Anatomy of Crude Pricing

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Anatomy of Crude Pricing and Hedging Strategies for Corda Corporation

-------------------------------------------------------------------------------------------------------------------------------- Gregor Max Georg Schlederer Auditors by: Prof. Dr. Bernd Gussmann, Prof. Dr. Ralph Kriechbaum Bachelor Thesis Course of Studies: Business Administration Fachhochschule Rosenheim University of Applied Sciences Dallas, TX, Jun 2012
LIST OF ABBREVIATIONS ..................................................................................................... 4 ABSTRACT .......................................................................................................................... 5 CORDA CORPORATION ....................................................................................................... 5 OVERVIEW OF THE OIL MARKET .......................................................................................... 7 BRIEF HISTORY OF THE OIL MARKET ........................................................................................... 7 CRUDE BENCHMARKS........................................................................................................... 12 World - Brent Crude ..................................................................................................... 13 American - WTI Crude .................................................................................................. 13
Bottleneck WTI .................................................................................................................................... 15
IMPACTS ON OIL PRICES ................................................................................................... 20 SUPPLY AND DEMAND .......................................................................................................... 20 Rising demand ............................................................................................................ 20 Tighter supply ............................................................................................................. 22 Inventories ................................................................................................................. 24 Spare Capacity ............................................................................................................ 25 Geopolitical Uncertainty .............................................................................................. 27 Weather Uncertainty ................................................................................................... 29 EXCHANGE RATES ............................................................................................................... 29 INTEREST RATES ................................................................................................................. 30 SCARCITY RENT- MODEL OF HOTELLING ..................................................................................... 30 Changes in the extraction costs .................................................................................... 32 New crude Discoveries ................................................................................................. 32 Backstop technology ................................................................................................... 33 Impacts of a monopoly ................................................................................................ 34 PRICE-INELASTIC IN THE SHORT TERM........................................................................................ 35 PRICE VOLATILITY ............................................................................................................... 35
Restructuring of Corda Corp .................................................................................................................. 38
INTRODUCTION TO DERIVATIVE OIL PRODUCTS ................................................................. 38 OTC DERIVATIVE ................................................................................................................ 39 Price Reporting Agencies.............................................................................................. 40 FUTURE MARKET ................................................................................................................ 41 Specifications of Light Sweet Crude and Brent ................................................................ 42 Future curves and Pricing ............................................................................................. 42 SPECULATION IMPACTS ON CRUDE MARKETS .............................................................................. 46 Parties on the future market ........................................................................................ 47 CALCULATING CRUDE PRICE ................................................................................................... 50 CASE STUDY ..................................................................................................................... 53 RISKS OF HEDGING .............................................................................................................. 54 AIMS OF HEDGING .............................................................................................................. 55 CORDA CORPORATOIN 2011 ................................................................................................. 57 FUTURE STRATEGY .............................................................................................................. 58 COLLAR STRATEGY .............................................................................................................. 62 2
CONCLUSION ................................................................................................................ 65 LIST OF REFERENCE ........................................................................................................... 66 DECLARATION OF AUTHENTICITY ...................................................................................... 68
LIST OF ABBREVIATIONS
API ASCI bbl BFOE EIA IEA IOC IOSCO NOC OPEC OTC PADD PRA TRC WTI American Petroleum Institute gravity Argus Sour Crude Index Barrel / 158 liter Brent Blend, Forties, Oseberg, Ekofisk U.S. Energy Information Administration International Energy Agency International Oil Companies International Organization of Securities Commissions Nationalized Oil Company Organization of Petroleum Exporting Countries Over the counter Petroleum Allocation for Defense Districts Price Reporting Agency Texas Railroad Commission West Texas Intermediate
ABSTRACT
Exploration and production companies like Corda Corporation have to face a variety of risks. The origin of these uncertainties arise from the complexity of the industry. In general, these risks can be divided into two groups: Element / technical risks: containing construction, operation, financing, and revenue generation risk Global / market risk: lasting from political, legal, commercial and environmental risk, to crude prices risk
Crude producers can sway the technical risks, since they can influence the volume of their production. Independent exploration and production companies are in a competitive market, therefore, they cannot influence market risks and have to find ways to roll over market risks. 1 The aim of this paper is to provide different crude price hedging strategies for Corda Corporation. In order to understand the specialties of the market, I will start with a broad history and overview. I will then determine factors that impact crude pricing and will pay special attention to the scarcity rent that is described by the Hotelling rule. I will ultimately show the need for hedging strategies for crude prices. I will then introduce derivative instruments that help to hedge crude prices. Finally, I will apply these methods to a case study on Corda Corporation.
CORDA CORPORATION
Paul DeCleva Jr. founded Corda Corporation in 1982. Corda Corporation is an oil and gas exploration corporation with an executive office in Dallas, TX and a production office in Wichita Falls, TX. Corda Corporation runs 56 producing wells in and around Texas. The players in the oil business can be divided into 3 categories: Upstream Midstream Downstream Exploration and production Transportation of hydrocarbons Refining, distribution, and retailing
Corda Corporation is one of the Exploration & Production companies. His father, Mr. Paul DeCleva Sr., came from Hungary to America after the Second World War, where he fulfilled the "American Dream." He drilled over 850 wells and set the course for his
On the State's Choice of Oil Company: Risk Management and the Frontier of the Petroleum Industry, Peter A. Nolan and Mark C. Thurber, Program on Energy and Sustainable Development, 12-2010 (S 7)
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son. Even though he is 97 years old, he is still in the office every day. Paul DeCleva Sr. has four children, all of whom have an interest in the business; his son Paul DeCleva Jr. runs the business. Because its a family business, the Corda Corporations strategy is conservative and aims for long-term success. To retain control over the development, Corda Corporation prefers operating on its own properties, while also financing its projects with a combination of its own capital and external private equity. Further, the management seeks to increase oil, gas reserves and production through a combination of new exploratory drilling and takes advantage of techniques for the development of existing wells. Corda Corporation is concentrating on their core business: the exploration and development of vertical wells in the Fort Worth Basin in Texas. The Fort Worth Basin is famous for its unconventional energy sources of shale gas and shale oil. The oil and gas is captured in tight formations. These unconventional sources became available through new technologies like horizontal drilling. Horizontal drilling is an expensive and risky drilling method for independent firms. The costs for drilling a h orizontal well are three times higher than a comparable vertical well. Due to the h igh capital intensity of horizontal drilling, an independent exploration and p roduction firm would have to shoulder a higher risk compared to major companies, since they could drill less wells, resulting in a lower diversification. As a result, horizontal wells are mostly operated by major or second- tier integrated companies rather than by independent exploration and production companies. However, the Fort Worth Basin contains other types of layers with hydrocarbons that can be reached through the classical vertical drilling. Corda Corporation outsourced the drilling rigs in the 1980s and books the drilling as a service from a drilling rig contractor. In the section "Consequences of Oil Price Volatility," I will take a closer look at the reasons for this decision. High oil prices made the past year extraordinary for Corda Corporation. The average price for the WTI crude was $92.37, and Corda Corporation's gross oil and gas revenue from operated properties were $9,436,249 in 2011. A minor part of Corda Corporations income is due to gas sales. The wells of Corda Corporation are producing a mixture of oil and gas. However, gas prices are tumbling at a low price level. This paper is going to focus entirely on oil, as it plays the leading role for Corda Corporation
OVERVIEW OF THE OIL MARKET

BRIEF HISTORY OF THE OIL MARKET
Control of Spare Capacity Price setting
1870- Standard Oil Company Standard Oil Company 1911 1931- TRC Seven Sisters / netback pricing 1971 1971- OPEC-Seven Sisters / posted pricing and buyback OPEC 1973 pricing 1974- OPEC 1975 OPEC / administered oil-pricing regime 1984- OPEC Market pricing - finished product 1986 1986- OPEC Market pricing crude 2012 In order to understand the current oil price system, it is important to take a closer look at previous oil pricing systems and their major changes. This chapter discusses the main alterations in the oil market. 2 The history of the modern oil market begins in 1870 in America with John D. Rockefeller forming "The Standard Oil Company." Rockefeller controlled 90% of the American oil market, and thus was frightening the American public and government. In 1911 The Standard Oil Company was split in to 34 companies. Some of todays major oil companies, like ExxonMobil, Chevron, and ConocoPhillips, have their origin in The Standard Oil Company. The next era began in 1931 when massive oil fields were discovered in Texas. The US government imposed production restrictions through the Texas Railroad Commission (TRC) in order to support the oil industry. At that time the TRC was in control of the crude spare capacity and thus controlled the global crude pricing. This was the time of the International Oil Corporations (IOC), also called the Seven Sisters. The Seven Sisters controlled the upstream, midstream, and the downstream. Furthermore, they controlled the rate of supply through concessions that they received from major oil producing countries. The profits were split 50/50 between the foreign government and the IOC.
The history is based on four books: The Prize: The Epic Quest for Oil, Money, & Power, Daniel Yergin, ISBN 978-0671799328, 2011 / The Quest - Energy, Security, and the Remaking of the Modern World; Daniel Yergin, ISBN 978-1-59420-283-4, 2011 / Understanding Oil Prices - A Guide to What Drives the Price of Oil in Today's Markets, Salvatore Carollo, ISBN 978-119-96272-4, 2012/ and the history part of Oil 101, Morgan Downey, ISBN 978-0-09820392-0-5, 2009
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The oil majors set the posted price over netback pricing. Netback pricing linked the crude in a foreign country to the transparent US gulf price and discounted it by the freighting costs to the US gulf coast. The result was an underdeveloped spot market where the posted price did not respond to the actual demand and supply on the market. Basically, it had no function of allocation. Instead, the Seven Sisters set the posted price and controlled the revenues of the oil exporting countries. After the oil fields in the Middle East were developed with the help of the IOC, the foreign oil producing countries had no need for the IOC. Some of the foreign producing countries began to nationalize their oil sectors. At the beginning of the nationalization process, the oil producing countries gained control over the oil companies with equity participations. These participations increased over time, finally resulting in a complete nationalization, like in Kuwait in 1980 or in Iraq in 1972. This was not the only problem for the IOC between 1960 and 1970. The competition in the exploration and production sector was increasing, and more and more independent oil companies were appearing. These independent oil companies were entering the upstream market and were assuring concession in countries like Venezuela, Libya, Iran, and Saudi Arabia. Furthermore, the independent companies started to produce huge volumes of crude, forcing the majors to lower the posted prices. The major oil-producing countries formed a supply cartel: Organization of Petroleum Exporting Countries (OPEC). The main idea of OPEC was to organize the different national oil companies. Furthermore, the OPEC was formed as a correspondent to the Seven Sisters in order to fight against the declining posted prices. 3 In 1971, six OPEC Gulf members: Abu Dhabi, Iran, Iraq, Saudi Arabia, Qatar, and Kuwait, formed the Ministerial Committee. The Ministerial Committee was empowered by the Saudi Arabian Oil minister. The Saudi Arabian Oil minister should negotiate the posted prices with the oil companies and collectively for the other OPEC member. These changes led to a shift in the balance of power, from the IOC to OPEC. Now, OPEC members gained control over the oil pricing system, and they would change it in its foundations. Instead of the posted price being set by the IOC, OPEC published an official selling price. This price was not only published by the IOC, but also, OPEC tried to sell their crude to their rising competitors in order to be more independent. However, the governments were unable to market all of their crude to third party buyers, so they sold their crude to the major oil companies for the buyback price. On the other side of things, the oil companies were still holding on their old price system and thus were also posting their prices. This system was complex and highly inefficient, because the purchaser could choose between three different prices. This pricing system was discarded by the administered oil-pricing regime, ruling from 1974 to 1975. In this pricing system, the Saudi Arabian Light crude was chosen as the
Oil Politics: A Modern History of Petroleum, Parra, London: IB Tauris, 2004, (Page1-10)
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reference crude. The different crudes of the OPEC countries were set in relation to the market price, and they were adjusted depending on crude quality. This was the final power exchange, with OPEC setting the oil prices. Between 1965 and 1973 global crude demand was sharply increasing. The increasing demand was mainly met by higher production rates from OPEC countries. OPEC increased its share in the global production from 44% in 1965 to 51% in 1973. 4 During the 1980s, the US oil production peaked. Now the OPEC controlled over the spare production capacity, and OPEC was setting the oil prices in a time of rising demand. It was the first time that OPEC had set the posted price in a unilateral role. Before, OPEC had only been able to prevent oil companies from reducing the price. In 1973, some of the OPEC members imposed an oil embargo on the US and the Netherlands for a period of six months. The reason being that the US supported Israel with its military. The embargo resulted in a 5% to 10% cut in crude supply and a price increase in todays terms, from $14.00 to $50.00. This was the first time that oil was used as a weapon, and this led to the first oil crisis. Shortly after the first oil shock, the second oil shock came during the period 1978-1981. This time it was caused by a strike of Iranian oil workers and was followed by the Iran-Iraq War. The price was rising to new heights, reaching price levels of $90.00 in todays terms. During this time, the general public in the developing countries began to realize how dependent they were on crude oil and especially how dependent they were on OPEC countries. In addition, a new environmental movement came along, resulting in technological improvements and higher fuel efficiency. This led to a sinking demand of crude oil. During the second oil crisis, the crude spot prices were rising faster than the official selling price. The official selling price was linked to the reference price of Saudi Arabian Light crude. The problem for the OPEC countries was that they had long-term contracts with the oil companies based on the official selling price. The oil company could make profits by selling the differential between spot and official selling price. As a result, OPEC producer countries were abandoning their long-term contracts and starting to sell large volumes of crude to the players in the spot market. During this time, the major oil companies had lost large percentages of their oil reserves through equity participation and nationalization. Thus, they were searching for new reserves outside the OPEC.5 These reserves were found in Canada and the Gulf of Mexico. However, it would take until the early 1980s to bring these reservoirs to the oil market. In addition, small independent market players, piqued by high oil prices, were entering the market and exploring
An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute for Energy Studies, 01-2011 (Page 15)
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On the State's Choice of Oil Company: Risk Management and the Frontier of the Petroleum Industry, Peter A. Nolan and Mark C. Thurber, Program on Energy and Sustainable Development, 12-2010 (S26)
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new fields. In the mid 1980s, oil demand was declining, whereas supply was rising. Furthermore, these new suppliers were undercutting the oil prices set by the OPEC in the spot market. As a result, OPEC market shares in the world oil production were sharply dropping from 51% in 1973 to 28% in 1985. Disagreements started to arise between the OPEC countries about how to set the oil prices effectively. It became clear very quickly: independent producers could always sell their crude at a discount to the official price, and this pricing system is therefore unlikely to hold. 6 In 1984 the power of setting the crude prices changed and set up a new chapter in the history of oil pricing. The oil price was first set by multinational oil companies, then by the OPEC, and this time by the markets in the future exchange marketplaces. The system is called a market-related pricing system. At the beginning crudes were linked to the finished products. The refinery paid the producer the difference between the selling prices of their finished product and subtracted the fixed refinery margin. In this pricing system, refineries had an incentive to run at high capacity and oversupplied the markets with their products. This resulted in lower product and crude prices. The crude prices sharply decreased from $26.70 per barrel in July 1985 to $9.15 per barrel in July 1986. The yields (finished-products) of one barrel (42-gallons) of crude are dependent on the type of refinery and the characteristics of the crude. These figures show the average yield of US refineries: Finished Product Gasoline Distillate Fuel Oil (Home Heating and Diesel) Kerosene (Jet Fuel) Residual Fuel Petroleum Coke Other Products
Source: Database - refining crude oil from IEA
Gallons 19.3 9.83 4.45 2.1 2.1 6.68
During this time there were spare refinery capacity and OPEC crude oil producers replaced the refining margin netback pricing with the crude oil formula netback pricing system. OPEC producers would set their crude price in relationship to a crude benchmark, also known as a Risk Management at Apache, Lisa Meulbroek, Harvard Business School, 08-272001(Page 4)
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price marker, plus or minus a differential. The market-related pricing system became standard in 1988 and is still the main method used today; all market participants are now setting the oil prices. During the year 1990, the price for crude spiked again, doubling within a week. This time it was a result of uncertainties related to the Iraq invasion of Kuwait. Saudi Arabia and other countries were increasing their production, and the crude prices were rising and falling very quickly in succession. In late 1998 the crude prices plummeted due to an oversupply of almost $11.00. The oversupply happened because of the Asian financial crisis and the United Nation "oil-for-food" program for Iraq.

