Let's get physical

Beyond the paper markets

We are going to start a series of posts aiming to dive deeper into the oil/refined products physical markets, going from the basics to more complex hedging, arbitrage, cross-barrels strategies and so on. This is a topic that there isn’t much info available on-line so I decided to tackle this in a more approachable way, breaking it into pieces and starting from the basics for anyone to understand.

So, we are going to attack this beast in 4 separated installments:

• Oil Market design (structure, player, available instruments)

• “Arbing” and hedging refined products (the mechanics)

• Crude oil “arbs” and hedging (same mechanics than products but with an added layer)

• How oil traders make money

To get into the mindset of oil trading let’s revise some basic rules:

1. YOU DON’T CARE ABOUT OIL PRICE! That’s an oil producer problem, don’t make it yours

2. Lying, stealing, cheating, bribing... anything goes in this industry, but you don’t break rule number 1

With that out of the way, let’s revisit the history of oil markets and how we got here.

I would say, well into the 1960s the oil industry (it wasn’t even a market back then) was a consolidated in all areas, we just a few big hands handling the production, distribution, refining, and marketing. In terms of trading, there wasn’t much of that since everyone owned their molecules from well to tank. The spot market as we know it started to take shape in the 60s/70s, first with the Arab waves of nationalization, that resulted in new oil producers with no refinery assets that had to sell their crude to 3rd parties, usually Middle Eastern producers selling back to western oil majors with little to non-existent price discovery. When OPEC gained some traction, they started to set their own prices, that era culminated in the infamous oil embargo, tanker wars, etc that led to more exploration and production, specifically in the North Sea in the mid 70s, and with the advent of liberalization (Tatcher, Reagonomics) the first spot market was born, and with that the oil traders came to life. A need emerged for transparent, market-based pricing to reflect real-time supply and demand dynamics, leading to the first crude oil benchmarks, Brent was the first one that enabled cargoes to be traded spot instead of the industry standard “Term Deals”

Term vs Spot

Buying and selling oil is largely organized in Term deals and spot deals, with some barrels clearing in open and public tenders.

Term deals, or term supplies are the preferred method of allocating oil production for National oil companies, Saudi Aramco, ADNOC, SOMO, most of the Middle Eastern producers basically, and they range from 6 months to a year or two and the only discussions are about the volume to be lifted, the quality of the oil and in some cases the premium/discount to a benchmark, in other cases just volume adjusted for a formula (the mighty OSPs). Most of these deals are on a FOB (free on board) basis, where the seller loads the barrel on the tanker that the buyer sent, and then they send the invoice.

Typical deliveries have a standard cargo size, ie. One Suezmax per month over the next year at Dated +1, and usually involve a “take or pay” clause, if you don’t send a vessel, you pay a fine.

In the recent years the trend from these producers is to shift a portion of the monthly production to the spot market, today the split is roughly 70% term, 30% spot. Depending on market conditions, if it is in the master agreement, a customer could ask for extra allocations for any given month, or ask for a smaller batch.

What are OSPs? Official Selling Prices (OSP) are prices set by national oil companies (NOCs) for their term crude oil sales. These prices are used as a pricing reference for long-term contracts, set monthly taking into account a few metrics from previous trading month, companies like Aramco set the OSP depending on where the Dubai first line month (M1) vs the 3rd month is, the spread, and where the “cash premium” was. Cash premium refers to actual barrels changing hand in the spot market vs a benchmark. To reflect market dynamics, OSP are differentiated by crude grade and customer location, Arab light to Asia might be cheaper than Arab Light to Europe or the US by a few cents up to some dollars.

A recent example, given the Dubai strength at the beginning of February, the April OSP was set at Dubai +3.5, so if you lift a term cargo during April you will be invoiced (in May) the average of April Dubai prices + 3.50.

Are the remaining spot cargoes affected by OSPs? Yes, but they rarely trade at that mark, since they better reflect current market conditions. Today the “Cash Premium” is $1.50 over the benchmark, and the few cargoes the were trading did so at OSP-$2...it doesn’t make much sense.

Supply tenders are kind of a relic of the past, but some NOCs still use them in Latam, Africa, where market participants are invited to bid on scheduled cargoes for the month/quarter. The bids come to a benchmark +/-, the highest bid gets the oil. This scheme is common for cash striped countries, and consequently attracts the most unscrupulous oil traders. Here is where almost all the bribing and embellishment happens.

Spot market is where physical crude oil is bought and sold for near-term delivery, typically within 30 to 60 days each deal is negotiated individually, including terms like grade, volume, price (linked to a benchmark + differential), delivery window, and incoterm (FOB/CIF/CFR/DAP).

The delivery window, about to 3 days in range is given by the oil terminal that does all the scheduling and planning on how much oil there is in the tanks, available berths and so one. If you are a producer, you sent you barrels to a marine terminal and they will tell you when to send a ship to pick them up, that’s your window and the one you will use when trying to sell your crude.

Without getting into much detail about futures and swap yet, the spot market evolved around 3 major benchmarks: WTI for Noth America, Brent for North Sea and Dubai for Middle East crude. The relevance of these markers is because these were the first Crude oil stablished futures, which unlike grain and Agri futures, the just only date back to the 1980s with the advent of electronic trading, you could say they are relative recent.

