Analysis of the Problems of and Alternatives to the Asian Marker Crude Oil

KEEI Research Report 17-17

Dalseok Lee

Research Staff

Head Researcher: Dalseok Lee, Senior Research Fellow of KEEI

Research Associates: Dong-uk Park, Postdoctoral Researcher of KEEI

Sunghee Choi, Professor of Keimyung University

Jeongseok Oh, Head Researcher of KCIF

ABSTRACT

This study examines the characteristics of a marker crude which plays an important role in the international oil market, and analyzes the problems of and alternatives to Dubai oil, which is the marker crude in Asia. One such alternative is to improve the price assessment method for Dubai oil performed by the price reporting agencies(PRA) to prevent price distortion. The other is to find a new benchmark that can replace Dubai oil. Additionally, this paper proposes a strategy to promote each alternative through international cooperation. The study can be summarized as follows.

The fundamental problem of the Asian marker crude, which is Dubai oil, is that it does not meet the basic requirements of a benchmark, such as adequate production volumes, stability of supply, and a variety of sellers and buyers. Despite these inadequacies, Dubai oil remains a marker crude because Platts, a price reporting agency, evaluates and publishes its prices. However, the current assessment of the price of Dubai oil carries with it several problems.

First, there is little transparency in the pricing process engaged in by a PRA. Many problems are likely to occur in evaluation: PRA evaluators may be subjective in their pricing in the absence of sufficient information; information providers may selectively offer distorted information favorable to them; and market participants may act in collusion with a PRA.

Second, a broadening of the kinds of oil tradable through Platts eWindow(Platts' price evaluation system), made to improve the liquidity of Dubai oil, has not greatly increased trading volumes. Since January 2016, Platts has added two more crude oils(Al-Shaheen and ALS, Murban) to the existing three crude oils(Dubai, Upper Zakum, and Oman) in the basket for Dubai benchmark. However, this broadening of the number of deliverable oils has not brought about a significant impact on market liquidity, and has simply undermined stability of the benchmark since crude oils with different characteristics are now included in the benchmark basket.

Third, some issues in Platts’ Market-on-Close(MOC) price assessment methodology can be pointed out. If the last transaction just before the close of the trading market is not a normal one, the price will be seriously distorted.

Of course, a more fundamental reason for possible price distortion is that a small number of companies are participating in the transaction.

Fourth, there is a time lag in the pricing of Dubai oil. The closing price is determined at 4:30 pm Singapore time, making for a 10-hour difference with the time of the closing price of Brent, or the price of ICE futures (2:30 am Singapore time, the following morning). As a result, Dubai oil prices reflect major market events one day later

than those of other benchmark crudes.

Despite these problems, Dubai oil prices remain a benchmark for long-term crude oil contracts in Asia, and are also linked to the prices of various petroleum products and derivatives markets. It will not be easy to change the market order centering on Dubai oil. Therefore, in the short term, improvement of the price evaluation process performed by Platts is desirable, while in the long term, finding a more suitable alternative to Dubai oil is the goal.

In order to improve the logic in PRA price evaluation in the short term, it is necessary to monitor PRA valuation activities, increase liquidity, and create an environment in which PRAs are held in check.

Above all, as there is still a possibility of price distortion due to opacity in the qualitative evaluation methodology and the possibility of subjective judgment in the PRA evaluation, continuous monitoring is essential.

However, it should be noted that if regulations and oversight are too tight, quality market participants and information will leave the market, thereby impairing the reliability of price evaluation. Inclusion of an offshore crude oil that is similar in quality to Dubai’s in the basket of tradable oils, and allowing reselling, would help to increase liquidity in the price evaluation system.

Next, the creation of an environment that will assist in holding PRAs in check is a way to respond to the information monopoly that they, and some market participants, presently hold and induce reasonable market pricing. To do this, it will be necessary to examine the establishment of an Energy Data Hub (EDH), which allows all market participants access to all information for minimal cost. Another option is to open a futures market for crude oil that reflects the characteristics of Middle Eastern crude oil traded in Asia. If crude oils in the Asian futures market are traded through an all-day trading system as are WTI and Brent, the problem of a price lag due to the time difference can be avoided.

New marker crudes likely to replace Dubai oil as a long-term alternative include Russia’s ESPO, Oman oil futures listed in the Dubai Commodity Exchange(DME), the crude oil futures of the Shanghai International Energy

Exchange(INE) to be made in China, and Brent, which is an existing European marker crude. However, these oils are not sufficient to function as an Asian marker crude. The existing oil pricing methodology in Asian countries, using Dubai crude oil as the benchmark, is expected to persist for a considerable period of time. Noteworthy is the recent move by Iraq to convert its marker crude, applied to the sale of its domestic crude oil, to the futures prices of Omani oil listed on the DME.

There are a few strategies, achievable through international cooperation, in relation to the matters reviewed and presented as alternatives in this study. Regarding comprehensive improvements to a PRA pricing assessment, the framework of the existing international coordination system established through the G20 Summit is expected to

be utilized. In other words, IOSCO, IEA, OPEC, and IEF, centering on the G20 meeting, form the framework of cooperation. With regard to improvement in Platts' Dubai oil price assessment, it is necessary to utilize a regional multilateral energy cooperation bodies.

Regarding replacement of the existing marker crude, which is a long-term alternative, the Omani futures listed on the Dubai Commodity Exchange(DME) are likely to be partially used, despite their several weaknesses. It is more advantageous for oil importing countries to have diversified marker crudes that are used in the calculation of export prices by oil producing countries in the Middle East. This is because competition between these oil- producing countries can increase when different prices are applied rather than a single price. Therefore, it is more appropriate for Asian oil importers to discuss issues related to substitution of the marker crude through bilateral negotiations, rather than multilateral, with nations in the Middle East.

Table of Contents

Chapter 1. Introduction ·······························································································10

Chapter 2. Crude Oil Pricing Methods and Marker Crude Oils ·················································12

1. Crude Oil Pricing Methods ·····················································································12

A. Changes in Crude Oil Pricing Methods ···································································12

B. Price Formula for Term-Contract Crude Oil ·····························································14

2. Marker Crude Oils by Region (and Market) ·································································16

A. Types of Crude Oils and Roles of Marker Crude Oils ··················································16

B. U.S. Market’s Marker Crude Oil: West Texas Intermediate (WTI) ···································18

C. European Market’s Marker Crude Oil: Brent·····························································20

D. Asian Market’s Marker Crude Oil: Dubai ································································21

3. PRAs ··············································································································22

Chapter 3. Volatility of and Correlations Among Marker Crude Oil Prices ···································24

1. Overview ·········································································································24

2. Volatility of Marker Crude Oil Prices ········································································24

A. Price Volatility Measurement Model and Results ·······················································24

B. Identification of Structural Changes in Price Volatility ·················································29

3. Synchronicity Between Prices of Marker Crude Oils ·······················································33

A. Correlation Analysis ·························································································33

B. Cointegration Test ···························································································36

4. Causality Between Prices of Marker Crude Oils ····························································39

Chapter 4. Problems of the Asian Marker Crude Oil ·····························································41

1. Overview ·········································································································41

2. Pricing Method of Dubai Crude Oil ···········································································42 6

A. Priority in Data Use ··························································································42

B. Transactions of Dubai Oil on Platts eWindow ···························································43

3. Problems with Dubai Oil Price Assessment ··································································44

A. Opacity of PRAs’ Price-Assessment Process ····························································44

B. Doubt Regarding the Usefulness of Alternative Deliveries·············································45

C. Problems with the MOC Methodology ····································································47

D. Time Lag in Pricing ·························································································48

4. Influence of the Price Distortion of Marker Crude Oils ····················································49

Chapter 5. Alternative Measures to the Asian Marker Crude Oil ···············································50

1. Improvement of Price Assessment of PRAs ·································································50

A. Improvements Made Through G20 Summit Meetings ··················································50

B. Plans to Increase the Reasonability of Pricing ···························································52

2. Search for a New Marker Crude Oil ··········································································54

A. Qualifications of Marker Crude Oils ······································································54

B. Review of New Marker Crude Oils ········································································55

3. Strategy for Policy Implementation through International Cooperation ··································65

Chapter 6. Conclusion ································································································67

References ··············································································································70

List of Tables

Table 2-1. Components of Price formula for Term-Contract Crude Oil of Each Region ····················15

Table 2-2. Marker Crude Oil Used in Price Formula of Each Exporter ········································15

Table 2-3. Properties of Major Marker Crude Oils ································································17

Table 2-4. Properties of ASCI Oils ··················································································19

Table 2-5. Properties of BFOE Oils ·················································································20

Table 3-1. Structural Changes in GARCH (1,1)-Based Volatility of Dubai Crude Oil Prices ··············31

Table 3-2. Structural Changes in GARCH (1,1)-Based Volatility of Oman Crude Oil Prices ··············31

Table 3-3. Results of Dickey-Fuller Unit Root Test ······························································36

Table 3-4. Results of Johansen Cointegration Test (Entire Period) ·············································37

Table 3-5. Result of Johansen Cointegration Test (Four Sub-Divided Periods) ·······························38

Table 3-6. Test of Causality between the Prices of Dubai Oil and Other Marker Crude Oils ···············39

Table 4-1. Properties of eWindow Dubai Basket Crude Oils ····················································46

Table 5-1. SWOT Analysis of ESPO ···············································································58

Table 5-2. Details of Oman Futures Contract ······································································58

Table 5-3. SWOT Analysis of Oman Crude Oil Futures ·························································60

Table 5-4. Details of INE Crude Oil Futures·······································································62

Table 5-5. SWOT Analysis of Chinese Crude Oil Futures ·······················································63

Table 5-6. SWOT Analysis of Dated Brent ········································································64

List of Figures

Figure 2-1. Crude Oil Production in Texas and Oklahoma ······················································18

Figure 2-2. WTI Futures Trading Volume Trend on NYMEX ··················································19

Figure 3-1. Daily Price Volatility of Dubai and Oman Crude Oils ·············································25

Figure 3-2. Daily Price Volatility of WTI and Brent Crude Oils ················································26

Figure 3-3. Price Volatilities of Dubai and Oman Oils Based on GARCH (1,1) Model and Rate of Change

···························································································································28

Figure 3-4. Price Volatilities of WTI and Brent Oils Based on GARCH (1,1) Model and Rate of Change

···························································································································29

Figure 3-5. Structural Changes in GARCH (1,1)-Based Volatility of Oman Crude Oil Prices··············32

Figure 3-6. Six-Month Rolling Correlation Coefficients of Prices of Dubai Oil and Other Marker Crude Oils

···························································································································34

Figure 3-7. Twelve-Month Rolling Correlation Coefficients of Prices of Dubai Oil and Other Marker Crude Oils

···························································································································35

Figure 4-1. Change in Dubai Crude Oil Production·······························································41

Figure 4-2. Screen Layout of Platts eWindow ·····································································42

Figure 4-3. Difference in Daily Fluctuations of Brent and Dubai Oil Closing Prices ························48

Figure 5-1. ESPO Pipeline ···························································································56

Figure 5-2. ESPO Crude Oil Exports by Country (2016) ························································57

Figure 5-3. Daily Volume of Traded Oman Crude Oil Futures Contracts ·····································60

Figure 5-4. China’s Dependence on Imported Crude Oil ························································61

Chapter 1. Introduction

International crude oil prices are determined by supply and demand in the market, as with the prices of general goods. However, this is not the case with various types of crude oil that have different quality levels and are produced and consumed in different areas. Most crude oils, which lack liquidity, are traded at discounted or premium prices based on the price of a “marker crude oil”1 that is actively traded in spot and futures markets. West Texas Intermediate (WTI) in the United States, Brent Blend in Europe, and Dubai crude in Asia are marker crude oils that serve as standards for determining the prices of crude oils produced in or exported to each of the world’s largest oil-consuming regions.

Since the late 1980s, when the pricing system administered by the Organization of the Petroleum Exporting Countries (OPEC) collapsed, the prices of all crude oils traded on spot, forward, and term contracts have been based on the prices of marker crude oils. Even for crude oils traded over periods of one year or more, only their volumes are fixed, and the prices are calculated based on the price formula linked to the price of the given marker crude oil. The prices of marker crude oils play both direct and indirect roles as reference points in determining the prices of various petroleum products and derivatives, in addition to crude oil prices.

However, Dubai crude, which is the Asian marker crude oil, is not traded in the futures market, unlike other marker crude oils. And with the decreasing production volume and resulting reductions in spot trading, Dubai crude’s price-discovery function has been found to be quite limited. According to the statistics provided by Energy Intelligence (EI), Dubai oil production exceeded 400,000 b/d in the late 1980s, when it began serving as a marker crude oil, before declining to about 100,000 b/d in 2005 and 25,000 b/d in January 2017. Naturally, there is doubt as to whether the price of Dubai crude, with its insignificant production and trade volumes, can serve as a reference. In addition, the absence of large numbers of buyers and suppliers in the Dubai crude transaction market means that there is a high likelihood that its prices will be manipulated by specific market participants.

Even under these circumstances, Dubai crude continues to function as the Asian marker crude oil because Platts, one of the pricing-reporting agencies (PRAs), evaluates and makes public the price of Dubai crude. However, the lack of transparency in its valuation process and the possibility of price distortion has caused considerable controversy over the appropriateness of PRA-evaluated Dubai crude prices. Distortion of the price of the Asian marker crude oil could lead to a wide range of unreasonable gains and losses. In particular, if the Dubai crude price rises significantly more than other marker crude oils, the prices of Middle East crude oil sold to Asia would rise as well. This, in turn, would lead to increased costs and weaker competitiveness of refineries in the Asian region, including South Korea. It is therefore necessary to analyze the problems of the Asian marker crude oil and present corrective measures.

Despite the importance of marker crude oil prices, it seems that only one study on the issue has been conducted in Korea, jointly by the Ministry of Strategy and Finance and the Korea Energy Economics Institute (2013). However, this study covers only the “functions of oil PRAs” in relation to the “mitigation of energy price volatility,” which was one of the energy sector agendas of the G20 Summit. That is, instead of addressing the price of the Asian marker crude oil, the study looks at the problems of the overall evaluation process of the PRAs and the improvement efforts made at the G20 level.

This study analyzes the problems of Dubai crude, the Asian marker crude oil, and seeks to identify alternative measures for achieving two goals: improving the current method of assessing the Dubai crude price to prevent price distortions and finding a new marker crude oil capable of replacing Dubai crude. Furthermore, this study suggests strategies for implementing each of the alternatives based on international cooperation.

This study is organized as follows. Chapter 2 examines the role and importance of marker crude oils in determining international oil prices, while Chapter 3 analyzes the volatility of and correlations among the prices of major marker crude oils. The volatility of marker crude oil prices is then estimated using the GARCH (1,1) model, and the correlations among marker crude oil prices are identified by analyzing synchronicity and causality.

1 Marker crude oils, also referred to as reference crude oils and benchmark crude oils, are the standards for determining crude oil prices. In this study, mainly the term “marker crude oil” is used. 10

Synchronicity is examined by estimating the correlation coefficient and conducting the cointegration test, while causality is examined by conducting the grandeur-causality test. Chapter 4 discusses Dubai crude’s lack of liquidity and specific problems related to its price assessment, while Chapter 5 suggests alternative solutions to the problems discussed above. Chapter 5 first suggests measures for enhancing the rationality of the Dubai crude price assessment, which is carried out by PRAs, and then reviews the characteristics and advantages and disadvantages of each of the crude oils that are seen as having the potential to replace Dubai crude in the long term. In addition, the chapter presents strategies for implementing the previously suggested alternative solutions through multilateral and bilateral international cooperation frameworks. Finally, Chapter 6 summarizes the main contents of this study and presents policy proposals.

Chapter 2. Crude Oil Pricing Methods and Marker Crude Oils

1. Crude Oil Pricing Methods

A. Changes in Crude Oil Pricing Methods

It has not been long since international crude oil prices started being decided by market forces. If the determination of oil prices by market forces is considered to have started in the late-1980s, when the OPEC- administered pricing system collapsed, the current system has thus been in place for only 30 of the 160 years of the modern oil industry’s history. Prior to that, crude oil prices were determined in a number of different ways. So far, however, the market’s oil-pricing methods have undergone numerous changes. Considering the continuous controversy over the lack of transparency, information asymmetry, and potential for price distortion under the current oil-pricing methods, it is expected that the international crude oil-pricing methods will continue improving and developing in the future. This chapter aims to examine the changes that have occurred in the international crude oil-pricing methods in order to identify the process through which the marker crude oils, which play an important role in current oil pricing, came into existence.

1) Posted Price System of the Oil Majors (1920s to early 1970s)

The era of the oil majors, often referred to as the “Seven Sisters,”2 began after Standard Oil, founded by J. Rockefeller, was dissolved into 34 entities in 1911 by the Sherman Antitrust Act. The oil majors are large oil companies with a coherent operating system across all sectors of the industry, spanning exploration, development, transportation, storage, refining, and sales, in the upstream, midstream, and downstream sectors. The governments of the oil-producing countries granted long-term crude oil concessions to the oil majors in exchange for fees. These fees were determined by the posted prices of the oil majors. As the posted prices were not generated by the market, they lacked transparency and did not properly reflect market conditions. Nonetheless, the system was viewed as having contributed to increasing oil consumption, as the oil majors kept oil prices low so that they could pay less in fees to the governments involved.3

The Achnacarry Agreement of 1928 played a pivotal role in the oil majors’ efforts to dominate the world oil market. The agreement established the first oil cartel,4 through which the oil companies divided the entire world, except the United States, into several regions and assigned oil sales quotas for each. Initially, three companies participated: the Anglo-Persian Oil Company (predecessor of BP), Royal Dutch Shell, and Standard Oil Company (predecessor of Exxon). After the Second World War, four more companies joined, completing the formation of the Seven Sisters. Under the Achnacarry Agreement, oil prices were determined according to a one-base pricing formula, which added shipping costs to the free-on-board (FOB) price of the oil of U.S. Gulf of Mexico.5

In the mid-1950s, the market entry of independent oil companies, which had previously operated only in the upstream sector, created signs of change. These companies acquired oil concessions in Venezuela, Libya, Iran, and Saudi Arabia, targeting the markets dominated by the oil majors, and underwent rapid growth, coming to occupy 15% of Venezuela’s oil production by the mid-1960s.6 However, their share of global crude oil production and trade was insufficient to have a significant effect on the world oil market. With the advent of OPEC, however, the market dominance of the oil majors has weakened, which will be explained in more detail later.

2 This refers to Exxon, Mobil, Texaco, Socal (predecessor of Chevron), Gulf, BP, and Royal Dutch Shell. 3 Energy Charter Secretariat (2007), p.53. 4 Because the Achnacarry Agreement was in violation of the anti-trust law, it did not apply to the United States. 5 Energy Charter Secretariat (2007), p.54. After the Second World War, the price of oil in the Persian Gulf region was also reflected in the price formula. 6 Requoted from Parra, F. (2004) and Fattouh, B. (2011), p.15. 12

2) OPEC-administered Pricing System (Early 1970s to 1986)

The Organization of the Petroleum Exporting Countries (OPEC) was established in September 1960 as an intergovernmental organization in response to the oil majors’ price (posted price) reduction. 7 Initially, it concentrated on protecting the interests of its member states against the oil majors. Since the mid-1960s, however, with the dramatic increase in global oil demand, it began taking control of its member states’ oil industries by excluding the oil majors.

