An Anatomy of the Crude Oil Pricing System
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- Table 1: Main Benchmarks Used in Formula Pricing Asia Europe US
- Figure 4: Price Differential between Dated Brent and BWAVE ($/Barrel)
- Table 2: Some Basic Features of Benchmark Crudes First-quarter 2010 averages by Argus ASCI WTI CMA
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24 Platts continues to call the physical market Dated Brent or Dated North Sea Light while Argus calls it North Sea Dated. As shall be discussed later, the continued use of the term „Dated Brent‟ by Platts and much of the industry is not an arcane point, because the price of physical Dated Brent cargoes will be different from its „Dated Brent‟ price. The prices of physical Brent, Forties and Oseberg all differ from the (Argus) North Sea Dated/(Platts) Dated Brent value.
25 Some governments (Oman, Qatar, Abu Dhabi, Malaysia, and Indonesia) do not use benchmarks at all and instead set their own official selling prices (OSPs) on a monthly basis. These can be set retroactively or retrospectively. -10.00
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0 0 M ay 0 0 S ep 0 0 Jan
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1 0 Saudi Arabia Light-33.0 Saudi Arabia Arab Medium-3.5 Saudi Arabia Arab Heavy-27.6
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Asia Europe US Saudi Arabia Oman and Dubai BWAVE from Jul.'00, Dated Brent Until Jun.'00 ASCI from Jan.2010, WTI until Dec.'09 Iran Oman and Dubai BWAVE from Jan.'01, Dated Brent Until Dec.'00
Kuwait
Oman and Dubai BWAVE from Jul.'00, Dated Brent Until Jun.'00 ASCI from December 2009 ; Previously WTI Iraq (Basrah Blend)
Oman and Dubai Dated Brent ASCI from April 2010, Previously WTI Second Month
Nigeria
Dated Brent Brent Mexico (Maya Blend)
+ 3.5%HSFO x0.467 - 1%FO x.25 + 3.5%FO x0.25‟ WTS x0.4 + 3%HSFO x0.4 + LLS x0.1 + Dtd.Brent x0.1
The pricing may be based on „physical‟ benchmarks such as Dated Brent or on the financial layers surrounding these physical benchmarks such as the Brent Weighted Average (BWAVE), which is an index calculated on the basis of prices obtained in the Brent futures market. Specifically, the BWAVE is the weighted average of all futures price quotations that arise for a given contract of the futures exchange during a trading day, with the weights being the shares of the relevant volume of transactions on that day. Major oil exporters such as Saudi Arabia, Kuwait and Iran use BWAVE as the basis of pricing crude exports to Europe. As seen from Figure 4 below, the price differential between Dated Brent and BWAVE is quite variable with the differential in some occasions exceeding plus or minus three dollars per barrel. This is expected as BWAVE is considerably less prompt than Dated Brent and thus variability between the two should consider this time basis issue. 26 Therefore, the choice of benchmark has serious implications on government revenues. This is perhaps most illustrated in the recent shift from WTI to ASCI by some Gulf exporters. Figure 5 plots the price differential between the two US benchmarks WTI and ASCI. WTI traded at a premium to ASCI through most of this time but occasionally (four significant times) WTI moved to a discount when WTI collapsed versus other world benchmarks, with the WTI discount to ASCI reaching close to $8/barrel on 12 February 2009. The January/ February events prompted Saudi Arabia to consider alternatives to Platts WTI cash assessment.
