Brent: Episode 5, Part 1 – Dr. Adi Imsirovic, Saket Vemprala

Neil: Hello and welcome to the Price of Everything, a podcast that aims to shine a light on pricing. The cost of commodities, that's energy, food and so on, is such an important part of our lives. But how are those prices actually calculated? Why do they move up and down quite so much? And what's next? The Price of Everything is the first podcast dedicated purely to how pricing works. My name is Neil Bradford and I'm the founder and CEO of General Index, which is the world's first technology led benchmark provider. Together with my colleagues from around the world and some special guests, we'll be taking you through how some of the world's most important commodities come to be priced and what the future looks like for them in the age of climate change and the energy transition. Dated Brent is the world's most widely recognised price for crude oil. But why Brent? How did an oil field off the coast of Scotland become so pivotal in global oil pricing? My colleague David Ellwood explores the history. David: "To be in Brent is to be where the action is. The history of Brent is that of a market continually facing new circumstances and continually finding new functions to perform, new reasons to trade and prosper," or so wrote Paul Horsnell and Robert Masbro in their 1993 book Oil Markets And Prices. Hello everyone. Welcome back to the Price of Everything, our journey through Brent, the world's most important oil price, perhaps even the most important price has so far been part historical, part geological, political, economic as well as given a flavour of the personalities who made the early days trade in Brent flourish. Now, we chose Brent as a topic for our first podcast series, not only because it's the king of prices, but because as many of you will know, the benchmark is going through a period of upheaval. But as Horsnell and Masbro's quote suggests, Brent has a strong survival instinct, which was as true in 1993 as it is now in 2022. But amid existential challenges, are its days now numbered or will it live to fight another day? To help me discuss the future of Brent, I have two guests. First, my colleague Saket Vemprala, who leads the European oil pricing team at General Index. He's joining us on the podcast for the first time. Saket, welcome to the price of everything. And I'm also delighted, very pleased to welcome back veteran industry trader, academic, and someone who's been keeping a very close eye on our topic today. Dr. Adi Imsirovic, who returns for his second outing on the podcast. Thanks so much for joining us again, Adi. Well, let's do a bit of scene setting. So we're at something of an inflexion point in global energy markets. Commitments are being made the world over to drive down carbon emissions by reducing our dependence on oil to tackle climate change. Here in Europe, the Russia-Ukraine conflict has caused an energy crisis, pushing up prices and fueling inflation. And lest we forget, the Coronavirus pandemic also upended oil markets. In the United States, WTI Crude, another key benchmark, crashed to negative pricing in 2020 at the start of the pandemic, something that turned the spotlight on the performance of key benchmarks. And as we'll be exploring over the course of this episode, Brent has its own problems and is at a crossroads. Adi, how would you characterise this period we're living in? Adi: Well, David, thanks. It's pretty exciting is what I can say, and let me elaborate on that a little bit. I think you've already laid the background. We tend to imagine very often that we live in exceptional times, but most of our colleagues that worked before us had various wars in the Middle East, various upheavals, financial crises and so on. It is just another thing that in financial market happens every now and then. What is particularly interesting about this period is that we do have a very big shift in terms of oil flows, mainly from the Atlantic-centric situation, with the oil market more towards the Far East and Middle East, where most also of the new refining is coming up. So with that change in flows, normally you do have a change in benchmarks and Brent is also a very, very good example of that. What tends to happen is that those who are the marginal bias tend to start setting the price for oil. And the marginal bias right now are in Asia. And it's a very good and slightly a difficult question to explain, and we'll have some time here to talk about this, what makes benchmarks what they are. By all rights, we should have more benchmarks coming from east of Swiss and they are appearing but they're not taking over yet. And the reason for that is what I've often mentioned in my book, which we talked about in your first podcast, is the fact that to have a market, you have to have a proper legal system that will support that market. You have to have a proper policy that will support the market. Markets don't exist in a vacuum. Markets need to be nourished and looked after, so anyway, that would- But the times are very interesting. We have changes in the benchmarks, which we're going to talk about today. We have some new benchmarks in the Gulf. We have benchmarks ... changes obviously in Dubai, which is closely linked to Brent. And we have INE, a Chinese benchmark as well, which potentially could be becoming important. David: That's great. Well, Saket, I'm going to come to you next. I'd like us to go back to basics a little bit. I'm not going to take for granted that all of our listeners will know exactly what we are