4. Oil pricing

The most important variable parameter that influences financial results of the company is the price for sold oil. We shall consider:

• history of oil pricing;

• factors influencing on the oil pricing;

• long-term prospects of oil pricing;

• oil price influence on financial estimate of the company.

4.1. History of oil pricing

Development of oil market began in 1859 and passed through some stages which can be divided into three basic stages: before 1971, 1971-1986 and since 1986 by present time.

The first stage

Prior to the beginning of 1970th the market was actually monopolized by the large vertically integrated companies of the International oil cartel. Eight transnational companies (earlier as Standard Oil: ВР, Chevron, Exxon, Gulf, Mobil, Shell, Texaco and French CFP) controlled about 85-90 % of the market at all stages of oil production. The oil prices also were established mainly by these companies as independent companies have about 5 % share of oil market. At this stage the large companies actively used transfer pricing for minimization of tax deductions.

Before 1947 oil price in any place of world was defined on the basis of the price FOB (free on board) in gulf of Mexico plus cost of delivery which included freight of a tanker, oil transshipment, insurance, customs clearing, etc. Thus there was no matter where oil was actually produced. In 1947 the system of oil price calculation was changed. It was caused by role increase of the countries of Persian Gulf in the world oil production and also by necessity of economy restoration of the Western Europe countries after the Second World War. According to the new rules the oil price was calculated as though it was delivered already from two points - the Mexican or Persian gulfs. Thus the FOB price was still defined in Gulf of Mexico but only expenses for delivery were differed. Clearly, that the new system resulted to occurrence of places where both prices coincided. Originally such point was in Mediterranean sea. Then, in process of FOB oil prices reduction in Persian gulf it was displaced on East coast of USA and in 1949 New York became uniform base for oil prices calculation.

The first stage of oil market development was the most stable, since 1947 through 1971 nominal price grown from 1,87 dollars up to 3,56 for barrel. Basically this stability promoted economic growth in the USA and in Western Europe which, in turn, was accompanied by annual 7 %-s' growth of oil demand.

The second stage

In September, 1960 the international Organization of Petroleum Exporting Countries has been created. Quick strengthening of OPEC lead role in world oil export created preconditions for revision current agreements of the Arabian countries with the oil companies concerning reference prices and distribution of profit.

Besides the important factor were refusal of the fixed dollar exchange rate and the subsequent easing of the American currency. Long negotiations resulted nothing and in October, 1971 ОPEC begun process of International oil cartel actives nationalization which was finished in 1973. Oil resources control passed to the countries of OPEC and they received opportunity to define oil prices. Companies of International oil cartel lost an opportunity to influence market condition from supply however they kept the control over transportation, processing and selling.

Actions of OPEC frequently caused essential disbalance of demand. So, the oil embargo in 1973 and the Iranian revolution in 1979 caused oil deficiency, increase of oil recovery in Saudi Arabia in 1986 caused the superfluous supply. Oil prices were sharply changed: they grew from 4 up to 10 dollars for barrel in 1973, from 16 dollars up to 40 dollars in 1979-1980 and fell from 30 down 13 dollars in 1985-1986. Shocking jumps of the oil prices caused reduction of annual rates of demand growth from 7% to approximately 1 % (after 1973). The structure of oil trade essentially was changed: reduction of operations on the basis of long-term contracts proceeded, the prices started to be established on the basis of short-term and spot-contracts. Thus their share in total value of the tenders grew from 5-8 % in the beginning of 70th years up to 40-50 % in the middle 80.

Third stage

Third stage essentially differs from first two: exclusive pricing gave up the place to market pricing. At this stage ОPEC does not establish the prices directly as it was in 70th years, however it still is the major player in the world market of oil. Positions of the cartel are provided qualitative and quantity indicators of its resource base. So, share ОPEC is about 78 % of world reserves and 42 % of crude oil production. Besides in the countries of Persian gulf the oil production cost of one barrel is only 0,5-2 dollars (in Northern sea - about 10-12 dollars; in Russia – 5-7 dollars).

