An Anatomy of the Crude Oil Pricing System
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Figure 9: Average Daily Volume and Open Interest of ICE Brent Futures Contract
Source: ICE An interesting feature of the Brent futures contract is that at expiry it cash settles against the ICE Brent Futures Index, also known as the Brent Index which is calculated on the basis of transactions in the forward Brent market. In other words, unlike other futures contracts whose price converges to spot price at expiry, the Brent futures contract converges to the price of forward Brent. Specifically, the Brent index is calculated on the basis of weighted average of first-month and second-month cargo trades in the 21-day BFOE plus or minus average of the spread trades between first and second months as reported by oil price reporting agencies. At expiry, the Brent futures contract relies on the forward market for cash settlement. Thus, the effectiveness of the futures market in the role of price discovery relies on the liquidity of the forward market which as discussed previously is quite variable and concentrated in the hand of few players. This feature of the Brent futures contract is the result of historical events where the development of the forward market preceded that of the futures market plus the fact that no producer in the North Sea would back a physically delivered contract. This meant that for any Brent futures contract to succeed, it has to be strongly linked to the forward market.
Although the Brent futures contract is not physically settled, the Exchange for Physicals (EFPs) market allows participants to swap a futures position (a financial position) with a physical one. Specifically, by executing an EFP, a party can convert a futures position into Brent Forward or a 21-day BFOE cargo. 66
is straightforward. Party A with a futures position sells the futures contract and buys the physical commodity. His counterparty B buys the futures position from A and sells the physical commodity to A. Through this process, A is able to gain physical exposure to the underlying commodity while B has swapped his physical exposure for a financial one. Such trades can be transacted at any prices agreed between A and B and are often different from the price prevailing in the futures market. EFPs are often quoted as differentials to the Brent futures price but usually do not exceed it by more than a few cents.
66 It is important to note that Brent EFPs are not qualitatively equivalent to physically delivered contracts such as WTI. EFP is optional while for WTI contract, the trader has no choice but to close the position or make or take delivery. 45
Parties need to notify the Exchange about their agreement so it can close A‟s position and open B‟s position. Thus, the importance of EFP is that it provides a link between the futures market and the physical dimension of the Brent market. As discussed below, in periods of thin trading activity in the forward Brent market, the EFP provides the necessary link to identify the price of forward Brent.
Dated Brent/BFOE, also known as Dated North Sea Light (Platts) or Argus North Sea Dated refers to the sale of cargo with a specific loading slot. It is often referred to as the spot market of Brent. 67 A spot transaction is often thought of as a transaction in which oil is bought or sold at a price negotiated at the time of agreement and for immediate delivery. However, Dated BFOE contracts contain an important element of forwardness as traders rarely deal with cargoes bought and sold for immediate delivery. Instead, cargoes are sold and bought for delivery for at least 10 days ahead. To reflect this fact, the price of Dated BFOE is quoted for delivery 10 to 21 days ahead. For instance, on 25 th May, the price of Dated BFOE reflects the price of delivery for the period between the 4 th of June and the 15 th of June (11 days). On 26 th
th and 16
th
of June (11 days), and so on. This element of forwardness in Dated BFOE also implies that there is a price risk between the time when a Dated BFOE cargo is bought and the time when it is delivered. Formula pricing can mitigate part of this risk by pricing the cargo of Dated BFOE on the time of delivery or by using the average of prices around the loading date, such as three days before and after the loading date. One interesting feature of the Dated BFOE market is that very few deals are done on an outright basis. Instead, since 1988, actual deals for physical cargoes of BFOE, including Brent, are priced as a differential to forward Brent or Dated Brent/ North Sea Dated. As seen from Figure 10 below, by 1991, deals based on outright prices became negligible. Thus, while the forward Brent sets the price level, the Dated BFOE market sets the differential to the forward market. More recently, forward Brent itself is been priced as a differential to the Futures Brent.
Source: Horsnell and Mabro (1993)
The Contracts for Differences (CFDs) have become an integral part of the Brent market and as discussed in detail in Box 1 provide the link between the forward Brent market and Dated BFOE. CFDs are swaps contracts which allow the buyer and seller to gain exposure to the price differential between Dated BFOE
67 It is important to note however that physical Brent or Brent/Ninian Blend trades at a differential to the Dated Brent or North Sea Dated Price.
