Physical

On April 20, that fateful day in crude oil markets when the CME May contract for WTI at Cushing collapsed to negative $37.63/bbl, the number of contracts involved in the chaos was relatively small. So you might think that most producers sat on the sidelines, watching Wall Street paper traders writhe in stunning financial pain. But not so. Almost all producers saw their crude prices that day crashing in exactly the same magnitude. That’s because the daily price of the CME WTI contract is part of the formula pricing used in a very large portion of crude oil contracts in U.S. markets, both directly and indirectly. There are two formula mechanisms that are commonly used in crude oil sale/purchase contracts that are responsible for that linkage: the CMA and WTI P-Plus. These arcane pricing mechanisms are complicated, but in order to understand U.S. crude markets, it is critically important to appreciate how they work. Today, we continue our deep dive into crude oil contract pricing mechanisms.

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.

With crude prices close to six year lows and the futures market pointing higher, a number of the larger commodities trading houses are buying and holding cheap crude in huge floating tankers for later sale. For the trade to work, prices today must be lower than they are in the future and the spread must cover the storage cost and other expenses. Players in the floating storage game have to be high rollers – the minimum cost of a bet at this table is ~$100 million. Today we complete a two-part series on contango-spread trades with a look at floating storage.

North Sea Brent crude plays a critical rolet in setting world oil prices. Here in the US, most folks pay more attention to West Texas Intermediate (WTI)  - the North American equivalent benchmark. We regard Brent as just a figurehead for the international market and rarely look beyond the Brent/WTI spread. Yet Brent crude assessments based on physical trades or the ICE Brent futures market are used directly or indirectly to price 70 percent of world oil. Today we begin a “deep dive” series explaining how the Brent crude market operates.