Streetwise Professor

June 15, 2015

Always Follow the Price Signals. I Did on Brent-WTI.

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 8:18 pm

As a blogger, I am long the option to point out when I call one right. Of course, I am short the option for you all to point out when I call one wrong, but I can’t help it if that option is usually so far out of the money (or if you don’t exercise it when it is in) 😉

I will exercise my option today, after reading this article by Greg Meyer in the FT:

West Texas Intermediate crude, once derided as a broken oil benchmark, is enjoying a comeback.

Volumes of futures tracking the yardstick have averaged 1m contracts a day this year through May, up more than 45 per cent from the same period of 2014, exchange data show. WTI has also sped ahead of volumes in rival Brent crude, less than two years after Brent unseated WTI as the most heavily traded oil futures market.

. . . .

WTI has also regained a more stable connection with global oil prices after suffering glaring discounts because of transport constraints at its delivery point of Cushing, Oklahoma. The gap led some to question WTI as a useful gauge of oil prices.

“I guess the death of the WTI contract was greatly exaggerated,” said Andy Lipow of consultancy Lipow Oil Associates.

But in the past two years, new pipeline capacity of more than 1m barrels a day has relinked Cushing to the US Gulf of Mexico coast, narrowing the discount between Brent and WTI to less than $4 a barrel.

Mark Vonderheide, managing partner of Geneva Energy Markets, a New York trading firm, said: “With WTI once again well connected to the global market, there is renewed interest from hedgers outside the US to trade it. When the spread between WTI and Brent was more than $20 and moving fast, WTI was much more difficult to trade.”

Things have played out exactly as I forecast in August, 2011:

One of the leading crude oil futures contracts–CME Group’s WTI–has been the subject of a drumbeat of criticism for months due to the divergence of WTI prices in Cushing from prices at the Gulf, and from the price of the other main oil benchmark–Brent.  But whereas WTI’s problem is one of logistics that is in the process of being addressed, Brent’s issues are more fundamental ones related to adequate supply, and less amenable to correction.

Indeed, WTI’s “problem” is actually the kind an exchange would like to have.  The divergence between WTI prices in the Midcontinent and waterborne crude prices reflects a surge of production in Canada and North Dakota.  Pipelines are currently lacking to ship this crude to the Gulf of Mexico, and Midcon refineries are running close to full capacity, meaning that the additional supply is backing up in Cushing and depressing prices.

But the yawning gap between the Cushing price at prices at the Gulf is sending a signal that more transportation capacity is needed, and the market is responding with alacrity.  If only the regulators were similarly speedy.

. . . .

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

So Brent boosters, enjoy your laugh while it lasts.  It won’t last long, and remember, he who laughs last laughs best.

This really wasn’t that hard a call to make. The price signals were obvious, and its always safe to bet on market participants responding to price signals. That’s exactly what happened. The only surprising thing is that so few publicly employed this logic to predict that the disconnection between WTI and ocean borne crude prices would be self-correcting.

Speaking of not enjoying the laugh, the exchange where Brent is traded-ICE-issued a rather churlish statement:

Atlanta-based ICE blamed the shift on “increased volatility in WTI crude oil prices relative to Brent crude oil prices, which drove more trading by non-commercial firms in WTI, as well as increased financial incentive schemes offered by competitors”.

The first part of this statement is rather incomprehensible. Re-linking WTI improved the contract’s effectiveness as a hedge for crude outside the Mid-continent (PADD 2), which allowed hedgers to take advantage of the WTI liquidity pool, which in turn attracted more speculative interest.

Right now the only potential source of disconnect is the export ban. That is, markets corrected the infrastructure bottleneck, but politics has failed to correct the regulatory bottleneck. When that will happen, I am not so foolish to predict.




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  1. I believe what ICE was referring to (and CME has made somewhat similar comments) is that concerns about storage capacity in Cushing created significant speculative interest in WTI prices and thus led to elevated non-commercial trading of WTI relative to Brent.

