2014

Energy Risk Professional

ERP Exam Course Pack

READINGS THAT ARE FREELY AVAILABLE ON THE GARP WEBSITE

Readings for Oil, Gas and Coal Markets
In addition to the published readings listed, the Oil, Gas, and Coal Markets section of the 2014 ERP
Study Guide includes several additional readings from online sources that are freely available on
the GARP website (link to 2014 Online Readings). These readings include learning objectives that
cover specialized topics or current trends in global oil, gas, and coal markets that are unavailable in
traditional text books.
The 2014 ERP Examination will include questions drawn from the following AIMs for each reading:
Crude Oil Benchmarks, Global Pricing and Market Transactions
1.

William Bailey, Benoit Couet, Ashish Bhandari, Soussan Faiz, Sunaram Srinivasan and
Helen Weeds. Unlocking the Value of Real Options. (Oilfield Review, 2004).

Understand and apply a net present value (NPV) calculation to make investment
decisions in a gas/oil field.

Explain how a binomial lattice is used in the valuation of an asset or option and be
able to calculate the value of an up or down move.

Describe of the use of real options in circumstances such as switching or salvage

decisions with an existing oil or gas project.

2.

Bassam Fattouh. An Anatomy of the Crude Oil Pricing System.

(The Oxford Institute for Energy Studies). (Sections 3 to 9 only)

Summarize the process used to determine price differentials and identify factors that
influence the price differential including the equivalence to the buyer principle.

Describe the role of price reporting agencies (PRAs) in price identification; summarize
the methodologies used by PRAs to assess commodity prices, and identify criticisms
of PRA price assessment.

Understand the mechanics and specifications of the 21-day BFOE (Forward Brent), the
Brent Futures, the Exchange for Physical (EFP) and the Dated Brent/BFOE contracts.

Define Contracts for Differences (CFDs) and understand its application when hedging
basis risk associated with Forward Brent contracts or deriving forward prices from a
combination of Dated Brent prices and CFDs.

Understand the relationship between futures contracts and physical supply.

Compare and contrast the Brent, WTI, and Dubai-Oman crude oil benchmarks in terms
of liquidity, price transparency, and available financial products.

Summarize the mechanics of WTI futures contracts including related delivery requirements, and compare WTI Posting-Plus (P-Plus) pricing to NYMEX CMA pricing.

Understand the logistical challenges that can impact the effectiveness of WTI as a
global crude oil benchmark.

Explain how the Dubai benchmark price can be calculated using swaps.

2014 Global Association of Risk Professionals. All rights reserved.

2014

Energy Risk Professional

ERP Exam Course Pack

READINGS THAT ARE FREELY AVAILABLE ON THE GARP WEBSITE

Readings for Oil, Gas and Coal Markets
Petroleum Refining
3.

Brent Yacobucci. Analysis of Renewable Identification Numbers (RINs) in the Renewable

Fuel Standard. (Congressional Research Service, July 2013).

Describe Renewable Identification Numbers (RINs) and explain how RINs are
produced and traded.

Summarize the mechanics of the Renewable Fuels Standard (RFS) and describe the
classes and categories of RINs which can be used to meet biofuel requirements as
part of the RFS.

Describe factors which can impact the market prices of RINs.

The Global Natural Gas Market

4.

International Gas Union. Wholesale Gas Price FormationA Global View of Price Drivers
and Regional Trends. (Sections 1 to 5 and 8 to 10 only)

Understand and apply the following natural gas pricing terms: wellhead price,
border/beach price, hub price, citygate price, end user price and netback price.

Describe potential short, medium and long-term supply-side and demand-side drivers

Summarize the eight key mechanisms for pricing gas and identify the geographic

for natural gas prices.

regions where each mechanism is most prevalent.

Describe the relationship between a local gas pricing mechanism, the observed
market price and the hypothetical market-clearing price.

Identify the factors that influence the volatility of natural gas prices, including
oil-linked prices.

Assess the relationship between price volatility and natural gas supply across various
hypothetical price levels.

2014 Global Association of Risk Professionals. All rights reserved.

2014

Energy Risk Professional

ERP Exam Course Pack

READINGS THAT ARE FREELY AVAILABLE ON THE GARP WEBSITE

Readings for Oil, Gas and Coal Markets
Global Coal Markets
5.

Richard Morse and Gang He, The World's Greatest Coal Arbitrage: China's Coal Import
Behavior and Implications for the Global Coal Market. (PESD Stanford, August 2010).

Understand the basic economics of the Chinese coal market; compare domestic
reserves to domestic demand.

Explain the arbitrage opportunities available to coal buyers in southern China.

Describe the role of freight costs in setting coal market prices.

Explain how Chinese arbitrage has impacted prices on the global coal market.

2014 Global Association of Risk Professionals. All rights reserved.

Unlocking the Value of Real Options

Management often has exibility in carrying out projects, capitalizing on new

information and new market conditions to improve project economics. Real-options
analysis provides a means to determine the value of exibility in future activities.

William Bailey
Benot Cout
Ridgeeld, Connecticut, USA
Ashish Bhandari
El Paso Corporation
Houston, Texas, USA
Soussan Faiz
Strategic Management Consultant
Walton on Thames, Surrey, England
Sundaram Srinivasan
Sugar Land, Texas
Helen Weeds
University of Essex
Colchester, England

In the early 1990s, Houston-based Anadarko

Petroleum Corporation outbid competitors for
the Tanzanite block in the Gulf of Mexico. It
found oil and gas there in 1998 and was producing within three years. The Tanzanite discovery
is significant not so much for an abundance of
oil and gas, but that in bidding for it Anadarko
broke with industry tradition. Rather than using
only conventional discounted cash ow (DCF) to
help it decide what the block was worth and how
much to bid for the lease, the company opted for
a new technique called real-options valuation
(ROV). ROV gave Anadarko the confidence to
outbid others because it suggested that there
was more to Tanzanite than met the eye. 1
Anadarko now routinely uses ROV when making
investment decisions.
Options embedded in, or attached to, physical or real assets are real options. These are
distinct from options relating to financial
assetssecurities and other financial claims.
ROV is a process by which a real or tangible
asset with real uncertainties can be valued in a
coherent manner when exibilityor potential
for optionsis present.
Most oil companies still use DCF to appraise
potential investments. This method has served
them well. Increasingly, however, companies are
asking whether ROV might be used to complement DCF. ROV supporters argue that it gives a
truer value than DCF only because the ROV
model more closely reflects the variability and
uncertainty in the world. ROV often can highlight extra value in projects, value that is

possibly hidden or even invisible when DCF is

used alone. Some companies that use ROV are
reluctant to divulge parameter details of their
models because of fears that revealing those
details gives away a competitive advantage.
ROV is not on the verge of displacing DCF.
In fact, real-options valuation employs DCF as
one of its tools. In practice, ROV combines and
integrates the best of scenario planning,
portfolio management, decision analysis and
option pricing.
This article reviews DCF and describes how
ROV overcomes some, but not all, of its shortcomings. After explaining the parallels and
differences between financial options and real
options, it examines two of the many methods of
valuing options, the Black-Scholes formula
and binomial lattices. ROV is illustrated by a
case study of a liquefied natural gas (LNG)
transport option. A series of linked, synthetic
examples describes several simple forms of
binomial lattices.
Discounting Cash Flows
Discounted cash flow analysis is relatively
simple. It predicts a stream of cash ows, in and
out, over the expected life of a project, then discounts them at a ratetypically the weighted
average cost of capital (WACC)that reflects
both the time value of money and the riskiness
of those cash flows. The time value of money
indicates that money held in the future is worth
less than money held now, because money we

Oileld Review

Oil price

Time

have in hand can be invested and earn interest,

whereas future money cannot.2
The crucial item in any DCF calculation is
net present value (NPV), the present value of
cash inflows minus the present value of cash
outows, or investments (right). A positive NPV
indicates that the investment creates value. A
negative NPV indicates that the project as
planned destroys value.
A DCF analysis provides clear, consistent
decision criteria for all projects (see Working
Out Net Present Value, page 6). However, it also
has limitations:3
DCF is static. It assumes that a project plan is
frozen and unalterable and that management
is passive and follows the original plan irrespective of changing circumstances. However,
management tends to modify plans as circumstances change and uncertainties are
resolved. Management interventions tend to
add value to that calculated by DCF analysis.

Winter 2003/2004

Time

Cash flow

Discount
factor

Present value
of cash flow

Present

5000

1.0000

5000

One year

+4500

0.9091

+4091

Two years

+3000

0.8264

+2479

+2500

Undiscounted cash flow

+1570

Net present value

n

Discount factor = 1/(1+Discount rate) .

> Net present value (NPV) calculation. A discount factorbased on a 10%

discount rateapplied to future cash ows indicates the greater value of cash
in hand compared with future cash. In this case, the difference between the
NPV and undiscounted cash ow is almost a thousand, regardless of the
currency used.

For help in preparation of this article, thanks to Steve

Brochu, BP, Houston, Texas.
ECLIPSE is a mark of Schlumberger.
1. Coy P: Exploiting Uncertainty, Business Week
(US edition) no. 3632 (June 7, 1999): 118124.

2. Hussey R (ed): Oxford Dictionary of Accounting.

Oxford, England: Oxford University Press (1999): 131.
In a deationary economy, money in the future may not
be worth less than money held now.
3. Mun J: Real Options Analysis: Tools and Techniques for
Valuing Strategic Investments and Decisions. New York,
New York, USA: John Wiley & Sons (2002): 59.

A Synthetic-Reservoir Example

Working Out Net Present Value

A series of examples using a ctitious eld

and simple synthetic models is presented in
this article to illustrate some key valuation
concepts. This section sets up the case and
determines the net present value (NPV).
The ctitious Charon eld in the Sargasso
Sea is an anticline, divided into two blocks by
a fault. The reservoir interval consists of shallow marine sediments up to 200-ft [61-m]
thick, capped by a sealing shale. The operator,
Oberon Oil, has devised a development plan to
obtain rst oil in three years. The plan calls
for drilling six wells tied back to a dedicated
production platform that can handle 50 million scf/D [1.4 million m3/d] of produced gas
from the live oil. Expected development costs
will be $177.5 million spread over three years
(above right).
Company experts assign values to key
reservoir properties, such as porosity and permeability, based on probability distributions
(below right). The oil/water contact is not
known precisely, which impacts the estimate
of oil in place. Several geological realizations
are constructed and used for simulation models. Hydrocarbon resources are computed for
low, median and high estimatesconsidered
representative of the oil in place occurring at
the 5%, 50% and 95% values of the probability
distribution (next page, top).
Decision-making is based on these three
representative scenarios. ECLIPSE oil production predictions are made for each realization
(next page, bottom). Oil production decline
with time for this ctitious case can reasonably be modeled as a hyperbolic function,
making the results easier to use for prediction. A standard discounted cash ow (DCF)
model computes project NPV. The oil price is
assumed to be $25/bbl at the start of the project and to increase 1% per year, with a tax
rate of 33% for net positive revenue and no
tax paid for negative net revenue. In this scenario, the median-case NPV for Charon eld
is $236.3 million.

Period

Time, years

Total development cost,

million $

0.6

50.0

1.2

75.0

1.8

107.5

2.4

150.0

3.0

177.5

> Investment schedule for the synthetic Charon

eld. The three-year construction schedule is
broken into ve equal-length time periods. These
ve time steps are used in later examples.

Well 1 Well 5
Well 2

Well 4
Well 6
Well 3

Oil saturation
0.0

0.2

0.4

0.6

0.8

> Reservoir model of the synthetic Charon eld. This ECLIPSE reservoir model provided input for
obtaining production predictions, using a large number of simulations with geostatistically
derived porosity and permeability values.

Oileld Review

Oil/water
contact
depth, ft

Field-wide average,
ratio of net-togross thickness

Average
porosity

Original oil
in place,
million BOE

Initial oil
production,
B/D

Low

9625

0.65

12.5%

138.6

25,384

Median

9650

0.75

14.4%

228.2

27,930

High

9675

0.85

16.3%

350.4

28,225

DCF assumes future cash ows are predictable

and deterministic. In practice, it is often
difcult to estimate cash ows, and DCF can
often overvalue or undervalue certain types
of projects.
Most DCF analyses use a WACC discount factor. But instead of a WACC, companies often
use a company-wide hurdle rate that may be
unrepresentative of the actual risks inherent
in a specic project.
The first two limitations relate to circumstances changing after a project begins. A new
DCF analysis can be performed to reect the new
circumstances, but it may be too late to inuence
basic project decisions, since the project is
already under way. The third limitation above
results from companies adopting a company-wide
hurdle rate for consistency rather than carefully
recalculating a WACC for each project.
A sensitivity analysis can enhance information
provided by DCF analysis. The consequences of
possible changes to key variablesfor example,
interest rates, cash ows and timingare evaluated to determine the results of a number of
what if scenarios. However, the choice of which
variables to alter and how much to alter them is
subjective.4 Sensitivity analysis makes assumptions about future contingencies, rather than
incorporating those contingencies as they occur.

> Results of model realizations. Three models represent the low (5%), median
(50%) and high (95%) production predictions in Charon eld.

30,000

Production rate, B/D

25,000
20,000
15,000

High

10,000
Median
Low

5,000
0
0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

5500

6000

Time, days

250

236.3

200

Present value, million $

150
100
Median case
50
0
50
100
150
200
0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

5500

6000

Embracing Uncertainty and Adding Value

Unlike DCF, ROV assumes that the world is
characterized by change, uncertainty and
competitive interactions among companies. It
also assumes that management has the flexibility to adapt and revise future decisions in
response to changing circumstances. 5 Uncertainty becomes another problem component to
be managed. The future is regarded as one that
is full of alternatives and options, both of which
may add value.
The word option implies added value. When
we speak of keeping our options open, having
more than one option, or not foreclosing on our
options, the underlying implication is that just
holding the option usually has value, whether or
not we exercise it. The same is true of real options.

Time, days

> Calculation of Charon net present value (NPV). Production begins in the third year of the project
and declines (top). The low (5%), median (50%) and high (95%) probability model predictions are
shown. The projects cumulative cash ow for the median case shows the expenditures in the
rst three years followed by income over the remainder of the project (bottom). The median-case
NPV of the project is $236.3 million.

Winter 2003/2004

4. Bailey W, Cout B, Lamb F, Simpson G and Rose P:

Taking a Calculated Risk, Oileld Review 12, no. 3
(Autumn 2000): 2035.
5. Trigeorgis L: Real Options: A Primer, in Alleman J
and Noam E (eds): The New Investment Theory of Real
Options and Its Implications for Telecommunications
Economics. Boston, Massachusetts, USA: Kluwer
(1999): 3.

Real-options analysis draws heavily on the

theory of financial options.6 Financial options
are derivatives; they derive their value from
other underlying assets, such as shares of a company stock. A financial option is the right, but
not the obligation, to buy or sell a share on (or
sometimes before) a particular date at a particular price. The price at which a share can be
bought or sold, if the option holder chooses to
exercise the right, is known as the exercise, or
strike, price. The two main kinds of options are a
call optionto buy the share at the exercise
priceand a put optionto sell the share at
the exercise price (below right).
If the share price exceeds the exercise price,
a call option is said to be in the money. If it
exceeds it by a large amount, it is termed deep
in the money. If the share price fails to reach
the exercise price, the option is said to be out of
the money. An investor would not exercise an
out-of-the-money option since doing so would
cost more than the market price for the share.
This is where the caveat that the option holder
has the right but not the obligation to buy the
share at the exercise price is important. The
investor allows the option to lapse if exercising
it would not be benecial.
Financial options can be further subdivided
into many types.7 Two of the most common are
European and American options. A European
option can be exercised only on the expiration
date specified in the option contract. An
American option may be exercised at any time
up to and including the expiration date.
Options have two important features. First,
they give an option holder the possibility of a
large upside gain while protecting from downside risk. Second, they are more valuable when
uncertainty and risks are higher.
Financial and Real Options
Real-options valuation applies the thinking
behind nancial options to evaluate physical, or
real, assets. By analogy with a nancial option, a
real option is the right, but not the obligation, to
take an action affecting a real physical asset at a
predetermined cost for a predetermined period
of timethe life of the option.8 While real and
financial options have many similarities, the
analogy is not exact.

ROV allows managers to evaluate real

options to add value to their firms, by giving
managers a tool to recognize and act upon
opportunities to amplify gain or to mitigate loss.9
While many managers are not accustomed to
evaluating real options, they are familiar with
the concept of project intangibles. ROV gives
managers a tool to move some of those intangibles into a realm where they can be dealt with in
a tangible and coherent fashion.
Petroleum developments and mining operations were among the first examples used by
ROV pioneers to demonstrate the parallels
between real and nancial options (see How Oil
Companies Use Real-Options Valuation, next
page).10 The exploration, development and production stages of an oileld project can be seen
as a series of linked options.11
At the exploration stage, the company has
the option to spend money on exploration and,
in return, receive prospective oil and gas
resources. This is like a stock option, which
gives the holder the right, but not the obligation,
to pay the exercise price and receive the stock.

Money spent on seismic surveys and exploration

drilling is analogous to the exercise price; the
resources are analogous to the stock. An exploration option expires the day the lease terminates.
Once the company has exercised its option to
explore, it is in a position to decide whether to
exercise a second option, the option to develop
the eld. This gives the company the right, but
not the obligation, to develop the resources at
any time up to the relinquishment date of the
lease for an amount of money given by the cost
of development. If the company exercises the
development option, it obtains hydrocarbon
resources that are ready to be produced.
The nal option is the option to produce. The
company now has the right, but not the obligation, to spend money on extracting the oil and gas
from the ground and sending it to market. It will
do so only if a number of uncertainties are
resolved, most notably that the oil price is likely
to reach a level that makes production protable.
This series of options is called a sequential
or compound option because each option
depends on the earlier exercise of another one.12

Call optionthe right, but not the obligation, to buy shares at the exercise price within
a given time period.
Put optionthe right, but not the obligation, to sell shares at the exercise price within a
given time period.
Widgets, Inc., has a moderately volatile share price with a current price of $100. For a
small fee, an investor may buy a call option with an exercise price of $110. If the share
price subsequently rises to $120, the option holder would exercise the option to buy the
shares for the agreed exercise price of $110 and sell them on the open market for $120,
making a profit of $10 per share less the option-purchase fee.
Alternatively, if the investor has a put option with an exercise price of $90 and shares of
Widgets, Inc. fall below $90, it will benefit the option holder to buy shares from the open
market at the lower price and exercise the option to sell them at $90. Both examples
ignore the usual transaction fees paid to a broker.

> Call and put options.

6. Bishop M: Pocket Economist. London, England: Prole

Books in association with The Economist Newspaper
(2000): 197.
7. Wilmott P: Paul Wilmott on Quantitative Finance,
vol 1. New York, New York, USA: John Wiley & Sons
(2000): 217.
8. An option may be attached to a real asset or to cash
ows associated with that asset. Stewart Myers rst
coined the term real options in 1985. For more information: Copeland T and Antikarov V: Real Options: A
Practitioners Guide. New York, New York, USA: Texere
(2001): 5.

9. Brealey R and Myers S: Principles of Corporate Finance,

6th Edition. Boston, Massachusetts, USA: Irwin/
McGraw-Hill (2000): 619.
10. Paddock J, Siegel R and Smith J: Option Valuation of
Claims on Real Assets: The Case of Offshore Petroleum
Leases, The Quarterly Journal of Economics 103, no. 3
(August 1988): 479485.
11. This simple series of linked options ignores any
contractual obligations to drill or develop that may
accompany a lease.
12. Copeland and Antikarov, reference 8: 1213.

Oileld Review

How Oil Companies Use Real-Options Valuation

Companies as diverse as BP, ChevronTexaco,

Statoil, Anadarko and El Paso have shown an
interest in real-options valuation (ROV). They
usually regard it as complementary to techniques like discounted cash ow (DCF) and
decision-tree analysis rather than as a standalone method of valuation.
In the mid-1990s, the executive management of Texaco (now ChevronTexaco) was
split over what to do with a signicant leaseholding in a developing country. The lease
included several existing oil discoveries and
many other substantial undeveloped discoveries. It was at an early stage of exploitation.1
Part of the management team wanted to sell
the asset, using the proceeds for more capitalefcient projects, while others on the team
felt it could lead to other lucrative follow-up
opportunities and the development of valuable relationships in the region.
The company management used ROV to
decide which action would be better for the
company. Results from the ROV substantiated
parts of both viewpoints. Even after key
options values had been included, the ROV
indicated the asset was far less valuable than
suggested by DCF. However, there was sufcient value to convince Texaco to retain the
asset until some of the uncertainties were
resolved, but to be prepared to sell if the price
was right. Moreover, ROV enabled a major
restructuring of the base plan. Texaco believed
that ROV helped its executives reach a better
strategic understanding of its holding.2
A recent analysis of a transaction that took
place in the early 1990s involving Amoco
(now BP) and independent oil and gas company Apache Corporation showed how
real-options analysis can disclose value that is
not apparent when using DCF analysis alone.3
In 1991, after a strategic review, Amoco
decided to dispose of some marginal oil and
gas properties in the United States. It formed
a new, separate company, MW Petroleum

Winter 2003/2004

Corporation, to hold its interests in 9500 wells

spread across more than 300 elds. Apache
indicated interest in obtaining the properties,
but Iraqs invasion of Kuwait in the spring of
that year had pushed oil prices to historic
heights while increasing price uncertainty.
Amoco and Apache agreed on most of the
provisions for the MW Petroleum transaction,
but disagreed on oil-price projections. The gap
was about 10 percent. The two companies
found common ground by agreeing to share
the risk of future oil-price movements. Amoco
gave Apache a guarantee that if oil prices fell
below an agreed price-support level in the
rst two years after the sale, Amoco would
make compensating payments to Apache. For
its part, Apache would pay Amoco if oil or gas
prices exceeded a designated price-sharing
level. The MW Petroleum portfolio included
121 million barrels of oil equivalent (BOE)
[19.2 million m3] of proven oil and gas
reserves, plus 143 million BOE [22.7 million
m3] of probable and possible reserves.
This transaction was reexamined by independent analysts in 2002. They compared a
deterministic DCF valuation of MW Petroleum
assets with a real-options valuation. The DCF
value of $359.7 million was $80 million less
than the ROV result of $440.4 million, indicating additional value in the assets not included
in the DCF analysis.4 In comparison, the purchase price agreed on by Amoco and Apache
was $515 million plus 2 million shares of
stock. Both methods gave values short of the
actual price, but the ROV valuation was much
closer than the DCF one.
In a third example, Anadarko, a Houstonbased independent, is an enthusiast for ROV.5
A recent ROV analysis by the company examined the impact of deferring a project until
new technologies became available.6
Anadarko had a deepwater development
opportunity that the company approached in
two stages. At the end of the rst, exploration

stage, uncertainties about the amount of oil

and gas in place had been resolved. In the
development phase, the operator could decide
to develop the eld using conventional means
or wait and develop the eld using new subsea
completion technology that at that time was
still at the research and development stage.
Conventional analysis neglecting the value
of exibility showed that development of the
eld using current technology would yield a
value of $4 million. Including the exibility
associated with being able to wait until new
technology was availableusing a deferral
option and waiting until the new technology
was readyincreased the value to $50 million.
1. Faiz S: Real-Options Application: From Successes in
Asset Valuation to Challenges for an Enterprise Wide
Approach, paper SPE 68243, Journal of Petroleum
Technology 53, no. 1 (January 2001): 4247, 74. This
paper was revised for publication from paper SPE
62964, originally presented at the SPE Annual Technical Conference and Exhibition, Dallas, Texas, USA,
October 14, 2000.
2. Faiz, reference 1.
3. Chorn L and Sharma A: Project Valuation: Progressing
from Certainty through Passive Uncertainty to Active
Project Management, paper SPE 77585, presented at
the SPE Annual Technical Conference and Exhibition,
San Antonio, Texas, USA, September 29October 2,
2002.
4. Tufano P: How Financial Engineering Can Advance
Corporate Strategy, Harvard Business Review 74,
no. 1 (JanuaryFebruary 1996): 143144.
5. In its 2001 annual report, Anadarko says that it seeks
to maximize enterprise value by maintaining a strong
balance sheet and applying option theory to assist
investment decision-making.
6. Rutherford SR: Deep Water Real Options Valuation:
Waiting for Technology, paper SPE 77584, presented
at the SPE Annual Technical Conference and Exhibition, San Antonio, Texas, USA, September 29October
2, 2002.

The extraction option is contingent on exercising the development option, which is contingent
on exercising the exploration option. At each
stage, a company obtains information to determine whether the project should be taken to the
next stage.
Comparing Financial- and
Real-Option Parameters
The variables used to value a nancial option can
be compared with their analogs in real options.
An option to develop oil reserves, for example, is
similar to a nancial call option (below).
The NPV of the developed hydrocarbon
reserveswhat they would be worth at todays
pricesis similar to the price of the underlying
stock, S, in a financial option. The NPV of the
expenditure needed to develop the reserves is
like a financial options exercise price, X. The
time left on an exploration and production
(E&P) lease is equivalent to the time to expiration of a nancial option, T. The risk-free rate of
return, rf the rate of return on a guaranteed
asset, such as a government bondis identical
for both nancial and real options. The volatility
of cash flows from an E&P project, including
hydrocarbon price uncertainty, is analogous to
the volatility of stock prices, . Finally, profits
foregone because production has been delayed
are like the lost dividends in the financial
option, . As long as management holds an unexercised option to invest in a project, it foregoes
the money that would have flowed from it had
the project been producing revenue.
The analogies between real and financial
options are not exact. Trying to force real
options into a conventional financial-options
framework may result in misleading outcomes.
One key difference in the two options types is
that the exercise price of a financial option is

normally fixed. For a real option, this price is

associated with development costs, and may be
volatile, fluctuating with market conditions,
service company prices and rig availability. In the
E&P industry, volatility is usually a consolidated
value comprising the uncertainty involved in
many things, including oil prices and production
rates. Determining volatility in real options can
be difcult.
Another key difference between financial
and real options lies in uncertainties surrounding an options underlying asset. With a nancial
option the uncertainty is external. The option is
an arrangement between two outsiders
the option writer and the option purchaser
neither of whom can inuence the rate of return
on the companys shares.13 In contrast, a company that owns a real option can affect the
underlying assetfor example, by developing
new technologies for the assetand the actions
of competitorsfor example, by developing an
adjacent property rst, as described later in this
articlewhich in turn can affect the nature of
the uncertainty that the company faces.14
Black-Scholes Option Valuation
Real options often are valued using financialoption pricing techniques. However, real-option
valuation can be extremely complex, so any
financial-option technique can provide only a
rough valuation. Two approaches are discussed
in this article: the Black-Scholes formula (a
closed-form solution) and binomial lattices.
Early attempts to use DCF to value options
foundered on the appropriate discount rate to
use and in calculating the probability distribution of returns from an option. An option is
generally riskier than the underlying stock but
nobody knows by how much.15

Financial and Real Options Compared

Financial call option

Variable

Real option to develop hydrocarbon reserves

Stock price

Net present value of developed hydrocarbon reserves

Exercise price

Present value of expenditure to develop reserves

Time to expiration

For example, time remaining on lease, time to first oil or gas

Risk-free interest rate

rf

Risk-free interest rate

Volatility of stock price

Volatility of cash flows from hydrocarbon reserves

Dividends foregone

Revenue or profits foregone

> Comparison of nancial and real options. The variables of a nancial call option can be
related to similar variables for a real option to develop oil reserves.

10

The insight of Fischer Black, Myron Scholes

and Robert Merton, who derived the BlackScholes-Merton formulamore commonly
referred to as Black-Scholeswas that options
could be priced using the arbitrage principle
with a portfolio that is constructed to be riskfree, overcoming the need to estimate
distributions of returns at all.16 They showed that
it was possible to establish the value of an
option by constructing a replicating portfolio,
which consists of a number of shares in the
underlying asset and a number of risk-free
bonds. The portfolio is constructed in such a way
that its cash ows exactly replicate those of the
option. Prices of bonds and of underlying shares
are directly observable in the nancial market,
so the value of the replicating portfolio is known.
If the option were sold for a price that is different from that of the replicating portfolio, there
would be two identical assetsthe option and
the replicating portfolioselling for different
prices at the same time. Any investor would then
use the strategy of arbitrage, buying the cheaper
of the two and selling the more expensive to
prot from the unequal prices.
The existence of the replicating portfolio
implies that there is a combination of the option
and the underlying asset that is risk-free. In
effect, the risk-free rate is used as the discount
rate during the option-pricing calculation and is
usually taken to be the interest rate on a government-guaranteed nancial instrument like a US
Treasury Bond.17
The Black-Scholes formula has fairly limited
applicability. The formula is a closed-form solution to a more general expressionthe
Black-Scholes partial differential equation
for the case of European puts and calls, which
can be exercised only on their maturity date.
Most real options are not analogs of European
options. However, the Black-Scholes partial
differential equation itself has far wider
applicability. With appropriate boundary
conditions, this partial differential equation can
be solvedusually numericallyto evaluate
many types of options, such as American and
compound options.
A numerical method using binomial lattices
is applicable across a wide range of options.
Since this process of valuation can be visualized
in a diagram, lattices are comparatively easy to
understand, although actual problems typically
are more complex than the simple lattices
shown in this article.

Oileld Review

5
Probability distribution of
future assets

S0u5
S0u4

S0u3
S0u3d1

S0u2
S0u2d1

S0u2d2

S0u1d1
S0d

S0u3d2

1 2

S0u d

S0d2

S0u2d3

S0u1d3
S0d3

u = exp( T )
d= 1
u

Large Lattice

S0u1d4

Price

S0u1
S0

S0u4d1

S0d4
S0d5

Probability

> Construction of a lattice of the underlying asset. The deterministic value for the asset today, such as a stock price, goes into the
left-most lattice node (left). In the rst time step, this value can increase by a multiplicative factor, u, which is based on the volatility,
, and length of the time step, T, or it can decrease by the inverse of that factor, d. Each node in subsequent time steps can similarly
increase or decrease, resulting in an expanding lattice. Results from a ve-step lattice are coarse. As the number of steps increases,
T becomes smaller and the resolution increases as the lattice becomes larger. A probability distribution of future assets (green
curve) can be obtained from the values in the right-hand column of a lattice with thousands of steps (right). The assumptions
governing the denition of u and d factors always give rise to a log-normal distribution of asset value at expirationthis is a basic
assumption of the Black-Scholes model.

Binomial-Lattice Option Valuation

Binomial lattices allow analysts to value both
European and American-type options. 18 This
section describes how to construct a lattice for a
simple European call option.
A lattice is a way to show how an assets
value changes over time, given that the asset has
a particular volatility. A binomial lattice has only
two possible movements in each time stepup
or down. It looks like a fan laid on its side. ROV
uses two lattices, the lattice of the underlying
asset and the valuation lattice.
Lattice of the underlying assetThe underlying asset pricing lattice, also known simply as
the lattice of the underlying, is read from left to
right and indicates how possible future asset
values could evolve. The value of the left-most
node is the NPV of the underlying asset, as calculated from the DCF model. In each time
interval, the value of the asset increases by a
multiplicative factor u (greater than 1), or

Winter 2003/2004

decreases by a multiplicative factor d (between

0 and 1), represented as a step up or a step
down the lattice (above). The factors u and d,
which determine the upward and downward
movements at each node, are functions of the
volatility of the underlying asset and the length
of time between the periods under consideration. The right-hand nodes of the lattice
represent the distribution of possible future
asset values.
The most difficult issue in constructing the
lattice of the underlying asset is estimating
volatility. This value must reect the uncertainties, both economic and technical, in the value
of the underlying asset, and the way in which
these uncertainties evolve over time.19 Methods
for estimating volatility are nontrivial, and a
discussion of these methods is beyond the scope
of this article.

13. The case of company executives who are given share

options as an incentive to improve company value is
an exception.
14. Copeland and Antikarov, reference 8: 111112.
15. Ross S and Jaffe J: Corporate Finance. Boston,
Massachusetts, USA: Irwin (1990): 576.
16. The Black-Scholes formula estimates the value of a call
option, C:
C = S * e T * {N(d 1)} Xe rf T * {N(d 2)},

where d 1 = {ln(S/X) + (rf - + 2/2) T}/ ( * T),

d 2 = d 1 - * T,
and where N(d) = cumulative normal distribution function, ln is the natural logarithm and other terms are
dened in the text.
17. Rogers J: Strategy, Value and RiskThe Real Options
Approach. Basingstoke, England: Palgrave (2002): 61.
18. In a European option, uncertainty is assumed to be fully
resolved at expiration. However, valuation of Americantype options can be more complex and caution is
required. An American option can be exercised at any
time prior to expiration, but that does not mean that all
uncertainty has been resolved at the time the decision is
made. New information about project uncertainties is
likely to be streaming in all the time, so the decision is
based on incomplete information. Unless all pertinent
uncertainty has been resolved, it might be prudent to
wait until the last moment to decide on the option.
19. Some ROV specialists argue that it is better to keep
technical and market uncertainties separate, especially
when managerial decision-making is tied to the resolution
of technical uncertainty.

11

5
Maximum (SX, 0)

$80
$67.66
C

Excercise cost
X = $100
Stock price, S,
at expiration

A
$50

$150

$20

$120

$0

$90

$0

$60

$0

$30

Option
Value

p=

exp(rf*T )-d
u-d

> Construction of a valuation lattice. Nodes in a valuation lattice are constructed from right to left.
The asset value, such as a stock price, S, at expiration is taken from the lattice of the underlying
asset. The exercise cost, X, is known in advance. The nodes in Column 5 contain the difference
between stock and exercise price, unless that difference is negative, in which case the node contains
zero. The value in the node labelled C comes from the two adjacent Column 5 nodes, A and B, and
uses the risk-neutral probability, p, as shown in the formula (bottom left). Remaining nodes and columns
are constructed similarly, from right to left. The single node on the left contains the value of the option.

In summary, the lattice of the underlying

illustrates the possible paths that an underlying
asset valuelike a stocks price, and similarly
designated as Swill take in time, given that it
has a certain volatility.
Valuation latticeThe valuation lattice has
exactly the same number of nodes and branches
as the lattice of the underlying asset (above).
Analysts work backward from the values in the
terminal nodes at the right side to the left side of
the lattice. The value placed in each terminal
node is the maximum of zero and the difference
between value S and exercise price X, MAX(S X,
0). Disallowing negative values reflects the
holders right to refuse to exercise an option with
negative value.
From these starting values in the terminal
nodes, it is possible to work backwards through
the latticeusing a process called backward

Salvage an Investment

$180

C = [ p*A+(1-p)*B]*exp (-rf*T )

Synthetic-Reservoir Development Guarantee

inductionto obtain an option value at the farthest left node of the lattice. Backward
induction relies on a factor p, the risk-neutral
probability of a movement in the price of the
underlying asset. This is the probability that
would prevail in a world in which investors were
indifferent to risk. Applying this to each pair of
vertically adjacent nodes in the lattice provides
the real-option value at the farthest left node of
the lattice.
Binomial lattices are often referred to as
binomial trees. However, the two methods
operate differently. Trees require an analyst to
specify probabilities and appropriate discount
rates at each node, which can be highly subjective. ROV, embodying ideas such as risk-neutral
probability for financial uncertainty and riskfree rate of interest, is less subjective.20

Oberon, operator of the ctitious Charon

eld, has reservations about the eventual
economic viability of the eld. To protect
itself from a negative result, the company
has entered into negotiations with Thalassa
Energy, which is eager to add Sargasso Sea
assets to its portfolio. Thalassa offers
Oberon, for an up-front premium of $45 million, a guarantee to take over the Charon
eld and reimburse Oberon all development
costs incurred up to the exercise date, if
Oberon chooses to exercise the option. The
salvage value at any time is assumed to be
the amount invested at that point. Oberon
performs a real-options valuation (ROV) to
determine whether the exibility to recoup
development expenses is worth the price
asked by Thalassa.
The ROV involves four steps: identifying
the underlying asset, determining its volatility, constructing the lattices and interpreting
option value.
Oberon identies the underlying asset as
Charons project NPV. This NPV exhibits a
log-normal probability distribution, so the
volatility of the underlying asset is based
on the logarithm of the future cash ows.
Monte Carlo simulation on the DCF model
indicates that the implied annual volatility
is 66.41%, including both private and public
uncertainties.
The engineers construct a lattice of the
underlying asset with 0.6-year time steps
using a ve-step binomial lattice (next page).
The asset value, S, or Oberons NPV for the
project without any exibility from salvage
potential, is $236.3 million (see Working Out
Net Present Value, page 6). The risk-free
rate for the three-year period under consideration is 5% per year. The valuation and
decision lattices are identical in form to that
of the lattice of the underlying asset.

20. Mun, reference 3: 242245.

12

Oileld Review

These lattices allow Oberon to interpret

option value. The added exibility provided
by the Thalassa contract increases Charons
NPV to $285.5 million. This is the value a
rational, frictionless, free market would,
given the same information, assign to the
project. It is $49.3 million more than the NPV
without exibilitysimply because of the
presence of the salvage option.
An offer to provide this exibility for $45
million should be accepted by Oberon management since it appears that Thalassa
underpriced the option by $4.3 million, the
difference between the option value and the
premium price. This apparent underpricing
indicates that Thalassa has a different perception of risk and uncertainty than Oberon.

Input Parameters

Lattice of the underlying asset

= 66.41%
T = 0.6
u = exp(T )
= exp(0.6641*0.6)
= 1.67265

2
1

4
1849.4

1105.7
661.0

395.2

236.3

= 0.59785

3
1105.7

661.0

395.2

1
d= 1 =
u
1.67265

141.3

395.2
236.3

236.3
141.3

exp(rf *T)-d
u-d
= exp(0.05*0.6)-0.59785
1.67265-0.59785

p=

84.4

141.3
84.4

50.5

50.5
30.2

= 0.40250

18.0

Salvage Value

> Real option for salvage. The lattice of the

underlying asset begins with the project net
present value in the left node and projects
potential future values to the right (top right).
The up and down multiplying parameters, u
and d, are calculated from the inputs of
volatility, , and the time step size, T (top
left). The salvage value is based on investment to date (middle left). The valuation and
decision lattice has the same form as the lattice of the underlying, but it is constructed
from right to left (middle right). The last column of the valuation lattice is constructed by
comparing the equivalent node in the lattice
of the underlying with the salvage value at
the nal time step (bottom right). If the salvage value is greater, that amount is entered
and the salvage decision is noted. Otherwise,
the value from the node in the lattice of the
underlying is used for the valuation-lattice
node, and the decision is to retain ownership. The value in the node in the next column
to the left comes from back-regression from
two adjacent nodes, as indicated by the
arrows. That value involves the risk-neutral
probability, p, the risk-free interest rate, rf,
and the time step size, T (bottom left).

3093.3

Period

Years

0.6

Valuation and decision lattice

Value,
million $
50.0

1.2

75.0

1.8

107.5

2.4

150.0

3.0

177.5

3
1105.7
2
668.1

1
420.6

4
1849.4

1105.7
retain
661.0

continue

407.4
continue

285.5
start

395.2
retain

257.3

275.3

continue

continue

209.1
continue

retain

continue

continue

continue

continue

5
3093.3

200.4

177.5
salvage

continue

175.2
continue

172.3

continue

167.2
continue

177.5
salvage

172.3

continue

177.5
salvage
Work from right to left
Salvage if < 177.5

Example: backward-induction
calculation

[
=

3093.3
1849.4

* p+

1105.7

3093.3

Retain ownership

3093.3

1105.7

Retain ownership

1105.7

395.2

Retain ownership

395.2

177.5

Salvage

141.3

177.5

Salvage

50.5

177.5

Salvage

18.0

1849.4

* (1-p)] * exp(- r f* T )
661.0

257.3

172.3

172.3

Valuation and decision lattice

Winter 2003/2004

Lattice of underlying

13

Types of Real Options

Analysts generally classify real options by the
type of flexibility they give the holder. 21 The
options may occur naturally, or may be built into
a project. Management can defer investment,
expand or contract a project, abandon for salvage or switch to another plan. Compound
options also can be created.22
Option to defer investmentAn opportunity
to invest at some point in the future may be
more valuable than an opportunity to invest
immediately. A deferral option gives an investor
the chance to wait until conditions become
more favorable, or to abandon a project if conditions deteriorate. An E&P lease, for example,
may enable an oil company to wait until present
uncertainties about oil and gas prices and about
development technology have been resolved.
The company would invest in exploration and
development only if oil price increased enough
to ensure that developed acreage on the lease
would be protable. If prices declined, the company would allow the lease to lapse or would sell
the remainder of the lease to another company.
The exercise price of the option is the money
required to develop the acreage.
Option to expand or contract a project
Once a project has been developed, management
may have the option to accelerate the production rate or change the scale of production. In
an oil or gas eld, there might be the option to
increase production by investing in an enhanced
oil recovery plan or by drilling satellite wells.
The original investment opportunity is defined
as the initial project plus a call option on a
future opportunity.
Option to abandon for salvageIf oil and
gas prices go into what seems likely to be a
prolonged decline, management may decide to
abandon the project and sell any accumulated
capital equipment in the open market. Alternatively, it may sell the project, or its share in the
project, to another company whose strategic
plans make the project more attractive (see Salvage an Investment, page 12). Selling for
salvage value would be similar to exercising an
American put option. If the value of the project
falls below its liquidation value, the company can
exercise its put option.
21. Rogers, reference 17: 49; and Trigeorgis, reference 5:
510.
22. A project with many embedded options can be difcult
to evaluate using the simple forms of the Black-Scholes
and lattice models presented in this article.

14

Option to switch to another planA switching option can provide a hedge against the
likelihood that another technology or project
will be more economic sometime in the future
(see Switch Option, page 16).
Sequential or compound optionsReal
options may lead to additional investment
opportunities when exercised. The process of
exploration, development and production
described earlier in this article was a sequential option.
This list of options is not exhaustive. Many
other types of options are available. El Paso Corporation, the largest pipeline company in North
America and a leading provider of natural gas
services, used a location spread optionrelying
on a difference in a price between different locationsto evaluate a new line of business. Various
other spread options are possible, for example
based on different prices at different times or at
different stages of commodity processing.
Real Options for LNG Transport
El Paso owns a liquefied natural gas (LNG)
terminal at Elba Island, Georgia, USA, one of
only four land-based terminals in the USA. The
company investigated purchasing transport
vessels and expanding into the LNG transport
business. Each tanker, outfitted specifically for
use in LNG transport with a regasication capability for downloading at offshore buoys called
energy-bridge buoys, costs several hundred million US dollars.
The essence of the problem facing the evaluation team was how to value shipping and
diversion exibility. The company had a variety of
potential LNG sources and destinations, and the
evaluation was intended to determine how many
tanker ships El Paso should purchase.
El Paso felt DCF was decient for this analysis. The LNG market and its related shipping
were relatively new ventures for El Paso, and the
company had no history for forecasting the revenues and costs required by DCF. Even if those
forecasts had been available, the DCF technique
does not have the exibility necessary to reect
the additional value of a price difference between
delivery locations that occurs only for a brief time
period. The team tried to model the simple case
of a xed source and destination using DCF, but
the model could not correctly value inbuilt
options allowing El Paso not to sell if the LNG
delivery price did not cover variable expenses.

The base case for this ROV involves transporting LNG from a terminal in Trinidad, West
Indies, to the companys Elba Island facility. The
LNG producer in Trinidad would pay for infrastructure costs to enable this base-case trade and
would in turn receive the netback gas price,
which is the gas price at Elba Island less the
cost of shipping and regasication and less the
margin paid to El Paso. For example, for the
analysis presented here this margin was
assumed to be $0.20/MMBtu [$0.19/million J].
The NPV of this business over 20 years was
$176.7 million.
The rst option evaluated included diversion
flexibilityadding a second destination terminal offshore New York, New York, USA. El Paso
evaluated both intrinsic and extrinsic values for
this option. The intrinsic value of this spread
option represents the difference in pricethe
basis spreadbetween the Georgia and New
York markets (next page). The extrinsic value
includes the effects of time and reflects the
probability that the basis spread will change
over the 20-year period of the analysis.
In this spread option, El Paso would buy
the LNG on the basis of the Elba Island price
and sell it at the New York price, when that
choice adds value. Otherwise, El Paso would sell
at Elba and receive no incremental value. With
an average basis spread of $0.62/MMBtu
[$0.59/million J], the total intrinsic value of this
spread option is $558.7 million. In this model,
El Paso would assume the costs for converting
the terminals and purchasing an additional ship
to effect this option. The net value of the option
after those expenses is $68.5 million. Including
the variability over time gives an additional
extrinsic value of $101.7 million.
The company then added in the value of having multiple choices of source and destination,
termed a rainbow option. The value of a rainbow
option increases with increased price volatility
at the individual locations, and it also increases
when the cross-correlations between prices are
low. With two additional destination options, offshore New York and Cove Point, Maryland, USA,
there is an additional value of $14.8 million,
even though the price correlations between
these pairs of locations are high. The rainbow
option value increases when there is more exibility in source and destination locations. In
certain scenarios with additional sources in the

Oileld Review

Middle East and Africa and additional destinations in Europe and North America, El Paso
found the rainbow option added more than $100
million to the value of each ship.
The evaluation team provided a caveat to the
company. Spread options tend to overestimate
available exibility, because contractual obligations would have to be maintained. In addition,
the effects of price shifts caused by any reduction in supply were not included in the analysis.
Although real-options analysis indicated a
positive value to a business model based on LNG
imports to the USA and to diversion exibility as
a value-maximizing technique for shipping, El
Paso made a strategic business decision not to
enter this market.

Land-based terminal
Offshore transfer buoy
Base-case trade route
Spread-option trade routes

USA

New York City

Cove Point
Elba Island

TRINIDAD

Alternatives and Options

In the English language the word option may be
used in two technically different senses. In ROV
the term option (or real option) is used to
denote a decision that may be deferred to some
time in the future, and that is accompanied by
some uncertainty that can be resolved. On the
other hand, in common parlance, an option can
simply be an operational alternative, which is a
decision that is to be made today and for which
there is no future recourse.
For example, a company may decide to drill a
well in a certain location. If the well is dry, then
the company has lost the cost of drilling. The
well location was an operational alternative, a
decision that had to be made there and then.
However, if there were another party guaranteeing some minimum return on the well, the
company drilling the well would have a real
option, because it could decide in the future
whether to call on that guarantee, thereby minimizing any downside risk and maximizing any
upside potential.
A project containing an option is always
worth more than one with just a corresponding
alternative. This is because deferral allows an
owner to eliminate unfavorable outcomes while
retaining favorable ones. This is often referred
to as optionality. A project having only a set of
alternatives has no such cushion. The decision,
which must be made today, is effectively irreversible. The estimated NPV must average over
all outcomes, both favorable and unfavorable.
Both options and alternatives can be
computed using standard lattice-type methodologies (see True Option and an Alternative
Valued under Uncertainty, page 18). Alterna-

Winter 2003/2004

0
0

1000
500

2000
1000

1500

3000 km
2000 miles

> Liquied natural gas (LNG) transport routes in a spread option. El Paso
Corporation evaluated the LNG transport business using a base case between
Trinidad, West Indies, and its terminal at Elba Island, Georgia, USA. The
company considered purchasing transport ships with regasication
capabilities to give it the capability to transport gas to other locations, such
as Cove Point, Maryland, USA, or New York, New York, USA. This rainbow
option increased the value of the business opportunity.

tives may often be evaluated using simpler methods that automatically average out the
possibilities. For example, a forward contract,
which obligates the holder of the contract to buy
or sell an asset for a predetermined price at a
predetermined time in the future, may be valued
simply, without the volatility assumption that is
required in the Black-Scholes or lattice valuation of a European option.
Within the class of options there are many distinctions. One is the distinction between nancial
and real options that has been discussed. Another
is that between options that are purely internalresiding solely within the company
itselfand ones in which an outside party provides flexibility for some agreed up-front
payment. Many real options possess just an internal character, while nancial derivatives normally
exist in the presence of a contracted external
party. Fortunately, all these option types can be
computed using the same techniques, most
notably standard lattice-type methodologies.

Real-World Complications
A real-options methodology attempts to model
behaviors of real properties. However, the many
possibilities created by human ingenuity limit
any such modeling. Actual situations typically
have many embedded options, making any analysis complicated. The few examples discussed in
this section illustrate a few types of complications that may have to be dealt with in using
real options.
The holder of a financial option is guaranteed that the option may be held until the
expiration date and, apart from general market
movement, its value cannot be undermined by
the actions of other individuals. In most real
options, there is no such guarantee.
Two oil companies might hold identical
leases on adjoining blocks. In effect, they would
both have identical options to spend money on
exploration and receive undeveloped resources
in return.
(continued on page 18)

15

Synthetic-Reservoir Surface-Separator Decision

Switch Option

16

Case 50

Case 60

Throughput, million scf/D

50

60

Volatility

66.41%

71.28%

NPV, million $

236.27

228.99

> Comparison of volatility and net present value (NPV) for two surface
separator cases in the synthetic Charon example.

4.0

Switching option value, million $

At this time, the design criteria for the ctitious

Charon eld project have been established
and a three-year development phase is about
to begin. A critical technical issue is the gasthroughput capacity of a surface separator.
Economic analysis suggests a maximum
separator capacity of 50 million scf/D
[1.4 million m3/d]. A facilities contractor,
Proteus Fabrication Inc., has been commissioned to design, fabricate and install it.
Although a 50 million scf/D throughput
designtermed Case 50is deemed adequate, an upside production potential of an
extra 10 million scf/D [286,000 m3/d] is possible. A 60 million scf/D [1.7 million m3/d]
separatorCase 60would be more expensive, and Charon might not have enough
production potential to utilize it fully. The company would like to delay the design-capacity
decision for as long as possible.
Proteus can implement this design change
within the rst year of construction, but cannot make changes after the rst year. The
implementation cost to switch from a smaller
to a larger design, set at $17.72 million, is
equivalent to an option exercise price, X.
In addition to this exercise price, Proteus
insists on an additional up-front nonrefundable payment. This up-front payment
accommodates changing the initial design to
allow for later expansion and covers a possible
overrun on the agreed exercise price. Oberon
initiates a simple switching-option study to
determine what the initial payment to Proteus
should be.
Case 50 and Case 60 are independent cases
with different cash-ow NPVs and volatilities.
ECLIPSE modeling establishes the static NPV,
excluding switching costs, and associated
volatility of the two cases (top right).
Values for Case 60 are obtained in manner
similar to Case 50, the base case used in the
previous examples.
A switching option can be analyzed by constructing two lattices, one for each of the two
underlying assets (next page). The simplest
case assumes these two lattices are completely

3.5
3.0
2.5
Switching option value for
200-step lattice is 1.653

2.0

200-step
lattice

1.5
Switching option value for
five-step lattice is 1.305

1.0
0.5
0.0

17.72
10
15
Switching cost, million $

Five-step
lattice

20

25

> Effect of lattice size on option valuation. The coarse, ve-step lattice has
been used for illustrative purposes only, yielding a less accurate option value
than the more rened 200-step lattice. At the $17.72 million switching cost,
that ner lattice indicates the option value is $1.653 million.

correlatedeach step up or down in one

underlying lattice corresponds with the same
step in the other. In this way, nodes in the two
cases can be directly compared to construct a
valuation lattice for the upgrade.
The valuation lattice is obtained by subtracting the upgrade cost, $17.72 million, from

the last column of the Case 60 lattice, comparing this to the last column of the Case 50
lattice, and selecting the larger value at each
node. This reects Oberons right to choose
the better of the two cases in any eventuality.
The option value is then computed by backward induction using the Case 50 risk-neutral
probabilities, p.

Oileld Review

0
(Now)

1
(0.2 year)

2
(0.4 year)

3
(0.6 year)

4
(0.8 year)

5
(1.0 year)

1,043.10

Case 50 Underlying Lattice

775.07
575.91

575.91

427.93
317.97
236.27

427.93

317.97

175.56

317.97

236.27

236.27
175.56

130.45

175.56

130.45
96.93

96.93

72.02
53.52
1,127.26

Case 60 Underlying Lattice

819.57
595.86

595.86

433.21
314.96
228.99

433.21

314.96

166.48

314.96

228.99

228.99
166.48

121.04

166.48

< Lattices for synthetic Charon surface separator cases. Case 50 and
Case 60 have different lattices of
the underlying asset, but the lattice
structure is the same, allowing a
node-by-node comparison between
them (top). Nodes in Case 60 are
greyed out, except for the nal column, to indicate that no decision is
made until the end of one year. The
last column of the valuation lattice
is constructed by comparing the
value of Case 50 to equivalent node
value of Case 60 minus the implementation cost of $17.72 million
(bottom). This also provides the
decision to keep Case 50 or switch
to Case 60. The other nodes of the
valuation lattice are constructed by
back-regression, using the risk-neutral probabilities from Case 50, the
base case. The value of the project
with the switch option is
$237.57 million.

121.04
88.00

88.00

63.98
46.52
0
(Now)

1
(0.2 year)

2
(0.4 year)

3
(0.6 year)

4
(0.8 year)

5
(1.0 year)
MAX(Case 50,
Case 60-17.72)

Decision and Valuation Lattice

1,109.64

589.77
continue

434.24
320.85
237.57
Start

continue

175.64
continue

continue

318.40

805.44

Switch to Case 60

428.91

Switch to Case 60

236.27

Keep Case 50

130.45
continue

Keep Case 50

72.02

Keep Case 50

continue

continue

317.97

continue

236.46
continue

130.45
continue

175.56
continue

96.93

continue

175.56
96.93

continue
continue

Lattice node values, million $

Changing the cost to upgrade affects the

value of the upgrade option (previous page,
bottom). In this case, the ve-step lattice is
too coarse, resulting in an unrealistic kink in
the result. A ner 200-step lattice resolves the
kink and indicates that it would be appropriate for Oberon to pay Proteus a $1.653 million

Winter 2003/2004

578.14

53.52
Keep Case 50

premium for the option to switch in the rst

year at the stated upgrade price. In an actual
case, nal decisions would be based on ner
lattices than the ve-step lattices used in
these illustrations.
With this arrangement Oberon gains the
ability to demand a design change resulting in

accelerated cash and throughput from reservoir production, if conditions warrant. Proteus
gets an up-front premium of $1.653 million
and a locked-in payment of $17.72 million if
Oberon chooses to upgrade the facility. Proteus has a cash incentive to explore more
cost-effective and efcient design solutions
for the upgrade.

17

Actions of one company can affect the business results of the other. Most governments now
insist on unitization, an arrangement that
requires parties on both sides to jointly develop
reserves located on more than one lease or auctioned tract. Each party pays a share of the costs
and receives a proportionate amount of the
revenues. In a sense, when governments do
this, they are ensuring the purity of the real
options involved.
It is possible to conceive of circumstances
such as constructing a pipeline to an area where
only one is neededin which if Company A took
up the option to invest, it would preempt Company B from doing so, rendering Bs option
worthless, or certainly worth less. The realoptions approach attaches a positive value to
delay, but in instances such as this one, delay
can undermine value.23
Finally, the parameters used in real-options
calculations can be difcult to determine. There
is no simple road map to computing volatility
and there is still debate over the correct
approach to nding this value. Obtaining an estimate often entails performing a Monte Carlo
simulation on the existing DCF model and examining the standard deviation of the natural
logarithm of the cash-flow returns. The cost of
deferment requires knowledge of the profits
foregone during the period prior to exercising an
option, but the value of the missed cash flows
may be poorly known.
Financial-option pricing relies on an assumption that the underlying asset can be traded,
meaning there is a large liquid market for the
asset. This is often not true for real options. Factors affecting the prices of nancial options are
also easier to determinethat is, more transparentthan those for real options.
The simplified discussion in this article is
intended only to introduce the concept of real
options. It uses simple examples that correlate
with nancial options. Use for an actual case is
typically more complicated, with an expanding
array of possible options available, as demonstrated in the El Paso LNG case. Ultimately, real
options are not financial options. The techniques of financial options provide a basis for
23. For a discussion of such investment behavior: Weeds H:
Strategic Delay in a Real Options Model of R&D Competition, Review of Economic Studies 69 (2002): 729747.
24. Trigeorgis, reference 5: 3.

18

Synthetic-Reservoir Intervention

True Option and an Alternative Valued under Uncertainty

The ctitious Charon eld, operated by

Oberon Oil, has been producing for a few
years. Production is declining and water cut
is increasing in some of the wells. Engineers
propose a production-enhancement operation
involving water shutoff on one of the wells.
Their analysis has determined what
incremental production is likely to be
from this intervention.
With DCF, the expected NPV of the incremental cash ow, which is the option asset
value S, is $1,280,000, excluding the actual
intervention cost. The cost of the intervention,
or exercise price X, is $750,000. The resulting
NPV is $530,000.
Analysts estimate a 40% volatility of the
incremental cash ow subject to oil price and
technical uncertainties, and use a 5% risk-free
rate of interest.
The service provider offers Oberon two
choices:
1. Pay the $750,000 job cost up-front and
accept whatever may happen.
2. Pay an additional up-front premium to the
service provider for the right to claim back
some or all the job cost if the incremental
net revenue generated from this intervention is negative after one year.
The second choice provides Oberon with
protection from downside risk, up to the cost
of the job, but the intervention would still
have an unlimited upside potential. For example, if after one year the net incremental cash
ow (after job cost) were negative $100,000,
then the service provider would reimburse
Oberon that sum. Oberons net incremental
cash ow from this operation would be zero.
In effect, this option offered by the service
provider provides a cost-reimbursement guarantee for an agreed up-front premium. Oberon
wants to calculate what a reasonable value for
this up-front premium should be.
The rst choice is a pure operational alternativeto intervene or not to intervene. If
Oberon takes this choice, then any job cost is
sunk; the decision to spend money on the job is

irreversible. This arrangement is an alternative,

not an option in the sense discussed in this
article. A valuation lattice for this alternative
differs from an ROV lattice in that the righthand terminal nodes of the valuation lattice
contain the simple term, S-X, rather than the
conventional terms used in those nodes, that
is, the maximum of zero and S-XMAX(S-X,0)
(next page).
The difference between the alternative and
real-option lattices$8,198represents the
premium the service provider should theoretically demand in order to agree to a contracted
cost-reimbursement provision. It is small in
this case because there is a small likelihood
that the provision would be required and the
option would be exercised.
The NPV of $530,000 undervalues this project. Even with no reimbursement provision,
the value added to the asset from the intervention is $36,578 more than the NPV. This
additional value emerges solely because of the
presence of volatility in the underlying asset.
Adding the revenue reimbursement provision
increases this net value by $44,776 beyond the
NPV calculation.

Oileld Review

0
(Now)

1
(0.2 year)

2
(0.4 year)

3
(0.6 year)

4
(0.8 year)

Lattice of the underlying asset

5
(1.0 year)

3,130,796

evaluating real options, but an expert in ROV

should be consulted to assure the techniques
are properly applied.
These complications should not dissuade a
company from using real options. Valuation
experts can determine when ROV should be
used, and when other methods, such as decision
trees incorporating Monte Carlo simulation, are
more appropriate. Working with managers and
experts in other disciplines, valuation experts
can help place a value on the options inherent in
many projects.

