Study of Fundamental Analysis for Crude

Oil Futures Prices

Xun Luo1

Apr 15, 2007

   Abstract:   This project studies the analysis of fundamental drivers for the prices of crude
oil futures. The report first presents a summarization of the crude oil basics, including types,
futures trading and modelling approaches. Then the NYMEX-traded crude oil futures data
from 1983 to 2006 is used to undertake four types of fundamental analysis, in a basic-to-
advanced order: supply-and-demand balances, geopolitical factors, inflation factors, and
market expectations. Four quantitative models that use fundamental as parameters for crude
oil price forecasting are subsequently evaluated. Following the individual sections for
different factors the report conducts a case study of China Aviation Oil's trading loss in 2004,
and the synergy of multiple fundamental drivers is investigated.

   Key words:   Crude Oil Futures Price, Fundamental Analysis, Case Study.

   Project Advisor:   Professor Stanley R. Pliska (Department of Finance, College of

Business Administration, University of Illinois at Chicago).

   Revision History:  

 January 8, 2007, first draft.

 March 5, 2007, revision 1.
 April 15, 2007, revision 2.

1  Introduction
1.1  Motivation

Few will argue that the recent decades are interesting times for energy industry. This
observation is true for both traders and investors. On the traders' side, for example, the
deregulation of natural gas in the United States in the early 1990s is slowly but inexorably
moving into Europe and Asia. Natural gas deregulation has strongly fostered competition, as
well as called for needs for risk management. On the investors' side, a significant
phenomenon is that for many of today's hedge funds, commodities were the hot tickets from
2000 to 2005, as their prices began to rocket, fuelled in large part by China's boom [9].

Although research in quantitative analysis has achieved undisputed success in financial

markets, most models for pricing of energy derivatives (such as those in [10] and [4]) are still
empirical and yet to be solidly verified. In the financial market, there are no arbitrage or term
structure interest rate models which attempt to model the values of the interest rate securities
as functions of one or a few variables, for example, spot interest rates, long-term interest
rates, etc. The models must be consistent with the observed initial term structure and/or
volatilities of the interest rates. A one-factor interest rate model uses short interest rates as a
fundamental variable, so that the prices of interest rate derivatives depend only on short
interest rates even though there are other factors that affect the prices, like tax effects,
marketability, etc. Several one-factor interest rate models are widely used in the literature and
practice, they include the Hull-White Model [7], Black-Derman-Toy model [5] and Black-
Karasinski model [2], to name a few. Although there is no doubt that there are many
similarities between the energy and financial markets, their difference are difficult to ignore
that sometimes even experienced traders get deeply hurt.

A Connecticut hedge fund called Amaranth Advisors unluckily became such a victim and lost
5 billion in natural gas trade (it was thus listed as one of 2006's top 10 losing hedge fund,
with regard to annual return). Below is the excerpt from the Wall Street Journal article [3]
which attempted to gave reasons for Amaranth's loss:

"Unlike oil, gas can't readily be moved about the globe to fill local shortages or relieve local
surpluses. Forecasts of freezing U.S. temperatures in winter or heat and hurricanes in
summer can send prices jumping, while forecasts of mild weather can do the opposite. Last
December, amid a cold snap, gas soared to a record 15.378 a million British thermal units
on the New York Mercantile Exchange, or Nymex. This month, prices fell below 5 in the
absence of major hurricanes and with forecasters talking about another warm winter.
Yesterday, gas for October delivery settled at 4.942 a million BTUs on Nymex, off four
cents."

The features of natural gas futures listed in the WSJ article, i.e., characteristics of supply
patterns, susceptibility to seasonal weather conditions, as well as high volatility in price, are
all non-significant factors in interest rate models but typical properties of energy derivatives.
This example illustrates that how difference in fundamental drivers cause the uniqueness of
energy derivative in their types, price evolution process, payoff calculation and risk
management tools. To explore the effect of these fundamental drivers over real market data
forms the main motivation for this project. Due to the market-to-market difference of
commodities, limitation in report scope and data availability, this project focuses on the
fundamental analysis approaches for the prices of a major kind of energy derivative: the
crude oil futures.

1.2  Organization of This Report

This report is not strongly research-oriented, but more a literal reproduction of the processes
of background information learning, get-hands-dirty practice and practical analytical problem
solving on crude oil futures. To serve this purpose, it is organized as follows. Section 2
summarizes the background for crude oil futures, including crude oil types, futures trading at
NYMEX, and a couple of modelling approaches. Section 3 illustrate the details about the data
sources where the data sets for this project is obtained. In this section types of data providing
agencies, data set scope and attributes are introduced. Two basic fundamental analysis -
supply-and-demand balance and geopolitical factors are studied in Section 4. Section 5 drills
further down to cover two more factors, namely inflation factor and market expectations.
Following these, four quantitative oil price forecasting models which use fundamentals as
parameters are evaluated in Section 6. In Section 7, the individual approaches are glued
together towards a case study of China Aviation Oil's trading loss in 2004. Section 8
concludes the report. Appendix A lists a glossary of crude oil-related terminologies. At last,
supplemental materials including data sets and literatures are available for download from the
author's homepage [8].

2  Crude Oil Futures Basics

This section briefly describes the types of crude oil, futures trading at NYMEX and several
price modelling approaches. Details of the modelling approaches mentioned are available in
the corresponding references, while the definition of terminologies could be found in
Appendix A.

2.1  Types of Crude Oil

There are literally hundreds of different crudes produced in the world, with there price
differences not simply reflecting transportation costs to principle oil-consuming centers, but
quality differences as well. In general, the two characteristics that are used to classify crude
types are sulfur content and specific gravity (American Petroleum Institute (API) gravity). In
a given refinery, higher API gravity crude oils inherently produce more "light" products, such
as gasoline, jet fuel, and kerosene, while lower gravity oils will tend to produce more of the
middle and "heavy" products, such as heating oil, diesel, and residual fuel. As a result, crudes
that have a relatively high API gravity are referred to as "light" oils, and relatively low-
gravity crudes are termed as "heavy". For example, West Text Intermediate crude, which has
an average API gravity of 40, is a light oil, and Alaskan North Slope crude oil, which has an
API gravity of 27, is a heavy crude.

The other general defining characteristic of crude oil, sulfur content, is considered a
barometer of foreign materials contained in a given crude stream. When crude is produced, it
contains a number of impurities, which are removed during the refining process, partly to
prevent damage to the refining unit themselves. These materials include, among other things,
heavy metals, waxes, dissolved gases and sulfur. Sulfur is the foreign material that garners
the most attention because it is particularly difficult to remove during refining. Crude oils that
have a sulfur content of 0.5 percent, or higher, by weight are referred to as "sour", while oils
with a content under 0.5 percent by weight are termed "sweet". For example, Nigerian Bonny
Light crude, which has a very low 0.1 percent sulfur content, is classified as a sweet oil, and
Mexican Maya, which has a very high 3.3 percent of sulfur content, is categorized as a sour
crude.

In many cases, light crude oils tend to be sweet. Conversely, heavy crudes tend to be sour. As
a result, it is common within the oil industry to hear to term "sweet-sour spreads", referring to
the price differential between heavy/sour oils and light/sweet crudes. In general, light/sweet
oils almost always command a price premium to heavy/sour crudes, reflecting the inherently
higher value of the refined products that are yielded from the refining process and the
relatively lesser difficulty of refining these oils.

2.2  NYMEX Trading

Crude oil began futures trading on the NYMEX in 1983 and is the most heavily traded
commodity (trading symbol: CL). The futures trade in units of 1,000 U.S. barrels (42,000
gallons). The trading months are 30 consecutive months plus long-dated futures initially
listed 36, 48, 60, 72, and 84 months prior to delivery. Additionally, trading can be executed at
an average differential to the previous day's settlement prices for periods of two to 30
consecutive months in a single transaction. These calendar strips are executed during open
outcry trading hours. Crude Oil Futures are quoted in dollars and cents per barrel, with a
minimum price fluctuation of 0.01 (1) per barrel (10 per contract). With regard to the
maximum daily price fluctuation allowed, initial limits of 3.00 per barrel are in place in all
but the first two months and rise to 6.00 per barrel if the previous day's settlement price in
any back month is at the 3.00 limit. In the event of a 7.50 per barrel move in either of the first
two contract months, limits on all months become 7.50 per barrel from the limit in place in
the direction of the move following a one-hour trading halt.

