COLUMN-Saudi move is bid to realign oil market: John Kemp

-- John Kemp is a Reuters columnist. The views expressed are his own --

By John Kemp

LONDON Oct 29 (Reuters) - Saudi Aramco's decision to abandon a light sweet oil benchmark closely linked to NYMEX futures as the basis for crude sales to U.S. customers reflects growing frustration with its performance over the last two years.

While it will not imperil NYMEX's status as the main forum for oil futures trading, it will increase pressure on the exchange to consider adjustments to its contract. In time NYMEX may have to allow a wider range of crudes to be delivered and add a delivery location on the U.S. Gulf Coast [ID:nLN445640].

WRONG GRADE, LOCATION, STORAGE

The problems with the NYMEX contract are well known. It is the wrong grade of crude oil, in the wrong location, and with inadequate pipeline and storage infrastructure linking it to the wider global market:

(1) The light sweet grades deliverable against the NYMEX contract, which include West Texas Intermediate (WTI), represent only a tiny fraction of the crude produced and traded each day, and are increasingly unrepresentative of the wider market. Most new production in the United States and around the rest of the world is heavier and sourer, and refineries in the United States and the rest of the world are being upgraded to deal with lower quality blends.

(2) The landlocked delivery location at Cushing, Oklahoma, is disconnected from the global seaborne crude market. The location made sense when the contract was introduced in the early 1980s as a benchmark for the domestic market. It was centrally located near the main Texas oilfields, capturing the typical base price for crude oil paid by refiners across the continental United States.

In 1983, U.S. oilfields produced more than 8 million barrels per day (bpd), about three out of every four barrels consumed by U.S. refiners, and the country imported only 3 million bpd. But domestic production has fallen steadily, and now amounts to just 5 million bpd, just one third of refinery consumption, while imports have tripled to more than 9 million bpd. Prices paid by U.S. refiners are set on global markets, where the majority of crude traded internationally is delivered in ocean-going tankers and cannot easily be delivered against contract positions.

(3) Cushing suffers from a shortage of storage capacity (currently around 45-50 million barrels), and limited pipeline capacity linking it with the coast as well as the rest of the country hampers deliveries into and out of the tank farms. NYMEX prices reflect the price and availability of crude at Cushing, and there may not be enough opportunity for physical arbitrage to force convergence with the wider market.

PROBLEMS ON WAY UP -- AND DOWN

During the price spike to $147 per barrel last year, OPEC repeatedly criticised the NYMEX price for overstating the real degree of tightness in the physical market and causing prices to overshoot on the upside. While soaring prices seemed to point to an acute physical shortage, Saudi Arabia could not find buyers for the extra 500,000 bpd offered to the market in May-June 2008.

Rather than acknowledge there was something wrong with the reference price, some market participants suggested Saudi Arabia should increase the already large discounts for its physical crude to achieve sales in a market that clearly did not want or need the oil, and accept an even larger contango to make storing all the extra oil economic.

But in late 2008 and 2009, the problem was reversed. The build up of inventories and congestion around the delivery point at Cushing put intense downward pressure on nearby futures contracts, forcing the market into a record contango. Saudi Arabia complained that low nearby prices for the NYMEX contract understated demand for its oil and did not reflect the price it was able to command in the wider market.

REFERENCE MUST REFLECT MARKET

The point about a reference price is that it is only a starting point for pricing of individual crudes and transactions. Actual contracts are normally priced at a premium or discount, reflecting differences in quality and delivery location. But premiums and discounts need to be relatively small and relatively stable. If they become too large and variable, the reference price loses its utility.

Saudi Arabia currently sets official selling prices (OSPs) for U.S. customers on the basis of a Platts price (which is closely linked to the NYMEX futures contract) with a discount or premium to take account of crude quality and differences between prices at Cushing and in other markets.

But as the NYMEX prices become increasingly de-coupled from conditions in the wider global crude market, the premium and discount structure has become large and unstable. Saudi Arabia has had to introduce greater variability into the OSPs to make up for the deficiencies in the reference price. A reference price that has to be offset by large swings in the OSP is no longer fulfilling one of its core functions.

ARGUS SOUR CRUDE INDEX MARKER

The impact of NYMEX's erratic performance has encouraged Saudi Aramco to switch the reference price in its contracts to the Argus Sour Crude Index (ASCI). The ASCI is the volume-weighted average of physical spot market transactions for three medium sour crudes (Mars, Poseidon and Southern Green Canyon) produced in the U.S. Gulf and delivered by pipeline to coastal refining centres in Texas and Louisiana.

In some senses the shift is a technical one. Mars, Poseidon and Southern Green Canyon are themselves traded with reference to NYMEX, plus or minus a discount, so calculation of the ASCI incorporates the NYMEX price.

The advantage for Aramco is that its OSPs will be more stable and it will no longer have to forecast the sweet-sour differential when setting them. By breaking out the differential and including it in the contract by reference to Argus, Saudi Arabia can have more stable OSPs and still ensure its crude is competitively priced.

Saudi Arabia has shifted the basis of its crude sales before. In 2000, Aramco changed the basis for European customers from Platts Dated Brent to a volume-weighted average (BWAVE) of futures prices on the International Petroleum Exchange (now part of ICE). But in that case Aramco was simply changing from one form of Brent pricing to another. In this instance it is changing both the grade (light sweet to medium sour) and the location (Cushing to the U.S. Gulf Coast).

RECAPTURING MARKET MANAGEMENT?

In the longer term, Saudi Arabia may hope to pressure NYMEX into reformulating its own contract. While Saudi crudes are not tradable on the open market, Aramco's move may persuade other producers and customers to start using the ASCI reference price as well, compelling NYMEX to broaden its own contract to protect its benchmark status.

In early 2008, when prices were spiking, Saudi Arabia strongly hinted western governments should look at reforming their own futures markets rather than call for more oil production as a means of curbing the excessive rise in prices.

Saudi Arabia still aims to manage market prices. Senior officials have expressed frustration with the extent to which speculators rather than fundamentals drive crude prices. But the kingdom's ability to manage the market is limited because the crude it can supply at the margin (medium and heavy sour, on a tanker) cannot be delivered against NYMEX.

At the moment, when prices spike, Saudi Arabia is a bystander. Speculators can go long of NYMEX futures contracts and drive prices sharply higher, knowing there is no real risk Saudi Arabia will emerge on the other side of the market and force them to take delivery.

But if the NYMEX pricing basis was broadened to include medium sour crudes delivered at the coast, Saudi Arabia could take (or threaten) a short position and send a fleet of very large crude carriers (VLCCs) steaming towards the United States, putting the longs at real risk of having to take delivery. For a snap analysis on the motives and implications of Saudi Arabia's move, click on [ID:nLT290696]