Ice Brent changes prove a hard pill to swallow
Commodity exchanges have one central goal in life: to list contracts that are heavily traded, with prices perceived as benchmarks for their respective underlyings. By that standard, Atlanta-based Ice should be quite happy about its Brent crude oil futures, which enjoy open interest in excess of 1.5 million contracts and are often seen as a better benchmark for global oil prices than their chief rival, the West Texas Intermediate futures offered by Chicago-based CME Group.
But there are downsides to having a hugely popular and highly liquid futures contract. For instance, if you need to make a fix to it, you run the risk of irritating a large number of market participants.
That is the quandary Ice faces, as it seeks to remedy a divergence that has emerged between the Brent futures expiry calendar and the underlying physical market (see box, below).
Ice's new initiative follows the failure of an earlier attempt to address the issue by launching an entirely new contract. In December 2011, the exchange launched Brent NX – a name that stands for ‘new expiry' – with expiration dates that matched the physical calendar. Ice encouraged market participants to adopt the new contract, but few did so, and liquidity in Brent NX remains poor.
On December 6, Ice will implement a plan that takes a different approach. Instead of setting up a parallel contract, Ice will modify the expiration dates of existing Brent futures and options, beginning in the March 2016 contract month and extending onward throughout the Brent futures curve. The change involves shifting the expiration dates of the affected contracts to roughly 15 days earlier than where they currently stand. Ice initially proposed its plan in a circular released on September 9 and finalised it on October 17, following feedback from market participants.
What Ice can do with participants in its markets is not something that we can do with our clients
While shifting the expiration dates might not seem like a big change, some market sources fear it will be a back-office nightmare, as firms with large positions in Brent attempt to revalue their books and push the change through their IT systems. Moreover, the prospect of the shift has created uncertainty in the over-the-counter market and sharply diminished liquidity in long-dated Brent options, complain market participants.
Winners and losers
The complication in Ice's proposal is that shifting the expiration date of a futures or options contract changes its valuation. Some market participants will find their Brent contracts have gained in value overnight when the expiration dates change, while others will find their contracts have become less valuable. While it is difficult to say how much value will change hands, most traders expect it to be relatively small and far less than $1 per barrel for any individual contract. Still, all those pennies are likely to add up, particularly for banks and other large market participants with positions throughout the forward curve. "If the positions are big enough, it becomes a real profit-and-loss event," says a New York-based oil derivatives broker.
To keep everyone happy, Ice is proposing a compensation mechanism in which firms that benefit from the shift in expiration dates would make cash payments to firms that lose out. The payments would be processed automatically through Ice's clearing house, making the compensation process relatively seamless for Brent instruments traded via Ice.
Much of Ice's September 9 circular is devoted to the details of the cash compensation mechanism. The formula is relatively simple for Brent futures, which will be adjusted by an amount that depends on the slope of the forward curve at the contract's expiration date. But for Brent options, the adjustments are much more complex, triggering concern from some quarters. Broadly speaking, participants holding long positions in Brent options would stand to lose out from a decrease in the time value of the options, while firms with short positions would stand to benefit.
"The amount of work required to reprocess the position information is going to be a lot bigger for options than for futures, because the methodology they have proposed to revalue the options requires you to run a check on any strike price that you have in your portfolio," says Claude Philoche, Paris-based co-head of energy markets at Société Générale Corporate & Investment Banking (SG CIB). "So that's much more work than just for futures. It's a two-dimensional problem."
Peter Davidsson, New York-based global head of oil options at Morgan Stanley, says Ice's methodology for calculating the cash compensation payments is sound. "The mechanics of how Ice is going to value-adjust the futures and options seem reasonable," he says. "It's a fairly straightforward exercise to work out what they should be worth based on the new expiry dates."
Even if Ice's methodology is mathematically sound, implementing the compensation mechanism will be messy, according to market participants and consultants familiar with energy trading and risk management (ETRM) systems.
"It's logical, it all works, at the end of the day no-one is hurt, but administratively it's a hassle," says a New York-based oil market source. "It has put a lot of burden on the futures commission merchants to administer this thing and start moving cash balances around. It's just not a pretty situation."
Paradoxically, the firms that could be hurt the most are those with positions that gain in value, because they will be called upon to make actual cash payments, while their gains remain unrealised.
"Let's say the value of my options goes down by $200,000," he says. "I get a $200,000 cash credit from the other side to make me whole. Theoretically, I'm happy, because my cash position plus my mark-to-market value stayed exactly the same when they changed that settlement date. But you've got to think about it from the other side, too. They're getting $200,000 taken out of their cash account and going into their options value."
Such a move would reduce the amount of cash firms have at their disposal – potentially forcing them to liquidate futures or options positions, he adds.
