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Commodity Investing Maximizing Returns through Fundamental Analysis · 1 This makes it the second most consumed fossil fuel in the United States, behind oil and. The report of the special committee on commodity exchange trading was that the present system of futures trading is fundamentally sound, efforts should. Etienne, Irwin and Garcia's paper is a big step forward because it carefully distinguishes between the influence of the commodity index traders. RUTGERS FINANCIAL MANAGEMENT Table skids when different parts of a small application the demand for for even light. This can include the common ports. A stable internet to the left.

By John Kemp. LONDON Reuters - A thoughtful new paper from researchers at the University of Illinois marks a significant step forward in research on how commodity futures prices are formed. Until recently, the academic and policy debate about futures price formation has been locked in an acrimonious and polarized standoff between market fundamentalists, who insist all price moves reflect supply and demand fundamentals, and those writers who blame speculators for every rise in food and fuel prices.

Both views tend to be colored by the policy outcomes researchers favor. Anti-poverty campaigners focus on the role of speculation because they want governments to impose more controls on the cost of food and fuel. Free-market economists stress the role of fundamentals to deny governments any ammunition to meddle. Both positions are extreme and unconvincing. Now Xiaoli Etienne, Scott Irwin and Philip Garcia have published an innovative paper examining the evidence for temporary price bubbles in markets where prices are otherwise driven by fundamental factors.

According to the authors, futures prices for grains, livestock and soft commodities like sugar have all exhibited multiple bubbles over the last four decades, with bubbles more common in the s and again in the s than during the s and s. There is no evidence bubbles have become more frequent or larger following the entry of more financial investors into commodity futures markets since In fact most of the biggest and long-lasting bubbles occurred in Financialisation may have ensured bubble-like price movements are now smaller and reverse more quickly.

The arrival of new traders in recent years, coupled with a dramatic increase in trading volumes, has increased market liquidity, apparently reducing the frequency of bubbles," the authors write here. The persistence of bubbles remains perplexing. As markets overreact to new information, commodity prices may thus show excess volatility and become explosive.

When there are too many feedback traders for the markets to absorb, speculative bubbles can occur in which expectations of higher future prices support high current prices. Recent empirical evidence does suggest that herding behavior exists in futures markets among hedge funds and floor participants. The paper concludes with an appeal for more research to identify the source of bubble-like price behavior.

In most other asset classes, it is now accepted market prices are basically driven by fundamentals, especially in the medium and long run, but in the short term can department from them, sometimes significantly, as a result of speculative factors. From January enough data is available to interpolate a return using either the cash price or a two-month price. Nickel: Until February , the change in the three-month forward price is used as a proxy for the return. From February enough data is available to interpolate a return using either the cash price or a two-month price.

Spot Data All of the spot commodity price data is from CRB with the following excep- tions and augmentations. Soymeal: Data is adjusted over the October—November period to account for the change from 44 percent protein to 48 percent protein. Cotton: January through December uses monthly average prices obtained from the National Cotton Council. From February from Citigroup index 7 to 10 year sector U. Bills Through January these returns are approximated total returns using three-month bill rates from the Federal Reserve.

Starting February they are returns based on the Citigroup one-month Treasury index. In this chapter we will explore, as best as we can, the long-term performance of commodities. As with most economic studies that seek to reach far back into history the primary diffi- culty is the availability and quality of data.

Though commodity prices and commodity futures are everywhere today, the salience of commodities in financial markets is a relatively recent development in the history of hu- manity. True, the Chicago Board of Trade was formed in , but crude oil futures were not introduced until It is arguably with the intro- duction of crude oil futures that the modern age of commodity investing began. In this chapter we will look at two series, the price of wheat and the Economist Commodity Price Index,1 to get a sense of the long-term per- formance of commodities.

Unlike the last chapter, we will be focusing on the price of physical commodities, instead of futures, as that is what data availability allows. Why wheat? It is the prime ingredient in bread, and bread, of course, is the staff of life. Cereal crops such as wheat have been in continuous use since humans first became farmers 10, years ago.

In contrast, the commodities humans have used for energy have changed over time. Humans first lived in warm climates where fuel was not necessary. As they moved out of Africa into cooler areas, they first burned wood, then coal, and now oil. Other commodities such as gold or coffee have been around for a long time, but each has its flaws.

Gold has served primarily as a form of currency, and coffee is a luxury, not essential to life. Wheat also has the advantage that a long history has been assembled. Clark draws on various sources to put together long histories of agricultural prices in England. The data is restated in terms of U. The Economist Commodity Price Index is the longest commodity price index publicly available. Though early data is incomplete, it is collected as far back as The weightings and commodities have changed over time, and it currently contains 25 items based on United Nations import data for , , and It currently consists of It contains no energy and no precious metals.

Aluminum has the highest weighting, It is U. Figure 3. The price of wheat does appear to have an upward trend, but it is very volatile. Wheat could have been had for less than one hundred cents a bushel in both the s and in the s. From to wheat appreciated by 0. This has been good for consumers; less so for those who might have wished to invest in physical wheat. Though volatile in general, the price of wheat is punctuated by some significant spikes.

Until recently, these tended to be associated with wars. There were also significant spikes associated with the Crimean War, the U. Civil War, and both world wars of the twentieth century. The spike to new highs in the s was due to the generally inflationary environment and the after-effects of the Great Grain Robbery, in which the Soviet Union bought large amounts of U. See Ulrich for a good account of this episode and a good narrative of grain prices in general over the past years.

