Opinion

The Great Debate

NYMEX oil benchmark again in question

December 23, 2008

John Kemp Great Debate– John Kemp is a Reuters columnist.  The views expressed are his own –

The record differential between the front-month and more liquid second-month contracts at expiry last week once again raised pointed questions about whether the NYMEX light sweet contract is serving as a good benchmark for the global oil market, or sending misleading signals about the state of supply and demand.

The expiring January 2009 contract ended down $2.35 on Friday at $33.87, while the more liquid February contract actually rose 69 cents to settle at $42.36 – an unprecedented contango from one month to the next of $8.49.

Criticism of the contract is not new, and past calls for reform have been successfully sidelined. But with policymakers taking a keener interest as a result of wild gyrations in oil prices this year, and a continued focus on regulatory changes to improve market functioning in future, there is at least a chance changes will be adopted as part of a wider package of futures market adjustments.

AN UNREPRESENTATIVE PRICE

During the surge to $147 per barrel earlier this year, OPEC repeatedly criticized the NYMEX reference price for overstating the real degree of tightness in the physical market and causing prices to overshoot on the upside.

While rallying NYMEX prices seemed to point to an acute physical shortage and need for more oil, Saudi Arabia could not find buyers for the 200,000 barrels per day (bpd) of extra oil promised to U.N. Secretary-General Ban Ki-moon or the 300,000 bpd promised to U.S. President George Bush in June.

Bizarrely, rather than acknowledge there was something wrong with the reference price, some market participants suggested Saudi Arabia should increase the already large discounts for its physical crude to achieve sales in a market that clearly did not need the oil, and was not paying enough contango to make storing it economic (contango is where the futures price is above the spot market).

The NYMEX WTI price may have achieved unprecedented media fame as a result of the “super-spike”, but a futures price to which producers and consumers were paying ever larger discounts for actual barrels was clearly not a good indication of where the market as a whole was trading.

Now the market risks overshooting in the other direction. Intense pressure on the front month in recent weeks has more to do with the contract’s peculiarities (in particular storage restrictions at the delivery point) than a further deterioration in oil demand or a market vote of no-confidence in the 2.2 million barrels per day further cut in oil production announced by OPEC at the end of last week.

The collapse in NYMEX prices nearby risks exaggerating the real degree of oversupply  and demand destruction, sending the wrong signal to producers and consumers about the wider availability of crude in the petroleum economy.

DOMESTIC PRICE, GLOBAL BENCHMARK

The NYMEX contract is for a very special type of crude oil (light sweet) delivered at a very special location (Cushing, Oklahoma) in the interior of the United States. It is not representative of the majority of crude oil traded internationally (most of which is heavier and sourer) and delivered by ocean-going tankers.

These specifications made sense when the contract was introduced as a benchmark for the U.S. domestic market.

U.S. refiners have a strong preference for light oils, for which they were prepared to pay a premium, because of their much higher yield to gasoline. The inland delivery location, centrally located and near the main Texas oilfields, rather than one on the coast, made sense for a contract that tried to capture the “typical” base price for crude oil paid by refiners across the continental United States.

But these specifications make much less sense now the NYMEX price is increasingly used a benchmark for the global petroleum economy, in which light sweet crudes are only a small fraction of total output. Just as NYMEX prices sent the wrong signals about physical oil availability on the way up, distorting the market and triggering more demand destruction than was really necessary, they now risk sending the wrong ones on the way down.

Earlier this year, the problem was a relative shortage of light sweet crude oils at Cushing, while all the extra barrels being offered to the market by Saudi Arabia were heavier, sourer crudes that could not be delivered against the contract. Moreover, extra Saudi crudes would have arrived by ship, and the pipeline and storage configurations around Cushing would have made it difficult to deliver them quickly against the contract.

Financial speculators were able to push NYMEX higher safe in the knowledge Saudi Arabia could not take the other side and overwhelm them by delivering physical barrels to bring prices down. The resulting spike exhibited all the characteristics of a technical squeeze:  tight contract specifications ensured there could be shortage of NYMEX light sweet inland oils even while the global market was oversupplied by heavier, sourer seaborne ones.

