With this series of articles, BSIC will present the supply and demand dynamics of the oil industry which are most relevant to create well-grounded predictions of the future. This week’s article will focus on the supply side trends including supply disruption resulted from geopolitical issues, pipeline construction projects around the world, and countries’ exploratory initiatives that lead to new sources of oil.


Oil is more than the sometimes-sticky black substance that we know of and is quite literally running our lives. Its price is an up and down story often being governed by political decisions and yet oil is still one of the most valuable commodities on earth. But what is it? How is it made? And more importantly, what do we make out of it? The black gold is essential not only for the production of fuel and plastics but also for every-day products from chewing gums to guitar strings to fishing lures. What does this mean for the industry, the economy, and consumers? You should be able to answer those once you are done reading this piece.

Essentially, oil is a liquid found under the Earth’s surface, which develops over long periods of time. It was initially formed by great amounts of dead zooplankton and algae buried under the sea, under many layers of sand and mud which at one point were imposing such heat and pressure on them that they eventually started transforming into natural gas and oil.

It is measured in barrels (1 bbl = 42 US gallons or 159 litres). Other notations worth mentioning are: b/d (barrels per day), kb/d (1 000 barrels per day), Gb/y (1bn barrels per year), etc. In terms of production, in fact, only around 19 gallons of gasoline are created from one 42-gallon barrel of oil. The rest is used to make products such as contact lenses, crayons, perfumes, toothpaste, artificial limbs, etc. The specific steps required to bring crude oil to end product will be reviewed at a dedicated section as you proceed with this article.

Valuing oil – Classifications

The main characteristics defining an oil’s quality are its weight and sulfur content. Light, low-sulfur oils are considered the highest quality, while heavy, high-sulfur ones – the least expensive and lowest quality. Light sweet crude oil is the most sought-after version of oil as it contains a large fraction that may be directly processed into gasoline. Other classifications include the level of toxicity and region of origin.

Weight. API gravity (The American Petroleum Institute gravity) – a weight measure for petroleum liquids. It is used to compare their densities. The denser the petroleum liquid, the smaller its API gravity is. Unit of measure: API gravity degree, an inverse measure of a petroleum liquid’s density relative to that of water (which is 997 kg/m3).

Based on API gravity, oil divides into the following categories:

Type of crude oil Light Medium Heavy Extra heavy
Density low; < 870 kg/m3 medium; 870 – 920 kg/m3 rather high; 920 – 1000 kg/m3 high; > 1000 kg/m3
API Gravity > 31.1° 22.3° – 31.1° < 22.3° < 10.0°
Water flotation Floats on water; typically of highest quality and price Sinks

Exact differentiation, however, may slightly vary depending on the oil’s region of origin.

Sulfur content. In terms of sulfur content, oil may classify as:

Sweet crude oil: total sulfur level less than 0.5%. Considered high quality. Easily refined, safer to extract and transport than sour oil, causing less damage to refineries which results in lower maintenance costs. Commonly processed into gasoline, kerosene, and high-quality diesel. Highly demanded. The term refers to the fact that oils low in sulfur have a ‘sweet’ taste and pleasant smell. Found in the Appalachian Basin in Eastern North America, Western Texas, the North Sea, etc.

– Sour crude oil: total sulfur level more than 0.5%. Lower quality than that of sweet oil. There are several reasons why it is considered less valuable: first, the sulfur in it reacts to different air components and produces greater toxic emissions that stimulate global warming. Second, high-sulfur oils cause oxidation and corrosion and may damage refineries. Third, the more the sulfur, the less the hydrocarbons, and given that hydrocarbons are the essential component of petroleum that generate energy, their scarcity lowers its value – as in such case oil produces less energy per barrel. Sour oil impurities have to be removed before refining into petrol. The current global environmental regulations tend to strictly limit the sulfur content in refined fuels. Common in the Gulf of Mexico, South America, and Canada. OPEC countries produce relatively sour oil (average sulfur content of 1.77%).

