Forward contracts, each of which is linked to an OTC (over the counter¹) Physical contract for delivery of 600,000 barrels (+/- 1%) of Brent or Forties or Oseberg crude oil. Each is commonly referred to as an EFP, meaning 'Exchange of Future for Physical'. These standard Forward/EFP contract combinations are designed to enable the management of 'price risk' separate from the management of 'physical delivery risk'.

Brent (BFO) Futures contracts are traded on the IntercontinentalExchange (IPE) in London. They are still called 'Brent Crude Futures contracts' for historic and legal reasons. However the official Brent Dated (DTD)² and Futures prices published for this contract actually take into account a blend of the prices applicable to reported transactions in three crude grades, namely Brent, Forties and Oseberg, each day.

Brent Crude Futures are designed to enable the management of 'price risk' (also called 'market risk') and they are an integral part of the 21 Day BFO pricing system. The DTD Brent price is also used as a reference price in over 65% of the world's traded crude oil contracts.

Brent Crude Futures are traded for each month, up to 36 months into the future. The counterparty for each such Futures contract is the London Clearing House (LCH) and settlement is guaranteed³. All Futures contracts are closed on the last business day before the 10/11^th day of the month preceding the delivery month of the contract, i.e. 21 days before the first day of the delivery month. Cash settlement of each of these contracts takes place two days after the date they are closed; except for those that are 'exchanged for physical cargoes', as described below.

How does an EFP (Exchange of Future for Physical) work?

When the holder of a Brent Future wishes to ensure Physical settlement – rather than cash settlement – an OTC¹ arrangement is made with a Producer of Brent or Forties or Oseberg. This arrangement enables the separation of the physical commitment from the price determination. That is to say, parties agree the delivery of crude oil in the future without the price being determined (decided) until the future date arrives.

The linking of a Brent Futures contract with a Physical delivery converts the transaction to a 21 Day BFO Forward, which is an OTC settlement transaction. This 'conversion' is registered with the IPE and London Clearing House (LCH). After this registration the LCH no longer guarantees the settlement, and the contract does not 'cash settle' two days after trading ceases for such contracts.

How are Physical Cargoes of Crude Oil Allocated to EFPs?

Physical delivery of BFO crude oil is scheduled to take place during the designated delivery month of each BFO Forward/EFP contract combination.

About four weeks before a BFO Forward delivery month, the number of wet cargoes to be delivered under related EFP contracts, is declared by BFO crude Producers. This averages 70 ( 17 / 36 / 17 ) per month, being a function of the estimated production quantity, in barrels (bbls), divided by 600,000.

Each cargo is given a loading date range (lay-can) in the delivery month, and a unique parcel number.

When these lay-cans are allocated to BFO crude oil Producers (equity owners) the Producers commence the creation of 'chains' of Forward contracts linked to each declared wet cargo, at the beginning of the 21^st day before the first date of the related lay-can.

An equity owner (seller-Producer) initiates a 'chain' by telephoning a counterpart that has contracted with it to buy a cargo in the particular month, and then nominating that counterpart as the buyer-receiver of that day's cargo; at the Forward price previously agreed and on the lay-can dates assigned.

The counterpart (nominated receiver) then chooses whether [a] to receive (lift) the cargo, or [b] to use the cargo to perform under one of its open EFP sale contracts for the relevant delivery month. If the latter is decided, another counterpart will be passed the cargo and the related sell/buy 21 Day BFO EFP contract will join the related chain. 

The 'chains' of contracts linked to each physical cargo can include numerous counterparties, some counterparties more than once, as they weave across the market.

What is a 'Dry Book-Out'?

In cases where two opposite EFPs between the same parties (a buy/sell and a sell/buy) are joined into the same chain, the parties can agree to offset the two transactions and cash settle only the difference (based on the nominated quantity, 600,000 bbls plus or minus 1%) on the 30^th day after the Bill of Lading date. In such cases the quantum of any credit risk will only be the net amount due by the counterparty, if any. Refer to the section 'What are the Contractual Arrangements?' below.

When/How do Forward ('dry') contracts convert to Physical ('wet') contracts?

At 17:00 (5pm) London time on the day a 'chain' is formed, the process of passing a cargo along that chain stops. The buyer counterparty 'holding' the cargo at that point in time will;

1. nominate whether the cargo will be 'min.' (be 594,000 bbls) or 'max.' (be 606,000 bbls), and

2. sell the cargo on the 'spot' (Dated Brent or Forties or Oseberg) market, or

3. nominate a vessel to collect (lift) the cargo within the lay-can.

