A Model for the Russian Energy Trading Market: An Assessment of the American Exchange Trading Experience

Transcription

1 Alexander Gudkov A Model for the Russian Energy Trading Market: An Assessment of the American Exchange Trading Experience Introduction Alexander Gudkov*, Chief Executive Officer of Non-Commercial Partnership Council of Commodity Markets, Ph. D. Exchange trading on Russian commodity markets started 23 years ago. The main Russian commodity exchange the Sankt-Petersburg International Mercantile Exchange (SPIMEX) was founded in 2008, which renders its history rather short when compared with American exchange trading that began more than 150 years ago. Currently, Russian exchange trade faces certain challenges that American exchange trade overcame over one hundred years ago. Experience shows that we can't simply take American or West European economic institutions and move them to Russia without adjustment. They won't work correctly without taking into consideration some region-specific features. Recently, petroleum (oil) products exchange trading on the Russian spot market has enjoyed some success. From 2012 the volume of the exchange trade almost doubled and amounted to more than 17 mln tons. Although the exchange along with the market participants managed to solve many problems that hindered trading development, the recent increase in trading volumes was largely the result of regulatory efforts. In mid-2012, the Federal Antimonopoly Service (FAS) and the RF Ministry of Energy issued a joint decree that obliged the domestic monopolists to sell on exchange some volume of fuels in order to eliminate the risk of antitrust fines. Thus, by act of regulation the volume of trading has grown, but the fact remains that even Russia's most developed oil products market still faces systemic problems that hamper growth and must be solved. In October 2014, SPIMEX launched exchange trading of natural gas. Until recently Gasprom the state-owned monopolist that controls infrastructure, primarily pipelines has impeded the development of natural gas exchange trading. In 2007, Russia initiated experimental natural gas spot trading that allowed Gasprom to sell surplus natural gas at market-determined prices. At the time of rapid economic growth such prices were higher than regulated prices established for Gasprom by the Federal Tariff Service * Mr. Aleksandr Gudkov is the CEO of NP SPTR (Non-profit Partnership Council of Commodity Markets ), a professional association of independent oil product trading companies. The mission of the Partnership is to create in Russia a civilized commodity market based on principles of responsibility, respect, professionalism and equality of all its participants. Mr. Gudkov received his Ph.D. in Economic History in 2006 from Moscow State Lomonosov University. Being an author of a high-profile business newspaper Kommersant from 2006 to 2012, Mr. Gudkov published analytical materials on oil and oil products market as well as about antitrust and tax regulation. In 2013 Mr. Gudkov was with Argus Media, a British price agency. 1

2 the state regulator. However, following the global economic crisis that affected Russia's economy, the exchange price for natural gas fell below the regulated price. In turn, this affected Gasprom's willingness to further develop exchange trading. The experiment was found to be successful, but was ultimately suspended. The advocates of natural gas exchange trading have a powerful ally in their fight against Gasprom's monopoly position. Rosneft the world s largest public oil company and a monopolist on the Russian oil products market has its own natural gas assets and is highly regarded among independent producers. Moreover, Rosneft is consistently fighting for the liberalization of the domestic natural gas market and stripping Gasprom of various privileges, such as exclusive rights for gas exports and/or tax allowances. There is little doubt that the natural gas exchange trading project will eventually be re-implemented because the President of Rosneft and Chairman of the Board of Directors of SPIMEX is Igor Sechin, an opinion leader in Russia's energy sector. In addition, in 2014, the Russian Federal Antimonopoly Service declared its intention to issue a new rule which obliged major oil companies to sell not less than 5 percent of domestic crude oil on the exchange market. This should give an impulse to the development of exchange trade in crude oil in Russia next year. A major impediment to implementation of these plans is that in late 2014 the Russian economy dropped into the deep financial crisis. The crisis in the banking system and the decreasing volume of credit will lead to crisis in the real economy triggered by expected widespread defaults and bankruptcies in the second half of The depth, duration and consequences of the current economic crisis are unpredictable at the moment. A pressing current Russian government objective is to take control of the ruble inflation. In some circles, this also means taking control over commodity prices, including exchange prices. Regardless, as the Russian energy market climbs its way out of this crisis, it will need not only new solutions to old problems; it will also need a new model of the exchange market. The current situation offers exceptional opportunities to develop this model. Brief Description of the Russian Market for Refinery Products Russia produces more than 500 million tons of crude oil per year (or more than 10 million barrels daily) and exports over half of it. The remaining oil is refined domestically, where Russia produces about 200 million tons of refined products and exports about 100 million tones. According to the Russian ministry of Energy, in 2014 Russia produced 38.1 mln tons of gasoline, 76.8 mln tons of gasoil, 79.1 mln tons of fuel oil and 10.7 mln tons of jet fuels. The Russian export basket mostly consists of gasoil and fuel oil. The domestic prices for these products correlate with export netback and depend on export taxes and logistic costs. The Federal Customs Service states that in 2014 Russia exported mln tons of oil and mln tons of oil products, including 4.2 mln tons of gasoline and 47.4 mln tons of diesel fuel. But when using these statistics it is crucial to account for the fact that a significant amount of crude oil is exported as oil products after primary processing. The reason is that the export tax on processed oil is almost half the tax on crude oil. So export of the refinery products after primary procession allows exporters to save considerably, on the order of $100 $150 per ton. The Russian gasoline market is more complicated. Due to low efficiency of oil refining in Russia, the production of gasoline is equal to domestic demand (taking into account seasonal fluctuations). Export of Russian gasoline is rather insignificant, so, in fact, internal prices on it don't correlate well with prices in the world market (netback prices). Indeed, domestic gasoline price discovery has proven to be a great challenge for state regulators and market participants due to the extremely high economic concentration in the Russian market. Recently market prices for gasoline and other products have been formed with high liquidity in trading. A few years ago in Russia there was a sufficiently representative open market of oil products with independent sellers (independent owners of oil, who processed it in oil refineries on processing terms) and independent buyers (chains of retail gas stations). This situation was caused by the fact that vertically integrated firms in the oil market had 2

