Publications: Notes at the Margin

The Likely Impact of the First Excellent Futures Contract for Internationally Traded Crude (March 15, 2021)


Traders, economists, and commodity exchange executives have struggled for more than a century to create a high-quality energy futures contract. In the process, they have encountered, for several reasons, far more significant problems with crude oil, natural gas, and electricity contracts than for other commodity futures. Take crude oil, for example. The absence of a top-quality futures contract for delivering crude in international markets has denied consumers the economic benefits that come with perfect contracts, e.g., crude oil markets have remained uncompetitive, and producers have enjoyed higher prices than would otherwise prevail.


The ICE Murban futures contract (labeled the ICE Futures Abu Dhabi, or IFAD, contract) will probably resolve this issue. The IFAD contract will provide buyers of internationally traded crude—particularly those who rely on Middle Eastern crude—with an instrument that reduces their financial risks dramatically. It will also make the global oil market more competitive and reduce the more prominent producers’ market power. Ultimately, oil may become “just another commodity” like cotton or wheat.


The transition to a more competitive market could be accelerated if efforts to restrain fossil fuel emissions decrease oil use over the next ten years. If this occurs, the new contract’s backers could realize immense gains relative to higher-cost producers like those in the North Sea, Brazil, Russia, Kazakhstan, the United States, and Canada.


The IFAD contract’s introduction and other steps taken by the United Arab Emirates, particularly the Emirate of Abu Dhabi, are a huge deal. Quite simply, the contract can be likened to an insurance policy to assure the UAE’s economic survival as a major oil-exporting country, possibly making it the sole survivor in the Middle East.


This Notes at the Margin returns to the origin of the PKVerleger LLC publications and the company’s founder by reviewing the basis of futures contracts, their historical success, and the IFAD contract’s potential impacts. We present our analysis in four parts.


Part I examines the futures markets’ history. We cite works by Williams (1986, 2001), Hieronymus (1971), and others. These analyses lay out the conditions for successful contracts, that is, a contract that allows market participants to shift price risk to others willing to accept it. They also identify the effect of successful contracts, which is the creation of highly competitive commodity markets. We note, too, that competitive commodity markets can, at times, be exceedingly profitable for low-cost producers.


Part II briefly discusses the linkage between storage, futures, and forward markets. Historically, the success of futures markets has been linked to the availability of storage capacity. Markets that lack storage can work but not as successfully as markets that have it. Electricity futures markets and the Brent crude market suffer from this absence of integrated storage.


Part III reviews the history of oil futures and commodity markets. The first markets created were for heating oil and gasoline in the United States. Then came markets for gasoil in Europe and crude oil and natural gas in the United States. These markets had the expected impact. Competition increased, profits fell, and the firms seeing high returns (such as the integrated oil companies) exited because returns were depressed by increased market transparency.


Part IV focuses on the failure of current international crude futures contacts. Despite the Intercontinental Exchange's extensive efforts, the Brent futures contract has suffered because it has not met the critical conditions for success. The lack of a deliverable crude that can be stored at the delivery location is partly responsible. Another more significant problem, though, is the heterogeneity of North Sea crude. S&P Global Platts’ expansion of its Dated Brent assessment to include WTI produced in Midland for delivery in Europe highlights the lack of a real, trustworthy, non-manipulable indicator of the North Sea crude’s market value.


Part V concludes by explaining how the Murban contract could become the true price measure of international crude. Other candidates that might have taken the role are Saudi Arabia’s Arab Light or Iran’s Iranian Light. However, Murban is the first of these crudes to meet all the requirements for a successful futures contract. Absent government interference, the UAE’s Murban will be the crude the world uses to set prices.


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