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    WTF!! West Texas FIASCO

    Brent crude oil is a benchmark price for about two thirds of the world’s oil contracts. This influential benchmark, which is based on five specific grades of crude oil produced in the UK and Norway and sold FOB North Sea ports, stands at a crossroads: the trading community is being asked to accept the inclusion of the USA’s West Texas Intermediate (WTI) crude oil as a deliverable grade in the Brent benchmark contracts.

    The reason for this proposal is to boost the volume of oil that is potentially available to be traded and provide a database of transactions that can be considered in the daily price assessments of the price reporting agencies (PRAs). The volume of crude that can set the price of Brent is on an ever-declining trend. Furthermore, not all of the actual deals done in Brent oil find their way into the price assessment process.

    It is hoped that the inclusion of WTI will boost the volume of trade that can inform price assessments and protect the benchmark from being manipulated. But the fundamental adjustments that would have to be made to what we call “Brent” to accommodate the inclusion of WTI raise a number of questions

     

    • Is WTI too different in terms of quality, cargo size, location, freight costs and scheduling logistics to fit into the Brent basket?
    • Does the settlement of an order in May 2022 brought by the US Commodity Futures and Trading Commission (CFTC) against trading company Glencore, for, among other things, the manipulation of fuel oil price benchmarks, specifically some S&P Global Platts (Platts) fuel oil benchmarks, have a bearing on whether or not the influential Brent benchmark is similarly at risk?
    • If it is shown that Brent is at risk of manipulation as the volume declines further, would the inclusion of WTI Midland solve the problem?
    • Would the inclusion of an American crude into a North Sea contract constitute what the International Swaps and Derivatives Association (ISDA) calls a Material Change in Formula or a Material Change in Content, leading to a Termination Event and Calculation Agent Determination of the settlement price in the vast number of outstanding contracts in the long- term derivatives swaps and options markets?

     

    How Important is Brent? Why Should We Care?

     

    “Brent futures” is the title of the flagship contract of the Intercontinental Exchange (ICE) that trades 96 calendar months into the future. Between January and May 2022 the ICE Brent contract traded roughly 235 times more volume of Brent than total world production of all grades of oil worldwide over the same period.

    Much more difficult to estimate is the considerably greater volume of over-the-counter (OTC) derivative swaps and options contract that trade worldwide within the International Swaps and Derivatives Association (ISDA) master contract framework.

    The vast majority of physical contracts that use Brent as a reference price use the particular assessment published by the PRA, Platts, although such prices are also reported by their main rival, Argus Media, and the newcomer, General Index.

    The Brent benchmark has evolved over the years from the 1980s into a very complex system for generating prices each day that can be plugged into contracts by companies and governments around the world many of whom have no direct market involvement themselves. It is taken on trust that the benchmark they are using is representative of the “true” market value of oil.

    What is Brent Currently?

     

    To recap, what we call Brent currently has the following characteristics:

    • Brent is actually a basket of North Sea grades of oil including Brent, Forties, Oseberg, Ekofisk and Troll (BFOET);
    • The Dated Brent price reported by the price reporting agencies (PRAs) on any given day is the lowest, after quality and freight adjustments, as discussed later, of Brent, Forties, Oseberg, Ekofisk or Troll for delivery 10-30 days forward of the PRA reporting date;
    • The 30-Day Brent forward contract is a standardized contract traded for delivery on any day in any forward month commencing from 30 days later than the PRA reporting date. The contract seller must declare to the buyer which of these 5 grades of oil will be delivered and the precise 3-day delivery date range 30 days before the first day of said date range;
    • The standard cargo size is 600,000 barrels (bbls) +/- 1%;
    • In the case of Forties the price is subject to a sulphur de-escalator if the actual sulphur content of the cargo is above 0.6%. The size of the de-escalator is set and published by Platts each month;
    • If Oseberg or Ekofisk or Troll is the grade option declared by the seller in the 30-day contract, the price is subject to a quality premium, which is set and published by Platts at 60% of the net price differences between Oseberg, Ekofisk and Troll, and the cheapest grade of crude among Brent, Forties, Oseberg, Ekofisk and Troll for the full month prior to announcement of the premium;
    • Dated Brent and 30-Day BFOET prices, as quoted by the PRAs, are traded Free on Board (FOB) North Sea ports or sold on a Ship-to- Ship (STS) basis in the region. In FOB contracts the buyer charters the tanker;
    • Any of the 5 grades delivered Cost Insurance and Freight (CIF) Rotterdam, but including deliveries from Gibraltar to the Baltic, are reflected in the PRA Brent price assessment adjusted for delivery time between the FOB location and the CIF delivery location and adjusted for freight cost by 80% of market levels, as assessed by Platts. In CIF contracts the seller charters the tanker;
    • The influential Dated Brent price assessment reflects the market at 4.30 pm London time as reported to Platts in accordance with a very strict set of rules about who qualifies to report to them, which deals qualify to be included and at what time they are indicated to Platts and by which communication medium;
    • The price reported need not reflect deals done. It may simply reflect bids and offers for whole or part cargoes as small as 100,000 bbls, i.e. one sixth of a full Brent cargo size, even though no volume may actually be transacted at that price at that time.

