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Home Archive Spring 2014 Issue Issue Content Asian Oil Markets in Transition

Asian Oil Markets in Transition

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In the last few years, we have witnessed major changes in the oil industry. Persistently high oil prices and oil nationalism have led the major oil companies to retreat to the marginal plays which are less accessible and more expensive to produce. Developed countries, continuing to suffer from the financial crisis of 2008, have seen poor energy demand growth.   Growing Emerging Market (EM) economies, particularly those in Asia, have taken over as the world’s major oil consumers.  This has led to a  growth of new refineries in the Middle East (ME) and Asia, channeling oil flows away from the Atlantic basin.   In the process, Asian oil companies have increased their trading activities supporting development of new trading hubs in the region.   But what are the implications of these changes for Asian oil markets particularly with respect to energy supply security issues arising from a potential disruption in the Middle East?

Disruptions in the Middle East Such would result in at least short term oil price spikes which would cascade through global oil markets.  However, as markets are the most efficient place to work through the impacts of such disruptions,  Asia should work harder to develop liquid and representative regional benchmarks. While Asia writ large is very vulnerable to a potential disruption in ME oil, increasing oil supplies, shifting center of gravity in trading towards the continent and the increasing sophistication of Asian oil companies are factors contributing to rapid progress in reducing this impact of growing Asian oil dependence on the Middle East and exposure to political turmoil there on potential oil supply disruptions.

Asia is particularly dependent on oil supply from the ME (see Chart 1 below). While Japan and Korea have a typical Asian import profile (Charts 3a and 3b), China is more diversified in its sources of supply (Chart 2).

Chart 1: Asian Oil Supply (China, Japan and South Korea only)

Source: Author’s calculations from data by Reuter’s Analytics. Data for 2013 are up to December 2013. Author takes full responsibility for any possible errors

 

Chart 2: China Oil Imports

Source: Author’s calculations from data by Reuter’s Analytics. Data for 2013 are up to December 2013. Author takes full responsibility for any possible errors

 

Chart 3a: Japan Oil Imports

Source: Author’s calculations from data by Reuter’s Analytics. Data for 2013 are up to December 2013. Author takes full responsibility for any possible errors

Chart 3b: Korean Oil Imports 

Source: Author’s calculations from data by Reuter’s Analytics. Data for 2013 are up to December 2013. Author takes full responsibility for any possible errors 

However, this is largely a historical accident as Chinese refineries have traditionally had lower upgrading and hydro-treating capacity (limiting the types of oil they could refine) and therefore often needed oil imports from outside the ME. For example, low sulfur imports from Angola have historically been an important staple diet for the Chinese refineries. However, with the growth of Chinese upgrading capacity, this is changing. On top of high dependence on the ME, Asian oil stocks with the exception of Japan and China are relatively small and any supply disruption from this region would be a major shock for these economies at least in the short term.

Globally, increasing US & Canadian production and resurgence of Iraqi supplies suggest a potential oversupply of oil in the next two years. According to the latest report by the Department of Energy (DOE), US production is expected to reach 9.5 m/bd in 2016 and maintain it to at least 2019.  In terms of the overall oil balance, The ‘IEA Medium Term Oil Market Report 2013’ expects annual growth of supply at an average of 1.4 m/bd while demand is expected to grow at 1.1 m/bd to 2018. This will result in OPEC spare crude oil capacity of over 7 m/bd in 2014 - 2017 period. While the demand projections have been slightly adjusted upward since, the overall picture of likely plentiful supplies remains unchanged.

Soft oil markets and growing competition between producers

Being the only significant growth market, Asia is currently enjoying competition among the crude oil suppliers from the ME, offering increasingly better terms. Following higher production and exports, Iraq’s State Oil Marketing Organization (SOMO) has been discounting prices for Basra Light to its main competitor in Asia, Arab Light, in order to win greater market share. According to some estimates by Reuters, these discounts were between $0.40 and $1.10 per barrel. Iraq has been the main beneficiary of the US imposed sanctions against Iran, capturing a greater share of Iran’s traditional customers such as China and India. This year, Iraq overtook Iran to become the fifth largest supplier to China. This reinvigorated OPEC producer has also beaten Kuwait in getting the most recent term contract to supply a new refinery in China. Iran, hard hit by the US led sanctions has offered cheaper oil on delivered basis using subsidized shipping or even free shipping as in the case of India as a pricing weapon. Iraq, Iran and Kuwait have all offered term oil supplies on extended credit terms, up to 90 days in order to secure large contracts from  countries such as India. UAE’s ADNOC has recently offered first oil cargoes without destination restrictions hoping to make them more attractive to customers by making crude optimization and trading easier.  Saudi ARAMCO has increased both length and volumes of the leased storage facility in Okinawa, Japan so that they can offer short hauled crude oil to their North Asian customers. Abu Dhabi has signed a similar contract to lease storage in Yosu, Korea. Many similar deals are in the pipeline.

