Rolling In The Spread? How The Brent/WTI Crude Futures Relationship Got Trickier

In January 2016 the ICE futures Exchange changed the expiration calendar for its flagship Brent crude contract. The March 2016 contract expired on January 29, 2016 under new calendar rules that stipulate expiration one month and one day prior to delivery. This was done belatedly to reflect a change in the assessment of the physical Brent market that was implemented back in January 2012. On paper the change is just an overdue action by ICE to properly align the timing calendar for their popular futures contract with the underlying physical market. But in practice - as we suggest in today’s blog, the change has significant impacts on the calculation and analysis of the commonly utilized spread between ICE Brent (the international benchmark crude) and the U.S. equivalent West Texas Intermediate (WTI) crude futures contract traded on the CME/NYMEX.

Note that this blog is primarily educational – describing the mechanism and impact of the new ICE Brent contract expiration rules on the analysis of the Brent/WTI spread.

We have previously described the Brent physical trading market where traders buy and sell 600 MBbl cargoes produced from four North Sea crude streams (Brent, Forties, Oseburg and Ekofisk – BFOE - see Crazy Little Crude Called Brent Part I). There are two distinct markets assessed for physical Brent. The first is the so-called “Dated Brent” market that involves transactions between buyers and sellers for BFOE cargoes that have been assigned to equity producers and given a 3-day lifting window for the buyer’s vessel to pick up the crude. Because these cargoes have an assigned load date they are known as dated Brent. Reporting agencies like Platts and Argus assess Brent dated transactions and publish prices used in pricing formulas that determine the value of BFOE and a host of other international crudes. The second market for physical Brent is the BFOE “cash” market for cargoes that have yet to be assigned a loading date. This market is also known as “paper Brent” and the crude cargoes are traded for delivery during a specified forward month – further out into the future than dated Brent. These forward trades then morph into dated cargoes once a load date is assigned – at least 25 days before the 3-day loading window. In “Crazy Little Crude Called Brent Part 2” we described how the BFOE cash market is linked to ICE Brent futures delivery through an exchange for physical (EFP) mechanism and pricing via an ICE Brent Index that is linked to BFOE market assessments. ICE Brent futures contracts are not physical because they only involve 1000 Bbl parcels and they are cash settled rather than physically delivered. The ICE Brent futures market provides a financial exchange for trading Brent for delivery several years into the future. In “Part 3” of the Brent primer series we discussed market concerns with the quality and volume of Brent stream crudes included in the BFOE market. It was in response to these concerns that price reporting agencies such as Platts and Argus changed their methodology in 2012 to include more transactions in their Brent Dated assessment by extending the trade window from 21 to 25 days before loading.

Prior to the change made this year - the ICE Brent Futures contract was set up (way back in 1988) to reflect the 15-day timing window for Brent Dated cargoes that prevailed at the time. The futures contract specified that each delivery month contract would expire on the ICE exchange at least 15 calendar days prior to the delivery month (e.g. the Brent contract for February 2016 delivery expired on January 14, 2016). This meant Brent futures contracts usually expired in the middle of the month before delivery – allowing the Brent Index price calculated at expiration to most closely match physical market prices for Brent cargoes to be delivered in the following month. However, since the physical market changed to a 25-day window in 2012, the Brent futures timing was out of sync with the physical market. It took ICE 4-years to implement a Brent futures change to better reflect the physical market because of concerns about upsetting futures trader positions by switching to a new contract. The change finally came in with the March 2016 Brent delivery contract that expired on January 29, 2016 – the last business day of the second month before delivery. The new expiration date mechanism is designed to accommodate at least a 30-day window between the contract expiring and delivery – reflecting the 25-day window in the physical market as well as a 5-day additional grace period.