Published on EBF 301: Global Finance for the Earth, Energy, and Materials Industries (https://www.e-education.psu.edu/ebf301)

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Lesson 2 - Supply/Demand Fundamentals for Natural Gas & Crude Oil

Lesson 2 Introduction

Overview

In mid-2008, crude oil shocked energy markets as it reached an all-time High of $147/barrel (Bbl.) on the New York Mercantile Exchange. (See Figure 1 below.) Within four months, prices had sunk to $50 per barrel. Then, again in 2014, prices hit a High of about $100/Bbl in June only to fall to under $50/Bbl by December. How could this happen and what were the factors causing this level of price volatility? We will be exploring these questions in Lesson 2.

Figure 1: NYMEX Futures Prices

Learning Outcomes

At the successful completion of this lesson, students should be able to:

  • Recognize the various factors impacting supply & demand for natural gas & crude oil
  • Research major supply/demand influences
    • Global economy
    • Domestic economy
    • Weather
    • Currencies
    • Energy commodity relationships
    • Inventory and storage reports
  • Assess the potential impact on market pricing for each factor researched

What is due for Lesson 2?

This lesson will take us one week to complete. There are a number of required activities in this module. The chart below provides an overview of the activities for Lesson 2. For assignment details, refer to the location noted.

All assignments will be due Sunday, 11:59 p.m. Eastern Time.

Lesson Two Requirements
REQUIREMENT LOCATION SUBMITTING YOUR WORK
Reading Assignment: Oil & Gas Basics
Video Viewing Assignment: Understanding the Drilling Process
Reading Assignment: Fracturing Operations
Lesson 2 Reading Assignment page No submission
Lesson 2 Activity: "Fundamental" Factors exercise Lesson 2 Activity page Submit through Canvas
Lesson 2 Quiz Summary and Final tasks page Submit through Canvas

Questions?

If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), located under Modules in Canvas. The TA and I will check that discussion forum daily to respond. While you are there, feel free to post your own responses if you, too, are able to help out a classmate.

Reading Assignment: Lesson 2

Before we begin our discussion of the logistics and value chain for natural gas and crude oil, we need to have at least a cursory understanding of the “upstream” processes for the exploration, drilling, fracturing, and production of these fossil fuels. The following readings and video support this learning.

Reading Assignment:

Oil and Gas Basics

Go to the PetroStrategies web site [1], click on the section marked "Oil and Gas Basics" and read the following sections:

  • Products from Oil and Gas Make Our Lives Better
  • What are Crude Oil and Natural Gas?

Viewing Assignment:

Understanding the Drilling Process

The focus of this course involves the sectors of the oil and gas industry known as “midstream” and “downstream.” These occur after the exploration and production, or “upstream” processes. In these videos, you will view this aspect of the energy industry and see how the drilling, completion and production of an oil and/or gas well is accomplished from start to finish. This will give you a cursory understanding of how oil and gas is developed. The midstream and downstream activities start once the oil and gas has risen to the top of the well and is ready to be produced.

Natural Gas from Shale
Chevron
Using Hydraulic Fracturing and Horizontal Drilling for Natural Gas Production
Chevron

Reading Assignment:

Fracturing Operations

Go to the PetroStrategies web site [2], click on the section marked "Fracturing Operations" and read the following sections:

  • Hydraulic Fracturing
  • Fracturing Fluid
  • Proppant
  • Environmental Concerns
  • Marcellus Shale Regulations

Crude Oil

Economists have long recognized that we are truly a global society and all of our economies were intrinsically tied-together. Growth or recession in one region of the world could have a ripple effect on other regions. China and India were emerging as large-scale industrial countries with vast exports of manufactured goods. Both were consuming new, higher levels of energy, and most specifically, crude oil. News of increasing crude imports by both countries sparked buying of the financial commodity contracts.

The so-called “speculators” were blamed for a lot of the price increase that year, but there was a whole new set of players who greatly influenced the market. Investment funds and private investors, both domestic and international, saw the crude market as a “safe harbor” from the ups-and-downs of the stock market and the US dollar. When the stock market fell, they bought crude oil contracts. And when it rose, they sold those same contracts. The dollar is a little more complicated. When the value of the US dollar falls relative to foreign currency, overseas investors have more “buying power,” that is, they can buy more crude with their currency than those holding US dollars. So to some extent, it is true that “traders” had a major influence on oil prices that year. But the definition of “trader” had changed from the stereotypical “day trader,” who wreaks havoc on markets, to sophisticated investors and real demand from emerging nations.

