Liz Gall
Enterprise Oil plc
London
Over the last 10 years, attitudes towards the causes of oil price volatility and how to cope with the attendant price risk have undergone a revolution.
This is nowhere more apparent than in the trading rooms of the non-integrated North Sea oil producers.
The aspirations of such companies remain straightforward-to sell their crude oil at the highest price possible.
The tools available to help achieve this goal have increased in number and improved in sophistication over the 1980s.
But the oil market is still evolving and the risk management tools will also have to evolve to handle the new types of risk which emerge in the 1990s.
A KEY INNOVATION
During the 1970s there were several quantum leaps which took prices from a low of less than $2/bbl to a high of $40/bbl. But there was not the same consistent day-today volatility in prices which has been witnessed in the latter half of the 1980s.
In those sedate days the sale and purchase of a cargo was often a long drawn out affair between a producer and a refiner, where a 2 bid/offer spread could be a deal breaker. Each party had a view of market direction and would hold out for days for a 10 move in the market.
This attitude to pricing provided a role for speculative trading companies who would bridge the gap between the producer's and the refiner's views by assuming the absolute price risk of carrying the cargo until a change in market direction had occurred.
Hedging was regarded as a remote theoretical concept in a market dominated by quarterly administered prices and OPEC Government Sales Prices (GSP's).
The "commoditization" of the North Sea oil market predates screen trading. And, if a single watershed were to be isolated, most players would identify the appearance of 15 day Brent trading as the most significant innovation in the management of price risk.
Opinions vary as to why it became necessary to invent the 15 day market, but clearly the divergence of spot and terms prices in 1981, together with the opportunity this provided for tax optimization by the integrated majors, played a pivotal role.
Fifteen day Brent as a price risk management tool was well established when Nymex West Texas Intermediate (WTI) trading came along in 1983 bringing with it a different breed of hedgers, speculators, spreaders, and arbitrageurs.
It cannot be said that the oil producers welcomed these market developments. And there was much debate about whether the new tools were the cause of-rather than the solution to-increasing price volatility in the mid 1980s.
The abandonment of OPEC GSP's and the winding up of the British National Oil Corp. early in 1985, as "the market" broke loose from administered prices, forced a grudging acceptance of the paper markets by the trade. The most obvious manifestation of this acceptance was the practice of setting term prices by reference to average or published spot prices over a period of time, usually 15-30 days, rather than negotiating prices on a quarterly or monthly basis against a framework of GSP'S.
Many producers were reluctant to use the paper markets themselves. But they were at least accepted as a mechanism to allow the trading fraternity to continue their role in assuming the new increased price risk of holding positions to bridge the gap between the time when refiners wished to make spot purchases and when producers wished to make spot sales.
The price collapse of 1986 did much to eliminate any fastidiousness about dealing in paper markets on the part of small equity producers. The danger of abdicating control of prices to a market average formula was illustrated graphically as prices slumped below $10/bbl.
For those who survived the lesson, hedging price risk has become a more significant activity.
TRADING PROBLEMS
The direct involvement of the producers and refiners in paper markets has given rise to a tailoring of the trading tools to meet their specific needs. It has also highlighted the inadequacies of existing mechanisms.
For the North Sea producer, the Nymex WTI futures market has recently lost whatever relevance it once had as a hedging medium for North Sea oil, other than over very short periods. The extent of the basis risk across the Atlantic is now so large that a substantial movement in absolute prices must be anticipated before the differential risk becomes worth taking.
This, rather than concern over the problems experienced by the WTI contract over the summer of 1989 when the cash market and the futures market diverged at settlement, has relegated Nymex to the status of hedging medium of last resort for many European players.
Liquidity is the only advantage of using WTI to hedge North Sea barrels, this liquidity reflecting WTI's satisfactory performance as a speculative tool. Nor does 15 day Brent provide a complete solution to the North Sea hedgers' problems.
The performance problems experienced at regular intervals by the unregulated 15 day market have not been solved by the Financial Services Act of 1986.
It was unreasonable to expect that it would be since the act was aimed at protecting small investors who do not get involved in 15 Day Brent because the contract size is currently 500,000 bbl, upwards of $9 million in value.
Periodic attempts at appealing to the Self Regulating Organizations established under the act by aggrieved parties suffering from performance or payment defaults by third parties, have demonstrated the law of Caveat Emptor still prevails in the 15 day market.
The increased incidence of default in 1986 marked the start of the liquidity problems of the 15 day market. The Japanese trading houses, or Soga Shosha, were the first to withdraw in the face of unruly behavior which proved to be the last straw for them. Some large scale, unfortunate trading decisions had already left them disenchanted with the 15 day market.
This may have been exacerbated by a change in U.K. tax legislation which theoretically reduced the incentive for the large equity producers to use the 15 day market as a tax optimization mechanism. This further impaired liquidity.
The advent of the "Wall Street refiners" filled the liquidity vacuum for a time.
Although the "Wall Streeters" were not universally welcomed in Europe, particularly by the majors, they brought with them a different attitude to the risk management needs of the small players.
Their willingness to make markets in part cargoes of 15 Day Brent (albeit at a price) proved invaluable to the small hedger who was reluctant to swallow the Nymex basis risk and for whom 15 Day Brent cargoes, then of 600,000 bbl, proved indigestible.
This was especially the case since the Wall Street players were happy to make markets in Partial Brents 12 months or more ahead, a service most likely to be of a value to small producing companies who have an interest in forecasting future revenue streams in order to justify-or sometimes even finance-current development projects.