2,617,977
2,189,157
1,830,577
1,530,731
1,280,000

1,530,731

1,530,731
1,280,000

1,280,000
1,070,338

2,189,157
1,830,577

1,070,338
895,019

1,070,338
895,019

748,416

748,416
625,827

523,317

Max(S-X, 0)

Valuation lattice with true option

2,380,796
1,875,439
1,439,157

1,454,008
1,102,742
810,248
574,776

1,088,039
795,582

365,671

780,731
537,463

552,378

334,604
198,119

320,338
153,291

73,335

0
0

The Real-Options Mindset

Actually recognizing options that are embedded
in a project takes practice. Managers often learn
to discern options simply by brainstorming with
one another about the project.
In many ways, having a real-options mindset
is as important as using the mathematics. Realoptions thinking emphasizes and values
management flexibility. It recognizes that in a
world characterized by change, uncertainty and
competitive interactions, management can be
active. It can alter and modify plans as new
information becomes available or as new possibilities arise.24 It can be reactive to changing
circumstances or proactiveintervening to take
advantage of possibilities that may improve the
value of the project. If management understands
that flexibility is valuable, it will look for that
flexibility in its projects and capitalize on it to
increase shareholder value.
MB, MAA

S-X

Valuation lattice with alternative

2,380,796
1,875,439
1,454,008
1,102,742
810,139
566,578

795,582

780,731
537,463

552,166
349,746

1,439,157

1,088,039

335,189
167,184

320,338
152,481

13,267

1,584
116,711

Lattice node values, $

226,683

> Comparison of an option and an alternative. The lattice method can be used to
value an alternative. Both use the same lattice of the underlying (top). For an
option, the right-hand column is the maximum value of zero and the difference
between the underlying value and the $750,000 implementation cost (middle).
The values for an alternative can be negative, because the function is simply the
difference between the value and the implementation cost (bottom). This leads to
an $8,198 difference in value between the option, valued at $574,776, and the
alternative, valued at $566,578.

Winter 2003/2004

19

An Anatomy of the Crude Oil Pricing

System

Bassam Fattouh1
WPM 40
January 2011

Bassam Fattouh is the Director of the Oil and Middle East Programme at the Oxford Institute for Energy Studies;
Research Fellow at St Antonys College, Oxford University; and Professor of Finance and Management at the
School of Oriental and African Studies, University of London. I would like to express my gratitude to Argus for
supplying me with much of the data that underlie this research. I would also like to thank Platts for providing me
with the data for Figure 21 and CME Group for providing me with the data for Figure 13. The paper has benefited
greatly from the helpful comments of Robert Mabro and Christopher Allsopp and many commentators who
preferred to remain anonymous but whose comments provided a major source of information for this study. The
paper also benefited from the comments received in seminars at the Department of Energy and Climate Change, UK,
ENI, Milan and Oxford Institute for Energy Studies, Oxford. Finally, I would like to thank those individuals who
have given their time for face-to-face and/or phone interviews and have been willing to share their views and
expertise. Any remaining errors are my own.

The contents of this paper are the authors sole responsibility. They do not
necessarily represent the views of the Oxford Institute for Energy Studies or any of its
members.

Copyright 2011
Oxford Institute for Energy Studies
(Registered Charity, No. 286084)

This publication may be reproduced in part for educational or non-profit purposes without special
permission from the copyright holder, provided acknowledgment of the source is made. No use of this
publication may be made for resale or for any other commercial purpose whatsoever without prior
permission in writing from the Oxford Institute for Energy Studies.

ISBN
978-1-907555-20-6

Contents
Summary Report ........................................................................................................................................... 6
1.

Introduction ......................................................................................................................................... 11

2.

Historical Background to the International Oil Pricing System .......................................................... 14

The Era of the Posted Price ..................................................................................................................... 14
The Pricing System Shaken but Not Broken .......................................................................................... 14
The Emergence of the OPEC Administered Pricing System .................................................................. 15
The Consolidation of the OPEC Administered Pricing System.............................................................. 16
The Genesis of the Crude Oil Market ..................................................................................................... 17
The Collapse of the OPEC Administered Pricing System ...................................................................... 18

3.

The Market-Related Oil Pricing System and Formulae Pricing ......................................................... 20

Spot Markets, Long-Term Contracts and Formula Pricing ..................................................................... 20
Benchmarks in Formulae Pricing............................................................................................................ 24

4.

Oil Price Reporting Agencies and the Price Discovery Process ......................................................... 30

5.

The Brent Market and Its Layers ........................................................................................................ 36

The Physical Base of North Sea .............................................................................................................. 37
The Layers and Financial Instruments of the Brent Market ................................................................... 39
Data Issues .......................................................................................................................................... 39
The Forward Brent .............................................................................................................................. 40
The Brent Futures Market ................................................................................................................... 43
The Exchange for Physicals ................................................................................................................ 44
The Dated Brent/BFOE....................................................................................................................... 45
The Contract for Differences (CFDs) ................................................................................................. 45
OTC Derivatives ................................................................................................................................. 48
The Process of Oil Price Identification in the Brent Market ................................................................... 50

6.

The US Benchmarks ........................................................................................................................... 52

The Physical Base for US Benchmarks .................................................................................................. 52
The Layers and Financial Instruments of WTI ....................................................................................... 55
The Price Discovery Process in the US Market ...................................................................................... 56
WTI: The Broken Benchmark? ............................................................................................................... 58

7.

The Dubai-Oman Market .................................................................................................................... 61

The Physical Base of Dubai and Oman .................................................................................................. 61
The Financial Layers of Dubai................................................................................................................ 62
3

The Price Discovery Process in the Dubai Market ................................................................................. 64

Oman and its Financial Layers: A New Benchmark in the Making?...................................................... 66
8.

Assessment and Evaluation................................................................................................................. 70

Physical Liquidity of Benchmarks .......................................................................................................... 70
Shifts in Global Oil Demand Dynamics and Benchmarks ...................................................................... 71
The Nature of Players and the Oil Price Formation Process ................................................................... 73
The Linkages between Physical Benchmarks and Financial Layers....................................................... 74
Adjustments in Price Differentials versus Price Levels .......................................................................... 74
Transparency and Accuracy of Information ........................................................................................... 76

9.

Conclusions ......................................................................................................................................... 78

References ................................................................................................................................................... 81

List of Figures
Figure 1: Price Differentials of Various Types of Saudi Arabias Crude Oil to Asia in $/Barrel .............. 21
Figure 2: Differentials of Term Prices between Saudi Arabia Light and Iran Light Destined to Asia (FOB)
(In US cents) ............................................................................................................................................... 23
Figure 3: Difference in Term Prices for Various Crude Oil Grades to the US Gulf (Delivered) and Asia
(FOB) .......................................................................................................................................................... 24
Figure 4: Price Differential between Dated Brent and BWAVE ($/Barrel) ............................................... 26
Figure 5: Price Differential between WTI and ASCI ($/Barrel) (ASCI Price=0) ....................................... 26
Figure 6: Brent Production by Company (cargoes per year), 2007 ............................................................ 37
Figure 7: Falling output of BFO ................................................................................................................. 38
Figure 8: Trading Volume and Number of Participants in the 21-Day BFOE Market ............................... 42
Figure 9: Average Daily Volume and Open Interest of ICE Brent Futures Contract ................................. 44
Figure 10: Pricing basis of Dated Brent Deals (1986-1991); Percentage of Total Deals ........................... 45
Figure 11: Reported Trade on North Sea CFDs (b/d) ................................................................................. 46
Figure 12: US PADDS ................................................................................................................................ 52
Figure 13: Monthly averages of volumes traded of the Light Sweet Crude Oil Futures Contract ............. 55
Figure 14:Liquidity at Different Segments of the Futures Curve (October 19, 2010) ................................ 56
Figure 15: Spot Market Traded Volumes (b/d) (April 2009 Trade Month) ................................................ 57
Figure 16: Spread between WTI 12-weeks Ahead and prompt WTI ($/Barrel) ......................................... 59
Figure 17: WTI-BRENT Price Differential ($/Barrel)................................................................................ 60
Figure 18: Dubai and Oman Crude Production Estimates (thousand barrels per day) ............................... 62
Figure 19: Spread Deals as a Percentage of Total Number of Dubai Deals ............................................... 63
Figure 20: Oman-Dubai Spread ($/Barrel) ................................................................................................. 64
Figure 21: Dubai Partials Jan 2008 - Nov 2010 .......................................................................................... 65
Figure 22: daily Volume of Traded DME Oman Crude Oil Futures Contract ........................................... 67
Figure 23: Volume and Open Interest of the October 2010 Futures Contracts (Traded During Month of
August)........................................................................................................................................................ 68
4

Figure 24: OECD and Non-OECD Oil Demand Dynamics........................................................................ 71

Figure 25: Change in Oil Trade Flow Dynamics ........................................................................................ 72
Figure 26: The North Sea Dated differential to Ice Brent during the French Strike ................................... 76

Summary Report
The view that crude oil has acquired the characteristics of financial assets such as stocks or bonds has
gained wide acceptance among many observers. However, the nature of financialisation and its
implications are not yet clear. Discussions and analyses of financialisation of oil markets have partly
been subsumed within analyses of the relation between finance and commodity indices which include
crude oil. The elements that have attracted most attention have been outcomes: correlations between
levels, returns, and volatility of commodity and financial indices. However, a full understanding of the
degree of interaction between oil and finance requires, in addition, an analysis of interactions, causations
and processes such as the investment and trading strategies of distinct types of financial participants; the
financing mechanisms and the degree of leverage supporting those strategies; the structure of oil
derivatives markets; and most importantly the mechanisms that link the financial and physical layers of
the oil market.
Unlike a pure financial asset, the crude oil market also has a physical dimension that should anchor
prices in oil market fundamentals: crude oil is consumed, stored and widely traded with millions of
barrels being bought and sold every day at prices agreed by transacting parties. Thus, in principle, prices
in the futures market through the process of arbitrage should eventually converge to the so-called spot
prices in the physical markets. The argument then goes that since physical trades are transacted at spot
prices, these prices should reflect existing supply-demand conditions.
In the oil market, however, the story is more complex. The current market fundamentals are never
known with certainty. The flow of data about oil market fundamentals is not instantaneous and is often
subject to major revisions which make the most recent available data highly unreliable. Furthermore,
though many oil prices are observed on screens and reported through a variety of channels, it is important
to explain what these different prices refer to. Thus, although the futures price often converges to a spot
price, one should aim to analyse the process of convergence and understand what the spot price in the
context of the oil market really means.
Unfortunately, little attention has been devoted to such issues and the processes of price discovery in oil
markets and the drivers of oil prices in the short-run remain under-researched. While this topic is linked to
the current debate on the role of speculation versus fundamentals in the determination of the oil price, it
goes beyond the existing debates which have recently dominated policy agendas. This report offers a
fresh and deeper perspective on the current debate by identifying the various layers relevant to the price
formation process and by examining and analysing the links between the financial and physical layers in
the oil market, which lie at the heart of the current international oil pricing system.
The adoption of the market-related pricing system by many oil exporters in 1986-1988 opened a new
chapter in the history of oil price formation. It represented a shift from a system in which prices were first
administered by the large multinational oil companies in the 1950s and 1960s and then by OPEC for the
period 1973-1988 to a system in which prices are set by markets. First adopted by the Mexican national
oil company PEMEX in 1986, the market-related pricing system received wide acceptance among most
oil-exporting countries. By 1988, it became and still is the main method for pricing crude oil in
international trade after a short experimentation with a products-related pricing system in the shape of the
netback pricing regime in the period 1986-1987. The oil market was ready for such a transition. The end
of the concession system and the waves of nationalisation which disrupted oil supplies to multinational oil
companies established the basis of arms-length deals and exchange outside the vertically and
horizontally integrated multinational companies. The emergence of many suppliers outside OPEC and
many buyers further increased the prevalence of such arms-length deals. This led to the development of a
complex structure of interlinked oil markets which consist of spot and also physical forwards, futures,
options and other derivative markets referred to as paper markets. Technological innovations which made
electronic trading possible revolutionised these markets by allowing 24-hour trading from any place in the
6

world. It also opened access to a wider set of market participants and allowed the development of a large
number of trading instruments both on regulated exchanges and over the counter.
Physical delivery of crude oil is organised either through the spot (cash) market or through long-term
contracts. The spot market is used by transacting parties to buy and sell crude oil not covered by long
term contractual arrangements and applies often to one-off transactions. Given the logistics of
transporting oil, spot cargoes for immediate delivery are rare. Instead, there is an important element of
forwardness in spot transactions. The parties can either agree on the price at the time of agreement, in
which case the sport transaction becomes closer to a forward contract. More often though, transacting
parties link the pricing of an oil cargo to the time of loading.
Long-term contracts are negotiated bilaterally between buyers and sellers for the delivery of a series of oil
shipments over a specified period of time, usually one or two years. They specify among other things, the
volumes of crude oil to be delivered, the delivery schedule, the actions to be taken in case of default, and
above all the method that should be used in calculating the price of an oil shipment. Price agreements are
usually concluded on the method of formula pricing which links the price of a cargo in long-term
contracts to a market (spot) price. Formula pricing has become the basis of the oil pricing system.
Formula pricing has two main advantages. Crude oil is not a homogenous commodity. There are various
types of internationally traded crude oil with different qualities and characteristics which have a bearing
on refining yields. Thus, different crudes fetch different prices. Given the large variety of crude oils, the
price of a particular type is usually set at a discount or at a premium to marker or reference prices, often
referred to as benchmarks. The differentials are adjusted periodically to reflect differences in the quality
of crudes as well as the relative demand and supply of the various types of crudes. Another advantage of
formula pricing is that it increases pricing flexibility. When there is a lag between the date at which a
cargo is bought and the date of arrival at its destination, there is a price risk. Transacting parties usually
share this risk through the pricing formula. Agreements are often made for the date of pricing to occur
around the delivery date.
At the heart of formulae pricing is the identification of the price of key physical benchmarks, such as
West Texas Intermediate (WTI), Dated Brent and Dubai-Oman. The benchmark crudes are a central
feature of the oil pricing system and are used by oil companies and traders to price cargoes under longterm contracts or in spot market transactions; by futures exchanges for the settlement of their financial
contracts; by banks and companies for the settlement of derivative instruments such as swap contracts;
and by governments for taxation purposes.
Few features of these physical benchmarks stand out. Markets with relatively low volumes of production
such as WTI, Brent, and Dubai set the price for markets with higher volumes of production elsewhere in
the world. Despite the high level of volumes of production in the Gulf, these markets remain illiquid:
there is limited spot trading in these markets, no forwards or swaps (apart from Dubai), and no liquid
futures market since crude export contracts include destination and resale restrictions which limit trading
options. While the volume of production is not a sufficient condition for the emergence of a benchmark, it
is a necessary condition for a benchmarks success. As markets become thinner and thinner, the price
discovery process becomes more difficult. Oil price reporting agencies cannot observe enough genuine
arms-length deals. Furthermore, in thin markets, the danger of squeezes and distortions increases and as a
result prices could then become less informative and more volatile thereby distorting consumption and
production decisions. So far the low and continuous decline in the physical base of existing benchmarks
has been counteracted by including additional crude streams in an assessed benchmark. This had the
effect of reducing the chance of squeezes as these alternative crudes could be used for delivery against the
contract. Although such short-term solutions have been successful in alleviating the problem of squeezes,
observers should not be distracted from some key questions: What are the conditions necessary for the
emergence of successful benchmarks in the most physically liquid market? Would a shift to assessing

price in these markets improve the price discovery process? Such key questions remain heavily underresearched in the energy literature and do not feature in the consumer-producer dialogue.
The emergence of the non-OECD as the main source of growth in global oil demand will only increase
the importance of such questions. One of the most important shifts in oil market dynamics in recent years
has been the shift in oil trade flows to Asia: this may have long-term implications on pricing benchmarks.
Questions are already being raised whether Dubai still constitutes an appropriate benchmark for pricing
crude oil exports to Asia given its thin physical base or whether new benchmarks are needed to reflect
more accurately the recent shift in trade flows and the rise in prominence of the Asian consumer.
Unlike the futures market where prices are observable in real time, the reported prices of physical
benchmarks are identified or assessed prices. Assessments are needed in opaque markets such as crude
oil where physical transactions concluded between parties cannot be directly observed by outsiders.
Assessments are also needed in illiquid markets where there are not enough representative deals or where
no transactions are concluded. These assessments are carried out by oil pricing reporting agencies
(PRAs), the two most important of which are Platts and Argus. While PRAs have been an integral part of
the oil pricing system, especially since the shift to the market-related pricing system in 1986, their role
has recently been attracting considerable attention. In the G20 summit in Korea in November 2010, the
G20 leaders called for a more detailed analysis on how the oil spot market prices are assessed by oil
price reporting agencies and how this affects the transparency and functioning of oil markets. In its latest
report in November 2010, IOSCO points that the core concern with respect to price reporting agencies is
the extent to which the reported data accurately reflects the cash market in question. PRAs do not only
act as a mirror to the trade. In their attempt to identify the price that reflects accurately the market value
of an oil barrel, PRAs enter into the decision-making territory which can influence market structure.
What they choose to do is influenced by market participants and market structure while they in turn
influence the trading strategies of the various participants. New markets and contracts may emerge to
hedge the risks arising from some PRAs decisions. To evaluate the role of PRAs in the oil market, it is
important to look at three inter-related dimensions: the methodology used in indentifying the oil price; the
accuracy of price assessments; and the internal measures that PRAs implement to protect the integrity and
ensure an efficient assessment process. There is a fundamental difference in the methodology and in the
philosophy underlying the price assessment process between the various PRAs. As a result, different
agencies may produce different prices for the same benchmark. This raises the issue of which method
produces a more accurate price assessment. Given that assessed prices underlie long-term contracts, spot
transactions and derivatives instruments, even small differences in price assessments between PRAs have
important implications on exporters revenues and financial flows between parties in financial contracts.
In the last two decades or so, many financial layers (paper markets) have emerged around crude oil
benchmarks. They include the forward market (in Brent and Dubai), swaps, futures, and options. Some of
the instruments such as futures and options are traded on regulated exchanges such as ICE and CME
Group, while other instruments, such as swaps, options and forward contracts, are traded bilaterally over
the counter (OTC). Nevertheless, these financial layers are highly interlinked through the process of
arbitrage and the development of instruments that links the various layers together. Over the years, these
markets have grown in terms of size, liquidity, sophistication and have attracted a diverse set of players
both physical and financial. These markets have become central for market participants wishing to hedge
their risk and to bet on oil price movements. Equally important, these financial layers have become
central to the oil price identification process.
At the early stages of the current pricing system, linking prices to benchmarks in formulae pricing
provided producers and consumers with a sense of comfort that the price is grounded in the physical
dimension of the market. This implicitly assumes that the process of identifying the price of benchmarks
can be isolated from financial layers. However, this is far from reality. The analysis in this report shows
that the different layers of the oil market form a complex web of links, all of which play a role in the price
discovery process. The information derived from financial layers is essential for identifying the price
8

level of the benchmark. In the Brent market, the oil price in the forward market is sometimes priced as a
differential to the price of the Brent futures contract using the Exchange for Physicals (EFP) market. The
price of Dated Brent or North Sea Dated in turn is priced as a differential to the forward market through
the market of Contract for Differences (CFDs), another swaps market. Given the limited number of
physical transactions and hence the limited amount of deals that can be observed by oil reporting
agencies, the value of Dubai, the main benchmark used for pricing crude oil exports to East Asia, is often
assessed by using the value of differentials in the very liquid OTC Dubai/Brent swaps market. Thus, one
could argue that without these financial layers it would not be possible to discover or identify oil
prices in the current oil pricing system. In effect, crude oil prices are jointly or co-determined in both
layers, depending on differences in timing, location and quality of crude oil.
Since physical benchmarks constitute the pricing basis of the large majority of physical transactions,
some observers claim that derivatives instruments such as futures, forwards, options and swaps derive
their value from the price of these physical benchmarks, i.e., the prices of these physical benchmarks
drive the prices in paper markets. However, this is a gross over-simplification and does not accurately
reflect the process of crude oil price formation. The issue of whether the paper market drives the physical
or the other way around is difficult to construct theoretically and test empirically and requires further
research.
The report also calls for broadening the empirical research to include the trading strategies of physical
players. In recent years, the futures markets have attracted a wide range of financial players including
swap dealers, pension funds, hedge funds, index investors, technical traders, and high net worth
individuals. There are concerns that these financial players and their trading strategies could move the oil
price away from the true underlying fundamentals. The fact remains however that the participants in
many of the OTC markets such as forward markets and CFDs which are central to the price discovery
process are mainly physical and include entities such as refineries, oil companies, downstream
consumers, physical traders, and market makers. Financial players such as pension funds and index
investors have limited presence in many of these markets. Thus, any analysis limited to non-commercial
participants in the futures market and their role in the oil price formation process is incomplete and also
potentially misleading.
The report also makes the distinction between trade in price differentials and trade in price levels. It
shows that trades in the levels of the oil price rarely take place in the layers surrounding the physical
benchmarks. We postulate that the price level of the main crude oil benchmarks is set in the futures
markets; the financial layers such as swaps and forwards set the price differentials depending on quality,
location and timing. These differentials are then used by oil reporting agencies to identify the price level
of a physical benchmark. If the price in the futures market becomes detached from the underlying
benchmark, the differentials adjust to correct for this divergence through a web of highly interlinked and
efficient markets. Thus, our analysis reveals that the level of the crude oil price, which consumers,
producers and their governments are most concerned with, is not the most relevant feature in the current
pricing system. Instead, the identification of price differentials and the adjustments in these differentials
in the various layers underlie the basis of the current crude oil pricing system. By trading differentials,
market participants limit their exposure to the risks of time, location grade and volume. Unfortunately,
this fact has received little attention and the issue of whether price differentials between different markets
showed strong signs of adjustment in the 2008-2009 price cycle has not yet received due attention in the
empirical literature.
But this leaves us with a fundamental question: what determines the price level of a certain benchmark in
the first place? The pricing system reflects how the oil market functions: if price levels are set in the
futures market and if market participants in these markets attach more weight to future fundamentals
rather than current fundamentals and/or if market participants expect limited feedbacks from both the
9

supply and demand side in response to oil price changes, these expectations will be reflected in the
different layers and will ultimately be reflected in the assessed spot price of a certain benchmark.
The current oil pricing system has survived for almost a quarter of a century, longer than the OPEC
administered system. While some of the details have changed, such as Saudi Arabias decision to replace
Dated Brent with Brent futures in pricing its exports to Europe and the more recent move to replace WTI
with Argus Sour Crude Index (ASCI) in pricing its exports to the US, these changes are rather cosmetic.
The fundamentals of the current pricing system have remained the same since the mid 1980s: the price of
oil is set by the market with PRAs making use of various methodologies to reflect the market price in
their assessments and making use of information in the financial layers surrounding the global
benchmarks. In the light of the 2008-2009 price swings, the oil pricing system has received some
criticism reflecting the unease that some observers feel with the current system. Although alternative
pricing systems could be devised such as bringing back the administered pricing system or calling for
producers to assume a greater responsibility in the method of price formation by removing destination
restrictions on their exports, or allowing their crudes to be auctioned, the reality remains that the main
market players such as oil companies, refineries, oil exporting countries, physical traders and financial
players have no interest in rocking the boat. Market players and governments get very concerned about oil
price behaviour and its global and local impacts, but so far have showed much less interest in the pricing
system and market structure that signalled such price behaviour in the first place.

10

3. The Market-Related Oil Pricing System and Formulae Pricing

The collapse of the OPEC administered pricing system in 1986-1988 ushered in a new era in oil pricing in
which the power to set oil prices shifted from OPEC to the so called market. First adopted by the
Mexican national oil company PEMEX in 1986, the market-related pricing system received wide
acceptance among most oil-exporting countries and by 1988 it became and still is the main method for
pricing crude oil in international trade. The oil market was ready for such a transition. The end of the
concession system and the waves of nationalisations which disrupted oil supplies to multinational oil
companies established the basis of arms-length deals and exchange outside the vertically and
horizontally integrated multinational companies. The emergence of many suppliers outside OPEC and
more buyers further increased the prevalence of such arms-length deals. This led to the development of a
complex structure of interlinked oil markets which consists of spot and also physical forwards, futures,
options and other derivative markets referred to as paper markets. Technological innovations that made
electronic trading possible revolutionised these markets by allowing 24-hour trading from any place in the
world. It also opened access to a wider set of market participants and allowed the development of a large
number of trading instruments both on regulated exchanges and over the counter.

Spot Markets, Long-Term Contracts and Formula Pricing

Physical delivery of crude oil is organised either through the spot (cash) market or through long-term
contracts. The spot market is used by transacting parties to buy and sell crude oil not covered by longterm contractual arrangements and applies often to one-off transactions. Given the logistics of
transporting oil, spot cargoes for immediate delivery do not often take place. Instead, there is an important
element of forwardness in spot transactions which can be as much as 45 to 60 days. The parties can either
agree on the price at the time of the agreement, in which case the sport transaction becomes closer to a
forward contract.19 More often though, transacting parties link the pricing of an oil cargo to the time of
loading.
Long-term contracts are negotiated bilaterally between buyers and sellers for the delivery of a series of oil
shipments over a specified period of time, usually one or two years. They specify, among other things, the
volumes of crude oil to be delivered, the delivery schedule, the actions to be taken in case of default, and
above all the method that should be used in calculating the price of an oil shipment. Price agreements are
usually concluded on the method of formula pricing which links the price of a cargo in long-term
contracts to a market (spot) price. Formula pricing has become the basis of the oil pricing system.
Crude oil is not a homogenous commodity. There are various types of internationally traded crude oil
with different qualities and characteristics. Crude oil is of little use before refining and is traded for the
final petroleum products that consumers demand. The intrinsic properties of crude oil determine the mix
of final petroleum products. The two most important properties are density and sulfur content. Crude oils
with lower density, referred to as light crude, usually yield a higher proportion of the more valuable final
petroleum products such as gasoline and other light products by simple refining processes. Light crude
oils are contrasted with heavy ones that have a low share of light hydrocarbons and require a much more
complex refining process such as coking and cracking to produce similar proportions of the more valuable
petroleum products. Sulfur, a naturally occurring element in crude oil, is an undesirable property and
refiners make heavy investments in order to remove it. Crude oils with high sulfur are referred to as sour
crudes while those with low sulfur content are referred to as sweet crudes.
Since the type of crude oil has a bearing on refining yields, different types of crude streams fetch different
prices. The light/sweet crude grades usually command a premium over the heavy/sour crude grades.
Given the large variety of crude oils, the price of a particular crude oil is usually set at a discount or at a
19

Although spot transactions contain an element of forwardness, they are considered as commercial agreements
under US law and are not subject to the regulation of the Commodity Exchange Act.

20

premium to a marker or reference price. These references prices are often referred to as benchmarks. The
formula used in pricing oil in long-term contracts is straightforward. Specifically, for crude oil of variety
x, the formula pricing can be written as
Px = PR D
where Px is the price of crude x; PR is the benchmark crude price; and D is the value of the price
differential. The differential is often agreed at the time when the deal is concluded and could be set by an
oil exporting country or assessed by price reporting agencies.20 It is important to note that formula pricing
may apply to all types of contractual arrangements, be they spot, forward or long term. For instance, a
spot transaction in the crude oil market, is - pricing wise - an agreement on a spot value of the differential
between the physical oil traded and the price of an agreed oil benchmark, which fixes the absolute price
level for such trade, normally around the time of delivery or the loading date.
Differences in crude oil quality are not the only determinant of crude oil price differentials however. The
movements in differentials also reflect movements in the Gross Products Worth (GPW) obtained from
refining the reference crude R and the crude x.21 Thus, price differentials between the different varieties of
crude oil are not constant and change continuously according to the relative demand and supply of the
various crudes which in turn depend on the relative prices of petroleum products. Figure 1 plots the
differential that Saudi Arabia applied to its crude exports to Asia for its different types of crude oil
relative to the Oman/Dubai benchmark during the period 2000-2010 (January). As seen from this figure,
the discounts and premiums applied are highly variable. For instance, at the beginning of 2008, the
differentials between Arab Super Light and Arab Heavy widened sharply to reach more than $15 a barrel;
fuel oil, a product of heavy crude, was in surplus while the demand for diesel, a product of lighter crudes,
was high. In the first months of 2009, the price differential between heavy and light crude oil narrowed to
very low levels as the implementation of OPEC cuts reduced the supply of heavy crude and increased the
relative value of heavy-sour crudes.
Figure 1: Price Differentials of Various Types of Saudi Arabias Crude Oil to Asia in $/Barrel

Jan-00
May-00
Sep-00
Jan-01
May-01
Sep-01
Jan-02
May-02
Sep-02
Jan-03
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Sep-06
Jan-07
May-07
Sep-07
Jan-08
May-08
Sep-08
Jan-09
May-09
Sep-09
Jan-10

+10.00
+8.00
+6.00
+4.00
+2.00
0.00
-2.00
-4.00
-6.00
-8.00
-10.00

Arab Super Light-50

Arab Extra Light-37

Arab Medium -31

Arab Heavy-27

Arab Light-33

Source: Petroleum Intelligence Weekly Database

20

Official formula pricing refers to the process of setting the differential in relation to a benchmark with the
resultant price known as official formula prices. This should be distinguished from official selling prices in which
the government sets the price on an outright basis.
21
Individual crudes have a particular yield of products with a gross product worth (GPW). GPW depends both on
on the refining process and the prices at which these products are sold.

21

The differential to a benchmark is independently set by each of the oil-producing countries. For many
countries, it is usually set in the month preceding the loading month and is adjusted monthly or quarterly.
For instance, for the month of May, the differential is announced in the month before, i.e. April based on
information and data about GPW available in the month of March.22 Since the process of setting price
differentials involves long time lags and is based on old information and data, the value of the price
differential does not often reflect the market conditions at the time of loading and much less so by the
time the cargo reaches its final destination. In the case of multiple transactions under a long-term contract,
buyers can be compensated by sellers by adjusting downwards the differential in the next rounds if the
price proves to be higher than what is warranted by market conditions at the time of loading or at
delivery. This continuous process of adjusting differentials is inevitable given that setting the differential
is based on lagged data and if oil exporters wish to maintain the competitiveness of their crudes.
In other countries such as Abu Dhabi and Qatar, the governments do not announce price differentials, but
rather an outright price known as the official selling price (OSP). These are, however, strongly linked to
Dubai-Oman benchmark and thus, one can assume that outright prices contain an implicit price
differential and hence are close to formula prices (see Horsnell and Mabro, 1993; Argus, 2010).23
In setting the differential, an oil-exporting country will not only consider the differential between its crude
and the reference crude, but has also to consider how its closest competitors are pricing their crude in
relation to the reference crude. This implies that the timing of setting the differential matters, especially in
a slack market. Oil-exporting countries that announce their differentials first are at the competitive
disadvantage of being undercut by their closest competitors. This can induce them to delay announcement
of the differential or, in the case of multiple transactions, compensate the buyers by adjusting the
differential downward in the next rounds. Competition between various exporters implies that crude oils
of similar quality and destined for the same region tend to trade at very narrow differentials. Figure 2
below shows the price differential between Saudi Arabia Light (33.0 API) and Iranian Light (33.4 API)
destined to Asia. As seen from this graph, the differentials are narrow not exceeding 30 cents most of the
time although on some occasions, the differentials tend to widen. Such large differentials do not tend to
persist as adjustments are made to keep the crude oil competitive. In the mid 1990s, Saudi Arabia Light
was trading at a premium to the Iranian Light, but this premium turned into discount in the slack market
conditions of 1998. In the period 2002 to 2004, the two types of crude oil were trading almost at par, but
since 2007, Saudi Arabian Light has been trading at a discount, making its light crude more competitive
compared to the Iranian Light, perhaps in an attempt by Saudi Arabia to maximise its export volume to
Asia or due to mispricing on the part of the Iranian National Oil Company.
The above discussion focused only on the pricing mechanism implemented by an oil exporting country
via its national oil company. The value of the differential does not need not to be set by an oil producing
country and can be assessed by price reporting agencies.

22

For details see Horsnell and Mabro (1993).

Abu Dhabi and Qatar set the OSP retroactively so that the OSP announced in the month of October applies to
cargoes that have already been loaded in the month of September while Oman and Dubai dropped retroactive pricing
when they moved from Platts Oman-Dubai to DME Oman in August 2007.
23

22

Figure 2: Differentials of Term Prices between Saudi Arabia Light and Iran Light Destined to Asia
(FOB) (In US cents)
0.50
0.40
0.30
0.20
0.10
0.00
-0.10
-0.20
-0.30
-0.40
Jan 95
Jun 95
Nov 95
Apr 96
Sep 96
Feb 97
Jul 97
Dec 97
May 98
Oct 98
Mar 99
Aug 99
Jan 00
Jun 00
Nov 00
Apr 01
Sep 01
Feb 02
Jul 02
Dec 02
May 03
Oct 03
Mar 04
Aug 04
Jan 05
Jun 05
Nov 05
Apr 06
Sep 06
Feb 07
Jul 07
Dec 07
May 08
Oct 08
Mar 09
Aug 09
Jan 10

-0.50

Source: Oil Market Intelligence Database

The equivalence to the buyer principle, which means that in practice prices of crudes have equivalent
prices at destination, adds another dimension to the pricing formulae. The location in which prices should
be compared is not the point of origin but must be closer to the destination where the buyer receives the
cargo. Since the freight costs vary depending on the export destination, some formulae also take into
account the relative freight costs between destinations. Specifically, they allow for the difference between
the freight costs involved in moving the reference crude from its location to a certain destination (e.g.
Brent from Sollum Voe to Rotterdam) and the costs involved in moving crude x from the oil countrys
terminal to that certain destination (e.g. Arabian Light from Ras Tanura to Rotterdam). In such cases, the
sale contract is close to a cost, insurance and freight (CIF) contract. This is in contrast to a free on board
(FOB) contract which refers to a situation in which the seller fulfils his obligations to deliver when the
goods have passed over the ships rail. The buyer bears all the risks of loss of or damage to the goods
from that point as well as all other costs such as freight and insurance.
A major advantage of formula pricing is that the price of an oil shipment can be linked to the price at the
time of delivery which reflects the market conditions prevailing. When there is a lag between the date at
which a cargo is bought and the date of arrival at its destination, there is a big price risk. Transacting
parties usually share this risk through the pricing formula. Agreements are often made for the date of
pricing to occur around the delivery date. For instance, in the case of Saudi Arabias exports to the United
States up to December 2009, the date of pricing varied between 40 to 50 days after the loading date. The
price used in contracts could be linked to the price of benchmark averaged over 10 days around the
delivery date, which rendered the point of sale closer to destination than the origin. In 2010, Saudi Arabia
shifted to Argus Sour Crude Index (ASCI) and it currently uses the trade month (20 day minimum)
average of ASCI prices for the trade month applying to the time of delivery.
Oil exporters may have different pricing policies for different regions. For instance, for Saudi exports to
the US, the price that matters most is the cost of shipment at the delivery point. For its exports to Asia, the
pricing point is free on board and hence the price that matters most is the price at the loading terminal.
Figure 3 below shows the price difference between crude delivered to the US Gulf Coast and the price
sold at FOB to Asia for different variety of crude oils. As seen from this graph, the price differential is
highly variable depending on the relative demand and supply conditions between these two markets and
the degree of competition from alternative sources of supply. While in the US, Saudi Arabia faces tough
competition from many suppliers including domestic ones and hence its crude has to be competitive at
23

destination, the strong growth in Asian demand and the limited degree of competition in Asia give rise to
an Asian premium. Hence, in some occasions the price of a cargo delivered to the US is less than the
FOB price to Asia despite the fact that it takes longer for a cargo to reach the US.
Figure 3: Difference in Term Prices for Various Crude Oil Grades to the US Gulf (Delivered) and
Asia (FOB)
15.00
10.00
5.00
0.00
-5.00

Saudi Arabia
Light-33.0

Saudi Arabia
Arab Medium-3.5

Jan 10

Sep 09

Jan 09

May 09

Sep 08

May 08

Jan 08

Sep 07

Jan 07

May 07

Sep 06

Jan 06

May 06

Sep 05

Jan 05

May 05

Sep 04

Jan 04

May 04

Sep 03

May 03

Jan 03

Sep 02

Jan 02

May 02

Sep 01

Jan 01

May 01

Sep 00

Jan 00

May 00

-10.00

Saudi Arabia
Arab Heavy-27.6

Source: Oil Market Intelligence

Benchmarks in Formulae Pricing

At the heart of formulae pricing is the identification of the price of key physical benchmarks, such as
West Texas Intermediate (WTI), the ASCI price, Dated Brent (but also called Dated North Sea Light,
North Sea Dated, Dated BFOE)24 and Dubai. The prices of these benchmark crudes, often referred to as
spot market prices, are central to the oil pricing system. The prices of these benchmarks are used by oil
companies and traders to price cargoes under long-term contracts or in spot market transactions; by
futures exchanges for the settlement of their financial contracts; by banks and companies for the
settlement of derivative instruments such as swap contracts; and by governments for taxation purposes.25
Table 1 below lists some of the various benchmarks used by key oil exporters. As seen from the table,
countries use different benchmarks depending on the export destination. For instance, Iraq uses Brent for
its exports to Europe, a combination of Oman and Dubai for its exports to Asia, and until very recently
WTI for its exports for the US. In 2010, Saudi Arabia, Kuwait and Iraq switched to the Argus Sour Crude
Index (ASCI) for exports destined to the US. Mexico uses quite a complex formula in pricing its exports
to the US which includes a weighted average of the prices of West Texas Sour (WTS), Louisiana Light
Sweet (LLS), Dated Brent, and High Sulfur Fuel Oil (HSFO). For its exports to Europe, Mexico uses both
high and low sulfur fuel oil (FO) and Dated Brent.

24

Platts continues to call the physical market Dated Brent or Dated North Sea Light while Argus calls it North Sea
Dated. As shall be discussed later, the continued use of the term Dated Brent by Platts and much of the industry is
not an arcane point, because the price of physical Dated Brent cargoes will be different from its Dated Brent price.
The prices of physical Brent, Forties and Oseberg all differ from the (Argus) North Sea Dated/(Platts) Dated Brent
value.
25
Some governments (Oman, Qatar, Abu Dhabi, Malaysia, and Indonesia) do not use benchmarks at all and instead
set their own official selling prices (OSPs) on a monthly basis. These can be set retroactively or retrospectively.

24

Table 1: Main Benchmarks Used in Formula Pricing

Asia

Europe

Saudi Arabia

Oman and Dubai

BWAVE from Jul.'00, Dated Brent

Until Jun.'00

Iran

Oman and Dubai

BWAVE from Jan.'01, Dated

Brent Until Dec.'00

Kuwait

Oman and Dubai

BWAVE from Jul.'00, Dated Brent

Until Jun.'00

Oman and Dubai

Dated Brent

ASCI from
December 2009 ;
Previously WTI
ASCI from April
2010, Previously
WTI Second
Month

Dated Brent

Brent

Iraq (Basrah
Blend)
Nigeria

Mexico (Maya
Blend)

Dated Brent x0.527

+ 3.5%HSFO x0.467
- 1%FO x.25
+ 3.5%FO x0.25

US
ASCI from
Jan.2010, WTI
until Dec.'09

WTS x0.4
+ 3%HSFO x0.4
+ LLS x0.1
+ Dtd.Brent x0.1

The pricing may be based on physical benchmarks such as Dated Brent or on the financial layers
surrounding these physical benchmarks such as the Brent Weighted Average (BWAVE), which is an
index calculated on the basis of prices obtained in the Brent futures market. Specifically, the BWAVE is
the weighted average of all futures price quotations that arise for a given contract of the futures exchange
during a trading day, with the weights being the shares of the relevant volume of transactions on that day.
Major oil exporters such as Saudi Arabia, Kuwait and Iran use BWAVE as the basis of pricing crude
exports to Europe. As seen from Figure 4 below, the price differential between Dated Brent and BWAVE
is quite variable with the differential in some occasions exceeding plus or minus three dollars per barrel.
This is expected as BWAVE is considerably less prompt than Dated Brent and thus variability between
the two should consider this time basis issue.26 Therefore, the choice of benchmark has serious
implications on government revenues. This is perhaps most illustrated in the recent shift from WTI to
ASCI by some Gulf exporters. Figure 5 plots the price differential between the two US benchmarks WTI
and ASCI. WTI traded at a premium to ASCI through most of this time but occasionally (four significant
times) WTI moved to a discount when WTI collapsed versus other world benchmarks, with the WTI
discount to ASCI reaching close to $8/barrel on 12 February 2009. The January/ February events
prompted Saudi Arabia to consider alternatives to Platts WTI cash assessment.

26

Furthermore, as volatility is strongly backwardated itself along its own forward curve for most markets, this is
also a relevant factor.

25

Figure 4: Price Differential between Dated Brent and BWAVE ($/Barrel)

4.00
3.00
2.00
1.00
...
-1.00
-2.00
-3.00

-4.00
-5.00

Source: Petroleum Intelligence Weekly

Figure 5: Price Differential between WTI and ASCI ($/Barrel) (ASCI Price=0)
8.00
6.00
4.00
2.00
0.00
-2.00

-4.00
-6.00
-8.00
-10.00

ASCI

WTI vs ASCI

Source: Argus
Given the central role that benchmarking plays in the current oil pricing system, it is important to
highlight some of the main features of the most widely used benchmarks. First, unlike the futures market
where prices are observable in real time, the reported prices of physical benchmarks are identified or
assessed prices. These assessments are carried out by oil pricing reporting agencies, the two most
important of which are Platts and Argus.27 Assessments are needed in opaque markets such as oil where
physical transactions concluded between parties cannot be directly observed by market participants. After
all, parties are under no obligation to report their deals. Assessments are also needed in illiquid markets
27

There are other PRAs but these are often more specialised such as OMR (focus on Germany, Austria, and
Switzerland), APPI (focus on Asia), RIM (focus on Asia), ICIS-LOR (focus on petrochemicals) and OPIS (focus on
US). In December 2010, Platts announced an agreement to acquire OPIS. The acquisition is expected to be
completed in the first half of 2011, subject to regulatory approval.

26

where not enough representative deals or where no transactions take place. Oil reporting agencies assess
their prices based on information on concluded deals which they observe, or bids and offers, and failing
that on market talk, other private and public information gathered by reporters, and information from
financial markets. It is important to note that PRAs do not use in all markets a hierarchy of information
cascading down from deals to bids and offers, which would imply that deals are the best price discovery
and bids/offers are a poorer alternative. The methodology may vary from market to market in accordance
with the published methodology for that market. In some markets, bid/offer information takes precedence
over deals in identifying the published price e.g. if the deal is either not representative of the market as
defined in the methodology, or was done earlier or later in the day to the prevailing depth of market. In
other markets, price identification relies on observed deals. For instance, Argus main benchmark ASCI is
entirely deal based. Most however accept that a done deal does represent the highest form of proof of
value, unless there is a supervening issue with the trades conduct. If assessments are intended to
represent an end-of day price, analogous to a futures settlement however, a fully evidenced bid/offer
spread at a later point when markets have clearly moved in value is an acceptable proxy in the absence of
a trade .
Sometimes a distinction is made between prices identified through observed deals or transactions using a
direct mathematical formula such as volume-weighted average (referred to as an index) and prices
identified through a process of interpretation based on bids and offers, market surveys, and other
information gathered by reporters (referred to as price assessment) (see Argus, 2010). The choice of the
method varies across markets and depends on the structure of market, particularly on the degree of market
opaqueness and liquidity. While an index is suitable for markets with high trading liquidity and
transparency, assessments are more suitable in opaque and illiquid markets. In this paper, we do not make
this distinction and refer to both categories as price assessment. However, regardless of the method used,
there is an important element of subjectivity involved as the methodology has to be decided by managers
and editors. The choice of methodology (the time window in which the price is assessed, the grade
specification, location) in an index based system is just as subjective as price assessment. In that respect,
one approach (index or assessment) is no more subjective than the other.
Second, these agencies do not always produce the same price for the same benchmark as these pursue
different methodologies in their price assessments. Even if price quotations are based on a mechanical
methodology of deals done, two price reporting services could publish different prices for the same crude
because their price identification process and the deals they include in the assessment could be different.
For example, one PRA might use a volume weighted average of transactions between 9.00am and 5.00pm
while another PRA might use last trade or open bid/offer at specified period of time. Or one PRA might
include transactions within a 10-21 day price range and another includes transactions in a 10-15 day price
range. Or one PRA might only include fixed-price transactions and another include fixed-price and
formula-related transactions.
Third, the nature of these benchmarks tends to evolve over time. Although the general principle of
benchmarking has remained more or less the same over the last twenty-five years, the details of these
benchmarks in terms of their liquidity and the type of crudes that are included in the assessment process
have changed dramatically over that period. The assessment of the traditional Brent benchmark now
includes the North Sea streams Forties, Oseberg and Ekofisk (BFOE) and that of Platts Dubai price
includes Oman and Upper Zakum. These streams are not of identical quality and often fetch different
prices. Thus, the assessed price of a benchmark does not always refer to a particular physical crude
stream. It rather refers to a constructed index28 which is derived on the basis of a simple mathematical
formula which takes the lowest priced grade of the different component crudes to set the benchmark.
28

This may take the form of a matrix of closely-related prices which use the total physical liquidity by engineering
price floors and caps to reduce or eliminate the possibility of price distortion or skews.

27

Table 2 below summarises some basic statistics of the main international benchmarks: BFOE in the North
Sea, WTI and ASCI in the US, and Dubai-Oman in the Gulf. In terms of production, the underlying
physical base of the benchmark amounts to slightly more than 3 million b/d, i.e., around 3.5% of global
production. In terms of liquidity, there is wide difference across benchmarks. While in the US the number
of spot trades per calendar month is close to 600, the number of spot trades does not exceed three per
month in the case of Dubai. The divergence in liquidity across benchmarks reflects the low underlying
physical base and the different nature of benchmarks where US crudes are pipeline crudes with small
trading lots whereas Brent and Dubai are waterborne crudes with large trading lots. Table 2 also shows
that the degree of concentration in traded volumes varies considerably across markets. From the sellers
side, Dubai, Oman and Forties exhibit a high degree of concentration in the total volume of spot trades
especially when compared to US markets. From the buyers side, Dubai and Forties exhibit a high degree
of concentration whereas Oman compares favourably with other benchmarks.
Table 2: Some Basic Features of Benchmark Crudes
First-quarter 2010 averages
by Argus

ASCI

WTI CMA
+ WTI PPlus

Forties

BFOE

Dubai

Oman

Production (MBPD)

736

300-400

562

1,220

70-80

710

Volume Spot Traded (MBPD)

579

939

514

635

86

246

Number of Spot Trades per

Cal Month

260

330

18

98

3.5

10

Number of Spot Trades Per

Day

13

16

<1

<1

<1

Number of Different Spot

Buyers per Cal Month

26

27

10

Number of Different Spot

Sellers per Cal Month

24

36

Largest 3 Buyers % of Total

Spot Volume

43%

38%

63%

72%

100%

50%

Largest 3 Sellers % of Total

Spot Volume

38%

51%

76%

56%

100%

80%

Source: Argus
Notes: Daily statistics are per trade day, except production which is per calendar day; Forties: The physical grade
usually sets North Sea Dated/Dated Brent; BFOE: Forward cash contracts deliverable as physical BFOE cargoes,
used in setting the flat price against which North Sea Dated is calculated; Oman: Excludes physical deliveries
through DME. Estimated deliveries on DME contacts are 300,000-400,000 barrels per day; WTI: Includes cash
market trade for WTI Calendar Month Average and WTI P-Plus. Cash market at Cushing no longer trades except at
last three days of trade month as spread for 2 nd month. Roll trades are not included here. Also does not include any
volumes on CME Nymex futures.

Finally, in the last two decades or so, many financial layers (paper markets) have emerged around these
benchmarks. These include the forward market (in Brent), swaps, futures, and options. Some of the
28

instruments such as futures and options are traded on regulated exchanges such as ICE and CME Group,
while other instruments, such as swaps and forward contracts, are traded bilaterally over the counter
(OTC). Nevertheless, these financial layers are highly interlinked through the process of arbitrage and the
development of instruments that link the various markets together such as the Exchange of Futures for
Swaps (EFS) which allow traders to roll positions from futures to swaps and vice versa. Over the years,
these markets have grown in terms of size, liquidity, sophistication and have attracted a diverse set of
players, both physical and financial. These markets have become central for market participants wishing
to hedge their risk and to bet (or speculate) on oil price movements. Equally important, these financial
layers have become central to the oil price identification process. In Sections 5, 6 and 7, we discuss the
main benchmarks used in the current oil pricing system and the financial layers surrounding these
benchmarks.

29

4. Oil Price Reporting Agencies and the Price Discovery Process

The oil price reporting agencies (PRAs) are an important component of the oil industry. The prices that
these agencies identify or assess underlie the basis of long-term contracts, spot market transactions,
futures markets contracts and derivatives instruments. Some PRAs argue that through their
methodological structure for reporting physical transactions, they act as a mirror to the trade and provide
transparency on what would otherwise be a collection of bilateral deals.29 However, as argued by
Horsnell and Mabro (1993:155) oil PRAs are
far more than mere observers of crude oil and oil product markets. If they were, then their only
role would be to add to the price transparency of the market. However, deals worth hundreds of
millions of dollars per day ride on published assessment and the nature and structure of oil
reporting create trading opportunities and new markets and affect the behaviour of oil traders.
Price reporting does more than provide a mirror for oil markets; the reflection in the mirror can
affect the image itself.
Indeed, in their attempt to identify the price that reflects accurately the market value of the oil barrel,
PRAs enter into the decision-making territory that can influence market structure. For instance, Platts
decides on the time of pricing of oil (the time stamping), the width of the Platts window, the size of the
parcel to be traded, the process of delivery, and the time of delivery of the contract. PRAs make these
decisions on the basis of regular consultations with the industry. In return, PRAs influence the trading
strategies of the various participants and their reporting policies. In fact, new markets and contracts may
emerge to hedge the risks arising from some of the decisions that PRAs make. Even when price
assessments are based on observed transactions and mathematical formula, there is still an important
element of decision-making involved as this entails the choice about the assumptions behind the
methodology. Editors and managers in PRAs choose how to build the index (in the case of Argus) and
how to allow for non-deals-based methodologies in case of a lack of deals.
While PRAs have been an integral part of the crude oil market especially since the shift to the marketrelated pricing system in 198630, their role has recently been attracting considerable attention. In the G20
summit in Korea in November 2010, the G20 leaders called on the IEF, IEA, OPEC and IOSCO to
produce a joint report, by the April 2011 Finance Ministers meeting, on how the oil spot market prices
are assessed by oil price reporting agencies and how this affects the transparency and functioning of oil
markets .31 In its latest report in November 2010, IOSCO points that the core concern with respect to
price reporting agencies is the extent to which the reported data accurately reflects the cash market in
question.32 As discussed below, the accuracy of price assessments heavily depends on large number of
factors including the quality of information obtained by the PRA, the internal procedures applied by the
PRAs and the methodologies used in price assessment.
To evaluate the role of PRAs in the oil market, it is important to look at three inter-related dimensions: the
methodology used in identifying the oil price; the accuracy of price assessments;33 and the internal
measures that PRAs implement to protect their integrity and ensure an efficient price assessment process.
There is a fundamental difference in the methodology and in the philosophy underlying the price
assessment process between the various pricing reporting agencies. As a result, different agencies may
produce different prices for the same benchmark. Even if price quotations are based on a mechanical
methodology of deals done, two price reporting services could publish different prices for the same crude
29

Argus Response to the Report of the Working Group on the Volatility of Oil Prices chaired by Professor JeanMarie Chevalier, p.5.
30
PRAs assessment were already widely used in the price formation process for refined products prior to 1986.
31
G-20 Seoul Summit 2010, THE SEOUL SUMMIT DOCUMENT, Paragraph 61.
32
IOSCO (2010), Task Force on Commodity Futures Markets: Report to the G20, November 2010, p. 17.
33
Though other attributes such as representativeness and usefulness could also be included.

30

because their mechanical price identification process could be different. This raises the issue of which of
the methods generates a more accurate price assessment. Given that assessed prices underlie long-term
contracts, spot transactions and derivatives instruments, even small differences in price assessments
between PRAs have serious implications for exporters revenues and financial flows between parties in
financial contracts.
PRAs use a wide variety of methods to identify the oil price which may include the volume weighted
average system, low and high deals done, and market-on-close (MOC). In January 2001, Platts stopped
using the volume-weighted average system and replaced it with the MOC methodology.34 In this system,
Platts sets a time window, known as the Platts window, and only deals transacted within this time window
are used to assess the oil price.35 The price is assessed on the basis of concluded deals, or failing that, on
bids and offers. Assessment will also make use of information from financial layers about spreads and
derivative to help triangulate value.36 Thus, the MOC can be thought of a structured system for
gathering information on the basis of which Platts assesses the daily price of key physical benchmarks. In
a way, it is similar to a futures exchange where traders make bids and offers, but with two major
differences: the parties behind the bids and offers are known, and Platts decides on the information to be
considered in the assessment, i.e., the information passes through the Platts filter. These price assessments
are then transmitted back to the market through a variety of channels. The reason for the shift to MOC is a
concern that an averaging system for price determination could result in assessments that lag actual
market levels as deals done early in an assessment period at a level that is not repeatable, could
mathematically drag prices down or up (Platts, 2010a:7).37 Thus, Platts emphasises the time sensitivity of
its assessed prices which are clearly time-stamped on a daily basis.38 Time stamping not only allows for
an accurate reflection of price levels at particular point in time, but also for accurate assessment of time
spreads and inter-crude spreads.
Both the volume-weighted average method and the MOC have received their share of criticism. While the
volume-weighted average method allows the inclusion of a large number of deals and hence is more
representative, the method has been criticised as it
34

In the US, Platts used a volume weighted average for domestic crude. But for products, it has always used a low
and high of deals done. In the WTI crude market prior to 2001 Platts used a volume weighted average of a 30minute window. In Asia, Platts used the window or page 190, its first market on close, also before 2001. The
market on close went global for Platts in 2001.
35
It is important to note that the window opens all day and Platts will accept trades, bids and offers at any time of
the day. But only deals transacted within a specified period of time (for instance from 4:00 to 4:30 for European
crudes) are considered for assessing the price for that day. Some argue that this may encourage traders to present
their bids/offers to Platts during this time window in order to maximize their impact on prices.
36
Thorne, S. (2010), A User guide to Platts Assessment Processes, Presentation at the Platts Crude Oil
Methodology Forum 2010, London, May.
37
Platts (2010a), Methodology and Specifications Guide: Crude Oil, The McGraw Hill Companies, October.
38
Some commentators consider that through its window, Platts is able to establish the marginal price of oil, which in
principle should set price for the rest of the market. It is not clear what is meant by the marginal price, but in terms
of theory, the closest one can think of the Platts window is in terms of the Walrasian auctioneer. The Walrasian
auctioneer is a fictitious construct who aggregates traders demand and supplies to find a market clearing price,
through a series of auctions. While Platts window resembles the Walrasian auctioneer, it differs fundamentally in
many respects such as the existence of transactions costs, barriers to entry and the fact that the auctioneer does not
perform a passive role in the market. It decides who enters the market and when to the set the price. It has also been
long realised that trading has a timing dimension. While over time, the number of buyers and sellers may be equal,
at any particular the time, this is not guaranteed in which case it is not possible to find a market clearing price
(Demsetz, 1968). This could be overcome by participants paying an immediacy premium in which case the
equilibrium will be characterised by two demand and supply curves and two prices. Furthermore, the literature
shows that market structure such as the number of players, their size, the timing of entry matters and could affect the
trading price. Therefore, the actual mechanism used to set the price is not simply a channel, but is an input into the
price and as such cannot be ignored (see O'Hara, 1997).

