Financial Oil: A Statistical Markets & Analysis of West Texas Instruments Professor Intermediate and Brent Goldstein Crude 12/9/13 Adam Jarolimek | Joseph Lorusso | Thomas Walsh Philip Yudin “The authors of this paper hereby give permission to Professor Michael Goldstein to distribute this paper by hard copy, to put it on reserve at Horn Library at Babson College, or to post a PDF version of this paper on the internet.” “I pledge my honor that I have neither received nor provided any unauthorized assistance during the completion of this work.” Phil Yudin Joseph Lorusso Thomas Walsh Adam Jarolimek _____________________________________________________________________________________ 1 Table of Contents Executive Summary 3 Overview 4 Determinants of Price 5 United States Petroleum Reserves 5 NYMEX Natural Gas Price 6 Treasury Note 6 LIBOR 6 S&P500 7 USD/GBP Exchange Rate 7 OPEC Oil Production 8 Analysis of Spot Prices of WTI and BRENT 8 Hypotheses 8 Hypotheses Testing Methods 9 R-Squared 11 P-Value of Coefficients 11 Predictions Using Regression Models 12 Conclusion 15 References 16 Regression Data 17 2 Executive Summary: Crude oil is one of the most fundamental and influential commodities in modern society. At home and abroad, it is the underlying fuel for the vast majority of anything that requires power, and for this reason, its geopolitical importance is unparalleled. With advances in refining and fracking techniques, and the ever-increasing usage of natural gas in conjunction with it, crude oil will continue to be the primary driver of the energy market for the foreseeable future. By examining the effects of various industrial, economic and financial factors related to the industry, this paper will deliver an implicit as well as statistical analysis of price movement within two of the biggest oil extraction pricing benchmarks, the Brent Crude and the West Texas Intermediate. The paper will give an overview of the industry and the role of the WTI and Brent within it and will identify a cross-section of factors that are involved in the day-to-day valuation and trading of the different benchmarks. The paper will inspect and break down what each individual factor is and its importance to the industry. By exposing how each factor acts in relation to the others and to the benchmarks, their importance and functionality within the larger context of the oil industry can be observed. After the factors are analyzed, they will be quantified and used in a regression attempting to establish a relationship between the two benchmarks and their underlying factors. By observing and manipulating the data outputs, the paper will show a model that predicts the prices of each benchmark as a function of the different variables. The examination of the two benchmarks from a holistic as well as quantitative standpoint will provide a much larger breadth of information than basic research could. The paper hopes to give readers not only an understanding of the primary American and European oil pricing benchmarks, but an understanding of how they react to vibrations in other industries and entities throughout the global economy. 3 160 WTI vs. Brent Spot Price 140 120 100 80 60 40 20 0 Jun-09 Jun-04 Jun-99 Jun-94 Oct-12 Oct-07 Oct-02 Oct-97 Oct-92 Apr-10 Apr-05 Apr-00 Apr-95 Apr-90 Feb-11 Feb-06 Feb-01 Feb-96 Feb-91 Dec-11 Dec-06 Dec-01 Dec-96 Dec-91 Aug-08 Aug-03 Aug-98 Aug-93 Cushing, OK WTI Spot Price FOB Europe Brent Spot Price FOB (Dollars per Barrel) Overview of the Oil Market Brent Crude and the West Texas Intermediate are two types of oil that serve as benchmarks in current oil pricing. Both are considered “sweet” oils, a term which is derived from the percentage of sulfur in the fuel. A value below 0.5% signals that the oil is “sweet”, while any greater than 0.5% indicates that the oil is “sour”. Sour and sweet oils are both useful, however users of oil prefer sweet oil because it takes moderately less refining in order to remove the impurities.1 Each oil commodity varies in price based on a plethora of different factors that include the state of the global economy, geopolitical tensions, emerging market demand, and price of substitutes. Brent Crude comes from a variety of drilling sites in the North Sea in Europe and is the primary global price benchmark for crude oils.2 This crude oil had its name derived from the a shared project between ExxonMobil and Royal Dutch Shell that named each of the drilling locations after birds, with this specific project named after the Brent goose. Brent is also an acronym for the different layers of an 1 "What Is Brent Oil?" Commodity HQ. 2 "Brent vs. WTI." Energy and Capital. 