The Emperor’s New Clothes

04/12/2018

The oil industry has just completed another annual round of budgeting, sales contract negotiations and hedging for 2019 and, in many cases, further into the future. And once again the Brent benchmark price has played a central role in worldwide negotiations and planning, despite growing recognition of the Brent basket’s shortcomings.

Dwindling Brent production has prompted the acceptance of alternative grades of oil, namely Brent, Forties, Oseberg, Ekofisk and Troll for delivery into the forward Brent (30-Day BFOET) contract and for inclusion in Dated Brent published price assessments. But the disparate quality of the basket grades and imperfections in the operation of the market mechanism call into question the accuracy of the Brent price assessments that set the price for the majority of the world’s crude oil contracts. 

The Hunt for a Better Brent

2018 has seen serious time and money expended in trying to find a better way of addressing the differences amongst the various grades of crude oil that can be delivered into the forward 30-Day contract and which are used to determine the daily value of the ubiquitous Dated Brent benchmark. Not least of these efforts has been a study commissioned by the Intercontinental Exchange (ICE), and compiled by well-qualified external consultants, Energex, which has not resulted in the publication of any radical new thinking about the components of the basket and how to use them for wider price discovery.

Readers of this blog may be aware that Consilience suggested a methodology for determining fair and market-responsive price differentials amongst the grades in the basket - see “Let’s Go Fly a Kite”

This can be summarised briefly as using Gross Product Worth (GPW ) calculations to determine the price differentials amongst basket grades. These GPWs differentials, in Consilience’s proposal, would be calculated as if the crude was refined at reference refinery in Rotterdam that has the Nelson Complexity Index  equivalent to the average of actual refineries in the Amsterdam-Rotterdam-Antwerp (ARA) area. We maintain that this proposed methodology is the one that would produce a result closest to a fair and objective value for Brent.

“Too complicated!” say interested parties, perhaps with some justification: there are no simple answers to this issue. However the methodology currently in use by the influential Price Reporting Agency (PRA), Platts, is no less complicated and no better understood by all but the traders involved in the forward Brent market and the compilation of the Dated Brent published price assessment.

The current system of establishing price differentials amongst the BFOET grades in the Brent basket side-steps much of the complexity of the real situation by making some assumptions. This methodology assumes that the price differentials amongst cargoes of Brent basket grades for delivery next month are comprised of 60% of historic market price differentials. This is how the Oseberg and Ekofisk Quality Premia are calculated. From April 2019 an equivalent Quality Premium will be calculated for Troll.

There is no obvious reason why this assumption should be considered as correct, other than that the industry is prepared to go along with it, rather like the townsfolk who agreed that they saw and liked the emperor’s new clothes. 

Consilience has encountered at least one occasion where a Platts Quality Premium has been misused as a market price differential. No blame attaches to Platts for this misuse: Platts methodology for calculating Quality Premia could not be more publicised or transparent than it is, whether one agrees with it or not.  

There are no quality premia for Brent and Forties in the Platts methodology. In the case of Brent it has thus far been deemed unnecessary to establish a Brent quality premium to what is, after all, a Brent instrument. However, since Brent is rarely the grade that gets delivered into forward Brent contracts and is only infrequently the lowest priced grade in the Brent basket used to set the price of Dated Brent, the lack of a Quality Premium has not been considered a deal-breaker. That assumes that one agrees with the calculated quality premium mechanism in the first place, which I do not.

Similarly In the case of high-sulphur Forties there is no quality premium in the Platts methodology. Forties, when it is available, is the usually lowest priced grade in the Brent basket so that is said to justify the absence of a quality premium for it. This is a logical inconsistency. If we do not need a quality premium for Brent because Brent is a Brent instrument then surely we need a Forties quality premium (or discount) to Brent in the Brent instrument because Forties and Brent are different animals?

This inconsistency arises, in Consilience’s opinion, because Brent has actually been a Forties instrument, not a Brent instrument, since Forties quality declined sharply after the inclusion of high-sulphur Buzzard in Forties Blend in 2007. The grade to be delivered is at the seller’s option and a seller acting rationally will always deliver the least valuable grade.

In recognition of Forties’ high sulphur content, and instead of a Quality Premium, a sulphur price de-escalator mechanism is published by Platts and is applied by traders when buying and selling Forties cargoes in the physical and forward markets.

