Oil Futures Forward Curves: Economics Explained

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Oil futures forward curves:

economics explained

www.pjk-international.com www.enfx.net Oil futures forward curves

• ir. Patrick Kulsen, MSc. B. Mail: [email protected] Tel: +31-(0)76-7676 325

• Managing Director @ PJK International B.V.

• PJK International:

‘Market research company specialized in NWE oil markets’

– ARA / Rhine barge freight rates – ARA oil product stocks – Market analysis reports – Consultancy & Quant research – Freight Control App

Contents

1. Forward curves in focus

2. Economics of forward curves

3. Relevance of ARA gasoil stocks for ICE gasoil forward curve

4. ICE gasoil & Brent forward curves: analysis of recent developments

Forward curves in focus (1)

Oil futures forward curves??

Futures prices on Nov. 11th 2012 at 14:14 CET: Forward curves in focus (2)

What do we know about forward curves….

….. and why is this important?

• Relevance for various market players

• Stylized facts of oil forward curves

Forward curves in focus (3)

Relevance for various market players:

1. Physical traders: – Physical differentials (Gasoil 0.1% barges fob ARA) – Basis risk of hedge using derivatives (futures / swaps) – Inventory management: max. inventory or JIT – Availability of product / storage capacity

2. Tank storage companies: – Demand for tank capacity is linked to shape • Contango: much demand • Backwardation: little demand

3. Futures traders: – Speculative spread trading

Forward curves in focus (4)

Stylized facts of oil forward curves:

Most important:

1. Shape of curve: – Upwards sloping (contango) or – Downwards sloping (backwardation)

2. Shape is persistent and fairly independent of daily swings in futures prices

3. Crude and oil products forward curves are linked

Forward curves in focus (5)

Stylized facts of oil forward curves: 1. Slope of curve: contango / backwardation Forward curves in focus (6)

Stylized facts of oil forward curves: 2. Shape is persistent and fairly independent of daily swings in oil prices  look at time spreads to see dynamics  Time spread = price differential between two consecutive futures

contracts

Time spread Time

Feb. – Mar. 2013 Forward curves in focus (7)

Dynamics of time spreads:

Shape is persistent:

2 1

Long period of: • Contango (1) • Backwardation (2) Forward curves in focus (8)

Stylized facts of oil forward curves: 3. Crude and oil products forward curves are linked: Economics of forward curves (1)

What fundamentals drive crude oil forward curves?

Distinguish between front-end and back-end of forward curve

1. Back-end of curve Both ends are connected by arbitrage mechanisms 2. Front-end of curve }

Front-end of curve

Back-end of curve Economics of forward curves (2)

What fundamentals drive crude oil forward curves?

1. Back-end of curve  long term fundamentals

Supply side of crude market  Price to justify investments/divestments in exploration and development of oil wells

Demand side of crude market  Price to justify investment/divestment programs for • developing alternative fuels • increasing fuel efficiency • Etc..

Price = expected marginal ‘exploration, development and production’ costs to balance market in the “long run”

Economics of forward curves (3)

What fundamentals drive crude oil forward curves?

2. Front-end of curve  short term fundamentals – Current and expected supply and demand – Current and expected inventory levels

If supply > demand: price drops to stimulate players to increase inventories to balance market

If demand > supply: price rises to stimulate players to free up inventories and/or lower or postpone consumption to an extent that the market is balanced

Economics of forward curves (4)

Arbitrage mechanisms connect front and back end of curve

Storage arbitrage play  Prevents time spreads from becoming too large  Links futures prices along the curve

Economics of forward curves (5)

Storage arbitrage play?

If contango and -(time spread) > marginal storage cost:

 Long 1st month, short 2nd month  Hold both futures contracts till expiry  After expiry 1st month: collect and store product  After expiry 2nd month: deliver product

Profit = -(time spread) – storage costs

Storage costs: • Transportation costs (transport product to tank terminal) • Tank Terminal lease fee (opportunity costs: only if ‘spot’ market for storage capacity) • Finance costs Economics of forward curves (6)

Storage arbitrage play?

If backwardation and time spread > shipping costs - interest

Subject to: inventory level > min. level + replenishment lot:

 Short 1st month, long 2nd month  Hold futures contracts till expiry  After expiry 1st contract: deliver product from storage tank  After expiry 2nd contract: collect product  stock is replenished

Profit = time spread – shipping costs + interest

Shipping costs: • Freight rate • Insurance Economics of forward curves (7)

Link crude oil & oil products forward curves?

 Crude oil is feedstock for refineries to produce oil products  Most important input cost!

Difference between oil product price and crude price:

“Crack spread”

 Proportional to refiner’s gross profit margin

Economics of forward curves (8)

ICE Gasoil – ICE Brent crack spreads Forward curves Gasoil, Brent crude 1000

950 900 6th of Nov. 2012 850 Crack spreads

800 Gasoil 750 Brent crude

Futures price [$/ton] 700

650

600

13 13 13 14 14 14 15

12 13 13 14 14

13 14

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- - - - -

- - Jul

Jul Gasoil - Brent crack spread

Jan Jan Jan

Sep Sep

Mar Mar

Nov Nov Nov

May May 150

140

130

120 Gasoil - Brent crack 110

Crack spreadCrack [$/ton] 100

90 Economics of forward curves (9)

Crack spread forward curve:

• Back-end: gross profit margin to justify investments/divestments in refining assets • Front-end: short term fluctuations in supply/demand + inventory levels • Storage arbitrage play limits spreads • Refiner’s production capacity is limiting factor in arbitrage play Gasoil - Brent crack spread 150

140

130

120 Gasoil - Brent crack

110 Crack spread spread [$/ton]Crack 100

13 14 12 13 14

13 13 13 13 14 14 14 14 15

12 13 13 13 14 14 14

13 14

- - - - -

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- -

Jul Jul

Jan Jan Jan

Jun Jun

Oct Oct

Feb Sep Feb Sep

Apr Apr

Dec Dec Dec

Mar Mar

Aug Aug

Nov Nov Nov

May May Relevance of ARA oil product stocks (1)

ICE gasoil futures are traded all over the world….

