Crude oil spot and futures markets

There appears to be a lot of confusion about the relationship between spot and futures markets for crude oil after Paul Krugman set the ball rolling with his remark: “Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price.” Krugman led up to this with an even more provocative example:

Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil – the actual price people pay to have a barrel of black gunk delivered?

The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference.

Such provocation was bound to elicit an extreme response and Peak Oil Bebunked did just that with the oppposite claim:

Most crude oil is traded based on long-term contracts, and the prices in those contracts are set by ... adding a premium to, or subtracting a discount from, certain benchmark or marker crudes. ... Originally, the benchmark prices were spot prices, but over time ... many key oil exporters shifted away from the spot market, and began to use futures prices as the benchmark.

... Krugman and Birger are profoundly confused about the way the international oil markets actually function. Futures aren’t a paper bet on the direction of prices determined by some independent process. Futures themselves *determine* the price of most physical oil traded today. The futures price (+ or - the differential) literally *is* the price of oil.

Peak Oil Bebunked left many commentators on his blog thoroughly confused. One commentator for example wrote:

I always wondered about this. I figured the futures prices had to adjust to the spot price (which was driven by actual oil) as the contract expired. If they didn’t, a arbitrage opportunity would exist that would correct the imbalance.

But given this explanation, I guess not. I guess the “spot” prices adjusts to the futures price.

The downside to this approach is that supply/demand fundamentals don’t necessarily determine the price.

Crude oil markets are pretty complex and Peak Oil Bebunked’s description of this market is actually quite correct, but there is a sense in which Krugman’s textbook model is not totally wrong either. It is worthwhile understanding this market in some detail. For concreteness, I will focus on the Brent Crude market.

The term Brent crude today refers to crude coming out of any of four oilfields in the North Sea – Brent, Forties, Oseberg and Ekofisk – collectively referred to as BFOE.

The most important market for physical Brent crude is the cash BFOE market which is essentially a forward market. It is based on 21 days advance declaration (though 15 day and other periods are also in vogue). In July, a buyer and seller may conclude a transaction for delivery in August without fixing even the approximate date within the month. The buyer can choose the date later but has to give 21 days advance declaration to the seller. It is the price of this contract that most participants would regard as the price of physical Brent crude oil. Price discovery does happen in this market though it is heavily influenced by the futures price. Moreover, though this is a market for physical crude, it is a forward rather than a true spot market.

Let us then move to the closest that we get to a spot transaction – the dated Brent crude market. The terms are usually FOB – the buyer brings the vessel and the seller provides the berth at the terminal and loads the cargo. Dated Brent is a market for a specific cargo (typically 600,000 barrels) to be loaded at the terminal close to Brent during say July 23-25. The middle day (July 24) is the scheduled day of loading, but the buyer can usually bring the vessel to the terminal at any time within the three day period known as the laydays. Dated Brent contracts are actively traded between oil industry participants. Also, when a buyer gives an advance declaration in the cash BFOE contract, it effectively becomes a dated Brent contract.

Since the laydays span three days and the loading period itself could be close to two days, there is considerable deviation in the precise day of loading of the cargo even in the dated Brent market. Similarly, if the buyer of an August cash BFOE contract gives declaration for a date late in August, it is possible that loading takes place only on say the 2nd of September. Contracts often allow for further exceptions even beyond this if there is a curtailment of production in the oilfield or for other reasons beyond the control of the buyer or seller. These complications are natural in any genuine spot market for a non financial asset.

The dated Brent market probably has very little impact on price discovery for Brent crude. This is because these transactions are concluded on a differential to the (forward) cash BFOE price. The dated Brent for July 23-35 might for example be traded at August cash BFOE plus 10 cents.

Finally, we come to what is by far the most important price of Brent crude – the Brent crude futures at ICE. The ICE Brent Futures is a deliverable contract based on EFP delivery with an option to cash settle. Cash settlement is based on the cash BFOE market as explained in the contract specifications:

[T]he ICE Futures Brent Index ... is the weighted average of the prices of all confirmed 21 day BFOE deals throughout the previous trading day for the appropriate delivery months. These prices are published by the independent price reporting services used by the oil industry. The ICE Futures Brent Index is calculated as an average of the following elements:

First month trades in the 21 day BFOE market.

Second month trades in the 21 day BFOE market plus or minus a straight average of the spread trades between the first and second months.

A straight average of all the assessments published in media reports.

Essentially, therefore, the underlying for the Brent futures is the cash (21 day) BFOE market. The standard textbook model of cash-futures arbitrage implies that the futures price cannot deviate too much from this underlying “spot” price. Even if we regard cash BFOE as a forward rather than spot contract, it is linked to its underlying which is dated Brent. The moment the buyer of cash BFOE gives declaration, he effectively turns his contract into dated Brent crude. Arbitrage would therefore tie cash BFOE down to dated Brent. At this level, Krugman’s argument that a futures contract is a bet about the future price is not without merit.

But things are much more complex than this because long term contracts for crude in regions far away from the North Sea are based on Brent futures price plus/minus a differential. ICE claims that the Brent contract “is used to price over 65% of the world's traded crude oil.” On the other hand, BFOE is only a miniscule part of the total crude oil production in the world. This is the point that Peak Oil Bebunked is making. Brent futures are far more important and influential than any of the markets for physical crude. Most price discovery actually happens in the futures market and the physical markets trade on this basis. In an important sense, the crude futures price is the price of crude.

Crude is a particularly nasty example, but similar phenomena exist even in financial assets. Much of the price discovery in stock markets happens in the index futures market. Individual stocks are priced taking the broader market index as given. If the index has fallen 5% on a day and a specific stock has not traded so far, a person contemplating placing a bid for this stock would implicitly price it off the index futures price taking into account the beta of the stock and any stock specific information. Yet the index futures contract is settled using the cash index value and is therefore itself tied down to the cash market through cash-futures arbitrage. This is not inconsistent with the fact that the major element of price discovery happens in the index futures market.

Posted at 3:32 pm IST on Fri, 4 Jul 2008 permanent link

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