A market for Arabian Heavy

Posted in Energy Security , Other | 01-Jul-08 | Author: Prof. Giacomo Luciani| Source: Gulf Research Center

An oil facility in Dhahran, Saudi Arabia.

Saudi Arabia has taken a courageous step in calling for a conference of oil producers, consumers, companies and "speculators" to discuss the runaway price of oil, but the Kingdom risks being proved unable to bring prices back to the level that it sees desirable. In a market in which demand continuously rises while supply is constrained, investors have reached the conclusion that prices can move in only one direction: upwards. At the same time, the US balance of trade and federal budget deficits, coupled with the excessive level of debt throughout the American economy, have convinced investors that the dollar also can move in only one direction: downwards. The announcement that Saudi Arabia will increase production to about 9.7 million b/d will have little impact on this reality.

The problem of the oil market is not that it attracts "speculators": traders and investors are needed for liquidity and risk management. The problem is rather that the oil market lacks a "reality check". In most other markets, if "speculators" temporarily push the price beyond or below what is justified by fundamentals, the latter finally prevail and speculators are punished. In contrast, the oil market lacks an effective "reality check", because the price of all major crude oil streams - notably the Saudi Arabian crude oils - are indexed to the prices of futures contracts, which are financial instruments.

There is no physical market for oil which may discipline speculation. Buyers of physical oil - refiners and traders - are price takers, and the price that is offered to them is dictated by the futures market. In turn, refiners pass on price increases to the final consumer, whose demand tends to be rigid. He cannot in the short run change the kind of car he drives, nor the home he lives in or the distance between home and work. This means that the physical market reacts only very slowly to changes in the price of oil, and primarily through an income effect (a slow down of the economy) rather than through a price effect.

In order to regain some influence on oil prices, major oil producers must abandon their hostility to trading of their own crude oils. Ideally, they should themselves organise a broadly based and transparent physical market. The idea that a market for Gulf oils cannot exist because each quality has only a single producer is nonsense: a market can be created by resorting to auctions. Ideally, Saudi Arabia may consider setting up a system of weekly auctions to sell its Arabian Heavy crude oil, which is the effective "marginal crude oil" in today's conditions.

Auctions should be based on inviting bids without specifying ex ante the quantity that will be sold: this would be decided ' together with the settlement price ' in the light of the shape of the "demand curve" that bids would reveal. This method guarantees the seller against unwelcome surprises. Information acquired in the process would definitely clarify whether existing supply is sufficient, as claimed by OPEC, or more oil needs to be pumped, as OECD political leaders advocate.

Auctions should be for standard lots of physical oil to be delivered not earlier than three months forward - in fact a longer delay may even be preferable. This would create an element of certainty in the market which would greatly improve the "reality check" for traders and investors in financial futures. Buyers should be free to trade their contracts in an open and transparent secondary market, which would facilitate price discovery on a continuous basis. A financial futures market in heavy crude would then naturally develop. Creating a transparent and effective physical market for Arabian Heavy would also facilitate the discovery and trading of quality differentials, which in turn would help justifying investment in enhanced refinery conversion capacity. The physical market in Arabian Heavy would of course still be influenced by trading in Brent and WTI futures, but the link would be quite more elastic than it is today, and the influence might be in both directions.

Put simply: curbing speculation is not the right objective, what is needed is a proper market for physical oil.