It was only 3-4 days ago but the slump in oil prices at the beginning of the week has speedily been erased from memory. Bulls have fought back with vengeance and currently they seem to be in control of their own destiny. Yesterday’s price action suggests that speculative buying interest is being coupled with some physical tightness. Not only outright Brent jumped $1.57/bbl but the front-end backwardation is now more than $1/bbl.
After Vladimir Putin’s re-assuring words on Wednesday about the prolonged co-operation with OPEC it was the turn of the latter to provide further impetus yesterday. Sources within the organization provided the strongest hit yet that the current output deal with its non-OPEC peers would be extended until June when the issue will be re-visited. It is a reasonable approach as the second half of the year is usually tighter than the first six months. The extension is probably nothing new and is expected. The supportive part of the potential agreement is that whilst deeper production cuts will be ruled out stricter compliance would be emphasized. A disciplined approach from Iraq and Nigeria should shave off another 300-400,000 bpd of the group’s production level leading to a balanced market in 1H 2020 and to a possible supply deficit on 2H.
The relationship between flat price and structure in the European benchmark has not exactly been harmonious in the recent past but over the last few days they go hand in hand – strong outright price is coupled with deep backwardation. This implies physical tightness, which is likely down to the IMO ruling requiring ships to cut the sulphur content of their fuel from 3.5% to 0.5% effective January 1, 2020. Refiners started to focus in crude grades that yield more LSFO pushing up differentials and supporting the Brent structure. The January/February Brent spread has jumped from 89 cents/bbl on Tuesday to $1.03/bbl yesterday and further gains are witnessed this morning. The Brent CFD market is displaying a backwardation of more than $2.10/bbl for the next six weeks. The current momentum is definitely to the upside, but the question is whether it can be maintained without stock market support. US equities have been less than enthusiastic in the past few days and the Shanghai Composite Index fell to a 3-month low this morning due to the lack of clarity in trade talks. Any progress on this front will provide further ammunition to oil buyers and they will not be afraid to use it.
The new crude oil benchmark
There have been numerous attempts in the past to challenge the dominant position of the two main crude oil futures contracts as the choice of hedging and investing. WTI and Brent, however, have more or less successfully fended off these efforts, perhaps with the exception of the Oman futures contract on the DME and the crude oil futures introduced on the Shanghai Commodity Exchange – the latter more than the former. Although average daily volume (ADV) for Oman crude futures were up 33% in June from the same period last year the absolute volume of less than 7,000 lots per day is still anything but attractive. During the same period the Shanghai crude oil futures contract showed a growth of 60% and its ADV stood at 367.059 contracts in June. The Urals crude oil futures contract introduced on the St Petersburg International Mercantile Exchange has never really taken off and is basically dead.
There is a new candidate on the horizon. We first saw on Reuters back in July that state-run ADNOC was planning to launch a crude oil futures contract, a regional benchmark, something that can compete with WTI and/ or Brent. The logic is unquestionable. The oil market has undergone its biggest changes in decades and crude oil has become a much more global commodity than ever before.
US crude is now reaching China and South Korea whilst Saudi Arabia is sending its oil up to Poland and Sweden. The traditional market for Middle East producers is the Far East. This segment has come under immense competition of late and something needs to be done, the logic goes. Offering alternative pricing and hedging tools for existing customers is one of the possibilities.
The UAE produces around 3 mbpd. The plan is to turn one of its grades, Murban, into a regional benchmark. Its output is around 1.6 mbpd. As a comparison the BFOE marker has an underlying physical volume of around 0.9-1 million bpd. It has similar characteristics to Brent or WTI, it is relatively light. It is exported from Fujairah, the east coast the Emirates meaning that it does not have to travel through the Strait of Hormuz on its way to international destinations.
There are quite a few criteria that need to be fulfilled for the contract to be successful. The first one is to remove pricing restrictions. In the past Murban was directly sold to end-users and it was based on retroactive pricing – buyers did not know how much they’d pay until after they received the cargo. Then there is the question of trading platform. ADNOC has picked ICE to launch its Murban futures contract, which could start trading as early as February next year. The dilemma here is whether having two or three similar types of grades on the same exchange would split market players or would create additional liquidity. Having said that, ICE is reportedly planning to launch a new exchange in Abu Dhabi to host the Murban crude oil futures contract. Liquidity is also an integral part of the potential success. From this respect the good news is that several majors and trading houses -BP, Shell, Total, Vitol, Petrochina amongst others- agreed to be partners in the new exchange.
Additional liquidity then must be provided by financial players for the new futures contract to succeed. Take the well-established European benchmark for comparison. As said above the physical volume of the BFOE grade is around 1 mbpd. This benchmark is used to determine the value of probably 60 million bbls of oil daily. Yet, the average daily volume traded on ICE 15 times more, over 900 million bbls. The contract must appeal to market makers, commodity funds and other financial investors.
There are naturally lots of uncertainties surrounding the Murban crude oil futures contract. The latest one that caused some confusion was the remark from ADNOC’s head of trading who said that Murban is intended as a replacement for Brent. The comment was retracted later saying that ADNOC wants to make the Murban contract a price marker alongside Brent. Time will tell whether the new benchmark becomes popular or not, but it will take time, years rather than months, to turn the idea into a popular hedging and investing tool.