereforecapable of removing,or at least lessening,the impedimentsthat exist to the flow of informationin the petroleumindustry. In thisrespect, spot market price informationwill lose its significanceas the futuresmarket is recognizedas a more con- venientsource of price information.

The risk transferfunction of the spot market can also be performedmore efficientlyby the futuresmarket. Indeed,the risk transferpotential of the spotmarket has alwaysbeen less thanthat desiredby the industry.The participantsin the spot market are petroleumbusiness agents either directlyor indirectlyinvolved in the production,processing, distribution and consumptionof petroleum.They normallytry to avoid risk in order to managea smoothoperation. During a softmarket period, they want to avoid the risk of a capitalloss due to a declinein the value of their stock. Duringa tightmarket period, they want to avoidthe risk of payingtoo much for supplies. For these agentsto avoid risk throughspot market trading, thereshould be enoughspeculators willing to acceptthe risk. The majority of these risk takers normallycome from outsidethe industry. However, since spot markettransactions require substantial capital and specializa- tion,outsiders are not likelyto participatein spot trading. Even if they have the capital,they would not knowwhat qualityof petroleumto look for, from whom to buy the oil, where to keep it, and to whom to sell it.

Futures trading removesmost of the barriersto the entry of outside speculatorsin petroleumtrading. It providestwo importantfacilities: standardizationand impersonality.Futures contracts are standardizedwith respectto quality,quantity, and locationof delivery.Participants do not need to know much about the technicalcharacteristics of petroleum.Also, futurescontracts are impersonalin that tradersdo not need to knowwho is on the other side of the trade. The clearinghouse of the futuresexchange assumesthe role of buyer to all sellersand the role of sellerto all

9 purchasersof contracts.Furthermore, a tradermay participatein a futures marketby investingas littleas a few thousanddollars.

The facilitiesprovided by the futuresmarket for speculativetrading will be clarifiedin Chapters5 to 7. At this stage,it is importantto note that the standardizationand impersonalityof the futuresmarket stimulate the participationof speculatorsand therebyincrease the possibilityof transferringthe risk. A fully developedfutures market would serve this functionmuch more efficientlythan the spot market.

The third functionof the spot market,to serve as a channelof petroleum supply,cannot be taken over by the futuresmarket because,as will be explainedin Chapter-- , futurescontracts are not a convenientway to trade petroleumphysically. However, the physicalsupply of petroleumis affected by futuresmarkets in two differentways. First,in the short and medium terms futuresmarkets provideinstantaneous information on prices which considerablyfacilitate spot trading. Today, most spot tradingin the UnitedStates is basedon futuresprices. Second,in the long run, futures markets,if fully developed,will reducethe scope for spot tradingsince futuresmarkets can, in practice,provide all the flexibilitiesthat spot tradingcan offer. Therefore,both sellersand purchaserswill be able to returnto contracttrading as a basis for making investmentdecisions and use futuresmarkets to preserveflexibility in their businessoperations. This is, however,dependent on the futureworldwide development of petroleum futuresmarkets covering crude oil as well as major petroleumproducts.

10 CHAPTER2 MECHANICSOF SPOTTRADING

How It Works

The spot marketis not a formalinstitution. It is an informalworldwide networkof personaland professionalcontacts carrying out cargo-by-cargo sales and purchasesof crude oil and petroleumproducts. Significant refiningor storagecenters such as those in Rotterdam,New York or the Caribbeanare likelyto be the sceneof spot transactionsand price quotations,although market participants can be locatedanywhere, as can the oil traded. The cargo being tradedcan and usuallyis alreadyat sea. Par- ticipantsdo not meet to match bids and offers;the transactionstake place throughtelexes of tradingoffices.

The transactionprocess has becomeincreasingly complex. In the 1950sand 1960s most of the trade was in the form of uninvoicedexchanges. This was acceptableat a timewhen only a few companieswere involvedand tradingwas basedon personaltrust. Afterthe oil price hikesof the 1970s,it became impossibleto conductbusiness on such a basis. The cargo became too valuableto be securedby simpletrust, which itselfbecame untenable by the entry of numeroussmall traders. Today,there is very littleuninvoiced exchange. Instead,a spottrade involves millions of dollarsand is carried out by sale and purchaseagreements with a host of safeguardmeasures. Sincea typicalcargo of gasoil,i.e., 20,000 to 24,000tons, is worth about $4 millionand a typicalcargo of crude may be worth at least$20 million, banks are involvedin any transaction,insurance arrangements have to be made, and qualityand inspectionprocedures must be definedin detail.

Even so, disputesstill arise. The most commonare:

o non-deliveryor non-lifting- normallyin periodsof sharpprice changebased on allegedor real forcemajeure, etc.;

o delayeddelivery;

o qualitydisputes and price differentials;

o inspectiondisputes;

o paymentdisputes; and

o bankruptcydisputes.

11 Productspot tradingis a much longerestablished process than spot trading in crude. Worldwide,only 1-3% of crudeoil was tradedon the spot market before1979. The proportionhas since increasedto an estimatedone third of all crude oil tradedinternationally.

It is difficult to calculate the quantity of petroleum (crude or products) moving through spot channels. Due to multiple exchanges between traders, the volumeof trade is alwaysmuch largerthan the amountof oil actually delivered.Each shipmentis tradedseveral times before reaching the final consumer,and each time it is added to the statisticson the volume of trade. A remarkableexample of spot tradinginvolved the "daisychain" tradingof a cargo of Brent crude tracedby PetroleumIntelligence Weekly in 1984. The trade involvedone cargo of crude oil boughtand sold by 24 tradingentities in 36 transactionsover a periodof three months. The trade for March 1984 deliverystarted in January. The 24 tradingentities involvedincluded major international oil companies,national oil companies, refiners,and independentmarketers and traders. [From the majorscom- panies,Shell appearsthree times (as Shell U.K., Shell Internationaland Pecten),British Petroleum (BP) appears twice, and Chevronand Texacoonce each. Two nationaloil companies,the BritishNational Oil Company(BNOC) and Finland'sNeste, were also involved,as were four U.S. refiners-- Occidental,Sohio, Charter, and the final buyer,Sun. Charter'strading affiliate,Acron, alone accounted for four transactions,and Charteritself for one. U.K. independents,Tricentrol and Ultramar,also participatedas did the Japaneserefiner, Idemitsu.] Trader Phibro appears six times in the chain,Transworld and the Shellgroup three timeseach, and severalothers twice.

This exampleoccurred during a time of speculation,and probablyinvolved a largerthan averagenumber of transactions.But the natureof the chain is typical. [Manycompanies trade a singlecargo, and someof the repeaters in the chain do not realizethey are tradingthe same cargo.]

MarketParticipants

"Majorsare becomingtraders, the traders are becomingbrokers... and brokersare becomingjournalists."

PetroleumIntelligence Weekly, January 20, 1986

Participantsin petroleumspot tradingcan be broadly classifiedinto: (a) major oil companies; (b) independents;(c) petroleum traders; and (d) brokers.

12 THE MAJOR OIL COMPANIES:

Major oil companiesused to regardthe spot market as a last resortto procureneeded supplies or disposeof surpluses.In each refineryrun there is alwaysa mismatchbetween output and demand. Majorsformerly balanced these mismatcheseither redistributingthe surpluseswithin their own extensivesystem or correctingthe mismatchesthrough the spot market. But in the last five years the economicsof the operationhave forcedthe majors to make their refining/marketingsystems more flexible. If the productyield of a barrelof crude oil can be boughtmore cheaplyin the spot marketthan it can be producedin a company'sown refineries,it is economicalto reduce refineryruns and buy productsfrom othersat spot marketprices. Moreover,the availabilityof crudeto major oil companies, which far exceededtheir productsales until mid-1970s,is now less than total productsales.

The trend towardbuying rather than refiningon the part of majorscan be observedin the tablebelow. Today,product purchases from othersaccount for 30-40%of totalsales by most major oil companies.Much of this growth is met by smallerindependent and state owned refineries.

The increasedreliance on spot marketsby major oil firms is not confined to products.Majors are now activelyinvolved in tradingcrude oil as well. Much of this began in 1979, when contract supplieswere curtailedby producingcountries. Majors could eitheraccept a reducedshare of the productmarket or purchaseexpensive crude on the spot market,refine it, and sell at a loss. They chose the secondoption. In late 1979, majors became the biggestbuyers in the crude spot market: no other potential buyershad sufficientcontract oil at low pricesto supporthigh priced spot purchases. Immediatelyafter the 1979 crisis,there was a scrambleamong majors to secure as much contract crude as possible. As the market softened, and spot prices fell below official prices, spot or spot-related purchasesof crude becamemore attractivethan term contracts. Today, outsideNorth America,majors accountfor about 19% of spot trade and acquire20-30% of their crude supplieson a spot basis. The spot share is lower in North Americawhere most large companieshave their own crude supply.

To deal with the changedsituation, majors have set up their own trading affiliatesand becomeinvolved in complextrading exercises. For example, Shell'strading affiliates are not only involvedin spottrading but compete among themselves,and evenwith Sitco,Shell's central trading unit. Shell has recentlysplit its crude trade activitiesgeographically into Atlantic and PacificBasin regions. Mobil has reorganizedits tradingactivities to separatethe functionsof crudeand producttrading among its subsidiaries.

13 THE INDEPENDENTOIL COMPANIES:

Independentshave alwaysplayed an importantrole in spot trading. They were to a largeextent the drivingforce behind the creationand growthof spot markets. Unlikethe majors,the independentshave alwaysdepended on the spot marketsfor much of their needs. In soft marketconditions, this has workedto theiradvantage. For example,in the slackyears between 1975 and 1978 the independentspurchased cheap products on the Rotterdammarket and undersoldthe majors' retail outlets in many Europeancountries. However, this dependencebecame a major disadvantagein 1978-79 when suppliesto the independentswere cut back as the majorspassed on OPEC supplycuts to their third party customers. The independentswere then forcedinto the spot marketand had to buy their suppliesat much higher prices than the officialprices chargedto the majors. Initially,the retailmarket settled into two price tiers in some Europeancountries. In West Germany,for example,the majors'low pricesand the independents'high spot-relatedprices coexisted in the retailmarket. As the majorssecured more contractoil, they enlargedtheir market share, squeezing the independents out of the market. The extentof harm to independents,however, varied from countryto country. In West Germany,government officials obligedthe majors to provide "life boat" suppliesto independents.In Italy,the independentswere badly hurt.

Despitethese setbacksand the growth in the numberof spot market participants,the independentsremain a vitalpart of the spotmarket, accounting for about 11% of the totalspot crude transactionsmonitored by Petro- leum Argus in 1986-87.

TRADERS:

The number of tradersinvolved in the oil businesswas very small until the late 1960swhen more tradingcompanies entered the fieldas demandgrew and supplydiversified. Trader participation became particularly intense after the crisisof 1973-74, since the costs of entry into the industry (basicallya telex and telephone)were low and the potentialrewards were high. As a result,the numberof tradersproliferated to more than 300 in the Rotterdamarea alone, though the trade was dominatedby those with accessto crude and productsat the same time. Duringthe slackperiod of 1975-78a large numberof these traderswent bankrupt. Again, the 1979 crisisencouraged some new entrants,while the subsequentslack period saw increasedspot activity.

A trader'sbasic function is to "takeup positions"with regardto crudeoil and petroleumproducts. That is, he contractsto buy or sell real cargoes of oil and is fullyresponsible and liablefor the cargo. Once a traderhas

14 taken title to a cargo, he must sell the cargo,exchange it for another cargo,or storethe cargo once it reachesthe port of delivery. The least risky operationfor a trader is a "back-to-back"deal, i.e., where both sellerand buyer have been arrangedin advance. In such deals,the trader behavesvery much like a broker,buying and sellingalmost simultaneously. If he foreseesa price rise,a tradermay buy a cargowithout the immediate securityof a buyer;by doing so, he would take a "long position." Con- versely,when pricesare falling,a tradermay decideto arrangea sale, withouthaving the oil in his possession,in anticipationthat nearerto the date of completionhe will be able to purchasethe oil at a lower price. This is called "sellingshort." Some tradersmay have their crude oil refinedand then sell the productspartly on the spot marketand partly under contractor multi-cargoarrangements. Finally,some traderstake advantageof seasonaldemand for heatingoil, purchasingit cheaplyin the summer,storing it, and sellingit in winterwhen demandand pricesare up. The price fluctuationsof recent years have made the profitabilityof seasonaltrading more uncertain.

Today,international petroleum trading is concentratedin the handsof a few large reputabletrading companies like Phibro,Marc Rich, Bulk Oil and TransworldOil which accountfor more than half of the businessdone by traders. At the locallevel, a largenumber of sporadicallyactive traders are involved.These small, peripheral traders enter and leavethe business in responseto the marginsavailable. When pricesare fluctuating,margins widen, motivatingmore tradersto enter the market. When spot product pricesrose explosivelyin 1978,some tradersacquired fortunes overnight. But in 1979 when traderswere paying greaterand greater premiumsover currentprices to secure scarcecargoes, the spot market turned down-- especiallyin gasoline--andmany small traderswent bankrupt. When prices stabilized,the volumeof trade shrunkand survival,rather than profit, becamethe traders'main objective.

BROKERS:

Brokeragefirms are oftenone-man operations, mostly operating out of London and New York. Many are generalbrokers for whom oil is only part of their business. Unlikea trader,the brokerholds no title to the cargo traded, but is a paid go-betweenwho discoversavailability or needs and brings togetherbuyers and sellers.Brokers are compensatedon a commissionbasis, and are thereforenot exposedto the risks involvedin price fluctuations. The commissionis normallyspecified in dollarsper ton and is paid by the seller.

Brokers are a useful source of market intelligenceas they need good knowledgeof the marketin order to operateand are preparedto impartsuch

15 informationin return for an occasionalcommission. They also have a differentrelationship with their clientthan traders. For the trader, clientsare adversariessince he makes his profitby purchasingcheaply and sellingdearly at their expense. The broker,on the other hand, operates from a positionof neutralityand, as such, is less controversialthan the trader.

The RotterdamMarket

Spot tradingin generalis often referredto as the Rotterdammarket. This associationarose becauseRotterdam was the birthplaceof petroleumspot tradingbecause of its extensiveoil production,storage and distribution facilities.Rotterdam has alwaysbeen the most activespot marketas well as the only marketwhich both importsand exportslarge quantities of spot crudeand products. It also playsa centralrole in the world spotmarket. However, any referenceto the Rotterdamspot market embracesall spot tradingconcluded in northwesternEurope--Sweden, Denmark and Norway,the east coast of England, the Federal Republic of Germany (FRG), the Netherlands,Belgium and northwesternFrance. Furthermore,all spot transactionstaking place elsewherein the world,but relatingto crudeoil or productsstored in Rotterdam,or destinedfor or leavingone of the above countries,are normallyregarded as transactionson the Rotterdammarket.

Logistically,Rotterdam trade consists of two distinctbut relatedsegments:

o an internationalcargo trade via large oil tankerswhich takes place between Rotterdamand ports throughoutthe world, but especiallythose in the North Sea area; and

o a barge trade from Rotterdamand the Rhinedelta to consumersin the Netherlands,West Germany,Belgium, Switzerland and France.

Rotterdamlinks these two traders togetherby providingfacilities for breakingcargo shipmentsinto barge lots.

Developmentof the Rotterdammarket has beenclosely related to developments in the petroleumindustry itself. Rotterdamfirst became significant to the oil trade in the early 1960swith the discoveryof Libyancrude suppliesby U.S. independents.These discoveriesrepresented a substantialsource of low pricedcrude oil outsidethe majors'closed system. Barredfrom the U.S.market by importquotas, this oil was divertedto the largeand rapidly growing Europeanmarket; independentrefining and tradingof petroleum productswas then developingin Europe,and particularlyat the port of Rotterdam.

16 Rotterdam'sgeographic position made it a particularlyattractive center for oil trading. Locatedat the mouthof the Rhine,it offersindependents easy accessto the hinterlandmarkets in WesternEurope as well as to overseas markets. And deep-wateras a port, Rotterdamcan accommodatelarge oil tankers.Recognizing these attractive features, major oil companies,joined the independentsby graduallydeveloping their swing refiningcapacity there. These developmentstook the Rotterdammarket through its birth and infancy.

The second stage of Rotterdam'sdevelopment began with the 1973-74oil embargoand continueduntil 1978. High petroleumprices and the recession of 1974-75depressed petroleum demand and left the Rotterdammarket with excesscapacity in all its operations. At the same time, demandshifted towards lighter productsand the less sophisticatedrefineries became unprofitableto operate.The marketforced these refineries to run at lower ratesof utilization,and theiroperators to meet productshortages (and to disposeof surpluses)in the Rotterdammarket. During this period the marketwas also recognizedby the governmentsof many Europeancountries as a "free"market for petroleum,on whichmany domesticprice control policies could be based.

The third stage of Rotterdam'sdevelopment started in late 1978,when the market there became recognizedas the barometerof globaloil demandand supply. At this time, the price of crudemoved towardsits peak of $40 a barrel. OPEC and non-OPECproducers began to use informationfrom the Rotterdammarket to set increasesin prices,and justifiedthe increasesby the growthin marketdemand exhibited by Rotterdamprices. Actualtrading on Rotterdamwas very thin, but it was viewed, at least by producing countries,as the only validreference point for the demand/supplybalance. This view was not sharedby consumerstates, which were irritatedthat such a small portionof total supplies,not even representativeof Europeas a whole,could be given such disproportionateimportance.

Concernabout the effectsof high Rotterdamprices on the world economy promptedthe governmentsof industrialcountries to seekways to controlthe market. The leadersof six major oil importingcountries (the United States,Federal Republic of Germany,France, Italy, Japan and the United Kingdom)pledged at the Tokyo summit in June 1979 to try to moderate Rotterdammarket activity. At the same time, the EuropeanCommission undertooktwo separateexaminations of the Rotterdammarket. The firstwas the reintroductionof a registerof spot transactionsthat had been carried out for six months in 1978 under the name "checkrun."The new register, called"Comma" (Commission Market Analysis), ran fromJune 1979 to May 1980 with the voluntaryparticipation of the industryand the aim of providing a deeperunderstanding of the Rotterdammarket's structure and operation.

17 The secondexamination organized by the Commissionwas undertakenby a group of expertsfrom variousparts of the oil industry. Called the "Bourse Group,"these experts studied the possibilityof establishinga formalized tradingfloor for oil. The outcomeof both examinationswas, in effect,an endorsementof the Rotterdammarket as a more or less free market for petroleum. The Commissiondecided that neithera continuingmonitoring of spot transactionsnor the creationof a petroleumtrading floor was necessary. It should be noted that by the time these investigationswere completedprices had softenedsubstantially, and Rotterdamhad turnedfrom a sellers'to a buyers'market.

Today,Rotterdam is stillconsidered the most importantoil tradingcenter of the world,and its pricesstill representthe referencepoint for market analysisand many trade agreements. However,Rotterdam is no longerthe only importantspot market;there are growingspot marketsin the United States,the Far East and the PersianGulf. In addition,the rapid growth of the futuresmarket in the UnitedStates has shiftedsome attentionaway from Rotterdamprices and to the price of West Texas Intermediate(WTI) crude on NYMEX.

OtherSpot Markets

Partlyin responseto growthin spot trading,as well as to other developments in the oil industry,spot markets are growingrapidly worldwide. U.S. spot markets increasedin importanceafter the deregulationof petroleum pricesby the Reaganadministration in 1981. The Far East markets have becomerather well establishedand the PersianGulf marketsare expanding quickly. However,the most influentialof these are the United Kingdom Brent and the Singaporespot markets.

THE BRENT MARKET:

The Brentmarket is a recentdevelopment in oil trading. It includesboth spot and forwardtrading. The developmentof this markettook placeduring 1981-82in responseto a numberof factors,the most importantof which was the incentivefor sellingthe crude oil in advanceof its productionin order to avoid the risk associatedwith fallingoil prices. At the initial stage,trade was limitedto actualoil (wetbarrels) even thougha specific cargocould have changedhands several times before the delivery. However, by the end of 1982, the marketexpanded to cover a large numberof paper deals which were struckbased on speculatingfuture prices and were closed beforedelivery.

The developmentof the Brentmarket was initiallydue to the coincidenceof: (a) the interestamong tradersto "sellshort"; and (b) the willingnessby

18 a numberof oil companiesto sell theirequity oil into the spotmarket for tax purposes. The interestamong tradersto sell short was due to the expectationthat crudeprices would falland the hope that the traderwould be able to buy the oil he neededto fulfillhis obligationat a price lower than the price at which he had sold the oil. The oil companies'incentive to sell into the spot marketemerged from the fact that,prior to the 1987 revisionsin tax laws, oil companieswere able to pick the lowestpriced cargo,from many sales over a periodof severalmonths, as equityoil on which upstreamtaxes would be paid. In this manner,oil companiescould minimizetax liabilitiesthrough multiple buying and sellingof theirequity crude. Therewas, therefore,a matchof incentives;the traderwould sell short and then balanceit from forwardsales by the oil companies.In other words,at this stage,short-selling also meant forwardselling.

In 1982,short-selling went beyondforward selling of futureoil supplies. It insteadstarted to includesales which were not reallyintended for end- users but to be closedbefore the date of delivery. In this regardthe Brent market startedto serve like a futuresmarket althoughthe Brent market is not formallyinstitutionalized and regulated.

The Brent market is frequentlycalled a tradingclub. There is a limited numberof participantswho know each other. Contractsare large (500,000 barrelsof 380 API, low-sulphurBrent blend)and are negotiateddirectly betweenparticipants. There are no membershiprequirements but the ability to enter the actualdeal dependson the identityand reputationof the participant.All deals are made verballyand a telex confirmationfollows. The terms of transactionsare not disclosedand not registeredanywhere. There is no clearinghouse. Contractsare seriesof pair-wisedeals. Each contractinvolves a bindingcommitment to buy (sell)the actualoil and will be executedunless the contractis cancelledsufficiently ahead of delivery time and throughan explicit"book-out" agreement. Thus, trading of "paper oil", i.e.a transactionwith no intentionof delivery,is much more complic ated in the Brent marketthan in a typicalfutures market like NYMEX.

Thereare two types of transactionsin the Brentmarket: a dated cargoand a 15-daycargo. The datedcargo is a sale/purchaseagreement for a specific cargoof oil withina specifieddate range. Thus, it is a spot transaction like those in Rotterdamor elsewhere. The 15-day cargo is a forward transaction. It is a sale/purchaseagreement for a cargo of oil to be deliveredon an unspecifiedday of a specifiedmonth. Thus it would not referto a specificcargo of oil but wouldonly specify,for example,August Brent. The actualdelivery date will be determinedat a laterstage by the sellerwith a minimumnotice of 15 calendardays. (Thisis where the title of 15-daycargo comes from.)

19 The dated cargo involvesa physicaltransaction in which a specificcargo actuallychanges hands. The 15-daycargo, on the other hand,can be actual or only a speculativedeal which would be cancelledbefore delivery. The 15-dayBrent is tradedup to three months ahead of the date of loading. Thus participantscan take shortor long positionsin the market,buying or sellingcargos of forwardmonths withoutphysical coverage in the first instance.As the monthof deliveryapproaches, the primaryseller (a seller who actuallyhas the oil) issuesa 15-daynotice of deliveryto his buyer. The buyer,who may not be the end-userand who may have sold a contractto anotherbuyer, would issue the samenotice to the secondbuyer. The process continuesuntil somebodytakes the oil. The 15-day requirementis an importantcondition and each sellershould issue the deliverynotice before the 15-daydeadline. In additionto thosetraders who get out of delivery obligationsby passing the cargo to the next firm in the chain, some participantscancel their obligationsto buy (or sell) by agreeingamong themselveson a book-outbefore delivery notices are issued. The book-out takes place based on an agreed reference price, with a cash settlement for the difference between this reference price and the initial sales/purchase price in the contract.

The Brent market served quite a significant role in the petroleum industry during 1982-85 in two distinct regards. First, the Brent market becamethe industry'sown futuresmarket as opposedto otherfutures markets which were viewedto belongto commoditytraders. Secondly,the Brentblend becamean important"marker" crude the price of which was extremelyimportant in reflectingthe demand/supplyconditions of crude oil. The significanceof the Brentmarket has now somewhatdeclined due to: (a) revisionof the U.K. tax laws in 1987; (b) acceptanceand utilizationof NYMEX by the oil industry to hedge or speculate about future prices; and (c) increased reliance on NYMEXprices as the market barometer. The new tax laws that took effectMarch 1, 1987 obligeoil companiesto designatea sale within two days if they wish the transactionto countas the sale of equityoil on which the companyhas to pay taxes. This removesthe incentiveto keep on sellingand buyingback papercargoes many monthsahead of deliveryin order to achievethe lowestpossible sales price for tax purposes. In addition to the revisionof tax rules,the U.K. FinancialServices Act, which took effect in October1987, imposesonerous obligations on companiesengaging in "investment"business in the U.K.,making Brent potentially less attractive to many speculativepartici pants. The restrictionsimposed by the Act would make it difficultfor companiesto choosetheir tradingpartners or to offer betterterms to favoredcustomers. As a result,the Brentmarket is becomingless attractivefor tradersand financialhouses which par- ticipatedin this market to take advantageof the flexibilitiesof an informaland unregulatedmarket.

