The Barrel Blog

It may well have passed your attention, but the low sulfur ICE gasoil contract marked its first birthday this week. How come this wasn’t marked on my diary? Is my smart phone playing up? Has my secretary let me down? Should I send flowers? Chocolates? How do I mark this occasion? Or you might think… ‘Er… And…?’

Well, hold hard there; this is important. New futures contracts come along from time to time, and most are rapidly consigned to the dustbin of history, passing unremarked and–critically–untraded. Not this one. This is widely touted to be the future, the apprentice to one of the most successful futures contracts that’s currently out there.

For middle distillates across Europe particularly, and as a financial instrument across global markets, the 0.1% gasoil futures contract overseen by the IntercontinentalExchange is a runaway success.

In terms of activity, since 1995 the monthly volume of 389,709 contracts in January 1995 surged to regularly average more than 1,000,000 contracts per month by 2006, rising exponentially through the lean, difficult years after the 2008 contraction to peak at 6,655,441 in October 2011.

Although that volume has eased through 2012, the exchange saw its monthly volume topping 5,000,000 contracts in all but one month of 2012.

So why the young upstart? Why the need for the new contract? As discussed previously, this is all about Europe’s drive toward low sulfur and its ever increasing reliance upon 10 ppm diesel.

The biggest heating oil market in Europe, Germany, has effectively moved to low sulfur 50 ppm gasoil, and almost at a stroke the bedrock link to a physical oil market upon which the 0.1% contract is founded has been severed.

While that may not worry many of the financial institutions that see the huge liquidity as the perfect marketplace to get into and out of positions, it’s a worry for many others in the market.

With the physical 0.1% market in Northwest Europe casting around for a new outlet, whether into the Mediterranean, South America, the Red Sea or ever further afield, the dynamics of the 0.1% market are drifting ever further from the staple, reliable, cozy undercurrents of heating oil.

So, the answer was a new contract . That was beyond dispute, and with the dominance of the 10 ppm market across Europe, ICE did the humane thing in mid-September of 2011, providing a timeline for the discontinuation of the senior 0.1% contract (it will continue out to January 2015) and, thereafter, handing the future to the ultra low sulfur 10 ppm gasoil.

And how has it fared in its first year? Clearly the new contract, which although launched in September was actually focused on the first contract of January 2012, has lived in the shadow of its more established parent for the entirety of its short life to date.

That’s hardly a surprise when faced with such a behemoth. But market participants have broadly welcomed the new contract, although liquidity remains something of a concern.

Marking the first anniversary of its arrival, ICE reported that the contract had actually seen its second highest volume of 3,625 lots on September 18, a feat only surpassed by the opening day when volume reached 5,747 lots. Alongside that, the average daily volume through September is also moving in a positive direction, averaging over 900 lots per day, the highest so far since it launched in September 2011.

Its a fraction of the efforts 0.1% is posting, and a quick comparison is tough on the fledgling wannabe. September 18 saw open interest number 4,861 and volume number 1,121 lots, compared to open interest of 609,206 on 0.1% and daily volume of 319,036 lots, but the contract itself has had opportunities to hog the limelight.

In the matter of deliveries–the settling of exposure at the expiry of the front month contract through physically delivering or taking delivery of oil–the outgoing August low sulfur gasoil contract saw 1,260 lots delivered as physical oil, 126,000 mt of 10 ppm.

That was the fifth biggest delivery of 2012, across either contract, and exceeded the 1,000 lots (100,000 mt) delivered against the outgoing August 0.1% contract.

There is an argument that the 10 ppm contract is capturing perhaps more accurately the dynamics of the market it serves than the 0.1% gasoil contract too.

From a structural perspective, the 10 ppm contract has been rooted in a backwardated market through much of the recent months. That is a fair reflection most sources would say of a short market, with limited stocks in reserve and starved of the sort of arbitrage flows that have covered the 10 ppm shortfall in the past.

The higher sulfur 0.1% gasoil contract’s structure has wavered and wandered a touch aimlessly through the summer months after emerging from a dramatic backwardation through much of April through to July. That backwardation seemed to many to be unjustified by the onset of summer, the underlying poor end user demand environment (remember, the bedrock domestic market has gone) and the strong outright prices which seldom incentivize anyone to stump up cash for something they don’t really need.

That has left many middle distillate traders in Europe scratching their heads.  Most agree that the grade is finding homes somewhere else, whether South America, West Africa, the Red Sea or the Mediterranean, and thereby bypassing the ARA hub, which is central to the 0.1% contract’s fundamentals.

In so doing, it creates a tightness amidst a market that has evolved, leaving the grade close to extinction, shunned by end users and increasingly unloved by refiners. Indeed, the move toward 10 ppm seems to be accelerating, with rumors circulating among European circles that refiners and oil majors within the Northwest European region are starting to lobby governments of the remaining high sulfur countries to clarify their own plans on the future of heating oil.

So, happy anniversary, low sulfur gasoil futures contract. Any parent will tell you the first year is about getting to know your new arrival. But things really start to happen when you reach the terrible twos.
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