3 Alexander Gudkov. A Model for the Russian Energy Trading Market: An Assessment of the American Exchange Trading Experience unbalanced sales in their upstream, downstream and retail arms; in other words, they extracted less crude oil than they could process in their refinery plants or produced more oil products than they were able to sell in their own gas stations. This created a market opening for independent operators along the oil value chain. However, industry consolidation has mitigated the past market structure, and high profile oil companies have successfully expanded their vertically integrated dominant position. Some companies purchased independent chains of gasoline stations, while others purchased oil refineries. As a result, in 2007 independent oil processors stopped working on the Salavat oil refinery (Bashkortostan region) in 2009 they left the Moscow oil refinery and Ufa oil refinery. Rosneft's acquisition of TNK BP was crucial to these developments. Prior to that agreement, TNK-BP was a surplus fuel producer, as it produced more oil products than it was possible to sell at TNK-BP gas stations. Rosneft, on the other hand, didn't have enough oil products to sell at its retail gasoline stations. In fact, TNK-BP sold in the open market, including on the exchange, more than 1 million tons of oil products. After the acquisition, this volume of oil products stayed within Rosneft thus leaving the open market. Eventually, the Russian oil wholesale market ceased being representative, as almost all oil products were sold under transfer pricing mechanisms internally through the vertically integrated structures of the major oil companies. Increasing economic concentration of oil products in Russia became an issue of regulatory concern. According to Russian law on competition, major companies cannot be accused of fixing prices, if the price was formed in the exchange market under the conditions set by the regulator. One of those conditions stipulates a minimal volume of sales in the exchange market. In the summer of 2012 both the Federal Anti-Monopoly Service and the Ministry of Energy published an order, which obliged monopolies to sell at least 10% of gasoline, 5% of diesel oil and aviation kerosene, and 2% of fuel oil residue. Failing to meet this recommendation could result in anti-monopoly legal actions and fines up to 10% of annual turnover. Later, the FAS repeated the above recommendation by issuing the relevant binding instructions. Due to this administrative impact, oil products exchange trading in the Russian spot market significantly increased. Most sales of oil products in the Russian open market are carried out via SPIMEX Russia's largest exchange. According to SPIMEX, in 2014, 17.2 million tons of oil products were sold on the exchange, which is a 3.7 million ton increase over 2013 and 7.7 million tons more than in According to the rules of the SPIMEX exchange, the auctions are divided into sections where the largest is the oil products spot trading section, which applies a bilateral trading model where the participants conclude auction-based transactions. Clearing procedures are reduced in order to control the performance of the transaction by its participants. Auctions are carried out simultaneously in dozens of liquid locations, each of which is presented as a well known window. As a rule, the supply location is a major refinery and most of the transactions imply railway deliveries. But, there are also instruments that imply pipeline and truck deliveries. A specific feature of the auction is that each trading instrument implies a certain delivery method that is unchangeable. For instance it is possible to sell the same quality diesel fuel from the same basis through two instruments on free in pipeline or free on rail terms. The trade participants can initiate registration of a new trade instrument, but if there are no transactions within two months then it is canceled. The auction rules and delivery terms stipulate that the market participant shall furnish a collateral deposit for transaction clearing purposes that is about 5% of the transaction amount. If the trade participant fails to fulfill the transaction terms, the clearing company shall withdraw the above sum in favor of the affected counterparty. The sellers of oil products on the exchange are generally the large producers who have a dominant position in the market (more than 35% in the local market, according to antimonopoly law) and have the order from the Federal Antimonopoly Service to sell a minimum volume in the exchange market. The largest producers in the Russian market are Rosneft, Lukoil, Gazprom neft, Bashneft, Surgutneftegaz, and Tatneft. The buyers of oil products on the exchange are generally traders and brokers acting on behalf of their 3

4 customers. About twenty independent trade companies are buyers of more than 50% of refined products being sold on the exchange. Other participants are several hundreds of end users and small trading companies. Resale transactions by traders account for less than 3% of exchange operations. The reason for low resale figures is the auction rules. Namely, a trade company that concluded a purchase transaction has only two days for resale. Within two business days after the date of transaction the Buyer has to send the Seller the shipping details, including the destination. In the case of free in pipeline terms, the Buyer shall within 7 days send the Seller the Transneft (the pipeline operator) route, but the receiving procedure takes time for coordination. In some cases, if the Seller agrees, the Buyer can change destination within a fortnight from the transaction date. But the Buyer hasn't got a contract with the expeditor company and has to ask the Seller about it. Usually expeditor companies are the Sellers' subsidiaries. For instance, RN-Trans for Rosneft, Gazprom Neft Logistika for Gazprom Neft, etc. Often oil companies are not interested in resale of their fuels by independent traders and block destination changes. Another reason for the low resale number is extremely high transaction costs. The transaction is concluded on 100% advance payment terms. The Buyer shall pay for the commodity on or before the 5th business day after the transaction date. In general, the payment shall reach the clearing company account and be held until confirmation is received that the shipment was performed. That means that 100% of the Buyer's payments are held in the clearing house for a month or longer. There are no netting or clearing deals on the SPIMEX spot trade. If the Buyer resells purchased volume on exchange within two days from the initial transaction, the clearing house takes 200% of the fuel cost (100% payment of the first buyer and 100% payment of second buyer). Extremely high interest rates for commercial loans in Russia (about 35% per year at the beginning of 2015) makes costs of the exchange transaction prohibitive and hinders the development of exchange trade as a whole and for the increase in resale in particular. In the case of non-performance, the payment shall be returned to the Buyer with the 5% Seller's collateral. The Seller shall ship the sold commodity within 30 days of the transaction date. If the clearing company fails to receive the above confirmation within 4 days of the expiry of the 30 day period, the Seller shall be deemed insolvent and subject to a penalty, after which the transaction shall be terminated. The counterparties can agree to extend the shipping period and there are some exceptions and privileges for producers. In particular, producers get payments from Buyers directly and immediately without confirmation of shipping and clearing procedure. Under this exception, if there is a shipping delay or a Seller's default, the clearinghouse can't help the Buyers recoup their payment and they are recommended to apply to court. Key Problems of the Current Model of the Market The key problem of the Russian exchange trade market is its low liquidity, caused by the fact that major companies lack commitment to selling their products in the open market and developing the exchange trade market in particular. The main cause of this problem is an extremely high economic concentration of the Russian refinery products market, an artifact of the planned economy of the USSR. Indeed, according to the Federal Antimonopoly Service (FAS), in 2013 four Vertically Integrated Oil Companies (VIOCs) accounted for 92.4% of total gasoline deliveries to the Russian domestic market. High market concentration and vertical integration of oil companies allows dominant firms to exercise monopoly power, but this is limited due to a high rate of state regulation, primarily by the FAS, which controls retail price levels. However, the regulators' pressure on retail prices creates distortions and provides a disincentive for producers to operate in the open market. This follows because the FAS's control of retail prices and artificial maintenance of stability reduces the profitability of firm operations. Vertical integration allows VIOCs to sell crude oil to their refineries at internal transfer prices in order to reduce taxes for the upstream 4

