Changing Oil Market Dynamics – A Call for Asian Benchmarks
Dr. V Shunmugam, Niteen Jain and Jayati Mukherjee
Constantly emerging new developments in the global oil economy have assured that crude oil prices never remains out of the market headlines. Strong oil demand growth in emerging economies, U.S. self-sufficiency impinging on the health of the shale industry, increasing volatility in geo-politics among oil producing nations, technological innovations, persistent concerns over energy security etc., have been some of the key factors that are shaping up the dynamics of global oil economy. One of the key emerging trends is a slow but a guaranteed shift of the global oil market’s center of gravity from the west to the east. Pricing happens at a market place where the supply in meets demand and the prices become benchmark as the market matures in terms of information and transparency.
Existing global crude benchmarks
Historically, WTI has been a global benchmark for pricing crudes driven by its high trading volumes in an exchange traded market i.e. NYMEX and a lot of data releases that has the potential impact on its supply and demand estimates. Such data releases includes stock levels, refining output, imports, exports and potential underlying at periodic intervals from the US Department of Energy.
With literally no trade outside the North American borders on WTI, it has been declining in its significance as a benchmark. However, Brent – a north sea light sweet crude, slightly heavier than WTI emerged as a leading benchmark since 2010 due its better global connectivity and larger physical transactions in Brent happening outside of Europe. It provided a better hedge for the worldwide players as the products market tracked Brent more closely than WTI and provided lesser basis risk, thereby establishing itself as the most trusted and traded physical reference price. Since March 2012, ICE Brent has been the world’s most traded oil futures contract. However, with changing market dynamics, there have been some growing concerns about Brent’s sustainability as a global price benchmark. The most critical concern is the faster than expected decline in production from aging fields of the North Sea. The decline in supply has led to concerns that physical volumes could become too thin and hence making the benchmark vulnerable to manipulation in the hands of just a few players. Hence, as a measure to address volumes, Norwegian crude Troll is planned to be added to the existing basket from January 1, 2018 by the pricing agency Platts. Also, with the UK government announcing a ‘windfall tax’ on the North Sea oil industry has reduced the incentives for explorers and producers in the region. Additionally, with the recent lift of the 40 year crude export ban in the US, surplus US crude has now found its way into international destinations, undermining
Brent as a benchmark and making WTI regain its popularity once gain. Finally, the shift in oil demand’s center of gravity to the east raises concerns about the existing benchmarks as reference price for their purchases.
Asia is now the main destination for the world’s incremental crude production with its crude slate dominated by medium-sour types. It makes all the more relevant for any one keenly following crude oil markets to question the relevance of the light sweet WTI and Brent crudes as benchmarks for pricing Asia’s medium-heavy grades. However, in absence of a better benchmark, WTI and Brent continue to serve as international benchmarks as it represent a global macro-picture and provide great execution liquidity for both commercial and non-commercial players.
New center of gravity for oil markets – The East
Asian economies, representing 32 percent of the total global GDP consumes almost 53 percent of total global oil exports. Additionally, economies in the APAC region have shown an average impressive GDP growth rate of 7.2% in the last five years. Looking at individual economies and numbers, China overtook US as the world’s largest crude importer in 2016 and its monthly imports for January 2017 rose to 8.01 million barrels per day (bpd), the third-highest volume ever. Meanwhile, India saw its crude oil
 The World Bank
 General Administration of Customs, China
imports of 4.58 million bpd in November 2016, the highest level since April 2009. Notably, India, which is known for importing about 70-75% crude oil to meet its demand, is now the third largest importer in the world.
Further, Asia is all set to post its biggest refining capacity addition in the last three years. New and expanded refineries in China and India will offset closures in Japan by adding a net 450,000 barrels per day (bpd) of crude processing capacity in 20174 in Asia on top of existing 29 million bpd of capacity, making it the largest target market for crude. Moreover, with increasing growth in the secondary conversion units like fluid catalytic cracking, coking and hydrocracking, the refining system in Asia is becoming increasingly complex in nature (Table 2).
 Petroleum Planning and Analysis Cell, India
4 Wood Mackenzie, Thomson Reuters
These complex refineries are designed to run medium to heavy grade crudes and therefore we believe that the consumption of medium to heavy crude in Asia is further expected to rise to match the supplies from the Middle-east. Both Brent and WTI are light, sweet crudes, and very different from the heavier, sour crudes produced in the Middle East that are now the dominant diet for Asian refineries. Asian giants like India and China import, refine and consume grades of crude oil which are different from either Brent or WTI. Hence, there is no reason why their pricing benchmark should not reflect the fundamentals of the oil grades they deal in, instead of less-relevant global benchmarks.
Asia, therefore, needs to have its own pricing benchmark which is representative of the crude feed quality for the region and at the same time has enough liquidity, transparency and swift response to price signals. Let us explore to find what this benchmark should constitute of and what needs to be done about making it a bilateral ‘price signaler’, given various other ICT and politico-institutional developments.
Data availability and dissemination – Key to benchmark evolution
To emerge as a robust crude oil benchmark, certain set of criteria’s needs to be met. These criteria’s include adequate and stable production, adequate infrastructure support, responsiveness to global fundamentals, transparency in settlement and convergence with the physical transactions. One of the major enablers that helped WTI and Brent in emerging as benchmarks was high level of data transparency of their underlying markets. Hence recognizing the paradigm shift in the oil markets dynamics towards East, it’s clear that the time has come to improve data transparency from such markets so that Asian region can have a meaningful benchmark of their own.