Source: Database - spot prices WTI from IEA
In the beginning of the 21st century, demand was soaring, and the Asian economies recovered. In addition, it was the beginning of the Internet bubble, a time of great world GDP growth rates. The prices were almost tripling - even sharper than during the Iran revolution. At the beginning of 2006 the oil prices dipped slightly, followed by a time of rising prices, lasting until the financial crisis of 2008. 7 There are three main reasons for the rapid price increase, resulting in a crude price bubble from mid 2006 until the world financial crisis in 2008: first, Chinas rapidly growing economy; second, the rising impacts of financial speculation on the crude markets, and third, the threat that the world production had passed its peak. Furthermore, it seemed that the markets had become very sensitive to small shocks and news, resulting in high volatility.
Understanding Oil Prices - A Guide to What Drives the Price of Oil in Today's Markets, Salvatore Carollo, ISBN 978-119-96272-4, 2012 (Page 10-17)
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The financial crisis of 2008 led to a collapse of the oil prices. As fast as the prices collapsed in 2008, they were rising again in the middle of 2010. In this period, the daily oil prices tended to walk random, with an upward trend.8 The history of the last two decades especially shows the great volatility of crude prices. Further, it makes clear that the pricing system is not always underlined by rational decisions. 9
CRUDE BENCHMARKS
Nowadays, there are a variety of different indicators for determining crude prices. However, there are three major international benchmarks. Two of them are mainly used for the western countries: WTI in the US, Dated Brent in Europe, and Dubai crude for the Asian region. 60-70% of the international oil trades are directly or indirectly based on the Brent Benchmark. Dubai crude, also known as Fateh, is used with Oman crude as the benchmark for countries from the Middle East. There is a new fourth index arising also: the Argus Sour Crude Index (ASCI). The ASCI benchmark is seen as an addition to WTI. In the long run there is an equilibrium relationship between these benchmarks where the world market is unified and homogenous. There is an impulse response function between the markets where WTI crude leads Brent and the ASCI; Brent leads Dubai and Oman crude. 10 Most of the crude prices are linked to benchmark prices plus or minus a differential, which represent a special type of crude in a specific area. However, these benchmarks represent a relatively low volume of production, while they set the price for a high volume of crudes. The problem becomes even more serious when the benchmark markets get tighter, and production rates are declining. In thin markets, the price discovery process becomes more difficult, and the danger of market players manipulating and squeezing the benchmark rises. 11 Squeezing occurs when a party goes long in the forward/future market with a volume that exceeds the physical market. It is only possible to squeeze a market if the parties have anonymity and if the parties are trading relatively huge volumes. The results are prices that are not reflecting actual market conditions and higher volatility.
Empirical Evidence of Some Stylized Facts in International Crude Oil Markets, Ling-Yun He, College of Economics and Management, Chinese Agricultural University,2008 (Page 2) 9 Probability Distribution of Return and Volatility in Crude Oil Market, Tung-Li Shinih, Hai-Chin Yu, MingoDao University Taiwan, 2009 (Page1-4)
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Lead-Lag Relationship between World Crude Oil Benchmarks: Evidence from WTI, Brent, Dubai and Oman; Mohammad S. AlMadi, Baosheng Zhang, China Petroleum University Beijing, 2011 (Page 1-5)
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In future markets the parties are anonymous, however, these markets are very liquid, so it is hard for one party to accumulate significant percentages in the volume in order to influence the market. The physical market is therefore much easier to squeeze, even though the parties evolved are known.
WORLD - BRENT CRUDE

Now, I will take a closer look at the Brent market, as it is one of the most important benchmarks for the international crude market. There is no simple explanation for the rise of Brent crude to the most important international oil benchmark. One contributing factor may be the geographic location of the Brent crude, as it is near the European refineries. Also, it is in an area controlled by the UK. The UK has a stable government compared to most OPEC countries like Mexico and Russia. Yet, the most important factor for the rise of Brent is that its ownership is highly diversified. This diversification can be seen in the exchange market rather than in the Brent OTC market. The Brent market developed in to a complex benchmark. Markets can only work effectively if they are open to a broad range of parties.12 An oligopoly-structured or monopoly-structured market could easily be manipulated, and outstanding parties would be reluctant to enter the market. As a result, these markets would not develop such a variety of financial layers. Crude markets in the past have been in such positions, with the Seven Sisters or the OPEC cartel. Further, a certain crude production volume is important for an oil benchmark as it assures a liquid market. Nowadays Brent production volumes cannot compete with crude field like in the Gulf of Mexico or the Middle East. During the high times of Brent in the 1980s, the daily trading volume was around 30 cargos compared to todays trade volume of less than one cargo. In order to add volume to the Brent field production, new streams were added: in 1992 the Ninian system, in 2002 the Forties and Osenberg system, and in 2007 the Ekofisk system. These crudes are now forming the BFOE benchmark (Brent Blend, Forties, Oseberg, Ekofisk). 13
AMERICAN - WTI CRUDE

The WTI crude has financial layers, like futures and option contracts and OTC derivatives. But these layers are fewer compared to the complex Brent market. In the US, the WTI plays the leading role. WTI plays a significant role in the global crude market, as the US is an important market for oil consuming, producing, and importing. The US market consumed more than 21% of the global world consumption in 2011. 14 They produce 10% of the global crude production. An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute for Energy Studies, 01-2011 (Page 36)
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Database: EIA Total Petroleum Consumption/Production 2011 13
All of Corda Corporation's production is somehow linked to the WTI benchmark, and changes in WTI directly affect the revenues.
Source: based on Today in Energy Feb 07.2012 IEA

Source: Database - IEA PADD Production 2011
In order to understand the US oil market, it is important to get the overview over the allocation of crudes in the US. The EIA divides the US into five "Petroleum Allocation for Defense Districts" (PADDs); these PADDs were defined in the Second World War. The most important PADD for the US crude production is PADD III, as it has large volumes of crude production and refining capacities. PADD II receives a special importance for the oil market, as PADD II has large crude storage facilities and refineries. PADD II can be divided into two subregions: Midcontinent with huge storage facilities and Midwest with refineries. The Midcontinent region is the heart of the storage facilities in the US and is gathering the crude 14
from Oklahoma to Texas. Cushing, a small city near Oklahoma City, is the delivery point for WTI crude future contracts. The storage capacity of Cushing exceeds 45 million barrels.
Acronym Name Type API Location / Composition
Benchmark
WTI ASCI LLS
West Texas Intermediate Argus Sour Crude Index Light Louisiana Heavy Louisiana Deep-water Mars Poseidon West Texas Sour Southern Green Canyon
Light sweet crude Medium sour crude Light sweet crude Heavy sweet crude Sour and medium crude Sour and medium crude Medium sour crude Heavy sour crude
39.6 Cushing, Oklahoma 38 37 31 30 Mars, Poseidon, SGC Offshore US Gulf Coast Offshore US Gulf Coast Offshore US Gulf Coast
Popular Crude Types
HLS
Mars Poseidon
29.1 Offshore Louisiana 33 Midland, Texas
WTS SGC
28.2 Offshore US Gulf Coast
As it is shown in the table above, there are a variety of important crudes in the US. However, most of these indices could not establish themselves as a leading benchmark. These crudes are defined by their physical characteristics and their production location. These popular crudes are mostly traded over the OTC market and measured by PRA in order to determine price differentials to the underlying benchmarks. Even though the US has a variety of crudes, WTI is the predominate benchmark. The WTI crude is produced in Texas, New Mexico, Oklahoma, and Kansas. The main difference between the WTI and Brent crude is that Brent is a waterborne crude, whereas WTI is a pipeline crude. Pipeline crudes like WTI have the advantage of a higher diversification in the physical market. As mentioned above, diversification plays a key role in the success of a benchmark. In the US the typical trading volume for a pipeline crude over the OTC market is around 30.000 barrel, a fraction when compared to the 600.000-barrel ship cargos traded on the Brent market. BOTTLENECK WTI However, the infrastructure of WTI cannot handle the traded volumes resulting in a physical bottleneck and in high price volatiles. Pipeline crudes have logistic- and storage- problems and are less flexible than waterborne crudes. Cushing is not accessible by tankers or ships. In history, the problem was to get enough oil into Cushing, resulting in a dislocation of the WTI price above international benchmarks. Nowadays, this problem has been solved and the problem has shifted in getting the crude out of Cushing to the refining hubs located in the Gulf of Mexico. The refineries around Cushing have a high utilization, and while supply is growing, refineries and pipelines are not.
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Source: Database - spot price from CME / ICE
Year 2006 2007 2008 2009 2010
Correlation (WTI to Brent) 0.960956621 0.973611742 0.99438944 0.983931855 0.936289999
2011 0.65571719 Brent is trading at a premium to WTI, as WTI has higher transportation and storage costs. The signs of this change began in mid 2007. As it can be seen in the graph above, WTI lost for a short time period the correlation to Brent beginning in January 2007 to July 2007. At that time, the explanation was that this shift would be temporary, caused by the impacts of the financial markets. It was not considered that these differences were the result of the physical limitations of Cushing. Besides, at this time imports, especially from Canada, were flooding the market, whereas North Sea production was steadily declining. In addition, the crude production in Midwest PADD II was rising due to the development of shale oil and gas, which became available through new technologies like horizontal drilling and more efficient ways of fracking. 15 As new crude reserves became available, the scarcity rent of crude declined, which resulted in a lower
What's the real price of oil?, Joachim Azria, Credit Suisse Fixed Income Research, 02-17-2012 (1-8)
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world crude price. However, these crudes were not able to reach the world markets since pipeline facilities were missing (compare Hotelling rule). The table above shows that the correlation (Brent,WTI) in the years from 2006 to 2009 was always above 0.95. This changes in 2010, yet still there is a strong relationship between WTI and Brent. It can be seen that the relationship has begun to weaken. In 2011 this relationship changes from a strong relationship to a moderate relationship: 0.65. This is mainly due to the huge discounts on WTI over Brent.

