Saudi Arabia and the Price of Crude Oil

Here's an interesting report from over the weekend out of Saudi Arabia via The Telegraph. It appears that the Kingdom is unhappy with using West Texas Intermediate crude oil as traded on the New York Mercantile Exchange as a basis for its oil sales.

Who could blame them after what's happened over the last year?

That is, when huge spreads between WTI crude and brent crude developed and then, like clockwork every month when the near-month futures contract was about to expire, the price of that expiring contract would plunge - to as low as $32 a barrel at one point - as the next front-month contract was trading $10 or $15 higher.

The Saudis have dropped a key US benchmark for crude oil – but why?

For Saudi Arabia, it is a philosophical issue that the black gold pouring out of its deserts should be treated as a tangible, physical commodity – not the paper plaything of traders on Wall Street hedging against the weak dollar. This thinking is at the heart of the Middle Eastern country's decision last week to abandon its long alliance with West Texas Intermediate crude – the famous oil used by most global producers to price their exports to the US.

The decision is loaded with symbolism, but not likely much more than that.

It's not like they're selling the oil for yuan or rubles or some other far-away currency, though that may happen soon enough - that would be much more than symbolism.

Some details on how the Saudi oil export market works and what this change might mean...

Saudi Arabia exports around 1.5m barrels per day of oil to the US, making it the second largest supplier after Canada, but its physical crude output is not actually traded on the exchange. This is done separately through contracts between countries and oil companies – but Saudi Arabia still bases its prices on the dominant benchmark, WTI.

For several years now, Saudi Arabia has argued that it has not been well-served by the New York Mercantile Exchange's faith in this oil. Saudi Aramco, the national oil company, is fed up with being given a price for WTI crude that it claims fails to represent the global picture of supply and demand.

This year, the dominant crude oil's volatility and disconnection from the fundamentals of the physical market went one step too far.
...

The question now is: how much clout does Saudi Arabia have to destroy the dominance of NYMEX and who could be next to follow its rebellion?

The exchange moved quickly to assure its customers that it would launch two products linked to the new Argus sour crudes index. But the new benchmark will not be so inextricably wedded to the famous Wall Street exchange.

In practice, the shift may not after all make an immediate difference. But all oil market observers will wait to see whether the Saudis really do get a better, more stable price for their oil with the benchmark of sour crudes. Brazil, Venezuela and even Canada could all follow suit if they see that Saudi Aramco has made a smart move.

This is just one more, albeit quite small, step away from U.S. hegemony in global financial markets and part of the blame must surely lie with some Wall Street firms who, for years now, have profited from increased volatility in energy markets, everyone's favorite whipping boy Goldman Sachs topping that list.

Comments

[junkyarddog:]

I must confess I'm ignorant as to how oil is traded in the world and how its price is really determined. Is it by the OPEC, perceived supply and demand, hedge funds, private contracts? What really is it?

Like most everybody, I need to work to make a living and I still remember gas prices at over $4.20 / g last year. The volatility is what hurt me financially (add heating oil costs to that). If this move by Saudi Arabia will reduce oil volatility -- albeit temporarily -- I'm all for it; with or without our good ol' USA involvement. I wonder if the US does more harm than good here...

I guess it remains to be seen what the impact will be on us consumers, if any in the short run. In the not-so-long run we need alternative forms of energy.

Very informative article, thanks!

Nov 02 01:43 PM

[ryanclarke:]

The alternative forms of energy everyone is "yoohooing" about won't come on line until the existing capital structure is wiped away in a depression ... that is, the current power players in energy ... namely XOM, PBR, etc. Aren't about to let any other small new concepts in energy take hold until they can squeeze every lost drop out of money from gasoline powered engines and the economy it serves ... even if the consumer has to pay $20 gallon at the pump two years from now. The $4 per gallon gasoline you saw last summer is just a warm up ... remember the weak dollar is helping those oversees PAY LESS for oil ... and ramping up foreign consumption of oil.


On Nov 02 01:43 PM junkyarddog wrote:

> I must confess I'm ignorant as to how oil is traded in the world
> and how its price is really determined. Is it by the OPEC, perceived
> supply and demand, hedge funds, private contracts? What really is
> it?
>
> Like most everybody, I need to work to make a living and I still
> remember gas prices at over $4.20 / g last year. The volatility is
> what hurt me financially (add heating oil costs to that). If this
> move by Saudi Arabia will reduce oil volatility -- albeit temporarily
> -- I'm all for it; with or without our good ol' USA involvement.
> I wonder if the US does more harm than good here...
>
> I guess it remains to be seen what the impact will be on us consumers,
> if any in the short run. In the not-so-long run we need alternative
> forms of energy.
>
> Very informative article, thanks!

Nov 02 03:00 PM

[Tony Petroski:]

I agree with the junkyarddog that this was an interesting and informative article. The gyrations of the oil market stink of manipulation.

I'm fascinated by the quotes backing the Saudis against an unstated enemy.

Nov 03 09:09 AM

[JeffDB:]

I too thank you for an informative article, but do think that the whipping boy spoken of in the final paragraph is being unfairly scapegoated, even if there is some legitimate blame there:

"...and part of the blame must surely lie with some Wall Street firms who, for years now, have profited from increased volatility in energy markets..."

To my mind, the real culprit in the volatility associated with speculation in the oil markets, by far and away, is the U.S. government and their partners in crime, the Federal Reserve. Charts have shown an almost mirror image/inverse relationship between the value of the dollar and the price of oil.

People might lament children running up and down the road picking up loose dollar bills blowing in the wind after the Brinks money truck flipped over and broke open, but ultimately, the blame shouldn't lie with the kids trying to take advantage of the situation, but rather the driver who flipped the truck while taking a turn too fast with a beer in his hand.

Nov 03 01:08 PM

[Old Trader:]

Tim,

Its my understanding that WTI (and to a lesser extent, Brent, the other global benchmark price) have fallen out of favor with the Saudis because both are "sweet" (low sulphur content) crudes, unlike the oil the Saudis typically export, which is much higher in sulphur content, making it more expensive to refine. The proposed substitute benchmark price is the Argus Sour Crude Index (ASCI), which is based on Gulf Of Mexico crude, also of the "sour" variety. Btw, many refiners support the Saudi move, as they've made the investment in their refineries to handle sour crude.

Nov 03 11:14 PM