Today, the economic health of various countries still impacts the volatility in oil prices, and the US dollar and crude prices have a very high but inverse correlation. Concerns over the stability of Portugal, Ireland, Spain, and Greece (not so politely known as the “PIGS”) impact the perception of world demand for oil on a daily basis as the collapse of even one of them could create a “domino effect” across other economies. Various economic reports on growth, manufacturing, etc. are monitored continuously.

And, geopolitical conflicts involving oil-producing countries and regions always cause concern over potential supply disruptions.

US oil production has risen steadily over the past (10) years and currently stands at about 9.0 million Bbl. per day. This represents a +13% increase from 2013 to 2014 alone and now stands at a 30 year high. Production for 2015 & 2016 is forecasted to remain slightly over 9.0 million Bbl/d. Current production represents only about 53% of consumption, with the remainder coming in the form of imports. However, as Figure 2 shows, imports continue to decline as domestic crude supplies increase.

The rise in domestic oil production is mostly attributed to the new, “unconventional”, sources found in shale formations. Advances in seismology (“3-D”), directional drilling (“horizontal”) and, fracturing methods (“fracking”), have made this once inaccessible resource common place today. Contrary to some beliefs, the number one source of imported crude oil in the US is not the Middle East but, Canada. Oil from tar sands in their Western Provinces is shipped via pipeline into the US.

Figure 1 shows the upward trend in oil production over the past (6) years with projections to 2016. (Based upon the latest completed study by the Energy Information Agency of the US Department of Energy.) Figure 2 shows the downward trend in oil imports for the same time period.

Figure 1
Figure 2

Many, many factors can influence the price of crude oil either directly or, indirectly. Some of the major factors influencing US crude oil prices are:

  • US weather – mostly winter, as the demand for heating oil impacts crude oil prices. The Northeastern part of the US is the world's single largest consumer of heating oil.
  • Geopolitical events - in any oil-producing region of the world where conflicts exist that could potentially interrupt supply.
  • US dollar vs. foreign currencies - as mentioned previously, a de-valued US dollar gives foreign investors more money to buy crude oil contracts and, vice versa, a stronger US dollar discourages foreign investment in crude oil contracts.
  • US economy - strength or weakness directly impacts the perception of energy consumption. Several economic indicators are released weekly.
  • World economy - as stated in the introduction, we are now in a truly global economy and what happens in one country can affect all others.
  • Production & imports vs. demand - reports on domestic oil production & imports vs. consumption can cause prices to vary greatly.
  • Baker Hughes Drilling Report of active rigs - this oilfield service company keeps track of the total number of rigs actively drilling for oil and gas, and they report the statistics weekly. A rise in rigs means more potential supply coming-on down-the-road. A drop in the rig count could mean less supply down-the-road.
  • West Texas Intermediate (WTI) crude vs. Brent North Sea crude - Brent crude oil is presently the global standard and trades in London. Its prices reflect demand in continental Europe which can influence the price of imported crude here in the US.
  • Weekly Crude Oil & Distillates Inventory Report (Energy Information Agency) - The Department of Energy releases a report every week that gives the current amount of crude oil and distillates in the nation's storage facilities. (Distillates include heating oil, diesel, gasoline, etc.) Increases in the inventory are viewed as an increase in supply, while decreases are seen as an indicator of increased demand. Another key piece of information presented is that of "refinery utilization". The higher the ultiization percentage, the higher the demand for crude and vice versa.

The following video goes into greater detail for the factors which can influence crude oil prices. (The lecture notes can be found in Modules under Lesson 2: Supply/Demand Fundamentals for Natural Gas & Crude Oil in Canvas.)

EBF - 301 Fundamental Factors for Crude Oil
Tom Seng - John A. Dutton e-Education Institute

 

Natural Gas

In contrast to crude oil, natural gas is almost strictly a domestic North American commodity* whose price is more influenced by weather and the health of the US economy. Other factors, such as the level of US natural gas inventory, impact prices on a weekly basis. While US economic indicators, such as the stock market, employment figures, housing and, manufacturing indexes, are deemed to be indicative of demand for natural gas, global economies and the US dollar do not have much affect on pricing in this country.

