Putin’s Oil Benchmark Dream Fails to Attract Foreign Tradersby and
Russian crude futures contract begins trading on Tuesday
Clearing costs, low liquidity concerns deter foreign traders
Vladimir Putin’s dream of trading Russian oil in Russia is being realized Tuesday on the St. Petersburg International Mercantile Exchange. He has the participation of domestic traders to thank, since foreign firms are holding back.
Futures on Russia’s Urals crude represent the country’s most serious attempt to get what it sees as a fair price for its oil. Russian authorities have sought to create a financial market for its oil ever since Putin called for oil, gas and other commodities to be traded within Russia in a 2006 speech. Every attempt has faltered because foreign traders haven’t wanted to use it.
As yet, no foreign oil company, bank or algorithmic trader has agreed to buy or sell the Urals futures, according to Mikhail Temnichenko, first vice president at the St. Petersburg exchange. Traders at seven international oil companies said they will take a “wait-and-see” approach before deciding whether to trade the derivatives. They asked not to be named, citing confidentiality.
"This has a very low probability of success," said Craig Pirrong, professor of finance at the University of Houston. "I would assess for a variety of reasons that the prospects are relatively poor: liquidity and clearing costs are the two big obstacles."
Spimex, as the St. Petersburg exchange is known, thinks it will succeed because the state, the country’s oil producers and the central bank are all supporting it.
“We want to develop a transparent price-discovery mechanism for Urals crude oil,” said Temnichenko. “We think that over one to two years, we will establish a liquid market that will be equally attractive for everyone: the exchange, oil companies, crude traders and financial firms. We expect that during the initial period of trading, primarily Russian oil producers and Russian banks and brokers will participate.”
Urals typically trades at a discount to Dated Brent, the collection of North Sea crude oils that make up the world’s most popular benchmark for oil. More than half of internationally traded oil uses Dated Brent as its benchmark. Urals has a higher sulfur content than Brent, meaning it is a lower quality blend. Knowing this, traders price Urals at a discount to Dated Brent. The Russian authorities and Spimex want to set the price of Urals within Russia, rather than leaving it to international financial markets.
Russia has the physical supplies needed to set up a successful benchmark oil contract. The country was the world’s largest oil producer last year, according to the Energy Information Administration, Urals is one of the most popular crude oils, and Russia has a dependent buyer on its doorstep in the European Union. Russia’s proven reserves of 80 billion barrels are greater than Nigeria, Norway and Angola combined.
While foreign firms will not trade Spimex Urals -- at least to begin with -- the exchange will have at least some volume from its first day. One major Russian bank has told traders that they have to use the new benchmark, according to a person familiar with the matter. With the new contract expected to be illiquid, hedging may be difficult, the person said. In other words, Urals futures, which are designed to hedge against risk, will themselves need to be hedged against.
Foreign firms are shunning Urals futures for multiple reasons. They fear the market will lack sufficient liquidity, Spimex doesn’t offer the high-speed connections needed by modern market makers, and there are technical concerns about how crude oil is physically delivered to investors who buy the futures.
Temnichenko plans to address these concerns in the first half of next year.
“For now we have a very concrete goal: to launch trading,” he said. “After that, we will work on building up liquidity and further enhancing the product for participants.”
The biggest obstacle to foreign banks and oil companies may be the high cost of clearing Urals futures. All of Spimex’s futures are cleared by SDCO, a clearinghouse owned by Russia’s Gazprombank. Every clearinghouse collects collateral known as initial margin from traders. Initial margin acts as a protective barrier; if a trader defaults, the clearinghouse will use the initial margin deposited by the bank or oil company to honor their trades.
The world’s biggest energy traders are accustomed to clearing their Brent trades on ICE Clear Europe and their WTI trades on CME Clearing. By pushing the vast majority of trades through ICE and CME, the traders lower the amount of collateral they have to post with the clearinghouses.
SDCO uses the same methodology as ICE and CME to calculate how much traders deposit as collateral. However, ICE and CME then use a process called netting to further reduce the collateral required. Both firms use algorithms to calculate connections between different trading positions. The price of Brent and the price of heating oil, for example, are correlated to some extent. There are more than 50,000 such pairings on ICE.
Clearing helps explain why ICE and CME operate the dominant oil benchmarks. SDCO and Spimex will have to battle against the gravitational pull from the pools of initial margin at ICE and CME. Neither ICE nor CME discloses how much collateral is held against just energy trades, but their total initial margin is $87 billion and $142 billion, respectively. SDCO holds an estimated $230 million.
Spimex could do a lot to encourage foreign firms to trade Urals futures. It could allow high-frequency traders to locate their servers in the same data center as its matching engine. It could make physical deliveries of crude oil more flexible. It could even do a deal with a foreign clearinghouse to net positions between two different institutions -- a big potential source of savings.
Speaking at the launch event for Urals futures in London on Nov. 7, Spimex Chief Executive Officer Alexei Rybnikov said, “If the market does not accept it, what’s the point of launching it?”