Crude oil is not that useful in the form it comes out of the ground. It requires a lot of processing to make it into the products that we all know and love. Nor is all crude oil the same. Different oil fields deliver crude oil of varying viscosity and sulfur content.
The more viscous crudes (as measured by a lower API gravity) are called “heavier” and crudes with higher sulfur content are known as “sour” rather than “sweet.” A heavier, sulfur-rich crude would be called “heavy sour,” and it is more difficult and expensive to turn into usable refined products. In addition, not all refineries can process lower grades of crude oil.
Refined oil products are grouped into three categories: light distillates, including liquid propane gas (LPG), gasoline and naphtha; middle distillates, including kerosene and diesel; and heavy distillates and residuum, including fuel oil, lubricating oils, paraffin wax and tar. The classifications are based on the way crude oil is distilled and separated into fractions (called distillates and residuum).
Breakdown
Let’s look at how a barrel of black sludge becomes all of these many useful things.
The refining process has three different steps: separation, conversion and treatment (see “Get them separated”). Modern separation involves piping crude oil through hot furnaces, with the resulting liquids and vapors discharged into distillation towers. Inside the towers, the liquids and vapors separate into components, or fractions, according to weight and boiling point. The lightest fractions of the crude oil, including gasoline and LPG, vaporize and rise to the top of the tower, where they condense back into liquid as they cool. Medium-weight liquids, including kerosene and diesel oil distillates, stay in the middle. Heavier liquids, called gas oils, separate lower down in the tower. The heaviest fractions settle at the bottom.
When light sweet crude is processed, the gasoline yield is about 40%. The yield is less for lower grades of crude oil. Considering a barrel of crude oil naturally produces such ratios for various products, that means that by using a simple distillation tower, there would be too much supply of some products and too little supply of others.
A process called “cracking” works around this problem. This refining method uses heat and pressure to “crack” heavy hydrocarbon molecules into lighter ones. A cracking unit consists of one or more tall, thick-walled, bullet-shaped reactors and a network of furnaces, heat exchangers and other vessels. Cracking is not the only form of conversion. Other techniques include alkylation, reforming and unification.
Whatever the technique, in making gasoline, refinery technicians carefully combine a variety of streams from the processing units. Among the variables that determine the blend are octane levels, vapor pressure ratings and special considerations, such as whether the gasoline will be used at high altitudes.
Pricing crude
The Energy Administration Association Web site supplies prices on all of the different grades of crude from all over the world. For example, on Aug. 15, 2008, Ecuador Oriente 30 crude was $99.96 a barrel, while U.S. crude oil was $108.11. The spread on a percentage basis for different oils can get large. Mexican Maya, a heavy sour crude, was almost 25% less than U.S. crude on April 1, 2005.
One problem is that sweet crude is becoming scarce. Lower grade crude oil is relatively plentiful, but many refineries cannot process it. In addition, U.S. Environmental Protection Agency’s Tier 2 low-sulfur gasoline requirements, proposed during the Clinton administration, caused many refineries to target higher-grade crude as an easier way to meet these standards.
These facts, and considering no new refineries have been built in the United States in decades, add to the problem of short supplies of sweet crude. If refineries could process lower grade crude oil into high-grade products, the cost of the products could be better controlled.
New refineries that can handle lower grades of oil — not to mention produce gasoline and other products from our plentiful coal reserves — are a big key to greater U.S. energy independence (see “Coal conundrum,” below).
The complex nature of crude oil means there is no easy answer to supply and demand. First, we need to look at demand for Organization for Economic Co-operation and Development (OECD) countries vs. demand for developing countries. The demand for oil in OECD countries from 1997 to 2008 has been flat at roughly 0.4% growth. However, growth of demand in developing countries has been greater, increasing at 3.2%, with China in a class by itself increasing at 6.7%.
Looking at the supply side of the equation, OPEC production has been steady at 33% to 36% of total production, with the rest being produced by non-OPEC countries. Caspian Sea regional production has increased from 9.6% in 1997 to 15% in 2008, while the OECD share of production has declined from 29.6% to 23.1%.
From 1997 to 2008, world demand has increased 18%, while supply has only increased 15%. Developing countries are becoming more affluent with growing income levels, developing financial systems and younger populations. Their need for energy is a prime consideration in the oil supply/demand equation.
Of course, increasing crude oil supplies is difficult because the supply of oil is finite. It is estimated that there are currently enough oil reserves for 38 years. The estimate peaked at 42 years in 2002. The change in the estimate explains some of the price increase, but not all of it.