Meanwhile, Ice's plan will mean a lot of work for back-office and IT personnel, as companies tweak the expiration dates and revalue positions in Brent-linked contracts. In addition to exchange-traded contracts, these issues will also affect OTC swaps and physical forwards, notes Jim Caffrey, a Houston-based director at ETRM advisory firm Structure.
"Some systems will handle this better than others," he says. "It's not just a matter of ‘okay, let's change the date' and everything goes forward from there. In a lot of systems, they will have to touch every single trade that's in the system and do some kind of mass update in order to get that change to flow through."
Depending on what kind of ETRM systems firms use, this process could either be "a nightmare" or "fairly trivial", adds Caffrey.
Given the back-office burden posed by Ice's changes, Ice had to back down from its original timetable for carrying out the plan. In its initial September 9 circular, Ice proposed that the changes would take effect on November 7 – a date that many firms argued was far too soon. Following their feedback, Ice delayed the implementation date to December 6.
"There has been some pushback on the proposal to do this in early November, including from us," says Morgan Stanley's Davidsson. "It just takes time to reset all of your systems and go through the conversion process. It's totally manageable, but if you rush it, there is a risk that you could have some errors."
In the September 9 circular, Ice floated two possibilities – March 2015 or March 2016 – as the first contract month to be affected by the date shift. After soliciting feedback from market participants, it opted for March 2016. Market sources say that if Ice had chosen the earlier of the two contract months, the changes would have affected much more open interest in Brent futures and options, creating greater hassle and affecting a larger number of market participants.
The exchange's final plan for fixing the Brent expiry-date problem was "thoroughly vetted at each step by all market participants, end-users as well as financials," says a London-based spokeswoman for Ice. "The outcome must be a benchmark in which the market has confidence and can evolve, just as the Brent benchmark has done for the past three decades."
Perhaps the biggest question hanging over Ice's proposals is how they will impact the market for bilateral OTC contracts that reference Brent. While Ice can easily rewrite the rules for contracts traded on its exchange, changing the terms of contracts in the OTC market is a far trickier proposition, market participants point out.
"What Ice can do with participants in its markets is not something that we can do with our clients," says SG CIB's Philoche. "The way OTC contracts are currently written makes it difficult if you need to adjust the underlying commodity. For instance, if we have sold an investor a structured product that references Brent, we don't necessarily have the ability to adjust the price to reflect Ice's changes to the Brent contract. So there are a number of complications in the OTC market, which makes the process of carrying this change through to clients much more complex and less predictable."
Some changes will be required, though, because banks trading Brent OTC with clients frequently lay off their risk using the Ice contracts. Unless OTC trades are also modified, such banks would find themselves at the mercy of mismatches between the two products.
The International Swaps and Derivatives Association declined to comment for this article, but a New York-based spokeswoman for the association confirms it has set up a working group to look into Ice's planned changes to Brent. Luca Salerno, a London-based lawyer at law firm Dentons, says there is a potential risk that counterparties with OTC contracts will become embroiled in litigation over disputes arising from the Brent expiry date shift. However, this is only a slim possibility, he adds, and Isda can help minimise it through issuing a best practices statement.
"Most such situations will be resolved amicably, especially if Isda comes out with a best practices statement," says Salerno, who is a member of Isda's working group looking into the Brent issue. "Because then the best practices statement will more or less say what the consensus in the market is, so it would be difficult for anyone to argue against that. But even a best practices statement cannot fully rule out the possibility of arguments."
Some market participants point to the transition of the benchmark US gasoline contract as a precedent for what might happen with Brent. From 2005 to 2007, the New York Mercantile Exchange (Nymex) moved from its old futures contract for New York Harbor unleaded gasoline to a new contract for Reformulated Gasoline Blendstock for Oxygen Blending (RBOB). That came in response to a congressional ban on one of the additives used in New York Harbor unleaded gasoline – namely, methyl tert-butyl ether, or MTBE – on environmental grounds. The switchover posed a challenge for firms holding OTC gasoline contracts, but Isda helped ease the transition by releasing a best practices statement in May 2006. That statement recommended counterparties fix the problem by replacing any references to the old futures with references to RBOB in their contracts.
Morgan Stanley's Davidsson believes the changes to Brent will play out in a similar way. "We don't think this is going to be that different from when the Nymex changed their contracts from unleaded gasoline to RBOB," he says. "Everybody thought that was going to be problematic, but everybody was able to come to an agreement on how to revalue [the OTC contracts] and make adjustments. At the moment, everybody's looking at this as a big task from an IT and operations standpoint, but eventually it's going to be pretty seamless."
Among some market participants, a more immediate concern is that Ice's plan has slowed trading activity in the long-dated Brent options market. After Ice's initial proposal came out on September 9, many traders that had normally been active participants in the market for long-dated Brent options pulled back, says Jean-François Brault, co-head of the crude oil and refined product options desk at New York-based brokerage GFI.
