Brent and West Texas Intermediate used to be the best of partners. Wherever one went, the other soon followed in near perfect harmony. However, in recent years ruptures have emerged in the marriage and prices have diverged hurting end users and prompting demand for a fragmentation of global oil benchmarks, finds Galen Stops.
WTI is traded on the CME-owned Nymex exchange and is the oldest and still most widely used oil benchmark around, with the equivalent of approximately 500 million barrels being traded per day off of it. The IntercontinentalExchange owned Brent crude contract though has been attracting market share away from WTI in recent years, a trend that accelerated rapidly since 2008 and culminated in record volumes last month.
Since the launch of Brent on Ice, a number of different market forces have converged to cause a tectonic shift in global benchmarking. WTI has faced significant structural challenges. An oversupply at the WTI repository at Cushing, Oklahoma, where the Nymex contract is settled, caused prices to plummet last year.
The fall in WTI came as the price of Brent rose following the Arab Spring and the war in Libya, which produced 2.2m barrel a day of high quality Brent. At the start of 2011, WTI traded at nearly $5 below Brent but then fell to more than $27 under Brent.
This marked a divergence from tradition – the higher quality WTI usually traded at a premium of roughly one or two dollars a barrel above Brent. This dislocation has had a significant impact on a number of market participants from airlines to oil speculators who found that their exposures no longer matched their hedges.
However, Ice has emerged as a winner in the dislocation. As WTI moved away from Brent pricing in 2011 airlines such as Delta and Southwest moved their jet fuel hedge exposure away from WTI to Brent. Now though the market is fragmenting further with the launch of new oil contracts setting their sights on becoming regional benchmarks.
Logistical problems, erratic prices and key clients switching to a competitor makes it sound as though WTI is in terminal decline. However, not everyone agrees with this view, even some of the emerging competitors for global oil benchmarks are quick to acknowledge the long term appeal of WTI.
“WTI is here to stay and the structural aspects of its physical contract will change with these pipeline pressures being relieved and then it will return world parity at that stage,” says Tom Leaver, the outgoing chief executive of the Dubai Mercantile Exchange (DME), whose Oman Crude Oil contract is gaining increasing attention as a benchmark.
The US government announced at the beginning of the year that the Seaway pipeline was to be reversed to get oil out of Cushing. Also, while a decision on the Keystone XL pipeline has been delayed by the Obama administration, should this project go ahead and the 0.6mb/d pipeline gets going it will further help diminish the oil glut Cushing has experienced in recent years.
One advantage that WTI maintains over Brent is that the former is a physically deliverable contract whereas the latter is financially settled, leading Leaver to describe Brent as a “poor cousin” to WTI.
“There’s a lot of crude oil that is pricing off Brent but the benchmark itself is relying on a very small oil supply,” explains Oliver Jakob, managing director of Petromatrix, an independent research group specialising in the oil markets. “This means that from time to time you can have issues that impact Brent that are not really reflective of crude oil worldwide.”
This decoupling between the physical supply and demand fundamentals and the economics of the futures contract were evidenced last year. A series of supply glitches at the Buzzard field, an important field for the Forties blend, one of the four that make up the benchmark price of Brent, had a strong impact on the structural prices of Brent. While supply from the Buzzard field is minimal in relation to global oil production, it weighs heavily on the price of Brent.
A new benchmark?
That a global oil price can be swayed by oversupply to a small town in Oklahoma or a glitch at a tiny oil field in the North Sea has invariably led to talk of a new global benchmark. However, despite DME’s Oman contract being touted as a contender, Leaver, questions the very meaning of the term.
“There’s no such thing as a global benchmark. I don’t know who started it but it’s not one size fits all and to say that Brent is a global benchmark in particular when it’s only got 140,000 barrels per day production and declining and is not even physically backed begs reality,” he says.
Indeed, many of the major benchmarks can be viewed as somewhat regional. WTI is used for sales in North and South America, Brent is used for Europe, the Mediterranean, Africa and Russia and the smaller and the now perennially declining Dubai benchmark is used for the Middle East and sales into Asia.
Oil production linked to the once influential Dubai benchmark has fallen to less than 500,000 barrels per day. In 2007, the Dubai government did not renew the oil concession for private companies, which, according to Bassam Fattouh of the Oxford Institute, means that Dubai no longer satisfied the ownership diversification criteria that is a precondition of a benchmark.
However, in the place of the Dubai contract comes a challenger in the form of DME’s Oman contract, which is pitching itself as a benchmark for Asia.
