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The New Crude Oil Benchmark That Could Change the Oil Market's Price Dynamics by Investment U Research Team Tuesday, November 24, 2009 Earlier this month, the world's largest oil producer set the table for a move away from traditional light, sweet crude oil. Saudi Aramco, the state-owned company of Saudi Arabia has decided to drop West Texas Intermediate (NYMEX: WTI) as the basis for pricing its oil sold to the U.S. market. The Saudis priced off WTI for 15 years. Why? Well, quite simply, WTI crude oil is dangerously volatile - as evidenced by the drop from $150 per barrel to $30 crude over the past year. In its place, Saudi Aramco will start using the Argus Sour Crude Index (ASCI), which measures heavier oil with higher sulfur content. Traditionally, heavy, sour crude is cheaper than WTI. Heavy crude requires extra processing at the refinery to remove impurities, which is why it's discounted. So what? Why does it matter that one company is changing its benchmark for oil from January 2010? Let me explain... Current Benchmarks at Risk The primary benchmarks for crude oil are...
Brent is the dominant benchmark for oil pricing outside of the United States. However, oil exported to the United States is benchmarked using WTI crude. And there are growing problems with the WTI benchmark... Volatility of WTI Crude Skews Market In a word, the problem for WTI is volatility. Over the past year, prices moved by 15% in one day. And oil prices have also jumped by $10 per barrel in one week. The reason for these huge spikes was constraints on storage for WTI. Cushing, Okla., the delivery and pricing point for WTI crude, was (and still is) oversupplied. This unhinged WTI crude from Brent crude and U.S. Gulf Coast crude prices. In addition to buildup at Cushing, different players and speculators entered the oil market. Historically, producers and refiners held the largest positions in the oil futures market. But over the past decade - and increasingly over the past year - non-commercial traders such as banks, financial firms, and other speculators have taken over. In late January 2009, for example, WTI crude, which usually traded $1-$2 per barrel over Brent - fell to a record discount of $12 per barrel. In February, the sour, heavier ASCI crude sold at an $8 per barrel premium to WTI. But a month later, WTI topped ASCI by $6 per barrel. That said, Saudi Aramco has struggled to price its crude exports competitively. Because Saudi cargoes spend 7-8 weeks en route, the WTI price could flail unpredictably during that time. Simply put, ASCI is less volatile. And many oil producers are calling for an oil benchmark that more accurately reflects supply and demand. Follow the Leader After Saudi Aramco announcement, Venezuelan president Hugo Chavez said his country would follow its lead in using ASCI as the benchmark crude import to the United States. And there is also speculation that many Canadian producers, particularly those planning to use TransCanada's Keystone Pipeline, will do the same thing. If this trend grows, it signals a fracturing of the global oil market. Currently, growth in Asia is booming, while the United States and most of Western Europe has peaked. Sweet & Sour Basically, heavier crude oil is becoming the dominant player as companies spend money to update their refineries. The Argus Sour Crude Index, launched in May, is the average price of three U.S. Gulf Coast medium-sour crudes. U.S. Gulf Coast crude is now at the forefront of production and price discovery. Consider this...
Already, companies like Exxon Mobil Corp. (NYSE: XOM), Valero Energy Corp. (NYSE: VLO), and Royal Dutch Shell Plc (NYSE: RDS-A) have invested billions in technology to refine sour crude along the U.S. Gulf Coast - home to 40% of U.S. refining capacity. The thing is, though, sour crude isn't represented very well on the exchanges at the moment. But a stable market price for sour crude would help producers and refiners manage risk. And speculators' influence on oil price would fall. The Future for Crude Pricing For the Argus Sour Crude Index to gain benchmark status, it would need to trade hundreds of thousands of contracts per day - a process that could take years. What's more, previous NYMEX contracts for sour crude failed due to low demand. Both the NYMEX and the Intercontinental Exchange (ICE), the world's leading energy exchanges, have introduced new contracts based on ASCI, which will begin trading this month. And it's possible this contract could take off with support from major state-owned producers and heavy oil producers in Canada. If an active over-the-counter (OTC) or futures market based on ASCI arises, then the dynamics for U.S. oil trading could be forced to change. Still, gaining volume and traction on a new financial product is still difficult. In the medium-term, Saudi Aramco's turn toward a heavy oil index should have little impact on the market. But within the next decade, I expect that a heavy crude benchmark, such as ASCI, will become the primary marker for oil prices in the United States. Sheena Martin |
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