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In the second of a two-parter, we explore the proliferation of trading around Brent crude oil, the role of the so-called ‘Wall Street Refiners’, and our guests offer their take on the Brent benchmark.
Welcome to The Price of Everything, a podcast that aims to shine a light on pricing. The cost of commodities – energy, food, etc. – play such an important role in our lives: accounting for around $5trillion worth of worldwide trade. But how are those prices actually calculated? Why do they move up and down so much? And what’s next?
The Price of Everything is the first podcast dedicated purely to how pricing works. Introduced by Neil Bradford, Founder & CEO of General Index (GX), and hosted by David Elward, Senior Pricing Analyst at GX, The Price of Everything takes listeners through how the world’s commodities are priced and what the future looks like for them in the age of climate change and the energy transition.
In this second series, we’re exploring the new markets coming to prominence, and how commoditisation in those sectors – hydrogen, voluntary carbon, sustainable aviation fuel and others – is often elusive; pricing and standards far less well defined; and value derived by their capacity to help combat climate change.
Neil:
Hello and welcome to the Price of Everything, a podcast that aims to shine a light on pricing. The cost of commodities, that's energy, food, and so on is such an important part of our lives. But how are those prices actually calculated? Why do they move up and down quite so much? And what's next? The Price of Everything is the first podcast dedicated purely to how pricing works. My name is Neil Bradford and I'm the founder and CEO of General Index, which is the world's first technology led benchmark provider. Together with my colleagues from around the world and some special guests, we'll be taking you through how some of the world's most important commodities come to be priced and what the future looks like for them in the age of climate change and the energy transition.
Dated Brent is the world's most widely recognised price for Crude oil. But why Brent? How did an oil field off the coast of Scotland become so pivotal in global oil pricing? My colleague David Ellwood explores the history.
David:
Thanks, Neil. I've been speaking to Liz Bosley and Colin Bryce, two oil industry veterans, and we've been discussing the emergence of Brent Crude Oil and the pricing structures which evolved around the new North Sea oil production in the 1970s and 80s. If you've not already listened to the first part of episode two, probably best go check that one out now. You'll find a link in the show notes.
In this second part, we discuss more about the complex methodologies, which built up around the spot trading of Brent, the role of the so-called Wall Street refiners in creating a Brent hedging culture. And we also squeeze some thoughts out of our guests on the future of the dated Brent benchmark. Okay, let's rejoin the conversation where we continue to discuss the role of the British National Oil Corporation and the influence of the UK taxation system on trading practises.
So you'd gone, Colin, you'd left a few years earlier you said, and we're going to come on in a little while to talk about how the market evolved through the 1980s. And I know, Colin, you have good memories of that and a sort of firsthand view of what went on. Liz, I just want to pick up with you to lead us to that point. One, you mentioned earlier, one of the aspects, the links with BNOC was to the taxation system, and there were opportunities there that oil companies identified in order to optimise their trading around the tax bill, and that led into more sort of emergence of more complex trading practises. Tell us about that.
Liz:
Well, the interesting thing that you have to remember about the North Sea taxation regime is once you added up all the taxes, petroleum revenue tax, royalty, corporation tax, your marginal tax rate was sometimes over 80%. If you could take your sales of your North Sea oil outside that tax, high tax level and take it into just the corporation tax level, then you could reduce your tax bill quite considerably. A key concept here is the ring fence.
David:
The ring fence, okay.
Liz:
Yes. And the ring fence concept is that if you're developing an oil field and producing from that oil field, then your petroleum tax is based... Your revenue from that field, less cost recovery of that you can reclaim from the revenue stream. So if you spend a lot of money developing an oil field and you are allowed to claim that back out of the revenue stream. So to avoid companies cheating by bringing costs from other [inaudible 00:04:25] fields into the revenue calculation, they put a ring fence around each field, and each field was considered on its own merits for petroleum revenue tax, royalty, and corporation tax.
Now, if you sell an equity cargo, one of your own cargoes, it attracts that high rate of taxation. If you sell oil that isn't your own equity and you buy oil from outside to supply that sale, then your profit or loss is subject to corporation tax or corporation tax relief, which might be considerably lower, may be around in some cases 25%, 30%. So one of the things that would be attractive to do was if you could sell lots of cargoes and buy lots of cargoes, then when it came to clearing the market for a particular delivery month, if you could put your highly taxed own production into the lowest price sale you have made, then you would save quite a bit of taxation money. And that is the concept of spinning and in the early days of BNOC. And that is something that was recognised very quickly and triggered the proliferation of deals of 15 day Brent, this is where 15 day Brent really came into its own.
