New York, 1 June 2011: Reuters

Dysfunctional, disconnected, distorted, depressed. Call it what you will, but the landlocked WTI U.S. oil futures contract is no longer giving oil companies operating in the world's biggest refining region -- the U.S. Gulf Coast -- an accurate price for their coastal crude.

As a result, some have begun using other products to hedge their exposure to the exceptional volatility that has emerged in cash crude differentials, the premium or discount at which companies typically buy and sell physical barrels of oil.

More companies are taking an interest in once-neglected swap contracts to help manage the growing risks emerging between the benchmark price and the real cost of a physical cargo of Gulf of Mexico crude.

Open interest in the Argus LLS differential swap against WTI abruptly trebled last November and has remained high ; open positions in the Argus LLS vs Argus WTI swap doubled from January to March, as WTI crude collapsed to a record discount versus Europe's benchmark Brent.

The shifts are modest for now. The combined positions in both contracts are equal to only about 1 percent of the total for the New York Mercantile Exchange's oil futures contract.

But they reflect growing interest among traders grappling with the probability of a prolonged distortion in their benchmark. "The pressure on the WTI contract make it unfavorable to use as a real indicator of global crude demand," said Carl Larry, director of energy derivatives and research at New York-based Blue Ocean Brokerage. "The idea of trading a more viable crude that covers the Gulf Coast and also the Brent contract, LLS seems a good place to be."

The New York Mercantile Exchange's light sweet oil futures contract, also called West Texas Intermediate, has come under fierce pressure this year as inventories in the Cushing, Oklahoma delivery point for the contract swelled to record levels. The rising inventories have depressed WTI prices against global benchmark Brent crude, as well as regional crudes such Light Louisiana Sweet, a high quality oil popular with refiners in the Gulf Coast. LLS prices are now closer to those of Brent, and reflect the fundamentals of the region far more closely than WTI, according to traders.

Benchmarked against pricing service Argus, LLS swaps are cleared into futures through ClearPort, allowing traders to lock in prices on supplies and remove counterparty credit risk. ClearPort is owned by NYMEX, part of CME Group.

Other swaps contracts versus WTI for other crude grades, including Mars sour and West Texas Sour exist but are not as actively traded because the physical trade is not as active as that of LLS.

"People are getting interested in the financially settled swap," said Robert Levin, Managing Director of Energy Research and Product Development at the CME. "It's a good way to hedge your exposure. We have seen interest in demand in clearing because of the efficiencies. It helps manage your collateral."

These swaps are not new. Beginning in June 2008, CME began offering the LLS versus WTI swaps and then branched out to Mars and West Texas Sour, all cleared through ClearPort. Traders have always used them but they have become more popular due to recent, extreme market volatility coupled with more risk aversion.

Oil companies hedge to manage price risk when buying and selling oil, gasoline, diesel and jet fuel. The migration of hedging, while small, marks another blow to the NYMEX WTI benchmark. Parent company CME is locked in battle with the Intercontinental Exchange for dominance in oil trade. While WTI volumes are up 57 percent from last year, according to CME data, ICE has been growing more quickly. On some days trading this year, trade has eclipsed that of NYMEX.

The growing popularity of swaps has not gone unnoticed by ICE. On May 23, 2011, the exchange introduced several crude swaps contracts using Argus pricing including LLS against Brent and LLS against WTI cleared through ICE.

THE BLACK GOLD STANDARD?

Since its inception in 1983, NYMEX's WTI contract has been the oil futures king, drawing more trade than any rivals and claiming the title of benchmark for the world's largest oil market.

Still, market experts frequently noted WTI's value was more indicative of landlocked domestic oil than imports, which account for about 63 percent of crude used in the United States. These problems have grown considerably this year as rising flows of oil from Canada and North Dakota rush into the Midwest, swamping the region due to a lack of pipeline capacity to shift it south to the Gulf Coast. This has pushed U.S. crude futures to a record discount to Brent crude this year -- as well as to Gulf Coast grades like LLS -- driving oil companies to seek new alternative hedge mechanisms.

"Volatility is up. Risk exposure is up. We have a huge intraday move in prices. We have an unprecedented relationship between WTI and Brent," said Dominick Chirichella, senior partner at Energy Management Institute and long-time oil trader of the growing interest in swaps.

Many market players, including Bill Klesse, chairman and chief executive of large independent refiner, Valero Energy Corp. have said that WTI is disassociated with the market. He feels LLS, which travels to the St.James terminal on the Louisiana coast via pipeline, is a better indicator of value of crude on the U.S. Gulf Coast because of its accessibility to the region's large concentration of refineries. The Louisiana grade is similar in quality and portability to Brent crude, has always been an important benchmark for Gulf Coast refiners.

MANAGING RISK

Over the years, the NYMEX has launched several alternative U.S. oil contracts, but each failed to create enough liquidity to be successful. Pricing service Argus met with more success, getting Saudi Arabia to adopt a sour crude index as a benchmark for its sales to the United States.

Traders initiating new or spot trades are most likely to use swaps. By buying grades like LLS and Mars against the price of benchmark WTI and then selling WTI against the grades in an exchange settled swap keeps risk at a manageable level.

"It's the incremental barrels not in the NYMEX that are finding swaps an attractive choice," said Mark Routt, analyst with Houston-based KBC Advanced Technology.

WTI remains the most popular contract in the energy complex, however, becoming more popular with non-commercial players who are not hedging physical risk.

While trading of the the Brent contract has grown sharply -- even eclipsing WTI volumes at times -- the U.S. contract regularly draws more volumes.

"There is a massive structural contractual momentum associated with WTI," said Routt.

Ends --

By Janet McGurty, Reuters – for Commodities Now.