An Anatomy of the Crude Oil Pricing System Bassam Fattouh1 WPM 40 January 2011 1 Bassam Fattouh is the Director of the Oil and Middle East Programme at the Oxford Institute for Energy Studies; Research Fellow at St Antony‟s College, Oxford University; and Professor of Finance and Management at the School of Oriental and African Studies, University of London. I would like to express my gratitude to Argus for supplying me with much of the data that underlie this research. I would also like to thank Platts for providing me with the data for Figure 21 and CME Group for providing me with the data for Figure 13. The paper has benefited greatly from the helpful comments of Robert Mabro and Christopher Allsopp and many commentators who preferred to remain anonymous but whose comments provided a major source of information for this study. The paper also benefited from the comments received in seminars at the Department of Energy and Climate Change, UK, ENI, Milan and Oxford Institute for Energy Studies, Oxford. Finally, I would like to thank those individuals who have given their time for face-to-face and/or phone interviews and have been willing to share their views and expertise. Any remaining errors are my own. 1 The contents of this paper are the authors’ sole responsibility. They do not necessarily represent the views of the Oxford Institute for Energy Studies or any of its members. Copyright © 2011 Oxford Institute for Energy Studies (Registered Charity, No. 286084) This publication may be reproduced in part for educational or non-profit purposes without special permission from the copyright holder, provided acknowledgment of the source is made. No use of this publication may be made for resale or for any other commercial purpose whatsoever without prior permission in writing from the Oxford Institute for Energy Studies. ISBN 978-1-907555-20-6 2 Contents Summary Report ........................................................................................................................................... 6 1. Introduction ......................................................................................................................................... 11 2. Historical Background to the International Oil Pricing System .......................................................... 14 The Era of the Posted Price ..................................................................................................................... 14 The Pricing System Shaken but Not Broken .......................................................................................... 14 The Emergence of the OPEC Administered Pricing System .................................................................. 15 The Consolidation of the OPEC Administered Pricing System .............................................................. 16 The Genesis of the Crude Oil Market ..................................................................................................... 17 The Collapse of the OPEC Administered Pricing System ...................................................................... 18 3. The Market-Related Oil Pricing System and Formulae Pricing ......................................................... 20 Spot Markets, Long-Term Contracts and Formula Pricing ..................................................................... 20 Benchmarks in Formulae Pricing ............................................................................................................ 24 4. Oil Price Reporting Agencies and the Price Discovery Process ......................................................... 30 5. The Brent Market and Its Layers ........................................................................................................ 36 The Physical Base of North Sea .............................................................................................................. 37 The Layers and Financial Instruments of the Brent Market ................................................................... 39 Data Issues .......................................................................................................................................... 39 The Forward Brent .............................................................................................................................. 40 The Brent Futures Market ................................................................................................................... 43 The Exchange for Physicals ................................................................................................................ 44 The Dated Brent/BFOE ....................................................................................................................... 45 The Contract for Differences (CFDs) ................................................................................................. 45 OTC Derivatives ................................................................................................................................. 48 The Process of Oil Price Identification in the Brent Market ................................................................... 50 6. The US Benchmarks ........................................................................................................................... 52 The Physical Base for US Benchmarks .................................................................................................. 52 The Layers and Financial Instruments of WTI ....................................................................................... 55 The Price Discovery Process in the US Market ...................................................................................... 56 WTI: The Broken Benchmark? ............................................................................................................... 58 7. The Dubai-Oman Market .................................................................................................................... 61 The Physical Base of Dubai and Oman .................................................................................................. 61 The Financial Layers of Dubai................................................................................................................ 62 3 The Price Discovery Process in the Dubai Market ................................................................................. 64 Oman and its Financial Layers: A New Benchmark in the Making?...................................................... 66 8. Assessment and Evaluation ................................................................................................................. 70 Physical Liquidity of Benchmarks .......................................................................................................... 70 Shifts in Global Oil Demand Dynamics and Benchmarks ...................................................................... 71 The Nature of Players and the Oil Price Formation Process ................................................................... 73 The Linkages between Physical Benchmarks and Financial Layers ....................................................... 74 Adjustments in Price Differentials versus Price Levels .......................................................................... 74 Transparency and Accuracy of Information ........................................................................................... 76 9. Conclusions ......................................................................................................................................... 78 References ................................................................................................................................................... 81 List of Figures Figure 1: Price Differentials of Various Types of Saudi Arabia‟s Crude Oil to Asia in $/Barrel .............. 21 Figure 2: Differentials of Term Prices between Saudi Arabia Light and Iran Light Destined to Asia (FOB) (In US cents) ............................................................................................................................................... 23 Figure 3: Difference in Term Prices for Various Crude Oil Grades to the US Gulf (Delivered) and Asia (FOB) .......................................................................................................................................................... 24 Figure 4: Price Differential between Dated Brent and BWAVE ($/Barrel) ............................................... 26 Figure 5: Price Differential between WTI and ASCI ($/Barrel) (ASCI Price=0) ....................................... 26 Figure 6: Brent Production by Company (cargoes per year), 2007 ............................................................ 37 Figure 7: Falling output of BFO ................................................................................................................. 38 Figure 8: Trading Volume and Number of Participants in the 21-Day BFOE Market ............................... 42 Figure 9: Average Daily Volume and Open Interest of ICE Brent Futures Contract ................................. 44 Figure 10: Pricing basis of Dated Brent Deals (1986-1991); Percentage of Total Deals ........................... 45 Figure 11: Reported Trade on North Sea CFDs (b/d) ................................................................................. 46 Figure 12: US PADDS ...............................................................................................................................