Oil Fundamentals: Upstream, Midstream, Downstream & Geopolitics

Crude oil is a scarce resource which means that at some point the existing oil wells will be exhausted. The current estimations, given the actual extraction and consumption rates, sustain that the black gold will be available for another 40 years but any increase in the demand would reduce the aforementioned projections. The USA has a Strategic Petroleum Reserve which has been specifically created in order to face shortages in the supply, however, rising oil prices and new technologies are pushing towards alternative source of energy.  Companies and businesses are considering potential substitute for crude oil and the alternative energy sources, that are increasingly becoming popular, are biofuels (like ethanol), hydrogen fuels, fuel cells, solar energy, nuclear power (even though nuclear power is not an environmentally friendly solution) and wind power.

Nevertheless, the demand for refined products is still very high and each oil derivative has its own market and its own price driver. A perfect example of divergence in price drivers for refined products comes for Europe. In the 90s many European governments guaranteed tax incentives to all the drivers who would have bought diesel–powered cars because diesel fuel emits less greenhouse gases than gasoline. Needless to say that such policy provoked a sharp augment in diesel prices but not in other oil derivatives.

Let’s now have a look at the oil industry as a whole.

First of all, it is worth mentioning that the oil industry is subdivided into 3 subsectors: upstream, midstream and downstream. The upstream involves the exploration and the extraction of crude oil, the midstream sector consists of transportation and storage while the downstream segment refers to the refining industry, marketing and distribution of refined products.

Upstream – The supply chain falls within the upstream segment. Here, the most important thing to determine is the capacity of the on–shore or off–shore site because this measurement identifies how big the oil well is and, consequently, the extraction rate. It is worth noting that major companies tend to retain a certain amount of unused capacity in order to face unexpected or sudden explosion in demand (usually caused by geopolitical issues).

Midstream – Once the extraction process is over, the oil “enters” the second segment: the midstream. This sector has to do, predominantly, with the transportation of the extracted petroleum liquids towards the refining centers. The transition can be processed using pipelines, trucks, barges or rail.

Downstream – Downstream operations are strongly connected with the refining industry because it is in this segment of the production chain that diesel, kerosene, jet fuel oil and all the other petroleum liquids get synthesized. Now, refining capacity is often closely related to demand for obvious reasons but not all refineries can deal with a broad range of crude oils so there are certain production boundaries. Nevertheless, the business is straightforward: refineries buy crude oil, they refine it and then sell the synthesized outputs. The income generated by refineries is measured with the so–called “crack spread” (there will be another study entirely focused on this product).

The cost of crude oil is not solely influenced by upstream, midstream and downstream operations. In fact, exogenous variables or unexpected events such as natural disasters, political turbulences and quality reduction of a specific oil well can push market players to increase their inventories. Consequentially, an augment in the short term demand and forward delivery would increase the cost of storage and, in turn, the cost of carry.

Amongst all of the exogenous factors that can alter oil prices, the geopolitical ones are certainly the most dangerous.

Conflicts and political instability in the Middle East have always had a remarkable impact on oil prices. Besides, African or Latin American countries, such as Nigeria and Venezuela, have often “hosted” violent riots that have increased the buying pressure on the oil market. Geopolitical issues create nervousness among market players and increase prices because internal riots, civil wars, unstable or corrupted governments could jeopardize the supply and limit the amount of oil available. Also, extreme forms of governments (fascism, communism, military controlled countries, etc) are not well seen by oil importing countries because dictators and/or non–democratically elected governments could threaten to limit the extraction or the export of oil.

The next chart provides a better clue on the relationship between geopolitical factors and oil prices:

Geopolitics - WTI Crude Oil Futures

The chart shows the fluctuations of WTI Crude Oil futures prices since July 1986 so far. The graph does not really need any comment because the arrows are self explanatory. Wars, civil wars, political turmoil, crises and cuts in the extraction rate have always added a significant pressure on crude prices which have been inevitably pushed higher. The only 3 big events, worth mentioning, that have depressed oil prices have been the Asian Economic Crisis in the mid 90s, the terroristic attack to the Twin Towers in September 2001and the Credit Crunch in 2008–2009.