Now the opposite problem is occurring. Crude stocks at Cushing have doubled from 14.3 million barrels to 27.5 million since mid-October. Stocks around the delivery point are at a near-record levels and approaching the maximum capacity of local tank and pipeline facilities (https://customers.reuters.com/d/graphics/CUSHING.pdf).

As a result, the market has been forced into a huge contango as storage becomes increasingly expensive and difficult to obtain, ensuring the expiring futures trade at a substantial discount.

But Cushing inventories are not typical of the rest of the U.S. Midwest (https://customers.reuters.com/d/graphics/PADD2_EX_CUSHING.pdf) or along the U.S. Gulf Coast (https://customers.reuters.com/d/graphics/PADD3.pdf), where stock levels are high relative to demand but nowhere near as overfull as in Oklahoma.

Once again the problem is geography. Coastal refiners have responded to the downturn by cutting imports of seaborne crude, limiting the stock build. But the inland market is the destination for some Canadian crudes that have nowhere else to go, and the pipeline configuration means they cannot be trans-shipped to other locations readily.

Light sweet crude has been piling up in the region, with refiners choosing to deliver the unwanted excess to the market by delivering it into Cushing.

NEW GRADES, NEW DELIVERY POINTS

The easiest way to make NYMEX more representative would be to widen the number of crude grades that can be delivered, and open a new delivery point along the U.S. Gulf Coast. Both reforms would link the contract more tightly into the global petroleum economy.

NYMEX already permits some flexibility in delivery grades. Sellers can deliver UK Brent and Norwegian Oseberg at small fixed discounts to the settlement price, and Nigerian Bonny Light and Qua Iboe, as well as Colombia’s Cusiana at small premiums.

In principle, there is no reason the contract cannot be modified further to allow a wider range of foreign oils to be delivered at larger discounts to the settlement price.

More importantly, NYMEX could open a second delivery location along the Gulf Coast, increasing the amount of storage capacity available, and linking it more closely into the tanker market.

If prices spiked again, a coastal delivery location would make it much easier for Saudi Arabia to short the market and deliver its own barrels into the rally. By widening the physical basis, it would also make it easier to support the market by cutting international production and avert a glut trapped around the delivery location.

So far, the market has continued to resist change. But there are signs policymakers might enforce one.

Earlier in the year, Saudi Arabia strongly hinted western governments should look at reforming their own futures markets rather than call for production of even more barrels of oil that could not be sold at the prevailing (unrealistic) price.

Naturally, some of the reform impetus has ebbed along with prices and demand. But policymakers continue to show interest in structural reforms, as was evident at last week’s London Energy Meeting, and there is an increased willingness to challenge unfettered market dynamics.

It is still possible the incoming Obama administration might force contract changes as part of a wider package of reforms designed to improve the functioning of commodity markets, reduce volatility and send clearer, more consistent price signals to the industry and consumers.

For previous columns by John Kemp, click here.

Comments
15 comments so far | RSS Comments RSS

An excellent piece of analysis by Mr. Kemp. The one thing that is not addressed is whether he thinks that he is the only one to notice these distortions or whether other insiders in and outside the industry may have purposely destabilized the markets based on this scenario. The chances are that Mr. Kemp is not the only one who has noticed the the disconnect between market pricing mechanisms and reality.

Anyone care to do the math of what excess profits accrued to market players by calculating the difference between the price of crude 2 years ago and the huge run-up that happened since then. Certainly well over a trillion dollars of excess charges has been extracted from consumers worldwide. This is what you get when the government is in bed with the petroleum industry. No oversight, no regulation, no accountability and grand larceny on a scale that is unprecedented in history. The new kinder, gentler fascism, except it is only kinder and gentler to its paymasters as in previous historical periods.

Time for a major correction or the world is in for an unprecedented period of instability and decline. I hope Obama has it in him, because certainly the Democrats for the most part have been limp-wristed accomplices to the criminal destabilization of the world that is now on our doorstep.

Posted by Jonathan Cole | Report as abusive
 

what part do you feel the hedge funds played in running up these commodity prices. and do you think the seemingly demise of the (some) hedge funds will play in the future of oil prices.

