Petroleum Economics and Policy Course Notes Part II PDF

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Summary

This is the second part of the lecture notes. This document would help the reader to use economic analysis to understand issues in international oil and gas markets. It would also explain to others what forces are driving the industry, markets and players. This was delivered as part of a lecture o...

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4. Petroleum Transportation Oil can be transported by a variety of means including water-borne barges and tankers, pipelines, railways, trucks and even horse wagons. In comparison, gas transportation is pretty much limited to pipelines unless it is converted liquid.

4.1 Tankers Oil has a long history of transport by water. It dated back almost at the start of the modern oil industry. In 1861 a sailing ship of oil barrels was sent from Philadelphia to London. Oil was also loaded in barrels and shipped by horse wagons on land. Originally, barrels held 50 gallons but contracts were written on a 42 gallon per barrel basis to allow for spillage. This practice has lasted to today – each oil barrel contains 42 gallons. The first bulk crude ocean carrier began its commercial operation in 1863. To prevent oil from sloshing and destabilizing the vessel, tanks were used to separate oil in these carriers. This is how the tankers were named. The main economic characteristic of such tankers is economies of scale. Since surface area increases as a square and volume (or capacity) goes up as a cube, there are significant economics of scale - i.e. the average capital cost declines as the size of the tankers increases. This is illustrated in Figure 32: Figure 32 TANKER CONSTRUCTION COSTS 1000 900 800

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There are also other sources of scale economies. The longer the ship the easier it can move through the water. Hence a 200,000 dwt tanker can operate with a similar engine to a 100,000 dwt tanker. 25 Furthermore, crew size is pretty much the same on a 50,000 dwt compared to a 250,000 dwt tanker. In the early 1950s, the largest oil tankers afloat were 32,500 dwt. By 1990, 46 percent of the fleet consisted of tankers over 200,000 dwt and there were 22 tankers over 400,000 dwt sailing the high seas. A key implication of scale economies is that tanker costs are dominated by fixed capital costs and relatively low variable costs. There are however disadvantages on size. The larger the ship, the more limitations there are on routes. For example, the largest tanker that can pass the Suez Canal is 200,000 dwt. Also the larger the tanker the harder it is to stop (a 250,000 dwt tanker at 16 knots takes 3 miles and 20 minutes to stop) and the harder to manoeuvre (a 300,000 dwt tanker travelling at less than 5 knots cannot be steered). Finally, the large volume of oil makes a good target for pirate attacks and the liability for oil spills following accidents has put a distinct limit on size. The direct result of the economies of scale of the oil tankers is that the average seaborne transportation cost is very low compared to the value of oil. Figure 33 shows the average transportation cost along with the FOB cost of crude oil from the Persian Gulf to the United States. From 1999 to 2008, the share of transportation cost is about 5% of total crude oil cost. The relatively low transportation cost in turn leads to the integration of global oil market as low transportation costs make it possible to arbitrage between regions (or continents), which will ultimately eliminate price differentials. Figure 33

Cost of Transporting Oil Persian Gulf - US 120 100

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 25

dwtShortforDeadWeightTonnesthatistheconventionalmeasurementforthesizeoftankers.It indicatesthetotalcarryingcapacity,includingcargo,fuel,provisionsandcrewofatanker.

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THINK

What is the requirement for a price differential between regions to induce oil to move to the higher priced region? 

First of all, the price differential must be sufficient to more than cover the actual cost of transporting to oil. Another condition is that the seller must be confident the price differential will still be there when the oil physically arrives. The development of futures market (see below) means sellers can by using futures market lock in the price differentials.

