By Christopher Johnson - Analysis
LONDON (Reuters) - U.S. crude futures are likely to remain unchallenged as the world’s top benchmark for oil for the foreseeable future despite the wild swings that its front-month contract has seen over the last three months.
The New York Mercantile Exchange (NYMEX) contract for U.S. crude, also known as West Texas Intermediate (WTI), offers more liquidity than any other oil futures market. Although it has peculiar problems, its idiosyncrasies are generally understood by energy markets.
A good case can be made for using several other grades of crude oil as a benchmark -- the best candidate being North Sea Brent -- but all have drawbacks of one sort or another.
“Rumors of the death of WTI as the benchmark are greatly exaggerated, even if it faces short-term challenges,” said Lawrence Eagles, head of commodities research at JP Morgan.
The behavior of NYMEX oil futures has caused consternation among some investors and producers over the last three months as its nearby contract has fallen to a steep discount below later months and has traded below other crudes of inferior quality.
U.S. crude is a light, sweet oil that is normally highly prized for its content of high-value products such as gasoline.
But the economic crisis that has gripped the United States and the world’s other major economies over the last year has turned normal assumptions about the oil market on their head.
For the first time in a generation, global demand for oil is falling. Oil prices have fallen more than 70 percent from their all-time high of nearly $150 per barrel last year and oil for immediate delivery is worth far less than future barrels.
In Cushing, Oklahoma in the U.S. Midwest where the NYMEX futures contract is settled, oil tanks are almost full as firms keep oil they cannot sell now in the hope prices will recover.
As storage costs rose, delivery into the NYMEX became more expensive, forcing down prompt oil prices. Nearby NYMEX crude moved to a record discount below Brent futures on the Intercontinental Exchange (ICE), exceeding $11.50 on January 15.
These discounts for prompt U.S. crude are now back to more normal levels but they cost some firms dear while they lasted.
Middle East oil producers, who use the NYMEX as a benchmark for sales to the United States, saw their sales prices fall, and funds invested in some exchange-traded oil found themselves paying huge roll penalties as nearby futures contracts expired.
“If you have a benchmark which fluctuates quite widely from historical norms, it has the potential to create distortions in the market,” said Eagles. “But that doesn’t negate the benchmark. The market has a way of fixing these distortions.”
Adam Sieminski, chief energy economist at Deutsche Bank, argues the key requirement for any benchmark is ample liquidity, so that no one party or parties can corner the market.
It should also be traded in a well-regulated and transparent market with a legal system that is considered fair, and a strong financial center nearby to provide sophisticated investors. So long as these conditions are met, the market can trade almost any grade against the benchmark in a series of spreads.
“The reason it is so hard to get serious competition from other possible benchmarks is that there is usually one or more necessary ingredients missing,” Sieminski said.
Most traders and analysts see Brent as the most obvious viable alternative benchmark to WTI. Brent is already used as a benchmark for sales of Saudi Arabian and West African exports.
Traded volume on ICE is high, though not as high as NYMEX, and London provides a deep well of liquidity. The North Sea crudes which act as the underlying instrument for ICE Brent are produced, distributed and traded by a wide variety of players.
But Brent has drawbacks. Although the main North Sea fields together produce more than 2.25 million barrels per day (bpd), production is declining and the Brent stream itself is now only around 140,000 bpd. To cope with this decline, traders use a basket of North Sea crudes and the number of crudes comprising this basket is gradually rising.
Another option is Oman crude and the Dubai Mercantile Exchange (DME) launched futures for this grade in 2007. Volume has improved but is still too low to support options. DME wants to see over 10,000 lots a day, almost double the current record.
“Higher volumes are a prerequisite to attract producers to use it as a pricing tool,” said Mike Wittner, head of oil research at Societe Generale. “It is not an alternative yet.”
Harry Tchilinguirian, senior oil analyst at BNP Paribas, says “neither WTI nor Brent will tick all the boxes as ideal, but that will be true of any current or future benchmark.”
So long as NYMEX liquidity stays high, U.S. crude is likely to be the benchmark of choice, at least for oil to the United States, and the market will trade on premiums or discounts to it.
“WTI is and has been prone to occasional distortions,” said Wittner. “But in the bigger picture, there’s nothing wrong with it that the market cannot and will not fix.”
Morgan Downey, author of market handbook Oil 101, agrees: “There is no need for an alternative. WTI is a great benchmark.”
Editing by James Jukwey