When US bank JP Morgan took an equity stake in the Dubai Mercantile Exchange (DME) in mid-October, the exchange’s leadership publicly proclaimed the move as a sign of the DME’s success.
DME chairman Ahmad Sharaf said the readiness of a Wall Street giant to buy into a fledgling Middle East energy futures exchange confirmed the strong future prospects for the exchange, and Dubai in particular, which has long held designs on establishing itself as a financial hub and energy trading centre.
JP Morgan has been busy salvaging some of the US financial institutions that have been damaged by the current financial market turmoil.
Yet the bank’s decision to buy into the region’s first energy futures exchange should not imply that Dubai is in a similar predicament.
According to Tom Leaver, chief executive officer (CEO) of the DME, apart from a slight summer dip, the exchange has had steady average monthly trading volumes throughout 2008.
But the bank’s decision to line up alongside a string of previous investors, including US banks Goldman Sachs and Morgan Stanley, Swiss energy company Vitol and the UK/Dutch Shell Group, in the acquisition of a 20 per cent equity stake offered by the DME is a boost to confidence in a financial climate where investors have been bailing out of futures markets.
Like exchanges across the world, liquidity on the DME has drained away over the past few months.
“Trading volumes have been impacted somewhat over the past month by the recent instability in the global economy, but we remain confident that steady growth in the coming months will be supported by a number of factors, including expected further development of our global customer base beyond the 70-plus international firms already holding membership at the DME,” says Leaver.
In some ways, this is not the biggest challenge facing the DME, or other possible pretenders to the crown of the regional energy futures trading hub.
The real problem is attracting the liquidity that will bring in the critical mass of investors needed to make the exchange a success.
Those chances have not been increased by the global financial crisis. “The liquidity has worsened in the past three to four months,” says one Dubai-based trader. “Investors simply aren’t willing to trade.”
This concern may have been the trigger for the DME’s approach to heavyweight investors, first in August, when the first group of investors came on board, and then in October, with the entry of JP Morgan.
The reality is that if the DME is to meet its ambitions to establish itself as the premier international energy futures and commodities exchange in the Middle East then it must increase daily trading volumes.
Establishing an energy futures market from scratch is no easy task, even with the New York Mercantile Exchange (Nymex) on board as a core investor – a Nymex/Dubai Holdings joint venture was signed in June 2005 to set up the DME.
Other exchanges have already launched spoiler efforts, such as the Intercontinental Exchange’s launch in 2007 of its own sour crude contract, backed by crude from Oman, Dubai and Abu Dhabi, and settled against a Platts Dubai price assessment.
“The real difficulty in trying to establish any new futures contract or exchange is to build a critical mass of trading volume,” says Tim Evans, an analyst at US-based Citigroup Futures Research.
“It is particularly difficult to attract a flow of speculative business into a market that lacks established liquidity .”
The relatively low liquidity on the DME puts off the traders upon whom any increase in liquidity is dependent.
The DME was initially conceived in June 2005, in part to provide a mechanism for transparent pricing of sour crude oil, mainly traded over the counter in Singapore.
It also provides a new mechanism for Gulf investors that lack hedging or diversification instruments in their real estate and commodity-based portfolios to achieve more effective risk management.
This ambition still holds true, says Leaver. “The increasing global importance of the east of Suez markets, coupled with the steady increase in demand in the longer term from that region, further heightens the need for a transparent pricing benchmark for crude oil headed east,” says Leaver.
“We believe that the DME Oman crude oil futures contract answers this requirement.”
The market may take time to appreciate the benefit, but it will come, says Leaver. “The contract provides far more price transparency than the existing assessment methodology, and the region is awaking to this realisation,” he says.
“We have seen strong support for greater price transparency that accurately reflects the fundamentals of the east of Suez markets.”
The DME announced its presence with the launch of the first physically delivered Oman crude contract in June 2007.