Source: Database - Crude Imports Report Feb. 2012 from EIA

Source: Database - Crude production by country from EIA
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Source: modified from Canadian Association of Petroleum Products, Crude Oil Forecast June 2011

Source: Database - Petroleum and other liquids, stocks from EIA
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In the following I want to show the impacts of Canadian crude imports on the WTI market. In 2011, almost 30% of crude imports came from Canada. Enbridge, a Canadian pipeline company, bought important pipelines in the US, like the 190-k bd Spearhead pipeline from Cushing to Chicago (red line in "Canadian and US Pipeline"). This pipeline system was pumping crude from the storage facilities of Cushing to the refineries in Chicago. Most of the Canadian crude imports are pumped towards Chicago and then to Cushing. Enbridge changed the flow of the Spearhead pipeline. Nowadays, Canadian crudes are transported from Chicago to Cushing over the 190-k bd Spearhead pipeline, resulting in a higher crude supply in Cushing. 16 It seems that this trend will extend in to the future, as Enbridge has new projects, like the expansion of the Flanagan South Pipeline, which will supply Cushing with more crude. The steady rise of the supply can be seen in the rise of stock inventories at Cushing, which are plotted in the graph above. If the supply in Cushing is rising, the costs for the storage are rising too. 17 One possibility of transporting the oversupply out of Cushing would be to transport it by railway or trucks to the US Gulf Coast. However, these ways of transportation are limited in their volume and only occur if the arbitrage between WTI and Brent is significant enough to equalize the higher transportation costs. Until there are no solutions found to debottleneck the oversupply in Cushing, the WTI crude will likely have a very volatile discounted relationship to Brent. Thus, investors will move their interest from WTI, towards Brent or ASCI. Additionally, this shift is supported by the negative roll yields in the short-term of WTI. It is interesting to take a closer look at the stock inventory during the financial crisis. Before the world financial crisis of 2008, crude inventories in Cushing were decreasing, while during the financial crisis, crude stocks were sharply rising as the demand was sinking. This underlines a positive correlation between the GDP growth rate and the stock storage in Cushing. If the WTI price is affected by local supply and demand in Cushing, WTI prices are not reflecting the supply and demand balance of the US or the world market. The WTI price in such a case would decouple from the Brent market. Further, the bottleneck of WTI directly impacts the revenues of Corda Corporation. The indices that are underlying for Corda Corporations crude production are all directly linked to WTI and have a high positive correlation. As a reaction to the WTI price volatilities in 2008, Saudi Aramco (NOC of Saudi Arabia), one of the leading exporters to the US, dropped WTI as their main benchmark in favor of the Argus Sour Crude Index (ASCI). This index was published by the price-reporting agency (PRA) Argus and is based on three types of US crudes: Mars, Poseidon, and Southern Green Canyon. The crudes from the ASCI are mostly located on the Gulf of Mexico, and thus they have not the logistical problems of a pipeline crude. The importance of the ASCI as the benchmark for the US crude market is rising on behalf of the WTI benchmark.
What's the real price of oil?, Joachim Azria, Credit Suisse Fixed Income Research, 02-17-2012 (Page 5)
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Canadian Enbridge to expand pipeline into Oklahoma, Tulsa World, 03-28-2012 19
IMPACTS ON OIL PRICES

In order to reduce the negative impact of oil price fluctuations it is important to understand what determines the oil price. There is no demand for crude oil from the end consumer. The demand for crude is deducted from its refined products. Further, crude is not a homogenous commodity; instead there are various different kinds of crude. The specific crude price is linked to the refined products that can be produced out of it. 18 An important key measurement for the physical components of crude oil is the American Petroleum Institute gravity (API). The API gravity calculates the density of crude. Water, for example, has an API gravity of 10, WTI of 39, Brent of 38, and Dubai of 31. Thus, Dubai crude is a heavier crude with higher a sulfur content. Heavier crudes have to be cracked or cocked and have, in general, higher sulfur content. Crudes with high sulfur content are referred to as sour crudes, and refineries have higher expenditures in removing the sulfur. Refineries can gain more gas and gasoline out of lighter crudes. Since crude prices are linked to the yields of the final products, light crudes achieve a premium over the heavy crudes.
SUPPLY AND DEMAND

There are a variety of explanations for the sharp swing in oil prices during the past decade. Some of these explanations are based on the tightening demand and rising supply side.
RISING DEMAND
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Source: Database - from World Bank World Development Indicators, International Financial Statistics of the IMF
The key driver for the demand of crude oil is the global economic growth.19 For example, during the financial crisis from 2008-2009, or during the dot-com crisis, the global demand for petroleum fell slightly. Still, the demand for petroleum had been growing rapidly by 12.6% over the last 10 years. As it can be seen in the graph above, the growth rate of crude production could not measure up with the GDP world growth rate. (Remember the graph - Cushing, stocks of crude and products and the impacts of the financial crisis)20

Source: Database - Crude Demand 2012 from EIA
The rise of the demand side is largely driven by non-OECD and emerging markets with high GDP growth rates. The shift of oil flowing to Asia is remarkable. These economies have a high GDP
Interim Report on Crude Oil Interagency Task Force of Commodity Markets, Commodity Future Trading Commission, 06-2008 (Page 8)
19
20
21
growth, while simultaneously their economies are shifting from being labor-intensive towards oil-intensive. Additionally, many of the emerging markets, like Indonesia and India, are supporting their economy by price subsidies on fuel oil. Due to subsidies, the oil price in some emerging economies is set below the global oil price, and the demand is not adequately responding to price signals, resulting in a higher demand for crude oil.21
TIGHTER SUPPLY

Source: Database - April 2012 Monthly Energy Review from EIA
On the other side, crude supply has not kept up with the crude demand. If crude prices are rising, oil reserves, which were not economical in times of low crude prices, will become available, and the crude supply will rise. In 2011 the non-OPEC crude production counted for 57.12%, with nearly 1/4 of this coming from Russia. The graph above shows the change in the production volumes in 2011 compared to 2000. While global demand and crude prices were rising, the non-OPEC countries, except Russia, couldnt keep their production in balance with the rising demand. The reason why the Russian production is sharply rising is due to private investments made after the fall of the Soviet Union. However, the graph shows that non-OPEC countries have passed the peak production, and that they are not able to hold the production levels from past decades, even with higher crude prices. OPEC producing countries and Russia are equalizing this imbalance of supply and demand. In order to supply the growing demand, OPEC has increased their production from 2000 to 2011 by 2.71 million barrels per day. However, the "call on OPEC," which is defined as the world
Oil Subsidies: Costly and Rising, Benedict Clemens, David Coady, John Piotrowiski, International Monetary Fund, 06-2010
21
22
consumption, subtracted by the non-OPEC production, has increased over the same period to over 7.07 million barrels per day. This imbalance results in tighter markets. 22 However, as it is getting more difficult to explore conventional crudes, OPEC production growth rates are slowing down. And in order to replace the production of conventional crudes, unconventional crudes have to be explored. Unconventional crudes are difficult to explore and are causing higher production costs. Unconventional crudes are all the crudes not produced from a classical wellhead. According to the IEA, unconventional crudes can have the following sources: Oil sands (i.e. Alaska) Oil shale (i.e. Forth-Worth Basin in Texas) Coal based liquid (i.e. German production in the Second World War) Biomass based liquids (i.e. Brazil) Natural gas based liquids
Expectations play a major role in the financial market and in the crude market. The current crude spot price should be based on expectations in the future, making changes in the price hard to predict.23 In the crude market there are a lot of uncertainties about the future in oil supply and demand. These uncertainties lead to a risk premium and increase demand, as the parties involved are gathering crudes and storing it for uncertain times. As a result, the oil price in future markets can differ from its true underlying value and may cause a crude bubble like in 2008.24 The result is an imbalance in rising demands and declining supply. This imbalance is likely to rise in the future and is the main reason for large and rapid price increases in order to reestablish the equilibrium between supply and demand.
22Database: 23
IEA Short Term Outlook May 2012
Interim Report on Crude Oil Interagency Task Force of Commodity Markets, Commodity Future Trading Commission, 06-2008 (Page4) Price of Oil: Manipulation? Bubble? Supply/Demand?, Natural Resources, 0606-2008 (Page 2-3)
24
23
INVENTORIES
24
Time Period 1992-1996 1997-2001 2002-2006 2007-2011
Correlation between WTI-Price and US-Crude Stocks -0.527304116 0.389332895 0.8459272 -0.261635432
Source: Database - US Stock history from EIA WTI pricing from NYMEX spot
One indicator that is used by crude market experts to predict future price developments is the US-Stock inventory. In order to determine if there is any correlation between crudestocks and crude prices, I plotted the WTI crude prices from different time periods to the crude oil inventories in the US. After the Hotelling theory, crude oil prices and inventories should have had a negative correlation. This means if crude inventories are rising, crude prices should be decreasing, and the other way around, everything else equal. The plot above shows that there is little systematic relationship between oil inventories and oil prices, especially in the last time period from 2006 to 2011. Furthermore, the correlation of the different time periods seems to vary. In the first period, from 1992 to 1996, there is a moderate negative correlation, which changes in the next five-year period to a weak positive correlation. This positive correlation cannot be explained by theory. Furthermore, in the period of 2002 2006, the correlation is high positive, whereas in the last period, the correlation changes again to a weak negative covariance. The relationship between crude inventories and crude pricing is not clear, and therefore, US crude inventories fail if used for future price predictions. 25 This plot diagram may show some evidence that speculation has an increasing impact on crude pricing. In the last period, from 2006 to 2011 it seems that there is almost no correlation between rising oil prices and US stock inventories. In past periods, the dots in the graph were closer together. Through excessive speculation, the future price would be above the equilibrium. This would result in higher stocks, as production would rise and demand would fall. Further, rising inventories could be interpreted in that way, that the market believes, that there is a relatively low scarcity today and that there will be a supply shortfall in the future. Otherwise, the market would have no need to hold crude inventories, as inventories have to compensate storage costs and interest costs.
SPARE CAPACITY
The party who controls the crude spare capacity sets the crude prices. The controlling party can be a superficial organization that sets quotas on oil like the TRC and OPEC or a private company,
The Role of Speculation in Oil Markets: What have we learned so far?, Bassam Fattouh, Lutz Kilian, Lavan Mahadeva, Oxford Institute for Energy Studies, 03-182012 (Page 13)
25
25
like the Standard Oil Company. However, these parties can only influence the oil supply as long as they have spare capacity and as long as they are taking on the role of a swing producer.

