The New “Tools of Choice” in American Oil Markets
Oil may be the most heavily traded commodity in the world, but as industry veterans know all too well, not all oil is exactly alike.
Crude oil can vary significantly in quality and price.
In fact, there are literally hundreds of different oil grades worldwide, each reflecting the particular consistency and composition of a specific production area.
That means there’s a whole lot more to this story than West Texas Intermediate and North Sea Brent, the two benchmark grades that oil trades are pegged to.
And with the dramatic new increases in North American shale and tight oil production, it was only a matter of time before new regional oil grades would emerge here at home.
They go by names like Louisiana Light Sweet (LLS), Western Canadian Select (WCS), and Mars, just to name a few.
However, market veterans are surprised at how quickly these oil grades have become the new “tools of choice” when it comes to hedging.
Here’s why these obscure markets have suddenly become a lot more liquid…
Risk Insurance Against a “Hair Raising” Experience
The importance of these markets lies in the need for both producers and end-users to hedge contracts. Remember, an initial end user for crude oil is a refinery and the “netbacks” between the field and the processing facility, and then between the refinery (now the producer of oil products) and wholesalers (the immediate end user customer for the refinery’s products) are decisive in determining profitability.
For its part, hedging is nothing other than taking out risk insurance against a sudden change in raw material prices.
This is done with futures contracts – the so-called “paper barrels”-employed to offset swings in the actual price of oil (the so-called “wet barrels”). Options and more exotic derivatives are then used to cushion any forward swings in the actual price of the underlying oil.
But with only two primary benchmarks (WTI and Brent), hedging problems started to the rise in North America.
As Alexander Osiovich observed last week on Risk.net:
But that’s no longer true… and for good reason.
In the last two years, the market has witnessed new grades of oil being employed to facilitate better paper markets as tight and shale oil came to occupy a greater portion of the oil actually traded.
As Osiovich correctly noted:
The fundamental reason why interest has grown in derivatives tied to North American crude grades is an explosion in crude pricing volatility. The differentials between WTI and regional grades have undergone wild moves in recent years – something that has proven a hair-raising experience for companies with exposure to specific regional crudes.
Consider the case of WTI Midland, which historically traded within a tight band relative to WTI priced at Cushing. From 2009 to 2011, the daily spot price of Midland was never more than $1.20 per barrel lower or $1.46 per barrel than the price of WTI at Cushing, according to London-based price reporting agency Argus Media. But in 2012, booming shale oil production in the Permian Basin in Teas and New Mexico created an oil glut at Midland, thanks to a lack of sufficient transport capacity. Midland prices then fell steeply, hitting a discount of more than $14 per barrel to WTI at Cushing during December 2012.
For oil producers exposed to Midland prices, the sudden volatility served as a wake-up call to enhance their hedging programs. “A producer with exposure to Midland suddenly had basis risk they hadn’t been worried about before,” said one analyst. “As a result of that basis volatility, we started seeing a lot more interest from producers.”
Another Boost to the North American Oil Revolution
Goodrich Petroleum Corp. (NYSE:GDP) is a good case in point.
Until 2013, Goodrich used WTI as the basis for its oil hedges, but last year it hedged a significant portion of its 2014 and 2015 production with Louisiana Light Sweet (LLS) instead.
According to the company’s filings with the SEC, Goodrich says LLS is an appropriate hedge for its oil-producing assets in the Tuscaloosa Marine Shale – a geological formation located near the LLS delivery point in St James, Louisiana – as well as its assets in the Eagle Ford Shale in Texas, where producers are increasingly using LLS-based formulas for pricing.
This rapidly expanding liquidity (i.e., trading increases in futures contracts and derivatives) using LLS as the hedge grade of choice makes it easier for companies like Goodrich to find attractive prices for LLS basis swaps (a kind of option used to insulate against pricing differences between oil grades).
As a Goodrich spokesman put it: “With the shale revolution, these markets have become a lot more liquid. There are counterparties willing to trade, and there are entities that are actually producing the physical commodity in areas that would like to get better premium pricing. So a lot of things have migrated towards LLS.”
Today, both of the emerging Gulf Coast grades – LLS and Mars – are benefiting from a shift in pricing formulas, in which a growing number of oil producers and their buyers are moving to LLS- or Mars-linked prices for their physical deals, rather than trading oil at fixed differentials to WTI.
That, in turn, has driven companies to hedge with LLS and Mars derivatives.
And according to Argus Media, what really kicked off all the swap activity for LLS and Mars was that they started being used as secondary benchmarks. That meant you had LLS for pricing the lighter crudes, like Eagle Ford and Bakken, while the Mars grade would be used for pricing heavier crudes and medium sours (crude with a greater sulfur content).
As the American and Canadian production base moves progressively toward a higher concentration of unconventional production, grades like LLS and Mars will become even more utilized by traders.
That development will cause the trading in these grades to better reflect the actual value of the regional crude being produced – and further bolster the North American oil revolution.