ABC of Crude Oil and Fuel Prices - Part 4
Wet barrels vs. paper barrels. What is the relationship between real markets and paper markets? How are physical markets and paper markets connected?
Wet barrels vs. paper barrels. What is the relationship between real markets and paper markets?
The activity of financial investors, that is paper trading, far surpasses the actual volume of physical transactions − by at least tenfold, if we think globally and take into account all varieties of crude oil. Paper trades support market liquidity and enable price signals to be generated continuously, while the physical market acts as a counterweight, through which the entire market can be related to the fundamental drivers of supply and demand.
In the global context, the WTI and Brent segments are significantly more active than the other two regions (Asia-Pacific and Dubai), and are characterised by markedly stronger ties between the physical and paper markets. Essentially, the Asia-Pacific and Dubai markets are shaped by price signals from the Atlantic region, particularly the Brent market.
Links between key oil market segments
Source: The International Crude Oil Market Handbook 2006
How are physical markets and paper markets connected?
Over the last two decades, many layers of financial paper markets have grown around the crude oil benchmarks. These include the forward market (Brent and Dubai), and swaps, futures, and options markets. Some of the instruments, such as futures and options, are traded on regulated exchanges, e.g. ICE or CME Group, while other instruments, such as swaps, options and forward contracts, are handled as bilateral over-the-counter (OTC) trades. All of these financial layers are highly interlinked, through arbitrage and instruments that bring the various layers together. Over the years, the markets have grown in size, liquidity and sophistication, and have attracted a diverse set of players, both physical and financial. These markets have become extremely important to market participants wishing to hedge their risk, or bet on oil price movements. Equally importantly, they have become essential to the oil price identification process.
In the early years of the current market-based pricing system, the linking of prices to benchmarks in formula pricing gave producers and consumers a sense of comfort – prices were grounded in the physical aspect of the market. The implicit assumption was that the process of identifying benchmark prices could be isolated from financial transactions. However, the latest studies show this to be far from the actual case. The process of 'discovering' the often unobservable benchmark spot prices primarily makes use of information on prices observed on an ongoing basis in various paper market transactions.
For example, on the Brent market, the oil price used in forward contracts (physical market contracts with postponed delivery) is sometimes priced as a differential to the price of Brent futures (on the paper market) using the Exchange for Physicals (EFP) market, on which futures contracts are swapped for physical contracts (Brent Forward or 21+day BFOE cargo, or Dated Brent when one party informs the other that it wants to perform physical delivery). Dated Brent (physical with delivery) is itself priced as a differential to other oil forwards through the Contract for Differences (CFD) market – another physical swaps market. Also, given that oil reporting agencies can only feasibly observe only a very small number of physical transactions on the Dubai benchmark oil market, the price of this benchmark oil (used for pricing crude oil exports from East Asia) is often determined using the value of Dubai/Brent differentials on the highly liquid OTC Dubai/Brent swaps market. All these examples go to show that the current market-based crude oil pricing system could not function without the paper markets.
On the other side of the coin, as spot benchmark prices constitute the pricing basis for a large majority of physical transactions in various types of crude, some oil market observers claim that derivative instruments (such as futures, forwards, options, and swaps) derive their value from the spot price of these physical benchmarks. In other words, the prices of the physical benchmarks drive the prices in the paper (financial) markets. Ultimately though, this is a gross over-simplification and does not accurately reflect the process of crude oil price formation.
The issue of whether it is the physical or the paper market that is dominant in shaping crude oil prices is complicated and theoretically complex, and also difficult to test empirically (a complex test model would have to be constructed first).
But despite all this, the majority of studies conducted so far, some of which also account for the panic on the oil market during the 2008/2009 crisis, seem to conclude that both markets are sensitive to changes in the underlying physical components of the crude oil market (supply and demand, physical reserves, use of available production capacities, continuity of supplies), that is to tensions in current as well as expected crude oil and fuels balance, as the crude oil and fuel markets are closely interconnected. Each market reacts to these changing fundamentals differently. For example, the paper markets are more forward-looking and react quickly and robustly to real-world stimuli, which makes crude oil prices highly volatile. Even so, no-one has been able to conclusively prove that the paper markets have such a strong destabilising effect on the crude oil market as to significantly deviate average crude prices for a period of several quarters away from anticipated changes in the global supply-demand balance.
On a rational and properly functioning crude oil market (with physical and paper layers), as described in the theory, the influence of changing futures prices on spot prices is limited to their effects on decisions about reserves, production and consumption of crude oil. These decisions in turn affect the supply-demand relationship on the physical market (for example, on the WTI market in Cushing), forcing spot prices to adapt. So if the physical market is unaffected by changing futures prices, the balance between supply and demand on the spot market is not affected and the spot prices remain unchanged.