oil derivatives: in the beginning

making markets

In the first of two articles tracing the beginnings of energy derivatives, Roderick Bruce talks to oil trading pioneers about the market’s formative years in the 1980s and 1990s

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July 2009

oil derivatives: in the beginning

July 2009

of the forward curve on at least one side of the trade,” says Kitchen. “I thought: boy, half of my problem has been solved here, now it’s just a pricing issue.” That half required some guesswork. “You did have to make leaps of faith,” says Kitchen. The same was true for the people on the other end of the trade. Gaylen Byker and Ron Liesching at Chase Manhattan had already been examining the potential of extending the bank’s risk management offering into energy. Byker told Energy Risk in 1995: “I had long talks with Ron, and if this was such a good idea, I told him, then why don’t we just do it?” Chase was already involved in financing activities for airline Cathay Pacific, and had convinced the company’s representatives that an oil swap would allow it to manage its fuel costs more

Exporting Countries (Opec) E&P and a push to develop recent North Sea oil discoveries. The rise of spot trading meant that for the first time, oil prices could be set transparently by supply and demand rather than by the whim of Opec. However, a price benchmark therefore became necessary. The second big change came in 1981, when US President Ronald Reagan removed all remaining domestic price controls on crude oil that had been imposed during the 1970s by Richard Nixon, ushering in a new era of transparency. Up to that point, the US crude grades such as West Texas Intermediate (WTI) Louisiana Light Sweet crude (LLS) had traded on posted prices, which oil companies such as Koch, Exxon or Amoco would disseminate to the market irregularly.

We’d be oblivious and sometimes be taken by people who were more informed about how the market was moving John Shapiro, formerly of Conoco and Morgan Stanley

effectively. Until Koch, however, no other company had the market exposure, understanding or desire to take the other side of the deal. Kitchen and Byker sat down and inked a cash-settled four-month swap on 25,000 barrels per month, as Koch agreed to pay the average spot price of oil over the period while Cathay hedged a rise in jet fuel prices by paying a fixed $14–15 rate per barrel. Such was the success and compelling logic of the deal that Koch entered over one million barrels’ worth of swap transactions over the next two years. While the deal owed its genesis to the traders involved, much had happened in the external environment in the previous years to make the Koch/Cathay deal possible. First, spot pricing had come about because of the oil shocks of 1973 and 1979 that forced oil majors away from fixed contracts, eventually leading to more non-Organisation of Petroleum

Posted prices caused the market to move very slowly, as the physical oil market players of the time recall. “I’d describe the movement of posted prices like plate tectonics, where prices would just sit and make a gap move every few weeks if there was enough pressure in the system,” recalls John Shapiro, a trader at Conoco from 1975 to 1983 before going on to join Morgan Stanley, where he rose to head of commodities. “Companies might raise their posting from $24 to $24.50, but prices wouldn’t be intraday volatile or move in small increments.” Deals could be struck based on a certain company’s posted price, or on a differential to that price. Companies were often keen to take advantage of a lack of transparency. “If spot prices were on the way up then they were quick to change the posted price, but not so much if they were going down,” says Michael Cosgrove, managing

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rading in the exchange-based and over-the-counter (OTC) crude oil derivatives markets is estimated to represent over 1 billion barrels of crude oil per day, valued at $70 billion at current prices, according to the Centre for Global Energy Studies (CGES). Derivatives trade now dwarfs the physical market by a factor of 14. While today’s energy traders may take this advanced level of liquidity and complexity for granted, the foundations of the market were only laid thanks to the intellect and determination of trading and broking pioneers staking their careers on innovation in the mid1980s and early 1990s. The OTC derivatives market had its beginnings in the first ever oilindexed price swap, which took place on October 6, 1986 between Koch Industries and Chase Manhattan Bank. It was the brainchild of Lawrence Kitchen, a trading manager at Koch Industries, who had been wrestling with the conundrum of how to apply the rapidly evolving financial derivative theories of swaps and options to the commodities markets. Four years earlier, the launch of the crude oil contract on the New York Mercantile Exchange (Nymex) had helped to blow open the previously closed, opaque trading world of the vertically integrated oil majors, but while crude oil futures were beginning to gain traction, barriers to more advanced products remained. “Nymex listed contracts 18 months out at the time, but the liquidity at the fourth month was very low, so as you tried to monetise a pricing mismatch, you had a bid/ask problem on top of the forward curve shape,” says Kitchen. “The bottom line is: I was getting nowhere.” But persistence paid off for the former pupil of Fischer Black and Merton Miller as “suddenly the light bulb went on”, he recalls. Kitchen realised that one way to manage price volatility and protect Koch’s cash flows was through the use of a swap, an instrument already being put to good use by financial institutions in the interest rate and currency markets. “A swap allowed you to monetise part