talking about when it comes to Brent and Brent prices. And when we refer to Brent, we are talking about really a galaxy of different things. I know you've got a list of five or six different items, so perhaps you could take us through that. What's your number one on that list? Saket: Yes, with pleasure. I think Brent is a label which can, and is often, applied by the industry to many different aspects of the market. The first is that of course the benchmark takes its name originally from a field in the North Sea that was discovered back in 1971 and which began production five years later. At its peak, the Brent Field was producing something like half a million barrels a day of oil. But following subsequent production declines in the 1990s and 2000s, production from the four original platforms at the field began ceasing from 2011 onwards, the last of which was shut down in 2021. And so, the original Brent, from which the entire complex and the benchmark gets its name, effectively has ceased production. The second Brent, you can say, is the blended crude, or the stream, or the grade which is sold from the Sullom Vow Terminal. And this grade originally comprised a commingled streams from the Brent and Ninian fields, starting from the early 1980s onwards. But following the shutdown of the original Brent platforms, now effectively only comprises crudes from Ninian and other nearby fields. The third Brent refers to a group of five crudes that are collectively known in the market as the Brent Basket. And this basket of crudes is used by price reporting agencies and by benchmark data providers like General Index, to assess a spot value for a cargo of light sweet crude in the North Sea. And the spot value, the spot assessment, is effectively the fourth Brent, which is often known in the market as dated Brent or other variations thereof. We then move into the world of derivatives contracts, that share the same name, or a related name. At the core of these instruments is the forward contract, also known in the marketers cash BFOE. And this is a contract for physical delivery of oil and represents the value of a cargo of North Sea crude loading in a particular month. And the terms and conditions of this contract are governed by the well-known Shell SUKO 90 contract. And finally, if we were to take a step back from the little niche of oil trading and price reporting to the wider world, when people think of BRENT they think of what we know as the ICE Futures Contract, which is one of the most liquid energy related derivatives contracts in the world. And this is a cash settled contract, which represents the future value of light sweet North Sea crude in a given month. And this contract expires contemporaneously with the expiring forward contract, as assessed on its final day. So, there are many different instruments, all of which are connected and all of which share this name of Brent, but it all traces its history back to four platforms, which now really only exist in history. David: Thank you for that and know that these topics are technical and we don't apologise for that. But that was a really useful overview of the spectrum or the galaxy of Brent. Something that makes this whole galaxy a little bit more complicated is that each of these interact with each other, and that changes to one or more of the interlocking parts could ricochet throughout the whole ecosystem. So, without going into too much detail, maybe pick out a couple of examples of how these interact, Saket. Saket: Well, at the heart of the interlocking components that you talk about is the cash BFOE contract. This is what makes the entire benchmark system work. It's almost like the sun of the centre of the solar system. And whereas ICE Brent futures allow traders to take position on the eventual value of the forward contract, the forward contract is also delivered into the dated Brent spot price. Once a cargo's loading dates are finalised, it as considered to be dated or wet. And so, you have the cash BFOE contract sitting between the spot price assessment and the ICE Brent futures contract. But then in between these three, you have another set of derivatives contracts which allow market participants to hedge their exposure to the spreads between these three instruments. The first is EFPs. The second CFDs and the third, DFLs. And effectively these three contracts respectively represent the price spread between the cash BFOE and ICE Brent futures, between cash BFOE and the dated Brent spot price assessment. And finally, between the spot price assessment and the futures contract. And changes to the dated Brent spot price assessment, which we'll be discussing with Dr. Adi in this episode, have to align effectively with changes to the SUKO 90 contract and all the other instruments, because you have effectively a ricochet of changes that can knock through the system the moment you change one underlying set of assumptions because you've got many millions of barrels worth of financial exposure linked to all of these instruments. And therefore any changes, or any announcements of changes in the future, can result very quickly in volatility, as indeed we saw in the past year and a half. David: That's great. Adi in his colourful book The Squeeze, Tom Bower described the Brent market, which had emerged by the 1990s, and I quote, "An impenetrable matrix of contracts," and that, "The benchmark for oil prices worked so long as no one tried too hard to understand the complications." Well, for you of course, for many years it was your job as a crude trader to