1. SPE October Meeting Presentation 2006 Copyright Dalton H. Garis 2006 1

2. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 20062 Where s My Benchmark? Oil Price Formation, Benchmarks, and the Upper Zakum Stream

3. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 20063 Crude Price Formation

4. SPE October Meeting Presentation 2006 Copyright Dalton H. Garis 2006 4... How most think crude oil prices are formed...

5. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 20065 Are they right ?

6. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 20066 For producers, what is essential to know is that the crude oil price is demand-driven. Price = Marginal Cost is not used; Marginal Price = Marginal benefit is used. Price = Marginal Cost is not used; Marginal Price = Marginal benefit is used. Price therefore based onwillingness to pay and not on willingness to supply. Price therefore based onwillingness to pay and not on willingness to supply.

7. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 20067 For producers, what is essential to know is that the crude oil price is demand-driven. There is no surplus supply capacity as existed before. There is no surplus supply capacity as existed before. Price therefore follows fear of shortages in the presence of persistent demand increases. Price therefore follows fear of shortages in the presence of persistent demand increases.

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9. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 20069 In the Long Run, crude prices based on supply and demand Fundamentals. Daily Oil Balance (EIA) tells the story and is watched carefully. Production is watched (news events). Production is watched (news events). And, demand is watched (GDP). And, demand is watched (GDP). USA biggest consumer, but China steals the show for analysts Production is watched (news events). Production is watched (news events). And, demand is watched (GDP). And, demand is watched (GDP). USA biggest consumer, but China steals the show for analysts

10. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200610 But in the Short Run, crude prices are based on future price expectations for buyers and sellers. Trading itself forms prices, which subsequently induce more trading. Trading itself forms prices, which subsequently induce more trading. Traders act and react in anticipation of what other traders likely to do. Traders act and react in anticipation of what other traders likely to do. And news drives fear and greed in the markets. And news drives fear and greed in the markets.

11. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200611 Economic models differ from models in the physical sciences in that agents are supposed to anticipate the future. - Didier Sornette, U-Cal Professor of Geophysics (2003) OUTLIERS ARE THE NORM!Economic models differ from models in the physical sciences in that agents are supposed to anticipate the future. - Didier Sornette, U-Cal Professor of Geophysics (2003) OUTLIERS ARE THE NORM!

12. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200612 A price-auction market is characterized by qualitatively hierarchical behavior imitation, herding, contrarianismin the presence of endogenously generated singularities (critical points) triggered by exogenous information cascades. This dynamical system exhibits self-organization about chaotic bifurcationsboundedly rational responses to extreme events.

13. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200613 It is computationally irreducible and therefore unpredictable. But we see extreme events constantly generated by imitation between traders which cause localand eventually globalself reinforcement. --Sornette 2003 Probabilistic models of markets exhibit fat tailsnumerous outliers.

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16. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200616 Expectations for future demand: We have enough oil now... We have enough oil now... BUT MARKETS DONT CARE. BUT MARKETS DONT CARE. NOW THEY ARE MORE NEGATIVE NOW THEY ARE MORE NEGATIVE ON THE L.R. FUTURE. ON THE L.R. FUTURE. No one wants to be the last to hold a No one wants to be the last to hold a big and highly leveraged position. big and highly leveraged position.

17. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200617 Expectations for excess production capacity: Prices rise when excess production capacity falls below 1-1.4 mbd. Based on risk. Prices rise when excess production capacity falls below 1-1.4 mbd. Based on risk. If OPEC cuts supply to support prices... If OPEC cuts supply to support prices... It increases excess capacity It increases excess capacity And erodes risk premium. And erodes risk premium.

18. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200618 Value and Price are like Love and Marriage! Fundamentals say lots of oil. Fundamentals say lots of oil. More now than when $28.00/bbl. More now than when $28.00/bbl. 2003 balance was less, but so was price. 2003 balance was less, but so was price. 2004-5 balance larger, and so 2004-5 balance larger, and so was crude price. was crude price. 2006 even higher: little daily surplus and even less excess production capacity. 2006 even higher: little daily surplus and even less excess production capacity.

19. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200619 Real change is in price stability, not volatility, which has remained largely unchanged. Price gaps more common. Price gaps more common. Extremely news sensitive. Extremely news sensitive. Strong contrarian thinking. Strong contrarian thinking.

20. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200620 Benchmarks & Prices

21. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200621 What is a Benchmark Crude? A Crude standard against which other crudes in a market can be priced. Atlantic Basin: Brent. North America: WTI. For Pacific-Asia: Dubai-Oman.

22. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200622 What makes a good Benchmark crude? Sufficient volume for physical trades. A representative crude in weight and sourness similar to extensively traded crude streams. Reselling and derivative sales capabilities.

23. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200623 What will a good Benchmark Crude do? Reduce buyer and seller risks. Reduce buyer and seller risks. Transparently discover prices. Transparently discover prices. Reduce price volatility. Reduce price volatility. And... Correctly underpin forward and retrospective crude sales.

24. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200624 Hedging Is Big Business Derivative traders are competing vigorously for business, evidence that risk is being transferred to those who profit from bearing it at competitive rates. Derivative traders are competing vigorously for business, evidence that risk is being transferred to those who profit from bearing it at competitive rates. Energy Information Agency

25. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200625 NYMEX Crude And Product Futures Contracts

26. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200626 Contract Specifications: Light, Sweet Crude Trading unit: Crude Oil Futures trade in units of 1,000 U.S. barrels (42,000 gallons). Trading Months: Crude Oil Futures trade 30 consecutive months plus long-dated futures initially listed 36, 48, 60, 72, and 84 months prior to delivery. Additionally, trading can be executed at an average differential to the previous days settlement prices for periods of two to 30 consecutive months in a single transaction. These calendar strips are executed during open outcry trading hours. Options: 12 consecutive months, plus three long-dated options at 18, 24, and 36 months out on a June/December cycle. Price Quotation: Crude Oil Futures are quoted in dollars and cents per barrel.

27. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200627 Contract Specifications (contd.): Minimum Price Fluctuation: $0.01 (1¢) per barrel ($10 per contract). Maximum Daily Price Fluctuation: Futures: Initial limits of $3.00 per barrel are in place in all but the first two months and rise to $6.00 per barrel if the previous day's settlement price in any back month is at the $3.00 limit. In the event of a $7.50 per barrel move in either of the first two contract months, limits on all months become $7.50 per barrel from the limit in place in the direction of the move following a one-hour trading halt. Last Trading Day: Crude Oil Futures: Trading terminates at the close of business on the third business day prior to the 25th calendar day of the month preceding the delivery month. If the 25th calendar day of the month is a non- business day, trading shall cease on the third business day prior to the last business day preceding the 25th calendar day.

28. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200628 Contract Specifications (contd.): Delivery F.O.B. seller's facility, Cushing, Oklahoma, at any pipeline or storage facility with pipeline access to TEPPCO, Cushing storage, or Equilon Pipeline Co., by in-tank transfer, in-line transfer, book-out, or inter-facility transfer (pumpover). Delivery Period: All deliveries are rateable over the course of the month and must be initiated on or after the first calendar day and completed by the last calendar day of the delivery month. Alternate Delivery Procedure (ADP): An Alternate Delivery Procedure is available to buyers and sellers who have been matched by the Exchange subsequent to the termination of trading in the spot month contract. If buyer and seller agree to consummate delivery under terms different from those prescribed in the contract specifications, they may proceed on that basis after submitting a notice of their intention to the Exchange.

29. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200629 Contract Specifications (contd.): Exchange of Futures for, or in Connection with, Physicals (EFP). The commercial buyer or seller may exchange a futures position for a physical position of equal quantity by submitting a notice to the Exchange. EFPs may be used to either initiate or liquidate a futures position. Deliverable Grades: Specific domestic crudes with 0.42% sulfur by weight or less, not less than 37° API gravity nor more than 42° API gravity. The following domestic crude streams are deliverable: West Texas Intermediate, Low Sweet Mix, New Mexican Sweet, North Texas Sweet, Oklahoma Sweet, South Texas Sweet. Specific foreign crudes of not less than 34° API nor more than 42° API. The following foreign streams are deliverable: U.K. Brent and Forties, and Norwegian Oseberg Blend, for which the seller shall receive a 30¢-per-barrel discount below the final settlement price; Nigerian Bonny Light and Colombian Cusiana are delivered at 15¢ premiums; and Nigerian Qua Iboe is delivered at a 5¢ premium.

30. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200630 Contract Specifications (contd.): Inspection:Inspection shall be conducted in accordance with pipeline practices. A buyer or seller may appoint an inspector to inspect the quality of oil delivered. However, the buyer or seller who requests the inspection will bear its costs and will notify the other party of the transaction that the inspection will occur. Position Limits: Any one month/all months: 20,000 net futures, but not to exceed 1,000 in the last three days of trading in the spot month. Margin Requirements: Margins are required for open futures or short options positions. The margin requirement for an options purchaser will never exceed the premium. Trading Symbol: Futures: CL; Options: LO.

31. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200631 Brent, Dated Brent, and 21 Day Brent make up largest Benchmark 60% of world s physically traded crude uses the Brent as marker. But Brent is lighter and sweeter than most Middle East crudes

32. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200632 Most of the world s crude reserves are in the MENA region. And most of world s crude is heavy and becoming more sour.

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35. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200635 But where is the heavier sour marker crude? And where is the price for Middle East crudes benchmarked and discovered? NOT IN THE MIDDLE EAST

36. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200636 the Upper Zakum Benchmark Crude Alternative Proposal. the Upper Zakum Benchmark Crude Alternative Proposal.

37. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200637 What about Dubai-Oman? Production falling off. Dissimilar characteristics. Faces thin-market problems. Production falling off. Dissimilar characteristics. Faces thin-market problems.

38. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200638 Platts has already moved to include Upper Zakum to support the Dubai-Oman contract. UZ as a benchmark is a superior solution

39. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200639 Can Upper Zakum be the Benchmark Crude? Saudi Light is largest single stream … But KSA refuses to allow reselling. UZ has the volume, physical characteristics and acceptability to work.UZ has the volume, physical characteristics and acceptability to work.

40. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200640 Contracting revenues would not be affected. Assured price discovery – Less price drift and retrospective corrections. Greater counterparty trust – Transparent process and timely pricing means no lags in pricing.

41. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200641 Additional benefits: Significant technology transfer into UAE: Local price discovery integration between producers, DME, and consumers. Value additions to local and regional economy also large: New energy marketing and financing infrastructural establishment.

42. SPE October Meeting Presentation 2006Copyright Dalton H. Garis 200642 In Sum: LR: Prices determined by fundamentals. SR: Prices determined by the interplay of traders to news and their own actions. Reactions to production- consumption news. Reactions to excess capacity news. In Sum: LR: Prices determined by fundamentals. SR: Prices determined by the interplay of traders to news and their own actions. Reactions to production- consumption news. Reactions to excess capacity news.

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