oil derivatives: in the beginning

director at GFI, who began his career at physical oil broker Amerex in 1981. During his first year in the job, Cosgrove’s boss mentioned that staff from Nymex – best known at that time as a trading platform for potatoes and a moderately successful heating oil contract – wanted to start a crude oil contract, following price deregulation. Cosgrove was sceptical about the idea. “When I heard that they were coming to visit to learn about crude oil I thought that I was being forced to host a bunch of Martians,” he admits. Despite his reservations, he told Nymex that its specifications for a physically delivered futures contract based on WTI delivered at Cushing, Oklahoma, looked promising, as the Cushing storage run by Arco offered a robust settlement mechanism. The contract launched on March 30, 1983, the same day as a rival contract at Chicago Board of Trade (CBOT), based on LLS. Cosgrove felt the CBOT contract looked less promising as constraints on the Capline pipeline at St James, Louisiana, would make settlement more difficult. “When we listed the crude oil contract, CBOT was also looking for approval for an LLS contract,” says Nymex chairman at the time Michel Marks. “The man who wrote our contracts, Arnold Safer, told me: ‘the CBOT contract’s not going to work, there’s not enough supply, it’s the wrong delivery point’, and he was right on. Their contract lasted a month, had delivery problems and failed.” (See the full interview with Michel Marks on page 40) The Nymex WTI launch coincided with Opec’s historic price cut [see box], though Marks says the timing was coincidental. “The timing was all a function of what was happening in the US with deregulation,” says Marks, “though instinctively I felt that the cartel days were coming to an end and inevitably there was going to be more free market pricing.” Saudi Arabia’s oil minister at the time, Sheikh Yamani, tells Energy Risk in an interview in this issue (see page 36) about his opposition to futures markets. It is perhaps ironic then that it was Yamani’s 1986

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A series of seismic events The emergence of futures and vanilla financial products with crude oil underlyings in the 1980s had its roots in the oil price shocks of 1973 and 1979. The second shock in particular forced the oil industry to restructure, as shifting geopolitical forces ended the era of the vertically integrated oil major and gave birth to a freely traded spot market. Majors such as Shell and BP had previously been able to rely on their own producing oil fields and transfer their price risk along the value chain from upstream production and refining to downstream distribution and retail. But during the 1970s, international oil companies were frozen out of Middle Eastern countries as national oil companies seized control of strategic producing assets. Integrated firms were forced to source their oil on long-term deals from producers, but as the Organisation of Petroleum Exporting Countries (Opec), driven

by the economic and political motivations of Iran and Libya, raised its price from $12.70 a barrel at the end of 1978 to $32 by the end of 1980, majors moved to the spot market where prices were lower. According to Daniel Yergin, chairman of Cambridge Energy Research Associates, by 1982 more than half of internally traded crude oil was sold on the spot market, compared with less than 10% in the late 1970s. At the same time, Opec was pricing itself out of the market, as cheaper supply came on stream from the North Sea and Mexico. The cartel was forced into its first ever price cut from $34 a barrel to $29 in March 1983. “The fixed prices being set by Opec were much higher than the spot market price, and therefore oil companies could not lift according to long-term contracts, so they went to the spot market,” recalls former Saudi oil minister and head of Opec Sheikh Yamani.

