Mike Wittner, Head of Oil Market Research, ICE
When 2020 began, new rules to cut sulphur dioxide from shipping fuel seemed poised to drive the oil markets. However, the global coronavirus pandemic quickly eclipsed shipping and came to dominate the scene. It caused an unprecedented collapse in oil demand, as populations were locked down and the global economy tanked. This was followed by historic production cuts by OPEC+ countries. By mid-year, the oil markets were in a gradual and lengthy process of market rebalancing.
Market fortunes will to a large extent be dictated by the path of the coronavirus and the recovery in the global economy — which are of course two sides of the same coin. Both commercial oil market participants and investors are seeking reliable benchmarks to navigate extraordinary price turbulence and volatility. This isn’t the first time the market has seen a significant shift. And just as ICE's BrentTM benchmark has helped manage new supply and demand dynamics amid previous upheaval, it provides security to traders today.
The crude oil blend on which ICE’s Brent benchmark is based is a waterborne crude oil. As such, it can be put on a vessel and shipped anywhere. This waterborne crude, referred to as brent oil has access to global shipping capacity, global port capacity, and global storage capacity, both onshore and on vessels. It is sold to, and processed by, refiners — not just in Europe, but around the world. Because of all these factors, ICE’s Brent benchmark reflects global oil market fundamentals and the global economy. This makes oil more attractive than other crudes which are landlocked and have logistical and storage constraints which can influence the price. In markets where available storage capacity is in short supply, such as the one seen earlier this year, this confers a clear valuation advantage for waterborne crude oil.
Around 78% of globally traded (i.e., exported) physical crude oil is priced off the Brent benchmark, either directly or indirectly, according to Energy Intelligence. As markets grapple with ongoing uncertainty, the global nature of the crude oil complex offers security to global market participants. Physical traders overwhelmingly choose ICE Brent Futures contracts to manage their risk through all market cycles.
The brent crude oil blend extracted from the North Sea, comprises Brent Blend, Forties Blend, Oseberg, Ekofisk, and Troll crudes, commonly referred to as BFOET. The Brent complex includes the trading of physically delivered oil such as Dated Brent and cash BFOET, along with financially settled derivatives like ICE BrentTM Futures, Dated-to-Frontlines, Contracts for Differences, and many others. As ICE Brent Futures are cash-settled, there is no need to take physical delivery. At the same time, the Exchange for Physical (EFP) mechanism, together with the ICE Brent IndexTM, ensures that the ICE Brent Futures market remains linked with the physical crude oil markets. This ensures that the fundamentals driving the physical market are translated into the ICE Brent Futures contract expiry price.
Physical traders prefer a brent oil because of its waterborne and global nature, its flexible logistics and storage, and its dominance in global crude pricing. Physical traders play a leading role in the brent complex, which is comprised of more than 600 related oil products. For ICE Brent Futures, commitments by commercial participants (producers, refiners, consumers, and physical traders) average 40-45% of total open interest. By contrast, physical players represent only around 20-25% of commitments in other major crude futures. This dynamic enables ICE’s Brent benchmark to more accurately reflect global physical oil market fundamentals; importantly, this also makes brent oil less subject to the extreme price swings that can be caused by speculators, market makers, and other investor flows.
The role of brent crude as a basis for an international oil benchmark is more crucial than ever. The brent oilfield’s location in the European export-import market, straddling Asia and the U.S., helps facilitate global trade between the world’s major oil players. As a waterborne contract, its accessibility means it is easy to price against other locations and grades. This determines whether it is profitable to move crude oil from one location to another — or in other words, whether the “arbitrage window” is open or closed. This dynamic cements brent oil’s role as a global crude.
U.S. producers use the Brent benchmark to determine the destination of exports, either to Europe or to Asia. West Texas Intermediate (WTI) is a landlocked crude with logistics and storage constraints; it reflects regional fundamentals in the US midcontinent. In the physical oil markets, WTI is primarily used for U.S. and Canadian oil trading. However, once WTI reaches the US Gulf Coast as an export barrel, its price relative to brent oil and Dubai oil is what matters.
The Brent-WTI spread remains the most active in the export market, representing the difference between U.S. pricing and the rest of the world. This price differential is key to determining whether it is profitable for US crude oil to be exported to Europe. In practice, the way the physical market functions means exports of US light sweet crude from the US Gulf Coast depend on brent oil versus WTI priced at Houston (MEH) or at Midland, rather than WTI Cushing. Notably, MEH and Midland are themselves traded as differentials to WTI Cushing.
How do traders hedge US crude exports to Europe? For exports, traders are exposed to WTI where it meets the global waterborne market on the US Gulf Coast, as opposed to the midcontinent. In order to manage this risk, they do two trades: MEH or WTI Midland vs. WTI Cushing and a WTI Cushing vs. BrentTM Spread. The WTI Cushing legs of those positions cancel out, and traders are left with WTI in Houston or Midland vs. brent oil. In short, as US crude exports have grown since 2016, the physical market has had to adapt and adjust within the US, to determine a fair and accurate value for waterborne export barrels that are then priced against brent oil.
Similarly, the WTI-Dubai spread regulates crude oil flows between the US and Asia; the discussion above applies here as well, with WTI prices referring to MEH or Midland, rather than Cushing.
Finally, the Brent-Dubai spread determines the economics of crude oil movements from the Atlantic Basin and Middle East to Asia. While most Middle East sour crude is priced against Dubai, the Dubai benchmark itself is priced against brent oil. All of these crude price differentials or spreads are important signals for the oil market regarding the fundamentals of supply and demand in different regions.
As one of the world’s most liquid crude grades, brent oil forms the pricing benchmark, directly or indirectly, for over 75% of the world’s exported crude oil, as noted above. This includes Russian Urals, West African crudes from Nigeria and Angola, and Middle Eastern grades from the largest OPEC producers. Differential contracts for brent oil are central to these connections. The liquid differentials markets of brent versus Dubai, WTI, Russian Urals, Caspian Sea oil (CPC), Light Louisiana Sweet (LLS) and Gulf Coast Mars oil — among others — support physical players looking to manage their risk exposure. These markets also allow financial traders to take positions and express views on market events and anticipated developments. In this way, brent oil forms the basis of the most influential oil benchmark price.
The brent oil complex also enables players to manage risk across refined product markets in Europe, Asia and North America. Crack spreads represent the difference in value between a specific refined product such as gasoline or diesel, versus the price of a particular crude. This means traders can hedge refined products with crack spread derivative contracts. Similar to the way in which brent oil versus WTI and brent oil versus Dubai give the market important signals on global and regional crude fundamentals, refined product crack spreads provide critical information on product supply and demand. The refined product and crude oil markets are, of course, very closely linked. While crude oil is extracted from oil fields, end-users consume refined products. Refineries link producers and consumers, buying crude oil from producers, processing it, and selling the resulting refined products to end-users.