Other factors must also be causing such an exponential rise even though demand is outstripping supply; the changes are relatively slow when compared to the price increases.
One factor is that interest rates have been kept artificially low, devaluing the dollar and causing inflation. In April 2008, in Congressional testimony, an executive vice president of Exxon Mobil, said the price of oil should be between $50 and $55 per barrel based on supply and demand fundamentals.
Other issues are ongoing conflicts in oil-producing countries and adverse weather conditions. These factors lead to concerns that oil supply would be disrupted. As a result, oil markets have been in the grip of backwardation during the 2008 rally.
Currency effect
North Sea Brent crude cash prices from Jan. 27, 2000, to July 31, 2008, offer a good example of the effect of the dollar on crude prices. We picked that starting date because the dollar and the euro were at parity.
“Pair pricing” (below) shows that oil went up in terms of euros, but only as high as €92.25, not the $145.03 seen. On July 31, 2008, Brent North Sea crude was at €79.1269. Now, consider the change from July 31, 2007, to July 31, 2008. On July 31, 2007, Brent crude was $75.96 and €55.57. Based on this observation, half of the increase in oil prices is due to the devaluation of the dollar.
Oil is priced in dollars worldwide, and there may be risk of the dollar being dropped as that standard if the greenback keeps falling. During 2003 and 2004, there was a lot of talk about pricing oil in euros. The main argument against it was that U.S. dollars are universal and if dollars were not used, oil producing countries might want different currencies depending on their trade partners.
On another note, some countries that are not friendly with the United States, such as Iran, have already started making the move.
During 2007, Iran asked its petroleum customers to pay in non-dollar currencies and reported to have completed the process by Dec. 8, 2007. If the United States is going to head off this trend, it will need to take care of its debts and institute a legitimate strong dollar policy to convince the rest of the world the dollar is indeed a currency standard too viable to drop.
Trading the link
Intermarket divergence is a method of using intermarket analysis to develop mechanical trading systems. This methodology is powerful and continues to work long after its widespread introduction in the mid-1990s. The dollar and crude oil have a demonstrated negative correlation. When markets have a negative correlation, the rules for trading are as follows:
If the opposing market is in an uptrend and the traded market in an uptrend, then sell; and if the opposing market is in a downtrend and the traded market is in a downtrend, then buy.
We are using price relative to a moving average to define trend. Our system rules in TradersStudio Basic are expressed as follows:
Sub CrudeDollar(MkLen,TrLen)
Dim MKOsc As BarArray
Dim TrOsc As BarArray
MKOsc = Close Of independent1 -
Average(CloseOf independent1,MkLen,0)
TrOsc = Close - Average(Close,TrLen,0)
If MKOsc < 0 And TrOsc < 0 ThenBuy("BuyInt",1,0,Market,Day)
End If
If MKOsc > 0 And TrOsc > 0 Then
Sell("SellInt",1,0,Market,Day)
End If
End Sub
In the code, MkLen is the length for the Dollar Index moving average, and TrLen is the length for the crude oil moving average.
We used crude oil as our traded market and the dollar index as the intermarket. Using a 14-period moving average for crude, and a 22-period average for the dollar index produced a hypothetical $118,980 from Jan. 3, 1986, to Aug. 8, 2008, with no deduction for slippage and commissions. The profits on the long side are $124,220 and there was a loss of ($5,240) on the short side. “Time analysis” shows both an annual and a more recent monthly report.
The table shows that in 2007, the system made $34,000 based on this relationship. We also can see that this relationship worked well from 1986 to 1995 with only one losing year. The problem with the relationship between the dollar and crude oil is that it is on-and-off. At times, it is strong; other times, it does not exist. This is because the relative importance of the many factors that affect crude oil is constantly shifting.
This effect is obvious in 2008, shown in the second table in “Time analysis.” The relationship between the dollar and crude oil was working until the system lost $25,400 in the past two months. Until that time, we were up $12,650 for the year. The reason has been that the dollar has lost importance as a large blow off rally was followed by a major correction.
While the relationship between the dollar and crude oil may not be tradable on its own, it is a factor that traders need to watch and should play a role in a more complete trading program for crude.
Especially critical in these volatile times, traders need to be aware of all factors — the dollar, weather, geopolitical tension, supplies, the types of supplies, distilleries and new technologies such as coal distillation — to trade crude oil effectively and safely.
Murray A. Ruggiero Jr. is a consultant. His firm, Ruggiero Associates, develops markettiming systems. He is the author of "Cybernetic Trading Strategies" (Wiley). E-mail him at ruggieroassoc@aol.com.