    Brent physical, or “cash”, contracts and the quasi-physical forward contracts are largely unregulated. No-one has the mandate to dictate how companies construct physical oil contracts. The PRA, Platts, has stepped into this regulatory void by simply excluding from the database of transactions it uses to assess daily Brent prices any deals that are not compatible with the methodology laid down by Platts. This methodology is complex and detailed[1]. The number of companies actually inputting data to Platts is limited and these can only contribute data into the “Market on Close” (MOC) price assessment process, if, and for as long as, they have been approved by Platts to do so[2].

    The oil trading community continues to use the Platts Brent benchmark as the calculation reference price in its unrelated contracts. The majority of companies that use the Brent benchmark tend not to have the expertise or the market involvement to participate in the MOC price assessment process. Those that can and choose to participate in MOC activities have only to focus for a limited time period every day, the so-called “window”, which concentrates trades into 30-45 minutes before the close.  This gives them input to the Brent price that is published every day by the PRAs, without the need to transact large volumes of oil throughout the day to demonstrate their belief in any particular price level.  Some active oil and trading companies choose not to participate in MOC or the window, as a conscious policy decision.

    The execution of MOC trades transacted in the Platts window is carried out on the ICE trading platform using the ICE matching engine.

     

    The Proposed Inclusion of WTI in Brent

     

    It has now been announced by Platts that the Brent basket they consider in their Brent assessment will be expanded to include WTI Midland crude oil from June 2023. Companies are not obliged to comply by changing their contract methodology, but if they do not their deals will not qualify for inclusion in the published price assessment.

    WTI Midland is an emerging benchmark in its own right[1]. Since the ban on crude exports from the USA was lifted in December 2015, WTI has and continues to become a key export grade in the international market. The volume involved is well in excess of 1 million b/d although the current picture is obscured by releases from the US Strategic Petroleum Reserve in response to the war in Ukraine. Total US exports are much higher from the USGC, but not all is WTI that has been collected at Midland.

    The export logistics for WTI crude are still evolving. Comparatively stable quality light, sweet crude from the Permian Basin are collected at Midland Texas, and other gathering stations, and are exported from the ports of Houston, Corpus Christi and the Beaumont/Port Arthur/Nederland US Gulf Coast (USGC) area. This is a work- in-progress because additional storage and jetty capacity is still being added in the Texas area.

    Standardisation, control and clarity of US exports from the USGC are likely to emerge over time but do not yet exist and are unlikely to exist by June 2023 when Platts would like to annex WTI Midland volume to bolster the crumbling Brent benchmark.

    “Platts Assessment Methodology Guide, March 2022” and “Specifications Guide Europe and Africa Crude Oil, February 2022”.

    https://www.spglobal.com/commodityinsights/process/moc-participation-review-process

    “Argus Media Texas Ports Guide: Fall 2020 Edition”.

    The Location of a major WTI gathering point in Midland, Texas

    “Argus Media Texas Ports Guide: Fall 2020 Edition”.

     

    The Location of WTI Midland:

    Unsurprisingly, commercial entities with a vested interest in prolonging the life of Brent are keen to appropriate the tempting volume of WTI Midland into the Brent basket. However, in order to accommodate WTI, it is recognised by the PRAs that the Brent contract and Brent price assessment process would need some fundamental modifications.

    Shell, the widely accepted custodian of the general terms and conditions of trade (GTCs) in the Brent market, are proposing further amendments to their time-honoured Shell UK (SUKO) 1990 GTCs to accommodate WTI Midland[1].