4. Pay for the cargo in full 30 days after the Bill of Lading date.

All the other buyer parties in the chain will have to pay the full cargo value to their counterparts 30 days after the Bill of Lading date; except for those that agreed a 'dry book-out'.

What are the contractual arrangements?

When a Forward is exchanged for a Physical in this way, the Physical (commonly called 'wet') delivery contract is governed by Shell's General Terms & Conditions (GT&Cs) for Brent contracts.

Shell's GT&Cs for Brent contracts allow legally enforceable netting (setoff) of Buy contracts with Sell contracts positioned within the same 'chain'; i.e. linked to the same physical cargo, between the same parties.

What is the meaning of the term '5 o'clocked'?

In the countdown to the 5pm deadline for any particular cargo, a receiver may be prepared to accept its position; having a use for the oil, or being satisfied with the price, or wishing to exercise the min./max. option, or having no 'sold-to' EFP counterparty to pass the cargo.

On the other hand the cargo may be passed from one counterpart to another with increasing speed as the deadline approaches. The counterpart holding the parcel when 5pm strikes (unable to contact another in time) will be left with the unpopular cargo; that is to say, 'will be 5 o'clocked'.

What is a 'Wet Book-Out'?

During the period of about ten days after 5pm on the day a cargo is passed along its 'chain', the final receiver-buyer may negotiate with the equity supplier (Producer) to 'book-out' (net off) its purchase obligation against a sale obligation it has to the supplier, in respect of an EFP for the same delivery month, an EFP not yet allocated to a 'chain'. Subsequently – 30 days after the Bill of Lading date of the related cargo - only the difference would be settled, based on the quantity nominated i.e. the 'min.' or 'max.' quantity. The equity supplier would meanwhile sell the cargo on the spot market as a 'Dated² Brent or Forties or Oseberg', or send it to its own refinery.

What about EFP contracts that are not allocated to a chain?

BFO crude oil producers are not obliged to put any of their cargoes into 21 Day BFO EFP chains. In practice this means that some, many or all of the cargoes produced in a month may be either [a] sold in the Dated² (or spot) market (i.e. sold over the counter¹ direct to a non-EFP contract holder), or [b] delivered into one of the Producer's own refineries.

This results in some, many or all of the 21 Day BFO EFP contracts maturing in a given month not being allocated to a 'chain'.

When the cargo allocation period closes on the 9^th day of the delivery month, all unallocated/remaining EFPs have to be settled outside the system. This is achieved by the middle-office operational personnel in the companies concerned creating so-called 'dry chains'. Effectively contract holding companies contact each other and agree to link related contracts into sell-buy-sell-buy-sell-buy chains. They agree a settlement date for each such chain - typically the 15^th/16^th of the month after the delivery month - and cash settlement takes place accordingly, thus extinguishing the unallocated EFP contracts.

What is the Counterparty Credit Risk profile of a 21 Day BFO EFP?

Refer to the linked PowerPoint slide for an illustration of the counterparty risk profile of an obligation to deliver-sell a Brent or Forties or Oseberg crude oil cargo under a 21 Day BFO EFP contract.

Ron Wells

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1. Over the Counter (OTC) = A direct transaction with a disclosed counterparty; that is to say, not a transaction through the intermediation of an exchange.

2. Dated (DTD) Prices = Prices applicable to crude oil cargoes to be delivered during this current month. Such cargoes are also referred to as ‘spot cargoes’ or ‘prompt cargoes’.

3. London Clearing House (LCH) maintains a key position in international financial markets. Independently owned and governed LCH, as the buyer to every seller and the seller to every buyer, acts as sole intermediary on some of the world’s leading trading exchanges and over-the-counter marketplaces. Trades executed on the International Petroleum Exchange (IPE) are cleared by the London Clearing House which acts as a central counterparty, thereby guaranteeing the financial performance of contracts registered in the names of the Exchange's clearing Members. To fulfill this obligation, LCH collects an initial margin, a form of deposit, from clearing Members to cover adverse daily price movements. This process is supported by a reserve fund of £150 million, provided by the owners of LCH. At the end of each day variation margin is calculated and transferred net to or from the clearing Member's account at LCH.