Why has Saudi Aramco moved to partially price off the DME?
This week Saudi Aramco begins implementing its new pricing policy to use a formula based on the Dubai Mercantile Exchange (DME) Oman as its official selling price (OSP) for shipments of sour crude to Asia.
Since the mid-1980’s, Saudi Aramco’s price marker was the average of Platts Dubai and Platts Oman assessments. This refers to the physical price of crude oil loading in the Arabian Gulf through the month of assessment. The company’s new Asia marker will replace Platts Oman with DME Oman effective Oct. 1, 2018. This will create a hybrid between two major benchmarks for Asia. Saudi Aramco believes it will provide customers with better visibility into price dynamics.
Launched back in 2007, DME with its Oman Crude Oil Futures contract has promoted itself as the pricing benchmark for sour crude going from the Arabian Gulf to Asian refineries. This is similar to what the Intercontinental Exchange’s (ICE) North Sea Brent is to Europe and the New York Mercantile Exchange’s (NYMEX) West Texas Intermediate is to North America, which eventually became the Argus Sour Crude Index (ASCI). There has been much debate about the validity of DME Oman, but that is over now with the Saudi Aramco move.
Saudi Aramco’s monthly OSP is based on a pricing formula which considers month-to-month changes in refining margins, benchmark market structure movement, related crudes’ competitiveness, an adjustment factor that takes into consideration crude oil quality and the point of sale, and a timing mechanism that stipulates when the value of the formula is to be calculated.
From Oct. 1, for buyers in Asia, the base price for crude oil will be linked to the average spot prices of Oman and Dubai crude oils as valued by DME and Platts respectively during the month in which the crude is loaded for delivery to the Asian market.
Saudi Aramco’s decision to make DME Oman crude oil futures part of its pricing formula for sales to Asia is a major breakthrough. It may set the stage for the DME contract to become the global medium/sour benchmark for Arabian Gulf producers. DME already bills itself as the “premier international energy futures and commodities exchange in the Arabian Gulf.”
With all the attention given by world markets to this pricing change, it must be wondered why it took Saudi Aramco more than a decade to consider DME?
There was also a qualitative argument that Oman crude was not very representative of Arabian Gulf sour crude. Unlike Dubai crude, Oman’s crude has a lower sulfur content and higher fuel oil yield of up to 50 percent fuel oil.
In all honestly, DME’s launch came at a difficult time during the 2007-2008 financial crisis. DME’s crude futures contract was struggling with liquidity and limited participation from major trading firms that deal in physical crude from Oman. DME did not attract the needed interest from key refiners, local players and financial firms that would enhance its liquidity.
It was an awkward situation. The weak start of DME supported opponents’ arguments that DME was not a suitable representative benchmark for sour crude from the Arabian Gulf producers. It was felt that liquidity and transparency were lacking.
There was also a qualitative argument that Oman crude was not very representative of Arabian Gulf sour crude. Unlike Dubai crude, Oman’s crude has a lower sulfur content and higher fuel oil yield of up to 50 percent fuel oil. Sophisticated refiners in Asia have high desulfurization capacity. It was felt that this makes Oman crude’s lower sulfur property undesirable and unrepresentative of the needed base load crude oil requirements. As a result, refiners hedged their refining margins against Dubai and that had limited interest in DME. As long as hedging is against Dubai, this leads to having limited demand to trade on the DME.
The wrongful rejection of DME as a true representative of sour crude for Arabian Gulf producers diluted interest in the exchange. Also, it was believed to be far from a reliable marker for sour crude or a successful risk management tool, as was intended.
Over the last decade, the opponents of DME have become more content with the exchange as its liquidity has improved. However, they were mostly passive observers, rather than taking part in trading on the exchange. Refiners would be more motivated to trade if others, apart from the governments of Oman and Dubai, were to use DME in their crude term contract pricing. Hence, refiners elected to wait for suppliers to adopt DME first.
DME advocates have pointed out that the ability to take physical delivery of Oman crude has ensured the DME contract’s survival from the very beginning. That the contract did not die in the first three months after it was launched gave it the possibility of being nurtured to success.
There have been some issues when aggressive Chinese traders managed to delink DME’s benchmark crude from where most market players would value it. This caused some divergence in the market structure of Dubai marker crude compared to other major crude benchmarks. Problems with the Dubai benchmark emerged whenever heavy market activity by large Chinese oil firms pushed the forward structure out of line away from market fundamentals and sentiments.
All robust benchmarks have liquid financial markets behind them. Dubai has large physical delivery, but not much of a forward market, which is key in determining how to price Arabian Gulf crudes. Saudi Aramco did not partially shift to DME to stop the new Shanghai International Energy Exchange’s (INE) crude oil futures contract. While the INE has Arabian Gulf deliverable crudes and it aims to move pricing power to China by becoming a regional marker, it is far from that.
It is irrational to compare DME contracts with other global benchmarks such as Brent. DME can scale up fast once Arabian Gulf producers commit to the futures market. Saudi Aramco’s move to partially price from DME will likely be followed by other Arabian Gulf producers. DME Oman will likely become the benchmark for around 15 million barrels per day of Arabian Gulf crude exported to Asia.
Saudi Aramco’s switch will provide a much-needed boost in the DME’s liquidity. It has struggled to expand activity beyond a few traders, producers and refiners who mostly use the exchange to sell or buy physical supply.
For now, Saudi Aramco’s move to include DME Oman might have a limited impact, since its OSP formula remains more or less the same. However, DME has the potential to develop a robust forward market even if the Arabian Gulf producers might shy away from wading too deep into oil futures trading. DME is set to gradually be the largest physically delivered crude oil futures contract in the world.
- Faisal Mrza is an energy and oil marketing adviser. He was formerly with the OPEC and Saudi Aramco. Twitter:@faisalmrza