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
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 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
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
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
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
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
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
As such, Brent's problems have not been resolved but merely
kicked down the road.