20 The tradingvolume of the Brentmarket increased from about 10 transactions per day in the firstquarter of 1984to about30 transactionsper day by the end of 1985. 1/ This volumedropped to about 20 transactionsper day in 1987 afterthe revisionof the U.K. tax laws. Loadingof physicalcargoes has been about 40-45 per month during the last three years. Thus the averagenumber of tradeper each cargohas variedbetween 5 to 15 depending on the level of speculativeactivity. The distributionof transactions betweenspot and forwarddeals changeswith the volumeof trade. In the Brentmarket, deals can vary from being for the currentmonth to being for threeor even fourmonths ahead. An analysisof the tradevolumes shows 2/ that most trade is concentratedin the categoryof one-monthdeals. Trade in two and three-monthdeals seems to increasewhen the total volumeof trade increases.

Participantsin the Brentmarket came from a populationset of 125 trading entities. About25% of theseentities are continuallyactive in the market while others trade occasionally. From the total number of participants about 35% are integratedoil companies,5% non-integratedoil companies includinginvestment firms. However,the strikingfeature of the marketis the concentrationof activityin the handsof a relativelysmall number of participants.The top ten companiesaccount for 53% of recordedsales, the top 20 for 75% and the top 30 for 87%. The ten most activeparticipants includefive oil companiesand five traders. Among the most activeoil companies,BP has the highestprofile while Sun, Gulf and Shell play importantroles in the market. Traders frequentlynamed were Phibro, TransworldOil, Voest Alpine,Internorth, P&O Falco and Gatoil.

THE SINGAPOREMARKET:

Singapore'scentral locationat the crossroadsof Asia has made it the secondlargest petroleum port of call in the world next to Rotterdam.With aboutone millionb/d of nominalrefining capacity, Singapore is the world's third largestrefining center after Rotterdamand the U.S. Gulf Coast. It has traditionallyserved as the "balancing"refining center for the Pacific Asianregion in that it suppliesconsuming centers when shortagesof certain productsarise. As shown in Table 2.2, Singapore'srefining activities

1/ PetroleumArgus keeps detailedrecords of spot transactionsin the Brent marketas a basis for their daily and weeklyreports. They dis- tinguishbetween "dated" and "15-day"contracts. Their recordsbegin in late July 1983 and continueto present. For detaileddiscussion, see Mabro,et al, The Marketfor NorthSea Crude Oil, OxfordUniver- sity Press,London, 1986.

2/ Marbo,et al, The Marketfor North Sea Crude Oil, page 198.

21 include: (a) conventionaloperations like importingand processingcrude, and sellingproducts on a term or spot basis; (b) term processing,i.e., receivingcrude from nationaloil companies(Indonesia's Mindo, Malaysia's Petronas,China's Sinochem and the UnitedArab Emirates'Adnoc), processing it, and returningto them all or part of the productyields; and (c) spot processing,i.e., receivingcrude from tradersand returningthe refined productsto them.

Table 2.2: SINGAPOREPETROLEUM PROCESSING IN 1985/86 ('000b/d)

Term processing Indonesia(Mindo) 30-100 Malaysia (Petronas) 50-65 China (Sinochem) 80-100 UAE (Adnoc) 20 Subtotal 180-285

Spot processing Indonesiancrude 50-75 Iraniancrude 30-50 Subtotal 80-125

Other processing 340-290

Total 600-700

The outlook for Singapore is somewhatmixed. The future of its refineries is not very brightsince demandfor crude processing,which has long been the refineries'main activity,is less than in the early 1980s,and processing marginshave been cut to the bone. In the face of increasingcompeti- tion from exportrefineries in the MiddleEast, Singapore's refineries now must consider whether to build sophisticatednew upgradingunits and positionthemselves to tap the growingdemand for gasoline. At the same time, the outlook for trading in Singapore looks exceptionallygood. Becauseof its historyas a majorrefining center, Singapore has infrastruc- tural servicesto supportlarge scale tradingin oil. At present,it has over 30 oil trading companies,including: subsidiariesof major oil companies,national oil companiesof OPEC countries,independent U.S. tradingcompanies, and Japanesetrading houses. These companiesdeal both with on-the-spotand term transactions.

22 Singaporeis in an ideal positionto take advantageof tradingopportuni- ties. With crude oil importsfrom all sourcestotaling more than 600,000 b/d in 1986 and domesticdemand at just 66,000b/d, about 90% of imports were for re-exporting.Its tradingpotential is particularlygood in view of the followingfactors:

o The flow of MiddleEast productsinto the PacificAsian market is rising. Continuingcrude oil disposalproblems are also pushingAsian producerssuch as China, Indonesiaand Malaysia into productsmarketing. As a result,product trading in the PacificAsian area is risingtogether with opportunitiesfor Singaporeantrading companies to expandtheir regionwiderole in productbalancing deals.

o The presenceof almostall major world oil companiesand oil tradingorganizations allows major decisions on producttrading to be coordinatedfrom Singapore.

o The large storagefacilities of Van Ommerenand Paktankas well as refiner-ownedfacilities mean that large-scaleproduct trading can take place.

o A free marketeconomy as well as excellenttelecommunications and otherinfrastructure make Singaporeideally suited to respond to changesin the PacificAsian oil market.

o Implementationof the new petroleumprice reportingsystem and possibleintroduction of a petroleumfutures market in Singapore will providemuch of the price transparencyand market information needed.

As oil tradingincreases in the region,Singapore's trading role will be furtherenhanced. The emergenceof new productsfrom the Middle East flowingto Asia, Europeand, to a lesserextent, the UnitedStates, could resultin fundamentalrealignment of crude and productprices whereby the movementof Middle Easternproducts will be influencedby regionalprice variationsresulting in much closerprice linkagesbetween the Rotterdam, Singaporeand U.S. (EastCoast and Gulf Coast)markets.

23 CHAPTER3 SPOT-RELATEDDEALS

Introduction

It is not reallypossible to quantifyspot tradingsince, as indicatedin the previouschapter, spot cargoescan be tradedmany times, leadingto inflatedreports of the total volumesold in this way. It is nevertheless clear that the lowerspot prices of the recentpast, comparedwith official sellingprices, have attractedmore buyersto the spot market: it has been estimatedthat up to 30-35%of oil in 1984-85was tradedon the spot. While this stillleaves the greaterproportion of oil tradeas term business,many term tradesare agreedto under conditionsheavily influenced by the spot market. More and more, termtransactions are struckin relationto the spot priceprevailing at the time of the deal and allow for price changesduring the term of the contract.

A wide varietyof mechanismsare used to tie the priceof oil to prevailing spot market prices,depending upon the circumstancesof the buyers and sellers. Such mechanismsinclude countertrading and variouspremium and discountingschemes such as packagedeals, spot-relatedtransactions and deals with favorablefinancial terms.

Countertrading

A countertradeis basicallyan exchangeof oil for goods and services. These trades,with an estimatedvolume of about 2-2.5 millionb/d, take a varietyof forms, the most common being barter deals, counterfinancing arrangementsand deliveryof oil for past debts.

As the name implies,barter transactions include the exchangeof oil for a specificset of goods and services. During 1984-86,for example,Saudi Arabiatraded oil for ten Boeingairliners and Abu Dhabireceived 18 French Miragejet fighters. Iran and New Zealandexchanged oil for lambs while Algeriaand Japan tradedoil and vehicles. Malaysiaand Brazilexchanged oil for ore and Iranand Japan exchangedoil for constructionprojects, and on and on.

In counterfinancing,part of the oil revenuesmust be used to purchasegoods from the oil importingcountry. This arrangementis more flexiblethan a barterdeal, by allowingthe oil exportingcountry to chooseall or part of its paymentfrom a wide rangeof goodsand services. Iran has enteredinto counterfinancingarrangements with a large numberof countriesincluding

24 Austria, Brazil, Greece, Pakistan, Spain, Syria, Taiwan, Turkey and Yugoslavia.Similarly, agreements between Iraq and Braziland betweenLibya and South Korea requirethe oil exportingcountry to receivea certain portionof theiroil revenuesin the form of goodsand servicesfrom the oil importingcountry.

Facinga squeezeon their oil revenues,some oil exportingcountries have offeredto pay part of their past debts in oil. These includedebts to other governmentsas well as to privatecompanies. Iraq,for example,has used oil to repaydebts owed to France,Italy, India, and severalJapanese companies. Libyahas likewiserepaid past debts to the U.S.S.R.and Italy.

Countertradearrangements are not limitedto the exchangeof oil for other goods,but can take the form of "oil for oil." A notableexample of this type of countertradeis Indonesia'sterm contractsto sell its crudeto and buy Arab light and petroleumproducts from the satelliteoil trading companiesthat market330,000 b/d of Indonesiancrude. Specifically,the arrangementcalled for the traders to: (a) buy Indonesiancrude from Pertaminaat the officialprice; (b) sell Arab light crude (requiredfor Indonesian refineries) to Pertamina at the official price; and (c) sell back to Pertaminathe middledistillates from the processingof Indonesiancrude at officialcompany postings, which were normallya few dollarsabove spot prices. This arrangementenabled Indonesia to move its oil withoutupset- ting the OPEC price structure1/ while effectivelyselling its crude at $4 to $6 below the officialprice.

Countertradedeals can, in theory,be attractiveto both sidesof the trade. Petroleumexporting countries can use them to securea marketfor theiroil and a supplyof some criticalimport items such as food and militaryequip- ment; petroleumimporting countries can use them to promotetheir exports and increasethe securityof theiroil supplies. However,the real incentive for countertradedepends on the conditionsof the petroleummarket. When the oil marketis tight,with spotprices higher than officialprices, oil importingcountries insist on countertradeboth for its favorableprice terms and its self-financingof foreignexchange. Under soft market conditions,on the other hand,oil exportingcountries pursue countertrade arrangementsto increasetheir oil salesby effectivelycutting the price. The practiceof discountingis, of course,implicit and in many instances quite complicated.The transferprice, on paper,is normallythe same as the officialprice; but the supplierof the goods is permittedto inflate

1/ Indonesia'sincentive to adhereto the officialprice was not only to followOPEC agreementsbut also to preserveits revenuefrom the sale of liquifiednatural gas (LNG),the price of which is linkedto the officialprice of Indonesiancrudes.

25 the price of his goods,thus effectivelydiscounting the oil price. The extentof this discountdepends on the differencebetween the officialprice and the spot market price since (a) the oil purchaserhas the optionof buyingit on the spot, or, in some instances,of disposingof the oil at spot-relatedprices; and (b) the oil exportingcountry has only one option --to sell the oil on the spot or at spot-relatedprices.

Countertradearrangements have not been free of undesirableconsequences. Countertradecreates problems for sellersby discouragingconventional term sales and fosteringthe beliefthat ample volumesof cheaperbarter crude are available.This was experiencedby Nigeriain September1985 when seven companies,six of them third party buyersand one a producer,started to phase out official-priced purchases on the ground that countertrade deals offered to other buyers resulted in much cheaper oil.

For buyers,negative consequences are primarilyincurred by traderswho do not intendto use the oil. Most of these problemsare avoidedwhen the purchaseris the governmentof an oil importingcountry which substitutes oil acquiredthrough countertrade for normal supplies. However,in the majorityof cases,the buyer is a privateor publicentity involved in the productionof othergoods and services,and receivesthe oil as paymentfor its goods and services. In such cases,the buyingentity have problemsin disposingof the oil after receivingit due to a drop in price betweenthe time when the countertradeagreement was signedand the time the oil was delivered.

An interestingexample of buyers'problems is the VoestAlpine case. Voest Alpine,the Austrianstate steel company,had countertradeagreements with Nigeriaand Iran to receivetheir oil at the prevailingofficial prices. To lessen the risk of a market price movement,Voest had taken short positionson Brent'sforward market. The Nigeriancoup and consequent reviewof barterpolicy put a stop to Nigeriancountertrade in the second half of 1985. At the same time, Iraqi air attacksprevented oil exports from Iran. The delay in liftingsresulted in a loss of about $65-70 million. In the meantime,short positions in the forwardmarket were held open in expectationthat oil priceswould fall sharplyin late Novemberor earlyDecember. However, Austrian public discussion of this "gambling"with taxpayers'money forcedVoest to liquidatethe positionsjust as the market was peakingin Novemberat around$30/b. If these positionshad been kept open for anotherten days,when pricesfell by $3.50-4.00/b,they wouldhave yieldeda profitof $25 million. Held open a furtherthree months,they would have given a profitof $120 million. The lessonfrom this case is that countertradearrangements become very difficultto administerunder fluctuatingprices and unstablepolitical environments.

26 Discountsand Premiums

Discountingor addinga premiumto the officialprice of oil was originally a priceadjustment practiced by majoroil companies;they liftedthe oil at the officialprice and sold part of it to third party customersat a discountor premiumdepending on marketconditions. In 1977and early1978, when the market was weak, oil companieswere forced to sell crude to contractbuyers at substantialdiscounts off officialprices. In 1979,when the markethad pickedup, companiesstarted to chargepremiums of about 10- 20% a barrelin the form of shortercredit terms, and "servicefees" of 5 to 50 cents a barrel. These premiumson oil companysales were increased to more than $8/b in a matterof months.

Thispractice encouraged OPEC governments to seeksimilar premiums in return for guaranteeingfuture oil supplies. Despitethe statementby the OPEC president,Mr. Ali al-Otaiba,"It's the buyerwho offersus much higherthan OPEC prices...pleasedon't offer us higherprices than we demand",2/OPEC membercountries actively sought premiums on theircrude supply. The trend began with Nigeria and Iraq. In mid-1979Nigeria asked its long-term contractagents to pay for half of their liftingsat spot prices(giving an effectivepremium of $6/b);and Iraqrequired new contractcustomers to pay a $10/bpremium payable in advanceas a lump sum,non-refundable "signature bonus." Beforethe end of the year, the practicehad spreadto almostall OPEC membersas they startedto chargepremiums in the formof "exploration fees," "compensationfor retroactivity,"etc. Even non-OPEC members followedthe same strategy. BNOC adopteda surchargeof $3/b in January 1980,just a few days after it had raisedits officialprice from $26/bto $30/b.

The trend towardhigher premiums came to an end afterthe first quarterof 1980. It initiallytook the form of deductionsin the amount of the premium,but by the end of 1980 premiumsbegan to disappearaltogether. In mid-1981,buyers started to ask for discountsand in responseIran cut the price of its light crude by $1/b. Other producersgradually adopted the practice,although they oftendisguised the discountin the formof favored creditterms, package deals, processing deals, etc.

Discountsbecame very prevalentin 1985-86and playedan importantrole in breakingOPEC's price structure. Discountswere offeredby all producing countriesin a varietyof forms includingdirect (temporary)discounts, package deals, transportationand delivery allowances,and favorable financialterms. Directdiscounts are, clearly,the easiestto detect.

2/ PetroleumIntelligence Weekly, October 8, 1979.

27 They were initiallydiscounts off the officialprice; but later became discountsbelow the spotmarket price. Directdiscounts also took the forms of differentialscharged on nonmarketcrudes which were less than those prescribedby OPEC. Packagedeals are more difficultto trace;both the volumeof oil involvedand the magnitudeof the discountare often unclear. Packagingcan be done in one or a combinationof the followingforms:

o packagingofficially priced crudes with crudesthat are not priced by the OPEC conferenceor the equitycrude that is fictitiously priced;

o employmentof incentivessuch as parallel liftingof specific volumesof petroleumproducts or condensatesat low prices,taking advantageof the fact that refinedproducts and condensatesare outsidethe mandateof the OPEC conference;and

o packagingcrude oil with liquifiedpetroleum gas (LPG),LNG, and petrochemicalproducts.

Transportationand deliveryallowances are made either in the form of a direct (perbarrel) freight subsidy or by absorbingthe cost, indirectly, in one of the followingforms:

(a) sellingthe crude on a cost and freight(C+F) or cost, insurance and freightbasis, with fictitiouslylow freightand insurance rates;

(b) disposingof the crude at a terminal nearer to the buyer's refinery,thereby granting the buyer a discounton officialfree on board (FOB)prices; and

(c) transportingthe crude to the buyer's facilitiesand actually payingstorage fees to the buyer while the paymentfor the crude is made 30 days from the date of actualuse by the buyer. In this case, storageis hypotheticaland the fixingof the date of use is made to allow the refinerfree creditand greaterliquidity.

Providinga discountby grantingfavorable financial terms occursquite often. The most frequentpractice in this regardis to extendthe credit periodof the buyerto two or threemonths, from the normal30 days. Other formsof favorablefinancial terms are interest-freeor low-interestloans to buyerscovering all or part of the shipment;long-term loans, extending over ten years, to financecrude shipments;and noninvoicedquantities deliveredtogether with quantitiessold at officialprices, thereby effec- tivelygranting the buyer a discount.

28 Term Contractswith Spot Prices

The link betweenterm contractprices and crude spot prices is either implicitor explicit. An implicitlink refers to term contractswith weekly, monthlyor quarterlyrenegotiable prices. An explicitlink is establishedthrough a specificprice formula,included in term contracts, which relatesthe contractprice to Platt'sspot price (monthly,fort- nightly,or weekly)averages.

Implicitlinks have, in one form or the other,been part of term contracts since the early 1980s. Iran was the firstproducing country to startthis practiceon a largescale. In the firstquarter of 1982 Iran signedseveral contractswith Europeanbuyers for six-tonine-month terms, under which priceswere set eachmonth on what was virtuallya spot level. By May 1982, Iran offeredsome Japanesebuyers quarterly deals at prices set ten days ahead of each quarter.

The practiceof eitherimplicit or explicitterm/spot price linkageswas begunin 1984 by Norway'sStatoil Company. In December1984 Statoil and its term customersagreed to settlethe price of volumeslifted in each month at the end of that month,in the light of open markettrends. This could be a singleprice, or if the spot marketfluctuated widely, cargo-by-cargo pricingbased on the date of nominationof loading. Seven monthslater, Mexico followedsuit by using "marketresponsive" prices in its term contracts. Mexicohad alwaysadhered to its officialprices, but this had cost it almost half of its market share. The market-responsiveprice mechanismwas chosenas a way to get exportsback to the target of 1.5 millionb/d.

By mid-1986,spot-related term contractsbecame common. NorthSea producers effectivelyabandoned the conceptof settinga fixed "official"contract price. Iranwas sellingabout 300,000 b/d to Japanesefirms under so-called "frame"contract which linkedprices to spot marketquotations. Iraq was sellingabout 200,000 b/d of Basrahlight crude to Japanesebuyers based on averagespot prices of Dubai,Oman and Arab lightin equalproportions, less the freightdifferential. Saudi Arabiawas sellingproducts from its new refineriesat spot-relatedprices. Other OPEC members, in particular Nigeria and Libya, were involvedin similarpractices. Even Canadian crudes,with twelveyears' experienceof state administeredprices, were sold at spot-relatedprices. (TheCanadian system is similarto that in the UnitedStates: insteadof a seller'sofficial price, there is a buyer's posted price which is kept in constantrelationship with spot market prices.)

29 The spot-relatedterm contractswere not withoutproblems however. These problemsarise becausethere is a big debateover: which marketsprovide the best indication of basic trends for specific crudes and products; and which source of published prices provides the most reliable information. While the debateover "whichmarket to choose"continues, some consensus seems to be emerging. For the price of crude oil, most attentionis now focusedon the North Sea Brent,West Texas Intermediateand the Dubai markets. For refinedproducts, Rotterdam is influentialin gas oil and naphthapricing, the UnitedStates is in gasoline,heating oil and low- sulphurfuel, and east of Suez in distillatesand fuel oil.

The growingneed for price informationis promptingproducers and oil companiesto searchfor "unbiased"market indicators. This has enhancedthe influenceof the futuresmarket and the spot price reportingof various print and electronicservices. Reportingservices being used have rapidly expandedfrom traditionalsources such as Platt'sPrice Service, Petroleum InformationWeekly, Petroleum Argus and Oil Buyer'sGuide to includea host of others like Reuters,Tolerate, Petroflash, Oil Market Trendsand the industry-sponsoredAsian PetroleumPrice Index . To minimizethe risk of manipulation,some deals rely on a basketof quotesfrom variouspublished sourcesand are tied to spot price quotesover a numberof days beforeand after loadingor arrival. Price informationpitfalls are most pronounced for the secondarycrudes and productsnot activelytraded every day. In the absenceof adequatedata, sellingprices are usuallycalculated from the best comparablemarket, with an agreed link or index to anotheroil or location.

TENDERS:

Short term tenders for the purchaseand sale of crude oil and refined products are an increasinglypopular adjunct to spot-relatedprices, both in industrializedand developingcountries. The U.S. Governmentbuys roughly 550,000 b/d on tender for use domesticallyand overseas (for civilianand militaryneeds), plus 35,000b/d (in fiscalyear 1986)for the StrategicPetroleum Reserve. Other countrieslike Japan also purchase stockpileoil, runningabout 50,000 b/d throughtender offers. In the developingworld, there are numerouscases of oil tendering,as in India, Taiwan,Thailand, Bangladesh, Tanzania, Madagascar, etc. The buyingpolicy of the Ceylon PetroleumCompany of Sri Lanka is a good example. While retainingterm contractswith Saudi Arabia,Iraq and Malaysia,Ceylon buys around20,000 b/d of crude,around 60% of its total requirements,through tenderoffers. It also tendersfor all its productsales or purchases, inviting20 to 30 selectedoil companiesand tradersto offer crude oil about once every six weeks.

30 NetbackPricing Contracts

Netbackpricing of termcontracts was firstpracticed by Libyaand Iranin the early1980s for limitedvolumes of salesand limitedperiods of time. In 1986,netback pricing became much more significant because: (a) for a limitedperiod of time,it replacedOPEC's official pricing scheme; (b) it providedthe oil producing countries with a price-warweapon; and (c)it may returnwhenever oil producing countries disagree on a coordinatedproduction andpricing policy. It is thereforevery useful to analyzethe consequences of the 1986netback pricing experience and to assessthe impactit hashad on marketparticipants within and outsideOPEC.

In 1982,when the marketstarted its downwardtrend, Saudi Arabia, which feltsomewhat responsible for flooding the market during the 1979-81period, voluntarilyreduced its levelof productionfrom 9.9 to 6.5 millionb/d. In March1983, it acceptedan implicitproduction quota of 5 millionb/d 3/ and,more importantly,proclaimed itself OPEC's swing producer. In this latterrole, Saudi Arabia was forcedto reduceits outputto about2.3 millionb/d by the thirdquarter of 1985. Unhappywith its lesspowerful positionin OPEC,Saudi Arabia announced in July1985 that it wasabandoning the roleof swingproducer and wouldtry to boostproduction to a minimum targetof 3.5 millionb/d. Saudiofficials realized that customers would onlybe attractedby marketresponsive prices, and considered three options on whichto basetheir sales price: the Arab Lightspot price, the spot prices of other crudes; or the spot prices of refined products. The relatively small amountof Arab Light traded on spot madecontracts linked to itsspot price unattractive. Among the other crudes, it considered North SeaBrent (Saudi Arabia does not view West Texas Intermediate as an internationalcrude), but thiswould have meant linking production and pricing policiesto a veryvolatile spot market. Netback value pricing was there- forechosen by a processof elimination.

SaudiArabia's drive to recapturemarket share through netback deals was quitesuccessful, and largesegments of lostmarkets in the Atlanticbasin and eastof Suezwere won back. By the firstquarter of 1986,its output increasedto about4.5 millionb/d, even though it was moreinterested in consolidatingsales to establishedcustomers than in dramaticallyraising exports. This was done by convertingexisting Petromin contracts at officialprices into new netback deals. MostSaudi customers, such as BP, Elf,CFP and Neste,as wellas Taiwan'sCPC andSouth Korea, switched from

3/ The SaudiArabian production quota was adjustedto 4.35million b/d in 1984.

31 Petromin term contracts to netback deals. The table below contains estimatesof SaudiArabia's netback contracts in early 1986.

Table3.1: SAUDIARABIA'S NETBACK CONTRACTS IN 1986 ('000b/d)

WesternDestinations

MajorsWest 1,070 Europe 425 Americas 235 Exxon 340 MotorOil Hellas 125 Petrobras 75 Texaco 200 Neste 50 Champlin 60 Mobil 180 Garrone 50 Ashland 50 Chevron 100 Saras 50 Marathon 50 Shell 100 Cepsa 50 BP 100 Enpetrol 50 CFP/Elf 50 Turkey 50 SubtotalWest 1 730

EasternDestinations Ma.iorsEast 450 Other East 230 Japan 220 Caltex 250 Bahrain 100 Mitsubishi 100 Mobil 100 Taiwan 60 Kyodo 70 Exxon 100 South Korea 50 Marubeni 50 Pakistan 20-35 SubtotalEast 900

Total 2,630

Source: PetroleumIntelligence Weekly, February 10, 1986.

Calculationof Netbacks

Calculationof a netbackvalue is aimedat derivinga valuefor crudeoil by deductingfrom the revenueobtainable from sellingthe refinedproducts the costs of refiningand transportation.Since productprices and the yield patternof refinedproducts vary betweencrudes and betweenmarkets, the calculationneeds to be specificto crude and to refinerylocation.