Toxicity. Oil is also ranked based on how harmful it is to people and the environment. In most general terms, the lighter the oil, the more toxic it is considered. Due to the constant threat of potential oil spills, the Environmental Protection Agency has introduced four categories to distinguish oil by the levels of toxicity, which are the following:

Class of oil A B C D
Physical description Light, volatile Non-sticky oils Heavy, sticky, usually brown or black Nonfluid, usually black or dark brown
Toxicity Highly toxic to humans and fish Less toxic and more adherent to surfaces than the ones in class A Not very toxic, but still threatening wildlife with contamination Relatively non-toxic. Examples: heavy crudes, residual oils, some high paraffin ones, etc.
Info Fluid; Flammable; Evaporate quickly; Strong odour; Do not tend to stick to surfaces; Removable by water flush The higher their temperature, the higher the ability to soak into different surfaces. Removable by intense flushing High viscosity; Density near the one of water; Often sinks; Penetrates surfaces with difficulty Nonfluid; May penetrate surfaces when heated (because they melt); Not easily cleaned up; Usually black or dark brown.
Examples Highest quality light oils; Most refined products Medium to heavy paraffin-based oils Medium to heavy oils, residual fuel oils Heavy crudes; residual oils; some high paraffin ones, etc.

*The above-mentioned categories are dynamic for spilt oils.

Geographical (Trading classification). Since the content and quality of oil vary depending on the reservoir locations, benchmarks have been established in order to make the process of evaluation (in terms of price) more manageable and universal. These benchmarks serve as a reference price for buyers and sellers and correspond to different regions where oil is extracted. The two main internationally recognized benchmarks in crude oil pricing are Brent Crude and West Texas Intermediate (WTI).

Brent Crude: also known as Brent Blend, refers to oil extracted from 15 oil fields in the North Sea. Refined and used primarily in Europe. High-grade crude oil, but less light and sweet than WTI’s.

It is the underlying commodity of futures contracts on the Intercontinental Exchange (ICE).

ICE Futures Europe symbol for Brent Crude futures: B (1 contract = 1,000 barrels)

API gravity: approx. 38.06°

Sulfur content: approx. 0.37%

WTI West Texas Intermediate: also known as Texas light sweet, refers to oil that is produced, refined, and consumed in North America. Light and sweet. It is the underlying commodity of the futures contracts on the New York Mercantile Exchange (NYMEX)

NYMEX symbol for WTI Light Sweet Crude Oil futures: CL (1 contract = 1,000 barrels)

API gravity: 39.6°

Sulfur content: approx. 0.24%

Other major ones: Dubai Crude, Urals oil (Russia), OPEC Reference Basket (ORB), Tapis Crude (Singapore), Bonny Light (Nigeria), etc.

Value chain

The oil industry covers an array of interconnected activities that collectively transform crude oil into usable products for customers. Its value chain consists of three main pieces (areas) – the upstream, midstream, and downstream sectors. Upstream comprises exploration and production, midstream refers to the transportation of the oil from the production site to a refinery, while downstream encompasses the actual refining process and distribution of end products for consumer use. Different companies may operate in one or more components of the value chain.

Upstream (E&P)

Source for all icons: flaticon.com

1 – Exploration. First, geologists identify potential oil wells. One way to do so is by examining rocks on the earth’s surface with the help of satellite images and make a reasonable guess if oil could be found beneath it. The most common method for oil detection that provides an idea of what kind of rocks are located below the surface is the seismic survey. In essence, it consists of generating a wave (via machinery or explosives, e.g. with a thumper truck or dynamite) to pass through different rock layers. The time taken for the wave to return to the surface gives valuable information about the properties of the rock. The Earth’s gravitational and magnetic fields could also signal a petroleum prospect, so studying them (using sensitive gravity and magnetometers) is another way to predict a potential source. Once a field has been identified, an exploration well is drilled to ultimately determine the presence or absence of oil. If oil is present (=exploratory drilling is successful), more wells are dug (‘production wells’), the size of the field is determined, and production is ready to take place.

2 – Production. The production process includes the extraction of oil from beneath the earth’s surface and takes place on both land and sea. Subsequent oil wells are created by drilling a deep hole into the earth with a rig. A pipe is positioned into the hole and a group of valves (called a “Christmas tree”) is put at the top to regulate pressure and control oil flow.



