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Home Archive November 2012 Issue Issue Content Exploring the Asian Premium in Crude Oil Markets

Exploring the Asian Premium in Crude Oil Markets

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The issue of challenges to Asian energy security is exemplified by the debate over the existence of what some refer to as an ‘Asian Premium’. Asia is far more dependent on oil imports from the Middle East (ME) than any other mayor importing region in the world. In 2011, over 14 million barrels per day (mb/d) or some 57% of oil imports originated in the ME, compared with 1.9 mb/d (17%) for the US and 2.5 mb/d (21%) for Europe (EU). Because of this dependence, it is widely believed that Asian customers have been paying a premium for Middle East crude oil relative to those in the US and EU. Indeed, a number of studies have consistently identified higher prices for exports to Asia relative to US and EU prices amounting to about $1.00 to $1.50 per barrel during the 1990s and early 2000s. This has led to calls for intervention by some observers of the Asian crude oil market in order to eliminate this so-called “Asian premium.” More recently, it has been argued that the “premium” has been reversed because Asian has emerged as the dominant consuming region for oil from the ME forcing Middle East oil producers to reduce their crude oil prices relative to the other oil consuming regions.

The ‘Asian Premium’ debate
Several papers by government-funded research institutions in the key Northeast Asian crude oil importing countries such as Japan, South Korea, and China and by US academics have analyzed this issue and have attempted to calculate the size and variations in  this so-called premium.

The Institute for Energy Economics Japan (IEEJ) has suggested that crude oil prices for Asia have remained higher than those of European and US markets by $1.00 - $1.50/barrel (bbl) throughout the 1990s.  In another paper by the IEEJ, the Asia crude oil premium to Europe was estimated to have averaged $0.94/bbl over the period January 1991 to June 2002.  More recently, an article in the Wall Street Journal (WSJ) indicated that the Asia premium has been on average “about $1.20 a barrel since 1988”. Utilizing data from Petroleum Intelligence Weekly  for the period 1990 – 1997, American researchers found that Saudi FOB prices for crude oil destined for Asian markets have been on average $0.83 higher per barrel (bbl) than for Western Europe and $0.93 higher than for the United States.  In another paper, the authors calculated the Asia-Europe differential for Saudi Arab Light FOB sales to average $0.90/bbl over 1988 – 2002, increasing to $1.48/bbl over 1997 – 2002.  In another careful study, covering the period January 1992 – November 1996, the Asia-destined loadings for Saudi Arab Light (AL) realized prices were found to be on average $1.00 - $1.20/bbl higher than for European loadings.  All these estimates from the cited sources are broadly consistent, with the “Asian premium” being in the range of $1.00 - $1.50/bbl over the 1990s and the early part of the 2000s.

The implications of these higher prices for Asia are obvious. The IEEJ estimates that the Asia premium imposes on Japan an additional burden of $4-8 billion annually.  Furthermore, it is claimed that higher crude oil prices also lead to higher prices for other energy commodities such as LNG and coal, which are typically linked to oil prices. Similarly, the Korea Energy Economics Institute (KEEI) points out that the financial burden of extra costs adversely affects economic and industrial activity and leads to the deterioration of the competitiveness of Asian economies. Its estimate of the burden placed by the Asia premium on the Korean economy is $800-900 million dollars a year. 

Evolution of oil pricing mechanisms
In 1973 the Organization of the Petroleum Exporting Countries (OPEC) inherited from the major oil companies  a pricing regime which effectively administered the price of oil by fiat. In the pre-1974 period, they simply posted a fixed price for crude oil. This price was used to compute royalties and the income tax paid to producing countries. When OPEC countries nationalized their upstream hydrocarbon assets, the administered price effectively was the price at which oil was sold and bought in arms-length transactions from the exporting countries.

The administered, fixed price system collapsed in 1985.  In the years leading to 1985, there was disarray in the OPEC ranks over pricing policy and its fundamental long-term pricing strategy. This was particularly obvious in the 1980 conference in Algiers. OPEC official prices were falling out of line with competing freely-traded crudes in Atlantic Basin spot markets. The problem arose from the difficulty encountered by OPEC in defending a given price in the face of strong competition from emerging, and rapidly growing, non-OPEC sources. Increasing non-OPEC supplies, at a time of stagnant world demand, resulted in the emergence of considerable surplus capacity within the OPEC region. This induced intra-OPEC competition which meant price discounting by several OPEC member countries to protect their export volumes. By adhering to the system of official prices, which most of OPEC was abandoning, Saudi Arabia was forced to reduce output and take on the role of swing producer.  The Kingdom suffered a continuous decline in the volume of their exports, from about 10 million barrels a day (m/bd) to just under 3 m/bd between 1980 and 1986. In the end, due to huge losses in export revenue, Saudi Arabia abandoned the system. The OPEC administered price system, which had been in operation since 1974, collapsed.

