Financial Daily from THE HINDU group of publications
Wednesday, Mar 30, 2005
Agony of the Asian oil premium
Much of Asia is chafing at the premium charged on oil imports from the Gulf, while the US and Europe enjoy discounts.
It signalled that he was departing from the path treaded earlier by the government. Viewed against these steps, his attack on the Asian premium seemed bang on. He announced with panache that he would organise a meeting of oil producers and Asian consumers to take up the issue. He did raise the matter with the Organisation of Petroleum Exporting Countries at a meeting in Vienna in September 2004.
At this meeting, he dwelt on ``Petroleum and Sustainable Development'' and took OPEC to task for exploiting Asian countries by charging a premium on their imports from West Asia. Blaming the formula pricing system, which penalised poorer importers while offering huge discounts to the US and Europe, he pleaded for a rectification of the system.
He was also determined to raise the issue at the January meeting. But by then, the premium was snuffed out by market developments. Mr Aiyar had to retract and add, "It was not a conference on Asian premium" but "one to discuss cooperative approach" between buyers and sellers.
For an understanding of the Asian premium and how it came about, it is necessary to understand the "formula pricing system" and its twin,the "marker crude."
The oil industry has always been rife with conflict. Mainly between producers and consumers over stability of prices and security of supplies. Efforts to harmonise or resolve them has been equated to the search for the Holy Grail.
Before the mid-1980s, there was price stability and OPEC's fear was one of falling prices. Developing countries in Asia secured favourable deals from producing countries. . In 1983, the oil futures market was established at the New York commodity market (Nymex). By 1986, a market-oriented pricing system was introduced to regulate oil transactions. The system of pricing crude oil through long-term supply contracts between OPEC and importing governments was abandoned and prices were to be determined by the spot prices for crude oil as `markers'.
This change followed OPEC's erosion as the oil market power, with the emergence of rival sources in the North Sea, Mexico, Nigeria, and so on. The oil market was getting transformed. The "politics of oil" was giving way to the "market for oil". The year 1986 was the watershed. Crude prices began to crash. Though OPEC tried to return to the fixed price system, by end-1986 with the basket price set at $18/bbl crude prices remained bearish what with a surplus capacity exceeding 10 million barrels a day. To hold the price, Saudi Arabia introduced sale of crude oil on netback price or the formula method early in 1987. Briefly, the idea was to determine crude oil prices on a long-term basis with the adoption of the so-called `markers' for three regions. Now, what are markers?
Benchmarks or thresholds had to be fixed to serve different regions. The market was demarcated into three regions the US, Europe and Asia and markers were designated for each region. Markers are referrals embedded in the historical and economic contexts of the relevant market. For the US, the marker was the the West Texas Intermediate (WTI). For Europe, it was Brent, produced in the North Sea.
For Asia, there was no comparable source of crude. The closest with spot trading was the one at Dubai/Oman and it was taken as the marker. It is significant that these markers do not bear any relationship to the actual cost of production of crude.
Critical for the formula pricing system is not the marker per se, but the spot prices. Spot prices, in turn, are largely influenced by the strength and depth of the financial market. For WTI and Brent, the market got crowded with "oil futures", `derivatives', and other new-fangled instruments. Asia did not have comparable financial muscle to create them. Against this medley, how did the formula pricing system operate?
Virtually, all Saudi Aramco sales to international buyers are made under long-term contracts linked to spot market prices in the three geographic zones. Most contracts are for one year. Prices are generally determined under monthly pricing formulae that include a base price calculated by taking an average of spot market prices of the widely traded `marker' crude.
The f.o.b. price for European stations is linked to the average spot price of North Sea Brent crude; and that for US supplies to WTI crude. Prices for supplies to Asia (or Far East) are linked to a 30-day spot average of Oman and Dubai crude during the month of delivery. The base price is modified by an adjustment factor that takes into account the differences between the market value of the Saudi Arabian crude and the spot market indicator crude.