Major Chokepoints of International Oil Transport According to the US EIA, in 2007 around 50% of total world oil production was transported by ocean tankers on fixed maritime routes. The international energy market is dependent upon reliable transport. However there are a few chokepoints along the global sea routes. 26 Figure 34 lists the major chokepoints of international oil transport, among which the Strait of Hormuz leading out of the Persian Gulf and the Strait of Malacca linking the Indian and Pacific Oceans are two of the world’s most strategic chokepoints. The Strait of Hormuz is the world's most important oil chokepoint due to its daily oil flow of 16-17 million barrels, which is roughly 40 percent of all seaborne traded oil (or 20 percent of oil traded worldwide). The Strait of Malacca is the shortest sea route between Persian Gulf suppliers and the Asian markets –notably China, Japan, South Korea, and the Pacific Rim. It is the key chokepoint in Asia with an estimated 15 million bbl/d flow in 2006. Figure 34 Major Chokepoints of International Oil Transport Bottlenecks

2006 Throughput

Strait of Hormuz (between Persian Gulf and Arabian Sea)

16.5 MMB/D

Strait of Malacca (between Indian Ocean and S. China Sea)

15 MMB/D

Suez Canal (between Red Sea and Mediterranean Sea)

3.9 MMB/D

Bab el-Mandab (between Red Sea and Gulf of Aden)

3.3 MMB/D

Panama Canal (between Caribbean Sea and Pacific Ocean)

0.5 MMB/D

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Chokepointsorbottlenecksarenarrowchannelsalongwidelyusedglobalsearoutes.Theyarea criticalpartofglobalenergysecurityduetothehighvolumeofoiltradedthroughtheirnarrowstraits.

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THINK

Why are these chokepoints important to the security of the global energy supply? First, the blockage of a chokepoint, even temporarily, can lead to substantial increases in total energy costs because transporting through alternative routes can significantly increase transportation costs. Second, chokepoints leave oil tankers vulnerable to theft from pirates, terrorist attacks, and political unrest in the form of wars or hostilities as well as shipping accidents which can lead to disastrous oil spills.

Tanker Chartering Oil companies may own tankers or charter tankers to ship oil. Around 80% of the world’s tanker capacity is owned by independent tanker owners (Dahl, 2003). This way, when an oil company does not need a tanker it does not sit idle – other companies may hire it. There are three common chartering agreements: voyage charter, time charter and bareboat charter. 

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A voyage charter is the hiring of a vessel and crew for a specific trip between a load port and a discharge port. The charterer pays the vessel owner on a perton or lump-sum basis. The owner pays the port costs (excluding stevedoring), fuel costs and crew costs. A time charter is the hiring of a vessel for a certain time period ranging from several months to several years. The owner of the vessel still manages it but the charterer selects the ports and directs the vessel where to go. The charterer pays for all fuel the vessel consumes, port charges, and a fair return to the owner of the vessel. A bareboat charter is an arrangement for the hiring of a vessel whereby no administration or technical maintenance is included as part of the agreement. The charterer pays for all operating expenses, including fuel, crew, port expenses and hull insurance. Effectively, the owners finance the purchase of the vessel.

The charter rate is typically quoted in an index called Worldscale. For each conceivable voyage in the world, there is an estimated dollar cost per tonne of carrying the oil in a standard tankship (19,500 dwt) under specific conditions including a return for the owner. This figure, published annually, is designated Worldscale 100. The actual rate for the voyage is then measured from this benchmark. For example if World Scale 100 for a trip from A to B is $4 per tonne and the actual vessel is hired at $2 per ton, this is reported as World Scale 50. Tankers sometimes sail under flags of convenience, i.e. they are registered in a country which is neither the home country of their owners nor their charters. The country of registration determines the laws under which the ship is required to operate 

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and to be applied in relevant admiralty cases. The major rational for this practice is to take advantage of lower tax rates and lax operating and environmental standards in the registry countries. According to the US CIA, the two most populous countries of flags of convenience are Panama and Liberia with 528 and 464 registered tankers respectively in 2007. In contrast, only 59 tankers are registered in the United States.

