THE EVOLUTION OF SPOT MARKET PREMIUMS

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management Book 1
(Feb 2004)
CHAPTER 3B
THE EVOLUTION OF SPOT MARKET PREMIUMS
Daniel F. Riemer
Manager, Crude Oil Marketing
Marathon Oil Company
Houston, Texas

Crude oil pricing practices date back to the late 1800s when posted prices were the first method of establishing value for crude oil at a production facility. Postings were primarily issued by refining companies, and had a tendency to remain constant for extended periods of time. As time progressed, postings were established for different regions, different crude types, and for individual fields. Beginning in the 1970s, as the OPEC nations began to influence crude oil prices, postings started responding to international markets. In an attempt to moderate escalating prices, our Federal Government extended the 1971 price controls in 1973 through the Emergency Petroleum Allocation Act, and again in 1975 with the Energy Policy and Conversation Act. However, these programs did not achieve the desired results and was eliminated by the Reagan administration in 1981. The U.S. quickly began to move toward a spot based market, a move that Britain, Norway and other North Sea markets had initiated several years earlier. By 1983, the first truly successful crude oil futures contract came into being on the New York Mercantile Exchange. In the midst of all this change, postings somehow managed to survive, and they continue to serve as the basis for the majority of spot market or cash market transactions today.

The Structure of Crude Oil Markets

Market structure is broadly defined as the change in a commodity price curve going forward from a given point in time. If the price curve going forward is increasing over time, the market is considered to be in contango. If the price curve going forward is decreasing over time, the market is considered to be backwardated. Mature commodity markets generally have a contango structure, with higher prices in future months to reflect the cost of carrying inventory. For years refiners, producers, transporters and international governments handled their crude oil business on a long term contract basis which was generally void of daily price volatility. This business model supported a contango market structure. More recently, however, the trend has been a continued movement toward spot-related transactions, which have a duration of one month or less. The economic focus has shifted to the value of the last barrel produced or the incremental barrel refined, and this focus has led to greater liquidity and increased volatility for prompt barrels. The demand for inventory and a perception of scarcity of supply often translate into a premium for prompt barrels, which explains why the crude futures market today spends the majority of the time in a backwardated state.

Factors that Influence Crude Oil Markets

Crude oil prices and market structure are influenced by many factors, the most significant of which are fundamental data, technical data, perception and manipulation. Fundamental data tends to deal with physical aspects of the marketplace such as supply, demand, inventory, refinery utilization and weather. Advances in media coverage have enabled fundamental data to be captured and reported on a more contemporary basis, which in many cases leads to increased volatility because disruptions from production, refining and transportation operations tend to be viewed as having long term consequences rather than the short term anomaly that they turn out to be.

Technical data primarily relates to futures markets and includes items like volume of contracts traded, open interest, daily price continuation charts, and price support and resistance levels. For every long or short position there is an offsetting short or long position, and all open contracts must eventually be closed either with an offsetting paper instrument or by physical receipt or delivery. Trading activity for the prompt NYMEX contract averages...