31

may result in an index that is out of step and not reflective of the actual market price prevailing at the
close of the day. This would especially be the case on days with high volatility. Trade- weighted
averages may also be distorted by the pattern of trading liquidity over the day. A key weakness in
all trade-weighted average assessments is that they will lag the market price. They always reflect a
price that was rather than the price that is. (Platts, 2010b:6).39
The main criticism of the MOC methodology is that the Platts window often lacks sufficient liquidity and
may be dominated by few players which may hamper the price discovery process. For instance, Argus,
Platts main competitor, argues that in US crude markets
MOC methodology would work if the industry poured liquidity into the window. Without this
liquidity, the methodology is left to assess the value at the close based on bids, offers and other
related factors. This means that the price derived from an MOC assessment can diverge widely
from a weighted average of all deals done in the trading day.40
This divergence is expected given that the average price is different from the stamped price and the
convergence of the two is just a statistical accident if it ever happens.
Argus conducted a study on the US crude oil market in 2007 which compares the spot market traded
volume inside the window with the volume traded during the entire day. The study finds that the volume
traded within the Platts window constitutes only a very small fraction of daily traded volumes, as seen in
Table 3 below. This applies to a wide variety of US crudes. Argus argues that such low liquidity and
complete lack of participant breadth raise serious questions about the efficiency of price discovery in
the US oil market.41
Table 3: Spot Market Traded Volumes in May 2007 (May traded during May Trade Month)
Window
LLS

Entire Day (Argus)

Window % of Total

446,920

0%

26,425

378,445

7%

Mars

5,418

185,252

3%

WTS

1,000

154,706

1%

WTI Midland

3,000

138,470

2%

HLS

1,000

100,032

1%

WTI P-Plus

1,000

88,802

1%

Eugene Island

40,044

0%

Poseidon

73,857

0%

SGC

22,100

0%

0
37,843

9,140
1,637,768

0%
2.31%

WTI Diff to CMA

Bonito
Source: Argus (2007)

One response to such a criticism is that if some market participants think that prices in the window are not
reflecting accurately the price of an oil barrel at the margin, then those participants should enter the
39

Platts (2010 b), Platts Oil Pricing and MOC Methodology Explained, The McGraw Hill Companies, June.
Argus Global Markets (2007), Liquidity and Diversity Prevail, 24 September, p. 15.
41
There are other markets, such as Asian products which would show in contrast very high % figures for Platts
window trades. Ultimately market participants decide upon which and whose pricing system and by implication,
methodology, they wish to use. However, once a critical mass of players is using one in a market or series of
markets, it is difficult and expensive to make a switch.
40

32

window and exert their influence on the price. However, in some markets, there might be barriers to entry
preventing such an adjustment mechanism from taking place. For instance, in the context of Dubai, Binks
(2005) argues that participation (in the window) requires knowledgeable and experienced trading staff.
And many of the national oil companies that represent end-users in Asia are not allowed to participate in
speculative trading. For the same reason, Middle East producers will not participate in the partials market.
Even independent commercial buyers without these restraints in Asia feel reluctant to participate in the
partials trade out of concern that doing so could threaten their relations with Middle Eastern producers.42
It is important to note that while some barriers such as having experienced and professional staff and
qualified companies with the necessary logistics to execute physical trades can be considered as natural
barriers, others barriers arise due to policy and strategic choices which limit the trading activity in the
window to a small group of what so called professionals.43
Market participants are under no legal or regulatory obligation to report their deals to PRAs or any other
body for that matter. Whether participants decide to share information depend on their willingness, their
reporting policies, and their interest in doing so. In the US, the system is voluntary, but one potential
interpretation of the Sarbanes-Oxley legislation is that companies must report all or nothing, and cannot
selectively disclose information.44 Many companies have reporting policies that only bind them to report
deals that take place at a certain time of day, or in certain regional markets. In some markets such as the
US, confidentiality concerns dictate that some PRAs do not publish the names of the counterparties to a
deal. To ensure enough reporting takes place, PRAs such as Argus sign confidentiality agreements to
facilitate deal reporting in the US though companies may have the incentive to report prices without such
agreements. Since market participants have different interests and different positions, some traders may
have the incentive to manipulate prices by feeding false information to reporters though there have been
regulatory efforts to limit such behaviour. In the US, the Commodity Futures Trading Commission
(CFTC)45, the Federal Energy Regulatory Commission (FERC), and the Federal Trade Commission
(FTC)46 have passed regulations that prohibit false reporting. In the EU, the Market Abuse Directive is
42

Some interviewees also pointed to the high subscription cost involved in the entry of E-window, by which Platts is
assessing larger number of markets.
43
One interviewee considers this aspect as necessary otherwise enlarging the base of participants may create
logistical and serious performance issues, including safety issues.
44
Initially a law/regulation was passed in 2000 by the SECURITIES AND EXCHANGE COMMISSION (SEC)
known as Regulation FD (Fair Disclosure). This came out of and expands upon the Insider Trading law framework
and pertains to equities reporting. Sarbanes-Oxley Act expanded on this regulation. The Act deals with voluntary
reporting areas. The obligation is stated that should you volunteer to report information, the obligation is to report
that information fully. However, companies are not required to report trades to the PRAs. Lobo and Zhou (2006)
investigated the change in managerial discretion over financial reporting following the Sarbanes-Oxley Act and find
an increase in conservatism in financial reporting.
45
On November 3, 2010, the CFTC and the Securities and Exchange Commission (SEC) proposed rules under the
new anti-manipulation and anti-fraud provisions of the Dodd-Frank Wall Street Reform and Consumer Protection
Act. One of the proposed rules states that, It shall be unlawful for any person, directly or indirectly, in connection
with any swap, or contract of sale of any commodity in interstate commerce to intentionally or recklessly:..
make, or attempt to make, any untrue or misleading statement of a material fact or to omit to state a material fact
necessary in order to make the statements made not untrue or misleading. deliver or cause to be delivered.by
any means of communication whatsoever, a false or misleading or inaccurate report concerning crop or market
information or conditions that affect or tend to affect the price of any commodity in interstate commerce, knowing,
or acting in reckless disregard of the fact that such report is false, misleading or inaccurate. Source:
http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2010-27541a.pdf
46
The Energy Independence and Security Act (Energy Act) signed into law December 19, 2007, gives the Federal
Trade Commission (FTC) new authority to police market manipulation and false reporting in the petroleum
industry joining the Federal Energy Regulatory Commission (FERC) and the U.S. Commodity Futures Trading
Commission (CFTC) in this role. In section 812, the FTC is given the authority to act against false reporting in the
petroleum industry. FTCs authority however is limited to the false reporting of wholesale transactions and those to

33

also meant to perform a similar role, though its impact on price reporting is not yet clear. As discussed
above, Platts relies on a more structured system for gathering information. However traders can undertake
some anomalous deals in the Platts window by accepting high offers or underselling by delivering into
low bids in an attempt to influence the assessed price. The losses made by such transactions can be more
than compensated by entering into other contracts such as swaps. Thus, PRAs must ensure that the
information received is correct and accurate and that deals done in the window are genuine, otherwise the
whole price discovery process will be undermined. For instance, Platts will not knowingly publish any bid
or offer that is not within the market range. In addition, when offers are lifted or bids are hit, there is a
secondary process to ensure that there is no gapping and if such gapping is detected to ensure that price
assessment process is not affected by it. There are also other mechanisms to avoid the influence of nonrepeatable deals.
In a liquid market, false reporting can be less of a problem as reporters could observe concluded deals and
confirm the information they obtain from both parties. At the same time, reporters will make use of the
regular flow of information originating from the futures and OTC markets. In contrast, in illiquid markets,
a small number of reported deals or a few bids and offers can heavily influence the price assessment
process. In days when reporters cannot observe active buyers, sellers or transactions to determine the
price or simply when such deals do not exist, 47 PRAs rely on a variety of sources of information sources
or market talk to make intelligent assessments.48 In such circumstances, the reporter will look at bids
and offers from other markets, draw comparisons with similar crudes but with higher trading activity,
analyse forward curves, survey market participants opinions, and assess spread across markets to reach a
price assessment. In fact, in some instances, as in illiquid markets, the price assessment could be more
accurate in the absence of transactions, if these transactions were intended to manipulate the oil price.
In some instances, a PRA can retrospectively correct previously unidentified assessment errors. There are
some instances in which traders may dispute the assessed price reached by a PRA. There is no evidence to
suggest that this problem is widespread, but from time to time these disputes filter into media reports. For
instance, in 29 April 2010, Platts assessed the value of the June and July cash BFOE spread at minus
$0.68 a barrel. Some brokers in the market claimed that Platts assessment of the differential is inaccurate.
Based on information from the futures market and the EFP, these brokers claimed that the value of the
differential should have been minus $0.94 a barrel.49 Regardless of which value is more accurate, what is
important to note that if such disputes over price assessments ever arise there is no supervisory or
regulatory authority which would look into these claims and counter-claims.
In order to safeguard the price assessment process, PRA seek to verify the accuracy of the information
they receive and when they are unable to do so they retain the right to exclude data and information. In
this way, they guard against false data distorting their assessments. They also undertake many procedures,
both within their own organisations as well as in relation to outside participants. For instance, Platts has
control on the parties that can participate in the window. The companies behind every bid and offer must
be clearly identified with a track record of operational and financial performance and be recognisable in
the market. Trading is closely monitored and those participants that fail to meet editorial standards and/or

a Federal Department or agency. It remain unclear if the Energy Act encompasses the reporting of false or
misleading information publicly into the market or to private organizations or PRAs.
47
It should be noted that when this is the case, companies who sign contracts linked to PRA prices tend not to use
pricing centres that are illiquid. They know that no matter how well the PRA does their job the price may be volatile
or unresponsive. In many cases, the PRA chooses not to assess a crude or product because the market is too illiquid,
or there are insufficient parameters available to make an assessment based on correlative data points.
48
Intelligent assessment refers to the process of assessing prices in illiquid markets where transactions are not
observable to reporters.
49
Paddy Gourlay Dated Brent Assessment Sparks Calls For Methodology Change, Dow Jones Newswires, 30
April 2010

34

make spurious offers and bids are expelled from the window.50 Concluded transactions between parties
are sometimes subject to verification by the various price reporting agencies; spurious deals are excluded
from the assessment process. PRAs may request documentation for concluded deals such as contract
documentation or other supporting materials such as loading and inspection documents.51
Another important dimension is compliance procedures within PRAs. The accuracy of the price
assessment will depend primarily on the policies, procedures and training put in place by the PRA. Such
procedures are needed to ensure both internal and external independence and to ascertain that reporters
are following the same rules, reporting procedures and methodology as set out by the RPA. All the
regulations and compliance procedures are designed and enforced internally without being subject to
governments regulations or supervisory oversight. However, in theory, the incentive to self-regulate is
very strong. Any reputational damage due to error of design, fraud, use of insider information, or a market
perception that PRAs are herded by one party would imply a loss of confidence and would eventually
lead to their demise. If PRAs produce regularly inaccurate prices, they will cease to exist because their
subscribers will shift to another service.52

50

Nevertheless, concerns still arise that such procedures will not stop companies from using the Platts window as a
way of executing a wash trade, or trading only to set the index on index-related deals done earlier in the day. Platts
cannot track every deal down to the contract level and ask for documentary bona fides.
51
It is highly unlikely however that a PRA requesting this information would always receive it, and certainly not in
a timely enough manner to have any impact on price assessments on a given day.
52
One anonymous interviewee noted that in theory this may be true in a competitive environment but not in the case
of oil PRAs where the market is characterised by almost a duopoly.

35

5. The Brent Market and Its Layers

The Brent market in the North Sea assumes a central stage in the current oil pricing system. The prices
generated in the Brent complex constitute the main price benchmarks on the basis of which 70 percent of
international trade in oil is directly or indirectly priced. In the early 1980s, the Brent market only
consisted of the spot market (known as Dated Brent) and the informal forward physical market. Since
that time, the Brent market has grown in complexity and is currently made up of a large number of layers
including a highly liquid futures and swaps markets in which a variety of financial instruments are
actively traded by a wide range of players. As noted by Horsnell (2000), the Brent market was not predesigned and grew more complex according to the needs of market participants.
A number of special features favoured the choice of Brent as a benchmark. The geographic location of the
North Sea which is close to the refining centres in Europe and the US gives it an advantage over other
basins. Brent is waterborne crude and is transferred by tankers to European refiners or, when arbitrage
allows, across the Atlantic Ocean to the US. The introduction of tax regulations on the UK North Sea in
1979 provided oil companies with the incentive to trade and re-trade their output in the spot market which
gave rise to an actively-traded spot market in Brent.53 Furthermore, in the mid 1980s, the volume of
production of the Brent system was quite large (around 885,000 b/d in 1986) which ensured enough
physical liquidity for trading. But similar bases of physical liquidity could also be found in other regions
of the world, especially in Gulf countries which constitute the largest physical base in the crude oil
markets. Thus, the volume of production, although important, is not the determining factor for a crude oil
to emerge as an international benchmark. An important determinant is the legal, tax, and regulatory
regime operating around any particular benchmark. Brent has the UK government overseeing it and a
robust legal regime. Horsnell and Mabro (1993) identify additional determinants, the most important of
which is ownership diversification. The commodity underlying the forward/futures contracts should be
available from a wide range of sellers. Monopoly of production increases the likelihood of squeezes and
manipulation, increasing in turn the risk exposure of buyers and traders who would be reluctant to enter
the market in the first place (Newbery, 1984). Most countries in OPEC are single sellers and hence OPEC
crudes did not and still do not satisfy this criterion of ownership diversification. Monopoly of production
also prevented the development of a complex market structure in other markets with a larger physical
base such as Mexico. This is in contrast to the Brent market which has always been characterised by a
large number of companies with entitlement to the production of Brent (see Figure 6). The widening of
the definition of the benchmark to include other crude streams over the years has reinforced this aspect
and resulted in an even higher degree of ownership diversification. Another important aspect is the degree
of concentration in the physical delivery infrastructure. Here the degree of concentration is much higher.
For instance, the Forties Pipeline System (FPS) which collects oil and gas liquids from over 50 fields
through a complex set of pipelines is 100% BP-owned.54

53
54

See Argus (2010), Argus Guide to Crude and Oil Products Markets, January.
BP Website: https://www.icmmed0ty.com/fps/content/brochure/brochure.asp?sectionid=1

36

Figure 6: Brent Production by Company (cargoes per year), 2007

4

31

1
1

23

38
53
2

3
2

10

35

5
1

AGIP (ENI)

Amerada HESS

BGGROUP

BPPLC

CHALLENGER

CHEVRONTEXACO

CNR

DANA

DYAS

EXXONMOBIL

ITOCHU

LUNDIN

MARUBENI

MITSUBISHI

PALACE E&P

SHELL

STATOIL ASA

TFE

Source: Bossley, L. (2007), Brent: A Users Guide to the Future of the World Price Marker, London: CEAG, p.83.

The Physical Base of North Sea

Crude oil in the North Sea consists of a wide variety of grades which include Brent, Ninian, Forties,
Oseberg, Ekofisk, Flotta, and Statfjord just to mention few. In the early stages of the current oil pricing
system, Brent acted as a representative for North Sea crude oil and price reporting agencies relied on the
trading activity in this grade to identify the price of the benchmark. The Brent is a mixture of oil produced
from separate fields and collected through a main pipeline system to the terminal at Sullom Voe in the
Shetland Islands, UK. From the mid 1980s, the production of Brent started to decline, falling from
885,000 b/d in 1986 to 366,000 b/d in 1990 (see Table 4 below). Low physical production caused
distortions, manipulation, and squeezes leading the Brent price to disconnect from the rest of grades with
far-reaching effects.55 To avoid potential distortions and squeezes, the Brent system was comingled with
Ninian in 1990 leading to the creation of a new grade known as the Brent Blend while Ninian ceased to
trade as a separate crude stream. The co-mingling of the Brent and the Ninian systems alleviated the
problem of declining production level with the combined production reaching 856,000 b/d in 1992, as
shown in the table below. Thereafter, however, the production of Brent Blend started to decline, falling to
around 400 thousand b/d in 2001. In terms of cargoes, this represented around 20 per month, or less than
one cargo per day.
Table 4: Oil Production By Brent and Ninian System (Thousand Barrels/Day)

Brent System
Ninian System
Total Blend

1986
885
346
885

1987 1988 1989 1990(a) 1990(b) 1990

791 734 503
450
320 396
302 373 374
366
345 357
791 734 503
450
665 540

1991
450
324
773

Notes:
(a) January 1 to July 31 1990 before comingling
(b) August 1 to December 31 1990 after co-mingling
Source: Horsnell and Mabro (2003)

55

See for Instance, Liz Bossley (2003), Battling Benchmark Distortions, Petroleum Economist, April.

37

1992
547
309
856

In July 2002, Platts broadened its definition of the benchmark Dated Brent to include Forties (UK North
Sea) and Oseberg (Norway) for assessment purposes and as deliverable grades in the Brent Forward
contract. Forties is a mixture of oil produced from separate fields and collected by pipeline to the terminal
in Hound Point in the UK. Oseberg is a mixture of oil produced from various Norwegian fields and
collected to the Sture terminal in Norway. The new benchmark was known as Brent-Forties-Oseberg
(BFO). The inclusion of these two grades increased the production volume of the benchmark. It also
resulted in the distribution of cargoes over a wider range of companies with none having a dominant
position. However, as seen from the graph below, the production of BFO started its decline, falling from
63 cargoes a month in August 2004 to around 48 cargoes in the first months of 2007. In early 2007, BFO
production amounted to less than 30 million barrels a month, distributed over more than 55 companies.
Figure 7: Falling output of BFO

Source: Joel Hanley, Assessing the Benchmarks, Platts Presentation, January 31, 2008.

In 2007, a new grade, Ekofisk, was added to the complex which led to the creation of the current
benchmark known as BFOE, though it is still commonly referred to as Brent or North Sea. Ekofisk is a
mixture of crude oil produced from different North Sea fields and is transported to the Teesside terminal
in the UK. The bulk of BFOE output is traded on the spot market or transferred within integrated oil
companies where only about one out of seven BFOE cargoes is sold on long-term basis.56 This feature
combined with the highly diversified ownership gave rise to an active trading activity around BFOE. The
inclusion of this new stream increased the physical base of the benchmark to around 45 million barrels a
month in early 2007 but since then it has been in gradual decline. Production of BFOE is expected to
decline to less than 1 million b/d by 2012. As noted by Platts (2010a:3), further changes to the
benchmarks cant be ruled out, especially if production of the key grades is deemed too low or if their
qualities were to deviate significantly from the norm. In fact such a change might occur sooner rather
56

Argus (2010), Argus Guide to Crude and Oil Products Markers, January.

38

than later. A recent article warns that unless the contract is enlarged, it faces the risk of serial squeezes
and distortions.57
Given that these various grades are not of similar quality as shown in Table 5 below, the widening of the
definition of the North Sea benchmarks has implications on the price assessment process. In particular,
the start-up of the Buzzard field in 2007 increased the viscosity and the sulfur content of Forties Blend
making Forties the least valuable among the various crudes in the BFOE benchmark. Since any of the
four varieties can be delivered against a BFOE contract, sellers often tend to deliver the cheapest grade
and hence it is Forties that sets the price for the BFOE benchmark.58 This problem becomes more acute
during periods when other fields in the Forties system are shut down for maintenance. As a result of
including the Buzzard stream, Platts had to introduce a quality de-escalator in July 2007 which applies
for deliveries above the base standard of 0.60% sulfur: the higher the sulfur content, the bigger the
discount that the seller should give. Currently, a de-escalator of 60 cents/barrel applies for every 0.10 per
cent of sulfur specified above the base standard. Prior to this innovation, the market was not sure on
how to deal with the sulfur issue and in some periods in 2007 there were no trades in the Platts window.59
This episode almost brought the physical market to a standstill with traders complaining that Platts
changes to its pricing assessment process had paralysed the market.60
Table 5: API and Sulfur Content of BFOE Crudes
Forties Before Buzzard
Buzzard
API
44.1
32.6
Sulfur Content 0.19
1.44
wt.

Brent

Oseberg

Ekofisk

38.1
0.42

37.7
0.23

37.5
0.23

Source: Bossley, L. (2007), Brent: A Users guide to the Future of the World Price Marker, London: CEAG, Table
5.

The Layers and Financial Instruments of the Brent Market

Around the Brent/BFOE physical benchmark, a number of layers and instruments have emerged, the most
important of which are: Brent Forwards, Contract for Differences (CFDs), Exchange for Physicals
(EFPs), and Brent futures, Brent options and swaps. Some of the instruments such as futures are traded on
regulated exchanges such as ICE while others such as swaps are traded bilaterally over-the-counter
(OTC). Nevertheless, these layers are highly inter-linked and are essential for the risk management and
the price discovery functions.
Data Issues
In the Brent complex, data about the different layers such as the volume of trading, the number of
concluded deals, the composition of participants and the degree of concentration are not publicly
available. Oil PRAs are under no legal obligation to report or publish such data although oil trading data
gathered by PRAs are made available to subscribers at a price. This section relies on data provided by
Argus. While this is one of the best sources for data on the Brent complex, the data suffers from some
limitations. There are no legal or regulatory obligations on participants in the Brent market to report their
deals and thus the coverage depends on the willingness of participants to provide information to the oil
57

Kemp, J. (2011), Falling Output Imperils Brent Benchmark, Reuters, 19 January 2011.
For instance on May 25 2010, Forties was assessed at $67.57-67.59, Oseberg at $68.49-68.52, Ekofisk at $68.2968.32, and Brent at $68.02-68.05 by Platts. The BFOE or North Sea Light was assessed at 67.57-67.59, the same as
the assessment of the value of Forties.
59
FT.com/Alphaville (2010), Brents Got Its Problems Too, September 2010.
60
Reuters (1997), Platts to modify new oil price system after turmoil, 19 June.
58

39

pricing reporting agencies. This has a number of important implications. First, since there is OTC trade
that goes unreported, the volume of market activity reported by Argus is likely to be a fraction of the total
volume of trade conducted in the various Brent layers. Nevertheless, it is representative of the market
activity and hence any proportions based on this sample such as the relative sizes of OTC markets and
the shares held by different companies are likely to represent fairly accurately the structure of the market.
Second, when analysing trends over a period of time, changes in statistics related to liquidity or to the
number of reported deals may reflect changes in coverage by the price reporting agency rather than
underlying changes in the statistic. Third, other problems arise when making comparisons across the
different Brent layers. For instance, in the futures markets, every deal is reported and the size of the
contract is 1000 barrels. In some layers such as Dated Brent and 21 Day BFOE, players can end up with a
ship full of crude which limits the attractiveness of these markets to a large number of participants.
Hence, one should be careful when comparing across markets as although these are all part of the Brent
complex, they differ in nature and function. Furthermore, the nature of trading can be different across
markets. For instance, in Dated Brent and 21 Day BFOE, trade in outright differentials or spreads is the
norm though 21 Day BFOE can also trade on a fixed price basis. In the futures and options, trade in
differentials also constitutes an important component of trade between months. This involves buying a
contract in one month (say a June contract) and selling a contract in another month (say a July contract).
In terms of reporting, each of the two legs of the transaction is reported as an outright deal. Thus, any
comparisons across markets should adjust for the volume of such trade in spreads.
The Forward Brent
The Forward Brent is one of the first layers to emerge in the Brent complex. The forward Brent is also
referred to as 21-day Brent, 21-day BFOE or simply as paper Brent. Forward Brent is a forward contract
that specifies the delivery month but not the particular date at which the cargo will be loaded. Forward
Brent price is often quoted for three months ahead. For instance, on 25th May, the Forward Brent is
reported for the months of June, July and August. These price quotations represent the value of a cargo of
physical delivery in the month specified by the contract.
In order to understand the nature of the Forward Brent market, it is important to look at the precursor of
the 21-day Brent, the 15-day Brent market. The incentive for oil companies to engage in tax spinning
through the forward market was the main factor responsible for the emergence of the forward 15-Day
Brent market (Mabro et al. 1986; Horsnell and Mabro, 1993; Bacon, 1986). The valuation of oil for UK
fiscal purposes was based on market prices. In an arms-length transaction, market prices were obtained
from the realised prices on the deal.61 If oil was merely transferred within a vertically integrated system,
then the fiscal authorities would assign an assessed price to the transaction based on the prices of
contemporary and comparable arms-length deals. Until 1984, these followed the official British
National Oil Corporation (BNOC) price. Because of the differential rates of taxation between upstream
and downstream with the tax rate being lower in the latter, the impact of the fiscal regime was not neutral
and affected a vertically integrated oil companys decision to sell or retain crude oil.62 When the spot
price was lower than the official BNOC price, integrated oil companies had the incentive to sell their own
crude arms-length and buy the crude needed for their own refineries from the market. When the spot
price was higher than the assessed price, oil companies had the incentive to keep the oil for use in their
own refineries. In doing so, the oil companies would achieve higher after-tax profits. After the abolition
of BNOC, the assessment process of transactions within the firm became more complex. The market
value of non-arms-length transactions was based on the average price of contracts (spot and forward)

61

The fiscal authorities specified a number of conditions before a contract could qualify as arms length including
the condition that the deal is not made back to back.
62
Tax spinning refers to this situation in which for fiscal reasons oil companies would resort to buying and selling
crude oil in the market though it would have been more convenient and cheaper to internalize the transaction
(Horsnell and Mabro, 2003:63).

40

preceding the deal. This encouraged oil companies whether vertically integrated or not to engage in tax
spinning through the forward market.63
Although tax spinning continued to provide a motive for trading in these markets, its importance has
declined as tighter regulations, introduced later in 1987, made it more difficult and much less predictable.
But by then, the 15-day forward market was well established and expanding fast as various market
participants including oil companies, traders, and refiners began to trade actively in this market for risk
management and speculative purposes.
The 15-day Brent market largely evolved in response to the peculiar nature of the delivery schedule of
Brent. Companies producing crude oil in the Brent system nominated their preferred date for loading at
the relevant month by the 5th of the preceding month. The loading programme was then organised and
finalised by the 15th of the preceding month. Until the schedule was completed, producers did not know
the exact date when their crude oil would be available for delivery. But these producers may have already
entered into forward contracts in which they agreed to sell their cargoes for forward delivery for a
specified price. Under the 15-day contract, sellers were required to give the buyer of the forward contract
at least 15 days notice of the first date of a three-day loading window. Under the 21-day BFOE contract,
the seller is required to provide the purchaser at least 21 days notice as to when the cargo will be loaded.
For instance, assume that on the 10th of May, the producer enters into a 21-day BFOE contract for
delivery in July. On that day the seller does not know when its crude oil will be available for delivery. In
the month prior to delivery, i.e. in June, the loading schedule is published. The seller is given a 3-day
window between the 22nd and 24th of July in which he can load the oil into tankers. The seller has to
nominate the buyer at the latest by the 1st of July which is the period required to give the buyer notice to
take delivery. Depending on the market conditions at the time of nomination, the original buyer may or
may not want actual possession of the cargo. In fact, it is likely that the original cargo purchaser has
already sold another 21-day contract (i.e. booked out his position)64, in which case he must give notice to
the new buyer to take the cargo at least 21 days in advance. In this way, the 21-day BFOE contract can
transfer hands between buyers and sellers through a daisy chain of notices until a purchaser is ready to
accept delivery or the 21-day period expires and/or the holder of the forward can no longer provide notice
for any more buyers.65 Once the notice period is expired, the oil to be loaded on a specific date is
classified and traded as Dated Brent. For instance, on the 5th of July, the cargo is traded as Dated Brent
where the delivery date is known (17-19 days ahead).
The 21-day BFOE can be either cash-settled by traders offsetting their position in the daisy chain or can
be physically settled. However, only a small percentage of forward contracts are physically settled. Figure
8 below shows the average daily traded volume on a monthly basis and the number of participants in the
21-day BFOE market. As seen from this graph, the number of players during one month is small between
four and 12 players. Furthermore, the traded volume is low not exceeding 600,000 b/d. Between
September 2007 and August 2008, liquidity in the forward market declined at a fast rate reaching the very
low level of less than 50,000 b/d in August 2008. However, liquidity recovered in 2009 and 2010 with
daily average liquidity in the first half of 2010 reaching more than 400,000 b/d. This is less than one
cargo a day compared to around 30 cargoes a day at the heyday of the 15-day Brent market during the late
1980s. Features such as the large size of the cargoes, clocking and the daisy chain games make trading in
forward Brent a risky proposition and the domain of few players. This has pushed the industry to find
63

For details on how tax spinning can be transacted through trading in the forward market, see (Horsnell and Mabro,
1993, Chapter 6 and Bacon, 1986).
64
Book out is used to describe the process whereby a daisy chain of forward transactions having been identified
(such as creating a circle in which A sells to B who sells to C who sells to A) is closed by financial settlements of
price differences rather than physical delivery.
65
In trading terms, the holder of the contract who is unable to require another purchaser to take delivery is said to
have been five-oclocked.

41

alternative ways to manage their risk without trading in the forward market, which can explain the decline
in its trading activity. The futures market has provided such an alternative. Given the central role that the
forward market assumes in the Brent complex, ensuring that there is enough liquidity in the 21-day BFOE
is crucial to the price discovery process. This is especially the case as the settlement mechanism of the
ICE futures Brent contract is based on trading activity in the forward Brent market.
Figure 8: Trading Volume and Number of Participants in the 21-Day BFOE Market
14

600,000

12

500,000

10
400,000
8
300,000
6
200,000
4
100,000

2
0

0
Jul-07

Dec-07

May-08

Oct-08

Mar-09

Participants

Aug-09

Jan-10

Jun-10

Liquidity (b/d)

Source: Argus

There are few participants in the 21-day BFOE. Unlike the futures market, the forward contract involves
trading in 600,000 barrels which is beyond the capability of many small players and hence the
composition is not as diverse as in the futures market. Table 6 below shows the various participants in the
Brent forward market and their total volume of trading during the period 2007 and 2010 (September). On
the sales side, the main players include oil companies with equity interest such as BP, Shell, Conoco
Phillips and Total and some of their trading arms such as Totals TOTSA and physical traders such as
Vitol, Phibro and Mercuria. On the purchase side, these same companies also dominate the trading
activity. For instance, in 2010, Shell was the most important seller and the third important purchaser
while Totsa was the second important seller and the second important buyer. On the purchase side, the
four top players Vitol, Mercuria, Totsa, and Shell captured more than 70% of the observed volumes by
Argus. On the sales side, these companies captured more than 60% of the trading volumes in 2010. The
degree of concentration varies across months and in certain months few players capture the bulk of traded
volumes.

42

Table 6: Participants in the 21-Day BFOE Market and their Shares in Trading Volume

Arcadia
BP
Chevron
ConocoPhillips
Glencore
Hess
Hetco
Mercuria
Morgan
Stanley
Noble
Phibro
Sempra
Shell
StatoilHydro
Total
Totsa
Trafigura
unknown
Vitol

2007
0
23,786
0
18,447
0
0
0
12,136
0
0
46,602
15,534
34,951
0
0
31,068
0
0
68,447
252,978

Sales (b/d)
2008
2009
0
0
3,005
13,699
273
274
11,749
12,329
0
274
0
9,315
0
822
12,842
64,658
0
0
19,126
18,306
62,022
273
0
16,667
0
273
12,842
159,386

274
548
25,479
13,151
125,205
0
0
53,425
0
0
48,219
369,681

2010
0
29,545
0
32,143
0
37,338
7,143
79,545

2007
485
25,243
0
6,311
0
0
0
13,107

28,896
6,494
23,377
8,766
91,883
0
649
62,987
16,234
0
56,818
483,828

0
0
36,408
18,447
46,117
0
0
61,650
0
0
43,204
252,979

Purchases (b/d)
2008
2009
0
0
273
10,959
273
0
5,464
12,329
546
548
0
10,137
0
1,096
24,863
54,247
0
0
23,770
19,672
32,787
0
0
28,962
0
273
20,492
159,383

3,014
822
36,164
13,699
73,151
0
0
108,767
0
0
42,740
369,682

2010
0
12,662
0
29,545
0
20,779
974
89,286
19,805
5,844
14,935
7,792
75,000
0
2,273
83,442
10,714
0
108,766
483,827

The Brent Futures Market

The Brent futures contract was initially launched on the International Petroleum Exchange (IPE), now
known as the InterContinental Exchange (ICE), in London in June 1988 after a number of failed attempts.
As in the case of other futures contracts, the ICE Brent Futures contracts terms and conditions are highly
standardised, which facilitate trading in these contracts. The futures contract specifies 1,000 barrels of
Brent crude oil for delivery in a specified time in the future. The contract expires at the end of the
settlement period on the business day immediately preceding the 15th day of the contract month, if such
15th day is a business day. For instance, a December contract will expire on the 15th of November if it is a
business day. The ICE Brent Crude futures contract is cash settled with an option of delivery through
Exchange for Physicals (EFP). The trading takes place through an electronic exchange which matches
bids and offers between anonymous parties.
The ICE Brent crude oil futures market has grown dramatically in the last two decades; in 2010, the daily
average volume traded exceeded 400,000 contracts or 400 million barrels, more than five times the
volume of global oil production (see Figure 9 below). Initially, the features of the Brent futures contract
attracted small players but after few years of its development, it started attracting large physical players
who enter the market to manage their risk, hedge their positions as well as bet on oil price movements.
The futures market has also attracted a wide range of financial players including swap dealers, pension
funds, hedge funds, index investors, and technical traders.

43

Figure 9: Average Daily Volume and Open Interest of ICE Brent Futures Contract

Source: ICE
An interesting feature of the Brent futures contract is that at expiry it cash settles against the ICE Brent
Futures Index, also known as the Brent Index which is calculated on the basis of transactions in the
forward Brent market. In other words, unlike other futures contracts whose price converges to spot price
at expiry, the Brent futures contract converges to the price of forward Brent. Specifically, the Brent index
is calculated on the basis of weighted average of first-month and second-month cargo trades in the 21-day
BFOE plus or minus average of the spread trades between first and second months as reported by oil price
reporting agencies. At expiry, the Brent futures contract relies on the forward market for cash settlement.
Thus, the effectiveness of the futures market in the role of price discovery relies on the liquidity of the
forward market which as discussed previously is quite variable and concentrated in the hand of few
players. This feature of the Brent futures contract is the result of historical events where the development
of the forward market preceded that of the futures market plus the fact that no producer in the North Sea
would back a physically delivered contract. This meant that for any Brent futures contract to succeed, it
has to be strongly linked to the forward market.
The Exchange for Physicals
Although the Brent futures contract is not physically settled, the Exchange for Physicals (EFPs) market
allows participants to swap a futures position (a financial position) with a physical one. Specifically, by
executing an EFP, a party can convert a futures position into Brent Forward or a 21-day BFOE cargo.66
EFPs are carried outside the exchange and at a price agreed between the parties. The way the EFP works
is straightforward. Party A with a futures position sells the futures contract and buys the physical
commodity. His counterparty B buys the futures position from A and sells the physical commodity to A.
Through this process, A is able to gain physical exposure to the underlying commodity while B has
swapped his physical exposure for a financial one. Such trades can be transacted at any prices agreed
between A and B and are often different from the price prevailing in the futures market. EFPs are often
quoted as differentials to the Brent futures price but usually do not exceed it by more than a few cents.
66

It is important to note that Brent EFPs are not qualitatively equivalent to physically delivered contracts such as
WTI. EFP is optional while for WTI contract, the trader has no choice but to close the position or make or take
delivery.

44

Parties need to notify the Exchange about their agreement so it can close As position and open Bs
position. Thus, the importance of EFP is that it provides a link between the futures market and the
physical dimension of the Brent market. As discussed below, in periods of thin trading activity in the
forward Brent market, the EFP provides the necessary link to identify the price of forward Brent.
The Dated Brent/BFOE
Dated Brent/BFOE, also known as Dated North Sea Light (Platts) or Argus North Sea Dated refers to the
sale of cargo with a specific loading slot. It is often referred to as the spot market of Brent.67 A spot
transaction is often thought of as a transaction in which oil is bought or sold at a price negotiated at the
time of agreement and for immediate delivery. However, Dated BFOE contracts contain an important
element of forwardness as traders rarely deal with cargoes bought and sold for immediate delivery.
Instead, cargoes are sold and bought for delivery for at least 10 days ahead. To reflect this fact, the price
of Dated BFOE is quoted for delivery 10 to 21 days ahead. For instance, on 25th May, the price of Dated
BFOE reflects the price of delivery for the period between the 4 th of June and the 15th of June (11 days).
On 26th May, the price of Dated BFOE rolls forward one day to cover the period between the 5th and 16th
of June (11 days), and so on. This element of forwardness in Dated BFOE also implies that there is a price
risk between the time when a Dated BFOE cargo is bought and the time when it is delivered. Formula
pricing can mitigate part of this risk by pricing the cargo of Dated BFOE on the time of delivery or by
using the average of prices around the loading date, such as three days before and after the loading date.
One interesting feature of the Dated BFOE market is that very few deals are done on an outright basis.
Instead, since 1988, actual deals for physical cargoes of BFOE, including Brent, are priced as a
differential to forward Brent or Dated Brent/ North Sea Dated. As seen from Figure 10 below, by 1991,
deals based on outright prices became negligible. Thus, while the forward Brent sets the price level, the
Dated BFOE market sets the differential to the forward market. More recently, forward Brent itself is
been priced as a differential to the Futures Brent.
Figure 10: Pricing basis of Dated Brent Deals (1986-1991); Percentage of Total Deals
90
80
70
60
50
40
30
20
10
0
1986

1987

1988

1989

1990

Outright Price

Differential Price to Forward Brent

Differential Price to Dated Quotations

Differential Price to other North Sea

Differential Price to WTI

Differential Price to Other

1991

Source: Horsnell and Mabro (1993)

The Contract for Differences (CFDs)

The Contracts for Differences (CFDs) have become an integral part of the Brent market and as discussed
in detail in Box 1 provide the link between the forward Brent market and Dated BFOE. CFDs are swaps
contracts which allow the buyer and seller to gain exposure to the price differential between Dated BFOE
67

It is important to note however that physical Brent or Brent/Ninian Blend trades at a differential to the Dated
Brent or North Sea Dated Price.

45

and Forward Brent. These CFDs can be traded in Platts window or negotiated bilaterally outside the
window or the exchanges. The high volatility in the above differential increased the risk exposure for
physical players, pushing them to hedge using CFDs. This in turn created an important niche for market
makers. Figure 11 below reports the daily volumes of traded CFDs which vary from as low as 250,000
b/d in March 2008 to as high as 1.4 million b/d in April 2010. However, these figures seem to understate
the actual volume of CFD trade with some market participants indicating that the volume of traded CFDs
is much higher.
Figure 11: Reported Trade on North Sea CFDs (b/d)

1,600,000
1,400,000
1,200,000
1,000,000
800,000
600,000
400,000
200,000
0

Source: Argus

The players in this market are quite diverse and include a large number of companies as seen in the table
below. On the sales side, the dominant players are equity producers such as BP, Chevron, Shell, Statoil;
banks such as Morgan Stanley and physical traders such as Vitol, Mercuria and Phibro. On the buying
side, these companies are also dominant. There are many companies that occasionally enter the market
and trade small volumes mainly for hedging purposes.
Table 7: Participants in the CFD Market and their Trading Volumes

Addax
Arcadia
Astra
BNP Paribas
BP
Cargill
Chevron
Chinaoil

2007
0
23,301
0
0
26,214
485
17,233
0

Sales (b/d)
2008
2009
0
411
4,918
4,658
0
0
0
548
55,601
74,085
1,913
411
26,093
70,699
0
0

46

2010
0
14,448
0
5,519
76,948
0
84,659
0

2007
0
6,553
2,427
0
43,083
485
43,811
0

Purchases (b/d)
2008
2009
0
740
10,109
6,575
1,298
0
0
2,192
37,432
24,397
4,918
274
47,541
53,863
0
1,233

2010
812
17,208
0
4,221
75,010
1,136
73,195
0

ConocoPhillips
Glencore
Gunvor
Hess
Hetco
IPC
Iplom
Itochu
JP Morgan
Koch
Lukoil
Maesfield
Marathon Oil
Masefield
Mercuria
Merrill Lynch
Mitsubishi
Mitsui
Morgan Stanley
Murphy
Natixis
Neste
Nexen
Noble
OMV
ORL
Petraco
Petrodiamond
Petroplus
Phibro
Pioneer
Plains
Preem
Sempra
Shell
Sinochem
Sinopec
Socar
Sonatrach
Standard Bank
Statoil
StatoilHydro
Totsa
Trafigura
Unipec
Valero
Veba
Vitol

485
1,456
0
971
0
0
0
0
9,223
33,010
971
0
0
0
34,345
1,942
0
0
20,388
0
0
971
1,942
0
1,485
0
0
0
5,583
20,146
0
0
0
971
47,694
0
0
0
0
0
6,796
14,563
19,782
971
8,738
1,456
0
36,044
339173

10,410
1,940
7,240
273
0
273
0
546
11,380
36,284
13,798
0
0
273
46,809
4,781
0
273
24,317
0
0
4,372
4,577
0
0
1,093
820
0
3,825
48,656
0
2,732
0
7,978
131,929
0
0
0
0
0
2,186
77,945
23,087
16,940
7,377
546
0
58,579
641772

23,041
14,219
13,151
2,192
0
2,055
548
7,671
9,153
23,556
28,559
1,644
0
1,233
59,726
1,918
0
0
57,882
0
42,033
2,740
4,003
822
14,562
0
1,644
0
1,918
68,923
0
0
685
9,644
132,079
0
1,932
0
274
932
8,630
59,233
45,260
29,315
4,521
1,096
0
132,060
961675

Source: Argus

47

33,766
24,968
3,571
22,240
3,571
325
0
7,253
7,792
3,247
24,513
1,136
0
3,247
79,471
1,299
0
0
100,487
0
19,968
0
6,951
14,286
28,545
0
974
1,948
0
82,867
0
0
0
2,273
149,221
1,136
2,597
25,000
974
5,575
108,224
0
25,974
27,955
8,955
0
0
245,692
1259585

728
485
1,942
0
0
0
0
0
1,456
11,165
485
0
11,408
0
31,311
7,646
0
1,456
20,146
0
0
0
2,427
0
0
0
0
0
1,942
36,772
0
0
0
4,854
52,699
0
0
0
0
0
4,369
6,796
14,078
3,641
0
9,951
0
15,049
339172

24,863
4,372
5,464
0
0
1,481
1,093
6,126
29,358
37,205
7,049
0
9,699
3,825
68,415
4,645
0
546
17,760
410
0
3,005
2,691
0
5,787
2,186
1,735
0
0
52,117
0
0
0
15,929
39,727
273
0
0
0
0
273
54,781
46,325
13,798
12,432
14,208
1,093
49,795
641772

28,630
9,863
3,836
2,192
1,096
3,068
548
11,041
54,973
34,849
20,411
0
548
685
99,841
0
3,014
0
51,238
0
36,849
822
5,189
548
36,995
0
2,192
822
1,644
34,400
137
2,466
3,562
15,616
83,995
603
2,800
0
7,260
548
8,630
61,863
47,397
28,877
29,170
19,726
0
112,447
961674

60,065
26,299
1,299
17,532
974
1,786
1,136
10,844
14,935
32,305
21,753
1,623
6,494
0
117,156
0
0
0
88,377
0
27,110
1,623
11,685
8,442
48,880
0
0
0
0
50,487
0
1,299
0
2,922
129,545
974
1,867
9,091
8,279
5,195
118,130
325
60,575
32,649
11,578
54,545
0
98,214
1259585

OTC Derivatives
In addition to the above layers, a whole set of financial instruments that link to the Brent complex are
currently traded over the counter (OTC). These OTC contracts are customised and until recently have
been negotiated bilaterally between parties either face-to-face or through brokers. However, as the use of
OTC became more widespread, OTC contracts became more standardised and part of the OTC activity
has shifted to electronic OTC exchanges. Furthermore, after being matched, counterparties can use the
clearing facilities of exchanges such as ICE and the CME Group. The landscape has become less benign
in a number of ways for bilateral uncleared OTC, and so there has been a shift toward clearing OTC
contracts except for those with either impeccable credit/ unimpeachable credit lines, or those who simply
cannot afford the cash flow/cash flow volatility of a cleared environment (such as airlines). IOSCO
(2010) reports that market participants conduct 55% of their trades in financial oil (crude oil and refined
products) using exchange-traded instruments and hence are subject to clearing. The remaining part of the
business is conducted through OTC. A large part of this OTC trade is now being cleared where 19% of
survey participants trades are being cleared. Only 27% of the total volume traded remains un-cleared.68
The growing similarity between more standardised OTC and exchange-traded instruments has raised the
issue of disparity in supervision and oversight between markets and is at the heart of current plans to
strengthen the regulation of commodity derivatives markets. Exchange clearing of OTC has aided their
transparency already, as they make available daily settlement figures to those clearing the instruments.
The large variety of OTC instruments and the limited information on these instruments precludes an
extensive analysis of OTC markets. ICE lists more than 30 financial contracts (for crude oil alone) that
are cleared on their exchange. These contracts are used primarily for hedging, but also for speculative
purposes and are an integral part of the Brent complex. Using these instruments one can hedge between
the various layers such as between Dated Brent and futures Brent or between further away markets such
as Dubai and futures Brent or between Dated Brent and WTI. One important and active market discussed
above is CFDs. Another active swaps market is the Brent Dated-to-Frontline (DFL) market which trades
the difference between Platts Dated Brent assessments and the ICE first month futures contract. Another
related but less liquid market has emerged which trades the difference between Dated Brent and the daily
trade-weighted Brent average reported by the ICE. Through these customised contracts, traders can
establish a series of inter-linkages not only between the different layers of the Brent market, but also
between Brent and the different benchmarks and hence are likely to influence the price formation and
price discovery processes.
BOX 1: CFD Explained with an Example
To explain the rationale behind CFDs and how it works, it would be useful to provide a simple example,
but based on real data. A refiner bought a cargo of BFOE on 19th March 19 for loading on 21st-23rd of
April. The refiner has accepted to buy the cargo at the Dated Brent price averaged over five days around
the loading date (i.e. 19th-23rd April). The refiner observes that the current value of Dated Brent is $77.88.
He is concerned that by the time of loading the price of Dated Brent could increase: he would like to
hedge his risk. In principle, he could use the April Forward contract to hedge the risk. However, this
hedge is far from perfect because there is the risk that the price of the April Forward may not follow the
movements of Dated Brent at the time of loading. This risk, referred to as the basis risk, constitutes the
main rationale for CFDs.
To hedge the basis risk, the refiner could buy (a) a second-month Forward contract (i.e. a May contract in
our example) and (b) CFDs for the week of 19th-23rd April. The price for the Forward May contract on the
68

These figures however should be treated with caution and some market participants have indicated very different
numbers. The fact remains that the size of the OTC market is not known and less so the percentage of OTC that goes
to clearance.

48

19th of March stood at $79.53 while the CFD for the week 19th-23rd April was at -$0.57. By buying the
second-month forward contract and CFDs, the refiner is able to lock the price of his cargo at $79.53.
So how does the hedge work? Somewhere between 19th-23rd April (say 22nd of April) i.e. when the cargo
is being loaded, the refiner sells the Forward May contract. On the 22nd of April, the BFOE May contract
settled at a price of $84.78. Thus, the refiner has made a profit on his forward position of $5.25: he bought
the forward contract at $79.53 and sold it at $84.78. What about the gain and losses on the CFD position?
The easiest way to think of a CFD is that it is a swap in which the refinery agrees to receive the price of
Dated Brent and agrees to pay the Forward price. Assuming that the refinery unwinds his CFD over the
week, we can calculate the net gain or loss on the CDF as illustrated in the Table below.
CFD Explained
Date
19/04/2010
20/04/2010
21/04/2010
22/04/2010
23/04/2010
Total
Loss/Gain

Dated Brent
83.19
84.74
84.47
84.64
86.49

Loss/Gain CFD
0.2(83.19-83.53)
0.2(84.74-84.86)
0.2(84.47-84.62)
0.2(84.64-84.78)
0.2(86.49-86.43)

BFOE MAY
83.53
84.86
84.62
84.78
86.43

Loss/Gain CFD
-0.068
-0.024
-0.03
-0.028
0.012
-0.138

The refinerys final position as of 23rd of April 2010 is shown in the table below. The high price paid for
the cargo in April has been compensated for by the gain in forward position. In this example, the refiner
has lost on his CFD position.69
Example of CFD (continued)
Refinerys Final Position
(23rd of April 2010)
Price Paid for the Cargo
(Average Dated Brent over the period April 19-April 23)
Gain on Forward Position
Loss on CFD

84.706
5.25
-0.138
79.594

Notice from the above example that the CFD allows us to derive in March the Forward price for Dated
Brent for the week 19th-23rd April. The Forward Dated Brent is simply the CFD plus the second month
forward i.e.
Forward Dated Brent = CFD + Second Month Forward Brent
Thus, the CFD is not the price differential between the current price of Dated Brent and the Forward
Brent Contract. It is rather the difference between the Dated Brent at some stated point in the future and

69

Notice that the refinerys position is not perfectly hedged. In the above example, the May Brent is sold in one day
and is not being closed over the five day period. The average of the BFOE May over 19th-23rd April period is
$84.884 in which case the refiner would have made a profit of $5.314 on his forward position. This will yield
$79.53, the price of the original hedge.

49

the Second Month Forward Brent.70 Since CFDs are reported for eight weeks ahead, it is possible to
derive the price of Forward Brent for eight weeks ahead. Platts refers to these forward prices as BFOE
swaps. These prices provide the vital link between the 21-Day BFOE and Dated Brent and are central for
the price discovery process in the Brent market.

The Process of Oil Price Identification in the Brent Market

Trades in the levels of the oil price rarely take place in the various layers that link the physical dimension
of Brent with the Brent futures. Instead, oil price reporting agencies such as Platts and Argus infer or
identify the oil price level for a wide variety of crudes by exploiting the linkages and the information
derived from the various layers of the Brent market. The process starts by identifying the price of
Forward Brent/BFOE. The price quotation will represent the value of a cargo for physical delivery within
the month specified by the contract. These price quotations are produced daily for three months ahead. Oil
price reporting agencies derive the forward Brent price from deals reported to them by brokers and traders
in the forward market (Argus) or based on deals conducted in the window (in the case of Platts).
However, movements on ICE futures Brent market can also be factored into the assessment.
Furthermore, spread values and EFPs could also be considered. Thus, oil reporting agencies often rely on
information from the futures market to derive the price of Forward Brent, especially at times when the
forward market is suffering from thin liquidity and is dominated by few deals.
The contract that links the futures Brent and the forward Brent is the Exchange for Physicals (EFPs). Oil
PRAs have increasingly relied on EFPs to derive the Forward Brent price. These are often priced as
differential to the Brent futures price. The Brent futures prices and the EFP for a particular month allow
the identification of the forward Brent price for that month. The formula can be as simple as adding the
value of EFP in a particular month (say July) as assessed by the oil reporting agency or generated by the
futures exchanges to the closing price of the July contract in the futures market i.e.
Forward Brent (July) = Futures Price (July) + EFP (July)
Having derived the price level for Forward Brent, the next step is to derive the price of Dated Brent. As
discussed above, the price of Dated Brent is important to the oil price discovery process as it is considered
as the spot market for Brent and should closely reflect the physical conditions in the oil market. As in the
case of Forward Brent however, the price of Dated Brent needs to be identified with the help of another
layer: the OTC market of Contract for Differences (CFDs). The CFD allows us to derive the Forward
Dated Brent using the following formula
Forward Dated Brent = CFD plus Second Month Forward
Given that CFDs are reported for eight weeks ahead,71 the Forward Dated Brent can be derived for 8
weeks into future which give us the Forward Date Brent Curve. For each of the weeks, the price of
Dated Brent/BFOE swaps is reported.
Based on the derived Forward Dated Brent Curve, it is possible to calculate the average of the Forward
Dated Brent from day 10 to day 21. These days are the ones assessed for physical delivery. For instance,
if today is 21st May, the 10-21 day cargoes refer to 6th -17th June. Argus reports this as the Anticipated
Dated Average for the 10-21 days Forward while Platts uses the term North Sea Dated Strip or the
Forward Dated Brent. These are reported as an outright price.
Since BFOE is comprised of four different crudes, these blends of individual crudes often trade as
differentials to the 10-21 average of the Forward Dated Brent or North Sea Dated Strip. Based on an
70

An alternative way to understand the equation above is to go through the above example. By buying a Forward
contract and CFDs, the trader is able to lock today the price for Dated Brent for delivery at a certain time in the
future.
71
In essence CFDs can be traded for any week that is needed to trade, but are only reported for 8-weeks ahead.

50

assessment of these differentials through MOC process or observed deals, it is possible to calculate the
price of Dated Brent/BFOE or Dated North Sea Light (Platts) or Argus North Sea Dated (Argus) for the
day.72 Specifically, the price of Dated Brent will settle on the most competitive crude among the BFOE
combination which is usually Forties.73
The above discussion implies that during the last three decades the Brent market has evolved into a
complex structure consisting of set of interlinked markets which lie at the heart of the international oil
pricing system. The Brent market is multi-layered with the various layers being strongly interconnected
by the process of arbitrage. Thus when referring to Brent, it is important to specify what Brent is being
referred to: Dated Brent, 21-Day Brent, Brent futures, Brent CFDs or even to Brent altogether as the
continuous decline in the physical liquidity meant the Brent Blend has become less important in the North
Sea physical complex. These layers and links are central for the price discovery process as identifying the
oil price relies heavily on information derived from the financial layers. The implications of these
linkages on the oil price formation process are discussed in details in Section 8.

72

Alternatively, one can take a simple average of the four crudes which would result in Platts North Sea Basket.
As an example, on May 25, 2010, North Sea Dated Strip was priced at 68.13-68.14. This value was derived from
the Dated Brent Swap based on the average of 10- 21 window. Each of the four crudes is priced as a differential to
the forward Dated Brent. On May 25, 2010, Brent was priced at -0.11/-0.09; Forties at -0.56/-0.55, Oseberg at
0.36/0.38 and Ekofisk at 0.16/0.18. These differentials are obtained from concluded deals and failing that on bids
and offers. Since Forties is the most competitive crude, the Dated Brent/BFOE is obtained by applying the Forties
differential. Specifically Dated Brent/BFOE=North Sea Dated Strip (68.13-68.14) + Differential (-0.56/-0.55) =
67.57-67.59.
73

51

6. The US Benchmarks
West Texas Intermediate (WTI) is the main benchmark used for pricing oil imports into the US, the
worlds largest oil consumer. More crude oil is priced-off the Brent complex, but the Light Sweet Crude
Oil Futures Contract, which is based on WTI,74 is one of the most actively traded commodity futures
contract. While WTI is the most widely known US crude stream, other crude streams exist alongside
WTI. One such is the Light Louisiana Sweet (LLS) crude which has become the local benchmark for
sweet crude in the US Gulf Coast. Other important streams include the US-Gulf Coast Sour and Medium
crudes such as Mars and Poseidon (produced offshore Louisiana) and Southern Green Canyon (produced
offshore Texas). On the basis of transactions in these three crude streams, Argus derives ASCI. Platts
publishes a similar index known as Americas Crude Marker which incorporates the value of the four sour
grades: Mars, Poseidon, SGC and Thunder Horse (produced offshore Louisiana).

The Physical Base for US Benchmarks

The US constitutes the largest oil market in the world. In 2009, US consumption accounted for almost a
quarter of global consumption. The US is also an important producer, its production reaching 5.3 million
b/d or about 5% of the global production in 2009. The US is also an important refining centre with an
operable refining capacity exceeding 17 million b/d in 2009.
Central to understanding the physical base of US benchmarks is the Petroleum Allocation for Defense
Districts (PADD) regional definitions. The US is divided into five regions or PADDs as seen from the
map below. The most important district in terms of production is PADD III where in 2009 it produced
more than 3 million b/d out of total USs production of 5.3 million b/d (see Table 8 below). PADD III is
also the most important refining centre in the US, with refining operable capacity of around 8.5 million
b/d accounting for almost half of operable refining capacity in the US (see Table 9).
Figure 12: US PADDS

Source: EIA
74

The Light Sweet Crude Oil Futures contract is also referred to as the WTI futures contract.

52

Table 8: US Oil Production by District

2004

2005

2006

2007

2008

2009

5,419

5,178

5,102

5,064

4,950

5,361

19

23

22

21

21

18

435

443

458

470

538

591

Kansas

93

93

98

100

108

108

North Dakota

85

98

109

123

172

218

U.S.
PADD 1
(East Coast)
PADD 2
(Midwest)

Oklahoma
PADD 3
Gulf Coast)

171

170

172

167

175

184

3,016

2,804

2,838

2,828

2,699

3,121

Louisiana

228

207

202

210

199

189

Texas
Federal
Offshore
(PADD 3)
PADD 4
(Rocky
Mountain)

1,073

1,062

1,088

1,087

1,087

1,106

1,453

1,282

1,299

1,277

1,152

1,559

309

340

357

361

357

357

141

141

145

148

145

141

1,640

1,569

1,426

1,385

1,336

1,274

Alaska

908

864

741

722

683

645

North Slope

886

845

724

707

670

638

656

631

612

594

586

567

Wyoming
PADD 5
(West Coast)

California
Source: EIA Website

Table 9: Operable Refining Capacity by District

2004

2005

2006

2007

2008

2009

16,974

17,196

17,385

17,450

17,607

17,678

PADD 1

1,736

1,717

1,713

1,720

1,722

1,723

PADD 2

3,526

3,569

3,583

3,595

3,670

3,672

PADD 3

7,967

8,159

8,318

8,349

8,416

8,440

PADD 4

582

589

596

598

605

622

PADD 5

3,164

3,162

3,175

3,187

3,195

3,222

U.S.

Source: EIA Website

While PADD III constitutes the major production and refining centre in the US, PADD II assumes special
importance as it is the main centre for crude oil storage and the delivery point at the expiration of the
53

Light Sweet Crude Oil Futures contract. Cushing, Oklahoma located in PADD II is a gathering hub with
large storage facilities: an estimated operable crude storage capacity of 45.9 million barrels and nameplate
storage capacity of 55 million barrels.75 PADD II itself can be divided into two sub regions: the
Midcontinent and the Midwest (Purvin and Gertz, 2010). Cushing is located in the Midcontinent. It
collects crude oil from Texas, surrounding Oklahoma and other imported crude. It links to major
refineries centres both in the Midcontinent, the Midwest (PADD II) and PADD III through a complex set
of pipelines.76 Historically, the refineries in the Midcontinent relied on domestic crude for their runs.
However, with the decline in domestic production, refineries in the Midcontinent increased their reliance
on foreign imports and Canadian crude delivered into Cushing and the broader region. A similar picture
also emerged for the Midwest where historically it has relied heavily on domestic production. However,
given the decline in production and its proximity to Canada, Canadian crude started to rise in importance
displacing domestic production and imports from outside Canada, a trend which is likely to continue. As
seen in Table 10 below, in 2009 Canadian imports accounted for 90% of total oil imports into PADD II.
In contrast, refineries in PADD III have access to a wide variety of crude oil with offshore imports from
OPEC constituting the bulk of total imports.
Table 10: Total Imports by District from OPEC and Canada (Million b/d)
PADD1 (Total)

2004
1,549

2005
1,605

2006
1,497

2007
1,495

2008
1,421

2009
1,244

OPEC

764

893

844

936

807

587

Canada

197

215

210

263

260

215

PADD 2 (Total)

1,584

1,516

1,514

1,497

1,517

1,407

OPEC

370

323

300

345

297

154

Canada

1,054

1,039

1,150

1,125

1,176

1,222

PADD 3 (Total)

5,768

5,676

5,656

5,611

5,375

5,090

OPEC

3,448

3,131

3,147

3,533

3,521

3,013

Canada

18

20

59

96

106

126

PADD 4 (Total)

260

271

278

278

264

232

Canada

260

271

278

278

264

232

PADD 5 (Total)

926

1,057

1,173

1,149

1,206

1,040

OPEC
Canada

460
87

469
88

493
105

574
126

790
151

601
148

Source: EIA

Although a wide variety of crude oils is produced in the US, WTI assumes special importance in the
global oil and financial markets since WTI underlies the Light Sweet Crude Oil futures contract, one of
the largest traded commodity futures contract. It should be noted however though that trade around
Cushing, and a forward market around that trade, existed prior to the establishment of the futures market.
75

Storage operators keep 41pc of tank space for their own use and lease 59pc to third parties. Plains and Magellan
plan to add a combined 8.25mn bl of new storage at Cushing next year. See Argus Global Markets (2010), EIA
Reveals Cushing Tank, 6 December
76
For details see Purvin and Gertz, 2010.

54

That forward market existed in parallel to the futures market through the late 80s and early 90s. However,
unlike the Brent market, as futures volumes grew, it eventually eliminated the need for the forward
market. This forward market was knows as the WTI Cash Market. Its last vestige exists now only in the
3 days between futures expiry and pipeline scheduling on the 25th of each month, discussed in details
below.
WTI is a blend of crude oil produced in the fields of Texas, New Mexico, Oklahoma and Kansas. It is a
pipeline crude and deliveries are made at the end of the pipeline system in Cushing, Oklahoma. As in the
case of Brent, the WTI market is also characterised by a large number of independent producers who sell
their crude oil to large number of gatherers. However, unlike Brent which is waterborne crude, WTI is
pipeline crude and thus is subject to problems of logistical and storage bottlenecks. Brent is exportable
which makes it more flexible and more responsive to trading conditions in the Western Hemisphere.
Furthermore, as discussed later in this section, WTI can show serious dislocations from other markets in
some occasions, reducing its attractiveness as a global benchmark or even as a US benchmark.

