Originally posted to The Daily Kos on Friday Apr 23, 2010 · 11:40 PM PDT
Current link to original: http://www.dailykos.com/story/2010/04/24/860218/-Oil-The-Cost-of-Oil-and...

I have updated this to contain information on "take-or-pay" contracts, which I left out of the original because it was already lengthy enough. However such contracts have become more relevant of late.

Our lives and environment are literally saturated with petroleum and petroleum products. The "ahl bidness", as they say in Houston, has a large effect on our economy both directly and indirectly. We need a clear understanding of exactly how it all works to hold informed debates on things like how to best approach climate change, how capping emissions or taxing carbon imports and extraction will alter both the economy and the environment, etc. Unfortunately, it has its own somewhat unique wrinkles as well as impacts that few of us immediately think of when the topic of oil and oil prices arises. I hope to present just a few of the basics here. Because this is intended as "Oil & Gas 1a", I plan on linking to a lot of more comprehensive articles, especially in Wikipedia, although I don't necessarily agree with everything in all of the articles I will link to.

I would like to get into who uses it for what and most importantly who does and doesn't pay those quoted prices and what they really mean but there is one minor detail in the way. Like many things, oil has its own language, so it is appropriate to begin with some vocabulary.

As with society, crude is that which is not refined. Crude oil, aka Crude is a flammable liquid mix of hydrocarbons, per this link [https://en.wikipedia.org/wiki/Petroleum]. There are, however, oil sands, tar sands and assorted other things which, for the purpose of this diary, I will lump in with crude for most purposes even though they aren't liquid and in some cases aren't even that flammable. This may generally be thought of as that stuff in the ground and which is extracted from the ground and very often refined. (I recall hopping out of a bus in Ecuador, smelling fresh tar, and seeing earthmoving equipment which had been digging fairly righteous bituminous paving material straight out of the hillside and applying it to the road, it will always fail the smell test, burn or no burn.)

Refined Oil really doesn't exist. Your motor oil is really a mixture of chemicals extracted from crude oil by the refining process(es). Crude is refined into a significant number of "fractions", kerosene, pentane, paraffins and what have you. In a Refinery [https://en.wikipedia.org/wiki/Oil_refinery] oil is subject to numerous processes. The most basic, suitable for SWEET LIGHT crudes is to heat it and boil it off at the base of a tall tower. As it rises it cools and, as each fraction has its distinct boiling and condensing point, the various fractions liquefy and are drawn off at different elevations. Historical sidenote:In the early days in some places, they grabbed the kerosene and dumped the rest. It is said that there are embankments in Chechnya where one can insert an appropriate length pipe into the bank, build a fire below it and extract useful fuels like diesel. Chechnya, which may ring a bell, is part of pipelinestan; a whole nother issue.

Heavier crudes need special treatment, generally some type of "cracking" to make them more amenable to refining. Sour crudes also need some tweaking along the way.

Part of this often requires additions of various chemicals and additional grades of crudes, all of which, along with the crude itself, become refinery inputs.

Upstream operations are exploration and production; seeking oil, and getting it out of the ground when one finds it.

Downstream operations are everything else, transport, refining, marketing, distributing and selling, etc. EXCEPT that some break out Midstream [https://en.wikipedia.org/wiki/Midstream] as per this link, and then reincorporate it back into downstream. This distinction is important for reasons that will be explained very shortly when we look at who really pays those quoted prices for oil.

Suffice it to say that some companies are strictly upstream, but those are often mere "temporary" joint ventures, others are purely downstream (Valero, for example) and some are both, and are called "Integrated" as well as a plethora of other things including "Pirates" and "criminals".

If you take nothing else away from this diary note that Upstream and Integrated companies are lumped into the category known as

PRODUCERS
Producers PRODUCE oil, the downstream midgets BUY it. Exxon and Chevron produce, Valero buys, and the costs of these two types of companies are enormously different.

It may begin to appear that oil isn't really fungible, not one thing, and that is where sweet, sour, api grades and all suchwhat come in, which leads to benchmarks and those crazy price quotations and what they're good for (oooh futures traders) and what they aren't (like gasoline prices, by and large).

VISCOSITY [https://en.wikipedia.org/wiki/Viscosity] is weight or thickness or how slowly it pours or how slowly a ball bearing falls through a tube filled with it. Olive oil isn't very viscous, molasses is. For our purposes, we look to API Gravity [https://en.wikipedia.org/wiki/API_gravity] from the American Petroleum Institute which is kind of like specific gravity with a special scale, a high API gravity is "light" and and floats on water while a low API is "Heavy" and sinks into water

THIS IS VAGUELY IMPORTANT:

LIGHT CRUDE [https://en.wikipedia.org/wiki/Light_crude_oil] floats on water, is easier to distill into its fractions and has a higher proportions of the more valuable fractions, like the components of gasoline, and a lower proportion of the less valuable fractions like bunker oil, tar and stuff needing reprocessing.
There are a ton of different grades of "light"

HEAVY CRUDE [https://en.wikipedia.org/wiki/Heavy_crude_oil] is not light. It may even be solid if you lump in tar sands and the like. Pour it on water and it sinks. There are many grades of "heavy". It is less valuable and harder and more costly to refine with fewer of the more valuable fractions and more of the less valuable fractions.