“Where is the crude oil coming from? It’s coming from Asia. What kind of crude oil are they running on? It’s mostly the heavy sour type of crude oils. So in that sense Oman should be a pretty good benchmark for the growth in Asia,” says Jakobs.
Unsurprisingly Leaver concurs about the Oman contract suitability as a benchmark for the east of Suez region and is effusive about its design. “The construct of this contract is brilliant. It seamlessly morphs from a futures contract into a physically delivered contract the likes of which no one has ever seen,” he claims.
It can certainly be argued that things are looking good for the DME. Liquidity is building in the contract. Trading on the contract was up 57% for the first quarter of 2012 compared to the same time last year and it set a daily and monthly trading record last month.
However, the exchange still has a mountain to climb if it is to be considered in the same league as WTI or Brent. Jorge Montepeque, global director of markets reporting at Platts, says that less than 1 million b/d of physical crude is currently priced against the Oman contract in a global oil market that is roughly 87 million b/d: the DME has a long way to go.
While a 57% increase in trading in just one year is not to be dismissed, the monthly trading record on the DME still stands at a relatively meager 123,162 with an average daily volume of just 6,158 contracts.
For all its advantages in reflecting the supply and demand fundamentals of the region and having the oil-hungry Asian countries as its target demographic, DME still faces a lack of liquidity.
What the DME really needs to help build liquidity is for more producers to adopt the Oman contract as a price reference, which then allows their customer base in Asia to use the DME Oman contract to hedge their price risks for all those barrels.
In February the CME threw its weight behind the exchange, upping its stake in the DME to 50% and signaling its intention to put its considerable expertise and resources in building up liquidity on the contract. In his interview in this magazine, the new CEO of CME Phupinder Gill expressed his optimism in the development of the Oman benchmark.
Oman is not the only emerging oil benchmark, EPSO in Russia is sometimes mentioned as another. It is currently producing around 600,000 barrels per day but this figure is expected to rise to as much as 1.6m by the end of 2015, meaning that it is certainly robust enough to price off.
However, there remains uncertainty about how much of this volume will be available for sale in the spot market as much of it is sold on a long-term basis or used in Rosneft refineries.
One of the main problems with EPSO is that it has already been pricing off of Dubai or Oman oil which inherently undermines any credibility it may have as a benchmark in its own right as it cannot just start producing prices arbitrarily Also, for a global benchmark to emerge it is vital that market participants have confidence that the benchmark will not be subject to manipulation and currently there is a strong concern amongst many companies that an EPSO benchmark could fall victim to political persuasions.
A far more realistic challenger has emerged from China in recent weeks. The most recent challenge to the Oman contract as the next big oil benchmark is from the Shanghai Futures Exchange (SHFE) after the head of the exchange, Wang Lihua, announced at a recent forum in Shanghai plans to launch a new physical crude oil contract on the exchange. Wang explicitly stated that the exchange intends for this new contract to become one of the benchmarks for the international crude oil market.
The new contract will be open to foreign investors and be traded in both renminbi and US dollars, making it China’s first dual-currency commodities contract. China is the second largest importer of crude oil in the world it and this new contract from SHFE would certainly represent the supply and demand fundamentals of the country better than any of the other benchmarks currently out there.
Domestic private refineries will certainly be keen to trade on this new contract as they are not permitted by the Chinese government to import crude oil directly. Only the state owned Sinopec and CNPC have the right to import crude oil directly and as such they currently have a monopoly on domestic wholesale crude oil pricing, although the new contract being touted by SHFE may threaten this.
Although SHFE is apparently hoping to launch the contract later this year this could be an ambitious time frame for the exchange given the delays that China’s derivatives markets have become notorious for, caused by cautious regulators and high levels of red tape that must be overcome for new contracts, especially ones available to foreign investors to trade, to be allowed to launch.
WTI has been branded as a ‘broken benchmark’ by some media sources and perhaps it has been in recent years. However, it remains the biggest contract in the world. Confidence in the contract has been shaken, but the conditions that caused this crisis of confidence look set to improve.
Brent has been doing well in recent years but it remains unsustainable that oil prices outside of Europe and West Africa should be priced off a benchmark that does not reflect the supply and demand fundamentals and for some it’s continually dwindling supply physical supply is a concern.
A fragmentation of oil benchmarks looks inevitable considering the strength of the challengers and the ever increasing demand from Asia. The battle for dominance on Asia oil pricing looks set to be a fight between the DME and the SHFE. Even with the backing of the CME, the DME faces a potentially formidable rival.