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 US$2.35 on Dec 19 at US$33.87, while the more liquid February contract actually rose 69 cents to settle at US$42.36 — an unprecedented contango from one month to the next of US$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 the 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 US$147 a barrel earlier this year, the Organisation of Petroleum Exporting Countries (Opec) repeatedly criticised 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 UN Secretary-General Ban Kimoon or the 300,000 bpd promised to US 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 (West Texas Intermediate) price may have achieved unprecedented media fame as a result of the “superspike”, 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 US domestic market.
US refiners have a strong preference for light oils, for which they were prepared to pay a premium, because of their much higher yield to petroleum. 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 as 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 that 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.
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 US Midwest or along the US Gulf Coast, 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 transshipped 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 US 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. — Reuters
● John Kemp is a Reuters columnist