26 Furthermore, as volatility is strongly backwardated itself along its own forward curve for most markets, this is also a relevant factor. 26
Source: Petroleum Intelligence Weekly Figure 5: Price Differential between WTI and ASCI ($/Barrel) (ASCI Price=0)
Source: Argus Given the central role that benchmarking plays in the current oil pricing system, it is important to highlight some of the main features of the most widely used benchmarks. First, unlike the futures market where prices are observable in real time, the reported prices of physical benchmarks are „identified‟ or „assessed‟ prices. These assessments are carried out by oil pricing reporting agencies, the two most important of which are Platts and Argus. 27 Assessments are needed in opaque markets such as oil where physical transactions concluded between parties cannot be directly observed by market participants. After all, parties are under no obligation to report their deals. Assessments are also needed in illiquid markets
27 There are other PRAs but these are often more specialised such as OMR (focus on Germany, Austria, and Switzerland), APPI (focus on Asia), RIM (focus on Asia), ICIS-LOR (focus on petrochemicals) and OPIS (focus on US). In December 2010, Platts announced an agreement to acquire OPIS. The acquisition is expected to be completed in the first half of 2011, subject to regulatory approval. -5.00
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where not enough representative deals or where no transactions take place. Oil reporting agencies assess their prices based on information on concluded deals which they observe, or bids and offers, and failing that on market talk, other private and public information gathered by reporters, and information from financial markets. It is important to note that PRAs do not use in all markets a hierarchy of information cascading down from deals to bids and offers, which would imply that deals are the best price discovery and bids/offers are a poorer alternative. The methodology may vary from market to market in accordance with the published methodology for that market. In some markets, bid/offer information takes precedence over deals in identifying the published price – e.g. if the deal is either not representative of the market as defined in the methodology, or was done earlier or later in the day to the prevailing depth of market. In other markets, price identification relies on observed deals. For instance, Argus‟ main benchmark ASCI is entirely deal based. Most however accept that a done deal does represent the highest form of „proof‟ of value, unless there is a supervening issue with the trade‟s conduct. If assessments are intended to represent an end-of day price, analogous to a futures „settlement „ however, a fully evidenced bid/offer spread at a later point when markets have clearly moved in value is an acceptable proxy in the absence of a trade . Sometimes a distinction is made between prices identified through observed deals or transactions using a direct mathematical formula such as volume-weighted average (referred to as an index) and prices identified through a process of interpretation based on bids and offers, market surveys, and other information gathered by reporters (referred to as price assessment) (see Argus, 2010). The choice of the method varies across markets and depends on the structure of market, particularly on the degree of market opaqueness and liquidity. While an index is suitable for markets with high trading liquidity and transparency, assessments are more suitable in opaque and illiquid markets. In this paper, we do not make this distinction and refer to both categories as price assessment. However, regardless of the method used, there is an important element of subjectivity involved as the methodology has to be decided by managers and editors. The choice of methodology (the time window in which the price is assessed, the grade specification, location) in an index based system is just as subjective as price assessment. In that respect, one approach (index or assessment) is no more subjective than the other.
Second, these agencies do not always produce the same price for the same benchmark as these pursue different methodologies in their price assessments. Even if price quotations are based on a mechanical methodology of deals done, two price reporting services could publish different prices for the same crude because their price identification process and the deals they include in the assessment could be different. For example, one PRA might use a volume weighted average of transactions between 9.00am and 5.00pm while another PRA might use last trade or open bid/offer at specified period of time. Or one PRA might include transactions within a 10-21 day price range and another includes transactions in a 10-15 day price range. Or one PRA might only include fixed-price transactions and another include fixed-price and formula-related transactions. Third, the nature of these benchmarks tends to evolve over time. Although the general principle of benchmarking has remained more or less the same over the last twenty-five years, the details of these benchmarks in terms of their liquidity and the type of crudes that are included in the assessment process have changed dramatically over that period. The assessment of the traditional Brent benchmark now includes the North Sea streams Forties, Oseberg and Ekofisk (BFOE) and that of Platts Dubai price includes Oman and Upper Zakum. These streams are not of identical quality and often fetch different prices. Thus, the assessed price of a benchmark does not always refer to a particular „physical‟ crude stream. It rather refers to a constructed „index‟ 28 which is derived on the basis of a simple mathematical formula which takes the lowest priced grade of the different component crudes to set the benchmark.
