London, 9 December 2011

The CME Group's announcement that it is considering the launch of a new Gulf Coast oil futures contract has perplexed some market participants. Why would the exchange announce the idea on Wednesday, less than a month after news of the Seaway pipeline reversal, which should end the dislocation of the CME's crown jewel, the West Texas Intermediate crude oil futures contract?

A simple explanation is that the exchange is simply trying to innovate and provide new ways for market participants to engage with the market. Another is that the exchange wants to transition away from an inland delivery point at Cushing, Oklahoma to another in Houston that will be better connected to global markets.

After all, markets tend to prefer a single futures contract with deep liquidity over a fragmented market split between shallower pools of trade. When contacted on Thursday, a CME spokesman rebuffed the suggestion the proposal aimed to create a substitute for WTI and said the exchange was delighted with the Seaway reversal which it says ensures that WTI remains well connected with global markets.

So it is safe to say that the CME is not interested in unilaterally forcing market participants to shift their preference to a new contract, especially in the case of WTI, its most lucrative product. But there is demand for a Gulf Coast product for hedging, as evidenced by the growth in CME-cleared swaps based on physical Gulf Coast crude prices.

DEFENSIVE MOVE?

The proposed Gulf Coast contract would be based on the physical delivery of crude with WTI quality to Enterprise Products Partners' new ECHO terminal in Houston. Houston is rapidly emerging as a major trading center for U.S. crude oil, with the explosion in shale oil production, both in the Permian Basin and the Eagle Ford Shale.

ECHO will be a delivery point for Eagle Ford crude on Enterprise's system from 2012 and will also be eventually connected with the reversed Seaway line, allowing Midcontinent oil reach proposed delivery point via Cushing. Houston will also become a send-out point for crude to Louisiana with the expected reversal of Shell's Houma-to-Houston (HoHo) pipeline by early 2013.

Those connections alone would mean that ECHO, compared with Cushing, would be directly connected with a huge chunk of U.S. refining capacity. But crucially, ECHO will also be connected to the docks at Texas City which would allow foreign crude oil to be delivered against the proposed Gulf Coast contract.

Physical delivery of foreign crude against WTI was once a crucial feature of the global oil market, serving as a balancing mechanism in the Atlantic basin. The reversal of the Seaway pipeline has quietly killed off the possibility of delivering non-North American crude against the contract.

For now that is no problem given the assumption that steady growth in Canadian and U.S. shale oil output will keep inland oil prices below international levels for the foreseeable future.

But therein lies the problem. Few, if any, market participants expected WTI to get so badly dislocated from global markets this year. As such it is easy to imagine we're all missing the big development a few years down the line --a major Canadian pipeline to the Pacific for instance-- that upsets the North American market paradigm once again.

So it could be that the CME is simply being careful to defend its oil market franchise with this proposal. In any case even if the Gulf Coast contract is launched there is no guarantee of success.

For all the talk of broken benchmarks the oil market doesn't trade at theoretically optimal delivery points but rather where liquidity and price discovery are best.

That's why a small town in Oklahoma hundreds of miles from major production and consumption centers looms so large in the world oil market and why it has been will remain so hard to dislodge.

But by the same token, if the CME was to launch a Gulf Coast crude contract that ultimately became the dominant product in terms of liquidity, it would not be a surprise to see WTI eventually phased out.

Ends --

By Robert Campbell, Reuters market analyst – for Commodities Now with permission.

The views expressed here are his own.