By Economic Forecasts & Opinions

Saudi Aramco, national oil company of the world’s largest oil producer and exporter, decided earlier this month it will drop West Texas Intermediate (WTI) as the benchmark for pricing its oil for sale in the US market.

In January 2010, Aramco will use the Argus Sour Crude Index (ASCI) to price its oil for the market; it’s heavier and has higher sulfur content than WTI. The index, launched in May, uses the volume-weighted average of daily spot sales of the three U.S. Gulf Coast medium sour crudes: Mars, Poseidon, and Southern Green Canyon.

The news instantly sparked speculation that other major producers would follow. Chavez (not surprisingly), reportedly already indicated Venezuela would follow Saudi’s lead adopting the new index. Several Canadian companies, who expect to use TransCanada Corp.'s (TRP) proposed Keystone XL pipeline to send oil sands crude to the U.S. Gulf Coast, have also expressed interest in using the Argus benchmark.

Global Crude Oil Benchmarks

Crude oil benchmarks, also known as oil markers, were first introduced in the mid 1980s. There are three primary benchmarks, WTI, Brent, and Dubai. WTI, lighter and sweeter crude, usually trades at a premium to Brent and Dubai. Benchmarks are used because there are many different varieties and grades of crude oil (around 200 different blends). Using them is a way to give stability and transparency to the global oil market.

While Brent remains the dominant benchmark for oil pricing outside the US, the U.S. oil imports are usually priced off WTI. As much as three quarters of the world's physical oil is priced each day using Brent and WTI. Saudi Aramco has priced its U.S. deliveries against WTI since 1994.

Shifting Energy Landscape 

US Gulf oil output, currently at about 1.2mn b/d, is expected to climb to 1.4mn b/d next year and 1.9mn b/d in 2013 boosting spot market trading volumes. This decision by Aramco in part demonstrates the emerging importance of the US Gulf as the new center for price discovery.

Meanwhile, the abandonment of WTI, a longtime standard since the 1980’s, for a five-month-old Argus index by Saudi Arabia is a big deal in the crude pricing assessment world. The move not only highlights some specific problems of WTI, but also signifies ongoing shifts in the global energy landscape, as emerging countries take an increasingly prominent role in the oil trade.

Guilty by Disassociation

In principle, the movement in WTI prices is supposed to reflect supply-demand conditions in the US, the largest consumer in the world, burning almost one quarter of the of the 86.14 million b/d consumed worldwide in 2007. And sour crudes usually should sell at a discount to light crudes such as WTI because the latter are cheaper to refine.

However, distortions caused by logistical or inventory constraints at Cushing, Oklahoma, the WTI delivery and pricing point, can dislocate WTI prices away from North Sea Brent and US gulf crude prices.

Historically, WTI has traded pretty much in line with Brent and gulf sour crudes. But WTI price movement has become increasingly volatile in recent years. The recent inventory glut at Cushing, OK due to the demand slump, coupled with new pipelines transporting Canadian Oil Sands crudes has distorted the WTI price against other benchmarks throwing the global oil market into disarray.

According to FT, In January, WTI, which usually trades at a premium of $1-$2/b to Brent, fell sharply reaching a record discount to Brent at around $12/b.  (Fig. 1)  In February, the sour, heavier ASCI crudes were even selling at an $8/b premium to WTI. Then, just one month later, WTI had soared and ASCI had fallen to a $6 per barrel discount. This bounce around has made it difficult for Saudi to price its crude competitively and at the same time annoyed its customers.

Guilty Also by Speculation & HFT

Some analysts believe Saudi Arabia's decision likely reflects a "wider discontent" from its customers that want a new benchmark that more accurately reflects true supply and demand. Meanwhile, others blame NYMEX for failing to protect the integrity of the WTI contract as it has become the global speculative vehicle for mega commodity funds like the United States Oil (USO) and high frequency trading (HFT) strategies.

A Sour Move.. Plus an Eastward Shift

As the North Sea and onshore American wells deplete their reserves, the lighter and sweeter crude supply is also dwindling. The crude we burn is getting heavier and more sulphurous. According to BP, as much as two thirds of the world’s crude oil supply is now sour crude. New refineries with expensive desulpherization units and hydrocrackers are chasing the sour spread, hoping to make higher profit margins by buying cheaper, heavier crude oil.  (Fig. 2)

In addition, the underlying oil market is fragmenting, in geography as well as in chemistry. The only growth in the oil markets is now in Asia (think Chindia), while the demand in the developed countries, including the U.S. has already peaked (Fig. 3).

According to energy consultants Douglas-Westwood, the Middle East share of world oil and gas production is expected to grow from about 23% today to an estimated 30% by 2025 (Fig. 4). And a majority of the new and existing Asian and Middle East refineries are set up to process sour crudes.  As energy markets are moving east and sour (Fig. 3 & 4), this shift tends to render WTI, which is a lighter and sweeter crude grade, less relevant as a proxy for the price of oil.

WTI to Remain A Global Key

At its inception about five months ago, ASCI said it will use WTI as a basis for its price assessments. So, in essence, by switching to ASCI, U.S. Saudi marketed oil will still continue to price its Gulf crudes, at least in part, based on WTI.

In addition, NYMEX WTI futures are the most traded energy contracts and thrive on liquidity. So, WTI should continue to have a key role in spite of the Saudis move to ASCI, in part because of WTI's liquid NYMEX derivatives market.

However, if an active OTC or futures market based on ASCI eventually arises, then the dynamics could change. Both the CME and ICE have said that they will launch futures contracts tied to the Argus index. Of course, gaining volume and traction on a brand new financial product is an entirely different matter.

This benchmark change most likely will be a battle between the exchanges (CME and ICE) and the index providers (Platts and Argus), and not represent a dramatic change in the dynamics of the U.S. crude market in the medium term.

Speculation Knows No Benchmark

Realistically, crude oil is the most widely traded and speculated commodity in the world. Logistic and storage issues at Cushing aside, without a fundamental financial reform on a global scale, speculative price distortions will still occur regardless of the commodities exchange or benchmark.

WTI Problem Is Not New

For market participants, the periods of dislocation for the WTI do not pose serious problems. Exporters like Saudi Arabia can overcome pricing issues by adjusting their price differentials, while traders can hedge the dislocation risks by resorting to various other financial instruments. In short, the system has created mechanisms to deal with its own problems.

In the environment of high oil prices like last year, exporters seem to be happy selling their oil using less than perfect benchmarks. That is, a pricing system, however flawed or problematic, can survive unchallenged as long as market players have an interest in its survival.

So, Why the Change of Heart by the Saudis?

Taking this into consideration, in the context of growing Gulf States’ discontent with the U.S. monetary policy, and EIA data showing Saudi crude exports to the US plunged to a 22-year low in August, this move seems to be another effort by the Saudis to move away from dollar dependency and its relationship with the U.S.

In addition, it signals Riyadh’s total loss of faith in one of its oldest allies and trading partners. This should not come as a surprise in light of the IMF`s repeated slams against the dollar, and the U.S. government’s continued printing and spending binge.  Furthermore, it also seems to suggest Saudi’s trying to push and eventually take control of the world crude oil trading volume.  Or perhaps this is all part of a bigger movement towards a New World Order which many financial powerhouses, including George Soros, have advocated?

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Economic Forecasts & Opinions