The Layers and Financial Instruments of WTI

Very few layers emerged around the WTI, the most important of which are the futures and option contract
and OTC derivatives. The Light Sweet Crude Oil Futures contract has been trading on the New York
Mercantile Exchange (now part of the CME Group) since 1983. Figure 13 below shows the monthly
averages of volumes traded of the Light Sweet Crude Oil Futures Contract for the last 15 years. Between
1995 and 2010 (January-September), the monthly volumes of traded contracts grew at an average annual
rate of 15%. As seen from the graph below, the increase in traded volume between 2006 and 2010 has
been phenomenal with the average annual growth rate during the period 2007 and 2010 reaching 27%. In
2010, the monthly average volume exceeded 14 million contracts or 14 billion barrels. On a daily basis
this amounts to more than 475 million barrels of oil, around 6 times the size of the daily global oil
production. Most of the trading takes place through the electronic platform (known as GLOBEX) which
provides ease of access from virtually anywhere in the world almost 24 hours a day. A wide range of
players are attracted to the futures market including commercial enterprises such as producers, marketers,
traders as well as speculators and variety of financial investors such as institutional and index investors.
Figure 13: Monthly averages of volumes traded of the Light Sweet Crude Oil Futures Contract
16000000
14000000
12000000
10000000
8000000
6000000
4000000

2000000
0
1995

1996

1997

1998

1999

2000

2001

2002

Source: CME Group

55

2003

2004

2005

2006

2007

2008

2009

2010

Unlike the Brent futures contract (where delivery is elective via the EFP mechanism), the Light Sweet
Crude Oil Futures contract is fully physically delivered for every contract left open at expiry by default.
It specifies 1,000 barrels of WTI to be delivered at Cushing, Oklahoma. The contract also allows the
delivery of domestic types of crude (Low Sweet Mix, New Mexican Sweet, North Texas Sweet,
Oklahoma Sweet, and South Texas Sweet) and foreign types of crude (Brent Blend, Nigerian Bonny
Light and Qua Iboe Norwegian Oseberg Blend and Colombian Cusiana) against the futures contract. It is
important to note though that only a small percentage of the volume traded is physically settled with most
of the physical settlement occurring through the EFP mechanism. EFP provides a more flexible way to
arrange physical delivery as it allows traders to agree on the location, grade type, and the trading partner.
Crude oil futures contracts are traded for up to nine years forward. However, liquidity tends to decline
sharply for far away contracts (see Figure 14). For instance, on October 19, 2010 the bulk of the trading
activity concentrated on the December 2010 contract. There is some liquidity up to one year ahead, but as
we move towards the back end of the futures curve, liquidity tends to decline sharply. For instance, on
October 19, 2010, the traded volume of December 2017 and December 2018 contracts stood at 33 and 4
contracts respectively.
Figure 14:Liquidity at Different Segments of the Futures Curve (October 19, 2010)
500000

460127

450000
400000
350000
300000

250000
200000
150000
100000

20991

50000

4
Nov-18

Aug-18

Feb-18

May-18

Nov-17

Aug-17

Feb-17

May-17

Nov-16

Aug-16

Feb-16

May-16

Nov-15

Aug-15

Feb-15

May-15

Nov-14

Aug-14

Feb-14

May-14

Nov-13

Aug-13

May-13

Feb-13

Nov-12

Aug-12

May-12

Feb-12

Nov-11

Aug-11

Feb-11

May-11

Nov-10

Source: CME Group Website

In addition to the futures and option contracts, a group of OTC financial instruments link to the WTI
complex, allowing participants to use more customised instruments than those available in the futures
market. As discussed in the case of Brent, a large fraction of OTC deals linked to WTI are using the
clearing facilities of the CME Group or ICE. The CME group lists more than 90 OTC financial contracts
for crude oil that are cleared on its exchange. Contracts such as the WTI-Brent (ICE) Calendar Swap
Futures and the WTI Calendar Swap Futures are more customised and are traded OTC but cleared
through the exchange.

The Price Discovery Process in the US Market

Unlike the Brent market, trading in the US pipeline market is of smaller volumes typically around 30,000
barrels compared to 600,000 barrels in the Brent market. Trade in small volumes has increased the
diversity and number of players who find it easier to obtain the necessary credit and storage facilities to
participate in the US market. Furthermore, the US market has maintained its liquidity despite the decline
56

in physical production and consolidation within the industry. In 2009, the combined spot-market traded
volume for twelve US domestic grades (for the month of April) stood at more than 1.8 mb/d77 (see Figure
15) which is much higher than other benchmarks including BFOE, Oman and Dubai.
Figure 15: Spot Market Traded Volumes (b/d) (April 2009 Trade Month)
450,000
400,000
350,000
300,000
250,000
200,000
150,000
100,000
50,000
0

Source: Argus (2009), Argus US Crude Prices Explained, 24 September

Most of those crudes imported into the US and sold in the spot market are linked to WTI with some
exceptions such as Iraq, Kuwait and Saudi Arabias sales to the US which are linked to ASCI; some
imports from West Africa and the North Sea which are linked to Dated Brent; and some Canadian East
Coast crudes which also link to Dated Brent. While producers still use the assessed prices of WTI in
their pricing formula, those assessments are often made as a differential to the settlement price in the
futures market. In other words, it is the futures market that sets the price level while assessed prices by
oil price reporting agencies set the differentials.
The physical delivery mechanisms complicate the price assessment process. In the futures market, trading
in the current delivery month expires on the third business day prior to the twenty-fifth calendar day of
the month preceding the delivery month. For instance, the March WTI futures contract expires on the 22nd
of February. Under the terms of the futures contract, delivery should be made at any pipeline or storage
facility in Cushing, Oklahoma and must take place no earlier than the first calendar day of the delivery
month (March) and no later than the last calendar day of the delivery month (March). At expiration, three
business days are needed for pipeline scheduling to organise the physical delivery in March. The threeday window between the expiration of the monthly NYMEX WTI contract and the deadline for
completing the shipping arrangements (i.e. between the 22nd and 25th of February in our example) is
known as the roll period. During this period, the March WTI futures contract has already expired while
the spot (physical) month is still March.78 To derive the spot price of WTI March, PRAs assess the cash
roll which is the cost of rolling a contract forward into the next month without delivering on it. This
transaction can also simply be a purchase/sale of current month supply valued at an EFP to next month
futures. On the 26th of February, the physical front month becomes April which can then be linked to the
April WTI futures contract.

77
78

Argus (2009), Argus US Crude Prices Explained, 24 September.

In our example, the physical month extends in our example from 26th January through February 25th.

57

Historically, a large number of independent producers used to sell their crude oil to gatherers based on
WTI posting plus (P-Plus), which is the sum of the wellhead posted prices plus delivery costs into
Cushing. Nowadays the P-Plus market is widely used with its sister market, the differential to Nymex
Calendar Monthly Average (CMA) market. The P-Plus market used the Koch posting only as a basis up
until about 3 years ago when Koch stopped publishing that. Now companies tend to transact versus the
ConocoPhillips posting. The value that the differential to Postings (P-Plus) represents is the value for
delivery into Cushing in the current calendar month, assuming a certain cost to move the barrels to
Cushing. ConocoPhillips is known to use the Nymex settlement price, adjusted by the cost of moving the
barrel to Cushing, to set the price of the posting. This way the CMA and P-Plus markets are
mathematically connected and never too far out of synchronisation. The CMA market has been gaining
liquidity and is increasingly being used to value prompt crude oil in the US. It is the most active market in
terms of volumes of spot trade as seen from Figure 15. It is important to note that CMA is an extension to
the futures market. The CMA market does not trade price levels, but often trades at a differential to the
WTI futures contract settlement price. CMA and P-Plus have replaced the WTI Cash Window.79
Platts uses its window to assess WTI differential to CMA and other domestic crudes. While the CMA
market is quite liquid with large and diverse number of players, the percentage of transactions in the
Platts window is only a small fraction of total transactions during the day.80 In June 2007 for instance,
total window trade amounted only to 4% of entire day trade observed by Argus. For all US crudes, total
window trade amounted to 2.4% of all spot trade.81 Some crude streams such as Mars show 19 days of no
trade in June 2007 and prices were assessed based on bids and offers. 82 Furthermore, despite the diversity
of players in the market, the degree of concentration in the window is quite high with a few players
dominating the trading activity.83 Given these concerns and the fact the CMA is priced as a differential to
the price in the futures market, it is surprising that producers do not more widely use futures prices
directly into their pricing formula.84 The WTI futures contract is a physical one and the price of the
futures contract converges to the spot price at the expiration of the contract. Hence, in the case of WTI,
the use of the futures price instead of assessed prices in the pricing formulae would make little difference.
The depth and the high liquidity of the futures market surrounding WTI and the diversity of its market
participants should incentivise buyers and sellers to use the futures price in their formula pricing. In
practice, there is some evidence that the front-month WTI futures price can exhibit high volatility around
the expiry date in some instances, which may partly explain the preference of some traders to stick to
assessed WTI prices. Furthermore, both the P-Plus and CMA are means of valuing WTI that is one month
prompter than the promptest futures contract.

WTI: The Broken Benchmark?

It has been recognised that the links between the WTI benchmark and oil prices in international markets
can be at times dictated by infrastructure logistics. In the past, the main logistical bottleneck has been how
to get enough oil into Cushing, Oklahoma. In many instances, this resulted in dislocations with WTI
rising to high levels compared to other international benchmarks such as Brent. The problem has recently
been reversed. While the ability to get oil into Cushing has increased mainly through higher Canadian
imports, the ability to shift this oil out of the region and to provide a relief valve for Cushing is much
more constrained as the storing in Cushing is inaccessible by tanker or barges with few out-flowing
79

The WTI Cash Window, which was/is a Platts mechanism for setting the price of WTI at 3:15 EST after the close
of the Nymex at 2:30 EST, has not traded for about 3 years. It is no longer an operative index because very few
companies use it for price reference.
80
Argus Global Markets (2007), Liquidity and Diversity Prevail, 24 September.
81
Argus, State of the Market Report: US Domestic Crude, Argus White Paper.
82
Ibid.
83
Ibid.
84
It is important to note though that many companies do use the NYMEX settlement as a pricing index.

58

pipelines, especially southbound towards the US Gulf major refining centre. In some occasions, this has
led to a larger than expected build-up of crude oil inventories in Cushing. For instance, in 2007, due to
logistical bottlenecks, there was a large build-up of inventories as a result of which the WTI price
disconnected not only from the rest of the world, but also from other US regions. In 2008, the build-up of
inventories in Cushing due to a deep contango and reduction in demand induced by the credit crunch
caused a major dislocation of WTI from the rest of the world.
Given the major role that WTI plays in the pricing of US domestic crude, imported oil into the US and
global financial markets, the price effects of such logistical bottlenecks are widespread. First, dislocations
result in wide time spreads as reflected in the large differential between nearby contracts and further away
contracts as seen in Figure 16 below. For instance, in January 2009, the spread between a twelve-week
ahead contract and prompt WTI reached close to $8 with implications on inventory accumulation.
Figure 16: Spread between WTI 12-weeks Ahead and prompt WTI ($/Barrel)
+10.00
+8.00
+6.00
+4.00

+2.00
...
-2.00
-4.00
Jan 10

Sep 09

May 09

Jan 09

Sep 08

Jan 08

May 08

Sep 07

Jan 07

May 07

Sep 06

Jan 06

May 06

Sep 05

Jan 05

May 05

Sep 04

Jan 04

May 04

Sep 03

Jan 03

May 03

Sep 02

Jan 02

May 02

Sep 01

May 01

Jan 01

-6.00

Source: Oil Market Intelligence

Dislocations also have the effect of decoupling the price of WTI from that of Brent, as reflected in the
large price differential between the two international benchmarks (see Figure 17). For instance, in
February 2009, the differential exceeded the $8/barrel mark. Similar episodes occurred in May and June
of 2007. Such behaviour in price differentials however does not imply that the WTI market is not
reflecting fundamentals. On the contrary, price movements are efficiently reflecting the local supplydemand conditions in Cushing, Oklahoma. The main problem is that when local conditions become
dominant, the WTI price can no longer reflect the supply-demand balance in the US or in the world and
thus no longer acts as a useful international benchmark for pricing crude oil for the rest of the world. It
has also become less useful as a means of pricing crude in other US regions such as the Gulf coast.

59

Figure 17: WTI-BRENT Price Differential ($/Barrel)

+9.00
+7.00
+5.00
+3.00
+1.00
-1.00
-3.00
-5.00
-7.00
-9.00

Source: Petroleum Intelligence Weekly

Most Latin American producers85 and until recently also some Middle East producers used WTI in their
pricing formula in long-term contracts. In 2010, Saudi Arabia decided to shift to an alternative index
known as the Argus Sour Crude Index (ASCI) for its US sales. Kuwait and Iraq soon followed suit. ASCI
is calculated on the basis of trade in three U.S. Gulf of Mexico grades: Mars, Poseidon and Southern
Green Canyon. Unlike WTI and LLS which are sweet and light, the ASCI benchmark is a medium sour
index. These sour crudes also do not seem to suffer from infrastructure problems and the occasional
logistic bottlenecks that affect WTI, although disruptions could take place as they exposed to potential
hurricanes, as Hurricanes Rita and Ivan illustrated. Their physical bases have benefited from the increased
production in the Gulf of Mexico and as a result the volume of spot trade in the underlying crudes is
sizeable. It is important to note that like other local US benchmarks, ASCI is linked to WTI and currently
trades as differential to WTI. In a way, the WTI Nymex price is the fixed price basis for the index and
thus ASCI is not intended to replace WTI as fixed price but instead works in conjunction with other
markets to provide a tool for valuing sour crude at the Gulf Coast (Argus, 2010:3). This explains why
newly listed derivatives instruments such as futures, options and over the counter (OTC) around ASCI did
not gain any liquidity as most of the hedging can be done using the WTI contract.86

85

Mexicos formula for sales to the USA is much more complex. It may include the price of more than one
reference crude (WTI, ANS, West Texas Sour (WTS), Light Louisiana Sweet (LLS), Dated Brent and may be linked
to fuel prices.
86
Another potential reason as to why ASCI OTC has not gained volume is because the users of the
Saudi/Kuwaiti/Iraqi crude are also often producers of the ASCI grades and as such they are internally hedged
through their own activities.

60

7. The Dubai-Oman Market

Currently most cargoes from the Gulf to Asia are priced against Dubai or Oman or combination of these
crudes where around 13.1 mb/d or 94% of Gulf exports destined to Asia are priced of Platts assessment
of Dubai/Oman (Leaver, 2010). With oil starting to flow from East Siberia to Asia in 2009 through the
East Siberia-Pacific Ocean Pipeline (ESPO), one could argue that Dubais role has now expanded into
Russia, as ESPO currently trades as a differential to Dubai. Dubai became the main price marker for the
Gulf region by default in the mid 1980s when it was one of the few Gulf crudes available for sale on the
spot market. Also unlike other countries in the Gulf such as Iran, Kuwait, and Saudi Arabia, until very
recently Dubai allowed oil companies to own equity in Dubai production. Up until April 2007, the major
producing offshore oil fields of Fateh, SouthWest Fateh, Rashid, and Falah were operated by the Dubai
Petroleum Company (DPC), a wholly owned subsidiary of Conoco-Phillips. DPC acted on the behalf of
the DPC/Dubai Marine Areas Limited, a consortium comprised of Conoco-Phillips (32.65%), Total
(27.5%), Repsol YPF (25%), RWE Dea (10%), and Wintershall (5%). In April 2007, the concession was
passed on to a new company, the Dubai Petroleum Establishment (DPE), a 100% government owned
company while the operations of the offshore fields were passed to Petrofac which acts on the behalf of
DPE. The Dubai market emerged around 1984 when the spot trade in Arabian Light declined and then
ceased to exist. When the Dubai market first emerged, few trading companies participated in this market
with little volume of trading taking place. This however changed during the period 1985-1987 when many
Japanese trading houses and Wall Street refiners started entering the market. The major impetus came in
1988 when key OPEC countries abandoned the administered pricing system and started pricing their
crude export to Asia on the basis of the Dubai crude. Over a short period of time, Dubai became
responsible for pricing millions of barrels on a daily basis and the Dubai market became known as the
Brent of the East (Horsnell and Mabro, 1993).
Dubai is not the only benchmark used for pricing cargoes in or destined to Asia-Pacific. Malaysia and
Indonesia set their own official selling prices. Malaysias sales are set on a monthly-average of price
assessments by panel Asia Petroleum Price Index (APPI) plus P-Factor premium which is determined by
the national oil company Petronas. Indonesia sells its cargoes on the basis of the Indonesian Crude Price
(ICP) which is based on a monthly average of daily spot price assessments. While some cargoes are
priced as a differential to Indonesian Minas and Malaysian Tapis, these benchmarks have fallen in favour
with Asian traders. Since APPI and ICP are often used to price sweet crudes, trading against Dated Brent
for sweet crudes has been on the increase in Asia, a trend which is likely to consolidate as the physical
liquidity of the key Asian benchmarks Tapis and Minas continues to decline. This should be of concern to
producers and consumers as the Dated Brent benchmark may not necessarily be fully reflective of
supply/demand fundamentals in East of Suez markets. Abu Dhabi, Qatar and Oman also set their own
official selling prices. The former two countries set their OSP retroactively. For instance, the OSP
announced in October refers to cargoes that have already been loaded in September. To reflect more
accurately market conditions, spot cargoes traded in October or November are often traded as differentials
to OSP. Dubai and Oman shifted from a retroactive pricing system to a forward pricing system based on
the DME Oman Futures contract. The pricing off the DME contract however still comprise only a small
percentage of Gulf crude exports to Asia.

The Physical Base of Dubai and Oman

In the early stages of the current oil pricing system, Dubai benchmark only included crude oil produced in
Dubais fields. The volume of Dubai crude production has dropped from a peak of 400,000 b/d in the
period 199095 to under 120,000 b/d in 2004, with production hovering around 90,000 b/d in 2009 i.e.
there are about six cargoes of Dubai available for trade in every month (See Figure 18). The most recent
(unofficial) figures suggest that Dubais production may have fallen further to 60,000 b/d i.e. less than
four cargoes a month with few of these cargoes sold under long-term contracts. Thus, though Dubai
cargoes may be offered sporadically on the spot market for sale, it rarely if ever does trade. The
61

governments decision not to renew the oil concession in 2007 also meant that Dubai no longer satisfies
the ownership diversification criterion. The low volumes of production and thin trading activity render the
process of price discovery on the basis of physical transactions not always feasible. In a sense, Dubai has
turned into a brand or index which represents a sour basket of mid sour grades.87
The rapid decline in Dubai output has increased the importance of Oman in pricing crude oil in the East
of Suez. Oman has some of the characteristics to enable it to play the role of a benchmark such as the
volume of physical liquidity. In 2009, Omani crude oil production reached 815,000 b/d compared to an
average of 760,000 b/d in 1990-1995. The production is not subject to OPEC quotas as Oman is not a
member of OPEC and there are no destination restrictions. On the other hand, Omani crude oil production
is almost totally controlled by PDO, an upstream operating company which is responsible to all the equity
producers for optimising production and delivery through Mina Al Fahal. PDO is owned by the Omani
government (60%), Shell (34%), Total (4%) and Partex (2%). This structure has remained stable since
1977. There is an array of foreign and private domestic oil companies operating outside PDO, but these
constitute a small share of total oil output. In 2009, PDO accounted for more than 90% of the countrys
total crude oil production.
Figure 18: Dubai and Oman Crude Production Estimates (thousand barrels per day)
1000
900
800
700
600
500
400
300
200

100
0
1990-1995

1999

2004
Dubai

2005

2009

Oman

Source: Leaver, T. (2010), DME-Oman: Transparent Pricing and Effective Risk Management in a New Era,
Presentation at the Asia Oil and Gas Conference, Kuala Lumpur, June.

The Financial Layers of Dubai

Unlike Brent, very few financial layers have emerged around Dubai. Attempts to launch a Dubai futures
contracts in London and Singapore were made in the early 1990s, but such attempts did not succeed.
Instead, the informal forward Dubai market remained at the centre of the Dubai complex. In the early
stages of its development, producers with entitlement to production used to place their cargoes in the
forward market. Being a waterborne crude, Dubai shared many of the features of the forward Brent
market with some institutional differences such as the process of nomination, the announcement of the
loading schedule, and the duration of the book-out process (for details see Horsnell and Mabro, 1993).
87

One observer argues that the actual production or even non-existent of Dubai crude oil is irrelevant. What is of
relevance is that by buying the Dubai brand or index one can obtain physical oil and by selling the Dubai index one
has the obligation to deliver physical oil.

62

Currently, the two most important layers surrounding the Dubai market are the Brent/Dubai Exchange of
Futures for Swaps (EFS) and the Dubai inter-month swaps markets. The Brent/Dubai EFS is similar to the
EFP discussed above but where a trader converts a Brent futures position to a forward month Dubai Swap
plus a quality premium spread. This market allows traders to convert their Dubai price exposure into a
Brent price exposure which is easier to manage given the high liquidity of the Brent futures market. As in
the case of an EFP, the EFS is reported as a differential to the price of ICE Brent. It was not possible to
obtain data on EFS volumes, but sources estimate that the volumes of Brent-Dubai EFS and Brent-Dubai
swaps in total are about 1,000-2,000 lots on an average day (i.e. about 1 million-2 million b/d) and can
easily exceed 2,000 lots on a relatively busy day. The Dubai inter-month swap reflects the price
differential between two swaps and thus is different from cash spreads. It allows traders to hedge their
position from one month to the next. Dubai inter-month swaps are actively traded in London and
Singapore and are central to the determination of the forward Dubai price. The actual volumes of intermonth Dubai is also not available, but traders reckon that about 2,000 lots of Dubai swaps (which
includes Dubai outright swaps and inter-month Dubai swaps) trade on an average day. Other sources
suggest a higher estimate with the volume of total Dubai swap (the swap leg of Brent-Dubai and
intermonth combined) in the range of 8000-10000 lots per day of which around 60% is cleared by ICE or
CME. The participants in these markets are quite diverse. Apart from some Japanese refiners, the main
players include banks (Merrill Lynch BoA, JP Morgan, Morgan Stanley, Societe Generale), refiners (BP,
Shell), trading firms (Mercuria, Vitol) and Japanese firms (Mitsui, Sumitomo).
Since 1989, spread deals in Brent-Dubai and inter-month Dubai differentials have dominated trading
activity. As seen from Figure 19, while in 1986 outright deals constituted the bulk of the deals in Dubai,
by 1989 these had declined to low levels. By 1991, spread deals constituted around 95% of the total
number of deals in Dubai with the Brent-Dubai trades playing a central role. In 1991 Brent-Dubai trades
accounted for one third of the liquidity and half of the concluded deals with the Brent market providing
the Dubai market with the bulk of its liquidity. Given the links with the Brent market, Horsnell and
Mabro (1993) argue that Dubai has become close to being little more than another Brent add-on market.

Figure 19: Spread Deals as a Percentage of Total Number of Dubai Deals

100
90
80
70
60
50
40
30
20
10
0
1986 1986 1986 1986 1987 1987 1987 1987 1988 1988 1988 1988 1989 1989 1989 1989 1990 1990 1990 1990 1991 1991 1991 1991
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

Notes: Spread deals include Dubai one-month spread, Dubai two-month spreads, and Dubai-Brent and Dubai-WTI
Spreads.

63

The Price Discovery Process in the Dubai Market

The two main oil pricing reporting agencies Platts and Argus follow very different methodologies in their
assessment of the Dubai price which on many occasions may result in different Dubai prices. Over the
years, the declining production of Dubai has pushed Platts to search for some alternatives to maintain the
viability of Dubai as a global benchmark. In 2001, it allowed the delivery of Oman against Dubai
contracts. In 2004, Platts introduced a mechanism known as the partials mechanism, to counteract the
problem of Dubais low liquidity.88 The partials mechanism has the effect of slicing a Dubai cargo (as
well as Oman) into small parcels that can be traded. The smallest trading unit was set at 25,000 barrels.
Since operators do not allow the sale of cargoes of that volume, it has meant that a seller of a partial
contract is not able to meet his contractual obligation. Thus, delivery will only occur if the buyer has been
able to trade 19 partials totalling 475,000 barrels with a single counterparty.89 Any traded amount less
than 475,000 barrels is not deliverable and should be cash settled (Platts, 2004).90 Platts allows for the
delivery of Omani crude oil or Upper Zakum against Dubai in case of physical convergence of the
contract. In other words, the buyer has to accept the delivery of a usually higher-value of an Oman cargo
or an Upper Zakum against the Dubai contract. The addition of Oman has created problems of its own. In
the Dubai-Oman benchmark, Oman crude has lower sulfur content and higher gravity than the Dubai
crude. In some periods depending on the relative demand and supply for the various crudes, the price gap
between the two types of crude tends to widen. As seen in Figure 20, the differential is quite variable
reaching more than $1.50 in some occasions. As a result of this divergence, many observers have called
for the inclusion of another type of crude in the Dubai assessment process which is closer to Dubai than it
is to Oman.91
Figure 20: Oman-Dubai Spread ($/Barrel)
+2.00
+1.50
+1.00
+0.50
...

-0.50

Nov 09

May 09

Nov 08

Nov 07

May 08

Nov 06

May 07

May 06

Nov 05

Nov 04

May 05

Nov 03

May 04

Nov 02

May 03

Nov 01

May 02

May 01

Nov 00

Nov 99

May 00

Nov 98

May 99

May 98

Nov 97

Nov 96

May 97

Nov 95

May 96

-1.50

May 95

-1.00

Source: Oil Market Intelligence

The price of Dubai is assessed based on concluded deals of partials in the Platts window, failing that on
bid and offers and failing that on information from the swap markets surrounding Dubai. Thus, despite
the fact that NOCs in the Gulf have large physical liquidity which in principle allows them to set the oil
88

A market was developed in the 1980s to trade Brent partials but with the development of the Brent futures market,
the market became redundant. But trade in partials is still used by Platts to assess North Sea and Dubai crudes.
89
This is equivalent to a full 500,000-barrel cargo with an implied operational tolerance of minus 5%.
90
Settlement of cash differences that result from undeliverable partials uses the last price assessment of the trading
month.
91
The pricing of a crude off Dubai-Oman requires setting two coefficients of adjustment (one off Dubai and one off
Oman) and then taking some average between the two coefficients.

64

price, oil exporting countries have avoided assuming this role, shifting the power to set the price to few
traders that participate in the Platts window. Oil exporting countries do not participate in the window;
they simply take Platts assessment of Dubai and use it in their pricing formula. This transfer of the pricing
discovery role to Platts window achieves an important objective as oil exporters do not want to be seen
as influencing oil prices: it is the market that sets the oil price, and not oil exporters. On other hand, this
transfer of power creates some sort of mistrust in the trading activity in the Platts window.
Initially, the shift to partial trading in 2004 has produced encouraging results, increasing the volume of
trading activity and hence improving the efficiency of price discovery, reducing the bid/offer spreads, and
attracting new players to the market (Montepeque, 2005). However, in recent years, the liquidity in Platts
Dubai window has declined to a point when only few deals are concluded during a month (Figure 21). In
many days, there is no execution of partial trades. In fact, since October 2008, there has been no
execution of partial trades in 50% of trading days (Leaver, 2010). This however does not preclude Platts
from producing a value for Dubai, which can be based on bids and offers and/or information from the
value of derivatives. Only a few players such as Sietco, Vitol, Glencore, and Mercuria dominate the Platts
Dubai window at any one day. On the sell side, large Asian refineries such as Unipec and SK have been
dominant. The concentration of trading activity in the hands of few players in the Platts partials market
has raised serious concerns that some traders by investing as little as in a 25,000-barrel partial contract
can influence the pricing of millions of barrels traded everyday (Binks, 2005). However, market
participants who think that prices are being manipulated by a few players have the incentive to enter
Platts window and exert their influence on the price. Critics argue that barriers to entry can prevent such
an adjustment mechanism from taking place.
Figure 21: Dubai Partials Jan 2008 - Nov 2010

250

200

150

100

50

0
January

May

September

January

May

September

January

May

September

Source: Platts

The way that Argus derives the Dubai price sheds some light on the links between the various financial
layers surrounding Dubai. Argus approach for assessing Dubai is based on deriving information from
various OTC markets, the most important of which is the Exchange for Swaps (EFS) and the inter-month
Dubai spread contracts. The EFS price is reported as a differential to the ICE Brent futures contract. This
allows Argus to identify a fixed price for Dubai in a particular month referred to as the price of Dubai
Swap. But since Dubai is loaded two months ahead, the assessed price of Dubai say in the month of
65

December is the forward price of Dubai in February i.e. it is price for delivery of Dubai in the month of
February (call it x)92. But buyers and sellers are interested in the price of Dubai in December. To derive
the price of Dubai in December, the information from the inter-month Dubai spread market is used.
Specifically, the January-February Dubai swap price differential is subtracted from x which gives the
price of delivery of Dubai in January (call it y).93 The January-December Dubai swap price differential is
next subtracted from y to give us the price of Dubai for the month of December.94
Once the price of Dubai is identified, the derivation of the Oman price follows in a rather mechanical
way, mainly by exploiting information about Dubai-Oman spreads. If Oman partials are traded in the
window, Platts uses the price of concluded deals or bids/offers to derive the Oman price. When this is not
feasible, the Oman value will be assessed using the Oman-Dubai swaps spread95, a derivative contract
which trades the differential between Omans OSP and Dubai for the month concerned. The contract is
traded over the counter and does not involve any physical delivery. The Dubai-Oman swap price
differential will then be used in a formula which links it to the value of Dubai. Similarly, Argus assesses
the value of Oman by comparing the value of Oman with that of Dubai. Argus first calculates the
differential to Dubai swaps and then adds it or subtracts it from Dubai outright swap to get the Oman
forward price. So currently, the assessment of Oman price by PRAs is a simple extension of the Dubai
market, where the Dubai/Oman spread provides the necessary link.
The above price derivation shows clearly that the Brent futures market sets the price level while the EFS
and the inter-month Dubai spread market set the price differentials. These differentials are in turn used to
calculate a fixed price for Dubai. In a sense, the price of Dubai need not have a physical dimension. It can
be derived from the financial layers that have emerged around Dubai. This has raised some concerns as
calls to use swaps as pricing benchmarks for physicals are at best uninformed as swaps are derivatives of
the core physical instruments (Montepeque, 2005). But this neglects the fact that liquidity in Platts
Dubais window is thin. In addition, the argument against using swaps is inconsistent with Platts use of
swaps (CFDs) in identifying the price of Dated Brent. It is also inconsistent with the fact that at times
when no partials are trading, Platts has no alternative but to use the EFS to identify the Dubai price.
Another concern is that unlike the WTI-Brent differential which reflects the relative market conditions in
Europe and the USA, Horsnell and Mabro (1993) argue that the Brent-Dubai differential does not usually
reflect the trading conditions of Asian markets except on some rare occasions such as the Iraqi invasion of
Kuwait. In normal times, Dubai crude is more responsive to trading conditions in Europe and the US than
the Far East. Specifically, the authors argue that the Brent-Dubai differential reflects better the
relationship between prices of sweet and sour crudes. In support of this hypothesis, they argue that when
OPEC decides to cut production, these cuts affect the production of heavy sour crudes. As a result, the
price of these crudes will strengthen relative to sweet crudes leading to the strengthening of Dubai prices
relative to Brent. The recent growth of the Asia-Pacific market and the wide entry of Asian players may
have changed these dynamics with the Dubai-Brent spread currently responding more closely to Asias
trading conditions making Brent-related cargoes either more attractive (small Brent premium) or less
attractive (large Brent premium) to Asia-Pacific buyers, but this need further empirical investigation.

Oman and its Financial Layers: A New Benchmark in the Making?

In June 2007, the Dubai Mercantile Exchange (DME) launched the Oman Crude Oil Futures Contract to
serve as a pricing benchmark of Gulf exports to Asia and as a mechanism to improve risk management.
Figure 22 below shows the daily volume of DME Oman futures contracts traded between June 2007 and
September 2010. The figure suggests that the volume of contracts traded is highly volatile, but remains
92

This is referred to as Dubai Third Forward Month.

This is referred to as the Dubai Second Forward Month.
94
This is referred to as the Dubai Swap First Month.
95
Oman swap is a derivative of the Platts cash Oman assessment. However, in the absence of bids and offers for
Oman swaps, Platts uses the information from the structure of the Dubai forward curve for assessing Oman swaps.
93

66

relatively low. In 2009, the average daily volume of traded contracts amounted to slightly more than 2000
contracts, which is very low especially when compared to the traded volume of WTI or Brent futures
contracts.
Figure 22: daily Volume of Traded DME Oman Crude Oil Futures Contract
9,000
8,000
7,000
6,000
5,000
4,000
3,000

2,000
1,000
1st June 2007
2nd July 2007
1st August 2007
30th August 2007
1st October 2007
30th October 2007
29th November 2007
31st December 2007
31st January 2008
3rd March 2008
2nd April 2008
1st May 2008
2nd June 2008
1st July 2008
31st July 2008
29th August 2008
30th September 2008
29th October 2008
27th November 2008*
29thDecember 2008
29th January 2009
02nd March 2009
31st March 2009
30th April 2009
1st June 2009
30th June 2009
30th July 2009
28th August 2009
28th September 2009
27th October 2009
25th November 2009
24th December 2009
27th January 2010
25th February 2010
26th March 2010
27th April 2010
26th May 2010
25th June 2010
27th July 2010
25th August 2010
24th September 2010

Source: CME Group

DMEs Oman futures contract allows settlement against physical delivery of Oman crude. One interesting
feature of the DME futures contracts is the large number of contracts that converge for physical delivery
in any given month. Figure 23 below traces the evolution of the trading volume and open interest for the
October 2010 Futures contract during the month of August. On 31st August, 2010 the open interest
reached almost 21,000 contracts. This is equivalent to 21 million barrels a month comprising more than
80% of Omans monthly crude oil production. By any standard, these are very large volumes to be
delivered through futures contracts. For instance, physical delivery on the Light Sweet Crude Oil Futures
contract exceeded four million barrels only once in January 1995. Also in contrast with other benchmark
contracts, the open interest on the DME contract tends to increase as contract expiry approaches as shown
in Figure 21. This represents an important anomaly and implies that the DME contract is simply used as a
means to access physical Oman crude oil. This feature sets aside the DME contract from the other
successful futures contracts that have evolved around Brent and WTI.

67

Figure 23: Volume and Open Interest of the October 2010 Futures Contracts (Traded During
Month of August)
25000
20000
15000
10000
5000

Volume

31-Aug-10

30-Aug-10

29-Aug-10

28-Aug-10

27-Aug-10

26-Aug-10

25-Aug-10

24-Aug-10

23-Aug-10

22-Aug-10

21-Aug-10

20-Aug-10

19-Aug-10

18-Aug-10

17-Aug-10

16-Aug-10

15-Aug-10

14-Aug-10

13-Aug-10

12-Aug-10

11-Aug-10

10-Aug-10

09-Aug-10

08-Aug-10

07-Aug-10

06-Aug-10

05-Aug-10

04-Aug-10

03-Aug-10

02-Aug-10

Open Interest

Source: DME Website

The introduction of the DME contract has changed the pricing mechanism of Omani crude. From its
inception, it was clear that both a retroactive official selling price (OSP) and futures market-related price
undermined the market function of price discovery.96 Thus, it was a matter of time before Oman decided
to change its pricing from a retroactive pricing system to a forward pricing system based on the DME
contract. The OSP for Oman crude for physical delivery is calculated as the arithmetic average of the
daily settlement prices over the month. For instance, the OSP for Oman crude for the month of June is
calculated as the arithmetic average of the daily settlement of price over the month of June for delivery in
two months i.e. in the month of August. The Government of Dubai has also ceased the pricing of its crude
oil sales off its current mechanism and instead utilises DME Oman futures prices providing additional
boost to the contract. Dubai and Oman however have been the exceptions so far. Despite Dubais low
physical liquidity, Platts Dubai/Oman assessments are still the preferred price benchmark used in the
pricing formula for exports to Asia. This raises the question why other Middle Eastern producers have not
been enthusiastic about adopting the DME Oman Crude Oil Futures contract as the basis of pricing crude
oil.
The futures market plays two important roles: price discovery and hedging/speculation or what is termed
as risk management. Liquidity is crucial for the efficient performance of these two functions. Physical
deliverability, which the DME tends to emphasize, is less important. In other words, deliverability is not a
sufficient condition for the success of the DME Oman contract. In fact, physical deliverability can reduce
the chances of the success of a futures contract if market participants have doubts about the likely
performance of the delivery mechanism or if physical bottlenecks around delivery points result in some
serious dislocations although the extensive use of the DMEs physical delivery mechanism demonstrates
confidence in its performance. Nevertheless, inability to increase trading liquidity while physical
deliverability continues to rise may undermine the contract as the risk of physical delivery tends to rise,
especially for those players that are not interested in physical delivery in the first place. If low liquidity
persists, then the two functions of price discovery and risk management would be undermined and the
contract would fail to attract the attention of market participants.
96

In a retroactive pricing system, the OSP applied to cargoes that have already been loaded. In a forward pricing
system, the price for an oil shipment to be loaded say in May is determined two months before i.e. in March.

68

Asian interest is crucial for the long term success of the contract as the Asia-Pacific region is the main
importer of Middle Eastern sour crude oil. However, big Asian refineries havent so far shown strong
enthusiasm for the contract. As to the financial players/speculators, the DME futures contract can open
new opportunities for trading and risk management. But speculative and hedging activity will not be
attracted to a market with low liquidity. Market participants often prefer to trade only in the most liquid
markets. The recent launch by CME of DME linked swap and option contracts is geared to providing new
risk management tools in the hope of attracting more financial players and Asian refineries into the
market. While Gulf oil producers do not hedge their oil production in the futures market, they have
interest in a sour futures contract for export pricing purposes. Low liquidity however is likely to
discourage the already very cautious Gulf oil exporters from setting their crude price against the DME
futures contracts. So far, none of the big gulf producers such as Saudi Arabia, Kuwait, Qatar, and Iran
have shown much interest in the newly established sour futures contracts. However, there is the
temptation for some Gulf countries to shift part of the global oil trading activity to the region, which may
induce a change in some oil exporters attitude towards the contract. There is also strong interest in the
success of the DME contract as evidenced by the heavy involvement of the CME Group and the various
stakeholders.97 Without this strong interest and support, the contract would have perhaps failed by now.

97

The DME is a joint venture between Tatweer (a member of Dubai Holding), Oman Investment Fund and CME
Group. Global financial institutions and energy trading firms such as Goldman Sachs, J.P. Morgan, Morgan Stanley,
Shell, Vitol and Concord Energy have also taken equity stakes in the DME (Source: Dubai Mercantile Exchange
Website).

69

8. Assessment and Evaluation

Based on the above detailed analysis of the various benchmarks and their surrounding layers, it is possible
to draw some broad implications which can be grouped as follows: the physical liquidity of benchmarks;
the new dynamics of oil trade flows and its implications on pricing benchmarks; the nature of players in
the market; the linkages between physical and financial layers; the process of price adjustment; and
transparency in oil markets.

Physical Liquidity of Benchmarks

An interesting feature of the current oil pricing system is that markets with relatively low volumes of
production such as WTI, Brent, and Dubai-Oman set the oil price for markets with much higher volumes
of production in the Gulf and elsewhere in the world. Despite the high level of volumes of production in
the Gulf, these markets remain illiquid, as there are limited volumes of spot trading, no forwards or swaps
(apart from Dubai), no liquid futures market, and destination restrictions which prevent on-trading in
chains. Furthermore, these markets are characterised by lack of equity diversification.
While adequate physical liquidity is not a sufficient condition for the emergence of benchmarks, it is a
necessary condition for a pricing benchmarks long-term success. Some observers have argued that in
principle, there is not a certain level of production below which the integrity of the market is threatened.
Before its substitution by WTI, the Alaskan North Slope (ANS) continued to generate market prices
although the physical base was very narrow. The prices were derived completely from oil price reporting
agencies assessments of traders perceptions about what the price would be if there were actual trade in
cargoes. This argument however is unconvincing because confidence is unlikely to survive for long in
markets with low physical liquidity.98 As markets become thinner and thinner, the price discovery process
becomes more difficult as oil reporting agencies cannot observe enough genuine arms-length deals.
Furthermore, in thin markets, the danger of squeezes and distortions increases and as a result prices could
then become less informative and more volatile thereby distorting consumption and production decisions
(Pirrong, 1996). 99 A squeeze refers to a situation in which a trader goes long in a forward market by an
amount that exceeds the actual physical cargoes that can be loaded during that month. If successful, the
squeezer will claim delivery from sellers (shorts) and will obtain cash settlement involving a premium.
One consequence of a successful squeeze is that the price of the particular crude that has been squeezed
will rise relative to that of other marker crudes. Squeezes also increase the volatility between prices in
different layers such as between the Dated Brent and the forward Brent giving rise to new financial
instruments to manage this risk such as CFDs. Squeezes are made possible by two features: the
anonymity of trade and the huge volume of trading compared to the underlying physical base (Mollgaard,
1997). After all, squeezes are much easier to perform in a thin market (Telser, 1992). This is in contrast
with futures markets where the volume of transactions is quite large and thus there is less room for
squeezes and manipulation, although futures markets are not totally immune.100 Squeezes are also
98

The fact that ANS stopped acting as a benchmark suggests that there is a level below which integrity of the
benchmark is threatened.
99
See for Instance, Liz Bossley (2003), Battling Benchmark Distortions, Petroleum Economist, April. More
recently, concerns about squeezes arose when one oil trader HETCO took control of the first eight North Sea Forties
crude oil cargoes loading in February 2011 and two Brent cargoes with market observers describing such a move as
a trading play intended to influence the spot market. Reuters (2011), Oil Trader Takes Control of 10 North Sea
Oil cargoes, January 18.
100
The challenge of the U.S. Federal trade commission to the BP Amoco-Arco merger was partly based on the fear
that by controlling the physical infrastructure, the WTI futures market can be squeezed. The Federal trade
commission notes that the restriction of pipeline or storage capacity can affect the deliverable supply of crude oil in
Cushing and consequently affect both WTI crude cash prices and NYMEX futures prices (p.7). Then it states that a
firm that controlled substantial storage in Cushing and pipeline capacity into Cushing would be able to manipulate
NYMEX futures trading markets and they enhance its own positions at the expense of producers, refiners and

70

becoming less prevalent in jurisdictions where regulators enforce the laws against abuse of market power,
and where those laws are clear. Also important is the design or the architecture of the market/contracts in
which PRAs, in consultation with market participants, play a key role in determining its main features and
structures and evolution over time. Regulators have also turned their attention to this issue where some
observers consider that the proposed spot-month position limit formula seeks to minimize the potential
for corners and squeezes by facilitating the orderly liquidation of positions as the market approaches the
end of trading and by restricting the swap positions which may be used to influence the price of
referenced contracts.101
So far the low and the rapid decline in the physical base of existing benchmarks have been counteracted
by including additional crude streams in assessed benchmark. This had the effect of reducing the chances
of squeezes as these alternative crudes could be used for delivery against the contract. Although such
short-term solutions have been successful in alleviating the problem of squeezes, they should not distract
observers from raising some key questions: What are the requisite conditions for the emergence of
successful benchmarks in the most liquid market in terms of production? Would a shift to price
assessment in such markets improve the price discovery process? Such key questions remain heavily
under-researched in the energy literature and do not feature in the producer-consumer dialogue.

Shifts in Global Oil Demand Dynamics and Benchmarks

One of the most important shifts in oil market dynamics in recent years has been the acceleration of oil
consumption in non-OECD economies. Between 2000 and 2009, demand growth in non-OECD outpaced
that of OECD in every year (see Figure 24). During this period, non-OECD oil consumption increased by
around 10.5 million b/d while that of OECD dropped by 2.1 mb/d. At the heart of this growth lies the
Asia-Pacific region which accounted for more than 50% of this incremental change in demand during the
10-year period.
Figure 24: OECD and Non-OECD Oil Demand Dynamics
2500
2000
1500
1000
500
0
-500

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

-1000
-1500
-2000
-2500
OECD

Non-OECD

Source: BP (2010)
traders (p. 7) (United States of America Before Federal Trade Commission in the Matter of BP AMOCO P.L.C. and
Atlantic Richfield Company downloadable from http://www.ftc.gov/os/2000/08/bparco.pdf
101
Proposed Position Limits for Derivatives, Statement of Bruce Fekrat, Senior Special Council, Division of
market Oversight, CFTC, December 16, 2010.

71

The emergence of the non-OECD as the main source of growth in global oil demand has had far reaching
implications on the dynamics of oil trade flows. This is perhaps best illustrated in the shift in the direction
of oil flows from Saudi Arabia and Russia, the two biggest oil producers in the world towards the East.
As shown in Figure 25, in 2002 Saudi Arabias share of oil exports to the US and Europe amounted to
28.2% and 17.9% respectively. In 2009, these shares declined to 17.8% for the US and 10% for Europe.
In 2009 Saudi Arabia abandoned its St Eustatius storage facility in the Caribbean which was mainly used
to feed US markets and instead obtained storage facility in Japan to feed Asian markets.
Figure 25: Change in Oil Trade Flow Dynamics

Composition of Saudi Exports in

2009

Composition of Saudi Exports in

2002

15%
28%
US

10%

Europe

Europe
54%

US

Others

Others
75%

18%

Source: Barclays Capital, Oil Sketches, 23 April 2010

So far, Russias exports have been heavily concentrated towards Europe to which in 2009 it exported
around 7 mb/d compared with 1.17 mb/d to Asia Pacific.102 These dynamics however are changing as
Russia builds new infrastructure in an attempt to shift part of its oil exports towards the Far East. The
inauguration in December 2009 of the first section of the Eastern Siberia Pacific Ocean (ESPO) pipeline
represents a marginal but nonetheless important step in that direction. The first section of ESPO is a 2,757
km long pipeline connecting Taishet in East Siberia to Skovorodino in Russias Far East, near the border
with China. It has a capacity of 600,000 b/d is expected to grow to 1 million b/d by 2012, and potentially
to as much as 1.6 million b/d in 2015. The second stage of the project involved linking Skovorodino to a
new export terminal at Kozmino on the Pacific coast in order to supply some of the rapidly growing oil
demand in Asia. China and Russia then agreed to construct an offshoot from Skovorodino to Daqing in
China with a capacity of 300,000 b/d. It was completed by the close of 2010.
Such changes in trade flow patterns are likely to accelerate as the centre of consumption growth continues
to shift from OECD to emerging economies. The EIA103 predicts that between 2007 and 2035, oil
consumption is expected to increase by around 24 mb/d from 86.1 mb/d to 110.6 mb/d with non-OECD
accounting for almost all of the increase during this period. This shift in the dynamics of trade flows
towards the East is likely to have profound implications on pricing benchmarks. Questions are already
being raised as to whether Dubai, Minas and Tapis still constitute appropriate benchmarks for pricing oil
in Asia given their low liquidity or whether new benchmarks are needed to reflect more accurately the
102
103

BP (2010), BP Statistical Review of World Energy, June.

EIA (2010), International Energy Outlook 2010, US Energy Information Administration, Table A.5.

72

shift in trade flows. In this respect, a debate has already started on the suitability of ESPO to act as an
Asian benchmark.104 Since ESPO competes with Mideast crudes, so far ESPO has strengthened the Dubai
benchmark. Since December 2009, Platts has been assessing the value of ESPO but as a differential to
Platts Dubai. In the longer term, ESPO has some of the features that may allow it to assume the role of a
benchmark itself. The pricing point in Northern Asia is particularly attractive. ESPO is close to key
refining centres in China, Japan and South Korea where the sailing time from the loading port of
Kozmino to northeast Asia is just a few days, transforming the Asian market from a long haul to a short
haul market. Furthermore, ESPO volumes are larger than many of the existing benchmark and could
increase in the future. On the other hand, there is uncertainty about the volume that will be available for
sale in the spot market as a considerable amount of it is sold on long-term basis or used in Rosneft
refineries. There is also uncertainty about the quality of ESPO over time. Most importantly, for any
benchmark to emerge, market participants should have confidence that the benchmark is not subject to
manipulation which is yet to be proven. One must consider the legal, tax, and regulatory regime operating
around any particular benchmark. WTI has the US government overseeing it and a robust legal regimen.
Brent has also stable governmental oversight. Distrust of the Russian government is strong in many
companies and hence the reluctance so far to support an ESPO benchmark. Nevertheless, if discontent
with existing benchmarks intensifies, then ESPO could be one of the few options available for the
industry to fall back on.
Regardless of whether or not ESPO will eventually emerge as a benchmark, it is already having an impact
on pricing dynamics in Asia. In a sense, ESPO is likely to become or has become the marginal barrel in
Asia, displacing West African crudes in this role. Gulf suppliers have to monitor ESPO's performance
very closely when setting their price differential in relation to Dubai to maintain their export
competitiveness to Asia. This is likely to cause a decline in the size of the Asian premium over time.

The Nature of Players and the Oil Price Formation Process

In recent years, the futures markets have attracted a wide range of financial players including pension
funds, hedge funds, index investors, technical traders, and high net worth individuals. Many reasons have
been suggested on why financial players have increased their participation in commodities markets. The
historically low correlation between commodities returns in general and other financial assets returns,
such as stocks or bonds, has increased the attractiveness of holding commodities for portfolio
diversification purposes for some institutional investors. Because commodity returns are positively
correlated with inflation, some investors have entered the commodities market to hedge against inflation
risk and weak dollar. Expectations of relative higher returns in investment in commodities due to
perception of tightened market fundamentals have motivated many investors to enter the oil market.
Finally, financial innovation has provided an easy and a cheap way for various participants, both
institutional and retail investors, to gain exposure to commodities.
The entry and the impact of financial players has been the subject of various empirical studies. Some
examine whether these players had a destabilising effect on commodities futures markets.105 Other studies
focus on the impact of players on the inter-linkages between commodities markets and other financial
markets such as equity.106 While these and other similar studies provide some valuable insights into the
issue of linkages between financial layers and physical benchmarks, it is important to expand the analysis
104

See for instance, J.P. Morgan (2010), Will EPSO Emerge as a New Pricing Benchmark?, Presentation at the
Platts Crude Oil Methodology Forum 2010, London, May.
105
See for instance Brunetti and Bykahin (2009).
106
For example, Bykahin and Robe (2010) find that the composition of traders plays a role in explaining the joint
distribution of equity and commodity returns. Specifically, they find that a subset of hedge funds, those that are
active both in equity and commodity futures market can explain the increase in the commodity-equity correlations.
In contrast, swap dealers, index traders, and floor brokers and traders play no role in explaining cross-correlations
across markets.

73

to the trading strategies of physical players. The fact remains that the participants in many of the OTC
markets such as forward markets and CFDs which are central to the price discovery process are mainly
physical and include entities such as refineries, oil companies, downstream consumers, physical traders,
and market makers. Financial players such as pension funds, index and retail investors have limited
presence in some of these markets. Thus, any analysis limited to the role of non-commercial participants
in the futures markets in the oil price formation process is likely to be incomplete.

The Linkages between Physical Benchmarks and Financial Layers

At the early stages of the current pricing system linking prices to physical benchmarks in formulae
pricing provided producers and consumers with a sense of comfort that the price is grounded in the
physical dimension of the market. Suspicion still exists on whether the oil price derived from paper
markets such as the futures market reflects the physical realities of the oil market at the time of pricing.
Sceptics argue that prices in these markets are not determined on the basis of trading in real barrels, but
rather by trading in financial contracts for future delivery (Mabro, 2008).
The latter concern implicitly assumes that the process of identifying the price of benchmarks can be
isolated from financial layers. However, this is far from reality. As our analysis shows, the different layers
in the oil market are highly interconnected and form a complex web of links, all of which play a role in
the price discovery process. 107 The information derived from financial layers plays an important role in
identifying the price level of the benchmark. In the Brent market, the price of Dated Brent is assessed
using information from many layers including CFDs, forward markets, EFPs and futures markets.
Similarly, in the WTI complex, the prices of the various physical benchmarks are strongly interlinked
with the futures markets. The price of Dubai is often derived using information from the very active OTC
Dubai/Brent swaps market and the inter-Dubai swap market. Thus, the idea that one can isolate the
physical from the financial layers in the current oil pricing regime is a myth. Crude oil prices are jointly
or co-determined in both layers, depending on differences in timing, location and quality.
Despite the fact that the price discovery process is influenced by information from paper markets, most
players are still reluctant to adopt futures prices in their pricing formulae although some key producers
such as Saudi Arabia, Kuwait and Iran use BWAVE (futures price) in pricing their exports to Europe.
This can be explained by the fact that since prices in the futures markets reflect the price of oil today for
future delivery, they inject a substantial time basis risk. Currently, this basis risk is eliminated by
referencing against physical benchmarks and managing the price risk by using swaps against the
benchmark price.
The above discussion has also some implications on the pricing of derivatives instruments. Since physical
benchmarks constitute the basis of the large majority of physical transactions, some observers claim that
derivatives instruments such as futures, forwards, options and swaps derive their value from the price of
these physical benchmarks. In other words, the prices of the physical benchmarks drive the prices in paper
markets. However, this is a gross over-simplification and does not accurately reflect the process of crude
oil price formation as the two layers are highly interlinked. The issue of whether the paper market drives
the physical or the other way around is difficult to construct theoretically and test empirically.

Adjustments in Price Differentials versus Price Levels

Our analysis shows the importance of distinguishing between adjustments in price differentials and
adjustments in price levels. Trades in the levels of the oil price rarely take place in the layers surrounding
the physical benchmarks. Instead, these markets trade price differentials which fluctuate based on hedging
pressures and expectations of traders. It is rare (though not unheard of) for companies to take positions on
the basis of an outright price movement that is whether prices go up or down. This is far too risky for
107

Platts use the word triangulate: Assessments will use spread relationships and derivative values to help
triangulate value. See Platts Crude Oil Methodology Forum 2010, May 2010 (London).

74

most participants. Most trade is on spreads of some sort one regional price against another, one product
price against another, one product price against a crude (feedstock) price, one time period price against
another time period. These arbitrages self-correct by traders actions such as buying in one region, where
theres too much oil, and transporting it to another region where there isnt enough and where the price is
higher to draw in the oil. This feature of the oil pricing system poses a legitimate question: how can
markets that actively trade price differentials set a price level for a particular benchmark? As noted by
Horsnell and Mabro (1993) in the context of forward Brent,
In spread deals the relationship between specified flat prices and market prices may not be very
tight. And since the focus is to a large extent on relatives, the search for price levels that
correspond to the relevant market conditions becomes less broadly based and less active. The
liquidity in that part of the market which concerns itself with the oil price level has become a
small proportion of the total liquidity of the forward market.
We postulate that the level of the oil price is set in the futures markets; the financial layers such as swaps
and forwards set the price differentials. By trading differentials, market participants limit their exposure to
risks of time, location grade and volume. These differentials are then used by oil reporting agencies to
identify the price level of a physical benchmark. Perhaps this is most evident in the US market. As
explained by Platts (2010b),
physical crude oil assessments are still widely used by the industry, but the flat price formation
is originated by the New York Mercantile Exchange (NYMEX). The highly liquid sweet crude
futures contract traded on NYMEX provides a visible real-time reference price for the market. In
the spot market, therefore, negotiations for physical oils will typically use NYMEX as a reference
point, with bids/offers and deals expressed as a differential to the futures price. Therefore,
while NYMEX acts as a barometer of market value, and negotiations for physical oil may
reference the futures value, Platts plays a distinct and complementary role to that of the exchange
(p.3).
To illustrate this last point, the recent strikes in France in October 2010 present a good experiment. As
seen in Figure 26 below, during the strike between the period 11th and 21st of October, the price
differential between Dated Brent and ICE futures Brent widened considerably reaching a peak of -$1.53
dollars per barrel on the 22nd of October.108 The widening of the differential reflected the fact that while
global oil supplies were not affected by the strike, French refineries could not buy more crude oil which
resulted in less overall demand. Oil companies and physical traders holding more oil than originally
planned were forced to clear the ex-ante excess supply by offering larger discounts. Thus, in this episode,
the bulk of the adjustment took place through the changes in price differentials and not the price levels,
perhaps because the market thought the effects of the strike on the oil markets were only temporary.109

108

It is important to note also that there is a good chunk of term structure between prompt Dated Brent and the oil
deliverable under the nearest Brent futures contract.
109
Some consider that such evidence is a clear indication that it is the prompt physical that sets the futures price.
Such natural experiments however dont shed light on this issue. One needs to show that these adjustments in
differentials occur in other than crisis situations and they are strong enough to drag down the price level. More
importantly, such evidence doesnt provide an answer to the question of how the level of oil price is determined in
the first place. It reinforces the point, however, that the futures markets set the price level and the physical layers set
the differentials, which reflect changes in the underlying fundamentals of the oil market.

75

Figure 26: The North Sea Dated differential to Ice Brent during the French Strike

01 Sep
0.2
0.0

11 Sep

21 Sep

01 Oct

21 Oct

Ice Brent=0

-0.2

Strike
officially
ends

-0.4
-0.6

$/bl

11 Oct

-0.8
-1.0

French refinery
strike begins

-1.2
-1.4
-1.6
-1.8

Source: Argus

Thus, the level of oil price, which consumers, producers and their governments are most concerned with,
is not the most relevant feature in the current pricing system. Instead, the identification of price
differentials and the adjustments in these differentials in the various layers underlie the basis of the
current oil pricing system. If the price in the futures market becomes detached from prompt fundamentals,
the differentials adjust to correct for this divergence through a web of highly interlinked and efficient
markets. The key question is whether the adjustments in differentials are strong and large enough to
induce adjustments in the futures price level. The issues of whether price differentials between different
crude oil markets and between crude and product markets showed strong signs of adjustment and whether
those adjustments affected the behaviour of oil price over the 2008-2009 price cycle have not yet received
their due attention in the empirical literature.110
But this leaves us with a fundamental question: what factors determine the price level of an oil
benchmark? The crude oil pricing system and its components such as the PRAs reflect how the oil market
functions: if oil price levels are set in the futures market and if participants in these markets attach more
weight to future fundamentals rather than current fundamentals and/or if market participants expect
limited feedbacks from both the supply and demand side in response to oil price changes, these
expectations will be reflected in the different layers and will ultimately be reflected in the assessed price.
The adjustments in differentials are likely to ensure that these expectations remain anchored in the
physical dimension of the market.

Transparency and Accuracy of Information

The issue of transparency has gained wide credence in the aftermath of the 2008 financial crisis with
many organisations such as G8, G20, and the IEF calling for improved transparency as key to enhancing
110

In fact, one explanation attributes the upward rise in the crude oil price in the first half of 2008 to the high
demand for very-low-sulfur diesel (Verleger, 2008). This increased the price differential between diesel and crude
oil, which in turn pushed the crude oil price up. Such an explanation points to the importance of integrating products
into the analysis. Due to space constraints, products markets were not discussed in this paper, but are the subject of
current research at the Oxford Institute for Energy Studies.