Figure3.1 illustratesthe conceptand the computationmechanism of netback value. The physicalmovement of oil is from port of loadingto the ship; from ship to the refinery;and from refineryto market. Netbackvalue computationfollows the same steps in reverseorder, as follows:

32 o First,compute the weightedaverage value of the refinedproduct obtainablefrom a barrelof crude oil at the refinerygate. This is known as the gross productworth (GPW)of the crude. It is calculatedby multiplyingthe prevailingspot price for each productby its percentageshare in the yieldof one barrelof crude oil.

o Then,deduct from GPW the cost of refining,which consistsof the out-of-pocketoperating expenses involved in the handlingof the last barrelof crude by a refinerto arriveat the net product worth (NPW)of the crude. Since we are consideringthe marginal barrel,this does not includeany amortizationor depreciation.

O Finally,deduct from NPW the cost of transportationand insurance to arriveat the netbackvalue of crude at the port of loading. The transportcost is the costof charteringan appropriatelysized tankeron the spot marketfor a singlevoyage.

The logicof calculatingthe netbackvalue at the port of loadingshould now be clear. By subtractingrefining and freightcosts, spot productprices are translatedinto an equivalentcrude oil value at the loadingport--the so-called"FOB netback". Thus, if the price of crude is supposedto be determinedby the netbackvalue, the logicalchoice would be to relatethe FOB price of the crude to the FOB netbackvalue at the port of loading.

There are a few pointsworth notingin the netbackcalculation procedure. First,the most importantinformation in this calculationis the refinery yield,i.e., the mix of productsobtained from a barrelof crudeoil. This mix varies not only with the quality of each crude, but also with the patternof localmarket crudes--which can shiftfrom winterto summer--and with the technicalcapabilities of individualrefineries. Thus, looking for specificyield patternswould mean compilingthousands of mixes correspond- ing with variouscrudes, various refineries, and differentperiods of time. Recognizingthe impossibilityof sucha task,Petroleum Intelligence Weekly has developeddata on crude oil yield patternsthat are "typical"or "representative"of the refiningindustry in eachof the six major refining centers. The yield estimatesfor 1986 are given in AppendixA.

Second,the refiningcost, used in netbackvalue calculations,does not includecapital costs. The implicationis that netbackvalue is purelya marginal phenomenoncorresponding with the short-termoperation of a refinery. Thus,netback value is not intendedto providea basisfor long- term developmentand resourcemanagement.

33 Saudi Arabia'snetback pricing contracts followed the generalconcept des- cribedabove but, insteadof limitingthe refiningcost to "out-of-pocket" operationalexpenses, Saudi contractsallowed for some ($1.50-2.00/b) capitalcost. Thus,the totalrefining (operational and capital)cost could be as high as $2.00-2.50/b.

As to the mechanicsof the trade,the buyerwas responsiblefor refiningthe crude. Productprices were based on the average (betweenthe date of loadingand date of discharge)of Platt'sprice seriescorresponding to the locationof the refinerywhere the buyerwould run the crude. In the soft marketsof mid-1986,purchasers insisted on paying accordingto the spot prices of the latestpossible date. Some contractswere based on spot pricesof five or ten days aroundthe date of dischargeor relativelylong periods(25 days)after the date of loading. And the freightand insurance allowancewas based on actualcosts for each cargo.

Saudi netbackcontracts with the Far East were in some respectsdifferent from thosewith the West. First,pricing was basedon an averageof product pricesaround the date of lifting,while contractsfor Westerndestinations were linkedto pricesat the time of discharge.Second, Far Eastdeals were based on Rotterdamprices, due to thin tradingin localspot markets,with freightdeducted from Ras Tanura. An extra 60 cents a barrel was then chargedto compensatefor the lowerfreight costs that prevailto the East as well as historicallyhigher prices there. Third,fuel oil yieldsin the contractswith Japan were less than those in contractswith the U.S. oil companies,although the averagefuel oil yield in Japanwas much higherthan in the States.

Saudi netback contract provisions set an example for other producers to follow. In January 1986, Nigeria signed netback contracts with its equity partners, guaranteeing them a minimum$2 a barrel margin on theirown share of crude and $1 a barrel on government oil. These contract arrangements were similarto Saudi netbacksales with one importantdifference: the Nigerianprice was based on an averageof publishedproduct prices in the calendarmonth in which each crudecargo was lifted. Saudi contractswere based on the averageprice aroundthe date of discharge. In the Nigerian contract,the refiningcost allowancewas $1.80 for the U.S. Gulf Coast, $1.30 for NorthwestEurope, $1.20 for the Mediterranean,and $1.00 per barrelfor the Caribbean.

Iran'snetback contracts were also similarin structureto SaudiArabia's, with an additionalfeature, a floorand ceilingmechanism. A formulatied to spot crude prices defined the limits within which netback pricing applied. If the netbackvalue went above or below these limits,the spot crude formulawas used instead. Thus, if netbackvalues fluctuatedtoo

34 widely out of line with the spot crude market, they were disregarded, protectingboth buyer and seller. The spot crude formulawas based on an average of Brent and Dubai prices with the "floor" about $2 below and the "ceiling" about $1 above.

Consequencesof Netback Deals

Netbackpricing transfers the marketrisk from downstreamoperations to the producer. It also transmitsa price signalfrom the heartof the marketto the producer.

The risk transferrole is valuedvery highlyby oil companies.In a falling market, oil companiescan incur substantiallosses from price declines betweenthe date they buy the crude at the loadingport and the date they sell the refinedproducts manufactured from that crude. They are therefore interestedin avoidingas muchof this riskas possible.Some oil companies have startedto use the futuresmarket for this purpose. They could sell shorton the futuresmarket around the same date that they buy the oil at the loadingport, liquidatingthe positionaround the time they are selling the products. The futuresmarket, however, does not providea complete protectionsince it only coversone crude (WTI),two products(gasoline and heating oil), and only three locations(Oklahoma, New York Harbor and Rotterdam).

Netbackcontracts with a pricingdate close to the date of sellingthe productsprovide a more convenientway of transferringrisk. An even better arrangementin this regardwould be the so-called"realization" contracts under which the producersells crude at realizedproduct prices.

The secondfunction of netbackpricing, i.e., transmission of price signals, is more neutral. It does not favoreither side of the tradebut helpsboth sides to arriveat a commonunderstanding of market conditions. Finding relevantprice signalshas alwaysbeen a potentialarea of disputebetween producersand oil companies;netback pricing provides a vehiclefor the automatictransmission of price signals.

Servingthe above two functions,netback deals should not, in theory,cause any significantchange in the structureof the market. However,in practice, these deals have importantconsequences for Saudi Arabia,for OPEC, and for the world oil market.

To Saudi Arabia,the advantagesof netbackdeals over sale at crude spot priceswere more stableprice patternsand more relianceon integratedoil companiesrather than on traders.On the otherhand, these transactions had some severedrawbacks for Saudi Arabiacompared with officialsales and

35 crude spot sales.the most importantdisadvantage was a potentialloss of revenuesince netbackvalues tended to be lower than spot and official prices of crude oil; the agreedyields tended to favor buyers;and the refiningcosts were somewhatexcessive.

The reasonthat crude spot pricesstay abovethe netbackvalue is that the averagevalue of crudeto refinersin eachmarket is abovethe netback. The spot crude price is an indicator,produced by the market,of the average value of a crude; the netbackvalue is an indicator,worked out by the industryspecialists, of its marginalvalue. The negativemargin between the netbackvalue and the spotprice has persistedfor the last eightyears. However,it does not mean that refinershave been consistentlybearing losses. Thus, the netbackcontracts caused Saudi Arabia to take a loss by sellingat netbackrather than at spot prices,and the loss was exacerbated by includingin the refiningcost an allowancefor capital costs which reduced the price paid for its crude to a level below normal industry estimates of its netback value.

Added to the above areas of potential loss to Saudi Arabia was the refinery yield, or mix of product output, included in Saudi netback contracts. The contracts with U.S. oil companieswere based on approximately 40%gasoline, 20% distillates,30% fuel oil and 10%other (LPGand refinerylosses). The fuel oil percentagewas crucial. Allowancefor 30% fuel oil in the netback contractwith some sophisticatedrefineries which normally produce less than 10% fuel oil would in effectdiscount the valueof crude by about 5%.4/ In short,netback contracts had theirdrawbacks for SaudiArabia. They under- valued the crude by pricing it at its marginalrather than its average value, by allowing additionalrefining costs, and by allowinga high proportionof residualfuel oil in the notionalslate. In returnfor the lossof revenue,netback contracts ensured the attractivenessof Saudicrude at a time of oversupplyand re-establishedSaudi Arabia in the international petroleummarket.

Also, by virtueof their provisions,netback pricing deals encouragedoil companiesto increasethroughputs and salesof productson the spot market. As explainedpreviously, netback contracts cover all operatingand some capitalcosts. Thus, as longas a refinerhas excesscapacity he will gain from increasinghis utilizationrate. Furthermore,by basingthe netback on productspot pricesaround the time of productsale, refinersrun a low businessrisk and will have littleconcern about marketconditions at the

4/ Residualfuel is pricedon averageat 70-80%of the averageprices of No. 2 heatingoil and regulargasoline. A shift from 30% to 10% fuel oil would amountto a 4-6% increasein the GPW of the crude.

36 time of sale. Thiswill furtherprompt an expandedthroughput. Aggregating this behaviorover all the oil companiesresults in increaseddemand for OPEC oil and floodingof the productspot marketswith director indirect sales of the additionalrefinery throughputs, as was actuallyobserved in 1986 when netbackpricing became commonplace and the netbackvalue as well as the spot price of crudeoil droppedbelow $10/b.

37 CHAPTER4 THE ROLEOF PETROLEUMSPOT PRICES

Sourcesof Information

All tradingneeds market information, or strikinga bargainwith any confi- dencebecomes impossible. In petroleumtrading this informationis provided throughbusiness contacts to whichcan be added informationput out by such servicesas Platt'sOilgram, Oil Buyers'Guide, Petroleum Argus, Petroleum IntelligenceWeekly, and some other sources.

Platt'sOilgram was foundedin the 1920sto reporton pricesin Texas and in the US Gulf Coast. In the 1960s Platt'sbegan a Europeanprice series which was, in 1966, convertedto the currentRotterdam price information. In 1970 PetroleumArgus startedin Londonand, more recently,the daily price informationis made availablethrough: international press agencies, Reutersand AP/DowJones; Petroflash which was initiallyestablished as a joint ventureby PIW and Oil Buyers'Guide but acquiredby McGrawHill, the publisherof Platt'sin 1985.

All these prices share certainproperties: they are based on regular trawlingof marketinformation, but not on a comprehensiveformal survey or even a representativesampling of actualprice quotations. Platt's, which is the most influentialsource of price data, has developeda networkof contacts--traders,brokers and refiners(all of them deemedto be activein the trade)--fromwhich informationon the spot market is collecteddaily. From this information,Platt's staff daily prepare what they call an "assessment"of spot prices. The quotationsare not reportsof the extreme limitsbut are assessmentsof the day'sprices for "typical"or "generally available"products. These assessments,unavoidably, contain some subjec- tive elements.The subjectivitysurfaces in a numberof ways. For example, the spot price seriestend to lag behindlarge price changesin the market. Assessorsare reluctantto validatelarge price changes,even when the statisticalaverage of reportswould encouragethem to do so. Instead, pricesare increasedin smallshifts as the tradingcommunity's reaction is tested out. Nevertheless,the informationis considereduseful. It complementsthe traders'judgement of market conditions. As one expert describesit, "The processof collectingscraps of informationand piecing togetheran impressionof the whole is exactlywhat any traderdoes himself when evaluatingthe market. A (Platt's)journalist may have a betterchance

38 of puttingtogether an accuratepicture, since he can cast his net more widely".1/

Uses of Spot Prices

Use of spot pricesreported by agenciessuch as Platt'sis much wider than might be expected. The primaryareas of use are:

o product term contracts with variable pricing clause;

o crude oil sales based on spot crude or product prices;

o managementof refining/marketing activity;

o adjustments in refineries' posted prices;

o government retail price controls linked to spot product prices.

There are two ways by which product term contracts between refiners and marketersare normallyrelated to the spot price. Either there is an explicitlinking by includinga formulawhich automaticallychanges the contractprice as spot prices vary; or there is a de facto linkingby includinga periodicprice reviewclause, which would normallyprovide for monthlyor quarterlyrenegotiation of the price based on the spot market trends. Both of these arrangementsmay result in contractprices which somewhatlag behind the spot price;but the influenceof the spot price would,in any event,remain substantial

Crude oil sales based on spot pricesare of more recentorigin. They take the form of:

o term contractswith an automaticprice adjustment;

o term contractswith a monthlyor quarterlyrenegotiation clause;

o netbackvalue contracts;

o realizationdeals.

These arrangementshave been discussedin Chapter3.

1/ Roeber,J., "The RotterdamOil Market",Petroleum Economist, April 1979.

39 The use of productspot prices in managementof refining/marketingactivity is a productof recentmarket conditions. For severalyears refinersin the USA, Japan and Western Europehave been plaguedby overcapacity. Poor operationaleconomies stemming from low capacityutilization coupled with marginallyrefined and thereforecheap surplusproducts available on the spot markethave meant that some refining/marketingcompanies have had to considerthe possibilityof cuttingback on runningcrude themselves,and insteadbuying products manufactured by others. Spot prices are studied closelyto decidehow much of their needs these companiesshould produce throughtheir own refineriesand how much they shouldpurchase on the spot market.

The use of productspot prices in setting"posted prices" is becominga normal practice. The postedprice is an officialselling price set by refiners. Posted prices have traditionallylagged behind product spot prices,which may implythat thereis no stronglink betweenposted and spot prices. The catch,however, is that postedprices are not necessarilythe pricesat which tradeoccurs. They serveas a referencepoint for negotia- tionsand, dependingon the marketconditions, there will alwaysbe premiums and discounts. These premiumsand discounts,on the other hand, take accountof the prevailingdifference between the postedand spot prices, effectivelychanging the purchaseprice accordingto the spot price.

In the USA, postinginclude also the priceat which refinersbuy theircrude oil. These pricesare nowadaysrevised quite frequently.PIW presentsan analysisof the correlationbetween crude posted and spot prices in the USA.2/ It concludesthat US independents(like Koch, Permian,or Diamond Shamrock)are aggressivelymarket oriented, and the mini-majors(such as Sun, Conocoand Marathon)are not far behind. However,major oil companies (likeExxon, Shell, Amoco and Mobil)change postings much less frequently than the smallerfirms, but are stillmuch more marketresponsive than they were in the past.

The use of spot prices in governmentretail price controlsemerges from: (a) the need to regulatedomestic prices; (b) the need to set a reference point for internal price transfers of integrated oil companies; and (c) the lack of any other measure which could be used for these purposes.

As a result,most Europeancountries have worked out quitecomplex formulae to relateprice maximaand minimato Platt'sprices.

2/ PetroleumIntelligence Weekly, May 13, 1985.

40 Most FrequentComplaints Against Spot Prices: Politicaland Technical

Complaintsagainst spot pricesare of two types: politicaland technical. Politicalobjections are normallyraised when spotprices are movingagainst the interestof a group. The use of spot prices to supportpolitical objectivesis clearlydemonstrated by the periodicshifts of the position and attitudesof consuminggovernments and OPEC memberstowards the legitimacy of spot markets. Duringthe slack years (1974-78),governments of consuming countries used low spot prices as a lever against OPECprice increases and as a mediumto limit majors' domestic prices. OPECwas then playing down spot prices, denouncingtheir reliability,accuracy and representatives.In 1979consuming governments and OPEC switchedpositions on the validityof spot prices. OPEC used high spot prices, either explicitlyor implicitly,to raise its contractprices. Consuminggovern- ments,on the other hand,denounced spot prices as "no longeran indication of overallcommercial oil value"3/and embarkedupon variousstudies to limit the activityof the spot market. As the marketconditions reversed in recentyears, consumingnations have again discoveredthat spot prices representthe true value of oil, while OPEC blames spot prices for the presentinstability of the petroleummarket.

Technicalobjections to spot pricesare more systematicand worth noting. The most frequentcomplaints are: (a) the lack of an organizedtrading floor; (b) the thinness of trading; and (c) the inefficient assessment of spot prices.

LACKOF AN ORGANIZEDTRADING FLOOR:

A point often made about spot prices is that, withouta formal trading floor,information on spot pricesis necessarilyincomplete and unreliable. As spot trading does not take place on an organizedexchange or trading floor,there is no locationat whichall the deals are made,no registration of membership,no officialreporting of trans actions(price and volume), and no formaladministrative body. Instead,deals are individuallyregis- tered betweenagents who can be anywhere. Much of the assessmentof these deals is made throughPlatt's editors' telephone calls to selectedtrading contacts. Therefore,the marketinformation is not and cannotbe collected within a solid and systematicframework. This is a generallyaccepted problemin the transparencyof presentspot prices. However,the sourceof the problemis not in Platt'sprice reporting system, but with the structure of the spot market.

3/ See EuropeanCommission's press releasein PetroleumIntellicence Weekly,September 14, 1979.

41 THIN TRADING:

Thin tradingand lack of adequateand continuoussupply have occasionally been cited as fundamentalproblems with spot prices in general,and with Platt'sassessments in particular. If Platt'scan discoverno deal to report then it repeatsthe previousday's price. For some productsin certainmarkets it is not uncommonto have gaps of up to severalweeks betweenpublicly reported deals. Thus,when Platt'scan againreport a firm price it may well bear littlerelation to the one that has been continually restatedover the precedingweeks. A prominentexample of this is the 1985-86trend of Arab Light'sspot price. Platt'sassessment of the Arab Light spot price remainedat $27.00during the collapseof the oil market (November1985-February 1986) when the priceof WTI and Brentplummeted from around$30 to $15 per barrel.

Oil companieshave, during slack periods, extended the thin tradingargument to say that the spot marketis, in general,too thin and limitedin actual suppliesto providea basis for pricingof petroleumproducts in retail markets. This is, in nature,a more fundamentalcriticism than the reporting problemdiscussed above. However,this complaintindicates a lack of under standingof the role of the spotmarket. By definition,spot prices are predicatedupon marginal transactions; and significantvolumes need not be behindsuch prices. At any point in time, incrementaladditions to or disposalsof one's oil stocksvia spot purchasesor sales will have dif- ferentvalues to differentparties. Spot purchaseswill alwaysbe made by the buyerwho placesthe highestvalue on incrementalsupplies. Similarly, spot sales will alwaysbe made by the sellerwho least valueshis excess supplies. Consequentlyspot prices show the equilibriumpoint of the marginalvalues of oil to the sellerand buyer. These priceswill almost alwaysbe differentfrom the averagemarket prices. What oil companiesare pointingout is that the marginalprice shouldnot be replacingthe average price,which is presumablyrelated to the costof refiningand marketingthe oil.

SUBJECTIVITYOF PLATT'SPRICE ASSESSMENTS:

Objectionsto Platt'smethodology are primarilyconcerned with the subjectivityof its price assessments.Platt's subjectivity is to be expected. Such privateendeavors often lack a comprehensivedatabase, and what is missingin statisticaldata must be filledin by the assessor'sintuition about the market. Platt'smakes no pretensionsabout this point. It emphasizesthat its pricesare assessmentsof marketconditions. Neverthe- less,the subjectivityin performingthese assessments poses problems. For one, no two individualsare ever likelyto judge the marketprecisely the

42 same. How big a problemthis subjectivityof assessmentis dependson the ways and means of using these prices. The traditionalrole of Platt's prices,i.e., to providea feel of the market,is not severelyjeopardized by subjectiveassessments. In fact,some defendantsof Platt'sargue that its assessmentis more usefulthan a huge volumeof hourly fluctuating numberswhich would be providedby a "moreobjective" statistical compila- tion of data. But the main objectionsto the subjectivityissue arise when Platt'sprices are used as actualmarket prices in areas such as government price regulationsand contractprice arrangements, for which Platt'swas not initiallydesigned.

Is There an Alternative?

Wheneverso much hingesupon a set of numbers,the accuracyof which is subjectto question,all ways of improvingthem are likelyto be explored. The effortsin this directionhave intensifiedsince the mid-1970sand fall into the followinggeneral categories.

o developmentof registration/monitoringsystem;

o introductionof spot price indices;

o creationof a formaltrading floor;

o introductionof futuresmarkets.

Complaintsabout the inaccuracyand unrepresentativenessof spot prices are to some extentrelated to the self-interestof those raisingthem, but to a larger extent reflectconcerns about the problemsinherent in the structureof the spot marketand the natureof the reportingsystems. To evaluatethese complaints, the EuropeanCommission set up a six monthprice monitoringsystem (Check-Run)in 1978 followedby anotherone (Comma)in 1979-80.

The purposeof Check-Runwas to verifypublished spot quotations--in particular thoseof Platt'sOilcram Price Service--and cross check with the actual spot price. Thirtythree companiesand a numberof tradersparticipated. From the seven productstraded on the spot market (premiumand regular gasoline,naphtha, jet kerosene,gas oil, low and high sulphurfuel oil), all but jet kerosenewere includedin Check-Run.Spot transactionsby participants in these products were registered weekly with the auditors for their specified reporting area. Reporting areas were divided as follows: barge trade through the ARA (Amsterdam-Rotterdam-Antwerp);cargo trade

43 throughthe ARA ports,Hamburg-Bremen, French Atlantic coast, and the UK east and south coasts. Among twelveRotterdam price seriesexamined (six petroleumproducts in barge and cargo markets),three did not generate sufficientvolumes of trade to support regular let along daily price reports.These were regulargrade petrol in bargesand cargoes,and naphtha in barges. Anotherthree products(premium petrol, low sulphurand high sulphurfuel oil cargoes)had sizeablemarkets but did not generatesuffi- cient reportsto make comparisonsuseful. Of those priceswhich could be compared,the Check-Runconcluded that only three products (naphtha cargoes, gas oil cargoes,and low sulphurfuel barges)were accuratelyreported.

In early 1979 the EuropeanCommission's concern about the effects that exceptionallyhigh prices on the Rotterdammarket had on worldwideoil costs led the Commissionto reintroducethe registerof spottransactions. Comma, the secondeffort to registerspot prices,was carriedout with the purpose of understanding the structure and operation of the spot market. The results of this new exercise were more favorable to the Platt's price reportingprocedure, indicating that there was no easily implementable programto improvethe presentsystem. Specifically,the groupconcluded:

o There is not enoughjustification to maintaina price reporting systemon a permanentbasis.

o The abilityto reintroducethe registershould be maintainedon a stand-bybasis. This wouldbe done in such a way that it couldbe quicklyintroduced at timesof artificialdisruption of the supply/ demandbalance.

In short,it is easierto raiseobjections to the reportingand the roleof spot pricesthan it is to do somethingabout the system. Indeed,Platt's has not soughtthe burdensomerole it now holds. Rather,governments, oil companiesand traders have come to it, each seeking some independent barometerof marketconditions for its own reasons. Clearly,all the users realizethat Platt'sprices should not be utilizedas statisticalinputs into governmentregulations, contract arrangements and the like;but they justifytheir use primarilyby the lack of any alternative.

INTRODUCTIONOF SPOT PRICE INDICES:

Effortsto introducespot price indicesare of more recentorigin. In May 1985 the InternationalPetroleum Exchange of Londonlaunched a dailymarket index for Brent crude. This index appearsat noon Londontime with an averageprice for 15 day cargosupplies as reportedthe previousday. These are spot cargoesdeliverable at 15 days' notice in the month ahead at sellers'option. The indexis an averageof Petroflash,Arqus and London

44 Oil Reports. Platt'sdeclined to be used unless it was the exclusive source.

A much more extensiveeffort to prepareprice indices (with some common featureswith monitoringsystems) has been launchedin the growingeast of Suez spotmarkets. A numberof oil traders,refiners and stateoil refiners agreedin April 1985 to collectprice data on refinedproducts in Singapore and Japan. The pricegathering effort, known as Asian PetroleumPrice Index (APPI),involves seven refinedproducts in Singapore,and four productson a deliveredJapan basis. Participantssubmit price data weekly to an accountantfor collatingin accordancewith an establishedformula. The resultingindices are telexedback to the paid subscribers.This industry participationscheme was developedby a tradingcompany, Seapac Services, which is the administratorof the plan. SeapacServices appoints a panel, composedof producers,traders and refinersactively engaged in the Asian markets,which is to submitprice data. Seapacalso has the responsibility to keep the group "balanced".

The idea of Asian petroleumprice indexingwas then extendedto the Asian crude markets. The Asian crude oil index monitors 14 representatives crudes, includingthe most importantIndonesian, Malaysian, Australian, Chineseand MiddleEastern crudes. The crude price index is designedto serve a necessaryrole of pricereference in crude supplycontracts as well as spot transactions.However, some tradersview the marketto be moving too fast to make these weeklyassessments useful.