It is also interesting to note that wheat prices declined with the stock market in the late s and the early s. This is important because one of the main factors determining whether commodities fit into an investment portfolio is how they do during times of bad equity market performance.

Over the period for which there exists a lot of data on commodities, and hence the periods that are typically analyzed including those in this book , there are few stock market crashes. In real terms, the price of wheat has gone down. It has lost —0. Even though the real price of wheat spiked in the s, it did not keep pace with inflation and in was near its low in real terms.

Approaching wheat from the perspective of investing in physical wheat, Figures 3. The reason is that actually holding physical wheat would entail costs. Assuming a wheat price of cents per bushel and a daily storage of. And there are financing costs as well. The Economist Commodity Price Index ECPI has the advantage over wheat in that it is more broadly based, but the disadvantage that it is avail- able for a shorter history. Over the years this would have been an annual geometric appreciation of 1.

As mentioned previously, this 1. Over this same time period the annual return on equities was 9. Clearly, from a return standpoint, over the most recent century and a half, commodities were an inferior investment to equities. As with wheat, the ECPI does poorly over the period of the stock market crash and the initial years of the Great Depression.

Over this time period commodities would not have been a useful hedge against poor stock market performance. Later, in the s, when inflation was high, a Equity returns are taken from the website of Robert Shiller and updated by hand. See the data appendix. It is interesting to con- trast these two periods. The Great Depression was characterized by a drop in overall demand whereas the inflationary period of the s was effectively a debasing of the currency.

Equities did poorly in both periods whereas commodities did poorly only when demand shrunk. For commodities, this makes sense: a drop in demand typically does lead to a drop in price and high inflation is nothing more than increasing the amount of currency needed to purchase goods. Overall, the correlation of these two series over this time period is about —9 percent.

Since , commodity prices have declined in real terms. They have lost 0. Real commodity prices surged during the World War I period, and they were firm during the World War II period, but aside from that they have moved steadily downward. Even the inflationary period of the s provided only temporary support. The ECPI is generally an average of the prices that occurred in that year, whereas the equity prices are the averages for December.

Looking to the East, there has been work to construct long histories of rice prices in China Feng and Kaixiang It is again worth emphasizing that it is difficult to construct price series that stretch back into the haziness of distant history, both because good data is hard to get and because currencies are not always stable. That being said, Feng and Kaixiang show that from until the beginning of the twentieth century, the nominal price of rice was approximately unchanged. The twentieth century contained a significant period of hyperinflation and change in monetary regimes, making nominal prices less informative over this time period.

Therefore switching to real terms, the price series of Feng and Kaixiang imply that the real price of rice rose at an annual rate of about. Figure 15 from their paper is reconstructed using data provided by the authors and reproduced as Figure 3. This is positive real appreciation, but obviously very small and, again, it is unlikely to have been sufficient to cover the cost of storage and financing.

In summary, over the broad sweep of history commodity prices have gone up, but not rapidly. Comparing stock returns to commodity apprecia- tion shows that stocks have gone up much more, not even taking account of the storage and financing costs that would have been necessary to maintain physical commodity inventories. The year-end prices used are averages for the month of December. Wheat Wheat prices from through are taken from the website of Gregory Clark see Clark Wheat data since is taken from the CRB and is annual averages.

To provide continuity all wheat prices are converted to US dollars, see officer To adjust to real prices the inflation indexes from Officer and Williamson are used. It is thought that the majority of these organisms were single-celled and as they died their remains fell to the sea bed and were covered with sand and mud cre- ating a rich organic layer.

This process repeated itself over and over and the layers eventually developed into sedimentary rock. Over time increased pressure and heat from the weight of the layers caused the organic re- mains to slowly transform themselves into crude oil and natural gas, among other things.

Crude oil is made up of hydrocarbons, which are molecules made from both hydrogen and carbon atoms. These hydrocarbons are the basis of all petroleum, but they differ in their configurations of both hydrogen and car- bon atoms. The carbon atoms may be linked in a chain formation with either a full or partial balance of hydrogen atoms. An important characteristic of hydrocarbons is that each chemical compound has its own boiling point.

You could repeat this process over and over by raising the temperature. Each time more and more crude would boil off. This creates the distillation curve, the plot of temperature versus evaporation. Each type of crude oil has a unique distillation curve dependent on the kinds of hydrocarbons that make up that crude.

Gases typically have between one and four carbons, whereas heavier grades of crude oil can have 50 carbons. Both the weight and the distillation curve of a specific crude oil are important to refiners who need to separate the different components of the crude oil to make various products such as gasoline, heating oil, diesel, and jet fuel. Oil wells can be located onshore, as in West Texas, or offshore, as in the Gulf of Mexico.

The type of production process used is dependent on how much pressure is within the oil reservoir and whether additional pressure is needed to pump the oil towards the surface. Most oil is first produced using the natural pressure within the oil reservoir that forces the oil to the surface. Eventually this natural pressure dissipates, and a pump is needed to extract the remaining oil. At some point during the life of an oil well it is no longer economically viable to continue to operate the well because it no longer produces or production is very poor.

