We’re in an environment where the dynamics of the world’s oil market benchmarks are shifting. More accessible supply in the United States has more market users looking here for a price. In fact, Olivier Jakob of Petromatrix opened his report recently by writing “The world crude oil price is currently made in the U.S.” There are several factors that are causing the benchmark picture to shift. I’d like to highlight three: the long-term implications for market-based benchmarks, price convergence between several legs of BFOE (Brent Blend, Forties, Oseber, Ekofisk), and the direct implications of what major producers and China are saying about oil benchmarks.
1. Long-Term— Production Countdown
Both the North Sea, especially the BFOE streams, and North America have been undergoing substantial changes in oil production levels and prospects for future oil production, and these changes are in opposite directions – the North Sea is depleting and North America is increasing. With respect to the North Sea, this could be said to date back more than 20 years but, in less than five years, BFOE has declined by more than one-third and currently struggles to stay above one million barrels per day. But even that characterization can be misleading because, despite it being referred to as BFOE, it is really only F –forties – whose price serves as the benchmark, and that has been the case for nearly 10 years. In the everyday mechanics of price determination, B, O and E are essentially ballast.
The situation is completely reversed for the United States and Canada. Production is up significantly in onshore U.S., and Canada and is expected to rise even more sharply. Projections are that U.S. and Canadian production will increase by more than five million barrels per day over the mid-term and that would be in addition to the one to two million barrels per day increases it has experienced in recent years.
The impacts from these changes will not be limited to simply shifting the relative prices between oil delivered in the United States and oil delivered in Europe. At minimum, North America will be exporting more oil products and, its importance as a cog in the world oil market will strengthen, not weaken. In addition, Canadian and U.S. oil production are freely tradable and much of each already re-trades several-to-many times over in the physical market. The importance of West Texas Intermediate crude (WTI) in the oil market originated in its role as physical market numeraire, and the growing North American market is going to continue to require and benefit from such a numeraire. Because of this, North America will continue to be an important source for a crude oil price reference.
Meanwhile, the decrease in North Sea production has already impacted performance of the BFOE mechanism at times – there may be disagreement over how much and how often – but, as the production decline continues, this is becoming more commonplace. Has the market reached consensus that adding more letters to the string BFOE is the prescription to prevent this? The structural changes that await the North Sea benchmark would appear to dwarf anything that has been either applied or contemplated to date.
For North America and WTI in particular, the future began last month, when the Seaway pipeline started to flow oil, including WTI, southward to the U.S. Gulf. This is only the beginning. Scheduled additions in both pipeline and railway capacity are substantial in scope (1-3 million barrels per day) and they will have a positive impact on the continuing evolution of oil benchmarks. In the near-term, the Seaway reversal and other completed or soon-to-be completed actions will literally connect the Midcontinent southward to U.S. Gulf markets, and this will bolster the WTI mechanism. In terms of prognosis, the only thing market participants are speculating regarding this mechanism is how it may expand further over the mid-term, in light of increased U.S. and Canadian production and increased throughput to the U.S. Gulf.
2. Near Term– Brent Market Convergence
The most important immediate issue regarding Brent is the performance of the convergence processes between the sub-components of the Brent complex. This issue has spawned disagreement within the industry as to who is chiefly responsible.
. The bickering, however, may be serving more as a distraction from what is truly important – how convergence processes work and how they perform.
I divide the BFOE market into the components of futures, forward cargos (which are considered “paper” because they have not been assigned loading dates) and dated cargos (which are considered “physical” because they have been assigned loading dates). In principle, these are the components which need to connect in terms of pricing. Traded dated cargos are priced predominantly as differentials to the Platts Dated assessment. Similarly, the Platts Dated assessment is also frequently used in some national oil company sales formulas as well.
The essential reality is that the Platts assessment is not either bounded by or grounded in physical delivery obligations. From that perspective, it is not tethered to the physical market. However, from a different perspective it is connected to the physical market because it is the base by which virtually all traded dated cargos (which are physical) are priced. Though it is never identified as such, the Platts Dated assessment process is really a negotiation mechanism for oil market participants to determine the physical price of BFOE cargos.