I would venture to say that 70% of the oil that is traded spot is using Brent as a benchmark, since it was the fist “Seaborne”, ready for export crude, or as the industry refers to, oil in the water.

WTI until not long ago was just a domestic benchmark, and I would argue it still is, since is pricing oil in the Middle of the country, a tank farm in Cushing, OK. Also has the particularity to be the only one with Physical delivery, meaning if you buy a WTI contract and hold it to expiration, someone will call you to ask you in which tank in Cushing you want your oil to be delivered. Brent and Dubai are financially settled, just like a SP500 future, more on that later on.

By far, the most advanced benchmark is Brent, with a myriad of financial instruments and the most liquid (see previous post on Brent complex) and with multiple price discovery mechanisms. Derived from the Brent futures and Brent forwards is something called “Dated Brent”, that encompasses physical cargoes loading 10 to 25 days ahead, it’s called “dated” because those North Sea cargoes have an actual date for loading (the terminal has issued a loading window for each producer), so this is more representative of spot value of cargoes rather than virtual prices derived from a futures contract that anyone with $100 in a trading account can trade.

Benchmarks

Oil prices tend to move in lockstep, but the decision of using one benchmark over the other lies more on geography and type of crude. Brent and WTI are similar in quality, light-sweet crude, while Dubai is more representative of med-sour crudes. By definition, these are baskets of oil grades, and while Dubai and Brent crude grades exists, these are really small streams (50-100kbd) that by themselves wouldn’t set global oil prices. Brent benchmark is comprised of 6 grades from the North Sea + one American grade (Midland, which is not the same as WTI) that fall within certain specifications on API gravity and Sulphur content. WTI is not a crude grade, but a blend that has to meet certain specification and be delivered in a tank. Dubai is more ample since it has light and med API grades with varying sulphuric content, and is not a future, is a swap. There is a more equivalent futures contract in Middle East that is equivalent to WTI or Brent, the Oman futures, but is low liquidity, and since Dubai is cleared on exchanges, is pretty much a future now.

So, depending the location you may choose to use or another, right? No, not so simple

When you are using a benchmark, you assume you are placing your barrels in the region of the benchmark, but it takes time to get there, and also you need to account for the natural buying cycle of refineries, so more important than the origin of your barrel is the destination. For example, the spot assessment for a Brazilian barrel going to Rotterdam, you can’t price against “Dated” because you will be nominated to load in a month or two, hence your barrel will be (in theory) arriving within Brent M2 or M3 futures contract depending on the date of loading, so your spot assessment would be Brent M2 +/- something. If you are sending your barrels to the US Gulf Coast you will be competing with WTI, and that could fall within M1 so you will quote WTI+/- something.

Same for Canada, if you are shipping that heavy crude from Vancouver to the refineries in California you would use WTI as your maker, but if you ship it west to China, you need to use Brent and calculate back the transit time as it will go from Europe to Asia, and since China buys on delivered basis (freight included), they are probably buying one month ahead so in mid March (today) they will need a quote Delivered July, you use M3. As an example, West Canadian Select is trading at WTI -$10, or Brent M3 -$3 Delivered China Jul. Same molecules, different price structuring. West coast South American can trade vs WTI or Brent depending where they land, Russian ESPO in the far East is a rare example, since the crude quality is similar to Brent rather than Dubai.

Pricing

Physical oil is never bought and sold at a fixed price (hence rule 1&2), oil trades at “floating” price, meaning, you don’t know what price are you going to get until the “pricing period” is over.

What is this “pricing period” thing? It can be whatever you imagine, but the industry works on two schemes mostly, monthly averages for term cargoes, and what is called 2-1-2 or 5 days around B/L.

Spot cargoes mainly price using 5 days around B/L. The Bill of Lading (B/L) is the document of transport, signed by the Master that says the quantity, quality and who controls (not ownership) the cargo, and the receiver. The B/L is signed once final quantity is tallied and marks the completion of the loading operation.

Let’s say you buy one million barrels of Bonny Light in WAF, today (mid-march) and the seller agrees to sell you one Suezmax, FOB Bonny Terminal to load late April/ early May, at Dated +$2, 5 days around BL quotes, payment at sight 15 days after BL date (those Nigerians are always cash hungry, when they buy gasoline they pay 90 days after discharge… if they pay you at all). Do you know today how much would you pay for your cargo? No, you won’t even know it after the tanker sailed. For simplicity’s sake, let’s say the day comes, you sent the vessel and it finish loading on Wednesday, you won’t know how much you will be invoiced until Friday at market close. In this scheme you need to capture 2 days before the BL date (Mon, Tues), the day it finishes loading (Wed) and two subsequent days (Thu, Fri). This is done to smooth out volatility and avoid some evil practices of dating the B/L depending on prices (2% daily change represents $1.5M on a cargo like this one). So, now you know you will be invoiced $73.55 per barrel loaded in the ship ($71.55 + $2 for the negotiated premium) and here is where the hedging begins!

Subscribe because in the next episode we are going to do some math, get your excels ready.