Market organisation: Prospects and challenges for benchmark prices

The development of market organisation in crude oil markets has undergone several changes over the years. Since the end of posted prices, at the end of the 1980s, market-based solutions have been developed but they are under continuous evolution. The pricing of physical crude oil today is a complex web of financial and physical transactions, which result in a combination of futures, forward, and spot prices traded on open platforms, OTC, or assessed by price reporting agencies (PRAs). This system relies on pricing formulas.

Crude oil prices (typically sold FOB) are formed through long-term contracts or spot transactions with delivery a few business days after the conclusion of the deal. In the latter, in effect, it is a ‘forward’ because spot cargoes for immediate delivery are rare due to logistical issues of making the commodity immediately available (especially if delivered seaborne). Often, the price of an oil cargo is linked to the time of loading. Crude oil can be traded at sea (by acquiring ownership of an entire vessel or lots of it) or at a terminal where the crude oil will be made available FOB through vessels or pipelines to the buyer (the typical physical delivery of futures contracts). There are two important factors that need to be taken into account in the pricing formula: location and crude quality (mainly density and sulphur content).

As mentioned above, crude oil is extracted in several different locations across the world and sold in a global market. Therefore, differentials are usually assessed (by PRAs) and applied to a benchmark price (an average) that reflects the standard quality of crude oil. Three futures contracts are widely adopted as benchmark price for crude oil:

1. Brent blend (traded on Intercontinental Exchange, ICE).

2. West Texas Intermediate (WTI; traded on NYMEX).

3. Dubai (is the Oman crude oil contract traded on Dubai Mercantile Exchange, DME).

Each is used to price physical transactions in a different location. WTI is used for oil shipments or local transactions in North America. Brent is used today for oil imported in the European Union, and for most seaborne oil cargoes as it is a benchmark based on cargo delivery in the North Sea.

Finally, the Dubai benchmark is used for crude oil spot transactions in Asia and Africa (together with the Nigerian Bonny Light).

Published spot market prices, which rely on a combination of public prices and assessments, are also used in long-term supply contracts as a reference price. This system directly links prices under long-term supply contracts to prevailing spot market prices. Price reporting agencies also publish several official price differentials used in the pricing formulas of state-owned oil producers each month (Saudi Arabia, Iran, Iraq, Libya, Egypt, Nigeria, Mexico, etc.). The differentials applied to effects clearly emerge from the test in this dataset, an ARCH (1) model is used to understand the impact of key variables on soybean oil prices.

averages of benchmark crudes (so called ‘pricing formula’) are a central feature of the oil pricing system and are used by oil companies and traders to price cargoes under long-term contracts or in spot market transactions, by futures exchanges for the final settlement of their financial contracts, by banks and companies for the settlement of derivative instruments such as swap contracts, and by governments for taxation.

Formula pricing may have important advantages (Fattouh, 2011):

 It takes into account the large variety in crude oils by adding a (positive or negative) premium to the reference price adjusted periodically to reflect differences in the quality of crudes, location and refinery demand, as well as other demand and supply factors of the various types of crudes.

 It provides price flexibility to hedge from specific price risk, as it usually also accounts for time lags between the date of purchase of the cargo and the date of delivery at destination (e.g.

Dated Brent).

 It reduces the possibility to squeeze markets for less liquid benchmarks.

However, this system adds a level of discretion on how the price is assessed that increases the overall complexity of how the physical price is determined. In addition, benchmarks may rely on markets with limited volumes of production, such as WTI, Brent (the biggest with less than 1.2 million barrels a day of production, out of over 89 million produced globally) and Dubai, thus setting prices for markets with higher volumes of production elsewhere in the world.

Table 29. Liquidity of underlying physical markets, Q1 2010 ASCI WTI CMA +

For instance, Brent blend prices help pricing for roughly 70% of the international trade in oil (a physical market worth around $1 trillion every year), but the value of the underlying market is $52.6 billion a year (around 5%), assuming an underlying production of 1.2 million barrels per day at a settlement price of $120 per barrel.

As underlying physical markets become thinner and thinner, the price discovery process becomes more difficult although methods to overcome this have been applied. It also opens space for squeezes in the physical market directly, rather than the futures market. PRAs, therefore, may be unable to observe enough genuine arms-length deals and would need to rely more on general information based on pure research. Furthermore, in thin markets, the danger of squeezes and distortions increases and, as a result, prices could then become less informative and more volatile, distorting consumption and production decisions.

