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Saudi Aramco’s Switch to New Oil Benchmark

Saudi Aramco has recently announced the company’s plan to change its pricing formula that was used for long-term crude oil sales, which will come into effect as of October 2018.

Platts, a specialist energy information provider, has assessed the official crude oil selling price since the 1980’s by using an equally weighted average price of Oman and Dubai prices. The new formula, however, will be based on the average monthly prices of Oman crude futures contracts, known as the Dubai Mercantile Exchange (DME), and will be assessed by S&P Global Platts.

Although Saudi Aramco’s announcement was regarded as a shock, company officials stated they considered switching the benchmark for many years. The new benchmark of choice is important because of its chosen formula, which attempts to set the best possible pricing level while still remaining competitive for its customers. The older benchmark in Platts recorded almost no trading both in 2017 and 2018, however, in comparison, the DME was used in trade for over 3,200 contracts this year alone.

Currently, Saudi Aramco has chosen to conduct half of its trade with DME while the remaining trade will continue with the older benchmark. Once the traditionalists in Saudi Aramco are satisfied with the new benchmark, the company will shift its pricing mechanism completely to the new one. DME is a joint venture of a number of big banks, oil companies and investment funding –namely the CME Group, Dubai Holding and the Oman investment fund.

As the most liquid and physically deliverable futures contracts of the Middle East’s crude oil, DME would not only help Saudi Aramco achieve more flexibility in its contracts to hedge as a derivative instrument but also allow the company pliancy by providing more liquidity in futures trading.

The strong correlation between the Brent benchmark and the DME pricing mechanism is one of the main reasons for switching to the DME, which allows easier and efficient management of high liquidity. Secondly, the pricing mechanism is not subject to destination restrictions and its physical liquidity is relatively higher compared to any other available options.

The fact that monthly physical delivery volumes, which exceeded 30 million barrels in the region, have been achieved using DME paves the way for deliveries of future contracts with large volumes using DME as the primary price mechanism.

The two scenarios in which DME can further make inroads is firstly through Saudi Aramco’s decision to completely orchestrate contracts using DME, a move that would further strengthen the link between Brent and DME. Once Asian refineries find that DME contracts are an easier option to manage their risk, it will be much easier for Aramco to increase its DME share from 50 percent.

In the second scenario, if the DME cannot create the expected liquidity, hedgers would be put in a predicament and would retreat from further investing in DME-related contracts. In this case, DME, as a newly created instrument, would not be able to attract enough interest from Asian oil importers, and this, in turn, would eventually force Saudi Aramco to revert to using its old pricing mechanism.

Although it is still uncertain whether other Middle Eastern oil producer countries would follow Saudi Aramco in switching their pricing benchmarks, there is a strong sense that oil-producing countries like Kuwait, Iraq and Iran, which set their official sales price by closely watching Saudi Aramco, could well follow suit. They could gradually use DME for their crude sales to the Asian oil market making the transition towards the new benchmark swifter than expected.

The U.S. shale boom, which has generated self-sufficiency in the U.S., along with declining oil demand in Europe, has forced Middle Eastern oil producers to seek alternative markets where they can offload their excessive supply. Consequently, the Asian oil market has become the main target for Middle Eastern oil producers where they can potentially continue to expand their global oil market share.

Other Middle Eastern producers are highly likely to follow the decision of Saudi Aramco to switch to a new benchmark in the years ahead. Once other players all switch to the new pricing mechanism, undoubtedly Saudi Aramco’s position in the Asian oil market will strengthen. The structural transformation and greater interdependency in the Middle East and in the Asian oil market could mean that more radical changes are in the pipeline. And, above all, once the DME is established and other key oil-producing countries and Asian oil importers accept it, Middle Eastern producers will have achieved the founding of its first regional-based benchmark.

by Ersin Merdan -The Writer holds an MSc in Eurasian Political Economy & Energy from King’s College London and also an MA in European Studies from Sabancı University.

- Opinions expressed in this piece are the author’s own and do not necessarily reflect Anadolu Agency's editorial policy.

(Anadolu Agency)

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