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Brent is by far the most important crude oil benchmark in the world, with well over 70% of all global crudes tied either directly or indirectly to the North Sea crude’s price. But the original Brent crude oil production is almost played out, with all of the offshore Brent producing platforms soon to be decommissioned. This might seem to be a big problem, but in the world of crude oil trading, it is a total non-issue, because Brent is no longer simply a grade of crude oil. It is a multi-layered matrix of trading instruments, pricing benchmarks, and standard contracts linked together by price differentials traded across a number of mechanisms and platforms that form the foundation of a robust, vibrant, and extremely important marketplace. Today, we delve further into the mechanics of the Brent complex, the key components that make it work, and the transactional glue that binds them together.  This is the second part of our series on the Brent crude market. What follows will make more sense if you read Part 1 first. In that episode, we explored the history of Brent, from discovery of the prolific North Sea oil field in 1971, through the development of protocols for the sale and trading of physical Brent cargoes loaded at the Sullom Voe terminal near Shetland, Scotland; the development of Brent as a benchmark price for both North Sea and other global crudes; the role of PRAs (price reporting agencies) — primarily Platts — in the assessment of the benchmark; and the decline of physical Brent crude production in the 1980s and 1990s. The four Brent platforms shown below in Figure 1 will soon be decommissioned, and physical Brent crude will be no more. Figure 1. North Sea Brent Platforms to be Decommissioned. Source: Construction Enquirer In Part 1, we also covered the two-pronged solution that Brent producers and Platts (today S&P Global Platts) came up with to deal with the issue of declining production. The problem is that participants in the Brent market get concerned if there are only a handful of cargoes used to establish the price of the Brent benchmark. One way to address that problem is to put more grades into the basket of crude oils that can be delivered as Brent. That way, more volume gets included in the benchmark assessment, making the basket a better overall reflection of the value of North Sea crudes. Early on, one crude stream (Ninian) was combined with Brent to create Brent Blend. Then, over the course of 30 years, four other North Sea fields (Forties, Oseberg, Ekofisk, and Troll) were included with the Brent Blend basket to make up the crudes that collectively we call Brent, or more accurately, the crudes known by the somewhat awkward acronym of BFOET. The other mechanism that increased the number of cargoes included in the benchmark was the widening of the time window used for the benchmark calculation. Back in the early days, Platts included only the cargoes traded within a 15-day window before the assessment date. That time frame was lengthened several times to where today, the benchmark takes into account forward trades for loadings scheduled between 10 days and one month out. All these adjustments have been made over decades to broaden the number of cargoes considered by Platts in the assessment of the “Dated Brent” benchmark. In this context, “dated” means cargoes that have been assigned specific delivery dates in a schedule published a few days prior to the month of lifting by North Sea terminal operators. In a typical month, 30-40 BFOET cargoes of 600 Mbbl each are scheduled from North Sea terminals. Many of these cargoes are bought and sold many times, resulting in many more than 30-40 deals getting done. The benchmark value for these cargoes published by Platts is effectively the spot price of physical BFOET shipments. But there is a lot more to Brent than just that one Platts benchmark. In fact, the physical volume of Dated Brent makes up only a small fraction of trades done across the Brent Complex, which includes not only Dated Brent, Brent Forwards, and ICE Brent Futures (described below), but also incorporates a gaggle (remember Brent is named after a small goose) of standard contract deals and derivatives, such as Contracts for Differences (CFDs), Dated-to-Frontlines (DFLs), and Exchange-for-Physicals (EFPs). All these instruments make up the ecosystem called Brent, and they all play a part in assuring that Brent provides a robust set of trading vehicles to meet the needs of crude oil market participants. It also ensures that Brent fulfills its responsibility to be an accurate indicator of the value of physical crudes traded in the North Sea market. A full explanation of how all this works requires a lengthy, and some would say tortuous, explanation of the individual