5 Alexander Gudkov. A Model for the Russian Energy Trading Market: An Assessment of the American Exchange Trading Experience operations. Retail prices are subject to FAS control that sets the ceiling for the retail prices of independent participants. As such, the FAS determines a ceiling for wholesale prices in the open market where independent companies are ready to buy and sell oil products. So, if VIOCs sell oil products in the wholesale market to the independent counterparties at prices similar to those used for their own retail chains (as required by the FAS), it means that VIOCs fund independent companies at the expense of their upstream operations and processing. These are the economic reasons why VIOCs are motivated to strike collusive exchange transactions aimed at selling oil products at understated prices to their own retail chains, thereby reducing supply in the open market. This has left the development of exchange trading to being promoted mainly by the state authorities. As a result, suppliers are not motivated to sell through the exchange more than 10% of their gasoline volume, which is the minimum required by the regulators. The remaining 90% is sold under the over-thecounter and long-term contracts. Such a proportion of the exchange-traded and the OTC contracts renders exchange gasoline trading effectively a balancing market. As soon as the main fuel volumes are traded under long-term contracts, even a minor decline in production (or growth in demand) can cause a drastic drop in supply in the exchange market and a jump in the exchange prices on these marginal volumes. So the exchange market is extremely sensitive to the volume of supply and vulnerable to any price distortions and manipulations. The situation is aggravated by the fact that major companies are the shareholders of the largest Russian exchange, and SPIMEX rules of the exchange trade contain certain terms that discriminate against independent market participants, increasing their expenses and hindering the development of exchange trade. As we have said before, 30-day time of the exchange goods shipping and an 100 % upfront fee causes buyers' excess expenses of servicing the loans that let them carry out trading transactions. Traders purchase the fuel paying 100 % upfront fees, but sell it to the gas station chains on the deferred payment. After the introduction of economic sanctions in early 2015 the credit interest rate increased to 30 35%. 100% upfront fees and holding the buyer's money in a clearing-house for a month the buyer's transaction expenses are 3-4% of the goods' cost or 1000 rub/ton without the exchange fee. If the goods are resold on the exchange, the expenses double, and therefore prices soar, and either the trader or the consumers have to pay more. For example, if a trader buys a physical volume of fuel on ICE and then resells it at once, the clearing holds its collateral, which is about 10% of the goods' cost, for a day, until the next mark to market. If the same transaction takes place on the Russian exchange, they hold 100% of the goods' cost for a period of 6 weeks, which is crucial, as the interest rate in Russia is ten times higher than in Europe or the USA. What is more, producers are privileged on the Russian exchange and, selling the products, get the buyer's money directly, thus gaining a free loan on the buyer's expense. This is what economically motivates them to deliberately put off the shipping as long as possible, as such low efficiency increases their funds. Besides, hidden price regulation and administrative stabilization of prices motivates major companies which hold control over the significant segment of storage facilities to store commercial stock only for the needs of their own gas station chains. In wintertime, when the demand is comparatively low, producers tend to export excess amounts of fuel, and not to store them, which, for several years, has caused fuel shortages in the summertime, when oil consumption is higher than its production. To avoid annual summer shortages the Ministry of Energy recommends that companies stock sufficient amounts of fuels in advance of the growing seasonal demand, and companies report about meeting the recommendations, but the Ministry has no opportunity to check if, in fact, this stock had been created and is available. Independent companies also find it unprofitable to stockpile fuels in winter. One reason is that the producers can always export the fuels and sell in on more liquid a less volatile European or Asian markets. As a result, even in winter, when the demand for petrol is minimal, the prices in the domestic market are never lower than export netback. The second reason is that the Russian futures fuel market is not developed. Market participants cannot hedge their risks in case of unfavorably 5

6 changing prices and therefore it is much too expensive and risky to stockpile fuels for quite a long time. We see that the strategy aimed at reducing the volumes of fuels sold on the open market and exporting fuels rather than stockpiling them, enables major companies to make profits investing the money they get from export and cut the cost of fuel storage. Reduced offer and growing prices on marginal segment of domestic market, in turn, enables the monopolies to discriminate against independent competitors, selling them fuels for higher prices. So, the main problem of the Russian fuels exchange market is its low liquidity, caused by its monopolistic structure inherited from the USSR economy. And the main objectives of this research is to motivate a model of Russian exchange market development that would create an economic incentive for producers to increase the supply of refined products available on the exchange market and provide sufficient volumes of gasoline for consumers in peak demand periods. Brief Description of the American Energy Market We use the American experience of energy trading as a possible model for the development of a Russian exchange spot market for oil products. So, as well as characterizing US over-the-counter (OTC) trading of oil products, we will briefly describe how the exchange trade of oil products works in the futures market. We will also mention certain features of the exchange trade of crude oil and natural gas, which may be used for the development of the Russian market. To begin, a natural border that splits the US is the Rocky Mountains. The West Coast has a relatively autonomous energy infrastructure, so it is not the focus of this research. Instead, we focus on the region east of the Rocky Mountains, a region that has a welldeveloped energy and transportation infrastructure. Importantly, the oil products market is rather heterogeneous, especially on the retail end, due to different regional environmental standards related to emissions and blending requirements taking into consideration 40 characteristics. More specifically, there is an absence of a uniform standard of motor fuels across the United States. Since 2006 the use of MTBE as a high-octane fuel additive has been banned owing to environmental concerns related to water contamination from subsurface storages. MTBE has been replaced by ethanol whose portion in fuel can vary from one state to another. The fuel quality control is carried out by Environmental Protection Agency (EPA), who controls fuel compliance with technical and ecological standards set by state authorities. Ethanol is typically added to fuel immediately before dispatch to the wholesale customer. There are also other requirements to the blending component produced by a refinery. Two primary blending components that get mixed with ethanol are Reformulated Blendstock for Oxygenate Blending (RBOB) and Conventional Blendstock for Oxygenate Blending (CBOB). RBOB is more expensive and requires a low Reid Vapor Pressure (RVP). The most expensive component is CARBOB used in California, where the ecological standards are even stricter. The diversity of blends for marketed gasoline renders the US gasoline market to be segmented. In other words, if the plant intends to produce a certain type of fuel, its shipping destinations will be limited to those states that permit the use of this type of fuel. Such segmentation presents challenges to arbitrage in the US market, which has presented issues historically during regional refinery outages. However, emergency procedures to temporarily suspend blending requirements have been used to abate market dislocations. With regard to crude oil, West Texas Intermediate (WTI) and Light Louisiana Sweet (LLS) are basic for price formation in the US. LLS is transported to oil refineries on the Gulf Coast. WTI is priced at the Cushing terminal in Oklahoma. Since 2011, WTI has priced at a discount to LLS and other internationally traded light sweet crude oils. This is due primarily to growth in the domestic supply of light crude oils in the US and an inability to transport the oil away from Cushing to the Gulf Coast. The center of the US refining industry for more than one hundred years has been Texas, which is the second largest state after Alaska. About half of the total 6