Outside the ME, South American oil is looking for a role in Asia too. Cash strapped Venezuela is supplying China and potentially India with oil on favorable pre-payment terms. Columbia and even Mexico have recently shipped oil to the East. Newly built refineries in Asia have high upgrading capacity and therefore find heavy and cheap types of oil, often found in Latin America, more profitable to refine. With growing volumes of exports via the Eastern Siberia Pacific Ocean (ESPO) pipeline delivering oil from Siberia to its Eastern port of Kozmino, Russia is diverting more oil exports from Europe to Asia. Given the weakness in European demand, even the North Sea producers are struggling to find buyers. The main grade supplied into the Brent Marker, Forties, depends on regular monthly demand of at least one very large crude carrier (VLCC) from Korea or China. Even Canadian barrels have been moving east.

West African (WAF) and North African (NA) oil producers such as Nigeria, Angola, Algeria and Libya are hardest hit by the loss of the US market due to the shale revolution. Their exports are increasingly becoming ‘swing’ or marginal barrels as they mainly trade on spot basis and depend on Asian demand. Typically, China buys around 18 Very Large Crude Carriers (VLCCs) of Angolan crude per month; about a half of these are bought on a spot basis.  This makes these barrels vulnerable to changes in market balances such as a switch by China to Latin American grades. These grades have become more competitive following recent weakness in the WTI benchmark, against which these grades are priced.

To facilitate these large arbitrage flows, Asian oil companies are integrating their trading operations. China Oil, a subsidiary of the second largest Chinese refiner, PetroChina, operates storage in the Caribbean to facilitate their Venezuelan imports. Unipec, the trading arm of Sinopec, the largest Chinese refiner, handles all of their arbitrage using a truly global presence. They are sourcing oil using both term and spot directly from the producers and co-loading it whenever possible on more economical VLCCs for delivery into refineries in China. Rather than relying on trading companies or oil majors to arbitrage these markets, they increasingly control the strategic oil flows themselves.
 

Banks exiting from commodity trading?

Multi-billion dollar profits of Vitol, Glencore Trafigura and other trading companies have not gone unnoticed in Asia. Given the size of their refining systems and their financial muscle, Unipec and China Oil can be formidable competition even to the biggest majors and traders. These two state oil companies, as well as the largest Korean refiner SK, have become some of the main players in the Platts Pricing Window (see Chart 4.). They have become ‘price makers’ rather than ‘price takers’ meaning that they contribute to the price making process rather than wait for the majors and traders to set the world benchmark prices.  Indian Reliance and Thai PTT actively trade futures and derivatives. As a part of the learning process, Oman Oil Company teamed up with Vitol to set up Oman Trading International, a trading company. Even conservative Saudi Aramco is gearing up for product trading.  On its website, the Saudi oil company states that: ‘Starting off with 80 employees, Aramco Trading’s role will be to support the parent company’s efforts to maximize downstream integration and generate further value by optimizing its growing global downstream presence’. Under the pressure of increasing competition, the trading companies have started looking for long term profits elsewhere: Vitol (joint ventures such as OTI; also downstream), Glencore (upstream - Xstrata), Trafigura (storage in Africa, Australia). This process has been accelerated by gradual exit of banks such as Morgan Stanley, Deutsche Bank and JP Morgan from commodity trading.


It is not a surprise then that Singapore and Dubai have become major global oil trading centers along with Tokyo, Hong Kong and others. Large investments into storage capacity are reinforcing this activity. The Chinese state oil company Sinopec (parent of the trader, Unipec) is particularly prominent in this respect. Their huge new storage terminal built in Batam, near Singapore is due to open in 2016. The terminal will store 16.5 million barrels of crude and oil products and will be able to receive VLCCs.  This is an expansion of the Singapore trading hub including Indonesia and Malaysia, resembling Europe's Amsterdam-Rotterdam-Antwerp oil hub. In the Mideast, Sinopec’s 50%-owned Fujairah storage terminal would be able to store 4.6 million bbl of crude and fuel oil as well as 2.6 million bbl of other products. The jointly owned terminal is 48% controlled by a Singapore based trader, Concord Energy. It will begin operations, later this year. Sinopec also acquired a 50% stake in a 10 million bbl products storage facility in Europe late last year. This acquisition, together with its new projects in Batam and Fujairah, are likely to be a part of their global trading strategy. In Korea, construction of the first phase of the Ulsan storage hub will begin next year and phase two is expected to start in 2016. South Korea's expansion of the existing Ulsan storage hub will add a massive 18.5 million bbl of crude capacity and is expected to be completed by 2020. The first phase of the project with storage for 9.9 million bbl of mainly oil products will become operational in 2016.  This would add momentum to ambitions by Korea National Oil Corp. (KNOC) to develop Korea into a northeast Asian trading hub. Korea's largest oil storage facility, the 1.3 million cubic meter capacity Yeosu terminal began operations last year. The terminal can store 8.2 million bbl of crude and products. Korea has become Asia's major crude oil storage hub, with KNOC having concluded agreements to jointly stockpile crude with 12 companies, including Abu Dhabi National Oil Co., Norway's Statoil and Algeria's Sonatrach. Iraq’s SOMO may is also rumored to be actively negotiating a deal.