At that point the well is abandoned, and the flow to the surface is plugged. Technology has played a critical part in the advancement of energy production. The change in seismic testing from two dimensional to three di- mensional, advanced imaging systems, and stronger material used for both pipes and drill bits are a few of the common advances. Another major tech- nological advance is horizontal drilling. The drill path formed by horizontal drilling begins vertically into the oil field and continues in an arc shape into the reservoir where it proceeds horizontally.

The objective in horizontal drilling is to allow the well to be exposed to more reservoir rock than under the vertical drilling method. The horizontal drilling method is applied to fractured conventional reserves, fractured source rocks, and also to older wells in order to increase production. Unconventional Oil Both the oil sands and shale oil are sources of oil where extraction is more costly than conventional drilling methods. Since the extraction of oil does not use conventional drilling methods, these oil sources are called uncon- ventional oil.

The United States has the largest oil shale deposits in the world in two main deposits. The Eastern U. The Western U. Shale oil is a rock-like substance that is rich in the organic mat- ter kerogen, which is the primitive precursor to crude oil.

The oil can be extracted in two ways. In the first process, oil shale is mined from the ground and then processed at a facility where it is heated and enriched with hydrogen in order to extract hydrogen vapors. When the shale fractures it releases gases and liquids, which are then captured. Oil sand deposits are found in many countries across the globe, but the majority of oil sands are located in Venezuela and Canada.

The oil is trapped in a complex mixture of sand, water, and clay, which is why crude oil extrac- tion from the oil sands is costlier than current conventional drilling methods. The crude oil within the oil sands is called bitumen and is separated from the waste in the oil sands using one of two methods. The first method applies to approximately 20 percent of the oil sand reserves; the sands are mined in an open pit, and the bitumen is extracted using a hot water technique.

The other 80 percent of the oil sands are buried deep below the surface and cannot be extracted using open pit mining. The hot bitu- men is then brought to the surface using producing wells, and the sand is left beneath the surface. This process is sure to become a large future method of oil production, because most of the oil within the sands must be extracted in this way. OPEC was created on September 14, in response to pressure from major oil companies to lower payments and prices to oil producers.

In addition, Iraq has had no quota since March of because it is still trying to restore its oil production lost during the Gulf Wars. OPEC members hold the majority of the spare oil production capacity in the world and use it to change their production levels dependent on both prices and demand for crude oil. OPEC is often thought of as a cartel, yet it lists one of its primary missions as trying to achieve stable oil prices which are fair and reasonable to both the consumer and producer.

It shocked the world and heightened inflation by using oil as a weapon in the oil crisis. By the rest of the world had surpassed OPEC in oil production. Inter- nal conflicts ensued as Saudi Arabia, eager to gain market share, increased production in the mids, which further decreased prices.

The major characteristic of non-OPEC producers is that the large majority of them are net oil importers. Most of the non-OPEC oil production is run by private oil companies, with the notable exception of Mexico. OPEC is important to the world because as a whole those countries have the most spare production capacity available.

Since OPEC institutes production quotas for its members, production tends to run below total capacity. This enables OPEC to react to changes in the global oil market quickly. Unexpected increases in demand that raise the price of oil can be met by increases in the OPEC production quota.

The concept of peak oil has been talked about almost since the first barrel of oil was produced, given that oil is not a renewable resource. At some point in the future we will run out, but the question of when has been hotly debated. Hubbert was the first geologist to treat the issue of oil field depletion using quantitative methods. Working with this concept in mind, Hubbert observed that cumulative oil production, as a function of time, followed a logistic growth curve.

Taking this concept he was able to quantitatively model production of any given oil field based on discovery rates, production rates, and cumulative production. Hubbert assumed that after discovery of oil, production increases almost exponentially as new wells are put into place. At some point peak output is reached, and the production goes into exponential decline as the resource is depleted. This creates a bell-shaped curve that traces the production of oil. It is displayed in Figure 4.

Based on this chart it is evident that U. S oil production would peak somewhere during the early s. Although Hubbert was able to use his model to successfully estimate the peak in U. It is imperative to remember that no physical or chemical law compels production to follow a logistical growth curve.

Oil production is determined by a number of factors, including political and economic. These factors can keep the production of oil below the maximum possible flow rate for a long time. These proven oil reserve estimates, published by each producing country and private companies, have not always been freely accessible. Proven reserves are oil reserves that are reasonably certain to be able to be extracted using current technologies at current prices. Outside of proven reserves there are other classifications for oil reserves that do not have the same reasonable certainty of being produced.

Probable reserves are defined as oil reserves that have a reasonably probable chance of being produced using current or similar technology at current prices. Possible reserves have a chance of being produced under favorable circumstances. These reserves may need a higher price to be profitable for extraction or may require technology yet to be tested.

Unconventional oil sources such as shale oil, oil sands, biofuels, and the conversion of natural gas or coal to liquid hydrocarbons may be classified as possible reserves. According to the Oil and Gas Journal, the world has approximately 1.

Including reserve growth and undiscovered reserves, there are approximately 2. Table 4. It does not include un- knowns such as biofuels or the conversion of natural gas or coal to liquid hydrocarbons. Heavy hydrocarbons, also known as the oil sands and extra heavy oil, are an unconventional oil resource in which the majority of reserves are not listed in the proven reserves category. This oil resource will become essential for meeting future global oil demand.

