The overhaul of the regulatory regime for financial instruments, including commodities, since the banking crash of 2008 constitutes a lot more than the archetypal “butterfly flapping its wings” of chaos theory. So we should not be surprised to see far-reaching and unintended consequences in the market from the flapping of the weighty Dodd Frank and EMIR/MiFID wings of legislation.
This blog is pleased to include a guest piece from Lindsay Horn, an ex-Goldman Sachs, Lehman Brothers, AIG and Drexel employee. He gives a view from the sharp end of the impact of financial regulation on the banks that once provided hedging and financing solutions to the oil industry, but do so no longer.
What is most difficult to measure is how the loss of ancillary services once provided by the banks is changing the structure of physical oil contracts. Lindsay Horn mentions that opportunities are being lost by oil producers and refiners that do not engage with the futures and derivatives markets for fear of being sucked into, at best, time-consuming regulatory compliance or, at worst, accidental non-compliance. These opportunities are best exemplified by the “embedded optionality” that is an integral part of being an oil producer.
We have just come through the annual renegotiation of physical oil contracts and we are seeing increasing premia being paid over the reported spot price of different grades of crude oil for term contracts in the same physical oil. It has long been a feature of the industry that buyers of term physical oil are prepared to pay a premium over the spot price of the same oil as reported by the Price Reporting Agencies (PRAs). The more flexibility that the producer offers the buyer in terms of determining the date range and size of cargoes and in choosing the price formula, the greater the premium the buyer will pay. The more of the same grade of oil that the buyer has from other sources, preferably including an equity production position of its own, the more the buyer is prepared to pay as premium over the reported spot price. This premium can be >$1/bbl and represents the embedded optionality in the physical position of equity producers.
Uninformed producers that do not analyze the value of the optionality embedded in their position as a physical producer sometimes leave this premium on the table. But most producers are now waking up to the fact that they should be seeking a premium over the spot prices reported by PRAs for flexible term contracts.
We are also seeing a resurgence of the phenomenon of “trigger pricing”, i.e. the buyer permits the seller to choose the moment when key components of the oil price formula are fixed. This is a very handy option for sellers that do not want to engage with short-term operational hedging in the futures or CFD markets for fear of the regulatory compliance consequences, but who still want some control over their financial realization from the sale of oil. This trigger option costs the buyer little, if anything, because the buyer will probably already be hedging the price formula to lock in an arbitrage profit. So whether it closes those hedges in accordance with a standard average price formula or in tranches at a time of the seller’s choosing makes little difference to the buyer.
Given the state of flux in which oil price benchmarks find themselves (read it HERE) what conclusions can we draw about the price of oil and the impact of financial regulation? On December 4th last year the International Organisation of Securities Commissions (IOSCO) stated:
“Examples of relevant considerations of appropriateness for a user could be, to the extent they are applicable:
- the way in which the benchmark is determined, including the size, liquidity and potential evolution of the market being measured by the benchmark and other aspects of the relevant methodology, along with the transparency of the methodology;
- whether the benchmark provides an appropriately accurate and reliable representation of the market it seeks to measure, and is likely to remain so, and how factors that might result in a distortion of the price, rate, index or value of the benchmark are eliminated or reduced;
- in the case of interest rate benchmarks, whether or not it is desirable or necessary for the benchmark to include a term risk or credit risk element;
- how the benchmark is disseminated to users;
- the governance of, and accountability for, the benchmark determination process;
- the process by which changes to the benchmark’s methodology can be made, e.g. relevant consultation procedures;
- how the administrator deals with significant decisions affecting the compilation of the benchmark and any related determination process, including contingency measures in the event of insufficient or no inputs (e.g. the use of expert judgment), market stress or disruption, and failure of critical infrastructure;
- the provisions which could apply in the event of material changes to the benchmark and how they would operate in practice; and
- whether, and under what circumstances, provisions relating to cessation of the benchmark should apply.”
This is good advice. It is unwise to continue relying on old oil price benchmarks without an understanding first, of how those benchmarks are changing and, secondly, of the impact that the withdrawal of a key group of actors in the physical market, the banks, has had on the structure of term oil contracts.