An Anatomy of the Crude Oil Pricing System

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Article An Anatomy of the Crude Oil Pricing System

Spot Markets, Long-Term Contracts and Formula Pricing
Figure 1: Price Differentials of Various Types of Saudi Arabia’s Crude Oil to Asia in $/Barrel
Figure 2: Differentials of Term Prices between Saudi Arabia Light and Iran Light Destined to Asia (FOB) (In US cents)
Figure 3: Difference in Term Prices for Various Crude Oil Grades to the US Gulf (Delivered) and Asia (FOB)

It involved a general formula in which the price of crude oil was set equal to the ex post product realisation minus

refining and transport costs. A number of variables had to be defined in a complex contract including the set of

petroleum products that the refiner could produce from a barrel of oil, the refining costs, transportation costs, and the

time lag between loading and delivery.

These figures refer to First-month Brent. Source: Petroleum Intelligence Weekly (PIW)

3. The Market-Related Oil Pricing System and Formulae Pricing

The collapse of the OPEC administered pricing system in 1986-1988 ushered in a new era in oil pricing in

which the power to set oil prices shifted from OPEC to the so called „market‟. First adopted by the

Mexican national oil company PEMEX in 1986, the market-related pricing system received wide

acceptance among most oil-exporting countries and by 1988 it became and still is the main method for

pricing crude oil in international trade. The oil market was ready for such a transition. The end of the

concession system and the waves of nationalisations which disrupted oil supplies to multinational oil

companies established the basis of arm‟s-length deals and exchange outside the vertically and

horizontally integrated multinational companies. The emergence of many suppliers outside OPEC and

more buyers further increased the prevalence of such arm‟s-length deals. This led to the development of a

complex structure of interlinked oil markets which consists of spot and also physical forwards, futures,

options and other derivative markets referred to as paper markets. Technological innovations that made

electronic trading possible revolutionised these markets by allowing 24-hour trading from any place in the

world. It also opened access to a wider set of market participants and allowed the development of a large

number of trading instruments both on regulated exchanges and over the counter.

Spot Markets, Long-Term Contracts and Formula Pricing

Physical delivery of crude oil is organised either through the spot (cash) market or through long-term

contracts. The spot market is used by transacting parties to buy and sell crude oil not covered by long-

term contractual arrangements and applies often to one-off transactions. Given the logistics of

transporting oil, spot cargoes for immediate delivery do not often take place. Instead, there is an important

element of forwardness in spot transactions which can be as much as 45 to 60 days. The parties can either

agree on the price at the time of the agreement, in which case the sport transaction becomes closer to a

„forward‟ contract.

More often though, transacting parties link the pricing of an oil cargo to the time of

Long-term contracts are negotiated bilaterally between buyers and sellers for the delivery of a series of oil

shipments over a specified period of time, usually one or two years. They specify, among other things, the

volumes of crude oil to be delivered, the delivery schedule, the actions to be taken in case of default, and

above all the method that should be used in calculating the price of an oil shipment. Price agreements are

usually concluded on the method of formula pricing which links the price of a cargo in long-term

contracts to a market (spot) price. Formula pricing has become the basis of the oil pricing system.

Crude oil is not a homogenous commodity. There are various types of internationally traded crude oil

with different qualities and characteristics. Crude oil is of little use before refining and is traded for the

final petroleum products that consumers demand. The intrinsic properties of crude oil determine the mix

of final petroleum products. The two most important properties are density and sulfur content. Crude oils

with lower density, referred to as light crude, usually yield a higher proportion of the more valuable final

petroleum products such as gasoline and other light products by simple refining processes. Light crude

oils are contrasted with heavy ones that have a low share of light hydrocarbons and require a much more

complex refining process such as coking and cracking to produce similar proportions of the more valuable

petroleum products. Sulfur, a naturally occurring element in crude oil, is an undesirable property and

refiners make heavy investments in order to remove it. Crude oils with high sulfur are referred to as sour

crudes while those with low sulfur content are referred to as sweet crudes.

Since the type of crude oil has a bearing on refining yields, different types of crude streams fetch different

prices. The light/sweet crude grades usually command a premium over the heavy/sour crude grades.

Given the large variety of crude oils, the price of a particular crude oil is usually set at a discount or at a

Although spot transactions contain an element of forwardness, they are considered as commercial agreements

under US law and are not subject to the regulation of the Commodity Exchange Act.

premium to a marker or reference price. These references prices are often referred to as benchmarks. The

formula used in pricing oil in long-term contracts is straightforward. Specifically, for crude oil of variety

x, the formula pricing can be written as

P

x

= P

R

± D

where P

is the price of crude x; P

is the benchmark crude price; and D is the value of the price

differential. The differential is often agreed at the time when the deal is concluded and could be set by an

oil exporting country or assessed by price reporting agencies.