CREATIONOF A PETROLEUM"BOURSE":

The idea of an organizedbourse for petroleumspot tradingwas proposedby Francein early 1979 in the hope that it could controlgalloping prices on the spot marketand ensurethat quotationswere authenticand not manipu- lated. The feasibilityof implementingthe idea was then exploredby the EuropeanCommunity in 1979-80. The proposedscenario envisaged:

o Compulsoryparticipation by all "entities"in oil tradingin the EC;

o automaticregistration of all spot transactions;

o exclusivecomputer access to the "exchange"by registeredentities.

The proposalwas examinedby a group of expertsfrom differentparts of the oil industry,who reachedthe followingconclusions.

45 o A market in the sense of an effectivetrading mechanism already existed. It differedfrom an officialbourse in that therewas no registrationof membership,no officialregistration or reporting of transactions,no formaladministrative body, and no physical trading floor. But the existenceof modern telecommunication systemsrendered the physicalcentralization of tradingunneces- sary.

o The establishmentof a formalizedbourse for oil tradingdid not seem to be practical. Establishmentof such a boursewould not significantlyimprove the way in which spot tradewas handled.

o The initiativeof the LondonCommodity Exchange in establishinga marketin oil productfutures should be recalledand followedcare- fully.

INTRODUCTIONOF FUTUREMARKETS:

We have in this chapter,thus far, reviewed the way spot prices are assessed,the transparencyand accuracyproblems of these prices,and the effortsof governmentsto developalternatives. We have found out that, while the industryand governmentauthorities feel substantialdiscomfort with these prices, most effortsto develop alternativeshave ended in disappointment.It is somewhatunfortunate that the petroleumindustry had to repeatthe unsuccessfulexperiences of similarefforts in many other commoditymarkets just to find out that they did not work. However,the fortunatefact is that the experiencefrom other commoditymarkets also providessome clear guidanceabout what arrangementswould work.

Spot tradingis in the true meaningof the word a free marketphenomenon. Its informationneeds cannotbe met by any controlledor even monitored arrangement.When the informationneed becomes strongenough, it will, throughthe market mechanism,develop its own answer;and the "natural" answerto a need for price transparencyis the futuresmarket. Inception of a futuresmarket should not be undertakenby publicauthorities. It is simplya matterof demandand supplyfor price information.When there is enoughdemand, the marketwill prompta profitabilitysignal and entrepre- neurs will respondby creatinga futuresexchange.

Trading in futures markets takes place on a physical floor with deals struck by the method of open outcry and is thus quite different from the workings of spot and term business. Open outcry means that those allowed to trade on the floorof the marketface each other in a ringand bids and offersare shoutedaloud untila match is made. All are thus aware of every business opportunity.This informationis made fullyavailable to interestedparties

46 outsidethe marketvia visualdisplay unit systemsand is systematically reportedby the financialand trade press.

The suitabilityof futuresprices to take the leadingrole in price refer- encing is evidencedby the rapid penetrationof the New York Mercantile Exchange(NYMEX) and the InternationalPetroleum Exchange (IPE) oil futures pricesin petroleumtrading decisions in the USA and Europerespectively. Indeed, NYMEXprices have practically taken over, for the crude and products traded on this exchange,the functionof price referencingin the USA. The chart below shows the correlation between the prices of nearby (the next immediatemonth) futures and the spotmarket for the crudeoil (WTI)traded on NYMEX. The correlationbetween the two price patternsis very strong (the correlationcoefficient is above 99 per cent). This is becausespot prices nowadayssimply follow the futuresmarket. Most peopleacknowledge in New York,Houston, and increasinglyin other partsof the USA that there is littlespot markettrading that takes place until NYMEX actuallyopens in the morning.

In additionto the price referencingfunction in spot trading,futures pricesare increasinglyused in settingthe contractor postedprices. For example,Exxon used to adjust its heatingoil postingsin the New York Harboronce a week, late on Fridayafternoons. Now it changespostings almostdaily using the NYMEXheating oil futuresprice as a referencepoint. Anotherexample is Conocowhich uses futuresprices as a componentin its formulato establishposted prices.

There are three serious limitationsto the usefulnessof the existing futuresmarket as a sourceof referenceprices which would be valid worldwide.

o Problemof location- NYMEXcontracts represent only one segment of the market,a specificUS gradedelivered in a specificUS location. This limitstheir usefulness to tradersin Europeor the Far East. The solutionto this problemis the creationof futures marketsin otherimportant trading centers. It is very likelythat NYMEXand the InternationalPetroleum Exchange of Londonbe linked in the near future,providing some facilitiesin this regard.

o Problemof products- NYMEXproduct contracts are only for regular gasoline (leadedand unleaded)andheating oil, and there is no referenceprice for otherproducts. This is especiallya problem with regardto heavyfuel oil, the priceof which does not seem to correlatewith the productstraded on NYMEX.

47 o Problemof qualityand grades- NYMEX contractsare for specific gradesof crudeoil and petroleumproducts. Thus NYMEX prices cannot be readilyused as referencefor other grades and qualities. This is not as severea problemas the firsttwo. The oil trade is developingrules of thumbto arriveat some pricedifferentials which are used as "qualitybasis" to convertNYMEX prices into pricesof other crudesand productqualities.

Emergenceof New MarkerCrudes

In the past, Saudior Arab Lightcrude was the markercrude against which values of lower or higher qualityoils could be set. This conceptwas developedtwelve years ago when Arab Lightcrude emerged as price leaderon the strengthof its high volume (6.5mmb/d in 1977) and its similarityto other OPEC crudesinside and outsidethe Gulf. AlthoughSaudi Light is stillOPEC's de facto markercrude, it is no longerviewed in the industry as a "free"crude and its price movementsdo not carryas much prominence as in the past. Instead,the West TexasIntermediate (WTI) of the USA, the UK's Brent Blend,and Dubai'sFateh crude have becomethe new commercial markercrudes as theirprices reflect market conditions more realistically.

The chart below shows the spot pricesof Arab Light,WTI, BrentBlend and Fatehcrudes during the periodJuly 1985-March1986. The problemwith Arab Lightis that its spot pricedoes not followmarket patterns and indeedhas stayedrelatively stable through the recentviolent fluctuations in prices of other crudes. Further,the perceptiontoday is that Arab Lightis not spot tradedin any significantvolume, and the spot pricequoted is nothing more than the repetitionof previousprices. Whileproduction of Arab Light (about1.5 mm b/d) is stillhigher than that of UK Brent(750,000 b/d), spot trading of Arab Light is very small. In addition,WTI and Brent are extensively(up to 30 mm b/d) tradedon the futuresand forwardmarkets.

WTI is now becomingcentral to world oil market prices. Highly visible price quotas on NYMEX accountfor much of this phenomenon. Technically speaking,WTI is an unlikelyworld market indicator since physical supplies are largelylandlocked in the USA mid-continentpipeline system and are non- exportable.WTI pricesreflect US buyer thinking,but often do not match preciselywith landed prices of importedcrudes due to differencesin tradingpractices. For example,WTI tradesin minimumparcels of 10,000to 50,000barrels a month,with a few deals in the rangeof 150,000to 300,000 barrelsa month. This compareswith typicalworld marketcrude cargoesof 600,000to 1.8 mm barrels.

The centraldelivery location for WTI is in Cushing,Oklahoma, where several large pipelineswith about 1 mm b/d converge. Some suppliesare also

48 routinelyexchanged for similardomestic oils furthersouth, near the big Texas coastalrefining centers. WTI is gatheredover a wide area both by truck and smallpipelines, converging in the Midland,Texas, area where it is eitherrouted north to Cushing(thence to the inlandChicago and Upper Midwesternrefineries) or to the Texas refineries. In additionto Texas crudes,Cushing is a centerfor the Oklahomagathering system with its 20 mm barrelsof storagecapacity.

Brent'selevation to the statusof marker crude is primarilydue to the substantialsales of this crude in the physicalmarket and, more importantly,to enormousvolumes of speculativetrading on the forwardmarket.4/ In addition,the recent move to abolish the state oil tradingcompany, BritishNational Oil Corporation(BNOC), has furtherexposed the Brent to marketfluctuations. The Brent spot price is now widelymonitored and is often used as a yardstickby other producers,especially those in West Africaand the Mediterranean.The emphasisof Brent tradingis, however, shiftingtowards hedging--withtraders and refinersbuying or selling forwardincreasing volumes of Brentto covertheir future sales or purchases of Mideast,African, and even other North Sea grades. The forwardBrent marketprovides an effectivehedging tool because of its liquidityand price quotes up to six months forward. Europeanrefiners often prefer this forwardmarket to the futuresmarket because they can coverlarge quantities withoutmaking waves on the market. Also,because of its largesize deals and the unstableprices, the Brent spot marketis becomingconcentrated in the handsof some major tradersincluding integrated oil companies,large New York investmentbanks and Japanesetrading houses.

Dubai's Fateh Crude--sometimescalled the "Brentof the East"--hasnow turnedinto the primaryspot crudeof the PersianGulf. Also,forward sales have becomean establishedelement of the marketfor this crude. Fateh is viewedas a free crude because:

o its outputis free of OPEC limits;

o its production(350,000 b/d) is sold by severalfirms ratherthan a singlecompany; and

o its qualityis similarto Arab Light.

The marketfor Fateh crude,however, differs from that of Brent in that:

4/ A forwardcontract is an agreementfor the sale (or purchase)of a commodityat a specifiedtime in the futureat a certainprice.

49 o forwardtrading is confinedto one or two monthsahead as compared with Brent'sfour to six months;

o most participantsintend to obtain physicaldelivery and do not move in and out of paper barrelpositions as with North Sea oil; and

o pricedifferentials on forwardmonths tend to be smallerthan those in the Brentmarket.

Finally,in the Mediterranean,Libya's lighter Es Sidergrade is developing into somethingof a regionalreference crude due primarilyto barterdeals and the diversityof its suppliers. Forwarddeals are limitedto two months,often resultingfrom bartervolumes being sold in advance,rather than speculativeinterest. In spite of its significantoutput of about 400,000b/d, the influenceof Es Sider is kept fairlylocal sinceit cannot by US law move to the large US marketwhere light sweet crudespresently enjoy premiumvalues.

50 CHAPTER5 THE MECHANICSOF FUTURESTRADING

Petroleumfutures markets have, in the last fiveyears, grown very rapidly, with a profoundimpact on spottrading. It has now becomea commonpractice in the USA not to transacta spottrade before considering the NYMEXfutures prices.

Petroleumfutures were, until four years ago, dismissedby many industry analystsas of no significancein the oil business. Today,most people acceptthat petroleumfutures are here to stay; but there is still con- troversyover how importanta role futureswill play. Some analystsview oil futuresas a "papermarket'' with no significantrelationship to the real market. Othersargue that oil futuresnot only will turn into "something big", but will changethe structureof the petroleummarket considerably. This controversyis due partlyto differencesof opinionwith regardto the structureof the petroleummarket and partlyto widespreadconfusion about the workingof the futuresmarket and the mannerwhich it interactswith the spotmarket. This chapterprovides description of the mechanismof futures trading.

How FuturesTrading Works

Let us assumethat a distributoris holding100,000 barrels of heatingoil for deliveryto his customersin December. He is committedto supplythe heatingoil at the spot marketprice at the time of delivery.The petroleum market is unstableand he fears that the price of petroleumproducts (includingheating oil) may declinesubstantially by the time of delivery. A changein the price of heatingoil from 60 cents per gallonto 55 cents per gallonwould leave him with a loss of $210,000. Thus, a decisionto keep his inventorywould be very risky. A clear alternativeis to sell the inventoryon the spot marketand acquireit back beforethe month for which he has a deliverycommitment.

A much more convenientalternative for the distributoris to keep his stock of heatingoil and to avoid the price risk by signinga contractwith an "agent"according to which the distributorsells the 100,000barrels of heatingoil to that agent at a set price (say 60 cents)for deliveryin December. In this way, the price risk is transferredto that agent and the distributorwill bear no loss if the price drops by December. He has sold his heatingoil inventoryat the price of 60 cents a gallon,and he will receivethis price regardlessof the spot price in December. All the loss will be borne by the buyingagent. Of course,in such a risky market 51 situation,everything may work the otherway around. The price of heating oil may jump to 70 cents a gallon. The distributorwould have earned $420,000in capitalgain if he had not signedthe contract. But since he has signedthe contract,the buyingagent will receivethe gain. That is, the buying agent acceptsthe risk and, therefore,will receiveall the possiblegains and lossesassociated with risk.

What will happenin December? The distributorwill need the heatingoil for deliveryto his own customersbut, at the same time, he has an obligation to deliverthe heatingoil to the buying agent. This is where the "futuresmarket" mechanism solves the problem. The buyingagent has the optionof resellinghis contractto the initialseller (our hypothetical distributor)or to any other agent. Thus, by the time the contractis due, the distributor buys back the contract (of course at a different price).

The futures market mechanism provides two important facilities for this distributor. First, by Decemberwhen the distributor wants to buy back his contract,the futuresmarket (almost)guarantees that he can purchase the contractand avoidthe actualdelivery of the heatingoil to the buying agent. This is due to the fact that the contractitself will have its own marketalong with its own demandand supplyforces. The contractwill then alwaysbe availableto buy or to sellat the appropriateprice. Second,the distributor'spossible loss or gain from sellingand rebuyingthe contract is (normally)offset by his gain or loss on the valueof his inventorydue to the changein the spot marketprice so that he protectshimself from the marketrisk.

52 Figure2.1: A HEDGE

Status: A distributoris holding100,000 barrels of heatingoil to deliverto his customersin December.

Concern: He is concernedthat petroleumprices may fall by Decemberand he may lose on the value of his inventory.

HedgingAction:

(1) He signs a contractwith an "agent"and sells 100,000barrels of heatingoil for deliveryin Decemberat the presentmarket price.

(2) He buys back (liquidates)the above contractin Novemberat the then currentprice.

Results

(1) He loses,or gains,in the value of his inventoryin proportion to the fall, or rise, in the price.

(2) He gains,or loses,in the valueof his contractwith that agent in proportionto the fall, or rise, in the price.

(3) His loss,or gain, in (1) is offsetby his gain, or loss in (2).

Futures market provides the distributor with:

(1) A place to find that buying "agent".

(2) The possibility to buy back his contractin November.

MarketParticipants

Our aforementioneddistributor intended to protecthimself from the risk associatedwith a changein the priceof heatingoil. He is normallycalled a "hedger". In order to find someonewho is willingto take over the risk of the price change, the distributor goes to a "futures exchange". A futures exchange is nothing more than a central meeting place for buyers and

53 sellers (or their representatives)to transactbusiness. They enter into specialcontracts for the futuredelivery of commodities:these contracts are known as "futures". Each contractspecifies the exact qualityof the commodity,the month of delivery,and the place (or places) at which deliveryis to be made. A futurescontract is a promiseon behalfof the sellerto deliverwithin a specifiedmonth, and a promiseon behalfof the buyer to take deliveryof a standardquality and quantityof the commodity at an agreedprice. However,in most futuresmarkets, only a smallfraction of contractssold is closedby deliveryof the commodity.Since nearly all participantsare motivatedby the desireto tradeon pricemovements, they liquidateby undertakingoffsetting transactions. The buyer can liquidate his positionin the futuresmarket prior to deliveryof the commodityby sellingcontracts of the same futures. For each contractpurchased or sold and subsequentlyliquidated, the tradertakes a total profitor loss equal to the differencesbetween his buyingand sellingprice multipliedby the numberof units of the commodityspecified in the contract.

Three groupsof peopleare involvedin the futuresmarket. First,there is a "sellinghedger" who is a produceror a stockholderwho possesses(or will possess)the commodityand wants to protecthimself against a fall in its price;he will sell a futurescontract to hedge againsta price fall. Second,there is a "buyinghedger" who is again a user or stockpilerof a commodity. He will need the commodityfor sometimein the future;he does not intendto buy it now. He buys a futurescontract to hedge againsta possibleprice rise. Third is the speculator. He participatesin both buyingand sellingof futures. He is neithera producernor a stockholder nor a user of the commodity. This individualenters the marketwith only one goal in mind--tomake a profitfrom correctlyanticipating the direction of prices. By assumingthe risk that the producersand processorsdesire to avoid,the speculatorstands to losemoney if his judgmentproves wrong.

SELLINGHEDGER:

A sellinghedger, a personin the firstgroup, will take a "shortposition" in the futuresmarket and a "longposition" in the actual (spot)market. For example,a jobberwho is goingto have 100,000barrels of productin his inventorynext month is called "long in the actualmarket." The hedging actionwould requirehim to sell a 100,000barrel futurescontract for deliverythe next month. He will be short in the futuresmarket.

If the spot market price (also known as the cash market price) of petroleum products is currently $23 per barrel,the jobber'sposition in the market is worth $2,300,000 because he is holding 100,000 barrels. His position in the futures market is also worth $2,300,000 because he has sold 100,000 barrelsof the next month'sdelivery at the price of $23 per barrel. Now

54 let us assumethat by the nextmonth, the spotmarket price drops to $21 per barrel. The jobber'sposition will then deterioratefrom $2,300,000to $2,100,000;that is, he will have a $200,000capital loss in the spot market. However,at the same time, he buys back his futurescontract. The spot price havingdeclined by $2 a barrel,the futuresprices has declined by almost the same amount. Consequently,he will buy back the futures contractat $21 a barrel. Since he had sold this contractat $23, and is now buying it back at $21, the gain on futurestrading ($2 x 100,000= $200,000)offsets the loss in the spot market. This situationis normally known as a "perfect"or "efficient"hedge. In practice,however, the spot marketprice and the futuresprice may not move in such a parallelfashion and thereforethe gain and lossto the hedgermay not completelyoffset each other.

BUYINGHEDGER:

A "buyinghedger", a personin the secondgroup, will take a shortposition in the spot marketand a longposition in the futuresmarket. For example, a refinerdecides he needs200,000 barrels of crudenext November. He does not need to buy the crude now. However,he fears that by next Novemberthe priceof crudemay have gone up. To avoidthe pricerisk, the refinerbuys 200 Novembercontracts (each contractis for 1,000 barrels). If prices happento go up duringthis period,he will not be affectedby the price increasebecause he has alreadymade the deal at the specificprice; if, on the other hand,prices decline, the refinerwill not be able to gain from the pricedecrease because he has obligatedhimself to buy the crudeat the agreedprice.

It is, however,important to note that a "buyinghedger", the refinerfor example,does not normallyuse the futuresmarket as a sourceof supply. It is true that the refinercan plan on takingdelivery; in such a case, the sellerof the contractis obligatedto make the delivery. However, the usual practiceis to close the futurescontract before its maturity date. That is, futurestransactions do not reallyrequire the physical deliveryor even physicalexistence of the oil being traded. Participants simplysell an "obligationto take or make delivery",and buy back this obligationbefore it reachesmaturity. Thus the refinerbuys his crude on the spot marketat the same time that he sells his futurescontract. His gain or loss on a futurescontract will compensatefor the change in the spot value of the crude so that he is not affectedby any price movement occurringbetween the presentand nextNovember. He is stillusing the spot marketas the sourceof supply,but utilizesthe futuresmarket to protect himselfagainst price variations.

55 SPECULATORS:

A speculator,a person in the third group,will sell a futurescontract when he expectsthe pricesto go down. He may sell oil futuresto a refiner who will need the crude in two months. The speculatordoes not own the oil he contractsto deliver;nor does he want to own that oil. His only aim is to profiton a downwardprice movement. Thus, if the pricedoes indeedfall betweenthe time he sells the oil futuresand the time he must deliverit, he will make a profit. He can then enter the market and buy back his contractat a profitwithout even havingseen a barrelof oil. Conversely, the speculatorwill lose money if his judgmentproves wrong and he must purchasethe oil futurescontract at a price higherthan the price at which he initiallysold the contract. In the sameway, a speculatorwill buy oil futuresif he anticipatesa price rise. Again,he will sell his futures beforematurity (the delivery month) and will make a profitif the price has gone up.

Why Some PeopleHedge and Some Speculate

In the early discussionsand writingson futurestrading, the hedgerwas often describedas an apparently"unsophisticated" participant in futures tradingwho regardsthe making of prices as a full-timeoccupation for "experts". Speculators,on the other hand, were viewedas "professional dealers" who study the market systematicallyand have access to more information.Thus, the speculatorreceives a premiumfor his higherlevel of "wisdom"and "sophistication".

A somewhatmore classicalexplanation for the speculator'srole in the futuresmarket is that people are naturallydifferent: some avoid risk and otherstake it. The discussionabout the behaviorof so-called"risk averse"people versus "risk lovers" and "riskneutral" individuals is very involvedand theoretical.And, despiteits intellectualappeal, it has not yet providedmuch explanationfor practicalissues concerning the futures market. In particular,the theoryoffers littleexplanation as to why a company(whose decision makers may presumablyconsist of risk avertersas well as risk lovers)should consistently act as a speculatoror as a hedger.

A more recent explanationfor futurestrading is that both sellersand buyers of any futures contract base their decisions on speculation. However,two differenttypes of informationare availableto them and may resultin two differenttypes of speculation.In this respect,the futures marketis assumedto providea meansof sharinginformation. This informa- tionmay come from severalsources. First,speculators may have studiedthe marketconditions and acquiredinformation that is not readilyavailable to others. Second,each speculatormay specializein a certainpart of the

56 market (e.g.demand for oil by a sectoror region,or supplyby each group of producers): his participationin futurestrading will move the price towardsthe directionindicated by this specialinformation. Third, the futures market provides a means of pooling all the informationthat individualsuppliers and consumersmay have aboutconditions in the futures market.

Accordingto the abovetheory, speculation takes place based on the endow- ment of information.Agents or individualswho haveaccess to more accurate informationreceive more profitfrom their engagementin futurestrading. Therefore,these agents or individualssell their information(or at least part of it) and the speculative gain they acquire is the price for this information.

HolbrookWorking, a prominentleader of the field,and his followershave introduceda new theory regardingspeculation and hedging in futures markets.According to this lineof reasoning,the hedgerdoes not primarily seek to avoidrisk. Rather,he hedgesbecause of an expectedreturn arising from anticipationof favorablerelative price movementsin the spot and futuresmarkets. It is not realisticto view the traderpurely as a hedger or a speculator.Each traderchooses a combinationof hedgingand speculation as a form of "arbitrage".This line of reasoningis probablyone of the initialattempts to analyzethe fundamentalsof futurestrading within the frameworkof the conventionaltheories of economics.

Mr. Working views both hedgingand speculationas "multi-purpose"trade decisionswhich are, at any time,aimed at variousgoals. On the "hedging" side, he speaksof five differenttypes:

o carrying-charge hedging

o operationalhedging

o selectivehedging

o anticipatoryhedging

o pure risk-avoidancehedging

Carrying-chargehedging is done simultaneouslywith the holdingof the commoditystock for directprofit from storage. Operationalhedging is done to facilitateoperations involved in the merchandizingor "processing business". Selectivehedging refers to the incompletehedging and is also based on price expectations,but is used by producersand processorsas substitutefor a merchandizingcontract. Finally,pure risk-avoidance

57 hedgingmay be what people have in mind when they talk about hedging. Mr. Working'smain argumentis that pure risk-avoidancehedging is almost non-existentin the real world. That is, hedgingis (almost)always aimed at severalobjectives, one of which may be risk avoidance.

With regardto the other side of trading,Mr. Workingclassifies the role of speculationin futuresmarkets into four categories:

o price-leveltrading (or positiontrading)

o news trading

o scalping

o trend trading.

Price-leveltrading refers to speculationbased on the economicsof the market. The speculatoruses his informationabout the demandand supply of the commodityto judge whetherthe currentprice is higherthan, lower than, or equal to the levelwarranted by marketconditions. News trading refers to the type of speculationthat is based on early access to news about the demand and supplyof a commodity. The tradermakes his move basedon such news and then publicizesthe valueof that news in determining market movements. Scalpingis concernedwith buying on price dips and sellingon pricebulges. Thesedips and bulgesnormally arise from speculative buying or selling,and last for a very short period of time (a few minutesto a few days). Finally,trend tradingrefers to profitspecula- tions from "riding"the price trend. Again,Working's argument is that speculativetrading is alwaysa combinationof severaltypes of tradingand one cannotlimit the explanationof speculativetrading to only one of these types.

InvestmentOpportunities

Traditionally,the returnon investmentin futurestrading has been known to includea risk premium. Hedgerswish to avoid the risk of any price movement. Speculatorsprovide the hedgerswith a price-insuranceservice. They are paid for this servicein the form of an insurancepremium that materializesas a discounton the futuresprices as comparedwith the spot market price which is expectedto prevail at the maturitydate of the futurescontract. Thus, investmentin futurestrading is somewhatmore risky than investmentin, let us say, stocksand bonds. However,the risk involvedin futurestrading is relatedprimarily to the mechanismof futures trading.

