For the last 20 years, price discovery in the oil market
has been concentrated around three main regional crude
oil benchmarks, also known as 'marker' crudes: West
Texas Intermediate (WTI) from the United States, Brent
Blend from the UK North Sea and Dubai, or Fateh, crude
from the United Arab Emirates.
Since the marker crude system was introduced in the
mid-1980s, there has been general industry
acceptance that spot trade in these barrels acts as a
barometer of the overall market level. Different grades
of oil are priced on negotiable differentials to the
marker grade. The rationale is that, in any market, the
spot price represents the balancing point of supply and
demand. Even though the volumes of oil that trade
daily on a term contract basis between companies or
governments are much bigger than those that trade on
a spot basis, price is determined at the margin, that is,
in the spot market.
The relative value of crude oils is determined by two
main factors: location and quality. In the case of Brent
and WTI, the crude produced is light and sweet (low
sulfur). Both grades are produced in or near key oil
consuming and refining centers. The twin advantage of
quality and location mean that these crude oils
command relatively high prices in the market.
WTI is widely used in the pricing of US domestic crudes,
as well as oil imports into the US. Brent has become the
de facto international oil benchmark partly because of
its location and partly because it is a good quality oil
that can be used by a wide range of refineries. The
physical value of North Sea Brent ('dated Brent') is
widely used in benchmarking the bulk of oil from the
North Sea, West and North Africa, Russia and Central
Asia, as well as large volumes from the Middle East
heading into western markets. Dubai, meanwhile, is a
medium heavy, low sulfur crude typical of the grades
produced in the Persian Gulf, but distant from
consuming centers. As a result, it tends to sell at a
lower price than Brent and WTI.
Sour predominance
In recent years, the production level of each of the
marker crudes has fallen; and in the case of Dubai, it
has fallen drastically. Meanwhile, the proportion of
heavier and sourer (lower sulfur) crudes that change
hands in the term market have grown relative to light
sweet production. More than half the world's produced
oil is heavy and sour in quality and this proportion is
expected to increase.
Middle Eastern crudes, typified by the heavy sour
volumes that flow through the Strait of Hormuz, have
grown in importance as a supply source for markets in
both east and west. The dominant role of Saudi Arabia,
the world's largest oil exporter, has been a factor in
this, as the kingdom has the only immediately available
spare capacity among OPEC members. Meanwhile,
Russia has emerged as a major supplier to western
markets after a period of decline in the early 1990s.
Most of the oil exported from Russia is also relatively
heavy and sour in quality.
Whereas supply has typically become poorer in quality,
with more heavy and more sour crude in the mix,
demand for products has veered the other way; demand
for light products has grown most rapidly, whereas
demand for residual fuels from utilities has declined
mainly because of substitution by gas. Meanwhile, the
quality requirements for light products have become ever
more strict. Sulfur levels in transportation fuels have
tightened relentlessly, a trend which has accelerated
since 2000 when leaded fuel was outlawed within the
EU. In gasoline and diesel, the sulfur limits are now
below 50 ppm in Europe and the US, and similarly tight
rules apply in many of the industrialized Asian countries.
Much of the developing world is heading in the same
direction, albeit at a slower pace.
This disparity between crude and oil product quality will
continue to widen. Although they argue over the time
frame, most oil economists concur that crude
production from the North Sea and within the US is
likely to decline relative to demand in the coming
years, and that both Europe and the Americas are likely
to become more dependent on imported oil. These
imports are likely to be increasingly supplied from the
regions with the biggest reserves. Based on existing
estimates, these are concentrated in the Persian Gulf,
and are mainly sour in quality. Other countries with
large reserves such as Venezuela and Russia also
typically produce heavier sourer crudes.
As the world becomes critically more reliant on heavier
and higher sulfur streams, it is the sour crude that is
gradually assuming more importance in the price
discovery process. Urals in Europe and Mars Blend in
the US have emerged as alternative benchmarks to their
sweet counterparts Brent and WTI.
This change in emphasis has been encouraged by the
extreme volatility seen in recent months between light
sweet and heavy sour crude oils. The volatility is seen
in Chart 1, which plots the differential between key sweet
and sour benchmarks in Asia, Europe and the US. This
volatility can be problematic for setting monthly official
selling prices - for instance for oil from the Persian Gulf
- because of the mismatch in quality between the sour
oil being sold and the benchmark referenced. The
benchmark should act as a proxy for the market at large,
but if the dynamics of the sweet and sour barrel diverge,
that function is impaired.
Changing benchmarks
A key problem is the declining production of
benchmark crudes. As the number of cargoes
available to the market each month becomes less, it
leaves the benchmark vulnerable to potential
distortion. If fewer cargoes are produced, and some
that are produced are allocated in term contracts, the
volume of oil available for spot trading may fall below
a critical threshold. In such circumstances, it may
become possible for companies to buy or control all
the available cargoes and squeeze the market. Given
the huge volumes of oil tied to the benchmark, the
leverage exerted on prices can be huge.
This was the case with North Sea Brent Blend. In 2002,
as production volumes declined to less than 20 dated
Brent cargoes a month, pricing agency Platts (also the
publisher of Energy Economist) introduced its BFO
assessment methodology, which meant the dated Brent
price assessment reflected the most competitive in
value of three similar grades of North Sea crude, Brent,
Forties and Oseberg. The new methodology dramatically
increased the pool of physical supply being traded on a
spot basis, thereby reducing any one player's ability to
squeeze the market.
However, many Russian oil industry observers ask why,
when Russian oil supplies the bulk of spot market
volume in Europe, and when there is a clear rise in the
proportion of sour crude to sweet, Russia's relatively
heavy sour Urals crude remains tied to the traditional
North Sea benchmark rather than becoming a
benchmark in its own right.
Created: Mar 7, 2006
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