Master of Advanced Studies in International Oil and Gas Leadership
The interplay of physical and financial
layers in today's oil markets
Giacomo Luciani
IEA Energy Training Week
Paris, April 5, 2013
The Market for Brent
• Brent is a field in the UK North Sea.
• The market consists of:
 A “spot” market;
 A “physical forward” market;
 A “futures” market – based at the International
Petroleum Exchange (IPE) in London
The spot market, or “dated Brent”
• “Dated Brent” refers to the sale of a
specific cargo that is either available in a
specific loading slot or that is already
loaded and in transit to some destination.
• Main characteristics:
 Transactions are bilateral,
 Over the counter (OTC),
 For variable quantities.
The forward market, or “21-day Brent”
• The 21-day cargo is a standard parcel (600,000
barrels) that will be made available by the seller to
the buyer on an unspecified day of the relevant month
(buyer must be notified of loading date at least 21
days in advance.
• The clearing involves book-outs or seller’s
nominations, which can take place on any day in the
period starting 21 days before the beginning of the
relevant month.
• As dated Brent, 21-day Brent is bilateral and OTC –
but it is standardized.
Price Reporting Agencies (PRAs)
• If transactions are bilateral and OTC, prices
are not easily “visible”
• Price Reporting Agencies are private
providers who survey the market for prices
• Two main PRAs for oil: Platt’s and Argus
• Different methodologies: Platt’s “window”
• Are PRAs neutral or do they influence the
market?
• Should they be regulated? (issue being
discussed by the G20)
The futures market
• The futures market was launched by the International
Petroleum Exchange (IPE – today International
Commodity Exchange - ICE) in 1988
• 1 contract = 1000 barrels
• Contract based on cash settlement and not on physical
delivery
• If a contract is allowed to expire the settlement price
is the Brent index
• Central exchange and clearing house rather than
bilateral trades
• Several months (indeed, years) traded
Options
• Launched by the IPE in 1989
• A call option gives the holder the right to
buy the underlying futures contract, and a
put option the right to sell.
• Call and put options may be combined to
design complex risk management
strategies.
What are options for?
• Any buyer or seller on the petroleum
market faces a price risk.
• Options and futures allow parties facing a
structural risk to limit that risk, “selling” it
to speculators (or “insurers”).
Hedging
• A producer can sell futures or buy put
options to ensure a minimum level of
prices.
• A large consumer can buy futures or a call
option to ensure against very high prices
• Major companies are on both sides of the
market and may be doing both things at
the same time.
Why so many Paper Barrels?
• Most participants in the futures market are
there to manage their risk, not to acquire
Brent crude.
• Buying and selling Brent futures and
options is an effective strategy because
other crude prices follow Brent
movements.
The Structure of the Oil Market
• At the center, we find the market for Brent and
WTI, which influence each other
• Brent and WTI trade few physical and lots of paper
barrels
• Paper and wet barrels influence each other, but
paper barrels are more important
• Smaller markets, such as ANS and Dubai, are
influenced by Brent and WTI
The Influence of Brent
Physical = 83.6 million b/d in 2011.
Estimated that 2/3 priced by
reference to Brent = 20 billion/year.
The ICE futures contract for Brent
alone traded >130 billion bbls in
2011
Consilience Energy
Advisory Group Ltd
OTC forwards- volume unknown
but likely to be more than futures
PSC- cost recovery, profit share
Tax
Can’t be less than
200 billion bbls
per year, even on
conservative
estimates
Gas
contracts?