They told us that they were going to make us markets and we asked them what that meant Julian Barrowcliffe formerly of Sitco, Bankers Trust & Bank of America

Paul Horsnell, head of commodities research at Barclays Capital

decision to flood the market with its oil that really allowed the WTI futures contract to gain traction. As the price collapsed from $31.75 in November 1985 to $9.75 in April 1986, oil companies rushed to hedge their exposure. Some 8,313,529 light sweet crude contracts were traded on Nymex in 1986, a 2472.6% rise from their launch three years earlier. It took time for oil companies to accept that the transparency that Nymex brought to the market could be beneficial. Shapiro recalls the lukewarm reception a Reuters screen with Nymex prices received at Conoco. “In 83 my boss came in and asked ‘who wants a screen?’. I was the only one in the office to raise my hand,” he says. But within a month, fellow traders were regularly visiting Shapiro’s office to use the screen. “Before Nymex you just had to make a lot of phone calls, but if other people made more and, for example, found out there was a problem in Nigeria you didn’t know about, they bought your cargo at what turned out to be an offmarket

price,” he says. “We’d be oblivious and sometimes be taken by people who were more informed about how the market was moving.” Shapiro observes that domestic US crude traders were the first to catch on to the WTI contract, as other domestic crudes traded at a differential to WTI. Companies such as Philipp Brothers (Phibro), Koch and Apex Oil were early adopters, before international traders also realised its value. “Once the screen emerged, the markets became more and more tied together, though there still wasn’t really a derivatives market,” he says. Shapiro was to play a key role in forming that market two years later.

Northern exposure Meanwhile, in the North Sea, another benchmark was emerging. “The North Sea developed at roughly the same time as the world needed a marker price, as Opec took a step back from being the direct locus of price formation,” says Paul Horsnell, head of commodities research at Barclays Capital, and previously July 2009

oil derivatives: in the beginning

assistant director at the Oxford Institute of Energy Studies. “The development of oil derivatives has a lot to do with the development of the North Sea. Around 1983 and 1984 the granddaddy of all modern OTC markets grew – the Brent 15-day market.” Production in the North Sea had been growing steadily since the discovery of the giant Brent, Ekofisk and Forties fields in the early 1970s. In the 1980s an OTC forward market developed, in which sellers gave buyers a minimum 15 days’ notice of the intended loading dates for a 600,000-barrel cargo of oil. Prices were agreed on a telephone market, creating “daisy chains” of transactions before a final buyer was found. “The logistics of the market were fairly complicated, so traders could end up having to take delivery of cargos unexpectedly,” says Horsnell. The physical nature of the market and the sheer size of the cargos involved meant that only the biggest companies, usually those with a fundamental position such as Shell and BP or physical traders like Phibro, would take part in 15-day trading. The first derivatives, called CFDs (contracts for difference) that emerged were fixed versus floating price swaps. Again it was driven by a Yamani policy – the introduction of netback pricing, in which producers priced their crude based on the prices that oil companies received for the products refined from it. “With netback deals, people realised they had all sorts of exposures that they didn’t understand,” says Julian Barrowcliffe, who was the first graduate to be specifically hired as an oil trader at Shell International Trading Company (Sitco) in 1985. “Everyone was doing different formulas and timings and yields – nobody knew how to hedge. But that CFD fixed versus floating arrangement was the genesis of the swaps market.” Exchange trading in the European oil markets was yet to take off, and while some traders were aware of Nymex’ growing influence, some were dismissive. “I was told when I joined Shell in 1985 not worry about the July 2009

WTI contract because it was delivered in landlocked Oklahoma and would therefore never come to anything,” recalls Barrowcliffe. Shell and the other majors had their eyes firmly on Brent. Christine Crosley, now global products leader, risk management at Shell, joined the company in 1979. She says of the early days of Nymex: “At that stage we didn’t necessarily need to be aware of WTI, and I can remember days when we’d get to 5pm and someone would say: ‘Oh, we haven’t switched that Nymex screen on today.’” The flows of oil heading West from producing countries were increasingly using Brent as a marker crude; today two thirds of the world’s oil is priced linked to Brent. So while European traders weren’t watching Nymex, the US was watching Brent. “In the US you’d see pressure coming in from the Brent market: if the sellers couldn’t get their Brent cargoes sold they’d start selling some WTI,” says Cosgrove. “In 85, if you knew where the Brent market was you knew where the WTI market was going.” The International Petroleum Exchange (IPE) made two failed attempts at launching Brent futures before their eventual success. The complexity of the physical market made settling a delivered contract difficult. Contracts based on two potential delivery locations, at Sullom Voe and Rotterdam, stalled, but a cash-settled Brent futures contract launched on June 23, 1988 took off. “People had been fixated on the idea that a futures contract could only be credible if it goes to delivery, which all the others at that point did,” says Crosley. “But once everybody gained a