For , the Canadian Association of Petroleum Producers reported Canadian oil sands production at , barrels a day. Given current oil consumption, the oil sands and extra heavy oil could possibly give the world an additional years of supply. The other major unconventional oil resource is oil shale. In the United States, where the majority of oil shale resources are located, there is not yet sustained production from this resource.

No growth rate applied. These oil shale resources would be listed under probable or possible reserves. Given current oil consumption levels, shale oil could provide the world with years of supply. So how much oil supply is presently on hand, and how long will it last? The figures given previously provide a general idea of how much oil may be left globally. They are by no means final, as each year new estimates of reserves are announced.

The true answer is dependent on technological advances along with the price of oil in the future, given that the uncon- ventional oil resources discussed are much more expensive to develop than conventional oil resources. One issue with this estimate is the energy content of these unconventional oil sources. At this point additional supplies of oil are not of the light, sweet, high-energy type.

They are heavy crudes with less energy content per bar- rel. In addition, heavy crudes are more energy intensive to extract and to process. It is obvious that the true problem with unconventional oil sources is the issue of recoverability. It will take higher oil prices, technological ad- vances, research, and time to determine whether these reserves will be worth extracting. Overall, global oil supply could last for more than years if shale oil became a feasible source of oil production, but the issues cited previously would still remain.

It can be burned to power a car, generate electricity, or heat a home. It also can be used as a raw material to create plastics, petrochemicals, and many other products. The United States and Canada use oil more for transportation than for heat or electricity, but in the rest of the world oil is used more for heat and power than for transportation.

Globally the largest consumers of oil have traditionally been industrialized countries such as the United States, England, Germany, and Japan. Figure 4. China, South Korea, and India have shown huge increases in demand for oil whereas industrialized countries such as Germany and France have actually exhibited a decline in oil demand. This is partly because the industrialized countries are using energy more efficiently than the emerging economies. In addition, manufacturing has been moving out of countries such as the United States and Germany and into China and South Korea.

As these emerging economies such as China, India, and Brazil continue their growth, their consumption of oil will continue to increase. It is not unreasonable to suppose that these countries may have a growth pattern similar to that of the United States after the Great Depression. Although China and India are the most populous countries in the world, their global share of oil consumption is extremely small. As their economies grow and consumption increases, demand for energy is sure to grow as well.

This will create competition for oil imports between the industrialized countries and these emerging economies. The Energy Intelligence Group reports that there are about different internationally traded physical crude oils. Light crude oil has low wax content whereas heavier crude has higher wax content and thus higher viscosity.

This higher viscosity makes it harder to both pump and transport through pipelines. Sweet crude oil refers to the amount of sulfur in the crude oil, and sweet crude usually contains less than. Lower sulfur content in a crude oil allows it to be more cheaply processed into lighter products than sour crude. With sour crude more than 1 percent sulfur the impurities need to be removed before it can be processed into light products. Sweet crude oil is generally the ideal crude for refining into gasoline and other light end products.

Refining is the act of taking crude oil and processing it to make finished petroleum products that we use on a daily basis such as gasoline, heating oil, diesel, and jet fuel. Refining begins with simple distillation, which sep- arates the hydrocarbons in the crude into its fractions, or categories of its hydrocarbon components. This is done by heating the crude oil in a simple distillation chamber.

Different products boil off at different temperatures and are then captured. The lighter products such as liquid petroleum gases, naphtha, and straight-run gasoline boil off first. The middle distillate family, which consists of jet fuel, kerosene, heating oil, and diesel boil off next.

The heaviest product, residual fuel oil, is the last product to boil off. Refineries in the United States use much more complex processes than the simple distillation because end-user demand is focused on light prod- ucts. These light products create high value for the refinery; so after simple distillation, refineries reprocess the heavier products and change them into higher-value light products. A process called cracking uses the heavy distil- late captured in the simple distillation and puts it into a catalytic cracker in order to produce lighter distillates and gasoline.

Hydrotreaters are used to remove sulfur in petroleum products so that when burned for fuel or energy they emit lower levels of sulfur dioxide. The heaviest output of sim- ple distillation, residual fuel oil, is put through a coker in order to process it into lighter products and petroleum coke. Reforming units create high- octane components used in making gasoline from lower-octane byproducts captured in the simple distillation process.

The quality of the crude oil used in the refining process is important in determining how much processing is needed to achieve an optimal mix of products. Light sweet crude oil like WTI has a high yield of premium light products such as naphtha and straight-run gasoline using just simple distillation. On the opposite end of the spectrum, heavy crude like Iran Heavy yields a high level of residual fuel oil in simple distillation that must be reprocessed to create lighter products.

Refineries are aiming to process crude that yields an optimal mix of products, taking into account the cost of the available crude. Most of the U. Products are then shipped to the East Coast and the Midwest through pipeline and on tanker ships. Peak utilization occurs in the summer along with the demand for gasoline. The depth and duration of these maintenance periods depends on the current profit margin.

If margins are high due to demand for refined products, refiners will put off routine maintenance or go offline for a shorter time than initially anticipated. If refineries put off necessary and scheduled maintenance too long, accidents at the plant are more likely to occur. An unplanned outage results in the refinery being down for a longer time in the future. Thus, refineries need to balance the need for maintenance with their profit margins and the probability of an unexpected outage.