Spot price formation: The case study of Brent crude oil pricing

While physical delivery of WTI is done at a price very close to the settlement price of the front-month futures contract traded on NYMEX (plus or less a differential), with delivery in different varieties and

quantities at Cushing (Oklahoma) through pipelines, or through an index for sour crude published by Argus (Argus Sour Crude Index, ASCI),⁷³ the spot price of Brent blend (Dated Brent, published by Platts) is a more complex assessment that is based on transaction data, forward contracts, and non-publicly available information linked together by several financial layers. Additionally, as Brent is mainly a seaborne crude oil, the standard delivery of a Brent shipment is 600,000 barrels so participation in the underlying market is limited to big players, even though other contracts are often made available separately for delivery in lower amounts. To ensure constant liquidity in the underlying physical market, the calculation of Brent price at delivery was expanded in 2002 to two other North Sea markets (Forties and Oseberg) and in 2007 to Ekofisk (with Oseberg, two Norwegian oil fields). Identifying the spot price of these different key regional crude oils is more complex and is typically done through financial layers comprising prices of forward contracts and related financial instruments. These separate layers have been developed to improve the efficiency of hedging price risk and to make the market more liquid.

As a result of the seaborne nature of Brent crude’s physical delivery, which requires the predisposal of a schedule for delivery in the following month, there are at least three interlinked markets in addition to the other derivatives and CFDs built around them:

 Brent futures contracts (traded on ICE).

 25-day Brent forward (the ‘paper BFOE market’).

 Dated Brent (published by Platts).

Futures contracts on Brent are traded on ICE in London with expiry dates of up to seven years and daily settlement based on a weighted average of traded price over three minutes at a specific time of day. When the contract reaches the expiration date, the investor can notify (within one hour) whether he/she wants to cash-settle (as happens in 99% of the cases) at the ICE Brent Index price for the day following the last day of the futures contract. The index is calculated on data collected from the forward market that is linked to the futures contract.⁷⁴

If the trader opts for physical delivery, a sort of exchange of futures for forward delivery will apply.⁷⁵ First, when the contract expires the month before the delivery month (on the 15^th day of the month before the delivery month for the old ICE futures contract), the futures contract becomes a forward BFOE OTC contract with delivery in the next month but without a precise date of delivery (a loading schedule within a 2-3 day range). The producers should then forward a notice for the delivery schedule of the commodity to the buyers (holding the forward) to announce the final date of loading of the commodity onto a vessel provided by the buyer at the North Sea terminal. In the meantime, the forward contract can be traded OTC by the holder in a market that has very few participants, with prices assessed by PRAs⁷⁶ and a very high lot size for each contract (the standard size is a cargo of 600,000 barrels). When the notice arrives, the forward contract becomes a Dated Brent physical contract (wet crude), because the date of loading is scheduled, which gives valid legal possession over the oil lot. Otherwise, the forward contract can also be netted out before (cash settlement). Originally, the notice had to arrive at least 15 days before delivery. This is why the old futures contract expiration

73 In recent years, the Argus Sour Crude Index has emerged as a benchmark for US crude oil imports from Saudi Arabia, Kuwait and Iraq. It is a daily volume-weighted average price index of aggregate deals done for three

75 It is a similar concept to the standard exchange of futures positions for physical transactions (EFPs), which is typically done before expiration date between a party that wants to transform its position in a physical holding and another one with a matching physical position that wants to have a long position in futures markets instead.

76 “Reflecting the value of a cargo with physical delivery within the month specified in the contract.” (Platts, 2013, p. 2)

is on the 15^th day of the month before the delivery month,⁷⁷ in order to allow up to the full following month for delivery.

However, this notice period has widened over the years to the current 25 days, in line with the changes to the evaluation window made by Platts for the underlying spot price (Dated Brent) because of the limited liquidity in the underlying market and the risk of squeezes.⁷⁸ The daily assessment of the 25-day forward BFOE is done through the Market on Close methodology,which takes into account only trades with specific characteristics (e.g. firm bid and offers or completed transactions) collected all day long are put together 30 minutes before the end of the trading day (Platts 2013). In these 30 minutes, only adjustments to submitted bid and offers are allowed, in line with Platts’

incrementability and repeatability guidelines.⁷⁹ The final price assessment, which reflects end of the day value, is finally published at 16:30 hours (depending on location).