Source: Database - Short Term Outlook May 2012 from EIA
Today, OPEC countries still serve as a swing producer in the world crude market. The majority of the world crude production comes from National Oil Companies (NOC), like Saudi Aramco, a member of the OPEC. 26 However, there are concerns that OPEC countries are producing over the optimal production rate in order to stabilize the markets and that they are not able to serve as a swing producer in the long run. As seen in the graph above, OPEC surplus capacity stays low. Surplus capacities were sharply rising due to the world recession. These capacities are consumed and will decline to the lows before the recession. The spare capacity of 3.02 MBPD in 2011 is equivalent to 3.46% of the world crude consumption. This puts pressure on the supply market and on the crude price. Further, it is unclear who will take the role of the swing producer in the future; there may not be one. Besides, this low surplus capacity is also concentrated in a few OPEC countries, with Saudi Arabia holding the largest share, resulting in a higher geopolitical risk, because there is a lower diversification.
26
Database: Global Crude Oil and Liquid Fuels, IEA Short Term Outlook June 2012 26
GEOPOLITICAL UNCERTAINTY

Source: Database - International Energy Statistics; Total oil Supply from EIA
Oil production is highly concentrated in a few countries; this results in a higher risk of disruptions, as there is a lower diversification. In addition, in 2011, six of the ten largest crude- producing countries were either ruled by communistic parties or had nationalized their oil production and thus, have limited access to private investments. 27 Nationalized oil companies (NOC) have different aims compared to the private oil companies. The main aim in the private sector is to yield high returns, reached through a full and q uick development of oil prospects, with enhanced experts and technology. On the other hand, nationalized oil companies are driven by political agendas and public interests. Therefore, private oil companies would be more efficient in the supply of crude. 1 This phenomenon is described by the Hotelling rule of a monopoly supply, which will be discussed later. Geopolitical disruptions frequently appear in oil-supplying countries. It seems that oil-supplying countries are addicted to being unstable. During the last two years there have been over a dozen supply disruptions, lasting from a few days to a few months. These disruptions mainly occurred in the Middle East.
27
27

Source: unplanned production disruptions from U.S. Energy Information Administration
In the first quarter of 2012, four countries were responsible for the main unplanned production disruption: Canada, Libya, Sudan, and South Sudan. In 2011 Libya was holding in almost their entire oil production of about 1.65 mbbl/day due to a civil war, resulting in a crude price drive in the end of 2011. However, the situation in Libya got under control, and the offline production in April 2012 went down to 350 mbbl/day. In July 2011, South Sudan became independent from Sudan. Sudan and South Sudan had an argument over the pipeline transit fee, and South Sudan shut down their entire production of 460 tbbl/d.28 The disruption in Canada was caused by technical upgrades in the Alberta oil sand production facility in the mid of March and unplanned repair from February until March at the Horizon Oil Sand production facility. The analysis of the first quarter of 2012 shows that disruptions occur frequently and randomly. Political disruptions have long-term impacts on the crude supply compared to short-term technical disruptions. These supply disruptions directly affect the physical oil market and lead to a shortage in supply. Through the limited spare capacity, geopolitical problems cannot always be absorbed resulting in crude price jumps.
Crude Oil: The Shifting of Global Supply Disruptions, Where Food comes from, 418-2012
28
28
WEATHER UNCERTAINTY
In addition to geopolitical uncertainties, there are weather uncertainties which can have huge impacts on the supply side. Weather uncertainties are relatively similar to geopolitical uncertainties, as they occur frequently and randomly. These uncertainties include flooding, earthquakes, and hurricanes. These disruptions impact the crude production, refineries, or the transportation system. One typical example of a weather uncertainty is the frequently occurring disruptions during the hurricane season in the Gulf of Mexico from June to November.
EXCHANGE RATES
The crude price and the exchange rates are both variables that generate a significant impact on the real economy. The relationship between the crude oil price and the exchange rates is complex, and causality can affect each other. 29Crude is typically priced in dollars, and a depreciation of the dollar leads to a rise in the oil price; all other factors are equal. For example, if the value of the dollar depreciates against other currencies, it could boost foreign demand. Additionally, foreign oil exporters could suffer in their purchasing power of their earning. Thus, these exchange rate movements are canceling each other out. The United States has changed over time, from being a net oil exporter to a net oil importer, and this counts not only for their oil imports. The United States has a significant trade d eficit, resulting in increasing concerns about the sustainability of the US d ollar, and it sets the oil price against other currencies under pressure.

Source: Database: Yahoo finance (US.Dollar index); IEA (WTI Spot Price)
29
29
The above graph plots the WTI spot price and the U.S. dollar index performance since the beginning of November 2011. It seems that the negative correlation between the dollar and the oil price is lost over the time period of March YEAR??? to the beginning of May 2012. The latest tensions between Iran and the West have resulted in a rise of the oil prices. While the U.S. dollar index gained as the European currency struggled, in May 2012 the correlation snapped back to a normal negative correlation. The latest development shows that crude price developments are unpredictable and that long-term relationships and indicators can change in the short run.30
INTEREST RATES
The impact of changes in the interest rates, set by the FED on the oil price, is not evident. There are many studies about how the interest rate influences the oil price, and their results differ. However, a decline in the interest rates tends to lead to a raise in the oil price, all other factors equal. One explanation for the phenomena is that, if interest rates are declining, costs for oil- storing inventory are sinking, and thus, the temporary demand is rising. Furthermore, oil demand in general will rise due to a higher economic activity. Of course this phenomena will not occur if the reason for the decline in the interest rates is due to a struggling economy where low interest rates boost the economy. In a crisis, the oil demand will decrease and thus the oil price will decrease. The federal fund rate is still 0.25% almost four years after the financial crisis. Nowadays, these low interest rates may not be impacted as much from the financial downturn of 2008 and result in a rising oil demand and oil price.
SCARCITY RENT- MODEL OF HOTELLING

The Hotelling model is one model for the prediction of prospective oil prices.. In 1931, Harold Hotelling described in his article The Economics of Exhaustible Resources the scarcity rent of non-renewable resources. Mr. Hotelling explains how non-renewable resource owners are maximizing their present value until the completion of the resource. The Hotelling model should be seen as a general approach. It gives the theoretical idea of factors that are influencing the oil market.31 Economists define non-renewable resources as a commodity that cannot be replaced during the time period of demand. Through its limitations, the price for a non-renewable resource contains, besides the production costs, a scarcity rent. Hotelling assumes that the oil market is a competitive market, without barriers preventing rivals from entering or leaving the market. Another important context: the model is based on the efficient market hypothesis, which
Ties That Bind Oil and Dollar Snap, Christian Berthelsen, The Wall Street Journal, (03-07-2012) 31 Nonrenewable Resource Scarcity, Jeffrey A. Krautkraemer, Journal of Economic Literature, Dec. 1998 (Page 1-10)
30
30
proposes that stock prices reflect all available information. Further, it assumes that producers are price takers and could sell any quantity at the market price. Inexhaustible resource:
Pt = MCt
Exhaustible resource:
Pt = MCt + P0(1+r)
As oil is a non-renewable good, the producer has the option of leaving the crude in the ground for future production or producing the crude today and receiving interest (r) on the yields. The producer will hold the oil as a reserve if he believes that the future price will be above the interest rate (r).

Source: ON THE ECONOMICS OF NON-RENEWABLE RESOURCES
If the crude price were to rise slower than the interest rate, producers would sell off their stocks in order to receive the interest. If the crude price were to rise faster, producers would hold their stocks for the future. As seen in the left graph above, the market would get tighter and prices would rise exponentially. Furthermore, as prices rise, the production rates would continuously fall, as the resource stock gets exhausted (left graph). 32 The demand, on the other hand, would be cut off at a certain price level and in order to sell crude, the producers would have to decrease the crude price. In this model, the quantity produced would be the result of the equilibrium of the price rises in crude and the exponential interest (r). It makes no difference between selling a barrel today or at a future point. 33 34
Natural Resource Economics under the Rule of Hotelling, The Canadian Journal of Economics, Vol 40, No 4., 11-2007 (Page 1043)
32
On the Economics of Non-Renewable Resources, Neha Khanna , Invited contribution to Encyclopedia of Life and Social Sciences, UNESCO. Forthcoming,
33
31
However, there are four variables that confuse this steady development: Fluctuations in demand Changes in the extraction costs New crude discoveries Alternative fuels (backstop technology)
CHANGES IN THE EXTRACTION COSTS

In the Hotelling model, a change in the extraction costs has no impact on the absolute scarcity rent. The productions costs, the resource price minus scarcity rent, will rise and fall with the higher and lower marginal extraction costs.
Rt=Pt-MCt
Production costs would decrease as new technologies, like horizontal drilling or advanced fracking methods, promise a higher recovery. As a result of decreasing production costs, net prices can decrease in the short-term, as long as sinking production costs are outweighing the rising scarcity rent. Yet, after all this, the prices would rise even quicker, as the resource would be exhausted more quickly. Production cost would rise, since it would be getting harder to produce conventional crude. There are still new discoveries of conventional crudes. However, these discoveries are in remote places, and the production has to move to locations of extreme conditions, like to the offshore fields of the Gulf of Mexico or to fields near the Arctic. If conventional crude were depleted, expensive unconventional crude resources would have to be produced.
NEW CRUDE DISCOVERIES

One of the most important variables in the Hotelling model is the measurement of reserves. As reserves are rising, the scarcity of the resource is sinking and thus the scarcity rent is sinking too. The reserves are based on estimates and are continuously changing. The big crude discoveries in the 1980s resulted in low crude prices. Nowadays, new crude discoveries, like the offshore discovery of Petrobras, close to the coast of Rio de Janeiro, are relatively rare and not as big as historical discoveries.35 Department of Economics and Environmental Studies Program Binghamton 0130-2001 (Page 2-10) Hotelling Revisited: Oil Prices and Endogenous Technological Progress, Cynthia Lin, Haoying Meng, Tsz Yan Ngai, Natural Resources Research, 03-01-2009 (Page 1-10)
34 35
Petrobras finds new offshore oil reserves, Oil and Gas Technology, 03-13-2012 32
Resources are the total amount of undiscovered and discovered oil. They contain the produced oil as well as future predictions. Reserves are a part of the resources and are the economically and technically producible in the future. OOIP URR EUR Reserves Original Oil in Place Ultimate Recoverable Resources Estimated Ultimately Recoverable Proven Probable Possible Total Oil Resources Produced + Reserves 90 % probability 50-89 % probablity 10-49 % probability
BACKSTOP TECHNOLOGY
A backstop technology is a substitute for the non-renewable resource, like ethanol from sugar in order to use as crude. 36This resource can be produced at any quantity if the price reaches a certain level. When the price of crude is higher than the price of the renewable energy, the demand will switch to the renewable energy source. This switch can be seen in the oil market. High volatility and rising crude prices in the past decade have led to higher interest in non-conventional transportations fuels, like biofuels, GTL fuels, and CTL fuels. As a result, the crude market has rising impacts on the corn market, and the correlation between these markets is increasing.
Crude Oil Price Forecasting: A Statistical Approach, Armando Lara, Michael Leger, John Auers, National Petrochemical & Refiners Association, 03-18-2012 (Page 6)
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33

Source: ON THE ECONOMICS OF NON-RENEWABLE RESOURCES
IMPACTS OF A MONOPOLY
Lets assume OPEC has a monopoly market position. In this situation, crude prices would be higher in general and would rise more slowly, as the extraction would be slower. It is assumed that a monopoly would not complete the resource as fast as it would in a competitive market, and thus, oil production would last longer. Todays crude market is far from a monopoly market structure and is more characterized by perfect competition. On a country-based view, there are monopoly structures with NOC controlling the entire local production. 37The governments of these countries will adjust their production rates to their political agendas and will extract their crude reserves more slowly than private companies would. However, they are acting independent from other governments nationalized oil companies. The crude market was, with the Standard Oil Company, a monopoly market. OPEC countries as a whole never had a monopoly position, as the members were not acting as a group. OPEC members were acting independently from the group decision. This phenomenon is also known as the "Prisoner's Dilemma:" every country is acting in its best interest, so every party has an incentive to cheat on their production quotas.
On the State's Choice of Oil Company: Risk Management and the Frontier of the Petroleum Industry, Peter A. Nolan and Mark C. Thurber, Program on Energy and Sustainable Development, 12-2010 (S4)
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34
PRICE-INELASTIC IN THE SHORT TERM

In the short run, the demand for finished products and the supply of crude are relatively price inelastic. It takes huge price increases to lower the demand in the short-term. The price elasticity of the crude demand is less than 1.38 As a result, the expenditures for crude as a percentage of GDP are rising when oil prices are rising. The price elasticity of crude oil is difficult to calculate, as there are a variety of different parameters influencing it. James Hamilton calculates the price elasticity in his NBER Working Paper No. 14492 and finds evidence for the low price elasticity. It is interesting that the price elasticity for crude oil is higher in emerging markets compared to developing countries.39 % Change in oil demand < % Change in oil price The supply side is through the limitations in crude production in the short run prices inelastic. There are limited spare capacities, and in the short run the supply of crude is not affected by the market price. It takes time for oil producers to adjust their production rate to market demands. Further, some oil producers are already producing at their limits and cannot react to rising crude prices. As noted before, oil production cannot keep up with the pace of the world economic growth, resulting in a tight crude market. In this market, unplanned production disruptions result in huge price increases, as these short-term production cuts cannot be absorbed. As a result, the market is very volatile, and in order to reach a temporary equilibrium between supply and demand, it takes huge price increases and decreases.
PRICE VOLATILITY
In the following I want to determine the price volatility and the impacts on crude producers.
38
Understanding Crude Oil Prices, Matt Nesvisky , The National Bureau of Economic Research, 06-12-2012
39
35