7 Alexander Gudkov. A Model for the Russian Energy Trading Market: An Assessment of the American Exchange Trading Experience industry oil production and refining infrastructure is concentrated in Texas. There are about 30 oil refineries in Texas, most of them belonging to different companies that ship oil products to the East Coast and Midwest, as well as locally, thereby resulting in a highly competitive domestic market. Oil products are also exported from the Gulf Coast to Europe, Latin America and Africa where the US has been recently outcompeting European refiners. The total exports of oil products from the US have risen to almost 4 million barrels per day (200 million tons per annum). Importantly, exports allow an additional arbitrage mechanism for oil products between the domestic and international market, thus facilitating a very competitive market environment. Despite huge production capacities, well-developed transportation facilities and broad opportunities for domestic and international trade, organized trade floors do not generally practice electronic trading (e-trading) on the spot market. Some companies offer software that allows e-trading on the spot market, but it is not a widely used option. E-trading on the spot market is not well-developed largely because the relevant software appeared after the US market had long since emphasized the development of futures trading, which became the central mechanism for price discovery. Given that prices for oil products are being formed in the futures market, the electronic trading systems in the spot market are not in high demand. The basis for price discovery of a gasoline contract is the NYMEX RBOB gasoline futures contract, with a New York Harbor delivery point. Prices for other locations are negotiated by traders bilaterally by phone or messenger. A lot of transactions in the spot market are concluded at the prices formed by the price agencies on the basis of their analysis of the first month's futures quotations, the NYMEX daily indexes and other information. Antitrust regulation in the US futures market is provided by the Federal Trade Commission (FTC), which is entitled to fine a market participant for anticompetitive behavior. But, the US market is so competitive that FTC doesn't usually interfere in companies' pricing policy. According to the market participants, during the last ten years the FTC only once penalized a company for monopoly high prices; it happened in a district which suffered from Hurricane Katrina in 2009, when all communications had been destroyed and retail prices increased. Later the claim was challenged. In response to our request, FTC representatives said that they don't control the energy market and recommended that we contact the Commodity Futures Exchange Commission (CFTC), which, in turn, controls exclusively the futures market. In fact, wholesale as well as retail fuel prices are not regulated, and they may vary depending on the location of the gas station or other factors. Futures Market Both buyers and sellers of fuels, in fact all market participants, are exposed to the risks of price fluctuations. Trading of futures contracts is a principal risk mitigation tool available to market participants for hedging risk exposure and/or speculating on price movements. As such the futures market can be characterized as a market for risk on an underlying commodity. As such, the volume of futures trading far exceeds actual physical delivery of the underlying commodity. Indeed, the risk market is by far the largest in the world. The CME group which includes the CME, the CBOT, the NYMEX, the COMEX signs 3 billion contracts worth approximately $1 quadrillion annually. Since the futures market is not a market explicitly for the physical commodity but a market of the risk for the commodity, the buyers of derivatives do not pay the full cost of the amount fixed in the contract. Rather, the buyer pays only collateral, which is about 10% of the contract value. On the NYMEX this payment is called a performance bond; on the ICE it is an initial and variation margin. When you buy stocks on margin, you borrow money to make the purchase; however, in the futures markets your performance bond is not the partial payment for the product. The performance bond is the money the buyer/seller posts to ensure that they are able to meet the day-today obligations of holding that position. 7

8 Assume you own an oil refinery and would like to hedge the risk of increasing prices on the crude oil you purchase at a future delivery date. In January you buy one contract (1,000 bbl) on WTI due in March, and the current price of the March contract is $100/bbl. The contract suggests that you are obliged to buy 1,000 bbl of oil in March and pay $100/bbl, and the seller is obliged to sell you the product at this price. This amount of oil costs $100,000, but you can buy (long) a futures contract, posting only a $10,000 performance bond. If the oil price drops by $5/bbl, your performance bond will decrease by $5,000, and your broker will ask you to post more money; this is called a margin call. If the price continues going down and you are not able to cover the margin call, your position will be offset by selling (shorting) futures at the current price, thus fixing your losses. But if the price increases, you will have some funds free to use. By the expiration date you will be able to choose either a cash settlement of the contract or physical delivery. If by the expiration date the oil price is $110/bbl, the seller of the contract buys 1,000 bbls of oil and sells it to you, losing $10,000. If you choose the cash settlement, the seller just transfers you $10,000. But, if by the expiration date the oil price is $90/bbl, then you must transfer $10,000 to the seller. As we see from this example, the price of the futures contract is tied to the spot price as the two must match at the date of expiry. So, the futures market needs a liquid spot market to function for an arbitrage free market clearing to occur. In fact, this market model can exist only in the well-developed market, where not only producers and consumers, but also hedgers and speculators which include individual traders, portfolio managers, trading firms, and hedge funds all participate. Trading of gasoline futures began on the NYMEX in One factor that complicates using gasoline futures as a risk management tool is the aforementioned absence of unified gasoline standards and the regionally segmented US market. The basic gasoline contract on the NYMEX is the RBOB gasoline futures contract with a settlement delivery point at New York Harbor. Delivery is made free-on-board (FOB) at the seller's ex-shore facility in New York Harbor with all duties, entitlements, taxes, fees and other charges imposed prior to, or as a result of, delivery paid by the seller (NYMEX Rulebook, chapter 191,100, 150,105). In addition to futures contracts, there are other derivatives traded on the exchange market, such as options and swaps. An option is a contract that gives the right, but not the obligation, to buy (a call option) or sell (a put option) a commodity (called the underlying) at an agreed price (known as the strike or exercise price) by or on a certain date (known as the maturity or expiration date). So, the seller is obliged to sell the underlying asset if the option is exercised. The buyer of the contract pays the premium (bonus) to the seller for the right to buy (or sell) the product for the fixed price. There are several kinds of options. European options can be traded in the exchange as a contract whose price is dependent on the market situation, but it can be exercised at maturity only. By contrast, American options can be exercised at any time during their life prior to the date of contract expiry. A swap is a type of contract which allows the counteragents to swap cash flows at some future date according to a prearranged formula. As a rule, one price is fixed, while the other one is floating. The floating price is unknown at the moment of transaction. For example, a trading company sells natural gas for delivery in the next month to a consumer and receives a fixed price. At the same time the trading company buys this volume of natural gas, paying the floating price, which is designated to be the settlement price (where the settlement price is unknown at the time) of next month s futures contract. So, the company pays a floating price and receives a fixed price. To hedge its risks, the company can buy a swap contract. The US Commodity Futures Trading Commission (CFTC) has regulatory jurisdiction over the American futures market. Its key objective is to prevent market manipulation that could distort prices. CFTC activities include analysis of index-related futures positions for 25 commodities. Other regulatory agencies, such as the Securities and Exchange Commission (SEC), also exercise some jurisdiction, in particular over the effects of futures trading in spot markets, but the CFTC carries primary responsibility for futures and options trading. 8