58 Investmentin a futuresmarket differs in an importantway from most other investments.An investorin stocksand bonds,for example,has to pay the total amountof his investmentat the time he is makingthis investment. Clearly,he can borrow part of the funds, but essentiallythere is no differencein the opportunitycost of his investment.Commodity contracts, on the other hand, presentthe investorwith a differentsituation. The contractis an agreementbetween a sellerand a buyer for the deliveryof a commodityat a specifieddate for a specificprice. The initialinvest- ment on this agreementis a relativelysmall deposit to assurethe financial abilityof the buyer and seller. This deposit,called the margin, is normally3-5% of the value of the contractbeing traded.l/ However,the gains and lossesof the contractto the investorare based on the total valueof the contract.For example,if an investorbuys a contractof 1,000 barrels (42,000US gallons)of heatingoil at the price of 60 cents per gallon,the value of the contractwill be ($0.60x 42,000= $25,200). The marginhe depositsis only about$1,000. If the price of heatingoil goes up by 10%, his profitwill be $2,520. If we comparethis profitwith the initialmoney he invested($1,000), the rate of returnwill be about250%. In the same manner,a 10% declinein the price of heatingoil will result in a loss of about 250%. Thus, investmentin futurestrading involves a high (positiveor negative)rate of returnonly when profitsor lossesare comparedwith the depositedmargin.

1/ The marginfor petroleumfutures was about 4% until 1984. With increasingvolatility of petroleumprices, the marginhas been now increasedto 15% to 20% of the contractvalue. 59 Figure5.3: LOSERSAND WINNERSOF THE GAME

Hedgers * They buy a price insuranceat a low premium.

Small speculators

* They are the net losersof the game.

Large speculators

* They maintain more comprehensive and updated information about the market.

* They have the financialability to stay in the market for a longer periodof time.

* They are the net winnersof the game.

The above explanationof the investmentmechanism in futures trading indicatesthat this investmentshould, in general,be much more riskythan investmentin stocksand bonds. However,empirical research has shownthat while the averagereturn on futurestrading is about the same as that of commonstock, the variationof the rateof returnin futurestrading is less than that of commonstock, given that one holds a diversifiedportfolio of commodityfutures. That is, investmentin futurestrading is, on average, less risky than commonstocks. Furthermore,the rate of returnon futures tradingis substantiallyhigher than the return on common stocksduring inflationaryperiods: futurestrading provides a better hedge against inflationthan does investmentin commonstocks. However,during years of low inflation,common stocksyield a higher rate of return. All of the evidencesuggests that an investorwho keepsa portfolioof bondsand stocks may be substantiallybetter off to includesome holdingsof futurescontracts in his portfolio. This suggestionhas been empiricallysupported only when the investorholds a diversifiedcombination of commodityfutures.

In short,investment opportunities in futurestrading are not homogeneous to all traders. Empiricalresearch has shown that hedgersdo not pay much "insurancepremium" and, thus, there is no guaranteedminimum return to be gainedby all speculators.Rather, speculators win from each other. Large speculators usually make a consistent profit, while small speculators are,

60 on average, the net losers of the trade. To be a winner, one has to be a better speculator than others.

61 CHAPTER6 EVOLUTIONOF FUTURESMARKETS

From ForwardContracts to FuturesTrading

Futuresmarkets have evolvedfrom the so-called"forward trading", which dates back at leastto the seventeenthcentury. A forwardcontract is an agreementfor the sale (or purchase)of a commodityat a specifiedtime in the futureat a certainprice. Its majordifference from a futurescontract is that the forwardcontract is not standardizedwith respectto quantity, quality,and locationof trade. Rather,each contractis tailoredto the specialneeds of a specificseller and buyer.

The formalemergence of futuresmarkets occurred in the nineteenthcentury when futurestrading started in the US, UK, Germanyand elsewhere. The oldestcommodity exchange in the US is the ChicagoBoard of Trade (CBT), which was founded in 1848 and startedfutures trading in 1865. Other exchangesstarted their trading in the second half of the nineteenth century.

Futuresmarkets currentlyexist for a wide array of real and financial assets includinggrains and feeds, livestock,industrial raw materials, preciousmetals, financial instruments, and foreigncurrencies. In particular,the last two decadeshave witnesseda dramaticincrease in the types of contractstraded, and in the volume of transactionsand open interest. In the US, the volumeof transactionsin futuresIncreased from less than 4 millioncontracts in 1960 to over 200 million in 1987. The averageopen interestincreased from about 140,000contracts in 1960 to about 4 millionin 1987.

Many Europeancountries have also observedexpanding futures markets. Londonexchanges are activelyinvolved in futurestrading of cocoa,coffee, copper,cotton, grains, rubber and metals. Boursede Commerceof Paris and StitchingCocatermijn market in Amsterdamhave turned into importantfutures markets.

In Asia, there are numerouscommodity exchanges in Japan,India, Malaysia, and Singapore.The most importantexchange in Japan is the TokyoGrain and CommodityExchange. In India,there are a numberof exchangethat trade cotton,groundnuts, etc., while in Malaysiaand Singaporethere are futures marketsin rubber.

62 What are the main factorsbehind the developmentof futuresmarkets? Why have the futurestrading of some commoditiesexpanded so vastlywhile many othercommodities have never been subjectto futurestrading, or have failed to become futurescommodities after being introducedon one or several exchangesin the US or other countries.

A futuresmarket typically develops in responseto economicforces in the spot market. If the characteristicsof the spot market are suitable,a futuresmarket will emerge. After its development,the futuresmarket will facilitatethe operationof the spotmarket. Thus, futuresmarkets are not inventedor imposedon the spot market,but evolveout of the need for the performanceof functionsthat the existingmarketing system is not perform- ing effectively.

Futurestrading was introducedin responseto seasonalfluctuations in the supplyof crops. In particular,many authorsrefer to the corn trade in Chicago as an importantstep in the emergenceof forward and futures contracts.In fact,a reviewof the Chicagocorn tradeis a usefulexercise in understandingthe prospectfor futurestrading in other commodities.

After the openingof the Illinois-Michigancanal, substantial corn trading startedalong the river. Farmersproduced corn and hauled it to local elevators. Merchantsbuild corn cribs for subsequentshipment to Chicago.

Farmers hauledcorn during the lateautumn and winterwhen the roadsand/or canalswere frozen. The merchantsstored the corn until springand then shippedit to Chicago. The merchants,of course,had to make a relatively large capitalinvestment to build and maintainthe inventory.At the same time, however, farmerswanted payment on deliveryof the corn to the merchants.Merchants, then, needed considerable liquidity while they were takingthe risk of a declinein price by the springwhen they were going to ship and sell the corn in Chicago. And the merchantscould not get much help from the bankers: becauseof the greatprice risk involvedin holding corn from autumnto spring,bankers were reluctantto make large loanson the unsold corn. Thus, the price risk was a barrier to the efficient operationof the market by all agents involvedin the market: farmers, merchants,financial institutions and consumers.

A logicalextension of the marketwas the developmentof forwardcontracts. The merchantswould go to Chicagoand make a contract,at a firmprice, for the deliveryof corn in the spring. This forwardcontract would solvemany of the problemsin the market: bankerswould view the forwardcontract as a desirablecollateral for issuingloans; merchants would be free of price risk and behavemore rationallywhile dealingwith farmers;farmers would

63 find more suitablemarket conditions,adding to the efficiencyof their operation.

Forwardcontracting, which then becamea commonpractice in tradingother agriculturalcrops, was initiallylimited to individualswho were somehow involvedin the production,storage, processing or consumptionof these commodities.However, as timepassed, four new dimensionswere incorporated into these contracts,which finally led to the formal introductionof futures trading. First, for the purpose of promotingthe commerceof Chicago,the city'sBoard of Tradewas designatedas the officialagency for the measurement,weighing and inspectionof grains. This led to the developmentof qualitystandards which, in turn,facilitated the tradeeven for thosewho did not knowmuch aboutgrains. Second,an organizedexchange (ChicagoBoard of Trade)was introducedas the market-placefor thosewho wantedto buy or sell forwardcontracts. Third, contracts became increas- ingly transferableallowing a buyer of a contractto sell his contract beforethe time of delivery. Fourth,the tradingof forwardcontracts was expandedto covera new groupof people--speculators--whowere not actually involvedin the production,storage, processing or consumptionof the commodity,but who viewedthe forwardcontract deals as " a papermarket", which was very suitablefor makinga fast profit.

In the above manner,forward contracting developed into futurestrading. The administrationof futurestrading, however, has gone throughmany ups and downs sinceits inception.Numerous modifications have beenmade to the rulesof tradeand the organizationof variousexchanges. More importantly, the attitude of legislators and public authorities with regard to the nature and legitimacy of futures trading has changed significantly.

In 1867, the Illinoislegislature passed a bill that declaredall futures contractsvoid and a form of gambling,except for cases in which the seller was the owner or agent for the ownerof the grain at the time the contract was made. Similarly,many other public authoritiesobjected to futures trading,perceiving it as an instrumentspeculators could use to manipulate the spotmarket. Speculators,on the otherhand, had foundfutures trading an excitinggame holdingout the promiseof huge profits. They rushedinto the futuresmarkets and took the play away from commercialtraders. Public concerngrew over the pricedistortion and even the "immorality"of futures trading. Consequently,futures trading became subject to increasing governmentinfluence and control.

Currently,futures trading is a closelyregulated activity. The purpose of the regulationis to maintainthe "competitiveness"and "fairness"of the trade. To this end, the regulatorybody of each countryattempts, in one way or another,to governthe relationshipof an exchangewith its members

64 and that of the memberswith each other. The appropriatelevel of government interventionis stillsubject to controversy.However, futures trading is now a publiclyaccepted activity which is viewedas an exampleof a competitivemarket.

In the US, futuresmarkets were first regulatedby the federalgovernment in 1921. In the early 1930s, futurestrading turned into a legislative issueand Congresspassed the CommodityExchange Act, which assignedto the Departmentof Agriculturethe responsibilityfor monitoringthe activities of futurestrading: thiswas obviouslydue to the fact that futurestrading was then limitedto agriculturalcommodities.

After the significantincrease in the levelof futurestrading in the early 1970s,Congress decided to establishan independentfederal agency to pursue the task. To this end, the CommodityFutures Trading Commission (CFTC) was created in 1974. CFTC has been chartedby Congressto licensefutures exchanges,to approvethe terms and conditionsof any futurescontract beforeit is introducedon an exchange,and to monitorthe implementation of commodityregulations on all US exchanges. CFTC is especiallyrespon- sible for detectingand investigatingthe problemsof marketmanipulation.

FuturesTrading in the PetroleumMarket

Althoughfutures trading in the petroleummarket is a recentphenomenon, forwardtrading has existedin this marketfor a long time. Contractsales with fixed (or predictably fixed) prices have served the industry as a form of forward trade for several decades. However, at present, revisions, discountsand premiumsto the postedprice are becomingthe rulerather than the exception. Furthermore,many contractprices are now relatedto the spot marketprice. A recentstudy has estimatedthat about 50% of petroleum trade is eitherbased on the spot priceor transactionsin the spotmarket. Thus, contract sales have lost their forward-tradingcharacteristics, creatingan opportunityfor futurestrading to provideprice insuranceto petroleumtraders.

Petroleumfutures developed in responseto instabilityin petroleumprices. "First-generation"petroleum futures were introducedin 1974,1/reflecting the reactionto the 1973-74fluctuations in the priceof oil. Thesefutures failedfor variousreasons, the most importantof which was the relatively stable price that prevailedin the market in 1975. "Second-generation"

1, The first energyfutures was a propanecontract introduced on the New York CottonExchange in 1971. This contractwas amendedin 1981 and has since experiencedmoderate trading.

65 petroleumfutures started with the introductionof a heatingoil contract in 1978; it then expandedto includeseveral futures in crude oil and petroleumproducts.

First-generationfutures trading in the petroleummarket started with the introductionof a crude oil contracton the New York Cotton Exchangein autumn1974. The contractcalled for the deliveryof crude at Rotterdam. Technicalspecifications of the contract(340 API and 1.7% sulphurcontent) matchedthose of Saudi light crude. However,the contractprovided the sellerwith an optionto deliverother qualities (varying from 270-450API and 0.1-0.3%sulphur content) of crude at a discountor premium. In the same year, the New York MercantileExchange introduced two contracts--a BunkerC futuresand a gas oil futures--bothof which requireddelivery at Rotterdam.

All of the first-generationcontracts failed to attract the petroleum industryand faded into obscurity. There were severalreasons for this failure,the most importantof which was that petroleumprices did not fluctuateas expected. The internationalspot price of crude oil stayed between$10.30 and $10.46a barrelduring the periodOctober 1974-December 1975. Pricestability was furtherreinforced in the US by the EnergyPolicy and Conservation Act, passed by Congressin 1975. The Act limitedthe annual increase of the price of crude oil, leading to reasonable predict- ability of petroleum prices.

The second reason for the failureof these futureswas the petroleum industry'slack of participationin tradingthese futures. The presumption that the petroleumfutures market, like that of other commodities,can expandwithout the participationof the petroleumindustry, proved to be wrong. The industry'slack of participationwas, in turn, relatedto two discouragingfactors. First,the requirementfor Rotterdamdelivery was a technicalinconvenience for US refiners,jobbers, distributors, and consumers. Althoughthe oil industryhad been told that futurescontracts providedfinancial protection and that therewas no reasonto worry about delivery,the industrycould not see the rationaleof buyingor sellinga contractfor a deliverypoint so far away from the domesticmarket. Second, futuresmarkets were unknownto the oil industryand there were serious concernsabout its impacton the petroleumbusiness.

Second-generationfutures started with the introductionof two contracts on the New York MercantileExchange in November1978. The first contract calledfor the deliveryof No. 2 heatingoil with an API gravityof 300 and a sulphurcontent of a maximum0.2%. The secondcontract called for the deliveryof No. 6 fuel oil with an API gravityof 100-300and a maximum sulphurcontent of 0.3%. Both contractswere for deliveryof 42,000 US

66 gallons (1,000barrels) in the New York Harborarea. (The provisionsof these contracts,as well as otherpetroleum futures, are discussedlater.)

The No. 2 heatingoil turnedinto a successfulenergy future after a few months of slow trading. Its trade volumereached 34 millionbarrels in 1979, followedby 238 million,995 million,1,754 million barrels in 1980, 1981 and 1982,respectively. The successof this contractis due to several factors. The volumeof trade reached12 millionbarrels per day in 1987. First,gas oil was exemptedfrom price controlsin more than 40 statesin 1976. Second,the internationalprice of oil has been very volatilesince late 1978. Third,the completederegulation of the US oil price by the Reagan administrationin February 1981 forged a strongerlink between domesticprices and volatile internationalprices. Fourth,NYMEX has consistentlyattempted to communicatethe uses of its futurescontracts to the petroleumindustry.

The successof the heatingoil contractencouraged NYMEX and otherexchanges to introducevarious other petroleumfutures. In August 1981, NYMEX introducedanother heating oil contractfor deliveryin the Gulf Coastarea. This contractbecame dormant because traders were presumablymore comfort- able tradingin the alreadyestablished New York heatingoil market. The volume of trade for the Gulf Coast heatingoil was around 1.8 million barrelsin 1981 and ceasedin 1982.

In October 1981, NYMEX introduceda contractfor leadedgasoline. The deliverylocation for this contractwas New York Harbor and the unit of trade was 42,000 US gallons. This contracthas recentlybecome very successful. Its volumeof trade has increasedfrom 7 millionbarrels in 1981 to about 3,000million barrels in 1987.

Finally,on March 30, 1983,NYMEX introduceda crudeoil futurescontract. This contractcalls for the deliveryof 1,000 barrelsof sweet crude at CushingStorage, Oklahoma. The par crude is West Texas Intermediatewith 400 API and 0.4% sulphurcontent. However,other types of crude (UK Brent Blend,Nigerian Brass Blend and Bonny Light,Norwegian Ekofisk, Tunisian Zarzaitine,Algerian Saharan Blend, Mid ContinentSweet, New MexicanSweet and South TexasSweet) are all acceptablefor deliveryat certainpremiums or discounts. Cushinghas been chosenas the deliverypoint becauseit is commonfor companiesto tradecrude oil there. Fourteencrude oil pipelines flow in and out of Cushingand an averageof 35 millionbarrels of oil flows throughCushing each month. Crudeoil futuresstarted with an averagedaily volumeof 700,000barrels. Its total volumeof trade during1983 was 323 millionbarrels, and its averagedaily volumereached 5 millionbarrels in 1984. Todaythe tradingvolume is between40 to 60 millionbarrels per day.

67 In additionto NYMEX,the ChicagoBoard of Trade (CBT)introduced petroleum futuresin unleadedgasoline, No. 2 heatingoil and crude oil. Unleaded gasolinefutures commenced trading in December1982. Each contractcalled for the deliveryof 1,000 barrelsof regularunleaded gasoline, standard ColonialPipeline specifications, southern grade with a minimumof 87.0 and a maximumof less than 91.0 octanerating. The deliverylocation was the TexasGulf coast,but the mechanismof deliverywas the so-called"depository receipt"method. This methodrequired that the sellerof the contract obtaina depositoryreceipt from an issuerapproved by the exchange.

The volume of trade of unleadedgasoline on CBT was about 8.7 million barrelsin 1982,which representedan averagedaily volume of about600,000 barrels. In early 1983, the volume increasedto an averageof 800,000 barrelsa day. However,since April 1983, it startedto declineand went dormantby end of the year. The main reasonfor the failureof the contract seemsto be its deliverymethod. Oil tradersprefer a wet barreldelivery to the depositoryreceipt system.

In March 1983, CBT introduceda crude oil contracton the same day that NYMEX opened its crude oil futures. CBT's contractwas also for 1,000 barrelsof Light LouisianaSweet, while other crudes (BonnyLight, Brass River,Ekofisk, Qua Iboi,Saharan Blend and Zarzaitine)would be deliverable at appropriatepremiums or discounts.The deliverylocation was the Capline Systemin St. James,Louisiana, or other seller-designatedport facilities in St. James,St. John the Baptist,St. Charles,Jefferson, Orleans, St. Bernardor PlaqueminesParishes, Louisiana. The deliverymethod was "wet barrels".

CBT's crude oil contract initiallyperformed better than the gasoline contractbut eventuallyfailed. Its totalvolume of trade in 1983 reached 93m barrels,which representedan averagedaily volumeof about 400,000 barrels. However,the volumeof trade declinedover time and practically haltedby end 1984. Trade analystsbelieve that the depository-receipts deliverymethod of unleadedgasoline and No.2 heatingoil had a negative impacton the desirabilityof the CBT's crudeoil contract. Traderswould hesitateto take a simultaneousposition in crude and productfutures when the crude contractcalls for wet barreldelivery and the productfutures stipulatedepository receipts. Further, the designatedpremiums for foreign crude discouragethe trade.

Finally,CBT introduceda No. 2 heatingoil contractin April 1983. This contractwas for the deliveryof 1,000 barrelsof heatingoil in Harris, Galvestonor JeffersonCounties, Texas. The deliverymethod was the depositoryreceipt mechanism. Despite the successof the heatingoil contractsat NYMEX and the InternationalPetroleum Exchange of London,the

68 CBT's heatingoil contractdid not experiencehigh volumesof tradingand died after a few months.

Benefittingfrom NYMEX's experience,a petroleum futures market was establishedin London. This market,called the InternationalPetroleum Exchange(IPE), introduced its first contractin April 1981. The contract is for 100 tonnes (733barrels) of gas oil and is pricedin US dollarsper contract. Deliveryis designatedat specifiedtank installationsin the Amsterdam,Rotterdam and Antwerparea.

The total volumeof IPE's gas oil trade in 1981 reached14.9m tonnes, which is equivalentto 109m barrels: this representsan averagevolume of tradeof 670,000barrels per day. In 1982,the totalvolume of tradesoared to 454m barrels,which indicatesa dailytrade volume of 1.8m barrels. The volumeof trade in 1986 was about 770 millionbarrels.

The rapid growthof IPE'sgas oil futuresduring 1981-82 was not primarily due to the entry of new tradersin the market. Rather,it was the result of an increasein the level of trade activityby those already in the market. A survey,sponsored by IPE,has shown that about 160 companiesuse the IPE'sgas oil contract. However,more than 50% of the total trade is accountedfor by 25 companies.This findingindicates that the marketcan stillexpand in two ways: first,the volumeof tradecan grow significantly if the many small users alreadyin the market intensifytheir trade to a level comparablewith that of the leaders;second, the market can expand considerablyby attractingnew participants.

Encouragedby the successof its gas oil futures,IPE introduceda crude oil contractin November1983. Each contractwas for 1,000 barrelsof BrentBlend, while other crudes (Ninian Blend, Forties Blend, Ekofisk Blend, Bonny Light, Brass River, Zarzaitine,and SaharanBlend) would also be deliveredat appropriatepremiums or discounts.The basisfor deliverywas intotank, pipeline or f.o.b.Rotterdam/Amsterdam or by in-tanktransfer in Rotterdam/Amsterdamfor deliveriesof less than 50 lots. In addition,the contractterms providedan alternativedelivery procedure under which the buyer and sellercould agree (in the month prior to Rotterdam/Amsterdam deliverybecoming due) to alternativedelivery terms.

Crude oil tradingon IPE was not successful. The total volumeof trade during 1983 was about 2.8m barrels. In February1984 the daily volume reached77,000 barrels and then declinedvery sharplyto negligiblelevels in Marchand April. IPE introduceda revisedcrude oil contractin November 1985 but it again failedto attractsufficient number of participants.

69 Statistical Trends

In presentingthe statisticalpatterns of petroleumfutures, two distinct measuresof trade activityare used. The first measure is "volume"of trade: it simplyshows the numberof contractstraded during the period under discussion. The secondmeasure is "open interest": this measure shows the numberof outstandingcontracts, boughtor sold, that have not been offsetby an oppositetransaction or physicaldelivery.

For example,if agentA sells 100 contractsof Novemberheating oil in the morningand buys 100 of the same contractin the afternoon,he has con- tributed200 contractsto the volumeof tradeon that day. However,since his afternoonpurchase of contractsoffsets his morningsale of the same contracts,his transactionsdo not affectthe levelof open interest.Thus, roughlyspeaking, "open interest"shows the levelof trade while "volume" shows the intensityof trade.

As discussedpreviously, NYMEX is now the main exchangefor petroleum futurestrading. The volumeof trade and open interestfor NYMEX'scon- tractsare given in Annex C.

Oil IndustryParticipation

Despite an initialresistance to the developmentof petroleumfutures, petroleumindustry has takenan activerole in futuresand optionstrading. A surveycarried out in 1987indicates the integratedoil companiesaccount for about 21% of tradersat NYMEX. Every oil company,whether large or small,takes risks in order to be productiveand profitable.Each segment of the business from upstreamexploration for crude oil to downstream refining and marketing of refined petroleumproducts involves risk. Integratedoil companiesmust balancethe totalsystem from crude production to product distributionto producethe most profitableproduct slate. Companiesstrive to establishthe best cost/valuerelationship available in each operatingsegment in orderto maximizeprofit margins. This requires significantknow how, managementskills, and operatingflexibility with respect to refinery processes,market economiesand changing product inventoriesand demand. Becauseof limitationson each company'ssupply, refining,and distributionsystem this creates risk and priceexposure which must be managed. It requiresa continualprocess of pricing,buying, selling,trading and schedulingof variouscrude oil and productsto balance systemsupplies.

Energy futurescontracts are used by large integratedoil companiesto provideaccessibility and visibilityof marketprices for the purchaseand sale of physicaloil. Liquidityin the futuresmarkets ensures that

70 specifichedging strategies can be successfullyprocessed. Production can set forwardsales prices. Refiningoperations can be hedgedusing crack spreadsto set profitmargins by fixingdifferentials between crude oil and productprices. In addition,margins on the distributionof petroleum productscan be set.

The adventof optionson underlyingcrude and heatingoil futurescontracts (seeChapter 8) has introducedthe conceptof the "managedhedge" at a known cost, i.e., the premium. Optionsprovide the abilityto hedge crude and heating oil cash and futurespositions against adverseprice movements withoutforegoing all the benefitsof favorableprice movements. Options also allow a companyto fine tune a hedge by allowinga choiceof hedging insuranceat differentlevels, costs and degreesof protection.

An interview2/ with the marketingand tradingexecutives of three oil companies--Phillips,Conoco, and CITGO--providessome insightsinto the manner in which the petroleumindustry uses the futuresmarket.

PhillipsPetroleum Company is activein petroleumexploration and production on a worldwidebasis with petroleumrefining and marketingoperations in the UnitedStates. As operationsmanagers have becomemore familiarwith the hedgingtools availableand the appropriaterisk strategiesto implement, participationin the futuresand optionsmarkets has increased.The company enteredthe market in order to maintaina competitiveedge as oil markets becamederegulated and as volatilitybecame more visible. Phillipsfound the futuresmarkets provided an index for price discoveryand immediate market information.Liquidity in the NYMEX marketsprovided the company with the necessaryflexibility and ease of entry and exit in order to processspecific hedging transactions. The companyhedges crude and heating oil cash and futures positionsagainst adverse price changes without foregoingall the benefitsof favorableprice movements. Optionsprovide insuranceat a limitedknown cost. Its currenthedges include: (i) refinery supplycrude prices; (ii) purchase/salesfor supply;and (iii) inventories in tankage.

Phillipscontinues to formally segregatetrading operations. Formal strategymeetings, however, are held with supply,refining and marketing personnelto discussopen positionsand proposedhedging strategies. At the same time frequentinformal contacts between traders and supply/marketing staffare maintained.In order to maintainthe appropriateoperational and accountingcontrols for its futuresand optionshedging program, the trading departmentreports directly to the vice presidentof supplyand transportation.

