Save for later Print Download Share LinkedIn Twitter March 2021 Philip Verleger Traders, economists and commodity exchange executives have struggled for decades to create the optimal crude oil futures contract. Although trade is brisk, available contracts are seriously flawed. Inauguration of the ICE Murban futures contract (ICE Futures Abu Dhabi, or IFAD) will probably resolve this issue. IFAD will provide buyers of internationally traded crude -- particularly from the Middle East -- with an instrument that reduces their financial risks dramatically. It will probably become the world marker, making global oil markets more competitive and reducing large producers’ market power. Ultimately, oil may become “just another commodity” like cotton or wheat. The IFAD contract’s introduction, along with other steps taken by the United Arab Emirates -- mainly Abu Dhabi -- is a huge deal. Quite simply, the contract can be likened to an insurance policy to ensure the UAE’s economic survival as a major oil-exporting country. To understand the dramatic impact, it helps to know the basics of futures markets. Although rarely acknowledged, successful commodity markets, especially futures markets, destroy economic competition, monopolies and cartels, as economics papers published over the past century attest, even though they tend to dance around the subject. "Economics of Futures Trading," written by Thomas Hieronymus in 1971, emphasizes the importance of market information. “He who would control must first conceal. If a merchant possesses information that is not available to the people from whom he buys or to whom he sells, he is in a position to reap monopolistic profits. In the cash commodity trades, some firms are very much larger than others and the larger ones can afford the expense of collecting market information while the small ones cannot.” Liquid commodity markets break down these information barriers. This levels the playing field and reduces the economic advantage large firms hold. Futures markets, however, are complex institutions. The basic conditions for markets to work are that the commodity must be homogeneous and capable of being standardized, with one unit identical to the next; supply and demand must be large enough to discourage price manipulation; the commodity must flow freely to market without artificial restraints imposed by governments or private organizations; supply and demand must be uncertain; and the commodity must be storable so that forward and futures contracting can operate. Futures markets ideally also depend on the price of a commodity’s futures contract “converging” at its expiration to the price of an equivalent item in the cash market, ensuring the seller will provide the buyer with a good that meets the commercial standards if the traders choose to go to delivery. When these conditions obtain, large and small entities can compete successfully in supplying or purchasing a commodity. Smaller farmers, for instance, can survive in a world dominated by large agribusiness firms if they can achieve the same economies of scale. Equally, smaller independent oil producers can compete with large multinational corporations or state-owned oil companies, assuming they, too, can control their costs. Futures markets, then, level the economic playing field in industries where the bigger firms do not enjoy substantial economies of scale. Storage matters. The ability to store a commodity increases the usefulness of a futures contract, not least because futures markets enable a trader to transfer supplies from the present to the future with minimal financial risk through hedging. The West Texas Intermediate (WTI) futures contract has been far more useful than the Brent contract, despite the North Sea oil market having far greater importance than the US Midcontinent market, precisely because WTI’s Cushing delivery point has storage and the North Sea delivery points do not. Founding of Futures Markets Following the US government’s deregulation of petroleum product markets in 1978, large multinationals dictated term prices to US independent heating oil and gasoline marketers -- much as they did the flow of crude oil around the world. But the US domestic system was broken when the renegades at the New York Mercantile Exchange (Nymex) were allowed to launch a heating oil contract in 1978. Within two years, it was flourishing, because buyers and sellers could see actual transaction prices in real time. Heating oil, however, remained one of the few freely traded energy commodities. No one published cash prices for crude in 1978 because a cash market did not exist. In the US Midwest, buyers such as Koch posted whatever price they were willing to pay. There was no transparency. That system, too, changed when the Nymex in 1983 introduced a crude futures contract. The market structure was slow to change, however, until the UK government intervened, breaking the entire established pricing scheme when it enacted the Petroleum Revenue Tax (PRT). The PRT was a 75% tax on incremental revenues from selling crude after cost deductions. The tax was applied to cash oil sales if production was sold to a third-party buyer or on a “deemed price” determined arbitrarily by UK tax authorities if a producer kept its oil in its integrated system. Uncertainty regarding what the deemed price might be led all producers, mostly major oil companies, to sell their oil for cash. Thus, a transparent crude market was created. Creation of the Brent cash market was followed by a forward market, and the reporting of cash trade in “dated Brent” provided an opportunity to design a futures contract. The International Petroleum Exchange did so. After several adjustments, it flourished and today is the largest single crude futures contract. However, the Brent market suffers from the lack of commercial storage at delivery locations, making the US WTI contract more important when combined open interest is considered, despite the limited volumes of WTI available. While the Brent futures contract has been extraordinarily successful as a benchmark, over time output from the Brent field has almost vanished. Peak volumes of over 400,000 barrels per day in 1984 allowed eight to 10 tanker loadings daily. Output is now less than 100,000 b/d. Dated Brent prices continue to be published, with S&P Global Platts adding other crudes to the mix from time to time to compensate, thus maintaining the perception of a physical basis for the futures contract. WTI’s disadvantage of not being an international crude has lessened with the construction of pipelines and export terminals. However, the multiple export terminals scattered along the US Gulf Coast make WTI less desirable than Murban as an international benchmark. A controversial Platts effort to allow WTI delivered to Rotterdam to be included in the Brent contract pricing mix has been deferred (IOD Mar.12'21). Murban: The Ideal Commodity Crude Abu Dhabi National Oil Co. (Adnoc), the UAE and the IFAD together create the best structure for a crude oil futures contract. Now that the UAE has lifted destination restrictions from contracts, allowing buyers to move the oil to any destination -- without the requirement retained by other Middle East producers that buyers nominate in advance specific volumes to be moved to specific refineries -- IFAD should quickly become the world marker, absent unforeseen problems. Murban’s first advantage is volume. While various estimates exist, it appears that more than 2 million b/d and possibly as much as 4 million b/d can be supplied from what are ample reserves. Murban’s second advantage is storage. Adnoc has spent more than $1 billion expanding tankage adjacent to loading jetties in Fujairah, to perhaps more than 30 million barrels. This should meet the storage criteria, especially if buyers can contract to store on occasion. Finally, Murban is the ideal crude for the growing Asian market. Most forecasts see consumption increasing in Asia while declining in the rest of the world. These buyers depend heavily on Mideast crude, not Brent. Further, Murban is very similar to Saudi Arab Light, the crude that is in the widest use. Murban is especially ideal because Indian buyers can lock in prices when they choose and thwart Saudi efforts to control the market. Equally, a Chinese refiner needing crude will be able to buy a cargo by purchasing and taking delivery under the futures contracts, without risk of an energy minister or politician deciding to cancel the contract. For these reasons, the attention of global oil traders and speculators is likely to turn rapidly to the Murban contract as a substitute for Brent and possibly WTI. Murban will also become the major price indicator for Middle Eastern oil. Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980.