By Robert Campbell
NEW YORK Feb 20 Oil major Royal Dutch Shell and price reporting agency Platts have both come out with proposals to reform the BFOE, or "paper Brent" market at the core of the world's oil benchmark.
About time, some might say. After 2012 began with oil price spikes and squeezes amid shrinking supplies of Forties blend crude, the key grade in the BFOE framework, calls for Brent reform started to get loud in the spring. (See related column: )
Months would go by as evidence mounted that the increasingly narrow basis of the entire Brent market structure was proving to be a fundamental problem.
By the summer the nature of the problem was clear.
Already roiled by the emergence of new demand for Forties crude from South Korea due to the quirks of a trade treaty, the market sudden rallied after a dramatic tightening from heavy maintenance and a strike in Norway. (For a related column: )
At the time, some influential actors in the Brent space resisted any suggestion that the narrow basis of paper Brent was itself adding to upward momentum in prices.
Yet here we are a few months later looking at proposals that fundamentally aim to widen the basis amid broad agreement that the measures will curb the upward bias to the Brent market structure by enhancing the role of grades other than Forties.
FORTIES STILL KING
So far the market is still trying to figure out which of the two competing reform proposals will attract the most liquidity. But by and large this is a sideshow. One will win, and fairly quickly, as the market more than anything abhors fragmented liquidity.
The bigger picture is that the principle of price "escalators" has now been enshrined in the paper Brent market. How will this work and will it really curb the role of Forties?
The BFOE market is based on bilateral forward sales of cargoes of North Sea oil. The seller has the option to deliver any of the four grades - Brent, Forties, Oseberg or Ekofisk - to the buyer.
The idea of making four grades deliverable was to lift the basis of the Brent market to around 1 million barrels per day of production. But that has not worked out as planned.
As Forties is generally a lot cheaper than the other three grades due to its higher sulfur content, a seller faces a considerable economic penalty if he chooses, or is forced, to deliver a higher quality grade to satisfy his obligations.
As such, Brent effectively rests not on 1 million bpd of North Sea output but rather on roughly 350,000 bpd of Forties production.
This is the root of the problem with the entire Brent structure. The wide price gap between Forties and the other grades means any disruption to Forties output can become enormously expensive.
As Forties output shrinks due to natural decline, the situation gets worse. That, in turn, helps drive the strong backwardation in Brent futures as traders try to hedge their exposure to Forties or speculate on how Forties might affect prices.
The changes proposed by Platts and Shell to BFOE will reduce, but crucially, not eliminate the penalty for delivering non-Forties grades. Both proposals would effectively rebate back some, perhaps half, of the premium for alternatives to Forties back to the selling party.
But because the entire premium is not rebated, Forties will remain, under normal conditions, the most attractive grade to deliver against a BFOE position.
KICKING THE CAN
So in many ways, the market will be unchanged from today. Under most circumstances traders will still want to deliver Forties whenever possible.
In an environment where Forties rises quickly in price relative to the other grades, the new methodologies will more quickly cap the gains by making Ekofisk, generally the second-cheapest of the four grades, more competitive with Forties.
So in theory, unplanned outages at the Buzzard field, which supplies much Forties output and which wreaked havoc with Brent trading last year, should have less impact.
Similarly, the impact of the "South Korean arb," whereby traders move Forties to Asia instead of delivering it on the BFOE market, should be reduced.
But Forties price spikes will have a lingering effect.
Because both the Shell and Platts proposals derive their escalators from past spot prices, a month where Forties prices are strong relative to Ekofisk means a much smaller Ekofisk escalator in the subsequent month.
So the risk is that a tight month in Forties will leave the subsequent month more vulnerable to squeezes because the escalator will smaller.
This is a situation that is bound to become more prevalent as natural field decline eats away at the Forties production base.
Effectively the Shell and Platts proposals are both only half-measures. They curb, but do not eliminate, the larger-than-life influence of Forties.
By leaving in some of the economic penalties for delivering alternatives to Forties, the market's basis has not been substantially enhanced. Forties will remain a critical pricing influence.
As such, Brent's problems have not been resolved but merely kicked down the road.