Will Saudi move unsettle the oil price benchmarks?

Since the early 1980’s the price of physical oil has been effectively set by one of the two leading global benchmarks - Europe's Brent, and US-based West Texas Intermediate (WTI). On a daily basis these are used to price 75% of the world’s physical oil.

Brent has come to dominate the European and African markets, and is the yardstick for pricing about half of the world's physical oil flows, while a quarter is priced against WTI, which effectively rules pricing in the Americas. Dubai-Oman serves as the pricing point for the rest of the marketplace, especially Asia.

The unusual factor here is that while Brent and WTI dominate pricing, they represent a mere fraction of the hundreds of different crudes that are actually traded worldwide. According to the traders’ bible, Petroleum Intelligence Weekly's International Crude Oil Market Handbook, there are almost 200 different crudes, from Kutubu of Papua New Guinea to Caño Limón of Colombia.

So the market was surprised last week when Saudi Arabia announced its decsion to drop WTI as the mechanism for pricing US-bound exports, and instead use the Argus Sour Crude Index (Asci). Asci is an index that tracks the price of oil extracted in the US Gulf of Mexico and could potentially signal the end of the established staus quo for physical oil pricing.

The Saudi decision reflects several concerns about WTI, chiefy that it is based on oil delivered in Cushing, Oklahoma, the inland oil storage hub that is actually hundreds of miles from the main oil ports along the US Gulf Coast. Early in 2009, when the Cushing tanks held record supplies, the WTI price became disconnected from oil prices, which made pricing higly problematc not only for the Saudis but also many other global producers.

Another factor behind Asci’s appeal is that US and European refiners favour “sour” crude oil that is the main constitutent of the Asci basket, whereas both WTI and Brent represent “sweet” (lower in sulphur) and “light” (less dense) crude. US refiners have been investing heavily in equipment to turn higher-sulphur oils into acceptable fuels, mirrored by a shift towards heavier crude imports. This contributed to 75 per cent of US oil imports last year, up from 60 per cent in 1985.

With the backing of both the Saudis and the US refineries, some commentators beleve that Asci has a good chance of becoming the future benchmark, unseating the long-held dominance of Brent and WTI especially. Previous attempts to do this in the past have invariably failed because of the absence of these influential backers.

Some feel that the Saudi move will prompt a shift to Asci by other exporters such as Brazil, Canada, and Venezuela. Paul Horsnell, head of commodities research at Barclays Capital in London, says that the emergence of Asci derivatives will be critical. "However, establishing futures contracts based on delivered US Gulf sours has proved very problematic," he is quoted on ft.com.

WTI's big advantage is its liquidity, with traders and speculators using it to insure against or bet on the direction of prices. But if the physical traders move away from WTI what knock-on effect will this have on the financial sector?

Nonetheless, as the article on ft.com asserts, liquidity tends to beget liquidity in markets, so for the immediate future at least it is likely WTI and Brent will both retain their benchmark status.