The Oil Game - Don't Get Too Comfortable (Part I)

For today's post I thought I'd discuss something that at least used to be a cause of worry for many people, and something that, I think, still should be a source of concern. The world's energy industry is incredibly complex and convoluted. Why wouldn't it be? Since the industrial revolution, the world, especially industrialized nations, really on this energy infrastructure just to function. Furthermore, over the last few years, this industry has come to the cultural, economic, and political forefront due to an unprecedented rise in energy prices for the end-consumer. But, in order to really understand the reasoning behind the precipitous rise and even more precipitous fall in energy prices, one must think like an investor because, at the end of the day, it's investors, not necessarily the oil companies, that determine the price of a gallon of gas that you put in your.


How Oil Works




The process of getting oil (or any other type of fossil fuel) from the ground to a machine that will consume it is a symphony of logistics, geological sciences, politics, and a little luck. From my understanding, the oil complex can be broken down by components in the following way (keep in mind that I say Oil since that is the primary energy source for most of the world. Coal, natural gas, or any fossil fuel works in similar fashion with some variations):

1. Drillers - These are the guys that go out and perform the first major step: finding the oil and pulling it out of the ground. This often arduous and expensive process factors in two major components of the symphony mentioned earlier - Geoscience and Politics. The geoscience part is pretty self-explanatory. These companies spend tens of millions of dollars, extremely advanced technology with some of the fast super-computers on earth, and a bunch of very smart people researching the best places to find oil on the planet. Once they find this oil, however, they have to negotiate with whichever government the land/water belongs to so they can drill for that oil. Generally, the government gets a large percentage of the money made from drilling that oil, but sometimes, there are political hurdles to overcome (Venezuela being a prime recent example). Major players in the drilling business are Exxon-Mobil, BP, Shell, all the big name guys (these big names pretty much are involved in all components of the oil complex. Other, less household names are Transocean (the biggest name in offshore oil drilling), Constellation Energy, and StatOilHydro. These guys are common names on Wall Street.
2. Refiners - Once the oil is dug up, it needs to refined into a petroleum product that can be used in our engines, furnaces, poweplants, etc. The refining process is basically taking the oil that comes out of the ground, a.k.a crude oil, and doing all sorts of crazy chemistry stuff to it to break it up into individual component fuels. Example fuels are kerosene, gasoline, diesel, etc. This 'refined' product is then ready for consumption by the end user. The major players in the refinery business are the big names I've already mentioned plus others like Murphy Oil, Frontier Oil, Tresoro Corp.. These guys make their money by taking the oil and refining it to sell the component fuels. The difference between the crude oil price and the fuel price (known as the crack spread) essentially determines the profit margin that the refiners make.
3. Retailers - The retailers are the ones that actually sell the oil to the end user, the most common example of which is the gas stations we see every day. These guys take the finished product from the producers and sell it to consumers. Believe it or not, the retailers make very little profit from the fuel itself. For example, your local Mobil station will only make a few cents for every gallon of gas you buy; most of their money is actually made from ancillary products like the stuff they sell in the convenience stores. One thing to note, however, is that many gas station brands do not refine their own fuel. Some of the less known brands actually buy their fuel from a refiner like Murphy and then sell it as whatever brand they want to. I'm not saying that this gas is any better or worse than the major brands, but it is something to keep in mind
4. Pipelines, Shippers, Equipment - Finally these are the names that work within the above three to makes those components fit together. The pipelines are the on land transportation mode for oil. One common example are the lines we have from Alaska and mainland US. If you've been listening to the news lately, you've heard of another big example of the pipelines from Russia to the EU and how they're having issues with keeping them online due to the conflict with the Ukraine. Some big names are Williams, Kinder Morgan, and Enbridge. The shippers are the HUGE oil tankers you see on the news sometimes. These guys move oil from the drilling site to the refinery site and the refined product to its final destination. Teekay, Frontline, and General Maritime are examples. Finally, the equipment services names are the ones who make the large rigs and drills to give the drillers and refiners the ability to make the fuels. Big names there are Baker Hughes, Haliburtun (Yeah, Dick Cheney's Posse), and Schlumberger.

How Oil Works - On Wall Street and Futures Contracts



Now that we understand how the oil complex works, we need to understand how it's priced. In a way, the pricing of Oil is fairly simple - it's whatever the front month contract for light sweet crude is selling for (if you're looking in the US market). What is a contract, you say? Well, way back in the day, farmers had a dilemma - "how do I know how much seed to plant in a given season when I can't predict what the price for my crop will be come harvest season?" If they planted a whole bunch of corn, when it came time to sell the corn to merchants, if there was too much on the market, the price would be too low. The same issue worked the other way - merchants wanted some predictability as to what price they would be able to buy the corn so they could better forecast how much they should buy and what kind of margins they could achieve. This unpredictability created a level of risk for both sides that needed to be resolved. So what the farmers and merchants started doing was entering into contracts that would guarantee the price of the product at a specific time in the future. These contracts came to be known as...wait for it....wait for it...futures contracts (they're business people - not very creative I know)! The futures contracts (often just called futures) gave the farmer a minimum as to what price he would be able to sell the product, and the buyer a ceiling as to what price he would buy the product, thereby reducing the price fluctuation risk exposure both had. Entering into a futures contract is also known as 'hedging', the process in which to dramatically reduce risk while potentially reducing some reward (hence the term, hedge your bets).



Well, eventually futures were created for EVERYTHING....corn, sugar, hogs, chicken, steel, currencies, and, yes oil and it's products, gasoline, diesel, etc. Also, central market places were created to trade these futures, the biggest in the world being in Chicago. Here, buyers of the products (an example being an Airline buying kerosene for its planes) can enter into contracts with suppliers (maybe a refiner like Murphy) to receive their product at a specific date and a specific price and the price you see on TV for things like Oil is the price the latest oil contract is selling for on these exchanges.



However, there was an additional consequence of creating futures markets. Having these markets gave the ability to investors who had no intention of actually taking delivery of the product to trade the contracts as well. The investors would hope the either the demand or supply of the product would change significantly prior to the contract date, thereby affecting the value of the contract. If the value changed the way they expected, they would make some money out of it. Let's take an example. Let's say I buy a Oil barrel future for $40 because I think the price of Oil will increase. If I do nothing, on the expiration date for that contract I will take delivery of that barrel of oil and the contract is worthless. But let's say a conflict starts in the middle east, affecting the supply of oil to the refineries. Well, the supply/demand picture has changed and there will be expecation that the price will increase. Therefore, the value of that contract will likely increase. I can then go ahead and sell that contract (before it expires) to another buyer, either another investor or an end user (like that Airline) and make a profit.



I hope you guys can now see how investors really are the ones that determine the price of oil. There are so many investors in the market compared to actual oil buyers that for every $1 dollar of trading an actual buyer conducts, investors conduct $13.



You Still Haven't Answered Why The Prices Fluctuated So Much




I know, I know. I think I've given you guys enough info for this post. Stay tuned for the next one where I'll answer this question and why I think you shouldn't get too comfortable with the low gas prices at the pump.



Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.