Oil prices are headed toward a land without signposts

For a generation, the world’s oil market has depended upon surveillance of prices for crude passing through a handful of locations, with physical players in turn looking to the futures market for reassurance. If that system breaks down, this lodestar will be lost and confusion will reign.

THE best argument for taking a sanguine approach to oil prices collapsing into negative territory this week is that it’s strictly a local problem.

As my colleague Matt Levine has written, once you unpack what “oil prices” means, the bizarro-world implications of negative pricing aren’t so mysterious.

It’s common to talk about West Texas Intermediate crude oil priced at Cushing, Oklahoma as if it’s a proxy for the oil market as a whole, but that’s never been the case.

The world’s twin oil supply and demand shocks have made the shortage of storage and pipeline capacity at that specific location so acute that producers are prepared to pay to get their place in the queue. That need not have wider implications.

While WTI has always been a less important measure of the oil market than it might seem, the current turmoil poses deeper problems. Dated Brent, which forms the pricing benchmark for more than two-thirds of the world’s oil, may face similar difficulties if current low prices persist.

While Brent futures are cash-settled, meaning there’s no need to take the physical delivery that’s caused such problems at Cushing, they’re closely linked through derivatives to the Dated Brent index, which is an amalgam of physical prices at five terminals on the shores of the North Sea.

Taking the North Sea as a pricing point has advantages over landlocked Oklahoma: Its terminals are open to the global tanker trade, and production has been declining in recent years. As a result, the situation seen at Cushing is less likely to be repeated.

There’s no guarantee of that, though. Total storage capacity at Dated Brent’s five terminals is about 31 million barrels, roughly a third of the 93 million barrels available at Cushing. Their ability to offload cargoes onto tankers is being affected by the same worldwide production glut that’s hurting WTI. Indeed, one of the best options for North American shale producers looking to avoid the carnage in Oklahoma is to divert their barrels of Brent-style sweet, light crude to Houston for shipping to Europe.

The largest and most important of the crudes making up the Brent basket at the moment is Forties, which is shipped out from a terminal east of Edinburgh. Ineos Group, which manages that terminal and the attached pipeline network, announced last month that it would be delaying a planned maintenance shutdown because of requests from customers.

That should push North Sea supply above three million barrels a day in July, according to consultants Rystad Energy, the highest level since 2011.

Meanwhile, with tankers being turned into temporary storage facilities, the cost of shipping crude onward from Europe to Asia is surging from levels shy of US$2 a barrel to more than US$6 a barrel over the past month - a substantial move when Brent itself is below US$20. If that rises much further it will start providing a financial roadblock to getting crude out of Brent’s amply supplied terminals quite as potent as the physical roadblock at Cushing.

Those who trade liquid rather than paper seem to be taking notice. Dated Brent fell to US$13.24 on Tuesday, according to S&P Global Platts, and its discount to futures prices is at record levels. Negative prices still seem unlikely - but they seemed unlikely for WTI too, until Monday.

More importantly, you don’t need Dated Brent itself to go negative to push a huge share of the world’s oil production into the red. Middle Eastern and African crudes are mostly priced at a specified discount to either Dated Brent or to a handful of other contracts, which themselves tend to follow the physical North Sea grade.

For thicker grades such as Saudi Arabia’s Arab Heavy or Iraq’s Basrah Heavy, these discounts can often exceed US$10 a barrel, worryingly close to the levels where Dated Brent has been trading. Mexico’s Maya crude has already fallen below zero once this week, thanks to just such a pricing formula that links it to WTI.

There are workarounds in the event of problems at Dated Brent’s terminals. The North Sea’s physical and paper markets are linked by a complex system of derivatives that allows the pricing companies to switch their methodologies if the physical trade is too thin - but with billions turning on the outcome of those decisions, a huge amount of pressure is being brought to bear on a system that was never designed for such situations.

For a generation, the world’s oil market has depended upon surveillance of prices for crude passing through a handful of locations, with physical players in turn looking to the futures market for reassurance. If that system breaks down, this lodestar will be lost and confusion will reign.

Think oil market volatility is over after this week? Don’t count on it. — Bloomberg Opinion

David Fickling is a Bloomberg Opinion columnist covering commodities, as well as industrial and consumer companies. The views expressed here are the writer’s own.

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