Streetwise Professor

In its decision to change speedily the Dated “Brent” crude oil assessment to include US crude and to a CIF basis, Platts hit a hornets’ nest with a stick and now is running away from the angry hive.

Platts’ attempt to change the contract makes sense. Dated “Brent” is an increasingly, well, dated benchmark due to the inexorable decline in North Sea production volumes, something I’ve written about periodically for the last 10 years or so. At present, only about one cargo per day is eligible, and this is insufficient to prevent squeezes (some of which have apparently occurred in recent months). The only real solution is to add more supply. But what supply?

Two realistic alternatives were on offer: to add oil from Norway’s Johan Sverdrup field, or to add non-North Sea oil (such as West African or US). Each presents difficulties. The Sverdrup field’s production is in the North Sea, but it is heavier and more sour than other oil currently in the eligible basket. West African or US oil is comparable in quality to the current Brent basket, but it is far from the North Sea.

Since derivatives prices converge to the cheapest-to-deliver, just adding either Sverdrup or US oil on a free on board basis to the basket would effectively turn Dated Brent into Dated Sverdrup or Dated US: Svedrup oil would be cheaper than other Brent-eligible production because of its lower quality, and US oil would be cheaper due to its greater distance from consumption locations. So to avoid creating a US oil or Sverdrup oil contract masquerading as a Brent contract, Platts needs to establish pricing differentials to put these on an even footing with legacy North Sea grades.

In the event, Platts decided to add US oil. In order to address the price differential issue, it decided to move the pricing basis from free on board (FOB) North Sea, to a cost, insurance, and freight (CIF) Rotterdam basis. It also announced that it would continue to assess Brent FOB, but this would be done on a netback basis by subtracting shipping costs from the CIF Rotterdam price.

The proposal makes good economic sense. And I surmise that’s exactly why it is so controversial.

This cynical assessment is based on a near decade of experience (from 1989 to 1997) in redesigning legacy futures contracts. From ’89-’91, in the aftermath of the Ferruzzi soybean corner, I researched and authored a report (published here–cheap! only one left in stock!) commissioned by the CBOT that recommended adding St. Louis as a corn and soybean delivery point at a premium to Chicago; in ’95-’96, in the aftermath of a corner of canola, I advised the Winnipeg Commodity Exchange about a redesign of its contract; in ’97, I was on the Grain Delivery Task Force at the CBOT which radically redesigned the corn and beans contracts–a design that remains in use today.

What did I learn from these experiences? Well, a WCE board member put it best: “Why would I want a more efficient contract? I make lots of money exploiting the inefficiencies in the contract we have.”

In more academic terms: rent seeking generates opposition to changes that make contracts more efficient, and in particular, more resistant to market power (squeezes, corners and the like).

Some anecdotes. In the first experience, many members of the committee assigned to consider contract changes–including the chairman (I can name names, but I won’t!)–were not pleased with my proposal to expand the “economic par” delivery playground beyond Chicago. During the meeting where I presented my results, the committee chairman and I literally almost came to blows–the reps from Cargill and ADM bodily removed the chairman from the room. (True!)

The GDTF was formed only because a previous committee formed to address the continued decline of the Chicago market was deadlocked on a solution. The CBOT had followed the tried-and-true method of getting all the big players into the room, but their interests were so opposed that they could not come to agreement. Eventually the committee proposed some Frankenstein’s monster that attempted to stitch together pieces from all of the proposals of the members, which nobody liked. (It was the classic example of a giraffe being a horse designed by committee.). It was not approved by the CBOT, and when the last Chicago delivery elevator closed shortly thereafter, the CFTC ordered the exchange to change the contract design, or risk losing its contract market designation.

Faced with this dire prospect, CBOT chairman Pat Arbor (a colorful figure!) decided to form a committee that included none of the major players like Cargill or ADM. Instead, it consisted of Bill Evans from Iowa Grain, Neal Kottke of Kottke Associates (an independent FCM), independent grain trader Tom Neal, and some outsider named Craig Pirrong. (They were clearly desperate.)

In relatively short order we hashed out a proposal for delivery on the Illinois River, at price differentials reflecting transportation costs, and a shipping certificate (as opposed to warehouse receipt) delivery instrument. After a few changes demanded by the CFTC (namely extending soybean delivery all the way down the River to St. Louis, rather than stopping at Peoria–or was it Pekin?), the design was approved by the CBOT membership and went into effect in 1998.

One thing that we did that caused a lot of problems–including in Congress, where the representative from Toledo (Marcy Kaptor) raised hell–was to drop Toledo as a delivery point. This made economic sense, but it did not go over well with certain entities on the shores of Lake Erie. Again–the distributive effects raised their ugly heads.

The change in the WCE contract–which was also eminently sensible (of course, since it was largely my idea!) also generated a lot of heat within the exchange, and politically within Alberta, Manitoba, and Saskatchewan.

So what did I learn? In exchange politics, as in politics politics, efficiency takes a back seat to distributive considerations. This insight inspired and informed a couple of academic papers.

I would bet dimes to donuts that’s exactly what is going on with Platts and Brent. Platts’ proposal for a more efficient pricing mechanism gores some very powerful interests’ oxen.

Indeed, the rents at stake in Brent are far larger than those even in CBOT corn and beans, let alone tiny canola. The Brent market is vastly bigger. The players are bigger–Shell or BP or Glencore make even 1997 era Cargill look like a piker. Crucially, open interest in Brent-based instruments extends out until 2029: open interest in the ags went out only a couple of years.

My surmise is that the addition of a big new source of deliverable supply (the US) would undercut the potential for delivery games exploiting “technical factors” as they are sometimes euphemistically called in the North Sea. This would tend to reduce the rents of those who have a comparative advantage in playing these games.

Moreover, adding more deliverable supply than people had anticipated would be available when they entered into contracts last year or the year before or the year before . . . and which extend out for years would tend to cause the prices for these longer dated contracts to fall. This would transfer wealth from the longs to the shorts, and there is no compensation mechanism. There would be big winners and losers from this.

It is these things that stirred up the hornets, I am almost sure. I don’t envy Platts, because Dated Brent clearly needs to be fixed, and fast (which no doubt is why Platts acted so precipitously). But any alternative that fixes the problems will redistribute rents and stir up the hornets again.

In 1997 the CBOT got off its keister because the CFTC ordered it to do so, and had the cudgel (revoking contract designation) to back up its demand. There’s no comparable agency with respect to Brent, and in any event, any such agency would be pitted against international behemoths, making it doubtful it could prevail.

As a result, I expect this to be an extended saga. Big incumbent players lose too much from a meaningful change, so change will be slow in coming, if it comes at all.