Brent Contracts for Difference (CFDs) are one period commodity swaps.
As was previously explained in the article «Commodity Swaps», such swaps are cash settled and it can be said that all oil commodity swaps are CFDs.
However, the oil industry participants use the term CFD for a specific type of swap contracts.
Brent CFD implies a differential between the daily Platts Dated Brent assessment for physical cargoes and the BFOE daily Platts assessment for that day (More information on dated and forward Brent). With other words, CFDs track the price differential between the spot price at the time of settlement of dated Brent and the price of the first forward month at the time of settlement of physical trade.
Many types of physical crude oil are actually priced against dated Brent.
Taking into account that dated Brent itself isn’t a suitable hedging contract, Brent CFD is of particular interest because it allows to hedge the price differential and thus to eliminate the existence of a basis risk.
The market for CFDs emerged in 1988 but its significant development started since 1992.
CFDs are normally traded with weekly maturities out to 8 weeks with the size between 50 000 to 100 000 bbl. They also are traded for bi-monthly and monthly periods in the marketplace.
There are three essential components that must be specified at the outset:
-the forward month price against which CFD will be assessed, usually this is a nearest forward month
-the window that is the number of trading days over which an average price will be calculated. Usually, the window is the five day period.
When the market is in contango, CFDs are negative while backwardation causes a positive CFD quote.
The following example shows how a refiner can hedge its oil exposure by trading CFDs contracts.
A refiner needs Crude oil in October and thus buying a cargo on September 21, 2015 for loading on 13-15 October.
The price is the average dated Brent + 20 cents. The average is calculated during the period of 12-16 October.
The refiner has Oil exposure because dated Brent price floats and if the price goes up the refiner will suffer a loss.
The appropriate hedging strategy is to use CFDs contracts along with the first forward month contract at the time of the settlement. Our settlement is in October and thus BFOE forward should be dated as a November contract.
Let’s assume CFD 12-16 October is -0.67 and BFOE(Nov) forward is 48.03 as of September 21,2015.
Dated Brent = BFOE + CFD and by buying both contracts we hedge the dated Brent exposure.
On October 16, 2015, the hedge PnL is calculated based on the following input prices:
The price of dated Brent went up from $47.56 to $49.194 but the positive PnL result from the hedging deals gave the profit of $1.952 and totally compensated the loss.
As can be seen, this hedge wasn’t perfect.
This is because BFOE(Nov) price isn’t an average price of the week but rather the closing price of October 16 which is in contrast with the CFD price being calculated using the average price of the 12-16 week.
The calculations are attached in the Excel file.