    Cargo Scheduling

    The first issue to arise is that there is no terminal operator in the USGC accustomed to compiling and circulating a monthly schedule of standard-sized cargoes that are aggregated in accordance with standard terminal operating procedures and which are available for lifting and sale on standard contract terms. The North Sea terminal operators for Brent, Forties, Oseberg, Ekofisk and Troll release such monthly schedules on compatible, if not coordinated, timetables. The lack of similar data for WTI Midland makes it tricky to decide when cargoes exported from the USGC would arrive in Northwest Europe to qualify for inclusion in Brent.

    There is no publicly available, “official” information released in advance about when WTI cargoes will actually leave the Houston area to embark on an approximate 6,000 nautical miles journey to Rotterdam[2]. It is difficult to establish when WTI cargoes would reach the Rotterdam European reference destination port, or any other port to which the buyer may require delivery to its own refinery. At an environmentally- friendly 10 knots this journey would take about 26 days. At a “caps-on-backwards” rate of 15 knots this would take 17 days.

    So, there would be some doubt about into which 30-Day BFOET contract month such WTI cargoes would qualify for delivery. This is particularly problematic when there is steep backwardation or contango[3] in the market. When there is a big price difference for oil to be delivered on different future dates, the slippage of a WTI Midland cargo’s delivery date from one month to the next would make a substantial difference to the value of the cargo.

    FOB or CIF?

    Including WTI sales made FOB the USGC would not make a lot of sense for the FOB North Sea Brent basket. So, SUKO proposes including WTI Midland on a CIF Rotterdam basis and adjusting the price for the difference in the cost of freight from the USGC to Rotterdam and the North Sea to Rotterdam.  SUKO proposes using Platts freight cost  assessments to adjust for this distance differential.

    As mentioned above the seller, rather than the buyer as in an FOB sale, would charter the tanker in a CIF sale. So vetting tankers in advance to perform the voyage becomes an issue that is not relevant to an FOB sale in the North Sea.

    Buyers of oil FOB North Sea ports must have their tankers vetted as acceptable to the relevant seller and North Sea terminal in the 7-10 days before it loads. But buying a 30-Day contract that may turn out to deliver a WTI cargo to Rotterdam at the seller’s option and in the seller’s tanker, is another matter. The tanker has to be acceptable to the buyer, but it is unclear what would  happen under a 30-Day “BFOETW” deal, if that is the contract from June 2023,  if WTI is the grade declared by the seller and the buyer does not approve the seller’s tanker. Presumably the 30-Day notice period gives the seller time to propose a different tanker although, if the buyer has its own vessels on time charter or under a contract of affreightment, reaching agreement may be problematic.

    Cargo Size

    A further modification to standard Brent trading practice includes increasing the “Brent” cargo size from 600,000 to 700,000 bbls to reflect transatlantic freight economics. Economies of scale dictate that larger tankers are used to ship oil over longer distances. This requires a change in trading practices by  North Sea producers who typically accrue or co-load 600,000bbbl parcels under their lifting agreements with the terminal operators. There is no obvious reason why upstream producers should cooperate in this fundamental change to long-established joint operating agreements, transportation agreements and lifting agreements for the convenience of PRAs, even though the upstream producers’ own traders might support it. Many producers do not have a trading department to provide an opinion to their upstream colleagues.

    Quality and Origin

    In response to concerns over uncertain quality expressed by pioneering international buyers of WTI, when it first became an export grade, both Shell and Platts have stipulated quality specifications for WTI Midland as delivered FOB, including an API gravity range of 40-44o, total sulphur content of up to 0.2% and limits on bottoms, sediment and water (BS&W), reid vapour pressure (RVP) and heavy metals. Shell has also stipulated limits on organic chlorides and some distillation parameters.

    Platts has defined a certain number of pipelines that bring WTI Midland to the USGC as being eligible sources for their export price assessments.

    Says Ben Holt, Consilience Senior Associate[4], “At this stage there appears no plan to introduce a quality adjustment for WTI as exists for the other non-Brent grades, but Platts say they will keep this under review.  WTI is lighter and sweeter than most of the other grades in the Brent basket (Brent is quoted by Platts as 37.5 API  and Sulfur 0.4%) so as the relative refined product values of the different crudes change,  WTI’s competitiveness will vary: it will tend to be cheap when naphtha is cheap.”