Last trading day of crude oil futures is at the close of business on the third business day prior
to the 25th calendar day of the month preceding the delivery month. If the 25th calendar day
of the month is a non-business day, trading shall cease on the third business day prior to the
last business day preceding the 25th calendar day. Delivery is F.O.B. from seller's facility,
Cushing, Oklahoma, at any pipeline or storage facility with pipeline access to TEPPCO,
Cushing storage, or Equilon Pipeline Co., by in-tank transfer, in-line transfer, book-out, or
inter-facility transfer (pumpover). All deliveries are rateable over the course of the month and
must be initiated on or after the first calendar day and completed by the last calendar day of
the delivery month. An Alternate Delivery Procedure is available to buyers and sellers who
have been matched by the Exchange subsequent to the termination of trading in the spot
month contract. If buyer and seller agree to consummate delivery under terms different from
those prescribed in the contract specifications, they may proceed on that basis after
submitting a notice of their intention to the Exchange. The commercial buyer or seller may
exchange a futures position for a physical position of equal quantity by submitting a notice to
the Exchange, called Exchange of Futures for, or in Connection with, Physicals (EFP). EFPs
may be used to either initiate or liquidate a futures position. The deliverable grades include
specific domestic crudes with 0.42% sulfur by weight or less, not less than 37 API gravity nor
more than 42 API gravity. The following domestic crude streams are deliverable: West Texas
Intermediate, Low Sweet Mix, New Mexican Sweet, North Texas Sweet, Oklahoma Sweet
and South Texas Sweet. There are also foreign streams deliverable, including U.K. Brent and
Forties, and Norwegian Oseberg Blend, for which the seller shall receive a 30-per-barrel
discount below the final settlement price; Nigerian Bonny Light and Colombian Cusiana are
delivered at 15 premiums; and Nigerian Qua Iboe is delivered at a 5 premium. Position limits
in a month is capped at 20,000 net futures, but not to exceed 1,000 in the last three days of
trading in the spot month. Margins are required for open futures or short options positions.

2.3  Several Modelling Approaches

In [10], Pilipovic asserted that price mean-reversion was the most appropriate quantitative
model for energy markets. She described energy derivatives as exhibiting "split personality",
i.e., discrepancy between short-term and long-term behaviors. She attributed the reason to
different sets of fundamental drivers for short-term and long-term markets that caused term
structures in convenience yields. These statements could be put as:

Cy � (St  Lt) +
(2.1)
K
and
 Cy � K as t
(2.2)
��

Where Cy is the convenience yield, St is the spot price, Lt is the equilibrium price, and K is a
constant. Equation 2.1 and 2.2 manifest that the convenience yield is affected by supply-and-
demand imbalance in the short-term. In the long run, the imbalance effect goes to zero, and
the prices approaches equilibrium levels.

Some other researchers, such as Eydeland and Wolyniec, authors of [4], disapprove the
models that incorporate convenience yield. Eydeland and Wolyniec argued that in energy
markets, convenience yield was not observable, and the amount of historical data was not
large enough to deduce a model for its evolution in a stable and reliable manner. They
asserted that using liquidly traded products(such as forward contracts) for calibrating
convenience yield models can be misleading and may result in mispricing of common
structures such as recall options. The authors instead recommended several other models,
including simple forward pricing models, continuous forward curve models, and market
models. The debate over convenience yield, however, is beyond the scope of this report as it
is more about quantitative analysis rather than fundamental analysis.

Schwager in [11] suggested that the equilibrium price was mainly determined by OPEC
expectations and fell into a price band over a certain time period. he further listed three major
modelling steps when deriving a crude oil price forecast:

1. Construct the oil-balance projection using supply-and-demand analysis.

2. Evaluate the relevant geopolitical factors.
3. Gauging the market perception of fundamentals using crude oil time spread.

All the authors of [10,11,4] agree that seasonality is a significant fundamental driver of
energy derivative prices. Pilipovic proposes that every spot price model should be treated as
the synergy of two separate models, one for the "underlying price" where there is no
seasonality, another for the seasonality models. Meanwhile, the two models should have a
near-zero correlation. Eydeland and Wolyniec tended to construct multi-factor stochastic
models that incorporate the seasonality factor. Schwager instead suggested a
deseasonalization step before the analysis of other fundamental drivers.

3  Sources of Data
The data sets used by this report are mainly from two sources, namely, the Energy
Information Administration(EIA) and the American Petroleum Institute(API).

3.1  The Energy Information Administration

The EIA is a statistical agency of the U.S. Department of Energy and was created by
Congress in 1977. Its mission is to provide policy-independent data, forecasts, and analysis to
promote sound policy making, efficient markets, and public understanding regarding energy
and its interaction with the economy and the environment. Energy products covered by EIA
are:
Petroleum
 including crude oil, gasoline, heating oil, diesel, propane, jet fuel, and other petroleum
based products.
Natural Gas
including crude oil, gasoline, heating oil, diesel, propane, jet fuel, and other petroleum
based products.
Electricity
including sales, revenue and prices, power plants, fuel use, stocks, generation, trade,
and demand & emissions.
Coal
including reserves, including production, prices, employment and productivity,
distribution, stocks and imports and exports.
Nuclear
including Uranium fuel, including nuclear reactors, generation and spent fuel.
Renewable & Alternative Fuels
including hydropower, solar, wind, geothermal, biomass and ethanol.
[h]
Date Contract 1 Contract 2 Contract 3 Contract 4
12/11/2006 61.22 62.36 63.29 64.00
12/12/2006 61.02 61.99 62.92 63.63
12/13/2006 61.37 62.17 63.05 63.72
12/14/2006 62.51 63.33 64.22 64.87
12/15/2006 63.43 64.09 64.89 65.49
Table 1: EIA Data of NYMEX Crude Oil Futures Prices in the Week of 12/11/2006
 
For crude oil fundamental analysis, EIA data is a must-read, if not more emphasized. These
data sets are published on daily, weekly, monthly and annual basis. The daily data include the
spot prices of crude oil and petroleum products in the U.S. and selected international areas, as
well as futures price at NYMEX. Table 1 illustrates crude oil futures (WTI at NYMEX) of a
sample week. Contract n in the table refers to crude oil futures of the nth nearest month
(contract 1 specifies January 2007 WTI, contract 2 specifies February 2007 WTI, and so on).
EIA archived the historical data of these daily prices. For WTI, the historical data could be
back-traced to March 30, 1983. The weekly publications include: This Week in Petroleum,
which is generally released on Wednesdays and contains analysis, data, and charts of the
latest weekly petroleum supply and price data; Weekly Petroleum Status Report, which
reports the petroleum supply situation in the context of historical information and selected
prices; and several other reports, mainly about price information. The monthly publications
include: Company Level Imports, which is about imports data at the company level collected
from the EIA-814 monthly imports report; Petroleum Marketing Monthly, which is of
monthly price and volume statistics on crude oil and petroleum products at a national,
regional and state levels; Petroleum Supply Monthly, which details supply and disposition of
crude oil and petroleum products on a national and regional level. The data series describe
production, imports and exports, movements and inventories; Prime Supplier Report which
measures primary petroleum product deliveries into the U.S. where they are locally marketed
and consumed. At last, the annual publications include: U.S. Crude Oil/Natural Gas/Natural
Gas Liquids Reserves Annual Report, Petroleum Supply Annual, Petroleum Marketing
Annual and Refinery Capacity Report.

What is really valuable of the EIA data repository is that not only raw market data are
provided, a researcher could also get access to a compilation of frequently updated analyses
and forecasts. Figure 1 is a graph excerpted from the "China" section of Country Analysis
Briefs, an analysis of the worlds major oil producers and consumers. There are a great
quantity of analyses of other economic fundamentals about crude oil. Due to the page limit
they are not listed here. Interested reader could check the EIA website
(http://www.eia.doe.gov/).

[tp]
Figure
Figure 1: EIA Statistics of China's Oil Production and Consumption, 1986-2006

3.2  The American Petroleum Institute

In contrast to the EIA's government background, the API is the main U.S. trade association
for the oil and natural gas industry, representing about 400 corporate members involved in all
aspects of the industry. API is involved in lobbying and government liaison on behalf of the
American oil and natural gas industries. It takes positions on access, exploration, taxes, trade
regulation, environmental regulation, fuels, industry security and climate change. API
conducts or sponsors research ranging from economic analysis to toxicological testing. And it
collects, maintains and publishes statistics and data on all aspects of U.S. industry operations,
including supply and demand for various products, imports and exports, drilling activities and
costs, and well completions. This data provides timely indicators of industry trends. API's
Weekly Statistical Bulletin is the most recognized publication, widely reported by the media.

