Low Oil Prices: Don’t Eat the Seed Corn!

Low Oil Prices: Don’t Eat the Seed Corn!

March 5, 2015
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The old adage that “necessity is the mother of invention” is proving true in the independent E&P oil sector. Faced with low oil prices, independent oil producers are introducing oil price “optionality” into their crude oil sales contracts. Crude producers reeling from low prices are offering optionality as one way of boosting the prices they achieve.

Optionality has always been a feature of oil contracts, but hitherto it has been majors and traders offering optionality to the smaller players that do not have access to financial instruments to manage their price risk. But now it is the other way around. The small producers are offering the majors/traders contractual price optionality in physical deals. The larger players can valorise these options in the market using the derivative instruments with which they are familiar and the producers are not. The objective for the producer is that the buyer will share some of this market value with them in the form of a better price for the physical contract deal.

What Kind of Options?

For example a contract may offer the buyer the right to choose, on a cargo-by-cargo basis, from a range of price averaging periods in the contract price formula. The vast majority of contracts have a price clause that is expressed as an average of published benchmark prices over a period of time, plus or minus a price differential relevant to the delivery dates and the quality of the oil in question. It is very rare to have a fixed and flat physical contract price expressed simply in terms of $X/bbl.

Common averaging periods for published benchmark average price formulae are:

–  the five days around the loading or bill of lading (B/L) date; or,

–  the five days after the B/L date; or,

–  the thirty days of the B/L month.

The buyer may be given the option to choose which of these three price averaging periods will apply to each cargo and it must exercise this option typically by a few days before the cargo loads.

The Buyer’s Advantage

When the buyer makes its choice it has the benefit of the “Dated to Paper” contract for difference (CFD) swap market to inform it which of the three periods at that point in time is judged by the market to give the lowest price. The buyer can therefore lock in the desirable outcome of its choice by hedging in the CFD market at the same time as it exercises its option. By and large and with some notable exceptions, independent oil producers do not trade CFDs and have limited, if any, access to price data from that market.

In the case of some cargoes that are loading late in a given month in a rising market there is a lot of “price discovery” in the thirty day average price option. This is a no risk “look back” option for the buyer. In return the buyer pays a higher price differential to the seller for having this right to choose.

The Seller’s Risk

From the perspective of the seller it may feel that it is gaining a better price differential in exchange for a very small sacrifice of the absolute price to which this differential applies. After all it may be argued that if you look back in history the historic average over time based on, say,  five days around the B/L is not hugely different from, say five days after B/L, although in any given month the difference can be quite large. So offering the option, it may be thought, does not cost them much when averaged over time. But this misses a fundamental point.

If one were to go back in time and calculate the historic average based on the lowest of the three option prices at any given point in time the seller is actually giving quite a lot away because the difference is much, much larger and is always skewed one way- in favour of the buyer and to the detriment of the seller. The peaks and troughs do not average out because the buyer will always choose the lowest price.

How Traders Value Options

If a trading company were to offer an analogous option, say, to choose between three different price averaging periods for cash settling a fixed for floating price swap, it would be paid a premium based on such factors as:

–  the difference between the fixed price and the CFD market valuation of the price averaging periods;

–  the time allowed before the option must be exercised or expire;

–  actual historic volatility of the oil price;

–  interest rates; and,

implied volatility, which is a catch-all term for any other factors that have an impact on the option premium, for example the imminence of an OPEC meeting, public holidays that may reduce the number of players in the market at the time in question etc.

As mentioned above, in the case of cargoes that are loading late in the month in a rising market there is a lot of “price discovery” in the thirty day average price option. In an options model this would be considered “intrinsic value” that would be added to the option premium to be paid by the buyer.

When the swap cash settled the seller would crystallise a gain or loss on the swap, which would be reportable as a speculative trading income.

Most producing companies would baulk at taking any such trading position and in all likelihood would be prohibited from doing so by the company’s Memorandum and Articles of Association. But by offering these pricing options to buyers that is exactly the speculative punt they are taking. And the cards are stacked against them because it is always the buyer who gets to choose the lowest price.

The fact that the gain or loss on the option is hidden within the eventual price paid by the buyer of the physical cargo means that the speculative trading aspect of offering such a price option is never apparent to the outside world. All that is evident is that the seller in question is achieving good price differentials.

The Tax Kicker

For the producing company there may also be a tax angle – isn’t there always? Because the option premium paid by the buyer is embedded in the price of the physical oil sale it will be taxed at the production tax rate in the host country concerned. This rate is typically much higher than the corporation tax rate applied to trading profits, which would be how the option premium would be reported in a trading company.

Once the tax authorities have seen an increased price differential for one deal it is very difficult to claw back the increase in the tax reference price for the next deal, which may not contain optionality.

This will be particularly painful in regimes that tax oil producers based on a price averaging period that differs from the price averaging period that is eventually chosen by the buyer of the physical cargo.

A Postscript on PRAs

Faced with an increasing number of physical deals that include the type of price optionality described above what are price reporting agencies (PRAs), such as Argus or Platts or ICIS, supposed to make of these contracts when assessing and reporting price differentials?

The methodologies published by the PRAs suggest that deals that contain such optionality will either be excluded from the price assessment database, or will be adjusted to make the prices comparable to a plain vanilla deal.

But first the PRA has to know that any deal they pick up from the market contains such optionality. If the counterparties don’t tell them then all they will see is a price expressed as Dated Brent plus $X/bbl or Dubai minus $Y/bbl. The fact that the buyer has the option to choose the dates on which the Dated Brent or the Dubai element is calculated may not be apparent without some fairly thorough digging on the part of the PRA. Without this vital information the PRAs only see price differentials that will appear to be inexplicably more volatile.

Even if the PRAs know about the existence of an option within a physical deal, valuing options is a specialised skill. If the buyer is given the choice between the three pricing periods suggested above, that option will have a completely different value depending on, for example, whether it has to be exercised before the start of the delivery month or just before the start of the laydays of the cargo in question.

The likely response of a PRA that is increasingly put to proof that it has investigated to the nth degree the data it uses to inform its price assessments, is to exclude deals that include optionality when it knows such optionality exists.

This is a worrying development at a time when increased regulation is already making companies wary of sharing data with PRAs. Yet the vast majority of the world’s oil traders refer to the prices published by PRAs. The inclusion of price optionality in physical contracts is another nail in the coffin of price transparency.

 

Read the article on oilvoice: OilVoice | Low oil prices: don’t eat the seed corn!