For example, if the profit margin for gasoline is higher than for heating oil due to market demand for gasoline, refiners will switch to make as much gasoline as possible in lieu of heating oil. Refineries will also make adjustments to output levels dependent on their profit margin. WTI crude oil is produced in the United States and is of very high quality, making it ideal for refining into gasoline. Brent crude oil consists of a variety of crudes produced from the North Sea and includes Brent Crude, Oseberg, and Forties.

It is not as light or sweet as WTI but it is ideal for the production of gasoline and distillates. The name Brent is taken from the Brent goose, but it is also an acronym for the formation layers Broom, Rannoch, Etieve, Ness, and Tarbat of the Brent oil field. The Brent crude oil trades on an electronic trading platform, whereas the WTI crude oil trades side-by-side on both an electronic trading platform and in the exchange pit.

These two future contracts are highly correlated, and because of its physical characteristics, WTI usually trades at a premium to Brent. WTI futures are the most liquid mar- ket for crude oil hedging and trading. For the purposes of the speculative investor the Brent futures contract is cash settled, although it can be a deliverable contract if two par- ties agree to enter into an exchange for physical and register to do so with their brokers and the exchange.

Volume and open interest information for the most liquid oil futures are displayed in Table 4. This new contract drew many participants who were eager to trade on a transparent screen at their own discretion instead of calling the exchange floor pits to find a market. In June the NYMEX moved their futures contracts to side-by-side trading, which allows a trader to execute electronically or on the exchange floor.

By that time the ICE had picked up some market share in the WTI futures trading, and it is uncertain whether the marketplace will continue to trade both contracts or one will win out. This contract trades electronically and is half of the size of the WTI crude oil future. Much of it started in with the Arab oil embargo that halted shipments of crude oil to the United States and its allies in retaliation for supporting Israel during the Yom Kippur War. As imports dropped the price of oil in the United States soared, creating demand rationing and gasoline lines.

The second oil crisis of the s oc- curred in during the Iranian Revolution when changes in the governing regime caused a decline in oil production and in exports from Iran. Volume Avg. This panic increased prices even further, and lines appeared at gas stations yet again. Since the s the United States has not had a supply cut severe enough to require demand rationing.

The longest price increase began in and has been attributed to an increase in global oil de- mand, especially from Asian and emerging economies such as China, South Korea, India, and Brazil. This price increase occurred gradually over a few years, unlike the sudden price increases of the s. This has allowed con- sumers to steadily grow accustomed to higher prices. Large price declines occurred when Saudi Arabia increased production substantially in , during the Asian economic crisis of —, and again for a short time after September 11, reflecting uncertainty surrounding the U.

Outside of these major political and economic events, the market re- ceives other fundamental information that can affect the future price of oil. The most important data within the WSPR consists of the weekly stock change for crude oil, gasoline, and distillates. Trends such as a draw or build of stocks within the petroleum complex are extremely important when trying to establish the future price of oil.

Both of these reports paint a more in-depth picture of the fundamentals in petroleum by looking at the global markets in addition to the domestic market. The IEA publishes this report monthly and it encompasses the global petroleum balance sheet. The outlook for crude oil prices hinges on the availability of oil produc- tion at a specific price. Ultimately it is profit that will drive companies to search for new methods and forms of oil production. Of course the production of oil cannot be turned on and off like a water faucet.

Current prices and expectation of future prices would have to remain above the production price for a period of time to entice a company to start a new production source. Increasing demand brought on by global growth has moved the world away from an era of cheap oil. The most populous countries on the planet are just starting their expansion and their demand for oil, and other forms of energy will rise and fall with their changing economic growth.

This growth, along with the search for new supplies, is likely to create a rise in the price of oil over time. These alternative energy sources are substitutes for crude oil or petroleum products and are not made from fossil fuels. The most popular bio-fuels are ethanol and biodiesel. Ethanol is cur- rently made from both sugarcane and corn. Brazil uses ethanol produced from sugarcane as automotive fuel, and the United States uses ethanol pro- duced from corn mainly as an additive to gasoline.

Biodiesel is produced from vegetable oils such as soybean oil, canola oil, or palm oil. It is used as a substitute for diesel in automotive fuel or as a heating fuel in residential and commercial applications. Other alternative sources such as wind power, solar energy, wave power, nuclear energy, and methane hydrates can also be considered partial substitutes for crude oil products. While some of these alternative sources of energy have been around for some time and oth- ers are still being tested for real world application, the global marketplace continues to search for energy sources to compete and possibly take the place of nonrenewable crude oil.

The EIA also puts out monthly and annual reports on crude oil and various other energy sources. It contains global numerical data for production, reserves, and refining within the petroleum complex. The IEA publishes a monthly oil market report, an annual world energy outlook, and a variety of global petroleum statistics. All of these additional sources are available on the Internet.

H It is classified as a distillate along with diesel, jet fuel, and kerosene. All of the distillates have a similar chemical make-up, and in some areas heating oil is the same product as diesel fuel with the exception of a few additives. Heating oil goes by many names in the United States, including No. Outside of the United States it is called gas oil. Heating oil is used primarily in the northeastern United States to heat both residential homes and commercial buildings.

Approximately 78 percent of these houses are located in the north- eastern United States. The oil is burned in a boiler or furnace to generate heat for the building. Other regions of the United States typically use natural gas as a heating source, because it has his- torically been cheaper and the infrastructure is in place in those areas to take the natural gas directly to the homes and commercial buildings.