Natural gas is used in more than 50% of US homes for space heating and hot water. In addition, it is the second largest source of energy for electrical generation behind coal (Figure 1) and is widely used in commercial and industrial industries. Figure 2 illustrates the break-down by consuming sector.

Figure 1: U.S. Power Generation
Credit: http://www.eia.gov [3]
Break-out of natural gas use by consuming sector; pie chart. Industrial: 32%; Electric Generation: 24%; Residential: 22%; Commercial: 14%; Other: 8%
Figure 2: Natural Gas Use by Consuming Sector
Credit: http://www.eia.gov [3]

The main sources of natural gas supply in the US are domestic production, imports and, Liquefied Natural Gas (LNG). Canada again represents the largest source of imported natural gas, with Mexico contributing a minor amount. Additionally, there are export points into Canada and Mexico. The map below indicates the major import/export and, LNG import points in the US.

Credit: Energy Information Association

Domestic production in the US has grown dramatically in recent years due to the same advanced technologies that have allowed crude oil production to increase: “3-D” seismology, horizontal drilling and new “fracking” methods. All contribute to successful recoveries from hard formations such as the new “shales.” Figure 7 illustrates the growth in production of the currently active shale basins in the US.

Figure 3: Production Growth of Active U.S. Shale Basins
Credit: http://www.eia.gov [3]

Among the major factors influencing US natural gas prices are:

  • Weather – over 50% of American homes are heated by natural gas; hot weather leads to more electrical generation for air-conditioning loads, and natural gas represents about 25% of that market. Hurricanes in the Gulf of Mexico disrupt supply as platforms are evacuated ahead of the storms, and the hurricanes can also damage the rigs.
  • US economy - as with crude oil, fluctuations in the economy translate into an increase or, decrease, in energy consumption.
  • Production levels vs. demand indicators - statistics showing flowing natural gas are compared with demand indicators to determine if the market is "short" or "long" supply.
  • Weekly Natural Gas Inventory Report (Energy Information Agency) - every Thursday morning, the US government releases data on the amount of natural gas that is in the nation's underground storage facilities. Injections and withdrawals from storage are also indicative of supply and demand dynamics.
  • Electrical generation “fuel-switching” - a large amount of the country's power plants that are fueled by coal can actually switch to natural gas, but only if prices are competitive. Also, the Nuclear Regulatory Agency publishes a daily status report for all nuclear plants in the US. (See link on left of page.) When plants are down, more electricity is generated by natural gas.
  • Baker Hughes Drilling Report of active rigs - the field services company reports weekly on the number of drilling rigs actively pursuing oil and/or natural gas. The change in number and type impact the perception of supply in the future.

The following video goes into greater detail for the factors which can influence natural gas prices.(The lecture notes can be found in the Modules under Lesson 2: Supply/Demand Fundamentals for Natural Gas & Crude Oil in Canvas.)

As we explore pricing for crude oil and natural gas in a later lesson, we will consider the major influential factors for each and define their individual impact. We will also have a weekly activity about the market prices for crude oil and natural gas and the factors we believe affect them.

*In a future lesson, we will discuss the plans for exporting natural gas in the form of LNG. That will make North American natural gas a global commodity similar to crude.

EBF - 301 Fundamental Factors for Natural Gas
Tom Seng - John A. Dutton e-Education Institute

Lesson 2 Activity

Introduction to Fundamental Factors Activity

Note

You may wish to print this page to circle each corresponding decision (bearish, bullish, neutral) as you work through the scenarios.

Read each of the factor examples and scenarios given below for crude oil and then for natural gas. For each scenario, determine whether it could have a “bearish” (lower prices), “bullish” (raise prices), or neutral impact on the commodity price. When you are finished with the scenarios, synthesize them in your own mind to generate a recommendation to buy or sell the commodity.

Keep in mind, these are actual energy commodity contracts and not "stocks". So, you are buying or selling the actual commodity using the financial contracts. These decisions are also about trading for a profit. That is, if you think prices are going to rise, you want to buy contracts now and sell them later when prices do rise to make a profit. Conversely, if you think prices are going to fall, you would sell contracts now and buy them back later when prices do fall to make a profit. Buying or selling a commodity contract now is called "taking a position" and then offsetting that with a sell or a buy at a later date is called "closing a position." In the Fundamental Factors activities that follow in the weeks ahead you will be asked to take and close a position in crude oil and natural gas each week. For this week, however, we will warm up by focusing on understanding the various factors influencing crude oil and natural gas prices.