components of the Brent complex. But in the paragraphs below, we’ll do our best to boil things down to the basics. Figure 2 shows the key elements of the Brent complex. We’ll start with the three boxes, which represent the price mechanisms that anchor the system. In the next episode of this blog series, we’ll come back to some of the linkages that tie the three price mechanisms together, shown in brackets. The first price mechanism is what we discussed above: the Platts Dated Brent assessment for physical, light North Sea crude oil BFOET cargoes (green box #1). Platts makes this assessment each day using its Market-on-Close (MOC) process at 4:30 p.m. London time. (We’ll get back to how this MOC process works in a later blog.) For now, it’s enough to know that Dated Brent is a published index price, fulfilling the same price discovery role that several energy PRA indices provide across crude, gas, products, NGLs, and other markets. The Dated Brent number is published in Platts daily newsletters and in the company’s Global Alert real-time service. Figure 2. The Brent Complex. Source: RBN Forward Brent (BFOET) The blue box #2 in Figure 2 represents pricing for Forward BFOET cargoes that, as we mentioned in Part 1, started in 1983 as an informal, forward physical market developed alongside the spot market. This forward market was first called the “Open” market, since the cargoes did not have specific loading dates assigned. Now referenced as “Paper” or “Forward” Brent, it is basically a bilateral forward market for cargo-sized lots two to four months in the future for which a 3-day loading window has not been assigned (i.e., it is not yet part of the “dated” Brent market).  Under these deals, the seller provides the buyer at least 25-days’ notice as to when the cargo will be loaded. Say we are working for a North Sea major and know we’ll have a cargo loading in August, and we want to sell it. But today (June 16), we have no idea when the cargo will be loading. So we call our friendly Brent broker, who comes up with a buyer, and we enter into a Forward Contract for delivery in August. Toward the end of July, we are notified by the terminal operator of the loading program that assigns a 3-day window for when the cargo will be available for lifting, and we give our buyer notice as to when to show up with a ship to load the cargo. In reality, it is far more convoluted than that, with the cargo’s ownership probably changing hands multiple times in a chain of transactions and probably getting settled financially, instead of becoming a Dated Brent cargo and going to physical delivery. But it still ends up as a deal that either could go physical or settles against a price indicative of physical deals. Thus, Forward Brent is really an off-exchange market for trading BFOET cargoes two to four months out. The players trading Forward Brent, mostly the “Brent Club” introduced in Part 1, are companies large enough to wheel and deal in 600-Mbbl cargo lots — companies like Shell, BP, ConocoPhillips, Total, Chevron, Mercuria, Vitol, and Mercuria — or at “least” 100 Mbbl partial lots that can be rolled up and converted to full physical cargoes. Either way, it’s a pretty small club. As for the benchmark price itself, it works similar to Dated Brent — Platts makes this assessment using a Market-on-Close process and publishes the forward prices on a daily basis in its newsletters and data services. ICE Brent Futures The yellow box #3 in Figure 2 represents the ICE (Intercontinental Exchange) Brent futures contract. This market is orders of magnitude larger than Dated Brent. As shown in Figure 3 (left graph), in just the past five years, average daily open interest has grown from about 1.7 million contracts to 2.7 million contracts. With each contract representing 1,000 barrels, that means ICE Brent now has an open interest of 2.7 billion barrels, or about 27 times the worldwide total average daily crude oil production of about 100 MMb/d. In May, average daily volume for the ICE Brent contract (Figure 3, right graph) spiked up to 1.4 million contracts, the equivalent of 1.4 billion barrels, or 14 times daily global production. Any way you look at it, the importance of ICE Brent cannot be overstated. Figure 3. Average ICE Brent Daily Open Interest and Volume. Source: ICE via Morningstar ICE Brent is a true electronic exchange, with almost all deals conducted on the ICE trading platform continuously throughout each trading day. Like all futures instruments, each monthly ICE contract trades for years before it becomes the prompt-month contract — the contract that will be next to expire. And when an ICE Brent contract does expire (on the last day of the month two months prior to the month of delivery), it does so in a way that ensures that the price at expiry converges with the