It is important to note that formula pricing

may apply to all types of contractual arrangements, be they spot, forward or long term. For instance, a

spot transaction in the crude oil market, is - pricing wise - an agreement on a spot value of the differential

between the physical oil traded and the price of an agreed oil benchmark, which fixes the absolute price

level for such trade, normally around the time of delivery or the loading date.

Differences in crude oil quality are not the only determinant of crude oil price differentials however. The

movements in differentials also reflect movements in the Gross Products Worth (GPW) obtained from

refining the reference crude R and the crude x.

Thus, price differentials between the different varieties of

crude oil are not constant and change continuously according to the relative demand and supply of the

various crudes which in turn depend on the relative prices of petroleum products. Figure 1 plots the

differential that Saudi Arabia applied to its crude exports to Asia for its different types of crude oil

relative to the Oman/Dubai benchmark during the period 2000-2010 (January). As seen from this figure,

the discounts and premiums applied are highly variable. For instance, at the beginning of 2008, the

differentials between Arab Super Light and Arab Heavy widened sharply to reach more than $15 a barrel;

fuel oil, a product of heavy crude, was in surplus while the demand for diesel, a product of lighter crudes,

was high. In the first months of 2009, the price differential between heavy and light crude oil narrowed to

very low levels as the implementation of OPEC cuts reduced the supply of heavy crude and increased the

relative value of heavy-sour crudes.

Figure 1: Price Differentials of Various Types of Saudi Arabia’s Crude Oil to Asia in $/Barrel

Source: Petroleum Intelligence Weekly Database

Official formula pricing refers to the process of setting the differential in relation to a benchmark with the

resultant price known as official formula prices. This should be distinguished from official selling prices in which

the government sets the price on an outright basis.

Individual crudes have a particular yield of products with a gross product worth (GPW). GPW depends both on

on the refining process and the prices at which these products are sold.

-10.00

-8.00

-6.00

-4.00

-2.00

0.00

+2.00

+4.00

+6.00

+8.00

+10.00

Jan

-0

Jan

-0

Jan

-0

Jan

-0

Jan

-0

Jan

-0

Jan

-0

Jan

-0

Jan

-0

Jan

-0

Jan

-1

Arab Super Light-50

Arab Extra Light-37

Arab Light-33

Arab Medium -31

Arab Heavy-27

The differential to a benchmark is independently set by each of the oil-producing countries. For many

countries, it is usually set in the month preceding the loading month and is adjusted monthly or quarterly.

For instance, for the month of May, the differential is announced in the month before, i.e. April based on

information and data about GPW available in the month of March.

Since the process of setting price

differentials involves long time lags and is based on old information and data, the value of the price

differential does not often reflect the market conditions at the time of loading and much less so by the

time the cargo reaches its final destination. In the case of multiple transactions under a long-term contract,

buyers can be compensated by sellers by adjusting downwards the differential in the next rounds if the

price proves to be higher than what is warranted by market conditions at the time of loading or at

delivery. This continuous process of adjusting differentials is inevitable given that setting the differential

is based on lagged data and if oil exporters wish to maintain the competitiveness of their crudes.

In other countries such as Abu Dhabi and Qatar, the governments do not announce price differentials, but

rather an outright price known as the official selling price (OSP). These are, however, strongly linked to

Dubai-Oman benchmark and thus, one can assume that outright prices contain an implicit price

differential and hence are close to formula prices (see Horsnell and Mabro, 1993; Argus, 2010).

In setting the differential, an oil-exporting country will not only consider the differential between its crude

and the reference crude, but has also to consider how its closest competitors are pricing their crude in

relation to the reference crude. This implies that the timing of setting the differential matters, especially in

a slack market. Oil-exporting countries that announce their differentials first are at the competitive

disadvantage of being undercut by their closest competitors. This can induce them to delay announcement

of the differential or, in the case of multiple transactions, compensate the buyers by adjusting the

differential downward in the next rounds. Competition between various exporters implies that crude oils

of similar quality and destined for the same region tend to trade at very narrow differentials. Figure 2

below shows the price differential between Saudi Arabia Light (33.0 API) and Iranian Light (33.4 API)

destined to Asia. As seen from this graph, the differentials are narrow not exceeding 30 cents most of the

time although on some occasions, the differentials tend to widen. Such large differentials do not tend to

persist as adjustments are made to keep the crude oil competitive. In the mid 1990s, Saudi Arabia Light

was trading at a premium to the Iranian Light, but this premium turned into discount in the slack market

conditions of 1998. In the period 2002 to 2004, the two types of crude oil were trading almost at par, but

since 2007, Saudi Arabian Light has been trading at a discount, making its light crude more competitive

compared to the Iranian Light, perhaps in an attempt by Saudi Arabia to maximise its export volume to

Asia or due to mispricing on the part of the Iranian National Oil Company.

The above discussion focused only on the pricing mechanism implemented by an oil exporting country

via its national oil company. The value of the differential does not need not to be set by an oil producing

country and can be assessed by price reporting agencies.

