Iraq’s oil marketing company has entered a joint venture with LUKOIL’s trading arm to hedge against oil price volatility. Simon Watkins investigates.
Not intent on following blindly OPEC’s oil strategy, Baghdad has signed a deal with Russia’s Litasco to create a global oil trading subsidiary to hedge against oil price fluctuations. The move sees the Iraqi State Oil Marketing Organization (SOMO) team up with the trading arm of LUKOIL to create LIMA Energy, and follows high-level meetings late last year between the oil ministries in Baghdad and Moscow. SOMO’s current average crude exports are around 3.7 million bpd.
“Given the experience of the last three years it has become increasingly obvious that not knowing how the global markets operate on a daily basis can prove very costly to oil producers. There is a major lack of appropriately skilled people, knowledge, infrastructure and contacts with regard to oil and gas and products trading across the Middle East.,” Richard Mallinson, senior energy analyst for global energy consultancy, Energy Aspects, told NewsBase Intelligence (NBI) last week. He added: “A tie-up with Litasco to address all of these shortcomings is therefore a very shrewd move.”
Of Litasco, Mallinson said: “[it] is well known in the markets for its trading skills, controlling all of the international trading activities of LUKOIL [and run by highly-regarded BP trading veteran Tim Bullock], so it is ideally placed to offer SOMO all of these trading facilities and the requisite trader training and knowledge transfer.”
The new venture has already made its mark, selling 2 million barrels of June 2017 loading crude through the Dubai Mercantile Exchange (DME) ‘auctions’ platform. The bidding attracted 40 bids from 20 separate traders during the two-minute trading action and pushing the price up to a US$0.31 per barrel premium over the Basra Light Official Selling Price (OSP) for June.
“It just shows what real traders can accomplish – that is, not just safeguarding base price but also providing a very substantial additional income stream. It’s exactly what I’d expect from a sharp outfit like Litasco,” said Sam Barden, CEO of Middle East specialist energy trading firm and consultancy, told NBI.
“So, another 2 million-barrel cargo is scheduled for this week as well for July delivery, which should also do well,” he added.
Dubai is going to be the focus of the new venture’s activities in the short-term, NBI understands from sources close to SOMO and Litasco. Its aim is to develop the new trading firm’s presence to a point where it can substantially influence the price of the oil sold over the DME, and in turn, global oil prices.
“LIMA is in the process of building up a trading team of at least 10 based at the Dubai Multi Commodities Centre [DMCC], initially mostly from Litasco but with SOMO guys in tow learning the business, and trading in both Iraqi and Russian oil and focused both on European and Asian buyers,” said Barden.
Dubai is an integral part of Platts’ oil price setting mechanism (market-on-close), which acts as the leading benchmark for global oil prices, with deep liquidity available for hedging and a good track record as the sour crude benchmark of choice East of Suez.
“As Dubai, alongside Brent, are the most widely used benchmarks worldwide for physical crude oil prices, and underpinned as well by several million barrels per day of Brent/Dubai derivative spread trades, Iraq securing a market-influencing role here will be a major boost to its revenues from oil from now on,” Barden told NBI.
As an adjunct to this, NBI understands from the SOMO and Litasco sources that discussions are also well advanced on SOMO undertaking the world’s biggest ever oil trading hedge, which would dwarf even Mexico’s long-running famous ‘Hacienda hedge’.
This deal – effectively insurance against falling oil prices – is the largest known energy trade in the world, involving the Mexican government buying ‘put options’ (the right but not the obligation to sell oil at a predetermined future price) on around 250 million barrels of oil on average per year since July 2008, with the first hedge costing US$1.5 billion.
That deal made Mexico more than US$5 billion profit in one year. The Iraq hedge currently being discussed, however, would involve buying put options on at least 400 million barrels of oil in the first instance, NBI understands form sources in Baghdad and Moscow.
“The real catalyst for Iraq in getting involved in this type of deal is that the US shale producers have benefitted enormously from doing similar hedging activity in the past couple of years, locking in profits at levels even from US$35 per barrel and helping to push down their break-even prices in some cases to as low as US$20 per barrel,” Barden added.
The fact that Russia is already well-regarded by Iraq as a partner in its oil and gas industry is of key significance in this context.
“There is a trust between Baghdad and Moscow that has come from LUKOIL’s activities in West Qurna 2. This has been developed in close alliance with the Iraqi government, which helps to mitigate against the concerns that might arise from entering into this type of deal,” said Barden.
Two concerns were paramount before negotiations on going ahead with the hedge began in earnest, highlighted Mallinson. The first – in line with virtually all governments in the Middle East – is a basic lack of knowledge on how global financial markets work in general and how options work in particular.
“To non-market professionals, options can be seen as exotic instruments that are very difficult even to understand at their most basic level, let alone trying to comprehend how the risk/reward patterns manifest themselves. There was a long process involved in settling these issues before the Mexicans did their hedge, for example,” he told NBI.
The second is the political risk involved. “Buying options involves the client – in this case the Iraqi government – paying out premiums, just like insurance, for the hedge [insurance cover]. This would be difficult to explain to the public in any event but if the hedges were [not making a profit] for some time it would be even more difficult to explain why large amounts of money were going from Iraq to foreign banks,” he added.
Indeed, over the course of the ‘Hacienda hedge’ up to the end of 2016, NBI understands from Western investment banking sources in London that Mexico paid out US$11.7 billion in fees for the hedge to banks and brokers, notably including Barclays, Goldman Sachs, Morgan Stanley, and Deutsche Bank.
“Clearly, for a Muslim country like Iraq with its recent history of conflict, both military and religious, some of these names would be toxic in terms of paying out money to. However, Litasco would be a different matter, given [LUKOIL’s] history in Iraq, so the deal is likely to go ahead at some point in the near future,” concluded a senior oil and gas trading source in the Middle East.