2/ The Energyin the News, Third Quarter1988. 71 CITGOPetroleum Corporation, a petroleum refining, marketing and transportation companyis jointlyowned by the SouthlandCorporation and PetroleosDe Venezuela,S.A. each with a 50 percentequity interest. CITGO operatesa 320,000barrel per day high conversionrefinery at Lake Charles,Louisiana. It also operatesa wholesalemarketing operation primarily for gasolineand distillatefuels consistingof 41 equityowned refinedproduct terminals. Gasolinesales are distributedin 42 statesthrough 2,600 of Southland's 7-Elevenconvenience stores and 5,400 jobberoutlets. CITGO also markets jet fuel, distillates,lubricants and other petroleumproducts. CITGO initiallyused futuresas a hedgingmechanism against physicalproduct inventoryin New York Harbor. Today the companyuses futuresto hedge crude,refined products, intermediate feedstocks and blendingcomponents in New York Harbor,U.S. Gulf Coast and Chicago. Additionally,futures are used to supplementcash purchases/sales,minimize basis risk eitheron a locationor product basis and to lock in transportationeconomics when deliveringsystem suppliesof products. CITGO also utilizesoptions. Heatingoil optionsare used to protectphysical heating oil inventoriesby purchasingputs, and/orto enhancecash flow by sellingcovered calls.

Conoco Inc., is a major integratedoil firm and operatesas a subsidiary of Du Pont. Conoco'spetroleum exploration and productionactivities includethe productionof crude oil in the United Statesand Canada and abroad in the North Sea, Middle East, Africa and Indonesia. Petroleum refining,marketing and transportationoperations are also conductedby Conoco,which manufacturesand sells a wide range of petroleumproducts. Theseinclude gasoline, jet fueland dieselfuel for transportationmarkets; distillate;residual fuel oil, asphalt,and petrochemicalfeedstocks. The companysells gasoline and other refinedproducts through retail outlets in 41 states. As a resultof an uncertainpricing environment, more intense competitionamong firms in the industryand decreasingmargins, the company neededa vehicleto manageincreased price risk, and for price discovery. Conocobegan using heatingoil futuresin the early 1980sbut found crude oil optionsa more flexibleinstrument for hedging. Conoco,as an oil producer,purchases put optionsto protectits cash or futuresposition againsta price decline. Conocoalso uses optionsto implementstrategies specificto their own wet barrel system. For example,the companysells in-the-moneyoptions on expectationsof buyingfutures that are delivered into their Oklahomasystem via an Exchangeof Futuresfor Physicals(EFP). At the same time, the companysells options against oil inventoriesto earn premium income. The company also incorporatesoptions into marketing programsby guaranteeingprice ceilingsfor their customers.

72 Table 6.1: PARTICIPANTSIN NYMEX'SENERGY FUTURES IN 1987 (NumberOf Companies)

Crude oil Heavy oil Unleadedgasoline futures futures futures

Integratedoil companies 12 11 12 Refiners 8 4 9 Producers 4 - - Trader-resellers 7 14 12 Traders 17 16 22 End-user - - -

Total numberof participants 48 46 56

73 CHAPTER7 THERULES OF THEGAME

Organizationof a CommodityExchange

To participatein futuretrading, one cannotmerely walk into a futures exchangesand start makingbids and offerson futurescontracts. One must be a memberof the exchangeto be able to engagein such transactions.

A commodityexchange is a voluntaryassociation of peoplewhose business involves,among other things, trading in commodityfutures contracts. Most of theseexchanges have developed out of organizationstrading in spot markets. Thus, each exchangehas its own historyand traditionand each is independentof the others. The primaryaim of a futuresexchanges is to provideand regulatea tradingplace so that its members(and through them, other interestedparties) have the facilityto sell or buy futurescontracts for specificcommodities.

Exchangesare often referredto as nonprofitorganizations. They provide facilitiesthat theirmembers can use to make a profit,but the association itselfis not organizedto make money. The membershipin US exchangesis limitedto individuals:that is, no membershipsare held by companies. Each exchangehas a certainnumber of members,and only these individuals are allowedto trade in futurescontracts. Since the numberof seats is fixed (occasionallythe numbermay be adjustedby the boardof directors), the only way to enter the associationis to buy someoneelse's membership. Seatson some activeexchanges are very valuableand are sometimessold for severalhundred-thousand dollars. The personinterested in buying,however, shouldfirst apply to the membershipcommittee of the exchangeand, if the applicationis approved,may then proceededto purchasethe seat.

Many peoplebuy the membershipof an exchangenot becausethey want to get on the floorand trade,but becausethe commissioncost is lowerfor members even when they are not presentat the market and are representedby an agent. That is, if two individuals,one a memberand one a nonmember,hire a broker,the nonmemberpays a highercommission than the member.

Althoughmemberships are held by individuals,many of them are effectively administeredby companies. Most membersare employeesof companieswhose businessinvolves futures trading.

Once a memberof an exchange,you can enter the exchange'strading floor (the "pit")of the commodityyou want to trade (thereare specialtrading

74 hours for each commodity)and make a bid or offer. The first personwho acceptsthe bid or offerwill get the trade. Observersat each pit overlook the tradingand note the pricesat which tradesare made. These observers recordthe pricesand feed them into their communicationsystems. Prices are then almostinstantaneously displayed on the boardsand are also commu- nicatedto the brokerageoffices and commodityfirms all over the world. When a trade is made, each of the tradersmakes a note on a card of the price, quantity,delivery month, and the personwith whom the trade was made. This recordis submittedto the "clearinghouse"for reconciliation on a daily basis.

The Clearinghouse

Each commodityexchange has its own clearinghouse.The membersof the clearinghouseare not necessarilythe same as the membersof the exchange. Owninga seat on the exchangeentitles a personto trade on the exchange floor. However,any deal he makes has to be registeredwith the clearinghouse througha clearinghousemember. Each clearinghousemember has an accountwith the house. The memberwill then file a reportwith the house of the transactionsthat shouldbe includedin its account. After these transactionsare checkedto see if they agree with the tradingrecorded on the floor,the clearinghousewill becomethe "otherparty" to all buyersand sellers. Thus,a traderin the futuresmarket does not need to be concerned about who took the oppositeside of his trade. Any time he decidesto liquidatehis contract,he can do so withoutseeking the agreementof the other party. The clearinghouseguarantees performance of all contracts under the exchangerules.

To becomea memberof a clearinghouse,you have to satisfyrelatively high standardsof creditworthiness.This providesthe clearinghousewith a strongfinancial basis. Each clearinghousemember is requiredto deposit an initialmargin on its contractpositions with the clearinghouse.In addition,each day the membermust sendthe clearinghousea variation margin on each outstandingnet contracton which there has been a loss for that day. The clearinghousehas at its disposalall the depositedmargins to satisfyits financialobligations. Furthermore, the clearinghousecan draw upon its "guaranteedfund", which is a financialreserve provided by all its members.

The clearinghouseprovides a considerablefacility to buyersand sellersin the futuresmarkets. However,it shouldbe notedthat all of its functions are performedwithin the contextof an intermediaryagent. Thus,the clear- inghousedoes not earn any profitor bear any loss becauseof the futures deals--itsimply redistributes the money from losersto winners.

75 FIGURE 7.1: HOW A CONTRACT IS TRADED

Buyer of a L _ Don't Know Seller of a Contract j each other Contract

His Brokerage His Brokerage Firm _ Firm

Make bids and offers A Member of the A Member of the Exchange Transaction is Exchange registered with the clearing-house _

A Member of the A Member of the clearing-house clearing-house

s f ~~~Transactionis f f = ~~~Registeredwith ' the clearing-house

To the buyer, To the seiler, the clearing-house becomes the clearing-house becomes the seller of the contract the buyer of the contract

76 In short,in orderto trade in a futuresexchange, you have to act through a memberof the exchange. That membercan buy or sell futurescontracts on the exchangefloor. However,he may not be a memberof the clearinghouse. He shouldthen registerhis trade througha "housemember". After this is accomplished,a futurescontract is issuedthat declaresthe housemember as one party and the clearinghouse,as the otherparty. In otherwords, unlikecontracts in the spot market,futures contracts are not bilateral amongtraders; the clearinghouseacts as sellerto everybuyer and buyerto every seller.

Characteristicsof FuturesContracts

As explainedearlier, less than 1% of petroleumfutures contracts ever reach maturityand are actuallydelivered. However,a futurescontract is a valid,enforceable agreement. If the selleror the buyer shouldchoose to make or takedelivery, they may do so. Thus,the termsof the contracthave to be preciseand explicit.

A futurescontract is standardizedwith respectto fourelements (see Figure 7.2):

o the quantityto be delivered(for instance1,000 barrels of oil);

o the qualityor qualitiesto be delivered(for example, light sweet crudewith less than 5% sulphurcontent and an API gravityin the rangeof 34-45);

o the time intervalwithin which delivery is to be made (for instance,the month of October);

o the locationor locationswhere delivery can be made (forexample, CushingStorage, Oklahoma).

77 Figure7.2: CHARACTERISTICSOF FUTURESCONTRACTS

Futurescontracts are standardizedwith respectto:

* the quantityto be delivered * the qualityto be delivered * the time intervalwithin which deliveryis to be made * the locationor locationsof delivery * the methodof delivery

They may included:

* specificpremiums or discountsfor variationsin quality * specificpremiums or discountsfor differentdelivery points

They normallycontain limits on:

* the minimumprice fluctuation * the maximumpermissible price fluctuation

The contractson US exchangesimpose:

-k a limiton the numberof contractsthat each personcan hold.

In additionto the above information,futures contracts contain a consid- erableamount of detaileddescription of the characteristicsof the commodity and the methodof delivery. For example,the crude oil (lightsweet) contracttraded on the NYMEX containsthe followinginformation.

First,with regardto the grade and qualityof crude,the contractstates that the crude'sviscosity should be 325 (or less)seconds Saybolt Univer- sal; its vapor pressureshould be less than 9.5 lbs per square inch at 100°F;its basic sediment,water and other impuritiesshould be less than 1%; and its pour point should not exceed 500F. The acceptablestream designationsare: UK Brent Blend,Nigerian Brass Blend and Bonny Light, NorwegianEkofisk, Tunisian Zarzaitine, Algerian Saharan Blend, Texas Inter- mediate,Mid and South Texas Sweet. The par crude is West Texas Interme- diatewith 400 gravity(API) and 0.4% sulphur. If the gravityis less than that of the par crude,there will be a 2 centsper barreldiscount under the contractprice for each degreegravity below par. (Therewill be no gravity adjustmentif the gravityis abovepar.) If the sulphurcontent is different from that of the par crude,there will be a 5 cents per barrelpremium (discount)over (under)the contractprice for each 0.1% sulphurcontent

78 FIGURE 7.3: HOW THE DELIVERY IS MADE

The clearlng member The clearing member with long position: with short position: sends to the clearing-house sends to the clearing-house informatlon on the names of informatlon on the names of his customers, the number his customers, the number of contracts, and the of contracts, and the preferred site of delivery, location of supply.

Clearing-house: matches the positions and sends to the buyer the notice It has received from the seller.

Buyer: sends to seller the delivery instructions.

|Notice of No e/ r non-clearance to the buyer can meet the Instructions.

Yes

Notice of clearance to the buyer

Commodity is delivered

Payment Is made.

79 less (greater)than par. Finally,delivery of BrassBlend, Bonny Light and SaharanBlend will entaila 25 cents per barrelpremium over par.

Second,with regardto price fluctuations,the contractcontains a set of rules which aim at startingthe trade within a manageablerange of price fluctuationsand stretchingthis rangeas the marketseems to havedeveloped the capacityto absorbwider fluctuations.

These rulesare:

o the maximumpermissible price fluctuationin any day is $1 per barrelabove or below the precedingday's settlingprice (thisis calledthe basic maximumfluctuation);

o if the settlingprice for any month moves by the basic maximum fluctuationin eitherdirection, the maximumpermissible fluctuation in eitherdirection for all monthsduring the next business sessionwill be expandedto 50% above the basic maximumfluctuation;

o if the settlingprice for any month duringa businesssession for which the maximumpermissible fluctuation has been expandeddoes not move by the said expandedmaximum fluctuation, the maximum permissiblefluctuation for the next businesssession will be set back to the basic maximumfluctuation;

o if the settlingprice changes by the expandedpermissible fluctuation, the maximumpermissible fluctuation will be expandedagain to 100% above the basic maximumpermissible fluctuation;

o if the settlingprice does not fluctuateby this twice expanded range,the maximumpermissible fluctuation will be set back to the initiallyexpanded range (only 50% above the basic);and

o there will be no maximumlimit on price fluctuationsduring the month precedingthe deliverymonth.

Thus, rule (a) establishesthe initialrange, while rules (b), (d) and (f) determinehow this range is expanded. Rules (c) and (e) indicatethe con- ditionsunder which the rangeof price fluctuationwill be set back to its previousdomain.

Third,the contractimposes a limitationon holdingsof futurescontracts. This is very importantfrom the viewpointof the economicsof oil futures

80 becausethe limitationis aimedat barringthe developmentof monopolypower in the market. Accordingto the contract,no personshould own or control a net long or net shortposition in lightcrude petroleum in any one month, or in all monthscombined, of more than 5,000 contracts. In addition,in the monthpreceding a deliverymonth, no personshould own or controla net longor net shortposition of more than 750 contractsin lightcrude for the deliverymonth. The contractwill also take a precautionarystep by stating that: the positionsof all accountsowned or controlledby a personor personsacting in concertshall be cumulated. The exceptionto this rule is the case of a so-called"bona-fide" hedger. If a hedgercan show that the hedge is necessaryor advisableas an integralpart of his business (i.e.it is not a speculativeact), his limitwill be raisedto 10,000con- tracts(in any one monthor in all monthscombined), and to 3,000contracts in the month precedingthe deliverymonth.

Fourth,with regardto the deliveryprocedure (see Figure 7.3), the contract providesthat tradingin the currentdelivery month shall cease on the fifth businessday prior to the twenty-fifthcalendar day of the month preceding the deliverymonth. A memberwho has a long positionwill give the clearinghousea "noticeof intentionto acceptdelivery" by 12:00 noon on the first businessday after the final day of trading. This notice should indicatethe numberof contractsto be accepted,the buyer'spreferred out- going pipelineor preferredstorage facility and his preferenceof light "sweet"crude oil by origin,sulphur and API gravity. In the same manner, a memberwho has a shortposition will give the clearinghousea "delivery notice"by 12:00 noon on the first businessday after the final day of trading. This noticeshould indicate the numberof contractsto be delivered, the origin,sulphur and API gravityof the light "sweet"crude oil to be delivered.

The clearinghousewill match the noticescoming from both sidesand deter- mine the correspondingparties. The sellerwill then have untilthe last businessday of the month precedingthe deliverymonth to give the buyer a "schedulingnotice" in whichthe sellerstates the deliverytime. The buyer and sellerare, of course,free to change(by mutual agreement) the delivery terms with respectto the methodof delivery,timing of delivery,type of crudeto be delivered,and designationof buyer'sand/or seller's facility. In any event,after the deliveryis arranged,the buyermust pay the seller by 12:00noon on the twentiethcalendar day followingthe deliverymonth and the sellerwill give the buyer the pipelineticket and all other certifi- cates and documentsrequired for the transferof title.

81 Specifics of Petroleum Contracts

This sectionprovides a summaryof the provisionsof petroleumcontracts tradedin the US and a the InternationalPetroleum Exchange of London.

PETROLEUMCONTRACTS TRADED AT NYMEX:

As discussedin Chapter6, NYMEX has playeda leadingrole in US petroleum futurestrading in recentyears. Its firstsuccessful contract was the New York Harborheating oil contractwhich began tradingin November1978.

The heating-oilcontract-unit is 42,000US gallons(1,000 US barrels). Its deliverylocation is New YorkHarbor where, for the purposeof the contract, New York Harbor extends from the East River west of Hunts Point; the Narrows,the LowerBay west of NortonPoint, the NewarkBay, the Hackensack River and PassaicRiver south of the PulaskiSkyway Bridge, the Kill Van Kul,the ArthurKill and the RaritanRiver east of the GardenState Parkway Bridge.

The qualityspecifications of the heatingoil are:

Gravity API 300 minimum

Flash: 1300 minimum

Viscosity: Kinematic,Centistokes at 1000F, minimum 2.0 maximum3.6

Water and sediment: 0.05 maximum

Pour point: 0°F maximum

Distillation: 10% point, 480°F maximum; 90% point 6400 maximum; End point 670°F maximum

Sulphur: 0.2% maximum

Color: maximum2.5

Deliveryhas to be made f.o.b seller'sNew York Harborfacility with all duties,fees and othercharges paid by the seller. The buyerhas the option of takingthe deliveryinto his barge or truck,into tankeror pipeline,as a stock transferof the title,or as an intra-facilitytransfer and inter- facilitytransfer of the oil if the facilityused by the sellerand buyer allows such transfer. The deliverycan also be taken by truck,in which

82 case the buyer shouldpay a per gallonsurcharge on the amountdetermined by the Exchange.

Followingthe successof the New York Harborheating oil contract,NYMEX introducedin August1981 anotherheating oil contractfor deliveryin the Gulf Coastarea. This contractcontains the same provisionswith regardto contractunit and quality specifications.The major differenceis, of course,the deliverylocation. In this contract,the deliveryis made in the Gulf Coast area which extendsfrom Pasadena,Harris County (Texas)to Collins,Covington County (Mississippi) and includesfacilities located in BrazoriaCounty (Texas) and JacksonCounty (Mississippi) which have access to Colonial Pipelineinjection points in Pasadena (Texas)and Collins (Mississippi).As mentionedbefore this contractis not activeat present.

Gasoline(leaded and unleaded)contracts were introducedon NYMEXin October 1981. The contractunit is 42,000US gallons (1,000US barrels)and the deliverylocation is New YorkHarbor. The unleadedgasoline should meet the followingstandards of quality:

Gravity: API 520 minimum

Color: undyed

Corrosion: 3 hours at 1220,maximum 1

Lead: maximum0.03 grams per gallon

Doctor: negativeor, if necessary,Mercaptan Sulphur: weightper cent, maximum0.002

Octane: RON, minimum91.0; MON, minimum82.0; (RON + MON)/2minimum 87 and maximumless than 91.0

Reid vapor pressure: maximumpounds, January, February--14.5, M!ch, April- 13.5,May, June,July, August, September - 11.5, October,November - 13.5, December- 14.5

83 NorthernGrade Class

December,January, February E March,April, October, November D May, September C June, July, August C

B C D E 10% evaporationOF maximum 149, 140, 131, 122 50% evaporationOF maximum 170, 170, 170, 170 50% evaporationOF maximum 245, 240, 235, 230 90% evaporationOF maximum 374, 365, 365, 365 End point OF maximum 430, 430, 430, 430

The standardsof qualityof leaded regulargasoline are the same as the above,except for:

Color: orangeor bronzein sufficientquantity to meet US SurgeonGeneral's minimum requirements

Lead: maximum4 grams per gallon

Octane: Ron, minimum91.5; MON, Report;(RON + MON)/2 minimum89.0

Pricesof both contractsare quotedin dollarsand cents per gallon. The minimumprice fluctuation is 0.01 centsper gallon. The maximumpermissible price fluctuationin any one day is 2 cents per gallonabove or below the precedingday's settlingprice (calledthe "basicmaximum fluctuation"). The maximumprice fluctuationmay be extendedunder specialcircumstances. If the settlingprice for any month moves by the basic maximumfluctuation in either direction,the maximumpermissible fluctuation for all months duringthe next businesssession will be 50% above the basic maximumfluctuation. The maximumpermissible fluctuation may again be expandedif the price change hits the new limit. However,there is no maximum limit on price fluctuationsduring month precedingthe deliverymonth. This is to ensurethat the futuresprice at the maturitydate convergeswith the spot marketprice.

Tradingof the currentmonth's futures contracts will cease on the last businessday of the month precedingthe deliverymonth. By 12:00 noon on the firstbusiness day of the deliverymonth, both buyers(clearing members havingopen longpositions) and sellers(clearing members having open short positions)must filewith the Exchangethe formsprescribed by the Exchange. The buyerwill provideinformation regarding the namesof his customers,the

84 numberof contracts,and preferredsite of delivery. The sellerwill file a form,called a "deliverynotice", with the Exchangeproviding the number of contracts,the names of his customers,and the name and locationof the facilitythat will supplythe product.

The clearinghouseof the Exchangewill match the size of the positionsand will send the buyer the deliverynotice that it has receivedfrom the seller. The buyer is then obligedto give to the seller(identified in the deliverynotice) the initialdelivery instructions. The sellerwill then give the buyera noticeof clearanceindicating that he is preparedto make deliveryin accordancewith the buyer'sdelivery instructions, he must give the buyer a noticeof "nonclearance"and state the reasonfor such inabil- ity. He may, at his option,in the noticeof nonclearancesuggest an alternativedelivery site and/ora preferreddelivery date or time. A copy of all communicationsbetween the buyer and the sellergoes to the Exchange.

All the deliveriesmust be completedafter the fifthbusiness day and before the last businessday of the deliverymonth. For the purposesof the contract, shipmentis said to commencewhen the productpasses the buyer's cargo intakeflange, tank or pipelineconnection, at which point the buyer assumesthe risk of loss.

Finally,the buyer pays the sellerat the officeof the sellerby certified check by 12:00 noon of the businessday followingreceipt of the product. The amountof the paymentis basedon the volumedelivered as determinedat 600F.

The contractprovides some flexibilityto facilitatethe delivery. The sellerand buyer (matchedby the Exchange)may agreeto make and take delivery under termsand conditionsthat differfrom those containedin the contract. In such a case, the buyerand sellerexecute an "alternativedelivery notice"on the form prescribedby the Exchangeand delivera completed copy of such a noticeto the Exchange.This actionwill releasethe buyer, the seller,and the Exchangefrom their respectiveobligations under the contract.Upon receiptof the notice,the Exchangewill returnto the buyer and sellerall marginmonies held for the accountof each with respectto the contracts,and the Exchangeis indemnifiedagainst any liability,cost of expenseassociated with the execution,delivery, or performanceof the agreementbetween the sellerand the buyer.

PetroleumContracts Traded at the InternationalPetroleum Exchange

The organizationof IPE is somewhat different from the US commodity exchanges. The differenceis due to: the types of membershipof the

85 exchange;and the relationshipbetween the Exchangeand the clearinghouse. Membershipof IPE is in two categories:

o floor membershipwith votingrights; and

o associatemembership with no votingrights.

To becomea "floormember", a tradermust have a Londonoffice and minimum assetsof L 20,000($30,000). The floormember does not pay any commission on the trade and has a rightto vote.

Associatemembers consist of two groups. First,trade memberswho are, principally,established oil tradingcompanies: they pay a membershipfee and participatein futurestrading through a floor member,but pay a lower commissionthan thosewho are not membersof the Exchange.Second, general associatemembers, who are mostly small companiesand speculators:they cannotqualify for trademembership but are permittedto tradethrough the floor members.

The relationshipbetween IPE and its clearinghouseis of interestbecause the clearinghouseis completelyindependent from IPE. The International CommoditiesClearinghouse Limited has been providingfutures markets in Londonwith clearingservices since its formationin 1888. It is now pro- vidingIPE with clearingservices. Its operationis similarto that of US clearinghouses.It servesas a counterpartto each selleror buyer of a futurescontract. It guaranteesall contractson the marketand acts as an intermediaryto arrangedelivery, should the contractreach the maturity date.

The firstcontract introduced on IPE was gas oil futures,which began trading in April 1981. The contractunit is 100 tonnesand the deliveryloca- tions are at specifictank installationsin the ARA (Amsterdam,Rotterdam and Antwerp)area. The contractprice is quotedin US dollarsand centsper tonne,and the paymentshould be made in the same currencyin London. The minimumprice fluctuationis 25 cents per tonne ($25 per contract);the maximumprice variationin each tradingsession is $30 per tonne. If the price variesby $30 per tonne from the previousday's price,trading will cease for half an hour. It will then start with no maximumlimit on the price fluctuation.

The qualityspecifications of the IPE gas oil contractare:

Densityat 15°C: 0.855 kg per litermaximum

Color: 2.0 ASTM maximum

86 Flashpoint: 550C minimum

Total sulphur: 0.3% maximum

Cloudpoint: -20C maximum

Cold filter pluggedpoint: -goxCmaximum.

Tradingof the currentmonth's contract ends on the lastbusiness day of the month precedingdelivery. If a contractreaches the maturitydate, the deliverymust take place betweenthe fourteenthand the last day of the deliverymonth.

Encouragedby the successof the gas oil contract,IPE introduceda crude oil contractin November1983. The contractis dormantnow but is supposed to be re-introduced.The contractcalls for deliveryof a crude withinthe API gravityof 350-450with a maximumsulphur content of 0.4%. The par crudeis BrentBlend with NinianBlend, Forties Blend, Ekofisk Blend, Bonny Light, Brass River, Zarzaitineand SaharanBlend also deliverable,with appropriatepremiums or discountsapplicable. The choiceof BrentBlend as the market crude facilitatestrade becauseit is the largestcrude volume tradedon the Europeanmarket. Furthermore,its similaritieswith West Texas Intermediate(par crude at NYMEX)and LightLouisiana Sweet (parcrude at CBT) should encouragethe simultaneouspurchase and sale of futures (arbitrage)between IPE and the US exchanges.