For details see Horsnell and Mabro (1993).

Abu Dhabi and Qatar set the OSP retroactively so that the OSP announced in the month of October applies to

cargoes that have already been loaded in the month of September while Oman and Dubai dropped retroactive pricing

when they moved from Platts Oman-Dubai to DME Oman in August 2007.

Figure 2: Differentials of Term Prices between Saudi Arabia Light and Iran Light Destined to Asia

(FOB) (In US cents)

Source: Oil Market Intelligence Database

The „equivalence to the buyer‟ principle, which means that in practice prices of crudes have equivalent

prices at destination, adds another dimension to the pricing formulae. The location in which prices should

be compared is not the point of origin but must be closer to the destination where the buyer receives the

cargo. Since the freight costs vary depending on the export destination, some formulae also take into

account the relative freight costs between destinations. Specifically, they allow for the difference between

the freight costs involved in moving the reference crude from its location to a certain destination (e.g.

Brent from Sollum Voe to Rotterdam) and the costs involved in moving crude x from the oil country‟s

terminal to that certain destination (e.g. Arabian Light from Ras Tanura to Rotterdam). In such cases, the

sale contract is close to a cost, insurance and freight (CIF) contract. This is in contrast to a free on board

(FOB) contract which refers to a situation in which the seller fulfils his obligations to deliver when the

goods have passed over the ship‟s rail. The buyer bears all the risks of loss of or damage to the goods

from that point as well as all other costs such as freight and insurance.

A major advantage of formula pricing is that the price of an oil shipment can be linked to the price at the

time of delivery which reflects the market conditions prevailing. When there is a lag between the date at

which a cargo is bought and the date of arrival at its destination, there is a big price risk. Transacting

parties usually share this risk through the pricing formula. Agreements are often made for the date of

pricing to occur around the delivery date. For instance, in the case of Saudi Arabia‟s exports to the United

States up to December 2009, the date of pricing varied between 40 to 50 days after the loading date. The

price used in contracts could be linked to the price of benchmark averaged over 10 days around the

delivery date, which rendered the point of sale closer to destination than the origin. In 2010, Saudi Arabia

shifted to Argus Sour Crude Index (ASCI) and it currently uses the trade month (20 day minimum)

average of ASCI prices for the trade month applying to the time of delivery.

Oil exporters may have different pricing policies for different regions. For instance, for Saudi exports to

the US, the price that matters most is the cost of shipment at the delivery point. For its exports to Asia, the

pricing point is free on board and hence the price that matters most is the price at the loading terminal.

Figure 3 below shows the price difference between crude delivered to the US Gulf Coast and the price

sold at FOB to Asia for different variety of crude oils. As seen from this graph, the price differential is

highly variable depending on the relative demand and supply conditions between these two markets and

the degree of competition from alternative sources of supply. While in the US, Saudi Arabia faces tough

competition from many suppliers including domestic ones and hence its crude has to be competitive at

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-0.30

-0.20

-0.10

0.00

0.10

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0.30

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0.50

Jan

l 9

Jan

destination, the strong growth in Asian demand and the limited degree of competition in Asia give rise to

an „Asian premium‟. Hence, in some occasions the price of a cargo delivered to the US is less than the

FOB price to Asia despite the fact that it takes longer for a cargo to reach the US.

Figure 3: Difference in Term Prices for Various Crude Oil Grades to the US Gulf (Delivered) and

Asia (FOB)

Source: Oil Market Intelligence

Benchmarks in Formulae Pricing

At the heart of formulae pricing is the identification of the price of key „physical‟ benchmarks, such as

West Texas Intermediate (WTI), the ASCI price, Dated Brent (but also called Dated North Sea Light,

North Sea Dated, Dated BFOE)

and Dubai. The prices of these benchmark crudes, often referred to as

„spot‟ market prices, are central to the oil pricing system. The prices of these benchmarks are used by oil

companies and traders to price cargoes under long-term contracts or in spot market transactions; by

futures exchanges for the settlement of their financial contracts; by banks and companies for the

settlement of derivative instruments such as swap contracts; and by governments for taxation purposes.

Table 1 below lists some of the various benchmarks used by key oil exporters. As seen from the table,

countries use different benchmarks depending on the export destination. For instance, Iraq uses Brent for

its exports to Europe, a combination of Oman and Dubai for its exports to Asia, and until very recently

WTI for its exports for the US. In 2010, Saudi Arabia, Kuwait and Iraq switched to the Argus Sour Crude

Index (ASCI) for exports destined to the US. Mexico uses quite a complex formula in pricing its exports

to the US which includes a weighted average of the prices of West Texas Sour (WTS), Louisiana Light

Sweet (LLS), Dated Brent, and High Sulfur Fuel Oil (HSFO). For its exports to Europe, Mexico uses both

high and low sulfur fuel oil (FO) and Dated Brent.

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