The Role of Dubai in Oil Price Discovery

Located among the world’s most prolific oil and gas fields, Dubai is at the heart of global oil flows. According to the latest BP Statistical Review of World Energy, the oil industry’s pre-eminent annual data source, the Middle East accounts for 734 billion barrels of crude oil reserves, almost 62% of the world’s total. The region produced over 30%, while consuming less than 7%, of the world’s total output of oil in 2004.

 

The Middle East Gulf is not only the source of much of the world’s crude oil exports but remains a key exporter of refined oil products. This role will undoubtedly expand as the Middle East remains a focus of investments in the oil refining sector. While domestic demand for refined products in the Middle East is expected to grow strongly, reflecting rapid economic growth and subsidized domestic pricing systems, exports of refined products from the Middle East are expected to grow strongly as well. From an estimated 2.5 million barrels per day (b/d) of refined product exports (excluding LPG) in 2004, the Middle East is forecast to export over 3 million b/d in 2007 and 3.5 million b/d by 2010.

 

Yet, it is odd that prices for the Middle East’s refined product exports are determined by a complex process of price assessments in Singapore, an the island-state some 3,500 miles to the southeast. Why is this so? To an economist, this process of price discovery is often simply explained as the result of the “interaction of demand and supply”. Given that most of the Middle East’s refined product exports head to the major oil consumers in Asia, the prices of these products are simply the prices at which consumers in Asia are willing to pay for oil and at which suppliers in the Middle East are willing to accept.

 

And how are these prices discovered? Unfortunately, given the complexities of production schedules, the logistic of transport, storage and distribution, the time lags involved, and so on, there are no simple processes of daily auctions where prices can collectively emerge in any transparent way. Trades are carried out in informal markets by telephone, telex and fax, and there is no central authority collating the information. Such informal trades do not clearly generate observable market prices. As a result, special price assessment agencies have evolved various means which seek to report prices in such informal markets.

 

So, one might then ask, what is the price received by the typical Middle East supplier of refined products? In short, the answer is the ‘netback’ price: a reasonable price is discovered at the point of consumption, and that minus the cost of transportation gives the ‘netback’ price to the producer here in the Middle East. Price assessments of Middle East product exports typically use Singapore as basis for price reference, and “price discovery” in Middle East usually means nothing more than Singapore prices minus freight.

 

Unfortunately, given the volatility of freight rates in recent years, the Singapore-Middle East price differential has also been volatile. For instance, anyone buying a 180 CST fuel oil cargo quoted on a “netbacked” Middle East Gulf basis and attempting to re-sell it into Singapore or other Far East markets based on a Singapore reference price faces the risks of losses. First, the actual freight cost incurred in transporting the cargo may be quite different from the assessed freight rates used to derive the netback Middle East price. Secondly, the actual price it will be sold for, on a Singapore basis, may be very different by the time the cargo is actually delivered, or “locked in” for delivery.

 

The emergence of the Middle East as an increasingly important consuming centre in its right, together with more diversified patterns of the refined product trade, leads to the natural evolution of this region as a centre of price discovery. Existing price discovery processes, dependent on various non-transparent “netback” assessments, fall short of the risk management requirements of the oil products trade. Traders, suppliers and other market participants are exposed to price risks which can at best be only partially hedged via over-the-counter (“OTC”) instruments currently available.

 

Futures contracts are the most efficient and transparent instruments that markets can provide for price discovery. The Dubai Gold and Commodities Exchange, the first commodities futures exchange in the Middle East, located in Dubai, will promote transparent price discovery in a range of commodities including a fuel oil contract planned for launch in 2006.

 

This will allow far more efficient risk management for those who are producers, traders or end-users. It will resolve the inadequacies of current netback price assessment practices. As trade on the futures exchange is margined, counterparty risks are taken care of, unlike OTC markets where bilateral trade between parties carry counterparty credit risks of default.

 

 

·        Middle East refined oil product export prices are determined in Singapore via price assessment agencies.

·        Typically, the price received by a Middle East exporter of oil products is the Singapore price minus an assessed freight price, otherwise known as the “netback” price.

·        For suppliers and traders of refined products in the Middle East, selling on “netback” prices can carry risks, since actual freight costs might differ from assessed freight prices by pricing agencies.

·        As trading patterns get more complex, the Middle East region will increasingly emerge as a centre of price discovery in its own right.

·        Commodity exchanges trading futures contracts will play a key role in this price discovery effort.

·        The Dubai Gold and Commodities Exchange, the Middle East’s first derivatives trading centre, is an important step in this direction.