Source: Database - spot WTI from IEA
The graph above shows the volatility of crude prices in the last decade. Most of the peaks are due to economical booms or recessions. The abnormal peak in 2009 was caused by the world financial crisis. However, it seems that these peaks are getting bigger over time.
Count Mean Median Max Min Standard Deviation Skewness

Source: Database - spot WTI from IEA
843 0.0605 0.1100 7.6200 -8.9000 1.7182 -0.2606
The daily returns of WTI crude oil are plotted in the graph above. It can be seen that these returns are not following a normal distribution. The standard deviation is relatively low, which means that the majority of returns are clustered around the median. Furthermore, the 36
distribution is left skewed. This implies that most of the values are concentrated on the right of the mean, with extreme values to the left. The results from this graph are characteristic for crude pricing. It shows that huge negative fat tails disrupt the general trend. 40 In the last period of low oil prices in 1999, many of the major oil companies were moving their focus out of the United States as the recovering costs were too high. For example, the cost of recovering one barrel of crude out of the Gulf of Mexico is roughly $12, compared to OPEC countries, that have production costs of less than $2. 41 The oil business in general is a very volatile business, mostly depending on the actual oil price. Oil and gas producers are drilling circadian. They are spending too much money for drilling or the acquisition of new plays during times of high oil prices, resulting in a short cash flow during times with low oil prices. These producers have questionable methods for reducing fixed costs. During periods of low oil prices, it may be economical to "shut in" a well and wait for higher oil prices in order to eliminate the fix costs for keeping up the well structure. However, there is the risk that the reservoir is damaged during the closing time and has to be re-drilled.42 Besides, the exploration and production company may not be able to shut a well in for a longer time period, as the company has to pay back the drilling and completion costs to investors and banks. The costs for drilling an onshore vertical well in Texas are roughly about $300,000 and the costs for completion are about $100,000 In order to refinance these expenditures it is important to have a continuous return flow. Another possibility of reducing fix costs during periods of low oil prices would be to lay off personal like oil engineers and geologist in times of low oil prices. This strategy is used by many majors and second tier integrated. They have huge layoffs and employments, depending on the oil price. Of course, circadian fire and hire employee politic are not sustainable and great institutional knowledge is getting lost. Institutional knowledge is a crucial factor in the competitive advantage of an oil company. In the oil business, every play in a region has its special characteristics i.e. the formations or service companies. The management of Corda Corporation realized that these firing and hiring cycles were extremely costly for the company and made it to their advantage. The corporation is very lean managed and has only one engineering office in Wichita Falls. The director of the engineering office in Wichita Falls, Paul Leming, followed the footsteps of his father-in-law and has been working for Corda Corporation for 10 years. Thus he has a huge experience in the local oil fields
World Crude Oil Markets: Monetary Policy and the Recent Oil Shock ,Noureddine Krichene , IMF Working Paper, 03-2006 (Page 10-20)
40 41 42
Database: FACTBOX-Oil production cost estimates by country, Reuters 07-2009
Risk Management at Apache, Lisa Meulbroek, Harvard Business School, 08-272001(Page 4) 37
and the local structure. If the workload reaches the capacity of Corda Corporation, work is outsourced to local companies. RESTRUCTURING OF CORDA CORP Even more affected by the price changes are the suppliers of the oil producer, like for example the drilling rigs. Quoting Mr. DeCleva junior: "The oil service43 industry, are the last who are benefiting from high oil prices and the first who get out of business, if the prices go down." As explained above, most oil E&P firms nowadays do not own the drilling rigs. These services are outsourced. The business of drilling rig companies is more volatile than the E&P business. If the oil prices are high, drilling rigs are booked over 12 months in advanced, whereas if the price goes down, many oil plays are not economical for development, leaving the rigs tied up at the docks. Corda Corporation had to make this experience in the 1980s. Besides the exploration and production risk Corda Corporation had to manage the risks arriving out of the oil service industry. During the 1980ts the oil industry was near its margin of substance. Due to a massive oil oversupply in the mid 1980s oil prices were tumbling to new lows and so did the profits of most oil businesses. Many oil firms, especially mid and small sized firms had to declare bankruptcy. Corda Corporation and its affiliates were running three drilling rigs and a payroll of 30 employees, mostly roughnecks, engineers and geophysics. In 1986, Corda and its affiliates sold its drilling rigs at a steep discount, thereby allowing it to focus exclusively on prospectives and exploration. Rig services were outsourced and Corda Corporation had to reduce staff and overhead. Corda Corporation went back to a long-term oriented view with lean structures. This policy still dictates today's decisions and set a basis to the success of today's business.
INTRODUCTION TO DERIVATIVE OIL PRODUCTS

In the following I want to take a closer look at the derivative market as it plays a major role in todays crude pricing system. The rising influence of the paper market became possible through the development of the market pricing system. The two main markets for trading oil are the standardized exchange market with futures, options and the OTC market with forwards and swaps. The first standardization appeared in 1978 when heating oil was traded on the NYMEX. In 1983 crude became available for future trades. At the beginning of the future market, most of the crude was still hedged over the OTC market where the counterparties traded without a third clearing party. 44Beginning in 1988 crude prices were linked to benchmarks.45 This gave the
Reservoir Digs: on energy investing and private equity, JP Morgan, 03-22-2012 (Page 1-2)
43
Risk Management at Apache, Lisa Meulbroek, Harvard Business School, 08-272001(Page 5)

44
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producer and the consumer some kind of confidence that the crude price was grounded in the physical dimension of the market rather than set by oil majors or OPEC. Over time this led to the complex and interlinked structure with the spot market, futures and options. In todays world the price of the benchmarks cannot be isolated from financial layers. Spot cargos, for immediate delivery of crude are rare. 46 Through the high volatility of crude prices and their huge impacts on the daily business, the need for the producer evolves to roll over the risks to the market. By using derivatives the oil producer can focus on their strengths and build out their comparative advantage while they don't have to worry about the short-term price volatility.
OTC DERIVATIVE
The International Organization of Securities Commissions (IOSCO) reported in 2010 that 45% of the trades in crude or petroleum products were over the OTC market; the remaining was traded over exchanges. In the OTC markets in general there are more physical traders, including producers, refineries, downstream consumers, and physical traders. Financial players are trading for the purpose of speculation and are marginally presented in the OTC market. However, more and more OTC deals are traded over clearing houses. The OTC market has shifted from a market where parties were negotiating over brokers or face-to-face to a market over electronic OTC and became more similar to exchange markets. There are two main OTC derivatives for crude: forwards and swaps. I will focus especially on the forward market, as the forward market sets the price differentials.
45
46
39
One popular forward is the 21-day BFOE contract. For example, the producer of a Brent field can sell on the forward market one cargo, 600.000 barrel of the projected field production of July in May. After the loading schedule is finalized the purchaser receives at least 21 days before the actual loading date - a notice of the exact three-day loading window. The purchaser of the cargo of crude may not want to receive a physical load of crude and thus he sells his contract before expiration and is booking his position out. The purchaser, who is holding the 21 days BFOE beyond the expiration date, has to take the physical delivery. When the delivery date is known, the 21-days BFOE cargo turns into a Dated Brent cargo. Dated Brent, Dated BFOE, Dated North Sea Light (Platts), or Argus North S ea Dated refer all to the spot market, where a cargo has a specific loading date. However, Dated Brent contracts are not delivered immediately and still have a forward element that can be traded. In fact, the Dated Brent price published reflects the price of crude, delivered between 10 and 21 days ahead. For example, the Dated Brent on the May first represents the price for crude delivered on May 11 until May 22. The linkage between the forward Brent market and the Dated Brent market is through the Contracts for Difference (CFD) swap market. In the CFD market buyers and sellers can swap differences between positions of the Dated Brent and forward Brent.
47
PRICE REPORTING AGENCIES

The indices for the physical market are, unlike in the future market, where they are in real time, reported or assessed prices. Assessed prices are needed in elliptical or illiquid markets. 48Pricing reporting agencies (PRAs), like Platts and Argus, are assessing prices by asking as many trading parties, as possible, where they see the market. Price assessments from OTC markets are used to set billions of dollars worth deals. Around these PRA indices there have emerged many financial layers traded in the OTC and regulated exchange market. All kinds of forwards, swaps and futures have evolved using physical indices for speculation and hedging. The different indices published by the PRAs differ in their methods of price assessment and in the form of valuating bids, offers, and observed deals. In general observed deals are more representative for a market than bids and offers. If the physical market gets to illiquid, this is the only way for evaluating a price level. The trading parties behind the bids are known. The PRAs
47
An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute for Energy Studies, 01-2011 (Page 7-31)
48
40
decide which information they are using. Thus, physical indices have a big element of subjectivity. For instance, ASCI, the main index from Argus, and an important benchmark for US markets, is mainly based on observed deals during a day. The Platt's index has the same underlying data, however Platt's method differs from the Argus method, as Platt's only looks at deals in a certain time window. Platt's was using a volume-weighted average pricing system until 2001, when it changed to the market-on-close (MOC) methodology. The problem of the volume-weighted average pricing system used by Argus, is that it is always representing prices in the past, and thus it is lagging behind. This is especially a problem in high volatile markets. In the MOC system, there is a certain time window in which the markets are analyzed. The criticism about the MOC system is that involved parties may change their trading strategy in order to influence the benchmark, thus it would not be a reliable source for the physical market. This time window will only represent a fraction of the real market transactions and trading parties. The traders could for example, accept higher or lower offers during the Platt's time window. This would distort the market price. The losses made during the time window could be easily compensated over extern derivatives as the price direction is known. There are concerns about the huge influence of the PRA on the oil commodity market. In November 2010 the influences of the PRAs were discussed by the G20 and analyzes were done by the International Organization of Securities Commissions (IOSCO).49 The result is that PRAs are under a special oversight of the IOSCO and the G20 governments have imposed more control on the oil markets. PRAs, like Argus or Platts, are private companies, each having their own methodology of assessing prices. The difference of one to another PRA benchmark is over time less than one dollar. However, on the daily time, the differences for the same benchmark can be significant and has important implications on the export earning respectively on the financial flows of the involved parties.50
FUTURE MARKET
The advantages of standardized futures over forwards are that the exchange matches the parties and takes over the counterparty risk resulting in a higher liquid market. On the other hand, forwards have the advantage that they are more flexible in their contract agreements like location, price, or time. For example, WTI crude is priced in Cushing, Oklahoma. The entering party in the future contract has to take over the responsibilities of delivering the crude to Cushing even if the crude goes to a refinery on the Gulf Coast.
49 50
Oil price agency Platts too powerful, regulator told, Reuters, 04-05-2012 41
Future and option trading is mostly done through the electronic platform GLOBEX. The advantage of GLOBEX over an open outcry system is that GLOBEX provides access to a larger range of people and is almost around the clock. It is important to link both, the forward and the future market, in order to ensure the efficiency of the crude market. The oil price in a forward market is linked over the Exchange for Physicals market (EFP) to future contracts.
SPECIFICATIONS OF LIGHT SWEET CRUDE AND BRENT

In the following I will take a closer look on the future specifications of WTI and Brent, as they are important for the hedging strategy of Corda Corporation. WTI is underlying the Light Sweet Crude future contracts, traded on the NYMEX. These contracts are some of the largest traded commodities in the world. The settled price on the NYMEX has huge impacts on the physical market. Prices are "discovered" on the future exchanges and are taken as a benchmark for the physical market. The success of the Light Sweet Oil futures pushed WTI up in the global understanding of the oil pricing. Later, Brent futures were established and traded on the ICE in London. The settlement of Light Sweet Crude futures is through physical delivery compared to the cash settled Brent futures. Crude futures are highly standardized. For example, the Light Sweet Crude future has defined characteristics, like an API gravity of 39.6 and one contract, 1000 barrel has to be delivered at a specific date to Cushing. The Light Sweet Crude contract allows also the delivery of similar crudes to WTI like Low Sweet Mix and New Mexican Sweet. In the Light Sweet Crude future market the current delivery month expires on the third business day prior to the 25 calendar days of the preceding month. For instance, a June 2012 WTI future contract, expires on May 22, 2012. After the expiration it takes three days for scheduling the pipeline date, also known as the roll period. However, at NYMEX only about 0.4% of the futures are actually taken as physical delivery, the rest are closed out over offsetting contracts. The Brent futures are traded on the InterContinental Exchange (ICE) in a size of 1000 barrel per trade. These contracts are cash settled. In order to link the paper market to the physical market there is the option through physical delivery over the Exchange Futures for Physical (EFP). The EFPs are traded outside the exchange market. Where Party A wants physical commodities and swaps their futures to Party B in exchange for a forward agreement.
FUTURE CURVES AND PRICING