Fattouh (2011) views the 1970 agreement between Libya and Occidental, one of the independent oil companies, as a turning point in OPEC’s efforts to take control of the oil major’s international oil market dominance. At the time, Libya agreed with Occidental regarding the payment of income taxes based on the increased posted price and a retroactive payment to compensate for lost revenue since 1965. The contract was soon applied to all oil companies operating in Libya and spread to other Middle Eastern oil-producing countries as well.

In addition, OPEC pursued the nationalization of oil companies. Instead of granting oil concessions to Western oil companies, it began engaging them as shareholders. In October 1972, after a series of negotiations, six Middle Eastern OPEC members and Western oil companies agreed on a 25% equity participation agreement (which later increased to 51% in 1983). Afterward, Iraq, Kuwait, and Qatar expelled Western oil companies and nationalized their oil industries.8

OPEC, which achieved a hegemony in the international oil market, replaced the posted price system with the administered pricing system. This new system was centered on the concept of a marker crude oil. Individual oil- producing countries determined the official selling price (OSP) in consideration of supply and demand, crude oil quality, and petroleum product prices, with Arabian Light of Saudi Arabia as a reference.

Amid this change, the first oil crisis was a crucial event that gave OPEC the opportunity to become an oil powerhouse. In October 1973, six Middle Eastern OPEC member states raised the posted price of Arabian Light from USD 3.65 per barrel to USD 5.119 per barrel while announcing a production cut of 5% and a further cut of 5% per month until the total evacuation of Israeli forces from all Arab territories.9 In December of that year, the price was raised further to USD 11.651 per barrel.10 Although these measures seemed to have been taken in retaliation for the Third Middle East War, they were in fact a response to the breakdown in price negotiations with Western oil companies. In this way, OPEC replaced the oil majors and came to power in the international oil market.

The second oil crisis, from 1979 to 1980, once again reinforced the status of OPEC, but ultimately, it was the beginning of OPEC’s decline and fragmentation and the collapse of the OPEC-administered pricing system. The price of Saudi Arabia’s Arabian Light soared from USD 14 per barrel in early 1979 to USD 26 per barrel by the end of the year and reached a record high of USD 30 per barrel in April the following year.11

OPEC’s market share shrank dramatically, from 51% in 1973 to 28% in 1985, as non-OPEC oil producers emerged as a strong competitor amid the sharp decline in oil demand and subsequent global economic recession.12 The production quota system that had been introduced in 1982 to prevent a fall in oil prices was ineffective due to the observation-related failures of most of the member countries, except Saudi Arabia. In addition, the disagreements among member countries concerning oil prices and production drastically weakened the market influence of OPEC. Under these circumstances, Saudi Arabia introduced the netback-pricing method13 to replace the existing OPEC-administered pricing system in 1986 and started increasing production, which led to a dramatic

7 Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela are the founding members. In 2017, more countries—Algeria, Angola, Ecuador, Gabon, Libya, Nigeria, Qatar, the UAE, and Equatorial Guinea—joined, adding up to 14 members. 8 Fattouh (2011), p.16. 9 Fattouh (2011), p.16. 10 Fattouh (2011), p.16. 11 Bloomberg’s time-series data on international crude oil prices (www.bloomberg.com (retrieved March 25, 2017)). 12 Fattouh (2011), p.18. 13 The netback-pricing method inversely calculates crude oil price by subtracting the refining, transportation, and other costs. In this way, the market risk is shifted from the refiner to the producer. 13

fall in international oil prices. The price of Arabian Light declined to USD 8.6 per barrel in July 1986 from USD 28 per barrel in December 1985,14 resulting in the collapse of the OPEC-administered pricing system and the emergence of a market-related pricing system.

3) Market-related Pricing System (1987- today)

Paradoxically, the crude oil spot trading market was created in the wake of the first and second oil crises, at a time when the influence of OPEC was growing rapidly. As the OPEC embargo and Iranian Revolution increased the difficulty of securing crude oil through term contracts, buyers crowded into spot markets. At the same time, non-OPEC oil production in the North Sea regions increased sharply. These circumstances led to a dramatic rise in crude oil spot trading. According to the estimation of the 2007 Energy Charter Secretariat, the share of spot trading in the oil market expanded from 5 to 8% in the 1970s to 10 to 15% in the mid-1970s and further to 40 to 50% in the mid-1980s.

Given that the spot market handles any excess supply and demand that was not met through term contracts, the trend of spot trading growth well illustrated the market conditions of those years. The prices generated in the spot market serve as an important indicator of oil price determination. Since the collapse of the OPEC-administered pricing system, international oil prices have been decided using a market-related method that reflects the prices generated in the spot market. However, as not all of the hundreds of types of crude oils worldwide are traded on the market, the price of any given type is usually set at a discount or a premium in relation to a marker crude oil representing the given region. This is referred to as the market-related formula pricing system. The premium and discount rates are determined by the state-owned oil company of the given oil-producing country or a PRA, in consideration of the quality of the crude oil, value of petroleum products, export area, and market conditions.

Today, oil prices are typically set by this method. However, since the oil market is segmented into the real and derivative markets, market participants are divided into end users, suppliers, and financial investors, and the oil price-determination method has become much more complex. After the futures trading market was vitalized through the New York Mercantile Exchange (NYMEX), futures prices came to represent international oil prices, holding sway over spot prices.

B. Price Formula for Term-Contract Crude Oil

Since the late 1980s, when the OPEC-administered pricing system collapsed, the prices of all crude oils traded on spot, forward, and term contracts have been based on the prices of marker crude oils. Crude oils traded over periods of one year or more are fixed only in terms of their volume, and prices are calculated by applying the regional (market) price formula15 related to the price of the given marker crude oil.

Basically, the price formula involves adding or subtracting adjustment factors to or from the prices of the regional marker oils, as shown in the following equation. However, the point of sale, price timing, and calculation period of marker crude oil prices depend on the exporting country or sales area of the crude oil (United States, Europe, or Asia).

Pij = PMj ± ij (P: sale price of crude oil, PM: price of marker crude oil, : adjustment factor, i: type of crude oil, and j: sales area)

The representative marker crude oils are WTI (West Texas Intermediate) in the U.S. market, Brent in the European market, and Dubai in the Asian market. In addition, the Argus Sour Crude Index (ASCI), West Texas

14 Bloomberg’s time-series data on international crude oil prices (www.bloomberg.com (retrieved March 25, 2017)). 15 The market price formula was adopted by PEMEX, Mexico’s national oil company, in 1986 and has been the most commonly used pricing method to date (Fattouh (2011), p.20). 14

Sour (WTS), Brent weighted average (BWAVE), and prices of Oman crude oil and other petroleum products are used as marker prices as well (refer to Tables 2-1 and 2-2). The marker crude oil of each market will be described in more detail in Section 2 of Chapter 2.

The adjustment factors are determined in consideration of the quality of the crude oil, value of the petroleum products produced from the crude oil, market conditions, and sales strategy. Major oil exporters, including Saudi Arabia, usually announce adjustment factors early in the month for application in the following month.16

Table 2-1. Components of Price Formula for Term-Contract Crude Oil of Each Region

United States Europe Asia

Dated Brent Marker WTI → ASCI Dubai and Oman crude oil → BWAVE

FOB and Sidi Point of sale FOB and U.S. Gulf FOB Kerir

One month after 40 days after Price timing loading or on loading or on Loading date delivery date delivery date

Price- Five to ten days Five to ten days 30 days (monthly calculation before or after before or after average) period price timing price timing

Noted: Based on Saudi Arabia crude oil (BWAVE, Brent weighted average; WTI, West Texas Intermediate; and ASCI, Argus Sour Crude Index).

Source: Dalseok Lee & Namjin Roh (2010), p.79; and Energy Intelligence (February 13, 2017), p.4.

Table 2-2. Marker Crude Oil Used in Price Formula of Each Exporter

Asia Europe United States Dated Brent (until WTI (until June 2000) December 2009) Saudi Arabia (Dubai+Oman)/2 BWAVE (since ASCI (since July 2000) January 2010) Dated Brent (until December 2000) Iran (Dubai+Oman)/2 BWAVE (since January 2001) Dated Brent (until WTI (until June 2000) December 2009) Kuwait (Dubai+Oman)/2 BWAVE (since ASCI (since July 2000) January 2010)

16 These adjustments, which are set by the crude oil exporters, are also referred to as the OSP, based on the term “Official Selling Price (OSP)” used for the past OPEC-administered pricing system. 15

WTI (until March 2010) Iraq (Dubai+Oman)/2 Dated Brent ASCI (since April 2010) Nigeria Dated Brent Libya Dated Brent (Dated Brent⨯0.527) (0.4⨯ + Mexico (Maya- (WTS+3%FO)) (Dubai+Oman)/2 (3.5%FO⨯0.467) 22) + (0.1⨯ (LLS+ - (0.25⨯ Dated Brent)) (1%FO- 3.5%FO))) Ecuador (Oriente- WTI 24) Note: BWAVE, Brent weighted average; WTI, West Texas Intermediate; ASCI, Argus Sour Crude Index; WTS, West Texas Sour; LLS, Light Louisiana Sweet; and FO, Fuel Oil.

Source: excerpted and summarized from Energy Intelligence (February 13, 2017), p.4.

Using marker crude oil prices as a reference avoids the risk of sudden price fluctuations on specific days or at specific points in time by applying the average for a certain period.17 As for marker crude oil price calculations, the average market price over 5 to 10 days is usually applied to crude oil bound for the European and U.S. markets, which are sensitive to market conditions, and the monthly average price for the given shipment month is applied to that bound for Asia. Price timing is set based on the day of shipment, a certain time after the shipment, or the day of delivery. This is done to reduce the risk imposed on buyers by price fluctuations that could occur during the time the oil is being shipped to the refiner.18 For example, it takes about 42 days to travel from Ras Tanura Port of Saudi Arabia, around the Cape of Good Hope, and to Corpus Port of Texas, in the United States. Therefore, among the components of the price formula, the calculation period and price timing of the marker crude oil take market risk into consideration.

2. Marker Crude Oils by Region (and Market)

A. Types of Crude Oils and Roles of Marker Crude Oils

Crude oil is an organic material composed of oxygen, sulfur, nitrogen, and helium, in addition to its main components of carbon and hydrogen. There are hundreds of crude oils of different levels of quality around the world, each of which is usually named based on the region in which it is produced. Crude oils are divided into light, medium, and heavy oils, according to their density, and sweet and sour crude oils, according to their sulfur content. The density of a crude oil can be gauged by its specific gravity, which is calculated using the API gravity formula of the American Petroleum Association. The API gravity formula provides the specific gravity of crude oil at a temperature of 60℉ (15.6℃) compared to water at the same temperature.19 Light crude oil has an API of 31.1 or higher; medium oil, 22.3 to 31.1; heavy oil, 22.3 or less; and extra heavy, 10.0 or less.20 As for the sulfur content, crude oil with a sulfur content of 0.5% or less is classified as sweet (low-sulfur) crude oil, while crude

17 Descriptions of the marker crude oil price calculation period and price timing are extracted from the paper by Dalseok Lee and Namjin Roh (2010), pp.77-78. 18 Energy Intelligence Research (2009), p. A60 / Requoted from Dalseok Lee and Namjin Roh (2010), p.78 19 Water has an API gravity of 10. 20 http://www.petroleum.co.uk/api (retrieved April 14, 2017). 16

oil with a sulfur content of more than 0.5% is classified as sour (high-sulfur) crude oil.21,22

Generally, crude oil with higher API gravity and lower sulfur content is more expensive. Because light crude oil is relatively simple to refine, it can be used to produce petroleum products with high value added such as gasoline. In addition, sweet crude oil requires relatively fewer desulfurization processes. Heavy crude oil, which is also called “tar sand,” is considered to be of low quality due to its high sulfur content and nickel and other metal components, which is why it is used to produce low value-added products such as Bunker-C oil. However, as it is cheaper, refineries have been steadily upgrading their facilities in order to reprocess Bunker C oil into gasoline and other higher value-added products.

As such, crude oils have a wide variety of physical properties, and production costs and demand vary widely by region. In addition, not all crude oils are traded in volumes sufficient to enable market price formation. Therefore, it is reasonable that the price of an individual crude oil is determined based on a specific crude oil or marker crude oil with abundant liquidity and relatively transparent pricing.

Accordingly, international oil prices have been determined based on the prices of marker crude oils. For a long time, from the oil majors to OPEC, U.S. West Texas crude and Saudi Arabia’s Arabian Light served as markers. Since the mid-1980s, WTI, Brent, and Dubai have been the representative markers for the U.S., European, and Asian markets, respectively. In addition to these three types, Light Louisiana Sweet (United States), Ural (Russia), Tapis (Malaysia), Minas (Indonesia), Bonny Light (Nigeria), and Isthmus Light (Mexico) also play the role of marker crude oils in limited areas and scopes. The formula for determining the prices of term-contract crude oils includes Oman (Oman) along with Mars, Poseidon, and Southern Green Canyon, all of which make up the Argus Sour Crude Index (ASCI), which will be explained more in detail later.

The price of an individual crude oil is generally calculated by adding or subtracting the price differential specified by the exporter or PRA to or from the price of the given marker crude oil. The price differential is determined in consideration of the quality of the crude oil, shipping cost, value of refined petroleum products, and market conditions. As we have seen before, oil-producing countries use different marker crude oils, depending on the export region (market), even for the same crude oil.

Table 2-3. Properties of Major Marker Crude Oils WTI Brent Dubai Specific gravity 40.8 37.5 30.4 (API) Sulfur content 0.42 0.40 2.13 (w%) Source: Energy Intelligence (2015).

B. U.S. Market’s Marker Crude Oil: West Texas Intermediate (WTI)

WTI, the marker crude oil of the U.S. market, is a low-sulfur light oil with an API of 40.8 and a sulfur content

21 http://www.petroleum.co.uk/sweet-vs-sour (retrieved April 14, 2017). 22 The U.S. Environmental Protection Agency (EPA) classifies crude oils into four categories (Class A to D) depending on the degree of toxicity to humans and the environment. Class A is a light, volatile, liquid oil that easily penetrates into the soil, groundwater, and ocean water. In addition, due to its strong odor and rapid evaporation, light oil is generally more harmful to humans and the environment than others. Class B is non-sticky oil that is less toxic than Class A and easily absorbed into the soil at higher temperatures, making it difficult to remove. Class C is heavy sticky oil that is not easily absorbed into the soil due to its stickiness and is less toxic than the two preceding oils. However, it is very difficult to remove, and because of its low specific gravity, it can endanger marine ecosystems when it sinks down into the water. Class D is non-fluid oil that is not absorbed into the soil and is the least toxic of the four categories of oil. This oil is dissolved by heating and includes residual oils and bitumen (www.epa.gov/emergency-response/types-crude-oil (retrieved April 14, 2017). 17

of 0.42w% (Table 2-3) that is produced in Texas, New Mexico, Oklahoma, and Kansas. As the most widely recognized crude oil in the global oil market, WTI has long served as a reference for the prices of crude oils imported into the United States, the world’s largest oil consumer. In addition, WTI influences the pricing of local U.S. marker crude oils, such as Louisiana Light Sweet (LLS), Mars, Poseidon, and Southern Green Canyon.

Figure 2-1. Crude Oil Production in Texas and Oklahoma

Source: EIA (https://www.eia.gov/petroleum/ (retreived April 1, 2017).

원문 번역문 텍사스 Texas

오클라호마 Oklahoma

WTI emerged as a global marker crude oil following a series of incidents, including the commencement of crude oil futures trading in 1983. Considering WTI’s advantage of being produced in the center of the world’s largest oil industry (United States) and the rapid development of the spot market, WTI has an important influence on the price formation of various crude oils.

WTI has come to secure a solid position, owing to the vitalization of futures trading. A low-sulfur, light crude oil futures contract was launched with WTI as an underlying asset on NYMEX in March 1983. It is a representative crude oil futures contract that adopts a physical delivery settlement method23 and has contributed to the development of the international crude oil market with its price-discovery and risk-transfer functions. In particular, as the crude oil futures market became financialized in the 2000s, a large number of financial investors, in addition to end users and suppliers, became increasingly involved, which significantly enhanced the transparency and efficiency of pricing.

Figure 2-2. WTI Futures Trading Volume Trend on NYMEX

23 The physical delivery settlement location is Cushing, Oklahoma. It is possible to deliver other crude oils of similar quality, such as Low Sweet Mix, New Mexican Sweet, and North Texas Sweet, as well as imported crude oils, such as the United Kingdom’s Brent, Nigeria’s Bonny Light, and Colombia’s Cusiana (http://www.cmegroup.com (retrieved April 1, 2017)). 18

Source: Bloomberg (https://www.bloomberg.com (retrieved April 1, 2017)).

원문 번역문 백만계약 One million contracts

Meanwhile, some have taken a critical view toward WTI as a marker crude oil. WTI prices have long been underestimated compared not only to Brent, a light oil, but also to Dubai, a medium oil, due to the excessive overstock caused by the increase in shale oil production. WTI also has difficulty fulfilling its role as a marker crude because it does not properly reflect the supply and demand situation in the United States and the global market. Although the ban on U.S. crude oil exports was abolished in 2016, the shortage of export infrastructure restricts WTI’s capacity to respond to any excess or shortage in supply and demand in the global market. In addition, since WTI crude oil is transported mainly through pipelines, transactions are limited, and bottlenecks occur frequently. Moreover, as a result of excessive speculative trading through the futures market, volatility in oil prices has increased dramatically, and the sharp fluctuations in oil prices cannot be explained by changes in supply and demand only.

Since WTI prices lost stability with the dramatic declines that occurred due to the surge in U.S. shale oil production, oil-producing countries in the Middle East have been using ASCI as a substitute for WTI in their formula for calculating the price of crude oil for export to the United States. ASCI is a weighted-average price for the three medium sour oils—Mars, Poseidon, and Southern Green Canyon—and has been compiled and announced since May 2009 by Argus, one of the PRAs. At the end of 2009, a futures contract with ASCI as an underlying asset was launched on the InterContinental Exchange (ICE). As transactions of medium sour oil increased in the U.S. Gulf of Mexico, the oil-producing countries in the Middle East, including Saudi Arabia, chose ASCI as an alternative to WTI. Though ASCI has emerged as a reference for medium oils, it is difficult to see it as an independent marker crude oil, as its prices are basically formed based on WTI. And WTI is still widely performing the role and function of a marker crude oil.

Table 2-4. Properties of ASCI Oils

Southern Green Mars Poseidon Canyon

Specific gravity 28.8 29.7 28.2 (API)

Sulfur content 1.80 1.65 2.30 (w%)

Source: Energy Intelligence (2015).

