Streetwise Professor

Platts is preparing for a Brentless future by introducing a new Dated Brent CIF Rotterdam assessment.  The idea is that as North Sea production continues its decline, other streams of light crude that are imported into Rotterdam can be added to the assessment. Adding (or substituting) say Nigerian crude to the FOB Brent assessment would be much more difficult because of locational differences: FOB Nigeria and FOB North Sea can be quite different, even adjusting for quality, due to freight differentials. A CIF contract eliminates that.

The decline in North Sea production has been occurring for some time, so the need to adjust the pricing mechanism has been apparent. Plants has been thrashing around for a while, mooting the possibility of adding other crude (e.g., Urals Med) to the assessment.  It had already widened the delivery window to make more cargoes eligible (remember 15 Day Brent? 21? It’s now 25 Day.) This problem has become more pressing though, as the decline in prices is hastening the decline in North Sea production.

It is ironic that at the same time that Platts (and therefore, ICE) are grappling with the problem of  declining supply, the main rival to Brent has the exact opposite problem. The WTI contract is currently drowning in oil. Storage at Cushing is bumping up against capacity, and there are reports that some storage operators there are refusing requests to store additional crude.

Although the current situation at Cushing (and in the North American market generally) is as much a demand story as a supply story, the facts are that (a) the NYMEX WTI contract is linked to a much more robust and flexible production base than Brent, and (b) the WTI contract’s periodic difficulties are due to infrastructure issues that are more readily, cheaply, and rapidly addressed than production issues. Thus it has been for the past five years or so, as I discussed when I wrote that those foretelling the demise of WTI were fundamentally mistaken:

But these problems are all surmountable.  WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

Brent’s problems are more fundamental, because they arise from declining supply.  Even as paper volumes continue to rise, physical volumes available for delivery are falling inexorably.  The Brent complex had faced this problem before, and confronted it by adding Forties, Oseberg, and Ekofisk to the eligible stream.  But BFOE production has declined from 1.6 mm bbl/d in 2006 to barely more than half that today.  And the decline continues apace.  This makes the contract vulnerable to squeezes of a kind that were chronic in the 1990s and early 2000s, and which spurred Platts to add the three other grades to the benchmark.

. . . .

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.

The CIF alternative makes sense, and is probably superior to the “economic par” contract I suggested in the 2011 post. But once you move to a Rotterdam pricing basis, why remain tied to an assessment mechanism based on transactions in immense full cargoes? The large size of the lots inherently limits the number of transactions, which makes the assessment mechanism more erratic and subject to manipulation. The lumpiness of the market has also led Platts to design a baroque process involving bids and offers, contracts for differences, futures prices, spreads, etc., to increase the number of trades that go into the assessment.

The WTI contract, in contrast, is based on delivery in store of modest-sized (1000 barrel) units of crude. This is much more flexible, and permits a large number of firms to participate in the delivery process. This makes delivery and the threat of delivery a reliable and efficient way of ensuring convergence of futures to cash market values. The mechanism is not immune to all types of manipulation: delivery squeezes are still possible (though relatively unlikely in current market conditions). But small numbers of transactions can’t have a pronounced impact on pricing, and the in store delivery mechanism does not rely on an arcane and mysterious assessment mechanism (which also helps to enrich the party making the assessment).

So rather than shifting to a Rotterdam CIF mechanism, why not shift the futures market to a Rotterdam in store delivery contract? This mechanism is more flexible and resilient in the short run, and is readily adjusted in the long run to respond to changes in the underlying physical production base as NYMEX did by adding foreign crude streams (including Brent) to address the (then) declining domestic production base.

I can see why Platts wouldn’t like this, but it has some decided advantages for ICE, not the least of which is reducing its dependence on Platts. Given the difficulties of changing contract specifications, or generating liquidity for even a better contract introduced in competition with an established liquid one, I doubt this will happen. Which means that ICE, and the market generally, will have to continue to endure periodic changes the “Brent” assessment mechanism as North Sea production continues to decline.

I put “Brent” in quotes because the handwriting is on the wall: any future European-based contract may be called “Brent” even after Brent (and Forties, and Oseberg, and Ekofisk) no longer represent the bulk of the benchmark stream. The contract will come to resemble the old Harry Anderson comedy bit, where he juggled a chainsaw and an axe. He would stop juggling, hold up the axe and say: “This is George Washington’s axe. The handle was replaced years ago, and I just put on a new head, but it’s George Washington’s axe!” So it will be with Brent, and sooner than anyone would have thought even a few short years ago.