Ever since crude oil prices began their precipitous fall in June 2014 market watchers have picked through the tealeaves of every OPEC statement - particularly those of Saudi Arabia - for signs of a change in policy. One widely watched signal comes every month when the Saudi’s publish differentials that determine the price customers pay for their crudes. Today we explain how Saudi pricing formulas work.
We have previously discussed how international crude pricing works in the context of the Brent physical market based on cargoes loaded each month at the Sullom Voe terminal in the Shetland Islands and the related ICE Brent futures contract traded on the ICE platform (see Crazy Little Crude Called Brent). The Brent physical market, like the physical market for most U.S. domestic crudes is based on bilateral trades between counterparties owning physical crude. Price reporting agencies like Platts and Argus publish daily price assessments for these crudes using information traders share about deals done. In the U.S. most crude oil transactions are priced basis the benchmark West Texas Intermediate (WTI) crude delivered to Cushing, OK. The WTI price at Cushing is in turn underpinned by the heavily traded CME NYMEX light sweet crude futures contract (see The Cost of Crude at Cushing). In this way U.S. and international benchmark crude prices are set based on a more or less transparent spot market involving numerous counterparties. In contrast to these open market transactions, the price of crude sold by most OPEC producer nations is now based on formulas determined by a term contract between the crude buyer and the selling national oil company. Over time the Saudis and other OPEC members have experimented with various different pricing mechanisms including administered prices and for a brief period in the mid-80’s “netback” pricing where crude prices were determined by refining margins. Since then the system of formula prices emerged to become dominant. We have discussed one such price mechanism before in a couple of blogs - the Mexican national oil company PEMEX formulas for their heavy Maya crude that is just beginning a turf battle on the Gulf Coast against Canadian heavy crude competition (see Mamma Maya). This blog takes a closer look at Saudi crude price formulas.
Like PEMEX, the Saudi national oil company Aramco uses formulas to set the price that customers pay for its crude. As the world’s largest crude oil producer (for the moment – the U.S. is #2 and catching up), Saudi Arabia sells crude to buyers around the globe. For refiners, the big advantage to Saudi crude is that they are very unlikely to run out of crude and are therefore an extremely reliable seller. The Saudis can also deliver consistent crude qualities over time – something that refiners appreciate because they know what they are getting. But the Saudis do not just sell their oil to any old trader that pitches up at Ras Tanura with an empty tanker looking for a good deal. Rather they restrict their sales to members of their buyers club – think Costco but harder to get in. Members are required to enter into long-term contracts with Aramco that determines how much crude they can purchase each month and where it will be delivered. The contract also restricts the resale of Saudi crude to third parties. If you buy some of their crude for delivery to Europe and then turn around and sell it to a trader in Singapore, your membership in the Saudi buyers club will expire. The price that you pay for Aramco crude is determined by a formula that differs depending on where the crude is headed and that links the long term contract to spot market prices close to the time and location that cargoes are delivered to – using benchmark prices as a reference.
For their pricing formulas, the Saudi’s divide the world into four regions – North America, Northwest Europe, the Mediterranean and Asia/Pacific - using a different price formula depending on crude cargo destination. They use three different benchmark crude prices as a starting point in the formulas – providing a regional spot market element to compete with other suppliers to that market. For example, the underlying benchmark price for cargos destined for North America is the Argus ASCI price. In case you were wondering, ASCI isn’t the character code you had to mess with on your old dot matrix printer (that’s ASCII). It stands for Argus Sour Crude Index and it is the benchmark price for U.S. Gulf Coast sour crudes. The ASCI price is a daily volume-weighted average of reported trades for three offshore Gulf of Mexico production crudes. The three components are Mars (delivered to Clovelly, LA – the storage hub for the Louisiana Offshore Oil Port (LOOP) - see Thrown for a LOOP), Poseidon (Clovelly) and Southern Green Canyon delivered to Texas City or Nederland, TX. The ASCI index calculation has a whole methodology to do with deal timing and minimum volumes – you can read the 8-page Argus guide here. There are also CME NYMEX Clearport and ICE Futures sour crude futures contracts linked to ASCI. Since 2010 the Saudi’s shifted their America regional price formulas to ASCI from WTI at Cushing because the former is a more representative Gulf Coast price for the type of sour crudes that make up the majority of Saudi imports to the U.S. In 2010 Argus reported that daily production of ASCI crudes averaged 740 Mb/d in Q1 with 579 Mb/d traded in the spot market by an average of 24 traders making 13 spot trades a day. So by using the ASCI price as the benchmark element in their pricing for U.S. shipments, the Saudis are linking their crude price to the spot market for equivalent local crudes.