The qualityspecifications of the IPE crudeoil contractare:

Gravity: API 350 to 450

Sulphur: 0.4% maximum

Pour point: 50°F maximum

Viscosity: Kinematic,Centistokes at 500C, 45 maximum

Metals: 25 parts per million,maximum

Bottomsediment and water: 1% maximum

Reid vapor pressure: 10 lbs per squareinch maximum.

87 The contractunit is 1,000 US barrels(as opposedto the gas oil futures, which were in units of 100 tonnes). Delivery should be made in the Rotterdam/Amsterdamarea, f.o.b.ship, by inter-tanktransfer, by in-tank transferor "freein pipeline"at the buyer'soption. However,when deliveries are less than 50 lots (contracts),the deliverywill be made by in- tank transfer. Furthermore,if the buyer and selleragree on an alternative deliveryprocedure during the month prior to the deliverymonth, any locationor crude may be used at agreeddiscounts or premiums.

The contractprice is quotedin dollarsand centsper barreland the payment is made in US dollarsin London. The minimumprice fluctuationsis 1 cent per barrel.

Introductionof Propaneand NaturalGas Contracts

The instabilityof oil priceshas led to an increasedvolatility in other energyprices, which in turn,has forcedproducers, distributors and consumers of all energyproducts to seek ways of protectingthemselves against unfavorableprice movements. In response,NYMEX has prepareda propane contractwhich commencedtrading on August21, 1987 and a naturalgas contractwhich has been submittedfor CFTC approval.

PROPANECONTRACT:

The propane contractcalls for 42,000 U.S. gallons of propane at Mont Belvieu,Texas. Mont Belvieuis knownas the centerof propanespot trading in the UnitedStates. It is the point of origin for the Texas Eastern TransmissionPipeline serving the Midwestern,Eastern and Southeastern states. The Dixie pipeline,serving the Gulf Coast and Southernstates, also originatesin Mont Belvieu.

One of the importantfeatures of the propanecontract is its deliverymech- anism. Tradingof the contractterminates the last businessday preceding the deliverymonth. No later than an hour beforetrading terminates, all remainingshorts (parties who have soldcontracts which have not been offset and thereforeobligated to make delivery)must certifyto their clearing membersthat they will have at a bona fide deliveryfacility the quantity of propanenecessary for deliveryby the firstdelivery day. All deliveries are f.o.b.any pipeline,storage or fractionationfacility in Mont Belvieu, Texas,with directaccess to Texas EasternProducts Pipeline. On the first businessday afterthe terminationof trading,all customersare given several hours to arrangean Exchangeof Futuresfor Physicals(EFP) if they so desire. Throughan EFP, participantson oppositesides of the marketcan swap cash and futuresand make arrangementsfor subsequentdelivery under circumstancesin which all terms (price,location, grade, timing) are fully

88 negotiable. By 2 P.M. of that day, both the long and short customer (throughtheir clearingmembers) must file with the Exchangea Petroleum ProductNotice. Besidesbasic customerinformation (name of the short ClearingMember's customer, number of contracts,tender number of the matchedtransaction, etc.), the PetroleumProduct Notice enables the short ClearingMember's customer to designatethe deliveryfacility and the long ClearingMember's customer to indicatethe preferreddelivery facilities and preferencefor a deliverymode (i.e.,in storage,book transfer,etc.). While the Exchange'sClearing Department does not guaranteethat the long will be assignedto the deliveryfacility requested, it will make efforts to match partiesaccording to the preferencescontained in the Petroleum ProductNotice. On the second businessday of the deliverymonth the Exchangewill informeach long and shortClearing Member who will be on the other side of the deliveryand which deliveryfacility has been designated. As soon as possible,but not later than the fourthbusiness day of the deliverymonth, the longmust informthe short (and confirmin writing)of the precisedetails of the delivery(name, number of contracts,etc.) and most importantly,the ten day windowin which deliveryis to be made.

All movementof propane (physicalor otherwise)must take place in the designatedwindow, and windowscan only be designatedfrom the tenth calen- dar day untiltwo businessdays beforethe end of the deliverymonth. Prior to informingthe shortof the details,the long must contactthe scheduler at the designatedfacility and ensurethat the facilitycan accommodatethe deliveryrequest. In a pump-overor inter-facilitytransfer, the short providesthe longwith the finaldetails of the delivery,including the date and approximatetime the pump-overwill begin. This must be done at least three days prior to the initiationof the pump-overand the Exchangemust be given a copy of the instructions.

NATURALGAS CONTRACT:

Considerationof a naturalgas futurescontract began in 1983when it became clear that certaincategories of naturalgas would be deregulatedon Janu- ary 1, 1985. On this date, well-headprices for most new gas--drilledon or after February19, 1977--wereremoved from price controlthus affecting an estimated60% of availablenatural gas supplies. The early NYMEX pro- posed contractwas basedon the intrastatemarket in Texas since the state has the greatestgas productionand consumptionin the U.S. The intrastate marketwas selectedbecause, in 1984,interstate transportation service was not widelyavailable. After the FERC issuedthe Order436 programin Octo- ber 1985 and the interstatemarket became more accessible,NYMEX modified its proposal. In the new versionof the contract,Katy, Texas (southwest of Houston)was selectedas the deliverylocation largely due to the prox- imityof interstateand intrastatepipeline interconnections and accessto

89 most Texas supplyand consumptionareas.

In 1986and 1987,the Exchangecontinued to refineits proposedcontract and workedwith pipelinesin the Katy,Texas area to developa mechanismthrough which deliveriescould be carriedout under the futurescontract. These effortsresulted in the creationof the Katy InterchangeService which will providedelivery service for futuresand cash transactionsthrough access to the Katyarea facilities of the followingpipelines: Transcontinental Gas Pipe Line Corp.,Trunkline Gas Co., CoronadoTransmission Co., and Yankee PipelineCo. Interchange servicewill begin when naturalgas enters a designatedpoint withinthe Interchangeand will end when gas is delivered throughthe finaloutgoing Interchange point. YankeePipeline Co. has been selectedby the participantsto serve as the operatorof the Katy Inter- changeand will coordinatethe transferof gas throughthe Interchange.The selleris responsiblefor transportingthe gas to the Interchange;the buyer has responsibilityfor arrangingtransportation from the outgoingpoint of the Interchange. On December9, 1987, the above pipelineparticipants jointlyfiled an applicationwith the FERCto establishthe Katy Interchange Service.

The NYMEX naturalgas futurescontract which is being filedwith the CFTC is expectedto includethe followingspecifications. These contract rules are subjectto amendmentbefore formal approval by the CFTC.

TradingUnit: 10,000MMBtu. Deliverytolerance of 2% above or below contractunit.

DeliveryLocation: Katy, Texas

QualitySpecifications: Interchange Service in effectat the time of delivery.

DeliveryMonths: Such months as shall be determinedby the ExchangeBoard of Directors.

MinimumFluctuations: $.001 per MMBtu ($10per contract).

Price Limits: $.10 per MMBtu ($1,000per contract). No maximumlimit on the nearby(spot) contract.

Terminationof Trading:On the third businessday prior to the twenty fifth calendarday of the month precedingthe deliverymonth.

90 CHAPTER8 PETROLEUMOPTIONS TRADING

Introduction

Althoughpetroleum futures, and in particularcrude oil contracts,provide powerfulinstruments for managingthe risk associatedwith price fluctuations,there are at leasttwo areas in which furtherflexibility is desired. First,futures contracts extend over a fairlyshort period of time;trading is normallyactive only for contractsof up to six monthmaturity. Second, hedgingwith a futurescontract involves committing to a fixedprice regardless of forthcomingevents in the market. Optionstrading provides a bit of more flexibility,in particularin the secondarea. Optionscan be used independentlyor in conjunctionwith futurescontracts providing a wide rangeof possibilitiesfor managingrisk in petroleumtrading.

Optiontrading, in a generalsense, dates back to the 17th Century,when the Dutch used optionsin the notorioustulip bulb craze. Tulipmerchants boughtpromises of deliveryfrom the growersto protectthemselves against fluctuatingprices. This would obligatethe farmerto sell the tulipsat a predeterminedprice but would not obligatethe merchantto buy the tulips. For the merchant,the arrangementprovided a rightto buy for which he would pay a premium. If the price of tulipsdeclined, the optionwould be worth- less,but the tulipscould then be purchasedin the marketplaceat a lower price.

The modern day option tradinghas also existedfor decades in over-the- countermarket for many stocksin the UnitedStates. However,before 1973, optionshad not been standardized.The exerciseprice was usuallyset at the currentmarket price and the optionperiod was typicallythree, six, or ninemonths. So at any timeand on any stock,the previouslytraded options made up numerousexpiration dates and a wide rangeof exerciseprices. This meantthat, for all practicalpurposes, the originalmarket makers were the onlypotential buyers in a rathermakeshift secondary options market. There was not much opportunityfor resellingthe options. In April 1973,all this changedwhen the ChicagoBoard Options Exchange (CBOE) came into existence with its new "standardized"options and was soon followedby the American, Pacificand Philadelphiastock exchanges.

Over time, optiontrading expanded to cover a wide varietyof stocksand also of futurescontracts. In the case of petroleum,the need for option tradingemerged with an increasingvolatility of the spot price. This triggeredinitially some companies,including Morgan Stanley, Philbro and

91 StandardOil to offer their own tailor-madeoptions during 1985-86. The formaltrading of petroleumoptions started on November14, 1986when NYMEX introducedits optionon crude oil futures. This actionwas then followed by the openingof an optionon heatingoil futuresin June 1987.

Mechanicsof OptionTrading

The first step towardsunderstanding the workingof optiontrading is to becomefamiliar with the jargons--calls,puts, premiums, strike price, etc. In any optiontrading, one side reservesthe right (withno obligation)to transactthe businesswhile the other sideaccepts the obligationto trans- act the businessif asked to. The personwho reservesthe right is the buyer of the option;the personwho acceptsthe obligationis the writer of the option. The buyerof the optionshould, of course,pay a premiumfor reservingthe right for doing the businesswhile the writerof the option receivesthat premium in return for committinghimself to the business transaction.The business,itself, can be a purchaseor a sale of a commodity, a stock or a futurescontract. Thus the buyer of an optioncan be buyingthe right to purchaseor the right to sell. What he is buyingis the "right"to transactthe deal. When he reservesa rightto purchase,he is said to buy a "calloption". On the other hand, when he reservesthe rightto sell he is said to buy a "putoption". For each of theseoptions, there shouldbe an "optionwriter", i.e., the personwho acceptsthe obligation (to sell or to purchase)in exchangefor a premium. To avoid the normalconfusions, one shouldnote thatcall optionsand put optionsare not complementary;your buyingof a call optiondoes not necessitatetransacting a put optionon behalfof the other side of the deal. When you buy a call option,the otherside "writes"the calloption. That is, you buy the right to purchaseand he sells this right. You are in fact payinga premiumto acquirea specialprivilege: if pricegoes up you benefitby exercisingyour optionand buyingthe contractat a prior fixedprice; if price drops,you will not lose becauseyou do not have to buy--youjust let the option expire. So for you, the only cost is the premiumyou have paid;whatever the marketdoes, you eithergain somethingor lose nothing. The writerof the call optionreceives the premiumto put himselfin an especiallydis- advantagedposition: if the price goes up, he will lose becausehe has to sell the underlyingstock or futuresto you at a prior fixedprice; if the pricedrops, he will not gain becauseyou will not be buyingthe stockany longer. So, for him, the only gain is the premiumhe has received;whatever the marketdoes, he eitherloses somethingor wins nothing. If the option writer actuallyowns the underlyingstock or futures, it is called a "covered"write. Otherwise,it is calleda naked write to emphasizethe addedexposure of being calledto deliverthe stock or futures. The naked optionwriter is similarto the shortseller in the futuresmarket in the sense that they both are sellingsomething that they do not own.

92 Speakingof similaritiesbetween futures and options,it is also usefulto note the contrastsbetween the two methods. If you engagein the futures marketsyour transactionfalls into one of the two categories:(1) you are purchasinga commodityfor futuredelivery; or (2) you are sellinga commodityfor futuredelivery. However,if you engagein optiontrading your transactioncould be in one of the four categories:(1) you are buyinga rightto purchasethe commodity(buyer of a call option);(2) you are selling the obligationto sell the commodity(the writer of a call option); (3) you are buyingthe right to sell a commodity(buyer of a put option); or (4) you are sellingthe obligationto buy a commodity(seller of a put option). But it is importantto note that for each transactionyou have only two partiesinvolved. Each transactionis eithera trade between(1) and (2) or a trade between(3) and (4). In other words,a call optionis a totallyindependent transaction than a put optionand neitherof the two needs to be done in conjunctionwith the other. Indeed,most optiontrans- actionsare call optionsand there are normallya smallernumber of put optionstraded on stock or futuresexchanges of the UnitedStates.

The next step in comparingoptions trading with futurescontracts is to contrasttheir loss and profitmechanisms. We recallthat the commitments involvedin a futurescontract are symmetricalfor the buyer and the seller who have to meet their commitmentseven when it is not profitablefor them to do so. In contrast,an optionbuyer will only exercisehis rightwhen it is profitablefor him to do so and, then,the optionwriter has no choice but to meet his obligation. Thus, the premiumpaid by the buyer of an option contractis to compensatefor the asymmetrybetween the buyer's rightsand the seller'sobligations.

For example,a traderpurchases a calloption for the Augustcrude at $16.00 per barrel. He will pay, let us say, $0.50/barrelas premiumto reservethe right to buy this contract. If the price of the contractrises to $18 per barrel,he would exercisethe optionand make $2.00per barrelgross profit on the contract. From thisgross profit,we shoulddeduct $0.50 per barrel to arriveat the net profitof $1.50per barrelfor this trader. The writer (seller)of the optionwould lose $2.00per barrelon the contractbut has received$0.50 as premium,so his net loss will be $1.50 per barrel.

Now let us assumethat after the purchaseof the call option,the August crude contractfalls to $14.00per barrel. Obviously,the purchaserof the call optionwill not exercisehis optionand let it expire,because he can buy crude on the spot marketat a lowerprice than $16.00which is the strikeprice of his option. Thus,his loss is limitedto $0.50 per barrel (thepremium he had paid) while the price has actuallydeclined by $2.00. The writer(seller) of the optionwill gain only $0.50per barrel--thepre-

93 mium he receivedwhen sellingthe option. In summary,the purchaserof this call optionwill exercisehis optiononly if the Augustcrude trades above $16 per barrel. In case it does, his net profitwill be the gross profitminus the premiumof $0.50. Thus, he will be making a net profit only if price exceeds $16.50. The sellerof the option would have to deliverhis obligationonly when the buyerwants him to, i.e.when the price is above $16.00 and the selleris bound to lose becauseof the delivery. Thus,at a priceabove $16.00,the buyerprofits and the sellerloses; there is no limit to this gain and loss. At a pricebelow $16.00,the buyerdoes not losemore than the premiumhe has paid and the sellerwill not gain more than that premium.

The main differencebetween the reward systemsof future contractsand optiontrading is in the structureof price risk for sellersand buyersof contracts.In the case of a futurescontract, both the buyer and the seller can have unlimitedgain or loss dependingon pricevariations. In the case of options,the buyer has the possibilityof unlimitedgain but his losscan not exceedthe paid premium. The sellerfaces the possibilityof unlimited loss but his gain can not exceedthe premium. It may sound that the buyer of an optionis in a betterposition and we may wonderwhy some peoplewould want to be option sellers. This is clearlynot true. What more or less equalizes,at least in a probablisticsense, the positionsof buyersand sellersis the size of the premium.

What FactorsDetermine the Size of the Premium?

In general,the premiumthat a purchaserof, let us say a call option,is willingto pay dependson his judgmentabout the possibilityand the extent that the price of the underlyingstock or commoditymoves above the strike price of the option. More specifically,the premiumdepends on:

o the differencebetween the strike price of the option and the currentprice of the stock or commodity;

o the expectedvolatility of the price of the stock or commodity;

o the time of expirationof the option;and

o the levelof risk-freeinterest rates.

The first factor,the differencebetween the currentprice of a futures contractand the strikeprice of the optionon that contract,represents the minimumpremium for an option. It indicatesthe relativeposition of your bet. For example,if you are buyinga call optionwith a strikeprice of $14 per barrelfor an Augustcrude oil futurescontract while the current

94 price of the Augustcrude contractis $16.00,your bet is very favorably positioned. You are reservingthe right to buy the August contractat $14.00at any instantfrom now till the expirationdate of the option. The differencebetween $16.00 and $14.00is referredto as the "intrinsicvalue" and representsthe minimumpremium for the optionbecause you can receive this minimumvalue immediately.That is, you can decideto exerciseyour optionimmediately which means you buy an Augustcrude oil futurescontract at the priceof $14.00per barrelwhile the currentprice of the same contract is $16.00. If you decide not to exercisethe option now, it is becauseyou expectthat priceswill furthergo up and your optionwill be worth more than $2 per barrel some time in the future but before the expirationdate of the optioncontract.

The secondfactor, price volatility,is the main incentivefor optiontrading; with no price volatility,option trading would cease to exist. The greaterthe volatility,the greaterthe probableprice range in the future. With a wider price range,the optionbuyer is more likelyto profitand the optionwriter is more likelyto lose. Therefore,there is a directrela- tionshipbetween the optionpremium and the volatilityof the price of the underlyingcommodity. We recallfrom our discussionof futurescontract that price volatilitywas essentialalso for futurestrading. There is, however,a fundamentaldifference between the impactof price volatilityon futurestrading and on the optiontrading. In the case of futurescontracts price, fluctuationrepresents a risk for both sides of the trade. In a marketwith wide range of price fluctuation,both the buyer and the seller of a futurescontract take a riskby committingto deliveryof the commodity at a fixed price because,by the time of delivery,the marketprice may be substantiallyhigher or lower than the fixed price agreedunder a futures contract. In the case of an optioncontract, price volatilityrepresents only a benefitto the purchaserand only a risk to the seller. If the market price fluctuatesextensively and frequently,it is likelyto hit a levelfavorable to the purchaserof the optionat which he would immediately exercisethe optionand make a profit. With such fluctuations,the price is also likelyto hit a level unfavorableto the buyer but he would not exercisethe option. In short,price volatility plays a more importantrole in optiontrading than in futurestrading because the rewardsystem of the former is not symmetric. Becauseof the same reason,price volatility directlyimpacts the size of optionpremiums.

The third factoraffecting the size of an optionpremium, i.e., the time- to-expiration,also increasesthe probabilitythat the marketprice would hit a level favorableto the buyerof the option. For example,we compare two calloptions--both on the samecommodity, let us say,crude oil futures, and both with the same strikeprice, let us say, $18.00per barrel. The only differenceis that the firstoption will expirein one month time and

95 the secondoption in two months. In the case of the firstoption, the buyer will profitif price exceeds$18.00 at any instanceduring the next 30 days while in the case of the secondoption, the buyerhas the same opportunity, but lastingfor two months. Clearly,the secondoption offers a better profit potentialand is worth more than the first option. Thus, other things being equal,the longerthe periodto the date of an optionexpi- ration,the largeris the size of its premium. Becauseof the same reason, the market value of an option contract(i.e. the premium)declines very rapidlyas the optionapproaches its maturity. If the optionis not exer- cisedby the date of maturity,its value becomeszero.

The fourthfactor, i.e., risk-freeinterest rate, is less importantthan other factorsin determiningoption premiums. The idea here is that when peoplebuy options,they are indeedputting their capitalin this use and thus givingup other investments.Risk-free interest rate is then used as an indicationof the return on the alternativeinvestment (opportunity cost). When interestrates change,people would alter their demand for optioncontracts and therebythe optionpremium is affected.

The above four factorsaffect the size of optionpremiums in a ratherclear manner. A mathematicalmodel introducedby Blackand Scholesquantifies the relationshipbetween the size of the premiumand the strike price, the marketprice, the time to maturity,the interestrate and price volatility (measuredby the varianceof percentagechange in price). The actualoption premium is, of course,determined through the interactionsof bids and offerson the pertinentexchange, but the Blackand Scholesformula provides an estimateof a "fairpremium". This may be viewedas equilibriumpremium whichwould equalizethe returnprospects, as estimatedat the time of the trade, for both sides of an optioncontract. The Black-Scholesmodel is used for stockoption pricing. A variationof thismodel, called the Black Model, along with severalmodified versions of it, are used in pricing optionson futures.

The main difficultyin estimatingan optionpremium is assessmentof market volatility.Simply defined, volatility represents the degreeto which the underlyingfutures contract is likelyto fluctuate--ineither direction. It is measuredby takingthe standarddeviation of daily pricerelatives-- today'sprice relativeto yesterday'sprice. However,there are two ways *to calculatevolatility: on a historicalbasis or on an impliedbasis.

Historicalvolatility is thatwhich is actuallyobserved in the marketplace, most commonlyover a 10, 20, or 30-dayperiod. This is a deductivemeans of calculatingmarket volatility. Impliedvolatility is an inductive method. It backs out the volatilityof the underlyingfutures contract from the markettraded option premium. Impliedvolatility is a barometer

96 of expectationsfor the futurerather than a measureof what has happened in the past. Estimationsof futurevolatility can changeerratically over short periodsof time. Prior to the December1987 OPEC meeting,for example, the impliedvolatility in crudeoil jumpedfrom a low of 15% to a high of 46% over only a coupleof months. In general,implied volatility in the oil markethas peakedwith new price lows, indicatinga clear bearishbias in the market.

Impliedvolatility is helpfulin evaluatingwhether a particularoption is fairlypriced, overpriced, or underpricedin relationto other optionsor to other hedgingalternatives. For example,if call optionsare pricinga significantincrease in marketvolatility, their premiumsmay fall while underlyingprices remainunchanged, should volatility estimates suddenly drop. This can be seen by examiningthe premiumsfor each of three levels of impliedvolatility in Table 8.1. The potentialsensitivity of option premiumsto changingestimates of marketvolatility is clear.

Pricingmodels such as Black assume that optionswill not be exercised prior to expiration.Of course,few optiontraders actually do so, owing to timing mismatches,time decay, and short-termprofit opportunities. Thus, a commonderivation of the BlackModel measuressomething called the delta.

97 Table 8.1: IMPLIEDVOLATILITY AND PREMIUMFOR HEATINGOIL OPTIONS

$.43 $.44 $.45 Implied Option Option Option Strike volatility premium Delta premium Delta premium Delta

25 .0179 64 .0248 75 .0327 84 .42 30 .0202 62 .0269 72 .0344 80 35 .0226 61 .0291 69 .0363 77

25 .0082 39 .0127 51 .0184 63 .44 30 .0106 41 .0152 52 .0209 62 35 .0131 43 .0178 52 .0234 61

25 .0031 19 .0054 28 .0088 40 .46 30 .0049 23 .0076 32 .0113 42 35 .0069 27 .0099 35 .0138 43

Source: Kay (1988).

Deltameasures the sensitivityof optionpremiums to changesin underlying futuresprices. Delta also representsthe probabilitythat a givenoption will have valueat expiration,given current market prices and expectations about volatility.As such,delta is dynamic--itchanges with any changein marketprices or expectations.

Deltavalues range from 0 for deep-out-of-the-moneyoptions to 1.0 for deep- in-the-moneybullish positions and--1.0 for deep-out-of-the-moneybearish positions.At-the-money options ordinarily have a deltaof aboutplus (long calls)or minus (longputs) .5. To illustrate:a call optionwith a delta of .5 shouldmove up $.05 for a $.10 upwardmove in the underlyingfutures contract. Deep-in-the-moneyoptions behave a lot like futurescontracts, since they are almostcertain to have value at expiration.Options which are deep-out-of-the-moneyshow littleor no responseto movementsin the underlyingfutures contract, since there is very littlechance that they will have valueat expiration,regardless of what futuresprices do. Table 8.2 assumesan impliedvolatility of 25% and 31 days untiloption expiration. For a longoption, call deltasare positiveand put deltasare negative. As a call optionmoves furtherinto-the-money, its delta increases until it eventuallyapproaches 1.0. Meanwhile,a long put option'sdelta

98 gets more negativeas the optionmoves furtherinto-the-money, until it eventuallyapproaches--1.0.

Deltasfor shortoption positions work in reverse.A shortcall's delta gets increasinglynegative as the optionmoves furtherinto-the-money. And a short put's delta gets higheras the put moves furtherinto-the-money.

Table8.2: VALUE OF DELTA FOR LONG HEATINGOIL OPTIONS

FuturesPrice $.43 $.44 $.45 Buy $.44 Call +.41 +.52 +.62 Buy $.44 Put -.61 -.49 -.37

Source: Kay (1988).

We can combinetwo conceptsto show the effectof changesin impliedvola- tilityon optionsdeltas. While an increasein volatilityhas only a minor effecton at-the-moneyoption deltas, it significantlyincreases out-of- the-moneydeltas and significantlydecreases in-the-money deltas. Higher volatilityincreases the changethat out-of-the-moneyoptions will expire in-the-money,and vice-versa.

