Oman Contract Struggles to Benchmark Middle East Oil Prices

ANDRES CALA | NOVEMBER 2010 | SOURCE: Energy Trbune

The Oman oil futures contract –a standard for Middle Eastern sour crude that is traded in the Dubai Mercantile Exchange- has not only survived against many odds. It has matured and promises to keep on doing so. But it’s still a long way from becoming a benchmark like Brent or West Texas Intermediate, despite Omani claims.

The challenge remains to break market inertia in the Middle East and Asia against futures contracts, a “paper” derivate that prices oil depending on the delivery date. Spot prices or termed contracts can be hedged by betting on a future price of crude. But it’s speculative and the price rally in 2008 to around $150 a barrel illustrates that.

Oman Contract Struggles to Benchmark Middle East Oil Prices

Still, futures contracts and other energy derivative contracts are expected to increasingly play a greater role in oil markets, alongside traditional supply and demand fundamentals, which explains why the DME, backed by the New York Mercantile Exchange, set up its futures Oman contract in June 2007, with the attractive option of offering physical delivery.

An optimist assessment of the DME’s life is that its survival and its growth make it a relative success story compared to many of its ambitious peers. Several futures contracts introduced around the same time of the Oman contract have since died, no doubt impacted by low crude prices when recession took hold of global economies, but also over mistrust of derivatives in energy markets that many players find too speculative.

For the first half of 2007 and throughout 2008 the number of Oman futures contracts traded was equivalent to around 1.25 million barrel s a day. That grew to almost 2.2 Mbpd in 2009, and has continued increasing to around 2.9 Mbpd so far in 2010, boosted by increased physical delivery.

The same is true of growing open interest positions in the DME, that is, the unsettled oil contracts that serve to gauge liquidity. These have increased for the Oman contract throughout 2009 and 2010 to a record equivalent to almost 22 Mbpd, almost twice that in 2008. The physical delivery of settled contracts has also risen gradually to a record 15 million barrels in September, significantly more than the 8.7 million average for 2009 and 7.9 million barrels for 2008.

The DME’s resilience, however discreet, translated into hope that the Oman contract could evolve into the benchmark “east of the Suez Canal,” a would-be third option for the mainstream North Sea Brent and West Texas Intermediate markers.

That said, the DME is targeting at least three times more liquidity, equal to about 10 million Mbpd, but it has been unable to attract big players, namely Middle Eastern national oil companies and big Asian refiners. Average liquidity still represents under a quarter of the 12 Mbpd of Middle Eastern crude shipped to Asia, and unless Saudi Arabia, Kuwait or Iran decide to join, that is unlikely to change.

The big producing Gulf countries prefer termed and conditioned long-term contracts, especially bellwether Saudi Arabia, which prices its oil one month in advance applying a differential to each crude grade depending on the destination. It uses Intercontinental Exchange Brent for Europe, Argus Sour Crude Index for the US, and a Dubai price assessment published by Platts for Asia. Other Gulf countries link their prices to Saudi Aramco.

“As long as Saudis don’t participate, the Oman contract is not going to grow as much,” said Leo Drollas, chief economist of London-based Centre for Global Energy Studies, a specialist in strategy hedging and a former head of energy studies and econometrics in BP.

But the Saudis don’t partake in any futures contracts and few believe they will any time soon. In fact, soon after the DME launched its Oman contract, Riyadh said it would probably be the last to join. “Saudis generally don’t believe in paper contracts. They think it’s a casino. They feel it doesn’t serve a purpose and they prefer the term contracts with destination restrictions.”

John Cross, a founding partner of oil brokerage firm Daman Quattro and a trader in the DME, echoed the conclusion. “What we see is more and more companies coming in to trade in the DME. But it’s not quite where it should be for the time it has been working. It needs more support from more regional governments. If Saudis join everyone will follow, and if not nobody will.”

Saudi resistance could change, but only in the mid to long term, with a generational shift,” Drollas said. “The younger ones would be quite happy to trade in futures markets, but the older generation doesn’t understand what role they perform.”

It’s not that big Gulf oil producers don’t hedge on price volatility. But they prefer manipulating the market strictly through supply and demand, by opening and closing output valves, said PFC Energy market intelligence director David Kirsch. The hedging of the windfalls is done through sovereign wealth funds.

But without big producers to naturally regulate fundamentals, speculators undermined the future of the DME by increasing the price of Oman, making it less attractive as a hedging tool for buyers. “On the DME we are looking at sellers, but not producers,” said Kirsch.

The DME’s ability to increase liquidity is further hampered by Asian refiners’ “reluctance to engage in hedging programs,” said Kirsch. “Brent is the de facto marker crude for Asia. They are looking at more predictability. It’s less an issue of what the marker is and more about the relation and how prices are going to be set.”

In fact, Asian customers pay about $1.50 more per barrel for the same kind of crude than Western clients because it’s done on a monthly average. “There’s a premium Asians have accepted to keep the Saudis and others happy,” Drollas said.

The DME has done its homework in terms of transparency and other technical issues. But it needs to work on becoming more attractive. “If you’re trying to push a contract onto a reluctant market, it’s not going to work. The vast majority of exchanges fail because they come up with contracts that they think are very clever and good on paper, but successful markers is what markets demand,” said Kirsch.

“Oman makes a little more sense, but the key is if going to be getting smaller producers to price off Oman and more buying from Asian refiners,” he added.

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