The Brent & WTI Markets. The Suitable Hedging Practice and Their Recent Decoupling on the Two Atlantic Shores.

4 
 
INTRODUCTION 
 
How to specify a commodity? An economist would say it is a 
consumption asset whose insufficiency, whether in the sort of depleted 
reserves or consumed stocks, takes a key influence on the world and country-
specific economic growth. A banker would discern that it is not a financial asset, 
providing streams of cash-flows and evaluated by net present value debates. An 
environmentalist would put forward that it is a natural good whose unique 
candor should be unspoiled. An academic would claim that, given the 
contemporary volatility of all currencies, a commodity is a standard numéraire 
with respect to which portfolio values should be measured. Indeed, since the 
massive rally of the dollar currency with respect to the other ones that a valid 
suggestion could be to take as a universal numéraire, in the specific case of the 
crude oil markets, a barrel of crude oil relative to which all currencies would be 
expressed (the gold-standard mechanism that used to play decades ago).
1
  
Commodity markets have lately undergone an intense growth with 
respect to volumes, new traded contracts, number of operating exchanges as 
well as market participants. The most significant development has been in the 
trading of commodity derivatives, such as futures and options. Trading volumes 
in commodity futures have risen steadily over the past two decades on 
exchanges such as the InterContinental Exchange (ICE) and the New York 
Mercantile Exchange (NYMEX). Moreover, exchanges constantly announce 
futures and options on new commodities, such as electricity futures that are 
now trading in many countries after the liberalization of electricity markets. It is 
essential to note that futures commodity markets are the ones where most of 
the activity is taking place. In the case of oil for instance, volumes in these 
markets are nine times larger than those occurring in the spot market, and this 
                                                           
1
 Geman H. (2005). Commodities and Commodity Derivatives: Modeling and Pricing for 
Agricultural, Metals and Energy. London, Wiley Finance.
5 
 
ratio is consistently increasing with the arrival of new financial players.
2
 The 
reason have to be sought in the spot commodity markets prices which tend to 
be highly volatile and so risk management become an increasingly important 
issue in the whole commodity business and recently in the crude oil one. 
An operational practice of futures contracts in risk management needs an 
understanding of the aspects shaping futures prices and of the price sensitivities 
with respect to this underlying risk factors. Indeed, in literature it is well known 
the spot-forward relationship with the cost-of-carry playing a fundamental part 
of it. Basically, on commodity futures pricing, the notion of convenience yield, 
defined as the benefit which accrues to the owner of the commodity but not to 
the owner of the futures contract (Brennan 1991),
3
 net of storage costs, has 
been modeled in different ways. However, two are the main approaches that 
have been followed. Particularly in the crude oil market, the first is based on the 
paper by Gibson and Schwartz (1990) which introduced a two factor constant 
volatility model where the spot price and the convenience yield follow a joint 
stochastic process with constant correlation. In particular, the former evolves as 
a Geometric-Brownian-Motion (GBM) and the latter evolves as a Ornstein-
Uhlenbeck (O-U) mean reverting process. Here, oil futures prices are 
determined by the current oil price and the cost and benefit of storing it. 
The second approach mainly follows what Schwartz (1997) proposed, 
namely the idea is that futures prices are determined by the expected spot price 
at maturity of the contract. As a consequence, the drift rate of the spot price 
process becomes crucially important for valuation. In particular, prices of long-
term contracts will strongly depend on whether the spot price process is mean-
reverting or not. When it is so, either backwardation or contango can result 
from models of this kind depending on the spot price level. 
                                                           
2
 Svetlana Borovkova and Helyette Geman (2007). “Seasonal and Stochastic Effects in 
Commodity Forward Curves”. Springer Science+Business Media, LLC 2007. 
3
 For example, this benefit would result from the right of the owner of the physical commodity 
to use it for production purposes whenever necessary or when a there is a poor supply that 
specific commodity market rises in prices and a producer could sell it later to make profit.
6 
 
Another operational practice on futures contracts in risk management 
takes care of the designing the proper hedge. That is a key fact since exchanges 
have started to reach this goal. To this purpose, the classic textbook 
methodology for defining the proper size of a hedge position (i.e., the optimal 
hedge ratio) attempts to minimize the variance associated with changes in the 
value of the combined portfolio of the hedged item and the hedging derivative 
(e.g., a related futures contract). My investigation, based on the working paper 
proposed by Ira G. Kawaller and Paul D. Koch (2011), challenges the practicality 
and application of this approach and offers another approach that tries to 
satisfy a different aim. In practice, rather than pursuing to minimize variance, 
hedgers more normally use futures to lock in a price for a upcoming operation. 
Generally, when chasing this aim, hedgers accept some generally acceptable 
region of uncertainty, normally denoted as basis risk. I try to illustrate that these 
two different objectives - locking in an ex-ante price and minimizing variance - 
need two different regression conditions for their respective solutions. 
Generally, the minimum variance objective requires a regression on price 
changes if the hedging period is short while for long-term contract the use of an 
Error Correction Model is necessary since spot and futures are cointegrated. 
Further, the price fixing objective, in my case, could be implemented for both 
regressions on price levels and changing while in the Kawaller and Koch working 
paper just that on price levels was fair. I illustrate these results with a case study 
involving a hypothetical hedge that uses Brent and WTI front month futures 
contracts to cover the prospective purchase of crude oil barrels. The time span 
goes from 2009:01 to 2011:11. 
Another aspect analyzed regards the modeling and forecasting the two 
benchmarks volatility. Volatility is also fundamental to the risk management 
process in order to price derivatives, devise hedging strategies and estimate the 
financial risk of a firm’s portfolio. The whole volatility studying has been
7 
 
