Crude oil is traded through a variety of contract arrangement and in spot transactions. It is also traded on futures markets but not generally to supply
On Asian Premium of Crude Oil: Causes, Patterns and Counter Measures
physical volumes of oil, rather than as a mechanism to hedge the price risk.
These mechanisms play an important role in providing pricing information to markets.
The pricing mechanism of crude oil had changed several times. Before 1986, Arab Light crude(ALC) was used as an OPEC marker for transaction of Middle East crude. There were no destination restrictions, and all Middle East crude prices are based on ALC irrespective of importing regions. This system was abandoned by Saudi Arabia because other exporters are undercutting the ALC price in order to increase their market shares. After dropping off ALC as the marker, Saudi adopted the netback pricing mechanism. The netback pricing mechanism was introduced to reflect the idea that crude oil price should be determined by its product worth in the market. Even though its theoretical soundness, this system performed miserable in the actual market. Its consequence was a collapse of oil price in 1986 because of the spiral effect of the product prices to the netback value. This spiral effect is due to the incentive for refiners to increase crude runs and drive product prices lower, which in turn decreases the netback value of crude oil. This undesirable result caused the shift from the netback pricing system to the formula pricing.
Ⅱ.1. Formula Pricing of Crude Trades
Under formula pricing system, marker crude is used as the base and then a quality differential as well as a premium or discount is added depending on the crude being purchased. Thus in times of tight supply this premium will rise and gradually drag up the Marker crude price, whilst in times of surplus supply a reduced premium or even a discount will drag down the marker crude price. Of course big shock that can significantly influence crude supply levels will sometimes result in a large step change in the prices of crude (e.g.
OPEC announcements; a war; and major refinery outages). That is, crude being
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purchased does not always follow marker crude.
The adoption of the formula pricing resulted in a separation of Middle East crude market into three different regions, U.S. and European and Asia. The application of destination-based price formulas found that the same crude is priced differently depending on its destination. Asian oil importers are usually in a disadvantage position compared to Europe and U.S.
Ⅱ.2. Data Analysis
There exist significant differentials for Asia-Europe and Asia-U.S. so that Asia bound sales are generally at a premium relative to the West bound sales.
This Asian Premium has fluctuated in recent years. It averaged $1~1.5 per barrel through the 1990s and rose in the third quarter of 2002 to $3.50 per barrel above prices to US refiners.
<Table 1> Price difference between markets
Unit: US$/bbl
Spreads Mean Standard Deviation
Asia - Europe 1.119 1.133
Asia - U.S. 1.313 1.364
Europe - U.S. 0.105 1.015
Note: Based on monthly average formula prices from June 1991 to March 2002
The premium is charged by many Middle East oil producing countries, including Saudi Arabia, which strategically controls the destination of their oil, thereby preventing any of their discounted oil for the U.S. or European market from being switched to Asia.
On Asian Premium of Crude Oil: Causes, Patterns and Counter Measures
[Figure 6] Formula Prices of Arab Light by Destination
5.0 10.0 15.0 20.0 25.0 30.0 35.0
1995 1996 1997 1998 1999 2000 2001 2002
Europe-bound Asia-bound U.S.-bound
$ /bbl
Ⅱ.3. Explanations for Differentials
There exist several hypotheses about the causes of the Asian Premium: (1) oil producers' market segmentation and price differentiation based on demand elasticity (Soligio & Jaffe, 2000); (2) maintaining market share and discount on competitive market (???) (Soligio & Jaffe, 2000); (3) discount or premium of transportation cost; and (4) inappropriateness of marker crude and arbitrary adjustment factor in the price formula (Ogawa, 2002).
We fully acknowledge the fact that Asian Premium is caused by the lack of competition among various sources of crude oil in the Asian market. However, even if we accept such a structural limitation of Asian oil market, we still can find some measures to alleviate this problem. The following factors are assumed to be the major causes of Asian Premium.
Firstly, supply source of oil is not so diversified in Asia compared to Western market. Asia depends too much on Middle East due to its supply
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shortage. In U.S. and Europe, various sources of crude oil flow into the market and Middle East oil only takes account of less than 30%. In contrast to this, this share is approaching 70% and is expected to increase in the future.
[Figure 7] Sources of crude oil import (2001)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
U.S. W. Europe NE Asia Total World
America Europe M iddle East Africa Asa-Pacific Non Identified
High dependency of Middle East oil is a combined result of Asia's little export capacity and its geographical closeness to Middle East. If Asian refiners' crude selection is purely based on price competitiveness, Asia is a kind of captive market from the point of view of Middle East oil exporters. This situation of world oil market balance makes Middle East oil producers have some market power on Asian Market. If they execute their market power, their strategy will be price differentiation based on inverse elasticity rule. In order to test this hypothesis, the regression of Arabian Light Asian formula price with respect to U.S. and European price, using monthly average data from June 1991 to March 2002.