For a relatively short but dramatic period in 1986, “netback pricing” replaced administered prices. Under “netback” arrangements, the price of crude oil was referenced to the value of refined petroleum products derived from the given crude. In effect, netbacks guaranteed a refinery margin which, in periods of excess refining capacity that prevailed at the time, resulted in falling product prices. This, in turn, led to a collapse of crude oil prices. The effects were catastrophic for crude oil exporters. At one point oil prices, which were previously in the $24-26 per barrel (bbl) range, fell to $8-10/bbl.

The ensuing price recovery followed an OPEC meeting in November 1986. This meeting was significant as it changed the overall strategy from charging official administered prices to managing OPEC supply through the quota system in order to stabilize the price around a target level of $18/bbl. Given that neither the administered OPEC prices nor netback prices were acceptable any longer, a system of market-related formulae prices was gradually adopted. It involved setting “official” monthly discounts (or premiums) relative to the other marker or reference grades such as Brent or West Texas Intermediate (WTI).

Saudi Aramco’s pricing mechanism

Saudi Aramco’s pricing system is loosely tracked by most exporters in the Middle East. The other large producers such as Kuwait, Iran, Qatar and Abu Dhabi also use a similar system and are generally seen by the market as followers in terms of direction and the magnitude of the changes in the Saudi differentials (sometimes referred to as offsets). Saudi Aramco’s sales to international buyers are made under long-term contracts, usually “evergreen” contracts renewable annually. The pricing formula generally has four components: point of sale, a market-related base price, an adjustment factor that is reflective of crude oil quality and the point of sale, and a timing mechanism that stipulates when the value of the formula is to be calculated. The base price is calculated by taking the daily average of market prices of a particular widely-traded reference crude oil. The FOB price for European destinations is tied to Brent Weighted Average (BWAVE) price published daily for Brent crude oil for the period of 10 days around the delivery of the cargo, about 40 days after loading at the Saudi port of Ras Tanura.  For the US, the FOB price is linked to West Texas Intermediate (WTI) crude oil for the 10 days around the delivery of the cargo about 50 days after loading at the same port. For buyers in Asia, crude oil prices are linked to the average spot prices of Oman and Dubai crude oils as assessed by Platts during the month in which the crude is loaded at Ras Tanura for delivery to the Asian market. The base price is then adjusted by adding or subtracting an offset or adjustment factor as determined by Aramco, on a monthly basis, prior to the month of loading. This adjustment factor takes into account the point of sale (to adjust for the freight costs) and the “quality differential” between the Saudi crude and the reference crude for each particular importing region separately. The “quality differential” is essentially the difference between the “gross product worth” (GPW) of the Saudi crude and the reference crude. GPW is calculated by multiplying the refined product yield of each barrel under a given refinery process configuration with the price of the resulting refined products in the spot market.

The official selling price (OSP) for any particular Middle East export crude oil is simply the sum of the reference crude price and the announced monthly offset for given regional destinations, as explained above. For Atlantic markets, the reference crudes WTI (Aramco switched over to the Argus Sour Crude Index or ASCI for its crude oil sales in the US in January 2010) along with other reference crudes such as BWAVE are traded in highly liquid markets with prices set competitively, both in physical barrel trades as well as in the organized futures markets of New York and London. In contrast, Asia has no well established formal futures markets for crude oil. In the absence of an established crude oil futures market, the Dubai crude forward market was successfully developed in the 1980s. Dubai crude production went into decline in the early 1990s; there was a corresponding fall in liquidity in outright deals that provided absolute price signals. As a result, the Dubai market no longer served as an indicator of absolute prices, and instead became a relative price market where its price was set relative to Brent, and relative to the time structure of Dubai prices. The markets for Brent-Dubai spreads and Dubai inter-month spreads are well established, and Platts’ assessed Oman-Dubai-Upper Zakum prices became the basis for pricing Middle East crude exports on term contracts to Asia.

There has been extensive discussion in the oil industry regarding the problems with the Platts’ Oman-Dubai price quotation. However, the world’s largest flow of crude oil – that is, the flow from the Middle East to Asia amounting to some 15 mb/d – remains largely priced on the basis of this agency’s assessments. The price assessment, based on the Platts “partials assessment methodology” and which allows delivery of Oman and Upper Zakum crude oils in lieu of Dubai, remains the reference quotation for Middle East term contracts.