Brent futures are terminated through financial settlement. The settlement mechanism is supposed to be structured to mimic the value for the underlying commercial market and, for Brent futures, the underlying commercial market is “reported” traded BFOE forward next-month cargos (and its predecessors from previous decades) on contract termination day. However, for some time now, there has been a dearth of such cargos when the futures contract expires. There are several reasons for this:
- The reduction in production of BFOE has resulted in a continuing reduction in the number of cargos.
- The “reporting” of cargos is purely self-selecting and most cargos are not reported. In fact very few next month full-cargos seem to get reported during any part of a calendar month.
- By the time the most active Brent futures contract expires, a significant portion of the next month’s forward cargos have been displaced by dated cargos.
The self-selection which governs the reporting of traded cargos is independent of both minimum notification periods and futures contracts termination dates; so, even if there is consensus on those items, they are not addressing anything related to the self-selection character of reporting traded forward cargos, which has led to virtually none being reported. In fact, we at CME Group (NYMEX) feel so strongly about trying to improve the convergence process that we introduced a new Brent futures contract at the end of 2011 with a new cash-settlement mechanism that eliminates the self-selecting component altogether
Meanwhile, the reduction in BFOE production has led to frequent disruptions in scheduled loadings over the past year and it is reasonable to suggest, as some market observers have, that these unscheduled disruptions have impacted BFOE prices and pricing; arguably more than market supply, demand or storage.
During the first quarter 2009, the front part of the Brent curve, especially Platts Dated versus the first-month forward, was in backwardation more than 30 percent of the time even though Organization for Economic Cooperation and Development (OECD) petroleum storage levels were at historical highs and the world was suffering the most substantial levels of demand destruction since the onset of the Brent mechanism.
Since November last year, OECD’s commercial stocks have been approximately at the same levels they were in 2009 in terms of day’s supply and, yet, the BFOE market – in terms of futures and dated to second-month forward – has been stubbornly backward dated; are these market fundamentals or are these market mechanism impacts? If it is the latter, are there other impacts as well?
Many commentators emphasize that the WTI-Brent spread during 2011 could not be explained by WTI fundamentals. However, BFOE’s history over the past several years to defy the commercial stocks data directly increases the probability that the explanation lies elsewhere.
3. View from Outside
Frequently there is industry discussion about devising a new Arab Gulf-based benchmark, especially for crude oil exported to the Far East. However, major Arab Gulf producers have stated they do not want their actions to be the determinative factor in establishing, increasing or reducing a benchmark’s use. Historically, the Platts Dubai-Oman and Oman futures prices have maintained a correlation of approximately 99 percent in their daily Singapore Window timeframe price changes. Oman futures trade more than five million barrels per day, and results in physical delivery of about 10 million barrels each month. Collectively, these mean that: 1. Oman futures provide an extremely reliable hedge for Platts Dubai-Oman based pricing; and, 2. Oman futures converge smoothly with the physical market.
Major Arab Gulf producers have further said that they would follow the lead of their customers in establishing, increasing or decreasing the use of any benchmarks. Perhaps, figuratively, China is assuming that leadership. China is a significant consumer of oil – using over 11 million barrels per day – and it has said publicly that it is concerned that higher oil prices hurt its economy’s growth and that is one of the reasons it is supporting the development of oil futures in China.
I mention each of these because I expect them to become increasingly more influential during the next several years – producer sentiment on the adoption of benchmarks, the potential for Oman futures to increase its use for hedging and China’s hint that consumers will be adopting more aggressive positions in price determination. All of these are notable and warrant more attention.
As we look to the next several years, I believe we need to consider oil benchmarks with the understanding that long-term trends in production capacity and levels favor North American benchmarks versus the North Sea, that current issues on price convergence in Brent can be improved but they must first be confronted. and that some of most important influences on oil benchmarks could emanate from outside the established benchmark realms.
A version of this post first appeared in Oxford Energy Forum.