Streetwise Professor

February 4, 2011

This Too Shall Pass, or, In the Long Run, We All Equilibrate

Filed under: Commodities,Economics,Energy,Exchanges,Politics — The Professor @ 8:57 am

The controversy over the merits of the CME-NYMEX crude oil futures contract (West Texas Intermediate, WTI, also known as light crude, CL) vs. the Brent alternative is heating up again. In recent months, the spread between WTI and other crudes has widened, with WTI trading substantially lower than Brent, and US Gulf Coast prices (e.g., Louisiana Light Sweet–LLS–and Mars blend).

Critics of WTI question the long run viability of the contract. This is economically non-sensical. If there is a problem with WTI, it is a short run one; the very price relations that have drawn criticism provide the signal and incentive that will lead to its correction in the “long run”–as economists define it. Not “in the long run we are all dead” long run, but in the time frame that it takes to make adjustments to fixed capital such as pipelines and refining. This long run will arrive far before most of us are dead (based on reliable actuarial information:)–a period measured in months, rather than many years.

The WTI “disconnect” as it is sometimes termed reflects fundamental conditions in the oil market. (As an aside, those who obsess about the impacts of speculation should explain how speculation can wildly distort levels of prices but fundamentals drive intra-commodity price relations/spreads.) Increasing Canadian and US oil production has ensured that the US Midcontinent is well-supplied with crude. Indeed, along with demand that is still somewhat sluggish, this increased supply has led to increased inventories of crude in beautiful, windswept Cushing, OK. Cushing is the largest storage location in the US, and is the delivery point for the CL contract. At present, oil cannot flow from Cushing to the Gulf Coast. Gulf Coast refineries rely on US domestic crudes produced in the Gulf of Mexico (GOM) and imported crudes. The abundant supply of crude to the Midcontinent combined with the current inability of oil to flow from the Midcontinent to the Gulf has led to the widening basis.*

If you have been long WTI and short LLS (or some other Gulf Coast price) that relative price change is a problem (although it has been a boon if you have been short WTI and long the Gulf). But that problem is also an opportunity. It is a signal of the value of investments in capital that can move oil from the Midcontinent to the Gulf, and in refining capacity in the Midcontinent that can soak up some of that additional oil.

And indeed, a pipeline project–the third stage of the Keystone pipeline–is currently awaiting regulatory approvals.  With timely approval, the pipeline could go online in early-2013.

Indeed, adjustments are occurring even in the short run: the price relations are such that it is attractive to ship oil by rail–almost a throwback to the Rockefellar days–from the rapidly growing Bakken fields in North Dakota to the Gulf.  Moreover, Midcontinent refiners are operating at substantially higher rates than those elsewhere in the US.   (It is likely that in the longer run that refining capacity in the Midcontinent will expand relative to capacity in the Gulf to reflect the increased supplies of crude in regions tributary to the Midcon.)

Ironically, environmentalist opposition supposedly intensified by the Mocondo spill is the main obstacle to timely completion of Keystone.  Ironic because pipeline transportation is safer than deepwater production and seaborne transport (although it is not without environmental risk).  So delaying the pipeline only increases reliance on the riskier alternative.

So, like many economic “problems”, this one is self-correcting if the market is allowed to respond rationally to price signals.  Economic actors are ready to respond rationally.  Now it remains to be seen whether the political actors will do so.  Always a much more problematic proposition.

Several people have asked me whether it would be advisable to develop a new futures contract that would price off of seaborne crude or domestic production in competition with seaborne crudes: an LLS contract, for instance.

Having been intensely involved in the design of several commodity futures contracts, I am less than enthusiastic.  Sometimes the “long run” in designing a futures contract–going from the idea to the actual implementation–is longer and more treacherous than doing something like building a pipeline over hundreds of miles of Oklahoma and Texas prairies.  The implementation details are very difficult to get right.  Moreover, there are many parties with conflicting interests who try to influence the design to benefit them.  A futures contract is a one-size-fits-all endeavor, and it is very difficult to choose which suit gives the least bad fit to the most people.

Moreover, there is a kind of Heisenberg principle at work.  Designing a futures contract around a particular location and grade can change the pricing behavior of that location and grade.  You have to be sure that the logistics and infrastructure are robust enough to handle the demands of being a delivery point (or cash reference point).  That’s not easy to do.

What often happens is that dissatisfaction with one delivery design leads to inquiries which prove that that design is the worst possible one, except for all others that could be tried.

With respect to WTI, the economic factors that are the fundamental source of the current criticism could be a boon in the longer run, especially if the market is allowed to function and capital adjusts in response to changes in production and consumption patterns.  Historically, the US market was in supply deficit, and WTI traded at a premium to attract Brent in addition to other foreign crudes.  But currently the forward curves for WTI and Brent show WTI at a discount going out years.  This means that the market is anticipating that Cushing will be abundantly supplied for years–while Brent/North Sea production is inexorably declining.

The major problem that raises worries about the long run viability of a futures contract design is lack of supply.  Long run changes in grain marketing patterns put the terminal market in Chicago into terminal decline (no pun intended).  That caused serious difficulties with CBT corn, wheat, and soybean futures contracts.  Those problems took years to correct, and only after extremely rancorous infighting over how to change the contracts to address the problem.  (Efforts that I was involved in from 1990 through 1997–that timeline alone speaks volumes.  And I can speak authoritatively about the rancor, having had some of it directed my way–almost resulting in a fistfight with a prominent grain trader.  True story.)

