A Survey on Pricing of Asian Marker Crude Oil and Formation of Appropriate Market Prices 1

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1 A Survey on Pricing of Asian Marker Crude Oil and Formation of Appropriate Market Prices 1 Yasuhiko Nagata, Senior Economist, Oil and Gas Strategy Group, Strategy and Industry Research Unit Sanae Kurita, Researcher, International Strategy Analysis Group Zhang Yue, Researcher, International Strategy Analysis Group Kentaro Shida, Researcher, International Strategy Analysis Group 1. Trends of Major Crude Oil Futures Markets (North America, Europe and Asia) 1-1 Present situation of NYMEX representing North American oil markets The crude oil futures market at The New York Mercantile Exchange (NYMEX), where the well-known West Texas Intermediate crude is traded, represents North American oil markets. It is the world's largest energy exchange. Among futures contracts traded at NYMEX, the WTI futures contract, known as Light, Sweet Crude Oil, boasts the largest trading volume that leads to a transparent pricing system. Therefore, the WTI futures contract has become the most influential benchmark for international oil pricing. WTI futures daily average trading volume has continued to expand. In 2006, the daily average volume reached to million barrels, more than three times of the actual global crude oil demand (see 1-1). 1 This report is part of the FY 2003 Oil Industry System Survey and Research Report (Survey on Asian Market Benchmark Crude Oil Pricing and Appropriate Market Prices) conducted in FY 2003 for the Agency for Natural Resources and Energy at the Ministry of Economy, Trade and Industry. METI has recently allowed us to publicize this report. We would like to thank relevant METI officials for their understanding and cooperation in this regard. In the survey, we looked into formation of new markets, transaction types, major players and other latest trends of crude oil markets in the world. We also analyzed crude oil pricing in each market, oil purchase contract types and oil-producing countries' pricing policies. Furthermore, we studied market players' moves, market infrastructure development and other factors for formation of appropriate market prices for the Asian market benchmark crude oil brand of Dubai.

2 Figure 1-1 WTI Crude Futures Trading Volume on NYMEX (Daily Average) Trading volume World oil demand Source: NYMEX website 1-2 Present situation of London's ICE representing European oil markets In Europe, the Intercontinental Exchange (ICE) covers crude oil futures and its Brent crude futures trading volume has expanded rapidly since In 2006, the trading volume reached to 44,346,077 contracts (see Figure 1-2). The NYMEX WTI crude futures price has been closely linked to the ICE Brent crude futures price. Both futures prices have seen substantial hikes since Their price volatility has remained high since Source: ICE website Figure 1-2 Brent Crude Futures Trading Volume on ICE (Daily Average)

3 1-3 Present situation of Asian crude oil futures market In Asia, the Tokyo Commodity Exchange (TOCOM) is the only public crude oil futures exchange. The futures transactions of crude oil and oil product at TOCOM have decreased substantially since 2003 (see Figure 1-3). Figure 1-3 Annual TOCOM Crude Oil and Petroleum Products Futures Trading Volume 50,000,000 45,000,000 40,000,000 35,000,000 30,000,000 25,000,000 In contracts Diesel Kerosene Gasoline Crude oil Rubber 15% Crude oil 3% Kerosene 7% Gasoline 20% trading volume breakdown (2006) Aluminum 0% Palladium 1% Platinum 17% Gold 36% Silver 1% 20,000,000 15,000,000 (4,492,904 Contracts) 10,000,000 5,000, (12,932,848 Contracts) (1,961,190 Contracts) Source: TOCOM website *Diesel oil has been delisted since Middle East crude oil futures trading volume at TOCOM was limited to 1,961,190 contracts in 2006, far less than those of NYMEX or the ICE.

4 Figure 1-4 Comparison of NYMEX, ICE and TOCOM Crude Oil Futures Trading Volumes In barrels Sources: NYMEX, ICE and TOCOM websites In response to the declining trend, TOCOM has signed memorandums of understanding with the Shanghai Commodity Exchange and other Asian petroleum product futures exchanges to cooperate in developing Asian oil markets. It is attempting to utilize such cooperation to form petroleum product prices that reflect the supply/demand balance in Asia, where dynamic economic growth is expected and the liberalization of markets will progress. TOCOM plans to take advantage of this process for invigorating TOCOM trading in Middle East crude oil futures in a bid to send price signals for Middle East crude oil throughout the world. 1-4 Moves for realignment of oil markets While crude oil futures transactions have expanded, European and U.S. exchanges have made moves to realign futures markets through their participation in each other's territories and their mergers. NYMEX's founding of NYMEX Europe in 2004 triggered its race with the ICE for global leadership in crude oil futures transactions. The ICE started electronic trading of WTI futures in NYMEX, which still retains a floor trading system, has launched electronic trading in WTI futures through the Chicago Mercantile Exchange (CME). In late 2006, the CME have announced their plan to merge with the Chicago Board of Trade and NYMEX Holdings Inc and. made its initial public offering. November 2004: September 2005: February 2006: NYMEX Europe founded to launch trading in Brent futures NYMEX opens London trading floor ICE launches trading in WTI futures

