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The oil and gas trading business significantly changed during the adoption of the internet, and it has the potential to change again in the next few years due to a new technology that is experiencing rapid adoption. Blockchain technology, sometimes referred to as a decentralized-ledger technology, is the backbone for cryptocurrencies such as Bitcoin, and it has the potential to significantly disrupt the oil and gas trading business. It holds the promise to eliminate the need for intermediaries. Eliminate both accidental and malicious discrepancies. Eliminate or significantly reduce fraud. Provide immediately audited settlement, and significantly reduce the complexity and costs of routine transactions. Agricultural and precious metal traders have already adopted new platforms. It’s only a matter of time before blockchain is widely adopted by oil and gas trading.
At a basic level, blockchain is a peer-to-peer network of computers called “nodes” that come together with cryptography to create a decentralized, distributed, digital transaction ledger. Through a series of steps, the transaction records on the nodes become blocks that are added to a chain. The chain has established protocols that cannot be circumvented or altered.
The transaction record includes sender and receiver pseudonyms, date and time, asset type and the quantity of the asset. This means that no one entity has control over the transactions of the chain catalogues.
Access is also widespread which means that coordination of a fraudulent alteration in the chain would be impossible to achieve without detection. The transparency between parties and immutability of records provide trust that would otherwise be required by intermediaries. Therefore, intermediaries such as banks and exchanges are no longer needed to transact.
It is also done with fewer human steps that slow the process, increase costs and increase the likelihood of clerical error. Some tasks that currently take days, weeks or months to complete can happen in minutes using blockchain.
The core of the technology is the trust it creates through a combination of the distributed, immutable ledger and cryptology. Transactions that have a low amount of trust are inefficient, take more time and generally require intermediaries. They are also more costly as there is a concern over performance.
When transactions are executed and settled on a distributed ledger, counterparties don’t need to have an established relationship to create trust. Each participant trusts the blockchain itself. They don’t need to directly trust each other, thus opening new avenues for transactions directly at the buyer-seller level.
For oil and gas trading, this introduces a number of benefits, including process efficiencies, cost savings, transaction transparency, independent data verification, increased transaction security, reduced risk of fraud and the ability to monitor the operations process in real time. The cost benefits can be significant and have a realizable return on investment. Early tests in oil trading are noting transaction-cost savings of between 25% and 30%. This comes from the removal of intermediaries in front-office activities and efficiencies in middle- and back-office activities.
While immediate projects are focusing on middle- and back-office activities, front-office trading activities will likely have the largest disruption over the longer term. Intermediaries, such as exchanges and banks, are considered the norm in oil and gas trading. One of the primary benefits of utilizing an exchange is to increase trust in the transaction among the counterparties through the margining process, where the exchange provides guarantees of an ultimate settlement of the hedge.
Decentralized ledgers can provide the same benefit through a proof of collateral tied to the transaction. Trading financial hedges through banks is the standard at many E&P companies as the hedging is typically tied to reserve-based lending programs where the reserves act as the collateral. In the near future, buyers and sellers can access public or private blockchains to transact without an exchange or bank as an intermediary.
Transaction-cost reductions are also coming from middle- and back-office efficiencies. During the past 20 years, technology and the internet have radically transformed how businesses interface with their clients and other businesses.
Yet, despite these advancements, middle- and back-office functions have generally remained antiquated and slow, requiring significant human intervention. In most trading life cycles, much of the activities are essentially middle- and back-office functions that consolidate and organize. Within the next few years, blockchain technology has the potential through disintermediation to fundamentally change these functions and, generally, the way business is done. Industry leaders in agriculture, metals, energy and finance have already started to harness blockchain technology as an efficient strategy to settle transactions.
The use of distributed ledgers recording all aspects of the transaction has the potential to provide regulatory benefits as well. Regulatory- and compliance-reporting costs can be significant and burdensome. The information stored on the ledger increases the traceability and provenance of the products. If the ledger records all aspects of the transaction, regulators could potentially access the information to meet their regulatory-reporting needs—for both physical and financial transactions.
This new model for trading will disrupt the current structure for oil and gas hedging. Many of the initial blockchain commodity-trading projects are being led by large institutional players, such as ABN Amro, BP Plc, Gunvor, ING, Louis Dreyfus, Mercuria, Shell and Société Générale.
These companies are forming various consortia to develop platforms that will be the basis in the development of an industry standard. This standard is critical for the new platform to work and have widespread adoption.
As this is happening, smaller organizations will have an opportunity previously not available to effectively compete against larger organizations. The introduction of new technology that disrupts an industry generally provides significant opportunities to early-adopter and new-market entrants. Marriott didn’t create Airbnb, Microsoft didn’t create Google and Walmart didn’t create Amazon. The blockchain trailblazers for the oil and gas trading industry will likely come from niche firms that are getting started or have yet to be created. Smaller players should start considering the implications now to stay competitive.
Blockchain technology will likely be a game changer for oil and gas trading activities. These changes will initially take root behind the scenes and happen very quickly.
Many experts note that the adoption of blockchain technology is where the internet was in the mid-1990s; however, the adoption rate is happening exponentially faster due to the numerous benefits it can provide. All participants in oil and gas trading, including producers, consumers, traders, exchanges and banks should pay close attention to how the new technology is being considered or risk being left behind.
Shane Randolph is a managing director at Opportune LLP, and oversees risk management, derivatives, stock-based compensation and complex securities service offerings.
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