degree of confidence in that cash settlement mechanism, the contract took off.” The mechanisms were all in place to support an advanced exchangetraded and OTC derivatives market: freely traded spot markets, transparent price indexes and a variety of buyers and sellers. All that was missing was the financial engineers to spur that growth.

Banking on it Investment banks had been eyeing the commodities markets as the next forum for their recently developed risk management techniques. But first the banks had to convince the energy companies of the benefits of using their products. “Around 1984 the ‘Wall Street Refiners’ started to come in, and they were about as welcome as a rash,” says Cosgrove. Shapiro had moved from Conoco to Morgan Stanley in 1984 to set up the bank’s energy options business. Along with Nancy Kropp, who joined from Sun Company, he embarked on a series of 25 meetings, attempting to educate the industry on price risk management. “It didn’t take off very well at all,” he admits. “Getting people to think about options was slow going. We had more success in getting people to start thinking about separating their supply/distribution risk from their price risk. Historically, without derivatives, those two things had to be managed together.” Morgan Stanley developed the concept of ‘partial’ Brents, which allowed North Sea traders to deal in smaller contract sizes of 25,000-barrel increments, compared to the usual full 600,000-barrel 15-day cargo.

The larger players were so big that as long as they could take bid/offer spreads out of the market through the power of their own natural distribution, transparency was a good thing Paul Newman, Icap

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oil derivatives: in the beginning

Companies could price each part of the cargo separately, allowing them more control. “People could sell us 500,000 barrels of Ninian at a 6c differential to Brent, and then 10 days later they’d want to price 100,000 barrels of it, and 20 days later another 200,000 barrels, and eventually it would all get priced,” explains Shapiro. “That allowed the market to be traded more like WTI, particularly as there was no liquid IPE Brent contract at the time.” Shapiro’s presentations, and those from other banks such as Goldman Sachs, Bear Stearns and Drexel, were certainly causing a stir at the oil companies. “The Morgan Stanley presentation was received with bafflement and confusion,” recalls Barrowcliffe of listening to it at Shell. “They told us that they were going to make us markets and we asked them what that meant. They said that meant we could ring them and they’d give us both a bid and an offer. This was revolutionary for us – we stared at each other and asked: ‘don’t they know if they want to buy or sell?’” Banks were also surprising the brokers. “In June 1985 I got a call from a guy named Steve Semlitz, working for J Aron,” says Cosgrove. “Semlitz asked me the price of August Brent. I told him 28 bucks. He then asked the price of September. I said ‘September’s still in the ground!’.” Semlitz persevered, and while Cosgrove told him it was unlikely that anyone was even thinking about the price of September Brent, he’d try to find him a buyer. “Semlitz told me he wanted to buy August, sell September, and pay a quarter,” says Cosgrove, “I asked him: ‘are you buying or selling?’ and he said ‘I’m doing both!’.” Cosgrove was dubious about J Aron’s credibility – he’d never heard of them before so he asked Semlitz for a pedigree. “Steve told me that J Aron was a limited partnership and that Goldman Sachs was the general partner,” says Cosgrove. “I said ‘can you prove that?’ and he told me that he had a certificate of limited partnership so I asked him to fax me a copy. My partners and I passed that fax around and tried to decide whether it was genuine. We made a few calls

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Semlitz told me he wanted to buy August, sell September, and pay a quarter. I asked him: ‘are you buying or selling?’ and he said ‘I’m doing both!’ Michael Cosgrove, GFI

and determined that this J Aron company might in fact be the real deal so I went to work on Steve’s trade.” Cosgrove, finally satisfied that J Aron was a creditworthy trader, brokered a deal for them to buy a cargo of August Brent from Shell International Trading Company and sell September to Occidental at 25 cents in favour of the August. “That was the day that Wall Street really got into the oil markets. Nobody had ever traded a cargo spread until Steve Semlitz did those trades,” says Cosgrove. “He then phoned me back and said ‘I want to do it again’.” Semlitz, who helped found Goldman Sachs’ oil trading business, and who now runs Hess Energy Trading Company (Hetco), declined to comment for this article.