understand those complications and that was key to building a successful portfolio. How was that as an exercise? Adi: Okay, first of all, on the subject of the book, I think for anyone looking from the outside, it really is a complex contract. There's no doubt about it. I would often say that probably even a great majority of the traders in the oil industry don't fully understand how it works. But a great deal of them don't necessarily have to, if they're just using some simple hedging techniques and they're not what we call a market maker. I worked for many years in the 1990s as market maker, talked to many of them and actually, there's only a handful out there of companies that actually fully get involved in all the aspects of Brent trading. It's incredible that a very good example of how the contract worked was 2020 and the pandemic. And what's really interesting, unlike WTI, for example, Brent worked very well, or worked like a dream. And the beauty of the Brent contract and the complexity come from the fact that it organically grew over a period of time, in the way that made sense for most of the players in the market, particularly big players like BP and Shell, that historically were the major producers of oil that was going into that contract as well. For those listeners who are not fully familiar with the whole Brent contract, it worked extremely well during COVID 2020, but particularly because of all these bits in between the Brent contracts, which I'll explain in a second. So, for example, when the market became very, very weak following the Saudi decision to declare price war, particularly towards Russia, the first one to give up was the dated Brent, of course. With a weakness of dated Brent, if you're holding a futures contract and this dated Brent is extremely weak, your futures contract by definition becomes weak as well. So, whether it's cash or futures, it doesn't really matter because the only difference between the two is EFP or exchange of futures for physicals. Then the whole of the dated Brent structure, what we call structure, which is the forward CFD curve, gets weaker as well. That automatically puts pressure on the spreads of the Brent complex and the whole forward Brent curve. And finally, the expiry of the futures contract is affected. So essentially, it's almost like a wave which is created by a lot of little wavelets, that actually put the pressure on their price and it gradually settles. So, the whole complex is actually working extremely well. It is complex but generally tends to work very well. David: And it works well because they're all walking in lockstep, right? They're all reflecting the same basis. And that's something that's going to be key for us to ... for listeners to remember as we look forward in a little while to discuss some changes that are being proposed. Adi: Yes, but I'll just a little bit add to what I've just said, also for listeners. These things, these instruments didn't just evolve by chance. They actually evolved because of the need. So, for example, the reason the CFD market, because I was there trading at the early days in '91, CFDs emerged in 1990 just before I joined. It was one of the key reasons they evolved, was a desire to move fixed price over a forward Brent contract into a dated price. So, CFDs were the instrument, converting it into dated, cash into dated, dated into cash in terms of fixed price to floating price, and vice versa. So, it made a lot of sense. Over time, obviously involved into hedging instrument because if you're loading a cargo of Nigerian oil and selling it into India, you basically have a big dated to dated exposure. And as we know, dated to frontline can actually move by easily a dollar or more. So, all those instruments actually naturally evolved. The same with the EFP, where people would have big futures positions but wanted to move into cash or vice versa. So, complexity came about because of the need and also helped the whole complex work. David: That's great. We'll come back to some of more of the technical aspects of Brent pricing. I'm going to turn now back to one of the earlier threads that we've picked up. Saket, you noted that the last of the original four North Sea oil production platforms stopped pumping last year, and that was a big hint to our listeners, of the problems facing the Brent complex. And it reminded me of a quote that I read in coverage on this issue. "We're facing geology, you can't change the geology." So unpack for us, what's the problem with the dated Brent status quo? Saket: Well, I think that quote hits the nail on the head. In order for a benchmark to be robust and to have the confidence of the market for it to be utilised, there needs to be a sufficient amount of liquidity underpinning it, such that the benchmark is seen as representative of a well supplied market. And then that itself, that benchmark can be used as an anchor point to price other crudes within the region. And so, the North Sea Basin, although quite prolific over time, has faced the inevitable problem of terminal declines in production. At its peak, the Brent Field was producing on its own, more than half a million barrels a day, but we are now in a situation where all of the grades that are currently in the Brent Basket on their own are producing between say anywhere from 600,000 to 800,000 barrels a day given the month, over the last couple of years. And if it were not for the recent production startup of the Johan Sverdrup Field, then at certain points last year, production in the North Sea would've been at