A market for Arabian Heavy
1 July 2008- Prof. Giacomo Luciani Director Gulf Research Center Foundation
www.grc.ae:80/index.php?frm_action=view_newsletter_web&int_content_id=51694&sec_code=grcanalysis&frm_module=contents&sec_type=h&newwindow=1

Saudi Arabia has taken a courageous step in calling for a conference of oil
producers, consumers, companies and "speculators" to discuss the runaway
price of oil, but the Kingdom risks being proved unable to bring prices back
to the level that it sees desirable. In a market in which demand
continuously rises while supply is constrained, investors have reached the
conclusion that prices can move in only one direction: upwards. At the same
time, the US balance of trade and federal budget deficits, coupled with the
excessive level of debt throughout the American economy, have convinced
investors that the dollar also can move in only one direction: downwards.
The announcement that Saudi Arabia will increase production to about 9.7
million b/d will have little impact on this reality.

The problem of the oil market is not that it attracts "speculators": traders
and investors are needed for liquidity and risk management. The problem is
rather that the oil market lacks a "reality check". In most other markets,
if "speculators" temporarily push the price beyond or below what is
justified by fundamentals, the latter finally prevail and speculators are
punished. In contrast, the oil market lacks an effective "reality check",
because the price of all major crude oil streams - notably the Saudi Arabian
crude oils - are indexed to the prices of futures contracts, which are
financial instruments.

There is no physical market for oil which may discipline speculation. Buyers
of physical oil - refiners and traders - are price takers, and the price
that is offered to them is dictated by the futures market. In turn, refiners
pass on price increases to the final consumer, whose demand tends to be
rigid. He cannot in the short run change the kind of car he drives, nor the
home he lives in or the distance between home and work. This means that the
physical market reacts only very slowly to changes in the price of oil, and
primarily through an income effect (a slow down of the economy) rather than
through a price effect.

In order to regain some influence on oil prices, major oil producers must
abandon their hostility to trading of their own crude oils. Ideally, they
should themselves organise a broadly based and transparent physical market.
The idea that a market for Gulf oils cannot exist because each quality has
only a single producer is nonsense: a market can be created by resorting to
auctions. Ideally, Saudi Arabia may consider setting up a system of weekly
auctions to sell its Arabian Heavy crude oil, which is the effective
"marginal crude oil" in today's conditions.

Auctions should be based on inviting bids without specifying ex ante the
quantity that will be sold: this would be decided ' together with the
settlement price ' in the light of the shape of the "demand curve" that bids
would reveal. This method guarantees the seller against unwelcome surprises.
Information acquired in the process would definitely clarify whether
existing supply is sufficient, as claimed by OPEC, or more oil needs to be
pumped, as OECD political leaders advocate.

Auctions should be for standard lots of physical oil to be delivered not
earlier than three months forward - in fact a longer delay may even be
preferable. This would create an element of certainty in the market which
would greatly improve the "reality check" for traders and investors in
financial futures. Buyers should be free to trade their contracts in an open
and transparent secondary market, which would facilitate price discovery on
a continuous basis. A financial futures market in heavy crude would then
naturally develop. Creating a transparent and effective physical market for
Arabian Heavy would also facilitate the discovery and trading of quality
differentials, which in turn would help justifying investment in enhanced
refinery conversion capacity. The physical market in Arabian Heavy would of
course still be influenced by trading in Brent and WTI futures, but the link
would be quite more elastic than it is today, and the influence might be in
both directions.
Put simply: curbing speculation is not the right objective, what is needed
is a proper market for physical oil.