By Robert Campbell
NEW YORK, July 5 An explanation of why Brent
crude oil futures have jumped more than 10 percent since late
June that does not take into account the very narrow physical
basis of the contract is missing a big piece of the puzzle.
This is not to say that geopolitical tensions or investor
positioning played no role in the run-up.
But the idiosyncrasies of Brent, which periodically lead the
contract to decouple from the rest of the world oil market, have
again been at play. )
It is no coincidence that the surge in outright Brent
futures prices, and the unwinding of the brief contango in the
Brent forward curve, has coincided with the third-smallest
monthly loading program ever for the crudes that set the price
Brent futures are financially settled based on pricing in
the so-called paper Brent, or BFOE market.
The BFOE market, in turn, is governed by a complex
arrangement that allows crude sellers to place cargoes of Brent,
Forties, Oseberg or Ekofisk crudes into the "chains" of
bilateral deals for North Sea oil cargoes.
Since Forties is the lowest quality, and hence cheapest, of
the four crude oil grades, sellers almost always elect to
deliver Forties cargoes into the chains to satisfy any
So it is notable, to say the least, that BP twice
elected to place higher-valued Brent and Oseberg cargoes into
the chains in June.
At the time, traders interpreted these moves as bearish: it
only made sense to deliver higher-value crude into the chains if
very low demand left BP with a surplus of high quality crude.
The cheap values attached to July-loading cargoes at the
time were all the more remarkable as loading rates for major
North Sea crude streams were set to be the lowest rate yet for
2012 in July.
Loadings of the narrower set of crudes eligible to be
delivered against BFOE obligations were even weaker.
Scheduled loading rates for BFOE grades, even before the
Norwegian strike had much of an impact, were set at 890,000
barrels per day in July, the third-smallest monthly rate ever.
In other words, despite very low regional supplies, pricing
in mid-June showed very limited buying interest.
In hindsight, this was a market primed for a shock. And that
came in the form of the strike by Norway's oil workers' union.
BRENT BREAKS DOWN
The strike by Norwegian oil workers began earlier in June
but it was not until late in the month that the curtailment of
some production began to have a serious effect.
Yet up to late June, the Brent market was sanguine about the
loss of these barrels. Towards the end of the month, Forties
cargoes were being discussed at discounts to the Dated Brent
benchmark derived from the BFOE market.
This prompted yet another effort by a trader, Trafigura, to
exploit the arbitrage between North Sea and Asian oil prices, a
move that has been facilitated this year by a free trade
agreement between the European Union and South Korea.
The trade agreement cuts the price of British crude oil when
delivered to South Korea by exempting it from import duties.
There's nothing wrong with this agreement, but it has torn a
big hole in the rickety physical Brent market structure.
By siphoning off barrels that can be delivered against BFOE
chains, the trade introduces an artificial support to the Brent
Downward pressure comes only indirectly as European
end-users switch to non-BFOE grades: a time consuming process
that is not necessarily synchronized with sudden losses in BFOE
supplies to Asian arbitrage.
So from June 21, when Trafigura began arranging shipping for
2 million barrels of July-loading Forties to Asia, the BFOE
market was tipping into a short-term tight supply situation.
BP's June 26 delivery of a rare Brent cargo into the chains
may well have been due to limited supplies of Forties.
As delays to Oseberg cargo loadings due to the strike became
apparent in early July, the risks to firms on the short end of
BFOE obligations --i.e, those needing cargoes to deliver-- must
have become increasingly clear.
A natural move at this point would be to buy Brent futures.
This would hedge some of the risk sellers faced from the
physical shortfall in BFOE barrels in July.
Low Forties output, plus yet more Forties exports to Asia,
plus delays to Oseberg and the potential shutdown of the
Norwegian half of the North Sea made much of the price action in
Brent last week a local, not global story.
PLATTS MUST ACT
The foregoing analysis returns the discussion to the need to
reformulate the BFOE market. If this was a regional curiosity,
no one would care.
While BFOE underlies the price of a huge amount of
globally-traded oil, as its physical basis narrows it all too
often trades on the basis of short-term regional factors.
Platts, the McGraw-Hill unit that produces the price
assessments at the heart of the BFOE system, is aware of the
issue and is working on solutions. Related column
Adding more grades to the formula has been considered. So
too the introduction of adjustment factors to make the other
grades in the formula more competitive with Forties when setting
Given the complexity of the Brent market and the size, and
duration of swaps books written against Platts' assessments,
making changes is neither easy nor fast.
Yet the distortions in the Brent market demand a solution.
The resolution of the Norway strike will do something to
temporarily restore order, but annual maintenance season in the
North Sea is poised to wreak more havoc in August.
August and September Forties loadings are already being
forecast to be near record lows by Forties pipeline operator BP
due to planned maintenance.
This will force buyers into the more costly grades in the
BFOE structure. The effects of this scramble for barrels will
feed into Brent futures prices.
Will the resulting Brent futures structure reflect the
actual situation in global oil markets or only short term supply
shortages in a narrow slice of the North Sea market representing
a little more than 1 percent of global oil supply?
If the result is the latter, the calls for Platts to fix
Brent will only get louder.