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Feature of Physical Benchmarks:
Financial Layers and the Spot Price
• Many financial layers (paper markets) emerged around physical
benchmarks
• Financial layers highly interlinked with benchmarks through process
of arbitrage and development of products that link layers together
• Idea that one can isolate physical from financial layers in current oil
pricing system is simplistic
• Information derived from financial layers plays an important role in
identifying the price level of the benchmark
• Brent market: Price of Dated Brent assessed using information from
many layers including CFDs, forward markets, EFPs and futures
markets
• WTI complex: prices of the various physical benchmarks strongly
interlinked with the futures markets
• Price of Dubai often derived using information from the very active
OTC Dubai/Brent swaps market and the inter-Dubai swap market
Deep and Liquid Markets
The Inter-linkages Between Financial and Physical Layers
Inter-Dubai Swap
Market
Dubai Price
Forward
Dubai
Dated Brent
Contract
For
Differences
(CFDs)
Exchange
for
Physicals
(EFPs)
Dubai/Brent
Exchange for
Physicals (EFPs)
Forward
Brent
Brent
Futures
Market
DATED
LPG
Naphtha
Gasoline
Diesel
Fuel oil
EFP
FORWARD
BRENT
CFD
FUTURES
(several
years
traded)
WTI
Dubai
OIL
Several
traded
hubs
Oil
Products
Pipeline
GAS
COAL
LNG
POWER
CARBON
Other Crudes
• All other major crudes are priced on the
basis of formulas which tie them to Brent
or WTI
• The producing countries oppose the free
trading of their crudes, and restrict
destination and secondary trading
• Formulas are modified from time to time,
but the essence remains
Example: Saudi Arabia’s Prices for 04/13
Source: Middle East Economic Survey 15 March 2013
Why oil producing countries
like reference pricing?
• Accepting pricing out of a marker implies
that producers are giving up on an
important role
• They should naturally be price makers,
instead are price takers
• Why? First and foremost because in the
past they failed in the management of
posted prices.
Why there is no Arabian Light market?
• Setting up a market for a major crude,
such as e.g. Arabian Light, is not easy
because there is just one seller
• The seller does not want the responsibility
of making prices, because he is afraid of
international political pressure or domestic
dissension.
How is the Market Cleared?
• Brent/WTI are not the marginal crudes
that balance demand and supply.
• Yet, it is Brent/WTI that make the price.
• The implication is that demand and supply
are not necessarily balanced: OPEC and
other operators manage supply and/or
stocks, given the price.
Features of Benchmarks:
Physical Liquidity of Benchmarks
•
Markets with relatively low physical liquidity set the price for markets with much
higher volume of production
•
Low physical liquidity and squeezes
– As markets become thinner and thinner, squeezes and distortions become more widespread
– Prices and spreads become less informative and more volatile
•
Nature of these benchmarks tends to evolve over time but not without problems
– Widen the benchmark for assessment purposes
– Assessment of traditional Brent benchmark now includes North Sea streams Forties, Oseberg
and Ekofisk (BFOE)
– Dubai price includes Oman and Upper Zakum
•
Short-term solutions of adding additional streams successful in alleviating problem
of squeezes but should not distract observers from raising key questions
– What are necessary conditions for the emergence of successful benchmarks in the most liquid
market in terms of production?
– Would a shift to price assessment in markets with high physical liquidity improve the price
discovery process?
The Feedback Issue
• Given this market structure, operators that have no
interest in Brent crude trade in Brent futures and
options, to manage their risk
• In this way, a certain feedback is obtained between
the global physical oil market and Brent
• However, such feedback is limited and partial
 The feedback would be greater if all operators hedged
systematically; in that case, an excess of demand would raise
the price of calls, financial intermediaries would lower the price of
puts, producers would be incentivated…
Perception of Limited Feedbacks
• Uncertainty about existence of and timing of
feedbacks from prices to oil supply and demand
increased markedly during boom
– Perception of strong feedbacks replaced by perception of
limited feedbacks
• Key feedbacks that were perceived to be absent
– Oil demand response to oil prices
– High oil prices would trigger a rise in global inflation rates
and a subsequent recession, tempering growth in the
demand for oil
– High oil prices would induce strong growth in non-OPEC
supply
– OPEC would increase its oil supply to prevent oil prices
from rising to high levels or try to put a cap on the oil price
The Forward Curve
• At any point in time, we have several
prices for the same marker for different
maturity future contracts.
• If prices for subsequent months are lower
than the closest-month price the market is
said to be in backwardation
• If prices for subsequent months are higher
than the closest-month price the market is
said to be in contango
Brent Forward Curve
Source: Royal Bank of Scotland March 28, 2013
Parallel shift in the Futures Curve
Meaning of contango
• A contango occurs when the market expects future
prices to be higher than today’s
• Normally, a contango occurs when prompt prices
are low, backwardation when they are high
• Backwardation is the “normal state” of a market
because holding stocks has a physical and financial
cost (interest rate)
What is the impact of
backwardation/contango?
• Contango encourages the buildup of
physical stocks (you earn money by
buying spot and selling futures, while
holding the commodity)
• Backwardation encourages financial
commodity investors (you make money
by buying futures and waiting for futures
to converge to spot prices)