Most of API's data need a paid subscription. However there are abundant free-licensed
statistics on the API website (http://www.api.org) as well. These data are usually about
company earning and spending, and end-consumer aspects of petroleum price, such as
superimposed tax. Figure 2 shows an example graph taken from API website, which is about
gasoline taxes rate at all the 50 U.S. states. A large portion of API data are gathered from
sources of its industrial members. There are two main advantages of API's data and reports.
The first is that they reflect to a large extent the downstream petroleum parties' views and
concerns about the oil market (downstream parties are introduced in Section 4). Because of
this, API data and reports are good reference for the U.S. domestic market players'
expectations. The second is that as API is a liaison of industry to the general public, many
basic concepts of oil and data are interpreted in ways easily understood by non-professionals,
or novices in oil and natural gas research.

[tp]
Figure
Figure 2: API Statistics of U.S. Gasoline Taxes as of October 2006

4  Basic Fundamental Analysis

This section examines crude oil futures prices from the perspective of two fundamentals. One
is supply-and-demand balances and the other is geopolitical factors. They are the basic
fundamentals of crude oil futures. This fact is straightforward to understand: Supply-and-
demand balance largely dictates virtually all commodity futures price. While the strategic
role of oil for almost every country determines that oil price is bounded to be tied tightly with
the geopolitical factors.

There is a good example for the effects of these two fundamentals on crude oil futures price:
the 2003-2006 crude oil futures price curve. As illustrated by Figure 3, the price of WTI
traded at NYMEX went from 25 to 38 per barrel in year 2003 to over 70 per barrel in the
summer of 2006. If an analyst does not look at the fundamentals but believe that oil price has
a long term trend, she is inclined to draw the conclusion that oil price has an increasing trend
and explains it in the incorrect way. This false reasoning process could even be strengthened,
if a chart comparison between oil futures price and the Dow Jones Industrial Index (Figure 4)
is made. If Figure 3 and Figure 4 are put together, it will be found that trends of the two
during 2003-2006 is quite similar. To make the illusion more realistic, a supporting metric:
correlation between WTI future contract price and Dow Jones Index is as high as 0.7356!

However, any attempt to link the two and explain one with another will be deadly wrong.
Dow Jones Index has a long-term trend of increasing, and its performance during 2003-2006
is the natural exhibit of this trend. On the contrary, crude oil futures price is more mean-
reverting, globalized, and not necessarily associated with U.S. domestic economy. Actually, a
long-term trend believer of crude oil prices, in the 2003-2006 data case, will be inclined to
make the judgment that price will be keep increasing, or at least maintains at the same level
as summer 2006, in winter 2006. This assertion is proved to be incorrect by the continuous
decrease of WTI futures price after summer 2006. As of January 3, 2007, WTI future contract
1 price is 58.32 per barrel, a 24% drop compared with its peak of 77.03.

Using fundamental analysis, the author's opinion is that the price increase of crude oil during
2003-2006 could be attributed to: 1) limited surplus capacity, both upstream and downstream,
2) strong global demand growth, especially in Asia and the United States, and 3) geopolitical
risks that have highlighted the need for more surplus capacity, both upstream and
downstream. Below the analysis for each one is given more closely.
[tp]
Figure
Figure 3: Increasing WTI Future Contract 1 Price at NYMEX, 2003-2006
[tp]
Figure
Figure 4: Dow Jones Industrial Average Index, 2003-2006

4.1  Supply-and-Demand Balances

For the global oil industry, oil trade represents the close connection between two main
centers of activity: upstream exploration and production, as well as downstream refining and
marketing. The interactions between the upstream and the downstream largely determine
crude oil supply-and-demand balancing dynamics. Mechanisms of such interactions are as
following: Upstream parties are the major sellers of crude oil, and their productions are
valued by downstream demand; While downstream parties are the major buyers of crude oil,
and the cost of their feedstock is determined by the upstream supply. Operational decisions
about combining output from various fields to create a specific crude oil export stream with
certain characteristics are constantly tested in the market against the requirements of refiners
for specific feedstock to meet final demand for a changing combination of products. The
downstream marketing prices of the petroleum products, such as heating oil, gasoline,
propane, aviation oil and kerosene are also determinants of crude oil price. Due to the
extensive vertical integration of the oil industry until the early 1970s, these decisions used to
be largely kept under the umbrella of major oil companies.

There have been several profound changes in the upstream-downstream structure since
1970s. Increased crude price volatility since the early 1970s in combination with other price-
affecting factors, OPEC output quotas for example, signalled oil-importing developing
countries such as South Korea, India, and Brazil to invest in refining capacity to mitigate both
refined product volume and price risks. These same trends also created an incentive for
governments in oil-exporting countries, notably Iran, Kuwait and Saudi Arabia, to build
refineries in order to capture the value added in turning crude oil into refined products. Other
global trends of oil companies include privatisation and large mergers among majors. These
trends are finally challenging the long established dominance of big national oil companies in
the top tiers of the international oil industry. While the largest state-owned companies are still
playing a critically important role, the private sector companies are now becoming more
important rivals. As of today, global upstream and downstream composition has been quite
different from what it was in the 1970s. Figure 5 lists the top 10 crude oil exporters as of
2002, as well as the top 10 oil companies in 2002-2003.
[tp]
Figure
Figure 5: Top 10 Crude Oil Exporters and World's Largest Oil Companies, 2002-2003
 
Clearly, the extent to which upstream's or downstream's capacities are utilized during a
certain time period greatly determines the crude oil price level and volatility of that period. In
the case that the upstream has limited surplus in capacity, such as running tight on daily
productions or lacking of new explorations when the supply-demand in market is barely
balanced, a small portion of decrease in crude oil production would cause a significant price
hike. For this reason, the market players will prefer to pay crude oil future contracts with
higher premium. On the other hand, when the downstream has limited surplus in capability,
such as fully-operating refineries, oil transport ports and storages, an instability factor in
these facilities will trigger significant increases of the petroleum products price. Such
increases will subsequently affect crude oil price in a indirect manner, making bulls in the
futures market.

From 2003 to 2006, surplus global oil production capacity, which was as high as 5.6 million
barrels per day in 2002, plummeted to 1.8 million barrels per day in 2003, and has been
around 1 million barrels per day during most of 2004 to 2006. As demand has increased
rapidly during the same period, the world has dipped into the surplus capacity that had been
built up earlier. While some productive capacity has been brought online, it has been
insufficient relative to demand growth. As a result, surplus capacity is extremely limited,
dramatically reducing the ability to respond to any sudden surges in demand or disruptions in
supply. The situation is similar downstream, where global refinery utilization has increased
from an annual average of 85 percent in 2002 to 90 percent in 2005. This increase in refinery
utilization has also reduced the system's flexibility to respond to any disruption in refinery
production, either from hurricanes or other events. Increases in refinery utilization rates may
also make crude oil markets more responsive to seasonal patterns for refined products. All
these factors composed the first cluster of pulling-up forces for crude oil price during the
2003-2006 period.

This report also argues that strong growth in the world economy, and particularly in China
and the United States, has fueled the need for more oil, thus putting upward pressure on
prices. That is, strong global oil demands are the other cluster of factors causing oil prices to
rise in recent years. As shown in Figure 6, Asia Pacific and the United States are world's
largest oil consumption regions, and the main oil consumer in Asia Pacific are Japan and
China. As of 2006, the U.S. ranks first in daily oil consumption, Japan ranks the second, and
China the third. All these three counties' economy are in good shape from 2003-2006, with
China being the particular. As a result, after averaging annual growth of just under 1 million
barrels per day between 1991 and 2002 (under 0.9 million barrels per day for 2000-2002),
world oil demand grew by 1.5 million barrels per day in 2003, 2.6 million barrels per day in
2004, and at least 1.1 million barrels per day in 2005. This greater-than-historical growth
came even as oil prices more than doubled.
[tp]
Figure
Figure 6: Crude Oil Consumption Breakdown by Region, 2004
 
This report pays special attention is paid to the statistics about China, which is also the
author's home country. China is the world's most populous country and has a rapidly growing
economy. Its real gross domestic product (GDP) is estimated by EIA to have grown at 9.9
percent in 2005, down slightly from the 2004 rate of 10.1 percent. Economic forecasts remain
strong for China, with real GDP expected by EIA to increase 9.9 percent in 2006. Inflows of
foreign direct investment (FDI) into China totaled 86.1 billion in 2005, a new record and
roughly double the level of 2001. China�s merchandise trade surplus soared to 102 billion in
2005, its largest surplus ever and roughly three times larger than the 2004 figure.