5 April 2006: October 2006: December 2006: May 2007: CME launches trading in WTI futures CME merges with CBOT NYMEX announces plan to terminate floor trading DME created to launch trading in Oman crude oil futures The mutual participation in each other's territories and the intensifying competition between NYMEX and the ICE have contributed to enhancing the liquidity of crude oil futures markets and expanding trading volumes for WTI and Brent futures. Also the realignment of European and U.S. crude oil futures markets has been accompanied by a shift from floor trading to electronic trading. The share of electronic transactions in the total trading volume has been expanding and this move has emerged to integrate different electronic trading systems. While European and U.S. crude oil futures markets are being realigned, Asia has lagged far behind the Western World in developing crude oil futures markets. But we have recently seen creation of the Dubai Mercantile Exchange, or DME, and resumption of the Shanghai Futures Exchange, or SHFE. Beside TOCOM, DME is the first Middle East crude oil futures exchange, launching transactions of the new crude oil futures to trade Oman crude in May Also SHFE has listed fuel oil futures. China is unlikely to liberalize crude oil transactions in the near future, so listing of crude oil futures by SHFE to invigorate the transactions is viewed as a future issue. 1-5 Major players in crude oil futures markets In a bid to find trading tendencies and effects of speculative money inflow, we first analyzed the trends of commercial and non-commercial trading in NYMEX WTI futures contracts. In the category of Commercial traders, oil producers and consumers are included. Non-commercial traders include financial institutions and institutional investors. Over the past five years, both commercial and non-commercial traders have expanded transactions substantially. But commercial traders have seen their share of transactions falling from 70% to 60%. Non-commercial traders have expanded their share from 25% to 35%. The transactions in the form of large-lot have been increasing conspicuously (see Figures 1-5 and 1-6).

6 Figure 1-5 Trading Volumes of NYMEX WTI Crude Futures by Category (In contracts) Non-commercial L Nonreportable S Non-commercial S Commercial L Nonreportable L Commercial S Line (Commercial S ) Line (Commercial L ) Line (Non-commercial L ) Line (Non-commercial S ) Line (Nonreportable S ) Line (Nonreportable L ) Commercial trading volume Non-commercial trading volume Nonreportable trading volume /1/8 02/4/8 02/7/8 02/10/8 03/1/8 03/4/8 03/7/8 03/10/8 04/1/8 04/4/8 04/7/8 04/10/8 05/1/8 05/4/8 05/7/8 05/10/8 06/1/8 06/4/8 06/7/8 06/10/8 07/1/8 Source: CFTC website Figure 1-6 The Share of Trading of NYMEX WTI Crude Futures by Category 100% 90% 80% Non-commercial share L Nonreportable S Line (Non-commercial share S Line (Nonreportable S ) ) Non-commercial share S Commercial share L Line (Non-commercial share L Line (Non-commercial share S Commercial share ) ) Nonreportable L Non-commercial share S Line (Nonreportable L ) Line (Commercial share L ) 70% 60% 50% 40% Non-commercial share 30% 20% Nonreportable share 10% 0% 02/1/8 02/3/8 02/5/8 02/7/8 02/9/8 02/11/8 03/1/8 03/3/8 03/5/8 03/7/8 03/9/8 03/11/8 04/1/8 04/3/8 04/5/8 04/7/8 04/9/8 04/11/8 05/1/8 05/3/8 05/5/8 05/7/8 05/9/8 05/11/8 06/1/8 06/3/8 06/5/8 06/7/8 06/9/8 06/11/8 07/1/8 Source: CFTC website

7 2. Crude Oil Market Pricing North America, Europe and Asia are the world's three major crude oil consumption markets. Pricing methods in these markets are different as they have various crude oil supply/demand conditions (regional production, imports and suppliers) and various pricing policies toward oil-producing countries. In this section, we would like to outline supply/demand of crude oil for the three major markets and their trends. 2-1 Three major markets' crude oil flow and mutual relations In the world there are three major crude oil markets (North America, Europe and Asia) that have their own pricing benchmark crude types (WTI, Brent and Dubai) (see Figure 2-1). In the crude oil transactions, paper and cash transactions are included and the three markets are closely linked to each other. Paper transactions are overwhelmingly large in the WTI crude in New York and in the Brent crude in Europe as well. With their high liquidity and transparency, these two markets send signals in the pricing process throughout the world. At the Asian market, Dubai crude from the Middle East is primarily traded. As of March 2007, no futures transactions were seen. Compared to WTI and Brent, only small-scale forward transactions have been seen and the liquidity of the market has been limited.

