Fixing Brent

Fixing Brent

March 15, 2017

About a year ago I wrote a blog entitled “We’re Going to Need a Bigger Tank”. In that I indulged in a brief fantasy about how one would set about designing the perfect oil price benchmark in an ideal world. If proof were needed that this is not an ideal world, here we are again, another year older and still facing the same crumbling oil price benchmarks that we were last year.

Brent remains the most influential and widely used of the current crude oil price benchmarks. The attached Consilience discussion note outlines a possible robust and permanent solution to the tiresome issue of persistently declining volumes of each of the alternative grades of crude oil – Forties, Oseberg and Ekofisk- that have been added over time to the basket of crude oils currently referred to as Brent or BFOE.

The price reporting agency, Platts, is proposing another crutch to prop up the status quo of the existing Brent contract structure, namely including Norwegian grade, Troll, in the BFOE basket. The industry is conservative by nature and is likely to accept such a quick fix because it represents only a small incremental change to the status quo.

However, the simple addition of Troll would perpetuate the fundamental flaws that lie at the heart of the Brent basket. These flaws are robbing Brent of the liquidity and wide participation it needs to be a reliable price benchmark. Furthermore in a year or two we will be back in the same position of having to find another grade to add to the inexorably declining basket.

Consilience believes that a more fundamental change is needed to fix the current imperfections in the Brent contract and pricing methodology and to replace it with a more healthy system that will withstand the test of time, declining production and the decommissioning of the infrastructure that underlies “Brent” production.

Consilience proposes that:

  • A new 30-Day Brent forward contract is adopted. The new contract would be for 600,000 bbls of Brent Blend crude oil CIF Rotterdam, rather than FOB Sullom Voe, for delivery in a future calendar month at a fixed price. Brent Blend would be defined by a reference Brent assay fixed today (the Brent Standard) and which will not change even if (when) Brent production ceases altogether.
  • A wider agreed range of alternative grades of crude oil may be delivered into the new Brent contract giving 30-Days’ notice, the same notice that is given in the existing 30-Day forward BFOE contract.
    • If a grade with a higher value, or Gross Product Worth (GPW), than the Brent Standard is actually delivered, the buyer compensates the seller by paying a price premium for quality calculated as the difference between the GPW of the alterative grade and the GPW of the Brent Standard.
    • If a grade with a lower GPW than the Brent Standard is delivered, the seller compensates the buyer by paying a price premium for quality calculated as the difference between the GPW of the alterative grade and the GPW of the Brent Standard.
  • These alternative grades may be delivered into the new Brent contract at a pre-agreed and accepted number of alternative delivery locations in refining centres, giving 30-Days’ notice.
  • If the delivery point is other than Rotterdam the buyer compensates the seller if the delivery location is closer to Rotterdam than is Sullom Voe and the seller compensates the buyer if the delivery location is further from Rotterdam than is Sullom Voe.
  • The freight difference, for which compensation would be paid, would be the difference in the cost of freight between Sullom Voe and Rotterdam and the cost of freight between the alternative delivery location and Rotterdam.

Some readers of this blog may find the attached Consilience note a bit too heavy on technical detail: there would be a devilish amount of detail needed to make a new 30-Day forward CIF Rotterdam Brent contract work. Suffice to say that there are flaws at the heart of the Brent contract that the addition of Troll to the Brent BFOE basket alone won’t fix, although that is potentially a positive interim measure.

Any company that has a contract that includes a formula price that refers to Brent, or that uses a Brent price assumption in its economic modelling, or that has hedged a financing arrangement with a hedge expressed in terms of Brent has a stake in ensuring that the limited number of participants engaged in the Brent debate are playing fair and getting it right.

In the meantime the influential Brent price benchmark continues to be derived from a paucity of deal evidence from a limited number of market participants.

The lasting solution proposed by Consilience, or any other solution proposed by industry players, is unlikely to be implemented until the market is forced by operational circumstances to agree a new approach to benchmarks or until a regulator steps in and imposes a solution.

An independent “champion” is needed to bring together an industry working party to thrash out the details of an enduring forward contract and price discovery mechanism: some likely candidates might be the UK Oil and Gas Authority/ Norwegian Petroleum Directorate (in view of the decommissioning angle on BFOE pipeline facilities), the Energy Institute, the exchanges that trade Brent-related products or IOSCO, which regulates the futures and other derivative contracts expressed in terms of Brent. Any takers?

To read the Consilience discussion note Click Here