Clearly, the Middle East is a vital geographical area for oil so any turbulence in this zone is strongly felt by market participants. Likewise, the other OPEC members do not always enjoy a great deal of political and civil stability (the OPEC members are  Algeria, Indonesia, Islamic Republic of Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, Venezuela). The following chart shows the weight of each OPEC member in terms of number of daily extracted barrels:

Weights of OPEC members - June 2013

As previously mentioned, the chart displays the weight of each country expressed as a percentage of the total OPEC daily barrel production (the data are recent and they refer to the period January–June 2013). Saudi Arabia (29.68%), Iran (11.6%), Iraq (9.43%), Kuwait (9.17%) United Arab Emirates (8.78%) and Venezuela (8.63%) are the top 6 largest OPEC members. The fact that 5 out of 6 among the largest OPEC members are all located in the Middle East explains very clearly why this world region is so closely monitored by oil importing countries like United States, China, Japan, India and Germany.

If you are interested in trading oil or oil derivatives markets you might want to read the following HyperVolatility researches:

1) Oil Fundamentals: Reserves and Import/Export Dynamics

2) Oil Fundamentals: Crude Oil Grades and Refining Process

3) The Oil Arbitrage: Brent vs WTI

The HyperVolatility Forecast Service enables you to receive statistical analysis and projections for 3 asset classes of your choice on a weekly basis. Every member can select up to 3 markets from the following list: E-Mini S&P500 futures, WTI Crude Oil futures, Euro futures, VIX Index, Gold futures, DAX futures, Treasury Bond futures, German Bund futures, Japanese Yen futures and FTSE/MIB futures.

Send us an email at with the list of the 3 asset classes you would like to receive the projections for and we will guarantee you a 14 day trial.

Oil Fundamentals: Reserves and Import/Export Dynamics

The present study belongs to the Oil Fundamentals project that the HyperVolatility team initiated a few weeks ago with the article “Oil Fundamentals: Crude Oil Grades and Refining Process”. Credit must be given to Liying Zhao (Options Engineer at HyperVolatility) for helping me to gather the necessary material.

This analysis will provide information regarding the demand and consumption of oil on a global scale and it will subsequently examine the import/export dynamics.

The first variables that will be observed are oil reserves. Oil reserves are those quantities of oil whose availability is documented by geo–physical and engineering studies of the oil–well under examination and whose extraction falls within the parameters indicated by current economic conditions (transactional and operational costs) and structural resources (equipment and technology at disposal). In other words, it is the oil whose presence has been proven and that can be extracted given the current level of transactional costs and machinery’s sophistication. According to recent researches, OPEC countries possess more than 70% of the world proven reserves but Venezuela and Saudi Arabia are the largest “containers” on the planet. There is a standardized and worldwide recognized way to look at reserves: the Reserves–to–Production Ratio. The R/P ratio is a fairly simple number which expresses, in terms of years, how long oil reserves for a specific country would last assuming that the current extraction rate would remain constant over the years. It goes without saying that the calculation for the R/P ratio is trivial because it is performed by simply dividing the oil reserves at the end of the year by the production for the year. The next chart displays the R/P ratio for all continents (the data have been provided by British Petroleum):

Oil Reserves to Production Ratio

The interpretation of the above reported graph is very straightforward: the numbers on the Y axis measures the years it would take to terminate all oil reserves starting from December 2012. For example, Europe and North America would take almost 22.3 and 38.6 years respectively to finish all reserves should the current production rate remains constant in the upcoming years. The African continent would employ 37.7 years, the Asia–Pacific region would need only 13.6 years while the Middle East has 78 years of proven reserves. On the other hand, the “best equipped” part of the world is constituted by Southern and Central American countries with almost 122 years of available oil. It is interesting to notice that the whole world, according to this study, would finish its reserves in the 2065. The reason petroleum liquids have been shrinking is obviously due to an ever increasing global demand which went from 32 – 33 million barrels per day at the beginning of the 70s to 83 – 84 millions in the 2011 – 2012 (the International Energy Agency forecasted that the global demand will increase to almost 92 million barrels per day in 2014). The largest oil consumers are without a doubt the countries with a high industrial development rate: USA and European countries. USA remains the largest single oil consuming country because it employs 25% of the total oil extracted on the planet but the current scenario is changing rapidly. In fact, China, Japan and India are now becoming key market players and their internal markets are heavily weighing on global demand and price levels. Let’s now focus on imports/exports dynamics.