modeled by the Generalized Autoregressive Conditionally Heteroscedastic 
(GARCH) models. 
Finally, I also investigate on the recent happenings about the WTI and 
Brent crude oil price benchmarks which have attracted considerable attention 
with respect to their different trends. Particularly, their massive decoupling 
have reached levels never hit before in the history. The WTI contract has been 
the subject of particular criticisms alleging the unrepresentativeness of the 
Midcontinent market as a global price benchmark. The accumulation of stocks,
4
 
that represent one of the price discovery process element in the 
futures/forward price relationships, have been hugely reported by the 
International Energy Agency, the western crude oil market watchdog. This is 
highly uncommon and represent the  unusual conditions in the WTI crude oil 
market with respect to the domestic and global crude oil prices. Moreover, on 
the East Atlantic shore the Brent problems are basically fundamental since the 
poor oil supply as well as the recent Middle East and North Africa (MENA) area 
turmoil and the unceasing China and ultimately, after the closure of the nuclear 
plants, Japan oil demand. An attempt to explain such phenomenon has been 
discussed as well as some hints to sort the matter out. 
 
 
 
 
 
  
 
                                                           
4
 The designated delivery hub proposed by the CME futures contract is Cushing, Oklahoma, 
where actually the stocks are stored.
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CHAPTER 1  
BASIC CONTENTS OF COMMODITY SPOT AND FUTURES 
MARKETS 
 
1. Why Commodities Are Traded? 
 
As the risk of commodity prices have a huge impact on the global 
economy of both developed and developing countries, it has acquired a 
considerable matter of the world physiognomy at this date. If, on one hand, all 
agents
5
 being involved in activities of spot trading and physical delivery take 
part on the composition of the spot prices in that particular sector they operate, 
on the other one, the formidable development of liquid derivatives markets – 
forward, futures contract and options – has advanced the opportunity for risk 
management area as well as the optimal designation of supply and demand 
contracts.  
We call spot trading any transaction where delivery either takes place 
immediately (which is rarely the case in practice) or if there is a minimum lag, 
due to technical constraints, between the trade and delivery. Beyond that 
minimal lag, the trade becomes a forward agreement between the two parties 
and is properly documented by a written contract which specifies, among other 
things, who among the buyer and seller is responsible for shipping, unloading 
the goods and other transportation-related issues. 
Nowadays, commodities are exchanged on a spot market, but in the past 
buyers and sellers needed to meet each other on the marketplace where 
exchanges brought to immediate delivery. However, it was only two centuries 
                                                           
5
 In a rough approximation, one can state that all parties in developing market include most 
commodity producing countries while as for the developed one it has meant originators, 
marketers and manufacturers.
9 
 
ago that in north-east area of the US, particularly in the state of Maine, farmers 
began selling their crops at the time of pitching in order to finance the 
production process. Similarly, many other markets started to trade in a parallel 
manner facilitating the expansion of the forward market. But at that time the 
discrepancy among the various markets that started up needed standardization 
in terms of quantity, quality and delivery date. As a result, the New York Cotton 
Exchange (NYCE) in 1842 and the Chicago Board Of Trade (CBOT) in 1848 were 
established. The stabilization of a clearing house was the effective signal that 
the Exchange was working. Presently, clearing houses are managed by 
independent shareholders, others are primarily owned by market participants 
as in the case of the London Metal Exchange (LME) and the International 
Petroleum Exchange (IPE). Different quality of the same commodity is traded on 
different exchanges. Making one of the many examples, which is also the crucial 
aspect of the dissertation I chose to analyze, oil is traded on the New York 
Mercantile Exchange (NYMEX) as Western Texas Intermediate (WTI) and on the 
IPE in its Brent variety. 
In addition, let me underline the fact that any transaction on whatever 
particular commodity could be physical or financial. This fact is in contrast with 
the concept that all the transactions in a financial stock market are settled 
financially. However, all of that is not so important because of the fact that 
physical and financial commodity markets are, as expected, strongly related. As 
a matter of fact, in a futures contract, the seller at the expiring date needs to 
deliver the physical commodity.  
Importantly is to notice, in particular for the crude oil, that the 
commodity market has changed recently. Because of new environmental 
regulation, economic mutation, the increased and incessant demand of 
developing countries such as Brazil, China, India, Russia, the fact that take part 
fully in the rank of developed countries, and finally the political upheavals such 
as the last “Arab spring” have affected price volatility and uncertainty of this
10 
 