76

the functioning of the oil market and its price discovery function. Transparency in oil markets however
has more the one dimension. Although improving transparency in the physical dimension of the market is
key to understanding oil market dynamics and enhancing the price discovery function, our analysis shows
that transparency in the financial layers surrounding the physical benchmarks is as important. In this
regards, it is important to emphasize three dimensions to the transparency issue. First, obtaining regular
and accurate information on key markets depends largely on the willingness of PRAs to release or share
information. PRAs are under no legal obligation to report deals to a regulatory authority or to make the
information at their disposal publicly available. Thus, some basic but key information and data on market
structure, trade volumes, liquidity, the players and their nature, and the degree of concentration in a
trading day are not always available to the public, but they are sold to market participants at a price which
makes it worthwhile for PRAs to collect such data.
Second, the degree of transparency varies considerably within the different layers in the Brent, WTI and
Dubai-Oman complexes as well as across benchmarks. Within the Brent complex, the degree of
transparency between the various layers such as the Forward Brent, CFD and Dated Brent and futures
market is different. Similarly, in the Dubai complex, basic data on the Dubai/Brent Swaps market or the
inter-month Dubai swaps are not publicly available though the volumes and open interest of Dubai swaps
cleared through the exchanges are published. Transparency in the futures markets at least when it comes
to prices, open interest and traded volumes is relatively well established. The futures market generates a
set of prices throughout the day which are instantaneously transmitted through a variety of channels
increasing price transparency. On the other hand, a detailed description of the participants in the futures
market and the identity of counterparties to a futures contract are not made publicly available although the
exchange and regulators via the exchange do have detailed data for futures markets on these areas. This is
in contrast to the OTC market where the identities of counterparties to a transaction are known. Some
market players place a high premium on such information and thus prefer to conduct their operations over
the counter.
The third dimension of transparency relates to the extent to which assessed prices are accurate and are
reached through a transparent and efficient process. There are two aspects to this issue. The first relates to
the structural features of the oil market trading which impose certain constraints on these agencies efforts
to report deals and identify the oil price. As mentioned before, traders are under no obligation to report
prices; it is not always feasible to verify reported deals; in opaque and unregulated markets, PRAs may
need to rely on their evaluation of market conditions of specific crudes to reach an intelligent price
assessment. Thus, an important element of price transparency is the ability of PRAs to collect reliable
information in imperfect and often illiquid markets and analyse the information in an efficient and
objective manner. The second aspect is linked to the internal operations of PRAs. As discussed above, the
methodologies used to assess the oil price differ considerably across agencies. Their access to information
and the type of data used in their assessment process vary across PRAs and across markets. The
procedures applied within each of the organisations to ensure an efficient price discovery process differ as
these are internally driven and are not subject to external regulation or supervision. Thus, the degree of
price transparency is very much interlinked to the activities of PRAs and the reporting standards and other
procedures that they internally set and enforce.

77

9. Conclusions
Based on the above analysis of the current international crude oil pricing system, it is possible to draw the
following conclusions:

Markets with relatively low volumes of production such as WTI, Brent, and Dubai-Oman set the
price for markets with higher volumes of production elsewhere in the world but with fewer or
none of the commonly accepted conditions to achieve an acceptable benchmark status. So far
the low and continuous decline in the physical base of existing benchmarks has been counteracted
by including additional crude streams in an assessed benchmark. Such short-term solutions
though successful in alleviating the problem of squeezes should not distract observers from some
key questions: What are the conditions necessary for the emergence of successful benchmarks in
the most liquid market? Would a shift to assessing price to these markets improve the price
discovery process? Such key questions remain heavily under-researched in the energy literature
and do not feature in the producer-consumer dialogue. The emergence of the non-OECD as the
main source of growth in global oil demand will only increase the importance of such questions.
Doubts about the suitability of Dubai as an appropriate benchmark for pricing crude oil exports to
Asia have been raised in the past (Horsnell and Mabro, 1993). This raises the question of whether
new benchmarks are needed to reflect more accurately the recent shift in trade flows and the rise
in importance of the Asian consumer.

PRAs play an important role in assessing the price of the key international benchmarks. These
assessed prices are central to the oil pricing system and are used by oil companies and traders to
price cargoes under long-term contracts or in spot market transactions; by futures exchanges for
the settlement of their financial contracts; by banks and companies for the settlement of derivative
instruments such as swap contracts; and by governments for taxation purposes. PRAs do not only
act as a mirror to the trade. In their attempt to identify the price, PRAs enter into the decisionmaking territory. The decisions they make are influenced by market participants and market
structure while at the same time these decisions influence the trading strategies of the various
participants. New markets and contracts may emerge to hedge the risks that emerge from some of
the decisions that PRAs make. The accuracy of price assessments heavily depends on a large
number of factors including the quality of information obtained by the RPA, the internal
procedures applied by the PRAs and the methodologies used in price assessment.

The assumption that the process of identifying the price of benchmarks in the current oil pricing
system can be isolated from financial layers is rather simplistic. The analysis in this report shows
that the different layers of the oil market are highly interconnected and form a complex web of
links, all of which play a role in the price discovery process. The information derived from
financial layers is essential for identifying the price level of the benchmark. One could argue that
without these financial layers it would not be possible to discover or identify oil prices in the
current oil pricing system. In effect, crude oil prices are jointly co-determined and identified in
both layers, depending on differences in timing, location and quality.

Since physical benchmarks constitute the basis of the large majority of physical transactions,
some observers claim that derivatives instruments such as futures, forwards, options and swaps
derive their value from the price of these physical benchmarks i.e. the prices of these physical
benchmark drive the prices in paper markets. However, this is a gross over-simplification and
does not accurately reflect the process of crude oil price formation. The issue of whether the
paper market drives the physical or the other way around is difficult to construct theoretically and
test empirically in the context of the oil market.

78

The report also calls for broadening the empirical research to include the trading strategies of
physical players. The fact remains though that the participants in many of the OTC markets such
as forward markets and CFDs which are central to the price discovery process are mainly
physical and include entities such as refineries, oil companies, downstream consumers, physical
traders, and market makers. Financial players such as pension funds and index investors have
limited presence in many of these markets. Thus, any analysis limited to non-commercial
participants in the futures market and their role in the oil price formation process is incomplete.

The analysis in this report emphasises the distinction between trade in price differentials and trade
in price levels. We postulate that the level of the price of the main benchmarks is set in the futures
markets; the financial layers such as swaps and forwards set the price differentials depending on
quality, location and timing. These differentials are then used by oil reporting agencies to identify
the price level of a physical benchmark. If the price in the futures market becomes detached from
the underlying benchmark, the differentials adjust to correct for this divergence through a web of
highly interlinked and efficient markets. Thus, our analysis reveals that the level of oil price,
which consumers, producers and their governments are most concerned with, is not the most
relevant feature in the current pricing system. Instead, the identification of price differentials and
the adjustments in these differentials in the various layers underlie the basis of the current oil
pricing system. By trading differentials, market participants limit their exposure to risks of time,
location grade and volume. Unfortunately, this fact has received little attention and the issue of
whether price differentials between different markets showed strong signs of adjustment in the
2008-2009 price cycle has not yet received its due attention in the empirical literature.

But this leaves us with a fundamental question: what factors determine the price level of an oil
benchmark in the first place? The crude oil pricing system and its components such as the PRAs
reflect how the oil market functions: if oil price levels are set in the futures market and if
participants in these markets attach more weight to future fundamentals rather than current
fundamentals and/or if market participants expect limited feedbacks from both the supply and
demand side in response to oil price changes, these expectations will be reflected in the different
layers and will ultimately be reflected in the assessed price. The adjustments in differentials are
likely to ensure that these expectations remain anchored in the physical dimension of the market.

Transparency in oil markets has more than one dimension. Although improving transparency in
the physical dimension of the market is key to understanding oil market dynamics and enhancing
the price discovery function, our analysis shows that transparency in the financial layers
surrounding the physical benchmarks is as important. In this regards, it is important to emphasize
three dimensions to the transparency issue. First, obtaining regular and accurate information on
key markets is not straightforward and depends largely on the willingness of PRAs to release or
share information. Second, the degree of transparency varies considerably within the different
layers in the Brent, WTI and Dubai-Oman complexes as well as across benchmarks. The third
dimension of transparency relates to the extent assessed prices are accurate and are reached
through a transparent and efficient process. There are two aspects to this issue. The first aspect
relates to the structural features of the oil market trading which impose certain constraints on
these agencies efforts to report deals and identify the oil price. The second aspect is linked to the
internal operations of PRAs. Thus, the degree of price transparency is very much interlinked to
the activities of PRAs and the reporting standards and other procedures that they internally set
and enforce.

The current oil pricing system has now survived for almost a quarter of a century, longer than the OPEC
administered system did. While some of the details have changed, such as Saudi Arabias decision to
replace Dated Brent with Brent futures price in pricing its exports to Europe and the more recent move to
replace WTI with Argus Sour Crude Index (ASCI) in pricing its exports to the US, these changes are
79

rather cosmetic. The fundamentals of the current pricing system have remained the same since the mid
1980s i.e. the price of oil is set by the market with PRAs using various methodologies to reflect the
market price in their assessments and making use of information generated both in the physical and
financial layers surrounding the global benchmarks. In the light of the 2008-2009 price swings, the oil
pricing system has received some criticisms reflecting the unease that some observers feel with the
current system.111 Although alternative pricing systems can be devised (at least theoretical ones) such as
bringing back the administered pricing system or calling for producers to assume a greater responsibility
in the method of price formation by removing destination restrictions on their exports, or allowing their
crudes to be auctioned,112 the reality remains that the main market players such as oil companies,
refineries, oil exporting countries, physical traders and financial players have no interest in rocking the
boat. Market players and governments get very concerned about oil price behaviour and its global and
local impacts, but so far have showed much less interest in the pricing system and the market structure
that signalled such price behaviour in the first place.

111

See, for instance, Mabro (2008). Mabro argues that the issue is whether the current price regime for oil in
international trade is an appropriate one. Nobody questions it because the vested interests in maintaining it are
extremely powerful. Banks and hedge funds are wedded to it. Some of the major oil companies have trading arms
that operate in these derivative markets like financial institutions. Their trading profits are substantial. OPEC
accepted it because they thought that it would protect them from blame. It didnt. And the question always asked is:
What is the alternative? I will simply say that no alternative will ever be found if nobody is looking for one.
112
See for instance, Luciani (2010).

80

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83

Analysis of Renewable Identification

Numbers (RINs) in the Renewable Fuel
Standard (RFS)
Brent D. Yacobucci
Section Research Manager
November 16, 2012

Congressional Research Service

7-5700
www.crs.gov
R42824

CRS Report for Congress

Prepared for Members and Committees of Congress

Analysis of RINs in the RFS

Summary
The federal Renewable Fuel Standard (RFS) was established in the Energy Policy Act of 2005
(EPAct) and significantly expanded in the Energy Independence and Security Act of 2007 (EISA).
The RFS requires the use of renewable biofuels in transportation fuel. For 2012, the RFS requires
the use of 15.2 billion gallons of renewable fuel. Within the larger mandate, there are submandates (carve-outs) for advanced biofuels, including at least 1 billion gallons of biomassbased diesel fuel (BBD) in 2012. By 2022, the RFS requires the use of 36 billion gallons of
renewable fuels, including 21 billion gallons of advanced biofuels.
The RFS is a market-based compliance system in which obligated parties (generally refiners
and/or terminal operators) must submit credits to cover their obligations. These credits
Renewable Identification Numbers, or RINsare effectively commodities that can be bought or
sold like other commodities. For each gallon of renewable fuel in the RFS program, one RIN is
generated. Each RIN is a 38-digit number, with blocks of digits corresponding to various data,
including the year the RIN was generated, the producer of the fuel, and the type of fuel. RINs are
valid for use in the year they are generated and the following year.
From the beginning of the RFS program, there have been concerns with RIN generation and the
RIN market. As the RINs are essentially numbers in a computerized account, there have been
errors and opportunities for fraud. Because of concerns over transposed digits, invalid characters,
allegations of double-counting (intentional or unintentional) and other errors and inaccuracies,
when EPA finalized rules for the RFS as expanded by EISA (the RFS2), EPA also established a
new in-house trading system in an effort to address these concerns. All RIN transactions must be
cleared through this in-house system, called the EPA Moderated Transaction System (EMTS).
From the beginning of the RFS2 EPA has maintained that all due diligence remains the duty of
obligated parties. Under this buyer beware system those purchasing or receiving RINs must
certify their validity on their own, and they are responsible for any fraudulent RINs they pass on
to other buyers or submit to EPA for compliance.
In late 2011 and early 2012, EPA issued Notices of Violations (NOVs) to three companies that the
agency alleges fraudulently generated a combined 140 million biodiesel RINs in 2010 and 2011.
Because of these RIN fraud cases, EPA is looking at establishing a system whereby RINs can be
certified by third parties registered with EPA. (EPA may be considering other options but this is
the only one the agency has publicly discussed.) EPA is considering whether such certification
would provide obligated parties with an affirmative defense if RINs are later found to
fraudulentthat is, obligated parties would not be liable for penalties under the Clean Air Act for
the use of such RINs. Key questions include whether such an affirmative defense would also
eliminate the requirement to purchase make-up RINs. EPA expects to issue a proposed rule in late
2012 or early 2013, with a final rule some time in mid-2013.
In addition to agency action, at least one bill has been introduced that would amend the
compliance system. H.R. 6444 would require EPA to establish a RIN certification system and
would preclude the agency from later invalidating any certified RINs. Thus, under the bill, any
RIN found subsequently to be fraudulent would still count toward an obligated partys
compliance, without penalties.

Congressional Research Service

Analysis of RINs in the RFS

Contents
Introduction...................................................................................................................................... 1
Current RFS Requirements .............................................................................................................. 1
The Role of RINs ............................................................................................................................. 3
RINs........................................................................................................................................... 4
EPA Moderated Transaction System (EMTS) ........................................................................... 4
The Market for RINs........................................................................................................................ 6
RIN Prices ................................................................................................................................. 6
RIN Volumes ............................................................................................................................. 8
Fraudulent RINs............................................................................................................................. 11
Effects on Obligated Parties .................................................................................................... 11
Quality Assurance Program ..................................................................................................... 11
Policy Options ......................................................................................................................... 12
Additional Questions ............................................................................................................... 13
What Other Types of RIN Fraud Are Possible? ................................................................ 14
How Likely Is RIN Fraud in the Future? .......................................................................... 14
How Do Various Players Benefit from the Different Policy Options? .............................. 15
Conclusion ..................................................................................................................................... 15

Figures
Figure 1. Nested RFS Mandates for 2012........................................................................................ 3
Figure 2. Simplified Schematic of RIN Trading System ................................................................. 5
Figure 3. Spot Renewable Fuel (Corn Ethanol) RIN Prices ............................................................ 7
Figure 4. Spot BBD RIN Prices ....................................................................................................... 7
Figure 5. Spot Advanced Biofuel RIN Prices .................................................................................. 8
Figure 6. Total RINs Registered 2011.............................................................................................. 9
Figure 7. Total RINs Registered 2012 YTD .................................................................................... 9
Figure 8. Estimated Aggregate RIN Value for 2011 ...................................................................... 10
Figure 9. Estimated Aggregate RIN Value for 2012 YTD ............................................................. 10

Contacts
Author Contact Information........................................................................................................... 16

Congressional Research Service

Analysis of RINs in the RFS

Introduction
The Energy Policy Act of 2005 (EPAct, P.L. 109-58) established a renewable fuel standard (RFS),
requiring the use of biofuels (such as ethanol) in the nations fuel supply. The Energy
Independence and Security Act of 2007 (EISA, P.L. 110-140) significantly expanded this
mandate.1 The RFS mandate has been a major impetus to the development of U.S. biofuels
industries, especially the ethanol and biodiesel industries. In 2005, the United States produced 3.9
billion gallons of ethanol and 0.1 billion gallons of biodiesel. In 2011, production had increased
to roughly 14 billion gallons of ethanol and 1 billion gallons of biodiesel.
Covered parties meet their obligations under the RFS by surrendering renewable fuel credits to
EPA equal to the number of gallons in their annual obligation. These credits, known as
Renewable Identification Numbers (RINs), are generated when a batch of biofuel is produced,
and separated from the fuel by obligated parties (generally gasoline and diesel fuel refiners or
blenders). Once separated, these RINs may be traded like other commodities. Recent civil and
criminal action against parties accused of registering and selling fraudulent RINs has raised
questions about the integrity of the RIN market and EPAs oversight of the market.
This report outlines the RFS and the current RIN system, discusses the current market for various
RINs, and outlines policy considerations to address RIN fraud going forward.

Current RFS Requirements

Currently, the RFS requires the blending of 15.2 billion gallons of renewable fuel in
transportation fuels in 2012, including at least 1 billion gallons of biomass-based diesel
substitutes (BBD). The RFS increases to 36 billion gallons by 2022 with an increasing share
coming from advanced biofuelsbiofuels produced from feedstocks other than corn starch
including cellulosic biofuel and BBD fuels. As has been the case in previous years, in 2012 the
vast majority of the mandate is expected to be met with U.S. corn ethanol (and a smaller amount
of biodiesel, as well as sugarcane ethanol from Brazil).
By 2015 corn ethanols share of the RFS is effectively capped at 15 billion gallons per year. The
EISA amendments to the RFS specifically mandate the use of cellulosic biofuel (16 billion
gallons by 2022) and biomass-based diesel fuel (at least 1.0 billion gallons annually by 2012).
However, advanced biofuels, especially cellulosic fuels, have been slow to develop and fuel
production lags the EISAs mandate schedule.2
Within the overall RFS mandate, there are sub-mandates for specific types of fuel. For example,
for 2012 EISA requires the use of 15.2 billion gallons of biofuels, of which 2.0 billion must be
advanced biofuels. Within the advanced biofuel carve-out, at least 1.0 billion gallons must be
biomass-based diesel (BBD) fuels and 0.00865 billion gallons must be produced from cellulosic
feedstocks. In the early years of the program, the lions share of the mandate is unspecified, and
1

For more information on the RFS, see CRS Report R40155, Renewable Fuel Standard (RFS): Overview and Issues,
by Randy Schnepf and Brent D. Yacobucci.
2
See CRS Report R41106, Meeting the Renewable Fuel Standard (RFS) Mandate for Cellulosic Biofuels: Questions
and Answers, by Kelsi Bracmort.

Congressional Research Service

Analysis of RINs in the RFS

the vast majority of this unspecified portion has beenand is expected to besupplied by cornbased ethanol largely produced in the Midwest. At the beginning of each year, EPA determines a
percentage standard that all suppliers must meet, which is based on expected total U.S. gasoline
and diesel demand for the prior year. For example, for 2012, the overall biofuel standard is
9.23%, the advanced biofuel standard is 1.21%, the BBD standard is 0.91%, and the cellulosic
biofuel standard is 0.006%.3
The sub-mandates for advanced biofuels are nested together (Figure 1). As noted by the arrows in
the figure, fuel qualifying as one type of biofuel in the RFS qualifies for all levels above it. For
example, a gallon of cellulosic biofuel may be used to meet the cellulosic mandate, the advanced
biofuel mandate, and the overall RFS. A gallon of other advanced biofuel (e.g., sugarcane
ethanol) may be used to meet the advanced biofuel mandate and the overall mandate, but may not
be used to meet the cellulosic or BBD mandates. Corn starch ethanolthe most widely used
biofuel in the United Statesmay only be used to meet the overall RFS.4

The limitation on corn starch ethanol is roughly 8% on gasoline and diesel fuel combined.
Thus, the effective cap on corn-based ethanol is 13.2 billion gallons in 2012, based on the difference between the
overall mandate (15.2 billion gallons) and the advanced biofuel mandate (2.0 billion gallons).
4

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Figure 1. Nested RFS Mandates for 2012

(Not to scale)

Total Renewable Fuel

(15.2 Bgal)

Advanced Biofuel (2 Bgal)

Biomass-Based
Diesel (BBD) (1 Bgal)

Cellulosic Biofuel
(8.6 Mgal)

Source: CRS.
Notes: As noted by the arrows, fuel qualifying as one type of biofuel in the RFS qualifies for all levels above it.
For example, cellulosic biofuel may also be used to meet the advanced biofuel mandate and the overall RFS
mandate. However, non-cellulosic advanced biofuel (e.g., sugarcane ethanol) may not be used to meet the
cellulosic or BBD mandates. Likewise, corn starch ethanol may only be used to meet the total RFS mandate (and
not the advanced, cellulosic, or BBD mandates).

The Role of RINs

Compliance with the RFS is measured using RINs. When qualifying biofuels are produced, each
gallon is assigned a RIN. Until the biofuels are sold as fuel or blended into conventional fuels, the
RINs are attached to the fuel. Once the biofuel has been blended or sold, the RINs are detached,
and can then be bought and sold like other commodities. At the end of each year, fuel suppliers
must multiply the above percentage standards by their total gasoline and diesel sales to calculate
their renewable volume obligations (RVO), which indicate the total number of each type of RIN
that the suppliers must submit to EPA. To the extent that a supplier has excess RINs, that supplier
may sell them to others who may be short, or save them for use in the following year.

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RINs
A RIN is a unique 38-character number that is issued (in accordance with EPA guidelines) by the
biofuel producer or importer at the point of biofuel production or the port of importation.5 Each
qualifying gallon of renewable fuel has its own unique RIN. RINs are generally assigned by
batches of renewable fuel production. (See box at right.)
RIN Codes
Under the RFS2 RIN formulation, Code D
identifies which of the four RFS categories
RIN=KYYYYCCCCFFFFFBBBBBRRDSSSSSSSSEEEEEEEE
total, advanced, cellulosic, or biodieselthe
Where
biofuel satisfies. Together, SSSSSSSS and
K
= code distinguishing RINs still assigned to a
EEEEEEEE identify the RIN block which
gallon from RINs already separated
demarcates the number of gallons of
YYYY
= the calendar year of production or import
renewable fuel that the batch represents in the
context of compliance with the RFSthat is,
CCCC = the company ID
RIN gallons. The RIN-gallon total equals the
FFFFF
= the company plant or facility ID
product of the liquid volume of renewable fuel
BBBBB = the batch number
times its energy equivalence value (relative to
a gallon of ethanol). For example, because
RR
= the biofuel energy equivalence value
biodiesel has an equivalence value (EV) of 1.5 D
= the renewable fuel category
when being used as an advanced biofuel,
SSSSSSSS = the start number for this batch of biofuel
1,000 gallons of biodiesel would equal 1,500
6
EEEEEEEE= the end number for this batch of biofuel
RIN gallons of advanced biofuels. If the RIN
block start for that batch was 1 (i.e.,
SSSSSSSS = 00000001), then the end value (EEEEEEEE) would be 00001000, and the RR code
would be RR = 15.
Any party that owns RINs at any point during the year (including domestic and foreign
producers; refiners and blenders; exporters and importers of renewable fuels; and RIN traders)
must register with the EPA and follow RIN record-keeping and reporting guidelines. RINs can
only be generated if it can be established that the feedstock from which the fuel was made meets
EISAs definitions of renewable biomass, including land-use restrictions. The feedstock
affirmation and record-keeping requirements apply to RINs generated by both domestic
renewable fuel producers and RIN-generating foreign renewable fuel producers or importers.

EPA Moderated Transaction System (EMTS)

All RIN transactions, including generation, trade/sale/transfer, separation, and retirement, must be
cleared through the EMTS. When biofuels change ownership (e.g., are sold by a producer to a
5

For more discussion on RINs see Robert Wisner, Renewable Identification Numbers (RINs) and Government
Biofuels Blending Mandates, AgMRC Renewable Energy Newsletter, Agricultural Marketing Research Center, Iowa
State University, April 2009, available at http://www.agmrc.org/renewable_energy/
agmrc_renewable_energy_newsletter.cfm; or Wyatt Thompson, Seth Meyer, and Pat Westhoff, Renewable
Identification Numbers are the Tracking Instrument and Bellwether of U.S. Biofuel Mandates, EuroChoices 8(3),
2009, pp. 43-50.
6
Unlike the other biofuel categories, the BBD mandate is a requirement on actual gallons. Thus, the 1.0 billion (actual)
gallons required for the 2012 BBD mandate will generate 1.0 billion BBD RINs, but 1.5 billion advanced
biofuel/renewable fuel RINs.

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blender), any attached RINs are also transferred.7 The Code K status of the RIN is changed at
separation (generally when the fuel is sold from a biofuel producer to an obligated party). (See
Figure 2.)
As noted by EPA in the rule establishing the RFS2 and the EMTS, EPA views the EMTS solely as
a screening system, and all due diligence remains the duty of obligated parties.8 Under this
buyer beware9 system those purchasing or receiving RINs must certify their validity on their
own, and they are responsible for any fraudulent RINs they pass on to other buyers or submit to
EPA for compliance.
Figure 2. Simplified Schematic of RIN Trading System

Biofuel Producer /
Importer
Attached
RINs
EMTS
Renewable
Fuel

Separated
RINs

Secondary
Market

Retirement

Obligated Parties (Gasoline & Diesel

Refiners, Blenders, Importers)
Retail Sale

Source: CRS, based on Rakesh Radhakrishnan, Market ConsiderationsRECs and RINs Overlap, Thompson
Reuters, September 25, 2012, p. 8, http://www.renewableenergymarkets.com/docs/presentations/2012/
Radhakrishnan.pdf.

In many cases, the RINs are detached from the actual fuel at the point of initial sale or transfer, and thus RINs may be
detached for fuel that has not yet been blended into motor fuel or sold as motor fuel.
8
EPA, Regulation of Fuels and Fuel Additives: Changes to Renewable Fuel Standard Program; Final Rule, 75
Federal Register 14732, March 26, 2010.
9
Ibid., p. 14733.

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Notes: Black lines indicate RINs attached to actual biofuel gallons. Solid blue lines indicate separated RINs that
may be traded among all market participants. Dashed blue line indicates end-of-year submission of RINs by
obligated parties to EPA to meet RFS mandates. Green lines indicate actual biofuel gallons separated from RINs.
Orange lines indicate that all RIN transactions must be cleared through EMTS.

The Market for RINs

RIN Prices
Because RINs may be bought and sold as commodities, there are RIN spot markets. However,
these spot markets may only provide some insight into the actual value of the total pool of RINs
in a given year, as RINs may or may not be traded after they are detached by fuel suppliers.
Because RINs are not completely fungible, their values may or may not be affected by the
markets for other RINs. For example, RINs for conventional ethanol may only be used for the
overall (unspecified) renewable fuel mandate. However, biodiesel RINs may be used to meet the
BBD, advanced biofuel, and/or overall RVOs.
It should also be noted that unlike other commodities, RINs generally may only be used in the
year they are generated or for one additional year, although suppliers may only meet up to 20% of
their current-year obligation with the previous years RINs. Thus, RIN values diminish over time
and ultimately have no value in the second year after they are generated.
As there has generally been an excess of corn ethanol (beyond what is allowed for meeting the
unspecified portion of the RFS) in the U.S. market, ethanol RINs have generally traded at much
lower prices than other RINsgenerally between one and four cents per gallon, as opposed to a
dollar per gallon or more for other fuels. (See Figure 3, Figure 4, and Figure 5.) Because much
of the advanced biofuel mandate is met using BBD RINs, the advanced biofuel RIN price follows
the BBD RIN price closely when adjusted for energy content. For example, when BBD RIN
prices spiked in September 2011 (Figure 4), advanced biofuel RINs showed a similar spike
(Figure 5); there was no spike at that time in corn ethanol RINs (Figure 3). Similarly, BBD and
advanced biofuel RIN prices dropped in the second half of 2012 (apparently driven by concerns
over the validity of biodiesel RINs), while ethanol RIN prices increased as the 2012 drought
raised concerns over U.S. corn production and its effects on ethanol production.

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Figure 3. Spot Renewable Fuel (Corn Ethanol) RIN Prices

$0.05

Price per Gallon

$0.04

$0.03

$0.02

$0.01

$0.00
1-Jan-11

11-Apr-11

20-Jul-11

28-Oct-11
2012

5-Feb-12

15-May-12

23-Aug-12

2011

Source: Ethanol and Gasoline Component Spot Market Prices, OPIS Ethanol & Biodiesel Information Service,
various editions (January 10, 2011-October 29, 2012).
Notes: Weekly average prices for weeks when data are available. The years in the legend refer to the year the
RINs were originally generated. For example, a 2011 RIN was generated some time in calendar year 2011, and
generally may only be used for compliance with the 2011 or 2012 standards. Most biofuels are sold under
contract, and thus spot prices may not reflect the value of all RINs traded at any given time.

Figure 4. Spot BBD RIN Prices

$2.50

Price per Gallon

$2.00

$1.50

$1.00

$0.50

$0.00
1-Jan-11

11-Apr-11

20-Jul-11

28-Oct-11
2012

5-Feb-12

15-May-12

23-Aug-12

2011

Source: Ethanol and Gasoline Component Spot Market Prices, OPIS Ethanol & Biodiesel Information Service,
various editions (January 10, 2011-October 29, 2012).
Notes: Weekly average prices for weeks when data are available. The years in the legend refer to the year the
RINs were originally generated. For example, a 2011 RIN was generated some time in calendar year 2011, and
generally may only be used for compliance with the 2011 or 2012 standards. Most biofuels are sold under
contract, and thus spot prices may not reflect the value of all RINs traded at any given time.

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Figure 5. Spot Advanced Biofuel RIN Prices

$1.40
$1.20

Price per Gallon

$1.00
$0.80
$0.60
$0.40
$0.20
$0.00
1-Jan-11

11-Apr-11

20-Jul-11

28-Oct-11
2012

5-Feb-12

15-May-12

23-Aug-12

2011

Source: Ethanol and Gasoline Component Spot Market Prices, OPIS Ethanol & Biodiesel Information Service,
various editions (January 10, 2011-October 29, 2012).
Notes: Weekly average prices for weeks when data are available. The years in the legend refer to the year the
RINs were originally generated. For example, a 2011 RIN was generated some time in calendar year 2011, and
generally may only be used for compliance with the 2011 or 2012 standards. Unlike ethanol and BBD RINs, OPIS
only tracks prices for current-year advanced biofuel RINs. Most biofuels are sold under contract, and thus spot
prices may not reflect the value of all RINs traded at any given time.

RIN Volumes
The market for RINs is potentially very large, although the amount of RIN trading that occurs is
unclear. Although EPA reports total RINs registered by month, and the EMTS tracks trades and
RIN prices, EPA does not report these data. Likewise, publicly available data from other sources
are similarly limited.10 Figure 6 and Figure 7 show total RINs registered for 2011 and 2012
(through September). As noted above, by volume the RFS is dominated by ethanol produced from
corn starch. However, based on RIN value (multiplying yearly RIN volumes by average RIN
prices for the year), BBD RINs represented over 70% of the market in 2011 and 2012 (Figure 8
and Figure 9).

10

For example, OPIS reports daily RIN spot prices for four types of RINs, but does not report trading volume.

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Figure 6.Total RINs Registered 2011

Biomass-Based
Diesel
1.09 billion
7%

Advanced
Biofuel
0.23 billion
2%

Ethanol
13.6 billion
91%

Source: EPA, EPA Moderated Transaction System (EMTS).

CRS-9

Figure 7.Total RINs Registered 2012 YTD

2011

Biomass-Based
Diesel
0.90 billion
8%

Advanced
Biofuel
0.32 billion
3%

Jan.-Sept. 2012

Ethanol
9.8 billion
89%

Source: EPA, EPA Moderated Transaction System (EMTS).

Analysis of RINs in the RFS

Figure 8. Estimated Aggregate RIN Value for 2011

Figure 9. Estimated Aggregate RIN Value for 2012 YTD

2011

Jan.-Sept. 2012
Advanced
Biofuel
$0.16 billion
8%

Ethanol
$0.37 billion
19%

Biomass-Based
Diesel
$1.38 billion
73%

Advanced
Biofuel
$0.22 billion
14%

Ethanol
$0.21 billion
13%

Biomass-Based
Diesel
$1.18 billion
73%

Source: CRS Analysis of data from EPA and OPIS.

Source: CRS Analysis of data from EPA and OPIS.

Notes: Aggregate value based on total RIN volume for 2011, multiplied by the
mean of weekly average RIN prices reported by OPIS for 2011 ($0.027 for
ethanol RINs, $1.26 for BBD RINs, and $0.71 for advanced biofuel RINs).

Notes: Aggregate value based on total RIN volume for 2012 YTD, multiplied by
the mean of weekly average RIN prices reported by OPIS for January 2012
through September 2012 ($0.021 for ethanol RINs, $1.32 for BBD RINs, and
$0.70 for advanced biofuel RINs).

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Analysis of RINs in the RFS

Fraudulent RINs
As noted above, in late 2011 and early 2012, EPA issued Notices of Violations (NOVs) to three
companies (Clean Green Fuels, LLC, Absolute Fuels, LLC, and Green Diesel, LLC) that the
agency alleges fraudulently generated a combined 140 million biodiesel RINs in 2010 and 2011.11
Subsequently, individuals representing two of these companies have also faced criminal
prosecution.12 Because these investigations involve potentially criminal actions, EPA has limited
the amount of information available to traders and obligated parties who may have purchased
fraudulent RINs. Thus, it is unclear whether any other NOVs will be issued in the future.
The 140 million fraudulent RINs from the three NOVs represent roughly 11% of the biodiesel
RINs generated between mid-2010 and the end of 2011, but less than 1% of the total RINs
generatedas noted above, ethanol produced from corn starch currently dominates the RFS.
However, as noted above, biodiesel RINs trade at considerably higher prices than ethanol RINs.
Thus, the fraudulent RINs represent roughly 8% of the aggregate market value for that time.13

Effects on Obligated Parties

In the regulations establishing the RFS2 and the EMTS, EPA specifically stated that invalid
RINs cannot be used to achieve compliance with the Renewable Volume Obligations (RVO) of an
obligated party or exporter, regardless of the partys good faith belief that the RINs were valid at
the time they were aquired.14 Because of the buyer beware nature of the system, obligated
parties who purchased the fraudulent RINs must pay fines for each RIN submitted (EPA and the
companies have generally settled at about $0.10 per RIN), and must submit valid RINs to offset
the fraudulent RINs. Thus, the combined economic costs to the obligated parties may include:
1. the original cost of the fraudulent RINs (spot prices ranged between $0.70 and
$2.00 per RIN over that time);
2. penalties to EPA for Clean Air Act violations ($0.10 per RIN, capped at $350,000
per party);
3. the cost of all make-up RINs (currently trading at roughly $0.50 per gallon); and
4. any legal costs in pursuing restitution from fraudulent actors.

Quality Assurance Program

Because of these RIN fraud cases, EPA is looking at establishing a quality assurance program
whereby RINs can be certified by third parties registered with EPA. EPA intends that such
11

EPA, Civil Enforcement of the Renewable Fuel Standard Program, October 18, 2012, http://www.epa.gov/
enforcement/air/renewable-fuels/fuel-novs.html.
12
On June 25, 2012, Rodney R. Hailey of Clean Green Fuels, LLC was found guilty of 8 counts of wire fraud, 32
counts of money laundering, and 2 counts of violating the Clean Air Act. On August 8, 2012, a Federal Grand Jury
indicted David Gunselman of Absolute Fuels, LLC on wire fraud, money laundering, and violating the Clean Air Act.
13
140 million RINs represent 11% of the BBD market. 11% x 73% (aggregate market share for BBD RINs) = 8% .
14
40 C.F.R. 80.1431(b)(2).

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certification would provide obligated parties with an affirmative defense if RINs are later found
to fraudulentthat is, obligated parties would not be liable for civil penalties under the Clean Air
Act for the use of such RINs. As noted by Gina McCarthy, EPA Assistant Administrator for Air
and Radiation, the affirmative defense would ensure that refiners and other program participants
who meet the conditions of the affirmative defense will not face civil penalties.15
A key component of a Quality Assurance Program would be the establishment of a quality
assurance plan (QAP). The QAP would serve as the basis for audits by third party verifiers
certified by EPA. However, while EPA has issued draft requirements of what might be included in
a QAP, EPA has not issued proposed rules.16 According to various comments by the agency, EPA
expects to issue a proposal by the end of 2012, with a final rule some time in 2013.
Key questions include whether such an affirmative defense would also eliminate the requirement
to purchase make-up RINs. While refiners and others would prefer to not pay twice for RINs,
in general biofuel producers argue that not making up the RINs would undermine the legitimate
RIN market. Simply put, if obligated parties are not required to replace invalid RINs with valid
RINs, the size of the legitimate renewable fuel market is reduced.

Policy Options
There are various policy options to address the issues of RIN fraud. EPA could undertake some of
these under existing Clean Air Act authority, while others would require congressional action. In
general terms, there are at least four options:
1. Do nothing, and let market participants determine the credibility of actors they
trade with;
2. Establish a Quality Assurance Program or some other certification to provide
greater credibility, but do not tie it to EPAs determination on RIN validity;
3. Establish a certification procedure with an affirmative defense such that
purchasers of invalid RINs are not liable for civil penalties; and
4. Establish a system where all certified RINs are valid for RFS compliance
regardless of subsequent determination that they are fraudulent or otherwise
deficient.
Currently, RIN market participants are acting under the first option. They are independently
determining whether to trust the validity of the RINs they purchase. In many cases, obligated
parties have decided to purchase biodiesel and biodiesel RINs only from the largest producers.17
At the same time, small producers have complained that they are unable to afford the verification
procedures that some obligated parties now require. Others have argued that the RIN fraud
prosecutions have improved the integrity of the market. For example, one witness to a House
15
Letter from Gina McCarthy, Assistant Administrator for Air and Radiation, EPA, to The Honorable Gene Green,
Ranking Member, Ranking Member Subcommittee on Energy and Economy, Committee on Energy and Commerce,
August 14, 2012.
16
EPA, Public Release of Draft Quality Assurance Plan Requirements, EPA-420-B-12-063, Washington, DC, October
31, 2012, http://www.epa.gov/otaq/fuels/renewablefuels/documents/420b12063.pdf.
17
Testimony of various biofuel companies before the House Committee on Energy and Commerce Hearing on RIN
Fraud: EPAs Efforts to Ensure Market Integrity in the Renewable Fuels Program. July 11, 2012.

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Analysis of RINs in the RFS

Energy and Commerce Committee hearing on RIN fraud stated [i]n essence, the Wild West of
buying and selling RINs from market participants you dont know has ended, the wrongdoers are
being rooted out, and everyone now knows that deals that are too good to be true are in fact too
good to be true.18
Because of substantial remaining uncertainty about the integrity of the market, the National
Biodiesel Board (NBB) and others are working to establish a more formal process for RIN
certification. With the NBB, biodiesel producers have established a RIN Integrity Network where
obligated parties can subscribe to a service where they can receive information on participating
biodiesel producers.19 This and similar efforts are in their early stages, and it is unclear how much
credence RIN purchasers will give these networks. Further, it is unclear whether they will become
the industry standard.
EPA is currently pursuing the third option, where a Quality Assurance Program is established with
third parties auditing RIN generators. In its public communications, EPA has stated that the
agency plans to offer an affirmative defense such that users of certified RINs would not be
subject to civil penalties under the Clean Air Act. It is unclear whether an obligated party would
be required to purchase additional RINs to make up for any certified RINs later found to be
fraudulent. Obligated parties generally would prefer not to pay twice for RINs, adding to their
compliance costs. However, eliminating this requirement would effectively shrink the market for
biofuels under the RFS, harming legitimate biofuel producers. As EISA establishes specific fuel
volume requirements, it is unclear whether EPA has the authority under existing statute to waive
that requirement.
In addition to agency action, at least one bill has been introduced that would amend the RIN
system. H.R. 6444 would require EPA to establish a RIN certification system by January 1, 2013.
The bill would preclude the agency from later invalidating any certified RINs. Thus, under the
bill, any RIN found subsequently to be fraudulent would still count toward an obligated partys
compliance, without penalties. As noted above, refiners and other obligated parties would likely
prefer this to other policy options, while biofuel producers are unlikely to support such blanket
protection. Further, it is unclear whether EPA could issue a final rule for the new system by the
January 1, 2013, deadline specified in the bill.

Additional Questions
The concerns raised above, and proposed policy remedies, raise additional questions about the
potential for RIN fraud in the future, as well as the effects on stakeholders from any policy
solution. These questions include:
1. Beyond the instances of fraud currently being prosecuted, what other instances
are unreported, and what other types of fraud are possible in the future?
2. How likely is fraud in the future, and what are the implications? and
3. How do various players benefit from the different policy options?
18

Joe Jobe, Chief Executive Officer, National Biodiesel Board, Testimony Before the United States House of
Representatives Committee on Energy and Commerce Hearing RIN Fraud: EPAs Efforts to Ensure Market Integrity
in the Renewable Fuels Program, Washington, DC, July 11, 2012.
19
Genscape, Genscapes RIN Integrity Network, http://info.genscape.com/RIN.

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What Other Types of RIN Fraud Are Possible?

In the three cases of RIN fraud currently reported by EPA, fraudulent RINs were generated for
fuel that did not exist. However, other potential errors or opportunities for fraud include:
1. double counting, where the same RIN (representing a gallon of actual fuel) is
transferred to two different entities;
2. improper split, where a batch of RINs is separated into two or more groups and
sold to different entities, but the total number of RINs somehow changes (an
example of double counting);
3. improper reporting of RIN data (type of fuel, size of batch, etc.);
4. failure to report export (for every gallon of fuel exported any RINs from that
export must be retired, as the fuel was never used as transportation fuel in the
United States).
The EMTS was established in part to address errors of the first three types. However, it is unclear
whether the EMTS completely screens out these errors. Especially as regulations require all
transactions be reported within five business days, the real-time reporting requirements may
potentially lead to errors if entities feel rushed in completing reports and transactions on time. On
the other hand, real-time reporting may make it easier to catch errors and irregularities than under
the previous system, where most data verification was completed on a quarterly basis.
The latter issue, that fuel has been exported without retirement of necessary RINs, has been raised
by some stakeholders.20 RFS regulations are explicit that when renewable fuel is exported that the
exporter must have RINs to offset that volume: Any party that owns any amount of renewable
fuel, whether in its neat form or blended with gasoline or diesel, that is exported from any of the
regions described in 80.1426(b) shall acquire sufficient RINs to comply with all applicable
Renewable Volume Obligations under paragraphs (b) through (e) of this section representing the
exported renewable fuel.21
It is unclear to what extent, or whether, parties have been exporting fuel without securing the
necessary RINs. EPA has not reported any such activity to date. To the extent that this sort of
fraud is occurring, as with other types of fraud, it would lead to lower domestic renewable fuel
use than required under the act. That would likely lead to an oversupply of RINs and a lower RIN
price received by all market participants. However, unlike other types of fraud, actual fuel would
be produced, so the overall level of U.S. biofuel production may not decline.

How Likely Is RIN Fraud in the Future?

To date, all of the reported cases of fraud have occurred in the biodiesel market. There are several
reasons that have been given for this: (1) the market price for BBD RINs is much higher than that
for ethanol RINs, making any transaction (legal or illegal) that much more valuable; (2) in
general biodiesel producers are smaller operations than ethanol producers, and the companies
20

For example, see Jon P Fjeld-Hansen, Managing Director, Musket Corporation, Testimony Before the United States
House of Representatives Committee on Energy and Commerce Hearing RIN Fraud: EPAs Efforts to Ensure Market
Integrity in the Renewable Fuels Program, Washington, DC, July 11, 2012.
21
40 C.F.R. 1430(a).

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Analysis of RINs in the RFS

involved may be less well known to market participants; and (3) limited verification procedures
exist.
Between actions taken by industry, forthcoming regulations from EPA, and potential
congressional action, the latter two reasons for fraud in the biodiesel RIN market may be fully
addressed. However, the first causea high price for some RINsmay continue in the future. By
2022, the RFS requires the use of 36 billion gallons of renewable fuels, more than double the
amount required in 2012. Thus, the absolute volume of the market will be larger in the future.
Further, of the 36 billion gallons required in 2022, 16 billion gallons are required to come from
cellulosic biofuels. Currently, there is very limited production of these fuels, and their production
costs are high. To the extent that cellulosic fuel costs remain high in the future, the aggregate
value of the cellulosic RIN market could be significantly higher than the total RIN market
today.22 The higher value of this market might be a draw to actors looking to circumvent the law.

How Do Various Players Benefit from the Different Policy Options?

As noted above, obligated parties would like any new certification system to include an
affirmative defense against civil penalties if they act in good faith. As noted above, the details of
that affirmative defense will determine who might benefit from policy changes. For example, in
general obligated parties are more likely to benefit from a blanket exemption from both civil
penalties and the requirement to purchase RINs to make up for ones later found to be invalid.23 In
general, biofuel producers are more likely to benefit from a policy that still requires obligated
parties to purchase make-up RINs. Otherwise, the market for RINsand thus the fuel they
representwould effectively shrink by the amount of any fraudulent RINs.
Any third-party certification procedures will add to the cost of producing biofuels and RINs.
Various actors may be more or less able to absorb those costs. For example, obligated parties may
be able to pass the additional cost along to gasoline and diesel fuel consumers through higher
pump prices. Further, larger biofuel producers may be able to take advantage of economies of
scale and spread the cost across all gallons of fuel they produce. Smaller producers, however,
may be less able to spread the cost over the fewer gallons they produce and thus their per-gallon
production costs may increase relative to their larger competitors. As noted above, many biodiesel
producers are smaller operations who may feel more of these effects than ethanol producers (who
generally produce larger volumes of fuel). In the future, cellulosic biofuel producers may also
face similar pressures as these plants are expected to be on the smaller side.

Conclusion
The establishment of the Renewable Fuel Standard has created a market for RINs that has grown
both in volume and in value over time and is expected to continue to grow over the next decade.
However, cases of fraud in the early years of the biodiesel RIN market raise questions about the
22

For example, assuming a cellulosic RIN price of $0.50 in 2022, in aggregate cellulosic RINs would be valued at $8
billion, roughly four times the aggregate value of all RINs in 2011. A higher cellulosic RIN price would raise the
aggregate value proportionally.
23
H.R. 6444 would address this by removing EPAs authority to invalidate (for any reason) a certified RIN later found
to be deficient. Thus, even a deficient RIN could be traded or used to meet a partys RVO as long as it had been
certified by the agency.

Congressional Research Service

15

Analysis of RINs in the RFS

integrity of RIN markets, as well as EPAs oversight of the markets. Various policies have been
proposed to address the potential for RIN fraud in the future, and the details of those policies will
affect the potential for fraud in the future as well as the relative benefits to different market
players.

Author Contact Information

Brent D. Yacobucci
Section Research Manager
byacobucci@crs.loc.gov, 7-9662

Congressional Research Service

16

International Gas Union (IGU)

News, views and knowledge on gas worldwide

Wholesale Gas Price Formation

- A global review of drivers and regional trends

Foreword
Following the successful 24th World Gas Conference in Buenos Aires in October 2009, we have
decided to convert some of the study reports presented at the conference into IGU publications,
including the report Gas Pricing written by Study Group B2 of the IGU Strategy Committee
(PGCB).
The IGU Strategy Committee is updating the review for the WGC in June 2012. Some interim
findings have been published in the April 2011 edition of the IGU Magazine and are available on
www.igu.org.
Historically, gas prices have not been in the news to the same extent as oil prices. This is changing.
The share of gas in global energy and fuel consumption has increased and also the share of
internationally traded gas globally is greater than before. LNG is providing intercontinental linkages
that eventually could constitute a global gas market.
Natural gas is an abundant resource, it is clean and cost-competitive, and should therefore play an
important role in the mitigation of climate change. However, the pricing of this valuable commodity
is critical to a sustainable market growth.
It is our hope that this publication can serve as one example of how vital information related to
gas pricing can be shared across borders to the benefit of the global gas industry and also to enable
new gas regions to learn more about the different pricing models that are being used.
June 2011
Torstein Indreb
Secretary General of IGU

This publication is produced under the auspices of INTERNATIONAL GAS UNION

(IGU) by the Author(s) mentioned. The Author(s) and IGU enjoy joint copyright to
this publication This publication may not be reproduced in whole or in part without
the written permission of the above mentioned holders of the copyright. However,
irrespective of the above, established journals and periodicals shall be permitted
to reproduce this publication or part of it, in abbreviated or edited form, provided
that credit is given to the Author(s) and to IGU.
Sponsored by:

Table of contents
1. Executive Summary.......................................................................................................................................4
2. Introduction....................................................................................................................................................7
Mandate..........................................................................................................................................................7
Why this report?.............................................................................................................................................7
Outline of report.............................................................................................................................................8
Terms and concepts........................................................................................................................................8
3. Gas price drivers...........................................................................................................................................10
Competitive markets....................................................................................................................................10
Short to medium term supply and demand drivers...................................................................................10
Long term supply and demand drivers......................................................................................................11
Current scenarios.......................................................................................................................................13
Other market organisation ...........................................................................................................................13
OECD area................................................................................................................................................13
Non-OECD area........................................................................................................................................14
4. Key gas pricing mechanisms........................................................................................................................15
5. Origins of individual pricing mechanisms...................................................................................................18
Origins of gas or oil market based pricing...................................................................................................18
North America...........................................................................................................................................18
The UK......................................................................................................................................................18
Continental Europe....................................................................................................................................19
Asia Pacific................................................................................................................................................19
Origins of regulated gas pricing...................................................................................................................20
6. Recent gas price developments....................................................................................................................23
OECD area...................................................................................................................................................23
Rest of the world..........................................................................................................................................24
7. Current extensiveness of individual pricing mechanisms............................................................................28
Introduction..................................................................................................................................................28
Price Formation Mechanisms.......................................................................................................................30
Types of Price Formation Mechanism......................................................................................................30
Results..........................................................................................................................................................30
Format of Results......................................................................................................................................30
World Results............................................................................................................................................30
Regional results.........................................................................................................................................34
Wholesale Prices.......................................................................................................................................38
Changes between 2005 and 2007..............................................................................................................40
Conclusions...............................................................................................................................................41
8. Trends in the extensiveness of individual pricing mechanisms...................................................................42
Towards a globalisation of gas pricing?.......................................................................................................45
Bumps in the road toward globalised gas pricing.....................................................................................47
9. Price volatility..............................................................................................................................................51
General.........................................................................................................................................................51
Causes of volatility.......................................................................................................................................52
Volatility associated with gas price increases...........................................................................................53
Volatility associated with gas price declines.............................................................................................53
Volatility of oil indexed prices.....................................................................................................................54
Volatility and LNG.......................................................................................................................................54
10. Towards further changes in the extensiveness of individual pricing mechanisms?.....................................55

Appendix 1 Price Formation Mechanisms 2005 Survey...........................................................................58
Format of Results......................................................................................................................................58
World Results............................................................................................................................................58
Regional Results........................................................................................................................................61
Wholesale Prices.......................................................................................................................................65
Conclusions...............................................................................................................................................66

Gas Pricing; Study group B2 of IGU Programme Committee B (PGC B). The work was coordinated by Runar Tjrsland, Study Group leader
with contributions of Meg Tsuda, Mike Fulwood, Ottar Skagen and Howard Rogers.

June 2011 | International Gas Union 3

1. Executive Summary
Historically gas prices have not been in the news to the same
extent as oil prices. This is changing. The share of gas in
global energy and fuel consumption has increased. The share
of internationally traded gas in global gas consumption has
increased. LNG is providing intercontinental linkages that
eventually could constitute a global gas market. With most
gas producing OECD countries struggling to replace reserves
and sustain production growth, the centre of gravity of gas
production and exports has shifted towards the same regions
and to some extent countries that for 40 years have dominated
oil production and exports. Finally, gas prices have increased
and become more volatile.
Gas prices are not determined but definitely influenced by
individual markets choices between available price formation
mechanisms. The two main debates in this respect is the
one that goes on in Europe and to an extent in Asia between
proponents of continued indexation of gas prices to oil prices
and proponents of gas-on-gas competition based pricing, and the
one that goes on inside a number of Non-OECD countries and
between these countries governments and entities like the EU
Commission, the IEA and the multilateral development banks
on the sustainability of the more or less heavy handed price
regulation that prevails in big parts of the Non-OECD world.
Arguably the former of these debates is the least important.
Evidence from North America where gas prices are not
contractually linked to oil prices suggests that gas prices
nonetheless tend to track oil prices in a fairly stable long term
relationship. Gas and oil prices are linked by interfuel competition
in the industrial sector. They are also influenced in the same
manner and to the same extent by the oil and gas industrys cost
cycles. Finally price deviations may be arrested, eventually, by
changes in oil and gas industry investment priorities.

countries gas demand, and the gas flows from Russia, the
Middle East and Africa to the OECD are expected to further
increase. Several gas exporting non-OECD countries are however
struggling to sustain, let alone increase, their exports in the face
of booming domestic gas demand. Domestic demand reflects
among other things domestic prices. Consequently the outlook
for domestic gas pricing in these countries is no longer of local
interest only but of global importance.
This report examines the extensiveness in different parts of the
world of the following gas pricing mechanisms:

Gas on gas competition

Oil price escalation
Bilateral monopoly
Netback from final product
Regulation on a cost of service basis
Regulation on a social and political basis
Regulation below cost
No pricing

Chart 1.1: World gas price formation 2007 - total consumption

World gas price formation 2007 - total consumption
Oil price
escalation
20 %
No price
1%

Regulation
below cost
26 %

Gas-on-gas
competition
32 %

Regulation
social and
Regulation cost
political
of service
9%
3%

Bilateral
monopoly
8%
Netback from
final product
1%

In periods of ample gas supply, prices have delinked with

gas becoming significantly cheaper than heavy fuel oil, not
to mention crude oil or light fuel oil. But in periods of gas
market tightness the link has re-emerged with oil product prices
eventually putting an end to gas price rallies.

Globally, in 2007 one third of all gas sold and purchased was
priced according to the gas-on-gas competition mechanism.
Regionally the share of gas transactions in this category varied
from 99% in North America to zero in most of the developing
world.

For the moment by mid 2009 the US gas market is exceptionally

well supplied. As a result prices are softer than at any time since
2002 and well below crude oil and refined product prices in
energy equivalence terms. Possibly this situation will last for a
while due to the unexpectedly rapid growth in US unconventional
gas production. But that does not need to apply to Europe or
Asia. Consequently a radical replacement of oil linked contracts
with gas linked contracts in any or both of these regions had
such a thing been politically and practically possible would
likely have increased gas price volatility but might not have
materially changed long term price trends.

The second biggest category in 2007 was Regulation below

cost (see Chapter 4 for definitions) with 26% of the global total.
The share of gas supplied at prices contractually linked to oil
product or crude prices the dominant mechanism in Continental
Europe and the Asia Pacific OECD countries was 20%.

With respect to the latter debate, Non-OECD countries already

supply high shares of the European and Asian OECD member

A comparison of the results for 2007 with those of a similar

study carried out two years ago on 2005 data shows an increase
in the Regulation below cost category in both absolute and
relative terms. 85% of this change can be explained by robust
gas consumption growth in the Former Soviet Union, particularly
in Russia, where this pricing mechanism remains dominant.
Only 15% was due to shifts from other pricing mechanisms to
regulation below cost.

4 International Gas Union | June 2011

Gas-on-gas competition based pricing gained some ground,

largely at the expense of oil price escalation between 2005
and 2007 largely because of growth in Japans, Koreas,
Taiwans and Spains spot LNG imports, and in the trading
on Continental Europes emerging gas hubs. Also less UK
gas was sold into the UK market under oil linked contracts.
The combined impact of these changes dwarfed Brazils shift
towards oil price escalation, and Chinas first LNG imports at
oil linked prices, in this period.
A striking aspect of recent gas price developments is that prices
seem to have become much more volatile. This impression
may be slightly misleading. In absolute terms price gyrations
have become stronger. In relative terms i.e., if one takes into
account that prices in recent years have fluctuated around higher
averages volatility appears to have been roughly constant
during the 2000s.
Some short term price volatility is part and parcel of gas-ongas competition based pricing. As such it is typical for North
America, the UK and the short term trading around Continental
Europes emerging hubs but not for the bulk of Continental
Europes and Asias gas transactions. A typical Continental
European gas import contract links the gas price to a basket of oil
product prices in an averaged and lagged way that significantly
dampens the impact of oil price fluctuations. A typical Asian
LNG import contract is structured the same way, only with the
gas price indexed to a basket of crude oil prices.
However, if some price volatility is inevitable under gas-on-gas
competition, strong volatility also requires market tightness.
The last couple of years big gas price changes were due to
supply and demand intersecting with each other at very steep
segments of either the supply curve or the demand curve or
both. For the moment markets are loose and volatility as well
as prices are down.
Another aspect of price volatility is that not everybody would
agree that it is a bad thing that should be minimised. While some
investors pursuing low risk activities with correspondingly low
returns need stable, predictable prices, others thrive on price
instability because of the arbitrage opportunities associated
with a dynamic environment.
These findings beg the questions where gas prices and gas
pricing mechanisms will go in the future. This study was never
supposed to conclude with either another set of gas price scenarios
or precise predictions of the changes in the extensiveness of
individual pricing mechanisms that undoubtedly will occur 1.
Broad development directions may nevertheless be inferred

from the tensions that current pricing mechanisms have given

rise to, and from the debates on gas pricing that these tensions
have triggered.
The below figure is highly tentative and intended merely to
facilitate a discussion.
Chart 1.2: Hypotheses on future changes in the extensiveness
of individual pricing mechanisms in individual regions
2008
Gas-on-gas competition
Oil price escalation

North America, UK

u ro pe
enta l E
Con tin
Continental Europe,
Developed Asia

Bilateral monopoly
Netback from final product
Regulation cost of service
Regulation social and political
Regulation below cost
No price

2020
Gas-on-gas competition
Oil price escalation
Bilateral monopoly

Select market segments

Ru
ss
ia
,C
hi
na
?

The share of gas transactions at prices reflecting Regulation

on a social and political basis declined from 2005 to 2007
due mainly to changes in pricing mechanism in Brazil and
Argentina and also to below average growth in gas production
for the domestic market in Ukraine and in gas consumption
in Malaysia, two countries where this type of regulation is
widespread.

Select Non-OECD

EC
N on-O
Select

Select Non-OECD

Netback from final product

Regulation cost of service
Regulation social and political
Regulation below cost
No price

In the countries where gas-on-gas competition based pricing

prevails, there may be concerns about price volatility, and debates
on how to deal with the harmful effects of price spikes and
troughs. But there is little talk about a return to more regulation
or a shift to some variation on the market value pricing theme.
As such, gas-on-gas seems to be widely perceived as the end
game without more efficient alternatives.
In Continental Europe the EU Commission is seeking to pave
the way for a shift from oil price indexation to gas-on-gas
competition based pricing. The Commissions priorities are
being shared to varying degrees by the EU member states
governments depending on their ideological leanings and
prioritisation between efficiency, environmental and gas supply
security concerns, and by the regions commercial actors
depending on their status as incumbents or new entrants. The
enthusiasm for this or that mechanism also tends to vary with
the oil price and with outlook for the ratio between oil linked
gas prices and hub gas prices.
Though oil price escalation is not going to disappear any time
soon, gas-on-gas competition based pricing will likely gain
ground as more hubs mature.
In the Asia Pacific region, the main LNG importers are sticking
to crude oil indexation as the dominant imported gas pricing
mechanism. Gas market based pricing is not yet an option since
the Asian gas markets are characterised by limited competition
and have almost no gas hubs. This could change with market
reforms aimed at introducing third party access to LNG terminals
and pipelines and competition at the wholesale level.
1
A more thorough examination of the scope for changes could instead be the subject for
a follow-up study in the next WGC triennium.