Older homes in the Northeast generally do not have this natural gas infrastructure in place. Heating oil is very safe to use for heating. It has no self-ignition issues, and it also has a high flash point. The flash point is the lowest temperature at which something can form an ignitable liquid with oxygen.

Also, since these products are from the light gas oil streams, refiners have some ability to change the final product mix. But because they are limited in the amount of heating oil they can produce to meet demand, both storage and imports must cover the shortfall. In the United States during , total distillate produc- tion averaged 4 million barrels a day.

During the same time period, gaso- line production averaged 8. Because gasoline production has priority over production of distillate fuels in the United States, there is a focus on both storage and imports during peak demand times. The majority of U. Diesel is a popular fuel option for cars in Europe, and, along with a much more extensive public transportation system of trains and buses, this encourages fuel demand to be more focused on distillates than in the United States.

Heating oil storage in the United States plays an important role in balancing supply and demand during the winter months. Most heating oil storage in the United States is located on the East Coast with easy access to waterways for transportation.

As shown in Figure 5. Storage is rebuilt throughout the summer months when overall distillate demand is lower. In the other case, an extremely cold winter can cause a spike in both the demand and the price of heating oil. Traders in the heating oil market are very focused on both short-term and long-term forecasts for win- ter weather.

Because heating oil is considered a middle distillate along with diesel, jet fuel, and kerosene, the demand factors for these other products are also important. For example, strong demand for diesel may pull supply away from the heating oil market as refiners focus on yielding more diesel fuel from their distillates pool.

Diesel fuel is used in the United States in diesel engines for cars, trucks, trains, buses, boats, farm equipment, and military vehicles. This program requires 80 percent of on-highway diesel fuel to have only a 15 parts per million ppm sulfur content.

This low sulfur level results in a cleaner burning diesel that releases fewer emissions than before. Both jet fuel and kerosene are the lesser known distillates, but each can have an impact on the supply and price of heating oil. After September 11, airports around the United States were closed for days. In the months following, demand for air travel fell sharply. This had a significant impact on jet fuel demand because planes were flying less often, which in turn resulted in distillate fuel oil stocks building over 11 percent from mid- September through the end of the year.

This compares to a year average distillate stock build of 1 percent over the same time period. Jet fuel and its components are similar to heating oil and diesel, so refiners naturally made more of these two products instead of jet fuel. The switch to a production mix of more heating oil and diesel resulted in the rapid increase in distillate fuel stocks in the United States during the fourth quarter of It was launched on November 14, , trading only 22 contracts on the first day. Heating oil futures are deliverable in New York harbor.

This is the main trading location for the cash or physical heating oil market. Consumers of both jet fuel and diesel fuel often use the heating oil future for hedging purposes, because both jet fuel and diesel cash markets are often traded using a differential to the heating oil price.

The futures contract trades in cents per gallon, and one future is equal to 42, gallons of heating oil. One barrel of oil is equivalent to 42 gallons, so the heating oil future is also equal to 1, barrels of oil. This is identical to the crude oil futures contract; this is important because a common trade for speculators and a hedge for refiners is the heating oil crack spread.

The crack spread is the difference in price between the crude oil futures and the heating oil futures with the same delivery month. By trading the crack spread refiners are able to lock in a price to buy their crude oil and sell their refined products simultaneously. The crack spread previously mentioned implies that one barrel of crude oil would produce one barrel of heating oil, which in reality would not occur. The crack spread better approximates the results of a real-world refinery.

The crack spread comprises 3 barrels of crude oil, 2 barrels of gasoline, and 1 barrel of heating oil. Still the crack spread is not a true real-world refinery result, but it is the best approximation using futures contracts.

It does not take into account additional by-products from the refining process or pricing differentials between heating oil and other distillates. Supply and demand changes in the crude oil market will filter down to the heating oil market. This is why heating oil futures are highly correlated with the other futures contracts within the oil complex. If you expect crude oil to go down in price, it is highly likely that heating oil will move down in price also, although the magnitude of the price movement may not be the same.

This is shown in Figure 5. From this chart you can also see that the price of heating oil does not trade below the price of crude oil. This is because refiners need to have an incentive to refine crude oil into heating oil. If the refining company is not going to make a profit from doing so, it would just sell the crude oil on the physical market.

As mentioned previously, prices for the entire oil complex are corre- lated. Heating oil price volatility does increase during the winter months. Figure 5. These price spikes all occur during the winter months in conjunction with extreme cold weather in the northeast- ern United States that pushed up demand for heating oil. With this in mind, market participants keep a keen eye on the medium-term weather forecasts published by the National Weather Service NWS. The NWS daily forecasts give an outlook for above- or below-normal temperatures for one week to two weeks forward.

The WPSR heating oil stocks are grouped with diesel in the total distillate stock data. Given that the demand for heating oil is focused within PADD 1 in the Northeast, if a majority of the stocks in the United States are located within another PADD, it will take time to get supply to the major demand area. This could result in price in- creases if demand suddenly shifts higher as a result of cold weather or lack of supply within PADD 1.

The WPSR also reports weekly statistics such as distillate production, imports, and implied demand. Trends within all of these statistics are important for determining the fundamental picture that will influence the future price of heating oil. Some power plants have the ability to burn either natural gas or heating oil to generate power. Plant managers will make this decision based on which fuel is cheaper for them to burn and still generate the same amount of electricity.