Ensuring that the value of the sulphur component of the Forties price reflects the actual market penalty for sulphur in the future will keep Platts on its toes as we get closer to the implementation of the International Maritime Organisation’s (IMO’s) reduced cap on the sulphur content of bunker fuel: this will be cut from the current 3.5% level to 0.5% from the beginning of 2020.

Altering the Emperor’s New Clothes

Encouraged by the absence of consensus on the acceptance of any alternative methodology, Platts is currently in consultation with the industry about the further refinement of its existing methodology for the setting of price differentials amongst the Brent basket grades in the forward market and the assessment of the Dated Brent price. This is necessary because production of the grades of oil that make up the Brent basket is still on a downward trajectory and the number of deals being done is also sparse. This is partly because of diminishing production and partly because of less trading activity in the remaining cargoes, arguably because of dissatisfaction with current pricing practices. 

Now up for discussion is the boosting of “Brent” production by the inclusion in the Brent basket grades of oil from further afield than the North Sea, delivered to the North West European area. The prospect of seeing delivered grades such as Norwegian Statfjord and Gullfaks, Caspian CPC Blend, American WTI Midland, Nigerian Qua Iboe and Forcados being included in the Brent basket, which currently only includes grades sold FOB North Sea terminals, is disheartening.

If it is proving difficult, which it is, to establish the correct price differentials amongst the existing five BFOET basket grades that are at least produced in the same area, how much more difficult will it be to include grades, also of varying quality, from further afield that have to be shipped into the comparable ARA market?

If one of these proposed new grades is delivered, say, to Rotterdam at $65/bbl, it then has to be established how much of that $65 is attributable to the quality of the grade and how much to the cost of the freight to get it to Rotterdam. What size of ship did it come in? Was it a part cargo or a full cargo lot? Was it a time charter or a voyage charter? Was there a backhaul deal involved?

Both factors, quality and freight, will have to be quantified by an external observer, a PRA, before a meaningful price differential to “Brent” can be established from delivered price data. Similarly, quality and freight need to be quantified before it can be said that, say, Forcados is the lowest priced grade in the basket today and therefore it will set the price of the Dated Brent assessment  that in turn has an influence in contracts all around the world. This takes the accusation of “too complicated” to a whole new level.

Despite Brent’s shortcomings there is no alternative index currently in existence that is as widely accepted and as flexible as Brent. That will change over time. WTI and Oman/Dubai are evolving rapidly into their own niches and the new Shanghai futures exchange is turning over a decent volume, despite pricing in yuan. The Shanghai INE futures price is one to watch as it could gain ground quickly if there is a political decision in China only to buy crude in yuan rather than dollars, which with the US/China trade war and the re-imposition of Iranian sanctions, is not as far-fetched as it first sounds - see “Futures are Looking Up"

Why should you care?

Companies who have just signed up to another year’s contracts referenced to one of the Brent price indices have been forced to take the leap of faith that what is currently understood to be Brent will endure. Who knows what “Brent” actually represents and how this will change as a result of the current consultation process. Mercifully the PRAs recognise this problem and are unlikely to make an abrupt, short-notice change to the current methodology.

The danger arises when the General Terms and Conditions (GTCs) of trade for physical cargoes do not mirror the terms of the International Swaps and Derivative Association (ISDA) master agreements that typically govern hedges. ISDA provides for a re-opening of a hedge or other derivative contract if there is a material change in the formula or content of the price index. Physical contracts tend not to have a similar provision so there is a mismatch in risk between physical and derivative contracts.

Those companies who, for want of anything better, are continuing to use a Brent price index in their contracts are in effect agreeing that “the Emperor’s new clothes” have substance. They take comfort from the fact that, while their physical cargoes are priced by reference to nebulous Brent, so are their hedges, so they are protected from any flaws in the fabric of Brent.

This fails to take into account the legal basis risk between physical and ISDA contracts that should be borne in mind at a time when the “formula and content” of Brent is once again up for discussion.

The Consilience Guides

Consilience shares many years of front-line practical experience to provide these encyclopaedic guides to the international crude oil and refined oil product trading markets. If you are looking for a step-by-step guide to a future career as a trader or, if you are a business executive or industry professional seeking an overview of how the market works, these books will provide what you need. Find Out More Here

KeyFacts Energy Industry Directory: Consilience Energy Advisory Group

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