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## Crude Oil Derivatives

Crude Oil Derivatives are one of the most popular derivatives in the Energy Derivatives segment. They are traded in both exchanges and OTC markets, and some of the contracts are highly liquid. The main international centers of trading are New York, Chicago and London. The CME Group offers a range of crude oil derivative products for trading. The underlying asset for crude oil derivatives is crude oil itself. There are different types of crude oil and the crude oil that we get in the markets is blended for consistency. Therefore, it is important to understand a few basics of the underlying itself before trying to understand the derivatives on them.

Crude Oil is an important source of primary energy. It would not be wrong to say that the world runs on it. The following table shows the sources of energy and their shares as of 2020.

Energy Sources Consumption (Exajoules) Share of Primary Energy
Oil 193.0 33.1%
Gas 141.5 24.2%
Coal 157.9 27.0%
Renewables 29.0 5.0%
Hydro 37.6 6.4%
Nuclear 24.9 4.3%
Total 583.9 100

Note: 1 Exajoule = Energy of quintillion joules = 1018 joules = 3,41,20,842 tonnes of coal = 2,38,84,589 tonnes of oil

### Products made from Crude Oil

About 15 different products are made from crude oil. These products are either directly used or used as input for other manufacturing processes. The common products made are: petrol, diesel, kerosene, petroleum coke, still gas, asphalt and road oil, naptha, lubricants and waxes. Some of these products have derivatives of them, while others do not have any derivatives on them.

### Crude Oil Types

Not all crude oil is the same. The quality of crude, in general, depends on two factors: 1) Viscocity; and 2) Sulfur content. If the crude is more viscous then it does not flow easily. Such a crude may be difficult to transport through a pipeline. If the crude is less viscous then it can flow easily through a pipeline. All crude extracted contains some amount of sulfur. Ideally, the lesser the sulfur, the better it is. In general, all crude will have some viscocity and sulfur content. Based on these two factors, crude oil can be divided into the following four qualities.

### Crude Oil Qualities

• Sweet = Low levels of sulfur
• Sour = High levels of sulfur
• Heavy = More viscous and does not flow easily
• Light = Less viscous and flows more easily

### Crude Oil Types for Trading Purposes

Based on the above qualities of crude, the following types of crude are found in the market.

Crude Oil Type Feature Market price
Light Sweet Less viscous and low sulfur Sells at a premium
Light Sour Less viscous and high sulfur Sells at a premium
Medium Sour Medium viscous and high sulfur Sells at a middle rate
Heavy Sweet More viscous and low sulfur Sells at a discount
Heavy Sour More viscous and high sulfur Sells at a discount

### Crude Oil Products

The crude oil products available in the market are based on the crude oil types described above. There are many products or blends of crude. The following are the most common and traded ones - both in the cash market and derivatives market.

Product Type Product Name Source Market Price
Light Sweet Crude Western Texas Intermediate (WTI) USA Premium
Brent Crude North Sea
Saharan Blend Algeria
Medium Sour Crude Mars USA Average
Arab Light Saudi Arabia
Arab Medium Saudi Arabia
Urals Russia
Heavy Sour Crude Maya Mexico Discount
Cerro Negro Venezuela

### Crude Oil Derivatives

With the above understanding of the types and product names of crude oil, let us dicuss about the derivatives on crude oil.

The crude oil derivatives are based on a specific type of crude such as WTI or Brent, etc. The prices of WTI and Brent are different in the spot markets and therefore the prices of their derivatives are different. For example, the spot price of WTI as on 23rd October 2020 is $39.13, while the spot price of Brent on the same date is$41.05. While trading in crude oil, one needs to select a particular type of crude oil or undertaking to trade.

The derivatives are available both on exchanges and OTC market. While trading in Crude Oil, it is important to understand the technical specifications as the price is based on it. The following is the specification of WTI crude oil derivatives on CME.

WTI Crude Oil Specifications on CME

Terms Details
Contract Unit 1,000 Units
Price quotation US dollars and cents per barrel
Tick size $0.01 per barrel or$10
Contract Monthly contract listed for the next 10 calendar years
Settlement method Deliverable
Deliverable procedure Delivery should be made FOB at any pipeline or storage facility in Cushing, Oklahoma with pipeline access
Delivery period 1st calendar day of the delivery month

The above specifications are general in nature and can be used for trading and settlement in cash. If one wishes to take delivery of the crude then he/she must also understand the technical specifications such as actual sulfur content, viscosity, REID vapor pressure, basic sediment, water and impurities, pour point, micro-method carbon residue percentage, total acid number (TAN) number, nickel content, vanadium content, and High-Temperature Simulated Distillation (HTSD) number. This is important because the crude refineries are calibrated to a specific type of crude. If crude oil of right specifications is not purchased, it may not be useful for refining purposes.

### Trading in Crude Oil Derivatives

Let's consider the crude oil traded on CME. We could have taken example of contracts traded on any other exchange, it would work the same; but the choice of CME is due to the variety of crude products available, their liquidity, easy availability of data, and a bit of my personal preference. We will consider WTI Crude Oil Financial Futures for our example.

Currently, WTI Financial Futures are available for every month starting from October 2020 till December 2028. In other words, we can bet (or do risk management) for the next 99 months into future. Not all contracts are liquid, liqudity is found only in the nearest 30 months.

Let us suppose that the WTI crude oil prices will go up in the next one year. Currently, the one year forward price (Oct 2021) is $41.89 per barrel of oil. If we believe that the price will be more than this then we can take a long position. We have to buy the contracts in units. One unit is 1,000 barrels of oil. Assuming we are buying 5 units, our long position would cost us: Cost = 5 units x 1,000 barrels x 41.89 =$209,450.

If in October 2021, the price of WTI oil moved to $43.89, we can sell our contract or wait for the exchange to close our position automatically. Note: we do not have to fear about physical delivery in this specific contract because the contract "WTI Financial Futures" is settled in cash. If it were a different contract, we need to be careful as we may be forced to take delivery. If we close our positon at$43.89, our profit would be:

Profit = 5 units x 1,000 units x (43.89 - 41.89) = \$10,000

#### END OF MY NOTES

Updation History
First updated on 26th October 2020.