Aside from its value for short-termtrading, delta is a usefulconcept for the optionhedger as well. By addingup optiondeltas, it is possibleto constructan equivalentnet futuresposition. The net delta measuresthe degree of hedge coverageafforded by a particularcombination of option positionsat any givenmoment. By addingor subtractingadditional options to the originalposition and calculatingtheir effect in terms of net futuresequivalent, a hedgercan continuouslyadjust risk/reward profiles in line with changingmanagement objectives. In Table8.3, a totalof seven options have been combinedto form the equivalentof one short futures position. These optionpositions would providethe same degreeof price protectionas would sellingone futurescontract. In most cases, this degreeof priceprotection could better be gainedby goinginto the futures market. However,options provide more flexibilitywhen dynamichedging, ratherthan completeprice protection,is the objective.

99 Table 8.3: EQUIVALENTNET FUTURESPOSITION OR NET DELTA Example: OctoberHeating Oil Futures@ $.44

OptionPosition Delta Net Delta

Long 2 $.44 calls +.52 +1.04 Long 3 $.44 Puts -.49 -1.47 Long 2 $.46 Calls -.28 -.56

Total Net Delta -.99

Source: Kay (1988).

Participantsin PetroleumOption Trading

A marketsurvey carried out in 1987 indicatesthat participantsin the crude oil options include:eight integratedoil companies,four refiners,six trader-resellersand 25 traders.

Like those of the futuresmarkets, participants in option trading are hedgersand speculators,though the distinctionbetween the two is not alwayseasy. A hedgermay use optiontrading to limit his lossesin case price moves unfavorably. For example,a refinerwho would need to buy 100,000barrels of crude in two monthsmay buy a call optionat a desirable strikeprice. If the spot price moves above the strikeprice he would exercisehis optionand purchasethe crude throughhis optioncontract at the strikeprice. If the spot pricedrops belowthe strikeprice, he will buy his crude in the spot market,letting his optionexpire; he would,of course,lose the premiumpaid for the option.

Similarly,a traderwith long cash heatingoil position(a traderwho owns heatingoil) can fix a minimumsale priceby buyingput options. If prices decline,the traderis hedgedbecause he had alreadycontracted the right to sell. If pricesrally, the most the hedgewill cost is the premiumpaid. Appreciationin the value of his inventorywill offsetsome or all of the fixed cost of the hedge beyondwhich the tradercan enjoy the benefitof higherselling prices in the spot market. Thus, the buy put strategypro- vides the trader downsideprotection without jeopardizing the trader's potentialfor profitwhen pricesrally.

100 The hedgingfunction is similarto the one carriedout througha futures contractwith one major difference.In the case of futuresmarket, if the hedgeworks well (spotfutures prices move together),the hedgerwill protect himselfagainst the risk of unfavorableprice movements while he would also give up the potentialprofit from favorableprice movements. In the case of options,the hedgerwill protecthimself against unfavorable price variationsbut still may benefitfrom unexpectedlyfavorable price movements. That is, he transfersthe risk to the buyingagent but still keeps some of the profitpotential for himself. This is a more desirablehedging arrangementthan is providedby the futuresmarket. The hedger,of course, pays a price--theoption premium--for this more desirablehedging arrangement.

Hedgingthrough options is also more flexiblethan hedgingthrough the futuresmarket. For example,our aforementionedrefiner may want to take a hedgingpolicy of limitinglosses only if pricemovement is very unfavorable--letus say a surge beyond $20.00per barreldue to some political event. He will then buy a call optionwith a strikeprice of $20.00which would carry a small premium. The point is, with optionsthe hedger can choose the range of price he wants to avoid and select the appropriate option,combination of futuresand optionsor combinationof variousoptions to achievethis goal. With options,a hedgercan buy price insuranceat a fixed cost (premium)to protectagainst adverse price movementswithout foregoingthe potentialto profitfrom favorableprice movements. Further, he can choosethe extentor coverageof the insuranceand take the appro- priatepolicy.

For speculators,option tradingmay providean ideal tool. A speculator anticipatingan increasein the price of oil would buy a call option. If the price does actuallygo up, he will profitas much as he would with a futurescontract, minus the optionpremium. If the price drops,his loss will be limitedto the premiumpaid for the option. A put optionwould serve a similarfunction for a speculatorwho anticipatesa fall in the price. Quite often speculatorslimit their potentialloss to even less than the optionpremium by combiningoptions and futuresor combiningvari- ous options. As one moves towardsmore sophisticatedmethods and strategies,the managementof the positionsbecomes more complicated,premiums and transactioncosts go up and it would be harderto say who hedges and who speculates.What comeswith this sophisticationis flexibilityand a wide range of methodsto managerisk portfolios.

101 Hedgingwith PetroleumOptions 1/

In most hedgingstrategies, the hedge is designedto protectprofits or asset values,or establishcosts or revenuesat favorableprice levels. The subsequentmarket action affects cash flow,not finalcost. In a "fully hedged"approach, the objectivesare set, the hedge ratio calculated,and the positionimplemented. Only when the cashtransaction is executedis the offsettinghedge lifted. The use of futurespermits the attainmentof objectivesnot alwaysavailable in the physicalmarket, and the introduction of option strategiesbroadens considerably the range of goals achievable withineither the physicalsor futuresmarkets.

To designoptions-related strategy, three major issuesmust be considered and resolved:

o What is the objectiveof the risk manager(hedger)?

o What is the hedger'sopinion or forecastfor the relatedmarket duringthe hedgingperiod?

O What has been the volatilityof the underlyingfutures market, and what is it expectedto be duringthe hedgingterm?

Based on these considerations,the hedgingobjectives will be set. On the producers'side, these objectivesmay include:

- lockingin favorableprices for forwardperiods;

- protectingthe valueof existinginventories or futureproduction at currentvalues;

- settinga minimumprice for future sales,yet participatingif pricesrise; and

- enhancingrevenue by collectinga premiumfor acceptingthe obligationto sell productabove the currentmarket.

The first two objectivescan be achievedusing physicalsor futures,but the lasttwo requireoptions techniques. On the consumers'side, the objectives of hedgingmay include:

1/ Basedon examplesworked out by Leifferand Harwitt(1988), Colburn (1988)and Kaplanand Beutel(1988).

102 lockingin favorablecosts for forwardperiods;

protectingthe valueof raw materialspurchased, goods-in-process, or finishedgoods at currentvalues;

settinga maximumprice for forwardpurchases,while benefiting if pricesfall; and

developingthe potentialto buy belowcurrent market and collecting a premiumto do so.

Again, the last two objectivesincorporate option strategies rather than futuresalone.

Althoughthe use of futuresstrategies may not demanda market forecast, the choiceof an appropriateoptions strategy requires some appraisalof likelymarket ranges over the hedge period.

- a stronglybullish forecast would suggestbuying futures, buying calls,or writing(selling) puts;

- a stronglybearish forecast would suggestselling futures, buying puts, or writing(selling) calls;

- a moderatelybullish strategy would suggestbuying calls;

- an expectationof a narrowtrading range with decliningvolatility might suggestwriting both puts and calls;and

- a directionlessforecast with rising volatilitymight suggest buyingputs and calls.

With the availablefutures and optionsinstruments, one can designa wide range of hedgingstrategies. The followingcases are a few examplesof certainstrategies that can be pursuedon the production/distributionside, as well as, on the consumptionside.

As an exampleof the use of optionson the supplyside, let us assumethat, on October1, a heatingoil distributorhas finalizedcontract with a muni- cipalityto deliverheating oil at a guaranteedmaximum price of $0.48per gallon. The deliverieswill occur in January. If prices rise between Octoberand January,the distributor,if unhedged,would be forcedto absorb the highercosts. The distributor,however, may be reluctantto simplybuy calls to protectagainst a risingmarket. A buyerof a call optionhas the rightbut not the obligationto buy futuresat a specificprice during the

103 life of the option. Althoughthe risk of a long call positionis limited to its purchaseprice, this cost may seem excessiveto the distributor shouldprices drop.

One strategyto reducethis initialcost is a three-partoptions spread- designedto accommodatethe distributor'sforecast range of heatingoil- pricesthrough the early winter. The approachis to combinebuying and sellingof Februaryoptions at threedifferent strike prices such that the net cost of the optionspread is near zero. Specifically:

o Sell a put at a strikeprice near the bottom of the expected tradingrange.

o Buy a call at a strikeprice near currentfutures price levels.

O Sell a call at a strikeprice near the top of the expectedtrading range.

Note that the seller of a put expectsthe market not to fall below the strikeprice of the put option;the sellerof a call expectsthe market not to trade abovethe strikeprice of the call option. If theseforecasts provevalid, the sellerof theseoptions simply earns the premiumoriginally collected.

Assumptionsunderlying this exampleare:

o On October1st, Februaryheating oil futures= $.47/gallon.

O Distributor'smarketview: heating oil prices could fluctuate between$.42-$.50/gallon through early January.

O Heatingoil cash and futureprices move in tandem.

The strategyis:

o Buy February$.48 call at $.0200/gal.

o Sell February$.50 call at $.0135/gal.

O Sell February$.42 put at $.0065/gal.

Net Cost = zero

All optionsexpire January 13; optionprices assume a volatilityof 25% on October1.

104 The profit/lossresults of the hedge are:

Table 8.4: PROFIT/LOSSOUTCOME OF A HEATINGOIL HEDGE PROGRAM (per gallon)

Physi- Gain or Gain or Gain or Gain or No. 2 cal loss loss loss loss Total oil cash sales (physi- (short (long (short profit prices price cal) 42 put) 48 call) 50 call) (loss)

$.40 $.48* $ .08 $(.02) $ $ $ .06 .42 .48* .06 .06 .44 .48* .04 .04 .46 .48* .02 .48 .48 0 .50 .48 (.02) .02 0 .52 .48 (.04) .04 (.02) (.02)

Source: Kaplanand Beutel (1988).

Note that with this hedgestrategy, the distributorhas significantflexi- bility. If cash pricesfall, he has the abilityto offer low pricesto his customersdown to $.42 per gallonwithout losing money on his hedge. Below $.42, the short $.42put behaveslike a long futuresposition, losing value tick for tick as heatingoil pricesfall. In this situation,the distributor will need to offsetthe loss on his hedge by maintaininghis sales pricesin the physicalmarket.

If pricesrally, the distributorwill earn a profiton his long $.48 call positionup to $.50 per gallon. Shouldprices continue to rallyabove $.50 per gallon,the distributor'sprofit on his hedge is fixed since the gain from the long $.48 call will be offset by the loss from the $.50 call. However,if the distributorbelieves that $.50 per gallonwill be the maximumprice during the winter,he is likelyto realizefull profit participation from the call spread.

As an exampleof hedgingon the demandside, let us assumethat an end user needs to hedgeagainst possible increases in the priceof heatingoil by the time he would need to purchaseand consumethe oil. He can buy heatingoil futurescontracts at $0.45 per gallon. If he uses the futuresmarket for

105 hedging,a net price of $0.45will be receivedregardless of how dramatic- ally priceschange. However,with options,he would have a differentrisk- rewardprofile. Buy call strategiesprovide protection against an upward move in pricesbut allowparticipation in a downwardprice move. For example, the end user buys a December$.46 call optionfor $.0240per gallon. It has establisheda maximumpurchase price at $.4840per gallon,because the long call conveysthe rightto buy futuresat $.46 with a cost of $.0240 ($.4600+ .0240= $.4840). If prices rally above $.46, the companycan exercisethe call option. The flexibilityof the long call strategyis illustratedwhen pricesdecline. If pricesdrop to $.42per gallon,the end user has a net purchaseprice of $.4440after accounting for the costof the hedge,$.0240. Becausethe cost of the hedge is fixedat $.0240 (thepremium),the oil companyis able to participatein market-declines.Compared with the futures hedge, the buy call strategyis superiorwhen prices decline. At $.50, the futures hedge achievesa net purchaseprice of $.4541,while the $.46 call achievesa priceof $.4840. The futureshedge is superiorif pricesrally or if pricesremain unchanged. If pricesremain unchangedat $.4541,the futureshedger pays $.4541for oil; the option traderreceives $.4541 plus-the premium paid,$.0240, or $.4781.

Tradingdifferent strike prices also alter the risk rewardprofile of the hedger. For example,the $.46 call establishesa $.4840 ceiling,lower than the $.4975ceiling established by the $.48 call, and lower than the $.5125maximum purchase price establishedby the $.50 call. However,the best protectionagainst an upsidemove coststhe most. The premiumfor the $.46 is $.0240,while the $.48 and $.50 callscost $.0175and $.012,respectively. The cost of the optiondetermines how much the hedgerparticipates in a down ward move in prices. With prices at $.38 at expiration,the hedgerwho has purchasedthe $.46 call pays a price of $.4040,higher than the $.3975and the $.3925for the hedgerwho purchasedthe $.48 or $.50 call, respectively.

106 Table8.5: HEDGINGRESULTS USING FUTURES AND OPTIONS

Net PurchasePrice ($/gal) Fence Futuresat Futures Buy calls Sell puts B$46C expiration hedge $.46 $.48 $.50 $.44 $.42 $.40 S$44P

$.52 $.4541 .4840 $.4975 .5125 .5010 $.5085 .5130 .4650 .50 .4541 .4840 .4975 .5125 .4810 .4885 .4930 .4650 .48 .4541 .4840 .4975 .4925 .4610 .4685 .4730 .4650 .46 .4541 .4840 .4775 .4725 .4410 .4485 .4530 .4650 .44 .4541 .4640 .4575 .4525 .4210 .4285 .4330 .4450 .42 .4541 .4440 .4375 .4325 .4210 .4085 .4130 .4450 .40 .4541 .4240 .4175 .4125 .4210 .4085 .3930 .4450 .38 .4541 .4040 .3975 .3925 .4210 .4085 .3930 .4450

Net debit (.0240)(.0175) (.0125) (.0050) Net credit .0190 .0115 .0070

Source: Colburn(1988).

If an end user has the flexibilityto withstandsome increasein oil prices, a sell put strategymay be appropriate.By sellingputs the oil company takes advantageof high premiumsand expectssideways trading markets. The premium receivedfrom selling the puts acts as a hedge against rising prices. However,protection is limitedto the premiumreceived. If prices decline,the companyparticipates until prices reach the put'sstrike price. Losseson the shortput then begin to offsetgains on the cash position.

Net sales prices for three short put strategiesare illustratedin the tableof hedgingresults. By selling$.42 puts, the companybuys heating oil for $.0115below the marketprice if pricesremain above $.42. Other- wise if prices move lower, the hedgerpays $.4085,or the strike price minus the premium. Selling$.42 puts againsta shortcash positionbrings in less cash than the short$.40 put strategy. This impliesthat the $.40 put is not as effectiveas a hedgeagainst higher prices as is the $.42 put. The tradeoffis that the short$.40 call allowsfor more participationif pricesmove lower.The leastprice the hedgercan buy heatingoil usingthe $.40 strategyis $.3930,$.0055 lower than the $.42 shortput hedge. Sell- ing the $.40 call takesin the leastamount of premium,but allowsfor the most downsideparticipation of the threesell put strategies.

107 A hedgermay like the ideaof establishinga flooror ceilingprice through buy call strategiesbut may feel that premiumsare too expensive. The hedgercould sell out of the money puts and use the premiumreceived to offset the cost of the calls. This strategyis calleda "collar-or-a- fence." In our example,the hedgersells $.44 puts to offsetthe cost of buying$.46 calls. The puts are sold for $.0190and the calls are bought for $.0240,a net debit of $.0050per gallon. The maximumpurchase price is establishedat $.4650. If pricesgo above$.46, the hedgerexercises the optionto buy at $.46 and has paid $.0050premium upfront.

Reducingthe cash cost of a call by sellinga put is not done withoutsome tradeoff. In this case, the hedgeris givingup any downsideparticipation below $.44. If pricesgo below $.44 gains made on the short cash position are offsetby losseson the short put position. For example,at $.38, the hedgerbuys heatingoil for $.38 but loses$.06 on the short $.46 put. The hedgerpaid $.0050up front,so the net purchaseprice is $.4450.

Fences are effectivehedging strategies for oil companiesthat need to establishmaximum purchase prices and yet would like to participatein a down market. Floorsand ceilingscan be adjustedto reflectthe amountof downsideprotection needed, the levelof upsideparticipation and the amount of cash paid or receivedup front. The fence allowsthe hedgerto remove extremevolatility in price movementsat low cost.

Examplesof Volumeof OptionTrading

The NYMEX crude oil optionshave become the secondmost actively-traded commodityoption, trailing only the Treasurybond option contracttraded on the ChicagoBoard of Trade. The tradingvolume of crude oil option averaged10,000 contracts per day in 1987. By the secondhalf of the year, the tradingvolume increased to over 15,000contracts a day and on August 20, it hit a record high of 44,992 contracts. The number of contracts averagedaround 25,000 per day in the first half of 1988. Open interestin crude oil optionshas alreadyclimbed to 200,000contracts.

Acceptanceof crude oil optionsby the oil industryhas been quite rapid. In contrastto petroleumfutures contracts, which took some time after their introductionto be takenseriously by the oil industry,option trading grew rapidlyshortly after their commencement. There are at leasttwo major reasonsbehind this rapidgrowth. First,extensive volatility of petroleum pricesin 1986-87has providedthe rightcondition for optiontrading. In particular,many hedgingpositions on the futuresmarket have now turned into a combinationof futuresand optioncontracts. Secondly, option trading was introducedafter a relativelylong period of time that the oil

108 industrytook to digestpetroleum futures. When optionsarrived, the petroleum industrywas alreadyactive in the futuresmarket and viewedthe option contractas simplyone more instrumentof risk management.

Heatingoil optionshave grown at a much slowerpace. The averagevolume reachedabout 500 contractsper day in early 1988 and has remainedat this level.

Finally,NYMEX has receivedapproval from CFTC in December1987 for an option contracton unleadedgasoline. As an option on the underlying futurescontract, specifications for unleadedgasoline option will parallel the futurescontract. Optionsfor six consecutivemonths would be traded. Strikeprices would be in incrementsof 2 centsper gallonand sevenstrike priceswould be availableat all times.

109 GlossaryOf Terms

Actuals The physicalor cash commodity.

Arbitrage The simultaneouspurchase and sale of different contractsto profitfrom an expectedchange in the pricedifferentials between them. The contractscan be for differentcommodities, for the same commodity in differentlocations, or for the same commodityat the same locationbut for differentmonths.

Backwardation When the price of a good for later deliverystands below the price of the good for earlierdelivery. Thatis, nearbyfutures trade at a premiumto the more distantfutures.

Basis Describesa pricebased on anotherprice. In futures trading,basis is used to show: (1) the differencebetween the pricesof two commodities; (2) the differencebetween the pricesof the same commodityin differentlocations; or (3) the differencebetween the pricesof the same commodityat the samelocation but fordifferent deliverymonths.

Bear A person who sells with the expectation of a price fall.

Bid An offer to buy at a stated price.

Broker A personpaid a fee or commission for acting as an agent in makingcontracts or sales.

Brokerage A fee chargedby a brokerfor executionof a transaction.

Bull A personwho buys with the expectationof a price rise.

Buyinghedge Buyingfutures contracts equal to the amountof the cash commoditythat is eventuallyneeded.

110 Cash and carry The simultaneouspurchase of a commodityfor cash deliveryand sale of the same deliveryat a later date.

Cash market The actualor physicalmarket (spotmarket).

Carryingcharge The cost to store and ensure the deliveryof a physicalcommodity.

CFTC CommodityFutures Trading Commission in the US.

ChicagoBoard of The world'slargest futures exchange founded in 1848 Trade (CBT) in Chicago.

ChicagoMercantile The world'ssecond largest futures exchange founded Exchange(CME) in 1919 in Chicago.

Clearing-house A non-profitassociation that helps its members balancetheir accountswith one another.

Contango To gain controlof the market to sell at inflated prices.

Crack spread Simultaneoussale and purchaseof crude and products contracts.

Day order An order that only appliesfor one tradingday.

Day trading A purchaseand sale of the same futuresduring the tradinghours of a singleday.

Deliverynotice Noticeof a clearingmember's intention to delivera statedquantity of a commodityin settlementof a futurescontract.

Deposit The initialoutlay requiredby a broker to open a futuresposition.

Differentials Pricedifferences between qualities and locationsof delivery.

111 Discretionary An accountfor which buyingand sellingorders are account decidedby the brokerwithout the priorconsent of the client.

First noticeday The first day on which a notice of intentionto deliver the actual commodity against a futures contractcan be made.

Floorbroker A memberwho executesorders for the accountsof other memberson the tradingfloor.

Forwardcontract An agreementto make and take the deliveryof commodityin the future. A forwardcontract is normally tailoredto the particularneeds of the contracting parties.

Futurescontract A commitmentto makeor acceptdelivery of a specified (standardized)quantity and qualityof a commodity during a specificmonth in the future at a price agreedat the time the commitmentwas made.

Good till cancelled An open order that remainsin force untilthe client (GTC) explicitlycancels the order,or until the futures) contractexpires.

Hedge To use the futuresmarket to reducethe price risks associatedwith buying and sellingthe actual commodity.

IPE InternationalPetroleum Exchange formed in 1981 in Londonfor tradingpetroleum futures contracts.

Invertedmarket When the nearbyfutures trade at a premiumto the more distantfutures.

Last tradingday The last day for tradinga particulardelivery.

Limit The maximumfluctuation that is allowedon certain marketsin one tradingsession.

Limit order An order to buy or sell at a specifiedprice.

Liquidation The closingout of a previousposition by takingan oppositeposition in the same contract.

112 Long Describesthe market position of someonewho has purchasedsomething. In futurestrading, it refers to the purchaseof a futurescontract without an offsettingsale.

Long liquidation The closingof long positions.

Lot The minimumcontract size for a particularcommodity.

Margin A depositthat a clientmakes with his broker to securethe performanceof the futurescontract.

Margincall A broker'srequest to a clientfor additionalfunds to keep his originaldeposit intact a certainper- centageof the contractvalue.

Marketorder An orderto buy or sell at the best obtainableprice.

NYMEX Founded in 1872, New York MercantileExchange is currently the world's largest petroleum futures market.

Open interest The numberof contractsfor futuresdelivery outstand- ing at any time, i.e. the numberof contractsthat have not been cancelledby an offsettingtrade.

Pit The area on an exchangefloor where futurestrading of a commoditytakes place.

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120 Distributors of World Bank Publications

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RECENT WORLD BANK TECHNICAL PAPERS (continued)

No. 77. Gunnerson, Wastewater Managementfor Coastal Cities: The Ocean Disposal Option No. 78. Heyneman and Fagerlind, University Examinations and Standardized Testing: Principles, Experience, and Policy Options No. 79. Murphy and Marchant, Monitoring and Evaluation in Extension Agencies No. 80. Cemea, Involuntary Resettlement in Development Projects: Policy Guidelines in World Bank- Financed Projects (also in Spanish, 80S) No. 81. Barrett, Urban Transport in West Africa No. 82. Vogel, Cost Recovery in the Health Care Sector: Selected Country Studies in West Africa No. 83. Ewing and Chalk, The Forest Industries Sector: An Operational Strategy for Developing Countries No. 84. Vergara and Brown, The New Face of the World Petrochemical Sector: Implications for Developing Countries No. 85. Emst & Whinney, Proposals for Monitoring the Performance of Electric Utilities No. 86. Munasinghe, Integrated National Energy Planning and Management: Methodology and Application to Sri Lanka No. 87. Baxter, Slade, and Howell, Aid and Agricultural Extension: Evidence from the World Bank and Other Donors No. 88. Vuylsteke, Techniques of Privatization of State-Owned Enterprises, vol. I: Methods and Implementation No. 89. Nankani, Techniques of Privatization of State-Owned Enterprises, vol. II: Selected Country Case Studies No. 90. Candoy-Sekse, Techniques of Privatization of State-Owned Enterprises, vol. III: Inventory of Country Experience and Reference Materials No. 91. Reij, Mulder, and Begemann, Water Harvesting for Plant Production: A Comprehensive Review of the Literature No. 92. The Petroleum Finance Company, Ltd., World Petroleum Markets: A Framework for Reliable Projections No. 93. Batstone, Smith, and Wilson, The Safe Disposal of Hazardous Wastes: The Special Needs and Problems of Developing Countries No. 94. Le Moigne, Barghouti, and Plusquellec, Technological and Institutional Innovation in Irrigation No. 95. Swanson and Wolde-Semait, Africa's Public Enterprise Sector and Evidence of Reforms The World Bank Headquarters EuropeanOffice TokyoOffice N.W 66, avenue d'lena KokusaiBuilding 1818 H Street, 3-chome Washington,D.C. 20433, U.S.A. 75116 Paris,France l-1 Marunouchi Telephone:(202) 477-1234 Telephone:(1) 40.69.30.00 Chiyoda-ku,Tokyo 100, Japan (202)477-6391 Facsimile:(1) 47.20.19.66 Telephone:(3) 214-5001 -Facsimile: 214-3657 Telex:WUI 64145 WORLDBANK Telex:842-620628 Facsimile:(3) RCA 248423 WORLDBK Telex: 781-26838 CableAddress: INTBAFRAD WASHINGTONDC

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