The petroleum industry can be a very difficult subject to explain to the uninitiated; with its array of technical terminology it can bamboozle all but the most zealous student.
However as an educator I believe all topics can be dissected into small chunks of manageable learning allowing a student to easily process and assimilate very complex topics. One of the main areas that cause students confusion is the area of trading.
How is crude futures traded on the stock market? Another common question is how are contracts related to oil and gas trades?
Let's start by defining the term futures. This is a type of contract that fixes a price for something to be bought or sold; the buyer/seller is then obligated to buy/sell at that price. For example on a particular date in the future the buyer agreed to buy trades at
The price of crude oil, natural gas and petroleum products is constantly responding to changes in the market which can cause rapid fluctuations in price. For example if an oil well explodes, conflict erupts or an embargo is enforced such as the one imposed by
Trades on the stock market usually refer to single contract exchanges called lots. These lots are of 1000 barrels of light sweet crude and the investor would buy for delivery in the next three month, however as more investors speculate on the stock market the lot can now be bought for months or even years into the future.
The type of oil and gas future trades can be directly related to oil companies whose daily business is exploration and production (E&P) or indirectly from the companies or organisations who heavily rely on oil such as airlines or the military.
In the West, future trades take place at regulated futures exchanges using both modern and traditional methods. Before the time of widespread computer systems, trades would be bought and sold by effectively shouting out a price to the trading floor and someone else shouting back their interest. As you can probably imagine this was a noisy and chaotic experience and thankfully modern trading is mostly electronic, but you can still find places where you will see a mixture of the two styles.
Price and Contracts
The initial price is determined by a number of factors which can often be unrelated to the size of the reservoir but rather the political stability of the oil producing country and the economic stability of the surrounding region.
Investors will examine if political factors could cause a delay in production and supply of oil and gas to the market causing a spike in market prices. Also if the surrounding region is very poor or politically unstable, is there a risk of conflict or terrorism towards the refineries again resulting in a break to the supply chain. Furthermore when a new supplier enters the market a consideration is made towards the type of contract in place between the oil company and the country where the oil and gas is found.
The oldest type of contract is called a Concession, the host government gives the oil company exclusive rights to explore, drill, produce and refine for an agreed period of time. This gives the host country a number of benefits including simplification of the contractual process and this is a tried and tested method. However the bidding process is no more than an auction and the highest bidder may not have the relevant experience to know the potential of a concession contract.
A Joint Venture (JV) is sometimes used when the government does not have enough local experience of oil and gas production and contracts. The government and company will jointly make decisions and a JV is often referred to as a marriage contract. However this also means the host government must share the risks and costs of E&P, but unless properly maintained and developed like any marriage it can come to a bitter end.
Another common type of contract which can give investors confidence is the Profit-Sharing Agreement (PSA). The government maintains ownership of the resources and negotiate with the company a share of the profits. The company splits the oil into cost-oil and profit-oil as they have to pay for the initial exploration and development. The advantages for the government are that the oil company takes most of the risk however the contract is often inflexible and can stifle the negotiation process.
Whichever contract is used is open for negotiation but careful thought should be applied to the effect this has on future trades on the stock market.
Brian Sallery, is the Principal at the
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