C. European Market’s Marker Crude Oil: Brent

Brent, the European market’s marker crude oil, is a light sweet oil with an API of 37.5 and sulfur content of 0.40w% (Table 2-3) that is produced in the North Sea. Though its quality is similar to that of WTI, it serves as a reference for many more varieties and volumes of oil. According to ICE, 70% of crude oil transactions worldwide are directly or indirectly affected by Brent prices.24 Brent has covered a wider range of oil types and regions than WTI, thanks to factors such as a tax system favorable to spot transactions and competitive production system. The main reason, however, is that Brent is produced by offshore oilfields. Crude oils that are produced by offshore oilfields and transported by ship can be used to make swift responses to any excesses or shortages in regional markets and are inexpensive because they can be shipped in large volumes. Crude oils produced on land are difficult to transport to areas with the proper transportation infrastructure, such as oil pipelines and railroads, which limits their capacity to reflect the overall market supply and demand. The construction of oil pipelines is costly, and railroad transportation is expensive as well. Such factors hinder the competitiveness of crude oils produced by land-based oilfields.

Brent was first discovered in the Brent oil field in the North Sea in the 1960s, and its production expanded continuously until the mid-1980s. After Brent production entered a rapid decline, however, its position as a marker crude oil was weakened.25 To solve this problem, the PRAs added Forties and Oseberg in 2002 and Ekofisk in 2007 to the Brent crude group as deliverables.26 Thus, Brent is also called BFOE, which is a combination of the first letter of each newly included variety. However, as the lack of liquidity caused by declining production has not been resolved, many have suggested that new measures should be put in place. To increase the liquidity of Brent, the PRAs decided to add Norwegian Troll to the Brent benchmark basket from January 2018.27

Table 2-5. Properties of BFOE Oils

Brent Forties Oseberg Ekofisk Troll

Specific 37.5 38.7 38.5 38.5 35.9 gravity (API)

Sulfur 0.40 0.79 0.24 0.19 0.15 content (w%)

Source: Energy Intelligence (http://www.energyintel.com)

Brent pricing is more complicated than that of WTI, because its pricing comprehensively reflects the prices in the spot, forward, and futures markets. First, the price of Brent in the spot market, which is referred to as Dated Brent, is most commonly applied to physical transactions. Although it is a spot transaction, it has the nature of a forward transaction, as it usually takes about 10 to 25 days to ship the crude oil after the contract is signed.

24 ICE (2011), p.14. 25 Brent production decreased from 885,000 b/d in 1986 to 366,000 b/d in 1990 (Horsnell and Mabro, 1993). 26 Bossely (2017), p.3. 27 HIS (2017), p.3. 20

Accordingly, the PRAs evaluate the Dated Brent prices on the basis of the forward price.

Forward Brent, also referred to as 25-day Brent, specifies the delivery month but not the particular delivery date. The term “25-day” indicates that the buyer will be notified of the delivery date 25 days in advance. Forward Brent takes longer to deliver than Dated Brent. Typically, three-month forward transactions are common, and the PRAs evaluate prices accordingly. Forward prices are reflected in Dated Brent prices through contract-for- difference (CFD),28 which is a kind of short-term swap.

Brent futures prices resolve the price distortion problems caused by the lack of liquidity in forward trading. Brent futures, which were launched by the International Petroleum Exchange (IPE, now ICE) in the 1980s, became the world’s largest futures, along with WTI futures, on NYMEX when its trading volume and open interests underwent significant growth in the 2000s. Brent futures are basically cash settled. But, with agreement between the parties involved, exchange for physicals (EEP) is also possible, and EEP is reflected in Forward Brent pricing along with Brent futures.

As mentioned above, Dated Brent prices are generally applied to spot transactions. More recently, however, prices of Brent futures with high transparency and liquidity have been used as a reference more frequently. For the crude oils exported from Middle Eastern countries, such as Saudi Arabia and Kuwait, to Europe, BWAVE, the weighted-average price calculated based on trade volumes, is used. BWAVE is calculated by applying weighted averaging to the price of nearby-month contracts traded on ICE and the volume of month contracts traded on the day.

Meanwhile, Russia’s Urals was listed on the St. Petersburg International Mercantile Exchange (SPIMEX) in November 2016, creating the expectation that pricing transparency would improve and transaction volumes would increase.29 Some predict that Urals may be emerging as a new marker crude for Europe, replacing Brent. The Russian government is also making efforts to have its Urals crowned as an international marker. However, Urals crude oil has too many demerits to be a marker crude, including the fact that its production is controlled by state- owned enterprises.

D. Asian Market’s Marker Crude Oil: Dubai

Dubai, the Asian market’s marker crude oil, is a medium sour oil with an API of 30.4 and sulfur content of 2.13w% (Table 2-3). It is produced in the Fateh oilfield in Dubai, one of the seven emirates of the United Arab Emirates (UAE). The Fateh oilfield is an offshore oilfield located about 60 miles from Dubai that was discovered in 1966 and began production in 1969. The production of Dubai oil has increased rapidly with the establishment of more oilfields in South West Fateh in 1970, Falah in 1972, and Rashid in 1973. The Fateh and South West Fateh oilfields were classified as “giant” oilfields when their cumulative production exceeded 2 billion barrels in 1988.30

Dubai crude oil has been used as an Asian marker crude oil since the mid-1980s. Since the trading of Arabian Light, the marker crude at the time, in the spot market was suspended, Dubai oil, which was one of the few spot- tradable oils in the Middle East, naturally attracted attention. And as more Japanese brokers and U.S. oil refineries have participated in Dubai oil transactions, its liquidity has increased as well. When OPEC abandoned its administered-pricing system and decided to set the price of crude oil exported to Asia based on Dubai oil in 1988, Dubai crude oil became the “Brent of the East.”31 Most of the sour oils traded in the eastern Suez region, the crude oils sold by several state-owned oil companies in the Middle East, and Russia’s Sokol, Sakhalin Blend, and

28 CFDs are swap contract that exchanges the prices of Dated Brent (variable) and forward Brent (fixed). 29 Energy Intelligence (November 21, 2016), p.6. (Urals has an API of 31.7 and sulfur content of 1.35w% (Energy Intelligence, 2015)). 30 Dubai Petroleum Establishment (http://www.dubaipetroleum.ae/timeline.php (retrieved Apr. 15, 2017)). 31 Requoted from Horsnell and Mabro (1993) and Fattouh (2011), p.61. 21

ESPO have all adopted Dubai oil as their marker.32

Unlike WTI and Brent, Dubai oil is not traded on the futures market. In the early 1990s, attempts were made to launch Dubai crude oil futures in London and Singapore, but they resulted in failure. Dubai futures on the Tokyo Commodity Exchange (TOCOM), which began in 2001, went only as far as local crude futures, as their trade details, such as units and currencies, are different from the global standard. Dubai Crude Oil Financial Futures traded on NYMEX and Dubai 1st Line Futures listed on ICE are different from WTI futures and Brent futures in terms of price formation and settlement type.33

Over-the-counter (OTC) Dubai is traded relatively actively, particularly with Brent/Dubai Exchange of Futures for Swaps (EFS) and Dubai inter-month swaps. Brent/Dubai EFS is a differential between the Dubai oil price and ICE Brent futures price, allowing market participants to hedge their risks against Dubai oil prices. Dubai inter- month swaps are the differentials between two swaps with different delivery months and are thus used by market participants to hedge their positions from one month to the next. Dubai inter-month swaps are actively traded in London and Singapore and, coupled with Brent/Dubai EFS, have a significant influence on the pricing of Dubai crude oil.34

Although the Dubai OTC trade volume is not officially compiled, Fattouh (2011) estimated that the Brent/Dubai EFS trade volume ranged from 1,000 to 2,000 contracts (1 to 2 million barrels) a day, and that the Dubai inter- month swap was 2,000 contracts (2 million barrels) a day. OTC participants encompass a variety of entities, including Asian refineries, global investment banks such as JP Morgan, other international oil companies such as BP, and brokers such as Vitol.

On the other hand, as discussed in the section about the formula for calculating the term-contract prices of crude oil, the average prices of Dubai and Oman crude oils are used as a reference for the term-contract sales prices of Middle Eastern oil-producing countries. The average prices of Dubai and Oman crude oils began to be used as a reference to solve the liquidity problem that was caused by the sharp decline in Dubai oil production after the mid-1990s. This measure was taken because international oil companies such as Royal Dutch Shell owned shares in the Petroleum Development Oman (PDO) and other state-owned companies of Oman, which is not a member country of OPEC, and produced and sold Oman oil to the spot market themselves. Although Oman crude oil prices are used in the formula for calculating term-contract prices, Oman oil is not accepted as an independent marker oil because its spot price in the past was traded based on the differential between and the official selling price of Dubai crude (OSP) that the government retroactively applied. Currently, it is known that the spot price of Oman oil is based on Oman Crude Oil Futures, which have been traded on the Dubai Mercantile Exchange (DME) since 2007.

3. PRAs

A price-reporting agency (PRA) is a private entity that collects information on various types of transactions in the international oil market and evaluates and announces spot prices, petroleum product prices, and derivative prices of crude oils, including marker crude oils.35 It is difficult to standardize the prices of crude oils because of the various physical characteristics and trading methods involved. In particular, crude oils and petroleum products differ in price depending on their physical characteristics, such as their sulfur content, specific gravity, boiling point, viscosity, and impurity content, as well as transportation method and time of delivery. Also, crude oil

32 Platts (2015), “FAQ: Dubai Crude.” 33 The Dubai futures on NYMEX and ICE are settled in cash based on Platts prices. 34 For example, when Asian demand increases, the EFS price declines and the Brent and Dubai oil price differential narrows. Traders view this price decline as a signal suggesting the strength of Dubai oil. Argus refers to the EFS prices for its Dubai oil price estimation. 35 The PRAs generally valuate and announce the prices of low-liquidity products. They are active in various fields, including oil, metals, agricultural products, petrochemical products, and transportation, with each field having several PRAs. Platts and Argus Media are two of the largest PRAs, as they are active in almost every field. 22

transactions are carried out in the form of face-to-face deals.36 These factors led to the emergence of PRAs, which estimate market prices by collecting and analyzing information on crude oil and petroleum product trades.

The prices of crude oil and petroleum products valuated by PRAs are used as references in various oil transactions, and thus have a great influence on the market. Since the PRAs’ valuated prices serve as references for huge volumes of oils traded in term-contract, spot, and derivates transactions, even a small price difference may have a profound effect on the profits and losses of buyers and sellers. Furthermore, the timing and method of pricing and announcement also influence the strategies of market participants. For example, participants may create new contracts and new markets as means of hedging against the risks arising from the pricing of the PRAs. Therefore, although the PRAs only perform the task of valuating the prices of oil, a product that lacks liquidity, the role they play is far more significant than that of a simple observer in the oil market.

Platts, Argus Media, APPI, and ICIS are the representative PRAs that evaluate and disclose oil prices, but Platts holds a monopolistic position with a market share of 80%.37 Platts valuates the price of Dubai oil, which is the Asian marker crude oil.

Each PRA has its own methodology that underlies pricing, meaning that it is possible for different prices to be calculated and announced for the same subject. The PRAs understand oil prices in a variety of ways, such as the weighted average of trade volume, high- and low-price method, and market-on-close (MOC, or closing price). Platts and Argus Media, the two giant oil PRAs, use the MOC method and volume weighted-average method, respectively (Platts, 2017, and Argus, 2015).

In its MOC method, Platts sets a time range in the Platts eWindow and valuates the price based on the transactions carried out in this range. The price assessment uses not only the prices of concluded transactions but also bids and offers of non-concluded transactions. It also uses the spread of other products and information on the derivatives market to help with the price assessment. As such, eWindow is a system by which Platts collects information to serve as evidence for valuating the daily prices of major markers. The eWindow system is similar to the futures exchange system, where traders make bids and offers, but it is different in two major ways: the parties behind the bids and offers are known, and Platts decides what information is to be considered in the valuation.

The volume weighted-average method involves taking the weighted average of transactions occurring at a certain point in time, usually just before the close of trading, based on volume. However, both the volume weighted-average and MOC methods have advantages and disadvantages. The volume weighted-average method takes a number of deals into account and is thus more representative, but it is criticized for possibly not reflecting the actual market price prevailing at the close of the day. This would be the case especially on days with high volatility. On the contrary, the MOC method effectively reflects the actual market price at the time of market closing, but it is highly likely to result in distorted prices if there are unusual transactions at that time.

The transparency and accuracy of the price assessments of the oil PRAs have been given great importance in relation to “oil volatility mitigation,” which was one of the agendas of the G-20 Summit for the 2010-2013 period. The details and problems of the price-assessment method for Dubai oil, the Asian marker crude oil, will be discussed in more detail in Chapter 4.

36 Ministry of Strategy and Finance and the Korea Energy Economics Institute (2013), p.68. 37 http://www.blplaw.com/expert-legal-insights/articles/benchmark-manipulation-price- oil-spotlight (retrieved Apr. 20, 2017). 23

Chapter 3. Volatility of and Correlations Among Marker Crude Oil Prices

1. Overview

The prices of marker crude oils, which represent the major oil-consuming regions (as in Chapter 2), serve as a reference for the trading of crude oils and petroleum products. Although the prices of these regionally divided marker crude oils reflect the characteristics of each regional market, there are some interdependencies with the prices of offshore marker crude oils. In this section, the price volatilities of marker crude oils are compared, and the correlations among them (synchronicity and causality) are empirically analyzed to identify the interdependence of the marker crude oils. The subjects of analysis are the WTI, Brent, Dubai, and Oman crude oils. Though Oman oil is not recognized as an independent marker crude oil, as mentioned above, it is included in the analysis because it is used in the formula to calculate the selling prices of crude oil under term contracts in Asia. The price data used for the analysis are the daily spot prices from January 1, 2007 to December 30, 2016.

To measure price volatility, most existing studies use the simple price change rate or standard deviation. This study, however, uses the GARCH (1,1) model, which is often used to measure the volatility of financial asset prices in order to identify the volatility of marker crude oil prices. The GARCH (1,1) model weighs the historical residual values and variation values of the time-series data of marker crude oil prices, unlike the standard deviation, which has one constant value during the target period. After measuring the volatility of individual marker crude oil prices using the GARCH (1,1) model, this paper analyzes whether the price volatilities so measured show any structural changes over time using the Bai-Perron model.

Previous studies on the synchronicity of marker oil prices have presented different results. Since Adelman (1984) suggested the “one great pool hypothesis,” many researchers have supported the argument that regional marker crude oil prices have inter-synchronicity.38 The “one great pool hypothesis” says that, although there are quality differences and regional segregations among the marker oils, there are no significant price differences that will lead to profits from arbitrage. On the other hand, Weiner (1991) argued that the global oil market was localized, while Hammoudeh and Yuan (2008) argued that the four marker crude oils (WTI, Brent, Dubai, and Maya) are not in a long-term equilibrium relationship.

This study examines whether there is synchronicity between marker crude oil prices by estimating the rolling correlation coefficient and looks into whether the synchronicity changes over time. It also identifies whether a long-term equilibrium relationship exists between marker crude oil prices through a co-integration test. The cointegration test is conducted over both the entire target period and the four divided periods. Finally, causality between marker crude oil prices is analyzed by performing a grandeur-causality test.

2. Volatility of Marker Crude Oil Prices

A. Price Volatility Measurement Model and Results

There are various statistical methods for measuring price volatility, which is the degree to which prices fluctuate. In existing studies, standard deviation and rate of change are the most frequently used methods for measuring price volatility. However, since the standard deviation and rate-of-change formulas can generate results that vary greatly depending on the measurement period and number of observations, a volatility-measurement method that produces more consistent results is needed. In response to this issue, this study measures the price volatility based on the GARCH (1,1) model, which minimizes the volatility measurement errors of time-series random variables and implicitly reflects past volatility patterns. The GARCH (1,1) method maximizes coherence and predictability by implicitly reflecting the residuals and variance values of time-series random variables (Choi, 2013). The

38 In support of Adelman (1984)’s “one great pool hypothesis,” the phrase “The world oil market, like the ocean, is one great pool” has been quoted in several studies. Studies supporting this hypothesis are IMF (2008), Fattouh (2010), and Aimadi and Zhang (2011). 24

composition of the GARCH (1,1) model is as follows (Choi, 2013).

In general, the GARCH (p, q) model is determined by the parameter values of “p,” which is the number of lag in the GARCH model and “q,” which is the number of lag in the ARCH model. In the above formula, h is the time-series random variable, is the residuals, and is the error of GARCH (1,1). The ARCH (1) of the crude oil price variance, h, used to compose the above GARCH (1,1) is as follows.

If the variance of the random variable is interpreted as volatility, the price volatility of t is the sum of the squared value of the residual t-1 and variance value by reflecting the weighted parameter obtained through a maximum likelihood estimation.

The GARCH (1,1) model used to estimate price volatility shows that the volatility patterns of WTI and Brent are similar, as are the volatility patterns of Dubai and Oman oils. The reason for this is probably that WTI and Brent are marker crude oils in the Western region, including the United States and Western Europe, and Dubai and Oman are markers in Asia.

Figure 3-1 shows the conditional and unconditional volatilities of the daily prices of Dubai and Oman crude oils. Conditional volatility is the daily volatility measured under the GARCH (1,1) condition, while unconditional volatility is calculated by applying the daily residuals ( ) to the entire period. Therefore, conditional volatility data is used to understand the volatility in the form of random variables that change on a daily basis, whereas unconditional volatility, in the form of a constant value, is used to understand the volatility during the entire target period. As described above, the price volatilities of Dubai and Oman crude oils are very similar: the unconditional volatility of Dubai oil is 1.0566 and that of Oman oil is 1.0529.

The conditional and unconditional volatilities of the daily prices of WTI and Brent are shown in Figure 3-2. As can be seen here, the volatility patterns of the two crude oils are similar. However, the unconditioned volatility, which is the volatility over the entire period, of WTI is 1.3573, which is a little higher than the 1.3076 of Brent. The price volatility of both crude oils is higher than those of Asian marker crude oils.

Figure 3-1. Daily Price Volatility of Dubai and Oman Crude Oils

Note: The solid line is the daily volatility (conditional volatility) measured under the GARCH (1,1) condition. The dotted line is the standard deviation (unconditional volatility) calculated by applying the daily residuals ( ) to the entire period.

원문 번역문 두바이유 가격변동성 Price volatility of Dubai crude oil

오만유 가격변동성 Price volatility of Oman crude oil

Figure 3-2. Daily Price Volatility of WTI and Brent Crude Oils

원문 번역문 WTI 가격변동성 Daily price volatility of WTI crude oil

브렌트 가격변동성 Daily price volatility of Brent crude oil

Let’s look at how the volatility measured on the basis of the GARCH (1,1) model is different from the volatility measured according to the conventional volatility-measurement method, which uses the rate of change in the preceding period.39 As shown in Figure 3-3, the price volatilities of Dubai and Oman measured by the GARCH (1,1) model from January 2007 to December 30 of 2016 show similar patterns as the volatilities calculated based on the rate of change in the preceding period. As for the numeric code, the simple rate of change is marked with a positive sign (+) to indicate an increase and a negative sign (-) to indicate a decrease. However, given that the volatility based on the GARCH (1,1) model is always above zero, all the volatilities from mid-2008 to early 2009 have increased. After that, the volatility remained stable before increasing sharply in early 2011, entering another period of stability, and increasing again from 2015. However, in early and mid-2016, the volatility based on the GARCH (1,1) model is smaller than the volatility based on the rate of change. The reason for this seems to be that the sudden price volatility, in which the oil price fell drastically from USD 140 per barrel to USD 40 per barrel due to the global financial crisis from mid-2008 to early 2009, was recognized as a pattern in the GARCH (1,1) model.