Understanding the strong economic growth of China, it is consequently easy to see why
China's demand for energy is surging rapidly. EIA forecasts that China�s oil consumption
will increase by almost half a million barrels per day in 2006, or 38 percent of the total
growth in world oil demand. (See both Figure 6 and Figure 1). With China's entry into the
World Trade Organization (WTO) in November 2001, the Chinese government made a
number of specific commitments to trade and investment liberalization which, if fully
implemented, will substantially open the Chinese economy to foreign firms. In the energy
sector, this will mean the lifting or sharp reduction of tariffs associated with imports of some
classes of capital goods, and the eventual opening to foreign competition of some areas such
as retail sales of petroleum products. The improvement in domestic markets openess will be
surely be positive ingredients to China's oil demand. Readers who have further interest on
this topic could check the EIA website, as well the cover-story article on the August 25, 2005
issue of The Economist [1].

4.2  Geopolitical Factors

Just as the lack of surplus capacity is related to the growth in global demand, the impact on
prices due to geopolitical risks is related to the lack of surplus capacity. If surplus capacity
was sufficient to make up for any reasonable likelihood of a loss in supply, then the risks
would not have as great an impact on price. However, because there is very limited surplus
capacity, concerns about potential or existing supply problems in Nigeria, Iran, Iraq,
Venezuela, and elsewhere, have exacerbated price increases related to the supply-and-
demand factor above. Or put another way, these risks to supply would not be putting as much
upward pressure on prices if fundamentals were not tight to begin with.

The risks brought by geopolitical factors include instabilities of a nation's government and/or
domestic economy, such nations do not necessarily to be an major crude oil exporter. For
example, Singapore has strategic geographical location on the strait of Malacca, a main ocean
waterway where 11.7 million barrels of crude oil passing by daily (2004 data). As a result,
failure to crack pirate activities in the strait of Malacca by Singapore and other neighboring
nations' law-enforcement departments will sometimes bring a up curve in the crude oil
futures price. In another example for Venezuela, a disastrous two-month national oil strike,
from December 2002 to February 2003, temporarily halted the whole nation's economic
activity. Because Venezuela continues to be an important source of crude oil for the U.S.
market. Both the instant effect of oil output volume collapse and aftermath effects as inflation
and unemployment became fundamental drivers for a price hike of WTI future contact during
the period, November 2002 to March 2003. That price hike is clearly reflected by Figure 7.
Note also in Figure 7 that although Venezuela's national strike ended in February 2003, the
following U.S. invasion to Iraq, started on March 20, 2003, kept the crude oil futures price at
its local peak for another week.

During the period of 2003-2006, the forces exercised by geopolitical factors to global crude
oil market are clearly pull-up ones. Besides the situation of Venezuela as described above, the
U.S. invasion to Iraq successfully toppled the regime of Saddam Hussein in a short time
frame, however the following insurgent activities in the war-torn country have been put the
Middle East in long-time instability. During the same period, the conflicts between U.S. and
Iran, the world's fourth largest oil exporter in 2004, have never really come to a rest. In year
2003-2004, some analysts even believed that a U.S. invasion to Iran had been planned and
military actions of none-regular attacks, such as missile assaults might be taken. In Nigeria, it
is not uncommon for oil producing and transporting facilities to be vandalized and result in
sharp drop in oil output. In May 2005, Gasoline gushing from a ruptured pipeline exploded as
villagers scavenged for fuel in Nigeria, killed up to 200 and caused a 50% drop in the nation's
oil output for a week.
[tp]
Figure
Figure 7: Venezuela's Effects on WTI Future Contract 1 Price, 2002-2003
 
An interesting question is: how to determine the magnitude of a individual geopolitical
factor's influence to global crude oil price? This question is not NP-hard, but a very difficult
one if precise quantitative results are to be derived. In a gross level, a practical approach
could be using short-term events of a specific geopolitical factor to gauge the corresponding
factor's magnitude of influencing power. An example is shown below, about the world's
biggest oil exporter: Saudi Arabia. On February 24, 2006, Islamic extremists took a bold
daytime attack on the world's largest oil-processing facility, called Abqaiq close to Saudi
Arabia's main export terminals on the Gulf coast. Although the attack was defeated at the
security roadlock and did not affect the oil-processing facility's daily production at all, future
contract 1 of WTI (to be delivered in March 2006) had a 3.4% price increase the next day, as
illustrated by Figure 8. This is a terrific example of the magnitude of Saudi oil's influencing
power to the global market. One hedge fund manager anticipated that the fall of the House of
Saud would generate a 262 per barrel price in the year of 2006 [12].

[tp]
Figure
Figure 8: Saudi Arabia's Effect on WTI Future Contract 1 Price, Feb. 2006- Mar. 2006

5  Further Fundamental Analysis

In this section the use of two more fundamentals are studied: inflation factors and market
expectations. These ones are not as major as the two basic fundamentals introduced in
Section 4 but nevertheless inneglectable when analyzing crude oil future prices. Inflation
factors determine view of the real prices of the crude oil, despite its nominal ones. While
without knowledge of market expectations, even if all other fundamentals are reckoned
correctly, one may still have great difficulty in fitting his/her explanation with the price
behaviors.

5.1  Inflation Factors

A key difference between financial futures and commodity futures is that finance futures
prices usually incorporate variation of its pricing currency, while for commodity futures this
is not the case. Thus, sometimes changes of the nominal prices in commodity futures could
be actually caused by the changes in the pricing currency. As the crude oil futures traded at
NYMEX are measured by U.S. dollar, the factor of U.S. dollar inflation should be carefully
considered when investigate historical data that span a wide variety of years. There are
several indexes that can be used to measure inflation, such as gross domestic product (GDP)
deflator, producer price index(PPI), or the consumer price index (CPI). Short descriptions of
these indexes are given as follows.

The PPI measures average changes in prices received by U.S. domestic producers for their
output. The PPI was known as the Wholesale Price Index, or WPI, up to 1978. The PPI is one
of the oldest continuous systems of statistical data published by the Bureau of Labor
Statistics, as well as one of the oldest economic time series compiled by the Federal
Government. The origins of the index can be found in an 1891 U.S. Senate resolution
authorizing the Senate Committee on Finance to investigate the effects of the tariff laws
"upon the imports and exports, the growth, development, production, and prices of
agricultural and manufactured articles at home and abroad."
[tp]
Figure
Figure 9: Historical Data of the U.S. Consumer Price Index (CPI-U), 1983-2006
 
The CPI or retail price index (RPI) is a statistical time-series measure of a weighted average
of prices of a specified set of goods and services purchased by consumers. It is a price index
that tracks the prices of a specified basket of consumer goods and services, providing a
measure of inflation. The CPI is a fixed quantity price index and considered a cost-of-living
index. In the U.S., CPI figures are prepared monthly by the Bureau of Labor Statistics of the
United States Department of Labor. The CPI-U includes expenditures by all urban consumers
and and is based upon a 1982 Base of 100. The CPI-W includes expenditures by consumer
units with clerical workers, sales workers, craft workers, operative, service workers, or
laborers. A CPI-U value of 158 indicates 58% inflation since 1982. The commonly quoted
inflation rate of say 3% is actually the change in the CPI-U from a year earlier. The historical
data of CPI-U from 1983-2006 (in align with the available period of WTI futures price data in
this report) is plotted in Figure 9. The GDP deflator measures the change in prices in total
GDP and for each of the GDP component. Though the CPI is a more closely watched
inflation indicator, the GDP deflator is another key inflation measure. Unlike CPI, it has the
advantage of not being a fixed basket of goods and services, so that changes in consumption
patterns or the introduction of new goods and services will be reflected in the deflator.