Hey, surprise, there are also many grade of "intermediate" (WTI) in between the two and we are almost there.

SWEET CRUDE [https://en.wikipedia.org/wiki/Sweet_crude_oil] has less than 5% sulfur. It is less caustic easier to process into more valuable products and more valuable. The link has some names of some sweets, they are meaningful.

SOUR CRUDE [https://en.wikipedia.org/wiki/Sour_crude_oil] has more than 5% sulfur and is less valuable. The article mentions Platts [https://en.wikipedia.org/wiki/S%26P_Global_Platts] click and browse that, Platts is one of the original and premier "quotation media" which is one of the main sources of all that "Oil is trading at 42 dollars per barrel today" stuff that may or may not have anything to do with anything depending upon who you are.

Peek at Platts itself [http://www.platts.com/commodity/oil], but also AliBaba [https://www.alibaba.com/Crude-Oil_pid100110] If you'd like some idea of what goes on in that realm. Platts is, unfortunately by subscription but AliBaba is well worth a browse if you never have checked it out.

We are ready for BENCHMARKS [https://en.wikipedia.org/wiki/Benchmark_(crude_oil)] Some names will be familiar from list for sweet crudes. Hmm, sweet = valuable = benchmark. Cool. We're there, but we will eventually digress. Click this sucker, I assume you did. Benchmark is a standard to which the others are compared. There are a potentially infinite number of grades and such, and nobody wants to price each field so they use Benchmarks.

WTI. West Texas Intermediate, hot diggety damn, Texas, got thet, podnuh? A price quote for the U.S. Of Oil Consumers is most likely a quote for WTI or some bundle of US sweet light crudes. Meanwhile, price quotes for ROW (rest of world) will generally be Brent, even though there's damn little of it left (maybe). When the paper or the intertubes say oil is 42 dollars per barrel they are using an exchange price or a benchmark price, but the exchange price is for a benchmark and... ah the hell with it.

Forget the exchanges for a minute. WTI is 42 bux per barrel. Sam brings in a new field in Oklahoma so we see what inputs beside the crude we need in order to run it through the refinery and cost that crap out which we subtract from the value of the various amounts of the various fractions and we get a net revenue figure which we can compare to that for WTI at today's prices. Hey, awright, Sam's is about 80% of WTI. Nobody lists a separate price for Sam's, it is simply quoted at 80% of WTI, and this is one use for those price quotes, to value Sam's, and Fred's and Sally-Sue-Bob's and all thet there.

Whoa -- we're there, what do those damn prices mean and what are they good for? Well, we just saw one use, but what does it have to do with the price down at the local ARCO? Zip diddley shit, as they say in Houston.

Well, sour heavy is crap and sweet light is cool, so what if I maybe am one of the very few who can really use sour heavy and I am a PRODUCER (there it is) of sweet light. What if my Bonny from Nigeria (YetAnotherBenchmark) is trading at about 90% WTI and Kazakh makeyougag is trading at 45% of WTI and you are a particular European company what has a bargain source of Kazak crapola but can only refine sweet-light or, preferably Bonny because you built your refinery around it? Well, how 'bouts you swap me a couple barrels of that Kazakhcrap per each barrel of my Bonny and you pay the freight and insurance, sweetie.

Hoopdie hah, use numbah two, relative pricing for trading crudes. Iff'n you reccomember, refineries sometimes have plenty-beaucoups different inputs. Some are simply different crudes. Lets swap this stuff around to keep on hand the appropriate mix of inputs. How? To price it on an x barrels for y barrels swap basis we simply refer both x and y to WTI or Brent and solve for z. Howz that relate to the price of gasoline? It don't.

Mandatory Digression -- who uses all this petroleum? Chemical companies; fertilizers, pesticides, cleansers, herbicides, medicines, precursors for other industrial processes, etc.. Whoa, meds. too? Yep. Plastics, maybe sixty percent of what you own, but also all those disposable bottles and bags forming their own continent in the middle of the Pacific. Ecch. Textiles -- you, dude, and your serene ladyship there are probably wearing plastic. Are those skivvies/panties all cotton? If no, then Exxon. Scary stuff, that.