IPE BRENT MARKET
Doubtless the entrance of the small volume players made some modest contribution to the eventual success of the Brent futures market on the International Petroleum Exchange which commenced trading in June 1988. If success was not caused by their direct involvement at first, then it was indirectly through the Wall Streeters who needed to lay off the risks incurred at their behest in the Partial Brent market.
It was not long, however, before the small players were weaned off the unregulated Partial Brent market and were happy to have first hand experience of Brent futures themselves.
A side effect of this direct involvement has been the difficulties experienced by the speculative physical cargo traders who have lost their niche, since producers and refiners have learned how to handle their own price risk and no longer rely on a middle man to manage it for them by taking title to physical cargoes.
These traders have cut back drastically on their involvement in the North Sea physical market, although new niches are opening up for them in other parts of the world, for example, the Far East and the Eastern Bloc.
However, the IPE Brent market is not an unqualified success. Liquidity is erratic and towards the end of 1989, IPE Brent was still only trading on average less than 10,000 lots per day in only two forward months. Although this is comparable to Nymex WTI liquidity at the same stage in its development (WTI traded 7,000 lots on average in 1984), in the case of IPE a larger percentage is accounted for by Exchanges for Physicals (EFPs).
This is symptomatic of the fact that IPE is not, nor is ever likely to be, a "doctors and dentists" market to the extent that is true of Nymex. Most IPE players have not only an involvement in the oil industry by usually in some other Brent market as well.
Consequently IPE Brent is susceptible to the periodic bouts of illiquidity which infect 15 day Brent.
The 15 Day Brent squeezes which have plagued the market in 1988/1989, engineered by certain trading and Wall Street companies, have made 15 Day Brent an unreliable hedge for other North Sea grades.
IPE Brent, which provides for a cash settlement price at expiry based on published average 15 day Brent prices, has proved unsqueezable so far. However, in order to avoid the IPE cash settlement price being set by reference to the squeezed 15 day contract the IPE Brent contract expiry has been advanced to a date early in the month before delivery, before any potential squeezes can manifest themselves.
This necessitates hedging physical barrels by using the lagged month IPE Brent contract which involves a time spread risk.
AVOIDING SQUEEZES
The necessity of taking on a time spread risk to avoid squeezes gives rise to considerable irritation with the perpetrators of such squeezes.
But it has to be recognized that the unregulated Brent market is fundamentally flawed or it would not be so easy to manipulate.
Part of the problem has been a decline in volume of the underlying physical Brent production from 960,000 b/d at peak to 700,000 b/d today.
The disappearance of many speculative trading companies from the North Sea and the consequent concentration of 15 Day market in the hands of a small number of large players-both Wall Street and majors-has provided a hothouse in which squeezes and other forms of manipulation can blossom. An example is the use of shipping operational tolerances for commercial reasons.
The producers of Brent equity have proved unable or unwilling to address the problems of the 15 Day market, except for some tampering at the margin to alleviate the effects of individual squeezes.
But 1990 may eventually provide paper Brent with a new lease of life.
Declining volumes of physical Brent Blend production are mirrored in declining volumes of Ninian Blend, a grade which, like Brent, is exported from Sullom Voe in the Shetland Isles. Moves are progressing rapidly to commingle Brent and Ninian Blends into a common export stream which will bring a new group of equity players into the 15 Day market and boost the volume of the physical commodity underlying the contract.
This would render squeezes more difficult to perpetrate.
The race is on to put Brent/Ninan commingling in place before the summer of 1990 when essential, unrelated field maintenance work could shut the whole of the existing Brent network for a prolonged period. This would threaten the already flagging fortunes of the 15 Day, Partials, and IPE Brent contracts.
If the streams can form one blend before that happens then the physical commodity will be maintained over the period of the shutdown and the 15 Day contract will be in much better shape as the combined blends return to full production next autumn.
The temporary disappearance of the underlying commodity should not present any real difficulty for a healthy contract where there are adequate cash settlement or book-out provisions. But there is considerable nervousness about dealing forward into mid-1990 until this issue has been resolved for fear that there will be defaults or attempts to manipulate the settlement of the Brent-related contracts.
It is believed that those parties who have squeezed the market in the past have made net losses from the maneuver.
Whether or not this is true, the spirit of mistrust which has been the legacy of their actions has complicated the resolution of what should be a routine problem of a maintenance shutdown.
There is no doubt that, with some amendments (alternative grade delivery option? mandatory cash settlement provisions?), the 15 Day Brent market and the other Brent-related contracts will survive the test of 1990.
There are too many parties whose fiscal interests and whose need for some form of North Sea-based hedging and speculative medium are served by its continuation for it to be allowed to die.
At this time, using a combination of 15 Day Brent, partial Brents, and IPE Brent, a small North Sea producer can succeed in achieving a reasonable hedge of North Sea grades such as Forties, Ninian, Ekofisk, etc., but 1990 will be fraught with pitfalls for the unwary.
However, if prices continue to be as volatile as they have been over the 1980s, the nonintegrated North Sea producer will have an interest in encouraging the development of new risk management tools.
If the CFTC's decision to lift its ban on marketing foreign options in the U.S., starting with the IPE Brent and gas oil options with effect from Jan. 5, 1990, means that we will see true liquidity in a North Sea-based regulated options market, then the short term hedging needs of the non-integrated North Sea producer could be better served.
For those who require longer term hedging, the oil swaps market may provide an answer once more institutions are prepared to make a market and competitive bid-offer spreads are available. A period when market prices move from the now familiar backwardation pattern towards contango will give the oil swaps market the opportunity to demonstrate its viability as a hedging tool for producers.
Hitherto the swaps market has been of little value to those who wish to sell forward since extrapolating backwardation makes future prices unattractive.
Copyright 1990 Oil & Gas Journal. All Rights Reserved.