Many countries both import and export large amounts of oil but there are some of them which consume more than what they can produce, so they have to import the rest, and others that use only a very small part of what they extract, so they can export more. The following chart shows the top 20 oil importing countries in 2012 (the data have been provided by CIA World FactBook):

Oil Import

It is evident that the United States are the largest single oil importing country in the world with more than 10 million barrels per day followed by China (5 millions), Japan (4.39 millions), India (3 millions) and Germany (2.67 millions). However, if we group together all the import figures for the European countries in the top 20 we see that the States (10 million b/d) import almost as much as Europe (13.8 million b/d). The chart highlights that many Asian developing countries, excluding China and India, are suddenly augmenting their demand and industrial productivity, in fact, South Korea, Singapore, Taiwan, Thailand and Indonesia import almost as much as the majority of Western European countries: 1.5 million barrels every day.

The next graph ranks the top 20 oil exporting countries (the data have been provided by CIA World FactBook):

Oil Export

The top 5 oil exporters in the world are Saudi Arabia (7.63 million b/d), Russia (5 millions), Iran (2.52 million b/d), Arab Emirates (2.39 million b/d) and Norway (2.18 million b/d). The chart clearly highlights the superiority of Middle East countries in the role of global oil suppliers (almost 16.8 million b/d). The only 2 outsiders are Russia and Norway: the former is the only serious competitor that Saudi Arabia has while the latter is ranked at the 5th place because of the Brent Blend oil whose wells are placed in the North Sea. It’s worth noting that the USA does not export its oil (apart from a small part of Alaskan oil) and this is precisely why the States ranks so low. The ranking, however, has lately changed because Russia used to be the biggest oil exporter in the world for many years but a recent change in the policy adopted by the OPEC has re–shaped the oil supply scenario.

So far we have looked at importers and exporters and we know who buys and who sell the most but at this point an obvious question arises: Who buys from Whom?

There are 3 blocks of large buyers: USA, Europe and Asia (Asia means China, India and Japan) and their suppliers are the following:

1) USA imports oil from South and Central America, Middle East and Canada

2) Europe imports oil from Russia, Middle East and North Africa (Libya, Angola, etc)

3) Asia imports oil from the Middle East, Africa and, to a lesser extent, from smaller Asian countries (South Korea, Singapore, etc)

The inter–market connections are high and they range from Europe to Middle East and from Africa to Asia. Nonetheless, the aforementioned list is important to understand why OPEC countries are so important: the oil supply market is literally dominated by OPEC members

The presents study terminates here but the HyperVolatility team invites you to read our previous researches entirely focused on oil and commodity markets:

“The Oil Arbitrage: Brent vs WTI”

“Commodities and Currencies: Inter – Market Analysis”

Oil Fundamentals: Crude Oil Grades and Refining Process

“The Pricing of Commodity Options”

“Commodity Volatility Indices: OVX and GVZ”

The HyperVolatility Forecast Service enables you to receive statistical analysis and projections for 3 asset classes of your choice on a weekly basis. Every member can select up to 3 markets from the following list: E-Mini S&P500 futures, WTI Crude Oil futures, Euro futures, VIX Index, Gold futures, DAX futures, Treasury Bond futures, German Bund futures, Japanese Yen futures and FTSE/MIB futures.

Send us an email at with the list of the 3 asset classes you would like to receive the projections for and we will guarantee you a 14 day trial.

Oil Fundamentals: Crude Oil Grades and Refining Process

First of all, I would like to give credit to Liying Zhao (Options Engineer at HyperVolatility) for helping me to conceptualize this article and to gather the necessary information to develop it. There will be other articles describing the physical side of the crude oil market so this is simply “the first gear of a more complex apparatus”.