On Asian Premium of Crude Oil: Causes, Patterns and Counter Measures
europe us europe asia europe
asia asia
p p
p η
η η
η =
=
(1)If there is Asian Premium, the relative elasticity term should be estimated to be greater than 1. First, all relevant data series have unit root by the criteria of ADF test. By Johansen-Juselius cointegration test, we can find that the formula price of Asia and Europe is cointegrated in the order of one. Asia and U.S. formula price series is also I(1). But the relationship between Europe and U.S. is ambiguous. The regression of equation (1) confirms the long-term existence of Asian Premium and its coefficients are estimated -1.057 and -1.241 respectively.
Secondly, a representative Middle East crude oil market is absent. While Middle East oil producers export more than 15 million barrel per day, they deliberately restrain their oil traded in the spot market and sell most of their oil via term contracts. Though Dubai has been traded in the spot market and worked a marker grade, Dubai's reliability as representative Middle East crude has been suspected. Because the volume of Dubai is too small to reflect the changes in the conditions of the Middle East market, and furthermore its rapidly decreasing trade volume raises the worries of price manipulation. Once it was traded as many as 25 cargoes per month, it has now decreased to less than 10 cargoes.
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[Figure 3] Production trend of Dubai
0 50 100 150 200 250 300 350 400 450
1992 1994 1996 1998 2000 2002
Thousand b/d
Thirdly, destination restriction and third-party trade prohibition clause prevent the flexibility of Asian refiners in their selection of crude responding to relative price changes. This argument can be tested by the hypothesis such as Asian formula price are insulated from (or shows stickiness with respect to) the Asian product market conditions. Market conditions are assumed to be represented by a netback value of the crude oil and the flexibility of price formula can be measured by the change of adjustment factor. In the price formula, adjustment factor is supposed to consist of two components.
First one is the quality differential between marker grade and the selling crude oil. Second one is the transportation cost from Middle East to the exporting market. In case of U.S. and European market, adjustment factors set by Middle East oil producing countries were actually composed of these two factors.
On Asian Premium of Crude Oil: Causes, Patterns and Counter Measures
[Figure 4] ALC adjustment factors in European market vs. quality differential of crude oil and transportation cost
-5.0 -4.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0 5.0
1995 1996 1997 1998 1999 2000 2001 2002
Quality Difference & Transportation Cost Adjustment Factor
$/bbl
[Figure 5] ALC adjustment factors in U.S. market vs. quality differential of crude oil and transportation cost
-7.0 -5.0 -3.0 -1.0 1.0 3.0 5.0 7.0
1995 1996 1997 1998 1999 2000 2001 2002
Quality Difference & Transportation Cost Adjustment Factor
$/bbl
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However, adjustment factors for Asia bound crude oil seem to include only quality differential. Exclusion of transportation cost in the adjustment factor for Asia might need some explanations.
[Figure 6] ALC adjustment factors in Asian market vs. quality differential of crude oil
-2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0
1995 1996 1997 1998 1999 2000 2001 2002
Quality Difference Adjustment Factor
$/bbl
In reality, the formulas and adjustment factors which are set and announced by Middle East exporters in each month. Theoretically, the adjustment factor is supposed to reflect the difference between the Gross Product Worth (GPW) of the marker and traded crude and the difference of freight cost from the loading port to the consuming area for the two crudes. First term is the quality differential and the second term, which is more controversial, is the difference of freight cost. Quality differential is easy to understand to be included in the formula. The magnitude of this term depends on the sulpher content, gravity (crude yields), and product prices in the spot market. But second term can be interpreted as a premium or discount based on the
On Asian Premium of Crude Oil: Causes, Patterns and Counter Measures
market conditions of destination. Hypothetically, the role of second term is to make the traded crude competitive to the alternative sources of crude in the consuming area. In U.S. and Europe, crude markets are highly competitive, Middle East oil producers have to discount the price at least as much as the freight cost to grab the market. On the other hand, they do not need to discount for Asia bound crude because Asian refiners are always in a supply shortage situation. Therefore, the second term is set at best zero and for the most of time at positive number (premium).
Therefore, one option to reduce Asian Premium is through negotiating with Middle East oil producers to include transportation cost in their adjustment factor. Also changing marker crude from Dubai into Brent is desirable considering the inappropriateness of Dubai as an Asian marker. If this new price formula were to be applied, Asian Premium will be almost eliminated by data simulation of AL crude in the period of 1995-2002.]
[Figure 7] Simulation for ALC price differential between European market and Asian market by changing price formula
-5.0 -4.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0 5.0
1995 1996 1997 1998 1999 2000 2001 2002
$/bbl
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Ⅱ.4. Prospects of Asian Premium
It is quite possible that the Asian Premium will be sustained in the short run, but will vanish gradually in the long run. Under the trend of globalization, crude market cannot be an exception. Asian Premium is basically a result of the intended market segregation by Middle East oil producers. This kind of artificial price differentiation cannot be sustained due to the countervailing economic forces such as refiners crude diversification, price arbitrage, market integration, etc. If Asian importers increase the share of African and European crude as they do in the recent years, it will force exporters to reduce the premium. With the trend of oil product market globalization, significant crude oil price differential between regions cannot be justified or tolerated by both sides of the transaction. Though crude trade is prohibited by term contract, product trade will perform the role of arbitrage in the long term. Also the importance of Asian market for Middle East countries is expected to be larger, Middle East producers will be urged to change their marker to a more reliable one, such as ALC or a basket of their crude.