9 Alexander Gudkov. A Model for the Russian Energy Trading Market: An Assessment of the American Exchange Trading Experience Natural Gas Market In order to better analyze the American experience of well-developed trade we turn our attention to the natural gas market, which has a lot in common with the Russian oil products market. The US natural gas market is characterized by both over-the-counter trading and an exchange trading for derivatives and physical commodities. The primary location for price discovery for physical and contract trading in the US natural gas market is Henry Hub in Erath, Louisiana. There is also active trading at multiple other locations in the continental US that facilitates price discovery at those location, but these prices are typically often quoted in terms of basis to Henry Hub with derivative instruments offered around basis movements. Henry Hub is a transportation terminal and a storage facility, consolidating multiple pipelines which belong to different companies, thus connecting producers and consumers of natural gas. If one of the local pipelines has a surplus, the excess gas is to be pumped to the other pipeline through Henry Hub. So, the physical arbitrage between facilities at Henry Hub links consumers and producers, providing a robust location for benchmark formation. Contracts traded on the NYMEX are settled at the Henry Hub delivery and pricing point upon expiry. The trading of the NYMEX contract for delivery in the next month stops three business days prior to the beginning of the calendar month of delivery. The settlement of the futures price is the average of the market-on-close prices for the three last trading days. According to traders, the ICE commission is $ /MMBtu. If a market participant can find a counterparty off the exchange, they generally prefer a bilateral OTC transaction. The broker's commission for these types of transactions is negotiated, but the average level is $ /MMBtu. This commission is higher than the exchange commission, but a broker can usually offer a more favorable price. For instance, if the exchange market is highly volatile or the bidoffer spread is very wide, a broker can offer the price which is closer to bid. Figure 1: Diagram of the Henry Hub Source: U.S. Department of Energy. The delivery price for natural gas traded via futures in the USA is determined during the last 5 days prior to the delivery month. This period is known as the bid week and it is the time when the settlement prices of futures contracts for next month's delivery are determined. In the case of exchange trading, the exchange doesn't guarantee settlement and delivery procedures. At the moment of transaction both sides become known to each other. Then they get in touch and negotiate the details of settlement and delivery without exchange intervention. The counterparty could be one of two types: white are the companies who have high credit ratings (triple A), for instance BP or Shell, red are small companies who haven't got credit rating. If both counterparties are white, they use standard settlement and delivery procedures, which means that the buyer pays for received gas during the 55 days from the first day of gas flow starting (or 25 days after the end of delivery month). If the buyer is red, the white seller can ask him to prepay. In this case conditions are negotiated by credit managers on both sides of the transaction. The average prices of bid week transactions are collected by the price agencies such as Platts and Argus and published on the first day of the delivery month for Henry Hub as well as for other locations. 9

10 These prices are called Indices or monthly indices and they are used as settlement benchmarks for futures contracts. The price discovery process on delivery points different from Henry Hub is based on activity off the NYMEX, and the prices are formed as the NYMEX Henry Hub futures price plus a differential that reflects transportation costs and expected regional supplydemand balances. The differential is called the Basis or Locational Basis and it can be positive or negative. Historically, end-of-pipe markets see prices that are above Henry Hub, such as in the New England area, but recent growth in shale gas production, has altered the regional pricing dynamic considerably. In turn, the new market reality has incentivized investments in pipeline capacity to capture the arbitrage opportunities presented by shifting supply-demand dynamics, a fact that is facilitated by transparent regional pricing. Locational bases for most locations are traded as standalone contracts on the ICE for the difference between the locational index and the NYMEX L3D price (a basis swap). These contracts are part of index swap contracts that are used for hedging risks as well as futures contracts (Futures Swap + Basis Swap = Index Swap). For instance, let's assume that a trading company acting as a broker finds a customer who is ready to pay L3D plus $0.02/MMBtu for 10,000 MMBtu to be delivered next month at Henry Hub. But, the trading company also knows of a supplier that is ready to receive only the fixed price. What fixed price does the trading company offer? The trading company sees that the current price for next month s futures is $2/MMBtu, so it offers the supplier $2.01/MMBtu. Now, the trading company pays a fixed price ($2.01/MMBtu) and receives a floating price (unknown L3D plus $0.02/MMBtu). To hedge its risk, the trading company can sell futures (10,000MMBtu) at a fixed $2/MMBtu, which is the prevailing price on the exchange, and buys the physical commodity on the expiration day at L3D (that is making a swap between fixed and floating prices). As a result the trading company earns $0.01/MMBtu, thus securing a $100 profit without any risk. Figure 2 illustrates this transaction. Figure 2 This example is accurate if the delivery point of the physical gas matches the settlement location on the futures market Henry Hub. If the physical volume is sold at other hubs, the hedge will be more complicated. Let's assume that a trading company finds a consumer who is looking for 10,000 MMBtu for delivery next month at the Permian hub and is ready to pay the Permian Index at settlement. As above, the trading company finds a supplier that wants to receive a fixed price. So, the trading company receives a floating price (Permian Index) and pays a fixed price to the supplier. Note that the Permian Index price can be presented as the Henry Hub futures settlement price (L3D) plus a differential (basis). Each of these derivatives is traded in the exchange market (on the NYMEX). Thus, to hedge its risk and find a profitable fixed price to the supplier, the trading company must take positions in two derivative contracts: a futures swap (futures) and a basis swap (a contract for the difference between L3D and locational index, which we assume in this case is equal to $0.40/MMBtu). So, the trading company is swapping an unknown floating price (Permian Index) for a known fixed price which is $2.00 $0.40 = $1.60/MMBtu. If the trading company pays the supplier a fixed price of $1.55/MMBtu, it will reap a profit of $0.05/MMBtu or $500 (see Figure 3). 10