its lowest since the late 1970s. And so, what price reporting agencies have had to do in order to create a benchmark that has sufficient liquidity, in order to give the market confidence to use it as an anchor point for more broader pricing of other crudes, was to add more grades to the basket for inclusion. And so 20 years ago, Brent was joined by two other North Sea grades, Forties and Oseberg. In 2007, the Ekofisk grade was added, and then in 2018 they were joined by the Norwegian grade, Troll. And so, you now have, as I mentioned earlier, five grades in the Brent Basket. But despite that, and if it were not, like I said, for the startup of the Johan Sverdrup field, the inevitable problem is that eventually production will continue to glide lower and lower. And so, you have on any given day a production of the five benchmark grades combined, being the equivalent of one Aframax cargo. And so it is now at the threshold of liquidity, below which the market starts to get concerned that the price is no longer representative of the regional crude oil market and therefore, injecting new liquidity into the basket is inevitable. A few years ago, Platt's the current benchmark provider for dated Brent that's the most used in the market, began incorporating, delivered Rotterdam bids, offers and deals into their benchmark mechanism. And this helped to boost the number of market signals that were being used to calculate the spot price for dated Brent. Although under certain market conditions, even those signals dried up. And therefore, adding new grades to the basket is the only way to be able to sustain this basket as a liquid representative benchmark that can be used by the industry. David: That's a useful exposition of where we're at, what the problem is. Adi, would you add anything? Adi: Yes, I mean, I agree with everything Saket. It said the whole exercise for many, many years for Platt's as the originally, main reporting agency and everyone else, was to increase their liquidity by increasing also the number of dates. We used to have 15 day Brent, now it's 30 day and so on, increasing the volume one way or the other, just getting that volume in, which has been the key problem and still remains, until we'll see how this new Brent goes. David: So, another one of the big changes that has been proposed and actions that was kicked off, was at the end of 2020 and Platt's sought to add more supply, inject more supply into the dated ... into the Brent benchmark, by beginning a consultation on including WTI Midland crude, that's a US crude. And that was something of a revolutionary move. I know Adi, I think that's a word, an adjective you used in a paper that you published a couple of months later because Platt's later ... just for people who probably not in the know, there is quite a regimented process that's taken to these methodology changes. And first comes an idea, then comes a consultation, and then comes a more formal proposal. But when these formal proposals came out in the spring of 2021, I think it's fair to say that they were not, on the whole, at least the package, the idea that that were proposed, they didn't go down terribly well with the industry. And I know you were formulating your thoughts around that time as well. Why was it revolutionary? Tell us about what was proposed and why did it cause so much uproar? Adi: Yes, it always happens during the IP week, when verbally came out and then came out in Britain as well. I think there's no doubt that even Platt's would probably admit right now that the whole idea was quite rushed. The main problem with the original idea in '21, was that they basically moved the benchmark to CIF bases, which is delivered base. They'll try and make it as simple as possible. David: Do you want to just tell our listeners what is CIF? Because I know we can have some different terms here that will come up. Adi: Sure, of course. Normally, Brent is traded on free on board basis and it's assessed on free on board basis, that's before it gets on a ship, before oil gets on a ship. A CIF means cost, insurance and freight, which is delivered basis. So the original '21, February '21 Platt's idea was they would assess it on CIF for delivered basis in Rotterdam or around these area, which is the area, Antwerp, Rotterdam, and so on, that whole northwest European area. The problem with that idea is as follows. There's an unwritten rule among the price reporting agencies or as we often say PRAs, is that PRAs should be assessing the market and not influencing it. What happened very soon following that announcement by Platt's, that the whole data curve moved. Because obviously, if you're changing something from FOE basis to delivered bases, you've got freight element involved as well, so the price changes by itself. Now, that's very problematic because then you're influencing the value of all the derivatives. We're talking on millions and millions of barrels, including future trades. The other problem with that was the side of cash Brent on delivered basis is pretty difficult to trade cash Brent forward because you've got that freight element as well, that has to be somehow taken into account. So, that proposal in essence, would've endangered the whole of the Brent complex, least of all the future's part, which is as Saket mentioned, the most liquid and probably most important part of that whole complex. So yes, very quickly wrote a paper, said, "Oh, this is going to be a problem." David: I know you're a student of history, like myself. And in that paper, you wanted to remind readers that