The present analysis is not a quantitative research on the oil market and its aim is to list the most important aspects to consider before investing or trading the black gold. Consequently, the focus will primarily be on the petroleum physical market and on how the oil industry works. The HyperVolatility team spends a great deal of time analyzing and trading commodity markets, hence, crude oil positions have always had a considerable weight in our portfolio. Also, the great attention towards commodity markets generated by the credit crunch and the consistently high volume on crude oil futures and options are some of the reasons that convinced us to put together a general guideline for those who choose to venture into energy markets and in particular fossil fuels.

First of all, it is worth mentioning that there are almost 250 different types of crude oils in the world but the ones that are mentioned the most are primarily 2: the American West Texas Intermediate and the European Brent Blend (which is now the global benchmark).It is not unusual to hear financial journalists talking about other crude oils like the Nigerian Bonny, the Arab Light (Saudi) or the Dubai (UAE); nevertheless, the spotlight is almost exclusively on WTI and Brent. The reason these markets, particularly the Brent, have so much media coverage is due to their importance when pricing other crude oils worldwide. Again, the Brent is the nowadays global benchmark (although the WTI used to have this role) so every oil producer or buyer will have to know its price; the question is why?

Why all other crude oils have to be priced according to Brent price fluctuations?

The answer to this question is API gravity, sulphur content and export.

As we previously mentioned there are many types of crude oils in the world but the chemical composition of each crude grade differs slightly. Crude oil is a fossil fuel and it is made of hydrocarbons (molecules of hydrogen and carbon atoms) but what makes the real difference, in terms of commercial value, is the weight of the hydrocarbons. The rule is simple: the lighter, the better. In order to determine how heavy or light petroleum liquids are the American Petroleum Institute introduced a standardized scale called API gravity. The API gravity system is a standardized way to compare and rank the “lightness or heaviness” of diverse crude oils. The system is very simple: the API gravity coefficient measures how heavy or light petroleum liquids are with respect to water. Crude oils with an API gravity greater than 10 are considered to be light (so they float on water) while oils with API lower than 10 are classified as heavy (so they sink when mixed with water). Crude oils with high API values (10 and higher) are lighter and produce greater quantity of marketable product, hence, they are more commercially desirable. This concept can be better understood by looking at the following chart (source: The International Crude Oil Market Report):

Grade of Crude Oil

The graph displays the distribution of different crude oils according to API gravity (X axis) and sulphur content (Y axis). It is easy to notice that WTI and Brent are both located in the right – hand side of the chart and they are very close to the X axis. The reason these oils are situated in this area is because their API gravity is very high (which means they are light types of oil) and their sulphur content is lower than 0.5% which means they are sweet (the word “sweet” in technical jargon means that there is a low level of impurity).

Let’s summarize what has been stated so far:

1) API gravity measures the lightness / heaviness of crude oils

2) API higher than 10 means that the crude oil is light and more profitable in terms of commercial value

3) API lower than 10 means that the crude oil is heavy and produces a minor quantity of commercial product after refining

4) Sulphur content measures the degree of pureness of crude oil, the level of impurity that each crude oil type contains

5) Sulphur content higher than 0.5% indicates a high level of impurity (sour crude oil) that has to be removed

6) Sulphur content lower than 0.5% implies a low level of impurity (sweet crude oil). This condition is preferred because less work is needed and the refining process is faster

7) All the crude oils ranked at the bottom of the right hand side of the chart are considered to be the most attractive under a commercial point of view

The aforementioned bullet points explain fairly well why the Brent is one of the best crude oils in the world but why is it better than the WTI?

The answer is straightforward: the European Brent is exported while the West Texas Intermediate remains within the US.  Consequently, the WTI has a “minor impact” on international markets (in reality, a part of the Alaskan oil output is exported to Japan and South Korea but the quantity is so small to be irrelevant in terms of international impact).

