Crude-oil benchmarks’ ties go awry

The traditional relationship between regional crude-oil benchmarks has gone awry as changes in trade flows have created new pressures on the existing pricing system. The resultant stresses are prompting both reform and opportunity.

The main regional benchmark for the Americas is the New York Mercantile Exchange’s (NYMEX) futures contract for light crude oil, against which physical delivery can be made at the pricing hub of Cushing, Okla. While six domestic U.S. crudes and five foreign crudes can be delivered against the contract, the main physical stream that dominates the supply at Cushing is West Texas Intermediate (WTI). All the deliverable crudes are light and sweet (low sulfur).

In Europe, the Intercontinental Exchange (ICE) provides a successful cash-settled Brent futures market, while the main physical benchmark is the physical crude Dated Brent, as reported by pricing agency Platts. Dated Brent also comprises light sweet crudes, but ones that are heavier and sourer than the basket deliverable against the NYMEX futures contract. In Asia, the Platts-reported Dubai price is the main benchmark. There is no established futures contract, although two competing contracts were launched May 23 and June 1 respectively. Dubai is a heavy sour (high sulfur) crude.

Inverted relationship

Light sweet crudes produce a higher proportion of light clean refined products. As a result, it is rare historically for WTI to trade at a discount to Dated Brent, while Dubai typically trades at a large discount to both. The relationships between the regional benchmarks, expressed through their difference in value as the Brent/WTI spread and the Brent/Dubai spread, govern the flow of crudes internationally. For example, if Brent is cheap in comparison with WTI (i.e., the Brent/WTI spread is wide) then spot cargoes of crudes priced off Dated Brent will move to the U.S. Gulf of Mexico instead of to European markets.

However, the relationship between regional benchmarks has become inverted, owing to a logistical bottleneck at Cushing. On May 25, the Brent/WTI spread was at a record minus-6.54 dollars per barrel. Moreover, WTI has fallen in value below that of Dubai and domestic Gulf of Mexico sour crude Mars. This suggests that light sweet crude oil should be exported out of North America to both Asia and Europe. However, WTI’s weakness reflects the logistical shortcomings of the Cushing pricing hub, not the wider U.S. market, although the point of pricing at Cushing is exactly its value as a proxy for the United States.

Benchmark manipulation

A good benchmark needs to be liquid, have a wide range of both sellers and buyers, have no restriction on its tradability (for example destination restrictions), no bottlenecks in its supply and delivery infrastructure and should have easy terms of entry to the market. In addition, prices should be formed in a transparent manner through a robust methodology. If any one of these conditions is weak, the benchmark is more open to manipulation. Confidence in the benchmark drops and pressure for change rises.

Refinery outages have been responsible in large part for a glut of crude supply at Cushing. However, there have also been more fundamental changes in the Cushing system:

• Increases in Canadian crude imports to the United States, particularly of bitumen and synthetic crude made from oil sands, resulted in the reversal of two pipelines in 2006; Enbridge’s Spearhead line connecting Chicago and Cushing and ExxonMobil’s Pegasus pipeline from Patoka to Nederland.

• The two pipelines now take bitumen and synthetic crude into the Cushing system rather than crude away to refineries.

• BP says it too may reverse its 100,000 barrels per day pipeline currently taking crude from Cushing to Chicago in 2009, owing to a lack of demand.

Midwest refiners are displacing crude coming via the Gulf of Mexico and the Cushing hub with Canadian crude. This is trapping crude in Cushing, forcing prices down and making the pricing point vulnerable to manipulative plays predicated on a weak WTI price. In short, crude priced at Cushing no longer satisfies the criteria for a good benchmark.

In addition, both the Dubai and Dated Brent benchmarks have undergone change prompted by declining production profiles, which left them more open to manipulation:

• Platts now allows cargoes of Oman, Dubai and Upper Zakum — if free of destination restrictions — to be delivered against the physical Dubai contract.

• Forties, Oseberg and Brent can all be delivered against the Dated Brent contract, and another Norwegian crude, Ekofisk, is being added as of June 8.

Oxford Analytica is an international consulting firm providing strategic analysis on world events for business and government leaders. See www.oxan.com .