This report makes use of the U.S. CPI-U data from 1983 to 2006 to study the effect of
inflation factor on crude oil futures prices. The CPI-U data is incorporated for inflation
adjustment in two approaches. In the first approach, the CPI-U value in 2006 is normalized to
1, and the normalization coefficient obtained is used to normalize the historical CPI-U values.
Then the annual average prices of WTI contract 1 futures is multiplied by the normalized
CPI-U values in the corresponding years. In this way the inflation-adjusted crude oil futures
prices measured in the value of 2006 dollars are obtained. Figure 10 shows a graph of crude
oil nominal and 2006-dollar-equivalent prices. In a similar way, the prices are measured in
1983 dollars in Figure 11.

The inflation-adjusted price curves tell more information of crude oil futures price than the
nominal price curves, in terms of closeness to true market trends. Although the nominal price
curves indicate that the WTI contract 1 price is at its historical high in 2006, it can be seen
that this price level has actually been reached as dated back to 1983, when the inflation-
adjusted WTI contract 1 price was about 60 a barrel in 2006 dollars (Figure 10). Meanwhile,
it could be observed that the WTI contract 1 price is mean-reverting in this 20-year period,
measured by 1983 dollars, it is mostly in a band between the 10 and 30 lines (Figure 11).
[tp]
Figure
Figure 10: WTI Contract 1 Annual Average, Nominal vs. Inflation-Adjusted (2006 Dollars),
1983-2006
[tp]
Figure
Figure 11: WTI Contract 1 Annual Average, Nominal vs. Inflation-Adjusted (1983 Dollars),
1983-2006
 
It can also be learned from Figure 10 and Figure 11 that inflation factors are long-term
fundamentals. The difference between nominal price and inflation-adjusted price between
2003-2006, which is the time frame the basic fundamentals are studied in Section 4, is not
huge and does not affect the conclusions much. However, if the inflation factor is ignored in a
10-year time frame, the resulted trend conclusions or price-forecasting models are bounded to
be flawed. Due to limitations of data sources, this report is not able to associate WTI futures
prices with inflation factors earlier than 1983. But a third-party plot of crude oil spot prices
(Figure 12) could be a good example for this point. With this graph understood, it will be not
totally absurd for some analysts' opinions in 2006 that crude oil could rocket as high as 100 a
barrel.
[tp]
Figure
Figure 12: Monthly Average of Crude Oil Spot Prices, Nominal vs. Inflation-Adjusted (2006
Dollars), 1946-2006

5.2  Market Expectations

Market expectations could have radical influences on the price. Intuitively one of its
mechanisms could be described as follows. Before the release of key actual statistics in each
period, each player takes action to maximize his expected profit according to her expectation
of price. When players' expectations are highly correlated, the collective action of these
players can practically change the actual determinants of the price. Therefore neglecting the
market expectation could lead to non-ignorable mistakes in a certain price prediction model.
It seems reasonable that the market expectations during a given time period may be more
relevant to determining prices during that period than are the actual statistics that only
become know much later, and it may give us a more accurate model using past estimates
rather than actual statistics as the price-explanatory variables.

There are quite a few literatures which introduce practical approaches about making use of
market expectations. For example, three ways are described in [11] to incorporate expectation
in a model:

 Price is a function of estimates for concurrent-season statistics. Expectation is used

for concurrent-season data. i.e., using expectation to explain price variations that have
already taken place.
 Price is a function of concurrent-season actual statistics and expectation for the
following season. i.e., using expectation to predict price variations that have not
happened yet.
 Price is a function of concurrent-season estimates and expectation for the following
season. Expectations are used for both concurrent- and following-season data. i.e.,
using expectation to explain both happened-already and going-to-happen price
variations.

 
It is important to realize that expectations for a coming season can often have a more strong
price impact than do prevailing fundamentals. This is particularly true during the later half of
a season when the fundamentals for the given season are well defined due to players' action
results and not subject to significant variation. Players foresee the trend of the market in the
next period clearly and take effective action to protect her next period's profit. In another
word, under some circumstances expectation for the following period plays the dominant role
in price-determination.

Some traders actually follow this concept in practical trading decision-making. An 2005
article of the Federal reserve bank of San FRANCISCO predicts the crude oil price by using
"futures-spot spread" [13], which uses the spread between the current futures prices and the
spot price to predict movements in the future price of WTI crude oil at NYMEX. The central
idea of the article is that oil traders are knowledgeable about the industry, as a result, they are
trying best to make sound investments, making the price-driving force of expectations a
factor as strong as the spot price. The article compares the "futures-spot spread" model with
three other models: random walk model which predicts that spot oil prices will stay at their
current levels, cost-of-carry model which predicts that the future oil price will be the current
spot price adjusted for the interest rate, and "futures" model which predicts an oil price level
in the future identical to the current futures price level.
[tp]
Figure
Figure 13: Back-Test Accuracy of Expectation + Current Statistics Model on WTI Spot
Price(1985-2005), with 3- and 12-month Estimation Horizons
 
In [13], the authors make estimation of WTI future spot price using the "futures-spot spread"
model, over the WTI prices between 1985 and 2005, and calculate model forecasts for
horizons that vary from one to twenty four months, they then compare the forecasts with the
actual oil prices over these months. The results, shown in Figure 13 imply that this model
outperforms than all the other three models: random-walk, cost-of-carry, and "futures". This
study shows that expectation , as a fundamental for oil futures prices contain important
information about price movements, especially for the near term.

Another example of market expectations is the WTI price variation during Spring 2003, when
the U.S. invasion to Iraq took place. From Figure 14, it could be clearly observed that there is
a significant difference between the future price and the spot price from March 2003 to May
2003. This two-month-lasting difference is a good illustration of the influence of market
expectation on crude oil futures price. Before the war, many international observers
announced that the war would be lengthy, and Iraq would become another swamp that the
U.S. troops will have great difficulties to get out (ironically, this has quite become a reality as
of 2006, but discussion of the topic is not within the scope of a master project report). People,
at least those who made a living on the Street, widely believed so as well. The market thus
reflect an expectation that since the Iraq War would seriously influence the relationships
between U.S. and other important oil producing countries, the longer the war would go on the
more seriously the crude oil supply would dampen. As a consequence of this expectation, the
crude oil future price kept increasing, shown by the future prices' trend from January to early
April, 2003. Till April 2003, the invasion turned out to be swift, with the collapse of the Iraq
government and the military of Iraq in about three weeks. The oil infrastructure of Iraq was
rapidly secured with limited damage in that time. Securing the oil infrastructure was
considered of great importance to funding the rebuilding of Iraq after the invasion ended. In
April, U.S. forces moved into Baghdad and soon after President George W. Bush announced
"End of major combat operations". Initial plans which were for armored units to surround the
city and gradually move in soon became unnecessary. All these news from Pentagon soon
pushed down the crude oil futures price. Shown on Figure 13 that in April 2003, the crude oil
spot price achieves its minimal point. The effect of the specific market expectation
diminished in another month, and the large gap between the crude oil's spot price and future
price disappeared.
[tp]
Figure
Figure 14: Effect of Market Expectation on WTI Prices, Jan.-June 2003

6  Evaluation of Quantitative Models That Use

Fundamentals
This section presents and evaluates quantitative price-forecasting models that make use of
fundamentals. The fundamental to be discussed is market expectations, as introduced in
Section 5.2. When forecasting WTI price at NYMEX in a 3-month horizon, the market
expectations fundamental is represented by the 3-month futures price, i.e. the price of WTI
future contract 3 at NYMEX. Time series analysis techniques are used to estimate the model
parameters. I pick the daily WTI price and contract 3 futures price at NYMEX, starting at
January 2, 1986 (the first trading day of 1986) and ending in December 29, 2006 (the last
trading day of 2006). One dataset to establish the models groups prices data within a trading
month are averaged them. The other dataset to establish the models uses the price data of the
last trading day as the representative data of the corresponding monthly price. Each year has
12 trading months, so each time series contain 12(month)*31(year)=252 data points.