The Dubai Mercantile Exchange (DME) launched its Oman futures contract in June 2007, and since then the exchange achieved a record traded volume of 141,129 contracts.  However, its average daily volumes for a main trading month of delivery are typically below 3,000 lots (three million barrels) pale in comparison to some 150,000 lots (one hundred and fifty million barrels) normally traded in the front month Brent contract for example. Its emergence as a viable instrument for establishing a reference price for Middle East crude oil exports to Asia is still uncertain. To date, the Saudi, Kuwaiti, Iranian and other Middle East OSPs for Asia-destined crude oil sales remain based on Platts’ assessments.

Regional  price differentials 2007-2009
The focus of this analysis is on the biggest player in the Middle East, namely Saudi Arabia and its national oil company Saudi Aramco. We estimate the differentials in Arab Light (AL) official selling prices (OSPs) which are loaded on FOB terms at Ras Tanura port and destined for three major regions – United States (US), Western Europe (WE), and the Far East (FE) for the period over January 2007 to December 2009. For all three regions, we used the daily price data for the 2007, 2008, and 2009 (In 2010, Saudi Aramco changed the methodology for the US and started using Argus Sour Crude Index or ASCI so we excluded data from January 2010 except when used to price crude loaded at the end of 2009). We chose two different dates for the loading or bill of lading (B/L) day. The loading day chosen first was middle of each month (15th). Then we assumed that the oil to be delivered to all three markets was loaded on this very same date, clearly to compare the prices of the same barrels for the three different regions on the same temporal basis. Once we worked out the time series and obtained results, we chose another, arbitrary date (5th day of each month of loading) and calculated another set of prices. This was done to test for sensitivity of our results to the choice of B/L date.

It is worth examining the general trends in the price of oil over the period under consideration.
 

Figure 1: OSPs by Major Regions

Source: Authors based on Platts data

 

Three distinctive trends are immediately noticeable: One uptrend from January 2007 to July 2008 prior to the financial crises reaching almost $140/bbl on a monthly average basis; secondly, the collapse of prices from $140/bbl to below $40/bbl following the financial crises which began in the third quarter of 2008; thirdly, a recovery and uptrend from the end of 2008 and early 2009. The table below summarizes our results for Asia/Europe differentials for two different assumed B/L dates and compares them with the Petroleum Intelligence Weekly (PIW) estimates.

Table 1: Asia-Europe FOB Price Differentials for Arab Light
 
Year B/L (5th)
B/L (15th) PIW
 2007-2.24
 -3.57 -2.00
 2008 4.59 5.06 7.00
 2009 -0,04 -0.91 -0,50
 
Source: Authors' Calculations
 
The price differentials between Asia and Europe, as can be seen, are large and highly volatile. In 2007, Asia experienced a large ‘discount’ relative to Europe ranging from $2.00/bbl to $3.57/bbl. In 2008, Asia experienced a very large ‘premium’ to Europe, ranging from $4.59/bbl to $7.00/bbl. In 2009, the premium reversed again, and Arab Light sold to Asian buyers was at a discount to Europe ranging from $0.04/bbl to $0.50/bbl. Over the three years studied, Asia paid a small premium of $0.19 relative to Europe.
 
Figure 2: Asia-US AL FOB Price Differential
 

 
Source: Authors' Calculations
 
The figure above shows that the OSP differential between Asia and US for Arab Light (AL) ranges from a negative $20/bbl to over $30/bbl over 2007-2009. In 2007, we estimate that Asia paid on average $2.00/bbl less for its FOB purchases of AL crude while it paid about $4.70/bbl more in 2008 (when the differential spikes starting in March 2008) and $1.90/bbl less in 2009.
 
Figure 3: Asia-Europe AL FOB Differential
 


 Source: Authors' Calculations
 
 
Similarly, this figure shows that the OSP differential for FOB AL between Asia and Europe also ranges from a negative ($15/bbl) to a positive ($25/bbl) number. On average, Asia paid $2.24/bbl less in 2007, $4.60/bbl more in 2008, and $0.04/bbl less in 2009. Therefore akin to the Asia-US differential, annual averages for OSP differentials between Asia and Europe are also volatile.

We measured the FOB differentials for AL sold in the three markets utilizing a different arbitrary loading date. The arbitrary loading date chosen for all three markets was the 5th of each month. This advanced the pricing for crude destined to both Europe and the US by 10 days (from the 15th to the 5th of the consecutive month). Note that Asian pricing always remains the same with regards to the loading date, for Asian sales; the pricing period is the average of the month of loading irrespective of the actual B/L date in the month.
 