3 – Transportation. The storing and transporting of oil represent the midstream segment of the value chain. Once extracted at the production site, crude oil needs to be transported to the proper processing facilities. The main means of transportation are pipelines, ships (tankers, which are the most common form of intercontinental transportation), trucks, and trains.



4 – Refining. Before reaching consumers, crude oil usually undergoes some procedures, which take place in refineries. In essence, the refining process consists of three stages: separation, conversion, and treatment.

During the first one, molecules are separated according to their weight. The procedure is called atmospheric (or fractional) distillation. Precisely, oil is heated in 60-metre deep distillation columns at temperatures high enough to cause it to vaporize and reach the top of the column. Heavier molecules (i.e. ones with high viscosity, known as ‘residuals’) remain at its bottom, a part of the vapour turns into liquid, and only the lightest gases reach the top of the device. Once atmospheric distillation is completed, heavy residuals go through further distillation in other columns in order to turn into diesel or heavy fuel oil.

Lighter products are created during the conversion stage. This is achieved by heating and ‘cracking’ some heavy molecules into lighter tinier ones, thus converting a substantial part of the heavy products into gasoline and diesel, for example.

Treating consists of the removal of corrosive and polluting molecules (including sulfur) from the structure of processed oil.

Final petroleum products are often classified as light, medium, or heavy:

Light Medium Heavy
gasoline (petrol), naphtha kerosene, jet fuel, diesel oil fuel oil, asphalt, lubricating oil and waxes

5 – Marketing. The last step of the value chain includes the distribution and sale of refined oil products to businesses, industry, government, and the public. Sales are carried out through wholesale or retail (petrol stations). In terms of the wholesale channel, two main types ‘types’ of sale can be distinguished – end-users (customers such as airlines and chemical plants) and resellers. On the other hand, retailers sell oil products directly to end customers.

Geographical distribution

The global oil production in 2019 is expected to average 80.6 million barrels per day (mb/d). The Middle East region is expected to account for the biggest stake at about 35.3% of the global production. The percentage share is almost twice as high as the second-largest player, North America. Saudi Arabia produces the majority of the Middle East region’s oil, with 36.7% of production, and is the home to the world’s largest crude oil producer, Saudi Aramco. With 8.2% of the market share, Saudi Aramco is followed by other large players such as Exxon Mobile, Chevron, BP, Royal Dutch Shell, and National Iranian Oil Company.

Geographic Distribution of the Global Oil and Gas Exploration and Production

Source: IBISWorld Industry Report B0531: Global Oil & Gas Exploration & Production

Threats from geopolitical issues

Recent geopolitical issues and political unrest in some Latin-American and Middle-East countries are greatly influencing global output of the oil production industry. This article will mainly focus on Venezuela and Iran.


In 2016, Venezuela was estimated to control over 300 billion barrels of oil – the largest crude reserves on the planet – bigger than Saudi Aramco. In the last three years, Venezuelan oil production plummeted by over 50 per cent from 2.3 mb/d in January 2016 to 1.1 mb/d in January of 2019. The collapse of Venezuela’s oil production and the general deterioration of its oil industry is originated from the start of the Chavez government. The strong grip of the government control asserted over the state oil company PDVSA lead to underinvestment and undermanagement of the industry resulting in a series of issues ranging from the lack of operational rigs and equipment such as upgraders and processing facilities to the absence of relevant service providers and experienced personnel. Venezuela’s state-controlled oil production continued to collapse in recent years due to the presidential crisis between the Russian, China and PDVSA backed President Nicolas Maduro and the US-backed Head of Congress Juan Guaido. To increase the pressure on the Maduro government, the US imposed sanctions on PDVSA in January by prohibiting USD cash transactions for oil sales from Venezuela’s PDVSA or its units, and further tightened sanctions in August, threatening non-US companies with punitive action if they ‘materially assist’ Maduro’s government. One major impact of the sanction is that Venezuela can no longer import Naphtha, the diluent that must be blended with the country’s extra-heavy oil to allow it to flow through the pipelines, from the US, its major supplier. This forces PDVSA to look for alternative Naphtha suppliers in Europe or its allied country like Russia, and bear a higher freight cost.