11 Alexander Gudkov. A Model for the Russian Energy Trading Market: An Assessment of the American Exchange Trading Experience Figure 3 If the trading company is focused on physical trading and is not interested in transacting in the derivatives market, it can ask a swap trader for an Index Swap. In the example in Figure 4, the profit of the swap trader is $0.02/MMBtu or $200. Figure 4 The above examples addressed a transaction for delivery in the next month. It is also possible to secure supplies in a day ahead market, for next day delivery, which works similarly. A trading company can buy or sell physical volumes of natural gas under the condition of next day delivery via a bilateral OTC contract or an exchange contract on the electronic platform ICE. Price agencies publish daily spot prices for many hubs, and the pricing of next day delivery contracts is linked therein. Moreover, the manner in which price formation occurs is linked to the long term pipeline transportation contracts and the secondary capacity release market. Pipeline deliveries in the US natural gas market are based on three primary types of transportation contracts with different conditions of transportation by pipeline companies. 1 Firm contracts have priority and are not interruptible. These contracts are typically entered into by producers and/or consumers that desire long term capacity commitments on a particular pipeline route. This contract contains strict takeor-pay conditions and provides other fees for gas flow overdraft and other imbalances. Importantly, firm capacity holders can "release" their capacity for sale into the secondary market on a periodic basis. This allows other consumers to obtain more capacity if needed. It also allows the firm capacity holder to recoup some of the cost associated with holding the long term capacity position when the capacity is not needed on a short term basis. Indeed, during high demand periods, firm capacity holders pay a rate that is usually well below the price of the capacity as determined in the secondary market, which can convey significant rents to the firm capacity holder. It is for this reason that firm capacity commitments are often likened to insurance contracts because they allow the holder to avoid the costs associated with peak flow periods. Base load interruptible contracts allow the pipeline operator to disrupt delivery to the contract holder it if it is deemed necessary for maintaining pipeline pressure or balancing volumes in the system. This type of contract is often used for selling gas during the bid week for next month delivery where delivery is not tied to a specific date but can be done over a period of time. Swing contracts accommodate next day delivery or delivery over a particular set of dates. This type of contract is used for the balancing market. For example, firm contract deliveries can be augmented through the use of swing contracts, particularly during periods in which demand increases due to cold weather. The combination of spot and futures markets creates a very flexible market model, which allows participants to use different trading strategies. For instance, using 1 Fletcher J. Sturm. Trading Natural Gas. 11

12 futures for hedging, a trader can buy for a low fixed price and sell at a high fixed price and make a profit. In some cases a buyer can use futures contracts to pay the supplier for physical gas. This scheme, called exchange of futures for physical (EFP), allows a buyer pay to the seller the L3D price (including any negotiated differential) and transfer futures contracts from his account to the seller, thus effectively paying for delivery with the in-kind value of the futures contracts. The deep liquidity in the financial market for commodity sales allows such a transfer to occur seamlessly. Simultaneous trading of long-term and short-term contracts and the integration of futures and spot markets, as is characteristic of the US natural gas market, could be used to diminish the balancing market effect of the Russian exchange oil products market. Crude Oil Market The development of the crude oil exchange market was provoked by regulators. In the 1980s the British government controlled the transfer prices of crude oil from the upstream to the downstream, and obliged British companies to use the prices of the British National Oil Corporation (BNOC). But, if oil had been purchased in the open market, companies were allowed to use market prices in determining tax payments, and those prices were typically lower than those of BNOC. The desire of oil companies to lower their tax liability increased interest in the development of the open market for crude oil. The key oil benchmark, which is used as the index for pricing in about 70% of the world oil trade, is Brent. Brent crude oil is produced in the North Sea and shipped through the port Sullom Voe in the Shetland Islands operated by Shell. The Brent market consists of several parts, which are called the Brent complex and include the OTC Forward Brent market (25-day BFOE market), the Dated Brent market (market for cargoes of Brent, Oseberg, Forties, Ekofisk), the futures market (ICE and NYMEX Brent futures contracts), and various types of OTC Brent-related derivative contracts. The forward Brent market (25-day BFOE), the Dated Brent market and the contract-for-difference (CFD), which is a bridge between the forward and spot markets for Brent, are crucial for price discovery. The volume of the 25-day BFOE contract is 600,000 bbl. It is traded in the OTC market bilaterally or using the market-on-close window of Platts. The 25-day BFOE supposes that the buyer is obliged to provide a tanker for shipping at a certain time where only the month of shipment is known. The producer informs the terminal operator about the planned monthly volume then the operator schedules the shipment and sends the schedule to the seller. The seller is then obliged to nominate a cargo of physical Brent to a buyer with a three day loading date with a minimum 25 day notice. In 2002, the minimal period of the buyer's notice was 15 days, which was known as 15-day Brent ; now it is known as the 25-day BFOE, or cash Brent, market. According to standard delivery and settlement procedures (Shell General Conditions), 2 the buyer is obliged to find and rent a tanker within these 25 days. Before the nomination, a forward contract is called a dry, or paper, contract. After nomination it is called a wet contract. The 25-day BFOE (cash Brent) becomes the spot market for dated Brent. Platts publishes the assessments of cash BFOE for the next three months on a daily basis. 3 If the buyer does not need the physical oil, he will try to unload the contract before the dead line, which is 4pm of the nomination day. If the buyer cannot resell the contract, the nomination is to be accepted by the buyer, and it is his obligation now to rent a tanker. Starting at the moment of nomination, the cargo becomes tradable as dated Brent and is supposed to be sold with a specific date of loading in the spot market. The cargo must be paid for in full 30 days after the bill of landing date. If the counterparties agree, the contract may be settled as a paper contract. Dry book-out means that the transactions are netted and the difference in pricing 2 Agreement for the sale of Brent Blend Crude Oil on 25 Day Terms Part 2 General Conditions Shell U.K. Limited July downloads/trading-shipping/suko90-fob-brent15day1990gtcs.pdf. 3 MethodologySpecs/Crude-oil-methodology.pdf. 12

