London, 14 February 2011

The world's two biggest commodity futures exchanges are likely to switch the basis of one of their key oil benchmarks to diesel from heavier gasoil as tighter environmental standards spur demand growth.

The Chicago Mercantile Exchange , which owns NYMEX, and the IntercontinentalExchange are both consulting the market about a switch in the specification of their near identical gasoil and heating oil contracts to low-sulphur diesel, industry sources with knowledge of the talks say.

Demand for the lighter, low-sulphur product, used as a transport and heating fuel, has grown due to stricter environmental rules in Europe and rising use by Asian motorists. But futures exchanges have not kept up with the change in demand, investors and analysts say.

"It is very, very unlikely that they ( ICE will) keep the 0.1 percent (gasoil) benchmark. You need to keep a link between the physical market and the paper otherwise people won't trust the price of futures," said a distillates trader with an oil major.

ICE held a meeting with oil traders and investors in the distillates market in late January where it fielded questions about its popular benchmark's future. Trade sources said the Atlanta-based exchange was considering introducing a new contract with either 50 parts per million (ppm) or 10 ppm grade diesel to run in parallel with the existing gasoil contract, or replace it entirely.

ICE declined to comment on its plans. In 2008, the exchange revised the contract to 0.1 percent from 0.2 percent sulphur after new EU environmental legislation. Its main rival, New-York based exchange NYMEX, has already launched a contract that will replace its heating oil contract with 15 pmm diesel by 2014 to better reflect growing demand for lower-sulphur grades in the New York Harbor.

"It's a global problem. The world has moved towards lower sulphur fuels and that's not reflected in the price. I think they will have to change it (the gasoil benchmark)," said Olivier Jakob, analyst at Petromatrix.

DEMAND SHIFT

Gasoil consumption will this year form less than 8 percent or around 450,000 barrels per day (bpd) of the total middle distillates market in European countries within the Organisation for Economic Cooperation and Development, according to energy consultancy JBC Energy.

This follows a shift towards a diesel grade with 50 ppm sulphur in Germany -- Europe's demand hub for heating oil -- because of a tax incentive to use cleaner fuels and Turkey's recent switch to 10 ppm. A diesel benchmark would likely be welcomed by the wealth of non-commercial players that have piled onto the ICE gasoil contract since 2008 in a bid to capture the global surge in distillate demand as economic growth accelerates.

The ICE gasoil contract -- which is physically delivered at the mouth of Germany's River Rhine -- was once used mainly as a regional price marker, but now is favoured investment tool for hedge funds and algorithmic traders. Physical diesel cargo prices in Europe -- expressed as a premium to the ICE gasoil benchmark -- have shot to more than two-year highs of $50 a tonne in early 2011, according to Reuters data, but futures investors have missed the rally.

Market players have also emphasised the need to keep the link between the physical market and futures. "The benchmark grade for all pricing will become more volatile, largely detached from European aspects and therefore more difficult to assess," said David Wech at JBC Energy.

The debate over the validity of products benchmarks echoes similar concerns in the crude oil market where the spread between Brent and U.S. crude WTI has hit record highs over $16 a barrel this week, stoking concerns about whether they truly reflect fundamentals.

Despite the underlying move to lower sulphur grades, ICE's gasoil future contract has seen volumes rocket. But while some said this vindicates the current contract, most think diesel will be more representative of future market fundamentals.

ICE gasoil volumes rose to highs of around 5.2 million in January from 3.7 million in January a year ago, and now has enough liquidity for large players to take positions swiftly.

Volumes on the NYMEX heating oil contract rose to 2.5 million in January, partly boosted by exceptionally cold weather, but are down from peaks in 2008.

"The contract just needs good liquidity, that is to trade sufficiently for hedging purposes," said Harry Tchilinguirian, strategist at BNP Paribas. "Liquidity is still there."

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