4.2 Pipeline Economic Characteristics The other major means of transport crude and products is pipeline. As with so much of the rest of the industry, the economics of pipelines are also dominated by economies of scale and very high fixed costs. PipelineThroughput Thethroughputforagivenpipelineofaparticularproduct(oil,  gas orrefined products) is jointly determined by the diameter and the operating pressure. Foran oilpipeline,theruleofthumbisthatthethroughput isproportional to the square of the diameter. For example, a 36’’ pipeline is approximately equalthetotalcapacityof nine12’’pipelines.As the capitalcostof building the pipeline is proportional to the diameter itself, the average capital cost fallsexponentiallywiththediameter. Theoperatingpressureofapipeline isdeterminedbythe numberofpumps for an oil pipeline or compressors for a gas pipeline and the utilization of these pumps or compressors. The costs of laying down the pipes and installingpumpsorcompressorsconstitutethefixedcostofapipeline. As illustrated in Figure 35, when the diameter of pipeline increases, the throughput increases and the average cost falls. However, for a given diameter of pipeline, by adding more pumps or compressors, the capacity can be increased. This has important implications for the design of pipeline systems. Oftentimes, at the beginning operation of a pipeline the downstream market may not fully developed. It may be worthwhile to lay down a bigger diameter pipeline yet leave room for future expansion by adding more pumps or compressors.

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Figure 35 Pipeline Throughput and Average Cost Unit Cost

Pipeline as a Natural Monopoly Because pipelines attract very large economies of scale, they are natural monopolies. 27 It is quite common that the outputs from several large oil fields (or basins) are carried by one bulk pipeline. This is true not only for a pipeline between two points but also for a network of pipelines within an oil producing basin. For example, in the North Sea in different locations there are four key pipeline networks – The Brent and Ninian systems which deliver to Sullom Voe; the Flotta system which delivers to Orkney and the Forties system which delivers to Cruden Bay. Hence they must either be publicly controlled or, if in the private sector regulated. Without this, two things might follow. The owners may use their monopoly position to earn excessive profits. Equally they may use their ownership to deny access to users thereby restricting competition at both ends of the pipeline. It is worth remembering that the Standard Oil Trust of Rockefeller, which controlled much of the US oil industry, began as a pipeline operation.

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Naturalmonopoly.Thisoccurswhenthemostefficientscaleofoperationissolargeinrelationto thedemandthatonlyonesupplierisrequired.Morethanonesupplierwould implyhighercoststhan necessary,whichwouldbesociallyundesirable.Furthermore,becauseofthecoststructure‐high fixedcostlowoperatingcosts‐anyincumbentwouldbeabletoundercutanynewentrantbyvirtue ofthebygonesrule.Hencemorethanonesupplierwouldbeimpractical.

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THINK

How might the abuse of the natural monopoly position be avoided through regulation? Two options are available. One is to control the profits of the pipeline by restricting price of access or rate of return on the investment. The other is to guarantee access by others. This can be done by granting “common carriage” or “third party access”. 28

Trans-boundary Pipeline Issues Another issue of interest concerns trans-boundary pipelines. This refers to the pipelines that cross two or more countries’ territories (Figure 36). Several questions arise. 

First, which law regime should these pipelines apply?

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Second, it is often difficult to coordinate when more than two countries are involved, which naturally lead to long-lead time.

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Third, there is a security of supply concern for the consuming countries as the trans-boundary pipelines are particularly vulnerable to disruptions in both the producing country and the transit country.

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Fourth, when there are more than two countries involved, how to set the transit fee? Transit Fee

To allow this transit, an agreement is signed which pays the territory a transit fee. This can be a fixed sum per barrel and/or the right to offtake from the line, often at favourable rates. The problem arises because once thepipelineisbuiltand operating, thetransitcountryis inaverypowerful position to demand a renegotiation increasing its transit fee. Furthermore thetransitcountrycansqueezeoutagreatdeal.