David:
SO Liz, I'm just going to pause you there because I'm sure maybe to some of our listeners who are not okay with the tax system and all of these machinations of practises, perhaps their heads are spinning now as well. So break this down for me. Break us down going forward now, explain, when you say 15 day Brent, what do you mean?
Liz:
Okay, we have loads and loads of cargoes. In those days, Brent production was around 800,000 barrels per day, and there we are sitting on a trading desk in BNOC, having to buy 51% of that and sell 51% of that at a minimum each month. You also had your own equity, you had your own third party purchases. There was a lot of oil moving and there were only four of us. So it was quite a big job getting all those negotiations done and getting cargoes allocated each month. So what really facilitated the process was if you could say in advance, okay, well you are going to get six cargoes next month. We will not know until halfway through this month what the dates of each of those cargoes is going to be. So if we have to wait until the 15th of N minus one to tell you which cargo you're getting in N, there's going to be a last minute scramble.
From a BNOC perspective, the introduction of 15 day Brent meant that I can sell you a cargo of Brent, which is loading 3, 4, 5 months forward. I don't know what the dates are going to be because those are only allocated 15th of N minus one for month N. But if I can sell you at three or four months forward and tell you the dates 15 days before it loads, which is when I will find out the dates of the first cargo in month N, then my job becomes a lot easier. I can just shovel out a whole bunch of cargoes and sort out the operation of which one belongs to which company later. And that really made our lives in BNOC a lot easier.
David:
So this is equity producers? They weren't obliged then to inform the buyer of a cargo what the allocation dates would be until 15 days before loading. It was a trading practise to forward planning exercise, really.
Liz:
Yes, from BNOC's perspective it was an efficiency measure from the point of view of some of the other companies. It was something that would facilitate spinning. I mean, the first cargoes were done, it was really suggested by Chevron who were big producers of the Ninian field, and they tried to get the early 15 day Brent contracts to be 15 day Brent Ninian or 14th. They wanted it to be an auction contract where you could sell by a cargo and tell them 15 days before it loads which grades and which cargo you're going to get. The industry didn't like that. The refiners said, oh, I need to know much more in advance whether I'm buying Brent Ninian or 14th because these oils have different characteristics and my refinery needs to know what it's getting. So it became, although was suggested initially as 15 day Brent Ninian 14th, it very quickly became 15 day Brent, and that's really where it all started, and that was 1981.
David:
And so that's been a practise that's continued to this day. I mean, not 15 days, the period has grown, but that's a practise that's endured. To bring Colin back into this discussion, obviously we said earlier that the BNOC sort of met its demise, it was abolished by the facture government in 1985, but effectively meant what it did mean that there was no more UK government officials selling price. People in the market then were looking around, they must have been looking around for other price references.
And Colin, I think you mentioned, so there was a proliferation of activity and participants in Brent, and we talked about earlier how the ecosystem of oil trading in London was growing. You'd gone into Brit oil, sort of the privatised element of BNOC. What's your recollections of the period in terms of how the market evolved, there was the growth of exchanges, et cetera, just sort of further structures growing up to support all of this activity?
Colin:
Yeah, Liz's exposition of that period was very clear, I thought. But you can tell from what we heard, just how complex the methodology was, even in the early days. And of course as time has gone on, that complexity has become further complexity. But between 1981 and 1986, what we really had was the development of a physical forward market, the Brent 15 day market as described by Liz. And as she said, the reasons for that were fiscal spinning, very, very important. But also commercial folks who were involved in market facing activities in BP and [inaudible 00:12:39] and Chevron and mobile not only saw the opportunity to assist their company and optimising its fiscal position through spinning, but they discovered they could also make some money trading. Who better than the producers of the oil knowing when the supply is coming or not coming to be able to operate speculative businesses as well. So there were commercial as well as fiscal reasons, and that meant that between 1981 and 86, the market exploded in 15 day Brent, and the sport market became everything really as the BNOC price became redundant.
Right about 1986 though, there was a little bit of a, I suppose interregnum. There were two or three issues that arose with trades and with companies who have been involved in trades who reneged, if you like, on some of the transactions and that action reverberated throughout the industry because cargoes which were trading in the 15 day market, and they have passed through 20, 30, 40, 50 hands between inception and final loading.
So once such company that caused a problem was, I remember GAT Oil, [inaudible 00:14:14] was another where there was a fraudulent activity going on. And interestingly enough, the market self-regulated, it stepped in and Shell particularly were very active in helping to clean up what had happened and restore confidence in the marketplace. It tells you just how much value spinning and commercial trading must have meant to them that they stood up and sorted these things out. But they did. And that probably, I suppose was the high point of the 15 day market around about that sort of mid-80s time because the 85 to 87, 87 to 90 period became more characterised by derivative markets and futures markets. So the IPE crude oil contract, which had been unsuccessfully, floated on two occasions starting in 1983, finally floated successfully in 1987. And so you had a futures contract developing in these markets.