The price volatilities of WTI and Brent shown in Figure 3-4 are similar to those of Dubai and Oman. Generally, the GARCH (1,1)-based volatility and rate-of-change-based volatility have the same patterns—that is, they increase during the period from 2008 to 2009, during 2011, and again during the period from 2015 to 2016. In 2016, the GARCH (1,1)-based volatility is smaller than the rate-of-change-based volatility.

39 The formula for calculating volatility based on the rate of change in the preceding period is , and the average value is zero. 27

Figure 3-3. Price Volatilities of Dubai and Oman Oils Based on GARCH (1,1) Model and Rate of Change

Note: The blue lines are the rate-of-change volatility (left vertical axis), and the red and green lines are the GARCH (1,1)-based conditional and unconditional volatilities, respectively (right vertical axis).

원문 번역문 두바이유 가격변동성 Price volatility of Dubai crude oil

오만유 가격변동성 Price volatility of Oman crude oil

Figure 3-4. Price Volatilities of WTI and Brent Oils Based on GARCH (1,1) Model and Rate of Change

원문 번역문 WTI 가격변동성 Daily price volatility of WTI crude oil

브렌트 가격변동성 Daily price volatility of Brent crude oil

B. Identification of Structural Changes in Price Volatility

It is important to identify structural changes in time-series random variables. The results of the empirical analysis that integrates the separate periods with structural changes into a single period naturally reveal accuracy 29

problems. Studies that identify structural changes in time-series data usually divide the period subject to analysis into two specific periods of time and then examine whether these two periods show statistically meaningful differences. Andrew, Lee, and Ploberger (1996) suggested a methodology for identifying two or more structural changes, while Garcia and Perron (1996) and Liu, Wu, and Zidek (1997) proposed a methodology for identifying three or more structural changes using information on coefficients and residuals.40

Later, Bai and Perron (1998 and 2003) developed the model of Liu, Wu, and Zidek (1997) (known as the “LWZ model”) and presented a methodology for finding multiple structural changes.41 This methodology can identify the timing of structural changes in the ordinary least squares method (OLS) as well as in the auto-regression model and trend-analysis models. Moreover, this methodology can accurately identify structural changes in even the different distributions of the error term of each specific period. It does not require the assumption that the estimated coefficient of the applied equation changes at each estimation time point. In other words, some coefficients may change before or after a point in time corresponding to the structural change while others may not. Based on this, the methodology makes a great contribution to controlling the degrees of freedom of the time-series analysis. Bai and Perron’s multiple linear regression model is as follows.

In this model, m is the number of structural changes in the m+1 phase; is the observed price volatility; and are the and vector correlation matrices, respectively; and are the vector correlation coefficients; and is disturbance. Ultimately, the task of identifying involves identifying structural break points.

Bai and Perron (2003) identifies the structural changes in three steps. The first step is to find at least one structural break point by performing the “double maximum test,” while the second step is to identify whether there are m number of potential structural break points and maximum m+1 number of structural break points, according to the minimum value of the sum of the squared residuals. The third, and final, step is to identify the structural break points according to the global information criteria provided in Bai and Perron (2003).

Using the Bai and Perron (2003) methodology, four structural changes are identified in the GARCH (1,1)-based volatility of Dubai oil prices from January 1, 2007, to December 30, 2016. Table 3-1 summarizes the results of the analysis. The maximum number of structural changes is five, but the optimal number of structural changes is four, which has the smallest sum of squared residuals (SSR) according to both the Schwarz standard and LWZ standard. The identified structural break points are: ① July 15, 2008; ② January 22, 2010; ③ December 6, 2012; and ④ October 16, 2014.

Structural changes in Oman oil prices, which have volatility patterns similar to those of Dubai oil prices, are very similar to the structural changes in Dubai oil prices. Structural changes in the GARCH (1,1)-based volatility of Oman oil prices have occurred a total of four times. The structural break points are: ① July 15, 2008; ② January 22, 2010; ③ December 12, 2012; and ④ October 16, 2014. Except for the third point in 2012, which shows a six-day difference from Dubai oil, the structural break points of Oman oil prices are consistent with those of Dubai oil prices (see Table 3-2).

40 Sunghee Choi (2015), p.56. 41 The strengths of the Bai and Perron (1998 and 2003) model are excerpted from Sunghee Choi (2015), p.56. 30

Table 3-1. Structural Changes in GARCH (1,1)-based Volatility of Dubai Crude Oil Prices

Subjects of analysis and results Estimated no. of breaks: 4 Maximum no. of breaks: 5 No. of No. of Schwarz LWZ SSR Log-L breaks coefficients standard standard 0 1 704.353 -1997.784 -1.312 -1.306 1 3 576.858 -1735.800 -1.506 -1.488 2 5 546.565 -1665.026 -1.554 -1.523 3 7 524.486 -1610.926 -1.589 -1.547 4 9 509.413 -1572.670 -1.612 -1.558 5 11 512.230 -1579.904 -1.600 -1.534 Number and points of structural breaks (month/day/year) 1 1/11/2012 2 7/15/2008, 12/29/2011 3 7/15/2008, 1/22/2010, 11/28/2012 4 7/15/2008, 1/22/2010, 12/06/2012, 10/16/2014 5 7/15/2008, 1/22/2010, 11/16/2011, 5/27/2013, 12/02/2014 Note: 1) Total of 2,624 observed breaks.

2) HAC covariance (Quadratic-Spectral kernel and Andrews bandwidth) is used.

3) Heteroscedasticity between structural breaks is reflected.

Table 3-2. Structural Changes in GARCH (1,1)-based Volatility of Oman Crude Oil Prices

Subjects of analysis and results Estimated no. of breaks: 4 Maximum no. of breaks: 5 No. of No. of Schwarz LWZ SSR Log-L breaks coefficients standard standard 0 1 669.120 -1930.477 -1.363 -1.357 1 3 554.210 -1683.250 -1.546 -1.528 2 5 521.471 -1603.363 -1.600 -1.570 3 7 492.980 -1529.649 -1.651 -1.609 4 9 478.148 -1489.568 -1.676 -1.621 5 11 483.273 -1503.556 -1.659 -1.592 Number and points of structural breaks (month/day/year)

1 1/12/2012 2 7/15/2008, 12/30/2011 3 7/15/2008, 1/22/2010, 12/05/2012 4 7/15/2008, 1/22/2010, 12/12/2012, 10/16/2014 5 7/15/2008, 1/22/2010, 11/16/2011, 5/27/2013, 12/02/2014 Note: 1) Total of 2,624 observed breaks.

2) HAC covariance (Quadratic-Spectral kernel and Andrews bandwidth) is used.

3) Heteroscedasticity between structural breaks is reflected.

Figure 3-5 clearly illustrates the points of structural change in the price volatility of Dubai and Oman oils. The price volatility of Dubai oil was highest from July 16, 2008, to January 22, 2010, and lowest from December 7, 2012, to October 16, 2014.

The structural changes in the price volatility of WTI and Brent occurred four times according to the Schwarz standard and three times according to the LWZ standard. This means that the identification of structural change varies depending on the standard used. Since this study focuses on the analysis of the Asian marker crude oil, explanation of the structural changes in the price volatility of WTI and Brent is omitted.

Figure 3-5. Structural Changes in GARCH (1,1)-based Volatility of Oman Crude Oil Prices

Dubai oil

Oman oil

Note: 1) The horizontal axis is the period, the left vertical axis is the residual, and the right vertical axis is the GARCH (1,1) volatility.

2) The red line (Actual) represents the estimated volatility, while the green line (Fitted) represents the volatility accounting for structural changes.

3. Synchronicity Between Prices of Marker Crude Oils

A. Correlation Analysis

The correlation coefficient is a statistic commonly used to identify the relationship between two market prices. +1 indicates a completely proportional relationship, while a value of -1 indicates a completely inversely proportional relationship. A correlation coefficient of zero shows that there is no relationship between the two variables. So, selecting two marker crude oils and obtaining the correlation coefficient is the most basic method of confirming synchronicity between the prices of two marker oils.

The rolling correlation coefficient can identify how the correlation between the two variables changes over a long period of time, as it estimates values in different time segments, although it follows the basic concept of a simple correlation coefficient. The reference period for estimating the rolling correlation coefficient is set at six months and one year so that the effect of the events that occurred during a specific period is not over- or underexposed. In other words, the two types of rolling correlation coefficients of marker crude oil prices were calculated, and their changes over time were observed.

Figure 3-6 shows the six-month rolling correlation coefficients of the prices of Dubai oil and other marker crude oils from January 1, 2007, to December 30, 2016. The correlation coefficients of Dubai and Oman oil prices at the top show that the values have stayed close to 1 for 10 years. This suggests that the price volatilities of Dubai and Oman oils, which are the most frequently traded in the Asian market, are almost completely synchronized. Most of the rolling correlation coefficients of Dubai oil and Brent prices remain between 1 and 0.8, indicating that the prices of the two marker oils are highly synchronized.

Figure 3-6. Six-month Rolling Correlation Coefficients of Prices of Dubai Oil and Other Marker Crude Oils

Figure 3-7. Twelve-month Rolling Correlation Coefficients of Prices of Dubai Oil and Other Marker Crude Oils

원문 번역문 강동조기 Strong synchronicity

동조약화기 Weak synchronicity 최악동조 및 회복기 Weakest and recovered synchronicity 재강동조 및 유지기 Repetitive, strong synchronicity and its maintenance

However, the changes in the rolling correlation coefficients of Dubai oil and WTI prices were different. Until

March 2010, the synchronicity had been relatively strong and stayed near 1. But as the rolling correlation coefficient declined to around 0.8, synchronicity weakened. From March 2013 to December 2014, the rolling correlation coefficient declined dramatically, causing a decoupling of the two crude oil prices. Since January 2015, the synchronicity between Dubai and WTI has recovered.

Figure 3-7 shows the rolling correlation coefficients over a period of one year. Again, the prices of Dubai and Oman oils and Dubai and Brent are highly synchronized over the entire period. The changes in the correlation coefficient of Dubai and WTI prices over the one-year period are more gradual than those in the six-month period. However, the entire period of the 12-month analysis is also divided into four segments, as was done for the six- month analysis. However, the time points of the first three of the four periods with different synchronicities start about one year later. From mid-2011 to 2014, the price of WTI shows the weakest synchronicity with the Dubai oil price, probably because U.S. crude oil production surged with the expansion of the country’s shale oil production.

B. Cointegration Test

First, to examine whether the time-series data of marker crude oil prices are stable, the Dickey-Fuller unit root test is conducted. The formula for the test is as below.

In this formula, , and the term with the first lagged difference is added. The null hypothesis is established as “unit roots exist, and no time series is stable (i.e., ).” If the time series is not stable, the stability is obtained via first differencing. If the time-series data are stable after conducting first differencing, they are denoted as “I (1),” as the data are integrated by the first lag order.

Table 3-3 shows the results of the Dickey-Fuller unit root test of marker crude oil prices. The test was conducted for the entire 10-year period and again for each of the four periods divided according to the degree of synchronicity, which was identified using the 12-month rolling correlation coefficient. As a result, the original time-series data were not stable, both over the entire period and in the four divided periods. However, through first differencing, it was confirmed that the prices of the four marker crude oils were all stable at a significance level of 1%.

The Dickey-Fuller test above confirms that the time-series variables of the spot prices of the four crude oils become stable through first differencing. Based on this, the Johansen (1988) test is conducted to find out whether the spot prices of Dubai oil are in balance with those of the three other varieties with similar probability trends.

The cointegration tests conducted on the daily prices of Dubai oil and the other marker crude oils between January 1, 2007, and December 31, 2016, show that the null hypothesis was rejected at a significance level of 1%, indicating that a cointegration relationship exists (see Table 3-4).

Table 3-3. Results of Dickey-Fuller Unit Root Test

Hypothesis test Dubai WTI Brent Oman statistics

Entire period: 01/01/2007-12/30/2016

-1.837 Test statistics -1.53 (0.52) -1.81 (0.52) -1.49 (0.54) (0.36)

First differencing -50.10 -51.92 -52.45 -49.55 test statistics (0.00) (0.00) (0.00) (0.00)

Strong synchronicity period: 01/01/2007-4/30/2009

Test statistics -1.36 (0.6) -1.19 (0.68) -1.67 (0.45) -1.32 (0.62)

First differencing -31.81 -32.68 -32.61 -31.43 test statistics (0.00) (0.00) (0.00) (0.00)

Weak synchronicity period: 05/01/2009-04/30/2013

Test statistics 0.14 (0.73) -0.50 (0.5) 0.14 (0.73) 0.21 (0.75)

First differencing -29.24 -28.99 -31.01 -29.08 test statistics (0.00) (0.00) (0.00) (0.00)

Weakest and recovered synchronicity period: 05/01/2013-12/31/2014

Test statistics 2.55 (1.00) 2.43 (1.00) 2.41 (1.00) 2.55 (1.00)

First differencing -13.00 -16.92 -15.38 -12.86 test statistics (0.00) (0.00) (0.00) (0.00)

Repetitive strong synchronicity and its maintenance: 01/01/2015-12/31/2016

Test statistics -1.67 (0.44) -1.86 (0.35) -1.89 (0.34) -1.65 (0.46)

First differencing -21.62 -23.38 -23.04 -21.09 test statistics (0.00) (0.00) (0.00) (0.00)

Table 3-4. Results of Johansen Cointegration Test (Entire Period)

Type Eigenvalue Trace statistics Max-Eigenvalue

Dubai-WTI 0.03223 119.76 (0.00) 60.42 (0.00)

Dubai-Brent 0.03887 120.52 (0.00) 68.44 (0.00)

Dubai-Oman 0.04110 131.11 (0.00) 70.38 (0.00)

Note: 1) Up to three lags are taken into account.

2) The null hypothesis is that the time-series prices of the two oil varieties do not have a

cointegration relation.

Table 3-5. Results of Johansen Cointegration Test (Four Sub-Divided Periods)

Trace Max- Periods Type Eigenvalue Statistics Eigenvalue

Dubai-WTI 0.0129 14.24 (0.05) 13.63 (0.05)

January 1, 2007 - Dubai-Brent 0.0305 15.30 (0.05) 14.16 (0.05) April 30, 2009

Dubai-Oman 0.0422 23.12 (0.00) 21.85 (0.00)

Dubai-WTI 0.0168 18.45 (0.09) 13.02 (0.08)

May 1, 2009 - Dubai-Brent 0.0277 26.84 (0.00) 22.68 (0.00) April 30, 2013

Dubai-Oman 0.0202 22.41 (0.00) 18.15 (0.01)

Dubai-WTI 0.0273 10.91 (0.22) 8.91 (0.29) May 1, 2013 - December 31, Dubai-Brent 0.0551 24.13 (0.00) 19.08 (0.01) 2014 Dubai-Oman 0.0519 30.00 (0.00) 20.10 (0.01)

Dubai-WTI 0.0340 13.48 (0.10) 12.82 (0.09) January 1, 2015 - December 31, Dubai-Brent 0.0605 25.17 (0.00) 23.96 (0.00) 2016 Dubai-Oman 0.0415 23.74 (0.00) 17.97 (0.01)

Note: 1) Up to three lags are taken into account.

2) The null hypothesis is that the time series prices of the two oil varieties do not have a cointegration relation.

Despite the weak synchronicity period of Dubai and WTI prices, the Dubai-WTI cointegration relation is estimated to be significant for the entire period, for which there are two likely reasons. First, the period during which synchronicity was maintained is much longer than the period of weakest synchronicity (2011-2014), thus offsetting the period of non-synchronicity. Second, the non-synchronicity between the two varieties has been reflected to a very limited degree as it was measured on a daily basis over a 10-year period. Therefore, the cointegration test conducted for the divided periods examines the synchronicity between the crude oil varieties more closely.

As a result of the cointegration tests carried out on the relationships between Dubai oil and the other varieties over the four divided periods, which were segmented based on the changes in the one-year rolling correlation coefficients of the marker crude oils, the price of Dubai oil was found to have a cointegration relation with the 38

prices of Brent and Oman oils at a significance level of 1 percent over all four periods (Table 3-5). However, the cointegration relation between Dubai and WTI is relatively weaker than those between Dubai and Brent or Oman. The Dubai-WTI prices are found to have a cointegration relation with a significance level of 10% in the first and second periods, and the cointegration relation in the third period was not statistically significant, as the rolling correlation coefficients fell significantly. The cointegration relation between Dubai-WTI prices has recovered to a significance level of 10% since 2015.

4. Causality Between Prices of Marker Crude Oils

To identify causality between marker crude oil prices, the causalities between Dubai oil and other marker crude oils are analyzed. To this end, the granger-causality test is conducted based on the formula below.

Here, is the spot price of Dubai oil, and is the spot price of other marker crude oils. The prices of WTI, Brent, and Oman are input as , and the causality with the price of Dubai oil is estimated. Past prices up to five days before t-5 are taken into account.

For all six hypotheses, the results of the daily causality analysis between Dubai oil and other varieties over the 10-year period are shown in Table 3-6.

Table 3-6. Test of Causality Between the Prices of Dubai Oil and Other Marker Crude Oils

Lag_1 Lag_2 Lag_3 Lag_4 Lag_5

Ho: change in Dubai oil price does not cause change in WTI price

0.069 (0.79) 0.847 (0.43) 2.038 (0.11) 1.643 (0.16) 0.592 (0.71)

Ho: change in WTI price does not cause change in Dubai oil price

2341.45 217.14 767.76 551.48 420.3 (0.00) (0.00) (0.00) (0.00) (0.00)

Ho: change in Dubai oil price does not cause change in Brent price

2.717 (0.10) 1.914 (0.15) 1.935 (0.12) 1.298 (0.27) 0.521 (0.76)

Ho: change in Dubai oil price does not cause change in Brent price

3745.98 2090.49 1351.55 1029.30 805.58 (0.00) (0.00) (0.00) (0.00) (0.00)

Ho: change in Dubai oil price does not cause change in Oman oil price

0.084 (0.77) 2.671 (0.07) 3.156 (0.02) 2.055 (0.08) 1.849 (0.10)

Ho: change in Oman oil price does not cause change in Dubai oil price

13.100 8.009 (0.00) 7.259 (0.00) 5.104 (0.00) 4.684 (0.00) (0.00)

Note: The statistics are F-statistics, and the figures in ( ) are the significance levels.

As a result of the first and second hypothesis tests for examining causality between the prices of Dubai oil and WTI, it was found that change in the price of WTI causes change in the price of Dubai oil, but the reverse is not true. It was confirmed that the price of Dubai oil on any given day is influenced by changes in the price of WTI five days earlier (Lag_5). Therefore, besides the impact of the time gap between the United States and Singapore, the WTI price is deemed to have a significant influence on the Dubai oil price.

