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In the second of a two-parter, we continue to discuss the proposals to reform Dated Brent, ponder what lies beyond Brent, and, as we reach the end of the series, ask has it been an effective pricing tool?
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 Dr. Adi Imsirovic and Saket Vemprala about the feature of Brent. If you've not already listened to the first part of this episode, probably best to go check that one out first. You'll find a link in the show notes. Well, we're in the final stretch. We've done a couple of episodes now and we're on the London path to the climax of our story. Adi, before we left off, you were talking us through the different options that had been proposed, the second time round really, after initial proposals to reform Brent hadn't gone down very well. Tell us, this year Platts came back with a new plan. What was it, and how did they find consensus with the industry?
Adi:
Okay. Well, just to recoup what we said last time, it seems that most of the industry went with this inclusion of WTR Midland rather than inclusion of Johan's verdict for two reasons. One reason is quality, second reason is market concentration. The only other option, I think the other thing that I said last time was that the whole industry had a big problem in that any solution had to be done within a framework of constraints. And the main constraint is that all the legacy contracts remain unchanged, or reasonably unchanged, in terms of value. The latest proposal, again, always happens at Epic. At IPE week, sorry. February, when everyone gets together in London. Was, well, we are including WTI Midlands, and now I'm just trying to make it as simple as possible. We are going ahead with Midlands, with the WTI Midland in the Brent contract. But what we are going to do is we are going to use our very liquid and very good... I think most of the PRAs have very good freight assessments these days anyway, so it's a very transparent market.
So using these assessments to net back the values to FOB. So then we'll have Dated Brent and Cash Brent will be FOB again based. There'll be no change to all the legacy outstanding contracts, and everything will be hunky dory except that we'll have a lot more volume in terms of WTI Midland. Of course, since then there was another announcement that there is still some outstanding issues regarding the forward or cash cargo. I prefer to call it forward, cash sometimes can be a little misleading, although it's not commonly used. Dated Brent is the easiest one for listeners to understand. Basically, you take, let's say WTI Midland Cargo, which is on offer in Rotterdam. You assess the value of their cargo. It's, let's say dated whatever, even or dated plus 50 cents a barrel. You look at that dated curve and you actually decide what fixed price value that is in relation to all the other BF or ET cargos.
If that is the cheapest cargo, then you say, okay... In fact, sorry, I missed one step. Before you do that, you have to net it back, the freight, as if it was loaded in the North Sea. Okay, so essentially you take the five freight rates, North Sea freight rates for the five braids in the BF or ET contract, you average them out, and then you apply to WTI. And now you have WTI contract Midland as if it loaded in the North Sea. And then you simply take the cheapest one, and it's pretty straightforward. There's a lot of liquidity, and that's not a problem at all. The problem that appeared with what's on the cash side. Cash is a little bit problematic for the following reasons. Some big players, such as Shell, they very often have their US entities sell WTI Midland and other grades to their UK entity.
They have to be very, very careful of the tax exposure between the two entity. Of course, even though FOB and CIF contracts, the title passes at the load port for both, it seems that the legal advice for a lot of companies out there is that it's a lot easier to justify if it's done on delivered basis. So the outstanding issue was originally when Platts made the announcement, well, we still have to sort out the cash and see these GT&Cs. Now, for your listeners, just to explain what GT&Cs are, it stands for general terms and conditions. General terms and conditions is usually a contract which is written upfront and agreed by all the concerning parties trading to make it easier to trade.
So when two traders talk to each other, they don't have to talk about all the details like payment terms, bank, lay time, demurrage. They can if they want to amend those terms. But it's usually a deal is done based on those GT&Cs, so they could focus on the key issues such as price, for example, and pricing. Normally, as you mentioned in your previous podcasts, the normal Brent trades are done on SKO 1990 GT&Cs. So you would just do a deal, I would buy from you a Brent at price of, I don't know, $90 a barrel based on SKO GT&Cs, and that's it. We are done. No problem. The problem now with WTI is that Shell came with a proposal for their GT&Cs where their legal side or legal advice was that they really shouldn't go back to the FOB contract, it had to be delivered contract.