 

Another case of “If you don’t like the reality, shoot the messanger!”. I think that the problem isn’t that the current measures don’t work, it’s that they work too well>

 

There are plenty of other futures contracts with different specifications available. No need to mess with our light sweet crude contract.

Posted by Rose | Report as abusive
 

I can only agree completely with Jonathan Cole in his comments on the John Kemp article. Another example of “I’m doing very well Jack and **** you, I’m making millions and having a good laugh too”. Greed, lack of honour and professionalism as we’re all to busy making money no matter the cost. It’s not enough that these “responsible” people who earn large if not vast salaries anyhow need to have even more. Get rid of all of them and promote juniors to less money and i’m sure they would be happy

Posted by a. riicciardiello | Report as abusive
 

I am the unlucky owner of a typical ETF that seems to trade these futures however ambiguously.

I believe that I have paid for the run down of oil prices from 44.0 to 33.87 once in January through this fund and am I suppose to be repeating a ride down of these prices from 42.36-down for February?!. I consider this to be legalized fraud.

I can imagine why option dealers would like play this game, they will jack the prices of the next month options just before current month expires to unload them to ETFs to buyers like me who would have no clue, laughing all the way to the bank they can short them too.

Posted by T.V | Report as abusive
 

Clearly this is a major problem for crude but you ignore the same issue with heating oil. This contract for a product which is obsolete for much of the world is the only reference for diesel fuel. The contract is shamelessly manipulated and squeezed nearly every month by the major speculators who control the storage at the delivery point in New York harbor. The hedgers who actually participate in the physical market need a liquid contract for diesel fuel not heating oil and a delivery point that is not controlled by insiders.

Posted by Ben | Report as abusive
 

excellent, a must read for oil investors imo

Posted by DP | Report as abusive
 

Very good article, the futures markets can work very well if the delivery process is not manipulated. Making several delivery points, with various grades would correct a very important part of the problem and help bring about “true” price discovery.

Posted by Jeff J | Report as abusive
 

The Commodity Futures Trading Commission was run by Phil Gramm’s wife while the Senator acted as the strongest force of deregulation we’ve seen in generations.

Deregulation created a system of incentives that channeled the greed of an industry that has yet to have a crisis of conscience.

Deregulation: Catalyst to a Crash
http://www.gamingthemarket.com/2008/12/d eregulation-catalyst-to-crash.html

 

I find myself in T.V.’ situation and I am unhappy about it. It is worth reading John Riley’s commentary of 12/17/2008 in Cornerstone Commentary – John Riley: Out of Touch With Reality [PDF] (12/19). He reminds us that oil is declining at a rate of 1/2% per day in contrast to a depletion rate of 6.7% per day. These rates suggest that at some not too distant time in the future; oil prices will again begin to rise significantly.

Larry

Posted by Larry | Report as abusive
 

What is in the crude that makes it souer and worth less money?

Posted by craig | Report as abusive
 

“What is in the crude that makes it souer and worth less money?”

Sulphur and ash content.

 

Craig, decline rates of oil fields are about 6% per year for average sized fields according to recently published data. That would be a massive loss of oil resources per decade. And that is a recipe for more expensive oil so I am not sure why it would worth less, other than some people want it to be worth less, because the markets have ordered more of it than they had needed to extracted. Shorting the future market or manipulating the markets seem to be designed to help some people to make profit seems to be the reason behind this.

Posted by TR | Report as abusive
 

Major oil companies are masters at gaming the price of oil.

I wonder why you rely on NYMEX numbers.

It’s funny how after the price of oil dropped, several major oil refineries suddenly needed routine maintenance…..there was no issue of maintenance when oil was $140 per barrel.

Please, try to convince me there is no collusion. I’ll bet you $140 that you can’t.

The truth is Mr. Kemp, a relatively small number of traders (maybe 6-10 people) control the price of oil for the entire world. There is no ‘natural’ price of oil, as with other commodities. It is set by those few people.

Stop talking boards. You should know better when it comes to oil.

Your article gives too much attention to public oil trading, and too little to who controls it.

Does anyone want to buy shares in Madoff Securities? 10% return per year. Guaranteed.

Posted by Robert Pratt | Report as abusive
 

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