The behavior of the future curve is important to the pricing of crude. The future price rolls at a certain time into the spot price. Unlike other commodities like gold, the future curve of oil is under normal conditions in backwardation. This means that near future contracts will be traded at a higher price, compared to future contracts, with expiration dates further away. In conclusion, a future paper in backwardation will outperform the spot market.
42

Source: Database - Crude Production 2011 from IEA
The graph above plots the WTI and Brent future curve from the view of May 17, 2012. The steps of the Brent future curve occur due to different time periods of WTI and Brent. These two curves differ significantly. The bottleneck of WTI mentioned above and the resulting storage problems changed the WTI future curve. This is why the future curve of WTI crude begins with a contango and then changes after three months to backwardation. The formula for determining the price of a future is:
F0 = S0 e(r+u-y)^T
Where (F0) is todays future price, (S0e) is todays spot price, (r) is the riskless rate, (u) the costs for storage, (y) the convenience yields, and (T) the time from now to the expiration date. (r) and (u) are also known as the "costs of carry." In order that the future price is lower than the spot price, (F0 ) < (S0e,) the convenience yields have to be higher than the riskless rate and the costs for storage. Furthermore, (F0) declines as (T) gets larger. If futures are in backwardation, it means that there is an advantage of physically having the crude, rather than on paper. What is the advantage of physically having the crude? In order to understand the advantages of physical crude, I have to take a closer look at the crude characteristics.51 Crude is characterized by: Crude is actually consumed, unlike gold, which is mainly for a financial commodity Actual consume is highly volatile and is driven by a variety of parameters Crude inventories are relatively low
Futures Pricing- Contango and Backwardation, Jim Finnegan, Chartered Financial Analyst, 43
51Commodity
Consuming, in the short run, is price inelastic The supply has a high risk of disruptions Inventories for crude are expensive
Crude has high costs of carry, as it has high costs for storage and a high riskless rate. Crude can be used conditional as a security and if only with an advance payment resulting in a higher riskless rate. This would favor future price curves to be in contango. The high costs of carry, especially in the commodities market, are the reason why most commodity future curves are in contango. As mentioned above, oil supply and demand are full of uncertainties. The supply side has to guarantee that the demand for refined products is always met, independent from supply disruptions or higher demands. As supply has to be guaranteed in order to fulfill contracts, the suppliers can't take the risk of selling inventory and buying future contracts. According to Dr. John Hull the convenience yield of crude futures reflect the markets expectations concerning the future availability of the commodity. The greater the possibility that shortages will occur during the life of the futures contract, the higher the convenience yield. Therefore, convenience yields occur out of the risk aversion of the supplying party.52 However, this explanation only applies to physical parties and not to the financial speculator on the future market. What is the convenience yield for the financial speculator in crude? One explanation comes from John Maynard Keynes. Keynes argues that speculators are acting out of the same intention of risk aversion as physical parties. The physical parties are holding crude inventories and are selling futures out of the purpose of risk hedging. Speculators buy these futures, and they have to carry the risk. The risk was rolled over from the physical parties to the financial parties.
Commodity Futures Pricing- Contango and Backwardation, Jim Finnegan, Chartered Financial Analyst
52
44
Crude future curves are not always in backwardation. However, during the last decade the future curves have been mostly in backwardation. If future curves are in backwardation, roll yields can be made, as the expiration dates come closer, the future price is rises. They are the difference between future prices and spot prices. The historical development of roll yields can be seen in the graph above. In November 2008, due to the financial crisis, the future curves changed and stayed in contango until October 2011. The crude future curve was in contango as the market became less tight and crude prices fell. The result was that the crude prices and the absolute convenience yields sank, while the absolute costs of carry stayed the same. But, the relative carry costs increased compared to the crude price. Thus, the carry costs outweighed the convenience yields, resulting in a contango future curve.

Source: Database on IEA Future price and CME WTI crude Spot price
45
In the two graphs above, future curves at different times are compared. The data was taken on May 22 1987, and every 5 years after that, until May 22 2012. Contract 1 is in the nearest future for the next month in our example for June, contract 2 is for July, and so on. The future curves changed during this time period from backwardation in 1987 and 1992 to a more horizontal future curve.
SPECULATION IMPACTS ON CRUDE MARKETS

It is a widespread opinion among market experts that the increase in the crude volatility is the result of a changed market structure. Crudes commodities acquire the characteristics of financial assets, rather than being actual physical crude. The financial players are manipulating the true crude price through their investment strategies. As a result, commodity markets are no longer adequately performing their function of the crude price discovery. 53 In the past, commodities were only traded by physically involved parties or financial experts. The shift from the open outcry to electronic trading systems enabled a wider audience to participate in trading commodities. Due to the growing audience, there is a need for financial innovations. 54 New financial products have been developed and the unlimited variety of products make the market more complex. Speculators are using the commodity market for portfolio diversification, since there is a low or negative correlation between stocks and commodities. Commodities are seen as a safe harbor in times of high inflation and weak currencies. Unlike the pure financial derivatives, oil is linked to a physical market where crude is demanded, stored, and widely traded by the various parties. Thus, the prices in the financial markets should adjust themselves to the spot prices in the physical crude market. However, the crude market is more complex, and it is not always clear if this relationship is accurate. The oil price is underlined by the reference price set on the future market. The forward markets set the price differential. The PRAs are assessing these price differentials and publish the physical benchmarks. The spot market will use the future prices as a barometer and set a differential based on bids and offers from the OTC market. If the future market becomes detached from the underlying fundamentals in the physical market, the differential shall rise. The key question is this: is the differential strong enough to balance an unjustified change in the future market?
The Role of Speculation in Oil Markets: What have we learned so far?, Bassam Fattouh, Lutz Kilian, Lavan Mahadeva, Oxford Institute for Energy Studies, 03-182012 (Page1)
53
54
46
PARTIES ON THE FUTURE MARKET

Parties on the future market are trading out of different intensions. There are two main types of parties: hedgers that have a commercial interest and are connected to the physical market, and speculators. The Hedgers purpose on the future market is mainly to roll over risks to the market. Speculation, in the public mind, is often viewed as negative and excessive. Excessive in the way that it harms society and is only beneficial for the private person. 55 The aim of a speculator is to gain profits out of a price change in crude. These are the financial players: swap dealers, pension funds, hedge funds, mutual funds, technical traders, index investors, and individuals who are trading in high volumes. Typically, they do not want to take the physical delivery of crude, and thus they are for example in a WTI future going short before the expiring date, or if it is Brent or ASCI future, take the cash settlement. 56 Speculators can b e distinguished depending on their time horizon in which they trade. Scalpers are trading within seconds in order to sell position at a slightly higher price than they bought it. They are the market makers and insure that the market stays liquid. The other type of speculators take, depending on their opinion about the future oil price, long positions in one month and settle them with short positions the next month; they are important for the price discovery. It is important to understand the difference between the price level and the price differential. In our financial system, the actual oil price, which is frightening for consumers and governments, is not the major interest for the speculator. Parties can only make profits if there is a spread. They trade on spreads between crudes of different regions, times, and qualities. Thus, volatility in the market is necessary in order to make profits. The trades, concerned with the oil price level, become less interesting.57
The Role of Speculation in Oil Markets: What have we learned so far?, Bassam Fattouh, Lutz Kilian, Lavan Mahadeva, Oxford Institute for Energy Studies, 03-182012 (Page 2-10)
55
56
57
47

Source: Monthly Crude Report from CTFTC (May-2012)
The U.S. Commodity Future Trading Commission (CFTC) publishes the Commitments of Traders Report each week. In this report the parties involved in the future market are analyzed and divided into two groups: first the commercial participants include producers manufacturers and swap dealers. These parties are acting out of the purpose of hedging and second, the non- commercial parties, include hedge funds, floor brokers, and traders. These parties are speculating in the oil market. The first two graphs, commercial open interest and non- commercial open interest, show the open interest in oil futures. In the second two graphs, the net positions of the commercial and non-commercial parties can be seen. Commercial parties are generally short, whereas non-commercial participants are net long (see mutual funds). If the development of the open interest of both parties is compared, it becomes clear that the non-
48
commercial parties gained on weight in the future pricing. Thus, the long futures of the non- commercial parties could drive the future market.58 The mutual fund and hedge funds play an important role for the future market as they enter positions over long time p eriods. Both of these parties act out of financial speculation. By rolling their entire position forward on a regular basis, they can increase the pressure on the crude price. The interest of hedge funds in the commodity market increased over time as the expectations of the investors changed. In the past, hedge fund returns were compared to the returns of popular indexes like the Dow Jones or the S&P 500. Nowadays, hedge funds are assessed by their absolute returns, and the expectations on the hedge fund yields increased. Hedge funds have a rising interest in commodity assets, as they have, compared to stocks, a higher volatility with the opportunity of higher returns.1 Mutual funds are only allowed to enter into long p ositions, resulting in a long position bulge. As mentioned above, in order to ground the paper market with the physical market, both markets are linked. From the paper market there is a lot of information, impacting the forward market. Thus the question remains whether the paper market drives the forward market or the other way around. In February 2012 at a crude price of $108, Forbes magazine estimated that more than 21%, $23.39, was due to speculation on the crude price. 59 Forbes based its calculation on the assumption of Goldman Sachs estimates. Goldman Sachs believes that every million barrels of speculation adds $0.10 to the actual crude price. In the mid of February the held positions for crude speculations on the NYMEX where $233.9 Mio and thus, the Forbes magazine concludes that this equals $23.39 or 21% speculation on the actual crude price level.
The Role of Speculation in Oil Markets: What have we learned so far?, Bassam Fattouh, Lutz Kilian, Lavan Mahadeva, Oxford Institute for Energy Studies, 03-182012 (Page 5-10)
58
Speculation In Crude Oil Adds $23.39 To The Price Per Barrel, Robert Lenzner, Forbes Staff 02-27-2012
59
49
ETFs, ETNs, and ETCs are examples of investment instruments for the layman wishing to speculate in crude commodities. In the following I want to show that new financial innovations like ETFs are attracting the broad public. These investments are mainly in the future market and directly affect the physical market.1 One example of an easy way for a layman to invest in commodities is ETFs; they offer diversification and are traded like stocks. ETFs, compared to futures, don't require a daily management, as they are not rolled over on the expiration date. Further, ETFs have the advantage for a small investor, because the face value is very high. Thus smaller investors can use ETSs for the diversification of their portfolio (vs. on future contract of 1000 barrel). Popular Crude ETFs United States Oil Fund LP ProShares Ultra DJ-AIG Crude ETF iPath S&P GSCI Crude Total Return PowerShares DB Oil Fund United States 12 Month Oil Fund There are three different ways of how ETFs are linked to commodities: I) They can be linked to the p hysical spot price of a commodity, which is the case with most metals II) ETFs are linked to the future market III) They can invest in equity of commodity intensive companies. Crudes future are general in backwardation. Thus, most crude ETFs are linked to the future market, as they gain roll yields. F urthermore, ETFs differ from their dated time to the maturity, resulting in a variety of different products. In general, shorter dated ETFs have a higher correlation to the spot price. ETFs with a long-term expiry are affected by substantial changes in the crude market, like a rising demand in emerging economies or a long-term shortage in supply, resulting in a h igher volatility in short-dated ETFs compared to long-term ETFs. Besides the investment possibilities in oil through ETFs, there are two other ways of investing with a portfolio in the oil market. Exchange traded notes (ETNs) can be compared to ETFs. Besides that, they are issued mostly by large banks and thus have to carry the credit risk of the counterparty (which should not be underestimated as the latest history with AIG shows). The main advantage of ETNs is that they have lower handling costs compared to funds. The second possibility of investing is through exchange-traded commodities (ETC), that are a variation of the ETFs.
CALCULATING CRUDE PRICE