Work still needs to be done

In spite of these developments, Asia is still lacking robust sweet and sour Markers that would accurately reflect regional fundamentals. Markers are types of crude oil used as benchmarks against which all other types are priced. The main international price benchmark is Brent which actually consists of four different streams of North Sea oil: Brent, Forties, Oseberg and Ekofisk (BFOE). The main sour marker used in Asia is Dubai. Dubai price is determined at the end of the thirty-minute Platts ‘window’ (16.00 to 16.30 Singapore time) where 25kb size ‘partials’ (they are parts of full 500 kb cargo) are traded under a strict supervision and rules laid by Platts, a price-reporting agency or PRA). As chart 4 shows, the liquidity in Dubai trading during this window is significant and attracts a wide range of players, dominated by traders. These participants are often referred to as ‘price makers’ as they actively participate in determination of prices against which most of the oil is traded. However, these Dubai partials are essentially traded as a differential to Brent. They do not naturally trade in the market outside Platts Window. Most liquidity in the Asian crude oil markets is in Dubai swaps, an over-the-counter (OTC) derivative, because most regional buyers price their crude imports over one month average of all Dubai quotations (as published by Platts) during the calendar month of loading.  Even though Dubai swaps trading may equate to several million barrels per day, they are mainly traded either as swap spreads (differentials between two loading months, for example, January vs. February) or as a differential to Brent futures contracts. The latter is referred to as EFS (Exchange for Swaps, where futures Brent contracts are ‘exchanged’ for Dubai swaps). This EFS is the primary mechanism for determining the value of Dubai swaps. In a nutshell, Dubai is not a real oil price Marker or benchmark, as its price is actually derived from Brent futures price.

Recently, Dated Brent, the (Platts) assessed value of physical Brent, has been adopted as a regional Marker for sweet crude oil in most of Asia. While Brent futures may be a reasonable benchmark for sweet crude worldwide as it trades well ahead of loading, Dated Brent is potentially problematic as it is reflecting prevailing conditions in the North West European markets within a different time frame. For example, Dated Brent is assessed within 10-25 days before loading whereas Asian sweet grades trade up to two months before loading.

This lack of a regional benchmark may be detrimental for price discovery and optimal allocation in case of a major supply disruption in the region.   As Brent is the key international Marker with huge liquidity, any supply disruption in the Gulf would result in a widening of Brent/ Dubai spread. Traders exposed to a major supply disruption, as well as those speculating on such an event would hedge and trade Brent futures, the most liquid contracts. In financial markets, this is often referred to as  ‘Portfolio Adjustment’. Traders, facing a large price volatility in a portfolio, trade the most liquid assets in order to hedge and quickly reduce that volatility. Given that Dubai market is far less liquid, the brunt of the trading and hence price adjustments would be in the Brent futures market. Being a derived benchmark, Dubai price would be ‘sticky’. For this reason, most of the adjustment would be in the ‘quality’ premiums (and discounts) to Dated Brent and Dubai, reflecting crude oil quality, freight differences and of course scarcity.

Hence there is an anomaly in the Asian crude oil pricing, which would send the wrong price signals to the regional market. In case of a ME disruption, the Asian sweet grades of crude, the obvious and immediate substitutes, would initially be overpriced (as they are pricing off Dated Brent). Other sweet substitutes such as North Sea and WAF oil would be equally unattractive. On the other hand, Russian ESPO which is pricing off Dubai would initially, be too cheap in comparison. Traders would bid for cheaper ME crude which is scarce while ignoring the other available oil because it would be too expensive. The premiums for grades such as Oman, which loads outside the Gulf, but often prices off Dubai benchmark, would soar. The premiums for the regional sweet grades would go through a series of adjustments until their premiums to Dated Brent clear the market.

In a nutshell, a ME supply disruption would cause the Asian markets to go through a period of severe confusion with mixed oil price signals. This could be avoided by having one or more robust Asian oil price benchmarks which would send immediate and correct price signals. Therefore, it would be in Asia’s interest to develop one or more such Markers. In this respect, the newly found confidence of the Asian companies to get involved in the ‘price making’ process bodes well for the region.

In conclusion, all the recent changes in the oil markets discussed are likely to have profound consequences, making Asia the new center of gravity for the oil markets. Asia will continue to flex it newly acquired muscle to claim its position as a major player in the oil markets. Increasingly, endogenous Asian companies will be challenging even the largest oil majors and trading companies. Regional trading hubs are likely to grow. This trend is likely to continue in the light of the recent instability in MENA countries as diversification of supplies has become a major objective for many Asian consuming nations.  A large disruption in ME supplies would be a major shock for the region, as it is highly dependent on oil imports from ME. However, it is in a better position than ever before to handle it. While better regional co-operation and increasing strategic petroleum reserve capacity would certainly be beneficial in overcoming such a calamity, the prevailing political climate will make ‘free for all’ outcome more likely. Given that market forces are the best way to overcome such a disruption, improving regional markets and developing regional oil price benchmarks should be a new chapter in this development.

Contributor Adi Imsirovic is  General Manager of ‘Clearsource Commodity Services Ltd’, a UK subsidiary of a Singapore-based commodities trading company

 

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