There are four models to be addressed. Model 1 (Random Walk Model) and 2 (Interest Rate
Model) are for benchmark only and use just WTI spot price and/or interest rates. Model 3
(Futures Model) uses WTI futures contract 3 price as the sole determinant of future WTI spot
price. Model 4 (Future-Spot Spread Model) uses both the WTI spot price and futures contract
3 price to construct a spread in estimating the future WTI spot price. Below is a more detailed
description of these models:

1. Random walk model predicts that spot oil prices will stay at their current levels.
Mathematically, the model could be presented as:
 Spot Pricet = *Spot Pricet3 +  (6.1)

2. Interest rate model assumes that the opportunity cost of storing oil is the forgone
interest rate. Mathematically, the model could be presented as:

Spot Pricet = *Spot Pricet3 * e*(1+Interest Rate)t3 (6.2)

3. or:

logSpot Pricet = log + *logSpot Pricet3 + * log(1+Interest Rate)t3 (6.3)

4. Futures model predicts that an oil price level in the future is identical to the current
futures price level. i.e., market expectations fundamental is the sole determinant for
future oil spot price. Mathematically, the model could be presented as:

Spot Pricet = *Futures Pricet3 +  (6.4)

5. Future-Spot spread model assumes that future oil spot price is determined by a
combination of current spot price and current futures price, and a properly constructed
spread between these two current prices can predict the future oil spot price.
Mathematically, the model could be presented as:

Spot Pricet = *Spot Pricet3 + *Futures Pricet3 +  (6.5)

Performances of the different models are evaluated using two criteria. First, I estimate the
model over the full sample (January 1986 to December 2006), calculate its forecasts for a 3-
month horizon and then compare the forecasts with the actual oil prices over these weeks.
The model with the smallest average prediction errors is said to have the best "in-sample" fit,
since its parameters are estimated over the full sample.

Second, I conduct a more realistic "out-of-sample" forecasting experiment, where I still use
the parameters estimated using the data up to December, 2006, but make forecasts for oil
prices during January 2004 to December 2006, i.e. the price data of the most recent 36
months . The model with the smallest "out-of-sample" forecast errors has the most
forecasting power, because, in practice, people are only able to undertake "out-of-sample"
forecasts. However, both "in-sample fitness" and "out-of-sample fitness" criteria are used in
evaluation of models, in order to obtain more robust conclusions.

6.1  In-Sample Forecasting Results

Table 2 depicts the overall characteristics of interest rate, monthly average spot price and
monthly average futures price data. While Table 3 presents the linear regressed parameters of
the four models. It could be observed that with respect to RMSE (Rooted Mean Square
Error), Futures Model seems to have the best "in-sample" prediction. The rest three models
have similar RMSE values. With regard to explaining power, all four models have similar
R2values ( � 0.85), with Futures Model having the highest (0.911).
Table 2: Summary Statistics, Using Monthly Average Data

Variable Mean Std. Dev.

interest 4.959 2.175
spotp 25.919 13.491
futurep 25.705 13.883
N 252
Table 3: Fitted Parameters of Four Oil Spot Price Prediction Models, Using Monthly Average
Data

Random Walk Hotelling Future Price Future & Spot Prices

Y=Spot Pricet Y=Log(spot pricet) Y=Spot Pricet Y=Spot Pricet

Spot Pricet3 0.987^*** -0.151
(0.0204) (0.274)
[1em] Log(Spot pricet3) 0.928^***
(0.0259)
[1em] Log(interestt3+1) -1.245^*
(0.501)
[1em] Future Pricet3 0.967^*** 1.115^***
(0.0193) (0.267)
[1em] Constant 0.851 0.301^** 1.593^** 1.729^**
(0.584) (0.0938) (0.550) (0.603)
N 249 249 249 249
2
R 0.905 0.867 0.911 0.911
2
adj. R 0.904 0.866 0.911 0.910
RMSE 4.184 0.152^a 4.046 4.052
Standard errors in parentheses
^a Based on logarithm values
^* p < .05, ^** p < .01, ^*** p < .001
Table 4 depicts the overall characteristics of interest rate, last-day-of-month spot price and
last-day-of-month futures price data. While Table 5 presents the linear regressed parameters
of the four models. It could be observed that with respect to RMSE (Rooted Mean Square
Error), Futures-Spot Spread Model seems to have the best "in-sample" prediction. The rest
three models have similar RMSE values. With regard to explaining power, all four models
have similar R2 values ( � 0.85), with Future-Spot Spread Model having the highest (0.904).
Table 4: Summary Statistics, Using Last-Day-of-Month Data

Variable Mean Std. Dev.

interest 4.959 2.175
 spotp 25.931 13.737
futurep 25.752 14.115
N 252
Table 5: Comparision of Four Oil Spot Price Prediction Models, Using Last-Day-of-Month
Data

Random Walk Hotelling Future Price Future & Spot Price

Y=Spot Pricet Y=Log(spot pricet) Y=Spot Pricet Y=Spot Pricet

Spot Pricet3 0.982^*** -0.351
(0.0212) (0.310)
[1em] Log(Spot pricet3) 0.919^***
(0.0264)
[1em] Log(interestt3+1) -1.280^*
(0.516)
[1em] Future Pricet3 0.964^*** 1.306^***
(0.0200) (0.304)
[1em] Constant 1.027 0.334^*** 1.698^** 1.988^**
(0.608) (0.096) (0.574) (0.629)
N 249 249 249 249
2
R 0.897 0.861 0.904 0.904
2
adj. R 0.897 0.860 0.903 0.904
RMSE 4.419 0.156^a 4.273 4.270
Standard errors in parentheses
^a Based on logarithm values
^* p < .05, ^** p < .01, ^*** p < .001

6.2  Out-of-Sample Forecasting Results

It is worth noting that my "Out-of-Sample" test is a partial one, i.e., training data and test data
are not completely segregated.

6.2.1  Random Walk Model

Figure 15 illustrates how model 1 predicts the monthly averaged spot price. The average of
absolute prediction error is 5.174699167. The standard error of prediction values is
6.141294508.
Figure 16 illustrates how model 1 predicts the spot price of the last day of each month. The
average of absolute prediction error is 5.49767375. The standard error of prediction values is
6.514593256.
[tp]
Figure
Figure 15: Prediction of Monthly Average Price, by Model 1
[tp]
Figure
Figure 16: Prediction of Last-Day-of-Month Average Price, by Model 1

6.2.2  Interest Rate Model

Figure 17 illustrates how model 2 predicts the monthly averaged spot price. The average of
absolute prediction error is 5.324511702. The standard error of prediction values is
5.951021091.
Figure 18 illustrates how model 2 predicts the spot price of the last day of each month. The
average of absolute prediction error is 5.789853643. The standard error of prediction values
is 6.694696508.
[tp]
Figure
Figure 17: Prediction of Monthly Average Price, by Model 2
[tp]
Figure
Figure 18: Prediction of Last-Day-of-Month Average Price, by Model 2

6.2.3  Futures Model

Figure 19 illustrates how model 3 predicts the monthly averaged spot price. The average of
absolute prediction error is 4.946480417. The standard error of prediction values is
6.022400509.
Figure 20 illustrates how model 3 predicts the spot price of the last day of each month. The
average of absolute prediction error is 5.254040833. The standard error of prediction values
is 6.119488822.
[tp]
Figure
Figure 19: Prediction of Monthly Average Price, by Model 3
[tp]
Figure
Figure 20: Prediction of Last-Day-of-Month Average Price, by Model 3

6.2.4  Future-Spot Spread Model

Figure 21 illustrates how model 4 predicts the monthly averaged spot price. The average of
absolute prediction error is 4.905905. The standard error of prediction values is 6.019941115.
Figure 22 illustrates how model 4 predicts the spot price of the last day of each month. The
average of absolute prediction error is 5.230458958. The standard error of prediction values
is 6.026120626.
[tp]
Figure
Figure 21: Prediction of Monthly Average Price, by Model 4
[tp]
Figure
Figure 22: Prediction of Last-Day-of-Month Average Price, by Model 1

6.3  Evaluation Conclusions

My evaluation of the four models shows slightly different result depending on which type of
price is chosen as the monthly price representative: average or last-day-of-month. When
average price is chosen as the representative, the Futures Model is the best performer in out-
of-sample test; while when last-day-of-month price is chose the Futures-Spot Spread Model
seems to perform better. On the contrary, Interest Rate Model and Random Walk Model
seems to be weaker explanations for the test data, which spans from 2003 to 2006.
These evaluation result coincides with the result in [13], albeit the training dataset and testing
dataset of mine and theirs are not exactly identical. The results strongly suggest that market
expectations is fundamental that has significant effect on crude oil spot prices. There could
also be further discussions of the conclusion because that the models I constructed is by no
means comprehensive and sophiscated, and thus might not capture the effects of other
fundamentals.

7  Case Study: Chinese Aviation Oil Trading Loss

In this section a real trading case of oil derivatives is presented and studies. One of the
purposes of the case study is to examine synergies of the individual fundamental analysis
approaches introduced earlier. Another purpose is to put the conceptual reasonings on paper
into the practical environment, to get a sense of how people make use of fundamental
analysis when solve real problems that involve serious capital investments.

