Crude Oil Pricing Optionality and Contracts for Difference
While exposing some of the fragilities in the current international oil pricing system and oil benchmarks, the massive demand shock hitting the oil market also revealed the increasing sophistication and complexity of oil markets and the interconnectedness of the various layers surrounding the benchmarks. Perhaps this was best illustrated in the Brent complex, when at the apex of the crisis in April 2020, the layer connecting the forward/ futures Brent to the Dated Brent, i.e. the Contracts for Difference, did most of the stretching, sending signals to market players about the stresses in the physical markets and storage facilities while the futures market was reflecting expectations of a faster demand recovery and a large supply response from producers.
For the various financial layers, including the Contracts for Difference, to perform their functions of risk management and price discovery efficiently, ensuring that these markets attract sufficient liquidity is of vital importance. Nigerian and WAF crudes play a key role in the Brent complex. One key feature in the marketing of these crudes is the pricing optionality, which adds to the attractiveness of term contracts, especially in volatile market conditions and when the market changes structure from backwardation to contango (or vice versa). The main objective of this Energy Comment is to explain why, and how, pricing options are used, their links to the CFDs and how, in the current environment of high volatility, pricing optionality can contribute to market liquidity as traders position themselves on the Forward Dated Brent curve to manage their risk. We use the pricing options offered by Nigerian National Petroleum Corporation (NNPC) as an example.