Summary:
Prof. Jayanth R. Varma attempts to clear up the confusion about the relationship between spot and futures markets for crude oil, using Brent crude (BFOE) as an example. The price of physical Brent crude is a futures contract (21 day advance declaration). The closest we get to a spot transaction is the dated Brent crude, i.e. after a buyer has made the declaration. This market has actually very little impact on the price discovery for Brent crude, because of the small quantities of Brent that are actually trade. But Brent is a benchmark for ~65% of the world's traded crude oil. The physical price of this crude is determined by the ICE Futures Brent Index price (plus/minus a differential based on the type of crude), which is the weighted average of the prices of all confirmed 21 day BFOE deals throughout the previous trading day for the appropriate delivery months. i.e. "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." It follows that Brent futures are far more important and influential than any of the markets for physical crude. The crude futures price is the price of crude. (Published: 04/07/08)
Notes:
- which of the following is correct?
- Paul Krugman: "a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price"
- Peak Oil Debunked: "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 Debunked is correct, Krugman's textbook model isn't totally wrong either
- Crude oil markets, e.g. Brent Crude market
- Brent crude = crude coming out of any of four oilfields in the North Sea: Brent, Forties, Oseberg and Ekofisk
- collectively referred to as BFOE
- most important market for physical Brent crude is the cash BFOE market
- is essentially a forward market
- based on 21 days advance declaration
- e.g. 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
- though this is a market for physical crude, it is a forward rather than a true spot market
- closest we have to a spot transaction is the dated Brent crude market
- when the buyer gives an advance declaration in the cash BFOE contract, it becomes a dated Brent contract
- terms are usually FOB
- 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
- the buyer can usually bring the vessel to the terminal at any time within the three day period (known as laydays)
- dated Brent contracts are actively traded between oil industry participants
- dated Brent market probably has very little impact on price discovery for Brent crude
- because these transactions are concluded on a differential to the (forward) cash BFOE price
- the dated Brent for July 23-25 might e.g. be traded at August cash BFOE plus 10 cents
- most important price of Brent crude is the Brent crude futures at ICE
- ICE Brent Futures is a deliverable contract based on EFP delivery with an option to cash settle against the published settlement price
- i.e. the ICE Futures Brent Index price for the day following the
last trading day of the futures contract
- 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
- i.e. is based on the cash BFOE market
- i.e. the underlying for the Brent futures is the cash (21 day) BFOE market
- things get more complicated
- long term contracts for crude in regions far away from the North Sea are based on Brent futures plus/minus a differential
- the Brent contract is used to price over 65% of the world's traded crude oil
- note:
- West Texas Intermediate (WTI) used as benchmark for oil sold to North America
- Brent benchmark for oil sold to Europe and Africa
- Dubai-Oman benchmark for Gulf crude sold in the Asia-Pacific market
- on the other hand, BFOE is only a miniscule part of the total crude oil production in the world
- the point Peak Oil Debunked is making:
- "very little trading occurs in physical BFOE (or other benchmark crudes) [...] because this makes the process of price discovery very difficult [...] a futures market (based on the average of all future price quotations that arise for a given contract) is currently the basis for oil pricing."
- "Unlike the spot market, the futures market is highly liquid which makes it less vulnerable to distortions. In addition, the futures price is determined by actual transactions in the futures exchange and not on the basis of assessed prices by oil reporting agencies. "
- i.e. "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."
- i.e. Brent futures are far more important and influential than any of the markets for physical crude
- most price discovery happens in the futures market and the physical markets trade on this basis
- i.e. the crude futures price is the price of crude
