East of Suez Oil Markets Review

East Of Suez Oil Markets: Trade Flows, Pricing And Risk Management

The past decade has seen two major shifts to the structure of the global oil market. First, the centre of global oil demand continues has firmly shifted continued to shift Eastward, with China and India leading the charge in the Asia region (see: Fig.1). According to the IEA, the average GDP elasticity of global oil demand is 50% higher in non-OECD economies, highlighting the greater oil intensity of emerging market economies and the continued importance of oil in the global energy mix – even as governments seek to push forward with the global energy transition. The second major transformation has been the growth in US oil supply, particularly from the Permian basin (see: Fig.2). The US has driven almost all the growth in global oil supply over the past decade, anchoring its position as the key marginal oil supplier. The role of the US as a key price formation actor was further reinforced last year in May 2023 when WTI Midland – the world’s largest freely tradeable grade by output – was added to the Dated Brent basket of?deliverable grades.

These two mega-trends have intersected with newer features of the market, all likely to remain in place over the next decade:?

?China and the energy transition: the past several years have seen significant changes to Chinese product balances. At the heart of these changes have been slowing gasoline and gasoil demand growth, the former a function of rising Electric Vehicle (EV) sales. July 2024 saw China’s EV penetration rate reach almost 50%. Globally, China now accounts for around 65% of the global EV market. With battery costs continuing to fall, this number is only set to grow. With expectations that Chinese gasoline demand will peak in 2025, the other major change has also been in the?gasoil market. The slowdown in China’s gasoil-intensive property sector and the growing use of LNG in the heavy trucking sector has also raised the prospect of gasoil demand peaking next year. China’s oil demand pivot from transportation fuels to petrochemical feedstocks now looks complete, with LPG/ethane usage set to drive the future of Chinese oil demand (see: Fig.3). China’s shifting product balances have also reinforced the importance of government policy, particularly on crude and product quotas for import/export. China’s role as the global swing refiner and its ability to make or break Asian refining margins has implications for spot trade activity and procurement.

?Russia’s future role in global oil markets: Russia’s largest export grade, Urals, previously served as a staple grade for European refiners. Having previously been one of the world’s largest freely tradeable spot grades, Urals was even seriously considered as a candidate for the inclusion in the Brent basket! In 2019, more than half of Russia’s crude exports were destined to the EU (58%) and exports to Asia were just around 35% (with exports to India around 1%). Following Russia’s invasion to Ukraine, almost all Urals crude exports now head to Asia (see: Fig.4). As a result, Europe has lost an informal sour crude marker and Asia has gained a new source of tradeable flow (albeit one which remains subject to procurement risk and transparency challenges, particularly on pricing terms). Regardless, the fact that Urals flows to Asia are priced on a delivered basis (moving from FOB to CIF) has helped boost derivative volumes and ushered in new physical price assessments (e.g. Urals DAP West Coast India).

? Growing complexity of East of Suez refining: between 2010-2023, global primary refining capacity increased by around 11.3m b/d, with almost 76% of the gains made by the Asia-Pacific region and 30% by the Middle East (primarily the Gulf region). A trend over the past decade has been the closure of less complex, simple refineries in West of Suez locations (primarily Europe) and the start-up of greenfield complex refiners in East of Suez. Notable start-ups over the past few years have included Oman’s Duqm, Kuwait’s Al-Zour and Saudi Arabia’s Jizan refinery. This has several important implications for the next decade: first, East of Suez product length will grow (particularly for gasoil); second, the increasing complexity of East of Suez refineries means greater feedstock optionality (further supported by the build out of NOC trading arms able to use third-party crudes). The completion of ADNOC’s US$3.5bn Crude Flexibility Project (CFP) in late 2023 was a clear example of this, allowing ADNOC to swap out Murban at the 417kb/d Ruwais West refinery in favour of heavier crudes (e.g. Upper Zakum).

? Growing importance of price risk management as flows shift East: as the East of Suez market becomes more competitive over the next decade, derivatives and risk management demand is only set to grow. The past twenty years have already seen the growth in derivative volume across key benchmarks and futures contracts (e.g. DME Oman and the more recently launched Ice Futures Abu Dhabi Murban contract).?

Against this backdrop, we see 4 key trends to watch as the East of Suez oil market continues its onward transformation.

1? Global oil trade to be dictated by Asia’s structural crude shortfall

While oil demand in the OECD has already peaked, the story remains different in the Asia-Pacific. According to the IEA, in 2007, OECD oil demand was 50.2m b/d and accounted for 57% of global oil use. By 2023, this had fallen to 45.7m b/d (45% of total oil use). By 2030, the IEA sees OECD consumption fall even further to 42.7m b/d, 41% of the total. Meanwhile, oil demand in Asia-Pacific currently represents around 40% of global oil use and demand is expected to increase between 4-5m b/d over the next decade (see: Fig.6). While gasoline demand growth should flatten in China, petrochemical feedstock demand is set to grow – particularly LPG/ethane and naphtha. At the same time, rising non-OPEC+ supply in the medium-term and the ongoing diversion of Russian crude to Asia means that Asia’s structural shortfall in crude will be met by a growing diversity of grades. Rising competition for the Asian market also means a greater role will also be played by delivered crudes, increasing the need for effective hedging tools to manage basis risk as refiners manage a more complex suite of crudes – an important consideration as refinery LP models adjust to new flows.

2? The move from a term-driven marketplace to greater spot procurement?