Crude Oil Factor Examples

Read through these factor examples to help you with the scenarios that follow.

  1. Weather – Heating oil, a crude distillate, is still used in several homes in the Northeastern US for space heating and hot water. This part of the country is the world’s largest consumer of heating oil. (And, many old industrial factories and power plants still use heating oil.)
  2. Domestic Economy – The strength of the economy is a good barometer for energy usage overall. Indicators such as the stock market, manufacturing indexes, retail sales figures and unemployment numbers influence the perception of demand.
  3. Global Economy - In addition, crude oil has truly become a global commodity, so world economic factors impact oil prices. (The health of the Eurozone, China’s manufacturing, etc.)
  4. Currency – The strength/weakness of the US Dollar vs. other currencies directly impacts crude oil prices. Foreign investors trade crude oil contracts, which are priced in US dollars and cents. Thus, if the dollar is weak, foreign investors can buy more crude contracts with their currency. On the other hand, when the US dollar strengthens, foreign investment lessens and crude prices tend to fall. There is a very high correlation between these two.
  5. Geo-Political Situations – Unrest in any oil-producing region gives uncertainty to supply, and therefore, to prices. The current situations in Egypt, Iran, Syria, and the pirating of oil tankers by the Somalis, all give rise to concerns about crude oil interruptions. In Nigeria, the rebel group MEND has disrupted the shipment of crude oil by attacking facilities owned by Royal Dutch Shell. The Russia/Ukraine conflict has also raised concerns about oil supplies coming from Russia and ISIS now controls some oil fields in Syria and Northern Iraq.
  6. Cross-Commodity Markets – The price of crude can be impacted by the change in the price of the products derived from oil, such as gasoline and heating oil.
  7. Changes in Inventory – The US government reports the change in the amount of crude oil that is in the nation’s storage facilities. Increases in this are deemed to be “bearish” (supplies have increased) while decreases are seen as “bullish” (there was demand for the inventory). See the link on the left side of the course page for "Weekly Petroleum Status Report".

Crude Oil Scenarios

Determine whether each scenario could have a “bearish” (lower prices), “bullish” (raise prices), or neutral impact on the commodity price.

  1. Weather – US forecasts for September call for high temperatures in the Northeast. (Bearish, Bullish, Neutral)
  2. Domestic Economy – The Dow Jones Industrial Average fell 500 points today. (Bearish, Bullish, Neutral)
  3. Global Economy – The European Central Bank (ECB) loans money to a struggling Greece. And, China sees a large increase in exported goods. (Bearish, Bullish, Neutral)
  4. Currency – The US Dollar traded lower against the British Pound and Japanese Yen today. (Bearish, Bullish, Neutral)
  5. Geo-Political Situations – ISIS has attacked and destroyed an oil refinery in Iraq while Saudi Arabia continues to flood the market with cheap oil. (Bearish, Bullish, Neutral)
  6. Cross-Commodity Markets – the "peak" summer driving period is about to start and Americans are expected to drive 10% more miles than last summer due to lower gasoline prices. (Bearish, Bullish, Neutral)
  7. Changes in Inventory – The Energy Information Agency’s Weekly Crude & Distillates Report showed that 1.5 million barrels of oil were added to the nation’s storage facilities last week. (Bearish, Bullish, Neutral)

Given all of these, would you Buy crude oil contracts (you think prices will rise, i.e., "Bullish") or Sell crude oil contracts (you think prices will fall, i.e., "Bearish")?

Natural Gas Factor Examples

Read through these factor examples to help you with the scenarios that follow.