    The Midland Basin (and wider gathering region) has hundreds of producers and thousands of wells often with very different crude qualities being produced. Some control over the WTI Midland “blend” exists, but certainly not all. This has resulted in issues such as TAN spiking from time to time in cargoes loading in the Gulf. One of the specific problems with TAN is that it is nearly impossible to deal with via price escalators given that even modest amounts simply cannot be tolerated by many refineries“, adds Consilience Senior Associate, David Povey.

    Two Prices

    Shell proposes that the cargo price be in two parts:

    • one price for the first 600,000 bbls based on the cash price agreed by the counterparties to the deal plus a quality premium and a freight escalator based on Platts data; and,
    • a different price for the additional 100,000 bbls reflecting Dated Brent for delivery in month (M) +/- the difference between Dated Brent and WTI Midland prices published by Platts and averaged over the previous month (M-1).

    Risk and Title

    Shell proposes that risk in and title to WTI oil shall pass from the seller to the buyer immediately as the vessel carrying the crude leaves the Economic Exclusion Zone (EEZ) of the USA[5]. This is explained by Platts and the Intercontinental Exchange (ICE) as follows: “In their respective discussions, Platts and ICE have heard that several market participants are reluctant to take risk and title to crude in US territorial waters for taxation or environmental risk reasons”[6].

    Others suggest that this shifting of the point where risk and title passes out of the EEZ is because “it conveniently gets around any US legislation and oversight leaving the contract based on English law”[7]. This seems a somewhat naïve view of the reach of regulators.

    Regulation and the Glencore Order

    Older traders, such as myself, may recall  Judge William Connor’s ruling in the Transnor case back in 1990. This was that 15-day Brent, the precursor contract to today’s 30-Day BFOET, was a futures contract subject to regulation by the US Commodity Futures Trading Commission (CFTC), long before there was any suggestion that American oil could be delivered into the Brent contract. The CFTC over-turned this ruling saying that Brent was a forward contract not subject to CFTC regulation.

    But the world has moved on.

    On  24th May 2022,  the CFTC issued an order  under the US Commodity Exchange Act[8]  saying “From approximately 2007 to at least 2018 (the “Relevant Period”), Glencore engaged in a scheme to manipulate oil markets and defraud other market participants through corruption and misappropriation of material nonpublic information, designed to increase profit and decrease losses from physical and derivatives trading.”

    It also said “Glencore’s conduct during the Relevant Period involved the manipulation or attempted manipulation of price assessments of various fuel oil products published by S&P Global Platts (“Platts”), a price-reporting agency, and derivatives such as futures and swaps that settled by reference to those assessments, including derivatives traded on United States exchanges such as the New York Mercantile Exchange (“NYMEX”) and ICE Futures U.S. Inc.[Emphasis added]  During the Relevant Period and the Charging Period, Glencore had derivatives and physical trade positions, including positions held in the United States, that exposed Glencore to fluctuations in the Platts price assessments. Glencore traders understood that Platts made price assessments of various fuel oil products based primarily on the trading activity in a daily trading window, a process through which market participants could submit bids, offers, and trades on set amounts of particular oil products. On certain days on which Glencore had significant exposure to these Platts price assessment benchmarks, Glencore traders placed bids or offers in the relevant trading window with the intent of pushing or controlling the results of the trading window, and thus Platts’s price assessments, in a direction and manner intended to benefit Glencore’s exposure arising from its associated physical and/or derivatives positions. Glencore engaged in this scheme on hundreds of days during the Relevant Period and the Charging Period in order to manipulate Platts price assessments connected to four fuel oil products, and the associated derivatives, in three different United States geographic markets.”

    Glencore was ordered to pay $1.186 billion  (1.186 thousand million)  to settle the charges. The CFTC order against Glencore relates to the refined product Fuel Oil, not Brent. But it has placed front and centre the question of whether or not Platts benchmarks and the Platts window, in which the daily price of Brent is established, can be manipulated.

    Data is not in the public domain as to how exactly Glencore manipulated the Platts Fuel Oil benchmarks and how the CFTC became aware of the issue. If a company can manipulate one benchmark, is it perhaps time to review the PRA Principles, which set standards for governance and control systems for all PRA benchmarks? These principles  were introduced by the International Organization of Securities Commissions (IOSCO) and endorsed by the G20 in October 2012.