4 oil field. Brent is used to price a majority of the global crude oil supply market.3 This commodity trades on the InterContinental Exchange, or ICE, as well as the New York Mercantile Exchange. West Texas Intermediate is a crude oil that is sourced mainly from the Permian Basin in West Texas. It also trades on the InterContinental Exchange and the New York Mercantile Exchange. Currently, the two crude oils are the basis for a comparison known simply as the Brent – WTI Spread, which indicates the difference in price between equal volumes of the two commodity prices. This information is important to energy traders and is a useful piece of information as an indicator of current financial performance for each respective market.4 At the time of writing, WTI Crude Oil is trading at $97.65 per barrel and Brent Crude Oil is trading at $111.61. 5 The reasons for the difference in these prices will be further examined in a later section of this report, but first it will be important to understand the different factors that influence each commodity’s price. Determinants of Price United States Petroleum Reserves The existing inventory of crude oil in the United States is a major determinant in the current commodity price. The United States maintains a Strategic Petroleum Reserve that has a capacity of 727 million barrels and inventory of almost 700 million barrels at the end of 2012.6 This reserve affects the price of oil based on the availability of oil, as a sudden release of thirty million barrels would inflate the supply of crude oil and could devalue it, or conversely a large purchase of oil to add to the reserves could decrease the price of the oil. The likelihood of the government to make a purchase is the firm basis for consumer speculation, thereby causing the futures market for crude oil to sometimes shift unexpectedly in addition to the spot price for each commodity. 3 "What Is Brent Oil?" Commodity HQ. 4 Why the WTI Vs. Brent Crude Spread Is Shrinking." Minyanville. 5 "Crude Oil Price Forecast." OilPricenet. 6 "How Crude Oil Inventories Impact The Market." Energy Select Sector SPDR (ETF) 5 NYMEX Natural Gas Price Natural Gas prices can be directly linked to the price of oil commodities, particularly in Europe due to the proximity of the Brent mining fields. Some analysts argue that Natural Gas is now more closely following the pricing of Coal, however the widely accepted opinion is that the entire energy market has some correlation that can be analyzed statistically.7 Natural Gas is arguably one of the primary substitutes for oil and therefore it can be expected that if the price of Natural Gas commodities changes, the price for other energy alternatives would be affected in turn, either inversely or directly. Treasury Note Treasury Notes are debt instruments backed by the United States government. These instruments are sold on auction, meaning that the value of the note is derived from overall perception of the market and faith in the United States government. The 10 Year Treasury note specifically is a factor that can influence the spread of West Texas Intermediate to Brent Crude because of the geographic location of these commodities.8 Brent is based out of the North Sea while WTI comes from the Permian Basin in Texas, meaning that tension or conflict in the United States that influences the Treasury Note could also be a factor that impacts the ability for consumers to import or export crude oil, thereby affecting the price of the oil due to a change in the supply or demand thereof, though the magnitude of such a shift will need to be evaluated through statistical analysis. LIBOR LIBOR, or the London Interbank Offered Rate, is a calculated average interest rate that reflects how much interest the primary banks in London would be charged for borrowing from other banks. LIBOR is currently calculated for ten different currencies and fifteen time periods with the shortest being an overnight rate and the longest being a one year rate. This rate is a large determinant in borrowing 7 Farzad, Roben. "High Oil Prices Cut The Cost Of Natural Gas." BusinessWeek. 8 "What Are Treasury Bills, Notes and Bonds?" US Economy. 6 activity and has a large effect on various financial markets.9 It does not directly interact with the oil commodities, but a large enough change in LIBOR could create a financial ripple effect that is ultimately felt by the crude oil market due to the nature of lending and borrowing. S&P 500 Standard and Poor’s 500 is an index that is calculated using information from 500 publicly traded company stocks that is chosen specifically for market size, liquidity, and industry grouping. The intent of the index is to demonstrate the risk and return of the United States equity environment and the index components are weighted based on each firm’s market capitalization.