Who Is the Regulator?

The point where risk and title to the oil passes from WTI sellers to buyers is being changed to just outside the US economic exclusion zone, rather than FOB the loading point, which is the actual , or netted back delivery point in Brent basket contracts. This is reputedly to keep those cargoes of WTI going into Brent, and arguably Brent itself,  out of US jurisdiction and the US tax net. Whether this device will be effective remains to be seen. Those readers who were trading in the late 1980s and early 1990s will recall the ruling by Judge William Connor that Brent trades constituted a futures market under the U.S. Commodity Exchange Act and came under the jurisdiction of the Commodity Futures Trading Commission (“CFTC”). This alarming statement prompted furious back-peddling by the CFTC and out-of-court settlements by the protagonists in the case. If the status of Brent with WTI included ever gets challenged in a court, it is anyone’s guess what the outcome and consequences would be.

Who Needs Who?

The WTI Midland market has legs of its own and does not need Brent. In fact, one PRA stated in an International Energy Week presentation that WTI is not joining Brent, but that Brent is being swallowed by WTI.  Waning Brent needs the burgeoning volume of activity associated with WTI Midland to survive. It would be considerably simpler to let Brent atrophy and for WTI and/or some other benchmark to take over by a process of evolution. But those parties with a vested interest are going to extraordinary lengths to keep Brent alive.

ISDA and the Material Change Question

One possible reason is the “Material Change in Formula” provisions of the International Swaps and Derivatives Association (“ISDA”) master agreements that are entered into by over-the-counter swaps and options traders. These sit behind long-term positions entered into for the strategic hedging of oil field developments and for the loan financing of those developments.   A Material Change in Formula means the occurrence since the date of the deal in question of a material change in the formula for, or the method of, calculating the contract reference price. This may constitute a “disruption event”, in ISDA terminology, and a “calculation agent determination” of an adjustment to the price to bring it back into line with the original intention of the contract. It may even constitute a “termination event”, in other words the end of the contract. This takes us into some murky legal waters outside this writer’s area of expertise.

Arguably, there have been several material changes in Brent over the years, but none quite so material in my opinion, as the inclusion of WTI into the Brent basket. So far, the fact that the benchmark has kept the brand name “Brent”, may have protected it from challenge by the occasional disgruntled contract holder sitting on a loss-making position. Traders with nothing left to lose just might be tempted to have a go in court at claiming that a deal they entered into some time ago did not envisage such a significant change to the benchmark price.  Any update to the brand name following the inclusion of WTI, such as calling it “the Atlantic Basin Benchmark”, or something similar, would increase the risk of triggering claims of “Material Change” re-openers under ISDA contracts, whether justified or not.

Changing Price Differentials

The PRAs are changing their Brent price assessment process after consultation with industry, although the new methodology is not universally popular with all the major industry players. Many industry participants that use Brent as a benchmark in contracts are actually oblivious to the workings of the Brent market. They may not appreciate the fact that WTI is likely to be the most competitive grade in the Brent basket most of the time, i.e. the cheapest grade in the basket, for prolonged periods of time. WTI tends to trade at a discount to Brent. This means that the Dated Brent price in those periods will be lower than it otherwise would have been if WTI was not in the basket. This has implications for the grade differential in contracts. If the benchmark price is lowered by the inclusion of WTI,  the grade differential has to be adjusted upwards to compensate for this fact. It is debatable how quickly small companies without active trading departments, national oil companies that use Dated Brent as a benchmark, or revenue authorities that use Dated Brent as their tax reference price in upstream agreements, will be cotton on to the implications of the changing composition of Brent.

“With great power comes great responsibility.”  

The band aids necessary to keep the Brent brand name in common use, despite some substantial changes to the composition of the Brent basket,  such as sulphur de-escalators, quality premia, freight adjustment factors etc., are not negotiated and announced by industry participants. They are assessed and announced by PRAs, albeit by observing such trades as are disclosed to them and by having discussions with some eligible market participants. No-one is forcing oil industry participants to adopt methodologies or price assessments determined by a PRA, or to use the price of Dated Brent or cash Brent as a price benchmark in their contracts. Nor are they forced to adopt the general terms and conditions of trade published by major oil companies.  But for any one company to hold out against the custom and practice in common use by the dominant players in the market would be to swim against the tide.

Fasten your seat belts, it’s going to be a bumpy night.

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