Brent Crude is relied on to price 80% of the world’s crude oil due to its ability to withstand supply and demand shocks.
Energy markets were rocked this spring. The first of two shocks was the oil price war between the Saudis and the Russians in March. This coincided with COVID-19, a second shock that reduced travel and oil consumption. Given the volatile nature of energy, oil traders and investors should understand the role of benchmarks so they can make the smartest decisions while minimizing their risk.
A key stabilizing force amid the chaos was Brent Crude. Though it is only one of hundreds of different crude oils—the thick, unprocessed liquid that is turned into gasoline, heating oil and other products—Brent holds a unique place in the international energy market.
“Brent is less likely to react to a one-off piece of news, whether or not it is accurate,” says Charles F. Mason, a professor of petroleum and natural gas economics at the University of Wyoming. “In that way, it will be less likely to stray from a good representation of market forces when a new piece of information arrives.”
Extracted from several oil fields in the North Sea between the Shetland Islands and Norway, Brent sets the price for approximately 80% of oil traded on the global market. Its paramount position is due to important characteristics that enable Brent to withstand market shocks like political upheaval, weather catastrophes and global health crises.
“The fact that the U.S. has become the world’s biggest oil-producing nation has obviously gotten a lot of headlines,” says Jeff Barbuto, vice president of global oil at Intercontinental Exchange (ICE). “However, once U.S. crude hits the water for export, most of it actually prices as a differential to Brent Crude, not against a U.S. benchmark. In fact, more than two-thirds of the world’s crude oil prices against Brent—the global benchmark.”
Until the late 1970s, buyers purchased crude on the spot market, paying the current price and expecting delivery within a few weeks. The ’70s energy crisis pushed the industry to find new ways to reduce the risk of turbulent markets, with global strife and petroleum shortages leading to skyrocketing prices.
Brent is less likely to react to a one-off piece of news, whether or not it is accurate.Charles F. Mason, Professor, University of Wyoming
“Commodity markets played an important role in providing price transparency, access to liquidity, risk management and capital efficiency,” says Stuart Williams, president of ICE Futures Europe, where Brent Crude trades. “As markets evolved and went electronic, distribution became increasingly global and futures contracts like Brent futures emerged as key risk-management tools for buyers and sellers looking to manage price risk across a range of markets over time.”
Crude oil futures contracts are derivative securities that give the buyer the option to purchase a certain number of barrels at a predetermined price months or years in advance. “Oil derivatives allow our customers to manage price risk throughout the supply chain,” Barbuto says. “We have around 600 different oil derivatives that reflect different local specifications for products like jet fuel and gasoline, as well as regional crude grades.”
Futures contracts are linked to a specific benchmark, a reference point that allows buyers and sellers to determine a price for the many different types of crude oil varieties and blends. The three main crude benchmarks, encompassing different geographies and oil types, are Brent Crude, West Texas Intermediate (WTI) and Dubai Crude.
A benchmark tied to market fundamentals benefits everyone from investors to consumers, especially during volatile times. “Producers, refiners and end users have to make difficult decisions around whether fields are explored, developed or shut down, refineries are built or sold,” Williams says. “Brent helps give them the confidence that they can allocate capital to projects with the least amount of risk and the greatest chance of success.”
Brent Crude has several characteristics that make it particularly suitable as a benchmark. It is light and sweet, meaning it has low density and a low sulfur content. This makes it ideal for refining into gasoline, diesel and other high-quality fuel, which keeps demand consistent.
Brent oil fields are strategically situated between Asia and the United States along major travel routes. As a waterborne crude, it can be put on vessels and shipped anywhere in the world quickly and economically, a flexibility that ensures it is strongly connected to the underlying physical market.
Because the global crude market hinges on expectations of supply and demand, oil prices can be volatile, influenced by investor and public perceptions. Since Brent Crude was adopted as a benchmark in 1985, Brent futures contracts have continually evolved, incorporating new oil fields and extending the amount of time to exercise options, for example. This ability to evolve is another key reason Brent holds an integral pricing role in the global oil markets.
“One could make a strong case that any benchmark needs to broadly represent market forces,” Mason says. “The ability to avoid rapid, whipsaw-like responses to rumors and such would make Brent an attractive choice.”
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