By Edward Harrison of Credit Writedowns
Saudi Arabia on Wednesday decided to drop the widely used West Texas Intermediate oil contract as the benchmark for pricing its oil, dealing a serious blow to the New York Mercantile Exchange.
The decision by the world’s biggest oil exporter could encourage other producers to abandon the benchmark and threatens the dominance of the world’s most heavily traded oil futures contract. It is the main contract traded on Nymex.
Before anyone tries to spin this as an anti-dollar move, you should read what else the FT article says:
In January, WTI, which usually trades at a premium of $1-$2 a barrel to Brent, fell sharply, leaving it at a discount of almost $12 – a record gap. This dislocation in the market continued well into the summer.
From January, Saudi Arabia will base the price of oil for its US customers on a new index developed by Argus, the London-based oil pricing company.
The Argus Sour Crude Index will track the price in the physical market of a basket of US Gulf Coast crudes, including Mars, Poseidon and Southern Green Canyon.
The point of this move is not to undermine the dollar but to get away from the WTI contract where prices have been artificially inflated due to storage shortages at Cushing.
A friend familiar with this market also indicated that big bank punters active in this market will like this move as well as it helps them evade the position limits and regulation of the CFTC. He says, “In fact, the lack of transparency and regulation on the Dubai Merc was one of the reasons why you had such successful speculation in the oil market during the spring of 2008.”
I see a spike in oil prices as a risk to any sustained recovery. Anyone with more insight into why the Saudis made this move, do comment.
Will this, the current excess liquidity not available to Main Street and Dubai Merc help lead us to another bubble in oil?
To see how low we Homo Not-So-Sapiens Not-So-Sapiens have sunk, let us remind ourselves that only a few hundred years ago, people at least still had the aesthetic sense to speculate in something beautiful like tulips.
But today, we have had bubbles in ugly things like oil and equities. What’s next? Will there be a bubble in ‘gold diggers’ as those rich Wall Street traders and sovereign wealth funds bid up and horde up on useless odaliseques for their penthouse seraglios, creating a shortage for the remaining members of the Third Chimpanzee?
The “third chimpanzees” are now better known as “the chumps”.
The Saudi price formulae are developed carefully by a bevy of MBA’s and analysts in response to Saudi discontent with the price of their oil. WTI has suffered from several periods of disconnect from the market over the past few years, generally to the downside.
A few years back a pipeline to Canada was reversed, pushing oil back into Cushing. This crushed WTI and prices for physical at Cushing and other inland hubs. Yet, at the same time waterborne oil in the US Gulf was trading at huge premia to the futures meaning that most physical oil was properly priced at market levels.
A major drawback of WTI is its physical link to Cushing. Despite the storage and pipeline access, Cushing is susceptible to squeezes, generally to the downside these days. Brent (BFO, etc.) has several delivery points and offtake can be made by ship to any point in the world. This limits the “squeezability” of Brent.
Additionally, the Saudis prefer stable, serious clients for their oil. If WTI continues to be the plaything of banks and hedgefunds, clients get annoyed when it rises and demand lower premia. When it gets crushed, it’s the Saudis who are annoyed.
Cushing WTI as a benchmark has been in question for a long time now. With the economic downturn the US is consuming about 18.5 million bbls/day of oil and WTI accounts for probably 1 million of that or less, i.e. at best less than 6% of our daily oil usage. That isn’t much of a benchmark.
It is both a source of amusement and frustration to see how awful financial reporting is. The reason storage capacity is tight is because there is a glut. Those storing have to pay for it. In normal times, this would induce them to sell to clear the glut and avoid the storage charges. Prices would fall. But without batting an eyelid, the reporter reports as if the opposite were true.
I think the observation about avoiding the position limits that the CFTC is considering is astute. I have often thought that the sovereign wealth funds were the money behind Goldman and Barclays’ manipulations of the oil futures markets. It always seemed more than coincidence that the Saudis said that they wanted a price of $70/bbl and that just happened to be the price the NYMEX hovered around.