So, where are we? Plastics companies not affiliated with PRODUCERS are buyers, they pay that retail price net of hedges. Coke probably uses its own bottle mfg unit = buyer at retail net of hedges, Pepsi et. al. too. Textile companies not affiliated with PRODUCERS are buyers, they pay retail net of hedges. Chemical and Pharmaceutical companies not affiliated with PRODUCERS pay retail net of hedges. You name just about anything you use or want and it has some petroleum and if the manufacturer isn't affiliated with a PRODUCER, they pay retail net of hedges. Carbon fiber this, that, and damn near everything from fishing rods to golf clubs to spaceships? You got it -- if not affiliated with a PRODUCER, they pay retail net of hedges. See any pattern here?

OK, Hedges without the Benson. Whatthehell is that? A HEDGE [https://en.wikipedia.org/wiki/Hedge_(finance)], classically, is where a producer or consumer of a specific good or product tries to lock in a purchase or sales price by buying or selling futures and or options. Today it as often or not means some clown gambling in the derivatives market. At any rate, said clown is allegedly necessary to provide liquidity, except that he isn't, because in a real market there are differing opinions and theories as to the values and valuations of the various components of the product as delivered which offset each other except that in a perfect market everybody has instantaneous perfect knowledge of everything including where their towel is and always acts with perfect enlightened self-interest and nobody really believes any of that except Friedman, Geithner, Ayn Rand and that whole stupid crew.

Excuse, me, I digressed. Back to vocabulary for a minute. There are gas stations, and oil companies, and the Majors (everybody knows these guys, or did, Standard, Chevron, Texaco, BP, Esso, Exxon, Shell, Gulf, Mobil, AtlanticRichfieldCorporation (remember them?), Unocal, whatever.) Most of the Majors have merged and remerged and merged again into a few SuperMajors and a handful of Majors. A Major is a large uber-regional or national company and most folks in the appropriate country know its name. A SuperMajor almost always has a hyphenated name, orders nations and even entire subcontinents around and can buy everything bordering the Adriatic Sea and everything from there to China, The US Senate, Bolivia and much of Africa without severely impairing retained earnings, except that some other s.o.b. SuperMajor is trying to outbid it. Exxon-Mobil (plus a gazillion unnamed and forgotten companies they each swallowed), Chevron-Texaco (including Unocal, Gulf, and a ton of lesser companies), BP-ARCO, Total-Fina-Elf, Shell (Royal Dutch-Shell), etc. They are SuperMajors because they swallow majors whole, for a snack, as well as any even remotely corrupt medium sized government without blinking or impairing their balance sheet.

The SuperMajors and some of the majors have their own traders. They lock in profits when they can. But also try to balance all their inventory on hand, at sea, and in the form of contractual obligations with their need for various inputs. Not enough Bonny for all the Kazakh, Orinoco, WTI and OPEC we got, so buy a few tankers, at sea. (The average tanker load of oil changes hands and destinations many times while en route to wherever it finally winds up.) Those guys really hedge, and those hedges can have an effect on prices, as can the hedges of major consumers and the gambling of the professional gamblers on the street, but prices of what? Well, oil, sort of, and gas, and both, but not the way you'd like to think.

OK, here's how it goes.

The PRODUCERS pay some owner a royalty. There are as many ways to craft a royalty agreement as there are insects on the planet. Some are fixed, x bucks per barrel. For every barrel I take, I pay you x bucks. The price depends upon the cunningness, greed, and wisdom of the owner plus the date - some of these are shockingly old and ridiculous - 50 cents a barrel, a buck, two bucks, etc. Some of the domestic ones are with states and the feds who, for whatever reason, set ridiculously low rates and didn't always bother to collect or audit, and Native Americans, via BIA agents operating in collusion with the oil companies to rob the owners. Some are percent of market, the owner gets 1% or 2% of the value of the oil the day it is lifted..

I actually once held in my hands and inspected an old style contract where the owner and the PRODUCER agreed that the PRODUCER would do the exploration and development, but if any oil came in, they would be reimbursed 100% out of the first tranche of oil lifted valued at market as of that date. The owner and company would form a joint venture to run the field which would be reimbursed 100% for operating costs which would be reimbursed monthly to the joint operators in proportion to their expenditures for the period in question, and then the remaining oil, the "profit oil", would be divvied up 50-50. Read that through slowly and think about it. Free oil, stone cold free, tanker loads, free.

Gasoline and suchlike products are priced at what the sellers think that the market will bear. An upward change in "the cost of oil" simply prepares the suckers customers psychologically for the price increase that they think they know must follow because of "supply and demand". Meanwhile, PRODUCERS make their money getting the stuff out of the ground and would damn near give it away because their costs are so low.