…so why should ARA stocks be important?

Several reasons: 1. NWE main importer of middle distillates 2. ARA main trading hub in NWE 3. ARA physical delivery point of ICE gasoil contract

Relevance of ARA oil product stocks (2)

NWE main importer of middle distillates

S/D 'NWE' (broad definition) 25000

20000

15000

implied import demand 10000 NWE_demand

NWE_production Level [k [k ton/month] Level 5000

2008M03 2008M11 2008M01 2008M05 2008M07 2008M09 2009M01 2009M03 2009M05 2009M07 2009M09 2009M11 2010M01 2010M03 2010M05 2010M07 2010M09 2010M11 2011M01 2011M03 2011M05 2011M07 2011M09 2011M11 2012M01 2012M03 2012M05 -5000 Source: Eurostat (NWE incl. Iberian peninsula + Scandinavia)

Relevance of ARA oil product stocks (3)

ARA and hinterland S/D ARA and Hinterland 4000 3500

3000

2500

2000 implied import demand ARA demand_BENL 1500 production_ARA total demand (ARA+hinterl.)

1000 Level [k [k ton/month] Level

500

-500

2011M09 2008M03 2008M05 2008M07 2008M09 2008M11 2009M01 2009M03 2009M05 2009M07 2009M09 2009M11 2010M01 2010M03 2010M05 2010M07 2010M09 2010M11 2011M01 2011M03 2011M05 2011M07 2011M11 2012M01 2012M03 2012M05 2008M01 -1000 Source: Eurostat Relevance of ARA oil product stocks (4)

Import to ARA: Import to ARA 16000 14000 12000

10000

8000 Import to ARA

6000

4000

2000

0 Baltics America Far East Scandinavia Middle East MED Source: Eurostat Brent forward curve: time spread analysis (1) Brent forward curve: time spread analysis (2)

Balance global supply / demand, Crude 3

35 1

25 1

15 -1

5 2 4

5 -3

-5 3 Level[Mb] Implied stock change (RH) -15 cumm. Stock change (LH) -5

-25

-7 -35

-45 -9

Date Brent forward curve: time spread analysis (3)

cumm. Stock change (LH)

07 08 09 10 11 12 13

07 12 08 09 10 11 13

08 09 10 11 12 13

07 08 09 10 11 12 13

10 07 08 09 11 12 13

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Aug Aug Aug Aug Aug Aug Aug

Jun Jun Jun Jun Jun Jun Jun

Apr Apr Apr Apr Apr Apr Apr

Feb Feb Feb Feb Feb Feb

Oct Dec Oct Dec Oct Dec Oct Dec Oct Dec Oct Dec Oct Dec 5 0 -5 cumm. Stock change (LH) -10 -15 -20 -25 -30 -35 -40 -45 Gasoil forward curve: time spreads vs. stocks ARA stocks vs. US stocks (PADD 3) Gasoil forward curve: time spread analysis More information:

Visit PJK website

For outlook on oil forward curves see: www.pjk-international.com/scenarios

For more theory on forward curves see: www.pjk-international.com/downloads

?? – Questions - ??

? Outlook for forward curves

Crude oil market: main themes

Downside risks: • Global economic slowdown • Demand destruction due to high oil prices • Political risks: Eurozone crisis & Fiscal Cliff • Further surge in US tight oil production

Upside risks: • Unrest Middle-East • Militant clashes in Libya • North-Sea production outages Relevance of ARA oil product stocks (3)

Individual countries: Germany

Germany, gasoil/diesel 7,000 6,000

5,000

4,000

3,000 impl. import demand demand production

2,000 [k ton/month] Level import-export

1,000

-1,000

Source: Eurostat

Relevance of ARA oil product stocks (4)

Individual countries: France

France, gasoil/diesel 6,000

5,000

4,000

impl. import demand 3,000 demand production

Level [k [k ton/month] Level 2,000 import-export Linear (impl. import demand) 1,000

2010M01 2011M07 2008M01 2008M03 2008M05 2008M07 2008M09 2008M11 2009M01 2009M03 2009M05 2009M07 2009M09 2009M11 2010M03 2010M05 2010M07 2010M09 2010M11 2011M01 2011M03 2011M05 2011M09 2011M11 2012M01 2012M03 2012M05 2012M07

Source: Eurostat

Relevance of ARA oil product stocks (5)

Individual countries: UK UK, gasoil/diesel 3,000

2,500

2,000

1,500 impl. import demand demand production

1,000 import-export Level [k [k ton/month] Level

500

-500 Source: Eurostat

ARA ideal location for trading in NWE ARA: key benefits

• Ideal topographical position in NWE: – North Sea oil fields – Large consumer markets in Benelux, Germany, France, Switzerland and UK – Highly industrialized area and hinterland – Good logistics: sea ports, Rhine & canals

• Large oil infrastructure: refineries + tank terminals

• Global trading hub, links to: Med, USA, Caribbean, South- America, West Africa, the Mid East and the Far-East

• Liquid physical oil products market and oil derivatives market

• ICE Europe futures exchange and OTC swap markets for hedging physical positions

• Brent crude, a worldwide oil pricing benchmark EIA stocks: PADD 1 and 3