In early 2008, it added two more contracts: the Brent crude oil financial contract and Oman crude oil financial contract.
Replacing discontinued spread contracts, these new contracts provide traders with the tools for over-the-counter transactions, playing the price spread between sweet and sour crude oil benchmarks.
The new cash-settled versions of the Oman and Brent oil contracts may help to attract more trade from equity investors that are less interested in holding physical inventories of crude barrels, but appetite for them appears limited.
Doubters still need to be convinced that this is enough. “It is not a criticism of Gulf delivery points, it is a question of whether a start-up exchange can give speculative traders some incentive to abandon a West Texas Intermediate [WTI] or Brent contract and dedicate funds to a market maker in a new location,” says Evans.
The DME has, to date, traded 450,700 Oman crude future contracts, which is not bad for a start-up, but still small change compared with the 100 million that were traded on the three major US futures exchanges – the CME Group, Nymex and Ice Futures – last year.
If nothing else, Dubai hopes that the presence of its blue-chip strategic partners will raise the profile of the Oman contract.
“We will soon be announcing a number of strategic initiatives designed to improve the visibility of the contract throughout 2009, and will take greater steps to leverage the partnerships formed through the strategic investor group announced in August,” says Leaver.
“We will also be working to fully maximise and further strengthen our partnership with the Chicago Mercantile Exchange, which recently acquired one of our core shareholders, Nymex Holdings.”
The DME is not the only Dubai-based exchange that is bidding to become the region’s futures trading hub.
The rival, government-owned Dubai Gold & Commodities Exchange (DGCX) offers a fuel-oil contract and, earlier this year, launched two crude futures contracts, covering WTI and Brent, which are both cash-only settlements.
The DGCX, launched in 2005, is seeking to tap into the latent demand for commodity derivatives, offering the large liquidity pools of Asia and the Middle East access to strategic commodities without the operational complexities and cost inefficiencies of having to trade through Europe or the US.
In October, the DGCX reported that its total traded contracts had exceeded 1 million, up 50 per cent on 2007, with oil leading higher trading activity. The exchange had 385,000 contracts traded in the third quarter of 2008, valued at $20.5bn.
Malcolm Wall Morris, CEO of the DGCX, says volatility in the global financial and equity markets has led market participants to shift resources towards areas such as commodities and currencies. In the current high-risk climate, commodity derivatives offer the opportunity to diversify and achieve a balanced portfolio.
Doha is also looking to burnish its financial market credentials with the promised launch of an energy trading hub at Energy City.
Euro-American exchange NYSE-Euronext, which took a stake in the Doha Securities Market in June, is seeking to establish a platform on the Qatar market to handle energy derivatives, although its initial focus is on developing the stock market.
NYSE-Euronext’s interest in trading energy derivatives in Qatar is driven by the desire for a Middle East foothold and access to the region’s liquidity reserves.
But it also represents a strategic move by the bourse to seek out a presence in energy commodities, as opposed to the soft commodities that are its main speciality.
More ambitious still, leading Saudis have mooted the idea of establishing a regional products trading hub.
In a speech in April this year, Adil al-Tubayyeb, Saudi Aramco’s vice-president of marketing, supply and joint venture co-ordination, argued that prices in the region would no longer have to be calculated as a netback – linking the price of the crude to the market price of refined products – to other hubs if a local trading hub was in place.
“If this region is to be transformed into a truly world-class trading hub, then we will need more than just production facilities, refineries and shipping terminals,” said Al-Tubayyeb.
“We will need to develop our own transparent and liquid price benchmarks that will reflect the region’s fundamental supply and demand movements, and their relationship to the world markets.” The DME says it is already doing just that.
It is still early days for the exchange, but Leaver says it is now 18 months old, and other exchanges have not lasted that long.
“Looking back, there have been numerous failed attempts to launch a Middle East crude oil contract whereas the DME Oman crude oil futures contract remains actively traded 15 months after launch,” says Leaver.