28 This may take the form of a matrix of closely-related prices which use the total physical liquidity by engineering price floors and caps to reduce or eliminate the possibility of price distortion or skews. 28
Table 2 below summarises some basic statistics of the main international benchmarks: BFOE in the North Sea, WTI and ASCI in the US, and Dubai-Oman in the Gulf. In terms of production, the underlying physical base of the benchmark amounts to slightly more than 3 million b/d, i.e., around 3.5% of global production. In terms of liquidity, there is wide difference across benchmarks. While in the US the number of spot trades per calendar month is close to 600, the number of spot trades does not exceed three per month in the case of Dubai. The divergence in liquidity across benchmarks reflects the low underlying physical base and the different nature of benchmarks where US crudes are pipeline crudes with small trading lots whereas Brent and Dubai are waterborne crudes with large trading lots. Table 2 also shows that the degree of concentration in traded volumes varies considerably across markets. From the sellers‟ side, Dubai, Oman and Forties exhibit a high degree of concentration in the total volume of spot trades especially when compared to US markets. From the buyers‟ side, Dubai and Forties exhibit a high degree of concentration whereas Oman compares favourably with other benchmarks.
Production (MBPD) 736 300-400
562 1,220
70-80 710
Volume Spot Traded (MBPD) 579
939 514
635 86
246 Number of Spot Trades per Cal Month 260
330 18
98 3.5
10 Number of Spot Trades Per Day 13
16 <1 5
<1 Number of Different Spot Buyers per Cal Month 26
27 7 10 3 5 Number of Different Spot Sellers per Cal Month 24
36 6 9 3 6 Largest 3 Buyers % of Total Spot Volume 43%
38% 63%
72% 100%
50% Largest 3 Sellers % of Total Spot Volume 38%
51% 76%
56% 100%
80% Source: Argus
Notes: Daily statistics are per trade day, except production which is per calendar day; Forties: The physical grade usually sets North Sea Dated/Dated Brent; BFOE: Forward cash contracts deliverable as physical BFOE cargoes, used in setting the flat price against which North Sea Dated is calculated; Oman: Excludes physical deliveries through DME. Estimated deliveries on DME contacts are 300,000-400,000 barrels per day; WTI: Includes cash market trade for WTI Calendar Month Average and WTI P-Plus. Cash market at Cushing no longer trades except at last three days of trade month as spread for 2 nd month. Roll trades are not included here. Also does not include any volumes on CME Nymex futures.
Finally, in the last two decades or so, many financial layers (paper markets) have emerged around these benchmarks. These include the forward market (in Brent), swaps, futures, and options. Some of the 29
instruments such as futures and options are traded on regulated exchanges such as ICE and CME Group, while other instruments, such as swaps and forward contracts, are traded bilaterally over the counter (OTC). Nevertheless, these financial layers are highly interlinked through the process of arbitrage and the development of instruments that link the various markets together such as the Exchange of Futures for Swaps (EFS) which allow traders to roll positions from futures to swaps and vice versa. Over the years, these markets have grown in terms of size, liquidity, sophistication and have attracted a diverse set of players, both physical and financial. These markets have become central for market participants wishing to hedge their risk and to bet (or speculate) on oil price movements. Equally important, these financial layers have become central to the oil price identification process. In Sections 5, 6 and 7, we discuss the main benchmarks used in the current oil pricing system and the financial layers surrounding these benchmarks.
