London, 20 January 2011

ICE Brent crude futures have seized market share from the troubled NYMEX WTI contract as a result of well-publicised problems with WTI's delivery location at Cushing. But Brent risks becoming a victim of its own success. The number of futures contracts (including those in the spot month) is rising even as output of the four benchmark crude streams deliverable against those contracts is falling -- heightening the risk of delivery problems and distortions around contract expiry.

Most analysts argue waterborne Brent is now a better indicator of conditions in the international oil market than WTI, which remains depressed by the large amount of Canadian crude trapped around its landlocked delivery point.

Index investors and hedge funds seeking long exposure to oil are gradually shifting to Brent futures in a bid to escape negative roll returns and the holding costs associated with persistent contango in WTI.

The number of Brent futures still open for delivery 10 days before expiry has jumped from 109,000 in the Feb 2009 contract to 185,000 in Feb 2010 and 208,000 in Feb 2011. Over the same period, output of the four benchmark crude streams (Brent, Forties, Oseberg and Ekofisk) has dwindled from 1.45 million barrels (Feb 2009) to 1.32 million (Feb 2010) and now 1.22 million (Feb 2011).

One measure of underlying liquidity is the number of days of output required to cover short positions open a set number of days prior to expiry. For Brent, the number of days to cover short positions 10 days prior to expiry has risen from 75 days worth of output in Feb 2009 to 170 days of output in Feb 2011.

Brent's defenders point out that futures are not a substitute for the cash commodity. Only a minority will ever be taken to physical delivery. The contract is a "deliverable contract based on EFP [ exchange for physicals] delivery", according to ICE. But there is an option to cash settle against the ICE Brent Index, which "represents the average price of trading in the 21 day BFOE market in the relevant delivery month as reported and confirmed by the industry media".

But for convergence to occur between futures prices and the physical market, there has to be a real threat of delivery against a substantial percentage of open contracts as expiry approaches. More generally there have to be similar levels of liquidity, otherwise prices in the less liquid market (physical) will drive prices in the more liquid one (futures), and anyone with significant influence over the physical market will exert significant influence over futures.

Brent's problem is that investor interest is surging at just the time when the number of cargoes available for physical delivery each month is dwindling as the four crude fields age and output declines.

CHANGING CIRCUMSTANCES

Regulators in both the United States and the United Kingdom recognise the crucial importance of adequate physical supply to ensure futures trading remains free from distortions. Regulators will not authorise -- and exchanges will not list -- new contracts unless there is an adequate physical base with diverse buyers and sellers.

In the United States, the Commodity Futures Trading Commission (CFTC) and exchanges enforce limits on futures positions in the run-up to expiry to minimise disruptions and "the potential for corners and squeezes by facilitating the orderly liquidation of positions as the market approaches the end of trading", according to a forthcoming notice of proposed rule-making in the U.S. Federal Register.

Position limits are enforced on futures, options and (in future) swap contracts rather than the underlying physical commodity. But the concept of deliverable supply emphasises the fundamental importance of an adequate physical base to ensure derivative pricing is not distorted.

In a joint paper with the Treasury published in December 2009, Britain's Financial Services Authority (FSA) recognised "there is a particular risk where a derivative contract approaches expiry, and upon expiry, where the contract is settled by physically delivering an underlying product (most usually some form of commodity".

The FSA requires exchanges to have "position management" rules in place giving them authority to instruct traders to reduce or close positions if it is necessary to ensure markets remain fair and orderly. In the case of Brent, output is sliding in an existing contract. In June 2010, BFOE output dropped to just 965,000 barrels per day as a result of unexpected outages and maintenance, which was meant to be backing futures positions equivalent to 222 million barrels in the spot month 10 days prior to expiry.

Short traders would need to have bought 230 days of crude production that month to cover their liabilities (obviously impossible). But even when fields are operating normally, output is now scarcely above 1 million barrels per day.

CONTRACT REDESIGN?

Brent is not the first contract to come under pressure as a result of changing trading and output patterns. When the physical base changes, contracts must evolve or die. Over the past 50 years, various U.S. agricultural contracts became extinct when trade patterns moved, leaving them stranded. Others had their delivery location or grades changed to ensure continued relevance and usefulness.

The original Brent contract has already been expanded to include Forties and Oseberg (BFO), and later Ekofisk (BFOE), to offset output falls. ICE and the price assessment agencies may have to expand it again to include more crude streams to ensure adequate underlying physical liquidity.

Possible candidates for inclusion are Nigeria's Bonny Light and Qua Iboe streams or Colombia's Cusiana -- all of which are currently deliverable at a premium against NYMEX's own light sweet crude contract.

Unless the contract is enlarged, it faces the risk of serial squeezes and distortions. The old IPE Brent contract was the subject of repeated manipulation in the late 1990s and early 2000s before it was expanded. In the longer term, it is not obvious that Brent (any more than WTI) can serve as a benchmark or marker for the world market given (a) North Sea output is an increasingly small and unrepresentative fraction of global production and (b) marginal demand growth and pricing is shifting to Asia.

Brent pricing is at least linked to Asia by the seaborne market, unlike WTI. But idiosyncratic pricing factors in a small and declining oil province off the northwest coast of Europe make it a rather strained marker for oil supply, demand and pricing in China and east Asia.

Benchmarks follow customers. Senior figures within the oil industry have indicated both Brent and WTI are aging. In future, pricing may shift towards Asia, for example using Russia's Eastern Siberia-Pacific Ocean (ESPO) pipeline oil delivered (CFR) to Japan, China and North-East Asia as the new reference price.

Like WTI, it is likely Brent futures will remain the contract of choice for investors, even if they become less representative of the physical market and pricing shifts east. But ICE and the FSA will have to consider adjustments to contract design and/or stepped up enforcement to ensure the contract does not become repeatedly congested prior to expiry.

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