To meet the change to 25 days in the assessment window and so to support the expansion of the notice period to at least 25 days before delivery, ICE has introduced a new futures contract (Brent NX), which expires on the 25^th calendar day preceding the first day of the futures contract month to meet developments in underlying markets. However, the old contract (15^th day) is still very liquid and it will take some time to replace it. The new assessment of the physical price (Dated Brent) is based over a 10- to 25-day window assessment of end-of-trading day prices of trades of BFOE cargoes collected by Platts with relevant criteria for liquidity purposes (average size, etc.), expands the set of physical transactions that are part of the assessment (about two cargoes of 600,000 barrels), and also changes the 25-day BFOE forward (as its secondary trading is based on the new Dated Brent price). The delivery time (with the new Dated Brent) in the following month for the old futures contract might be now less than 20 days.

Nevertheless, rather than a pure physical transaction, the Dated Brent should be more accurately seen as a forward contract with delivery between 10 and 25 days ahead (Downey, 2009).

Dated Brent will be a floating price even during the delivery window. The divergence with the first month futures contract shows some seasonal patterns, since the delivery point is regularly under maintenance every year, but the spread has been widening in general in recent months, as liquidity of underlying physical remains a concern for the market (Figure 56).

On a particular date, the price of Dated Brent will reflect the price of oil delivery between 10 and 25 days ahead, and will roll over one day every day. For instance, on September 28^th, the price will reflect delivery between October 7^th and 21^st. During the loading window (at least three days) and from 25 days before, the buyer will be exposed to the floating Dated Brent price with no possibility to fix the price by buying the corresponding BFOE forward for that month (already expired). The best way to hedge would be to buy the following forward month (fixed price, implied 25 days), but there would still be exposure to basis risk between the BFOE forward and Dated Brent.

In this case, another financial layer comes into play. Contracts for Difference (CFDs) allow the buyer to receive the price of the Dated Brent in exchange for the next-month forward price (a swap), so the total cost for the buyer will be the forward month at the day in which he/she wanted to hedge plus or minus the differential between the forward (held by the buyer) and the Dated Brent at the day of delivery. Whether a buyer is receiving physical delivery of a futures contract or is purchasing it himself, he would eventually need to get into a CFD to hedge basis risk at delivery date. The alternative can be a Dated to Front Line (DFL) contract, which is a swap between the Platts Dated Brent and the ICE Brent futures front-month prices. However, most of the transactions involve forwards, as they are seen as a closer approximation of the final Brent spot price (dated). Being based on an OTC market, with few traders and significant trade size, the transparency of such transactions is

77 See Fattouh (2011) for the analysis of slink

78 On 6^th January 2012, Platts changed the timing window for North Sea crude cargoes (each cargo is 600,000 barrels) in its Dated Brent benchmark calculation from 10-21 days to 10-25 days ahead. This means that the physical price is estimated in a window of days up to 25, which would include two additional cargoes to the assessment.

79 For a more detailed explanation of the Market on Close (MOC) methodology, please see Platts (2013), p. 6.

low and trades are not linked to a system for the immediate delivery of the commodity or to inventories of BFOE oil.

Figure 56. Dated Brent vs. Brent first-month futures contract intermonth spread (bbl), 2011-2012

Source: Platts.

Brent can be delivered in any of the four grades and the Forties quality is usually delivered, which is cheaper with a 44° API. PRAs publish the ‘de-escalator’, to discount the lower quality grade from the final price. Quality of delivered crude oil comes with the notice of the loading schedule.

Finally, there is another kind of price transformation that is regularly used for pricing of physical transactions. For instance, exports pricing of oil to Europe (and also sometimes to other regions) from Saudi Arabia relies on a Brent futures weighted average price of all trades (BWAVE), published on a daily basis.

Box 5. Price reporting agencies (PRAs) in crude oil price formation mechanisms: the right of judgement Behind the complex interaction between futures and forward contracts lies the important role of price reporting agencies (PRAs) in assessing prices for key underlying physical markets. Over the years, PRAs have been an important tool for providing greater transparency in physical commodities markets where there are no legally binding transparency obligations for counterparties. Their price assessments have also helped price formation in adjacent futures markets when illiquid market conditions emerged.