June 2011 | International Gas Union 5

In addition to the political and regulatory push for liberalisation

there has been much talk about Henry Hub or the NBP price
becoming benchmarks also for Asian gas buyers. In 200708 when Japanese and Korean utilities had to dramatically
increase their imports of Atlantic LNG, this prediction gained
credibility. By 2009, however, with demand in decline due to
the financial crisis and with a string of new Middle Eastern and
Asian LNG trains at or approaching the commissioning
stage, the Atlantic-Asian LNG trade looks set for an equally
dramatic decline, potentially with a dampening impact on the
pace of price globalisation.
In the longer term, internal and external forces may well combine
to erode the position of oil price escalation also in the Asia
Pacific area. For the time being, however, this region looks
set to remain well behind Continental Europe in introducing
alternative mechanisms.
Bilateral monopoly pricing remains important in the Former
Soviet Union and characterises up to 8-9% of gas transactions
in the other Non-OECD regions. Bilateral monopoly pricing
may be expected to decline in importance probably to the
benefit of oil indexed pricing as Russia is negotiating netback
prices based on Western European border prices with its near
neighbours.
The netback from final product mechanism will likely prevail
in certain market segments. For industrial gas users it represents
a way to shift product market risk upstream. For gas sellers
it represents a way to sustain industrial demand in times of
potential market destruction. It is however difficult to see this
mechanism making major inroads into the much bigger shares
of gas transactions characterised by gas-on-gas pricing, oil
escalation or regulation.
Outside the OECD area, gas subsidisation is taking an increasingly
heavy toll. One trend seems to be for countries practicing below
cost regulation to move towards ad hoc price adjustments with
the purpose of keeping prices largely in line with supply costs
i.e. what we have termed regulation on a social and political

basis. Another trend seems to be for governments to liberalise

prices to select, presumably robust, customers, and increasing
remaining regulated prices to the extent politically possible.
Typically, households and industries perceived as strategic
such as the fertilizer sector continue to enjoy some protection.
Russia has embarked on a process of aligning domestic prices
with opportunity costs, i.e., with the netback to the producers if
they had exported the gas instead, and there is every reason to
believe that this process will be completed, if not necessarily on
schedule. Since Russia exports gas on oil linked contracts, this
means an effective gradual introduction of oil price escalation
in the domestic market.
Russia and other countries that have practiced gas price
regulation are also experimenting with gas-on-gas competition.
Gas exchanges intended to serve as safety valves for producers
with surplus gas and consumers with extraordinary needs are
being established. The volumes traded on such exchanges
and their price impact will however be minor unless and until
competition takes hold, and that could take some time.
China and India face challenges in incentivising the power
sector to shift from cheap indigenous coal to gas, but there is
significant industrial and household demand at much higher
prices. The future will likely see price regulation with a view
to both consumers ability to pay, supply costs and the prices of
competing fuels. But increasing gas imports will expose these
countries to gas-on-gas competition too, and affect the pricing
environment for the consumers with the highest willingness
to pay.
Middle Eastern countries face challenges in providing for
development of non-associated gas reserves in the context of gas
prices that reflect the very low costs of associated gas supply.
But the need for countries like Kuwait, Abu Dhabi, Dubai and
possibly Bahrain to start importing gas will introduce new
benchmarks to the region and may eventually drive broader
price reforms. To the small extent it still exists, the no price
category seems destined for phase-out.

6 International Gas Union | June 2011

2. Introduction

These differences between gas and oil are becoming less

pronounced:

Mandate
This report is as noted not an attempt to analyse in great
detail gas price movements around the world in great detail,
nor to provide another set of gas price forecasts. The mandate
given to IGU PGC B/SG2 was:
To carry out a comprehensive analysis of gas price formation
models at regional level: price drivers, indexation, price
arbitrage, demand elasticity;
To investigate future trends and the factors which could help
to minimize price anomalies and contribute to a sustainable
market growth
The work group has on the basis of this mandate set itself
the following targets:
Identify the main gas price drivers and discuss how they
operate in the short and longer term;
Offer a categorisation of how gas is priced around the world;
Discuss how individual pricing methods or models have
arisen;
Present the results of a global pricing method mapping
exercise;
Examine select trends in the use of individual pricing methods;
Discuss the roots and consequences of gas price volatility;
Offer some views on how the popularity and prevalence of
individual methods may change in the years ahead.

Why this report?

Ever since natural gas became a marketable good with an
economic value, gas pricing principles and price levels have
attracted producer, consumer, government and general interest.
Gas prices have however not been in the news to the same extent
as oil prices. This is because:
Historically gas has been less important than oil in most
countries fuel mix;
On balance gas border or hub prices has been lower, in energy
equivalence terms, than crude oil border or hub prices;
Unlike oil, gas has substitutes in its main applications, a fact
that has served to check gas price fluctuations; also the way
gas is indexed to oil in European and Asian contracts has
smoothened the gas price curve:
Gas has been a regional fuel and hence not in the same way
as oil a matter of global importance;
Gas reserves have been more widely distributed than oil
reserves with OECD countries holding a major portion of
the resource base; thus the divide between producing and
consuming countries has been less clear-cut and gas prices
less geo-politicised.

The gas share of the fuel mix has increased world wide;
Gas prices have increased;
Gas prices have become more volatile;
LNG is providing intercontinental gas price linkages that
eventually could constitute a global gas market;
With most gas producing OECD countries struggling to
replace reserves and sustain production growth, the centre
of gravity of gas production and exports has shifted towards
the same regions and to some extent the same countries that
for 40 years have dominated oil production and exports.
Gas prices in North America, Europe and developed Asia are
being more closely monitored than prices in the rest of the
world. This has several reasons:
Historically the OECD area has accounted for the bulk of
world gas consumption,
The worlds leading energy research institutions are located
in the OECD area and sponsored by OECD area governments
and companies,
While prices in the OECD area are market driven and therefore
amenable to standard economic theory and models, prices
in the rest of the world are with a few notable exceptions
politically determined and therefore essentially beyond
forecasting.
The validity of the first reason is wearing thin. 2007 world gas
use was split evenly between the OECD countries and the rest
of the world, and since OECD area consumption is growing
at a slower pace than non-OECD consumption, the latter area
will soon have a lead on the former. Moreover, several nonOECD countries are already playing key roles in determining
the supply of gas to world markets, and will only become more
important in this respect in the future. Their domestic gas pricing
decisions could therefore be strongly felt in the OECD area.
Russia is a case in point. Eurasian gas balance studies typically
conclude that the call on Russian gas will increase significantly
and that Gazprom, the Russian oil companies and Russias
independent gas producers need to invest massively in the upstream
and midstream to stave off shortages. This from time to time
prompts discussions on the adequacy of budgeted investments.
However, if a gap exists it may be closed by dampening future
demand as well as by boosting future supply. The bulk of Russian
gas currently almost 70% is consumed at home. Thus if the
pace of growth of Russian domestic gas use can be contained
through for instance price increases, budgeted investments in
supply may be more than adequate.
The Middle East is another case in point. Forecasters tend to
vest high shares of the responsibility for supplying world gas
demand in the decades ahead, with this region. But the Middle
Easts current and potential gas exporters are currently struggling
to sustain or start exports in the face of stagnant production and
booming domestic demand. The latter aspect of the regions

June 2011 | International Gas Union 7

fuel situation is closely linked to its traditionally very low end

user prices.
Estimates of the long term impact of gas price changes on
gas demand vary across countries and time periods. And if it
is difficult to reach consensus on price elasticities for OECD
countries, it is even harder for regions like the FSU and the
Middle East. However, although gas consumption per capita may
be lower outside than inside the OECD area, gas consumption
per unit of GDP produced in the sectors using gas in the first
place, is typically higher. Hence the fuel switching and savings
potential that could be released by gas price increases should
not be underestimated.

Outline of report
Chapter 3 of this report identifies the gas price drivers at
work in different markets and offers some views on how they
may develop in the years ahead.
Chapter 4 presents and briefly explains eight gas pricing
mechanisms that together capture nearly all gas produced and
consumed in the world.
Chapter 5 discusses the origins and history of each of these
mechanisms, with an emphasis on those in use in the OECD
countries.
The current interest in gas pricing models has a context, and
this context is the gas price turbulence experienced since 2000
in big parts of the world. For this reason chapter 6 offers a brief
overview of recent price developments inside and outside the
OECD area.
Chapter 7 is the core of the report in that it presents the result of
an empirical investigation of the prevalence of individual pricing
models in individual markets in 2007, and also a comparison of
the situation in 2007 to that in 2005. A sample of IGU member
organisations were asked to estimate the shares of gas sales in
their home countries that belonged to each of the eight pricing
categories. The member organisations were selected so as to
ensure that all regions and preferably all key countries were
covered. The replies were then analysed by SGB2.
Chapter 8 addresses the tensions inherent in individual pricing
mechanisms, the consequent challenges of sustaining the current
pattern of methods, and the attempts being made by market
players, politicians and regulators to introduce new methods,
typically with a view to shifting prices to more efficient levels.
Chapter 9 addresses this issue of gas price volatility. Since the
turn of the decade, gas prices have not only fluctuated around
(until recently) rising trends, they have also gyrated more
violently than typical for the 1980s and 1990s. The reasons for
and nature of the post 2000 gas price instability, and whether
the future will bring even more, or less, volatility, are questions
on every gas market players mind.

This chapter also addresses the issue of gas price globalisation.

As noted, gas prices have historically been regional. Price
formation in one region has largely reflected circumstances
within that region only, and has in turn not impacted on price
formation in other regions. This is changing, driven by the
growth in flexible LNG, and at a more general level by the
commoditization of gas, the better availability of global gas
price information and a higher awareness in every corner of
the world of the value of gas.
Chapter 10 offers a view on the sustainability of individual
pricing models, and a view on where we will most likely see
changes and where we probably will not see much deviation
from todays pricing habits.
Finally, Appendix 1 presents the full results of the 2005 mapping
exercise in the same way as Chapter 7 presents the 2007 exercise.

Terms and concepts

There are many prices along pipeline gas or LNG value
chains. The focus in this study is on wholesale prices, that is,
hub prices or in the absence of hubs providing reliable price
signals border prices.

FOB price (LNG)

Border or DES (LNG) price
Hub price

Wellhead
price Citygate
price

Large end user prices

Small
end
user
prices

Study object is wholesale

border or hub price
formation

Wellhead prices may be

unrepresentative for pricing
conditions further down the chain
End user prices reflect, in
addition to wholesale prices,
taxes, downstream margins and
local factors noise in the big
picture
Also, border/hub prices are better
documented

It is at the level of wholesale prices that battles over pricing

principles are fought. It is this level that is subject to national
or supranational regulation.
Moreover, wholesale pricing principles largely determine end
user pricing principles. One cannot have, e.g., gas-on-gas
competition based hub or border prices and at the same time
competing fuel linked citygate or end user prices.
A third reason for focusing on wholesale prices is that city gate
and end user prices are influenced by taxes and by local supply
and demand conditions reflecting in turn local weather patterns,
local infrastructural bottlenecks, the level of competition for
local distribution rights, local regulators ability to counteract
attempts at monopoly pricing, etc.
A fourth, related reason is the inherent complexity of end user
prices. Mature markets typically have extensive end user price
matrices with prices varying by geography, end user segment,
customer size and interruptibility of supply. Thus, end user prices
studies require a degree of accounting for the local context that
is beyond the scope of this study.

8 International Gas Union | June 2011

Finally, in many areas wholesale prices are as a rule better

documented than other prices.
There are however exceptions from the latter rule. There are
countries with immature gas markets, no hubs, no exports or
imports and with state companies that do not publish much
financial information in charge of gas supply but where one
can still find some anecdotal evidence of prices, typically at
end user level. In such cases it is necessary to combine what
little information exists into guesstimates of wholesale prices.
The following is an attempt to further define and explain the
pricing terms to be used in this report.

Wellhead price
The value of gas at the mouth of the gas well
In general the wellhead price is considered to be the sales price
obtainable from a third party in an arms length transaction
Wellhead prices are well documented for the US, less so for
other countries with less transparency in the upstream

Border/beach price
The price of gas at a border crossing or landing point
US and European natural gas and LNG import prices are
well documented by the US Department of Energys Energy
Information Administration (DOE/EIA) and Eurostat, and
by the International Energy Agency (IEA) in its quarterly
Energy

Prices and Taxes report

The reporting on European import prices is incomplete as
the long term export-import contracts that determine these
prices are as a rule not in the public domain
Non OECD/IEA country border or beach prices are not
systematically compiled and published, but a great deal of
information on individual agreements exists
Since so few countries have hubs providing reliable price
information, border/beach prices will often be the best
wholesale price proxies available

FOB and DES LNG prices

FOB (Free On Board) price
The price of LNG at the point of loading onto the vessel.
The FOB breakeven price needs to cover upstream costs (i.e.,
E&D, gas processing and field to plant transportation costs)
and liquefaction costs, but not shipping and regasification
costs.
DES (Delivered Ex-Ship) price
The price of LNG at the point of unloading off the vessel.
The DES breakeven price needs to pay for the same cost
components as the FOB price plus shipping costs

Hub price
The price of gas at a hub, typically a pipeline junction where
a significant amount of gas sales and purchases takes place
and where sellers and buyers can also purchase storage
services
A hub does not need to be physical, it can be virtual like the
UKs National Balancing Point
Serving as marketplaces, hubs are a prerequisite for gas
pricing through gas-to-gas competition
Hub prices are well documented as they underpin the worlds
gas futures markets
The US Henry Hub is the closest thing there is to a world
gas pricing point
Hub prices are optimal wholesale price indicators
However, hubs liquid enough to convey reliable price signals
exist for the moment only in the US, in the UK and to an
extent in the Benelux area

Citygate price
The price of gas at a citygate, typically at the inlet to a
low pressure pipeline grid owned and operated by a local
distribution company
US citygate prices on a monthly state-by-state and weighted
average US basis are published by the DOE/EIA
US citygate prices on balance reflect the prices on the hubs
where the gas is sourced plus transportation costs, but may from
time to time due to local supply and demand circumstances
include substantial premiums or discounts
Citygate prices are not systematically documented anywhere
else

End user prices

End user prices are the prices charged to power sector,
industrial, commercial or residential end users at the plant
gate or the inlet to their individual pipeline connections
End user prices for the OECD/IEA countries are published
by the DOE/EIA, Eurostat and the IEA, and by select private
market intelligence companies
End user price information is available for a few non-OECD
countries but not for most of them, and reliability is an issue
End user prices are important insofar as it is at that level
interfuel competition takes place
However, publishers aggregating and averaging make
significant price differences disappear, limiting the conclusions
that can be drawn from published end user price movements
Moreover, taxes ad local circumstances can distort the picture
End user prices should be resorted to only when necessary
due to a lack of wholesale price information

Netback price
Gas supply chains have multiple links, and for each point of
transfer from one link to another a so-called netback price
may be calculated by deducting from the end user price the
unit costs of bringing the gas from that point to the end user

June 2011 | International Gas Union 9

 The netback price to the upstream shows the value per unit
of gas produced left for sharing between the producer and
the state after distribution, transmission, storage and in
the event of LNG regasification, shipping and liquefaction
costs have been deducted from the end user price, and is as
such a key indicator of project feasibility

3. Gas price drivers

2 500

50

2 000

40

1 500

30

Trend lines

20

1 000

Recent droughts,
impact on LNG
imports

10

500
08

M
ar
ch

07

06

ar
ch
M

05

M
ar
ch

04
M

ar
ch

03
M

ar
ch

02

ar
ch
M

01
M

ar
ch

00

ar
ch
M

ar
ch

99

0
ar
ch

Monthly LNG imports (mill cm)

Monthly hydro level (per cent)

3 000

60

Sources: CERA, IEA

Business cycles affect gas demand especially industrial gas

demand in the medium term.
There are also examples of gas supply interruptions boosting
gas prices. Such interruptions may be due to extreme weather,
accidents or political or commercial tensions. When hurricanes
Katrina and Rita hit the US Gulf coast the result was a 13,5%
drop in US dry gas production from August to September 2005,
and a 26% increase in US gas prices as represented by the
Henry Hub monthly average over the same period (Chart 3.2).
Chart 3.2: US gas production vs Henry Hub, 1997-2008
US dry gas production vs Henry Hub
Jan 97 - Oct 08

16,00

Katrina, Rita

1800000

14,00
12,00

1700000

10,00

1600000

8,00

1500000

6,00

1400000

4,00

Source: US DOE EIA

10 International Gas Union | June 2011

jan.08

jan.07

jan.06

jan.05

jan.04

jan.03

jan.02

0,00

jan.01

2,00

1200000

jan.00

1300000

HH (USD/MMBtu)

1900000

jan.97

There are many examples of gas demand spikes leading to gas

price spikes. Such spikes may occur because of temperature
fluctuations. A cold spell during winter or in places with
much gas going into power generation and much power going
into air conditioning an unusually hot summer may boost
seasonal gas demand and cause a price spike. Droughts may
temporarily cut into hydro power generation capacity, boost
demand for thermal power and as a result increase power sector
gas demand. Spains drought problems since the middle of
the current decade have impacted on Atlantic and world LNG
demand (Chart 3.1).

3 500

70

jan.99

Short to medium term supply and demand drivers

Even modest short term gas supply or demand disturbances
may boost or depress prices significantly. The impact will
depend on the state of the market at the outset. A tight market
where either supply or demand or both are highly inelastic at
intersection will deliver a stronger price response to the same
disturbance than a relaxed market.

80

jan.98

Competitive markets

Iberian Peninsula: Variations in hydro reservoir

level and LNG imports, March 1999 - June 2008

Due to the nature of gas as a commodity and to the different

historical origins of national gas industries and markets, gas
prices are not everywhere set under competitive conditions. But
some markets have been liberalised, and others are at various
stages of introducing gas-on-gas competition and competitively
set prices. The factors that drive gas supply and demand, and
how these factors will evolve and interact in the future, therefore
need to be understood.

Chart 3.1: Iberian Peninsula: Hydro reservoir levels and LNG

imports

Production (million cubic feet)

In competitive markets, with multiple sellers facing multiple

buyers, prices are driven by supply and demand. Price changes
in turn feed back on supply and demand by providing signals
that in principle ensures market equilibrium. Since supply and
demand depend on more factors than price and since neither of
these variables typically move smoothly and precisely between
equilibrium levels but tend to undershoot or overshoot, the
simultaneous price, supply and demand adjustment process
never stops.

Chart 3.3: North European gas hub prices

North European gas hub prices

Weekly averages, autumn-winter 2008-09

14

NBP
Zeebrugge
TTF

USD/MMBtu

13
12
11
10
9

Chart 3.4: Long term marginal supply cost curve (illustration)

Supply option 11
Supply option 12
Supply option 13
Supply option114
Supply option 15

Supply option 10

Supply option 7
Supply option 8
Supply option 9

Supply option 6

Supply option 5

Supply option 4

Supply option 3

Supply option 2

Long term marginal supply

cost curve (illustration)

Supply option 1

The Russian-Ukrainian gas conflicts in late 2005 early 2006

and again in the beginning of 2009 caused some nervousness in
European markets but apparently did not have much impact on
spot prices. The former conflict occurred at a time when these
prices had already increased significantly. The dip in Russian
gas supply may have only marginally aggravated the price
spike. The latter conflict apparently did not affect prices on
the North European gas exchanges which, it should be noted,
are located far away from where the supply interruptions were
most acutely felt at all. Prices on these hubs kept fluctuating
around a steadily declining trend during the final quarter of
2008 and into 2009 (Chart 3.3).

Long term supply side drivers

Border or hub costs

Examples of accidents or commercial / political supply cut-offs

driving price spikes are harder to find. Even an incident as serious
as the explosion at the Algerian Skikda LNG plant in January
2004 that destroyed three trains with a combined capacity of
more than 4 mtpa did not have noticeable consequences for buyer
country prices as Sonatrach managed to quickly rearrange supply.

Volume

Long term marginal supply cost curves show as Chart 3.4

seeks to illustrate the incremental gas volumes that become
available to a given market as supply costs are allowed to
increase. Typically the cheapest supply is indigenous conventional
gas delivered via amortised pipelines, and the most expensive
supply high cost LNG, gas imported via long distance, not
yet amortised pipelines and unconventional gas. There are
however exceptions from this rule. In the US, the supply areas
onshore or just offshore the Gulf of Mexico that for decades
have constituted the backbone of the US gas industry no longer
account for the cheapest portion of supply.

8
7

Fe
b
10

Ja
n
27

ec

ec

Ja
n
13

D
30

ov

ov
N

D
08

24

ct

10

O
27

O
ct
13

19

Se
p

Source: WGI

Long term supply and demand drivers

Gas prices in competitive markets fluctuate around long term
trends determined by, graphically speaking:
The shape of the long term marginal gas supply cost curve
The extent to which the reserves on the marginal gas supply
cost curve can actually be produced, given the regulatory,
geopolitical and other constraints on oil and gas developments
world wide
Shifts in the demand curve

Snapshots of a given countrys long term marginal gas supply

cost curve may be inaccurate. Unlike volume and to some extent
price information, cost information is not easily available. Cost
curves therefore tend to be based on assumptions and generic
data as much as on solid project information. Moreover, the
shape of the curve is bound to change over time. New upstream
or midstream technologies may shift some supply options down
the curve and, by default, other options up the same curve. New
supply sources may displace existing supply sources. Examples
of such developments abound. Tight gas, shale gas and coal
bed methane used to be located on the uneconomic portion
of the supply curve. Today unconventional gas is part of the
mainstream supply in the US and is growing in importance in
other countries. On the other hand, whereas LNG became much
more competitive between the mid 1990s and 2004, since 2005
unit costs have rebounded and made new LNG that seemed
economic by a wide margin a few years ago, look marginal.
For these reasons, basing price analysis on static supply curves
is not recommendable.
Marginal cost curves are by definition sloping upwards and
are normally becoming steeper as more supply is brought into
the picture. However, new gas discoveries and technological
progress can flatten them and allow demand to shift out for
much longer before hitting the steep portion. Past predictions
of supply costs pushing prices outside their normal range on

June 2011 | International Gas Union 11

a permanent basis have generally proved wrong. Forecasters

have failed to take the cyclical nature of the oil and gas business,
with high prices dampening demand and stimulating E&D and
thereby paving the way for another downturn, as well as the
potential for technological improvements, fully into account.
The gas price explosion all developed countries experienced in
the years up to the financial crisis broke was widely assumed
to be of a different, more structural and permanent nature. The
price decline in late 2008 early 2009 put a question mark at
that assumption.
Access to the reserves on the long term marginal supply cost
curve is another key gas supply determinant. Access may be
constrained for a number of reasons. Host country governments
may:
Wish to reserve parts of their gas for future generations
Wish to reserve their gas, or parts of it, for their national
oil industries, which however may be unable for financial,
technological or manpower reasons to take on complex
developments
Put up environmental restrictions so severe as to effectively
block developments
Present oil and gas companies with fiscal terms too onerous
to allow projects to go forward
Independently of host government attitudes, countries or regions
may be inaccessible for long periods of time for geopolitical
reasons or because of local unrest and poor safety conditions
A related constraint which has slowed liquefaction plant projects
in recent years is the limited capacity of key equipment vendors
and the small number of engineering companies able to manage
such projects. This problem is likely cyclical. Some problems
may also be due to the industry pushing its borders with respect
to project size (the Qatari megatrains) and climatic challenges
(the Snhvit and Sakhalin projects), and may go away as plant
builders and operators gain experience. But by the autumn of
2008 project delays were undoubtedly aggravating gas price
inflation and volatility world wide.
Long term demand side drivers
The price-volume curve representing a countrys gas demand
typically shifts to the right over time in response to economic
growth, changes in the energy intensity of the countrys
economy, and changes in the fuel structure of the countrys
energy consumption.
Economic growth
Economic growth drives overall energy demand. The impact
which is called the income elasticity of energy demand changes
with the level of economic development. Emerging, industrialising
economies are typically characterised by high elasticities. A 1%
growth in such a countrys GDP may require a 1+ % growth
in energy use. Advanced, service based economies need less
incremental energy to support a given economic growth.

However, no economy has managed to break the link over an

extended period of time between economic growth and energy
consumption growth.
Energy intensity change
The energy intensity of a countrys economy refers to the energy
and fuel consumed per unit of GDP produced in the country.
Energy intensities change over time. Only in the unlikely events
that the income elasticity of a countrys energy demand is stable
at exactly 1, and there is no impact from energy or fuel price
changes, will its energy use per per unit of GDP be the same
year after year.
Moreover, energy intensities tend to trend downwards, due to
Normal structural changes, i.e. the transfer of resources from
energy heavy to energy light sectors
Autonomous energy efficiency improvements, meaning
progress that happens by itself, so to say, not because of
political signals
Policy measures to make car manufacturers produce more
fuel efficient cars, households insulate their houses better, etc.
This does not mean however that energy intensities cannot
increase in certain periods due to for instance temperature
fluctuations or the advent of new industries or products.
Fuel structure change
Companies and households switch between fuels mostly in
response to changes in fuel price relationships. Such changes may
in turn be market driven or policy i.e., tax or subsidy driven.
The ease with which consumers can switch between fuels in
response to price signals, depends on the flexibility of their
fuel using equipment. The more dual firing capacity, the more
interfuel competition, and vice versa. Consumers that have to
replace big parts of their equipment to capitalise on a change
in relative fuel prices, need strong incentives and confidence
that the new price relationship will last, to take action.
In the Atlantic markets gas initially competed mainly against
select oil products. Gas prices have therefore tended to move
in tandem with the regional light and heavy fuel oil prices. In
Western Europe long term contract prices referenced to oil
have provided an automatic link. In the US competition has
provided a similar though looser link (chart 3.5). Normally gas
in the US traded between heavy fuel oil and gasoil. But since
the beginning of 2006 gas appears to have effectively decoupled
from oil products.
A secondary reason why gas prices tend to shadow oil prices is
that gas and oil is produced either in one and the same process
or at least by the same actors employing the same rigs and other
upstream equipment. Hence gas and oil projects are subject to
joint feasibility evaluations and are exposed to the same input
factor price upturns and downturns.

12 International Gas Union | June 2011

Today, with a growing share of world gas supply going to fire

gas power plants, the coal price level is becoming another
important reference.

Chart 3.6: US gas consumption

Chart 3.5: US natural gas and oil prices

US gas consumption: History, EIA's 2009

reference projection

800
700
600

US natural gas and oil product prices

500
Bcm

Monthly averages, January 1999 - December 2008

30

US Gulf Coast No. 2 Heating Oil

US Gulf Coast Residual Fuel Oil 1,0% Sulfur

100

15

19
93

Source: US DOE EIA: Annual Energy Outlook 2009

08

07

Ja
n

Ja
n

06
Ja
n

04

03

02

01

00

05
Ja
n

Ja
n

Ja
n

Ja
n

Ja
n

n
Ja

99

19
96
19
99
20
02
20
05
20
08
20
11
20
14
20
17
20
20
20
23
20
26
20
29

10

Ja

300
200

Henry Hub

20

400

19
90

USD/MMBtu

25

Sources: US DOE EIA

One development that should favour gas relative to other fossil

fuels is the emphasis on curbing greenhouse gas emissions.
Two key remedies are fuel consumption taxes differentiated
by carbon contents, and emission trading schemes. Both will
increase the costs to consumers of all fossil fuels, but leave gas
relatively less affected. Whether the net effect on gas demand will
be positive (because of substitution from other fuels to gas) or
negative (because energy savings will wipe out the substitution
gains) will depend on how these remedies are designed and
implemented and how they come to interact with other policy
measures and the forces of the market.

Current scenarios
Will all these factors driving or dampening gas supply and
demand growth sustain prices at or close to the levels observed in early-mid 2008, or has the financial crises deflated prices on a long term basis? There are as many answers to this
question as there are market observers. However, the widely
held view from a few years back that gas as the obvious bridging fuel between the oil intensive 20th century and a cleaner
21st century could look forward to several decades of robust
supply and demand growth, is being challenged.
The International Energy Agency presents in its 2008 World
Energy Outlook a business as usual scenario where world gas
demand increases by some 1500 bcm between 2006 and 2030,
or by 1,8% a year. The IEA sees US gas consumption peak at
about 650 bcm a year in 2015 before declining to about 630
bcm a year by 2030. All in all this means a 0,1% a year growth
in demand for the entire 2008-30 period.

The Energy Information Administration of the US Department

of Oil and Energy expects in its 2009 Annual Energy Outlook
US gas consumption to peak in 2026 (Chart 3.6). Though it
implies an average demand growth expectation for the 2008-30
period of only 0,2% a year, this scenario is more optimistic in
volume terms than its predecessor. The EIA has lowered its long
term gas supply cost and price assumptions, with less demand
destruction as a result.

Other market organisations

OECD area
A high share of world gas supply is not priced according to gas
supply and demand. In Continental Europe and Developed Asia
small numbers of importers / wholesalers have been dealing
with small numbers of exporting countries typically represented
by their national oil companies.
In Europe this structure is breaking up. New entrants are gaining
access to the incumbents infrastructure. Norwegian gas is no
longer sold by a committee dominated by Statoil but by all the
actors on the NCS in competition with each other. Gas hubs
representing spot trading opportunities are popping up. Hubs
need liquidity to be useful for pricing purposes and so far only
the UKs NBP fulfil this criterion, but two or three others could
be on their way. Existing and new LNG vendors are descending
on a growing number of European LNG terminals, and new
piped gas suppliers are awaiting access to Europe via new long
distance import pipelines.
Developed Asia is proceeding at a slower pace, but Kogas is
no longer the only Korean LNG importer, and the Japanese
gas market could see the introduction of competitive elements
in the years ahead.
Continental Europes and Developed Asias long term gas import
contracts index the price of the gas to the prices of oil and oil
products. In Europe the indices are mostly light and heavy
fuel oil, in Developed Asia it is crude oil. The contracts have a
price clause that includes a base year price and a formula that
regulates the gas prices tracking of the prices of the indices.

June 2011 | International Gas Union 13

The clause also addresses the need for regular revisits to the
formula in response to structural changes in the marketplace.
Continental European and Developed Asian border gas prices
are thus driven by the prices of crude oil and refined products,
and indirectly by all the factors that drive these prices, rather
than by developments in Continental European and Developed
Asian gas demand or in world gas supply.
This is a simplification insofar as the price signals coming
from the spot markets around Europe, from the UK via the
Interconnector and from the US via LNG do influence Continental
European and Developed Asian contract prices. Long term
import contracts always have some offtake flexibility. If spot
prices fall significantly below contract prices, buyers will
respond by offtaking as little as they can under their contracts,
turning instead to the alternatives. This will lift spot prices but
could also lead to contract renegotiations and eventually some
realignment of contract prices with gas market realities.
The current trend is towards shorter, more flexible import
contracts, so the influence from gas supply and demand on
Continental European and Asian contract prices will likely
increase. However, as we will revert to later in this report, there
is currently little to indicate that either Continental Europe or
Developed Asia will abandon oil linked pricing any time soon.

Non-OECD area
Outside the OECD area there are many gas consuming countries
that neither allow gas supply and demand to determine
prices nor practice oil linked pricing. Instead they set prices
administratively according to principles and procedures that
are not always transparent.
Supply costs may be a consideration, but do not always receive
systematic attention. If supply costs are taken into account, they
may be defined so as to include both operating, depreciation
and financial costs and a return on investments, but they may
as well be defined so as to cover operating costs only, leaving
nothing for maintenance not to mention system expansions. The
more supply costs are ignored as a driver, i.e., the further below
full cycle supply costs prices are set, the smaller is the role that
sales revenues play in financing the countrys gas supply. The
state actor(s) involved then need to be funded directly from
the state budget.
Social and political considerations are probably the most important
regulated price drivers, with the regulators aiming to set prices so
as not to hurt industrial consumers competitiveness, overburden
residential consumers and potentially trigger political unrest.
These criteria are course ambiguous, reflecting what consumers
have grown accustomed to rather than objective thresholds. The
same gas bill as a share of a households real disposable income
may be acceptable in one country and intolerable in another.
In some countries gas prices are regulated at low levels to
stimulate substitution from other fuels to gas. This is common

practice in oil exporting countries struggling to increase oil

production and witnessing rapid growth in domestic oil use
eroding the oil surplus available for exports.
Regulated gas prices may be adjusted according to some simple
formula, e.g. by a certain percentage per year. More typical are
ad hoc adjustments in response to typically conflicting calls for
change from different sides from the budget, from the macro
economy, from companies involved in the supply of gas to the
domestic market demanding higher prices, and from industrial
and residential consumers demanding lower prices.
The different motives for gas price regulation at below economic
levels are in no way mutually exclusive. More often that not
governments that subsidise gas do it in the hope of killing several
birds with one stone attracting investments in petrochemical
and other gas intensive industries, containing inflation, keeping
the population happy and sustaining oil exports.
Participation in international and intercontinental gas trade
inevitably plays a role in shaping market actors views on the
sustainability of different pricing models. Trade means the
import and export of price signals. When a country decides to
start importing or exporting gas, pressures to align domestic
prices with import or export prices will inevitably start to build.
Chart 3.7: Impact on domestic pricing of opening for gas
imports or exports
Pdomestic
Gas imports
becoming possible

Pinternational
Pdomestic
Pinternational
Pdomestic

Gas exports
becoming possible

Pinternational
Pdomestic
Pinternational

>1

Incentives to grow imports => increased

competition in domestic market => domestic prices
depressed towards international level

<1

Subsidisation of imported gas or blending with

domestic gas or dual pricing needed to allow uptake
=> incentives to raise domestic prices to minimise
budgetary, administrative challenges

>1

If high domestic prices reflect high costs, countrys

gas not competitive in world markets => no exports
take place

<1

Incentives to reallocate gas from domestic market to

exports => need to either introduce export quotas/
enforced supply of domestic demand, or raise
domestic prices towards parity in netback terms with
export prices, to restore balance

Gas price regulation that does not take costs fully into account
and involves a degree of subsidisation typically becomes harder
to sustain when international gas prices are high. This was the
situation in 2008. Importing country governments needed if
they wished to continue shielding their populations to accept
increasing budget deficits. Producer country governments that
could export the gas rather than keeping it at home had to accept
increasing growth in export and tax revenues foregone. The latter
governments were on the other hand typically also the biggest
beneficiaries of the 2008 oil price escalation and therefore able
to continue offering cheap gas to the domestic market.
In response to such pressures governments typically deregulate
prices to some market segments while retaining regulated prices
to other, more vulnerable segments.
Deregulation may be a long and cumbersome process as the

14 International Gas Union | June 2011

pressures. Delayed responses to imbalances created by trying

to keep too many people happy at the same time for too long
may lead to draconian price hikes and retreats, in response
to popular protests and unrest.
Chart 3.8 seeks to illustrate how a government aiming to
introduce gas initially may need to consider and trade off only
a limited number of factors in a reasonably straightforward
exercise. However, as time passes and situations change a
consistent line on pricing may become increasingly difficult
to define and support.

Chart 3.8: Challenges of price regulation

Price
Incentives to
contain domestic
gas demand to
enable gas
exports

Higher cost
of new
domestic
production

Growing
dependence on
imported gas =>
Exposure to
world gas price
fluctuations

Time

Low incomes, drive

to support domestic
gas intensive
industry

Drive to shift
domestic fuel use
from oil to gas to
sustain oil exports

Price riots,
accommodating
leadership

4. Key gas pricing mechanisms

We propose to distinguish between the following gas pricing
mechanisms:

Gas on gas competition

Oil price escalation
Bilateral monopoly
Netback from final product
Regulation on a cost of service basis
Regulation on a social and political basis
Regulation below cost
No pricing

Chart 4.1: Pricing under gas-on-gas competition

Gas-on-gas competition

Price

Supply =
Marginal Cost

Demand

P1

Gas-on-gas competition is the dominant pricing mechanisms

in the US and the UK. It means that the gas price is determined
by the interplay of gas supply and demand over a variety of
different periods (daily, weekly, monthly, quarterly, seasonally,
annually or longer). Trading takes place at physical hubs,
e.g. Henry Hub, or notional hubs such as the NBP in the UK.
Trading is likely to be supported by developed futures markets
(NYMEX or ICE) and online commodity exchanges (ICE or
OCM). Not all gas is bought and sold on a short term fixed
price basis there are longer term contracts but these rely on
gas price indices rather than competing fuel indices for, e.g.,
monthly price determination.
Gas-on-gas competition does not mean that competing fuel prices
play no role in determining the gas price. Key groups of gas
consumers can switch between gas and oil products, or between
gas and coal, in response to price signals. This substitutability
of gas means that the prices of gas oil, HFO and at the low end
coal typically frame the range within which gas prices may
move. However, this market (as opposed to contractual) link
between the prices of different fuels is neither stable over time
nor able to prevent gas prices to move outside their prescribed
corridor for long periods of time.

Average
Cost

V1

Volume

Chart 4.1 illustrates price formation under gas-on-gas competition.

It is assumed that the price is set so as to clear the market.
The demand curve is inelastic at high prices and low prices,
where there is little scope for fuel-switching, and elastic in
the middle range where demand for gas can change readily
depending on relative fuel prices;
The supply curve is identical to the long run marginal cost
curve; and
The average cost curve cuts the long run marginal cost curve
at its low point, and then the demand curve at a lower price
than the competitive market price.
Under gas-to-gas competition the price in any given period
would presumably be at P1V1.
Oil price escalation is the dominant pricing mechanism in
Continental Europe and Asia. It means that the gas price is
contractually linked, usually through a base price and an

June 2011 | International Gas Union 15

escalation clause, to the prices of one or more competing fuels,

in Europe typically gas oil and/or fuel oil, in Asia typically
crude oil. Occasionally, coal prices are part of the escalation
clause, as are electricity prices. The escalation clause ensures
that when an escalator value changes, the gas price is adjusted
by a fraction of the escalator value change depending on the
so-called pass-through factor.
In addition to the link to the prices of competing fuels, it is
common to include a link to inflation in the escalation clause.
Oil price escalation does not mean that gas supply and demand
play no role in determining the gas price. If Continental European
or Asian buyers see the oil linked prices they pay for long term
gas or LNG falling out of line with the supply and demand
driven prices on the gas exchanges that are emerging, or on the
global spot LNG market, customers will switch to short term
gas to the extent they can, with contract price adjustments as
a possible result.
Chart 4.2 shows the possible prices under the oil price escalation
mechanism
Chart 4.2: Pricing under oil escalation
Oil price escalation
Price

Supply =
Marginal Cost

Demand
P2
P1

Average
Cost

P3

V2

V1

V3

Volume

The gas price under oil price escalation will likely be above the
market-clearing price if oil prices are very high, and below if
oil prices are very low. Thus by summer 2008, when oil prices
were in the $120-130/bbl range, gas prices may have been
close to P2, while at low oil prices they could be around P3. If
oil prices are in the fuel-switching range, the oil indexed gas
prices will presumably be close to P1.
Bilateral monopoly negotiations were the dominant pricing
mechanism in interstate gas dealings in the former East Bloc
including the Former Soviet Union (FSU) and Central and
Eastern Europe. The gas price was determined for a period of
time typically one year through bilateral negotiations at
government level. There were often elements of barter with
the buyers paying for portions of their gas supply in transit
services or by participating in field development and pipeline
building projects.
The underlying valuation of the gas, the capital goods and the

services that changed hands in the intra-East Bloc gas trade was
opaque, with politics playing a major role alongside economics.
Examples of gas pricing based on bilateral negotiations may
still be found in countries where one dominant supplier, e.g.,
the national oil company, faces one or a couple of dominant
buyers, say, the state owned power company and maybe 1-2
large industrial companies. A number of immature developing
country gas markets have this structure.
Netback from final product means that the price received by the
gas supplier reflects the price received by the buyer for his final
product. For instance, the price received by the gas supplier
from the power sector may be set in relation to, and allowed to
fluctuate with, the price of electricity. Netback based pricing is
also common where the gas is used as a feedstock for chemical
production, such as ammonia or methanol, and represents the
major variable cost in producing the product.
This mechanism should not be confused with contractual
arrangements whereby the price to the producer/wholesaler
is netted back from the wholesale gas prices in countries
further downstream. A netback arrangement such as this would
be categorised depending on how the wholesale gas price in
the downstream country is determined through gas-on-gas
competition, oil price escalation, etc.
Direct gas price regulation remains widespread. It would however
be unhelpful to lump all kinds of regulation together. We need
to distinguish between the principles applied by the regulator.
Under cost of service based regulation the price is determined,
or approved, by a regulatory authority, or possibly a Ministry,
so as to cover the cost of service, including the recovery of
investment and a reasonable rate of return, in the same way as
pipeline service tariffs are regulated in the US. Normally, cost
of service based prices are published by the regulatory authority.
Pakistan provides an example of cost of service based prices,
with the wellhead price being the target.
Prices may also be regulated on an irregular social and political
basis reflecting the regulators perceptions of social needs and/or
gas supply cost developments, or possibly as a revenue raising
exercise for the government. In all probability the gas company
would be state-owned.
Many Non-OECD countries still practice below cost regulation,
meaning that the gas price is knowingly set below the sum of
production and transportation costs as a form of state subsidy to
the population. Again the gas company would be state-owned.
In some countries where a substantial proportion of indigenous
gas supply comes from oil fields with gas caps or gas-condensate
fields, the marginal cost of producing this gas may be close to
zero and as such it could be sold at a very low wholesale price
and still be profitable. However, to the extent it is sold below
the average cost of production and transportation it would still
be included in the regulation below cost category.

16 International Gas Union | June 2011

The extreme form of below cost regulation is to provide the gas

free of charge to the population and industry, e.g., as a feedstock
for chemical and fertilizer plants. Free gas is typically associated
gas treated as a by-product with the liquids covering the costs
of bringing the gas to the wellhead. The gas supplier must still
somehow finance transportation and distribution costs crosssubsidising local gas supply from his oil or gas export revenues,
or the government must provide funding from the budget.
As hoc and below cost price regulation, and free gas supply,
is only thinkable when domestic gas supply is in the hands of
one or more state companies.
Chart 4.3 illustrates pricing under bilateral monopoly negotiations,
with netback pricing and under various types of regulation.

Under bilateral monopoly or netback pricing situations the price

could, in theory, be higher or lower than the market-clearing
price P1. In practice, as will be shown later, prices under these
mechanisms in 2005 were probably close to the P5 level, i.e.
just above or below average cost.
With below cost regulation the gas price could be at P4, that
is, materially below the average cost. Under cost of service
regulation the price would most likely be slightly above the
average cost at P5. Regulation on social and political grounds
would likely lead to a price somewhere in the range between
P4 and P5. In all cases, the price is likely to be below the
market-clearing price P1.

Chart 4.3: Pricing under regulation

Bilateral monopoly, netback pricing,
regulation
Price

Supply =
Marginal Cost

Demand

P1
P5

Average
Cost

P4

V1

V5

V4 Volume

June 2011 | International Gas Union 17

5. Origins of individual pricing mechanisms

The main dividing line with respect to gas pricing runs between
market based pricing where buyers are charged above or in line
with supply costs, and regulated pricing where buyers may be
charged below supply costs.

Origins of gas or oil market based pricing

The countries that practice market based gas pricing have
opted for different models because of differences in the level
and degree of concentration of their gas resources, in addition
to different historically and ideologically rooted preferences.
Countries with significant gas resources dispersed in large
numbers of fields typically saw the development of competitive industries and the early emergence of the physical
and institutional preconditions for gas market based pricing.
Countries with limited or zero gas resources of their own
could not as easily develop gas industries with multiple sellers and buyers. These countries instead tended to encourage
the emergence of national or regional import monopolies that
could interact on an equal footing with a limited number of
major foreign suppliers. Market value pricing was a response
to the need for risk sharing to underpin the building of
markets from scratch with the gas coming from major import
contracts.

North America
US gas production has always involved a number of companies, and US gas prices have as a rule been determined competitively by supply and demand. For decades prices were
very low, reflecting producer competition for very limited
local markets. After World War 2 rapid expansion of the US
pipeline system enabled a gradual absorption of the surplus
reserves.
The Supreme Court Phillips Decision in 1954 ushered in a period
of wellhead price regulation that was to last for 24 years. The
regulation applied only to gas traded across state borders. Gas
produced and consumed in the same state was not affected by
the decision.
The wellhead price controls were of the historic E&D cost plus
type. They stimulated gas demand but not investment in the
upstream and eventually led to gas shortages in those parts of
the US that depended on other states for their gas supply. The
Natural Gas Policy Act of 1978 sought to fix the imbalance by
deregulating high cost gas prices while retaining most interstate
gas under price control and placing also intrastate gas under price
regulation so as to eliminate the particular shortage problems of
the importing states. These steps however paved the way for a
further dismantling of price controls in the years that followed.
Deregulation, and the impact of the first and second oil price

shocks, increased wellhead gas prices 15-fold between the

beginning of the 1970s and 1984. US pipeline companies saw
opportunities and contracted heavily for new long term supply.
However, US gas demand proving unexpectedly sensitive to
higher prices and sluggish economic growth dipped by more
than one quarter in the in the 14 years between 1972 and 1986.
The resulting gas bubble arrested wellhead prices and pushed
them back into the USD 1,60-1,70 per mcf range.
FERC Orders 380 and 436 in the mid 1980s completed the
liberalisation of the US gas market by allowing first utilities
and then other customers to contract directly with producers
at market prices, and have the gas transported to their sites on
pipelines subject to third party access regulation.

The UK
The UK gas industry was nationalised in 1948. The UK at
that time neither produced nor imported any natural gas.
However, there were more than 1000 manufactured gas companies some private, the other municipally owned that
were vested into 12 so-called area gas boards. In 1959 LNG
imports commenced on a trial basis. In 1964 the government
started to issue North Sea E&D licences. In 1965 the first
natural gas discoveries were made. In 1966 the government
decided to introduce natural gas into the UK fuel mix on a
big scale.
The 1972 Gas Act paved the way for further centralisation of
the industry with the creation of the British Gas Corporation
(BGC). This entity was until 1986 the sole buyer of UKCS
gas and the sole transmitter and distributor of this gas to UK
customers. It was also a key upstream player.
Wellhead prices were in these years set through negotiations
between BGC and the producers. BGCs legal monopsony on
UKCS gas purchases, and good grasp on upstream costs thanks
to its own UKCS interests, ensured prices that left little rent
to the producers.
The Thatcher years saw a general, ideologically driven shift
from state involvement through major public enterprises in the
economy, towards private solutions. The gas sector exemplified
this trend.
The 1982 Oil and Gas (Enterprise) Act permitted UKCS gas
producers and major industrial customers to contract directly
with each other, and ordered BGC to offer third party access
to its pipelines. These first steps towards a liberalisation of the
market failed to boost competition. The customers that producers
could now approach directly were too few, and BGCs grip on
the market remained too strong. The next steps were however
more forceful. The 1986 Gas Act returned the gas industry to

18 International Gas Union | June 2011

the private sector, transformed BGC to British Gas Plc and

created Ofgas to regulate the industry and protect the interests of
consumers. In 1989 Ofgas limited British Gas purchase of new
UKCS gas supply to 90% of full capacity production. During
the 1990s the right for producers and consumers to deal directly
with each other was extended first to mid-sized industrial and
commercial buyers, and then to the entire gas market.

customer level, buyers in individual countries were split into

individual market segments (typically the residential segment,
the commercial segment, the industrial segment and the power
segment), a single price was calculated for each segment in each
country, a weighted average end user price was calculated for each
country, and transmission, storage and distribution costs were
factored in to arrive at an initial border price for each country.

Through the 1990s gas prices in the UK were generally lower

than gas prices in Continental Europe. Proponents of liberalisation
saw this as proof of the efficiency boosting effects of increased
competition. However, prices were also influenced by a strong
increase in UKCS gas production that came from new discoveries
and steady, technology driven growth in depletion rates. The
relative impact of each of these drivers on price developments
is not easily calculated.

The initial or start-up year border price would be continuously

adjusted in response to changes the prices of the fuels assumed
to be the closest competitors to gas, and the pricing formula
itself would be renegotiated from time to time in response to
changes in the relative importance of individual market segments
and other deeper shifts in the market.

Continental Europe
The market value pricing principle that dominates in Continental Europe originated in the Netherlands. The Groningen
field discovered in 1959 and put on-stream in 1964 presented
the Dutch government with a marketing challenge. Western
European gas consumption in 1965 was about 21 bcm a year
. The Dutch themselves consumed a mere 1,8 Bcm a year2.
Continental European cross border gas trade was negligible.
Thus Groningen had to be sold into a small and immature
market area. The government did not want to sell the field
cheaply, thus giving away value. Delaying its development
seemed an equally unattractive option. There was a perception of urgency stemming from the emergence of a new source
of energy nuclear that conceivably could shorten the era
of fossil fuels.
In 1962 the then Dutch Minister of Economic Affairs suggested
to base prices not on production costs which were low for
Groningen gas and would have left the government with limited
revenues, but on the market or replacement value of the gas to
individual market segment in individual countries.
Specifically, the idea was that the price of Groningen gas to
a given customer should be based on the price of the best
alternative to Groningen gas typically heavy fuel or gas oil
for that customer.
The price of Groningen gas should not be mechanically aligned
with the price of the best alternative. On the one hand rebates
could be necessary to encourage customers that did not already
use Groningen gas to start doing so, and discourage existing
customers from switching back to competing fuels. The rebates
to attract new customers might need to be substantial if switching
would require investment in new heating systems. On the other
hand, due consideration should be paid to the convenience of
burning gas compared to oil products, potentially giving rise
to a price premium.
Since it is not possible to price discriminate at individual
2

BP Statistical Review of World Energy, 2008

While the market value principle placed the price risk in the
Groningen gas sales contracts with the seller, the take or pay
principle another feature of these contracts placed the
volume risk with the buyer. These provisions on risk sharing
paved the way for rapid growth in Dutch gas exports and for a
rapid maturation of European gas markets. The latter effect was
accentuated when Algeria, Russia and Norway adopted both
market value pricing and the TOP principle in their contracting
with European gas buyers. .

Asia Pacific
Japan was a 2 bcm a year gas market until 1970 when imported (Alaskan) LNG entered the fuel mix. Import growth
accelerated in the 1970s and 1980s in response to the first
and second oil price shock. South Korea and Taiwan started
to import LNG in 1986 and 1990 respectively. Australia and
New Zealand the two developed economies in the region
with indigenous gas reserves started to exploit these reserves around 1970.
The Asian countries that do not have significant domestic natural
resources and access to international pipeline networks and
underground storages like Europe and the US, have come to
rely almost 100% on imported LNG for their natural gas supply.
The largest importers, Japanese LNG buyers, are gas and power
companies carrying out business in an integrated manner,
from procurement and imports to transmission, distribution,
downstream gas and power supply and marketing. When they
first initiated discussions on potential LNG imports, they had
to emphasize long-term security of supply to make sure that
they would be able to fulfil their supply obligation to end-users.
At the same time, since LNG projects require enormous initial
investments on the sellers side, the latter needed security of
demand, meaning long-term and stable offtake by buyers. Sellers
and buyers thus had a common interest in long-term and stable
relationships. Commercial LNG projects have been developed
based on cooperative arrangements, and this is reflected in the
history of LNG pricing as well.
In 1969 when LNG was first imported into Japan, and through the
early 1970s, the price was fixed. This suited the suppliers since
they could recover their huge initial investment with certainty.
Fixed prices also enabled them to lock in the economics of their

June 2011 | International Gas Union 19

LNG project, which was an immature business at that time.

Since the price of oil the main alternative fuel to Japanese
buyers was rather stable, a fixed pricing system was acceptable
to Japanese LNG buyers as well.
After the first oil shock in 1973, however, the oil price surge
left the price of LNG significantly lower than that of oil. In
response to requirements from suppliers, the price of LNG were
gradually raised in line with the price of oil. These LNG price
increases were, after the second oil shock in 1980, codified into
a formula based on the concept of oil parity pricing. At that
time, the Government Selling Price (GSP) was applied as
index in the formula. Although different crudes were utilized,
most LNG prices were 100% indexed to the GSP price.
As the OPEC countries share of global oil production went into
decline, oil turned from a strategic product into a commodity.
In response to that change, some countries started to sell oil
at prices that differed from the GSP, and market prices were
gradually established. Since the GSP was left unmodified, the
LNG price indexed to the GSP fell out of line with market
realities. Furthermore, after the 1986 oil price collapse, suppliers
selling LNG at oil parity prices ran into difficulties securing
the economics of their LNG projects. In order to cope with that
problem, the LNG pricing formula was modified again through
negotiations into a new price formula, which became the basis
for the current formula.
Today, most Asian LNG transactions except those that involve
Indonesian LNG apply the weighted average price of oil imported
into Japan (the Japanese Crude Cocktail, JCC) as index. The
price formula is generally as follows:

relied on oil thermal power plants for 70% of their power supply.
Therefore, it was a reasonable decision for them to make LNG
pricing competitive against oil. For Japanese gas companies, the
main competing fuels were oil products such as kerosene for
heating and fuel oil for industrial use. Hence indexation to oil
was to an extent acceptable to them too. JCC is used as index
since it is calculated from data in Japan Exports & Imports
Monthly published by Japan Tariff Association, and therefore
can be considered a credible, transparent and neutral index.
In the 1990s, the generally low oil price environment caused
LNG suppliers to suffer from deteriorating project economics.
In response to suppliers call for a helping hand, a new pricing
mechanism with lower slopes at very low or very high oil
prices the so-called S-curve was introduced (Chart 5.2).
Later, when the LNG industry started to suffer from the impact
of sluggish demand related to the Asian currency crisis in the
late 1990s, some buyers obtained price floors and ceilings as
an extension of the S-curve mechanism.
Chart 5.2: LNG pricing with S-curve

LNG indexed to oil: S-curve

LNG price
$/MMBTU

kinkpoints

Y (LNG price : $/MMBtu) = A x (oil price : $/bbl) + B

By applying this type of formula, the LNG price is indexed to
the realized oil price (import price). The exposure to the oil
price (JCC) is reduced to 80 to 90% through A, and a constant B makes the LNG price more stable than the oil price
(Chart 5.1). It also enables suppliers to secure economics of
LNG projects since a certain amount of income are secured
even when the oil price is low.
Chart 5.1: LNG pricing with no floor or ceiling

?
high oil
price zone

Oil price
$/BBL

As oil prices rebounded, LNG contracts with a lower slope became

hugely advantageous to buyers. At the same time, however, LNG
market tightness resulted in sellers market conditions and in
the abolishment of the S-curve in some contracts.

Origins of regulated gas pricing

LNG indexed to oil with no floor, ceiling

LNG price
$/MMBTU

?
low oil
price zone

Old price formula

Oil Parity

Modified price formula

85-90% indexed to oil

Oil price
$/BBL

In Japan, LNG was introduced in order to reduce an at that

time excessive dependency on oil. Japanese power companies

Regulated gas pricing may mean cost of service based pricing

as well as political pricing where costs may be considered but
generally play second fiddle to political and social concerns.
Regulated gas pricing with long term marginal supply costs
playing a minor role requires as a rule state companies in the
lead, at least from the start. Building a gas industry dominated
by private players on the basis of below cost prices would
likely be challenging. There are examples of state oil and gas
companies being part privatised with gas prices to end users
remaining under below cost regulation, but such combinations
tend to create tensions and lead to calls from, among other
quarters, the part privatised companies in charge for price reform.
Cost-plus pricing is practiced in different ways in different
countries. Cost-plus pricing and market based pricing may exist

20 International Gas Union | June 2011

side by side with households and vulnerable industries benefiting

from regulations while industries with a bigger choice of fuels
and suppliers are exposed to market based prices. Another
recurrent feature is that wellhead prices are set on a competitive
basis while transmission and distribution tariffs are regulated.
Cost based pricing shifts the rent in the affected links of the
value chain to the consumers and may as such boost gas market
growth at least for a while. But cost based pricing tends to
discourage efficiency improvements along the supply chain,
and even households and vulnerable industries may be offered
alternatives to regulated gas. Thus sooner or later the insensitivity
of cost based pricing to changes in the competitive landscape
may leave the gas priced this way unmarketable.
On the other hand, since cost based pricing may not provide very
strong incentives to invest in fields and pipelines, growth in gas
supply may fall behind growth in gas demand at regulated prices.
Both these developments may pave the way for awarding a
bigger role to market based pricing, and have indeed triggered
a number of price reform efforts around the world.
China is not one integrated gas market. China has multiple
regional markets that traditionally have received supply from
different production areas at different costs, with different prices
as a result. These characteristics are gradually giving way to
those of a more integrated market. Rapid construction of new
long distance pipelines will give sellers access to a bigger
variety of buyers and buyers access to a bigger variety of sellers.
In China as in other centrally planned economies, gas prices
were historically used for accounting purposes rather than for
resource allocation purposes. Gas produced under the national
plan was priced differently from gas produced outside the
national plan. End user prices differed not only by region but
also by consumption sector; thus the fertiliser industry paid less
than other industry. Neither the complexity and rigidity of the
gas price structure not the fact that many prices did not cover
supply costs encouraged gas E&D. On the other hand, gas was
much more expensive in energy equivalence terms than coal.
This prevented gas penetration into the power sector and other
sectors where coal was an option.
Cost plus pricing is still the rule but procedures are being
streamlined and standardised. Also an element of competitive
pricing is introduced. Wholesale buyers are allowed to negotiate
directly with suppliers.
In India decision makers started to take an interest in gas
only in the mid 1980s. Consumption was by then around 4,5
bcm a year. In 1984 the Gas Authority of India Ltd. (GAIL)
was established to manage the development of a genuine gas
market. In 1986 GAIL began the construction of the 2688 km
Hazira-Bijapur-Jagdishpur pipeline to give major fuel users
in the interior of the country access to gas discovered along
the west coast. Supply via this pipeline fell short of demand
almost from the start. In response the government established

the so-called Gas Linkage Committee to ensure that sufficient

gas was allocated to priority consumers namely the fertiliser
industry and the power sector at subsidised prices.
The Gulf war seriously weakened the Indian economy and
forced the government to turn to the IMF, the World Bank and
the Asian Development Bank for support. These institutions
typically request policy reform in return for loans, and in
the case of India they made support conditional on the state
reducing its involvement in select sectors, among them the
hydrocarbons sector. In response the government introduced the
ew Exploration and Licensing Policy (NELP) and eventually
the multi-tiered pricing system described in chapter 3. In the
beginning, however, the producer price was fixed on the basis
of a particular committees estimate of the long run marginal
costs of gas production. The decision to index the price of gas at
landfall points to a basket of fuel oil prices was made in 1990.
In Latin America cost based pricing was the rule until the
early 1990s. Argentina then de-controlled wellhead prices
with regulator Enargas continuing to regulate transmission
and distribution tariffs. These were originally set to ensure
a fair return on investments in pipelines and other facilities,
but emergency legislation passed in the wake of Argentinas
economic crisis in the early 2000s authorised the government
to re-impose price and exchange controls, with the result that
tariffs and prices in dollar terms dropped significantly.
In 2004 Argentinean authorities and the countrys main gas
producers agreed on a schedule for partially lifting the price
freeze, but progress has been limited, although more recently
producers and large industrial and power sector end users have
been free to negotiate prices.
Brazil in 2002 liberalised gas prices but continues to regulate prices
to qualifying gas power plants. Regulator ANP sets transportation
tariffs on a cost of service basis. Petrobras dominating role in
the upstream and continued hold on the transmission link limits
the role of competition in gas price formation, with wholesale
gas prices now increasingly following oil prices.
Below cost pricing was a hallmark of the 20th centurys centrally
planned economies. In the FSU, prices served accounting
purposes only. They were not supposed to carry signals between
market actors and drive resource allocation decisions. Instead
hierarchies of plans provided volume targets reflecting the
prevailing prioritisation between societys different needs,
and the planners attempts to optimise under all kinds of
constraints related to the unwieldiness of the productive sectors.
The centrally planned economies bias towards heavy, energy
intensive industries favoured low accounting prices. Ordinary
people were offered a meagre selection of consumer goods but
in return received free education and health care, and cheap
housing and other goods including gas.
The former East Bloc included a string of countries that
received Russian gas in return for pipeline construction or transit
services under the division of labour within the Comecon area,

June 2011 | International Gas Union 21

or cheaply for political reasons. In general terms, constructions

like the Comecon area need arrangements for their sustainability,
and one arrangement underpinning Russias authority within
the this area was Moscows provision of cheap gas and other
commodities to its neighbours.
East Europe has moved away from below cost pricing and the
FSU republics are implementing price reform. The countries that
have opted to retain gas price regulation at below cost levels,
at least for now, are the North African and Middle Eastern oil
producers and exporters.
Oil producers typically have associated gas at their disposal. In
the past associated gas was vented, flared or at best reinjected.
Though flaring continues in some countries, globally much of the
gas that was wasted is now harvested, processed and marketed.
As a free good at the wellhead, associated gas is low cost gas. It
can be supplied economically at prices covering only transmission
and distribution costs. Alternatively it can be supplied at even
lower prices or for free with an (at least initially) manageable
subsidisation burden falling on the state. Problems arise only
when gas demand starts exceeding associated gas supply, i.e.,
when need arises for much more expensive non-associated gas.
Iran began harnessing associates gas in the 1960s and Saudi
Arabia followed suit with the construction of the Master Gas
System in the late 1970s. Both countries, and eventually others
in the region, funded gas infrastructure investments from their
oil export revenues. The rulers main motivation was to contain
the growth in domestic oil consumption. This could have been
done in different ways, probably most efficiently by raising
domestic oil product prices. Oil price reform could however
have triggered political and social unrest. The nature of the

legitimacy of rentier state governments dictates generosity in

the provision of basic goods and services including fuels and
electricity. Positive price and availability incentives to switch
to gas appeared much safer.
Though Iranian gas use (net of reinjection) increased by 10,5% a
year between 1991 and 2006, domestic oil consumption growth
continued to outpace oil production growth. The countrys
position as a major oil exporter came under increasing pressure.
Iranian rulers have therefore since the 1990s intensified efforts
to make fuel users switch from oil products to gas by providing
for continuous growth in the gas grid and keeping domestic gas
prices at very low levels.
Saudi Arabia has also maintained the domestic gas price at a
very low level for a very long time. Between 2001 and 2008
no material adjustments have taken place. Saudi Arabia has
come under pressure internationally for its highly subsidized
prices. Trade partners have protested that the country now
a full member of the WTO is unfairly supporting Saudi
industries and utilities.
In an attempt to address the main distortions in the domestic
gas sector, Saudi Arabia recently adopted a new pricing policy
that could herald real price reform. In 2006, the local Eastern
Gas Company was awarded a two-year contract to become
Aramcos gas distributor to consumers in the Dhahran industrial
area. According to industry reports, its purchase price from
Aramco will be USD 1,12 per MMBtu and its sale price USD
1,34/MMBtu. In Riyadh, the Natural Gas Distribution Company
was granted a license to supply small-scale manufacturing plants
under a similar pricing structure. For the time being, the price
for foreign investors and other consumers remains unchanged.