13 Alexander Gudkov. A Model for the Russian Energy Trading Market: An Assessment of the American Exchange Trading Experience is settled in cash. The Platts published price of dated Brent represents the prices on the physical volumes of oil that will be shipped within 10 to 25 days of the day when the price is published (known as the pricing window). There are also a range of derivatives that are based on the difference between the prices of the aforementioned contracts. The most well-known is the contract for difference (CFD). CFD is used to hedge the risk of a change in the Dated Brent price and is based on the difference between Dated Brent and the second month forward Brent (Dated Brent Forward Brent = CFD). In addition to the 25-day BFOE market and spot market of Dated Brent there is also a market for futures Brent contracts that was launched in 1988 on the ICE. This is a deliverable contract based on EFP (Exchange of Futures for Physical) delivery with an option for a cash settlement. 4 The contract quantity is 1,000 barrels and trading stops 15 days prior to the first day of the calendar month of delivery. The settlement price is the weighted average price of the last two-minute trading period. If the owner of the contract prefers a cash settlement, then the deal is settled in cash against the ICE Brent Index. The index is based on the average price of trading in the 25-day BFOE market. 5 Another important benchmark for the world crude oil market is West Texas Intermediate (WTI). Futures contracts for WTI are traded on the NYMEX, and the contract nominates physical delivery at Cushing, Oklahoma. Similar to Henry Hub, Cushing is not a production center. Rather, Cushing is a large-scale storage facility situated on a transportation terminal connecting producers and consumers via a pipeline. The NYMEX contract for WTI is 1,000 barrels. WTI futures contract trading stops 3 business days prior to the 25th day of the month before the month of delivery. Delivery is FOB at any pipeline or storage facility in Cushing. The settlement price is the volume-weighted average price in the final 30 minute pricing window on the expiration day. 4 Explained.pdf. 5 Europe_Brent_Index.pdf. Problem Solution for the Russian Market As we have already mentioned, the main problem with the Russian exchange market is that major companies are not economically motivated to participate in it, which is caused by strict antitrust regulations. Underdevelopment and low liquidity of the exchange market turns it into a highly volatile balancing market of marginal volumes of fuel and makes it vulnerable to price distortions and manipulations. As a result, the monopolists' strategy, aimed at reducing offers on the open market by increasing exports and limiting stocked amounts of fuels to the demands of their own retail chains, leads to the increase of wholesale exchange prices, which discriminates against independent traders who are forced to purchase fuels at much higher prices than the monopolists' retail chains. As the aforementioned problems are caused by the monopolistic structure of the Russian fuels market, their solution lies in the sphere of restricting the power of major companies by increasing the share of open competitive markets and creating opportunities for price arbitration with foreign markets. As the open fuels market in Russia is concentrated on the exchange, our task is to find a model for the development of the exchange market that would offer market methods to increase the share of exchange trade. There are two ways to increase exchange trade: Increase the physical volumes of the products sold on the exchange; Increase the number of resales of the products that are already offered on the exchange. We can increase the physical volume of oil products sold at the exchange if we attract those products that are now sold through OTC long-term contracts. So we have to create a new exchange contract with conditions more attractive for producers than those they have got now on OTCs. The long-term contract, which VIOCs offer to their counterparts, gives its owner the right to regularly buy certain volumes of oil products for a formula price, based on the quotations of price agencies. The nearest exchange analogue of such a contract is the call-option, 13

14 which gives to the buyer the right but not the obligation to purchase a certain amount of products for a fixed price. The buyer of the contract pays a premium to the seller for this privilege. The problem here is that the strike-price is fixed, but the long-term contract price is floating. If there were a well-developed futures market in Russia, trading companies would be able to use fixed price options and hedge the risks of changing prices, buying futures contracts. However, in Russia the development of the oil products futures market is hindered by the reluctance of the producers to join the futures market, as it would not decrease but only increase their risks. If a producer sells fuel on futures, and then an emergency, e.g. fire, occurs at the plant, the producer, in order to perform the contract, will have to purchase the fuel for the prices that have increased due to the decreased offer. To solve the problem of the long-term contract introduction on the exchange, the participants in the Russian exchange market can be offered a new type of contract, combining option and futures features and being an option with a floating price, which will be calculated in the same way as the formula price of the longterm contract. For the right to purchase the fuel for this price, the buyer of the contract will pay the premium to the seller, and the rate of this premium will be auctioned on the exchange. In this case, the realization of the fuel using the new exchange contract will be more profitable for the producer than the long-term contract on the rate of the premium (the price of the option). What is more, the producer will get the premium (or the price of the option) even if the contractee doesn't use his right to purchase the products. We think that the launch of the exchange trade with such a contract will economically motivate the producers to bring extra physical volumes of fuels to the exchange from the OTC market. The next way to increase the share of exchange trade is to raise the number of resales of the products already present on the exchange. As we have mentioned, today the opportunities for resale on the Russian exchange are blocked by prohibitive transaction costs because there is no netting (clearing) of exchange deals, the shipping period is too long, and the upfront fee is 100%. While the loan interest rate soared up to 35% per year in early 2015, holding 100% of the cost of the product in clearing for the period of 6 weeks endangered the very existence of many enterprises. There are several ways of reducing transactional expenses. For example, we can cancel the privileges of producers, which allow them to get the buyer's money on their account immediately after the transaction. If the producers get the buyer's money only when the products are shipped, as all other exchange trade participants, it will encourage them to ship the products as soon as possible, while now they try to put it off, because, in fact, they use an interest-free loan during the period of time from the moment of transaction till the shipping. The other way to minimize transactional expenses is to change the shipping time from 30 to at least 14 days, so that producers would use the buyer's money for a shorter period. It is also possible to put off the 100% upfront fee closer to the date of shipping, or even offer a bank guarantee on the exchange deal performance instead of the 100% upfront fee, as the guarantee costs less than the interest rate of the loan. Nevertheless, the most efficient way to solve this problem would be the introduction of the classical netting (clearing) model of exchange deals on the Russian exchange. Netting of the exchange deals is used worldwide to save financial resources. 6 A particular Russian feature is that according to Russian tax regulations only securities are not liable for a value-added tax (VAT). Therefore, deals on the exchange spot market should be netted step by step, with VAT paid at every transaction. To avoid this, we could use the forward market Brent model: at the first stage, the contract should be traded on collateral and netted as a futures without paying VAT, and at the moment of nomination (when the Producer appoints the date of shipping), the contract turns into a spot one. At this stage, the contract owner is obliged to pay the 100% upfront fee. If this model is introduced successfully, one more problem of the Russian exchange market could be solved. Russian spot exchange trade is now, in fact, a market 6 Peter Norman. The Risk Controllers. 14