The physical oil contracts are either through spot markets, which are often used as a one-time transaction or through long-term contracts with the purchaser, like with ConocoPhillips or Sunoco Logistics.
50
Two parties in a long-term contract are usually negotiating the delivery of crude from certain wells over a time period, generally 6 months or longer. The price agreement in the long-term contract is typically linking the price over formula pricing to a market spot price benchmark. The formula pricing can be written as: Px = Pr + D(Q+L)60 Where Px is the price for the crude traded, with Pr as the reference price benchmark added with the difference D containing the quality of the crude Q and the location L. The reference price in a long-term agreement is typically set at delivery, to a benchmark like WTI or ASCI, whereas the difference is agreed upon when the deal is agreed upon. The difference is usually assessed by price reporting agencies (PRAs), like Platts and Argus. The price level, Pr, of main crude benchmarks like WTI or Brent, is set over the future market. The OTC market sets the price differentials based on quality and location. These differentials are then interpreted by the PRA and published in their physical benchmark. The physical benchmark and the paper market are linked together and adjust each other.
The center of the formula pricing method is the benchmark Pr. Producing oil countries are using different benchmarks for different export destinations. For example, Saudi Aramco sells their crude based on the two Arabian Gulf benchmarks: Oman and Dubai crude. These indices are published by Platt's and are the base of most Asian crude trades. Whereas if Saudi Aramco sells crude to Europe, it uses the Brent benchmark for the reference price and to the US the ASCI published by Argus.61 The chosen benchmark has a main impact on the revenue obtained from the oil producer. Given the large variety of crudes, the crude receives a differential, either a discount or premium depending on its physical components of the crude (Q) compared to the underlying crude benchmark characteristics. These differentials are periodically adjusted in order to meet the actual needs for a specific type of crude.
60
Saudi Aramco Raises Oil Premium For April Sales To Asia, U.S.; Cuts Europe, Stephen Voss and Mark Shenk, Bloomberg, 03-04-2012
61
51
A barrel of crude makes a variety of different products (see the diagram of finished products in the history). However, the refined products from one barrel vary depending on the crude characteristics. The demand for a refined product changes over time and so does the demand for a specific type of crude. The Gross Product Worth (GPW) is the spot price of a refined product times the percentage share of one refined product out of a specific crude. The spot prices for the refined products change as to the underlying demand changes. For example, the gasoline prices are typically highest during the driving season in summer, whereas no. 2 fuel oil and propane used for heating are highest during the winter period. Refineries are focusing their production on the products with the highest yield, thus the demand for specific types of crude are affected by the GPW. For example, by analyzing the gasoline seasonal price changes of the past, it seems that steep declines after the consumption peaks of summer are smoothing out. This shows that markets are getting more efficient, where consumers are buying anti-cyclical and building inventories.62 Since the price of a crude is very dependent on the location of the crude (L), freighting costs have to be considered in the formula pricing difference. This variable is determined after the "equivalence to the buyer" principle, where crudes can be compared at a certain destination. 63 The location where crudes can be compared is the destination harbor or storage facility of the crude before it goes to the refinery. These differentials are not the delivery costs that occur if the crude is transported from the field to the refinery, instead these are hypothetical costs that
Crude Oil Price Forecasting: A Statistical Approach, Armando Lara, Michael Leger, John Auers, National Petrochemical & Refiners Association, 03-18-2012 (Page 4)
62
63
52
would occur if the crude were to be transported from the field to the benchmark location, for example to Cushing. Transportation costs can play a significant role, especially in the case of gas. The casing head gas out of a wellhead is running through a separator that is differing between water, crude, and methane. Crude and water can be stored in a steel or fiberglass tank and are then fetched by trucks. Methane has to be directly injected into the pipeline system. The costs for connecting a well to the pipeline system can be so high that the gas cannot be economically used, and it is therefore released in to the air.
CASE STUDY
Crude oil markets are characterized by high price volatility, while the produced volumes are relatively steady. It is important for oil producers, as they are directly impacted by price fluctuations, to hedge the oil price risks in order to receive the following: Steady and predictable income Absorb price declines Higher credit reliability to lower borrowing rate
Financial intermediaries providing oil-collateralized loans require oil producers to hedge a minimum percentage of their future production in order to minimize the impact of oil price volatility on the oil producers ability to repay. In addition, some of the hedging strategies can reduce the need for financial capital as producers can sell their crude in advance and increase thereby the amount of leverage in the company, resulting in lower overall capital costs. 64
Energy Derivatives and the transformation of the U.S. Corporate Energy Sector" in the Journal of Applied Corporate Finance, Volume 13, Number 4, Winter 2001 pp 55-75
64
53

Source: Crude Oil & Natural Gas Hedging Study from Mercatus Energy Advisors
Mercatus Energy Advisors released a study about the hedging strategies of independent exploration and producing companies in 2009. Their findings were that hedging crude oil is common among E&P companies. 41% of the participants of the study claimed to hedge their crude oil and natural gas production. Of these, 80% hedged over 51% of their entire production. There are five ways of hedging the oil price volatility risks for an independent oil company like Corda Corporation: OTC o Swaps (fix against floating) o Fixed Price Forward Contracts Exchange traded o Futures o Options Puts Mixture of Puts and Calls (Collars)
RISKS OF HEDGING
Despite the advantages of stabilizing future incomes and the possibility of increasing the amount of leverage, skepticism about hedging strategies, especially under exploration and production companies, remains. The line between hedging and speculation is thin, and speculation is high risk, as it is not the core business of an oil producer. 65

65
54
Furthermore, hedging is costly in management time and resources. Independent oil companies are trading smaller volumes compared to the majors. The advantages may not offset the costs of a specialized risk manager and gets only efficient at a certain volume. Hedging could be risky for a producer, since it is not a standard in the industry. Producers, which are hedging over futures, could not take advantage of an upside in the oil price, or if the company is hedging over options it would have to pay an option fee in order to have the ability of taking advantage of rising oil prices. Thus, in times with high oil prices, companies that are hedging would stand relatively alone, while its competitors were making huge profits. If the oil price is decreasing, the profits of unhedged producers might crunch, but at least they would not stand alone, as they would have plenty of company. 66As the crude industry counts for an important part of the US GDP, crude producers might gamble that the US government supports the industry in rough times. This happened during the time of the low oil prices in 1988 with Ronald Reagan signing the tax act "Omnibus Trade and Competitiveness Act" in order to support the oil industry. A hedging strategy should take these points into account and should perform in a high price and low price environment. Further, it is crucial to understand that hedging is not a source of revenue, but rather, it is a risk management tool. Also, when companies are hedging over the OTC market, there is always a counterparty risk involved. In order to minimize the counterparty risk, it is important for Corda Corporation to find the right hedging provider. The recent history with the impacts of Lehman Brothers on the OTC market shows that the counterparty risk is not to underestimate. It is complicated to estimate the counterpartys risks, as it is almost impossible to estimate the involvement of the counterparty in the OTC market. 67
AIMS OF HEDGING
Corda Corporation can affect the revenue by lowering the element or technical risk of production in order to assure a certain volume. Corda Corporation cannot influence the second variable that determines the returns as the market sets the crude price and Corda Corporation is a price taker.

66
OTC Derivative Contracts in Bankruptcy: The Lehman Experience, GuyLaine Charles, NYSBA NY Business Law Journal, Spring 2009
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Crude Price $0 Utility for CC 0.0 Crude Price $70 Utility for CC 73.7
$10 $20
$30
$40
$50
$60
13.4 25.8 37.3 47.8 57.4 66.0 $80 $90 $100 $110 $120 $130 80.5 86.3 91.1 95.0 98.0 100.0
The graph above plots a simplified supposed utility function of Corda Corporations returns; the graph is shaped concave. This suggests that Corda Corporation is acting risk averse. Rising returns on high crude prices have a lower utility compared to rising returns on low crude prices. For example the U($0) would be 0, U($130) would be 100, the U($65) would be 70. U(E(W) represents the utility of the expected value of the uncertain payment,: E(U(W)) represents the expected value of the utility of a uncertain payment, and U(CE) represents the Utility of certain equivalent. The risk premium RP is the difference between the uncertain E(U(W)) and the certain U(CE). Thus the utility function would be maximized if the monthly prices would have a low volatility. () = (( ) + ( ) + ( ) + (. . . )) 12
!"
max

!!!
56
The main aim of hedging in Corda Corporation is to reduce the standard deviation and guarantee minimum revenue in order to provide a continual cash flow. If prices are predictable and constant, Corda Corporation can focus on their core business, the exploration and development of new wells. Corda Corporation tries to drill, independent of the actual price, 4-5 wells per year. The graph above plots a repetitive bet on the crude prices, where the red line shows the standard deviation of last year and the green line shows a target standard deviation. The utility for Corda Corporation is highest if the prices are around last years mean of $92.35.
CORDA CORPORATOIN 2011

In the following I am going to take a closer look at the returns of a specific oil well in the north of Texas. Then, I will examine two hedging strategies: a collar strategy and future strategy, and compare their yields during 2011. I have chosen these two hedging methods, since they are traded over the exchange, and also, public data is available.
Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11
Total Revenue $28,374.8 $36,286.4 $35,881.1 $33,937.6 $31,342.4 $30,005.8 $30,046.9 $34,908.8 $26,463.2 $27,035.8 $29,679.6
Sunoco North Texas Marketing Production Sweet Adjustment in bbl $86.19 0.35 328.07 $86.09 0.35 420.03 $99.49 0.35 359.53 $106.88 1.04 314.47 $97.65 1.04 317.52 $92.68 1.04 319.96 $93.56 1.04 317.62 $82.45 1.04 418.12 $82.07 1.04 318.45 $82.76 0.85 322.7 $93.50 0.85 313.97
57
Dec-11 $41,482.0
$95.05
0.85
432.6
The table above gives an overview of the returns of one producing well from Corda Corporation. Corda Corporation negotiated a one-year contract with Sunoco Logistics that included this well and 12 other wells. Sunoco Logistics will purchase all of their crude oil and condensate to the posted average monthly price of North Texas Sweet crude oil. Through the average pricing System of Sunoco, prices are already abraded on a monthly basis. In the agreement, Corda Corporation receives a "marketing adjustment" from January to March of $0.35, from April to September of $1.04, and from October to December of $0.85 per barrel. The marketing adjustments are set every six months. This index is posted by Sunoco and is in a correlation of 0.99 to the WTI NYMEX benchmark, it traded last year at an average discount of $3.6 per barrel. This difference, which is changing from period to period, is the basis risk. The basis risk cannot be hedged. However, through the high correlation between these two indices, the basis risk can be neglected.
Sunoco North Texas Sweet and Adjustment Average Price $92.35 Standard DV 7.813340136 Semi DV 5.729792693 Correlation to WTI 0.999343639
Source: WTI price from IEA and North Texas Sweet from Sunoco pricing
The graph above plots the deviation of the WTI crude and the index of Sunoco, plus adjustment on a monthly basis. As it can be seen, the graph is highly volatile with a mean of $92.35 and a standard deviation of about 7.8. The Semi deviation with 5.7 is relatively high; this implies a greater volatility in downward movements compared to upward movements.
FUTURE STRATEGY
58
Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11
Total Revenue $486,259.5 $621,841.2 $614,895.6 $581,589.9 $537,115.8 $514,211.3 $514,914.0 $598,234.0 $453,500.7 $463,313.6 $508,620.1 $710,878.7
Sunoco North Texas Marketing Production Sweet Adjustment in bbl $86.19 0.35 5619.22 $86.09 0.35 7193.99 $99.49 0.35 6158.75 $106.88 1.04 5388.93 $97.65 1.04 5442.29 $92.68 1.04 5486.50 $93.56 1.04 5442.84 $82.45 1.04 7165.25 $82.07 1.04 5456.89 $82.76 0.85 5541.50 $93.50 0.85 5390.78 $95.05 0.85 7412.86
In order to determine Corda Corporations monthly return on oil, I extrapolate the returns of the well above. I assume that the monthly returns of this one well reflect the overall relative monthly return of all other wells and thus can be used for the projection monthly return distribution of 2011 with a total revenue of $9436.249. I took into account that Corda Corporations total returns in 2011 were 70% from crude revenues. 68 In a perfect hedge, Corda Corporation would completely eliminate their crude price volatility by purchasing an equal and opposite position of their crude production through derivative. At the beginning of 2011 Corda Corporation does not know their exact production volume for the following months, thus Corda Corporation has to rely on the calculated historical production rates. This results in an additional basis risk, as production may not match the future contract size. The average production per month in 2010 was 6150 bbl. Corda Corporation held their monthly production steady for the past five years, around 6000 to 6500 bbl per month. The next step is to determine how much possible upside is Corda Corporation willing to pay for a lower volatility. Corda Corporation has to decide the percentage of their production volume that they want to hedge. This decision is established by the management of Corda Corporation and written down in the companys policy. At the moment, Corda Corporation is not hedging their production against volatility and has no policies for hedging. I assume that Corda Corporation wants to hedge 70% of the average production of last year, which is equivalent to 4305 barrels per month. One future contract is traded in 1.000 barrels, and so Corda Corporation is purchasing four future contracts each month, which is equivalent to 65.04% of 2010 and 66.9% of 2011 total crude production. I assume that there are no commissions for the trading house.
59
The future curve in 2011 was in contango until October 2011. The contango future curve is in favor of Corda Corporation, as future productions can be sold for higher prices. There are no storage costs for Corda Corporation, as they are selling their monthly average production. The spot price for WTI crude on January 3, 2011 was $91.59 per barrel. For example, the six month contract expiring in July 2011 could be sold for $94.45 per barrel. I examined three different time periods for locking the crude price over cross hedging Sunocos North Texas sweet crude oil with WTI futures: Case 1 - Short entire crude production at the beginning of 2011 Case 2 - Short crude in advanced of 6 months Case 3 - Short crude in advanced of 3 months
The table above shows the methodology on the evaluation of case three. Corda Corporation would enter into two different contracts: one contract with Sunoco Logistics and one contract 60
over the future market. These two contracts are working in the opposite direction. For example, Corda Corporation has sold their crude production of April 2011 on January 3, 2011 for $93.14 per barrel, while the average WTI spot price in January was $89.58 per barrel. On April 20 2011 the spot price for crude is $108.26. Corda Corporation will receive a margin call from their broker as the value of the futures depresses; this future will be offset by a long contract before expiration on April 20, 2011 (expiration day being three days before the 25th of the month), and Corda Corporation has to clear the difference of $15.12 per barrel. On the other hand, Corda Corporation receives $106.88 per barrel from Sunoco Logistic. Corda Corporation could lock in the January price level and would receive $93.14 per barrel. However, Corda Corporation had hedged 74.22% of their April 2011 production, the rest of the 1388.93 barrels are unhedged, resulting in an average price of $96.95 in April.
The results of the first two future cases have lowered the standard deviation from 7.813 (Case 0) to 3.09 respectively to 3.998. In the second case Corda Corporation could appreciate in the high future prices during June. The strategy where futures are purchased every three months could not accomplish the aim of reducing the volatility.
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The futures purchased have a hedge ratio of -1. By purchasing 4000 contracts in 2011 Corda Corporation would have a total delta of -48000 bbl as they are only hedging a portion of their total production resulting in a total hedge ratio of -0.66. The impacts of different contract sizes for the three cases can be seen in the graph above. While the standard deviation of case one and two is sinking, the standard deviation of case three is rising with the contract size.
Contract Size % of total Production
1000 2000 3000 4000 5000 16.7% 33.5% 50.2% 66.9% 83.7%
COLLAR STRATEGY
In this hedging strategy Corda Corporation will hedge their production of 2011 over options. In a collar strategy Corda Corporation would go along with an out of the money put option and short with an out of the money call option. The advantage over a normal put option is that through going short with the call option the hedging costs can be reduced. The crude price could float free between the bottom floor of the put and the cap of the call. The data for the historical option prices comes from the trading platform "Thinkorswim" from TD Ameritrade. TD Ameritrade publishes the option data for "Light Sweet Crude Oil ", with the symbol "/CL", for three months in advantage and the price for the May option of the following year.
62
Source: Calendar from Thinkorswim
The options are American styled, and underlined and settled by Light Sweet crude futures. The expiring of the trade is three business days before the future contract. The future contracts expire three days before the 25th of each month. For example, the January 2011 "Light Sweet Crude Option" will expire on January 14, 2011, and if the option is in the money, the purchaser receives a February future contract. The February future contract will expire three business days prior to the 25th, thus on January 20, 2011. I suppose that the price can float 7.5% from average price to the floor or from the average price to the cap of the future price. Further, I want to purchase options at the beginning of each quarter for the following three months. I assume that there are no costs of commission for the trading house.