  1. Weather – Until we start exporting natural gas in the form of Liquefied Natural Gas (LNG) in 2015, it remains a domestic North American commodity. It is really not influenced by world events or even the price of crude. So, the biggest factor affecting price is weather. About half of US homes use natural gas for space heating and hot water. In addition, about 25% of all electricity is generated with natural gas. This amount is actually increasing as the cheaper gas prices of the past several months have led to switching from coal to natural gas. And, as with crude oil, positive economic signals equate to the potential for increased energy usage which includes natural gas.
  2. Economy – The same factors that impact crude oil prices have an affect on natural gas prices.
  3. Changes in Inventory – The US government also reports the weekly change in the nation’s natural gas storage. Similar dynamics to crude inventories apply except that the projected amount of natural gas in storage as we head into winter is a huge factor in price movement as the April through October period is when we re-fill (inject gas into) storage. (See the link on the left of the course page for "Weekly Natural Gas Storage Report".)
  4. Power Generation – The mix of nuclear, coal, hydro, and wind power impact natural gas prices, but weather still dominates the demand for power, and as a result, the demand for natural gas usage. As more and more coal plants are taken offline due to more stringent emissions standards, more natural gas will be used to generate power. Also, some coal plants can burn natural gas if they need to.

Natural Gas Scenarios

Determine whether each scenario could have a “bearish” (lower prices), “bullish” (raise prices), or neutral impact on the commodity price.

  1. Weather – US forecasts for September call for high temperatures across the “southern tier” states. (Bearish, Bullish, Neutral)
  2. Economy – The Dow Jones Index rose +100 points today and the S&P gained +15 points. Unemployment increased, but the Consumer Price Index (a measure of inflation) fell. (Bearish, Bullish, Neutral)
  3. Changes in Inventory – The Energy Information Agency’s Weekly Natural Gas Storage Report showed an increase of +85 billion cubic feet. While this was more than forecasted, total gas in the ground is still -5% below last year’s level. (Bearish, Bullish, Neutral)
  4. Power Generation – Eight of the nation’s nuclear power plants are offline for maintenance and refueling ahead of the anticipated summer peak load, while coal plants continue to burn cheaper natural gas. (Bearish, Bullish, Neutral)

Given all of these, would you Buy natural gas contracts (you think prices will rise, i.e., "Bullish") or Sell natural gas contracts (you think prices will fall, i.e., "Bearish")?

Trading

Please answer the following two questions:

  1. Suppose that you believed that natural gas factors were bullish. Would you buy or sell natural gas contracts now? How would you close out your position in, say, a week's time?
  2. Suppose that you believed that crude oil factors were bullish. Would you buy or sell crude oil contracts now? How would you close out your position in, say, a week's time?

Grading Criteria

This Fundamental Factors activity will be worth 30 points, as per the EBF 301 grading scale described in the syllabus. You will earn two points for each of the crude oil and natural gas factors that you interpret, and 2 points for each buy/sell recommendation that you include and explain in your response. Each factor has to be explained individually, how it is going to affect the market and prices. You will also earn two points for each of the trading questions that you answer correctly and completely. Your trading suggestion should be based on the overall evaluation.

Submitting Your Work

Submit a single word processed document with your responses to the Crude Oil/Natural Gas Scenarios and the Trading questions to the Lesson 2 Fundamental Factors Activity in Canvas.

Summary and Final Tasks

Key Learning Points: Lesson 2

  1. In 2008, the record run-up in oil prices actually represented a dynamic shift in composition of market participants.
  2. Crude oil is a globally-traded commodity in a world where the economies of most countries are tightly intertwined.
  3. The US is gradually increasing its domestic oil production, thus reducing its crude imports.
  4. Natural gas is strictly a domestically traded commodity (until late 2015/early 2016 when we start to export LNG).
  5. Vast new reserves of natural gas have been found in “shale” plays due to new technological advances in exploration, drilling, completion and production.
  6. The US is both an importer and exporter of natural gas.
  7. Several factors influence the prices of crude oil and natural gas.

Now that we have examined production and consumption in the United States as well as the energy “mix,” we will focus on the fuel sources that comprise over 57% of the energy used in this country. Crude oil, with refined products, and natural gas and related natural gas liquids (NGLs) make-up this large sector.

Quiz

Complete the Lesson 2 Quiz

Reminder - Complete all of the Lesson 2 tasks!

You have reached the end of Lesson 2. Double-check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there before beginning the next lesson.


Source URL: https://www.e-education.psu.edu/ebf301/node/469

Links
[1] https://web.archive.org/web/20150930155519/http://www.petrostrategies.org/Learning_Center/oil_and_gas_basics.htm#What%20are%20Crude%20Oil%20and%20Natural%20Gas?
[2] https://web.archive.org/web/20150930215323/http://www.petrostrategies.org/Learning_Center/fracturing_operations.htm
[3] http://www.eia.gov