The oil market is characterized by hundreds of different grades of crude located all over the globe. However, oil prices are structured with reference to only a handful of benchmarks or oil markers produced in different geographical locations. The light sweet crude oil grade produced in North America is represented by the West Texas Intermediate delivered at Cushing, Oklahoma. Simliar grade is produced in Europe and benchmarked by Brent, which is extracted from the North Sea, while the medium sour crude produced in the Middle East is represented by Dubai/Oman. Finally, the heavy sour crude produced in the Gulf of Mexico is benchmarked by Maya which is produced in Mexico. The WTI and Maya contracts are traded at New York Mercantile Exchange (NYMEX), Brent at London’s International Petroleum Exchange (IPE), Dubai/Oman (currently) at Dubai Mercantile Exchange (DME), International Commodity Exchange (ICE) and Singapore Exchange among other Asian commodity centers.

Much of our research has examined two major issues associated with these benchmarks.  One line of research has decomposed the permanent and transitory components of the four major benchmarks. The other line of research has examined the asymmetric relationship between different benchmarks.

In our paper with Ramaprasad Bhar, we separate out the oil permanent (or long-run trend) component from the transitory (or short-run cyclical) component in each of the four major oil benchmarks (i.e., WTI, Brent, Dubai, and Maya).  We find that the long-run trends in each of the oil benchmarks are only explainable by the other oil benchmarks’ permanent components, but not by long-run interest rate movement, underscoring the difficulty of predicting oil prices in the long run, which requires predicting the fundamentals. This finding is further reinforced when we examined the short-run oil benchmark cycles and find that they are also not explainable by the other oil benchmarks’ long-run trends (with the main exception of the Maya benchmark), implying that oil cycles are not explainable by the fundamentals.

While we do not find long-run oil trends affecting the short-run cycles of the oil benchmarks, we do find evidence that cyclical movements in the benchmarks are affected by contagion spillovers from other benchmarks’ transitory components. This finding suggests that a short-run oil investment strategy that benefits from spillovers among the benchmarks is more beneficial than a benchmark diversification strategy that includes those benchmarks as a hedge against risk, as is often the case in commodity and stock markets.  In addition, investors may also gain from knowing that Brent and Maya cyclical movements are affected by the hurricane season.  Interestingly, the short-run interest rate cycle and geopolitical events did not affect (on average) the short-run oil cycle of the benchmarks, but did affect the volatility.  Major geopolitical events increased the volatility of the oil benchmarks in the short-run, with Dubai being most affected.

In a similar but different line of research, we examined the pricing relationship between these major oil benchmarks.  Since these benchmarks play a major role in the price/discovery process of the oil market, our paper with Bradley Ewing examines and models the spreads between these benchmarks.

Our results indicate that the each of the benchmark pairs forming a spread in the four bivariate groups has a long run, stable relationship.  Thus, there may be arbitrage opportunities when these spreads get out of alignment (i.e., deviate from the long-run position). However, this adjustment process may be asymmetric. While WTI and Brent are actively traded and that Dubai may be less responsive to spread changes, the establishment of DME in Dubai and the supplement Dubai crude with Oman crude may result in the Dubai benchmark being one to watch for. Spread traders would be sensitive to these changes in the future.  Finally, since the different spreads adjust differently in terms of asymmetry, traders’ strategies should be different and spread dependent to take advantage of profit opportunities.

Overall, this line of research has provided some interesting results across the different benchmarks.  That is, there are some similarities in the cyclical movements of the different benchmarks, but differences exist in the relationship between different benchmarks.  Future work would explore further the reasons for these differences among the different benchmarks and how the short-run oil cycles and long-run oil trends respond to similar macroeconomic and financial forces.

About the authors:
Shawkat Hammoudeh is professor of economics at Drexel University and Mark A. Thompson is the Cree-Walker chair of business administration at Augusta State University.  They can be reached at hammousm@drexel.edu and mthompson@aug.edu, respectively.