And reasons being tax, primarily. Kurt Chapman and I, in our paper, also suggest that there was also precedent. There was a court case in the United States where a federal judge announced basically that Brent is part of the US futures markets. He was settled out of court, and this is problematic when you have out of court settlements. Legally, it's never really settled. So is it really a part of the US futures trading system? Obviously, it's not. And who am I to argue with a federal judge? This is problematic. And now BP and Vito came out with their own proposals for general terms and conditions, which were actually on FLD basis. So clearly the situation has not been settled properly within the industry.
What is going to happen? Well, now that's very important. I think that the whole of the industry settles towards at least one aspect. Is it going to be delivered contract? Now this is very important, David. When I say delivered, we are not going onto delivered basis assessment. You can have a delivered contract but assess it on the FOB value, but will it be CIF or not? Now, is that problematic? Well, as long as both BP Vit... Well, both key players are BP and Shell agree on one or the other, I think there's no problem. There may well be a bit of a struggle to see which general terms and conditions we are going to use in future, but I don't think that's a big problem. And I'll tell you why. First of all, SKO GT&Cs are generally traded with BP amendments. Because BP's delivered contract is very often used in northwest Europe for all sorts of trades, so it's not necessarily a big issue.
Secondly, I think in your previous show you said SKO 1990, we all know that Brent started trading in the early 80s. It was training for good decade before we got to the 1990 agreement of GT&C. So it is possible that the markets do function and can function with different GT&Cs as long as eventually you agree what you're going to use. Now, just one technical point there, I hope I don't lose some of your listeners. But a lot of PRA assessments are based on cash partials, which are basically partials of 100,000 barrels trading at a fixed price, and then they're made up for full cargo.
Now, the key is now if you have two counterparties trading, to make it up to full cargo, at the end of the day you do need one set of GT&Cs. You can't have one cargo with two sets of GT&Cs. But what Kurt and I have pointed out is, as former traders of 35 years each, was, look, I think we are overthinking the problem. Brent market grew over time, it evolved. And we have to let it evolve. Rather than say, no, no, we need to have everything decided now exactly how it's going to happen. It never has happened in the past and I don't think it will happen now. So we envisage potentially, as long as the market agrees on a general principle how the GT&Cs are going to be set up, that something will evolve.
It will probably be some, again, SKO with BP amendments, or some mixture of the two, or just one or the other. That's where we stand right now. There is still quite a bit to do, and I would expect by February, by the IP week again, that there will be some announcement I guess on some sort of, at least halfway house agreement, regarding where the Brent is going.
David:
The core element of it that WTI, a US crude will be added into the Brent basket, traditionally a North Sea based crude oil assessment. So US crudes coming in on A FOB IE, a loaded or two be loaded basis with some key questions still out standard, but doesn't look like it's going to fall apart here. I'm going to move us on. Because we could, as we say, we'll include in the notes the links to Adi and to Kurt's papers, because they go into this in a lot more depth, and that will be good for our listeners if they want to do some more reading. Just want to touch on, we've alluded to this earlier. Obviously, there are different companies in the market who hold different assets, and they have influence. And there will be winners and potentially losers from these proposals. Saket, who might the winners stand to be?
Saket:
Well, the companies that were very keen, or certainly among the companies that were very keen to have US light sweet crude incorporated into the Brent basket, were those companies that had assets in the US market, holders of US export infrastructure, sellers of US light sweet crude. Equity producers of such crudes, whose streams would be incorporated into the new Brent benchmark, and therefore the signals that they would transmit by offering such cargos and selling such cargos into the benchmark would then help to set a global benchmark that would then ricochet across the wider crude market. And so we know from public statements that companies such as traffic error and Vito have expressed support for the new proposals, the new structure that will take effect next year. And they have put forward suggestions for how this could work in practise.
Even though the early proposal to have loading programmes made available from US terminals may now be abandoned, we know that Trafigura put out a public paper in which they explain how it may work in practise. Meanwhile, on the flip side of the coin, I think very much as Adi alluded to earlier, those companies that have equity production of the Johan's Sverdrup grade, the other North Sea heavier and sour barrel that was considered for possible inclusion in the Brent basket, will no doubt see this perhaps as a little bit of a setback, a little bit of a dilution of their influence upon the Brent benchmark. Equinor, of course, being the dominant producer. France's Total also has equity production of the Johan Sverdrup grade.
