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Concerns are mounting that $100 oil prices, if hit, could be enough to dislodge the precarious global recovery — thrusting the world economy back into recession, or even worse, into another global financial crisis.
But while that is certainly a legitimate worry, there may actually be another equally pressing one rearing its ugly head too.
We’re talking about what happens if volatility in the WTI-Brent spread doesn’t settle.
Those volatile spreads
As we’ve been reporting, the spread has in the last two years become increasingly erratic. This is due mostly to problems associated with the West Texas Intermediate delivery point at Cushing, but more recently also a reduction in the number of Brent, Forties, Oseberg, Ekofisk (BFOE) cargoes, which determine the spot price of Dated Brent, against which Brent futures are settled.
As the Intercontinental Exchange’s own methodology explains regarding its cash settlement process:
The ICE Brent Crude futures contract is a deliverable contract based on EFP delivery with an option to cash settle, i.e the ICE Brent Index price for the day following the last trading day of the futures contract.
The Exchange issues, on a daily basis at 12 noon local time, the ICE Futures Brent Index which is the weighted average of the prices of all confirmed 21 day BFOE deals and qualifying intra day assessments for the previous trading day for the appropriate delivery months..
So anyone who has the means to control a big slice of the BFOE market, has tangentially the ability to influence global oil prices too — especially as Brent prices come to trade ever more consistently over WTI, despite the lower quality of the barrels.
The volatility of the spread has now reached such highs that Olivier Jakob, an analyst at Petromatrix, speculates exchanges may want to raise margins on WTI-Brent spread related products soon.
And as he also wrote in his Wednesday note, there are other issues too:
Volatility on the Brent/WTI spread is starting to be greater than on flat price and if that trend continues there will be a risk down the line that the exchanges are forced to increase the margins on the Brent/WTI spread. With Brent getting more attention these days than WTI the CME is taking off all fees for those that want to trade Brent on the CME rather than on ICE.
Russian crude oil is trading at deeper discount to find any takers in Europe, cargoes from Latin America are starting to be priced to come to the old continent where refineries will start to go under maintenance. Brent might be closer to 100 $/bbl than WTI and that might attract some momentum traders that want to print the magic number but we still do not see how the European crude oil market will be able to sustain the current premium to other regions. Oman has started shifting back to a contango structure and a small contango has replaced a small backwardation in Brent. All the main futures markets (combined crude and products) are now in a prompt contango (but still very shallow in Brent).
To translate, it seems the scale of the Brent premium may be unjustified by the wider fundamentals — and this is the reason why other crude markets and arbitrage windows are being disrupted to such a degree.
So yes. Brent definitely seems too have its problems too.
Yet, WTI is also about as useful as a chocolate oven-glove.
From broken benchmarks to new ones
And herein lies the crisis point. The world’s two main oil benchmarks appear to be broken, and in need of urgent fixing or adjustment to stop them from being mispriced. One is land-locked and clogged. The other is suffering from the consequences of too little supply. However, no viable alternatives currently exist to take their place; and financial flows continue to pour in.
So could a completely new benchmark be the solution?
Most market experts, it turns out, would say no.
For a start, any internationally respected oil benchmark has to match certain criteria. Above all: quality, volume, independence, transparency and consistency.
Finding a crude blend that can do that is not so easy. There really isn’t enough independent light sweet crude in the world.
For example, the quality issue rules out most Opec and Russian crudes. The volume issue, meanwhile, rules most other light sweet barrels in the market (such as Mars, LLS, Azeri) — since there’s simply not enough of them to ensure specific players won’t try to dominate pricing. Independence and transparency, meanwhile, rules out most of the other lighter Opec barrels.
Which only leaves Dubai-Oman crude.
On the surface of it, this is not such a bad candidate.
For one, it’s already traded as a future on the Dubai Mercantile Exchange. Oman is also not an Opec member and, what’s more, its production volumes are considerable.
Furthermore, the future is drawing liquidity. The DME reported last week that the exchange saw a 35 per cent increase in volumes traded on its exchange in 2010, as well as record open interest.
That said, you can’t ignore its one major downside. It is a sour medium-grade crude.
For many, that makes it a non-workable alternative.
The battle over benchmarking
But where does that leave us in the event that the price-discovery mechanism of both WTI and Brent does fail? That is, if prices become so disconnected with the wider physical fundamentals that commercial and physical players stop using the benchmarks for hedging purposes altogether?
Unfortunately, and very probably, at the whim of one of the most powerful cartels in the world.
Opec has arguably been less relevant over the last few years, this is true. But this is only because plain old output adjustments have not been enough to influence run-away free-market prices. Hence Opec’s obsession with blaming speculators for rising price trends. Just this week, Opec Secretary General Abdalla Salem-El-Badri explained that the cartel would remain steadfast in the face of $100 per barrel oil and not raise production quotas exactly because of this speculator effect.
Of course, if the market did lose faith in WTI and Brent, you can bet the cartel would act quickly and decisively to fill the pricing void, with the global oil price having no choice but to fall back under its control. An oil shock 2.0, so to speak.
An unexpected benchmark candidate?
With the only alternative to market chaos being complete Opec price-control, other less perfect crudes do suddenly come back into the running as benchmarks however.
For example, the market should not underestimate Russia’s long-term plans for its brand new ESPO blend.
As Dow Jones reported on Tuesday:
BEIJING -(Dow Jones)- Russia’s new ESPO blend of crude oil, a rising star in Asian Pacific oil markets, may become a regional oil benchmark, although in the short term, volumes available internationally might fall, the International Energy Agency said Tuesday.
Since Eastern Siberia crude deliveries started in 2010 via pipeline from Taishet to Skovorodino and transported via railway to its outlet at Kozmino on the Sea of Japan, a regular clientele–including Chevron Corp. (CVX), Exxon Mobil Corp. (XOM), BP PLC (BP), Total SA (TOT) and Royal Dutch Shell PLC (RDSB)- -was built up, with the crude shipped to Japan, South Korea, China, Thailand, Singapore, the Philippines, Indonesia, Taiwan, Vietnam and as far afield as the U.S. West Coast, the IEA said in its January Oil Market Report.
The ESPO blend is sourced from Russia’s arctic fields (yes, the ones BP is investing in) and is a much better quality grade than other Russian crudes. In fact, Rosneft officials like to compare the quality to Dubai-Oman — which is mainly a medium-sour grade. Although, as Dow Jones reported, ESPO might end up being even better than that:
ESPO blend’s popularity among Asian and U.S. refiners is underscored by its widening premium to Dubai crude over the past six months, with another record posted in December, it said.
Now, if ESPO and Dubai-Oman are really being groomed to become the global benchmarks of the future — doesn’t BP’s Rosneft move suddenly make a helluva lot of extra sense?
Related links: Brent's got its problems too "“ FT Alphaville "?WTI about as useful as a chocolate oven-glove' "“ FT Alphaville Oil traders look to James Bond-style data collection "“ FT An unjustified WTI distortion? "“ FT Alphaville
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