Upstream - Downstream

For the global oil industry, oil trade represents the key nexus between the two main centres of activity: upstream exploration and production, and downstream refining and marketing. Not only does it determine the value of upstream output, but it also defines the cost of the main downstream feedstocks. Operational decisions about combining output from various fields to create a specific crude oil export stream with certain characteristics are constantly tested in the market against refiners’ requirements for specific feedstocks to meet final demand for a changing combination of products. Due to the extensive vertical integration of the oil industry until the early 1970s, these decisions were largely kept under the umbrella of major oil companies.

Increased crude price volatility since the early 1970s in combination with OPEC output quotas, for example, signalled national governments in oil-importing, developing countries such as South Korea, India, and Brazil to invest in refining capacity to mitigate both refined product volume and price risks. These same trends also created an incentive for governments in oil-exporting countries, notably Iran, Kuwait and Saudi Arabia, to build refineries in order to capture the value added in turning crude oil into refined products.

Ever since the simplest distillation units were invented more than a century ago to refine oil and produce illuminating kerosene, it has been the value of the end products that ultimately determines and drives the value of a crude oil.

Each unique stream of crude oil generates different combinations of final products, all of which compete in independent markets. The value of the crude oil is therefore derived from the combined value of these co-products, which range from the lightest liquid petroleum gases and sophisticated gasolines to the heaviest fuel oils for ships and industrial boilers.

The price of oil emerges from a complex interaction between the signals provided by product markets through the purchasing decisions of refiners, and the varying revenue objectives of producers. This process has rarely been purely economic, and it has had political overtones since the early 1900s because of oil’s strategic importance.

While OPEC is currently the most visible expression of this political dimension to oil prices, other countries and political groups within them have strongly held stakes.
Although most large industrial countries have adopted a pro-free-market stance, even these big consumers have clear concerns and preferences about the level, direction, and volatility of oil prices as they affect their economies. The structure of the markets and their importance as a source of tax revenue are also key political issues. Because of all of these political influences, oil markets do not single-handedly determine oil prices. Rather, they help to define the general level.

The Spot Market Key Role

The size of the international crude oil spot market is extremely difficult to gauge, but its enormous influence and its significance for virtually all aspects of the oil business are unquestioned. While spot deals are estimated to account for around one third of physical sales of crude oil, the prices generated by these transactions are now the primary determinant of almost all other world oil prices.

This presence is most apparent in the formula pricing systems now used for the bulk of term crude oil sales by OPEC and many other producer countries such as Mexico. Formulas typically specify direct price linkages to particular spot crude oil quotes. Spot prices are also closely tracked by the countries and companies that sell crude oil on the basis of postings or retrospective pricing arrangements. In today’s market, crude oil sellers have little scope for deviating from the trends established by the spot market — which comprises the trading of individual cargoes or partial shipments for immediate delivery, outside of any continuing supply commitment.

Beyond their dominant role in international crude oil pricing, spot markets have a significant impact on everything from an oil company’s share price to its investment plans. The spot market and closely linked futures trading are also used as the main barometer for measuring OPEC’s success at balancing global supply and demand. While oil companies tend to gear their long-term investment plans to future price expectations rather than to current market levels, it is also clear that spending plans are slowed or accelerated over the course of the year depending on the strength of current spot markets and on changes in exploration and development costs. Spot prices are used as the yardstick of a firm’s future cash flows, which are key determinants of capital investment expenditures.




One of the distinguishing characteristics of the physical crude oil spot market since the early 1980s has been its extreme price volatility. Wide swings in prices have fostered the growth of large forward and futures markets and an array of risk management tools that are effectively an extension of the physical spot market. The futures markets are dependent on the physical spot market in that they are linked to them at the point of delivery, but the two are constantly responding to each other and have grown mutually intertwined and dependent.

Futures markets trade oil volumes for future delivery that far overshadow the spot market. The New York Mercantile Exchange, or Nymex, and London’s IPE crude oil futures exchanges together trade the equivalent of over 300 million barrels in each session, or four times the volume of physical crude oil produced around the world daily.

Private Sector Turns Up the Heat on National Oil Corporations

The global trends of oil company privatisation's and large mergers among majors over the last decade are finally challenging the long established dominance of big national oil companies in the top tiers of the international oil industry.
While the largest state-owned companies are still playing a critically important role, the private sector companies are now becoming more important rivals. In a major switch, the largest private sector oil companies are in the majority among the top 10 firms in Energy Intelligence’s annual ranking of the world’s 100 biggest oil companies, edging ahead of the previously dominant national oil companies by a slim margin. Thanks to their mega-mergers, the largest private sector oil firms have achieved an operational scale that is at last a match for the giant state-owned companies.

The flip side of the mergers is that the marked consolidation in recent years among the leading US, UK, and French oil companies has pushed them upward in the rankings but has also substantially reduced the overall representation of these countries among the top 100. As the ranks of traditional Western oil companies have thinned through mergers, a host of new firms have come into the rankings. Russia has 10 companies in the top 100, as against 20 from the US and 3 from the UK. Fully 48 countries are now represented, underscoring the increasing internationalisation of the oil industry and the fading dominance of the traditional Anglo- American oil industry.

While the new supermajors and other private sector firms have managed to move up the rankings in recent years through aggressive privatisation and mergers, they have not been able to benefit much from a reduction in competition as a result of mergers. On the global scale, competition actually seems to be increasing with the appearance of new companies from emerging economies outside the OECD bastions of the traditional majors. In addition, the pressures on state oil firms to act in a more aggressive, commercial manner, along with further privatisations in OECD countries, such as Italy and Norway, have all added to the global competitive pressures.
In fact, it would seem that in many respects the mega-mergers are in part a result of these competitive pressures because they began later than the privatisation wave.

With the end of the Cold War, the former Soviet Union and China have spawned a host of new oil companies over the last decade and many of these are fully privatised or well on the way. The emergence of these dynamic new major oil companies has been a key factor diluting the dominance of US firms and traditional 100% state-owned national oil companies of a decade ago.