Figure 4 below gives a plot of the change in Asia offsets along with a plot of the change in the Asia OSP. During 2007-2009 the change in Asian offsets was insignificant compared to change Asia Official Selling Prices (OSPs). We can see that the magnitude of the change in Asian offsets is very small compared with the magnitude of the change in Asian OSPs.
 
Figure 4: Change in the price of the Asia OSPs and the Asia offsets ($/bbl)
 
 
Source: Platts
 
As can be seen in the figure above, Asian AL OSPs go to a discount of between $10-$20/bbl to European AL OSPs in March–May 2008 as BWAVEtrends up sharply from $90/bbl to $140/bbl. When BWAVE trends upward, pricing on a 10-day average forward will be higher than the Oman/Dubai average monthly price for the month of loading for Asian sales, i.e. in a rising market for BWAVE reference crude, one expects crude oil arriving in Europe some 40 days after loading at Ras Tanura to be priced higher than that loaded for the Far East which is priced on the average of the month of loading at Ras Tanura. When BWAVE falls off steeply from the $140/bbl peak to around $40 beginning around June/July 2008, we see the Asian OSP quickly becoming a premium over the European OSP of up to $20/bbl (around July to September 2008). A similar relationship of Asian OSP to US OSP holds as shown in Fig 5. In short, whether Asian customers were paying a premium or enjoying discounts over the past 3 years, relative to their counterparts in the Pacific Basin, seems to be determined by whether absolute reference crude prices in the US or European markets were on an upward or downtrend trend.  
 
Figure 5: Asia-US AL FOB Differential and WTI
 
 
Source: Platts
 
While Saudi Aramco aspires to be a major and preferred long term supplier of crude oil to each of the major consuming regions of North America, Europe and Far East, nevertheless its exports to Asia have grown significantly over time as a proportion of total crude exports over 1995–2008, from less than 50% to over 60% today. This is not unexpected, given growing investments by the exporting countries in the region and by the fact that Asia simply constitutes a natural market for Middle East oil both geographically and logistically.

There have been important developments that have expanded the crude oil diet for many Asian customers like introducing newer crude oil grades from non-traditional sources. With the advent of the financial crises in the developed world and recent increases in the supply of oil in the US, there has been a further shift in international oil flows. With the end of the war in Libya and the increase in oil production in the US, sweet, North and West African crude oil which used to flow to the East Coast of the US and the US Gulf is now looking for customers in still growing Asia. Russian exports of Eastern Siberia Pacific Ocean (ESPO) crude oil to Asia is about to get a major boost with gradual increases in pipeline capacity and output. Even some Canadian crude oil has been making its way to the region (Early in 2012, the Chinese NOC China Oil bought a cargo of Canadian Synthetic crude for test processing in their recently acquired SPC refinery in Singapore). All of these changes are expected influence the dynamics of crude oil prices in Asia. However, as overall demand continues to grow, the Middle East is likely to remain the most important single source of crude oil for Asia.

Conclusion

Since 1986, official Saudi prices are set only in relation to the freely traded reference or marker crude prices (Brent, WTI, Oman and Dubai). The monthly adjustments of these ‘differentials’ are usually relatively small. They generally change by less than 2% of the absolute price, while the implied volatility in the absolute price levels is usually about 30%. Hence, they are far too small in relation to the absolute price changes to be used as a tool for price discrimination between various consuming regions. What's more, our results have shown that the “Asian premium” during the period of our study (2007 – 2010) switched from an actual discount in 2007, to a very large premium in 2008, followed by a fall into a discount again, during 2009. We show that these changes can largely be explained by the structure of oil prices. All three crude oil markers show a clear upward trend during 2007, followed by a steep and persistent drop during the financial crises beginning in the summer of 2008 and the recovery at the end of that year and a slow uptrend throughout 2009. Due to deferred pricing in the official Saudi formula, the US and EU simply paid higher premiums in the rising market and received discounts in falling markets, relative to Asian markets. Therefore, during this period, we do not find any evidence of regional price discrimination by Aramco (This assertion is quite different from the argument that OPEC as a group sets global crude oil prices by imposing production quotas on its members. This “OPEC as cartel” argument is not the subject of this paper).
 
This conclusion fits well with what observers know about the overall Saudi exporting strategy. Saudi Arabia is a producer with vast oil reserves, and its strategic interest is in maintaining a significant market share in all the consuming regions and in doing so it may be perusing other political and economic objectives. However, further work is necessary to test whether the oil price structure can explain the ‘Asian Premium’ after 2010.
 
Contributor Adi Imsirovic is with the Petraco Oil Co.Ltd in Singapore.  The contribution was co-written by Dr. Tilak Doshi. 
 

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