When the price is right

Petroleum Review

Should Middle Eastern oil producers – Saudi Arabia in particular – be price makers rather than takers, confined to influencing prices through OPEC quotas? With OPEC’s contribution to overall oil production dwindling compared to non-OPEC producers’ output, and rising domestic demand in the Arab world, there are strong arguments for price signalling. However, the turmoil in the region means any change in strategy will be difficult to implement, writes Paul Cochrane in Beirut.


At the very tail end of 2012, a delegation from the Shanghai Futures Exchange visited Riyadh to lobby the Saudi Arabian authorities to use the Chinese bourse’s benchmark to sell its crude. The proposal, while unlikely to be accepted, highlighted the direction Saudi and Middle Eastern crude is increasingly heading – eastwards. And unsurprisingly, China wants to make the most of this – countering the dominant global crude benchmarks, London’s Brent and the US Western Texas Intermediate (WTI).
Notably, the news also restated the fact that the Kingdom, despite being one of
the largest oil producers and the world’s swing producer, remains a price taker not maker. OPEC, and Saudi Arabia, its most influential member, use a reference basket of 12 crudes – Arab Light, Saharan Blend, Murban, Basra Light and so on – known as the OPEC Secretariat Crude Oil Basket Daily Price, or OPECDALY.
Over the past year, that basket price has been closer to the Brent price per barrel than WTI, but the real point is that it is a reference price – there is no long-term strategy for oil pricing. Saudi Arabia and other OPEC members can only try to steer prices by ramping up or reducing production through collectively imposed quotas. As a result, barrel prices are driven by the futures markets rather than by producers, and this can – and as we saw in the wake of the financial crisis, does – cause price volatility.
For producers such as the Gulf States, dependent on hydrocarbon revenues to balance the books, being price takers may mean no accusatory fingers pointed at them when prices spike into the triple digits – but volatility can play havoc with their budgets. Currently there is the spectre of downward prices as non-OPEC countries, Russia and the US inparticular, ramp up production – OPEC now accounts for an estimated 40% of global output – while demand is weak due to sluggish economic growth.
‘The biggest thing going on right now is the huge change in expectations of supply and demand. Look at the International Energy Agency (IEA) forecasts before the financial crisis – demand at the end of the decade was to be 8.5mn b/d higher than is now expected,’ says Greg Priddy, Director of Global Oil at consultancy Eurasia Group. Handling such changes is a challenge for any oil producer, but Middle East and North African (MENA) countries need high oil prices to continue for domestic economic and political reasons, as well as to fund some $740bn in energy projects over the next five years, according to Arab Petroleum Investments Corporation. ‘The Saudi government requires $90/b-plus for their budgets and to meet population growth. The next three to five years is fine, but it will become a challenge,’ notes Priddy.

Managing markets

One proposal that is floated every now and again by economists as a solution to better control oil production and prices is for MENA countries, led by Saudi Arabia, to sell oil in the same way government bonds are sold – by auction. Through direct market feedback this would determine production output, and impact on how much needs to be invested in energy projects. Budgets could then be planned more effectively with the break-even oil price in mind, and there would be fewer barrel price fluctuations, which has led to huge budget surpluses due to conservative estimates or fiscal deficits as the price plunges.
‘A market decided by oil ministers doesn’t work. It did when OPEC dominated, but now there’s a lot of competition,’ explains Marcello Colitti, an independent oil consultant based in Rome. ‘The present situation has not been completely digested by oil producers still believing in the possibility of financing continuing as before.’ He advises Riyadh to manage the market rather than make calculations on how much it needs to keep the country going: ‘If they keep doing that, they will have a surprise. So, they should go into the market, sell oil at the price they believe is right, and give everybody the ability to resell it. It will mean the price is a market price. At that point you have a situation where you have the feedback on your production.’
However, if Riyadh became a price maker it could very well signal the end of OPEC, as other members would be forced to go to the market. ‘The OPEC group has become more or less irrelevant, although still relevant to the Asians,’ notes Kate Dourian, Editor of Platts Middle East in Dubai. ‘OPEC could set up a price benchmark reflective of the market, it is not an inconceivable solution, yet at the moment I’m not sure the Saudis want that kind of commitment. But if there is no price band and no production quota, what’s the point of OPEC?’

Make or take time

One reason the Saudis would be hesitant to sell oil directly is to avoid the experience of the 1980s, when OPEC official prices were out of sync with freely- traded crudes and there was surplus capacity. Competition between OPEC members led to price discounting.
However, Saudi Arabia kept to the official price system set in 1974 and had to reduce output, leading to a 70% drop in exports between 1980 and 1986, to 3mn b/d. A short-lived ‘netback pricing’ system also failed, and the debacle ended with the ousting of Saudi Oil Minister Ahmed Zaki Yamani in 1986 and the creation of the OPEC quota system.
‘The Saudis have been price takers not makers following the Yamani experience,’ says Dourian. ‘To be price makers is not an option in their psyche as they’ve been burned so many times and don’t want the responsibility. That is why they pushed for OPEC price targets [in 1986].’
A further factor against going to the markets, or for Riyadh to go on the Shanghai Exchange, is the performance of the Dubai Mercantile Exchange’s (DME) Oman Crude Oil Futures Contract. The region’s sole pricing benchmark has only attracted Dubai and Omani crude, and no other major Gulf producers.
Opened in June 2007, the DME recorded 2mn crude oil futures contracts by March 2011, but then rallied, passing the 3bn barrel mark in May 2012. While prices have largely mirrored Brent, trades pale by comparison and, notably, are primarily in actual physical trades of barrels, of which over 40% is bound for China.
‘If the Saudis do anything, and not anything I’ve been told, there is the potential for them to say: “There are a lot of benchmarks out there, why not use some of this, some of that, and maybe go with one of the exchanges". But to be exposed to a Shanghai Exchange or Dubai? Probably not,’ comments Dourian.
Ultimately, with all that is happening in the Middle East, from a population boom to rising domestic demand – slated to rise 1.8 times from 630mn toe in 2010 to 1,140mn toe in 2035, according to the Institute for Energy Economics, Japan – and political instability, producers do not want to rock the boat.
‘It is politically difficult to change these things, and there is no pressure yet,’ notes Priddy. This extends to energy subsidies, with MENA countries having spent some 210bn on energy and other subsidies in 2011, equivalent to 7% of combined GDP, according to statistics from the London School of Economics.
‘The whole pricing issue is a political hot potato following the Arab Spring, with many governments not willing to cut subsidies,’ concludes Dourian.