Like WTI, the Brent price is also found to have an influence on the price of Dubai oil. As seen in the hypothesis test results, the price of Dubai oil on any given day is influenced by changes in the price of Brent oil from one day (Lag_1) to five days (Lag_5) earlier at a significance level of one percent.

The last two hypotheses are for examining causality between Dubai and Oman oil. Change in the price of Oman oil causes change in the price of Dubai oil, but the reverse is not true. This suggests that the futures price of Oman oil traded on DME affects the spot price of Dubai oil as well as the pricing of Dubai oil by PRAs. In addition, this could be interpreted as meaning that, since Oman oil futures have been traded since 2007, the status of Oman oil has been raised.

Chapter 4. Problems of the Asian Marker Crude Oil

1. Overview

There are many problems with the price-discovery function of Dubai crude oil, which is its most important role as a marker crude oil. First, the production and trade volumes of Dubai oil have been declining continuously. According to EI statistics, Dubai oil production exceeded 400,000 b/d in 1991 but declined to around 100,000 b/d in 2005 and further to 25,000 b/d in January 2017 (see Figure 4-1). The current production volume of Dubai oil falls short of two cargoes per month, which is insufficient to secure full liquidity in the market.42 Second, only a small number of traders are involved in Dubai oil trades, meaning that the likelihood of price manipulation is high. As such, Dubai crude oil does not satisfy the basic requirements necessary to serve as a marker crude, such as large production volume, stable supply, diversity of sellers and buyers, and broad acceptability.43

The fundamental problem in relation to the Asian marker crude oil is that most of the major oil-producing countries in the Middle East that are producing and exporting large volumes of crude oil prefer to sell directly to refineries through term contracts rather than spot sales. In particular, large-scale producers such as Saudi Arabia, Kuwait, and Iran adhere to strict sales policies that restrict them to selling crude oil through term contracts only.

Figure 4-1. Change in Dubai Crude Oil Production

Note: Drafted based on Energy Intelligence (January 1991-June 2017).

원문 번역문 (천b/d) (1,000 b/d)

In addition, the Middle Eastern oil-producing countries have adopted inflexible sales systems that limit their shipping destinations to only a few locations and ban the resale of crude oil to third parties. As a result, crude oils from Middle Eastern countries are not actively traded in the spot market, which makes it fundamentally difficult for a marker crude oil, produced by the Middle East and consumed by Asia, to emerge.44

Though Dubai oil’s status as a marker crude oil is weakening due to its liquidity problem, it is able to maintain its marker oil function because PRAs evaluate its price. 45 However, there is much controversy over the appropriateness of the Dubai oil price evaluated and announced by Platts, which is one of the PRAs. In the following section, the way in which Platts determines the Dubai oil price is reviewed, and related problems are

42 One cargo is generally 500,000 barrels. 43 Dalseok Lee (2016), pp.50-51. 44 Dalseok Lee (2016), p.51. 45 Dalseok Lee (2016), p.52. 41

analyzed.

2. Pricing Method of Dubai Crude Oil

A. Priority in Data Use

Platts collects and utilizes various information, including data publicly available on eWindow as well as non- disclosed data collected through the internal evaluation process. In other words, Platts uses bids and offers and the prices of concluded transactions disclosed through eWindow as well as over-the-counter and non-disclosed transaction information. 46 Data other than those obtained through eWindow are collected through various channels, including messaging software, telephone, email, and fax. Trades on eWindow, however, form the most important means of price assessment.

Figure 4-2. Screen Layout of Platts eWindow

Source: Platts (https://www.platts.com/ (retrieved August 25, 2017)

Platts has adopted a market-on-close (MOC) pricing methodology for Dubai crude oil and various petroleum products.47 Based on eWindow, an online market, a pricing methodology that uses the market closing price or MOC is selected. Specifically, the MOC pricing methodology valuates oil prices based on information on transactions executed immediately before market closing (16:29, Singapore time), among all bids, offers, and prices of concluded transactions executed during the 30 minutes before market closing (16:00-16:30).

Platts has its own guideline on the criteria and priorities for selecting data for reasonable pricing. According to this guideline, Platts first looks at information on completed transactions, which is disclosed to the market, and the evaluation team uses the information on buy and sell orders after reviewing its appropriateness. In the event there is no order or transaction information, Platts collects similar information in the market, information on past transactions of the same product, and information on the relevant market.48 We will now take a closer look at the priorities of Platt’s data use.

In the price-assessment process, Platts first considers information on bids, offers, and concluded transactions that is disclosed to all trading partners. This means that non-transparent bids and offers may be excluded from the

46 Dalseok Lee (2016), p.52. 47 eWindow’s operations and priorities in the use of information described here is prepared based on information from Platts (May 2016 and January 2017). 48 Ministry of Strategy and Finance and Korea Energy Economics Institute (2013), p.70, and Dalseok Lee (2016), p.52. 42

evaluation process. For example, a bid higher than a disclosed offer or an offer lower than a disclosed bid may not be reflected in the pricing. In addition, each bid or offer price is considered only when the trading counterparty is given sufficient time to sell or buy at that price. Otherwise, the price may be deemed unfeasible.

In its final pricing process, Platts places greater weight on transparent, fully verifiable market information. It generally assesses the market price between the bid and offer disclosed to the market at the closing time, according to the MOC methodology. This is to make sure that the price tradeable at market closing is reflected in Platts’ pricing.

When data on bids, offers, and concluded transactions are unavailable, Platts uses verifiable data reported during market trading hours, including wholly or partially verified transaction prices, notional transaction prices, and other market information. In such a situation, it may take into account the price difference with the general price of the product, blending, and shipping cost. In addition, Platts analyzes the relationships between various products and considers the results in its pricing of products when there is only a small amount of data in the market. When there is no or only a small amount of transaction data, it normalizes all other available data (e.g., data on transactions in the relevant markets) that may be relevant to the price assessment. In this case, it considers representative transactions completed at market closing, as used in the MOC method, and additional bid and offer information submitted at this time. Platts’ evaluation team adheres to the principle of confirming all reported bid, offer, and transaction information directly with the relevant entity.

Platts’ MOC guideline aims to prevent the distortion of final pricing and eliminate unverified inputs while excluding one-off and non-repetitive transaction data from the pricing process. Of course, it is possible for a one- off transaction to reflect the market price. However, such a transaction should be assessed in comparison with a broad array of similar transactions. For example, if a buyer decides to take an offer but stops buying the volume re-offered by the same seller at the same price level, the buyer is judged to have failed the repeatability test. As such, if the seller does not resell, the seller is judged to have failed the repeatability test. Therefore, such transactions may not be fully reflected in pricing.

In addition, bid or offer prices based on unverified price resistance or price support line may not be declared. In addition, if the price change is drastic, rather than gradual, the transaction may be concluded at a price that is not sufficiently verified in the market. In this case, the actual market price may be determined to be somewhere between the last bid price and the contracted price.

B. Transactions of Dubai Oil on Platts eWindow

On Platts’ eWindow, Dubai commodity oil is traded on the basis of two-, three-, and four-month contracts. In other words, Platts evaluates actual Dubai oil prices over a three-month period two months after the assessment date. For example, in April, it assesses the bids of offers made in June, July, and August. Accordingly, June contracts are evaluated as nearby month contracts on April 30. On May 1, the nearby month contracts to be evaluated are July contracts.

The base point of the price assessment is the Fateh (Dubai offshore oilfield terminal) FOB, and the transaction is conducted in U.S. dollars per barrel. The bid and offer prices can be changed within a range of 1 to 10 cents. The trade units are a partial cargo of 25,000 barrels and a full cargo of 500,000 barrels. Platts reflects the bid, offer, and transaction prices of the partial cargo. When the same buyer and seller trade 20 partial cargoes, a full cargo of 500,000 barrels is delivered and received.49

Neither the seller nor the buyer may refuse the delivery or acceptance of cargo under a concluded contract. However, with mutual agreement, the parties may terminate the contract based on the price published on the last business day of the month. Parties that have traded fewer than 500,000 barrels should settle the contract in cash based on the price published on the last business day of the month. However, with mutual agreement, physical

49 On November 1, 2013, Platts changed its full cargo volume to 500,000 barrels, which was to be reflected in the valuation of the spot prices of Dubai, Oman, and Upper Zakum oils. The previous full cargo volume was 475,000 barrels, which was equivalent to 19 partial cargoes (Platts (May 2016), p.30). 43

delivery may be carried out.

The operational tolerance of the cargo delivered under the FOB Fateh terminal condition is less than 1,000 barrels, and its pricing is based on the Dubai oil price announced on the last business day of each month. For example, the price of the operational tolerance of cargo shipped in July is based on the price announced on May 31. Unless the buyer and seller agree otherwise, the shipment date of the cargo should be specified by the buyer no later than three days before the shipment takes place.

Currently, Platts accepts five oil varieties (Dubai, Upper Zakum, Oman, Murban, and Al-Shaheen), which can be accepted and delivered as a substitute for Dubai oil, which is traded on eWindow. Due to the decline in Dubai oil production, Oman oil was included in January 2002, and Abu Dhabi’s Upper Zakum oil was included in February 2006. Until 2015, alternative delivery had been limited to Dubai, Upper Zakum, and Oman oils. Since January 4, 2016, however, Al-Shaheen (ALS) has been included in the Dubai basket, and Abu Dhabi’s Murban has been included in the Dubai and Oman oil baskets. The production volume of these five varieties is estimated to be 3.6 million b/d, with a tradable volume of 2.4 million b/d. 50 However, cargoes with the destination restrictions usually applied by Middle Eastern oil-producing countries in their term contracts cannot be traded.

The purpose of including the five varieties is to increase the liquidity of spot transactions of Dubai crude oil by adding alternative oils to the Dubai basket and to prevent any price distortion or manipulation that could be caused by aggressive buying and selling.51

Meanwhile, in July 2016, Platts decided to introduce a quality premium for Murban crude oil, which is of relatively higher quality than the other four varieties. The quality premium is paid by the buyer to the seller upon delivery under a contract concluded during the evaluation process through eWindow. On the first business day of every month, Platts announces a quality premium for Murban oil cargo to be shipped two months later. For example, the premium for cargo to be shipped in September is announced on the first business day of July in order to reflect the general situation in which two-month crude oil contracts are traded. The quality premium for Murban oil is appropriated at 60% of the price differential between Murban and Oman oils in the previous month, which were declared by Platts. However, if the price differential between the two crude oils is less than EUR 25 per barrel, the quality premium is announced as zero.

In the MOC price-assessment process, offers for ALS, Murban, Oman, or Upper Zakum cannot be lower than the existing bids for Dubai crude. Similarly, bids for Dubai, Oman, Upper Zakum, or ALS cannot be higher than existing offers for Murban crude. If a bid for Dubai oil is higher than any bid for Murban, Oman, ALS, or Upper Zakum, the bid for Dubai oil is excluded from Platts’ current guideline. If an offer for Dubai is higher than any offer for Murban, Oman, ALS, or Upper Zakum, the offer for Dubai is excluded. If an offer for Murban is lower than any offer for Dubai, Oman, ALS, or Upper Zakum, the offer for Murban is excluded first. If a bid for Murban is lower than any bid for Dubai, Oman, ALS, or Upper Zakum, the bid is excluded first. This principle basically reflects the differences in quality among the five varieties in the same basket.

3. Problems with Dubai Oil Price Assessment

A. Opacity of PRAs’ Price-Assessment Process

A study by the Ministry of Strategy and Finance and the Korea Energy Economics Institute (2013) identified a

50 http://www.platts.com/IM.Platts.Content/MethodologyReferences/MethodologySpecs/Dubai-Crude-FAQ.pdf (retrieved April 6, 2017). 51 Dalseok Lee (2016), p.53. 44

few cases where prices could become distorted in the PRAs’ assessment process.52 These cases are where: the PRA assesses price based on subjective judgment, the information provider provides distorted information, and market participants collude with the PRAs.

The PRAs’ pricing can become distorted if they make subjective judgments using only limited information from a few transactions in the market, which they would only do when the amount of available information is insufficient. The PRAs assess price using a variety of information besides that on bids, offers, and prices of concluded transactions, which are publicly available. In addition, in cases where they do not have sufficient data, they use information on similar transactions, similar products, or transactions of the same products conducted in other regions. In this process, the PRA assessor may apply subjective judgement. In particular, qualitative assessments based on the subjective judgements of assessors serve a greater role in the pricing of Dubai crude oil, as it has relatively less liquidity than Brent or WTI and only a small number of market participants. The lack of transparency in the qualitative assessments of PRAs is a critical aspect of the concerns over marker crude oil price distortions.

Price assessment can become distorted when the information provider selectively provides data or provides distorted data. Market participants are motivated to provide the PRAs with distorted information depending on the status of the derivatives they hold, and they are not required to provide all of the specific details of the transactions they have made. Of course, most PRAs have a system that monitors and evaluates the completeness and validity of the information provided. However, if these systems fail to function properly, the price assessment will be distorted. For example, the Commodity Futures Trading Commission (CFTC) discovered that Marathon provided false information to Platts in order to lower the WTI price in November 2003 and imposed a USD 1 million fine on it in August 2007.53 In addition, in May 2013, the Commission of the European Communities investigated international oil companies (IOC), including BP, Shell, and Norway’s Statoil, regarding charges of oil price manipulation.54 These companies were suspected of having manipulated oil prices by providing false transaction prices to PRAs, including Platts and Argus, over a period of 10 years, beginning in 2002. At the time, the oil companies all denied the allegations. This eventually led the European Union to authorize the European Securities and Markets Authority (ESMA) to directly control the manipulation of international oil prices in September 2013. ESMA is allowed to impose fines on price manipulators of up to 10% of their annual sales or EUR 1 million.55

Through collusion, PRA assessors can manipulate prices in favor of some market participants. In the PRAs’ price-assessment process, the cooperation of large market participants with relatively greater influence on market price determination is critical. Therefore, the PRAs come to assess prices in consideration of the interests of major market participants who provide information.

B. Doubt Regarding the Usefulness of Alternative Deliveries

In January 2016, in order to solve the liquidity shortage problem and price distortion in Dubai crude oil pricing on eWindow, Platts added Al-Shaheen and Murban to the Dubai benchmark basket, which had been composed of Dubai, Upper Zakum, and Oman.56

In this way, Platts has taken steps to improve eWindow’s Dubai crude-pricing function. However, the EI claims that this has created many complex problems for crude oil producers, traders, and refineries as well as for buyers.57

One of the problems is that large oil producers such as Saudi Arabia began to have difficulty determining their crude oil prices based on Dubai crude. Similarly, buyers found it difficult to assess the differentials of the formula

52 Ministry of Strategy and Finance and Korea Energy Economics Institute (2013) pp.75-76.

53 http://www.cftc.gov/PressRoom/PressReleases/pr5366-07 (retrieved April 11, 2017). 54 https://www.bloomberg.com/news/articles/2013-05-15/eu-oil-manipulation-probe-shines-light-on-platts-pricing-window (retrieved April 11, 2017). 55 https://regtechfs.com/eulibor-eu-unveils-benchmark-intervention-powers/ (retrieved April 11, 2017). 56 Platts (May 2016), p.30. 57 Energy Intelligence (December 28, 2015), pp.4-5. 45

prices provided by crude suppliers such as Saudi Arabia. Although the EI did not specifically explain the fundamental causes of the problem, it seemed to point out the price instability of the marker crude oil caused by the trading of crude oils with different properties, as shown in Table 4-1.

Table 4-1. Properties of eWindow Dubai Basket Crude Oils

Upper Dubai Oman Al-Shaheen Murban Zakum

API 30.4 30.5 33.9 28.0 40.5 (gravity)

Sulfur content 2.13 1.38 1.84 2.37 0.74 (w%)

LPG 2.20 LPG 1.35 LPG 3.69 LPG 2.00 LPG 1.54

Naphtha Naphtha Naphtha Naphtha Naphtha 17.50 17.04 22.52 19.66 24.06

Kerosene Kerosene Kerosene Kerosene Kerosene Product 14.00 11.31 13.93 8.23 19.10 yield (v%) Light oil Light oil Light oil Light oil Light oil 26.90 19.59 15.93 30.80 26.71

Fuel oil Fuel oil Fuel oil Fuel oil Fuel oil 39.70 50.71 43.93 39.31 28.57

Note: Excerpted from Energy Intelligence (2015).

The EI also predicted that ALS oil could have a major impact on Dubai oil pricing. The unusual nature of ALS may excessively curb the rise of the price of Dubai crude oil and even set a price cap.58 ALS oil (API of 28.0 and sulfur content of 2.37 w%) is the heaviest oil with the highest sulfur content among the five varieties that are deliverable as a Dubai crude basket. This can hinder the active purchasing of buyers because of the concerns over the low quality of ALS. Most Asian refineries do not like ALS, which provides relatively high yields in fuel oil and lubricating oil production. Even Chinese refineries that are well equipped with upgrading facilities tend to avoid ALS.59 This means that if traders buy ALS through aggressive purchases on eWindow, they will have to resell the ALS on eWindow as well. Another problem with ALS that could cause the price of Dubai crude to decrease is its inflexibly in terms of shipping dates. ALS buyers must agree to fixed shipping dates, which can lead to difficulties such as additional shipping costs for loading another Middle Eastern crude oil cargo on the same tanker.

In July 2016, Platts introduced a quality premium for Murban, which is a high-quality oil (API of 40.5 and sulfur content of 0.74 w%). Used in the existing Dated Brent price assessment of Platts,60 this new mechanism aimed to prevent extremely high bid calls by ensuring that market participants consider the premiums they may have to pay. Most buyers do not need premium-charged Murban crude, so the quality premium is a kind of preventive measure against aggressive bids that could cause price distortions.

58 Energy Intelligence (December 28, 2015), p.5. 59 Energy Intelligence (December 28, 2015), p.5. 60 In the price valuation of Dated Brent or BFOE (Brent-Forties-Oseberg-Ekofisk) of Platts, Oseberg crude oil is of relatively high quality, meaning that sellers delivering Oseberg receive a quality premium from buyers. 46

However, the quality premium is unlikely to induce the sale of Murban oil on eWindow. The reason for this is that Murban’s quality premium is only 60% of the price differential between the previous month’s spot prices of Murban and Oman oils, meaning that the seller must give up 40% of the value. In fact, no physical deliveries of Murban had been made until April 2017. It is therefore quite doubtful that Murban can help secure liquidity in physical transactions and curb aggressive bidding, as initially expected by Platts.