The hedge funds killed the commodity exchanges last couple of years. To get around the restrictions on speculative positions on the commodity exchanges the hedge funds bought some physical storage facilities for many Ag and non-Ag commodities so they could take bigger positions and thereby game the markets so that legitimate hedgers were subjected to never ending margin calls.
First they blew up the Ag complex, then oil.
Why would farmers, grain elevators or the Saudis want to operate in these rigged markets?
If the Saudi’s had any brains they would just set the price at (almost) whatever they wanted. What would be people do, stop buying? Have you read Twilight in the Desert? It won’t be long now.
By its name, the new index is for sour crude. WTI is light, sweet (i.e. high quality) crude. Sour oil has a high sulphur content, and it is more expensive to refine. Also, I think sour crude tends to be heavy as well (not 100% sure of that), and heavy crude yields only 60% of the energy of light (plus a lot of asphalt), unless you process it heavily at a high energy cost (basically, you have to put the missing 40% back in, using natgas as the energy source).
Because of this, refiners really prefer light, sweet. However, we are LOOONG past the peak of light, sweet crude, and heavy, sour will be an increasing part of the mix going forward. Most of the new oil the KSA can bring online will be heavy, sour.
Heavy, sour should sell at a discount to light, sweet, but the producers hate that. Last year the Iranians through something of a hissy fit that refiners didn’t want to pay $125+ for their heavy, sour, so they stored it rather than sell it.
On the other hand, both London Brent & WTI have the problem that there isn’t enough oil produced in either the North Sea or Texas to cover the number of contracts being written. The physical oil market is supposed to anchor the futures price, so futures can’t get too far out of whack. However, when the amount of real oil being traded becomes too small a percentage of the total number of contracts, then it doesn’t serve as well as an anchor. So maybe the Saudis do want a more stable exchange.
Here are the characteristics of the Gulf crudes + Thunderhead another Gulf crude and WTI:
Mars: Sulfur (%) 2.231 Gravity (API) 29.18
Poseidon: Sulfur (%) 1.41 Gravity (API) 33.17
Southern Green Canyon: Sulfur (%) 2.479 Gravity (API) 28.40
Thunder Horse: Sulfur (%) 0.65 Gravity (API) 33.7
WTI: Sulfur (%) .34 Gravity (API) 40.8
Re heavy crudes, I don’t think there are any American refineries that can process the really heavy crudes.
Hugh, all of the major US independent refiners except Sunoco have complex refining systems based on refining heavy sour crude. That is their competitive advantage (they use Maya and ANS). COP also has this via an acquisition of Tosco, Tom O’Malley’s old company.
But, right now margins are incredibly low leading to losses at all the major independents, Valero included.
Thank you and Doc Merlin for the correction. This pdf has some information about the increasing use of heavier crudes.
And this article reflects your take on the problems heavy crudes are having
Maya certainly qualifies as a heavy crude with an API of 21.8. There are also Canadian heavy crudes. I know less about ANS ones and their contribution to North Slope production.
Yes american refineries can process really heavy crude. We process a lot of the venesuelan and canadian heavy crude.
I believe they dropped this because light sweet crude isn’t what is on the market this day and time. The NYMEX will design a new contract that mirrors anything over there so I wouldn’t go so far as to say it was an attack on them. I believe these markets have been used for outfits like Goldman to scam the US consumer and a few novice traders as well.
I read a few months ago that a really knowledgeable oil guy said oil could go to $20 or less. If you look at the headlines, Roubini says $50 and some oil promotor says $90. Oil generally stops at fibonacci numbers for whatever reason and I would take $90 to be a ceiling if it got there, a short signal. The way the markets are turning right now, I don’t believe it makes it. It has made a 3/8th retrace though, 46/113 is pretty close. $89 would be a 50% swing between 144 and 34. I am an oil bear, based on watching it for all of my adult life. A bet on prices at the current level is a bet we fully recover. China is not making good business decisions, regardless of what the press seems to indicate, so I don’t buy they continue real growth. Their entire economy is speculative investment, real and imagined. Another bubble.