Indexing Crude Prices

Although oil trading hasn't been my primary focus for many years, the recent announcement by Saudi Aramco that it is switching its price mechanism for oil delivered to the US caught my attention. Instead of basing its formula for deliveries here on the price of West Texas Intermediate crude oil, it will apparently reference the new Argus Sour Crude Index (ASCI.) While that lends substantial credibility to this new index and may gain Argus more than a few new subscribers, the implications for the widely-traded NYMEX WTI contract and the dynamics of the broader international oil market seem much less clear. In particular, I am skeptical of suggestions that this move could ultimately reduce whatever influence non-commercial financial participants--speculators, in common parlance--have on oil prices.

The question of how best to price crude oil for buyers and sellers is a perennial problem, particularly for oil that differs significantly in quality from the light, sweet grades behind the extremely liquid WTI and ICE Brent futures contracts. US refiners, in particular, have invested many billions of dollars in the hardware required to turn lower-quality oil into high-quality petroleum products. Any time the peculiarities of these contracts drag up the prices of the grades of oil they prefer to run, they grumble about basing deals on WTI. Likewise for sellers of sour crude, foreign and domestic, who suffer when the WTI price moves out of sync with world prices, such as when storage at its nexus at Cushing, OK fills up, as it did earlier this year. However, after listening to the Q&A podcast concerning the ASCI on Argus's website and reading the background document there, I'm skeptical that this index will settle the sour crude market's discontent, because it won't change the way this oil is traded by nearly as much as it might appear.

Without getting into all of its details, as I understand it the ASCI is effectively a composite daily report of the deals done for three specific streams of offshore Gulf of Mexico crude oil, all of which trade at a differential to WTI. In calculating a daily price, Argus will add the average daily discount or premium vs. WTI from the transactions it learns of to the daily price for WTI to come up with a single price in dollars per barrel. The Argus podcast was very clear that NYMEX WTI is still as the heart of the new index, not just because this reflects the way deals are done with reference to WTI, but also because WTI remains the highly-liquid futures contract that the buyers and sellers of the ASCI oil streams use to hedge their market risk. In other words, the new ASCI index is not a substitute for WTI-based pricing, but merely a more transparent gauge of the relationship between WTI and the sour crude market--though an index you have to pay to read falls a bit short of the kind of transparency currently provided by WTI itself.

What would happen if speculators drove up the price of WTI by $30/bbl? In theory, ASCI would reflect any disconnection between the fundamentals-based pricing of its included sour crude streams and the financially-driven WTI market by remaining more or less unchanged, after summing the combination of correspondingly wider discounts for the ASCI grades to the inflated daily WTI prices. Only by looking at the differentials themselves would we see any indication of distortion of the market by non-commercial players. But is that realistic? Consider that between January 2007 and July 2008, when the price of WTI rose more or less steadily from the mid-$50s to nearly $150/bbl, the discount between WTI and the monthly average refiner acquisition price for imported crude only widened from around $4.75/bbl to roughly $9/bbl. If WTI was being driven by speculation in that interval, differentials-based trading of the kind that ASCI will measure hardly insulated refiners from its effects.

That historical result might merely indicate that speculation had little real effect on the market in that period--a view to which I'm sympathetic--but it might just reflect the inertia of negotiated crude differentials. Either way, if you're Saudi Aramco and you're selling crude into the US based on ASCI, I'd conclude that your prices would still go up more or less in tandem with the NYMEX, despite the superficial "arms-length" mechanism flowing through ASCI. Perhaps I've missed some subtlety in the mechanism.

From what I can tell, neither ASCI nor the prospect of new futures contracts based on it addresses the underlying concerns I have had since the industry migrated to pricing based on differentials against the WTI and Brent futures contracts, and away from negotiating actual "fixed and flat" prices for each cargo or pipeline deal, back when I was trading oil in the 1980s and early 1990s. While that shift made life much easier for risk managers and took a lot of heat off traders to strike the best deal on any given day, it also opened the door to a host of other influences on pricing that I still don't think we entirely understand.

The market will pass its own judgment on ASCI and other new tools like it. If it proves useful to traders and risk managers, it could become the new industry standard, as Argus must hope, having made such a big splash over its launch. If it's not useful, it will fade into the background, becoming just another dataset in an already bewildering sea of energy-related information. With Gulf of Mexico output booming and more discoveries yet to be made, it looks like a reasonable bet to join other useful physical crude indices around the world. But anyone hoping it will shine a beacon on speculators in the next oil price spike is likely to be disappointed by the core of a system still rooted in WTI, the speculative influences over which remain uncertain and possibly unprovable.