8 Figure 2-1 Inter-relations between Three Major Crude Oil Markets North America Europe Asia WTI area Brent area Dubai area Asia Pacific Swaps Options Swaps Options NYMEX crude futures (WTI) ICE Brent futures 21-day Brent CFD Dubai forward delivery Tapis swap Paper African crude Dated Brent Dubai Tapis Cash WTI Latin American crude Other North Sea crude Mediterranean brands Governments set monthly contract prices Cash Others U.S., Canadian crude Russian crude Oman Qatar UAE Indonesia Futures Spot Forward delivery Spot benchmark Swaps, derivatives Others Note: The straight line indicates direct transactions. The dotted line represents indirect or partial transactions. Source: "Basic Survey on International Oil Market Trading Practices," Japanese Institute of Middle Eastern Economies, March Basic information on crude oil purchase contracts Pricing formula for a term contract usually consists of four elements -- sales area, benchmark crude, adjustment factor and the time frame of pricing. The benchmark crude oil is fixed accordingly to the three crude markets. The adjustment factor is used to adjust price gaps based on crude oil quality indicators (including API gravity and sulfur contents) and sales locations. The adjuster reflects the supply/demand balance, oil-producer's sales policies and other factors by each market. The pricing of crude oil also depends on the time frame for calculating the final sales price, such as the price after 40 days of lifting. 2-3 Three major crude oil markets' pricing formulas and benchmark crude (1) The crude oil pricing formula for the U.S. market

9 Many oil-producing countries including Saudi Arabia and other Middle Eastern nations have adopted the WTI crude futures price as the benchmark (see Table 2-1). On the other hand, Nigeria and other African countries have adopted the Dated Brent, the spot market price. (2) The pricing formula for Europe Most oil-producing countries have adopted the Brent crude as the benchmark. Some use the average ICE Brent futures price (B-Wave), including Saudi Arabia, Kuwait and Iran that shifted to B-Wave in Others use the Dated Brent, including Iraq, Yemen, Nigeria and Libya. (3) The pricing formula for Asia Many Middle Eastern countries including Saudi Arabia have adopted monthly average price of Dubai plus Oman crude spot prices as the benchmark. These prices are released by Platts. Table 2-1 Three Major Markets' Characteristics and Representative Crude Oil Pricing Formulas U.S. Europe Asia Major pricing formula WTI Adjuster Fare adjuster B-Wave Adjuster Fare adjuster Dubai Oman 2 Adjuster Benchmark crude WTI Brent Dubai Oman Crude oil market NYMEX ICE SGX, TOCOM Transaction type Futures, forward delivery and spot Futures, forward delivery and spot Futures, forward delivery and spot Present situation Crude oil supply sources Paper transactions have been highly advanced. Sufficient liquidity is secured and prices are very transparent. Rich supply sources include Canada, Mexico, Western Africa and the North Sea. Paper transactions have matured. Sufficient liquidity is secured and prices are very transparent. Rich supply sources include Africa and the North Seas in addition to Russia and the Caspian Sea region. Futures and forward delivery transactions have been limited. Low liquidity has caused problems regarding price transparency. The Middle East is a major oil supply source as Asian oil production is limited. Supply from Middle East Saudi Arabia, Kuwait, etc. Saudi Arabia, Iran, Kuwait, etc. Saudi Arabia, UAE, Iran, Kuwait, etc. Dependence on the Middle East at 16.7% in 2006 Dependence on the Middle East at 23.8% Dependence on the Middle East at 57.4% Source: JEEI has created the table based on various data. 2-4 Pricing and sales policies in major Middle Eastern oil-producing countries In order to analyze the pricing and sales policies in the Middle East as a major source of oil supply for Asia, we put in order their basic policies, sales methods, pricing methods, crude export destinations and Asia's positions in their scope of such major Middle Eastern countries as Saudi Arabia, Iran, Kuwait and the United Arab Emirates. Saudi Arabia, who depends on oil export income for most of its state revenue, has tried to maintain crude oil prices at appropriate levels for their financial stability. Saudi Arabia has focused to keep the OPEC production adjustment in order to "maintain crude oil prices at appropriate levels." Iran apparently aims its energy policy primarily at utilizing exports of its abundant crude

