Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Crude oil spot and futures markets

There appears to be a lot of confusion about the relationship
between spot and futures markets for crude oil after Paul
Krugman
set the ball rolling with his remark: “Well, a
futures contract is a bet about the future price. It has no, zero,
nada direct effect on the spot price.” Krugman led up to this
with an even more provocative example:

Imagine that Joe Shmoe and Harriet Who, neither of whom has any
direct involvement in the production of oil, make a bet: Joe says oil
is going to $150, Harriet says it won’t. What direct effect does this
have on the spot price of oil – the actual price people pay to have a
barrel of black gunk delivered?

The answer, surely, is none. Who cares what bets people not involved
in buying or selling the stuff make? And if there are 10 million Joe
Shmoes, it still doesn’t make any difference.

Such provocation was bound to elicit an extreme response and Peak
Oil Bebunked
did just that with the oppposite claim:

Most crude oil is traded based on long-term contracts, and the
prices in those contracts are set by … adding a premium to, or
subtracting a discount from, certain benchmark or marker
crudes. … Originally, the benchmark prices were spot prices, but
over time … many key oil exporters shifted away from the spot
market, and began to use futures prices as the benchmark.

… Krugman and Birger are profoundly confused about the way the
international oil markets actually function. 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 Bebunked left many commentators on his blog thoroughly
confused. One commentator for example wrote:

I always wondered about this. I figured the futures prices had to
adjust to the spot price (which was driven by actual oil) as the
contract expired. If they didn’t, a arbitrage opportunity would exist
that would correct the imbalance.

But given this explanation, I guess not. I guess the
“spot” prices adjusts to the futures price.

The downside to this approach is that supply/demand fundamentals
don’t necessarily determine the price.

Crude oil markets are pretty complex and Peak Oil Bebunked’s
description of this market is actually quite correct, but there is a
sense in which Krugman’s textbook model is not totally wrong
either. It is worthwhile understanding this market in some detail. For
concreteness, I will focus on the Brent Crude market.

The term Brent crude today refers to crude coming out of any of four
oilfields in the North Sea – Brent, Forties, Oseberg and Ekofisk
– collectively referred to as BFOE.

The most important market for physical Brent crude is the cash BFOE
market which is essentially a forward market. It is based on 21 days
advance declaration (though 15 day and other periods are also in
vogue). 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. Moreover, though this is a
market for physical crude, it is a forward rather than a true spot
market.

Let us then move to the closest that we get to a spot transaction
– the dated Brent crude market. The terms are usually FOB
– the buyer brings the vessel and the seller provides the berth
at the terminal and loads the cargo. 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, but the buyer can usually bring
the vessel to the terminal at any time within the three day period
known as the laydays. Dated Brent contracts are actively traded
between oil industry participants. Also, when a buyer gives an advance
declaration in the cash BFOE contract, it effectively becomes a dated
Brent contract.

Since the laydays span three days and the loading period itself
could be close to two days, there is considerable deviation in the
precise day of loading of the cargo even in the dated Brent
market. Similarly, if the buyer of an August cash BFOE contract gives
declaration for a date late in August, it is possible that loading
takes place only on say the 2nd of September. Contracts often allow
for further exceptions even beyond this if there is a curtailment of
production in the oilfield or for other reasons beyond the control of
the buyer or seller. These complications are natural in any genuine
spot market for a non financial asset.

The dated Brent market probably has very little impact on price
discovery for Brent crude. This is because these transactions are
concluded on a differential to the (forward) cash BFOE price. The
dated Brent for July 23-35 might for example be traded at August cash
BFOE plus 10 cents.

Finally, we come to what is by far the most important price of
Brent crude – the Brent crude futures at ICE. The ICE Brent
Futures is a deliverable contract based on EFP delivery with an option
to cash settle. Cash settlement is based on the cash BFOE market as
explained in the contract
specifications
:

[T]he 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. These prices are
published by the independent price reporting services used by the oil
industry. The ICE Futures Brent Index is calculated as an average of
the following elements:

  1. First month trades in the 21 day BFOE market.
  2. Second month trades in the 21 day BFOE market plus or
    minus a straight average of the spread trades between the first and
    second months.
  3. A straight average of all the assessments published in media
    reports.

Essentially, therefore, the underlying for the Brent futures is the
cash (21 day) BFOE market. The standard textbook model of cash-futures
arbitrage implies that the futures price cannot deviate too much from
this underlying “spot” price. Even if we regard cash BFOE
as a forward rather than spot contract, it is linked to its underlying
which is dated Brent. The moment the buyer of cash BFOE gives
declaration, he effectively turns his contract into dated Brent
crude. Arbitrage would therefore tie cash BFOE down to dated Brent. At
this level, Krugman’s argument that a futures contract is a bet
about the future price is not without merit.

But things are much more complex than this because long term
contracts for crude in regions far away from the North Sea are based
on Brent futures price plus/minus a differential. ICE claims that the Brent
contract “is used to price over 65% of the world’s traded crude
oil.” On the other hand, BFOE is only a miniscule part of the
total crude oil production in the world. This is the point that Peak
Oil Bebunked is making. Brent futures are far more important and
influential than any of the markets for physical crude. Most price
discovery actually happens in the futures market and the physical
markets trade on this basis. In an important sense, the crude futures
price is the price of crude.

Crude is a particularly nasty example, but similar phenomena exist
even in financial assets. Much of the price discovery in stock markets
happens in the index futures market. Individual stocks are priced
taking the broader market index as given. If the index has fallen 5%
on a day and a specific stock has not traded so far, a person
contemplating placing a bid for this stock would implicitly price it
off the index futures price taking into account the beta of the stock
and any stock specific information. Yet the index futures contract is
settled using the cash index value and is therefore itself tied down
to the cash market through cash-futures arbitrage. This is not
inconsistent with the fact that the major element of price discovery
happens in the index futures market.

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6 responses to “Crude oil spot and futures markets

  1. fee April 17, 2011 at 1:34 am

    what influence does opec have on the global economy?

  2. Mark August 28, 2011 at 4:34 pm

    Laydays are a seller’s option not a buyer’s option. The BFOE cargoes are entered into chains by the equity producer and passed down to the last buyer.

  3. Pingback: understanding the stock market

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  5. Pingback: wti crude future

  6. Pingback: crude oil barrel price

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