Inconsistent data can lead energy producers, consumers and investors to misread the true supply and demand trends, prompting them to make ill-informed decisions that can negatively impact global markets and distort pricing even further. Analysts rely on accurate data about individual wells, the value of reserves and other related data to form the foundation of their research and conclusions, which allow investors, producers, refiners and other stakeholders in the energy business to make more informed decisions. Thus, it is imperative that oil markets have accurate and timely data availability –raising market transparency – in turn enhancing price discovery efficiency of benchmarks. Hence, for a successful benchmark to emerge for Asian region, one of the major necessities would be high level of data transparency of the underlying markets. Consistent and synchronized data availability of underlying markets across both spatial and temporal is desirable.
In this context, various organizations that are already involved in data collation/analysis for oil markets along with individual sovereigns need to step up their data collection and dissemination standards in line with the standards followed by their counterparts in U.S. and European markets.
While sovereigns need to consistently release reliable macro-economic indicators such as GDP, industrial production etc.; independent organizations can provide impetus to data transparency through far and wide dissemination of analysis and forecasts apart from primary data. Apart from supporting primary data collation, sovereigns need to ensure the development of necessary physical infrastructure supporting oil economy in terms of storage facilities, pipelines, freight services etc., and periodic release of data on storages of crude and its derivatives which would have implications for pricing. Additionally, apart from large number of participants involved with physical trade of a benchmark, a secondary market/financial market offering risk management solutions to stakeholders is also desired for ensuring the effectiveness of benchmark. The role of a vibrant commodity derivatives market in Asia assumes significance in this context.
Opportunity for evolving Asian Benchmark
To make a robust crude oil benchmark, certain set of criteria’s needs to be met. These criteria’s include adequate and stable production, responsiveness to global and regional fundamentals, transparency in settlement and convergence with the physical market. The Asian benchmark should play a prominent role in price discovery in the East of Suez oil markets and also represent a strong link of the futures market with the underlying physical market. Below we look into a few eligible candidates in the run up to be a potential Asian crude benchmark.
The medium -sour crude Dubai has been the key price marker for the Gulf region since mid-1980s when it was one of the few types of crude available on sale on the spot market. Over a short period of time, Dubai became responsible for pricing millions of barrels of crudes from the Gulf destined for other Asian regions on a daily basis. Nevertheless, the nature of Dubai benchmark has evolved for decades and many pricing details have witnessed major transformation driven in large part the decline in production levels. However in recent times, its low trading liquidity, monopoly of few players, non-participation of key exporters poses serious threats to it benchmarking capabilities.
The next crude in the region is medium-sour Oman crude, which has the potential to evolve as an Asian benchmark. Physical production of Oman is robust with a target of producing 1 million barrel per day in 2017 and free from seasonal maintenance of oilfields. With loading outside the Straits of Hormuz, a potential geopolitical point for ME exports, Oman crude has no destination restrictions, making it an ideal regional candidate. Additionally, Oman is a not a part of OPEC, and hence not restricted to quota or the need to suppress supply policies. Further, it has emerged itself free of geopolitical tensions that had affected its counterparts in the Middle East in the recent years, allowing the country to boost crude oil production and bringing crude reserves to the global market and seamlessly respond to the emerging oil market fundamentals of the region.
With a robust and transparent delivery mechanism, steady production, and reflection of the underlying physical market, Oman futures can be in a good position to assume the regional benchmark role, however it might be important to note that the Omani government sells part of its oil on the basis of long term contracts which by definition is not available for spot trading and therefore the exact volumes of Oman available for spot trade is not very clear. Further, for Oman to evolve as a benchmark for the East of Suez markets, the adoption of Oman by other regional NOC’s (National Oil Corporation) particularly Saudi Arabia to price sales to Asia is highly crucial which will cement and enhance its legitimacy as the most appropriate regional benchmark.
Lastly, but not the least Russian ESPO blend crude, which has recently emerged as a key competitor to Middle East crudes in Asia. Its production is based in Russia’s Sakhalin-Eastern Siberian region and transported to Asia through the East Siberia Pacific Ocean (ESPO) pipeline, hence the name. ESPO blend caters widely to the Asian market with China being the top consumer followed by Japan and South Korea. Meaningful trade volumes and short export route to North Asia supports its sales channel to Asia. Further, the crude is free from ‘destination clause’ which is a condition attached to the sales of Middle Eastern crude oil and hence ESPO can be traded more freely. Despite its flexibility, its late release of shipment schedules remains one of the concerns in its evolution as a regional benchmark.
Pricing Middle East crudes and beyond
The key strategic motivation for any new benchmark would be to have higher pricing power based on its own fundamentals and provide the users with a lesser basis risk. Emergence of a medium-sour crude benchmark is what Asia desperately needs currently to price its production to better reflect that of regional dynamics. Once a successful regional benchmark is established, it will better suit Middle East producers to efficiently price its crude for Asian buyers. A launch of exchange traded derivatives contracts on the regional oil benchmark and strengthening information flow into the markets could offer better risk management for Asian stakeholders. The key factor for this link to be established is financial liquidity and flow of right type of information at the right frequency into the markets. As it evolves such a benchmark will also be relevant beyond Middle East players for pricing crude from several countries which export to Asia in the recent times. Russia is pivoting to Asia to diversify their customer base away from Europe, while OPEC member Angola from Africa is another big supplier to Asian economies. Latin American producers, notably Venezuela, have also made recently made inroads in the Chinese market. The success of an Asian benchmark with transparent pricing will be a radical development in the oil market and would help in reflecting a better global outlook that captures the essence and fundamentals of key emerging oil dynamics.