C. Problems with the MOC Methodology

Platt’s Dubai crude eWindow uses MOC as its price-assessment methodology. However, along with the liquidity issues of Dubai crude oil, the MOC methodology is likely to distort prices in the case of abnormal transactions done immediately before market closing.61

There have been several suspicious transactions on Dubai eWindow. For example, China Oil, a trading company under the state-owned China National Petroleum Corporation (CNPC), made bids for most of the tradeable crude oils on Dubai eWindow, which led to a sudden price surge. At the time, the seller was Unipec, a trading company of Sinopec, another Chinese state-owned oil company. Though it is unknown how the two companies gained any advantage by engaging in such activities in the Dubai oil market, two similar cases have occurred, first in 2014 and again in 2015. China Oil purchased 47 cargoes (23.5 million barrels) in December 2014 and 55 cargoes (27.5 million barrels) in June 2015 on Dubai eWindow. In August 2015, the price of Dubai oil rose when the company purchased the largest ever volume of 65 cargoes (32.5 million barrels).62

Market observers had various opinions on the case. Some interpreted the bulk buying of China Oil as merely a measure to meet China’s domestic demand and secure a strategic petroleum reserve or as the speculative trading activities of Chinese rivals seeking to make money in the paper market. Others viewed it as a “rehearsal” for China to take control of and wield influence over the Asian oil market.

According to the EI, the latest suspected case of Dubai oil price distortion was when China Oil purchased 85 partial cargoes of the 89 March shipment of Dubai oil cargoes from January 3 to 10, 2017, and the resulting surge in the Dubai oil price.63 At the time, China Oil secured only three physical cargoes, and the sellers were China’s Unipec and Shell, which offered 46 partial cargoes and 27 partial cargoes, respectively. The EI argued that the sharp decline in Brent-Dubai oil swap prices that occurred on January 10, falling to USD 0.48 per barrel from USD 1.82 per barrel in the previous month, was caused by the aggressive purchase made by China Oil and was thus not wholly attributable to the production cuts made by OPEC’s oil-producing countries.64

As such, Dubai eWindow has frequently experienced suspected case of price manipulation, which is fundamentally because only a small number of companies are involved in the market. There are only about 10 companies participating in Platts eWindow, most of which are production or trading companies. State-owned oil companies in the Middle East and end users do not participate. Even before Chinese oil companies started participating in the market in earnest, the trade volume of large oil companies such as Shell and Vitol and trading companies accounted for the majority of transactions. Inevitably, such limited market participation and small trade

61 Argus, one of the PRAs, uses the volume weighted-average (VWA) methodology, which weighted-averages the volumes of transactions made at a certain point in time (usually minutes before the close of the market). Since the VWA methodology uses a weighted average of transaction volume, price distortions due to abnormal transactions are less likely to occur, unlike the MOC methodology. However, this is also a short period of time where, if the price at a certain point, which is used for price assessments, is highly volatile, it does not accurately reflect the value of the commodity at the time when the price is calculated (market closing on that day (Ministry of Strategy and Finance and Korea Energy Economics Institute (2013), p.71). 62 Energy Intelligence (August 31, 2015), p.8; and Dalseok Lee (2016), pp.53-54. 63 Energy Intelligence (January 16, 2017), p.8. 64 OPEC started decreasing crude oil production by about 1.2 million b/d from January 1, 2017, in accordance with the decision made by the General Assembly on November 30, 2016. Production cuts in Middle Eastern oil-producing countries, most of which are OPEC members, are likely to cause the price of Dubai oil to increase compared to the prices of other marker crude oils. 47

volumes lead to suspicions of price manipulation.

D. Time Lag in Pricing

The closing price of Dubai oil is determined at 16:30 Singapore time. Since the Brent (ICE futures) closing price is determined at 19:30 London time (2:30 a.m. of the following day in Singapore), there is a 10-hour time gap with the closing price determination of Dubai oil. As long as there are no issues affecting oil prices during those hours, there will be no significant difference in the price fluctuations of the two varieties. Otherwise, the difference in the price and price fluctuation will increase temporarily. For example, on February 17, 2016, the Dubai oil price closed at USD 28.51 per barrel, down 3.2% from the price of the previous day, while the Brent price closed at USD 34.50 per barrel, up 7.2% from the previous day. The difference in the fluctuation rate between the two varieties was 10.4%p, and the price difference increased from USD 2.7 per barrel to USD 6.0 per barrel the day before. The reason for this was that the progress being made in discussions on production cuts between Saudi Arabia and Russia that were underway at the time was reflected in the Brent price after the closing of the Dubai market. There are many other such cases of lags in price determination due to time differences. This is because the influence of the European and U.S. financial markets has expanded with the financialization of the crude oil market.

Since the time lag of the Dubai oil price disappears within a short period, it does not affect the average price for a certain period of time. However, when the Dubai crude market reflects major market events later than other crude oil markets, and when there is a significant, although temporary, price difference, the reliability of Dubai oil as a marker crude will be undermined.

Figure 4-3. Difference in Daily Fluctuations of Brent and Dubai Oil Closing Prices

Note: Bloomberg (https://www.bloomberg.com (retrieved Apr. 8, 2017)).

원문 번역문

브렌트와 두바이유 일일 등락률 차이 Difference in the daily fluctuations of the closing prices of Brent and Dubai oil

4. Influence of the Price Distortion of Marker Crude Oils

The prices of crude oils and petroleum products announced by the PRAs are used as references in various fields, and thus have significant economic impacts. They serve as a standard for crude oil and natural gas spot transactions and influence derivative prices inside and outside of exchanges, government taxation, and product profit distribution. PRA-assessed prices are used as references for about 60 to 70% of derivatives transactions and are sometimes used as references for the breakup value of derivatives.65 Therefore, if the price assessments of PRAs become distorted, it could affect the selling prices of crude oils and petroleum products and cause losses to refiners and individual consumers.

As discussed above, Dubai crude oil, which is the Asian marker crude oil, is more likely to experience price distortions, because it is extremely limited in terms of liquidity in physical transactions. In particular, aggressive bidding, leading to suspicions of abnormal trading, on Platts’ eWindow causes the price of Dubai oil to increase more than the prices of other marker crudes and weakens the correlation between Dubai oil and the physical market. Furthermore, such aggressive bidding can distort the formula prices of 18 million b/d of Middle Eastern crude oil and some portion of Russian crude oil exported to Asia and reduce the refinery margins of Asian refineries.66 If Asian buyers pay USD 1 more per barrel due to the price distortion of the marker oil, the crude oil purchase price will increase by USD 6.6 billion per annum. To avoid this situation, Asian oil refiners favor buying light sweet Atlantic crude oil, as it is cheaper than medium sour Middle eastern crude oils. In this case, refinery compatibility and additional transportation costs can become issues. In addition, marker crude oil prices are also used as references for the pricing of petroleum products and various derivatives, meaning that price distortions could lead to unreasonable gains and losses in a wide range of areas.

65 Ministry of Strategy and Finance and Korea Energy Economics Institute (2013), p.68. 66 Energy Intelligence (January 16, 2017), p.8. 49

Chapter 5. Alternative Measures to the Asian Marker Crude Oil

1. Improvement of Price Assessment of PRAs

A. Improvements Made Through G20 Summit Meetings

1) International Organization of Securities Commissions (IOSCO)’s Rules for Pricing Improvement

Since the issue of oil price volatility was raised at the G20 Pittsburgh Summit in 2009, discussions have been held on how to improve the functions and operation of the PRAs. The G20 Seoul Summit in November 2010 requested that the International Energy Agency (IEA), International Energy Forum (IEF), Organization of Petroleum Exporting Countries (OPEC), and International Organization of Securities Commission (IOSCO) submit reports on the price-assessment methodologies of the PRAs and the impact of PRA-announced public prices on the market. Accordingly, in October 2011, these international organizations submitted reports on the issues listed below.67

· Although the PRAs’ price-assessment methodologies vary by agency, it is inevitable that the PRAs make subjective judgments in the pricing process, because their contracts involve various transactions of oils of different types, volumes, means of shipping, and trader credibility.

· The prices announced by the PRAs sometimes vary significantly by agency over a short period of time. However, the price difference is estimated to be very small in the long term, at less than USD 1 per barrel.

· Most of the respondents were of the opinion that the PRAs provide high-quality information and that their pricing processes are transparent. Some market participants, however, expressed concern regarding Platts’ excessive market influence and the lack of audits to monitor whether their price-assessment methodologies are applied in a fair and consistent manner.

· Since each PRA has a system that prevents collusion for the purpose of price manipulation, manipulating the market price is considered to be quite difficult.

· The PRAs’ publicly announced prices are known to be widely used as references for physical transactions, OTC derivative transactions, natural gas contracts, and oil development contracts. However, due to the lack of data (actual transaction volumes in the physical market), it is impossible to empirically analyze the market influence of the PRAs.

· Many oil market participants agree that it is necessary to monitor and supervise the PRAs, but further discussion is required to decide which of the PRAs’ functions should be supervised and by which organizations. However, it has been suggested that supervision by financial regulators would not be appropriate.

At the request of the G20 Cannes Summit (November 2011), IOSCO set up principles for improving the PRAs, with the cooperation of the IEF, IEA, and OPEC. IOSCO’s report, titled “The Principles for Price Reporting Agencies,” which it submitted in October 2012, recommended that the PRAs implement self-regulatory measures to reinforce the transparency of their pricing criteria and procedures, between market participants and assessors as well, and conduct constant internal supervision and management of the assessors and assessment process. The details are listed below.68

· [Reliability of methodology] The formal documentation and disclosure of all criteria and procedures that

67 IEA, IEF, OPEC, and IOSCO (October 2011). A summary of the reports was prepared by supplementing the study conducted by the Ministry of Strategy and Finance and Korea Energy Economics Institute (2013), pp.77-78. 68 This part is excerpted and summarized from IOSCO’s report (October 5, 2012). 50

are used to develop an assessment, including guidelines that control the exercise of judgment, the exclusion of data as well as the procedures for reviewing a methodology facilitates the evaluation of the impact of a methodology on the reliability of an oil derivatives contract.

· [Transparency of methodology] Transparency of procedures by which PRAs will advise stakeholders of any proposed changes to a methodology, including the opportunity for stakeholder comment on the impact of any changes is critical to allow a market authority to determine whether such changes, if proposed, may affect the reliability of a derivatives contract or otherwise result in possible market disruption. This principle also calls on PRAs to routinely re-examine methodologies to ensure their continued reliability.

· [Quality of price assessment material] PRAs to give priority to concluded transactions in making assessments and implement measures intended to ensure that the transaction data submitted and considered in an assessment are bona fide. These measures are intended to promote the quality and integrity of data and in turn the reliability of assessments.

· [Transparency of information disclosure procedures] Procedures to ensure the integrity of information, including procedures to set standards for who may submit data, quality control procedures to evaluate the identity of a submitter and internal controls to identify and respond to improper communication between submitters and assessors are intended to promote the accuracy and integrity of assessments.

· [Qualification of assessors] The adoption of guidelines to ensure the qualifications of assessors (including their training and experience levels) is intended to promote the integrity and consistency of assessment. This principle also addresses continuity and succession planning in respect of assessors.

· [Supervision of Assessments] The institution of internal controls requiring ongoing supervision of assessors and procedures for internal sign-off on assessments as a means to promote the integrity and reliability of assessments.

· [Audit Trails] The contemporaneous documentation and retention for five (5) years of all relevant information and judgments made in reaching a price assessment, including any exclusions of data. This is intended to facilitate inquiries by market authorities.

· [Conflicts of Interest] The documentation, implementation and enforcement of measures to avoid conflicts of interest. These measures are intended to insulate assessments from improper influences, such as commercial or personal interests of the PRA or any of its personnel. The measures call for the functional and operational separation of a PRA’s assessment business from any other business that may present a conflict of interest. These requirements are intended to protect the integrity of assessments.

· [Complaints] A written and published procedure for receiving, investigating and retaining records concerning complaints about a PRA’s assessment process, including recourse to an independent third party appointed by the PRA. The principle also requires that details concerning complaints should be documented and retained by a PRA. These measures are intended to promote the reliability of assessment methodologies through stakeholder input and alert a market authority to possible factors that might affect the reliability of assessments.

· [Cooperation with Regulatory Authorities] A commitment to make available to relevant market authorities audit trails and other related documentation. This is intended to facilitate a market authority’s ability to access data that are needed to determine the reliability of a given assessment referenced in an oil derivatives contract or to access information that might be needed to investigate and prosecute illegal conduct affecting a derivatives market.

· [External Auditing] An annual independent external auditing of a PRA’s compliance with its methodology criteria and the requirements of these principles, which should be published. This is intended to encourage compliance with the principles and provide additional confirmation to market authorities of such compliance.

2) Achievements of G20 Summit Discussions

In November 2012, the Finance Ministers’ Conference that was held in Mexico City instructed IOSCO to submit an interim report on the implementation of the principles in 2013. The IOSCO chairman submitted the report in a letter at the G20 Finance Ministers Meeting in September 2013. In the interim report, IOSCO said that the PRAs were having independent institutions conduct reviews on the implementation of the principles. The final outcome of the implementation of the principles was reported in 2014, as scheduled. Meanwhile, at the G20 Summit in Russia in September 2013, it was agreed that periodic monitoring of the implementation of the principles would be conducted. If necessary, regulations would be adopted to improve the operation of the PRAs.69

In 2014 and 2015, IOSCO submitted two reports on the implementation of the principles by four major PRAs— Platts, Argus Media, ICIS, and OPIS—which play an important role in the international oil market, with the cooperation of the IEA, IEF, and OPEC. 70 The reports said that the PRAs had put in place procedures methodologies consistent with their principles and based on discussions with their stakeholders and independent institutions, and that they had made significant progress in the implementation of the principles. In particular, the two reports stated that the external assurance reports had also confirmed that the PRAs had made policy changes in relation to compliance, external audits, record keeping, education, and complaint handling.71

IOSCO emphasized the importance of the voluntary submission of data, noting that there had been no change in the amount and quality of the data provided to the PRAs since the adoption of the principles. In the same context, it suggested that regulators should encourage market participants to provide market information to the PRAs in order to enhance transparency in the global oil market.72 Meanwhile, in April 2015, the IEA, IEF, and OPEC announced the results of a survey on the impact of the principles on oil market participants. According to the survey results, the majority of respondents believed that the principles were leading to improvements in the operation of the PRAs. However, more than half of the respondents still rated the services provided by the PRAs as “requiring improvement.”73

B. Plans to Increase the Reasonability of Pricing

1) On-going Monitoring of PRA Pricing and Expansion of Liquidity

Though the discussions held at the G20 Summit meetings have led to a certain degree of improvement, the problems of the PRAs have not been completely solved. Despite the efforts made so far, there is still opacity in the qualitative assessment and the possibility of price distortion caused by arbitrary and subjective judgement. Therefore, a continuous ISOCO-centered monitoring and supervision mechanism should be put in place. It is also worth considering requiring the PRAs to disclose their qualitative-assessment methodologies and have the methodologies verified by regulators and the market to an extent that such measures do not undermine the interests of the PRAs.

However, if regulation and supervision become excessively strict, market participants and high-quality information may leave the market, weakening the reliability of price assessment. In addition, if speculators occupy the market vacancies so created, market stability may be undermined.

According to a 2014 survey by Clyde & Co.,74 85.2% of respondents answered that they were satisfied with

69 Ministry of Strategy and Finance and Korea Energy Economics Institute (2013), p.79, p.83. 70 IOSCO (September 2015), p.1. 71 The reports on Argus Media, ICIS, and OPIS were prepared by PricewaterhouseCoopers (PwC), while the report on Platts was prepared by Ernst & Young (E&Y) (IOSCO (September 2015), p.2). 72 IOSCO (September 2015), p.6. 73 IOSCO (September 2015), p.8. 74 Hatcher, C., and Kraljevic, M. (2015). 52

the current pricing methodology when there was no alternative. In addition, a significant number of respondents indicated that, if regulations were tightened, the number of information providers would decrease (71.6%), liquidity would shrink (34.5%), and market participants would move to more loosely regulated markets (24.3%). Therefore, tightening regulations to enhance market transparency is not a panacea, and both positive and negative effects should be considered when determining appropriate levels of regulation.

The most feasible means of helping Dubai crude free itself of suspicions of price manipulation and opaque qualitative assessment and maintain its status as a marker crude oil in the current price-assessment system is to effectively increase liquidity. To this end, it is necessary to add more varieties to the current Dubai benchmark basket and expand and diversify the scope of market participants.

Given the reality that most Middle Eastern oil-producing countries do not allow spot transactions, making it difficult to add crude oils produced in the region, it is worth considering adding offshore crude oils, which are similar in quality to the other alternative deliverables in the basket and resalable. To solve the problem of liquidity shortage following decreased production, other marker crudes have also added alternative deliverables to their basket. WTI is deliverable with a total of 11 other varieties (six domestic and five imported oils).75 Brent also added Forties and Oseberg to its basket in 2001, followed by Ekofisk in 2007. However, as these inclusions failed to solve the problems arising from the decrease in production, it was decided to add Norway-produced Troll, as mentioned above.

It should be also considered to come up with measures to ensure the participation of more oil producing and trading companies, and include financial institutions as market participant. If a greater number and diversity of market participants are involved, liquidity naturally increases, and end users and suppliers are able to hedge against the risk of price fluctuations more easily, thus saving related costs.

Oil industry participants should be able to make complaints and suggest proposals for the improvement of the PRAs’ pricing procedures. The Principles for Price Reporting Agencies recommended that PRAs receive, review, store, and reflect on customer complaints (Articles 2.17, 2.18, and 2.19).

2) Creating an Environment for the Containment of PRAs

The information monopoly of PRAs and some market participants should also be weakened. Under the current price-determination system, a small number of market participants, including PRAs, are monopolizing all transaction information, including data on bids and offers. This makes it inevitable for information asymmetry to intensify and pricing fairness to be increasingly doubted. To resolve these problems, all market participants need to be given low-cost access to all data without discrimination. In this regard, the establishment and operation of an energy data hub (EDH) is an option worth considering.

An EDH is a service agency that collects information on concluded transactions and standardizes the information collected before releasing it into the market. Located in Texas, EDH Resources is one of the most well-known EDHs. It aims to contribute to the enhancement of the overall transparency of the energy market and help energy companies manage their overall business activities, including asset management, physical transactions, regulatory compliance, and risk management, by providing reliable market information.

Since EDHs collect data on concluded transactions only, unlike PRAs, imaginary orders are excluded, meaning that there is very limited room for qualitative assessment. EDHs also have price-discovery and pricing functions, which may help resolve the information monopoly of the PRAs.

As rivals of the PRAs in Asia, EDHs should collect as much information as possible in order to promote market transparency. In addition to the data collected by the PRAs, the EDHs should also collect information on individual B2B trades between trading and oil companies. In addition, to resolve the information asymmetry problem, market

75 CME Group (2009). 53

participants should have easy access to the collected information.

It is desirable EDHs are established by international private-public partnerships that engage with various countries and energy-related companies in the region. If only one country or a small number of energy-related companies are involved, the information-collection process would not likely proceed smoothly, making it difficult to solve the information asymmetry problem.

To address the problem of the time lag of price information, the introduction of incentives for information- providing agencies and companies should be considered. The provision of market information cannot be legally enforced and should be done in a voluntary manner, so proper incentives for information providers would be an effective way of promoting the efficient operation of EDHs.

Another option is to launch a crude oil futures market that reflects the properties of the Middle Eastern crude oils that are mostly traded in Asia. By learning from the failures of the 1990s and the stagnation of transactions of Oman oil, which is the only Middle Eastern oil that is traded in the futures market,76opening a crude oil futures market in the consumer area of Asia, rather than the production area, would have a greater chance of success.