15 Alexander Gudkov. A Model for the Russian Energy Trading Market: An Assessment of the American Exchange Trading Experience of deliverable futures, with physical volumes of products being shipped next month. Such a quasi-futures market exists while the spot market doesn't. As a result, the consumers are exposed to the risk of not receiving the products in time, because the traders cannot purchase fuels with immediate (on-the-spot) delivery, if the exchange contract is not performed. The introduction of the Brent market model on the Russian exchange, though, will create the OTC spot market, as the participants will be able to resell fuels during the whole period of its flow from the producer to the end consumer. Before the nomination the fuel will be traded on the exchange with a futures contract, and after the nomination on OTC as a dated good, like a dated Brent. But to eliminate all obstacles in the way of spot market development, we have to dissociate delivery services from the exchange contract, cancel the restrictions on the redirecting of the shipped goods, and let the buyer deal directly with the forwarding agent. At present, according to SPIMEX exchange trade rules, the seller executes the delivery at the buyer's expense, and the buyer cannot choose the forwarding agent. If we implement our model, some other, more technical problems of market participants will be solved or significantly simplified. Consider, for example, the procedure of penalty calculation and payment for abnormal idle time of tank-cars at the railway station (destination) of the buyer. Now, if the end consumer fails to unload the tankcars in due time, the buyer of the goods is obliged to pay the penalty. The forwarding agent calculates the penalty and sends the invoice to the producer, who then sends it to the buyer, and the latter, in his turn, sends it to the end consumer. This long chain of complaints often ends up in court, as only the forwarding agent and the end consumer have contracts with the railway companies, as well as access to the databases and the opportunity to check if the complaint is accurate. If the buyer of the exchange goods has the direct contract with the forwarding agent, then the latter will send the penalty invoice directly to the buyer, providing all necessary papers for redirecting the penalty to the end consumer. We also should be aware of the fact that the main obstacle to introducing this model the of exchange market will be the resistance of major oil companies and the clearing-house, which are going to lose a significant part of their revenues, which are based now on the highly overrated transactional expenses on the exchange. And last but not least, one more way to limit the market power of the monopolies, decrease the volatility of the exchange market, caused by the balancing effect, and minimize the risk of gasoline shortages in summertime, should be the enhancing of the arbitration by joining the outer (foreign) markets. Being aware of the fact that commercial storage of gasoline for covering summer shortages is not economically efficient, the FAS was considering the opportunity of giving the major oil companies the privilege of importing gasoline in the summer on preferential terms. The Russian fuels market is protected by export taxes, so the prices in Russia are lower than those on world markets by the taxes and transportation expenses. The FAS also offered to subsidize the importers indirectly, giving them the right to export a limited amount of other oil products tax-free, thus trying to make imported fuels able to meet competition with cheaper fuels produced in Russia. We see that this suggestion is unsustainable, as it supposes the conflict of interests. Major companies will have to import fuel, which will enter the competition with the fuel they produce themselves. To eliminate the negative features of the monopolistic structure of the market and provide real competition and artbitrage on the domestic market, the right to import the fuel on preferential terms should be given not only to the major companies, but to all market participants. To ensure price arbitrage and prevent shortages and rising prices in the domestic market in summertime, we have to work out a direct financial facility, which would subsidize the importers, refunding the export tax, and this facility should be controlled by the regulators. Such measure will be neutral for the state budget, as it will suppose that the importers in the summer will get the funds which had been paid by the exporters in the wintertime. If the regulators choose to subsidize the importers not in the amount of export tax, they will be able to have an effect on the prices establishing the import netback, which is closer to the market method of price regulation, than antitrust laws and fines. 15

16 Alexander Gudkov. A Model for the Russian Energy Trading Market: An Assessment of the American Exchange Trading Experience Conclusion A key problem of the Russian fuels markets is high economic concentration which was inherited from the planned economy of the USSR. This monopolistic market structure in turn leads to the need for strong antitrust regulation to prevent producers from exercising monopoly power and dictating high prices. Strong antitrust regulation, in turn, has led to price regulation and artificial price stabilization. This, in turn, reduces producers' economic motivation to stockpile inventories and sell refinery products in the open exchange market to independent market participants. Inadequate rules of the exchange trade, in turn, let the producers discriminate against independent buyers of the exchange goods. This market distortion contributes heavily to the annual gasoline shortage in summer periods of high consumption. In addition, a small share of the open exchange market converts it into a balancing market, where prices are extremely volatile and sensitive to the changes in demand or supply. In order to mitigate the negative effects of the monopolized market, we need to increase the share of the open exchange market. There are two ways to accomplish this. First, we can boost the share of the exchange trading by increasing resales of the physical volumes of oil products that are already present on the exchange market. Second, it's possible to increase the physical volume of oil products sold at the exchange, if we attract those products, which are now sold through OTC long-term contracts. To solve the problem we have to design a new type of exchange contract, based on the OTC long-term contract split by months. As the settlement price of the long-term contract is the floating price based on the indices of price agencies, the new contract should be a call option contract with the floating strike price. In other words, it should be a call option contract which the fixed strike price hedged by futures contract. However, as we don't have a developed futures market in Russia, additional flexibility should be granted, and the new type of contract should be a hybrid contract of call options and futures or call options with a floating strike price. The holder of the contract will have the right to buy a certain volume of fuels at the price of a long-term contract. In this case, producers will receive a guaranteed formula-based price similar to a long-term contract, but they will receive an additional premium as well. The buyers of the contract will be ready to pay the premium for the guarantee that they will be able to purchase fuel even in when there is a shortage in the market. To increase the number of resales we have to lower transactional expenses. So we suggest using the forward Brent market model, where the goods are first traded as a derivative and only at the moment of nomination some features of spot contracts are assumed. This model, applied in the Russian exchange market, will at the first stage allow the netting of exchange contracts as futures, traded on collateral without VAT, and after nomination the contract will be turned in a spot contract on selling the fuel with a 100% upfront fee. Such a measure will significantly cut down the expenses of the buyers of the exchange goods, caused by high interest rates on commercial loans and the 100% upfront fee, demanded by the exchange. If the transactional expenses are decreased, it will improve the situation with retail prices and help to provide consumers with fuel regularly, avoiding seasonal shortages. Acknowledgements The list of individuals and institution who helped me research this book is long. But there are two without whom this research couldn t have been written. I m especially grateful to Vincent Kaminski, Professor in the Practice of Energy Management at Jones Graduate School of Business at Rice University, who kindly invited me to attend his brilliant MBA level classes on energy markets, energy risk management and valuation of energy as well as encouraged me to find a solution for Russian Exchange trading problems through new type of exchange contract. Special thanks to Euan Craik, CEO Americas at Argus Media Inc. who shared his unique knowledge and kindly corrected some inaccuracies in my description of US OTC refinery products markets. The Yegor Gaidar Fellowship Program in Economics is a program of the U.S. Russia Foundation for Economic Advancement and the Rule of Law (USRF) and IREX. The Gaidar Program supports the long-term development of Russia s market economy by providing opportunities for leading Russian economists and legal experts working in the economic sphere to conduct collaborative research with U.S. economic experts. It is named in honor of Yegor Gaidar, the first Minister of Finance of the Russian Federation.