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4. Oil Price Reporting Agencies and the Price Discovery Process The oil price reporting agencies (PRAs) are an important component of the oil industry. The prices that these agencies identify or assess underlie the basis of long-term contracts, spot market transactions, futures markets contracts and derivatives instruments. Some PRAs argue that through their methodological structure for reporting physical transactions, they act as „a mirror to the trade‟ and provide „transparency on what would otherwise be a collection of bilateral deals‟. 29 However, as argued by Horsnell and Mabro (1993:155) oil PRAs are far more than mere observers of crude oil and oil product markets. If they were, then their only role would be to add to the price transparency of the market. However, deals worth hundreds of millions of dollars per day ride on published assessment and the nature and structure of oil reporting create trading opportunities and new markets and affect the behaviour of oil traders. Price reporting does more than provide a mirror for oil markets; the reflection in the mirror can affect the image itself. Indeed, in their attempt to identify the price that reflects accurately the market value of the oil barrel, PRAs enter into the decision-making territory that can influence market structure. For instance, Platts decides on the time of pricing of oil (the time stamping), the width of the Platt‟s window, the size of the parcel to be traded, the process of delivery, and the time of delivery of the contract. PRAs make these decisions on the basis of regular consultations with the industry. In return, PRAs influence the trading strategies of the various participants and their reporting policies. In fact, new markets and contracts may emerge to hedge the risks arising from some of the decisions that PRAs make. Even when price assessments are based on observed transactions and mathematical formula, there is still an important element of decision-making involved as this entails the choice about the assumptions behind the methodology. Editors and managers in PRAs choose how to build the index (in the case of Argus) and how to allow for non-deals-based methodologies in case of a lack of deals. While PRAs have been an integral part of the crude oil market especially since the shift to the market- related pricing system in 1986 30 , their role has recently been attracting considerable attention. In the G20 summit in Korea in November 2010, the G20 leaders called on „the IEF, IEA, OPEC and IOSCO to produce a joint report, by the April 2011 Finance Ministers‟ meeting, on how the oil spot market prices are assessed by oil price reporting agencies and how this affects the transparency and functioning of oil markets „. 31 In its latest report in November 2010, IOSCO points that „the core concern with respect to price reporting agencies is the extent to which the reported data accurately reflects the cash market in question‟. 32 As discussed below, the accuracy of price assessments heavily depends on large number of factors including the quality of information obtained by the PRA, the internal procedures applied by the PRAs and the methodologies used in price assessment. To evaluate the role of PRAs in the oil market, it is important to look at three inter-related dimensions: the methodology used in identifying the oil price; the accuracy of price assessments; 33 and the internal measures that PRAs implement to protect their integrity and ensure an efficient price assessment process. There is a fundamental difference in the methodology and in the philosophy underlying the price assessment process between the various pricing reporting agencies. As a result, different agencies may produce different prices for the same benchmark. Even if price quotations are based on a mechanical methodology of deals done, two price reporting services could publish different prices for the same crude
29 Argus Response to the „Report of the Working Group on the Volatility of Oil Prices‟ chaired by Professor Jean- Marie Chevalier, p.5. 30 PRAs assessment were already widely used in the price formation process for refined products prior to 1986. 31 G-20 Seoul Summit 2010, THE SEOUL SUMMIT DOCUMENT, Paragraph 61. 32 IOSCO (2010), Task Force on Commodity Futures Markets: Report to the G20, November 2010, p. 17. 33 Though other attributes such as representativeness and usefulness could also be included. 31
because their mechanical price identification process could be different. This raises the issue of which of the methods generates a more accurate price assessment. Given that assessed prices underlie long-term contracts, spot transactions and derivatives instruments, even small differences in price assessments between PRAs have serious implications for exporters‟ revenues and financial flows between parties in financial contracts. PRAs use a wide variety of methods to identify the oil price which may include the volume weighted average system, low and high deals done, and market-on-close (MOC). In January 2001, Platts stopped using the volume-weighted average system and replaced it with the MOC methodology. 34 In this system, Platts sets a time window, known as the Platts window, and only deals transacted within this time window are used to assess the oil price. 35 The price is assessed on the basis of concluded deals, or failing that, on bids and offers. Assessment will also make use of information from financial layers about spreads and derivative „to help triangulate value‟. 