This is because the conditions in Asia are more favorable for a futures market than those in the Middle East.77 As Asia has the fastest-growing demand in the world, there is a large demand for commercial hedging by state- owned and private companies in all sectors, including the upstream, midstream, and downstream sectors. On the contrary, Middle Eastern countries have little demand for commercial hedging, as the state-owned oil companies dominate the market. Second, unlike the Middle East, Asia has an advanced financial infrastructure, giving it an advantage in attracting speculative investors and designing contracts that meet the needs of commercial hedgers. Third, government policy support can be expected. In particular, South Korea, China, and Japan are likely to be the most active supporters of the launch of a regional futures market, especially because one of their policy tasks is to stabilize the supply and price of crude oil.

If a crude oil futures market is opened in Asia, and the liquidity problem is resolved as a result, it is expected that the manipulation or distortion of spot prices by certain forces will be prevented or eliminated through arbitrage transactions with the futures market. Specifically, as trading in the futures market is based on the spot market, traders can benefit from arbitrage trading when price disequilibrium between prices of futures and spot markets. This process eliminates the disequilibrium between spot and futures prices. Since the futures market has ample liquidity, it usually has a transparent and objective pricing process. Therefore, arbitrage trading between the spot and futures markets has the economic effects of efficient price formation and prevention of price distortion in the spot market.

Meanwhile, if the crude oil futures market established in Asia has an all-day trading system, such as those of WTI and Brent,78 trading will continue even after the end of the Asian trading hours, and prices can be checked on a real-time basis. This is expected to solve the problem of price lag caused by time differences.

2. Search for a New Marker Crude Oil

A. Qualifications of Marker Crude Oils

A marker crude oil is usually required to satisfy the following criteria. First, it must have a sufficient physical production volume. Although there is no specific production volume standard, it should be possible to buy and sell the desired quantity in the market at any time, thus ensuring that market participants accept it as a marker crude without hesitation. Most marker crude oils have been experiencing production shortages for quite some time, which has led to the inclusion of more alternative deliverables in the benchmark basket as a means of coping

76 Oman crude oil futures trading volume on DME was 31,058 contracts as of December 2016, which is equivalent to 0.1% of the volume of WTI futures on NYMEX (http:// www.dubaimerc.com/). 77 Till (2015) pointed out that the success of all futures contracts, including those for raw materials, requires sufficient commercial hedging demand, attraction of speculative force, and policy support. 78 WTI futures are traded for 23 hours a day (one-hour break), and Brent futures are traded for 22 hours a day (two-hour break) (see Dalseok Lee (2016), pp.26-32). 54

with the issue. As marker crude oils are used as brand names or indexes, it is difficult to say that the production volume is an absolute criterion for the determination of a marker crude. However, if the production volume is too small, the crude oil would be very limited in its capability to reflect market conditions, and market participants would continuously raise concerns about its appropriateness as a marker crude.

Second, there should be a large number of suppliers and consumers of the given crude oil. If there are only a few suppliers or consumers, they would be able to distort the supply and demand and manipulate the price. As the oil market has become more financialized since the mid-2000s, the participation of financial investors, such as investment banks, pension funds, and hedge funds, along with suppliers and consumers, has become important. Brent and WTI have a large number of diverse market participants. On the contrary, Dubai oil is traded under relatively limited conditions with only a few monopolistic suppliers and no futures market.

Third, suppliers should have a variety of equity structures. In other words, suppliers should not be dependent on any particular forces or groups. The reason for this is to prevent crude oil from being used as a political weapon in conflicts between countries. In the Middle East, the state-owned oil companies, in which governments own the majority of equity, dominate oil production. Thus, even a crude oil with a large production volume would not be able to serve as a marker crude.

Fourth, marker crude oils should be traded in the spot market and be resalable without limits at the final destination. Most of the Middle Eastern crude oils with large production and transaction volumes cannot serve as marker crudes mainly because they cannot fulfill this requirement, in addition to the diversity requirement regarding the equity structure of suppliers. In addition, physical transactions should be conducted in areas with established global regulation and taxation systems and based on standardized contracts.

Marker crude oils meeting these requirements serve as references for the pricing of other crude oils and are used as a means of hedging against the price risk of petroleum products. If futures contracts are listed and traded with such marker crude oils as underlying assets, the transparency of the price-determination and price-discovery functions will be enhanced, further strengthening their position as a reference.

B. Review of New Marker Crude Oils

Although Dubai crude oil remains the marker crude in Asia, it has many problems that need to be solved, as discussed above. To secure a long-term alternative, it is necessary to look for a new marker crude. New marker candidates include Russia’s ESPO blend (East Siberia-Pacific Ocean Blend), Oman oil, China’s crude oil futures, and Dated Brent. The characteristics, strengths, and weakness of each variety are outlined below.

1) ESPO Blend

ESPO is a 4,857-kilometer-long oil pipeline built by Russia. The pipeline links East Siberia and the Maritime Province of Siberia and is a strategic project that was initiated to develop energy resources in the Eastern Siberia region as a means of freeing the country from the current Western Europe-centered energy supply system and build a supply chain for Asia and the Pacific region, where demand is growing rapidly.

Figure 5-1. ESPO Pipeline

Source: Newsbase (September 28, 2017), p.4.

The first stage of the Taishet-Skovorodino section was completed in December 2009, and the second stage of the Skovorodino-Kozmino section was completed in December 2012. The branch line from Skovorodino to Daqing, in China, was completed in September 2010 and is now supplying crude oil to China. The transport capacity of the pipeline was planned to be increased from the initial 600,000 b/d to 1 million b/d in 2016, with an additional increase to 1.6 million b/d planned by 2020. The transportation capacity of the Skovorodino-Daqing section is 300,000 b/d. In 2009, Russia’s state-owned Rosneft signed an agreement with China’s state-owned CNPC for the supply of 300,000 b/d over the next 20 years.79

The ESPO blend gets its name from the name of the oil pipeline through which it is transported. Produced mainly in three oilfields in Siberia (Vankorskoe, Talakanskoe, and Verkhnechonskoe), ESPO is a light crude oil with an API of 34.6 and sulfur content of 0.6 w%.80 ESPO is often mentioned as a new candidate for the Asian marker crude oil, owing to its rapid increase in production, easy transportation to China, and geographical advantage, in that the export port of Kozmino is located close to both Korea and Japan. Moreover, given that its quality is higher than that of Dubai and its end users are located in a variety of regions, including China, Japan, Korea, United States, Malaysia, Singapore, and Taiwan, ESPO is drawing the attention of market participants seeking a new marker crude oil.

As shown in Figure 5-2, ESPO is mostly exported to China, with the country accounting for 70% of total ESPO exports as of 2016. In terms of China’s total crude oil imports, Russian oil has surpassed Saudi Arabian oil. However, ESPO’s lack of physical liquidity in Kozumino Port is hindering its growth. Initially, the inflow of crude oil to Kozumino was planned to be increased from 300,000 b/d in 2010 to 600,000 b/d in 2014, but the actual inflow reached only 498,000 b/d, failing to secure sufficient liquidity.81

Figure 5-2. ESPO Crude Oil Exports by Country (2016)

79 Requoted from Gorst (2014) and Weber (2015), p.5. 80 http://www.energyintel.com/pages/icoh_crudeoilproflanding.aspx (retrieved Apr. 16, 2015). 81 Weber (2015), pp.5-6. 56

Note: Prepared based on information from http://en.portnews.ru/news/232729 (January 17, 2017, retrieved June 28, 2017).

원문 번역문

중국 China

Japan 일본 Korea 한국 Malaysia 말레이시아 Singapore

싱가포르 Thailand

태국 United States

Others 미국

기타

Furthermore, since term-contract volumes have been increasing gradually, there are concerns that the liquidity of the spot market is going to decrease even more. It has also been noted that Kozmino’s crude oil inflow may become unstable if Russia voluntarily acts as a swing producer for the European market as a means of expanding its influence in the international oil market. Nonetheless, it is encouraging that Kozmino’s crude oil exports showed year-on-year increases of 22% and 4.6%82 in 2015 and 2016, respectively. However, in order for ESPO to become an alternative marker crude to Dubai oil, a liquidity-rich spot market and accompanying price-discovery function first need to be firmly established.

Another weakness of ESPO is that the state-owned Rosneft and Surgutneftegaz are the only suppliers. Some have raised concerns that ESPO could be used by Russia for political or strategic purposes, because both companies control all exports to China transported through pipeline and one-third of those transported through

82 http://en.portnews.ru/news/232877/ (retreived from June 28, 201)

Kozmino Port. In terms of demand, excessive concentration in China is also a problem. As mentioned above, China accounts for more than 50 percent of ESPO demand, so a likelihood of price manipulation by Chinese oil companies could arise in the ESPO market, as it did for Dubai crude.

Meanwhile, crude oil futures, with Urals as an underlying asset, started being traded on SPIMEX in Russia in November 2016. Urals crude oil futures trading uses global oil trade standards, which involve physical delivery settlement as the payment method, U.S. dollar as the transaction currency, and contract size of 1,000 barrels.83 Although the details of ESPO futures have yet to be announced, the ESPO futures market is likely to be launched to reflect the market need for standardized futures contracts if the Ural futures market successfully settles down.

Table 5-1. SWOT Analysis of ESPO

Strengths Weaknesses

- Strategically supported by Russia - Lack of liquidity in spot market

- Production increase - No futures market

- Geographical proximity to Korea, - Monopolistic supply and demand China, and Japan concentrated in China

Opportunities Threats

- Diversification of supply structure, - Supply likely to be controlled for mitigating the concentration in the political purposes Middle East - Uncertainty of Russian-Chinese - Strengthening relationship with Russia relationship

2) Oman Crude Oil Futures

Oman crude oil futures began trading in June 2007 on DME, the only futures exchange in the Middle East.84 Oman futures holds Oman crude oil, a medium sour oil, as an underlying asset, with U.S. dollars as the transaction currency. The size of one contract is 1,000 barrels, and contracts can be paid via physical delivery or also cash (Table 5-2). The basic structure of Oman crude oil futures is similar to that of WTI on NYMEX and Brent on ICE.

Table 5-2. Details of Oman Futures Contract

Item Detail

Trading unit 1,000 barrels

Transaction U.S. dollars currency

Price quotation USD 0.01 per barrel

83 http://spimex.com/en/derivatives/urals-crude-futures/contract-description/ (retrieved, August 21, 2017) 84 DME was established in 2006 by the co-investment of the state-owned Dubai Holdings, Oman Investment Fund, and CME Group (http://www.dubaimerc.com/ (retrieved August 21, 2017)). 58

16:00 (Sunday) to 16:00 (Friday)

Closed from 16:00 to 16:45 (Monday to Thursday) Trading hours (Trading is open for 23 hours and 15 minutes per day (North American Central Standard Time).)

Trading months Maximum 72 serial months

Settlement type Physical delivery

Last trading day Last trading day of the second month preceding the delivery month

USD 4,750 (as of June 2017, for nearby-month contract, varies Margin frequently)

Source: DME Oman Crude Oil Futures Contract Summary (http://www.dubaimerc.com/ (retrieved August 23, 2017)).

Oman crude oil has much more liquidity than Brent and Dubai, thus making it tradeable in the spot market, and no limits on its destinations of final consumption. Hence, it can be viewed as fulfilling the basic requirements of a marker crude oil. Since Oman futures are traded on DME, they are supervised and governed by the authorities of Dubai, rather than its producing country of Oman. Also, as all Oman futures transactions are guaranteed by the CME clearinghouse, they are regulated by the CFTC indirectly. The clearing guarantee of CME, the world’s largest futures exchange, is believed to help boost the credibility of DME and Oman futures, which are relatively new to the global oil market.

Oman crude oil futures were launched with the aim of having Oman crude serve as the marker crude oil for Middle Eastern crude oil exported to Asia. It was expected to provide risk management tools for market participants in the region and increase the transparency of the price-discovery function. 85 Its geographical advantages were also highlighted, as it is capable of filling the time gap in trading between the European exchange and Singaporean exchange, which is the Asian trading hub. The Oman futures have also changed the way Oman crude oil spot is priced, because the official selling price (OSP) of Oman spot is determined based on the arithmetic average of the daily closing prices of Oman futures. As discussed in Chapter 2, the Oman oil spot prices are used in conjunction with Dubai oil prices in the pricing of term-contract oils sold by Middle Eastern oil-producing countries to Asia.

However, from 2007, when the transaction of Oman futures began, to April 2017, the accumulated trading volume reached 11.78 million contracts,86 which is less than half of one month’s trading volume of WTI futures, with its liquidity falling far short. It is rated that DME has not fully achieved the original purpose it sought through Oman futures. In addition, the high volatility in the trading volumes of Oman futures has also been pointed to as a problem.

Figure 5-3. Daily Volume of Traded Oman Crude Oil Futures Contracts

85 Dubai Mercantile Exchange (http://www.dubaimerc.com (retrieved August 23, 2017)). 86 Dubai Mercantile Exchange (http://www.dubaimerc.com (retrieved August 23, 2017)). 59

Note: Prepared based on information retrieved from Bloomberg (https://www.bloomberg.com/ (retrieved August 25, 2017)).

Table 5-3. SWOT Analysis of Oman Crude Oil Futures

Strengths Weaknesses

- Larger production volume than other - No participation of state-owned oil varieties companies in the region - Adopting global standards for contract - Major lack of transaction volume details - Disinterest of global financial investors - Spot tradeable and re-exportable

Opportunities Threats

- As the only futures in the Middle East, - -Exposure to geopolitical risks of the they can serve as a reference for the Middle East region’s medium sour oil.

In order for Oman oil futures to establish itself as an Asian marker, both in name and reality, it first needs a liquidity expansion plan. Lack of liquidity leads to increased risk management costs and poor performance of the price-discovery function, making it difficult to attract the attention of market participants. This contributes to the formation of a vicious cycle by further decreasing liquidity. Considering the fact that the state-owned oil companies in the region do not participate in the market, it is necessary to attract international financial investors. Although financial investors and their speculative trading are frequently pointed to as the main cause of price volatility, they are a necessary evil if Oman futures are to be developed to the level of their competitors, such as WTI.

3) Chinese Crude Oil Futures

The launch of Chinese crude oil futures has been delayed, but Chinese crude oil is frequently mentioned as a candidate for the next Asian marker crude oil. Chinese oil demand grew rapidly in line with the country’s dramatic economic development, raising the country to the position of the second-largest oil consumer in the world, after 60

the United States, in the 2000s.

Figure 5-4. China’s Dependence on Imported Crude Oil

Note: Prepared based on information from BP (2004 and 2016).

원문 번역문 수요 대비 수입 비중 Import-to-demand ratio

China became a net oil-importing country in the mid-1990s and recently surpassed the United States in terms of crude oil imports. Now the world’s largest crude oil importer, China has strong purchasing power. However, as its dependence on imported oil has increased, the country has become increasingly vulnerable to risks in the international crude oil market, such as supply disruptions and price volatility. Especially, since the global oil supply shortage in the mid- to late-2000s drove the price of oil to USD 140 per barrel, there is now an urgent need for better risk management.

In response to this, China introduced crude oil futures contracts as a means of hedging against the risk of oil price volatility (see Table 5-4). In 2013, the Shanghai International Energy Exchange (INE), a subsidiary of the Shanghai Futures Exchange, began preparing for the establishment of a crude oil futures exchange in earnest. The crude oil futures contract that the INE has been preparing to launch is based on medium sour oil (API of 32 and sulfur content of 1.5 w%) as the underlying asset, physical delivery as the final settlement method, and the Chinese yuan as the transaction currency, instead of the U.S. dollar. The contract size is set at 100 barrels, which is one- tenth that of WTI and Brent futures.87

Trading of INE crude oil futures contracts was planned to commence on November 5, 2015, but it was postponed to the end of 2016 due to the instability of the financial market in China at the time. Later, it was postponed again, and no specific timetable was given as more time was needed to make legal modifications, among other changes. With these delays, there was a growing expectation that the opening of the Chinese crude oil futures exchange would be canceled. However, with the INE’s announcement of its intention to launch crude oil futures in the second half of 2017, China is expected to begin crude oil futures trading in the near future.88

If the launch of China’s crude oil futures exchange goes smoothly, it would be highly likely for China crude oil to emerge as the Asian marker crude oil, replacing Dubai crude. This is because Chinese crude oil futures will be the first crude oil futures traded in China, which has become the world’s largest oil consumer, as well as because they hold medium oil, which is preferred by Asian countries, as an underlying asset. In terms of attracting financial investors, Shanghai is in a more advantageous position to secure liquidity in the initial stage than Dubai, which is

87 http://www.ine.cn/en/regulation/regulation/911319603.html (retrieved June 28, 2017). 88 Oilprice.com (April 18, 2017). 61

located in an Islamic region. In addition, the Chinese authorities are more strongly committed to nurturing the development of the country’s own benchmark oil.89

Table 5-4. Details of INE Crude Oil Futures

Item Detail

Underlying asset Medium sour oil

Contract size 1,000 barrels per contract

Transaction RMB (yuan per barrel) currency

Minimum price RMB 0.1 per barrel fluctuation

Daily price limits ±4% from the settlement price of the previous trading day

Monthly contracts of recent 12 consecutive months followed by Listed contracts quarterly contracts for the following 24 months

Settlement type Physical delivery

Trading hours 9:00-11:30 and 13:30-15:00 (Beijing time)

Seven varieties: Basrah Light, Dubai, Masila, Oman, Qatar Marine, Shengli, and Upper Zakum (Other medium sour oils from Deliverables Russia, South America, and West Africa are currently being evaluated.)

Delivery period Five consecutive trading days after the last trading day

Source: INE Rules (http://www.ine.cn/ (retrieved June 28, 2017)).

However, there are some problems with INE crude futures that must be solved before INE crude oil can become a marker. Weber (2015) noted three major problems: short transaction time, nonconformity with the global standard for one contract unit, and use of the Chinese yuan as the transaction currency.90 First, INE trading hours span only 3 hours and 50 minutes, from 9:00 to 11:20 and from 13:30 to 15:00 (Beijing time). This is far shorter than the trading hours of the WTI and Brent futures, which are 22 to 23 hours. In addition, the hours do not overlap with 16:30 in Singapore time, which is when the Platts Dubai oil price is determined. The short trading time would thus undermine the competitiveness of INE crude as a reference and serve as an invisible entry barrier to market participants. In order for INE crude to be established as the Asian marker crude, the trading hours should be extended.

In addition, the unit of contracts should be in conformity with the global standard. WTI and other global futures set one contract unit at 1,000 barrels, because physical transactions of crude oil are generally carried out in units of 1,000 barrels. If the unit size of one contract is reduced to 100 barrels, more small oil companies and individual

89 Dalseok Lee (June 2016), p.55. 90 Weber F. (2015), pp.7-8, Dalseok Lee (June 2016), pp.55-56. 62

investors would be able to participate, invigorating the market. However, the resulting increase in transaction costs would hinder the participation of foreign companies, thus having a negative effect on liquidity overall.