Growing hedges Even though the regulatory climate for derivatives trading eased between 1986 and 1992, derivatives, and hedging in general, continued to be eyed with some suspicion by more conservative oil companies. That was until the first Gulf war of August 1990, when prices rose from $21 to $46 in just over two months. Smart companies who had agreed fixed price deals with consumers had

By 1994 the markets had become more sophisticated in every respect, not just in terms of transactions, but also the way people thought about and managed risk Dick Bronks, formerly of BP and Goldman Sachs

hedged their exposures. “By the time the war happened we’d got ourselves to the point of understanding how to manage our exposures, and we’d actually hedged our jet fuel exposure using IPE gas oil futures and then OTC jet swaps,” says Crosley. “We sat there and pondered the consequences of not having hedged – it would have been very painful.” Crosley says that Shell’s first deal was brokered by Icap, which was leading the way in creating bespoke OTC deals. “My first swap was brokered by Paul Newman – it was like the blind leading the blind,” she jokes. “I didn’t understand anything about swaps and he didn’t understand anything about jet fuel. We all just taught each other.” Newman, head of Icap Energy, observes that the oil companies that finally embraced a transparent marketplace flourished, since price transparency and increased flows magnified the natural relative strengths they owned. “Fighting the tidal wave of increased transparency started to make no sense to them,” he says. “The larger players were so big that as long as they could take bid/offer spreads out of the market through the power of their own natural distribution, transparency was a good thing. It was a Rubicon that everyone had to cross. Those that most readily embraced transparency at the outset, and moved to support the move towards free price discovery and market efficiency– like BP, Shell and Elf – went on to have great success.” Banks continued to pile into the oil market, eager to apply the concept of the risk warehouse – where a vast portfolio of futures, swaps and options positions could be managed easily by trading the net price value of the book July 2009

oil derivatives: in the beginning

rather than each position – which had been perfected in the FX and interest rate markets. Applying derivatives trading and the risk warehouse to oil was the next step. Notable early additions included Bankers Trust, Midland Montague and Crédit Lyonnais, which leveraged the established futures clearing mechanism of brokerage Rouse Woodstock to offer market access to smaller counterparties. Started up in 1990 and led by Chris Mason, the French bank’s OTC oil derivatives division was one of the first to enter the markets without any physical trading heritage or presence, and it thrived until 1994 when the wider business went bankrupt due to mismanagement. Another French bank, Société Générale (SG), joined at the same time, and remains an oil heavyweight today. Edouard Neviaski, today SG’s global head of commodities, started up the oil trading division in Paris with five staff and a direct line to

The market was tiny compared to nowadays. There wasn’t much liquidity or price movement Edouard Neviaski, Société Générale

their options broker on the Nymex floor. “The market was tiny compared to nowadays. There wasn’t much liquidity or price movement,” Neviaski says. “But it was great fun. I’m not sure we knew exactly what we were doing at first – we just had to learn as we went along.” Banks became indispensible providers of liquidity and risk transfer to the oil markets. Their arrival, just as the opaque vertically integrated era was being ushered out, created the foundation for the markets as we know them today. “The arrival of the Wall Street banks brought a nonmercantile, professional approach to the energy markets; prior to that it was merchants talking to merchants,”

says Barrowcliffe. “That was the only real step change in the market’s development – the rest has been linear and progressive.” Dick Bronks, former BP oil trader and global head of commodities at Goldman Sachs, says that by the time Energy Risk launched in February 1994, the evolution of oil derivatives was at an advanced stage. “By 1994 the markets had become more sophisticated in every respect, not just in terms of transactions, but also the way people thought about and managed risk – including credit and settlement risk – things that people were much less focused on in 1987. By 1994 it was a completely different market.” n

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