And Equinor, of course, much like Adi said a little bit earlier in the episode, already has significant stakes in some of the other light sweet grades that are currently included in the basket. And therefore, if and when WTI... Not if, but rather when WTI Midland enters the Brent basket next year, based on the pricing dynamics we've seen over the last few years, if it does continue to typically price at a discount to some of the more expensive grades in the basket, then we could see some of the pricing power within the Brent basket shift away from the incumbent producers of the lighter, sweeter grades within the basket towards the producers of the US crude.
David:
Adi, would you like to add anything in this space? This is a competitive area. We need to remember that we're talking abstractly here on the podcast, but this is competitive, it's commercial, and people do stand again or miss out. And there'll have been much intensive activity behind the scenes from the trading companies and others in different groups lobbying for their positions.
Adi:
Yeah, it's very hard to disagree with anything Saket mentioned. There will be some winners, some losers. Obviously, people with more assets in the United States, with more extensive trade links with WTI Midland on top of the existing Brent infrastructure will benefit out of it. But it's a fact that you have to go with a contract that makes more sense, first of all. Obviously, it would be ideal if there were no winners and no losers, but it's virtually impossible because oil market is not a perfect market. It's a market in which people trade with $1 is one vote. It's not a democratic system. Big players always have a big sway in the oil market, there's no doubt about it. And again, David, you said both of us are students of history.
If you look at the Brent market in the early days, it was basically BP, Shells, and Exxons that were running the whole thing. They're policing the market, they were deciding on the general terms and conditions and the way the market would run. Sometimes, also, my friend Kurt always has a good point as an ex Mercuria trader. Well, sometimes you need a bit of a carrot for some big players to actually come in and make markets. To get into trouble of actually providing liquidity. And one of those carrots in the old days of Brent was Brent tolerance, for example. In the 90s we had 5% tolerance, and then if you could create these chains... Which is another really interesting, I would suggest your readers if they're interested to read a bit of history of that, either through [inaudible 00:18:05] book, or my book. Obviously, the original is always better, which is something I read as a young trader.
But later on I got involved in that business as well. Basically, you try and create your Brent chain in such a way that at least you don't lose on tolerance. But bigger players would always have bigger books, and they would actually have that carrot at the end of the day. And the Shells, Phibros, BPs of the old would make a fair bit of money out of simply tolerance. And sometimes you need that carrot. Those are not massive advantages, they're not massive profits, but sometimes you need that carrot for some bigger players actually to get into the trouble of making markets and provide liquidity for these contracts.
David:
We're generally accepting that the US market is the big winner out of these changes, and companies who are active there. Are these proposals to add WTI into Brent, are they just a stick in plaster until the benchmark shifts wholesale over to Texas, say, as a FOB basis, US Gulf Coast, WTI, Midland benchmark? Or, is what's being proposed going to give a much longer extended life to Brent?
Adi:
Well, it's an excellent question, David. And it's a very difficult one to answer. Now, again, I think history is the best thing we have. I don't know if many of your listeners may not know, but in mid-80s, due to a price crash, a lot of US producers got decimated. And actually, the volume of WTI in the contract got ridiculously small. And actually, there was a big question mark where the WTI would survive as a benchmark. And then Nimex, that run the contract, did a great thing. They actually had alternative delivery. Alternative delivery is not a new thing. They introduced Brent into WTI contract, not just Brent, but lots of other grades. I remember when I was trading, we delivered a couple of times Bonny Light into WTI contract, for example. So, is this sticking plaster?
Well, now we look at WTI, yes, it's not a perfect contract, but it's still alive and kicking. So is this a plaster on Brent? I don't think so. I think these are just legitimate ways of increasing liquidity in an existing contract. Now we call it Brent just because we are familiar with the name, but obviously as of next year... There were some voices last year suggesting that we exclude Brent out of the main contract completely. The volume is so dire, because we only have a couple of cargos a month at the moment. And very often, one slips or something happens. Kurt and I mentioned at the end of our first paper, earlier this year, that, look, it's down to the market to decide what they want to do. Yes, I think it's very likely, especially now with the war in Ukraine, that WTI is going to be a dominant grade in the Brent basket.