On the demand side, the measures have scared away several of PDVSA’s largest customers and tanker operators, causing an accumulation of unsold crude that forced the company to reduce output. Venezuela’s oil exports sank 40 per cent in the first full month after the beginning of US sanctions and is now well below the 1 mb/d level. Venezuela’s current oil buyer list mainly consists of companies from its politically aligned companies such as Russia. In October, Russia’s state oil company, Rosneft, took 62% of Venezuela’s total oil exports of 0.81 mb/d via crude-for-fuel swap transactions that bypassed the sanctions, acting as the largest intermediary of Venezuela oil and selling most of the oil to refineries in India and China. Apart from its role of being a key ally of PDVSA, Rosneft is also a major lender of the company with the amount of $800 million by the end of October 2019. A potential sell-off of PDVSA to Rosneft is under discussion in exchange for Russia’s partial debt relief.

Source: CSIS using EIA/IMF data, and information from Oil ad Governance (Victor, D.G., et al)


Due to Iran’s nuclear activities and its Sectarianism conflicts with US-allied Saudi Arabia since 2014, the US has imposed multiple sanctions on the country’s oil industry, aiming at destabilizing its regime. Iran’s crude oil production decreased to 2.2 mb/d in September 2019 from 4.1 mb/d a year ago.

Source: OPEC

To retaliate against the US sanctions on its oil industry, Iran escalated the conflict on the global oil markets with actions including its capture of British tankers and its suspected involvement in the attacks on Saudi Aramco’s oil refineries, affecting about 5.7 mb/d of crude production capacity. Although the Brent price experienced a 19% surge to $71/bbl on the first trading day following the attacks, it soon fell back close to $58/bbl, around $2/bbl below the pre-attack level. This phenomenon can be attributed to Saudi Aramco’s impressive ability in restoring operations, but more importantly, it reflected that the increasing US oil output and other demand factors like the economic slowdown and rising demand for clean energy sources that we will cover in detail in the second article of this oil series have overtaken the security fears and the geopolitical premium that should be placed on top of the oil price as a result of the high possibility of recurring attacks. However, considering the economic slowdown is a cyclical phenomenon, the supply disruptions due to long-lasting geopolitical issues and the gradually slowing US shale product growth pose a possibly higher risk premium in the future.

Source: Energy Information Administration as of September 30, 2019

Although the geopolitical instability currently posted only short-term fluctuation to the oil price, countries are also actively seeking ways to minimize their exposure to the risks of disruptive activities. On the supply side, oil producers enhanced oil stocks for contingency and emergency use to offset possible production disruption. For example, OECD countries have increased their commercial oil inventories for the fifth consecutive month in August to 2.9 billion barrels, close to the record level seen during most of 2016. On the demand side, some large oil importers are forced to source alternative oil suppliers. Amid sanctions by the United States and rising Middle East tensions, China’s oil imports from Iran in August were 787,657 tonnes, far below 3.28 million tonnes of the year-ago period, and the country’s import from Venezuela in August was of 1.45 million tonnes, down 18.6% from 1.78 million tonnes a year earlier. Saudi Arabia, Russia and Iraq are the top three winners benefited from China’s increasing oil demand and lower import amount from Venezuela and Iran.

Fracking in the U.S.

The aim of this section of the article is to explain the phenomenon of fracking, summarizing how the process works and analyzing the changes it has caused in the oil production and prices. As will be pointed out later, there are several scientific papers which offer interesting contributions to the understanding of the economic importance of fracking.

The process known in the scientific community as “hydraulic fracture”, is a technique used to capture gas and oil from shale rock. Fracking works by injecting a mixture of water, sand and chemicals through a well. Typically, the well is first perforated vertically in the ground, then horizontally. The water creates fractures in the rock and the sand settles in spaces to keep them open. This allows the released gas to escape from the rocks and travel to the surface.

This process provides drilling companies with access to oil and gas resources that are particularly difficult to reach. In combination with horizontal drilling and micro-seismic imaging, the use of this set of technologies, originally developed for the exploration of natural gas, allows extracting crude oil from rock formations characterized by low permeability.

