To Hedge or Not to Hedge - That's the billion dollar question puzzling everyone from industry heads to govt policy makers in the wake of crude oil collapse . Before even attempting to answer that, it may be prudent to to look at the way indices work - and the economics behind it.
What should a market index reflect ? It should be a consistent & fair representation of the underlying supply & demand. Is that the case behind petro price indices ? Lets look at a few data points first.
Globally, there are two main crude indices - Brent & WTI . Brent crude index is computed as a mathematical function of spot & future prices of North Sea oil ( Click for details ) . Similarly, WTI or West Texas Intermediate is function of primary crude contracts settled in Cushing, Oklahoma . Both have different Sulphur content, density etc - which means there are different costs to refiners, though the end - market - Consumers is largely the same
For most part of the last 5 years, Brent has been higher than WTI. If you look at the Brent - WTI spread ( http://ycharts.com/indicators/brent_wti_spread ) , you will see a few interesting points. The spread has been highest ( $20+ ) at the peak time of quantitative easing. Or in other words, loose money often tends to flow into easily accessible commodity markets. The intermittent spikes have largely coincided with the political flare-ups. And, as of today, the spread stands at $3.09.
Suppliers naturally tend to lean to higher indices as it suits them. A large portion of oil purchase agreements are ( were ? ) based on Brent. But, is Brent, a fair representation of the market ? Most of the Brent Crude flows to Europe ( Of late, Russian oil also has a sizable market share there ) . When the market is largely limited to a region, is it really prudent for a consumer - in say China / India - to strike a contract based on an index that is not really favorable to them ?
The geo-political realities today are much different from the last decade. ONGC & CNPC - which represent two large consumer nations today have taken stakes in a lot of African / Russian oil fields. And these are driven by large volumes - which dwarf North Sea capacity ( It is depleting as well ) .
What this essentially means is that, in terms of producer - consumer combinations, the oil market has become a bit more fragmented / decentralized . In a decentralized market, centralized indices that predominantly cater to the demand of a region will lose relevance. Imagine, LIBOR being used as a standard to price securities world-wide. Using Brent to price crude is in some ways equivalent to that . As more and more consumers realize that, a large number of them will move away into different modes of pricing - Governments will tend to take stakes in oil fields , Companies will tend to rely on more localized & independent indices .
Another problem with these indices is that it is kind of self-reinforcing. Suppliers strike contracts based on indices - & indices take those contract settlements to recalculate themselves. It is somewhat debatable as to how quickly the demand signals get reflected in such a mechanism. What gets easily reflected are the speculative positions taken based on external political events.
How can indices stay relevant ? Can we imagine a world in which a consumer strikes a petrol contract with a next door petrol pump based on XYZ index ? I would say, fuel market will be truly deregulated only on such a day.