Natural gas is almost always the cheaper fuel, but in the past heating oil has been cheaper for short periods of time when natural gas prices spike due to short supply or high demand. The EIA shows that was the year with the largest deliveries of distillate to electric generators over the past decade.

From December through February heating oil was cheaper than nat- ural gas, as shown in Figure 5. During this time, electric generators that could burn heating oil instead of natural gas would have switched to heating oil as their fuel of choice.

This created an upward shift in heating oil demand on the part of electric generators. Biodiesel is fuel created using biological sources; in this case vegetable oils such as palm oil, canola oil, and soybean oil are used. The biodiesel can be used in pure form or blended with regular diesel to achieve a fuel mix. The concept of biodiesel originated in , when Dr.

Rudolf Diesel developed the first diesel engine to run on peanut oil. In the United States, singer Willie Nelson created his own brand of biodiesel called BioWillie, which is sold in outlets in eight states. Heating oil prices will continue to be volatile in the winter months and dependent on the realized weather in the northeastern United States. Demand for both diesel and jet fuel will grow globally with the need to transport both goods and people. Supply issues such as refining capacity must be addressed in order to produce enough distillate to meet demand over the long term.

Overall, prices will continue to be correlated with both crude oil and gasoline. In the longer-term, higher prices should prevail to attract companies to invest in future refinery and pipeline infrastructure to increase supply of refined products. The EIA also puts out monthly and annual reports on distillates, along with a special heating oil and propane update that focuses on these fuels during the winter.

You G are bound to pass a gas station while driving to work, running errands, or dropping the kids off at school. Most people know that there are different octane levels available and that higher octane levels are better because they are at a premium price. Most people will tell you that they drive more during the summer when the weather is better and they are taking vacations. Drivers usually know how many miles per gallon they get from their vehicles.

Gasoline has become a topic of conversation and is a commodity that many people are constantly aware of. Yet, it is also the most complicated of all the energy commodities. Gasoline has evolved throughout history as society has become more aware of the damage it has inflicted on our environment.

It is a fine line between maximizing the energy value of the fuel while minimizing its impact on the environment. This has resulted in many changes in how gasoline is made in the United States. When you pull into a gasoline station you usually are given three choices.

There is regular unleaded gasoline, mid-grade gasoline, and pre- mium gasoline. Each of these fuels is differentiated by its octane rating, with regular usually having an octane rating, mid-grade an octane rating, and premium a octane rating. What does the octane rating represent? It is the amount of fuel that can be compressed before it spontaneously ignites. Compression occurs in gasoline engines as a cylinder of air and gas is compressed and ignited with a spark plug.

When gasoline ignites from compression rather than the spark of a spark plug, it causes knocking on the engine. Knocking usually occurs just prior to the spark plug flashing and is aptly named because it sounds like a thud or knock. Knocking can cause mechanical damage to the engine and it is not something that you want to occur. So which grade do you choose to fuel up with? This is because octane and energy content are not related.

Contrary to popular belief, all gasoline contains approximately the same energy content and detergents to clean the engine. Experts say you will not receive any extra performance by using gasoline with a higher octane level than the one recommended for your vehicle. Most car manufacturers recommend regular gasoline, although some sport and luxury brands with higher compression engines require premium gasoline.

The higher compression results in more power for these cars. Since the s there have been many changes to gasoline specifications to make it safer for people and the environment. Leaded gaso- line was phased out beginning in July of , because TEL was found to be extremely toxic even in low concentrations. A full ban of leaded gasoline in the United States was made on January 1, Refiners experimented with many blending components to come up with the most economical way to increase the octane rating of conventional un- leaded gasoline.

Methanol was one of the first additives used. Methanol is the simplest alcohol compound, also called methyl alcohol. Over time inter- est in methanol as an additive died down for two main reasons. Methanol has an affinity for water and would separate from the gasoline mixture if it came into contact with water during transit.

In addition, when burned in an internal combustible engine, it emitted formaldehyde into the air through the exhaust. The Clean Air Act initiated in resulted in the requirement of re- formulated unleaded gasoline RFG in cities with the worst smog. The addition of oxygen to the fuel reduces the amount of carbon monoxide and unburned fuel in the exhaust, reducing smog. Methyl tertiary-butyl ether MTBE was chosen by refiners as oxygenate of choice in RFG, and its use in the gasoline pool increased even more.

It is a chemical compound manufactured from the chemical reaction of methanol and isobutylene. At room temperature it is volatile and flammable and dissolves easily into water. It helped refiners meet two separate needs—the 2 percent oxygen requirement and the octane requirement. Yet, like methanol before it, MTBE was discovered to have potential health risks associated with it. MTBE has been known to contaminate drinking water through leaks in storage tanks and pipelines, fuel tank damage during accidents, and poor disposal of old gasoline.

The first major incident of this occurred in Santa Monica, California in Finally, the EPA announced that as of May 5, it would drop the 2 percent oxygen requirement for reformulated gasoline. Globally, ethanol is primarily made from sugarcane or corn, although it can be made from wheat, sorghum, and other starch crops.

Fuel ethanol has been around for a long time. Today the largest use of ethanol is as a fuel and fuel additive. There are many reasons why ethanol is attractive to refiners even though the oxygenate requirement is no longer valid. Adding oxygen to fuel results in complete combustion of the fuel and lowers carbon monoxide emissions, helping refiners to meet the EPA emission control requirements. Ethanol is the highest octane fuel on the market and it has the advantages of MTBE without being harmful.