Table 5-5. SWOT Analysis of Chinese Crude Oil Futures

Strengths Weaknesses

- Chinese yuan used as transaction - World’s largest crude oil importer currency

- No global-scale crude oil futures in the - Limitedly open financial market region - Strong competitors - Connection point between Southeast and Northeast Asia - Frequent financial market turmoil

Opportunities Threats

- Excessive market dominance of Chinese - Arbitrage trade opportunities between government and large state-owned oil U.S., European, and Asian markets companies - Means of hedging against risks of - Containment from Japan and Western medium sour oil countries

Source: Modified and complemented information from Dalseok Lee (2016.6), p.38.

The use of the Chinese yuan, rather than the U.S. dollar, as the transaction currency will act as an entry barrier. Since the U.S. dollar is used as the settlement currency in the global crude oil market, market participants will not be willing bear the risk of yuan exchange rate fluctuations in order to engage in INE trading, especially considering the existing risk of oil price fluctuations.91 Since the petrodollar system is not expected to collapse any time soon, it is necessary to consider replacing the transaction currency with the U.S. dollar or using the U.S. dollar and Chinese yuan in parallel.

4) Dated Brent

Dated Brent is the spot price of Brent blend crude for which a loading date has been set, as mentioned in Chapter 2. Dated Brent is a spot price; however, given the time it takes from the contract signing date to the shipment date, it is essentially a forward price. Dated Brent has long been noted as a candidate for Asia’s new marker crude.92

In the past, Asian refiners have used several varieties of oil with different qualities as pricing references. For example, they determined the price of medium sour oil based on Dubai oil; the prices of light sweet oil and condensate oil based on Malaysia’s Tapis; the price of medium sweet oil based on Indonesia’s Minas; and the price of heavy sweet oil based on Indonesia’s Duri. However, the crude oils mentioned above dropped out of the ranks of marker crudes as their production volumes decreased. So, with no other alternative, Asian refiners and trading companies have increased the share of Dated Brent as a reference for transaction pricing.93 Since Asia

91 Dalseok Lee (June 2016), p.56. 92 Platts proposed the use of Dated Brent as the new Asian marker crude oil in 2008 (Platts, 2008). 93 Malaysia abandoned its existing Asia Petroleum Price Index (APPI) in 2011 and adopted Dated Brent. Indonesia, Australia, Papua New Guinea, and Vietnam also partially used Dated Brent as a benchmark. 63

has been expanding its oil imports from the Middle East and West and North Africa due to the supply shortage, its choice of Dated Brent is viewed as reasonable, according to its own estimation.

It seems that Asian refiners and trading companies considered the fact that about 70% of global crude oil transactions are directly or indirectly affected by the price of Brent.

Table 5-6. SWOT Analysis of Dated Brent

Strengths Weaknesses

- Production base geographically distant from Asia - World’s No 1. marker crude oil - Does not include varieties preferred by - Benchmark for crude oil from Africa, Asia whose imports to Asia are increasing - Production decrease

Opportunities Threats

- Various derivatives of Brent can be used - Its relative overvaluation is as a means of hedging against risk. disadvantageous to end users.

However, Dated Brent does not meet all the requirements of a marker crude. Especially, as its production volume has been declining, questions have been raised about its effectiveness as a marker crude oil. Moreover, the production site of Brent is geographically distant from Asia, so it has difficulties in accurately reflecting changes in the oil supply and demand in the region. In addition, it would be questionable to use light sweet oil produced in the North Sea area when Asian refiners prefer Middle Eastern medium sour oil.

As such, the varieties mentioned above have not been fully qualified to function as marker oils for Asia. However, the recent move by Iraq to replace the pricing reference that has been applied to its crude oil with the DME Oman futures price is noteworthy.94 Ultimately, it is expected that the pricing methodology of Asia, which uses Dubai oil as its benchmark, will be kept in place for the foreseeable future. In the long term, discussions on a new marker crude oil for Asia would do well to exclude varieties that are likely to be excessively influenced by particular countries. Oil varieties whose pricing is likely to be subject to significant influence from particular oil- producing countries, as well as those that may be under the influence of particular oil-importing countries, are beyond the scope of our interests. In this respect, Russia’s ESPO and China’s INE futures do not seem to be acceptable alternatives.

3. Strategy for Policy Implementation through International Cooperation

Ultimately, market participants are free to choose which pricing method to use for their crude oil transactions. Therefore, when many market participants use a particular pricing method, it is difficult to replace it with another one, and the relevant costs can become quite high. Although several problems have been identified with the Platts- assessed Dubai oil price, Dubai oil still serves not only as the benchmark for term-contract crude oils in Asia but

94 Iraq’s state-owned oil sales company (SOMO) asked its Asian customers on August 20, 2017, to comment on its plan to adopt the Oman oil futures price on DME as the reference for its domestically produced Basrah crude oil from January 2018. However, in a letter sent to its customers on September 10, 2017, SOMO said that it was going to take more time to review the plan (Thomson Reuters, September 12, 2017). 64

also as a refence for the pricing of petroleum products and various derivatives in the market. It thus does not seem feasible to change the market order that has formed around the Dubai oil price as a benchmark.

Therefore, in the short term, an international cooperation framework should be established and maintained to solve the problems of Platts’ price-assessment process. In the long term, however, it is desirable to find a new alternative to replace Dubai oil as a reference.

The improvement measures that are required to solve the problems of the price-assessment process will have to address two main areas: comprehensive matters related to PRA price assessment and matters related to Platts’ Dubai oil price assessment. First, to resolve the issues related to PRA price assessment, the price-assessment process of the PRAs, including Platts, should be monitored constantly and in accordance with the Principles for Oil Price Reporting Agencies. Moreover, the qualitative elements of the PRAs’ price-assessment process should be verified by observers, such as IOSCO. It is likely that the existing international coordination system established by the G20 can be mobilized toward that end.

Second, to improve Platts’ Dubai oil price-assessment process, measures to secure liquidity and create an environment to hold Platts in check should be implemented. More alternative deliverable varieties should be added to the Dubai benchmark basket of Platts eWindow, and a greater diversity of participants should be attracted to the market in order to increase the liquidity of Dubai oil. Building an information hub that provides market participants with easy access to information would be another option. In addition, a crude oil futures market should be launched in the region to facilitate efficient price formation by connecting the futures and spot markets and thus containing the market dominance of Platts. To implement such measures, it will be necessary to utilize regional multilateral energy councils, such as the Asian Ministerial Energy Roundtable and Northeast Asia Energy Council.

All the candidates for a new marker crude oil have strengths and weaknesses, as discussed above. Currently, the Oman futures listed on DME are likely to partially replace Dubai oil, despite their several weaknesses. This is well illustrated by the recent move by Iraq to change the pricing reference for its domestically produced oil from the existing Platts Dubai spot price to the Oman futures price on the DME.

However, for crude oil-importing countries, it would be better if oil-producing countries in the Middle East diversify the benchmark oils used in the price-calculation formula, as different pricing could promote competition among Middle Eastern oil-producing countries. Today, the pricing of Middle Eastern crude oil is led by Saudi Arabia. At the beginning of every month, Saudi Arabia sets the adjustment factors for the crude oil to be sold in the following month based on the spot prices of Dubai and Oman oils, and most Middle Eastern oil-producing countries use these factors to set the adjustment factors for their own crude oils. Actually, there is a certain degree of price competition among the oil-producing countries, even though the pricing is based on the same marker crude oil. However, it seems clear that, if the marker crude oils are diversified, the competition will become more intense.

Of course, oil producers in the Middle East, including Saudi Arabia, will be worried about the diversification of marker crudes. Perhaps partially due to such concerns, it seems that Iraq has abandoned its plan to change its pricing benchmark. However, the centers of global oil demand and trade are shifting from Europe and the United States to Asia, and the importance of the Asian oil market is expected to grow as a result. Therefore, competition among oil-producing countries to secure shares in the Asian oil market will grow increasingly fierce. Considering this, it would be reasonable for Asian importers to individually engage in discussions with Middle Eastern oil producers on matters related to the replacement of the marker crude through bilateral consultation bodies, rather than multilateral consultation bodies, between oil-producing and oil-consuming countries. Through such bilateral dialogue, the governments of Asian oil-importing countries, including South Korea, will be able to demand corrective actions regarding not only the problems of marker crude oils but also the rigid sales system of Middle Eastern oil producers, especially in relation to the restrictions on shipping destinations and the ban on resale to third parties. If necessary, they may also ask for the launch of spot transactions in addition to the term contracts to which the Middle Eastern oil-producers have been adhering.

Chapter 6. Conclusion

This study examines the characteristics of the marker crude oils that play important roles in the international oil market and analyzes the problems of and alternatives to Dubai oil, which is the marker crude oil for Asia. One of the solutions to solve the problems is to improve the PRAs’ price-assessment methodologies for Dubai crude to prevent price distortion. Another solution is to examine new marker crude oils capable of replacing Dubai oil. In addition, strategies for implementing each solution through international cooperation are proposed. The main contents of this study are summarized as follows.

To examine the characteristics of the major marker crude oils, the daily price volatilities of four crude oil varieties—WTI, Brent, Dubai oil, and Oman oil—from 2007 to 2016 were examined. All four varieties were found to have similar price volatility patterns. However, the price volatilities of WTI and Brent, which are the marker crudes for the U.S. and European markets, were slightly higher than those of Dubai and Oman, which are the markers for the Asian market. The synchronicity between the prices of marker crude oils was analyzed by correlation coefficient estimation and the cointegration test. The rolling correlation coefficient between Dubai oil, Oman oil, and Brent was very high, while that between Dubai and WTI declined sharply over a certain period of weakened synchronicity. By conducting the cointegration test for the entire target period, it was found that the prices of Dubai oil and the other marker crude oils were in a long-term balanced relationship. However, the test conducted to examine the granger-causality between the Dubai oil price and other marker crude oil prices showed that the prices of other marker crude oils (WTI, Brent, and Oman) influence the price of Dubai oil, but the reverse was not found to be true. The test also proved that changes in the price of Oman oil, which traditionally has not been recognized as an independent marker crude oil, lead to changes in the price of Dubai oil. This may be seen as reflecting the status that Oman oil has gained in the international oil market.

Dubai oil, an Asian marker crude, has the following problems. In particular, it does not satisfy the basic requirements of a marker crude oil, such as appropriate production volume and supply stability, diversity in seller and buyer composition, and wide acceptability. Even with such shortcomings, Dubai oil still serves as the Asian marker crude oil, because PRAs evaluate and disclose its price. However, there are several problems with the Dubai oil price-assessment process.

First, the price assessment of Platts, one of the PRAs, is not sufficiently transparent. This can lead to cases where an assessor makes a subjective judgement when sufficient data is not provided, information providers selectively provide distorted data that are favorable to them, or market participants collude with PRAs in the assessment process.

Second, although Platts eWindow, which is the price-assessment system of Platts, has added more alternative deliverables to its Dubai benchmark basket, it has failed to achieve the desired outcomes. In January 2016, Platts added two more crude oils (Al-Shaheen (ALS) and Murban) to the three existing crude oil varieties (Dubai, Upper Zakum, and Oman) as alternative deliverables of Dubai oil. However, rather than leading to the expected increase in liquidity, this addition only undermined the stability of the marker price, as various crude oil varieties with different properties were included in one basket.

Third, the MOC (market-on-close) assessment methodology has its own problems as well. In the MOC method used for the price assessment of Dubai oil on eWindow, an abnormal transaction executed immediately before the market closing time can distort the price. However, the more fundamental reason for the high likelihood of price distortion is that a very limited number of companies is participating in Platts eWindow trading, currently numbering at about 10 companies. Most of these companies are oil-producing companies or trading companies, and Middle Eastern state-owned oil companies and end users are not involved.

Fourth, the time lag of Dubai oil pricing poses another problem. The closing price of Dubai oil is determined at 16:30 Singapore time, which is 10 hours earlier than the determination of the closing price of Brent (ICE futures) (2:30 the following day in Singapore time). As a result, the price of Dubai oil reflects major market events one day later than other marker crude oils.

As such, there are several problems with the Platts-assessed price of Dubai oil, the Asian marker crude.

Nonetheless, the Dubai oil price serves not only as the benchmark for the term-contract trading of crude oils in Asia but also as a refence for the pricing of petroleum products and various derivatives in the market. Therefore, it does not seem feasible to change the market order, centered as it is around the Dubai oil price as a benchmark. Therefore, in the short term, efforts should be made to solve the problems of Platts’ price-assessment process, while in the long term, it is desirable to find an alternative to replace Dubai oil as a reference.

To make the oil price-assessment process of the PRAs more reasonable, from a short-term perspective, measures to monitor the process and secure liquidity should be implemented, and an environment in which the PRAs can be kept in check should be created.

First, because the possibility of price distortion still exists in the PRA assessment process, due to the lack of transparency of its qualitative-assessment methodology and arbitrary and subjective judgment, an IOSCO- centered continuous monitoring framework should be set up. It is also worth considering disclosing the PRAs’ qualitative-assessment methodologies and having them validated by the market and regulatory authorities, as long as such disclosure does not seriously undermine the PRAs’ interests. However, it should be noted that, if regulations and oversight are excessively tightened, high-quality market participants and information will leave the market, undermining the reliability of price assessment. Increasing the liquidity in the Dubai oil price assessment system is thus the most realistic way of eliminating the possibility of price manipulation and maintaining Dubai oil’s status as a marker crude oil. To this end, it is necessary to add more varieties as alternative deliverables to the Dubai benchmark basket and diversify the composition of market participants. However, given the fact that the majority of Middle Eastern oil producers do not allow spot trading and the difficulty of adding more regional varieties as alternatives, the inclusion of offshore crude oils that are resalable and of similar quality to existing crude oils should be considered.

Second, the creation of an environment to contain the market dominance of the PRAs is one way of responding to the information monopoly held by the PRAs and a small minority of market participants and promoting reasonable price formation. To this end, the establishment of an energy data hub (EDH), giving all market participants low-cost access to all data without discrimination, should be considered. An EDH is an institution that collects actual transaction information and standardizes the collected information before releasing it to the market. It would be desirable to establish an EDH through an international public-private partnership involving a number of countries and energy-related companies in the region. Another option is to open a crude oil futures market that reflects the properties of the Middle Eastern crude oils that are mostly traded in Asia. A liquidity-rich futures market has a transparent and objective pricing process, and the arbitrage between spot and futures leads to efficient price formation in the spot market. Moreover, if crude oil is traded in the Asian futures market on an all- day basis, like WTI and Brent, the problem of the time lag in pricing could be solved as well.

In the long term, the crude oil varieties that have the most potential to replace Dubai oil as a marker include: Russia’s ESPO, DME Oman futures, China’s INE crude futures, and Brent, which is the current marker crude for Europe. However, all these varieties have their own weaknesses. The production volume of ESPO is on the rise, and its production site is located in geographical proximity to South Korea, China, and Japan. However, Russian state-owned oil companies dominate its supply, and its demand is excessively concentrated in China. DME Oman futures contracts have a larger production volume than other varieties and meets the criteria for global crude oil futures. However, state-owned oil companies in the Middle East, including those in the oil-producing countries, and global financial investors have not yet participated in Oman futures trading, and its transaction volume falls far short of the standard. China’s INE crude oil futures contracts do not meet the global futures trading standard, with their transaction currency set as the Chinese yuan, rather than the U.S. dollar. And there is uncertainty as to whether the INE crude oil futures market will be launched successful and operated smoothly. Finally, Brent is currently the most widely used marker crude. However, it has difficulty accurately reflecting the supply and demand situation of Asia, and it is a light sweet oil, while Asian refiners favor medium sour oil from the Middle East.

As such, the crude varieties mentioned above have not been fully qualified to function as marker crude oils of Asia. However, the recent move by Iraq to replace the pricing reference that has been applied to its crude oil with the DME Oman futures price is noteworthy. Ultimately, it is expected that the pricing-determination system of Asia, which uses Dubai oil as a benchmark, will be maintained for the foreseeable future. In the long term, discussions on candidates for a new marker crude oil should exclude varieties that are likely to be excessively 67

influenced by particular countries. Oil varieties whose pricing is likely to be under the serious influence of particular oil-producing countries, as well as those that may be under influence of particular oil-importing countries, are beyond the scope of our interests. In this respect, Russia’s ESPO and China’s INE futures do not seem to be reasonable alternatives.

The issues reviewed and alternatives presented in this study can be implemented through international cooperation frameworks as follows.

In the short term, the improvement measures intended to solve the problems of the price-assessment process must address two major areas: comprehensive matters related to PRA price assessment and matters related to Platts’ Dubai oil price assessment. To improve the PRAs’ price assessment, it seems that mobilizing the existing international coordination system established by the G20 may be effective, as it is a framework through which IOSCO, IEA, OPEC, and IEF can all cooperate with the G20. Regarding matters related to Platts’ Dubai oil price assessment, it is necessary to utilize regional multilateral energy councils, such as the Asian Ministerial Energy Roundtable and Northeast Asia Energy Council

Regarding marker oil replacement, as a long-term countermeasure, DME Oman futures, despite several weaknesses, are likely to partially replace Dubai oil. This was well illustrated in Iraq’s attempt to change its oil- pricing benchmark to the DME Oman futures price in August 2017. However, for crude oil-importing countries, it would be better if oil-producing countries in the Middle East diversify the marker crude oils they use in their export price-calculation formula, as different pricing could promote competition among the Middle Eastern oil- producing countries. Therefore, it is more reasonable for Asian importers to individually engage in discussions on matters related to the replacement of the marker crude with Middle Eastern oil producers through bilateral consultation bodies, rather than multilateral consultation bodies, between oil-producing and oil-consuming countries. This strategy should be carefully pursued so as to avoid conflicts with the Gulf Cooperation Council (GCC) member countries, including Saudi Arabia. Still, securing a stable supply of crude oil from major oil- producing countries in the Middle East is a priority for the energy security of South Korea.

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Dalseok Lee

Current: Senior Research Fellow, Korea Energy Economics Institute

Major literary works and theses

“A Study on Enhancing Oil Security: The Oil Supply Vulnerability Index and its Implication,” KEEI, 2013.

“Strategies for the Oil Industry in the Future: Diversification Strategies,” KEEI, 2012.

“Development of the Domestic Continental Shelf: Analysis of Development Strategies and Conflict Factors of Neighboring Countries,” KEEI, 2009.

“A Study on Retail Pricing of Automobile Fuel,” Korea Energy Economic Review, 5-1, KREA and KEEI, June 2006.

Basic Research Report 17-17 Analysis of the Problems of and Alternatives to the Asian Marker Crude

Oil

Printed on: December 31, 2017 Issued on: December 31, 2017

Written by: Dalseok Lee Published by: Juheon Park Publishing company: Korea Energy Economics Institute (KEEI) 405-11, Jongga-ro, Jung-gu, Ulsan, 44543 Tel: (052)714-2114 / Fax: (052)714-2028 Registration Issue: Issue No. 7/December 7, 1992 Printed by: Hyomin D&P / Tel: (051)807-5100 ⓒ Korea Energy Economics Institute 2017 ISBN 978-89-5504-647-2 93320

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