22 International Gas Union | June 2011

Chart 7.43: Wholesale prices by price formation 2007

Parts of the world are in transit between gas pricing mechanisms.

Others are trying to fix problems with their existing mechanisms
without plunging into the unknowns of all-out system reform.
Yet others do not envisage significant changes, either because
there are no perceptions of tensions calling for release measures,
or because there are no perceptions of better models, or because
the risks of reform are considered too high.

Wholesale prices by price formation

mechanism 2007
$8,00
$7,00

$/MMBTU

$6,00
$5,00

Sellers, buyers and regulators preferences with respect

to retaining, adjusting or replacing pricing mechanisms are
influenced by a number of factors:

$4,00
$3,00
$2,00
$1,00
$0,00
OPE

GOG

BIM

NET

RCS

RSP

RBC

TOT

There have been some changes in the relative importance of

the different price formation mechanisms between 2005 and
2007, but much of it was due to changing consumption patterns
with the main switching between categories occurring with
moves away from OPE to GOG as spot LNG trade increased
and trading hubs developed in Europe.

Relative efficiency in resource allocation terms of alternative

mechanisms
Price outlook under alternative mechanisms
Long term gas supply and demand consequences of alternative
mechanisms
Price volatility under alternative mechanisms
Price risk mitigation opportunities in alternative mechanisms
Budgetary and macroeconomic consequences of alternative
mechanisms
Political risks of moving away from existing mechanisms
Other transition costs

8. Trends in the extensiveness of individual

pricing mechanisms
Efficiency arguments are typically heard from proponents of
gas-on-gas competition based pricing. Only when gas prices
are allowed to reflect gas supply and demand will the socially
optimal amount of resources flow to the gas sector relative to
other worthy causes.
The outlook for gas prices is on everybodys mind, and different
pricing models may deliver different prices. However, the
importance of this factor will vary, and while one model may
be the most (least) attractive from a sellers (buyers) point of
view under one set of circumstances, it may score differently
under another set of circumstances.
In 2008 Continental European and Asian oil linked prices
outpaced North American gas-to-gas competition based prices.
Again this may be seen as proof of the gas industry advantages,
and consumer disadvantages, of oil linked gas pricing. But
there have been periods in this decade when the relationship
has been the opposite.
Another observation is that at least over long periods of time
oil linked and gas-on-gas competition based prices tend to
move pretty much in parallel due to links provided by interfuel
competition and international gas trade.

The only firm but also rather trivial conclusion that can be
made on the relationship between gas pricing model and gas
price level, is that a shift from subsidised to unsubsidised prices
will push prices up.
The long term impact of alternative pricing mechanisms on
gas supply and demand has been a hot topic in particular in
Europe. Observers, and the gas industry itself, in 2008 noted the
incongruence between the need for gas to remain the preferred
fuel to the power sector if we were to see further growth in
overall demand, and the disincentives that oil linked gas prices
at USD 100-150/b oil represented to the dispatching of existing
and the building of new gas power plants.
On the other hand, demand destruction first became a big issue
in the US following the gas price spike in 2005, and the supply
boosting impact of the post 2000 price gas price environment
is nowhere more obvious than in the US. So again it is not so
that one pricing model necessarily represents a bigger threat to
future gas demand, and a bigger encouragement to future gas
supply, than another.
Gas price volatility is generally seen to be a problem mainly for
actors in liberalised markets with gas-on-gas competition based
pricing. And indeed, Europes and Asias oil linked prices are

42 International Gas Union | June 2011

less volatile, reflecting the way the indices are defined. With
gas prices set to reflect the average of oil prices over a period
of time many months prior to delivery, short term peaks and
troughs are automatically smoothened out.

buyers with minimal regulatory interference (apart from tariff

control of the natural monopoly elements in the supply chain,
aka the transmission link) seems to be widely perceived as an
end state without more efficient alternatives.

However, apart from the fact that price volatility to many actors
represents opportunities rather than problems, it might not be
very difficult to shape the price clause in a contract based on
gas indexation so as to obtain the same smoothening effect.

Continental Europe

To decision makers in countries with heavily regulated gas

markets where prices are adjusted as rarely as possible, the
volatility aspect may nevertheless seem a strong deterrent to
convert directly to gas-to-gas competition based pricing.
Price risk mitigation opportunities become indispensable as
price volatility increases. When demand for such tools arises,
banks and similar institutions normally rush in to provide them.
However, a limited availability of risk mitigation opportunities
in the early phases of market liberalisation may contribute to
the resistance that proposals to shift from one pricing model
to another typically encounter.
The budgetary and macroeconomic consequences of leaving gas
pricing mechanisms as they are, or embarking on reform, and
the inevitable political risks of reform, need to be considered
in those countries that practice below cost regulation. Fuel
subsidies are weighing heavily on many emerging economies
budgets. The IEA estimated for its World Energy Outlook 2008
that gas subsidies in 2007 cost the Russian state close to USD
30 billion and the Iranian state more than USD 15 billion. Even
the oil exporting countries that recently benefitted from record
high prices feel the pinch. On the other hand, raising domestic
fuel prices too quickly might boost inflation and trigger political
and social unrest.
Finally there may be other transition costs related to the
dismantling of old institutions and the establishment of new
ones, the teaching of new rules of the game to market actors
and regulators and possible dislocations in the transition period
from the old systems stops functioning properly to the new one
starts working.
Clearly the drivers for switching to other pricing models, and
thus the likelihood that changes will take place, differ strongly
from region to region:

North America and the UK

In the US, Canada and the UK that have adopted gas-on-gas
competition as the pricing mechanism there are virtually no
calls for shifts to other mechanisms. There is concern about the
level of price volatility, and a debate involving market actors,
regulators, politicians and observers about how to deal with the
harmful effects of price spikes and troughs. But there is little
talk about a return to more regulation or for a shift to some
variation on the market value pricing theme. As such, gas price
determination through multiple sellers competing for multiple

With respect to Continental Europe, the EU commissions

electricity and gas liberalisation agendas reflect the view that
the incumbents dominating electricity and gas supply and
cross-border trade in Europe have exploited their monopolist
or oligopolist positions to secure unreasonable margins for
themselves instead of delivering maximum benefits to the
consumers. In any event, it is argued, the incumbents need to
be exposed to competition to stay efficient.
Specifically, the commissions initiatives have aimed at securing
access at equitable terms to Europes electricity and gas grids
for new players, loosening the grip of long term take or pay
contracts, and pave the way for gas-to-gas competition based
pricing as an alternative to oil indexed pricing.
The Commissions priorities are being shared to varying
degrees by the EU member states governments and commercial
actors. Individual member state positions differ because their
incumbent gas companies differ in interests and influence, and
because views on the optimal extent of regulation of economic
life, and the proper influence of Brussels on national policy
making, still vary a lot.
Moreover, positions are changing in response to changes in the
context and to the surfacing of new issues. During the 1990s
signs of global warming triggered a debate on the sustainability
of policies to bring down fuel prices by providing for more
competition in the fuel sectors, given the environmental
downsides of continued fuel consumption growth. In recent
years gas supply security concerns have triggered a debate on the
compatibility of open access to gas infrastructure, a shortening
of contracts and prices set through gas to gas competition with
the required fast growth in investments in increasingly remote
upstream options and expensive midstream solutions.
As for the commercial actors, with oil prices at record levels and
with a series of new gas import facilities under construction or
at the drawing board, as of 2008 Europes gas suppliers seemed
to believe that oil linked prices will hold up better than gas-ongas competition based prices.
Another factor is the remaining lack of trust in Europes gas
hubs as sources of reliable price information. Apart from the
UKs National Balancing Point (which though significant is
dwarfed by the US Henry Hub), European hubs remain small
and thinly traded. Illiquidity spells unpredictability and entails
a risk of market manipulation. In contrast, the markets for
the crude oils and refined products are vast, liquid and well
understood by everybody involved.
Thus, while there has been considerable movement on the grid

June 2011 | International Gas Union 43

access issue, there is for the moment strong interest in retaining

oil linked pricing. European gas market players have also put
up a strong fight on the principle of long term contracts.
Testifying to the continued sympathy for oil linked pricing,
Gazprom in 2006-07 renewed a string of major gas sales
agreements with Western European buyers on oil terms.
Sellers and buyers perceptions of the pros and cons of alternative
contract forms and pricing models are not set in stone. Gas-ongas competition based pricing will likely gain ground as more
hubs mature. Additionally coal indexation could come to be
seen as an alternative. The fact remains that the gas industry
needs to look to a sector where oil is no longer an interesting
alternative for further growth opportunities (Chart 8.1). Gas
prices mirroring record high oil prices could as noted stop that
growth in its tracks.
Chart 8.1: Electricity generation by source in IEA Europe
IEA Europe: Electricity generation by source,
1973-2004
100 %
90 %
80 %

40 %

1974: Oil
share 25%

30 %
20 %
10 %
0%
1974

2004: Oil share 4%

1980

1990

2000

Gas
Oil
Coal

2004

Source: IEA

This being said, the transformation of the Continental European

gas market will neither be fast nor proceed at the same pace
across countries. Gas market based pricing, oil linked pricing and
formulae involving links to inflation, to coal or to electricity (the
spark spread) will likely continue to coexist for many years.

Asia Pacific

The changes that are occurring in Asian LNG import and gas
end user pricing are changes within the paradigm of oil linked
prices. As the Asian LNG market tightened, the gas priceoil
price curve steepened towards full parity in energy equivalence
terms between LNG and crude oil import prices. Also the S
shape of the curve that Japanese buyers prefer i.e., the ceiling
offering protection to the buyer if oil prices should increase above
a preset level and the floor offering protection to the seller if
oil prices should become too low came under pressure. The
financial crisis and the current outlook for slower growth in LNG
demand in a period when much new LNG will come on the
market, have reversed these trends but not affected the oil link.
However, the globalisation of the LNG business, the growth
in LNG spot transactions as a share of total LNG sales and
purchases (Chart 8.2) and in the future the emergence of LNG
transactions across the Pacific will shape Asian buyers pricing
habits too. Kogas uses the spot market to manage seasonal
swing in Koreas gas demand. As a result of several nuclear
incidents, since 2006 also Japanese buyers have been active
in the spot market. Japan in 2007 had to compete on price for
around 20% its total LNG supply. For the moment (1st quarter
2009) Asian buyers are not very active in the LNG spot market
but demand could bounce back once the financial crisis is over.
Asian buyers will then need to reckon with Henry Hub and the
NBP i.e., indirectly with supply and demand conditions in
North America and Europe as references that sometimes kick
in as floors, other times as ceilings.
Chart 8.2: Asian LNG importers spot purchases

The established Asian LNG importers are sticking to crude oil

indexation as the dominant imported gas pricing mechanism.
Gas-on-gas competition based pricing is not a target. Gas market based pricing is for the time being not an option other than
for spot cargos anyway since the OECD Pacific gas markets
are characterised by limited competition and have no gas hubs.

25

Bcm

20
15

Taiwan
Korea
Japan

10
5
-

19
95
19
96

The Japanese gas and power utilities, Kogas and Taiwans CPC
have traditionally paid more than European and North American
buyers for their LNG imports. This is mainly because of their
traditional preoccupation with supply security and ability to pass
the costs of added security on to their customers. Japanese end
user prices, to take them as an example, have been regulated by
the Ministry of Economy, Trade and Industry on a cost plus basis.
Some of these companies campaigned for lower prices in the early
2000s, in response to Indias and Chinas successes in securing

Established Asian LNG importers' spot

purchases, 1995-2007

20
06
20
07

50 %

Others
Hydro
Nuclear

The Japanese gas market has traditionally been highly fragmented

with regional monopolies tolerating no competition within their
concession areas and refraining from going for customers in
neighbouring regions. This is changing, with the revised Gas
Utility Law in Japan providing for third party access to LNG
terminals and pipelines. Also, customers using in excess of
100,000 cm of gas a year are now allowed to negotiate their
own prices with suppliers. But regulatory reform is only the
first step towards a level playing field and real competition.

19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05

70 %
60 %

cheap LNG, but since Indonesias supply challenges became

manifest their main interest has again been to secure volumes.

Source: PIRA, defining spot purchases as including contracts up to four years

44 International Gas Union | June 2011

Non OECD
In countries where gas end user prices are set below supply costs
and where the government is able to ensure that gas demand
growth is accommodated by supply growth, gas subsidisation
may increase to the point of representing a serious drain on
the budget. According to IEA estimates, gas subsidisation is
an issue for Iran, Russia, Ukraine, Kazakhstan, Pakistan and
Argentina in particular (Chart 8.3).
Chart 8.3: Energy subsidies by fuel in non-OECD countries, 2007
Energy subsidies by fuel in non-OECD countries, 2007

to the producers if they had exported it instead, and there is

every reason to believe that this process will be completed, if
not necessarily on schedule.
Other gas producers are proceeding more carefully. They can
hold back for a while but not necessarily forever.
China and India face the dilemma that if gas is to become a key
fuel to the power sector, and not just a marginal fuel for peak
load generation, and if imported gas is to become an important
part of the supply picture, coal prices need to be raised to make
gas competitive.
While the Middle Easts and North Africas needs for gas for
power generation and desalination is booming, the two regions
associated gas production is typically stagnant or declining,
forcing governments to add non-associated gas to domestic
gas supply to make ends meet. Since non-associated gas
developments require upstream investments and carry much
higher costs than associated gas, this aggravates the budgetary
consequences of continued gas subsidisation.

Source: IEA: World Energy Outlook 2008

Gas subsidisation takes a particularly heavy toll in periods

of extraordinary high international gas prices like 2007 and
2008. Countries that import or need to start importing gas find
it increasingly hard in such periods to sustain domestic price
freezes or very slow price adjustment schedules.
While domestic pricing options narrowed for a number of gas
importing countries, they widened in 2007-08 for some oil and
gas producers and exporters. These countries had spending
powers then that they did not have in the late 1990s, and may
have felt emboldened to continue ignoring recommendations
to dismantle subsidy arrangements.
The financial crisis has in a sense reversed the situation. Gas
has become more affordable and the subsidisation of gas end
user prices has become less burdensome in absolute terms.
However, oil and gas exporters need to cope with mounting
current account and budget deficits and may be less able to
sustain subsidies now than before the crisis broke and since
the crisis has weakened not only oil and gas prices but most
commodity prices, all countries on the IEAs list are probably
now facing bigger subsidy burdens relative to their ability to pay.
Governments as a rule respond in two ways: by liberalising
prices to select, presumably robust, customers, and by raising
remaining regulated prices to the extent politically possible.
Typically, households and important industries such as the
fertilizer sector continue to enjoy some protection.
Russia the worlds biggest gas producer and exporter has
embarked on a process of aligning domestic prices with the
opportunity costs of selling the gas at home, i.e., with the netback

In the late 1990s when oil prices dipped below USD 10 a

barrel and the oil exporters ran up record trade and fiscal
deficits, a preparedness to discuss domestic price reform could
be detected across a range of gas producing countries. Saudi
Arabia, Venezuela and others that took steps to involve IOCs
in non-associated gas E&D needed to make the economics of
involvement look viable. However, as oil prices have rebounded
and the oil exporters are again accumulating trade and fiscal
surpluses, the gas openings of the late 1990s/early 2000s
seem have lost momentum.

Towards a globalisation of gas pricing?

International gas trade serves to align prices across countries
and possibly continents. This is, simply speaking, because
trade allows gas to flow from the areas with the lowest prices
to the areas with the highest prices (adjusted for differences
in transportation costs; it is the netback that drives sellers
prioritisation between markets). In the former areas the gas supply
curve shifts to the left, up the demand curve. In the latter areas
the supply curve shifts to the right, down the demand curve.
The most interesting countries in this context are those that
enter the global marketplace with lower domestic prices than
international prices. The importers in this group then come under
pressure to raise domestic prices not to be left with unsellable
imported gas or increased subsidisation commitments. The
exporters come under pressure to raise domestic prices because
of the losses incurred by supplying domestic users at below
opportunity costs, and/or because unconstrained growth in
domestic consumption could choke exports off.
International gas trade is growing. BP estimates that in volume
terms, world gas imports and exports increased from 335 Bcm
in 1992 to 776 Bcm in 2007 or by an average of 5,8% a year.
As a share of world gas consumption which only increased by

June 2011 | International Gas Union 45

This development looks set to continue. Several new import-export

pipelines are under construction or nearing the construction stage.
Unsurprisingly, Europe which its large, dynamic, oil linked and
increasingly integrated gas markets, and its location in between
half a dozen or so of leading gas producers and exporters, is the
target of a multitude of pipeline projects. Examples on Europes
eastern borders include the Russian North and South Stream
pipelines, and Nabucco, the IGI project and the TAP project
that compete among themselves and with South Stream for
supply from the Caspian and Gulf areas. Further to the south,
one new Algerian export pipeline Medgaz to Spain is close
to completion, and another Galsi to Italy is going forward,
Libya is planning to extend the capacity of its Green Stream
pipeline, and Egypts Arab Gas Pipeline has reached Syria and
could, depending on the availability of gas for pipeline exports,
be extended to Lebanon and Turkey. In the more distant future
a pipeline could link Nigeria and Europe via Algeria.
In China the second West-East pipeline is under construction,
and will be extended to pick up Central Asian gas. China is
also likely sooner or later to gain access to Russian piped gas.
However it is the international trade in liquefied gas that is
seeing the fastest growth and makes observers wonder how
soon the characteristics of an integrated global gas market
will be in place.
Though LNG makes up only about 30% of world gas trade,
and less than 8% of world gas supply, LNG is beginning to
dynamically link more than half of global gas consumption. And
the list of countries importing LNG and gaining an exposure
to global gas prices is steadily growing. In 2008 Brazil and
Argentina commissioned regasification terminals, and Canada,
Chile, Croatia, Poland, Singapore, the Netherlands, Germany,
Indonesia have all taken steps to enter this segment of the
global gas market.

LNG imports by country

1964-2007

200

150

100

50

250

China
India
Dom.Rep.

200

Puerto Rico
Portugal
Greece
Turkey
Taiwan
South Korea
Germany
Belgium
Italy
USA

150

Bcm

250

LNG exports by country

1964-2007

Mexico

100

50

Spain
0

6 4 68 72 76 80 84 88 92 9 6 0 0 0 4
1 9 1 9 1 9 1 9 1 9 1 9 1 9 1 9 19 20 20

Japan
France
UK

Norway
Eq. Guinea
Egypt
Oman
Trinidad
Nigeria
Qatar
Australia
Malaysia
Indonesia
Abu Dhabi
Brunei
Libya
US
Algeria

19
6
19 4
6
19 8
72
19
7
19 6
8
19 0
8
19 4
8
19 8
92
19
9
20 6
0
20 0
04

Continental Europes interfacing with other market structures

has considerably modified its price dynamics. The opening of
the Interconnector gas pipeline in October 1998 created a link
between the oil-indexed North European gas markets and the
liberalised UK market. The UKs seasonal demand and relatively
flat production created arbitrage opportunities for continental
buyers who could buy UK spot gas instead of contract gas
within their Take or Pay (TOP) Annual Contract Quantity
(ACQ) ranges and use storage to further optimise their positions.

Chart 8.4: LNG imports and exports by country

Bcm

2,5% a year in this period imports and exports nearly doubled

between 1992 and 2008.

Source: Cedigaz

The growth in US LNG imports in the early 2000s and the

reemergence since 2005 of the UK as an LNG importer meant
additional opportunities and price influences for Continental
European gas buyers:
Contract LNG diverted to US/UK markets: At times when
Henry Hub was higher than European contract prices, France
and Spain were able to sell contracted LNG in the US and
obtain back-fill volumes by increasing offtake under their
long-term pipeline gas contracts within the TOP ACQ band.
Flexible LNG diverted from US/UK markets: When Continental
European oil indexed prices have exceeded Henry Hub or
the NBP price, LNG intended for delivery to the US or the
UK may instead be imported to continental Europe, with the
importers lowering offtake under their long term pipeline
gas import contracts correspondingly within the TOP ACQ
band. This has been made easier by the lack of firm long
term contracts with market participants in the UK or US.
The UK market is subject to the Interconnector and LNG
diversion dynamics described above. A conflict of market models
arose in November 2005 when, facing a supply shortage, the
UK was expecting Continental European players to send gas
bought from the UK the previous summer back to the UK in
response to price signals. This did not occur. The continental
players were more concerned with ensuring adequate supplies
for domestic customers during the first quarter of 2006.
An interesting development in 2007-08 was the rapid growth
in Asian imports of Atlantic i.e., North and West African,
Caribbean and even Norwegian LNG. This trade increased
from some 4,8 bcm in 2006 to 9,6 bcm in 2007 and close to 20
bcm in 2008. Offering higher netbacks the Asian importers made
Atlantic suppliers divert as many cargos as they could, given
their contractual commitments, from their regular markets. US
imports in the first 10 months of 2008 plummeted by almost
60% year on year.
The Asian importers dips into the pool of LNG supply which
otherwise would be delivered to the Atlantic Basin markets had
consequences for overall LNG availability and required Europe
and North America to rely more on gas in storage. While Asian

46 International Gas Union | June 2011

LNG contract prices are linked to the oil price, spot purchases
were apparently priced on an Atlantic basin netback basis,
though they could also reflect substitute fuel prices (usually in
Japan and usually distillate prices).
There were particular reasons for the Asian countries needs
for Atlantic LNG in 2007-08 in the case of Japan TEPCOs
temporary loss of big parts of its nuclear capacity, in the case of
South Korea a fuzzy regulatory situation that prevented Kogas
from signing new long term contracts, and in both cases poor
utilisation of storage tanks to manage seasonal demand and
Indonesias problems delivering on its commitments. Some of
these drivers will weaken, and the global recession has put an
end to the sellers market conditions that characterised LNG in
2007-08. In 2009 few Atlantic cargos have ended up with Asian
buyers. On the contrary, Asia Pacific exporters have needed to
place a few cargos with Atlantic buyers. These developments
do not constitute evidence that the integration of regional gas
markets has stopped in its tracks, but serve as a reminder that
the road towards globalised gas pricing may see set-backs and
could take longer than expected.

Bumps in the road toward globalised gas pricing

Though the differences between how gas is priced in individual
regions may narrow, the driving forces expected to deliver price
alignment do not look as powerful as they did some years ago.
There may for instance be reasons to revisit the question how
effectively LNG will serve to integrate world markets.
It seems a fair assumption that the LNG share of world gas supply
needs to reach a certain threshold whatever that threshold
may be if LNG is to play a key role in delivering market
integration and price globalisation. By 2008 the LNG share of
world gas trade was about 28%, but regasified LNG still made
up only 7,5% of world gas consumption. The conclusion that
LNG remains a niche product with limited capacity to drive
prices, seems to be still valid. Moreover, most LNG chains are
no less rigid than pipeline gas chains, with volumes, sources
and destinations laid down in long term contracts. It is only the
flexible portion of LNG the volumes purchased by portfolio
players, the volumes available from liquefaction plants after
contractual commitments have been fulfilled, etc. that can be
routed at short notice to the highest paying markets.
Clearly, even small supply increments can make a difference
in tight markets. Thus under certain circumstances flexible
LNG may already have reached critical mass in its role as
globalisation purveyor. Under other market circumstances,
however, the cargos available for rerouting will probably not
matter much to regional price differences.
During the first half of this decade forecasters expected rapid
growth in LNG exports and imports. This optimism reflected a
bullish outlook for gas in general, an apparent abundance of gas
reserves suitable for commercialisation as LNG, favourable gas
price / LNG cost developments and other attractions of LNG
in comparison to pipeline gas security of supply advantages

from the point of view of consumers, arbitrage opportunities

from the point of view of suppliers.
There is still much enthusiasm, and fairly robust growth
projections, for LNG. The reference scenario in the International
Energy Agencys 2008 World Energy Outlook had LNG supply
and demand growing by 6% a year between 2005 and 2015,
and 4,7% a year between 2015 and 2020. These rates were
lower than those suggested in previous WEOs but still a lot
higher that the Agencys 2008 projections for total gas supply
and demand. The IEA last year believed that in a business as
usual future the LNG share of total gas would increase from
6,7% in 2005 to 16-17% in 2030.
The globalization trend will get a boost from LNG in the years
to 2011-12. During this period some 90 mtpa of new liquefaction
capacity will be commissioned. Some 15 new LNG trains,
including several very big ones, are under construction with
a view to completion before the end of 2011. Nearly all this
capacity is tied into long term LNG sales and purchase contracts.
However, 35% of the capacity is contracted to the marketing
arms of the IOC participants in the projects, and another 24% is
contracted to Qatar Petroleum. Thus almost 60% of the capacity
to come onstream between now and the end of 2011 may be
characterized as flexible and it cannot be ruled our that the
gas and power companies and end users that have contracted
for the remainder of the new capacity have plans of their own
to engage in arbitrage plays.
However, the pace of LNG supply growth beyond 2012 is for
the moment highly uncertain. In 2006-08 only five liquefaction
projects took final investment decisions. The 22-23 mtpa of
capacity that these projects will add to the global total corresponds
to only about half of required incremental capacity over the
years when the projects may be expected to come onstream
if, that is, LNG demand grows at around 6% a year. The latter
assumption is of course open to question. The credit crunch
may well slow LNG demand growth down for a while. Still,
the assumption that there will be enough flexible LNG around
to support any conceivable growth in arbitrage operations and
price alignment across regions and basins also beyond 2012,
now seems bold.
The most intriguing aspect of the slowdown in the sanctioning
of new liquefaction projects, is that it took place in a period
characterized by record high oil and gas prices and extreme
tightness in the global LNG market. In 2008 LNG buyers
purchased spot cargos and signed short-medium term contracts
at prices representing parity with oil at USD 100-150/b. It
was widely assumed that parity would become the norm also
for longer term contracts. This still did not persuade many
LNG project sponsors to proceed from the planning to the
implementation phase.
A string of factors have recently thrown spanners in the wheels
of LNG supply projects:

June 2011 | International Gas Union 47

How quickly the flexible, divertible share of total LNG will

increase is just as uncertain. There are projections of this share
doubling from 15% to 30% over the next decade as well as
expectations of a decline. Unsurprisingly, the Atlantic and Mid
East actors that have positioned to become providers of LNG
hub services are the most optimistic. At the other end of the
scale are certain Asian and European incumbents pointing to
the Japanese nuclear problems and other special circumstances
that drove the growth in flexible LNG in 2007-08, and claiming
that with these problems out of the way it will be in everybodys
interest to refocus on long term contracts.
Independently of individual actors preferences, a tripling of
flexible LNG over a decade (a doubling of the flexible share of
a total increasing by around 50%) could require more projects
to be sanctioned with smaller shares of output under long term
contracts, than host governments, company sponsors and the
financial community seem to be ready for.
LNG project sponsors may have hesitated to proceed to FID also
because of doubts about the sustainability of the 2007-08 LNG
market boom. In the first place, there were signs that the prices
in 2007 and the first quarters of 2008 would lead to demand
destruction. Secondly some players may have suspected that the
price explosion in 2008 was part of a bubble that would burst
(although very few seemed to have anticipated something like
the current price and demand collapse).

The US market had, it was argued, what no other single national

market or cluster of national markets had: The size, the hubs
and the storage capacity to provide swing services to everybody
else without being destabilized itself in the process. As such US
gas prices (adjusted for differences in transportation costs)
principally the Henry Hub spot price were uniquely positioned
to become world benchmarks. Prices elsewhere could not drop
much below HH; if they did, flexible LNG would flow to the
US and stabilize prices elsewhere. Prices elsewhere could on
the other hand not increase much above HH; if they did, LNG
destined for the US would be rerouted to the higher priced
markets and again align prices across continents.
One thing necessary to make this vision a reality was robust
growth in US LNG demand, and that seemed an almost done
deal. On the one hand, US gas demand looked set to increase on
the back of massive investments in gas fired power generation
capacity. On the other, US gas production, and the availability to
the US of Canadian pipeline gas, appeared to be in irreversible
decline. Mexico also struggled to increase domestic gas
production in line with demand. In short, the North American
gas supply-demand gap that could only be filled by LNG looked
set to widen rapidly.
US LNG imports are by nature volatile since they are not normally
underpinned by long term take or pay contracts. Thus the flow
of LNG to North America was below expectations in 2006 with
European buyers stocking up gas in the aftermath of a cold winter
and with the Russian-Ukrainian gas crisis still on peoples mind,
and above expectations in first half 2007 as a warm winter had
left European storage inventories abnormally high. Until then,
however, the trend seemed to be pointing squarely upwards.
What many observers missed for a long time was the unconventional
gas revolution underway in the US. Tight gas, shale gas and
coal bed methane has been supplied in increasing amounts at
increasingly competitive costs. US gas productive capacity
which had been on a declining curve since 2001 bottomed out
in late 2005. LNG largely priced itself out of the US market in
2007 and failed to re-enter in 2008 (Chart 8.5).
Chart 8.5: US dry gas production and LNG imports
US monthly dry gas production
53

Bcm

45
43
41
39
37
35

Source: US DOE EIA

48 International Gas Union | June 2011

Jan 97 - Oct 08

Trend line

47

ja
n.
97
ja
n.
98
ja
n.
99
ja
n.
00
ja
n.
01
ja
n.
02
ja
n.
03
ja
n.
04
ja
n.
05
ja
n.
06
ja
n.
07
ja
n.
08

North America was and is a key piece of the puzzle expected

to give rise to one integrated world gas market and globalised
gas pricing. It was the new outlook for US LNG requirements
that emerged after the 2000-2001 US gas price spike, and
FERCs 2002 Hackberry decision to stop requiring so-called

51
49

Sponsors probably also noticed that US LNG demand was not

developing as expected in the early 2000s.

US monthly LNG imports

Jan 97 - Oct 08

Bcm

It remains to be seen how quickly these hurdles will be cleared

away or at least made more manageable. Certain cost components,
in particular material costs, are on their way down. Others seem
quite resilient to the financial crisis.

open seasons for new regas terminals, that got the globalization
debate started.

Trend line
1

0
ja
n.
97
ja
n.
98
ja
n.
99
ja
n.
00
ja
n.
01
ja
n.
02
ja
n.
03
ja
n.
04
ja
n.
05
ja
n.
06
ja
n.
07
ja
n.
08

Problems gaining access to gas reserves suitable for LNG

due to host country government decisions to prioritise supply
for the domestic market and/or for future generations rather
than (additional) LNG exports,
Shortages of input factors, contractor capacity and skilled
labour driving costs and undermining the pretax economics
of LNG; projects that seemed robust some years ago now
look marginal,
Increasingly tough fiscal terms as host country governments
responded to the shift from buyers to sellers market conditions
by seeking to increase government take,
Persistently high political risk in key supplier countries,
Project partner misalignment,
Technical challenges related to the increasing size of LNG
plants, and to the location of plants to more challenging
environments.

Observers/stakeholders like the US DOE have lowered their US

LNG import assumptions year by year in response to the signs
of demand destruction and the break-through for unconventional
gas. The DOEs Energy Information Administration almost
comes full circle in its 2009 Annual Energy Outlook. By the
turn of the decade the EIA believed that US LNG imports
would stagnate at 0,33 tcf (9,3 bcm) a year. In 2005 the EIA put
LNG imports by 2025 at 6,37 tcf (180 bcm) a year. In its most
recent Outlook the EIA sees LNG imports peaking at 1,51 tcf
(43 bcm) a year by 2018 before dropping to 0,84 tcf (24 bcm)
a year by 2030 (Chart 8.6).
Chart 8.6: US LNG import forecasts

Whether the US also will provide a ceiling to world LNG prices

as and when markets recover, and as such continue to serve as
market integrator, is a different issue.
If US LNG imports increase in the short term, a recovery in
world LNG demand in the medium term could to an extent
be supplied from these imports. European and Asian buyers
would only need to increase their price offers enough to shift
netbacks marginally in their favour. The re-routing potential
would however eventually become exhausted just as it was in
2007-08 when little else than Trinidad cargos under long term
contracts found their way into the US (Chart 8.7).
Chart 8.7: US LNG imports by supplier

US LNG imports

DOE/EIA's forecasts 2000-2009

US monthly LNG imports by supplier

7
6

2000

2500

2005

2006

2007

2008

2009

2000
Mcm

Tcf

1500
1000

03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
20
27
20
30

Trinidad
Qatar
Norway
Nigeria
Eq. Guinea
Egypt
Algeria

ja
n.
06
ap
r. 0
6
ju
l.0
6
ok
t.0
6
ja
n.
07
ap
r.0
7
ju
l.0
7
ok
t.0
7
ja
n.
08
ap
r.0
8
ju
l.0
8
ok
t.0
8

20

20

00

500

97
19

3000

Source: US DOE/EIA: Annual Energy Outlook, various editions

The situation is not that the US may not receive increasing

amounts of LNG. As a market of last resort the US will likely
receive a significant share of the LNG from the 15 new trains
set that will start producing in the years to 2012. But there will
at least initially be no bid wars for this LNG. The sellers will
have to accept or reject the prevailing US prices depending on
relative netbacks. In extreme situations they may have no choice
because other destinations are physically unable to receive more
LNG. The US will then provide a floor to world gas prices and
as such play its part in the price globalisation process.
The US gas market is not only large enough and well enough
equipped with storage capacity to accommodate such a
development, it now also has sufficient regas capacity. By the
end of 2008 the US had an estimated total of 62,3 mtpa (8,2 bcfd)
of capacity up and running, and Mexico had an additional 9,5
mtpa (1,2 bcfd). By the end of 2009 the US total will be almost
100 mtpa (13,1 bcfd) with Mexico and Canada contributing 19
mtpa (2,5 bcfd).
Wholesale gas prices in the US will reflect the long term
marginal costs of US unconventional gas. These costs are often
reported to be in the US$ 5-7/MMBtu range, though estimates
tend to come with warnings about their sensitivity to further
improvements in E&D technology, positive or negative surprises
in new basins, general oil and gas industry cost developments
and a host of other factors. Anyway, if Henry Hub drops below
long term marginal costs which certainly may happen drilling
and eventually supply will decline, pushing prices back into
the viability range.

Source: US DOE EIA

LNG prices could then decouple from the US price level which
if US gas demand and/or indigenous gas supply is flexible
enough to quickly accommodate any loss of flexible LNG to
other market regions might not change at all.
If the US instead develops the dependence on LNG that observers
in the early 2000s thought they could see around the corner,
but now tend to discard, US buyers would need to compete on
price with the rest of the world for LNG supply. Then the LNG
price ceiling provided by US indigenous gas supply costs could
disintegrate but we would still in this scenario characterised by
intercontinental competitive bidding see gas market integration
and price globalisation.
The differences between recent long term US LNG import
forecasts testify to the complicated nature of this issue. US gas
demand growth will play a key role, implying that economic
growth and the current administrations energy and environmental
policies will be important drivers. The exact shape of the North
American unconventional gas supply curve, today and 5, 10
and 20 years from now considering the resource base and the
scope for further technological progress, is another key to the
outlook for LNG. Whether incremental LNG supply costs will
stay at todays level or fall back towards their 2004 level is yet
another key.

June 2011 | International Gas Union 49

To state the obvious: If

US gas demand picks up on the back of an economic recovery
and policies favouring gas over competing fuels for mid- and
baseload power generation,
unconventional gas proves to have its limits, and
global LNG supply costs decline to the level of ensuring
competitiveness in netback terms to the alternatives in the
US market,
then LNG may only be temporary down as a component of the
US fuel mix, and the growth in LNG supply to the US that
many observers took for granted a few years ago could still
materialise. If on the other hand US gas demand, unconventional

gas supply and/or LNG costs develop differently, then the

anticipated recovery in US LNG imports linked to the need
for new Qatari, Russian, Indonesian, Yemeni etc. liquefaction
capacity to be accommodated, could be short lived.
The former scenario would underpin a rapid development of a
global gas market with unified pricing. The latter would mean
that a vital globalisation and unification driver would disappear
from the scene with the result that the processes might take
much longer.

50 International Gas Union | June 2011

9. Price volatility
General

Chart 9.3: Henry Hub standard deviation

Henry Hub next month delivery contract price
Standard deviation of daily observations

3,00
2,50

USD/MMBtu

In general terms, price volatility refers to the frequency and

amplitude of price fluctuations. In financial terms volatility
refers to the magnitude of stock variations. The concept of
volatility is used to quantify yield and price risk. The stronger
the volatility, the bigger the potential yield but also the bigger
the risk. The concept is typically used to describe short term
variations rather than long term oscillations, but may in principle be used to discuss all kinds of fluctuations.

2,00
1,50
1,00

There is a strong popular perception that gas prices fluctuate

more often and more strongly now than in the past. A glance at
select wholesale gas prices in the markets relying on gas-to- gas
competition supports this notion (chart 9.1).
Chart 9.1: Henry Hub and NBP price fluctuations

Henry Hub next month delivery

contract price

NBP spot price

Jan 97 - Dec 08, monthly basis

Jan 94 - Dec 08, daily basis

16

18

14

16

12

USD/MMBtu

12
10
8
6

0,00
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: US DOE EIA

The importance of not jumping to conclusions on volatility

developments becomes even clearer when we look at price
changes rather than absolute prices. Traders and risk managers
typically measure volatility in terms of the return on an
investment in a commodity, with returns calculated on a lognormal basis using the form

10

Return(t) = ln(Price(t)/Price(t-1)).

8
6
4

13
.0
13 1.9
. 4
13 01.
.0 95
13 1. 9
.0 6
13 1. 9
.0 7
13 1.9
.0 8
13 1.9
.0 9
13 1.
. 0 00
13 1. 0
.0 1
13 1. 0
.0 2
13 1. 0
.0 3
13 1. 0
.0 4
13 1. 0
.0 5
13 1. 0
. 6
13 01.
. 0 07
1.
08

Ja
nJa 9 7
nJa 98
nJa 99
nJa 00
nJa 0 1
nJa 02
nJa 03
nJa 04
nJa 0 5
nJa 06
nJa 07
n08

USD/MMBtu

14

0,50

Sources: US DOE EIA, CERA

It is however not evident that there has been a continued and

consistent increase in volatility through the 2000s. Prices
fluctuated less in 2002-04 and again in 2006-07 than in 2000
and 2001. (Charts 9.2 and 9.3).
Chart 9.2: Henry Hub means, highs, lows

In this perspective where a USD 2 increase in a USD 10/MMBtu

price represents the same level of volatility as a 40 cents increase
in a USD 2/MMBtu price, it becomes difficult to see any clear
trend in volatility over the 1994-2007 period (Chart 9.4).
Chart 9.4: Henry Hub daily returns

Henry Hub next month delivery contract price

Daily returns, January 2004 - December 2008

40 %
30 %
20 %
10 %

Henry Hub next month delivery contract price

Annual means, highs, lows

18

-20 %

16

14.01.08

14.01.07

14.01.06

14.01.05

14.01.04

14.01.03

14.01.02

14.01.01

14.01.00

14.01.99

14.01.98

14.01.97

-50 %

10

14.01.96

-40 %

12

14.01.95

-30 %

14

14.01.94

USD/MMBtu

0%
-10 %

Source: US DOE EIA

4
2
0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

What effects price volatility has on the affected markets and

economies is also a controversial issue.

Source: US DOE EIA

June 2011 | International Gas Union 51

In the 1980s and 1990s oil price volatility was much debated.
Many politicians and market actors recommended producer to
consumer cooperation to dampen price fluctuations. While the
oil price increases in 1973 and 1979-80 triggered consumer
country interest in this concept, the oil price collapse in 1986
persuaded many producer countries to support it too. The 1990
mini-shock related to the Iraqi invasion of Kuwait further
boosted enthusiasm for some kind of dialogue.
Economists however cautioned against politicising markets in
this way. One study5 examined the allegations that oil price
volatility had boosted inflation and dampened economic growth by:
Boosting oil prices
Reducing oil industry investments and thereby oil supply,
Boosting transaction costs e.g., costs associated with
investments in facilities to increase flexibility for consumers
and producers
The study failed to find conclusive proof for any of them. Price
volatility as such did not seem to be the reason for any of these
three situations.
Price volatility may keep investors that pursue low risk
activities with correspondingly low returns, and look for a
stable environment, from launching new investments. As such,
volatility may be an issue from a gas supply security point
of view. However, to other investors price volatility may, by
providing arbitrage opportunities, be seen as preferable to price
stability in terms of value added. It is important to nuance the
perception of volatility as a problem for the industry. It needs
to be acknowledged that different types of stakeholders look
for different price contexts.
This difference is related to the one between long term oil
indexed gas prices and shorter term gas to gas competition
based prices on gas exchanges.

changes in demand, or demand failing to accommodate price

signals due to changes in supply.
How quickly supply is able to respond to a shift in demand
depends on the state of the market i.e., on the shape of the
supply curve at the point of intersection with the demand curve
when the shift occurs.
Chart 9.5: Price volatility and the flexibility of supply
Price volatility and the flexibility of supply
Price
D 11

D 21

D12

D 22

P2
B

P1

Volume

The less suppliers are able to accommodate an increase in

demand by activating spare capacity, the stronger will the
price impact be.
How quickly demand is able to respond to a shift in supply
depends on the shape of the demand curve at the point of
intersection with the supply curve when the shift occurs
Chart 9.6: Price volatility and the flexibility of demand
Price volatility and the flexibility of demand
Price
D1

D2

S2

Causes of volatility
Many explanations have been offered for the perceived increase in
gas price volatility in the 2000s. Those that are most popular with
the media are not necessarily on top in terms of explanatory power.
Blaming fingers are pointed at commodity trading techniques
resulting from time to time in waves of speculative gas sales or
purchases. The public is also occasionally fired up by reports
on downright market manipulation. However neither trading
techniques nor criminal activity are credible explanations for
a general increase in price volatility.
Basic gas supply and demand fundamentals go a long way
towards explaining this increase.
Price volatility is the consequence of supply failing to respond
immediately, smoothly and precisely to price signals caused by
5

Philip K. Verleger, Jr.: Adjusting to Volatile Energy Prices, Washington DC 1993

If the market at the

outset is at A, with
plenty of flexibility on
the supply side, an
increase in demand
from D11 to D12 will
increase prices only
by P1.
If the
market at the outset
is at B, with limited
flexibility
on the
supply side, the
same increase in
demand will raise
prices by P2.

P2

P1

S1

If the market is
at A when
supply
shifts
from S1 to S2,
then if demand
is flexible (the
D1
curve)
prices
only
increase
by
P1, whereas
if demand is
inflexible (the
D2
curve)
prices increase
by P 2.

Volume

The less consumers are able to accommodate a decline in supply

by switching to other fuels or just cutting consumption, the
stronger will the price impact be.
On the margin, if supply has become so stretched that the
market is on the vertical part of the supply curve, or if demand
has become so rigid that the market is on the vertical part of
the demand curve, disturbances will need to be accommodated
100% by price adjustments. Since gas markets are disturbed
all the time by changes in the weather, maintenance of supply
facilities, etc., under such conditions there will inevitably be
frequent and sometimes violent price fluctuations.

52 International Gas Union | June 2011

Gas exchange prices reflect the supply and demand circumstances

of the day. Both variables are characterised by frequent deviations
from trend, and delayed and imprecise responses are the rule
rather than the exceptions. Gas exchange prices are therefore
inevitably characterised by fluctuations.

Volatility associated with gas price increases

Gas price increases incentivise producers to increase supply,
but liberalised markets as a rule have little spare productive
capacity that can quickly be brought on-stream. In the US the
gas sector restructuring that was triggered by the passing of
the Natural Gas Policy Act in 1978 led to efficiency improvements, cost cuts and a period of low gas prices, but also to
a decline in underutilised delivery infrastructure available to
dampen volatility.
Gas price increases incentivise buyers to cut their gas purchases within the limits set by their flexibility to switch to
alternative fuels. Typically, power sector gas demand declines
as generators switch from gas to coal or oil-fired capacity,
while industrial gas demand declines as firms relying on gas
for process heat switch to oil products and firms using gas as
a process feedstock temporarily shut down facilities.
However, only a portion of gas users can easily and quickly
switch to alternative fuels, and this portion is shrinking, because of efficiency considerations and also since environmental and land use policies many places have prevented duel
fuel power generating units from being constructed.
Prolonged periods of high gas prices trigger more drilling
for gas. Traditionally in North America the rig count has
responded quickly to price signals, and production has in
turn responded quickly to changes in the rig count. The latter
relationship seemed not to apply between early 2002 and late
2006 when prices more than tripled and the number of gas
rigs increased from fewer than 600 to more than 1400, but
production trended downwards. However, growth in unconventional gas production has since early 2006 been strong
enough to deliver a recovery in total gas, and demonstrated
that the old relationship still holds at least for now.
The UK industry would be stimulated by prolonged high
prices to harvest the remaining gas accumulations probably
through step-outs and extensions of existing fields. Aggregate
additional production is not expected to be significant.
As for demand, prolonged periods of high gas prices reduce
power sector gas needs by encouraging investment in alternative (typically coal fired) capacity, industrial sector demand
by encouraging plant owners to re-locate to countries offering
cheaper gas, and residential and commercial sector demand
by triggering conservation measures such as improved building insulation, double glazing and more efficient heating
boilers.

Volatility associated with gas price declines

Gas price declines incentive producers to curtail drilling. When
drilling goes down, lost production from wells in decline is not
fully replaced and aggregate production starts going down. But
all this takes time, and when production eventually starts to
sag in response to lower prices, the response is initially very
gentle. This is because it pays to shut in wells only at extremely
low price levels.
In the UK some fields which are nearing the end of their lives
are typically reducing production in the summer months when
prices are soft in the expectation of using the saved gas at
the end of their field lives and in addition capturing a winters
price premium.
How supply responds to price changes depends also on how
storage inventories are managed. A price increase encourages
accelerated withdrawal of gas from storage, and vice versa.
Gas price declines incentivise buyers to increase their gas use,
again within the limits set by their flexibility to switch from
alternative fuels to gas. Typically, power generators bring unused
gas fired capacity on line at the expense of coal fired capacity.
Industrial gas demand is unlikely to change.
Prolonged periods of low gas prices would strengthen the case
for new investment in gas fired power generation, and slow
the relocation of gas intensive industry to other parts of the
world, but probably do not affect residential and commercial
sector demand noticeably since past conservation measures
reflected in, e.g., building standards for new premises would
hardly be reversed.
On the supply side, the intensity of gas drilling in the US and
Canadian gas drilling would decline from current levels and
rapidly depress production, the Alaska and MacKenzie Delta
projects would be further deferred, and UK fields would be
shut-in and abandoned on earlier timings.
In sum, there are rigidities in both gas supply and gas demand
that results in price volatility in competitive markets, and these
rigidities appear to have hardened.
An increase in gas demand due perhaps to a cold snap does not
trigger any appreciable production response. A decline in gas
supply due perhaps to a hurricane damaging critical pieces of
infrastructure does not trigger any appreciable demand response.
Prices rise to activate whatever fuel-switching capacity exists
in the power sector. If this additional cushion is insufficient
to restore balance, prices continue to rise to the point where
storage withdrawal reach extraordinary levels, or to the point
where demand is rationed i.e. industry shuts down plant and
all alternative power generation options to gas are exhausted.

June 2011 | International Gas Union 53

Volatility of oil indexed prices

Volatility and LNG

In Continental Europe and Asia gas prices are as noted

indexed to oil prices depend on imported gas to satisfy
significant portions of their needs. This gas typically travels
significant distances from the well-head to the city-gate.

LNG under traditional long term take-or-pay contracts is

no different from pipeline gas under similar contracts in its
capacity to aggravate or dampen price volatility. Thus a shift
in gas supply from long term pipeline gas to long term LNG
will not in itself matter to price volatility. However, a material shift inside the LNG portion of gas supply from long term
contracted to flexible LNG would imply further commoditization of gas and different volatility patterns across countries.

Importantly, the indices are not crude or product spot prices,

which are highly volatile, but rolling price averages typically
ironing out fluctuations over 6-9 month periods in European
pipeline contracts and 3-6 months in LNG contracts. This
averaging (and where applicable, upper and lower limits to the oil
price range where indexation applies) significantly dampen the
impact of the underlying oil commodity price volatility on gas
prices. The result is long wavelength oil price driven volatility
From the perspective of price volatility, the long-term oil indexed
contract market structure gives rise to the following dynamics:
Supply and demand in these markets are managed through
contract volume nominations and storage operations. The gas
price does not automatically respond to gas demand. The buyer
is implicitly paying the seller to maintain a surplus supply
capacity in excess of the base capacity the buyer under normal
circumstances will need. City gate prices reflect contract border
prices and in addition in-country transmission and storage
costs. The latter are spread across the year hence there is no
seasonal shape to city gate gas prices.
Chart 9.7 confirms that short wavelength price volatility does
not really feature in pure form oil-indexed markets. From the
perspective of, say, a large Continental European gas and power
utility company, price uncertainty under the loose heading of
volatility would largely be confined to the existence of contract
re-openers. Whether triggered by the buyer or the seller, reopeners can result in significant re-basing of the underlying
contract price.
Chart 9.7: Standard deviations of monthly observations of
sample of gas prices
2008
Gas-on-gas competition
Oil price escalation

North America, UK
u ro pe
ental E
Con tin
Continental Europe,
Developed Asia

Regulation cost of service

If Atlantic markets in general, and the US market in particular,

had been tighter than they were in 2008, the only buffering
mechanisms would have been North American producers
flexibility to boost supply, European buyers possibilities to
vary their nominations of long term pipeline gas in Europe,
and storage inventories above annual norms.
By making local supply curves less rigid the advent of flexible
LNG will likely dampen average price volatility. On the other
hand, the commoditization of gas that is taking place is also
attracting the interest of financial investors, and does as such
imply a risk of speculative booms and busts.

2020
Gas-on-gas competition
Oil price escalation

-O EC
t N on

Selec

Netback from final product

Regulation cost of service

Select Non-OECD

Regulation social and political

No price

Select market segments

Ch
ina

Netback from final product

Regulation below cost

To an extent this happened in 2008 when Asia prompted by

strong economic and energy demand growth, Japans problems
with its Kashiwazaki-Kariwa nuclear power complex and a
severe drop in Indonesian LNG supply played the price card
to attract numerous flexible cargos from the Atlantic basin. If
these diversions had not been possible, Asian prices would
have gone even higher while US prices would have been even
lower than they were.

Bilateral monopoly

Ru
ss
ia,

Bilateral monopoly

Flexible LNG is diverted according to price signals. Thus

some countries may be deprived of LNG they had counted on,
with the result that local or even national prices escalate. On
the other hand the recipient countries may receive LNG they
had not counted on with the result that the price increases that
triggered the diversions in the first place are arrested.

Select Non-OECD

Regulation social and political

Regulation below cost
No price

Source of price data: PIRA

54 International Gas Union | June 2011

10. Towards further changes in the extensiveness

of individual pricing mechanisms?
Neither the IEA nor the DOE/EIA anticipates much change
in gas pricing mechanisms at least not in their respective
reference scenarios.
The EIA derives its US price assumptions mainly from its
supply cost assumptions. The IEA expects that gas prices will
remain linked to oil prices through contracts or substitution.
The IEA further assumes that gas will continue to be priced
at a discount to oil. The imported gas/imported crude oil ratio
was by 2008 assumed to stabilise around 75% for the US and
Japan, and around two thirds for Europe (Chart 10.1)
Chart 10.1: Oil and gas price assumptions in WEO 2008
Oil and gas prices assumptions in the IEA's
WEO 2008
25,00

USD/MMBtu

20,00
15,00
10,00

Crude oil - IEA imports

Gas - US imports
Gas - Japan LNG imports
Gas - European imports

5,00
0,00
2007

2010

2015

2020

2025

2030

Source: IEA: World Energy Outlook 2008

The split of gas transactions by price formation mechanism

could however change significantly between now and 2020.
As noted there is little to indicate that the countries that have
adopted gas-to-gas competition based pricing mainly North
America and the UK will turn away from this mechanism.
On the contrary, the still fairly significant share of oil linked
contracts in the UK market will likely diminish with buyers
insisting on competitive pricing as opportunities to do so arise.
In Continental Europe and in big parts of Asia, various pricing
mechanisms co-exist with oil indexation playing a dominant
role. Opinions on the sustainability of this situation differ.
The original rationale for oil indexation has weakened. Gas
still competes with oil in industry but faces mostly other fuels
in the battles for residential, commercial and power sector
market share.

The possibility of oil linked gas falling out of favour with the
key power sector is particularly worrisome. Here gas needs to be
perceived as competitive with coal and in the future increasingly
with biomass, wind, solar, etc. The competition from coal is
blunted by differences in capital costs, lead times, taxation and
regulatory provisions. The competition from renewables other
than hydro is blunted by the still high costs of these options.
Extended oil driven gas price rallies could still erode gas
position as the preferred fuel.
Industrial buyers benefit from oil indexation when oil prices
are sufficiently low for sufficiently long to make oil linked
gas cheaper than spot gas. Sellers of course benefit from the
opposite situation. Oil market cycles in combination with price
renegotiation clauses in long term contracts may deliver a
balanced distribution of costs and benefits over time. Oil driven
gas price rallies like the one in 2007-08 that led to significant
industrial demand destruction are nevertheless bad for gas
image as a reliable and affordable fuel across cycles.
More gas-on-gas competition and more use of gas exchange
prices would to an extent decouple gas prices from oil prices. It
would however increase short term price volatility, and whether
it would eliminate the risk of longer term price rallies is an open
question. Basically that would depend on Continental Europes
and Developed Asias future gas supply-demand balances.
For the moment there is ample spare capacity in Europes
pipeline gas supply chains as well as in the worlds LNG supply
system. The financial crisis, the recession and the consequent
drop in gas demand nearly everywhere have forced gas suppliers
to significantly lower capacity utilisation. Sharp declines
in sales revenues and doubts about the timing and shape of
the anticipated recovery are however delaying vital up- and
midstream investments. The IEA and others are concerned that
the current global gas market downturn will only pave the way
for another rally.
Evidence from North America underlines the question mark at
the long term consequences for gas prices of switching from oil
escalation to gas-on-gas competition. Although gas prices are
not in any way linked to oil prices in US contracts, gas has over
the years across frequent, sometimes violent short-medium
term disturbances tended to track oil in a fairly stable long
term relationship. This is probably because gas and oil prices
besides being linked by interfuel competition in the industrial
sector are influenced in the same manner and to the same extent
by the oil and gas industrys cost cycles, and with deviations also
being arrested, eventually, by changes in oil and gas industry
investment priorities.

June 2011 | International Gas Union 55

Oil indexation will in any event not disappear any time soon,
for several reasons.

Gaining acceptance for alternative pricing models will likely

take longer in Asia than in Europe.

Continental European buyers have signed medium-long term

contracts 6 for an estimated 350-350 bcm of gas a year, and a very
high share of these contracts are of the standard oil linked type.
Annual commitments start declining only from around 2015.