David:
Just to tell our listeners, so the IPE was the International Petroleum Exchange?
Colin:
Yes, that's correct. That's correct. And they got going. And around about the same time you had a group of companies called the Wall Street Refiners who were in fact American banks from Morgan Stanley, Goldman Sachs, Drexel Burnham, Bear Stearns came into the market and started to employ techniques which they had brought in from other commodity markets and financial markets and create derivative products which overlaid the existing market in 15 day Brent physical forward market.
So you started to get what John May Smith, who we referred to earlier, called video barrels on the screen, future exchanges, electronic trading towards the end of that period. So things changed and the market matured, and then that led to an explosion of activity actually, and trading volumes started to represent many, many, many times of all the oil actually being produced.
David:
That's a really useful whistle stop tour through the 1980s. I want to give a shout-out actually on the... You had mentioned some of the serious market issues, those are covered really excellent by Paul Horsnell and Robert Mabro in their excellent book on Oil Markets and Prices. If people want to know more about that, they can dig out, check out that book. Liz, during this period, you'd moved on from BNOC. What are your recollections of this, I guess, the financialization of Brent and the oil industry?
Liz:
Yeah, I left BNOC in January 1985, and it was wound up in March, and I'm sure that's just a total coincidence. Has nothing to do with me leaving. I went to the city and then when BNOC got wound up, I'd just been in my new job for two months and got a phone call from Enterprise Oil who had previously at a small exploration of production company, been selling all its oil to BNOC and all of a sudden didn't know what to do with it. So they recruited me. So I moved over back into oil trading for Enterprise oil. And it's still a function of production companies, that once they found the oil, they don't know what to do with it. And they're very much in the hands of the majors and very much of the hands of trading companies and even in some cases banks for financing and trading issues.
And back then, very few companies in the EMP sector that's explanation of production sector, were doing anything about the prices other than making sure the barrels were placed safely in the hands of somebody who was going to lift it, turn up with the tank at the right time and pay the bills, pay the money on time. It was very much, we are a price taker mentality. And I think the biggest change there was a lot of companies who wanted to hedge but were forbidden from doing so by their memorandum and articles of association were not allowed to enter into financial transactions, which were, even though they were done as a hedging mechanism, we're considered to be risky financial deals. So these companies could not manage their prices until the Wall Street Refiner stepped in and offered a concept called trigger pricing. This was very straightforward, vert initiative and hugely helpful.
Trigger pricing is if a company like Lasmo, for example, were selling to Goldman Sachs. They would agree a price differential between their cargo and Brent, and then they could agree which Brent price would apply in [inaudible 00:20:19]. So I'm selling to you at say 20 cents over Brent, but which Brent? And I can phone you up on any day and say, okay, I want to fix part of that cargo now. The IPE market is showing $25, I want to price 50,000 barrels of my 500,000 barrel cargo at the price on the screen. So you could actually get to...
Instead of it being a one-off the price that applies when we actually agree that you're taking the cargo, that decision could be chopped up into smaller pieces and allow the expiration of production companies who couldn't use the future's market, who couldn't use the 15 day market to actually start to take some control of their prices by deciding that today I want to price a bit of my oil and I'll pick up the phone to Goldman and say, okay, let's do it now. And Goldman would say, okay, and they would fix the price at that point in time. Then Goldman would go off and hedge it because they had total access to all of the exchanges, the 15 day market and every other tool available. So that sort of did a lot for changing the mindset of the expiration and production companies and getting them involved in the market too.
David:
So you mentioned the usefulness of the IPE price, the International Petroleum Exchange price, the Brent future contract. Also at this time you had the entry of price reporting agencies, PRAs as they known, some of them had been around for quite some time. And these are another participant in the market offering an independent view of market price, assessing prices. And I'd encourage our listeners to check out a separate interview that we recorded with a gentleman called John Kingston who was key in assessing the first dated Brent prices at one of the PRAs.
But just as we rapidly approach the end at this episode, Colin and Liz, I'd like to get your thoughts, just your reflections on this ecosystem of different prices that were around. So you had the exchange prices, you also had price reporting agencies given at an assessed view of the physical market price. And I guess two thoughts perhaps among others you might have, I mean what was the most important price around this period, perhaps for what you were using? And also just to wrap up your broader reflections on how the market has subsequently evolved and the role that the Brent price has had. So Liz, perhaps I'll start with you.