The increased Canadian and North Dakota production, reflected in part by the forward WTI discount vis a vis Brent, suggests that over the longer term the Cushing-based WTI contract does not face the prospect of a similar supply problem.  Moreover, the delivery in-store (or through pumpover) design for the CL contract offers many advantages over the much more cumbersome and opaque Brent pricing mechanism, not least due to the fact that Brent trades in huge cargoes whereas delivery in-store at a market served from a variety of supply sources with a variety of demand outlets permits greater flexibility in logistics and trade sizes.

In sum, the conditions that have created the wide spreads are self-correcting:  those self-same spreads give the incentive to make adjustments in transportation (and also production and consumption) that will re-integrate Midcontinent prices with waterborne prices.  And it’s also important not to exaggerate the magnitude of the de-linkage.  As I documented in a study released about a year ago, even during the throes of the financial crisis when spread and basis relations were also well out of historical norms, WTI still exhibited high correlations with other crude prices, including LLS and Mars.  (I am working now to update the main results of that study.)

In a dynamic market, changes in supply and demand patterns are inevitable.  By necessity, futures contract designs are relatively static–particularly so for something like crude oil, where contracts are traded going out to ten years so you just can’t change contract designs willy-nilly and strand a lot of open interest in the out months/years.  This mismatch between dynamic markets and static contract designs means that from time to time the contract will get out of alignment with the fundamentals.  Sometimes that mis-alignment is likely to be enduring–as with Chicago-based grain and oilseed contracts, which necessitated a major change in design.  Sometimes that mis-alignment is fleeting, because the price effects of the mis-alignment lead to adjustments on various margins that tend to bring things back into alignment.  That will almost certainly happen with WTI–if regulators allow it to happen.

And one point deserves repeating: the change in supply conditions that is causing the changes in price relations that are drawing so much attention will also help ensure the long run viability of the WTI contract.  If the supply is there, you can build pipelines to get that supply from low price locations to high price ones.  But you can’t base a futures contract on a market with no supply.

*Note how this represents a fundamental, and salutary change over conditions in the 1990s.  At that time, declining domestic production was turning the Midcontinent into a deficit region, and the Seaway Pipeline was built to bring crude from the Gulf to Cushing and the Midcon.

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3 Comments »

  1. […] This Too Shall Pass, or, In the Long Run, We All Equilibrate – via Streetwise Professor -The controversy over the merits of the CME-NYMEX crude oil futures contract (West Texas Intermediate, WTI, also known as light crude, CL) vs. the Brent alternative is heating up again. In recent months, the spread between WTI and other crudes has widened, with WTI trading substantially lower than Brent, and US Gulf Coast prices (e.g., Louisiana Light Sweet–LLS–and Mars blend). Critics of WTI question the long run viability of the contract. This is economically non-sensical. If there is a problem with WTI, it is a short run one; the very price relations that have drawn criticism provide the signal and incentive that will lead to its correction in the “long run”–as economists define it. Not “in the long run we are all dead” long run, but in the time frame that it takes to make adjustments to fixed capital such as pipelines and refining. This long run will arrive far before most of us are dead (based on reliable actuarial information:)–a period measured in months, rather than many years. […]

    Pingback by Simoleon Sense » Blog Archive » Weekly Roundup 114: A Linkfest For The Smartest People On The Web — February 6, 2011 @ 9:54 am

  2. Illuminating for those of us more familiar with the Brent complex – which has its own logistical problems too

    Bottom line: $100 is real – for the time being

    Comment by Nick Drew — February 7, 2011 @ 9:24 am

  3. –My personal experience has been that most physical sale contracts are based off of a pipeline tariff posting or Platt’s Oilgram. There is also usually an API adjustment. For hedging, people often use a NYMEX asian option (average of prompt month settles) and might lock in the “Roll” with the company we’re ultimately selling the oil to as well as the quality differential.
    –As a guy who tangles with hedging, there is value to using the most liquid contract, even if correlation is not 100%. It’s a tradeoff – the ideal is 100% correlated and super liquid. The ideal is rarely available…so you have to compromise. One example of such compromise each risk manager has to grapple with is how to hedge NGL’s (Ethane, propane, butane, Nat gasoline)– if you deliver to Conway, do you hedge with illiquid Conway, or liquid Mt. Bellvieu, or less-correlated but very liquid NYMEX CL?
    –Liquidity usually wins…people try, from time to time, to develop a non-dollar denominated oil contract – often for nationalistic reasons. Chavez, Putin, and A-Jad have all tried, as has Dubai. They have failed because it’s easier to hedge with the super-liquid NYMEX contract and hedge dollar exposure on the deep FX markets than to take a risk of a liquidity trap.
    –In addition to being unable to close a position, illiquidity has other valuation problems..such as financial statement disclosures (how can your external auditors get comfortable with your valuations) and credit-granting/margin calls (if you can’t agree on a mark, how can you agree to meet a margin call?)

    My two cents…it’s healthier for people to trade around one contract and jimmy it to fit, than several thinly-traded markets that are perfectly tailored. The analog is to Black-Scholes and VaR…two concepts that are used and abused in the financial community for a number of reasons…but everyone with some scars knows how to put a thumb on the scale so they’re useful.

    I think I just said what you did…but with less eloquence.

    Comment by HH Gwin III — February 7, 2011 @ 6:28 pm

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