Ethanol is economically attractive because ethanol blending is subsidized by a federal tax credit of 51 cents per gallon. Finally, ethanol allows refiners to meet the Renewable Fuel Standard Program. It started in with a mandate of 4. Ethanol added to the gasoline pool comes at a higher cost than MTBE. In addition, ethanol tends to separate from gasoline if stored for a long time, and it has an affinity for water that could contaminate the gasoline if the two came into contact.

This affinity for water results in ethanol being shipped separately from gasoline, usually by rail car or truck, and blended along with reformulated gasoline blendstock for oxygen blending RBOB at the distribution center. This adds an additional transportation layer to what is already a complex process.

Ethanol production in the United States is centered in the Midwest because that is where most of its feedstock, corn, is grown. As shown in Figure 6. Since then production has increased sharply as refiners have opted away from MTBE and towards ethanol. The common ethanol- gasoline mixture consists of 10 percent ethanol and 90 percent gasoline, called E This is the current fuel available in major metropolitan areas of the United States.

Flexible fuel vehicles can run on either straight gasoline or any blend of ethanol up to 85 percent. This fuel, called E85, is 85 percent ethanol and 15 percent gasoline. There were approximately 6 million flexible fuel vehicles on the road in the United States as of Since the percentage of flexible fuel vehicles on the road is quite small, gasoline stations have not been quick to add E85 pumps.

Fuel ethanol contains more than a third less energy content per gal- lon than conventional gasoline, resulting in fewer miles per gallon for fuel ethanol. Department of Energy DOE reports that it would take 1. In , the United States consumed 9. Since one bushel of corn makes ap- proximately 2. In the end what do all these changes in specification mean for the price of gasoline?

Each change to gasoline is costly for both refiners and consumers. The push for cleaner fuels requires upgrades to refining units and lighter and more expensive inputs. Upgrades to refineries will take refining capacity away for a while, and the market may have to rely on current product stocks or imports during that time. With the new gasoline grade of RBOB the market is dependent on both refineries and farms. If the corn harvest is poor one year, the cost of ethanol will rise, resulting in price increases in gasoline as well.

Furthermore, as previously discussed, the energy content of ethanol is less than the energy content of both gasoline and MTBE. So blending approximately 10 percent ethanol with gasoline will result in higher overall demand, because a full tank of gasoline will now contain less energy than it did before ethanol was added to the gasoline pool. When a bar- rel of crude oil is refined, it produces about 20 gallons of gasoline, a yield of 47 percent.

The increased production is to build stocks to meet the peak demand that occurs in the summer. The peak driving season in the United States occurs between Memorial Day and Labor Day when school is out and weather is good for traveling or vacationing. No new refinery has been built in the United States since All additional refinery capacity has been the result of expanding current facilities or technological efficiencies in refining.

During the summer, refineries are often close to maxing out their capacity due to the strong demand for gasoline. This results in little open refining capacity in the summer; therefore, unplanned refinery outages due to fire or other mechanical issues can create quite a stir in the gasoline markets. Refinery outages in the summer cut into gasoline production expectations, so price rises in order to entice other refineries to increase gasoline production.

This rise in price also acts to attract additional imports and to curb gasoline demand. Since refining capacity growth has not increased as fast as gasoline demand, both imports and storage help meet the production shortfall that occurs during the summer months. Gasoline imports can come in the form of finished gasoline or blending components which are then combined in the United States to make finished gasoline.

The majority of gasoline imports come from Caribbean, Canadian, and European refineries. These refineries make gasoline based on specifications and standards solely for export to the United States. Gasoline storage in the United States follows a pattern opposite to that of the distillate market. During the winter when it is cold and snow is building up, gasoline demand decreases.

This allows refiners to build up storage. Once the winter maintenance season ends, usually in February or March, gasoline production is increased to build supplies up in anticipation of the summer demand period. Throughout the summer, storage decreases as gasoline demand exceeds production and imports. Figure 6. Gasoline storage typically hits its lows for the year coming out of the summer demand season and from the refinery maintenance that occurs in October and November.

Gasoline demand rises over the summer vacation period, with peak demand occurring in the months of July and August. The lowest demand for gasoline occurs in the winter, usually during the month of February. Weather affects demand in the gasoline market to some extent, but not to the degree that it does so for heating oil. A lot of snow or other precipitation can lower demand for gasoline as people stay indoors whereas sunny, warm weather can entice people to go outdoors.

Gasoline demand in the United States has grown each year for the past 14 years — with an average yearly growth of 1. From to the average annual price of gasoline increased over 60 percent, and from to the same price increased 35 percent. If gasoline demand is elastic, changes in price will have an effect on its demand. If gasoline demand is inelastic, changes in price will have no effect on demand. The elasticity of demand can be different in the short and the long run.

In the short run your demand for gasoline is inelastic. Yet, in the long run you may make changes such as buying a more fuel-efficient car or looking for a job closer to home. These changes make your long-run demand for gasoline more elastic. With regard to gasoline, the ability people have to substitute other means of transportation is important in determining the short-run elasticity of demand. In the long run, there are options open to many people who want to lower their demand for gasoline.

This would suggest that price increases have not harmed growth in demand and that the long-run demand for gasoline is fairly inelastic.

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