Recently, their role in some crude oil prices has been attracting considerable attention. At the November 2010 G20 summit in Korea, leaders called for a more detailed analysis on “how the oil spot market prices are assessed by oil price reporting agencies and how this affects the transparency and functioning of oil markets” (IEA et al., 2011, p. 6). In an earlier report in 2009, IOSCO recommended that “futures market regulators should encourage private organisations that collect relevant fundamental commodity information to adopt best practices and should evaluate what improvements are appropriate to enhance fundamental cash market data and develop recommendations for improvements” (IOSCO, 2009, p. 12).

In particular, to address the core concern about price assessments using information that may not reflect cash markets, IOSCO (2012) has called for measures to enhance the transparency and integrity of such tools. Notwithstanding that methodologies to collect information and assess prices vary among markets to reflect differences in product characteristics and interaction between supply and demand, a set of common standards and best practices could be harmonised across the PRA industry.

Combining data reliability, transparency and enforcement in an environment in which there is no legal obligation, so information is instead disclosed by companies on a voluntary basis, requires sound policies. In illiquid market conditions, PRAs may need to exercise careful editorial judgement to avoid rumours or market expectations based on low-quality information feeding into their price assessment when an insufficient number of arm’s length transactions is available. “In the event of a wide bid/offer spread, Platts will not average the bid and offer. Platts will evaluate market conditions and establish an assessment that in its editorial judgment reflects the transactable level of Dubai and Oman.

Unusually high or low price deals will be scrutiniSed by Platts to discern whether the deal is fit for assessment purposes.” (Platts 2013, Dubai-Oman price assessment methodology, p. 15). In effect, PRAs such as Argus only exercise judgement when limited information is available about confirmed transactions. Actionable bids and offers, and other market data such as spread trades to include spread values between grades, locations, etc. (see Argus, 2013), would feed price assessments. Editorial judgement using available market data relies on a strict application of a methodology that should protect the assessment from the improper influence of market rumours, even if it may rely on transactions carrying lower quality information (such as spread trades based on arbitrage or outlier transactions). To ensure that judgement is impartial and accurate and the information disclosed voluntarily by companies is true, tests are usually applied to confirm the details of the transactions and their alignment with normal trading behaviour. Tests would also make sure that participants and the justifications behind trading actions are credible. Conflicts of interest policies, in addition, are typically adopted to create an environment of sufficient impartiality.

Like credit rating agencies, PRAs work in reputational markets that already provide incentives to comply with high quality standards. However, internal enforcement of methodologies requirements and external enforcement on the quality of information voluntarily disclosed by commodities firms might be a complex task that requires a minimum set of legal obligations. All entities that produce an assessment of prices (based on judgment) to be used for actual transactions should comply with common standards.

Full transparency of methodologies, governance, and access to underlying data become crucial aspects for regulators to ensure the smooth functioning of the market. A regulatory framework for the provision of price assessment services and for the reliability of the information that firms are voluntarily disclosed (e.g. market manipulation rules in the case of false or deceiving information) might ensure effective supervision by reducing monitoring costs and creating ‘public accountability’ for the performance of price formation mechanisms. Harmonised standards, through a common set of guidelines that may be voluntarily adopted or become listing requirements for products based on price assessments (IOSCO, 2012), appear to be a viable compromise to ensure reliability of benchmarks administrators, calculators, and publishers for submitters that want to avoid liabilities in the use of their data. However, legal obligations should be appropriately weighted to avoid prices assessed by PRAs becoming legally binding mechanisms of price formation. The voluntary nature of the disclosure by commodities

Full transparency of methodologies, governance, and access to underlying data become crucial aspects for regulators to ensure the smooth functioning of the market. A regulatory framework for the provision of price assessment services and for the reliability of the information that firms are voluntarily disclosed (e.g. market manipulation rules in the case of false or deceiving information) might ensure effective supervision by reducing monitoring costs and creating ‘public accountability’ for the performance of price formation mechanisms. Harmonised standards, through a common set of guidelines that may be voluntarily adopted or become listing requirements for products based on price assessments (IOSCO, 2012), appear to be a viable compromise to ensure reliability of benchmarks administrators, calculators, and publishers for submitters that want to avoid liabilities in the use of their data. However, legal obligations should be appropriately weighted to avoid prices assessed by PRAs becoming legally binding mechanisms of price formation. The voluntary nature of the disclosure by commodities