Historically, the majority of Asia’s crude import requirement has been met by crude governed under term contracts with Middle East suppliers. Saudi Arabia, for example, sells most of its crude to Asia under term contracts. Saudi Aramco also has term volumes sold to joint venture (JV) partners or where it holds direct equity in overseas refining stakes (e.g. Rongsheng). As can be seen in Fig.7, despite OPEC+ cuts, the share of Middle East crude exports to Asia have been growing over the past decade. Term contracts are likely to remain a mainstay of the East of Suez market over the next decade as they guarantee security of supply. Likewise, players such as Aramco are seeking to expand their downstream footprint in key Asian demand centres (e.g. China), further reinforcing this trend. Despite this, Asian refiners are becoming more sophisticated in their procurement strategies by looking at the spot market to supplement baseload grades. Fig.8 shows the growth of new grades entering the East of Suez market over the past several years, highlighting the importance of derivative trading instruments to manage price risk exposure, particularly as refinery intakes accommodate a greater suite of spot volumes.

3? Derivative trading volume and price risk management demand is only set to grow

The growth of spot crudes to the Asia market has also had major implications for benchmark pricing in Asia. Dubai has been the key Asia crude benchmark, supported by liquidity during the Singapore window and the gradual addition of spot crudes to the underlying benchmark. Spot crude purchases in Asia are regularly priced against underlying Dubai swap values and the benchmark has been key in allowing regional refiners compare netback values to other liquid spot grades, e.g. Oman. It has taken a substantial amount of time for the current ecosystem to develop, with Asia often being called the graveyard of futures contracts. Several oil futures contracts have attempted to be launched over the past twenty years to capture hedging and speculative activity. Not all have survived.

In today’s market, the key pillars of East of Suez derivative activity remain spread across:?

1) Physical Oman (Medium Sour) futures listed on the GME where pricing and procurement takes place.

2) ICE Dubai futures – cash settled futures based on Platts Dubai assessment prices.

3) Physical Murban (Light Sweet) futures listed on IFAD These key Middle East derivatives have grown considerable in volume during the last couple of years and growth levels have outperformed other key benchmarks such and Brent and WTI. This is highlighting the move away from traditional hedges to the more sophisticated and specific grade hedges that are required by modern refiners and physical players.

In addition, there also remain other regional contracts which have high liquidity but are limited to mostly retail players (e.g. Shanghai INE). As well as outright trading, there also exists substantial and growing volume in Brent-Dubai EFS contracts and other key arbitrage spreads (e.g. DME Oman/Brent, Murban/Brent).

In many ways, the futurization of trading in the East of Suez has been a gradual evolution, supported by the following developments:

?Shifts in OSP formula pricing: the decision by Oman’s Ministry of Oil and Gas (MOG) to switch its OSP formula to futures pricing in the mid-2000s heralded a major shift. Setting the Oman OSP on the monthly average of Oman futures traded on DME was the first domino to drive a shift in how major producers adjusted their OSP formula pricing, with Saudi Arabia, Kuwait, Bahrain and Dubai including a DME Oman futures component in their underlying pricing formula. The decision years later by ADNOC to also switch to futures pricing (supported by Murban futures, launched in 2021) further reinforced this “futurization” trend. In fact, it is now only Iran, Iraq and Qatar who are the outliers in the Middle East who don’t have a futures component to their OSP formula pricing.

?Destination restrictions slowly being moved from Middle East crude: with Oman having led the way in removing all destination restrictions on its crude in the mid-2000s, the removal of destination restrictions from ADNOC’s barrels in 2021 was a major shift. Having previously given term lifters an option to remove destination restrictions for a “premium” fee, the growth of the UAE’s crude production over the next decade will further increase the underlying trading volume underpinning the IFAD Murban contract.

?Middle East OSPs move from retroactive to forward-looking pricing: the past few years have seen Middle East producers shift their OSP formula pricing from retroactive to forward looking pricing, allowing refiners to accurately assess cargoes on an M+2 basis, rather than suffer misalignments in pricing between loading and delivery due to retroactive pricing.

4? Further futures contracts may develop in the East of Suez region

Currently, the East of Suez now has two major futures contracts – DME Oman and IFAD Murban futures. Other producers in the region may also seek to shake up their pricing strategies as opportunities grow to take advantage of their customer base, large export flow and growing demand for price risk management tools. For marginal sweet inflows, linkages between the US Gulf Coast and Asia are likely to become a new mega-theme for the next decade.

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For medium-sour crudes, the prospect of a Basrah Medium Futures Contract could also develop. Currently Basrah Medium crude exports average 2.3m b/d. Like the UAE, Iraq has a mix of term and equity customers. Equity lifters include major players such as CNOOC, PetroChina, Totsa, BP and Eni – all viable candidates who can support trading volume on a potential contract. At the same time, Iraq is planning major upgrades to its export infrastructure over the next decade helping further expand crude export capacity. The development of a Basrah Medium futures contract would allow for new pricing spreads to develop in the region (e.g. Oman-Basrah Medium spread), further enhancing the prospect of a growth in derivative trading volume to manage price risk.

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In many ways, the past decade has seen the successful development of a derivative ecosystem develop in the East of Suez, with greater liquidity improving across all major futures contracts. While there is no such thing as the “perfect hedge”, the East of Suez over the next decade offers multiple opportunities for new contracts to develop – an important requirement as refineries become more complex, capacity additions grow and crude optimisation requirements become more demanding. The shift in product balances further reinforces this trend, with deep and liquid derivative instruments set to become key requirements.

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