FUNCTION AND OPERATION OF NON-NYMEX CRUDE OIL MARKETS

• Jurisdiction: United States

Federal & Indian Oil & Gas Royalty Valuation and Management II
(Feb 1998)
CHAPTER 7A
FUNCTION AND OPERATION OF NON-NYMEX CRUDE OIL MARKETS
Daniel H. Pears
Marathon Ashland Petroleum LLC
Houston, Texas

Certainly one of most visible trends in the crude oil market has been the continued movement toward a 'spot' trading based marketplace complete with the volatility and competition associated therewith. For years refiners, producers, transporters and international governments handled their crude oil business on a long term contract basis which resulted in a market generally void of daily price volatility. With the move by both the producer and the end user of viewing their businesses on a marginal or incremental basis, the economic focus has moved to the value of the 'last' barrel produced or refined. This focus, along with a general move toward a commodity based marketplace, has led to an explosion of spot transactions or transactions with the duration of one month or less. This trend has had a significant influence on lease level trading and pricing as well.

Relationship of NYMEX Markets to Lease Level Purchase Prices

One of the fundamental differences between the vast majority of leased based prices and the NYMEX crude oil prices is related to the fact that the NYMEX is a 'futures' market, and leased prices are based on a prompt, or current, market. The NYMEX trades crude oil and products based on physical delivery in a future month. The first forward month, or front futures month, could be from eight to 43 days in the future. By contrast, most lease crude oil is priced on the day it is removed from the lease facility, or often times on an average of daily prices during the calendar month in which it is delivered. These daily prices are usually related in some manner to a 'futures' reference price, but need to be adjusted for a number of factors which may include overall market structure, transportation, quality, losses, crude oil grade (type), location, ratability and localized market conditions.

Market Structure

Market structure is broadly defined as the change in a commodity market going forward from a given point in time. Since most US crude oils are traded on a spot basis as ratable daily volumes for delivery over a calendar month, the market structure in the US is considered to be the month to month change going forward. The fact that most US produced crude oils ultimately get transported by pipelines requires that the trades for the forward month are completed prior to the commencement of the delivery month in order for the pipeline companies to schedule and coordinate crude oil movements. Many international markets, most notably the North Sea Brent market, are able to define market structure in more finite time periods, usually consisting of one week or even a few days. The month to month difference in the crude price in the US market is usually referred to as the intermonth spread or sometimes called the 'roll'. If the price going forward is increasing over time, the market is considered to be in 'contango'; if the price going forward is decreasing over time, the market is considered to be 'backward'. With most lease crude oil being priced based on some relationship to the value of crude oil in a future month, the value of either the 'backwardation' or 'contango' must be recognized as a

[Page 7A-2]

component part of the true value of the crude oil at the production facility, or...