price of the underlying commodity. In some futures markets, this happens because the contract requires physical delivery and receipt of the product on expiry. In other words, for a physically delivered crude contract, that means the seller must show up with barrels, and the buyer must take those barrels. That’s the way the CME/NYMEX Cushing WTI crude contract works, and almost all of the time, it works just fine. But the physical delivery mechanism was one factor that contributed to the chaos in that market on April 20, when WTI fell to negative $37/bbl (see One Way Out for more on what happened that day). In contrast, ICE Brent is primarily a financially settled contract. As indicated in Figure 2, it settles on the ICE Brent Index, which is itself based on trades in the Forward BFOET market that are tabulated and assessed by ICIS, another price reporting agency. This aspect of ICE Brent futures is unique, because a futures contract is settling not against a spot market (Dated Brent), but instead is settling on forwards for a spot market. We’ll get back to how ICIS does its assessment and how the ICIS number becomes the ICE Brent Index in a future blog in this series. We’ll also explore an alternative to this cash settlement which uses Exchange-for-Physicals (EFPs) contracts that can be used to swap an expired contract position for a Forward Brent Contract. That’s too much detail for us to get into today. But for now, it is important to point out that cash settlement solves a problem mentioned in Part 1 — namely, how does a 600-Mbbl Brent cargo get chopped up into 600 X 1,000-barrel lots? The answer is that the 1,000-barrel lots are cash-settled against the price of a 600-Mbbl cargo, assuring the contract holders that the price of their futures contract will converge with the value of a Brent cargo trading in the appropriate time window. In fact, the procedure used to make that happen is a bit tricky, so that’s another aspect of all this we’ll get into next time. Brent Complex Transactional Glue To make our story easier to follow, we’ve described the three price mechanisms that anchor the Brent Complex (the three boxes in Figure 2) as if they are independently functioning markets. Nothing could be further from the truth. These prices are intrinsically bound together by a set of derivative instruments that not only link the markets, but have far more influence on the absolute level of the underlying prices than you might expect. These instruments, the gaggle of standard contracts and derivatives, such as the Contracts for Differences (CFDs), Dated-to-Frontlines (DFLs), and Exchange-for-Physicals (EFPs) mentioned previously, are critical to the effective functioning of the Brent Complex, and each stands on its own as an important trading and risk management tool. In the next episode of this series, we’ll get into the details of these instruments and explain how they glue the Brent Complex together.  "Lift Me Up" was written by Trevor Rabin and Chris Squire, and appears as the fourth song on Yes's 13th album, Union. Released as the first single from the album in April 1991, the song went to #1 on the Billboard Rock Album Tracks, and #86 on the Hot 100 Singles chart. Personnel on the record were: Jon Anderson (lead, backing vocals), Bill Bruford (drums), Alan White (drums), Steve Howe (guitars), Trevor Rabin (guitars, lead, backing vocals), Chris Squire (bass, backing vocals), Tony Kaye (keyboards), and Rick Wakeman (keyboards). Union was recorded between 1989 and 1991 at Studio Guillaume Tell in Paris; SARM Studios in London; Record Plant Studios in Los Angeles, CA; Vision Sound Studios in New York City; and Langley Studios in Devon, England. The album was produced by Eddie Offord, Jonathan Elias, Steve Howe, Trevor Rabin, and Mark Mancina. The album was titled Union, because it combined eight musicians from different eras of Yes's history to make the album. It went to #15 on the Billboard Top 200 Albums chart and has been certified Gold by the Recording Industry Association of America. Yes is an English progressive rock band formed in London in 1968 by Jon Anderson, Chris Squire, Peter Banks, Tony Kaye, and Bill Bruford. Nineteen people have passed through Yes's ranks since its inception. They have released 21 studio albums, 14 live albums, 35 compilation albums, one EP, and 28 singles. They have sold over 13.5 million records in the U.S. The band has won one Grammy Award and has been inducted into the Rock and Roll Hall of Fame. Original members Peter Banks and Chris Squires died in 2013 and 2015, respectively. Yes, now fronted by lead vocalist Jon Davison, with Steve Howe, Alan White, Geoff Downes, and Billy Sherwood, still records and tours, with current touring plans postponed due to COVID. |
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