10 oil and natural gas reserves to secure maintenance or expansion of foreign currency income and develop its domestic economy. Since crude oil is a major source of foreign currency income for Iran, stabilization of crude oil prices at appropriate levels is important. Therefore, Iran is strongly committed to production adjustment as a central OPEC member. Kuwait, who is reported to have recoverable oil resources for more than 100 years, is trying to take advantage of abundant oil reserves for securing stable oil income and maximizing oil income over a long term. It basically views extremely high crude oil prices as undesirable and follows Saudi Arabia in OPEC production policy. Kuwait rarely takes the initiative in OPEC. The UAE has no unified oil policy among the emirates. Oil export and sales policies have not been unified for the entire emirates. Among the emirates, Abu Dhabi has established basic policies for preservation of hydrocarbon resources and maximization of exports under a law enacted in 1978 for protection of hydrocarbon resources. It aims to increase oil production capacity in line with demand growth and maximize oil exports. Qatar has the smallest population and the higher per-capita GDP among the OPEC countries. It is relatively well-off. Over recent years, Qatar has launched and expanded LNG exports rapidly, enjoying robust oil and gas income. Its apparent basic policy aims to secure stable oil income. Oman is basically an economy dependent on oil and gas sales income. Its most important challenge is to diversify its economy and departure from its heavy dependence on oil income while securing stable oil income. 3. Forming Appropriate Prices of Asian Benchmark Crude 3-1 Asian oil market and dependence on Middle East Asian oil consumption in 2005 totaled million barrels per day, accounting for some 29% of the global total. Between 2000 and 2005, Asian oil consumption increased at a steady average annual pace of 3.0%. Among the oil products, light petroleum products including transportation fuels have been leading on the consumption growth. In 2005, the entire Asian region was dependent on the Middle East for about 70% of their crude oil imports. 3-2 Methods for pricing Middle Eastern crude for Asia Each oil-producing country announces and fixes crude oil prices at the beginning of a month for shipments in the previous month. There are two methods for fixing prices. Under the first method, the adjuster is applied to monthly average Dubai and Oman prices as released by Platts. This method is used by Saudi Arabia, Kuwait, Iran and the neutral zone. Under the second method, the UAE and Oman unilaterally notify prices to importers. Whichever method is used, Saudi

11 Arabia s pricing influences to the other produces in the Middle East as the largest oil producer. 3-3 Asian crude oil price trends, characteristics and price-moving factors Benchmark crude price trend The trends of benchmark crude types (WTI, Brent and Dubai) between 2002 and 2006 indicate that they have fluctuated while maintaining certain differentials with each other. In the first half of 2003, these benchmark crude prices soared by the Iraq war but later turned down. After turning up in 2004, the WTI and Dubai prices soared to record levels in July The Brent price hit an all-time high in August 2006 and remained at the higher levels later on. Figure 3-1 Benchmark Crude (WTI, Dated Brent and Dubai) Price Trends (January December 2006) (Unit: $/BBL) WTI Dated Brent Dubai Source: "Oil Market Report," IEA Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Price-moving factors Factors behind fluctuations in Dubai crude oil price as the benchmark for the Asian market include the price changes in WTI price as the U.S. benchmark and the Brent price as the European benchmark. Basically, Dubai price as the Asian benchmark follow the trends of WTI and Brent prices. Price differentials are attributable to qualitative differences (in gravity and sulfur content). Dubai crude prices are also influenced by the changes of Asian oil supply/demand balances (including those emerging on weather changes, regular refinery maintenance or a drop in

12 Middle Eastern supply), and by Asian factors including fuel oil prices in Russia. Figure 3-2 Trends of Dubai Crude and Asian High-sulfur Fuel Oil Prices Unit $/BBL Dubai HSFO 180cst Source: "Oil Market Report," IEA Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Comparison with netback prices A comparison of Dubai crude and netback prices between 2002 and 2006 indicates the following findings: - The Dubai crude price remained almost at the same level as the netback price over five years between 2002 and Their deviation from each other in 2004 and 2005 can be explained by such special factors as a powerful hurricane attack in the United States and its adverse effects on oil production and refining operations. - In the second half of 2006, the Dubai crude price was overvalued in comparison to the netback price. This may be because petroleum products prices were undervalued in comparison to the crude oil price.