36 Thus, the MOC can be thought of a structured system for gathering information on the basis of which Platts assesses the daily price of key physical benchmarks. In a way, it is similar to a futures exchange where traders make bids and offers, but with two major differences: the parties behind the bids and offers are known, and Platts decides on the information to be considered in the assessment, i.e., the information passes through the Platts filter. These price assessments are then transmitted back to the market through a variety of channels. The reason for the shift to MOC is a concern that „an averaging system for price determination could result in assessments that lag actual market levels as deals done early in an assessment period at a level that is not repeatable, could mathematically drag prices down or up‟ (Platts, 2010a:7). 37 Thus, Platts emphasises the time sensitivity of its assessed prices which are „clearly time-stamped‟ on a daily basis. 38 Time stamping not only allows for an accurate reflection of price levels at particular point in time, but also for accurate assessment of time spreads and inter-crude spreads. Both the volume-weighted average method and the MOC have received their share of criticism. While the volume-weighted average method allows the inclusion of a large number of deals and hence is more representative, the method has been criticised as it
34 In the US, Platts used a volume weighted average for domestic crude. But for products, it has always used a low and high of deals done. In the WTI crude market prior to 2001 Platts used a volume weighted average of a 30- minute window. In Asia, Platts used the window or page 190, its first „market on close‟, also before 2001. The market on close went global for Platts in 2001. 35 It is important to note that the window opens all day and Platts will accept trades, bids and offers at any time of the day. But only deals transacted within a specified period of time (for instance from 4:00 to 4:30 for European crudes) are considered for assessing the price for that day. Some argue that this may encourage traders to present their bids/offers to Platts during this time window in order to maximize their impact on prices. 36 Thorne, S. (2010), „A User guide to Platts Assessment Processes‟, Presentation at the Platts Crude Oil Methodology Forum 2010, London, May. 37 Platts (2010a), Methodology and Specifications Guide: Crude Oil, The McGraw Hill Companies, October. 38 Some commentators consider that through its window, Platts is able to establish the marginal price of oil, which in principle should set price for the rest of the market. It is not clear what is meant by the marginal price, but in terms of theory, the closest one can think of the Platts‟ window is in terms of the Walrasian auctioneer. The Walrasian auctioneer is a fictitious construct who aggregates traders‟ demand and supplies to find a market clearing price, through a series of auctions. While Platts window resembles the Walrasian auctioneer, it differs fundamentally in many respects such as the existence of transactions costs, barriers to entry and the fact that the auctioneer does not perform a passive role in the market. It decides who enters the market and when to the set the price. It has also been long realised that trading has a timing dimension. While over time, the number of buyers and sellers may be equal, at any particular the time, this is not guaranteed in which case it is not possible to find a market clearing price (Demsetz, 1968). This could be overcome by participants paying an immediacy premium in which case the equilibrium will be characterised by two demand and supply curves and two prices. Furthermore, the literature shows that market structure such as the number of players, their size, the timing of entry matters and could affect the trading price. Therefore, the actual mechanism used to set the price is not simply a channel, but is an input into the price and as such cannot be ignored (see O'Hara, 1997).
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may result in an index that is out of step and not reflective of the actual market price prevailing at the close of the day. This would especially be the case on days with high volatility. Trade- weighted averages may also be distorted by the pattern of trading liquidity over the day…. A key weakness in all trade-weighted average assessments is that they will lag the market price. They always reflect a price that „was‟ rather than the price that „is.‟ (Platts, 2010b:6). 39
may be dominated by few players which may hamper the price discovery process. For instance, Argus, Platts‟ main competitor, argues that in US crude markets MOC methodology would work if the industry poured liquidity into the window. Without this liquidity, the methodology is left to assess the value at the close based on bids, offers and other related factors. This means that the price derived from an MOC assessment can diverge widely from a weighted average of all deals done in the trading day. 40
convergence of the two is just a statistical accident if it ever happens. Argus conducted a study on the US crude oil market in 2007 which compares the spot market traded volume inside the window with the volume traded during the entire day. The study finds that the volume traded within the Platts window constitutes only a very small fraction of daily traded volumes, as seen in Table 3 below. This applies to a wide variety of US crudes. Argus argues that such low liquidity and „complete lack of participant breadth‟ raise „serious questions about the efficiency of price discovery‟ in the US oil market. 41
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