Mainly changes of oil pricing principles are caused by occurrence and development of exchange trade. So, New York mercantile exchange (NYMEX) began to trade crude oil futures in 1986 before the "price war ". Two years later contracts on crude oil have been entered in the London international petroleum exchange (LIPE) and then in the Singapore international monetary exchange (SIMEX). Owing to market pricing oil price remained extremely varied on short-term intervals, in a range of 15-20 dollars for barrel before 2000.

Exchange pricing

The largest oil stock exchanges are NYMEX and LIPE on which oil grades Light Sweet and Brent are quoted. Both mixes are related to low-sulfur grades of oil. At both stock exchanges the tenders are carried out by "voice" way, however last years electronic systems are actively used.

Thus in London the basic tenders go from 10:02 through 20:13 and in New York - from 9:45 through 15:10 on local time. It is meant, that trade during almost five and a half of hours and also closing takes place at both stock exchanges simultaneously.

Trade of futures provides an opportunity of physical delivery of oil that connects it with the real market through the mechanism of arbitration. It is necessary to note, that physical delivery of oil under exchange contracts occurs seldom and makes only about 1 % of all tenders volume. One reason is oil of corresponding grades is really produced significantly less than virtual volume of the tenders.

The main advantages of exchange pricing are a relative transparency of the market and high liquidity. Besides it is competitive enough as basically it is opened for a wide range of potential participants. According to the American Commission on future trade the 8 largest players on NYMEX have share about 40 %.

Off-exchange market

The main oil grade is Brent on off-exchange market. Quotations on other grades of oil are established on the basis of differentials (discounts or premiums) to Brent or to any another grades (as a rule, WTI or Dubai). Cost of differentials depends as on quality distinction (density, content of sulfur) and as on current balance of supply and demand. The market is conditionally divided into segments on quality and grades-substitutes of type Urals and Kirkuk are compelled to compete constantly, first of all among themselves.

Not only spot contract but forward contract are actively traded(forwards, swaps, options) on off-exchange market. As there is a risk of contracts default on off-exchange market the large financial institutions with reliable reputation play the greater role. So, leaders on volume of the tenders by swaps and options for oil traditionally are Morgan Stanley and Goldman Sachs. Because of Brent is produced in the sea, actually there are no spot-prices. Instead of this Brent usually quotations Brent “dated” are used published in various specialized agencies like Platt's and Petroleum Argus. Based on methodology of Platt's price Brent dated is estimated under real transactions and bilateral quotations on forward delivery of oil not earlier than in seven days but not later than through 17.

Fundamental factors

Oil price (exchange and off-exchange) are defined by two key factors:

• current and expected parity of supply and demand;

• dynamics of costs.

As exact data about current world balance of oil supply and demand does not exist oil traders basically are guided by the information on change of oil warehouse stocks - strategic and industrial. Corresponding estimations appear in weekly and monthly bulletins of some agencies. The most known are reviews of the American petroleum institute, the Energy Information Agency and the International energy power agency. Growth of stocks is the indirect certificate in favor of that the oil supply exceeds demand and, as a rule, is accompanied by falling of the oil prices.

Disbalance in the oil market arises basically because of supply shocks, first of all from ОPEC, whereas average oil demand is more inertial. In particular, as numerous researches show, oil consumption is extremely inelastic in relation to the price for time intervals less than one year. Nevertheless the shocks influencing oil consumption also can cause essential fluctuations of the prices. Vivid example is financial and economic crisis in the countries of Southeast Asia. Last years consumption of oil grew on 5,5 % a year in this region, and traders were guided by rates of demand growth keeping the oil prices at a level 16-20 dollars during 1991-1997.Essential overproduction of oil, basically from ОПЕК, created preconditions and financial crisis of 1997 became the catalyst in Southeast Asia which caused a collapse of the oil prices in 1998.

Strong short-term (daily, weekly and monthly) fluctuations caused to relation between oil price and balance of a supply and demand is diffused by consideration of longer intervals -quarter and annual. The oil price have strongly seasonal component on monthly and quarter time intervals that is connected with fluctuations of demand. The largest consumers of oil (the USA and the Western Europe) are located in northern hemisphere and actively use oil for heating. During summer months consumption of gasoline, on the contrary, grows. The difference between maximal (December, February) and minimal (May) consumption of oil by these countries makes about 4 million barrels. Besides balance of a supply and demand the oil price are defined by dynamics of production cost in long-term prospect.