The interplay of physical and financial layers in today's oil markets

IEA Energy Training Week

Paris, April 5, 2013

Master of Advanced Studies in International Oil and Gas Leadership

Giacomo Luciani

The Market for Brent

• Brent is a field in the UK North Sea.

• The market consists of:

A “spot” market;

A “physical forward” market;

A “futures” market – based at the International

Petroleum Exchange (IPE) in London

The spot market, or “dated Brent”

• “Dated Brent” refers to the sale of a specific cargo that is either available in a specific loading slot or that is already loaded and in transit to some destination.

• Main characteristics:

Transactions are bilateral,

Over the counter (OTC),

For variable quantities.

The forward market, or “21-day Brent”

• The 21-day cargo is a standard parcel (600,000 barrels) that will be made available by the seller to the buyer on an unspecified day of the relevant month (buyer must be notified of loading date at least 21 days in advance.

• The clearing involves book-outs or seller’s nominations, which can take place on any day in the period starting 21 days before the beginning of the relevant month.

• As dated Brent, 21-day Brent is bilateral and OTC – but it is standardized.

Price Reporting Agencies (PRAs)

• If transactions are bilateral and OTC, prices are not easily “visible”

• Price Reporting Agencies are private providers who survey the market for prices

• Two main PRAs for oil: Platt’s and Argus

• Different methodologies: Platt’s “window”

• Are PRAs neutral or do they influence the market?

• Should they be regulated? (issue being discussed by the G20)

The futures market

• The futures market was launched by the International Petroleum Exchange (IPE – today International Commodity Exchange - ICE) in 1988

• 1 contract = 1000 barrels • Contract based on cash settlement and not on physical

delivery • If a contract is allowed to expire the settlement price

is the Brent index • Central exchange and clearing house rather than

bilateral trades • Several months (indeed, years) traded

Options

• Launched by the IPE in 1989

• A call option gives the holder the right to buy the underlying futures contract, and a put option the right to sell.

• Call and put options may be combined to design complex risk management strategies.

What are options for?

• Any buyer or seller on the petroleum market faces a price risk.

• Options and futures allow parties facing a structural risk to limit that risk, “selling” it to speculators (or “insurers”).

Hedging

• A producer can sell futures or buy put options to ensure a minimum level of prices.

• A large consumer can buy futures or a call option to ensure against very high prices

• Major companies are on both sides of the market and may be doing both things at the same time.

Why so many Paper Barrels?

• Most participants in the futures market are there to manage their risk, not to acquire Brent crude.

• Buying and selling Brent futures and options is an effective strategy because other crude prices follow Brent movements.

The Structure of the Oil Market

• At the center, we find the market for Brent and WTI, which influence each other

• Brent and WTI trade few physical and lots of paper barrels

• Paper and wet barrels influence each other, but paper barrels are more important

• Smaller markets, such as ANS and Dubai, are influenced by Brent and WTI

Consilience Energy

Advisory Group Ltd The Influence of Brent

Physical = 83.6 million b/d in 2011.

Estimated that 2/3 priced by

reference to Brent = 20 billion/year.

The ICE futures contract for Brent

alone traded >130 billion bbls in

2011

OTC forwards- volume unknown

but likely to be more than futures

PSC- cost recovery, profit share

Tax

14

Gas

contracts?

Can’t be less than

200 billion bbls

per year, even on

conservative

estimates

COPYRIGHT CEAG LTD

Feature of Physical Benchmarks:

Financial Layers and the Spot Price

• Many financial layers (paper markets) emerged around physical benchmarks

• Financial layers highly interlinked with benchmarks through process of arbitrage and development of products that link layers together

• Idea that one can isolate physical from financial layers in current oil pricing system is simplistic

• Information derived from financial layers plays an important role in identifying the price level of the benchmark

• Brent market: Price of Dated Brent assessed using information from many layers including CFDs, forward markets, EFPs and futures markets

• WTI complex: prices of the various physical benchmarks strongly interlinked with the futures markets

• Price of Dubai often derived using information from the very active OTC Dubai/Brent swaps market and the inter-Dubai swap market

Deep and Liquid Markets

The Inter-linkages Between Financial and Physical Layers

Dubai Price

Dubai/Brent Exchange for

Physicals (EFPs)