"A lot of traders have been unwilling to trade options on Brent beyond March 2015 because of the possible change of dates," says Brault. "Because typically, when traders transact, they transact based on certainty in the specifications of what they are transacting. So if there is any doubt that the specifications might be changed after the transaction, they would rather wait for the matter to be resolved."
Brault says firms are reluctant to increase their positions in long-dated Brent options because they do not want to add to their administrative workload. "Imagine that you already have, in your books, 100 options that qualify for these changes," he says. "So you know already that, when the changes happen, you will need to go into your system and change all the expiry dates for these 100 transactions. Why would you do another transaction now, so you would need to make 101 changes? You'd rather not. It's too much of a headache. And nobody is even sure that the compensation is going to be exactly proper."
The New York-based oil derivatives broker says he has also seen a drop-off in the number of market participants willing to trade options towards the back-end of the Brent curve. "Unfortunately, those guys do provide some liquidity and do make some markets, and if they stop making markets back there, it makes liquidity a lot less," he says.
A challenging feat
Everybody seems to agree Ice is trying to pull off a challenging feat, akin to fixing a jetliner while it is still in mid-flight. "It's unusual," says Craig Pirrong, a professor at the University of Houston's Bauer College of Business. "Usually exchanges have been able to make these changes without affecting contracts that have open interest. But that's not really an option in oil, given that you have open interest running out for years."
Much of the exchange's dilemma lies in the fact that Brent is heavily used by both financial players – global macro hedge funds and commodity index investors, for example – and physical market participants, such as oil producers, traders and refiners. While financial participants may not be quite as concerned about the nuances of physical crude trading, such issues are close to the hearts of physical hedgers.
Ice notes it must serve the needs of both constituencies. "Brent is a commercially oriented product with a considerable number of end-users that hedge positions throughout the curve to reduce their basis risk," says the Ice spokeswoman. The ultimate objective of the plan is "to provide a long-term solution so that hedgers can continue to use Brent futures and options as far out as 2020, with the futures and physical market aligned and reflecting the same expiry calendar", she adds.
Many oil market veterans agree, and say Ice's changes to Brent are necessary, even if some traders find them a hard pill to swallow.
"It's certainly something that needs to be done," says Ed Osterwald, a London-based partner at consultancy CEG Europe. "The whole idea of going to a full month-ahead basis and tying the Brent futures contract much more closely to what's happening in the physical market just makes a lot of sense to me, even if there are going to be some implementation wrinkles."
|Out of sync
Atlanta-based Ice's plan to shift the expiration dates of Brent futures and options starting in the March 2016 contract month is aimed at bringing Brent futures back into sync with the underlying physical market. The misalignment between the two stems from a series of moves made over the years by Platts, the New York-based price reporting agency that publishes benchmark prices for physical Brent.
When the Brent futures contract was launched in 1988, Platts's assessments of physical Brent were based on transactions involving cargoes with loading windows 7-15 days ahead from the day the price was published. In 2002, amid concerns that the decline in North Sea production was causing its assessments to be based on a dwindling number of cargoes, Platts extended the date range for its assessments to 10-21 days ahead. In January 2012, Platts extended the date range to 10-25 days ahead – and from March 2015, it plans to extend that to a full month ahead.
As Platts widened its assessment period, oil major Shell – the custodian of the Suko 90 contract that governs North Sea physical crude trading – extended its contractual ‘notice period' in parallel with Platts's adjustments. The notice period is the minimum amount of time that sellers of cargoes of North Sea crude have to notify their buyers of the cargo's loading dates. It now stands at 25 days.
Amid these changes, the expiry calendar of Brent futures stayed the same. Ice's Brent futures expire on the fifteenth day before the first day of the contract month – so Brent futures for delivery in December 2013 will expire on November 14, for example. At expiry, they are cash-settled against Ice's Brent Index, which is a measure of the Brent forward market during the contract month.
When the futures were launched in 1988, the notice period was just 15 days. That meant the price of a Brent futures contract at expiry mirrored the price of the first available crude for purchase that could be physically delivered during the next month, ensuring convergence between Brent futures and the physical market. But as the notice period has grown to 25 days, this link has become less precise.
As a result, it has become more difficult for physical market participants to use Brent futures as a hedging instrument. Some market observers say it has also increased the risk of manipulation.
"There has always been a concern that some market participants could attempt to move pricing of the physical at futures expiration time," says Ed Osterwald, a London-based partner at consultancy CEG Europe. "But if you have a situation where expiration is completely matched with the physical, the risk that someone could attempt to manipulate one to influence the other will be much lower."
Under Ice's plan, Brent futures would shift to a month-ahead expiry calendar in March 2016, bringing them into alignment with the changes that Platts is seeking to make beginning in March 2015.
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