The question then begs, should we go back to just FOB Houston? And I think there are number of PRAs and some exchanges that actually would love to see that. Having a benchmark is a very fickle thing. It's not always something that makes sense, but it's always something that's liquid. Traders like liquidity. And if traders see more basis risk, they will probably still stick to more liquid contracts. So at the end of the day, it's just a matter of what traders decide to use more, and very often, it's a matter of first mover. And if you have an already liquid contract, even if it's inferior to an alternative, it may go on for a very, very long time before you change to something that makes more sense.
WTI Houston, still very young contracts, still pretty much trades as a differential to Cushing. And Cushing already, as you mentioned, had a problem in 2020 when it went deeply negative. It has potential problem with the storage, and so on. Unless we get pure trading on the basis of FOB Houston, it's not going to happen. It may well happen, it's a matter for the industry to decide.
David:
Adi, I guess one thing we haven't mentioned, I mentioned it at the very start, is that we are in an energy transition. And many economies, many governments are putting in policies to try and move away from oil. Do you see a point where Brent and oil benchmark stops being the premier price reference, and that maybe another non oil energy market takes its place? Or, does Brent have characteristics that could prolong its life even further and be a good benchmark through the energy transition?
Adi:
David, that's a million-dollar question. Let me get my crystal ball out. And I'm quite happy to speculate a little bit. Which is obviously not easy, because we live in a very volatile times, as we said originally when we started our discussion. The key for a benchmark is a good legal system supported by good policy. What really worries me now everywhere is an extreme involvement of governments in the markets, and that really scares me. Talks of price caps, whether it's on Russian crude or all the LNG imports into Europe. I think they are not good ideas. I think they're going to lead to knock-on effects. Especially price cap on gas, for example. If it happens, I hope it doesn't happen because I'm an end user. I think if that happens, we could see shortages of gas in Europe, because Europe is a price taker in international markets. And you don't go to supermarket and say, well, I want to buy all of this, but I can't pay more than this.
Well, and if you can't pay more than this, somebody else will. Because Europe is a price taker, not a price maker. It doesn't make sense. Brent market I think is going to stay there for quite some time. Simply because I can see, from everything I read and when I talk to people, a willingness of some very big players to be there. Now, you asked me two big questions. One is on Brent its own as a marker and benchmark for crude, or now we are talking about all the alternative forms of energy. I think it's going to be around for a while as long as there's willingness to play, and the market actually can find a consensus of how to do so. Whether the market moves on to something better, it's really, really hard to say at this stage. But if it does happen, it's probably not going to happen very, very quickly.
In terms of other forms of energy, we are clearly going through a transition where oil is going to be less and less important in the energy transition. Of course, a lot of people disagree with me, including the OPEC Secretary General. Who said recently, "Well, you see OPEC demand growing into end of 2020s and then probably tailing off." Well, if that happens, I think we've lost the fight to stop climate change. As simple as that. I usually look at that situation backwards. Well, if that happens, the price of oil is the least of our problems.
The way I look at it, certainly LNG, we've seen huge growth in LNG and LNG benchmarks. I think that is going to continue. I am worried about government involvement with benchmarks such as TTF, because I don't think the governments realise that price is just information. So when a benchmark gives us that price information when it's very, very high, it means there's not enough supply and there's too much demand, it means something has to be done about it. TTF has been high because of congestion. Sorry, TTF.
David:
TTF, just for listeners, is a European gas price.
Adi:
Yes, it's a hub for European gas price. So the congestion around that hub is such that essentially what TTF high price is telling us that we need some more pipelines and more infrastructure around it, and not change the benchmark. Killing the messenger is not a way to solve a problem. Anyway, moving on. I think electricity market is a very good one, it's working very well. Again, we have a huge amount of government intervention, especially in Spain and Portugal, again, which distorts all these price signals. Let's just hope, David, that doesn't become a habit. Let's just hope that this energy transition proceeds in a orderly way with the market actually giving us signals, rather than us changing market prices just because they don't suit us. That would be our recipe for disaster. But I'm optimistic, and I think that all these benchmarks and many other new benchmarks are going to come, and we will be able to use them for many years in the future.