0 10 20 30 40 50 60 70 80 90 1986 1987
1988 1989
1990 1991
Outright Price Differential Price to Forward Brent Differential Price to Dated Quotations Differential Price to other North Sea Differential Price to WTI Differential Price to Other 46
and Forward Brent. These CFDs can be traded in Platts window or negotiated bilaterally outside the window or the exchanges. The high volatility in the above differential increased the risk exposure for physical players, pushing them to hedge using CFDs. This in turn created an important niche for market makers. Figure 11 below reports the daily volumes of traded CFDs which vary from as low as 250,000 b/d in March 2008 to as high as 1.4 million b/d in April 2010. However, these figures seem to understate the actual volume of CFD trade with some market participants indicating that the volume of traded CFDs is much higher.
Source: Argus The players in this market are quite diverse and include a large number of companies as seen in the table below. On the sales side, the dominant players are equity producers such as BP, Chevron, Shell, Statoil; banks such as Morgan Stanley and physical traders such as Vitol, Mercuria and Phibro. On the buying side, these companies are also dominant. There are many companies that occasionally enter the market and trade small volumes mainly for hedging purposes.
0 0 411 0 0 0 740
812 Arcadia 23,301
4,918 4,658
14,448 6,553
10,109 6,575
17,208 Astra 0 0 0 0 2,427 1,298 0 0 BNP Paribas 0 0 548 5,519
0 0 2,192 4,221 BP 26,214
55,601 74,085
76,948 43,083
37,432 24,397
75,010 Cargill 485
1,913 411
0 485
4,918 274
1,136 Chevron 17,233
26,093 70,699
84,659 43,811
47,541 53,863
73,195 Chinaoil 0 0 0 0 0 0 1,233
0 0 200,000 400,000 600,000
800,000 1,000,000 1,200,000 1,400,000 1,600,000
47
485 10,410
23,041 33,766
728 24,863
28,630 60,065
Glencore 1,456
1,940 14,219
24,968 485
4,372 9,863
26,299 Gunvor 0 7,240 13,151 3,571
1,942 5,464
3,836 1,299
Hess 971
273 2,192
22,240 0 0 2,192 17,532
Hetco 0 0 0 3,571
0 0 1,096 974 IPC 0 273 2,055 325
0 1,481
3,068 1,786
Iplom 0 0 548 0 0 1,093 548
1,136 Itochu 0 546 7,671 7,253
0 6,126
11,041 10,844
JP Morgan 9,223
11,380 9,153
7,792 1,456
29,358 54,973
14,935 Koch 33,010
36,284 23,556
3,247 11,165
37,205 34,849
32,305 Lukoil 971
13,798 28,559
24,513 485
7,049 20,411
21,753 Maesfield 0 0 1,644 1,136
0 0 0 1,623 Marathon Oil 0 0 0 0 11,408 9,699 548
6,494 Masefield 0 273 1,233 3,247
0 3,825
685 0
34,345 46,809
59,726 79,471
31,311 68,415
99,841 117,156
Merrill Lynch 1,942
4,781 1,918
1,299 7,646
4,645 0 0 Mitsubishi 0 0 0 0 0 0 3,014
0 Mitsui 0 273 0 0 1,456 546 0 0 Morgan Stanley 20,388
24,317 57,882
100,487 20,146
17,760 51,238
88,377 Murphy 0 0 0 0 0 410 0 0 Natixis 0 0 42,033 19,968
0 0 36,849 27,110 Neste 971
4,372 2,740
0 0 3,005 822 1,623
Nexen 1,942
4,577 4,003
6,951 2,427
2,691 5,189
11,685 Noble 0 0 822 14,286
0 0 548 8,442 OMV 1,485
0 14,562
28,545 0 5,787 36,995 48,880
ORL 0 1,093 0 0 0 2,186 0 0 Petraco 0 820 1,644 974
0 1,735
2,192 0
0 0
1,948 0 0 822 0
5,583 3,825
1,918 0 1,942 0 1,644
0 Phibro 20,146
48,656 68,923
82,867 36,772
52,117 34,400
50,487 Pioneer 0 0 0 0 0 0 137
0 Plains 0 2,732 0 0 0 0 2,466
1,299 Preem 0 0 685 0 0 0 3,562
0 Sempra 971
7,978 9,644
2,273 4,854
15,929 15,616
2,922 Shell 47,694
131,929 132,079
149,221 52,699
39,727 83,995
129,545 Sinochem 0 0 0 1,136
0 273
603 974
Sinopec 0 0 1,932 2,597
0 0 2,800 1,867 Socar 0 0 0 25,000
0 0 0 9,091 Sonatrach 0 0 274 974
0 0 7,260 8,279 Standard Bank 0 0 932 5,575
0 0 548 5,195 Statoil 6,796
2,186 8,630
108,224 4,369
273 8,630
118,130 StatoilHydro 14,563
77,945 59,233
0 6,796
54,781 61,863
325 Totsa 19,782
23,087 45,260
25,974 14,078
46,325 47,397
60,575 Trafigura 971
16,940 29,315
27,955 3,641
13,798 28,877
32,649 Unipec 8,738
7,377 4,521
8,955 0 12,432 29,170 11,578
Valero 1,456
546 1,096
0 9,951
14,208 19,726
54,545 Veba 0 0 0 0 0 1,093 0 0 Vitol 36,044
58,579 132,060
245,692 15,049
49,795 112,447
98,214 339173
641772 961675
1259585 339172
641772 961674
1259585 Source: Argus 48
In addition to the above layers, a whole set of financial instruments that link to the Brent complex are currently traded over the counter (OTC). These OTC contracts are customised and until recently have been negotiated bilaterally between parties either face-to-face or through brokers. However, as the use of OTC became more widespread, OTC contracts became more standardised and part of the OTC activity has shifted to electronic OTC exchanges. Furthermore, after being matched, counterparties can use the clearing facilities of exchanges such as ICE and the CME Group. The landscape has become less benign in a number of ways for bilateral uncleared OTC, and so there has been a shift toward clearing OTC contracts except for those with either impeccable credit/ unimpeachable credit lines, or those who simply cannot afford the cash flow/cash flow volatility of a cleared environment (such as airlines). IOSCO