13 Figure 3-3 Comparison of Dubai Crude and Netback Prices (January 2002-Decmeber 2006) ($/BBL) Dubai left scale Netback left scale ($/BBL) Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Differentials Netback - Dubai right scale Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Sources: Dubai price data from IEA "Oil Market Report," netback price data from Energy Intelligence "Oil Market Intelligence" Others Asian benchmark Dubai and Oman crude oil have expanded their price gap since October Behind the gap expansion might have been qualitative differentials, including sulfur contents. When we compare the Middle Eastern crude types and WTI crude, we find the differentials between the Dubai and WTI prices and those between the Dubai and other Middle Eastern crude oil prices have shown similar moves. Therefore, it may be appropriate to track the Dubai-WTI differentials rather than tracking prices of all Middle Eastern crude types versus WTI Asian oil market players and transactions Singapore has been the center of the Asian oil market. It is an oil refining and spot transaction center. Market players have placed their operation bases in Singapore, which has become an information and oil trading center. In the Asian oil market, just as seen in European and North American markets, market players include oil producers, refiners, traders, financial institutions, and as end-user airlines and shipping firms. In Asia, however, futures transactions have been far more limited than in Europe or the United States. Another difference in Asia is the concentration in over-the-counter transactions. The trend shows that the number of Asian oil market players has increased over the past years. Transactions in benchmark crude include not only cash transactions but also various paper transactions in swaps, time spreads, Brent-Dubai spreads, and crack spreads.

14 Platts has created the Platts window to determine the price of Dubai and Oman crude as a benchmark in Asia. In February 2004, Platts introduced the Partial Dubai and Oman market tradable in a unit set at 25,000 barrels in a bid to enhance liquidity. Trading in the Platts window takes place for 30 minutes from 4 p.m. (Singapore time) every day. Participants in the trading include international oil majors and traders. However, oil refiners participating in the trading are limited to South Korea's SK Corp. and China's Unipec. Since players and trading hours are limited for the Platts window, critics have pointed to the lack of liquidity and trading/pricing transparency regarding the Platts window. The Asian oil market depends on over-the-counter trading and is difficult to measure. Hearings from experts indicate the market size is estimated at 20 million bpd. 3-5 Moves to develop market for forming appropriate prices In February 2006, Platts added the Upper Zakum to the Oman as the crude type that can be delivered as a substitute for the Dubai crude in a bid to secure liquidity. However, substitute delivery of the Upper Zakum has been very limited. Doubts exist about the practicability of such substitution. The DME plans to list the Oman crude futures contract in May 2007, expecting futures transactions to provide a solution to the present pricing problems. Every market player has apparently taken a wait-and-see attitude regarding participation in Oman crude futures transactions. Any participants in the transactions are still uncertain. Also whether liquidity would be secured for the Oman crude futures seems uncertain. The Omani government has invested in the DME and announced a plan to utilize the DME Oman crude futures price for setting official selling price of crude oil. But whether other oil-producing countries would utilize the DME Oman crude futures price for fixing their respective official sales prices is still uncertain. The focus of attention regarding this point includes whether liquidity would be secured for the Oman crude futures contract and how Saudi Arabia would respond as a largest supplier. 3-6 Asian premium Crude oil prices for Asia are set relatively higher than those for Europe and the United States. The following are cited as factors behind the relatively higher crude prices for Asia including the so-called Asian premium: While Europe and the United States have a diversity of crude oil supply sources, Asia depends heavily on the Middle East for oil supply. This is a reason why oil suppliers have a greater bargaining power in the Asian crude oil market. Next, Asian oil markets and industry have traditionally been under tough government control. Asia has lagged far behind Europe and the United States in liberalizing markets and

15 promoting competition. Under strict government control, the Asian oil industry has given top priority to a long-term stability in trade and to long-term contracts. Therefore the necessity for more competitive terms for crude oil procurement in Asia has been weaker than in Europe or the United States. The Dubai crude as the benchmark brand for Asia now has liquidity problems as Dubai crude transactions have decreased due to the problem of price transparency and actual trade decline on a fall in Dubai crude output. We then considered how best to prevent any premium from emerging on Asian crude oil prices. The first measure should be diversification of crude oil supply sources from Middle East leading to increase competitiveness against Middle Eastern crude. Next, testing the other crude type for the benchmark and expansion in spot transactions in crude oil and petroleum products should be implemented for advancing the efficiency of Asian market functions. The Asian market should also become a highly liquid petroleum product market that can send pricing signals to the world. Furthermore, Asian countries should promote cooperation to seek the solutions, including regional cooperation and talks between oil-producing and oil-consuming nations. Contact report@tky.ieej.or.jp