Liz:
Tough one to wrap up because it's still evolving and it's evolving [inaudible 00:23:26] trader and I would get a phone call from a PRA. Pay a lot of attention, we did not give them a lot of information, and I have to say, it was considered a sport to see what you could get these idiots to publish on the trading desk. Just tell them anything and see if you could push the market in one way or another. Now, don't faint, but nobody was paying any attention and it didn't matter because it was all term prices and very little spot market. That began to change late 70s, early 80s when you started to see more sport deals and prices in term contracts. Instead of being fixed and flat, so many dollars per barrel fixed to whatever plots or [inaudible 00:24:29] oil report were publishing at the time. It became less of a negotiation on what was the absolute price to the differential. There also became a much more rigorous approach to what you were telling the publications because suddenly it mattered because there were deals that were pricing by reference to these publications.
So it wasn't just a case of, oh, just tell them anything to get them off the phone. I'm busy. It actually became a serious matter, and that became much more serious over the balance of the 80s and 90s as the price reporting agencies became a key reference point for price encouraged, internationally. Dated Brent, in my opinion, a huge role over the years in setting the price of oil right across the world. WTI has two and so did Dubai, but the wind has changed direction.
In my mind, dated Brent has passed its sell by date on the current effort to prolong its life are ill-advised. But certainly what we have seen over the years is a much, much more vigour in understanding and making the markets more transparent. And I think that's all to the good, and I think the more transparent they are and the more competition we have in reporting them either on behalf of the PRAs or the exchanges, then the better it is for the market and the less chance we've got of manipulative action being successful.
David:
Colin, I know obviously through the end of the 80s and into the 90s, perspective would've grown as you joined Morgan Stanley and had a view from financial side of things, but obviously Morgan Stanley very active on the physical too. What was the role of Brent for you, and just your broader reflections on it as a benchmark and as a reference price?
Colin:
Yeah, sure. And I joined Morgan Stanley very early in 1987, and in fact, a large part of my early career was supplying people like Liz with trigger pricing deals and having her call me up and panicking in case I gave her the wrong price and she went to Goldman Sachs instead. And essentially these trigger prices, they were just a part of the growth of the market where I think they came from the sugar market initially, and they enabled the exploration production companies, as Liz said, to be able to separate the timing of the decision between their supply decision and their pricing decision. And so it enabled a hedging culture to develop, and they were the forerunner to many other different derivative instruments, options, swaps, combinations of options and swaps that developed in the paper market. As the 1980s came to an end and corporations involved with price risk, real ways, real best companies, glass producers, all of these types of people started to come into the market to hedge their price risk.
And firms like Morgan Stanley were the provider of these sort of instruments for a large part of that period. At the same time in the, let's say the real market, going back to Brent, this dated Brent started to become ever more important and ever more complex, and it has become increasingly complex over the years to the extent I think that there are a few people I imagine, really understand what goes into the creation of the dated Brent price these days. I'm not sure if there are terribly many people who are very interested in researching that either. It's become a brand actually, and as long as a price is published in the Financial Times tomorrow, I think most people who use dated Brent as a reference price don't really care how it's come up and constructed. Liz is right, it may well have outlived its sell by date.
In my view, it's been an odyssey, and in fact, it's taken longer than Odyssey has took to get back home in the Homer tale. It's just gone on and on and on and on, become more and more and more complex as a creation and two of the price supporting agencies these days. So where it goes from here is difficult to predict, probably it just carries on with further complexity over laying on it, and not too many people caring too much about that, except for one thing, dated Brent associated contract to hedge their dated Brent exposure. Then there has to be a convergence at some point between dated and the futures markets so that the hedge is accurate.
And if in fact dated Brent is found in such a way that you don't see that convergence taking place, then I think the amount of liquidity that goes into, for example, the [inaudible 00:30:34] futures would decline significantly because there has to be that convergence. So that would be the one thing I think that might end the party for the dated Brent folks, and for the PRAs.
Liz:
Yes, less of an odyssey and more of an oddity these days.
David:
Liz, I think you have given us the perfect sound bite to end this podcast and to both of you, as we are discovering with each episode, we could speak for so much longer. But Liz, Collin, thank you so much. That was a really fascinating discussion. Delighted that you were able to join us. Just a last word to our listeners, if you'd like to engage with anything our guests have said, you can join in the conversation on Twitter and LinkedIn by using the hashtag GX price of everything.
Coming up in our next episodes, we'll be speaking to someone who had a front row seat at a major equity producer in Brent and who saw the growth of Brent as a global benchmark. We'll also be speaking to someone who was there at the start of the dated Brent benchmark at one of the price reporting agencies, and we'll consider the existential crisis this most important of benchmark faces as production in the North Sea declines. Until then, you've been listening to the Price of Everything, a new podcast from General Index, goodbye.