Oil Benchmarks Explained: Physical vs. Financial and Their Impact on Pricing

Physical vs. financial transactions

Brent, WTI. These are some of the most well-known oil benchmarks in the world, the origins of whose names reflect physical oil commodities. The ubiquity of these prices in popular culture, however, has been sustained not by transactions of physical barrels or cargoes, but rather by eponymous financial instruments traded on the world’s largest commodity exchanges. It is these prices for financial contracts one is most likely to encounter in the news or on social media.

Thousands of market participants – the vast majority of whom will never encounter a physical oil cargo – utilise oil-related financial contracts (derivatives) for the purposes of risk management or seeking to profit from a market view. The volume of trading in financial derivatives significantly exceeds the volume of hydrocarbons which trades on a daily basis. In a single day’s trading of certain futures contracts, billions of “paper barrels” change hands, dwarfing the estimated 40mn b/d of physical oil which trades in the spot market. Some estimates suggest no more than 5% of futures contracts entered into on exchanges reach physical delivery.

The relationship between physical and derivative markets in setting "the oil price"

The relationship between physical and derivative markets in setting “the oil price” has long animated analyst discussions and academic research. What is indisputable is that the two work in tandem to generate price discovery. Derivatives activity is an important indicator of market dynamics when physical trading activity is thin, while the transfer of physical volumes – or firm buy or sell signals for the same – remain the focal points around which price discovery takes place.

The depth of the financial oil market – populated with an array of participants spanning energy companies, banks, funds, airlines, industrial firms, and many others – outmatches that of the physical oil market, as participation in the latter necessitates access to expensive oil infrastructure and logistics assets: refineries, tankers, barges, terminals, storage tanks, blending operations and trading capabilities. After all, it is far easier to purchase Brent futures contracts on the ICE exchange than arrange to take delivery of a cargo of Brent crude oil at the Sullom Voe terminal in the UK’s Shetland Islands!

And so, with the financial oil market’s diversity and liquidity, one might take the view that financial oil benchmarks, consequently, are the best price data to utilise in broader macroeconomic or financial market analysis, as buyers and sellers in this market have comfort that they may enter and exit positions with relative ease, and intra-day price discovery can be facilitated by relatively tight bid-ask ranges in a transparent market.

And yet physical oil benchmarks offer unique advantages in understanding market dynamics. These advantages comedown to granularity.

It is well known that – for example – some airlines utilise crude oil futures rather than jet fuel swaps for price risk management purposes, for the reasons highlighted above. However, any analysis of the aviation sector would no doubt be enhanced by the utilisation of jet fuel price data, rather than crude price data, given that the price differential between crude oil and jet fuel is unpredictable. Indeed, General Index is currently working with a financial market participant to create jet fuel swaps to provide more risk management tools to the aviation sector.

What are the core criteria for framing a useful oil price?

What are the core criteria which ought to frame a useful oil price? “Quality and location!”, as a business school lecturer of mine once stressed. In other words, what is the quality specification of the oil in question, and what is the loading or delivery location? The more granular the product or region, the harder for an exchange-listed headline financial oil contract price to provide useful signals. Financial market participants who have credit exposure to companies active in certain niche oil markets – say high-sulphur fuel oil in the Mediterranean region – may seek refuge in the liquidity provided by well-known futures contracts, but utilising physical prices produced by General Index for those niche markets could help address basis risk.

For while a futures contract’s price is being informed by many thousands of individual market views on a daily basis, its ability to highlight localised trends is constrained by definition. For example, one General Index client utilises our marine fuel price data in its economic modelling, as a drop-off in bunker fuel demand in key locations near major manufacturing hubs could be an early warning of an economic slowdown.

And although the participant base within physical benchmarks is naturally smaller than that of their financial counterparts, these physical participants have a unique view of true oil supply and demand, owing to their physical assets and exposure to end-user demand, such as supply to fuel distribution hubs and retail stations. Therefore, pricing signals provided by such participants – the key input into the formation of physical benchmarks – offer unique insight into supply-demand dynamics.

Finally, while some of the most prominent energy futures contracts are cash settled, most rely on physical price assessments for their settlement – perhaps the ultimate recognition that the latter prices provide the best indication of fair market value of energy commodities.

Saket Vemprala, MD Markets - Europe & Asia

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