the very first Brent contract in 1983 was a CIF contract. And that ended up in failure, as the industry couldn't see a point in trading it. And it was another five years for another, FOB, which it remained that way for ... Well, it has to this day, for the best part of 35, well, going on 40 years. These are not easy things to do, right? To change benchmarks, to look at the complexities. Do you think that we have sufficient appreciation within the industry about history and the lessons that could be learned? Adi: Well, if you look at the price movement themselves, you'll realise that people have very short memories and it's the one part and parcel of us being human. We tend to forget some event that we don't want to remember. So, big price movements, big crashes, squeezes, name it, we tend to forget after a while and that they happen again. And you're right, I mean, the first couple of contracts failed because you can't just make up a benchmark. Benchmark has to make some rational sense. So, Brent Futures eventually were established, only after they started mimicking the forward contract, which is a Saket mentioned early on, at the heart of the Brent complex. So now, trying to make up another ... a different type of contract, is actually going at the heart of the essence of what Brent is all about. So, I think the forward contract or cash contract, as it's often called, really has to be seriously addressed before we actually go anywhere with it. David: So, after those initial plans in the spring of 2021, they were ... I mean, let's say paused, withdrawn, went back to the drawing board. Adi: Went for further consultations, let's put it that way. David: Okay, we'll be diplomatic. Could you outline for us what those options were? And once we've done that, I think we'll take a break because it'll be a good point for us to pause and reassess. So, having shelved or maybe paused the earlier proposals, what were the options going forward? Adi: Well, the pause was obviously for further consultation, discussions with the industry because it wasn't just my paper that came up very, very quickly. Fortunately, most of the industry basically revolted against it as well. Most of the industry said, "Hey, this is not going to work." So, I think the Platt's folks went back to the drawing board and said, "Well, okay, tell us what is going to work." And then we had a very long period of further consultations of another, at least nine months of consultations, where I think the key was in that period most likely, was a further consultations between ICE the Continental Exchange futures provider of Brent and Platt's as well and the essential ... I mean, my suggestion way before was to go back to the FOB basis contract and just increase the volume by adding WTI Midland in it, but then assessing the value by netting you back to FOB. The key reason for that would've been, or probably will be when the new contract starts, is that all the other derivatives and forward market and CFDs, DFLs, EFPs would pretty much remain on FOB basis i.e. unchanged or relatively unchanged. So, this big problem of legacy contracts would be overcome. So, let me just pause there just to explain to your listeners why this is such a difficult thing for everyone in the industry, for the whole of industry to fathom and resolve, is because you're trying to do the best possible solution given the constraints and constraints are massive, which is that all the existing contracts are not changed. So, any solution, they're probably better solutions, but if they are going to impact, impact all the legacy contracts, you have a problem. So, you are very constrained in your solutions. So, there aren't that many ... there's not much leeway within which you are operating. I hope that helps. David: It does. There was a second option that was mooted about adding in one of the other grades that Saket mentioned earlier, Johan Sverdrup? Adi: I'll tell you right away with that, at the end of the day, it was the industry that wrote it, but there was a sizable minority that supported Johan Sverdrup. And I'll tell you why I personally wasn't a big supporter of that idea, for several reasons, but I think there are two key reasons. One, is if you ... actually, I think in one of my papers, I plotted the values of all the BFOET cargo's, sorry crudes, with Johan Sverdrup. Quite frankly, it sticks out like a sore thumb because it's very heavy and it has different, very higher sulphur content. So, it really does not fit into that basket, sweet North Sea grade, light, sweet North Sea grade. The second problem is also that you have the market concentration. Markets don't work very well when you have an overwhelming player in the market. If you look at the BFOET, Brent, Forties, and then you have Ekofisk, Oseberg and Troll, these three come from pretty much one producer, which is Equinor. Johan Sverdrup a dominant producer, is Equinor ... Brent is virtually disappearing. So, you only have essentially Forties. So, the dominance of Equinor within that basket would be just huge. I think that's one of the key reasons why the market rejected the idea. David: Well, that was a nice little teaser about the trajectory of the conversation as we'll continue. I think that good place for us to pause and we'll bring the first part of this episode to a close. In the next part, I'll be asking Adi about which of these proposals won out. No prizes for guessing which trajectory we are on, as we continue to explore the history and the future of Brent, the world's most important oil price benchmark.