David:
It's certainly a fascinating part of the market, and one that many people, including ourselves, would be keeping a close eye on. Well, it would be remiss of me, I suppose, as we come to the very end of this series on Brent, not to get your final reflections on this as a benchmark. Look, it's almost 40 years since the first forward Brent market was introduced by a senior trader at Shell in 1984. It's been 35 years since the first Dated Brent price assessment was published by Platts in '87. And 34 years, as we said a little earlier, since the Brent futures was established by the IEPE. We've had four decades of relatively free international oil markets, which was spawned in the wake of North Sea oil discoveries and trade-in proliferated around Brent. Has it provided fairer pricing to what came before?
Adi:
Absolutely, David. We live in the age of benchmarks, and Brent is the key benchmark. One of the three key benchmarks by far, as we said in our previous show. Probably the most important one. What we had before that, well, we had a cartel that was setting prices. Surely cartel has a full right to protect the rights of its own members, but it's for the rest of us to actually protect ourselves. And market is a place where the supply and demand meet, and where producers and consumers actually exchange their views, and they trade. Even though since the introduction of benchmarks, somewhere at '87, originally it happened with Aramco partners actually decided not to lift Saudi oil any ever again unless the Saudis allow us market prices. And that's where we are roughly now. So, I think it's been good.
I think it's not been perfect. It never has been, ever will be perfect. As I said in the last show, oil market is not a democracy. It's where $1, one vote work. So bigger players will always have a sway in the oil markets, whether we like it or not. And I think from the policy perspective, it's for the governments to actually look at that side of things, rather than the benchmarks. Which, benchmarks and prices are the wrong thing to change, and the wrong way to go about it. If they want to reduce importance of some bigger companies on the price mechanism, they should look at that first. But it's been working remarkably well. And I think that the key test for Brent has been roll the two. It's been 2020, the COVID pandemic, and 2022, Russian invasion of Ukraine. And I think as a benchmark, it's worked remarkably well. And I think the reason for that is the fact that it really evolved over time in a way that just made sense for the market participants rather than being created artificially.
David:
Abi, Saket, thank you so much. That was a really fascinating discussion.
Saket:
It was my pleasure, thank you.
Adi:
My pleasure. Thank you very much, David.
David:
For our series on Brent, that's a wrap. Thanks to our guests, Dr. Adi Imsirovic, Liz Bosley, Colin Bryce, John Kingston, Mark [inaudible 00:32:02], and Saket Vemprala for helping guide us through some 160 years of oil pricing. Together, we've seen how the early years of oil trade-in around Oil Creek, Pennsylvania, in the 1860s, laid down practises such as the role of exchanges and forward contracts, which would survive into the modern day. Standard Oil's audacious power grab through its posted prices would ultimately fall foul of government intervention and regulation, but it would be far from the last corporate to accumulate and wield immense price in power. As the oil market proliferated outside the US at the turn of the 20th century, the IOCs, the international oil companies, dictated pricing. Only to later lose the role of pricing cartel heading into the second half of that century to the NOCs, the national oil companies, which had been incubated under colonial regimes.
Soon change would come again. The discovery of very fungible and accessible crude supply in the North Sea in the 1970s came at precisely the same time as favourable factors in the wider political and economic landscape to support more independent pricing. Free markets offered the swell of new independent oil companies the chance to seize pricing control from the NOCs, from OPEC, by supporting the price benchmarks being published by the PRAs, price reporting agencies, and using the associated hedging tools run by financial exchanges. Now, for the best part of 40 years, or a quarter of the oil trade in the modern era, Brent benchmarks have dominated the oil pricing landscape. They are now responsible for setting the price for over 70% of world exported oil.
As we've learned, Brent is now a galaxy of prices. And on the physical side, it now exists largely as just a brand name. The physical Brent basket of crudes now number five different grades from the North Sea. But Brent's most daring reinvention yet to remain the king of benchmarks will happen later this year as it's set to incorporate US crude. So from odyssey to oddity, as one guest concluded, or during an era of benchmarks, and questionably a fairer pricing tool to what came before. Feel free to offer your verdict on Brent. Join in the conversation on Twitter and LinkedIn by using the hashtag, GXpriceofeverything.
What's indisputable among all the posted prices, references, and contracts, Brent has emerged as the one benchmark to rule them all. Until the next time, you've been listening to The Price of Everything, a new podcast from General Index. Goodbye.