 28

CommonCarriage.Thisiswhenanyonewishingtouseapipelinecandoso(atagreedcommercial terms)evenifitmeansexistingusersmustreducetheirthroughputtomakeroom. ThirdPartyAccess.Thisiswhenanyonewishingtouseapipelinecandoso(atagreedcommercial rates)providingthelinehassparecapacity.Ifthelineisfullthenthepotentialusermustwaituntil capacitybecomesavailable.

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Figure 36 Trans-boundary Pipelines

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THINK

Why is the transit country able to squeeze out ever more transit fees without closing the line? The answer is the seller of the crude is often the owner of the pipeline. Hence line closure means the seller cannot get their product to market. Hence they not only lose the profit on the pipeline they also lose profit on the oil sales.

The Setting of Transit Fees In principle, for oil and gas transit, transit fees are supposed to cover the transportation as such, including profits, plus a payment for the right of way. What often complicates the comparisons of transit fees in different countries is that the services included in the transit tariff vary. In some cases transit may include storage and other load balancing services. In practice, transit fees and conditions are the result of negotiations between commercial interests. When transit may take place through alternative routes, the maximum price that will be paid is the opportunity cost, i.e. the cost of arranging for transit through an alternative route. In cases where there are no alternatives, the maximum price for transit is the price that makes the gas sales agreement unprofitable for the seller. These price levels could be considered as ceilings for the transit fee. The corresponding floor would be the real cost of transit. At the same time, the transit country, and its industry in some cases, will benefit from getting new or additional domestic gas supplies.

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Once the transit facilities have been built, the negotiating position of the parties involved changes. However, the relationship between the buyer of transit services and the transit service provider remains one of inter-dependence. The transit country will be tempted to increase the transit fees once the investment has been made. This position may be weakened if the transit country receives domestic energy supplies from the same shipper.

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5. Refining and Marketing 5.1 Refining Crude oil is a mix of chemical compounds and needs to be separated into useful products such as gasoline, kerosene, diesel, fuel oil, lubricants and so on. Essentially, refining breaks crude oil down into its various components, which then are selectively reconfigured into new products. All refineries perform three basic functions: separation, conversion, and treatment. Figure 37 shows a simple version of refinery. Figure 37 Simple Refinery Flow – Primary Distillation

The refining process always begins with distillation. The simplest refinery can have nothing but the distillation process. Modern distillation involves piping oil through hot furnaces which are fuelled typically by natural gas or residual fuel oil. As oil is heated, various fractions of oil boil off. The resulting liquids and vapour are discharged to distillation and cooling towers. The lighter products such as LPG, naphtha and gasoline are on the top and first to be separated out, then the middle distillates such as kerosene and gas oil/diesel. Heavier products such as fuel oil, asphalt and cokes are last to be separated. Figure 38 shows an example of boiling range of different refining product. However, 

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the cut points have some slack and can be adjusted. 29 For example, if the cut point of gasoline were changed to 230 from 220, then more gasoline and less naphtha would be produced. Figure 38 Boiling Ranges for Petroleum Products DegreesF

Product

800

StraightRunResidual

The outputs from the primary distillation process can rarely meet the market requirements both in quality and in quantity. Modern refineries usually have a series of complex conversion and treatment process to increase the output of lighter, cleaner and high-valued products. Some of the popular processes include Fluid Catalytic Cracking, Reforming, Hydrocracking, Hydrotreating, Delayed Coking and Alkylation. The most widely used conversion method is called cracking because it uses heat, pressure or catalytic, 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. Other refinery processes, instead of splitting molecules, rearrange them to add value. Alkylation’s, for example, makes gasoline components by combining some of the gaseous byproducts of cracking. For details on the refining process, see Leffler (2000).

Refinery Economics As with other segments of the petroleum indstustry, the economies of scale are important in refineries since a refinery is essentially a collection of pipes and tanks. The investment required for a larger refinery is proportionally smaller than that of a small refinery. Empirically, there exists the following relationship.  29

Cutpoi...