Source: Database Thinkorswim
The graph above shows that the standard variance can be reduced with the range of the floating prices. For example, on January 14, 2011 the underlining future price is $91.67. Corda Corporation goes long put at $85.00 and short call at $98.50 for February, March, and April. The crude price that Corda Corporation will receive is dependent on the price level of the option and the costs and gains from the collar option. The settlement of the March option is on March 18, 2011. The future price on this day is $104.02. Corda Corporation has a short call position at $98.50 and thus has to deliver the future and balance the difference of $5.52. Besides, the costs for the long put were $2.87 and the revenues from the short call were $1.93. Thus Corda Corporations received price is $97.56. 63
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Corda Corporation would receive a total average of $92.95 (total revenue and production), and the average price per month would be $92.81 (12 months price average) with a standard deviation of 6.3125 . The standard deviation could be reduced even more if option contracts would be purchased in advance for longer periods like six or nine months or by reducing the range of the price level between the long put and the short call position. These two simple hedging strategies illustrate that hedging makes sense even for relatively low crude volumes. In both cases the standard deviation could be reduced and the average price gained.
CONCLUSION
Based on the above analysis of the crude market and its pricing system, it becomes clear that there will be no change in the crude price volatility. The market pricing system has been in place for over 25 years, much longer than any pricing system before. 69This pricing system has problems and does not act in favor of the general public. Theoretically, there are alternative pricing systems. However, financial and physical traders are not interested in changing the market system. Thus it seems more likely that the crude price volatility is rising as markets are getting tighter and impacts of speculation are rising. Another problem of oil markets is its missing transparency resulting in a high uncertainty in the market where the oil price is decoupled from physical fundamentals. There is great transparency in the price of future markets, but the trading parties are anonymous. The future exchanges have the information for the counterparties involved in the deal. Furthermore, it would make the crude market more transparent if the data of the PRAs were to be published for the general public. Independent exploration and production firms like Corda Corporation are the bereaved of the rising volatility as they have not the resources and expertise for financial markets. However, in order to have predictable revenues this industry sector will have no other choice than to make friends with hedging strategies. Since the resources are not enough for an in house risk manager, hedging will be outsourced to investment banks like JP Morgan or Goldman Sachs. The origin for hedging comes out of the financial markets; they create a vicious circle and the only party profiting is the financial service industry.
69
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LIST OF REFERENCE
Risk Management at Apache, Lisa Meulbroek, Harvard Business School, 08-27-2001 An Anatomy of the Crude Pricing System, Bassam Fattouh, The Oxford Institute for Energy Studies, 01-2011 Empirical Evidence of Some Stylized Facts in International Crude Oil Markets, Ling-Yun He, College of Economics and Management, Chinese Agricultural University,2008 Ties That Bind Oil and Dollar Snap, Christian Berthelsen, The Wall Street Journal, 03-07-2012 Interim Report on Crude Oil Interagency Task Force of Commodity Markets, Commodity Future Trading Commission, 06-2008 On the State's Choice of Oil Company: Risk Management and the Frontier of the Petroleum Industry, Peter A. Nolan and Mark C. Thurber, Program on Energy and Sustainable Development, 12-2010 The Role of Speculation in Oil Markets: What have we learned so far?, Bassam Fattouh, Lutz Kilian, Lavan Mahadeva, Oxford Institute for Energy Studies, 03-18-2012 What's the real price of oil?, Joachim Azria, Credit Suisse Fixed Income Research, 02-17-2012 Crude Oil Price Forecasting: A Statistical Approach, Armando Lara, Michael Leger, John Auers, National Petrochemical & Refiners Association, 03-18-2012 Lead-Lag Relationship between World Crude Oil Benchmarks: Evidence from WTI, Brent, Dubai and Oman; Mohammad S. AlMadi, Baosheng Zhang, China Petroleum University Beijing, 2011 Price of Oil: Manipulation? Bubble? Supply/Demand, Natural Resources, 06-06-2008 Reservoir Digs: on energy investing and private equity, JP Morgan, 03-222012 Probability Distribution of Return and Volatility in Crude Oil Market, Tung-Li Shinih, Hai-Chin Yu, MingoDao University Taiwan, 2009 Oil 101, Morgan Downey, ISBN 978-0-09820392-0-5, 2009 Understanding Oil Prices - A Guide to What Drives the Price of Oil in Today's Markets, Salvatore Carollo, ISBN 978-119-96272-4, 2012 The Quest - Energy, Security, and the Remaking of the Modern World; Daniel Yergin, ISBN 978-1-59420-283-4, 2011 The Prize: The Epic Quest for Oil, Money, & Power, Daniel Yergin, ISBN 9780671799328, 2011 Nonrenewable Resource Scarcity, Jeffrey A. Krautkraemer, Journal of Economic Literature, 12-1998 Natural Resource Economics under the Rule of Hotelling, The Canadian Journal of Economics, Vol 40, No 4., 11-2007 Hotelling Revisited: Oil Prices and Endogenous Technological Progress, Cynthia Lin, Haoying Meng, Tsz Yan Ngai, Natural Resources Research, 0301-2009 66
Oil Politics: A Modern History of Petroleum, Parra, London: IB Tauris, 2004 Canadian Enbridge to expand pipeline into Oklahoma, Tulusa World, 0328-2012 Oil Subsidies: Costly and Rising, Benedict Clemens, David Coady, John Piotrowiski, International Monetary Fund, 06-2010 Crude Oil: The Shifting of Global Supply Disruptions, Where Food comes from, 4-18-2012 On the Economics of Non-Renewable Resources, Neha Khanna , Invited contribution to Encyclopedia of Life and Social Sciences, UNESCO. Forthcoming, Department of Economics and Environmental Studies Program Binghamton 01-30-2001 Petrobras finds new offshore oil reserves, Oil and Gas Technology, 03-132012 Understanding Crude Oil Prices, Matt Nesvisky , The National Bureau of Economic Research, 06-12-2012 World Crude Oil Markets: Monetary Policy and the Recent Oil Shock ,Noureddine Krichene , IMF Working Paper, 03-2006 Oil price agency Platts too powerful, regulator told, Reuters, 04-05-2012 FACTBOX-Oil production cost estimates by country, Reuters 07-2009 Commodity Futures Pricing- Contango and Backwardation, Jim Finnegan, Chartered Financial Analyst Speculation In Crude Oil Adds $23.39 To The Price Per Barrel, Robert Lenzner, Forbes Staff 02-27-2012 Saudi Aramco Raises Oil Premium For April Sales To Asia, U.S.; Cuts Europe, Stephen Voss and Mark Shenk, Bloomberg, 03-04-2012 OTC Derivative Contracts in Bankruptcy: The Lehman Experience, GuyLaine Charles, NYSBA NY Business Law Journal, Spring 2009
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DECLARATION OF AUTHENTICITY
The work contained in the thesis "Anatomy of Crude Pricing and Hedging Strategies at
Corda Corporation" is original and has not been previously submitted for examination that has led to the award of a degree. To the best of my knowledge and belief, this thesis
contains no material previously published or written by another person except where due reference is made. Place, Date Signature
68

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Anatomy of Crude Pricing and Hedging Strategies for Corda Corporation

OVERVIEW OF THE OIL MARKET

Gallons 19.3 9.83 4.45 2.1 2.1 6.68

WORLD - BRENT CRUDE

AMERICAN - WTI CRUDE

Database: EIA Total Petroleum Consumption/Production 2011 13

Source: based on Today in Energy Feb 07.2012 IEA

WTI ASCI LLS

Popular Crude Types

29.1 Offshore Louisiana 33 Midland, Texas

28.2 Offshore US Gulf Coast

Source: Database - spot price from CME / ICE

Year 2006 2007 2008 2009 2010

Correlation (WTI to Brent) 0.960956621 0.973611742 0.99438944 0.983931855 0.936289999

Canadian Enbridge to expand pipeline into Oklahoma, Tulsa World, 03-28-2012 19

IMPACTS ON OIL PRICES

SUPPLY AND DEMAND

IEA Short Term Outlook May 2012

Time Period 1992-1996 1997-2001 2002-2006 2007-2011

SCARCITY RENT- MODEL OF HOTELLING

CHANGES IN THE EXTRACTION COSTS

NEW CRUDE DISCOVERIES

PRICE-INELASTIC IN THE SHORT TERM

Count Mean Median Max Min Standard Deviation Skewness

843 0.0605 0.1100 7.6200 -8.9000 1.7182 -0.2606

Database: FACTBOX-Oil production cost estimates by country, Reuters 07-2009

Risk Management at Apache, Lisa Meulbroek, Harvard Business School, 08-272001(Page 4) 37

INTRODUCTION TO DERIVATIVE OIL PRODUCTS

Risk Management at Apache, Lisa Meulbroek, Harvard Business School, 08-272001(Page 5)

PRICE REPORTING AGENCIES

SPECIFICATIONS OF LIGHT SWEET CRUDE AND BRENT

FUTURE CURVES AND PRICING

SPECULATION IMPACTS ON CRUDE MARKETS

PARTIES ON THE FUTURE MARKET

CALCULATING CRUDE PRICE

Risk Management at Apache, Lisa Meulbroek, Harvard Business School, 08-272001(Page 7)

Risk Management at Apache, Lisa Meulbroek, Harvard Business School, 08-272001(Page 7)

CORDA CORPORATOIN 2011

Contract Size % of total Production

Source: Calendar from Thinkorswim

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