The Middle Eastern oil producer is anticipated to change its crude pricing formula for Asian buyers from October, Simon Watkins reports
Saudi Arabia is preparing to alter the formula it uses to price its long-term crude oil sales to Asia from October, trading sources in Asia have told NewsBase Intelligence (NBI). The change would be the first since the mid-1980s.
Rather than using the equally weighted average prices for Dubai and Oman as assessed by pricing agency S&P Global Platts, Saudi Aramco will replace Platts Oman in the formula with the marker price of the Oman Crude Futures Contract traded on the Dubai Mercantile Exchange (DME). This switch will form the basis for all of Saudi Aramco’s official selling prices (OSPs) for crude to Asia and, according to vice president of marketing, sales and supply planning Ahmed Subaey, will provide Aramco’s customers with better visibility into its price dynamics. This is because it will be more market-reflective, well-regulated and predictable than the previous pricing marker.
It also reflects both China’s efforts to take greater control over crude oil pricing – especially with the advent of the recently launched Shanghai International Exchange (INE) crude futures contract – as well as the growing threat to Saudi by other competitors in the Asian oil market, particularly Russia.
“It is a very positive change, both from the perspective of trading volumes and hedging possibilities,” the UK-based Surrey University Energy Economics Centre’s Adi Imsirovic told NBI. In terms of volumes, he said, the Oman component of the pricing formula as utilised by Platts is hardly ever traded in the agency’s ‘market-on-close’ (MOC) window assessment pricing system.
MOC involves bids and offers from oil companies, trading houses, banks and end-users coming up on the screen of the assigned Platts editor in the 30-45 minutes before the market closes. Once the MOC window closes, the editor uses the information from the window – and their judgment – to assess what the price of a particular oil product is.
“Given that the Oman component is virtually never traded, setting its price becomes more of an art than a science,” he said. Worse still, a source with close knowledge of the Platts’ pricing assessment system told NBI: “The entire MOC system, especially when it relates to lightly traded products, is prone to manipulation, as towards the end of the window – the last five minutes when the prices given for bids and offers form the basis of the key assessments – the same players crowd in and look to have the final word on pricing, which has a huge effect on the final pricing.”
Traders have repeatedly complained over the years that the Platts’ method of price assessment is vulnerable to manipulation by a very select group of major players. In 2013, the European Commission began one of the biggest multi-jurisdictional investigations into benchmark pricing abuse since banks were caught manipulating Libor lending rates six years ago, and this included Platts’ MOC window assessment pricing system.
A better benchmark?
Conversely, the DME has an Oman futures contract that is now based in very large part on real physical delivery in any given month.
“While the contract has been struggling for about a decade, plagued by lack of trading outside the settlement window, the volumes in it tend to be large, often well over 3 million barrels in a five-minute window,” Imsirovic told NBI. “This makes it a poor futures contract, but an excellent benchmark for Middle East oil.”
Oxford Institute for Energy Studies (OIES) director Bassam Fattouh highlighted that in 2017 the monthly physical delivery volumes had exceeded 29 million barrels. “By any standard, these are very large volumes to be delivered through futures contracts and reflect the fact that DME Oman has become primarily a mechanism for the delivery of Omani crude,” he told NBI.
A key downside for the contract that resulted from this was its lack of appeal as a risk management/speculative tool, especially for those players who are not interested in physical delivery in the first place. “The lack of activity in the second month has made it hard for non-physical players to roll their positions from month one to month two in the run-up to expiry,” he said.
There were also concerns that the high concentration of crude production in the hands of Petroleum Development Oman (PDO) might give equity producers an unfair advantage. “In addition, given that Oman is the only crude that can be delivered against the contract, if the Oman grade can’t be delivered for whatever reason, some serious mispricing issues could be created,” he added.
Opting for Oman
But the mere fact that Saudi Arabia, OPEC’s key player, will include the DME Oman Crude Futures Contract in its OSPs for Asia is likely to encourage other key exporters such as Iraq and Kuwait to make a similar move.
In fact, as exclusively reported by NBI last year, Iraq’s State Oil Marketing Organization (SOMO) proposed pricing its Basra crude sales to Asia on the DME Oman Futures Contract basis, starting with January 2018 loading cargoes, before the plan was delayed owing to ongoing trouble in the north and also the approach of nationwide elections in May.
While big Asian refineries have shown little enthusiasm so far for using the DME Oman Futures Contract for risk management – hedging has almost entirely been done only on a Dubai basis, with players accepting the Dubai-Oman basis risk – greater liquidity coming from the Saudi shift means that this may well change.
“We could also see the development of new financial products, particularly those that link Oman to Brent and Oman to WTI [West Texas Intermediate],” said Fattouh. “As in the case of the Dubai pricing complex, this is especially important in the early periods, where liquidity is expected to remain low and traders would want to manage their price risk exposure through the more liquid Brent complex.”
Indeed, as is the case with WTI, a cash-settled system might eventually develop around the Oman benchmark, with agency pricing assessments for other Middle Eastern grades being made in relation to Oman.
The timing of the announcement by Riyadh is also unlikely to be less a product of pure chance than of a reaction to the launch of China’s INE at the end of March, which offers seven grades of Middle Eastern and domestic crude – including those from Dubai, Abu Dhabi, Oman, Qatar, Yemen, Iraq and China’s own Shengli – for delivery to various locations inside the Asian country.
The Chinese yuan-denominated contracts, which include a freight component and a currency factor, have enjoyed trading volumes averaging around 80,000 lots per day, with the open interest around 16,000 lots. Daily front-month volumes for the DME contracts, meanwhile, are usually between 3,000 and 5,000 lots.
“This development, on top of the understandably major role that Chinese firms have played in the price assessments of the Middle East benchmarks in recent years, has pointed to a shift in the centre of crude pricing from the Gulf to Asia, a move that key oil exporters are keen to resist,” said Fattouh.
This view has been further underpinned by the more aggressive stance by Chinese companies when it comes to price discovery. For example, Unipec – the trading arm of Chinese refining giant Sinopec – has cut contractual terms volumes from Saudi Arabia for the past few months, after Aramco lifted the OSP of Arab Light crude grade to Asian customers in May. Following this, Saudi responded by twice reducing the pricing for its flagship grade. It initially cut the price for August delivery by US$0.20 to a premium of US$1.90 above the Dubai/Oman benchmark – the first cut in Arab Light pricing for Asia in four months and a drop from the highest OSP since July 2014. It again reduced pricing for September delivery by US$0.70 to a US$1.20 per barrel premium over the Dubai/Oman benchmark.
Fattouh said: “Chinese players have also been very active in Dubai partials, influencing the structure of the forward curve, which guides Saudi Aramco in setting its official prices. So the recent shift by Saudi would bolster the prospects of the DME futures contract providing, like the INE contract, Asian and Chinese refineries with the opportunity to hedge through a futures exchange.”