Brent Market Discussion Note
9th January 2017
The Problems with Brent. 3
Propping Up the Status Quo. 4
Kicking Away the Crutches- the Consilience Proposed Brent Methodology. 5
An Important Principle. 6
Quality Adjustment: the Current Problems. 6
Compensation for Quality Variations: Precedents and Off-the-Shelf Solutions. 7
Freight Adjustment: A New Factor. 8
What Might a New 30-Day Brent Contract Look Like?. 10
There is more to Price Differentials than Quality and Freight. 11
Who Owns the Brent Issue?. 11
The Problems with Brent
The international oil community uses an oil price benchmark, Brent, which sets the price of physical, forward, futures, swaps and options contracts throughout the world. Brent has been on a declining production trajectory for more than 20 years exposing it to potential price squeezes and manipulation, the impact of which is magnified by the number of contracts that are calculated using formulae that refer to one of more of the Brent price indices.
To shore up the number of physical cargoes available to inform the price-setting process the industry has added alternative grades of oil that can be delivered if Brent availability is squeezed so that its price exceeds its reasonable market value, as evidenced by the price of competing grades. Hence we now have a Brent basket– currently Brent, Forties, Oseberg and Ekofisk (BFOE)- to boost the number of cargoes that can be delivered into the 30-Day BFOE forward contract and to inform the physical, wet cargo Dated BFOE price discovery process.
There are a number of problems with this existing situation:
The production content of the BFOE basket has continued to decline such that there is a prospect of the price again becoming open to manipulation. More production needs to be added to the basket to augment the deal evidence on which price assessments are based.
As the existing BFOE basket demonstrates, the more dissimilar are the grades of crude oil added to the basket, the less keen are companies to trade the contract without some form of adjustment to compensate them when they have to give or receive delivery of Forties, Oseberg or Ekofisk, rather than Brent.
Forties is much higher in sulphur than the other three grades that can be delivered into the 30-Day BFOE contract and therefore it usually has the lowest price. So if a trader buys a BFOE cargo it is likely to receive a Forties cargo. The forward contract provides that the trader will be compensated for the higher sulphur content of Forties compared with Brent, Oseberg or Ekofisk, in accordance with a sulphur de-escalator price adjustment formula set by Platts. There is no corresponding sulphur escalator applied if a Forties cargo with an unusually low sulphur content is supplied, for example when the high sulphur Buzzard field is shut in for maintenance or other reasons and does not therefore form part of the Forties Blend stream temporarily.
Leaving aside the sulphur price de-escalator, Forties is still usually the cheapest grade in the basket of four and is therefore the grade that is normally delivered into the 30-Day BFOE contract. A rational supplier will always deliver the cheapest grade possible when it has the option to do so. But sometimes there is not enough Forties available to deliver because a number of refiners actually like to refine it and do not want to use it to supply 30-Day BFOE contracts. Unfortunately standard economics break down at this point and the price of Forties does not go up when Forties is in short supply. If the price of Forties went up in such circumstances Forties would no longer the cheapest grade in the basket. In which case, logically, Brent, Oseberg or Ekofisk would be delivered instead of Forties. But in the peculiar world of the BFOE basket an additional quality price premium has to be applied to Oseberg and Ekofisk to incentivise producers to supply those grades when there is no Forties available. This quality premium is set by Platts. In other words, when Forties is in short supply its price doesn't go up. So instead of market forces rationing the supply of cargoes in accordance with their price, Platts provides a quality premium assessment to restore the true difference in value between Forties and Oseberg and Forties and Ekofisk. This is one of the troubling flaws at the heart of the BFOE basket methodology.
There is no equivalent quality premium applied to incentivise the delivery of Brent when there is no Forties available. This is explained away as Brent being the “label” on the contract, Brent is what was expected to be delivered absent any shortage of Brent Blend at Sullom Voe. The original plan was that Forties, Oseberg and Ekofisk would only be delivered if Brent was squeezed. The quality premia that actually apply in the 30-Day forward contract are quality premia set by reference to the cheapest grade in the basket, which is typically Forties, not Brent. This is a further flaw at the heart of the BFOE basket methodology.
These are the issues that are undermining the liquidity and the reliability of the Brent suite of contracts that have historically made Brent a benchmark grade of oil.
Propping Up the Status Quo
Platts has initiated a consultation on the possibility of adding Troll to the Brent basket some time in 2017. Consilience is all for the introduction of Troll, now that it has been confirmed that its quality will not be downgraded by commingling with Johann Sverdrup, a future Norwegian giant field with considerably poorer quality than Troll or any of the BFOE grades. We expressed this opinion back in 2014 in our study entitled “The Brent Oil Price Marker: Future Prospects”.