There are other chemical and physical aspects that need to be mentioned when talking about crude oil and one of these is certainly viscosity. Viscosity is the “ability” of a specific crude oil or refined product to flow.

Why is this factor important?

The degree of viscosity is very important to determine how crude oil will be stored or transported which means that the cost of carry will be primarily influenced by this variable. Crude oils can be classified according to their viscosity coefficient:

1) Paraffinic crude oils have low viscosity but they are easily flammable. Most of the engines lubricating oils are made of paraffinic crude oil. Paraffinic oils have a high API gravity and therefore tend to be light types of crude oil

2) Naphthenic (or Asphaltic) crude oils have a high viscosity coefficient but they are not easily flammable. This is the case of bitumen. Naphthenic oils have low API gravity and therefore tend to be heavy types of crude oil

This classification is very useful because it helps us understand a bit better how the refining process works. Let’s combine all the information together:

– Light and sweet crude oils (Brent, WTI, Bonny) have high API gravity, low sulphur content, low viscosity, high flammability and therefore are paraffinic oils. Light and sweet crude oils, once refined, tend to produce high quantity of gasoline

– Heavy and sour oils (Venezuelan BCF, Russian Urals crude, etc) have low API gravity, high sulphur content, high viscosity, low flammability and therefore are naphthenic oils. Heavy and sour crude oils, once refined, tend to be used as bitumen feedstock

The refining process aims to separate petroleum liquids in different chemical components which will be subsequently treated and combined with solvents to generate new oil derivatives.

How does the process work?

The crude oil is essentially pumped into a furnace and here the raw petroleum releases gases and liquids which are subsequently channeled in a tower to start the fractional distillation process. The point of directing the oil in this tower is to separate or fractionate different chemical components using heat. Specifically, each chemical component will have a specific boiling point and by increasing the temperature every constituent will start vaporizing as soon as its own boiling point will be reached. This process is gradual so the crude oil will fractionate into different gases at different temperatures but it is also continuous, which means that new raw petroleum liquid will be injected into the distillation tower at regular intervals to replace the fluid that has been already fractioned. The refining process usually produces a standardized set of oil derivatives such as gasoline, jet fuel, diesel fuel and asphalt. Nevertheless, other products (methane, propane, kerosene, etc) are often distillated. Oil derivatives have a wide range of applications; here we list some of them:

1) Methane also knows as natural gas, can be used for heating

2) Ethane is usually employed as a feedstock for other production processes (like the one followed to produce plastic)

3) Propane can be used for both cooking and heating

4) Gasoline is primarily used as fuel for vehicles

5) Naphtha is another feedstock and it is generally reused in the petrochemical industry

6) Kerosene (known as paraffin in UK, Ireland, South Asia and South Africa) is predominantly employed to produce Jet fuel oil

7) Gas oils are used to distillate diesel engine fuels or for home heating

8) Fuel oils are reused to power refineries or power stations. Alternatively, they are often utilized as a fuel for ships but in this case they are referred to as bunker fuel or bunker fuel oil

Now, this information is surely very important to anyone who is seriously thinking to invest or trade oil markets. Oil fundamentals are sometimes overlooked but a sound understanding of the dynamics underlying the fossil fuel industry is essential to fully comprehend market movements. As we anticipated at the beginning of this article, this is only the first part of a broader project.

If you are interested in trading crude oil you may want to read some HyperVolatility researches dealing with this topic:

“The Oil Arbitrage: Brent vs WTI”

“The Pricing of Commodity Options”

Commodity Volatility Indices: OVX and GVZ

“Commodities and Currencies: Inter – Market Analysis”

The HyperVolatility Forecast Service enables you to receive statistical analysis and projections for 3 asset classes of your choice on a weekly basis. Every member can select up to 3 markets from the following list: E-Mini S&P500 futures, WTI Crude Oil futures, Euro futures, VIX Index, Gold futures, DAX futures, Treasury Bond futures, German Bund futures, Japanese Yen futures and FTSE/MIB futures.

Send us an email at with the list of the 3 asset classes you would like to receive the projections for and we will guarantee you a 14 day trial.

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