(2010) reports that market participants conduct 55% of their trades in financial oil (crude oil and refined products) using exchange-traded instruments and hence are subject to clearing. The remaining part of the business is conducted through OTC. A large part of this OTC trade is now being cleared where 19% of survey participants‟ trades are being cleared. Only 27% of the total volume traded remains un-cleared. 68
issue of disparity in supervision and oversight between markets and is at the heart of current plans to strengthen the regulation of commodity derivatives markets. Exchange clearing of OTC has aided their transparency already, as they make available daily settlement figures to those clearing the instruments. The large variety of OTC instruments and the limited information on these instruments precludes an extensive analysis of OTC markets. ICE lists more than 30 financial contracts (for crude oil alone) that are cleared on their exchange. These contracts are used primarily for hedging, but also for speculative purposes and are an integral part of the Brent complex. Using these instruments one can hedge between the various layers such as between Dated Brent and futures Brent or between further away markets such as Dubai and futures Brent or between Dated Brent and WTI. One important and active market discussed above is CFDs. Another active swaps market is the Brent Dated-to-Frontline (DFL) market which trades the difference between Platts‟ Dated Brent assessments and the ICE first month futures contract. Another related but less liquid market has emerged which trades the difference between Dated Brent and the daily trade-weighted Brent average reported by the ICE. Through these customised contracts, traders can establish a series of inter-linkages not only between the different layers of the Brent market, but also between Brent and the different benchmarks and hence are likely to influence the price formation and price discovery processes.
To explain the rationale behind CFDs and how it works, it would be useful to provide a simple example, but based on real data. A refiner bought a cargo of BFOE on 19 th March 19 for loading on 21 st -23
rd of
April. The refiner has accepted to buy the cargo at the Dated Brent price averaged over five days around the loading date (i.e. 19 th -23
rd April). The refiner observes that the current value of Dated Brent is $77.88. He is concerned that by the time of loading the price of Dated Brent could increase: he would like to hedge his risk. In principle, he could use the April Forward contract to hedge the risk. However, this hedge is far from perfect because there is the risk that the price of the April Forward may not follow the movements of Dated Brent at the time of loading. This risk, referred to as the basis risk, constitutes the main rationale for CFDs. To hedge the basis risk, the refiner could buy (a) a second-month Forward contract (i.e. a May contract in our example) and (b) CFDs for the week of 19 th -23 rd April. The price for the Forward May contract on the
68 These figures however should be treated with caution and some market participants have indicated very different numbers. The fact remains that the size of the OTC market is not known and less so the percentage of OTC that goes to clearance. 49
19 th of March stood at $79.53 while the CFD for the week 19 th -23
rd April was at -$0.57. By buying the second-month forward contract and CFDs, the refiner is able to lock the price of his cargo at $79.53. So how does the hedge work? Somewhere between 19 th -23
rd April (say 22 nd of April) i.e. when the cargo is being loaded, the refiner sells the Forward May contract. On the 22 nd of April, the BFOE May contract settled at a price of $84.78. Thus, the refiner has made a profit on his forward position of $5.25: he bought the forward contract at $79.53 and sold it at $84.78. What about the gain and losses on the CFD position? The easiest way to think of a CFD is that it is a swap in which the refinery agrees to receive the price of Dated Brent and agrees to pay the Forward price. Assuming that the refinery unwinds his CFD over the week, we can calculate the net gain or loss on the CDF as illustrated in the Table below.
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