    WTI in Brent: ISDA Implications

    The eyes of traders tend to glaze over when the International Swaps and Derivatives Association (ISDA)[9] is mentioned. Embarking on an analysis of ISDA without a safety net, and a competent lawyer, is inadvisable. As a trader, rather than a lawyer, the question that immediately occurs to me is “would the inclusion of an American crude into a North Sea contract constitute what ISDA calls a Material Change in Formula or a Material Change in Content and constitute a Market Disruption Event”?

    ISDA defines these material changes as:

    • Material Change in Formula: “the occurrence since the trade date of the transaction of a material change in the formula for or the method of calculating the relevant Commodity Reference Price”;
    • Material Change in Content: “the occurrence since the trade date of the transaction of a material change in the content, composition or Constitution of the commodity or relevant futures contract”.

    This is a question that may well be asked by any company sitting on loss-making contracts seeking to mitigate those losses or terminate the ISDA contract altogether by claiming, rightly or wrongly, a market disruption event leading to a termination event.

    Every ISDA is different depending on which option boxes the counterparties to the transaction has ticked. Counterparties may well have had the foresight to pre-agree a fallback reference price to apply when the benchmark they are using undergoes a material change. It is more usual for there to be “calculation agent determination” of the commodity reference price when there is a market disruption event. In many cases the calculation agent is one of the two parties to the deal, particularly when one of the counterparties is a small company without much involvement in the market and the other is a major oil company, trading company or bank that is providing hedging services within an ISDA framework to the smaller company to support, say, asset acquisition financing. So, in many cases, any issue of a replacement price may lie in the hands of only one of the counterparties to the deal. The position of calculation agent is an influential one, not to be relinquished lightly.

    There will be many ISDA agreements in existence stretching a number of years into the future that were agreed before the prospect of WTI Midland joining Brent was envisaged. But since it is looking increasingly likely that Platts and SUKO will proceed to include WTI Midland into Brent from June 2023, those entering into ISDA Master Agreements from now on would be well advised to consider the implications for their positions and consider how they can protect themselves, if there is a challenge to the revised composition of the Brent benchmark.

    Just Don’t Do It

    In my opinion, putting WTI Midland into Brent is just too complicated and it would further obscure the transparency of a key benchmark, which is already very convoluted.

    If Brent were to be shown to be manipulated or to produce unrepresentative prices as the volume of oil that we call Brent declines further, companies would choose to stop using it. Companies instead might decide to use WTI Midland as a new benchmark in its own right, or Murban/Oman, or any other new benchmark grade that emerges over time.  Trade does not stop when there is a problem with a benchmark.

    Letting individual companies choose how to trade must be better than pushing the industry to change their trading practices to prolong an international  benchmark, Brent, that should really be allowed to fade into a more regional role. But, it is unlikely that companies with too much invested in Brent will permit that to happen. If WTI is not forced into Dated Brent like a square peg in a round hole, then something else will be.

    [1] suko-90-final-amendments-2023.pdf (shell.com)

    [2] http://ports.com/sea-route/port-of-houston,united-states/port-of-rotterdam,netherlands/

    [3] The definition of contango is that at any given moment in time oil for delivery in the near future is worth less than oil for delivery further forward in the future. The definition of backwardation is that at any given moment in time oil for delivery in the near future is worth more than oil for delivery further forward in the future.

    [4] https://ceag.org/senior-associates/

    [5] SUKO 90 Final Amendments 2023: https://www.shell.com/business-customers/trading-and-supply/trading/general-trading-terms-and-conditions/_jcr_content/par/toptasks_copy.stream/1653300136349/ca261c49650e0c850ee18c6e82650ad3dfdfba95/suko-90-final-amendments-2023.pdf

    [6] “The Brent Benchmark Complex: Evolving Necessity”, July 2021.

    [7] “The Future of the Brent Oil Benchmark” Adi Ismirovic, The Oxford Institute for Energy Studies, March 2022.

    [8] CFTC Docket No. 22-16 and https://www.cftc.gov/PressRoom/PressReleases/8534-22

    [9] Commodities Annex ISDA 0321 and 2005 Supplement Commodity Definitions and Document Listing