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Brent Benchmark's Radical Overhaul Is Necessary

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Brent is the key global oil benchmark and also one of the most complex commodity markets in the world, thanks to its unique history. It could become even more complex if proposals for a radical makeover are accepted. But that is the price to be paid if the benchmark is to remain liquid — preserving the value of existing contracts in various Brent derivatives on and off the exchanges. The problem is that physical Brent production has been falling and now there are only a couple of cargoes loaded in any month. The best available solution comes with the surge in US crude exports to Europe, and in February this year, S&P Global Platts announced the latest proposal to shore up the Brent contract by introducing West Texas Intermediate (WTI) Midland into the basket. With a quality close to that of Ekofisk and a diversity of buyers and sellers, the grade is an obvious choice for inclusion into the Brent contract. That should more than double the volume of oil deliverable and could be a long-term solution for the benchmark.

The Brent futures prices we commonly see on “screen” are a product of evolution, with roots in the forward Brent market which has been evolving since the late 1970s and early 80s. Brent contracts developed because the British fiscal regime encouraged trading of forward cargoes by major oil companies to optimize taxation. Such trades created “daisy chains” and a peculiar nomination procedure for physical Brent, in which the seller passed on the loading dates (creating cargoes of "dated" Brent) to the buyer. Some “dates” or loading windows were more valuable than others which spurred trading in both physical “dated” cargoes and swaps or contracts for difference (CFDs), reflecting different values of oil loading on different dates.

The interplay of forward, futures and dated Brent prices is expressed in a plethora of traded derivatives such as CFDs, “dated to front line” swaps (DFLs), “exchange of futures for physical” (EFPs), and others. This complexity has allowed for different price risks to be fully hedged in liquid markets and even helped the assessment of the value of dated Brent itself.

Falling Volumes and Liquidity

However, Brent production has been falling and now there are only a couple of cargoes loaded in any month. Other sweet North Sea grades have been added to the basket over time to increase volume. In 2002 Forties and Oseberg were incorporated, Ekofisk followed in 2007 and Troll in 2017. Additionally, the “window” of cargoes considered when assessing dated Brent has been widened, from the original 7-15 days, to 10-21 days, then 10-25 days in 2012 and finally one month ahead in 2015. ICE correspondingly changed the maturity of the Brent futures contract in 2016. Other measures taken to improve liquidity were the acceptance of ship-to-ship Brent cargoes at Scapa Flow, Scotland, in 2001 and the inclusion of c.i.f. Rotterdam cargoes into the dated Brent assessment from 2019.

Despite all these efforts, the “Brent basket” grades of Brent, Forties, Oseberg, Ekofisk and Troll (BFOET) currently produce only around 700,000 barrels per day and are expected to fall further. One mooted solution to boost the liquidity of Brent was to add Norwegian Johan Sverdrup (JS) into the “basket.” In 2021, JS was producing over 500,000 b/d, making it the largest crude stream in the North Sea. By the end of this year production is forecast to be over 700,000 b/d. However, the quality of JS is significantly different to the other grades in the “Brent basket.” While its sulfur content of 0.8% is not dissimilar at times to Forties, its API gravity is 28º — 10º lower than BFOET, raising the risk of the Brent benchmark becoming heavy and sour.

Market concentration is another concern. Equinor is the largest shareholder in JS. If you include Equinor’s equity in Troll, Oseberg and Ekofisk, the company could hold a dominant position in the Brent trade. Until the invasion of Ukraine by Russia, the majority of JS was sold delivered to Asian customers. Very few cargoes changed hands in Northwest Europe. All these factors worked against JS as a suitable addition to the “Brent basket.”

At the same time, the volume of US crude arriving to Europe has ballooned. As the graph shows, the volume of all US imports into Europe started to exceed the production of “Brent” deliverable grades from 2019. A couple of years later, WTI Midland imports into Europe alone generally exceeded BFOET production. WTI midland is a well-known and accepted grade for European refineries, both in the Northwest and the Mediterranean. The quality is well established and sets it apart from the “WTI blends” of condensates and Canadian heavy oil, made in and around Cushing, Oklahoma, and deliverable into the Nymex (CME "CL") light crude oil contract. At 42º API and 0.2% sulfur, WTI Midland has a quality close to that of Ekofisk (39º API and 0.2% sulfur). Finally, a diversity of buyers and sellers of this grade make it an obvious choice for inclusion into the Brent contract.

The Latest Proposal

In February this year, S&P Global Platts announced the latest proposal to shore up the Brent contract by introducing WTI Midland into the basket, with all the grades to be assessed on an f.o.b. basis. Since WTI is generally offered on a delivered basis, it must be netted back to an f.o.b. basis, and to make an easy comparison, this is done as if it was loading in the North Sea. So, the trans-Atlantic freight is deducted from the delivered price in Rotterdam and North Sea freight is added instead.

However, the latest proposal is a little more complicated than that. For dated Brent, a freight adjustment factor (FAF) is introduced. For BFOET, the f.o.b. price is assessed by deducting 80% of the assessed freight, while for WTI Midland, a 40% FAF is proposed. The rationale for the 80% FAF is the loss of optionality for a c.i.f. buyer with a 20% discount on the freight compensating for that. Proposed, as an initial suggestion, the 40% FAF for WTI Midland is to prevent the grade dominating the dated Brent basket. But, with volumes of US exports gradually rising and the war in Ukraine shifting Russian Urals crude outside the region, WTI Midland is likely to dominate Brent anyway. For the forward Brent contract, there would be no FAF, and freight would be compensated by the seller to the buyer at a full 100%.

Since the US crude is shipped to Europe in parcels about 700,000 barrels, the proposal is to shift the BFOET grades to the same cargo size. This change will reduce the number of BFOET cargoes by about five, at current production, but it could gain at least 20 cargoes of WTI Midland. And to keep WTI Midland in line with the rest of the BFOET grades, only cargoes loaded at terminals with published loading programs — vetted and accepted by S&P Global — will be accepted for assessment.

Some players may rue the loss of optionality to move their loading dates once the loading programs are published, but the perceived premium associated with the ability to place oil in the Brent benchmark should make up for that. Terminals loading WTI Midland in the US Gulf should also be keen to meet S&P Global approval requirements and publish acceptable loading programs, as oil deliverable in the key global oil contract has more value.

Adi Imsirovic is author of the book Trading and Price Discovery for Crude Oils, published by Palgrave McMillan in June 2021. He is a senior research fellow at the Oxford Institute for Energy Studies (OIES), and a former global head of oil at Gazprom M&T in London. Kurt Chapman is an independent consultant based in London, and a former global head of crude oil trading at Mercuria.

Topics:
Oil Futures and Derivatives, Oil Trade, Oil Spot Markets
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