How Brent Calendar Expiration Changes Influence WTI-Brent Spreads During Contango (Or Vice Versa) -- RBN Energy -- March 21, 2016

RBN Energy: How The Brent/WTI Crude Futures Relationship Got Trickier. This is so cool. Back on January 26, 2016, I noted this change in the expiration calendar. I did not understand all the implications but I had some thoughts.

I am posting this for my benefit to help me understand this issue. I would recommend readers who are interested go to the RBN Energy link. I often make mistakes/misunderstand what I am reading/summarizing. 

Data points from the RBN article, first the background:

January 26, 2016:

• new rules stipulate expiration one month and one day prior to delivery
• the March, 2016, contract, therefore, expired January 29, 2016

How the Brent physical trading market works:

• traders buy and sell 600,000-bbl cargoes produced from North Sea crude streams (BFOE - Brent, Forties, Oseburg, Ekofisk)

Two distinct Brent physical trading markets

• "Dated Brent": transactions for BFOE cargoes that have been assigned to equity producers and given a 3-day lifting window for the buyer's vessel to pick up the crude
• because they an assigned load date, they are knonw as "Dated Brent"
• reporting agencies (e.g., Platts, Argus) assess and publish these prices
• "Paper Brent": BFOE "cash" market 
• for cargoes that have yet to be assigned a loading date
• traded for delivery during a specified forward month; further out into the future than dated Brent
• these forward trades then morph into dated cargoes once a load date is assigned; at least 25 days before the 3-day loading window
• BFOE cash market is linked to ICE Brent futures; the later not a physical market; only cash settled

The January, 2016, calendar change:

• a 15-day timing window for ICE Brent Futures and the 25-day Brent futures calendar resulted in markets being out of sync
• it took 4 years for ICE to implement a Brent futures change to better reflect the physical market
• the change finally came in with the March 2016 Brent delivery contract that expired on January 29, 2016
• the new expiration date mechanism is designed to accommodate at least a 30-day window between the contract expiring and deliver -- reflecting the 24-day window in the physical market as well as a 5-day additional grace period

How it affects the CME/NYMEX WTI futures market

• it turns out this is a big deal: because the prices or spreads between the two futures contracts are so often compared by analyst looking to understand the relationship between the US market (WTI is the benchmark) and the international market (Brent is the benchmark)
• there are also numerous trading strategies involving taking positions in the two crudes
• Both crudes are similar -- all things being equal the spread should be narrow

Now, the calendar dates for WTI:

• WTI is a pipeline-delivered crude that is traded based on US domestic pipeline scheduling
• physical WTI for prompt delivery (next month) has to be scheduled by the pipeline before the 26th of the month prior to delivery
• to reflect this, CME/NYMEX futures contracts expire 3 business days before the 26th of the month prior
• this becomes significant, because when comparing Brent and WTI, it is best to compare prices for the same delivery period
• up until the January 2016 change, one could compare like-delivery periods for all but a few days each month
• the old Brent contract "rolled" from one delivery period to another on/about the 15th
• the WTI contract followed on/about the 20th

How have things changed?

• the default spread between prompt Brent and prompt WTI is far less of an "apples to apples" comparison
• WTI prompt prices have not changed
• Brent now rolls to a new delivery month 16 days earlier 
• thus: for 2/3rds of every month, the spread compares "apples to oranges"
• look at the RBN Energy chart (Figure 1 at the link) to see the inconsistency in delivery periods
• prior to the calendar change, the discrepancy was irrelevant, averaging 15 cents/bbl over the courseof a year
• now, the February 2016 spread was $1.54/bbl higher 
• that "rather large" $1.54/bbl difference in February widened by differences in contango between the Brent and WTI futures market
• thus, the spread between WTI and Brent will be wider because of the contango
• repeating: the contango exaggerates the spread relationship whenever comparing two different delivery periods