The state energy giant’s decision to drop its long-standing US pricing benchmark could herald a wider change in oil pricing both in the Middle East and on Asian exchanges
After years of frustration over the way its crude oil is priced, the world’s largest oil company by reserves, Saudi Aramco, ditched the long-established West Texas Intermediate (WTI) benchmark at the end of October.
Riyadh has used WTI as a yardstick to price oil sold in the US since 1994, but has increasingly found that the formula bears little relation to the oil it sells. WTI is a light and sweet crude oil, while Saudi Arabia produces sulphur-heavy oil, which is far more expensive to refine.
Over the past few years, Aramco’s US customers have complained that the price they pay for the company’s crude is at odds with global market prices, due to the volatility of the WTI oil index.
That volatility has been particularly pronounced this year. WTI usually trades in a close range of $1-2 above or below the Brent oil price, which is used as the main pricing peg in Europe. But in January, the WTI price fell sharply, leaving a record $12-a-barrel gap between the two main global benchmarks.
At the same time, heavier crudes, which normally sell for less than WTI to reflect the higher cost of processing the oil, were priced at a premium of $8 a barrel over the US benchmark. Then in March, WTI bounced back to trade at a premium to Brent.
Such volatility makes it hard for both a supplier and its customers to plan for the future. “If you are the biggest producer in the world, like Aramco, you simply do not want to be captive to these types of price swings,” says Ed Morse, a former US energy official and managing director at LCM Commodities in New York.
Aramco has also been concerned that the WTI price sometimes fails to reflect accurately the relationship between supply and demand in the crude market.
Currently, the price of WTI crude oil is based on the physical supplies in the small, land-locked town of Cushing in Oklahoma, where tank farms have a capacity of 48 million barrels of crude oil. Storage limitations at the site can at times affect the price being paid for crude, even if there is plenty of supply in the wider market. When oil hit a record high of $147 a barrel in July 2008, for example, the market assumed there was a severe shortage of crude, yet Aramco complained at the time that it could not find a buyer for 500,000 barrels a day (b/d) of oil.
With Aramco expected to ship an average of 1.5 million b/d of oil to the US in 2009, the oil major has been under pressure to make a decision on how to improve the situation.
“Saudi Arabia is very conservative in terms of leading an oil market agenda, but it does, of course, listen to its customers if they have problems,” says Morse. “This switch from WTI has been under discussion since 2007.”
In place of WTI, Aramco decided on 28 October to adopt the Argus Sour Crude Index, with effect from January 2010. This price index is based on a weighted average of prices paid for three crudes from the Gulf of Mexico.
“We wanted to make sure our crudes were being priced off a marker that represented similar oil characteristics in terms of sulphur content, gravity and geography,” said Khalid al-Falih, chief executive officer of Aramco, at a press conference inaugurating the PetroRabigh refining and petrochemicals complex on 8 November.
“We were finding every month that there were wild variations between the prices of sour crudes traded on the spot market in the US Gulf Coast and WTI priced at Cushing.”
While the WTI benchmark will survive Riyadh’s departure, attention in the Middle East has now turned to whether the move away from the Oklahoma-based index will lead to a wider shift in the way Aramco and other Gulf producers price their oil. Early indications suggest Kuwait, Iraq, and possibly Iran, are likely to follow Saudi Arabia’s lead and also move away from the WTI benchmark.
One source close to Kuwait Petroleum Corporation (KPC) says it is only a matter of time before this happens.
“In the Middle East, when Aramco moves it makes it ok for everyone else to follow,” he says. “WTI prices have been fluctuating and have often been below where they should be. So a move away from WTI would also make sense for Kuwait and other exporters in the region, like Iraq and Iran.”
Kamel al-Harami, a Kuwait-based oil industry analyst and former KPC executive, agrees that a switch from WTI is likely to take place over the next 12 months.
“If the leaders of the market are going that way, then yes, I would expect Kuwait to follow,” says Al-Harami. “Whether that then goes on to shake up our regional pricing in the Middle East, however, remains to be seen.”
Asian buyers in particular are paying close attention to speculation that there may be a shake-up in the way global oil pricing benchmarks are used. Despite being one of the Middle East’s most valuable export markets, Asian countries currently pay a premium for Saudi crude, due to the different way Aramco prices oil for customers in the east.
Since 1986, Aramco has priced its Asian sales through a combination of the prices charged for two Middle East crudes: Dubai and Oman. Over the past decade, analysts estimate, this has meant Aramco has charged its Asian customers an average of up to $2 a barrel more than its European and US customers. An executive from one Asian refining company tells MEED the Oman-Dubai marker needs to be refreshed, or preferably changed.
“The prices we pay for our oil are very much connected to Dubai and Oman crude, but then Aramco also makes an adjustment to recognise the difference in value between its crude and that of Dubai and Oman,” says the Seoul-based refinery executive. “By the time it reaches us, there is little correlation to what other long-term customers are paying in other parts of the world.”
Given its recent switch away from WTI for US sales, traders now say Aramco could adopt the Dubai Mercantile Exchange’s (DME’s) fledgling Oman crude oil futures contract as an alternative benchmark for its Asian customers.
The DME launched its Oman crude contract in 2007 to establish a new benchmark price for the 12 million b/d of crude exported to Asia from the Middle East. While the contract has the backing of the Omani and Dubai governments as shareholders, trading volumes to date have been relatively small and the DME has been publicly courting Aramco for at least a year, realising that its support would give the contract a much-needed boost.
Aramco appeared to offer an olive branch last year to those calling for a change when it launched a study to set up a pricing and trading mechanism to make the Gulf region a hub for buying and selling refined products, such as fuel oil, gasoline and jet fuel. But while it has examined the prospect of moving away from the Oman and Dubai prices for Asian customers, it is not expected to make a change in the next 12 months.
“I think any pricing or index change tends to be driven by customers, and Asian buyers tend to be very conservative in how they give feedback to a major supplier like Aramco,” says one former Aramco executive. “I am not sure there is the drive there yet to make a change.”
But, Morse argues, even if Aramco does adopt the DME’s Oman oil contract as its benchmark, the DME may still lose out to Russia when it comes to setting a new Asian pricing index.
Russia is due to start exports to Japan, China and South Korea through its new East Siberia-Pacific Ocean (Espo) pipeline in 2010. Russian pipeline company Transneft expects to eventually transport about 1 million b/d of oil through the pipeline. With exports of this scale, it might well be Moscow’s prices, rather than those of the DME, that will be adopted as the new Asian benchmark.
“It [Espo] will be the largest single crude stream coming in to Asia and has the backing of Moscow,” says Morse. “It is in Russia’s interests to push crude east, and it is now likely to become the price-setter for Asia.”
China and Hong Kong have also announced plans to offer trading in futures for locally sourced oil on their exchanges, although no decision has been made on what crude will be traded at either exchange.
For customers, securing a fair, stable price is more important than who determines it.
“We are not worried who ultimately sets the Asian benchmark,” says the Seoul-based refinery executive. “What we want is better price security. But how that is created is difficult for us to assess.”
One source close to the DME says it will look at including crude from the Espo pipeline as part of a benchmark, but its aim of becoming the benchmark contract for pricing all Middle East sour crude remains speculative.
Despite the uncertainties surrounding pricing changes in the Middle East, growth in Asia over the medium term seems certain to drive further changes in crude contracts, as sellers and buyers try to get better value for crude.
“You have to see Aramco’s switch away from WTI as the first piece in a jigsaw puzzle,” says the former Aramco executive. “Further changes are on the horizon but, for now, it is a question of who will make the first move.”
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