    Comment by Abe Froman — June 16, 2015 @ 1:36 pm

  2. Funds making money in a regional backwater that has been more or less abandoned by commercials isn’t exactly a formula for long term success…

    Comment by Green as Grass — June 17, 2015 @ 5:11 am

  3. Perhaps some were suggesting the complete demise of WTI. However, the industry consensus was actually that WTI would lose its dominant position to Brent as the global oil benchmark, not that WTI goes the way of the dodo. Even at its nadir WTI was 49% of global crude trading volumes compared to Brent’s 51%. That said, its 55-58% share in recent months is still down from 60%+ in 2011.

    None of this invalidates the good professor’s thesis about structural issues with Brent, which could indeed reduce its relevance over time. However, don’t underestimate the ability of Platts to adjust the composition of the “Brent” basket over time. Also, ultimately a sea-borne crude is arguably a better benchmark than WTI because of fewer supply issues that can impact its price. For example, WTI traders have to worry about Cushing storage capacity, pipeline constraints, refinery issues, export limitations, etc. With Brent you only have to worry about global macroeconomic factors.

    Lastly, it’s important to pay attention to open interest. Despite WTI volumes > Brent volumes thus far in 2015, ICE’s Brent futures contract actually saw its open interest surpass CME’s WTI contract.

    Comment by Abe Froman — June 17, 2015 @ 11:59 am

  4. @Abe-Reasonable points. A couple of comments. 1. Open interest is a lagging indicator. If the volume trends continue, the open interest will follow. 2. One thing I didn’t mention is Brent’s comparatively baroque settlement mechanism based on limited trades of very lumpy cargoes vis a vis WTI’s relatively straightforward delivery mechanism based on delivery in relatively small lots. The “Brent” mechanism will only become more baroque (and might I pun, more broken) when it widens the set of crude to include-as has been suggested-things like Urals Med. It’s always a mystery as to what “Brent” is actually pricing, especially given all the Platts secret sauce that is added.

    The ProfessorComment by The Professor — June 17, 2015 @ 3:37 pm

  5. So how much did you make?

    Comment by d — June 17, 2015 @ 7:55 pm

  6. “It’s always a mystery as to what ‘Brent’ is actually pricing….”

    It is? The Brent future is pricing a front month BFOE cargo on expiry day. Put on a long futures position and at expiry what you will be cashed out at is the all-day average price of a cargo. You don’t get a cargo, just the money to go buy one, which needn’t be BFOE.

    “…especially given all the Platts secret sauce that is added.”

    So, are Platts prices actually used in the Brent Index? There’s only one Platts price a day. The Brent Index uses five prices intraday.

    Comment by Green as Grass — June 18, 2015 @ 1:44 am

  7. Hi, yes the final cash settlement price of the ICE Brent Futures is based on an average of Brent Forward deals (forward contract on a cargo available for a given month but with no date specified yet.)
    Platts prices on Forwards deals are reported by traders in the E-Windows, There s only one Platts price a day but many calcs, rules, diffs and editors behind it. (their secret Sauce can be found in Platts Methodology

    Once the cargo has been nominated (date/loading quantity assigned by sellers) the cargo becomes “wet”. Once the cargo is wet => the buyer of the cargo can sell it into the Dated Brent market ( this is a value widely reported)

    Also, In recent times of contango, grade differentials are bearing > negative element in Brent than in Western Texas Intermediate to reflect the value of time (but this is only based on my observation)

    Hope this helps.

    Comment by SJ — June 18, 2015 @ 12:10 pm

  8. Your 2011 description of Brent as a paper pyramid is an apt description of the Chicago wheat contract as well.

    Comment by Scott Irwin — June 22, 2015 @ 11:03 pm

  9. @Professor
    I am not sure about your other readers but much more helpful to me if you just eliminate the very small percentage of your calls that are wrong and just post the right calls henceforth.

    Comment by pahoben — June 23, 2015 @ 2:54 am

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