Source: BBC, UK, 15 October 2018, “What is fracking and why is it controversial?”

The oil extracted on the basis of fracking techniques is referred to as narrow or shale oil to differentiate it from crude oil obtained with conventional drilling methods. Nowadays, the commercial use of fracking has been limited to the United States. With this regard, it is relevant to note that many countries are strongly reluctant to use this technology due to its negative implications for the environment, notably potential hazards due to water pollution and seismic tremors.

In the last decades, the world oil market has undergone significant changes: world crude oil demand has increased by over 25% between 2000 and 2017, growing from 76.9m to 98.2m barrels a day, mostly driven by the Chinese demand. On the supply side, the production of non-OPEC countries has strongly increased in the last decade, particularly due to the boom of the fracking. However, one-third of the raw production still comes from OPEC countries. Due to the intensive use of the fracking, oil production in the United States has almost doubled in the last 15 years (see Figure).

Source: Frondel, M.; Horvath, M., “The U.S. fracking boom: Impact on oil prices”, Ruhr Economic Papers, No. 794


The process of fracking is often considered as a market-changer, as it has guaranteed the United States to become again one of the major producers of oil. Its importance may even further increase given that numerous other non-OPEC countries have commenced investigating the potentials of this technique. In this vein, it has been frequently announced in the press that OPEC’s market power has drastically diminished.

The most interesting scientific contribution on the subject comes from the paper “The U.S. fracking boom: Impact on oil prices” of Frondel and Horvath. It explores the role of fracking on the global crude oil prices, using monthly data from 2000 to 2016. The key finding is a statistically significant long-term negative relationship between U.S. oil production due to the use of fracking and prices. An equally negative influence is found when the OPEC supply volumes exceeding the established OPEC quota, indicating that OPEC is still important. The Table shows the final results of Frondel and Horvath results.

Source: Frondel, M.; Horvath, M., “The U.S. fracking boom: Impact on oil prices”, Ruhr Economic Papers, No. 794


Consistent with the economic theory, the analysis shows that production levels and increases in stocks in the U.S. have both a negative effect on the price of oil: higher production levels and increases in stocks put pressure on the oil price, as reliance on current production is diminished, thereby reducing the risk premium associated with a supply disruption. In particular, the percentage of shale oil in total U.S. production also negatively affects oil prices. This is not surprising: given a fairly stable conventional oil production, the increase in shale oil production is associated with an increase in total U.S. production. The coefficients related to OPEC’s activity are also in line with the theory. First of all, the OPEC “cheat” coefficient estimate is negative in all specifications. This is a plausible result: if OPEC production exceeds the established quota, this must reduce the oil price. We can interpret in a similar way the negative sign of the estimate of the coefficient on the use of OPEC capacity utilization.

Furthermore, an interesting simulation exercise proposed by the two authors demonstrates that oil prices would have been around $40 to $50 per barrel higher if the U. S. fracking boom had not occurred – a quite high result.

Hence, this empirical evidence shows that, without any doubt, the fracking boom is an example of a technological change in a single industry of one single country (the U.S.) that significantly affects the global oil prices. Furthermore, it is possible to speculate that, as the fracking technique is likely to be adopted in other countries, the impact of this technology on prices is expected to increase further over the next years.

Another important point of view comes from the paper “The Impact of the Fracking Boom on Arab Oil Producers” by Killian. Killian came up in this paper with two extremely relevant contributions, at least for our purposes. First, he shows that the recent increase in oil production in the United States has significantly reduced the oil exports coming from Arab countries. Killian estimates the cumulative losses of Saudi Arabia’s oil producers due to fracking to be over $100bn. Second, with the ambition to quantify for the first time how far the U.S. fracking boom has reduced the price of oil, Killen found that in mid-2014 the price of Brent crude was $10 per barrel lower than it would have been in the absence of the fracking boom; by mid-2015, however, this price differential dropped to $5.

However, and this is important to stress before concluding the analysis, fracking is clearly just one of the important factors which affect the global oil prices, among which the global economic development is the most important.