OK, oil is at 37 bux/bbl and jumps by 5 to the classic 42 bux per barrel. Everybody's inventory of finished product and raw material immediately jumps in value and they begin to jack the price up to see how far they can drive it. The Buyers will someday, if the price doesn't go back down before they deplete their inventories enough to have to buy, pay that price. They make all the chemicals, plastics, textiles, medicines and suchwhat. Some like Valero also make gasoline. Producer C-E-B-T still pays 1 and 2 bux respectively to the 1 and 2 bux fixed price royalty suckers owners, they still get as much free oil as they can pull out of the ground from country XXX but must pay the 1% dude an extra nickel per barrel. That is around .0024 cents per gallon of product, absolute maximum. As part of a super-oligopoly they drive the price to extreme extremes, bump it an additional 20 cents on top of the 30 cents that the small fry bumped it. Their VP of obfuscation gets before Congress and swears that OPEC made him do it. The marketing wallah gets on the tube and weeps crocodile tears about supply and demand while the CFO actually starts buying banks instead of banking with them. Most of us buy it, time and time again. Worse yet, we begin to discuss how to deal with climate change, and the price of soda pop and gasoline and energy and freedom from foreign control of oil and we blithely assume all the stuff they sell us, all about supply and demand and the cost of oil and nasty old OPEC and drill baby drill and endless more bullshit and lies. They pay extremely little (except in the lives of contractors and the occasional employee who die somewhere along the line) for the oil that they price based on every psychological "hidden persuaders" type trick in the book.

Don't buy it. If you are going to discuss carbon tax, cap and trade, drill v no-drill, or the cost of meds or plastics and all that, remember, the SuperMajors get more free oil per day than you can imagine, and they don't pay quotation prices for any oil whatsoever.

OH yeah, OPEC [https://en.wikipedia.org/wiki/OPEC] for what it is worth, The article is not exactly balanced and really light on the historic abuses they suffered, but who cares. They no longer really solidly control the quotation price, and the quotation price is only relevant to BUYERS and has little to do with the underlying reality.

Right, Valero and Kazakhstan. Kazakh oil is really terrible but very few can process or refine it. A few years ago, Valero, to much laughter, converted its refineries to handle Kazakh oil. As one of the very few buyers, With Kazakhstan sitting on a sea of this oil and attempting to export it through multiple consortia including nations like Russia and more than one SuperMajor, Valero was able to get rock bottom prices, mix in a tiny bit of WTI and other inputs and be very successful as a mere downstream midget. Very clever, too bad that they are actively anti-green, because they seem to be a tad smarter than a lot of the other midgets.

Fun Fact: When the older empires began to tank, a lot of unstable states with fluctuating boundaries and governments emerged. One such was Angola, which staked a claim to a nearby exclave named Cabinda. Some Cabindans challenged the agreements under which this was so, and the Cold War neo-imperial US saw an opportunity to rid the world of a left leaning Angolan Government by fostering guerrilla warfare and terrorism throughout Angola, but specifically with respect to cutting Angola off from its main source of revenue, the highly profitable oil fields in Cabinda. Not willing to allow this little bit of imperial heavy handedness to succeed, Cuba sent troops to successfully protect the Cabindan oil fields, operations and operating company, Gulf Oil, later merged into Socal, which became Chevron which merged with Texaco, etc. In the end, California was substantially enriched by a handful of Cuban troops' ability to withstand all the mercenaries that UncleSam could buy. Curiouser and curiouser.

Another pricing wrinkle: TAKE OR PAY CONTRACTS [https://en.wikipedia.org/wiki/Take-or-pay_contract] A buyer agrees to buy x much oil or natural gas from a seller per month (or other time period) at a fixed price per unit volume. Should it fail to take delivery of all of it, the buyer must pay the seller a penalty per unit volume that it doesn't take. The penalty is usually a bit less than the fixed price per unit volume. These contracts exist not only between buyers and producers, but between producers and joint ventures involving themselves. (Producer A and country B have a joint venture X operating in country B to lift oil which it sells to Producer A under a take or pay contract, for example.) This is one explanation for recent odd behaviors such as companies buying and storing oil where the carrying costs to store the oil exceed the spread on a future for the same type of oil (especially likely if the contract price is a sweetheart deal.) For example, take 100,000 bbl at 42 per, or pay 37 for under purchasing, 1 year carrying cost is 5 bux and futures spread is 4 bux. Five bux exceeds 4, but if you assume that you will want that oil one year out, you have to add the 37 take or pay penalty to the spread as part of the cost of using a future, and 5 is way less than 41. (Another possible reason is as insurance, in case a specific desired or needed type of oil might vanish from the market (Libyan sweet-light, anybody?)).

Quizzer:

WHY 42 BUX PER BARREL IN THE EXAMPLES ?

1) 42 is the answer to life, the universe and everything per Hitchhiker's Guide to the Galaxy

2) 42 is the number of gallons in a barrel

3) Shit, do you think those two are related?

4) Sludge

5) Gulf Oil se dice gracias, Fidel