particular commodity mainly because of the basic feature that oil is an 
exhaustible resource and its reserve estimates are regularly changed over time. 
As it has also been quoted and taking as example the very recent North African 
events: “Libya is the main culprit for the shortfall. In the first half of the year, 
the North African civil war-torn country produced 700,000 b/d on average less 
than in the same period of 2010. Libyan oil is sought after by European refiners 
because of its low sulphur content, which helps them to meet strict 
environmental rules for petrol and diesel.”
6
 This has made hedging activities 
(through forwards, Futures and options) indispensable for many sectors of the 
economy, the airline industry in particular being an important example. 
It is notable the fact that the existence of intermediaries in the 
commodity market play a significant part on the trade. In general, buyer and 
seller never meet and, even if they did, would rarely agree on prices, timing and 
so forth. Namely, the presences of intermediaries guarantee the successful 
conclusion of the contracts. 
I could represent the various stages of the physical execution of trade as 
in table 1.1:
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6
 http://www.ft.com/intl/cms/s/0/50697e20-e440-11e0-b4e9-00144feabdc0.html#axzz1aZyHw8Md 
7
 Source: Geman H. (2005). Commodities and Commodity derivatives:  modeling and pricing for 
agricultural, metals and energy. London, Wiley Finance.
11 
 
Reasonable could be to state some relevant terminology about physical 
execution of trade. The following are the most characterizing:
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 Bill of lading: The document that represents the ownership of the good. 
It is a receipt issued to the exporter by a common carrier (shipping 
company) which acknowledges possession of the oil described on the 
face of the bill. It serves as a contract between the exporter and the 
shipping company, specifying the services to be performed, the charges 
for those services and the disposition of the goods if they cannot be 
delivered as instructed. The bill of lading is also a document of title that 
follows the merchandise throughout the transport process; 
 Cost, insurance, freight (CIF): Seller must pay the costs, insurance and 
freight to bring the goods to the port of destination. However, risk is 
transferred to the buyer once the goods are loaded on the vessel; 
 Free on board (FOB):  The seller at his expenses must load the goods on 
board the vessel nominated by the buyer. Cost and risk are divided when 
the goods are actually on board of the vessel. The buyer must instruct 
the seller the details of the vessel and the port where the goods are to be 
loaded, and there is no reference to, or provision for, the use of a carrier 
or forwarder; 
 First notice day: The first day on which notice of intent to deliver a 
commodity in fulfillment of an expiring futures contract can be given to 
the clearinghouse by a seller and assigned by the clearinghouse to a 
buyer. It varies from contract to contract; 
 Force majeure: A standard clause which indemnifies either or both 
parties to a transaction whenever events which the Exchange declares to 
                                                           
8
 Notes of Futures Markets and Risk Management’s course attended at University of Study of 
Siena. Fall 2010. Terrence F. Martell, Ph.D. Except for CIF and FOB clauses where 
http://en.wikipedia.org/wiki/Cost,_Insurance_and_Freight#Cost.2C_Insurance_and_Freight 
has been used.
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be reasonably beyond the control of either party occur to prevent 
fulfillment of the terms of the contract; 
 Shipped or to be shipped: In the first case the merchandise has been 
traded, while in the second case the merchandise has been embarked 
leading to the qualification of cleaning on board; 
 Warehouse receipt: A document guaranteeing the existence and 
availability of a given quantity and quality of a commodity in storage; 
commonly used as the instrument of transfer of ownership in both cash 
and futures markets. 
1.1 Risks in Commodity Spot Transaction 
The main risks in commodity spot transaction are: 
 Price risks:  it will be discussed during the dissertation; 
 Transportation risks: it is the deterioration, partial or total, of goods 
during transportation. The expeditor of the goods or the FOB buyer 
directly holds the transportation risk, unless they purchase an insurance 
contract to be covered. Some companies such as Lloyds of London 
provide some freight insurance contracts. Importantly, we should not 
forget that transportation risk is a bad aspect of the oil contracts as it 
damages not only the part being involved, but also the entire community 
creating devastating environmental problem – the BP oil spill in 2010 in 
the Gulf of Mexico is a bad example, meaning that technological progress 
is not at all enough advanced in avoiding this kind of inconvenience; 
 Delivery risks: it is the risk that a buyer has to face when receive the 
merchandise due to its quality. No proper hedge could be implemented 
to avoid it, but a customized contract or a good seller reputation could 
prevent this sort of risks; 
 Credit risks: it is present all along until the final completion of the trade.