7.1  The Story

The full name of China Aviation Oil (CAO) is China Aviation Oil (Singapore) Corporation
Ltd. CAO is a Singapore-listed public company whose core business is to ensure the
procurement of jet fuel (kerosene) for the airports in China. Due to the high-volatility in jet
fuel prices, a large portion of its tradings involve energy derivatives. Initially, CAO traded
only swaps and futures to help optimising this procurement duty. Later in 2002, on behalf of
client airline companies, it started back-to-back option trading. Since 2003, the company
began its speculative trading in fuel options by writing call options and holding put options.
The speculations of CAO ended up bringing the company with big trading losses in October
2004, when the jet fuel price kept an one-year increase and the company failed to satisfy
exchange margin calls on its options positions. The losses totaled 55 million and almost
caused the company to go out of business.

PricewaterhouseCoopers (PWC) issued a postmortem report of the China Aviation Oil

trading loss. From PwC' report it is possible to summarize the CAO options trading records
as follows:

 starting Q3 2003, CAO took a bearish view on oil markets and expected oil prices to
go down;
 consistent with this view, CAO sold call options and purchased put options on jet
fuel;
 with the market moving against their position, CAO restructured their books at 3
different times (March, June and October, 2004) by repurchasing the call options sold
earlier and selling call options with a longer maturity.
 with oil prices continuing to rise, CAO could not satisfy the resulting cash (margin)
calls from the call option buyers and all its positions were forced to liquidate in
October 2004, ending up with the 55 million trading loss.

 
The above is, of course, just a simplified illustration of the CAO story. The real case is much
more complex and actually involves false accounted profit & loss book, poor high-level
management and intentional avoidance of information disclosure to the public share holders.
But the author's interest is only on the company's trading strategies which in turn reflect its
belief on oil prices - CAO was obviously holing a bearish view on jet fuel market. It is known
that as one kind of petroleum product, jet fuel has high volatility in prices. This fact could be
illustrated by its price curve (yellow) during 2003-2004 in Figure 23. Thus, it is not strange at
all if completely different conclusions might be drawn by using a variety of technical analysis
approaches (e.g., curve pattern recognition and chart reading). But could fundamental
analysis give some hints of the underlying price movement direction in this case?

7.2  Analysis

The analysis using fundamentals of crude oil for the CAO case are based on two assumptions.
The first is that crude oil and jet fuel are subject to similar composition of fundamentals, the
second is that the prices of these two products are closely correlated. Assumption 1 is
straightforward. With a stable oil processing capability in 2003-2004, the fundamentals to
drive jet fuel (a product of the downstream) were basically the same as those that drove crude
oil (feedstock from the upstream). As for assumption 2, some empirical evidence need to be
shown to make sure that it was sound for the 2003-2004 time frame.
[tp]
Figure
Figure 23: Crude Oil and Jet Fuel Prices, 2003- 2004
 
To prove assumption 2, the following data are collected from EIA: spot price for WTI at
NYMEX, spot price for New York Harbor Kerosene-Type Jet Fuel at NYMEX, and future
contract 1 price of WTI at NYMEX. The spot prices are of January 2003 to January 2004
period, while the future contract price is of December 2002 to December 2003 period, due to
its one-month advance of spot prices. To smooth the market fluctuations of jet fuel due to its
own supply-demand dynamics, a 60-day moving average of the jet fuel spot price is also
calculated. All data are plotted in Figure 23. It could be seen that despite the trading
decomposition of crude oil spot markets and futures markets, the spot price and the future
contract price of WTI almost fully overlap with each other. In the mean time, although the
spot price of jet fuel has lots of location variations that are different from crude oil, its
average trend (here in two-month) agrees with crude oil pretty well. Thus, assertions can be
made that the following equations holds for the 2003-2004 period and it is sufficient to use
WTI futures price to study the CAO case:

WTISpotPrice � WTIFutureContract1Price (7.1)

and

JetFuelSpotPrice � WTISpotPrice (7.2)

 
After deriving equations 7.1 and 7.2, the attention is switched onto crude oil futures prices
and examination of the fundamental drivers are conducted. To simplify the analysis process,
only the fundamentals mentioned in this report are used, namely supply-and-demand balance,
geopolitical factors, inflation factors and market expectation. The ultimate goal of the
analysis is a mocked market view that CAO trader should take in year 2004 - 1 for strong
bearish and 5 for strong bullish, and the values in between denote mild bearish, neutral and
mild bullish, in ascending order. The scoring process is broken down to each fundamental on
a weighted basis (Table 6). After the scores for each fundamental (each ranges from 1-5) are
derived, the weighted sum is calculated as the overall score.
[h]
Fundamental Scoring Weight (Percent)
Supply-and-Demand Balance 40
Geopolitical Factors 40
Inflation Factors 5
Market Expectation 15
Table 6: Scoring Weights of Each Fundamental in CAO Case Study
 
The demand for crude oil was in an growing trend in 2004. At the end of 2003, both
International Energy Agency (IEA) and EIA issued reports estimating crude oil demand in
2004 to increase over 1 million barrel a day. Different factors were responsible for this
increasing trend. Economy of China was maintaining a strong up arrow and accounted for
over one-third of the crude oil demand increase in 2003. Side-by-side to China's economical
achievement was the wake up of U.S. economy. The U.S. GDP growth rate was 6.6% in
2003, a historical high since the bust of Internet bubble and kept an up momentum. Global air
traffic, which had been hit heavily by 9-11 was recovering and brought a higher demand for
jet fuel. At the same time, the supplies were tight. OPEC decided to decrease its production
quota in November 2003, by 0.9 million barrels a day. This was a strong sign for decreased
global crude oil production, and OPEC's resolution to pull-up oil price. For Iraq,
reconstruction of the oil field and pipe infrastructures had been largely postponed. With all
these factors considered, this report assigns the 2004 score of 4 for the supply-and-demand
fundamental.

As far as the geopolitical factors were concerned, the concern of terrorist attack was major
among OECD countries. With Osama Bin Laden still at large, Al-Qaeda kept spreading
hoaxes about assaults to civil and government facilities in 2004. For example, an unusual
amount of nuclear power plants were shut down in Japan. There were not planned
maintenance shutdowns; the plants were taken out of operation because of fears relative to
their safety. The dates at which they would be brought back on stream were repeatedly
postponed, in February 2004, most had not yet been restored to service, so Japan had to rely
more heavily on thermal power plants burning crude or fuel oil. Accounting for all these
factors, this report assigns the 2004 score of 3.5 for the geopolitical factors fundamental.

As mentioned earlier in Section 5, market expectations could be partially observed from the
difference between futures price and the spot price. The 2004 crude oil futures curve
maintained to be closely overlapped with the spot price curve. Also, market commentaries
about price direction had been neutral and unclear. Based on these observations, this report
assigns the 2004 score of 2.5 for the market expectations fundamental. Because inflation
factor is a long-term fundamental, its effect on crude oil futures price is relatively small in a
single year and this report assigns the 2004 score of 2.5 to the inflation factors fundamental.

To sum all scores up, the 2004 score for crude oil futures market view is: (4 * 0.4 + 3.5 * 0.4
+ 2.5 * 0.05 + 2.5 * 0.15 ) = 3.3, between mild- and strong-bullish. Surely this calculation is
quite coarse, but still could serve as a warning sign for CAO's bearish bets of the market,
especially when it was speculating with option derivative, as the lever effect would make any
decision mistake very risky. This risky nature of CAO's trading strategy was exactly the root
cause for its huge loss in the oil deal.

8  Conclusions
This project tries to use fundamental analysis approaches for in-depth study of crude oil
futures price. Although quantitative models have been very successful in the financial
derivatives market, fundamental analysis is still an indispensable element for energy
derivatives, which crude oil futures is one kind of. At the beginning of this report, the basics
of crude oil and its future contracts are introduced. With the help of two main data sources:
EIA and API, as well as a compilation of news articles, analysis are subsequently conducted
over basic and more advanced fundamentals.