The attempt is to factor in the monthly changes in the refining value of Saudi Arabian crude grades in the various markets and the differences in transportation costs between Saudi Arabian supplies and the marker crude. Though finely structured, the formula began to create imbalances as between the US/Europe and Asian markets and markers because of the asymmetrical nature of the markets.
When the formula pricing began to operate since 1987, it seemed there was a truce with the Western market. The formula survived the Gulf crisis of 1990. In the 1990s, though OPEC was no longer in the driving seat to control or set crude prices, it contained fluctuations in crude oil prices in the $13-19/bbl by combining market-related price movements with production controls. Saudi Arabia, with huge reserves, acted as the "lender of last resort" within OPEC and maintained price stability.
As the formula pricing operated, it led to two developments:
Even as Asian imports were increasing exponentially with high rates of growth, China had turned a net importer by 1993. Unlike the US or Europe, Asia was tied to the Gulf and could not diversify its crude sources. Nor could it economically access crude from areas other than the Gulf, given the freight disadvantage.
The Saudi Arabian dominance was further bolstered by the US sanctions against Iran and Iraq. Extreme uncertainty prevailed over supplies from West Asia, especially after 9/11 and the subsequent war against Iraq.
Though IEEJ and others in North-East Asia have been criticising the Asian premium and want it to be `solved', on the substantive measures to be taken to eliminate the premium, they are cautious and pragmatic. They acknowledge that there are only three options: Procurement of crude oil from alternative sources; shifting of marker crude away from Dubai; and the establishment of an oil market in the East Asian region.
On the first option, though the member-countries are making frantic efforts to diversify their sources way from the Gulf, they would have to wait for years and also avoid rivalries among themselves. The scramble for a share in Yukos oil between India and China is well-publicised.
On shifting of marker crude, though Dubai is not reliable or dependable as a marker, they admit that unless other reliable Asian sources are linked, it might not be feasible to move away from Dubai.
Establishment of an Asian market is not only related to diversifying Asian sources but to other major measures like creating a market for oil futures, deepening of the financial sector, deregulation of the sector, etc. Clearly, there is an asymmetry between US/European and Asian markets.
The North-East Asian countries are more than aware of these ground realities. Therefore, their recent confabulation has been more on oil security and sharing of the common burden. When the 22nd Asem+3 (Asean Ministers on Energy Meeting + China, Japan and Republic of Korea) met in Manila on June 9, 2004, they reached an understanding to work toward an effective solution for energy security in the region. They agreed to concentrate on energy security, natural gas development, oil-market studies, stockpiling and renewable energy. Largely, they seem to have agreed to bring about greater Asian cooperation to ensure oil security in the region. Asian premium takes a backseat in all these.
India did not participate in the Manila meeting. Dow Jones reported (Disappointment looms as Asia bids to end oil premium, December 30, 2004), that the idea for the New Delhi meeting was mooted in Manila. "Ironically, India's Petroleum Minister, Mr Mani Shankar Aiyar, ruled out as late as September a joint effort by Asian importers." Surprisingly, by September, he seemed to have changed tack. Even as he was campaigning against the Asian premium, there were other developments about which he had not been advised.
By the last week of October, the oil market was in a turmoil and prices began to cross historical limits. Troubles in Iraq, Saudi Arabia, Venezuela, Yukos of Russia, and doubts over Shell's reserves were some of the contributory factors. Some analysts have highlighted the role of hedge funds.
What was not recognised was that the formula pricing, which had since 1987 worked against the interests of Asian countries, had now turned against the Western importers. It was the same formula pricing fuelled by "oil futures" and hedge funds, which had reversed the situation.
Certaindevelopments took place two months before the Delhi meeting. Perhaps, Mr Aiyar was advised rather late and he had to change tack and say that "the conference is not on premium, but one to discuss cooperative approach". It would have been more credible had the announcement come a month earlier. As on date, there is encouraging evidence about the government's bold initiatives to diversify and access new energy sources. In future, our agony would have to be more on these measures than on symptoms like the Asian premium.
(The author, a former Finance Ministry official, has extensive experience in international, financial and trade issues.)
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