Dwindling output of Brent, WTI and Dubai, and mounting concerns about the volatility of these marker crudes, are fuelling a debate about how to improve the pricing of oil. Finding alternatives is not easy, otherwise it would have been done long ago. However, with growing competition between the traditional futures exchanges and the new internet-based electronic markets, the scene could be set for another revolution in oil pricing.
There are only two practical alternatives – either the liquidity of the physical oil market is improved, or new derivative trading instruments, such as an oil price index, are introduced to help concentrate liquidity and avoid mispricing. Without the development of a broader market in Middle East crudes, which would require the active participation of the major Gulf producers, the oil industry could soon be forced to turn to these more artificial means of boosting liquidity as physical output of Brent, WTI and Dubai continues to decline.
Price indices – for example, the FTSE 100 or S&P 500 stock market indices – are used successfully by other financial and commodity markets, where they have both improved liquidity and reduced trading costs and risks by concentrating market activity in a standardised contract. The same could be done for oil, but it would require a concerted effort by both the industry itself and external bodies such as the futures markets. Just publishing a price index, as some of the price reporting services have already done, is not enough – there needs to be a liquid market in which the index is traded, preferably at a lower cost than trading the underlying physical commodity.
Simply substituting the word ‘Index’ for ‘Brent’ in the current North Sea market framework makes surprisingly good sense. Pricing cargoes off a more flexible spot price index based on a weighted-average mixture of North Sea crudes creates new arbitrage opportunities that would help avoid the price distortions experienced by the more restrictive Dated Brent mechanism. Moreover, the essential link between the less liquid physical oil market and the more liquid futures and derivatives markets could be provided by an Index CFD (contract for difference) market, fulfilling the same role as Brent CFDs.
Creating new market structures is easier than it used to be and a new Index contract could be introduced relatively quickly, either by the established futures exchanges or an industry-based internet trading platform. Liquidity could be generated by slashing trading costs and obtaining the backing of the biggest market makers to create a cost-effective alternative to the current system. The real challenge, though, will be to persuade the oil producers, the tax authorities and the regulatory bodies to accept new methods of pricing.