The downside of introducing Troll to the basket is that, because the large volume of Johann Sverdrup, which reaches landfall at Mongstad, (the port from which Troll is exported), will not be added to Troll Blend, Troll's contribution to the number of cargoes in the BFOE basket will be insufficient to provide a lasting solution to the problem of the dwindling cargo pool available to inform the benchmark price-setting process. It is just another band aid on a broken leg.
Platts is also teeing up Norwegian Aasgard and Alvheim to be the next generation of cargoes that might be added to the basket in future when production dwindles some more. It is doing this by beginning to publish oil price quotations for those two grades from 1st February 2017.
There is no harm in quoting another couple of grades in Platts' publications, except that it puts the cart before the horse. The reason we do not currently have standardised published price quotes for these grades is that they are not actively traded. And if they are not actively traded, why should we consider them as candidates for inclusion in the BFOE basket and the benchmark price formation process?
Flotta Gold (the old Flotta with Golden Eye commingled into the blend) is another obvious candidate for inclusion and it is surprising that it has not yet been added to the BFOE basket. Flotta used to be too heavy and too sour for inclusion in the light, sweet BFOE basket. But it's new, improved quality, combined with the ongoing deterioration of Forties Blend quality as Buzzard forms an increasing proportion of remaining production, makes Flotta Gold of not significantly worse quality than the current Forties Blend.
The stumbling block in adding Flotta Gold to the basket might be the significant shift in the balance of power in price setting amongst the larger oil and trading companies if Flotta were to replace Forties as the least valuable grade in the basket: the price of Dated Brent each day is set by the cheapest of the basket grades. Including Flotta Gold in the benchmark basket would catapult it straight into the regulatory limelight as it would be, de facto, the new Dated Brent. We have discussed long and hard in previous publications how many contracts around the world are influenced by the price of Dated Brent, so this would be a more significant step than it might at first appear.
Faute de mieux, as more and more increasingly disparate grades get added to the BFOE basket an accurate assessment of the size of the Forties sulphur de-escalator and of the Oseberg/Ekofisk quality premia will become increasingly important. This is particularly so for sulphur as the world will become increasingly short of desulphurisation capacity in the light of radically reduced limits on the sulphur content of marine fuel from 2020.
The stage is also being set for the inclusion of grades of crude oil that are delivered outside the North Sea into what has hitherto been a North Sea BFOE basket. This raises the spectre of more quality and freight adjustment factors being set and applied to grades from further afield when they are delivered into the 30-Day BFOE contract and used to assess the price of Dated Brent.
Kicking Away the Crutches- the Consilience Suggested Brent Methodology
The addition of any of the four grades mentioned above –Troll, Aasgard, Alvheim and Flotta Gold- to the BFOE basket, if accepted by the market, would do no more than maintain the unsatisfactory status quo a bit longer.
What we need is a recognition that Brent, Forties, Oseberg and Ekofisk are all on a declining production profile and over time any new grades that are added will decline too. As replacement grades get added to the basket over time the question of proliferating quality premia, and possibly later, opaque freight adjustment factors will have to be addressed. So too will the question of to which base price these premia should be applied if Brent is gone and some grade other than the suspiciously rigidly-priced Forties is the least valuable grade in the basket.
This is not an ideal world, and there is no perfect solution, but here is an outline of a pricing system that could be made to work if vested interests were set aside, or in response to regulatory pressure.
Set a reference quality for Brent system crude oil either from a widely publicised assay of typical production quality delivered FOB Sullom Voe Terminal or from a hypothetical Brent quality that would survive the cessation of actual Brent production (the Brent Standard). This would be the base quality represented by the Dated Brent price quotation and the base case Brent quality to be delivered in the 30-Day BFOE contract;
Set quality limits for the alternative grades of crude oil that price reporting agencies (PRAs) can consult when assessing the price of Dated Brent or that can be delivered into the 30-Day forward Brent contract;
Set distance limits for the alternative grades of crude oil that PRAs can consult when assessing the price of Dated Brent or that can be delivered into the 30-Day forward Brent contract;
Apply a price adjustment depending on how much the quality of the grade actually assessed or delivered diverges from the Brent Standard quality, within the permitted limits;
Apply a price adjustment depending on how much the location of the grade actually assessed or delivered diverges from the Brent Standard location, i.e. Sullom Voe, relative to the centre at which it is refined. (This is explained in more detail later under the heading “Freight Adjustment”.