It is also important to stress some economic intuition related to fracking, which comes from Dale’s paper, “New Economics of Oil”. The key point stressed by Dale is that the nature of fracking is far more akin to a standardized, repeated, manufacturing-like process than the one-off, large-scale engineering projects that characterize many conventional oil projects. And, as with many repeated manufacturing processes, fracking is generating strong productivity gains. As we know from the study of microeconomics, the strengthening of manufacturing productivity has always led to a downward trend in the prices of goods. To understand whether fracking will have the same long-term impact on the relative price of oil, it is necessary to know whether it will be applied massively even outside the United States.

The case of Exxon Mobile is particularly relevant in showcasing the impact of fracking on the decisions taken by corporations in response to the fracking boom. Exxon is among the companies that played a key role in the shale boom. It recently announced plans to increase its Permian output to 1 mb/d of oil and gas by as early as 2024. The Permian Basin is one of the U.S. oldest oil and gas producing regions. New technologies have transformed the region in the last decade, breathing new life into old wells and tapping new ones. Note that Exxon’s U.S. drilling and production business, which includes its Permian operation, has managed to generate profit in the past year, but it is much lower than for the company’s similar non-U.S. operations. Some analysts have even questioned whether too much growth in the Permian would lead the companies to be exposed to too much risk in one area. Exxon, due to this choice, will be the largest operator in the Permian, with almost 50 rigs. The company estimates its Permian wells can generate a 10% rate of return at an oil price of $35 a barrel. While many comparable companies reduced their activity in the fourth quarter of last year, Exxon boosted it to over 80 wells, more than double the total in the fourth quarter of 2017, according to Rystad Energy. The choice of Exxon is the latest sign that the next era of shale drilling is likely to be led by the major oil companies.

Pipeline Construction

The surge of the rate of production in the US due to fracking has led to the mismatch between the production level and the takeaway capacity of the existing pipelines. The inability to transport the excess production puts a significant downward pressure on WTI and the premium that Brent traded relative to WTI. This not only prompts large oil producers to adopt financial hedges to lock in oil price, but also to invest in new pipelines to ease the oversupply. For example, ExxonMobil signed a long-term agreement with oil pipeline company Plains All American Pipeline to oil pipelines out of the Permian Basin that allow the company to move oil to refine and export markets along the Gulf Coast. More than 10 Very Large Crude Carriers projects were proposed forecasted to load more than 8 mb/d from shale patches to the coast for the ease of exporting and increase of the US domestic output to 13.3 mb/d in 2020. Multiple pipelines have come online in August 2019 and more are expected to be done by next year. As a result, the widened spread between WTI Cushing and WTI Midland where most of the fracking activities happen has been gradually eliminated this year.

Source: Josh, S., “Permian Oil & Gas Production: What to Make of WTI Midland Basis?” Opportune, 1 Nov. 2018

Source: U.S. Energy Information Administration, based on Bloomberg, L.P.

The eased transportation constraints from the Permian basin to refineries and export terminals on the Gulf Coast is also reflected in the expected Brent-WTI spread estimated by the US Energy Information Administration. EIA expects WTI will average $5.50 per barrel less than Brent prices during the fourth quarter of 2019 and the Brent-WTI spread to average $4.00 per barrel in 2020, narrowing from the $6.60 per barrel spread during July. How the upcoming completion of major pipeline construction projects will bring down the spread in the future is interesting to look into.

Source: Bluegold Research


In this first part of BSIC’s comprehensive view on oil, we have focussed on analyzing the supply dynamics of this nuanced industry. We saw that the relevance of geopolitical tensions, while still not seen in the form of a risk premium, is undoubtedly significant, given the strong market reaction in the face of recent supply disruptions. On top of that, we discussed the effects of the adoption of fracking techniques in the US on the global market. In particular, we saw that it has put a significant downward pressure in the international prices at the same time that it reduced the participation of OPEC in the market, significantly reducing its market power. Lastly, we analyzed how the lack of infrastructure to deal with the increased American production disrupted the market equilibrium, creating anomalies like WTI-Brent price gap.

In the next part of our series, we will turn to the demand dynamics that are most relevant to the oil industry.



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