Inter-Dubai Swap Market

Dated Brent

Forward Brent

Contract For

Differences (CFDs)

Brent Futures Market

Exchange for

Physicals (EFPs)

Forward Dubai

GAS

POWER CARBON

COAL

OIL

BRENT

WTI

DATED

FORWARD

FUTURES (several

years traded)

EFP

CFD

Pipeline

LNG

Several traded hubs

Oil Products

LPG

Naphtha Gasoline

Diesel Fuel oil

Dubai

Other Crudes

• All other major crudes are priced on the basis of formulas which tie them to Brent or WTI

• The producing countries oppose the free trading of their crudes, and restrict destination and secondary trading

• Formulas are modified from time to time, but the essence remains

Example: Saudi Arabia’s Prices for 04/13

Source: Middle East Economic Survey 15 March 2013

Why oil producing countries like reference pricing?

• Accepting pricing out of a marker implies that producers are giving up on an important role

• They should naturally be price makers, instead are price takers

• Why? First and foremost because in the past they failed in the management of posted prices.

• Setting up a market for a major crude, such as e.g. Arabian Light, is not easy because there is just one seller

• The seller does not want the responsibility of making prices, because he is afraid of international political pressure or domestic dissension.

Why there is no Arabian Light market?

How is the Market Cleared?

• Brent/WTI are not the marginal crudes that balance demand and supply.

• Yet, it is Brent/WTI that make the price.

• The implication is that demand and supply are not necessarily balanced: OPEC and other operators manage supply and/or stocks, given the price.

Features of Benchmarks:

Physical Liquidity of Benchmarks

• Markets with relatively low physical liquidity set the price for markets with much higher volume of production

• Low physical liquidity and squeezes – As markets become thinner and thinner, squeezes and distortions become more widespread

– Prices and spreads become less informative and more volatile

• Nature of these benchmarks tends to evolve over time but not without problems – Widen the benchmark for assessment purposes

– Assessment of traditional Brent benchmark now includes North Sea streams Forties, Oseberg and Ekofisk (BFOE)

– Dubai price includes Oman and Upper Zakum

• Short-term solutions of adding additional streams successful in alleviating problem of squeezes but should not distract observers from raising key questions

– What are necessary conditions for the emergence of successful benchmarks in the most liquid market in terms of production?

– Would a shift to price assessment in markets with high physical liquidity improve the price discovery process?

The Feedback Issue

• Given this market structure, operators that have no interest in Brent crude trade in Brent futures and options, to manage their risk

• In this way, a certain feedback is obtained between the global physical oil market and Brent

• However, such feedback is limited and partial The feedback would be greater if all operators hedged

systematically; in that case, an excess of demand would raise the price of calls, financial intermediaries would lower the price of puts, producers would be incentivated…

Perception of Limited Feedbacks

• Uncertainty about existence of and timing of feedbacks from prices to oil supply and demand increased markedly during boom – Perception of strong feedbacks replaced by perception of

limited feedbacks

• Key feedbacks that were perceived to be absent

– Oil demand response to oil prices – High oil prices would trigger a rise in global inflation rates

and a subsequent recession, tempering growth in the demand for oil

– High oil prices would induce strong growth in non-OPEC supply

– OPEC would increase its oil supply to prevent oil prices from rising to high levels or try to put a cap on the oil price

The Forward Curve

• At any point in time, we have several prices for the same marker for different maturity future contracts.

• If prices for subsequent months are lower than the closest-month price the market is said to be in backwardation

• If prices for subsequent months are higher than the closest-month price the market is said to be in contango

Brent Forward Curve

Source: Royal Bank of Scotland March 28, 2013

Parallel shift in the Futures Curve

Meaning of contango

• A contango occurs when the market expects future prices to be higher than today’s

• Normally, a contango occurs when prompt prices are low, backwardation when they are high

• Backwardation is the “normal state” of a market because holding stocks has a physical and financial cost (interest rate)

What is the impact of backwardation/contango?

• Contango encourages the buildup of physical stocks (you earn money by buying spot and selling futures, while holding the commodity)

• Backwardation encourages financial commodity investors (you make money by buying futures and waiting for futures to converge to spot prices)