“Thou shalt not kill; but needst not strive officiously to keep alive” By LIZ BOSSLEY, CEO of the Consilience Energy Advisory Group Ltd
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DESPITE THE TITLE, this article is not about the medical profession: instead, it refers to the ubiquitous oil price benchmark, North Sea Brent, which features in an estimated 70% of oil contracts worldwide. This benchmark has been in trouble for the last 20 years because of declining production of the underlying Brent commodity, leaving the price open to manipulation. Increasingly complicated patches have been applied to the Brent price assessment methodology over the years to bolster the amount of oil that qualifies for inclusion in the database used by the Price Reporting Agencies (PRAs) to calculate the invoice price for cargoes as far apart as South America to Africa to Europe and the Far East. Over the years dwindling Brent production has been shored up by the inclusion of Forties, Oseberg, Ekofisk and Troll as deliverable grades in the Brent contract. To accommodate such disparate grades in Brent, the cargo size has been increased from 500,000 bbls to 600,000 bbls and quality adjustment factors and a sulphur price de-escalator has had to be applied. Cost, insurance, and freight (CIF) trades netted back to a free on board (FOB) basis were added subsequently. The latest band aid that is currently envisaged to keep Brent alive is the inclusion of US West Texas Intermediate (WTI) as a deliverable grade in the Brent contract. The extensive modifications that have to be made to the WTI price FOB the US Gulf to render it comparable to oil FOB North Sea call into question the role of Brent in the international price formation process. These modifications include increasing the Brent cargo size further to 700,000 bbl parcel sizes to accommodate transatlantic freight. This has an impact on the North Sea producers who typically accrue or co-load 600,000 bbbl parcels under their lifting agreements with the terminal operators. The intention is to pass risk and title to WTI in international waters, ostensibly to prevent US law and regulation applying when WTI is sold as part of the Brent complex. The naivety of this legal device is illustrated by recalling the ruling of Judge William Connor in the Transnor case back in 1990. This was that Brent was subject to regulation by the US Commodity Futures Trading Commission (CFTC), long before there was any suggestion that American oil should be delivered into the Brent contract.
Who Is in the driving seat?
The problem is that the Brent physical and the quasi-physical forward contracts are largely unregulated. No one has the authority to dictate how companies choose to buy and sell physical contracts. The PRA Platts has stepped into the vacuum by the simple device of stating that it will exclude from its database of transactions used to assess daily Brent prices any deals that are not transacted in accordance with the methodology laid down by Platts. The industry has accepted this role for Platts and the increasingly tortuous modifications devised by Platts to keep Brent alive. The original forward Brent contract that commenced trading in 1981
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emerged from an industry need. The associated Brent CFD and DFL contracts that were added later were similarly devised by the industry in response to a need. Companies found these contracts useful and adopted them because they chose to do so, not because Platts told them they had to in order to be included in the price formation process.
The solution
In my opinion, the best solution to the loss of Brent liquidity is to do nothing and let Brent wither and die. Brent liquidity is already low and is on a declining trend. If it starts to get manipulated or produce unrepresentative prices, companies will stop using it as a matter of choice. If the PRAs stopped publishing a Brent price tomorrow, oil trading would not stop. The industry, like nature, would find a way. Maybe that would be a return to fixed and flat pricing for a while; maybe there would be some quality GPW and freight adjustments to fixed prices based on actual quality and freight data; more likely WTI itself or Murban/Oman benchmarks with adjustments would take over. Letting individual companies choose how to trade has to be better than forcing the industry to change what they are doing to prolong a benchmark whose time came and went a long time ago. If the plan to include WTI is adopted, it remains to be seen if the ISDA Material Change in Formula or Content provisions will be triggered, with inevitable litigation, by the inclusion of US WTI in a North Sea Brent contract. q • Liz Bossley established the Consilience Energy Advisory Group in 1999. Her oil trading career spans more than 45 years in the international crude oil, refined product and freight markets. Her new software product, Revenue Analysis Apportionment and Hedging (RAAH), has just been launched. She is a certified expert witness for oil and freight trading and logistics and has acted in more than 50 disputes. Learn more about Liz at ceag.org/founding-partners and about RAAH at ceag.org/oil-field-hedging-software.