In basic fundamental analysis section, the 4-year price increase of crude oil futures from
2003 to 2006 is analyzed. Two fundamentals are presented: supply-and-demand balances and
geopolitical factors. Each fundamental are first introduced with concrete examples, then used
to explain the price increase phenomenon addressed. The section comes up with the argument
that strong growth in demands, geopolitical risks and limited surplus in both upstream and
downstream capabilities were the main pull-up drivers for crude oil future price during the
2003-2006 period. The further fundamental analysis section first demonstrates the use of
inflation factors, then the market expectations, the other important fundamentals. Concrete
examples are also given for each of these two fundamentals.

An important fact about crude oil futures prices is that seasonality plays an important role as
one determinant. However, seasonality analysis is not a topic of this report. One reason is that
seasonality patterns are not fundamental themselves, but rather derived results of other
fundamentals. This is why seasonality analysis is often listed in parallel with fundamental
analysis and technical analysis as approaches to study crude oil futures prices. The other
reason, as described in Chapter 9 of [11], is that pure random price variations are very
probably to cause seemly obvious "seasonality" patterns and result in misleading conclusions.
The last but not least reason is that seasonality analysis has already been largely quantified
and standardized by many popular statistical software packages, such as SAS.

After basic fundamental analysis and further fundamental analysis sections, four quantitative
models that use fundamental as parameters for crude oil price prediction are presented and
evaluated. The evaluation results using NYMEX data from 2003 to 2006 show that the model
that incorporates the spread between spot price and futures price to predict future spot price is
relatively more accurate. These results also partially reflected the quantified influential power
of futures price in determination of future spot prices.

A case study about China Aviation Oil's trading loss in 2004 is presented and studied in
Section 7, using the fundamentals listed in the previous sections for post-mortem analysis.
The study is led by explanation of the interchangeability between crude oil future contract
and jet fuel spot prices during 2003-2004, then followed by drilling down the contexts of
several key fundamentals during that period. The case study shows that fundamental analysis
could help to identify market directions if there are strong signals present, and control trading
risks when properly used.

To identify the fundamental drivers for crude oil during a specific time period and make
correct analysis of their effects are both non-trivial tasks, and require lots of experience and
common sense. This report, by no means, claims itself to be error-free and a trading guide
that could be followed. As stated in Section 1.2, its main purpose is to literally reproduce the
processes of learning, practicing and analyzing. The author benefited from these processes a
lot and sincerely wish this report could deliver them to the readers. Feedbacks in all forms
about errors and improvement opportunities are greatly welcome.
Acknowledgements
The author owes sincere thank to Professor Stanley R. Pliska, who is his MISI project advisor
and a renown scholar in finance. Without his substantial help in weekly meetings, data set
collection and literature review, the completion of this project would have been significantly
more difficult and slower. The author would also like to thank Jianhong Zhou for many
useful discussions and suggestions. This report is prepared with a nicely edited
LATEX template made by Matthias K. Gobbert [6].

A  Glossary of Terms
API
American Petroleum Institute.

API gravity
An arbitrary scale expressing the gravity or density of liquid petroleum products devised
jointly by the American Petroleum Institute and the National Bureau of Standards. The
measuring scale is calibrated in terms of degrees API. Oil with the least specific gravity has
the highest API gravity. The formula for determining API Gravity is as follows: API Gravity
= (141.5/Specific Gravity at 60�F)  131.5.

Brent Crude
Brent Crude is one of the major classifications of oil consisting of Brent Crude, Brent Sweet
Light Crude, Oseberg and Forties. Brent Crude is sourced from the North Sea. The name
'Brent' comes from the formation layers - Broom, Rannoch, Etieve, Ness and Tarbat. Oil
production from Europe, Africa and the Middle East flowing West tends to be priced relative
to this oil, i.e. it forms a benchmark. Brent blend is a light crude oil, though not as light as
West Texas Intermediate (WTI). It contains approximately 0.37% of sulfur, classifying it as
sweet crude, yet again not as sweet as WTI. Brent is ideal for production of gasoline and
middle distillates. It is typically refined in Northwest Europe, but when the market prices are
favorable for export, it can be refined also in East or Gulf Coast of the United States or the
Mediterranean region. Typical price difference per barrel is about 1 less than WTI, and 1
more than OPEC Basket. Brent Crude has an API gravity of around 38.6.

bunker
Originally, a coal-bin on a steamship. Later, by analogy, a shipboard fuel tank for marine
diesel fuel.

bunker oil
A residual fuel oil, used for marine diesel engines, power generators, and industrial boilers
and furnaces. Examples: Bunker C, Singapore 380.

centistoke
A unit of viscosity, used for defining crude oil grades.

CIF price
The CIF price includes cost, insurance, and freight charges, whereas the FOB price excludes
them.
crack spread
The price spread between the crude oil price and some specific amount of a product (e.g.,
gasoline, heating oil, or fuel oil) price.

crude oil time spread

The price differential between the first and second nearby NYMEX crude oil futures
contracts.

CTS
The acronym for centistokes.

EIA
The acronym for the Energy Information Administration. Created by Congress in 1977, the
EIA is a statistical agency of the U.S. Department of Energy. The EIA's mission is to provide
policy-independent data, forecasts, and analysis to promote sound policy making, efficient
markets, and public understanding regarding energy and its interaction with the economy and
the environment.

F.O.B.
The acronym for Free on Board. The F.O.B. price excludes cost, insurance, and freight
charges, whereas the CIF price includes them.

NYMEX
The acronym for the New York Mercantile Exchange.

OECD
The acronym for Organization for Economic Co-operation and Development. OECD is an
international organization of those developed countries that accept the principles of
representative democracy and a free market economy. It originated in 1948 as the
Organization for European Economic Co-operation (OEEC), led by Frenchman Robert
Marjolin, to help administer the Marshall Plan for the reconstruction of Europe after World
War II. Later its membership was extended to non-European states, and in 1961 it was
reformed into the Organization for Economic Co-operation and Development.

OPEC
The acronym for Organization of the Petroleum Exporting Countries. OPEC is an
international organization made up of Algeria, Angola, Indonesia, Iran, Iraq, Kuwait, Libya,
Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. Since 1965 its
international headquarters have been in Vienna, Austria.

paleotempestology
Examining the physical record to gather data on hurricanes that predate the historical record.

residual
What remains from crude oil after removing the more valuable products, such as diesel,
gasoline, kerosene, and naphtha.

sour crude
Crude oil that has a high sulfur content. The minimum level varies, depending on who's
defining, but 2.5% sulfur by weight is high enough by any standard.
spark spread
A long position in electrical power and short position in fuel (typically natural gas) that
simulates the profit from operating a power plant (e.g., a gas turbine generator). The heat rate
determines the size of the short position in fuel.

spark spread option

An option on a specific spark spread.

sweet crude
Crude oil that has a low sulfur content. The maximum level varies, depending on who's
defining, but 0.42% sulfur by weight is the cutoff for the NYMEX Light, Sweet Crude Oil
Contract.

swing option
An option that contains an embedded quantity option.

West Texas Intermediate

A grade of crude oil that has its main delivery point in Cushing, OK. The spot price for WTI
delivered to Cushing is the ultimate settlement price for the NYMEX oil futures contract.

WTI
The acronym for West Texas Intermediate.

References
[1]
The oiloholics. The Economist, August 25, 2005.
[2]
F. Black and P. Karasinski, Bond and option pricing when short-term rates are
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A. Davis, How giant bets on natural gas sank brash hedge-fund trader. Wall Street
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[6]
M. K. Gobbert, Homepage with LATEX Introduction.
http://www.math.umbc.edu/~gobbert.
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J. Hull and A. White, Price interest rate derivative securities, Review of Financial
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[8]
 X. Luo, Homepage with materials related to this report.
http://www.cs.uic.edu/~xluo.
[9]
T. Petruno, 2006 takes a soft bounce. The Baltimore Sun, December 26, 2006.
[10]
D. Pilipovic, Energy Risk, McGraw-Hill, 1997.
[11]
J. D. Schwager, Schwager on Futures: Fundamental Analysis, John Wiley & Sons,
Inc., 1995.
[12]
N. Schwartz, Ready for $262 a barrel oil? Fortune, April 11, 2006.
[13]
T. Wu and A. McCallum, Do oil futures prices help predict future oil prices?, FRBSF
Economic Letter. Number 2005-38, December 30, 2005.

Footnotes:
1
Department of Computer Science, University of Illinois at Chicago. 851 S. Morgan Street,
Chicago, IL 60607 (xluo1@uic.edu).

File translated from TEX by TTH, version 3.77.

On 15 Apr 2007, 19:07.