Regular readers of Liz Out Loud, who we hope will opt in to continue receiving our emails following the implementation of GDPR, will be very aware that there is considerable dissatisfaction with the current basket of very different grades of oil that underlies the Dated Brent price benchmark and the 30 – Day Brent/ Forties/ Oseberg/ Ekofisk/ Troll (BFOET) forward Brent market.
This blog makes a practical suggestion for how the mechanics of the quality issues currently facing the Brent basket might begin to be addressed and invites readers to contribute their own suggested refinements, improvements or alternatives anonymously.
The volume of oil in the Brent basket is declining and it is becoming increasingly apparent that new grades will have to be added to prevent any attempts to corner the market and to provide enough deal evidence to justify the prices reported by Price Reporting Agencies (PRAs).
One of the biggest stumbling blocks to adding new grades to the basket successfully is the increasingly disparate quality of the basket grades, currently Brent, Forties, Oseberg, Ekofisk and Troll. The current system of Quality Premia for Oseberg and Ekofisk and the sulphur price de-escalator applied to Forties is not adequate to the needs of the assessors of the Dated Brent price benchmark, the PRAs, or to the 30-Day forward market. Buyers of forward Brent can receive any one of the current five basket grades of oil which are becoming increasingly disparate in quality.
Hopes of including Johann Sverdrup in the basket when it comes onstream late in 2019 depend upon the goodwill of the operator, Equinor, the company formerly known as Statoil, in ensuring that cargo sizes and the scheduling of liftings is compatible with the other 5 grades in the existing basket. But equally important is the need for the industry to reach consensus on how best to continue to enhance the volume of oil in the basket by bringing in more and different grades into it by introducing a mechanism for compensating buyers when they buy “Brent” but receive an entirely different grade with different quality attributes.
How a GPW-based Price Differential could work in practice
One of the ideas currently under consideration is the use of a Gross Product Worth (GPW) calculation to establish a market price differential amongst all the grades in a basket.
A GPW is calculated as follows:
GPW ($/bbl)= Σ[ ((Mt of Product 1) x (Price per Mt of Product 1) x (Mt to bbls conversion factor for Product 1)) + ((Mt of Product 2) x (Price per Mt of Product 2) x (Mt to bbls conversion factor for Product 2)) + ((Mt of Product 3) x (Price per Mt of Product 3) x (Mt to bbls conversion factor for Product 3))…………..etc. ]
In other words if you take the quantity in tonnes of each product that can be extracted from a barrel of oil and multiply each product by its price per tonne, convert each product value from tonnes to barrels using the appropriate conversion factor for refined products of that API gravity and add the result up for all the refined products in the barrel, you get an idea of the value to a refiner of a barrel of the grade of oil in question.
Critics of this methodology are quick to point out that the GPW of a barrel of oil is not synonymous with its market price. The market price is influenced by factors other than quality and may be quite different from the GPW that any individual refinery can extract from it. Those refineries that can extract more in GPW than the market price will compete to buy and refine that grade. Those refineries that cannot extract more GPW value than the market price will look for other grades to buy. Nevertheless the GPW can be handy proxy for establishing the market price differentials amongst different grades of oil in a basket if the GPW calculation parameters are chosen with care.
One of the first decisions to be taken in calculating a GPW is which refinery should be chosen to calculate the quantity of each product yielded by each grade? The answer will be very different if a primary distillation “tea kettle” is used rather than a sophisticated coker that squeezes every last cent of value out of a barrel of crude oil.
It may be said that the refining of grades in the BFOET basket occurs predominantly, although not exclusively, in the N.W.E. catchment area. So it would, in my opinion, be appropriate to calculate the GPWs of basket grades in the type of refineries that operate in that area.
An actual existing N.W.E. reference refinery need not be selected. But one could be constructed artificially by averaging the Nelson complexity indices of all the refineries active in the relevant area.
Nelson Complexity Index
The complexity factors (CFs) of refinery processing units are published annually by the Oil and Gas Journal, allowing the Nelson Complexity Index (NCI) of any refinery, or group of refineries, to be calculated and updated whenever a refinery is upgraded or when any of its units are closed down. Primary distillation capacity is given a CF of 1 and each secondary processing unit is assigned a CF according to the amount of investment it requires and the value it adds to a barrel of oil.
For example an FCC unit might have a complexity factor of 6 where as a very expensive and high value added lube unit might have a complexity factor of 60. The NCI is calculated by summing the complexity factors (CFs) of each unit in the refinery multiplied by the capacity of each unit relative to primary distillation capacity.
NCI = Σ [(CFdistillation x Distillation capacity/ Distillation capacity) + (CFUnit 1 x Unit 1 capacity/ Distillation capacity) + (CFUnit 2 x Unit 2 capacity/ Distillation capacity) + (CFUnit 3 x Unit 3 capacity/ Distillation capacity)….etc.]
So a European Reference Refinery could be constructed with an NCI equivalent to the weighted average of all European refineries. It would then be possible to calculate the GPWs of all the grades in the existing or future Brent basket using this Reference Refinery. This may be done using neutral, off-the-shelf refinery modelling software such as that sold by Haverly Systems (1).
As stated above, the GPW of any crude rarely coincides with its market price. But the purpose of this exercise is not to establish the absolute value of the grades of oil in the Brent basket, only their values relative to each other, i.e. the price differentials. To test the robustness of the methodology the components of the NCI of the Reference Refinery can be tweaked to find the closest fit to, or correlation with, actual historic market price differentials amongst the basket grades.
Which Product Prices?
Initially it may be wise to use Amsterdam Rotterdam Antwerp (ARA) product prices when calculating relative GPWs, while the majority of the volume of oil within the Brent basket are still refined in N.W.E. But over time if grades from outside N.W.E. were to be added to the basket then there may be a need to introduce weighted average product prices and additional refineries from outside the catchment area.
These product prices would be updated daily as the PRAs update their data so that the crude oil price differentials generated reflect daily assessments of the future crude oil price differential based on product prices that apply to refined products being delivered up to 25 days in the future. One way of implementing this methodology would be to apply the GPW differential generated by the modelled published on the day on which a cargo is declared into a 30-Day BFOET chain.
So 30 days before the first day of the loading date range of a given BFOET cargo, the seller would declare to the buyer the date range and the grade it will deliver into its 30 Day BFOET(JS?) contract. The price differential that would apply if the cargo is not Brent, which it rarely is, but is Forties, Oseberg, Ekofisk, Troll (or Johnann Sverdrup?), would be the GPW differential published by the PRAs at close of business on that same declaration day.
It is to be anticipated that any GPW-based method of calculating price differentials will require maintenance to ensure that the Reference Refinery is up-to-date with the addition of new processing units or refinery closures either for maintenance or permanently. If the differential calculation methodology began to diverge from actual market price differentials then this would indicate that the NCIs or the RR or the product price set required adjustment and that a tug on the kite strings was needed.
Otherwise it would be a simple case of cranking the handle on the differential machine daily to churn out the quality adjustment factor, i.e. the GPW differential, that has to be applied when a basket grade of crude oil other than Brent is delivered into a 30-Day BFOET+ contract.
The objective of this somewhat cumbersome exercise is to improve liquidity in the 30-Day forward Brent market that underpins the regulated Brent futures and OTC swaps and options markets.
Views on the quality issue and this suggested methodology for establishing price differentials are very welcome and can be submitted anonymously below.