This would put an end once and for all to any suggestion of a squeeze because, if there were to be any attempt to “corner the market”, any grade of oil within the permitted quality and distance limits could be included when the PRAs are assessing the all-powerful Dated Brent price quotation and when short sellers of 30-Day Brent came to cover their positions. The PRAs could look at deals in any grade within the permitted quality and distance limits and adjust its price to a Brent Standard equivalent using the recognised industry adjustment methodology contained in the Brent forward contract.
To make this concept workable some discussion of details is required.
An Important Principle
Any attempt to change the status quo will be met with howls of protest along the lines that the new version is not how “real traders actually trade” and the suggestion made above is no different.
The concept of the basket originally attempted to achieve a solution to Brent squeezes of the type that proliferated in the 1980s and 1990s. If Brent was squeezed its price went up and one of the three alternative grades would be cheaper to deliver, thereby breaking the squeeze. We should not lose sight of the fact that that is still what we are trying to achieve.
Quality Adjustment: the Current Problems
The grades of crude oil in the current BFOE basket are broadly similar, but not identical, in quality. They are sufficiently different that if a refiner were to buy Brent it would not be indifferent if Forties, Oseberg or Ekofisk were to be delivered. But the original BFOE contract assumed that a refiner would be indifferent to which of the four grades was actually delivered because there was originally no price differential applied if an alternative grade was delivered.
However, consider the circumstance where a refiner buys a 30-Day BFOE forward contract with a view to running Brent in its system to produce, say, lube oil. If the Brent forward contract was squeezed, perhaps Ekofisk might be delivered instead of Brent. It was not anticipated that the refiner would actually run Ekofisk, which is a predominantly gasoline crude, in its refining system. It was understood that the refiner would sell the physical Ekofisk cargo and buy either an unsqueezed Dated Brent cargo or a cargo of another lubes-approved grade entirely.
As indicated above, the forward contract was based on the assumption that sellers would act rationally and would not supply, say, Ekofisk unless Brent was subject to a squeeze that inflated its relative price artificially. So the lack of a price adjustment for alternative grade delivery initially was not deemed to be a stumbling block to the efficient operation of the contract.
This was fine up until 2007 when the high sulphur Buzzard field devalued Forties Blend and a Forties sulphur price de-escalator had to be introduced. Inevitably different refiners each have their own views on at what level the sulphur price de-escalator should be set: this will vary depending on how much desulphurisation capacity is available at each refinery.
Nevertheless players in the 30-Day BFOE market have been reconciled to allowing Platts, a PRA, to determine and announce the value of the sulphur price adjustment factor. Those who did not accept Platts' assessment of the sulphur de-escalator exited the 30-Day BFOE market.
Then, as indicated above, owners of Oseberg and Ekofisk cargoes stopped delivering those grades into the 30-Day BFOE contract, even when there was insufficient low quality Forties or scarce Brent around. The fundamental economic principle that when a commodity is in short supply its price goes up, does not happen to the 30-Day BFOE contract. Sellers require a further incentive not provided by free market forces to encourage them to deliver Oseberg or Ekofisk. This incentive is given in the form of a quality premium the extent of which is again set by the PRA, Platts.
Again different refiners each have their own views on at what level these quality premia should be set: this will vary depending on how much separation, treatment and upgrading capacity is available at each refinery. Those who did not accept Platts' assessment of the quality premia again exited the 30-Day BFOE market.
If market forces were working perfectly it would be immediately obvious if Platts was setting the sulphur de-escalator or the quality premia too high or too low because there would be a rush to deliver over-valued elements and a dearth of deliveries of under-valued elements. But the market is imperfect and is not providing these clear signals. These imperfections will be exacerbated if more diverse grades are added to the basket.
The solution suggested here is to adopt a more mechanistic approach to setting grade differentials amongst a wider range of grades that qualify for inclusion in the basket using a Value Adjustment Mechanism/Quality Bank methodology explained below. But which mechanism to choose?
Compensation for Quality Variations: Precedents and Off-the-Shelf Solutions
There would be no need to re-invent the wheel to achieve an acceptable price adjustment mechanism to compensate for differences between the quality of the Brent Standard and the quality of an alternative grade that is actually delivered: most blended grades of crude oil are subject to some form of value adjustment mechanism (VAM) that compensates or penalises companies inputting crude oil to a pipeline for any change in quality between the crude input at the start of the pipeline and the blended crude re-delivered at the other end of the pipeline.
Some VAMs compensate by adjusting the number of barrels attributed to a party, giving more to companies whose oil quality has been degraded and less to companies whose oil quality has been improved. In other VAMs, typically called Quality Banks, the compensation can be achieved with cash rather than in kind. The Quality Bank methodology is more prevalent in the USA, but cash compensation is more likely to prove workable than a volume adjustment for the type of alternative grade delivery mechanism under discussion here.
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