Legislation to make these countries domestic gas markets

somewhat more competitive have been passed, and their recurrent
needs to purchase spot LNG will constantly bring them into
contact with the Henry Hub or NBP price levels. However,
there seemed by mid 2009 to be few champions in the region
for dramatic reforms.

By 2008 existing medium-long term contracts corresponded to

more than 80% of Continental European gas consumption (with
the rest being short term purchases). Going forward, this share
will of course decline (Chart 10.2). If gas demand increases
by 2,4% a year, in line with average annual growth between
1987 and 2007, already contracted supply will meet around
two thirds of Continental European gas demand by 2015 and
less than a quarter of demand by 2025. Moreover, the take or
pay provisions in most contracts give customers the option to
offtake somewhat less than 100% of annual contracted volumes.
Chart 10.2: Continental Europes contracted gas supply, mid 2008
Continental Europe's contracted gas
supply, mid 2008
400

Chart 10.3: Japans, South Koreas and Taiwans contracted

gas supply

350
300

bcm

Moreover, Japan, South Korea and Taiwan have just as Continental

Europe entered into a large number of oil linked medium-long
term gas import contracts that constitute a limit to the possible
pace of introducing alternative pricing principles (Chart 10.3).
The ratio of contracted supply to total demand was in 2007
when spot purchases reached unprecedented highs around
80%. If gas demand increases by 6% a year the share will fall to
around 50% by 2015 and less than 10% by 2025. A 6% annual
growth would be in line with the average for 1987-2007 but no
one expects these comparatively mature markets to continue to
expand this fast. A perhaps more realistic 3% a year demand
growth assumption gives ratios of already contracted supply to
future demand much in line with those of Continental Europe.

250

Japan's, South Korea's and Taiwan's

contracted gas supply, mid 2008

200
150
100

140

50

120

Source: Wood Mackenzie

100

bcm

2025

2024

2023

2022

2021

2020

2019

2018

2017

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

80
60
40

This is not to say that there is a desire among gas sellers and
buyers to get rid of the oil link overnight even if they could.
As noted, the incumbents on both sides of the table seem for
the moment to be broadly in favour of retaining oil indexation.
The EU Commission will likely continue to push for gas-on-gas
competition based pricing, but it cannot push very hard in the
absence of trading places offering reliable price information
and the full range of trading facilities and services. Continental
Europes gas hubs will take on these characteristics and functions
but that will take time.
Japanese, South Korean and Taiwanese gas importers have on
balance been even more hesitant than their Continental European
counterparts to switch from oil indexed import prices and cost
plus based domestic prices to more competitive arrangements.
6

20

2025

2024

2023

2022

2021

2020

2019

2018

2017

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

Still, the existing body of oil linked contracts considerably

reduces the maximum pace at which a shift towards, e.g., gas
indexation could proceed.

Source: Wood Mackenzie

China and India are in the midst of painful adjustments to world

level gas prices. These adjustments are driven by a need for
imported gas that is unlikely to peak any time soon, in spite of
gas discoveries that will allow significant growth in indigenous
production in both countries. They proceed, broadly speaking, by
introducing competitive pricing for the customers able to cope
with steep gas cost increases while retaining price regulation
for everybody else, but in a differentiated manner, and with the
aim of gradually increasing prices across the board. In other
words, they are on their way from domestic pricing systems
dominated by below cost regulation, to alternatives characterised
by a mixture of below cost regulation, some sort of cost based
regulation and gas-to-gas competition based pricing, with the
split of sales gradually shifting from the first to the second and
third pricing principle.

Including deals at HoA or MoU level as well as firm sales and purchase contracts

56 International Gas Union | June 2011

Russia appears to be on a broadly parallel course although from

a different starting point as the worlds biggest gas producer
and exporter. Russias traditionally uneconomic domestic gas
prices that have over-stimulated domestic gas use and limited
Gazproms and other companies ability to invest in new fields
and supply infrastructure, are as noted to be partly replaced by
opportunity cost based prices over a period of 4-5 years.
To the extent European border prices the starting point for
netback calculations remain oil linked, Russian wholesale
prices will come to reflect oil prices too. This could transfer
the problems of oil linked pricing into a Russian market
poorly prepared to deal with them, possibly leading to delays,
exemptions and special arrangements that would reduce the
transparency of the process.
A fair number of Non-OECD countries in particular those
in the Middle East and North Africa that benefit from high oil
prices will likely seek to continue subsidising domestic gas
prices. Cheap electricity, gas and motor fuels are widely seen
as obligatory government deliverables in these parts of the
world, and also indispensable to the global competitiveness of
the regions petrochemical industry. In periods with high oil
export revenues there has historically been limited interest in

challenging these perceptions. Now, with oil export revenues

considerably down on their 2007-08 levels, concerns about the
budgetary consequences of subsidisation are likely resurfacing.
At the same time, with many North African and Middle Eastern
countries beginning to feel the pinch of stagnant indigenous
gas supply, intraregional gas exports and imports look set to
increase, and this trade will not be at subsidised prices. Qatar
aims for the same netback from its LNG sales to Kuwait and
Dubai as from its other LNG sales, and if Doha decides to
contract additional pipeline gas to the UAE or Oman it will be
at international market prices. This will increase subsidisation
burdens in the importing countries and could eventually pave
the way for domestic price adjustments.
Chart 10.4 is an attempt to summarise these hypotheses.
Chart 10.4: Hypotheses on future changes in the extensiveness
of individual pricing mechanisms in individual regions
2008
Gas-on-gas competition
Oil price escalation

North America, UK

ro pe
enta l Eu
Con tin
Continental Europe,
Developed Asia

Bilateral monopoly
Netback from final product
Regulation cost of service
Regulation social and political
Regulation below cost

June 2011 | International Gas Union 57

No price

2020
Gas-on-gas competition
Oil price escalation
Bilateral monopoly

Select market segments

Ru
ss
ia
,C
hi
na
?

More countries than China and India possibly the majority

of countries in Asia and Latin America, apart from the richest
ones, and the gas importing FSU republics are struggling to
accomplish similar transitions. The timelines for getting there
vary across countries and as rulers come and go. As noted, price
reform is risky business. Factors such as the pace of economic
growth, inflation and the popularity and leeway of the incumbent
government need to be constantly considered.

Select Non-OECD

Select

EC
N on-O

Select Non-OECD

Netback from final product

Regulation cost of service
Regulation social and political
Regulation below cost
No price

Appendix 1
Price Formation Mechanisms 2005 Survey

Format of Results

World Results

In looking at price formation mechanisms, the results have

generally been analysed from the perspective of the consuming
country. Within each country gas consumption can come from
one of three sources, ignoring withdrawals from (and injections
into) storage domestic production, imported by pipeline
and imported by LNG. In many instances, as will be shown
below, domestic production, which is not exported, is priced
differently from gas available for export and also from imported
gas whether by pipeline or LNG. Information was collected for
these 3 categories separately for each country and, in addition,
pipeline and LNG imports were aggregated to give total imports
and adding total imports to domestic production gives total
consumption. For each country, therefore, price formation could
be considered in 5 different categories:

World Consumption and Production

Domestic Production (consumed within the country, i.e. not

exported)
Pipeline Imports
LNG Imports
Total Imports (Pipeline plus LNG)
Total Consumption (Domestic Production plus Total Imports)
Each country was then considered to be part of one of the IGU
regions, as described in the Introduction, and the 5 categories
reviewed for each region. Finally the IGU regions were aggregated
to give the results for the World as a whole for 2005.
In terms of the presentation of results, the World results will be
considered first, followed by the Regional results for the separate
regions North America, Latin America, Europe, Former Soviet
Union, Middle East, Africa, Asia and Asia Pacific.
As well as collecting information on price formation mechanisms
by country, information was also collected on wholesale price
levels in each country in 2005. These results on a country and
regional basis are also presented together with an analysis of
price trends.

Before considering the results on price formation mechanisms for

2005, it is useful to consider the regional pattern of consumption
and production. In 2005 total world consumption and production
was of the order of 2,800 bcm. Chart A?? below shows the
distribution of world consumption.
Chart A1: World gas consumption 2005
World gas consumption 2005
2,790 bcm
Asia
5%
Africa
3%

Asia Pacific
10 %
North America
27 %

Middle East
10 %

Former Soviet
Union
21 %

Latin America
5%
Europe
19 %

North America and the Former Soviet Union, followed by

Europe are the main consuming regions, and it is these regions,
therefore, which will have the greatest influence on the results
on price formation mechanisms at the World level. The Middle
East and Asia Pacific will also have an important, but smaller,
influence.
The Chart on the next page shows World Production by region.
The largest consuming region North America was largely
self-sufficient in 2005. The Former Soviet Union was a net
exporter, principally to Europe, which was a net importer. Asia
Pacific was a net importer, principally from the Middle East,
while Africa was a net exporter, mainly to Europe. Asia and
Latin America were largely self-sufficient.

58 International Gas Union | June 2011

Chart A2: World gas production 2005

Chart A4: Pipeline exports 2005

World gas production 2005

Pipeline exports 2005

2,785 bcm

Asia
Africa 5 %
6%

Asia Pacific
8%

663 bcm

North America
26 %

Middle East
0,9 %

Africa
6,7 %

Asia
1,8 %

Asia Pacific
1,0 %
North America
18,8 %
Latin America
2,6 %

Middle East
11 %

Latin America
5%
Europe
11 %

Former Soviet
Union
28 %

With respect to imports by pipeline (both intra- and interregional), Europe accounts for more than half of the world total.
Both European intra-regional gas imports (Norway to various
countries) and Europes imports of gas from outside Europe
(Russia and Algeria) are very significant. In the other regions,
pipeline imports are all intra-regional.

Former Soviet
Union
44,8 %

Europe
23,4 %

Chart A5: LNG imports 2005

LNG imports 2005
190 bcm
North America
9,5 %

Chart A3: Pipeline imports 2005

Latin America
0,5 %
Europe
25,2 %

World gas production 2005

Asia Pacific
61,6 %

2,785 bcm

Asia
3,2 %
Asia
Africa 5 %
6%

Middle East
11 %

Asia Pacific
8%

North America
26 %

Latin America
5%
Former Soviet
Union
28 %

Europe
11 %

With respect to gas exports via pipeline, the Former Soviet Union
in 2005 accounted for some 44% of the world total. Africa,
meaning in this case Algeria, is also a significant exporter to
Europe, while any trade in the Asian and American regions is
intra-regional.

June 2011 | International Gas Union 59

LNG imports are dominated by Asia Pacific principally

Japan, Korea, and Taiwan, with Europe being the second largest
importing region. When compared with the LNG Exports chart,
much of the Asia Pacific trade is intra-regional, but the region
also imports significant quantities from the Middle East, while
Africa and Latin America (Trinidad) are key exporters to Europe
and North America.
Chart A6: LNG exports 2005

Price Formation: Pipeline Imports

Chart A8: World price formation 2005 pipeline imports
World price formation 2005: Pipeline imports
660 bcm

Bilateral monopoly
22,7 %

LNG exports 2005

190 bcm

North America
1,0 %

Oil price escalation

54,8 %

Gas-on-gas
competition
22,4 %

Latin America
7,4 %
Middle East
23,0 %

Asia Pacific
44,5 %

Pipeline imports at 660 bcm account for some 22% of total world
consumption. Three categories account for internationally
traded pipeline gas OPE almost all in Europe; GOG in North
America with small amount in Europe into UK and BIM almost
all intra-Former Soviet Union trade.

Africa
24,1 %

Price Formation: Domestic Production

Price Formation: LNG Imports

Chart A7: World price formation 2005 indigenous production

Chart A9: World price formation 2005 LNG imports

World price formation 2005:

Indigenous production

World price formation 2005: LNG imports

190 bcm

1,940 bcm
No price
1,7 %
Regulation below
cost
33,6 %

Not known
0,4 %

Gas-on-gas
competition
13,4 %

Oil price escalation

4,4 %

Bilateral monopoly
3,7 %

Gas-on-gas
competition
36,3 %

Regulation
social/political
15,6 %

Regulation cost of
service
3,6 %

Netback
0,7 %

Bilateral monopoly
3,7 %

Domestic production, consumed in own country, accounted

for just under 2,000 bcm in 2005, around 70% of total world
consumption. The two largest price formation categories were
GOG accounting for some 35% mainly in North America, UK
in Europe and Australia in Asia Pacific and RBC accounting
for 34%, largely the Former Soviet Union and Middle East with
some in Africa. RSP at 16% is spread through all regions apart
from North America. RCS, at 4%, is principally in Africa and
Asia, while BIM, at 5%, is mainly the Former Soviet Union
and Asia Pacific. There is a small amount of OPE in Europe
and Asia.

Oil price escalation

83,0 %

LNG imports at 190 bcm account for some 6% of total world

consumption. Internationally-traded LNG is largely dominated
by OPE into Europe and Asia Pacific. GOG is mainly North
America with some spot LNG cargoes into Asia Pacific, while
BIM is in Asia reflecting the LNG cargoes to India.

60 International Gas Union | June 2011

Regional Results

Price Formation: Total Imports

Chart A10: World price formation 2005 total imports
World price formation 2005: Total imports
850 bcm

Bilateral monopoly
18,5 %

In presenting the World results all 5 identified categories

Domestic Production, Pipeline Imports, LNG Imports, Total
Imports and Total Consumption were reviewed and analysed.
At the regional level not all the categories will be relevant, for
example, there may be little or no LNG imports into a region.
The data and charts presented for each region, therefore, will
differ depending on the relevance of each consumption category.
North America

Gas-on-gas
competition
20,4 %

Oil price escalation

61,1 %

In terms of an IGU region, North America consists of only 3

countries Canada, USA and Mexico but it is the largest
consuming region.
Table A1: North America consumption and production 2005
(BCM)

Total imports at 850 bcm account for some 30% of total world
consumption. 60% is OPE with Europe (pipeline mainly) and
Asia Pacific (LNG) dominating. GOG is both pipeline and
LNG imports, with BIM largely intra-Former Soviet Union
pipeline trade.
Price Formation: Total Consumption
Chart A11: World price formation 2005 total consumption
World price formation 2005: Total
consumption
2,790 bcm
Regulation below
cost
23,3 %

No price
1,2 %

Not known
0,3 %

Consumption

Production

629.8
91.4
47.6
768.8

511.8
185.9
39.2
736.9

Imports
Pipeline
LNG
104.2
17.9
10.1
10.1
124.5
17.9

Exports
Pipeline
LNG
20.3
1.8
104.2
0.0
124.5
1.8

Consumption is dominated by the USA, which is also by far

the regions largest producer. All pipeline trade is intra-regional
with the USA importing from Canada, but also exports to both
Canada and Mexico. USA LNG exports are from Alaska to
Japan, while LNG imports are principally from Trinidad but
also small amounts from the Middle East and Africa.
Chart A12: North America price formation 2005 total
consumption
North America price formation 2005: Total
consumption
770 bcm

Regulation
social/political
10,9 %
Regulation cost of
service
2,5 %

Oil price escalation

21,7 %

Country
USA
Canada
Mexico
Total North America

Gas-on-gas
competition
31,4 %
Netback
0,5 %

No price
1,2 %

Bilateral monopoly
8,2 %

The respective shares of total world consumption for each price

formation mechanism reflect largely the dominance of domestic
production consumed in own country. OPE becomes more
important because of its dominance in gas traded across borders.
Just over 50% of total consumption is either OPE or GOG,
while over 1/3rd is subject to some form of regulatory control
including RBC, where it could be said gas is effectively
subsidised. Regulation of wholesale prices occurs in all regions
apart from North America.
The small amount of NET pricing is in Latin America (Trinidad
to methanol plants) while NP (gas effectively given away) is
principally in the Former Soviet Union (Turkmenistan) and North
America (in Mexico, where Pemex refineries and petrochemical
plants use gas as a free feedstock).

Gas-on-gas
competition
98,8 %

The gas market in the USA is completely deregulated and all

prices are effectively set by gas-on-gas competition. Imports,
whether by pipeline or LNG are effectively price-takers. The
market in Canada is linked to the USA markets and the price
formation mechanism is the same. Mexico imports gas from
the US at US prices. For domestically produced gas, a reference
price is set, which is based on the US price at the US-Mexico
border, plus the cost of transportation to the Los Ramones hub.
From the Los Ramones hub further south the reference price
gets reduced based on transportation costs. However, some 10
bcm of gas is estimated to be used by Pemex for its own internal

June 2011 | International Gas Union 61

consumption, related to feedstock for petrochemical plants,

fuel for equipment in refineries and plants and for secondary
oil recovery. This gas is not priced and has been allocated to
the No Price category.
Latin America

Country

Consumption

Production

40.4
2.1
19.9
8.5
6.8
0.3
0.3
1.5
0.7
16.3
0.1
28.9
125.7

45.6
12.4
11.4
2.0
6.8

Imports
Pipeline
LNG
1.7
8.8
6.5
0.3

0.3
1.6
30.3
28.9
139.2

Exports
Pipeline
LNG
6.8
10.4

0.7

14.0

0.1
17.2

0.9

17.2

14.0

Latin American gas is largely produced and consumed within

each individual country with Venezuela, Colombia and Peru
being completely domestic markets. All pipeline trade is intraregional with Argentina importing from Bolivia but also exporting
to Chile. Bolivia also exports gas to Brazil. Even then almost
all of Argentinas consumption is domestically produced and
over half of Brazils.
Chart A13: Latin America price formation 2005 total
consumption
Latin America price formation 2005: Total
consumption
125 bcm
Regulation below
cost
2,5 %

Oil price escalation

14,8 %
Gas-on-gas
competition
1,6 %
Bilateral monopoly
6,7 %

Regulation
social/political
59,5 %

Table A3: Europe consumption and production 2005 (BCM)

Country

Table A2: Latin America consumption and production 2005

(BCM)

Argentina
Bolivia
Brazil
Chile
Colombia
Dominican Republic
Ecuador
Peru
Puerto Rico
Trinidad
Uruguay
Venezuela
Total Latin America

Europe

Netback
9,5 %
Regulation cost of
service
5,4 %

Latin America consumption at 125 bcm accounts for less than

5% of total world consumption. The traded pipeline gas to Brazil
and Chile mainly account for most of the OPE. Wholesale prices
in the 2 largest consuming countries, Argentina and Venuezela,
are largely determined by regulatory and/or government control
(RSP). Some large customers in Argentina are free to negotiate
directly with suppliers (BIM), as are power generators in Trinidad.
NET is in Trinidad where gas is provided to Methanol plants.
There is a small amount of GOG in Chile.

Austria
Belgium & Luxembourg
Bosnia-Herzegovina
Bulgaria
Croatia
Czech Republic
Denmark
Estonia
Finland
France
Germany
Greece
Hungary
Ireland
Italy
Latvia
Lithuania
Netherlands
Norway
Poland
Portugal
Romania
Serbia & Montenegro
Slovakia
Slovenia
Spain
Sweden
Switzerland
Turkey
United Kingdom
Total Europe

Consumption

Production

10.0
16.6
0.4
3.0
2.7
8.5
5.0
1.5
4.0
45.8
86.2
2.8
13.2
3.9
78.7
1.8
3.3
39.5
4.5
13.6
4.2
17.3
2.2
6.6
1.1
32.4
0.8
3.1
26.9
95.1
534.6

1.6

1.5
0.2
10.4
1.2
15.8
3.0
0.6
12.1
62.9
85.0
4.3
12.1
0.3
0.2
0.2
0.9
87.5
299.7

Imports
Pipeline
LNG
8.7
18.0
3.0
0.4
2.9
1.2
9.5
0.7
4.2
36.2
90.7
2.3
10.8
3.1
71.0
1.2
2.9
23.0
10.2
2.6
6.3
1.9
6.4
1.1
11.6
1.0
2.8
22.2
14.7
367.4

12.8
0.5

Exports
Pipeline
LNG
4.4

5.3

9.8

2.5
46.8
79.5
1.6

21.9
4.9
0.5
47.6

9.7
155.4

0.0

Europe is highly dependent on imported gas both by pipeline

and LNG. Of the largest consumers, only the UK produced
almost all of its gas requirements, and this situation is rapidly
changing. Norway and the Netherlands provided a significant
proportion of the rest of Europes pipeline supplies, but Europe
remained heavily dependent on Russian and Algerian pipeline
supplies. The major importers of LNG were Spain and France with
Algeria being the principal supplier, but significant quantities of
LNG were also sourced from West Africa and the Middle East.
Out of the total European consumption in 2005 of 535 bcm,
only 124 bcm (23%) was produced and consumed within the
country and 2/3rds of this was in the UK market. The chart
below shows the price formation mechanisms for this domestic
production with GOG at 46% and OPE at 36% dominating.
This was largely the UK, where some of the older contracts
still retain key elements of competing fuel indexation, but also
domestic production in the Netherlands and Italy is largely on an
OPE basis. Wholesale prices for domestic production remained
regulated on a RSP basis in Poland and Romania. There were
small elements of NET in Norway and BIM in Denmark.

62 International Gas Union | June 2011

Chart A14: Europe price formation 2005 indigenous production

Europe price formation 2005: Indigenous
production

In total, at 540 bcm, Europe accounts for around 20% of world

consumption. The dependence in imports, most of which are
priced on an OPE basis, is illustrated in the chart above, with
OPE at 79%. GOG is largely the UK market.

124 bcm
Regulation cost of
service
1,2 %

Regulation
social/political
11,6 %

Netback
0,6 %

Former Soviet Union

No price
2,8 %
Oil price escalation
34,7 %

Bilateral monopoly
2,0 %

Table A4: FSU consumption and production 2005 (BCM)

Country

Gas-on-gas
competition
47,0 %

Chart A15: Europe price formation 2005 total imports

Europe price formation 2005: Total imports
415 bcm
Gas-on-gas
competition
6,0 %

Bilateral monopoly
1,5 %

Consumption

Production

1.7
8.9
18.9
1.5
19.6
0.7
2.5
405.1
1.4
16.6
72.9
44.0
593.8

5.3
0.3
0.2
23.3
0.0
0.1
598.0
0.0
58.8
19.4
55.0
760.5

Armenia
Azerbaijan
Belarus
Georgia
Kazakhstan
Kyrgyzstan
Moldova
Russian Federation
Tajikistan
Turkmenistan
Ukraine
Uzbekistan
Total FSU

Imports
Pipeline
LNG
1.7
4.5
20.1
1.5
11.6
0.7
2.5
25.6
1.4
0.0
55.3
0.0
124.8
0.0

Exports
Pipeline
LNG

7.6
229.0
45.2
2.5
12.4
296.7

0.0

The Former Soviet Union region is dominated by Russia, both

as the largest consumer and producer of gas. All the imported
gas within the region is intra-FSU trade i.e. no imports come
from outside the region. Russia exports gas to almost all its
neighbouring countries but Kazakhstan, Turkmenistan and
Uzbekistan are also exporters, including to Russia. Ukraine is
the major importer of gas.
Chart A17: FSU price formation 2005 total consumption

Oil price escalation

92,4 %

FSU price formation 2005: Total consumption

595 bcm

The situation for total imports (both pipeline and LNG, comprising
415 bcm or 78% of total consumption) is markedly different,
with OPE dominating at 92%. The small amount of GOG (6%)
is predominantly the UK, plus Ireland and a small amount in
the Netherlands. The BIM category (2%) is accounted for by
imports into the Baltic States (Estonia, Latvia and Lithuania)
from Russia.

No price
2,8 %

Regulation below
cost
65,1 %

Bilateral monopoly
29,1 %

Regulation
social/political
3,0 %

Chart A16: Europe price formation 2005 total consumption

Europe price formation 2005: Total
consumption
540 bcm
Netback
0,1 %
Bilateral monopoly
1,6 %
Gas-on-gas
competition
15,5 %

Regulation cost Regulation

of service
social/political
0,3 %
2,7 %
No price
0,6 %

At 595 bcm the Former Soviet Union accounts for just over
20% of world consumption. All imported gas is priced on a
BIM basis, together with some Russia domestic production
sold to large users. The dominant price formation mechanism,
however, is RBC in Russia, Uzbekistan and Kazakhstan. Since
2005, however, this situation in Russia, at least, is likely to have
changed with increased prices to domestic consumers raising
levels above the average cost of production and transportation.
Domestic production in Ukraine is the RSP category and NP
in Turkmenistan.

Oil price escalation

79,1 %

June 2011 | International Gas Union 63

Chart A19: Africa price formation 2005 total consumption

Middle East
Table A5: Middle East consumption and production 2005 (BCM)
Country
Bahrain
Iran
Iraq
Israel
Jordan
Kuwait
Oman
Qatar
Saudi Arabia
Syria
United Arab Emirates
Total Middle East

Consumption

Production

10.7
102.4
2.5
0.7
1.6
12.3
9.2
18.7
71.2
6.1
41.3
276.6

10.7
100.9
2.5
0.7
0.3
12.3
19.8
45.8
71.2
5.4
47.0
316.6

Imports
Pipeline
LNG
5.8

No price
1,1 %

1.3
1.4

1.4
8.5

0.0

5.7

275 bcm

In terms of consumption, Africa is the smallest region at 75

bcm, or 2.5% of total world consumption. Wholesale prices
are highly regulated, with RBC accounting for just under half,
in Egypt and Nigeria. RCS is predominantly Algeria and RSP
in Libya and South Africa. The OPE category reflects the only
traded gas with Tunisia importing from Algeria.
Asia

Regulation
social/political
14,8 %

Table A7: Asia consumption and production 2005 (BCM)

Afghanistan
Bangladesh
China
China Hong Kong
India
Myanmar
Pakistan
Total Asia

Regulation below
cost
80,4 %

Middle East consumption at 275 bcm accounts for almost 10%

of total world consumption. The dominant price formation
mechanism in the region is RBC in largely Iran, Saudi Arabia,
Kuwait and Qatar. The RSP category is accounted for by the
UAE, where price is regulated by each emirate. The BIM
category relates to Iranian imports from Turkmenistan and the
trade from Oman to the UAE.
Africa

Consumption

Production

0.2
14.2
45.7
3.1
38.1
4.1
29.3
134.7

0.2
14.2
50.0
32.1
13.0
29.3
138.8

Imports
Pipeline
LNG

3.1

3.1

Exports
Pipeline
LNG
3.1

6.0

8.9

6.0

12.0

0.0

Again there is not a large amount of traded gas within this

region China Hong Kong imports from China, while India
imports LNG, principally from Qatar. China, India and Pakistan
are the largest consumers. China and India are expected to
increase gas consumption significantly from both indigenous
resources and imports.
Chart A20: Asia price formation 2005 total consumption
Asia price formation 2005: Total consumption
135 bcm

Table A6: Africa consumption and production 2005 (BCM)

Algeria
Angola
Egypt
Equatorial Guinea
Ivory Coast
Libya
Nigeria
South Africa
Tunisia
Total Africa

Regulation cost of
service
32,6 %

Regulation
social/political
11,2 %

Country

Country

Netback
1,2 %

Regulation below
cost
48,2 %

7.1
43.5

Middle East price formation 2005: Total

consumption
Bilateral monopoly
2,6 %

Oil price escalation

5,7 %

9.2
27.1

Chart A18: Middle East price formation 2005 total consumption

No price
1,3 %

75 bcm

4.3

The Middle East region is largely an insulated market in terms

of gas consumption with very little gas being traded (excluding
exports) across borders. Small quantities of gas are imported
by Iran from Turkmenistan and Jordan from Egypt.

Not known
0,9 %

Africa price formation 2005: Total

consumption

Exports
Pipeline
LNG

Consumption

Production

23.2
0.8
25.8
1.3
1.3
5.8
10.4
2.2
4.3
75.1

88.2
0.8
34.6
1.3
1.3
11.3
22.4
2.2
2.5
164.6

Imports
Pipeline
LNG

1.8
1.8

0.0

Regulation below
cost
3,0 %

Exports
Pipeline
LNG
39.1
25.7
1.1

6.9

4.5

0.9
12.0

44.7

45.5

Oil price escalation

10,5 %
Bilateral monopoly
6,8 %

Regulation
social/political
57,9 %

Excluding its export trade, Africa has virtually not traded gas,
with only Tunisia importing some gas from Algeria via the
pipeline to Italy.

64 International Gas Union | June 2011

Regulation cost of
service
21,8 %

Asia accounts for less than 5% of world consumption at 135

bcm. Regulation of wholesale prices is widespread. RSP at 57%
is predominantly China and India, RCS in Pakistan and RBC in
Myanmar. OPE at 11% is all in Bangladesh. The BIM category
is Indian LNG imports and Hong Kong imports from China.

Wholesale Prices

Asia Pacific

As well as collecting data on price formation mechanisms the

IGU study also collected information on wholesale price levels
in 2005. As noted elsewhere, the results here should be treated
as broad orders of magnitude, since the definition of wholesale
prices is quite wide. It is typically a hub price or a border price
in the case of internationally traded gas, but could also easily
be a wellhead or city-gate price.

Table A8: Asia Pacific consumption and production 2005 (BCM)

Chart A22: Wholesale prices by region 2005

Country

Consumption

Production

26.8
2.4
37.5
79.0
39.3
3.5
3.0
6.6
33.7
10.7
29.9
6.9
279.3

40.3
11.5
73.8
5.1
59.9
3.8
2.9

Australia
Brunei
Indonesia
Japan
Malaysia
New Zealand
Philippines
Singapore
South Korea
Taiwan
Thailand
Vietnam
Total Asia Pacific

0.5
0.8
23.7
6.9
229.2

Imports
Pipeline
LNG

76.3

6.6
8.9
15.5

Exports
Pipeline
LNG
14.9
9.2
4.8
31.5
1.8

28.5

World: Average wholesale prices 2005

North America
Europe
Asia Pacific
Total World

30.5
9.6

Asia
Africa

116.4

6.6

84.0

Latin America
Former Soviet Union

After Europe, Asia Pacific is the region most heavily dependent

on internationally traded gas, principally LNG into Japan,
Korea and Taiwan, although much of the LNG comes from
within the region together with imports from the Middle East.
A distinguishing feature of Japan, Korea and Taiwan is that
they are virtually totally dependent on LNG imports for all
their gas consumption, leading to what some might argue are
the premium prices paid for the gas. The pipeline imports are
into Singapore from Indonesia and Malaysia and Thailand
from Myanmar.
Chart A21: Asia Pacific price formation 2005 total consumption
Asia Pacific price formation 2005: Total
consumption
280 bcm
Not known
2,0 %

Regulation
social/political
24,8 %

Oil price
escalation
50,4 %

Regulation cost of
service
2,9 %
Bilateral monopoly
8,1 %

Gas-on-gas
competition
11,8 %

Middle East
$0,00

$1,00

$2,00

$3,00

$4,00

$5,00

$6,00

$7,00

$8,00

$9,00

$/MMBTU

The chart above shows a snapshot of price levels for 2005.

Wholesale prices have changed since 2005, as discussed elsewhere.
Generally the highest wholesale prices are in regions where, it
could be said that, there is more economic pricing GOG and
OPE in North America, Europe and Asia Pacific. The lowest
wholesale prices are generally where regulation dominates in
the Middle East and Former Soviet Union, particularly RBC.
These conclusions are illustrated more clearly in the chart
below which considers wholesale prices at the individual
country level, at least for those countries with more than 10 bcm
annual consumption. Only Bahrain, UAE and Turkmenistan are
missing with over 10 bcm consumption. The highest wholesale
prices in 2005 were found in North America (USA, Canada
and Mexico). The LNG dependent countries of Japan, Korea
and Taiwan also had relatively high wholesale prices. These
were followed by a whole host of European countries headed
by UK and France. At the bottom of the chart were generally
countries where wholesale prices were subject to some form
of regulation, typically RBC Iran, Nigeria, Saudi Arabia,
Russia and Egypt.

At 280 bcm, Asia Pacific accounts for 10% of total world

consumption. Some 50% of gas is imported by countries. OPE
at 50% is the largest category and comprises LNG imports
into Japan, Korea and Taiwan, pipeline into Singapore and
domestically produced gas in Thailand. GOG is Australia and
spot LNG trade. BIM is mainly imports into Thailand and some
domestic production in Indonesia and New Zealand. RSP is the
majority of wholesale gas in Indonesia and Malaysia. RCS is
Vietnam.

June 2011 | International Gas Union 65

Chart A23: Wholesale prices by country 2005

Chart A25: World price formation 2005 total consumption

World price formation 2005: Total
consumption

Average wholesale prices 2005

USA
Taiwan
Mexico
Canada
South Korea
France
United Kingdom
Japan
Netherlands
Belgium & Luxembourg
Hungary
Austria
Poland
Turkey
Germany
Italy
Spain
Thailand
Indonesia
Romania
Brazil
Bangladesh
Australia
Pakistan
China
Algeria
India
Malaysia
Trinidad
Ukraine
Belarus
Russian Federation
Egypt
Kuwait
Kazakhstan
Venezuela
Argentina
Qatar
Saudi Arabia
Uzbekistan
Nigeria
Iran

2,790 bcm
Regulation below
cost
23,3 %

World Average

$1,00

$2,00

$3,00

$4,00

$5,00

$6,00

$7,00

$8,00

Regulation cost of
service
2,5 %

$9,00 $10,00

$/MMBTU

Chart A24: Wholesale prices by price formation mechanism 2005

Wholesale prices by price formation
mechanism 2005

North America
Latin America
Europe
Former Soviet Union
Middle East
Africa
Asia
Asia Pacific
Total World

Bilateral monopoly
8,2 %

OPE
0.0
18.7
426.6
0.0
0.0
4.3
14.2
140.8
604.6
22%

GOG
759.4
2.0
83.4
0.0
0.0
0.0
0.0
33.0
877.9
31%

Total Consumption
BIM NET RCS RSP RBC NP
0.0
0.0
0.0
0.0
0.0
9.4
8.4 11.9 6.8 74.8 3.1
0.0
8.7
0.7
1.7 14.4 0.0
3.5
172.9 0.0
0.0 17.6 386.6 16.6
7.2
0.0
0.0 40.6 221.5 3.6
0.0
0.9 24.5 8.4 36.2 0.8
9.1
0.0 29.3 78.0 4.1
0.0
22.6 0.0
8.0 69.3 0.0
0.0
228.9 13.5 70.3 303.2 651.4 33.8
8%
0%
3% 11% 23% 1%

NK
0.0
0.0
0.0
0.0
2.5
0.0
0.0
5.6
8.1
0%

TOT
768.8
125.7
539.1
593.7
275.3
75.1
134.7
279.3
2,791.7
100%

T
TO

t
be

lo
w

co
s

lit
ic
al

Netback
0,5 %

eg
ul
at

io
n

so
c

Gas-on-gas
competition
31,4 %

The chart above illustrates the overall results at the world level,
while the table looks at the breakdown by region.

eg
ul
at

io
n

co
s
io
n
eg
ul
at

ia
l/p
o

er
vi
ce

ck

to
fs

et
ba
N

op
ol
y

Bi
la

te
ra
l

m
on

tit
io
n

as
-o

nga

co
m
pe

es
ca

la
tio
n

$/MMBTU

il
pr
ic
O

Oil price escalation

21,7 %

Table A9: World price formation 2005 total consumption (BCM)

Region

$9,00
$8,00
$7,00
$6,00
$5,00
$4,00
$3,00
$2,00
$1,00
$0,00

Not known
0,3 %

Regulation
social/political
10,9 %

Countries over 10 bcm

Annual Consumption

$0,00

No price
1,2 %

An alternative way of analysing the data is to categorise by price

formation mechanism. The highest wholesale prices are GOG
followed by OPE. At the bottom end, as might be expected,
wholesale prices determined by RBC are less then RSP which,
in turn, are less then RCS. The low level of wholesale prices
for NET are presumably affected by low commodity prices for
the final products almost all Trinidad and some in Norway.
The result for BIM is largely impacted by the low levels of
wholesale prices in intra-Former Soviet Union trade.

Conclusions
In 2005 just over 70% of the worlds consumption of gas
comprised of domestic production consumed within that country,
with no trade across international borders. Some 22% was
traded through pipelines and some 6% LNG. The wholesale
price formation mechanisms are largely very different for
internationally traded gas compared to gas which is produced
purely for domestic consumption.

The largest price formation category is GOG at 31%, but

this is due to the impact of the North American market,
which is predominantly domestic gas production, plus
smaller quantities in the UK and, in Asia Pacific, Australia
and spot LNG cargoes;
The OPE category at 22%, is generally only found in
internationally traded gas, which is mainly pipeline and
LNG in Europe and LNG in Asia Pacific;
Together the GOG and OPE categories, which could be said
to reflect an economic or market value of gas, account
for just over 50% of total world consumption;
Wholesale price regulation, which covers 3 categories
RCS, RSP and RBC, accounts for 37% of total world
consumption, but is only found in domestic gas production
and not internationally traded gas. The RBC category in
2005 was the largest, as a consequence of the low levels
of prices in the Former Soviet Union, mainly Russia, and
the Middle East. While wholesale prices in Russia have
remained regulated there have been price increases, which
would mean that, by 2007, most of the market would not be
in the RBC category, probably moving to the RSP category;
The RSP category, at 11%, is found across all regions, apart
from North America;
The BIM category, at 8%, is mainly traded gas between
the Former Soviet Union countries, principally Russian
exports, plus, in Asia Pacific, imported gas in India and
Thailand and partly domestically produced gas in Indonesia.

66 International Gas Union | June 2011

In respect of wholesale price levels in 2005, the chart below

shows that price levels were generally higher in the GOG
markets of the US and the UK, as prices peaked at high levels
during the year, followed by OPE. At the bottom end, as might
be expected, wholesale prices determined by RBC are less then
RSP which, in turn, are less then RCS. The result for BIM is
largely impacted by the low levels of wholesale prices in intraFormer Soviet Union trade. In 2006/7, however, GOG prices
have declined to below comparable OPE prices.
Chart A26: Wholesale prices by price formation 2005
Wholesale prices by price formation
mechanism 2005

T
TO

t
be

lo
w

co
s

lit
ic
al
R

eg
ul
at

io
n

so
c

eg
ul
at

io
n

co
s
io
n
eg
ul
at
R

ia
l/p
o

er
vi
ce

ck

to
fs

et
ba
N

op
ol
y
m
on

tit
io
n
te
ra
l

Bi
la

co
m
pe

s
nga
as
-o
G

il
pr
ic

es
ca

la
tio
n

$/MMBTU

$9,00
$8,00
$7,00
$6,00
$5,00
$4,00
$3,00
$2,00
$1,00
$0,00

June 2011 | International Gas Union 67

IGU
The International Gas Union is a worldwide non-profit
organisation aimed at promoting the technical and
economic progress of the gas industry. The Union has
more than 100 members worldwide on all continents.
The members of IGU are national associations and
corporations of the gas industry. IGUs working organisation covers all aspects of the gas industry, including
exploration and production, storage, LNG, distribution and natural gas utilisation in all market segments.
IGU promotes technical and economic progress of
the gas industry emphasising environmental performance worldwide. For more information, please visit
www.igu.org

International Gas Union

Office of the Secretary General

c/o Statoil ASA
0246 Oslo
Norway

Telephone:
Fax:
Email:
Website:

IGU members

110352 IGU 2011, Photo: Eiliv Leren, Harald Pettersen, Helge Hansen, yvind Hagen

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www.igu.org

Sponsored by:

68 International Gas Union | June 2011

PROGRAMONENERGYAND
SUSTAINABLEDEVELOPMENT

WorkingPaper

#94

August2010

T HE
W ORLD S G REATEST C OAL A RBITRAGE : C HINA S C OAL

I MPORT
B EHAVIORAND I MPLICATIONSFORTHE G LOBAL C OAL

M ARKET

RICHARDK.MORSEANDGANGHE

FREEMANSPOGLIINSTITUTEFORINTERNATIONALSTUDIES

Photocredit:Reuters

Electronic copy available at: http://ssrn.com/abstract=1654676

About the Program on Energy and Sustainable Development

The Program on Energy and Sustainable Development (PESD) is an international, interdisciplinary

program that studies how institutions shape patterns of energy production and use, in turn affecting
human welfare and environmental quality. Economic and political incentives and pre-existing legal
frameworks and regulatory processes all play crucial roles in determining what technologies and policies
are chosen to address current and future energy and environmental challenges. PESD research examines
issues including: 1) effective policies for addressing climate change, 2) the role of national oil companies
in the world oil market, 3) the emerging global coal market, 4) the world natural gas market with a focus
on the impact of unconventional sources, 5) business models for carbon capture and storage, 6) adaptation
of wholesale electricity markets to support a low-carbon future, 7) global power sector reform, and 8)
how modern energy services can be supplied sustainably to the worlds poorest regions.

The Program is part of the Freeman Spogli Institute for International Studies at Stanford University.
PESD gratefully acknowledges substantial core funding from BP.

Program on Energy and Sustainable Development

Encina Hall East, Room E415
Stanford University
Stanford, CA 94305-6055
http://pesd.stanford.edu

Electronic copy available at: http://ssrn.com/abstract=1654676

About the Authors

Richard K. Morse leads global coal market research at the Stanford Program on Energy and
Sustainable Development (PESD). PESD's coal research examines the political economy of coal,
the international trade and pricing of coal, and coal's long term role in the world's energy mix.
Other research interests include carbon policy and carbon markets, carbon capture and storage,
renewable energy markets, and financial markets for energy commodities.

Richard received a B.A. in philosophy from Rice University, where he was awarded the James
Street Fulton Prize for the top graduate in the field. He has worked in commodities markets for
oil, natural gas, renewable energy, and emissions as an energy analyst and trader.

Gang He is a research associate at the Program on Energy and Sustainable Development

(PESD). Gang leads PESDs research on China, focusing on Chinas energy and climate change
policies, carbon capture and storage, the domestic coal sector, and its key role in both the global
coal market and in international climate policy frameworks. He also studies other issues related
to global climate change and the development of lower-carbon energy sources.
Gang received a B.S. in Geography from Peking University and a M.A. in Climate and Society
from Columbia University.

The Worlds Greatest Coal Arbitrage:

Chinas Coal Import Behavior and
Implications for the Global Coal Market
Richard K. Morse and Gang He

Introduction
In 2009 the global coal market witnessed one of the most dramatic realignments it has ever seen
China, long a net exporter of coal, suddenly imported a record-smashing 126 Mt tons (see
Figure 1). 1 This inversion of Chinas role in global coal markets meant that Chinese imports
accounted for nearly 15% of all globally traded coal, and China became the focal point of global
demand as traditional import markets like Europe and Japan stagnated in the wake of the
financial crisis. By the first quarter of 2010, even Colombia was defying established trade
patterns by sending cargoes to China despite its massive geographic disadvantage to export coal
into Asian markets. The middle kingdoms appetite for imported coal seems insatiable, and the
China Factor appears to have ushered in a new paradigm for the global coal market.
But China doesnt need the coal. The worlds largest coal producer cranked out 2.96 Bt of
production in 2009, backed up by 114.5 Bt of reserves. 2 While the worlds other fastest growing
importer, India, is plagued by a growing gap between coal supply and power demand that it is
unable to fill domestically, this is not the case in China. The spike in Chinese demand for
imported coal is therefore a more complex (and less easily predictable) phenomenon that
requires careful examination if the world is to understand what impact China might have on
global energy markets in the coming decade.

103 Mt net imports. Source: National Energy Administration of China.

This reserve number is widely used by IEA, BP Energy Statistics Review, etc. Chinas Ministry of Land and
Resources shows 183 Bt in its updated Mineral Resources Reserves Classification. See more details in Wang
Qingyi, China Energy Statistics.

5 August 2010

He and Morse, PESD WP #94

In this paper we outline a model that explains Chinese coal import patterns and that can allow the
coal market to understand, and to some degree predict, Chinas coal import behavior. We argue
that the unique structure of the Chinese coal market creates a series of key arbitrage relationships
between Chinese domestic coal markets and international coal markets that determine Chinese
import patterns. Based on this theory of Chinas import behavior, we construct an arbitragebased import model that explains the dramatic shift in Chinese net imports over the last several
years.
The implications of this model are significant for the development of the global coal trade in the
coming decade. First, we find that Chinas import behavior does not represent a structural
shift in global markets. China, as a participant in the global coal market, is a cost-minimizer
that will be both a buyer and seller in the global market as key price relationships fluctuate.
Second, and perhaps most importantly, the arbitrage relationships that we describe directly link
the domestic price of coal in China to the global price of coal. This linkage has significant
implications for the use of coal and the cost of generating power globally in the coming decades.
Developments in Chinas domestic coal market will be a dominant factor determining global
coal prices and trade flows (and by implication power prices in many regions). This makes
understanding the domestic Chinese coal market, which operates according to a unique economic
and political logic, crucial for any participant in the global markets.3

A series of forthcoming studies on the structure and long term future of the Chinese coal market will be release by
PESD Stanford in 2010, and can be found at http://pesd.stanford.edu

5 August 2010

He and Morse, PESD WP #94

MonthlyMillionMetricTons

18
16
14
12
10
8
6
4
2
0

Imports
Total
Exports
Jan10

Jul09

Jan09

Jul08

Jan08

Jul07

Jan07

Jul06

Jan06

Jul05

Jan05

Jul04

Jan04

Jul03

Jan03

Jul02

Jan02

Figure 1 Chinese net imports were negative until 2008, when historical trade balances inverted
dramatically. Source: McCloskey.

Geographic Fundamentals of the Chinese Coal Market

Chinas coal reserves and production are concentrated in the North and West of China. Three
provinces in these regions Shanxi, Shaanxi, and Inner Mongolia have 69% of the countrys
proven reserves and were home to half of national production in 2009. That same year Inner
Mongolia surpassed Shanxi to become the largest producer at 637 Mt; Shanxi produced 615 Mt,
and Shaanxi produced 296 Mt. 4 70% of the production in these three provinces is exported
outside of its home province to supply coal demand most heavily concentrated along the eastern
and southern coasts. Figure 2 illustrates the basic geography of Chinese coal regions.
Northern coastal Chinese coal demand is served by a network of truck routes and railways that
move coal east and south from western and northern production centers. But rail and truck
capacity to supply coal to Southeast China is both insufficient and prohibitively expensive.
Therefore coal supply for Southeast China is first transported east on rail lines like the Da-Qin
and Shuo-Huang to eastern ports like Qinhuangdao, Huanghua, Rizao, next loaded onto boats,
and finally shipped south via sea routes. Figure 3 illustrates Chinas major coal transport
infrastructure segments. This rail-to-sea link is still much cheaper than moving coal overland

National Bureau of Statistics China.

5 August 2010

He and Morse, PESD WP #94

from North to South. Though the costs associated with this transport route are still high; the
transportation cost of moving coal from Shanxi to Guangzhou can be as high as 50-60% of the
price of coal delivered to Guangzhou. 5 The high cost of moving coal to the heavily industrialized
coastal area that includes the Pearl River Delta and the Yangtze River Delta opens windows for
import coals to compete with domestic coals.
Southeast China is also the closest region in China to two major global coal exporting nations,
Indonesia and Australia. Coal buyers in Southeast China therefore are often confronted with two
options: buy domestic coal delivered by sea from Northern Chinese ports, or buy international
coal. This arbitrage opportunity allows Chinese coal buyers to take advantage of price
differentials between domestic Chinese coal and international coal prices. Until 2009, those
differentials had not favored imports.

Figure 2 Map of Chinese coal planning regions, as described by NDRCs Coal Industry Policy of
2007. Source: Kevin Tu.

This is an estimate. Costs fluctuate according to the price of coal and the price of shipping coal.

5 August 2010

He and Morse, PESD WP #94

Figure 3 Schematic of Chinas major coal transportation infrastructure. Source: Kevin Tu.

The Arbitrage Model of Chinese Coal Imports

We argue that modeling arbitrage spreads between domestic and international coals for coal
buyers in Southern China explains Chinas 2009 import spike and can also be used to reliably
analyze Chinas national import behavior under future market conditions. In this section we
describe the parameters of our model, called the China Coal Import Arbitrage Model
(ChinaCoalArb for short), and demonstrate how its results can be used to interpret Chinas
import trends.
Chinese coal buyers in Southeastern China can buy coal from multiple markets, and price
discrepancies between different markets create profit opportunities. For a portion of spot market
demand, buyers will compare the CIF 6 cost of coal landed in Guangzhou from multiple
F

destinations and, all other things equal, will take the cheapest coal. 7 The differentials between
CIF Guangzhou coal prices from multiple origins therefore create arbitrage opportunities for

CIF is a coal market term indicating that a price is for the delivered location, and thus includes all freight costs.
For purposes of modeling we have slightly simplified the dynamics of Chinese coal buying behavior to focus on
the domestic vs. import tradeoff. For instance, we have not included term contracts or prices at port stockpile in our
model.

5 August 2010

He and Morse, PESD WP #94

Chinese buyers who can shift their purchasing patterns to capture the differential between
domestic and international markets under different conditions. The model calculates these
arbitrage relationships of domestic to key international coals. We then compare these arbitrage
relationships to historical imports, demonstrating that import levels have broadly tracked these
arbitrage trends, increasing where price spreads favored international coals over domestic coals.

3.1

Supply Points and FOB Prices

Chinese domestic prices in ChinaCoalArb are represented by FOB 8 prices at the Qinhuangdao
port. Qinhuangdao port is mainly supplied with coal from Shanxi, Shaanxi and Inner Mongolia
and is Chinas largest coal port. Qinhuangdao throughput in 2009 was 206.33 Mt, and the total
throughput of the seven major coal ports serving Northern China was 433Mt. 9,10 Coal loaded in
Qinhuangdao and delivered to Guangzhou is transported south down the Chinese coast via
maritime shipping. Figure 4 below shows the historical development of prices at Qinhuangdao.
We select three key international coal supply countries as the models suppliers. Australia,
Indonesia, and Russia were the largest exporters of coal to China in 2009. 11,12 All three
countries are major exporters to the international market and benefit from reasonably proximity
to Chinese import markets. Table 1 shows 2009 total Chinese imports from these origins. FOB
coal prices in each of these markets are derived from bids and offers at those locations. 13 Figure
4 shows the historical development of Russian, Indonesian, and Australian export coal prices
from 2005.

FOB is a shipping term meaning Free On Board, and in the coal market it indicates the price quoted for coal
loaded on the vessel at the port of origin.
9
Qinhuangdao Port, China Coal Transportation and Distribution Association.
10
These ports include: Qinhuangdao, Tangshan, Huanghua, Tianjin, Rizhao, Lianyungang, and Qingdao.
11
China has historically imported coal from Vietnam, but due to increased Vietnamese domestic consumption and
price increases imports from Vietnam are expected to decline.
12
Russian imports are not necessarily delivered into Southern China as the port of Vostochny is north of the Chinese
border. But even though Russian ports are north rather than south, the general arbitrage principal applies and thus
we have included Russia in our model even if Russian material is not always imported to Guangzhou. Russian
exports to China are still comparatively small, but increased from 0.76Mt in 2008 to 11.8 Mt in 2009.
13
There are multiple price indices used in the coal market. We have used here indices provided by McCloskey and
Reuters.

5 August 2010

He and Morse, PESD WP #94

USD/metricton

180

Qinhuangdao(6,000kcal/kgNAR)

160

Newcastle(6,700kcal/kgGAD)

140

VostochnnyRussia(6,700kcal/kgGAD)

120

KalimantanIndonesia(4,900kcal/kg
NAR)

100
80
60
40
20
0
Apr10

Jan10

Oct09

Jul09

Apr09

Jan09

Oct08

Jul08

Apr08

Jan08

Oct07

Jul07

Apr07

Jan07

Oct06

Jul06

Apr06

Jan06

Oct05

Jul05

Apr05

Jan05

Figure 4 Major coal price indices in Asia. Source: McCloskey, Reuters.

Table 1 2009 China Coal Imports by Source

Total

Australia

Indonesia

Vietnam

Russia

Mongolia

126.491 Mt

44.602 Mt

30.461 Mt

23.932 Mt

11.787 Mt

6.002 Mt

Canada

North Korea

USA

South Africa

New Zealand

Other

4.093 Mt

3.599 Mt

.805 Mt

.732 Mt

.303 Mt

.145 Mt

Source: McCloskey. Units: Million metric tons.

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He and Morse, PESD WP #94

3.2

Import Demand Centers

The port of Guangzhou in Guangdong province functions as the demand center of our arbitrage
model. Guangdong is a heavily industrialized zone that has historically been the largest coal
importing province. Coal imports by province for 2009 are shown in Table 2. Guangzhou
ports coal handling capacity reached 56.5Mt/year in 2008. Nearby import centers witness
similar price relationships between domestic and international markets and exhibit import
patterns. Arbitrage relationships for Guangzhou can therefore be used as a proxy for arbitrage
relationships for all of Southeastern China. 14 Other major coal ports of Southeastern China
include Shanghai, Ningbo, Fuzhou, Xiamen, Quanzhou, Shantou, and Beihai ports.
Table 2 China coal import by provinces, 2009

Province Guangxi Guangdong

Import

14.14

33.72

Fujian

Zhejiang

Shanghai

All
other

Total

12.00

10.26

3.13

52.75

126

Source: Calculated from China Customs Statistics. Units: Mt.

3.3

Freight Prices

The delivered cost of coal in Guangzhou (CIF) is calculated by adding freight costs between
loading and discharge ports to the FOB coal cost. 15 Dry bulk freight rates from Indonesia,
Russia, or Australia into China largely track international dry bulk freight markets which are
volatile, internationally traded commodity markets (see historical freight rates in Figure 5). 16
The model uses specific freight prices quoted from each FOB loading port and delivered into
Guangzhou port provided by AXS Marine.

14

The basis difference between Guangzhou and other cities in Southeast China will be roughly the freight costs
differential between those two locations. Thus while Guangzhou is the center of coal imports in China and is
indicative of market conditions for imports in general, some minor basis differentials will exist for other locations.
15
There are a few other adjustments which we describe later.
16
The Baltic Dry Index, which is widely used to indicate the cost of chartering dry bulk freight vessels, reached
highs of 11,459 in 2008 before crashing to lows near 670 in late that year. The Index is comprised of charter rates
for four types of ships: capsize, panamax, supramax, and handysize. For further details see the Baltic
Exchange: http://www.balticexchange.com/default.asp?action=article&ID=1
A price history is available from Bloomberg:
http://www.bloomberg.com/apps/quote?ticker=BDIY&exch=IND&x=15&y=11

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He and Morse, PESD WP #94

Freight prices for the Chinese maritime coastal shipping market are not fully connected to
international freight prices, however. Smaller boats are typically dedicated to the domestic
market, though larger boats can switch into the international shipping markets when prices are
attractive. 17 The Shanghai Shipping Index measures the cost of sending coal from Qinhuangdao
to Guangzhou (see Figure 3). 18 Model freight price assumptions assume capesize vessels for all
international shipping routes, and 40-50,000 dead weight ton (DWT) vessels for Chinese coastal
shipping prices. Representative port handling charges for loading and discharge are added for all
ports. 19

NewcastletoGZO

50

QinhuangdaotoGZO

USD/metricton

40

KalimantantoGZO
VostochnytoGZO

30

20

10

0
Apr10

Feb10

Dec09

Oct09

Aug09

Jun09

Apr09

Feb09

Dec08

Oct08

Aug08

Jun08

Apr08

Feb08

Dec07

Oct07

Aug07

Jun07

Figure 5 Dry bulk freight rates from FOB ports to Guangzhou (GZO) port in ChinaCoalArb. Source:
AXS Marine, Reuters, authors analysis. Rates are based on historical quotes for specific shipping routes.
All international quotes are based on capesize vessels, China domestic quotes are based on 40-50,000 dwt
vessels.

17

We benefited from discussion with Jon Windham of Macquarie Securities who offered his views of the Chinese
domestic shipping market and generously shared his research and data.
18
More information on the Shanghai Shipping Index is available at http://en.chineseshipping.com.cn/html/index.asp.
19
We assign port fees based on rates provided by AXS Marine.

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He and Morse, PESD WP #94

3.4

Adjustments: Energy Content, Taxes, Exchange Rates, Transaction Costs

We make the following adjustments in order to more accurately reflect real market conditions:
First, coal buyers are buying energy. We therefore adjust all FOB prices to an energy equivalent
USD/metric ton basis of 6,700 kcal/kg gross air dried (GAD). 20

The original energy content of

FOB indices are shown in Figure 4 (above). Energy equivalent prices are shown in Figure 6
(below).
Second, relevant taxes are added to all coal prices. Chinese VAT of 17% is added to the CIF
price of all coals. We do not adjust for Chinas import tax because it has been phased out by
2007, before Chinas import surge. 21
Third, all coal and freight prices are adjusted for historical exchange rates between RMB and
USD.
Fourth, Chinese buyers face increased transaction costs when purchasing coal from the
international market as compared to the domestic market. 22 Transaction costs for Chinese
buyers associated with import vs. domestic coal include raising letters of credit (LCs), dealing
with foreign sellers and more onerous contracts. Though it is impossible to know precisely the
increased transaction costs for individual buyers, we add a $3/ton advantage to Qinhuangdao
coal over all international coals. 23

20

We assume a linear relationship between price and energy content, though in some cases pricing may not exactly
follow this method, especially pricing for price lower CV coal. For instance, historically, lower CV Indonesian
coals have traded at a deeper discount to higher CV material. For more information see PESD Stanfords
forthcoming study of the Indonesian coal market by Bart Lucarelli at
http://pesd.stanford.edu/publications/the_history_and_future_of_indonesias_coal_industry_impact_of_politics_and_
regulatory_framework_on_industry_structure_and_performance/
21
Chinas coal import tax for all coals with the exception of coking coal was 6% prior to April 1, 2005, 3% till Nov.
1, 2006, and 1% until May 31, 2007. The import tax was abolished after June 1, 2007. Coking coal import taxes
were 3% until January 1, 2005, at which point they were abolished.
22
Stuart Murray of London Commodity Brokers shared his insights with us on what transaction costs Chinese
buyers of international coal face.
23
Results are not highly sensitive to this assumption because shifts in arbitrage relationships that we describe here
are much larger than $3/ton. The overall impact is to make domestic coal slightly more favorable in all
circumstances. For instance, the highest import disadvantage prior to 2009, which was for Newcastle against
Qinhuangdao, would only drop from highs of $70/ton to $67. Conversely the highest import advantage after 2008,
which was for both Indonesian and Russian material, would only increase from highs of about $43/ton to about
$46/ton. Though domestic coals at the margin that are less than $3/ton more profitable than import coal may
become unprofitable against imports if this assumption is eliminated.

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He and Morse, PESD WP #94

USD/metricton

200
180

Qinhuangdao

160

Newcastle

140

VostochnyRussia

120

KalimantanIndonesia

100
80
60
40
20
0

Apr10

Jan10

Oct09

Jul09

Apr09

Jan09

Oct08

Jul08

Apr08

Jan08

Oct07

Jul07

Apr07

Jan07

Oct06

Jul06

Apr06

Jan06

Oct05

Jul05

Apr05

Jan05

Figure 6 Energy equivalent coal price indices (6,700 kc/kg GAD). Source: McCloskey, Reuters,
authors analysis.

3.5

Implications of Key ChinaCoalArb Assumptions

Several necessary assumptions in ChinaCoalArb may impact the performance of the model and
should be noted when comparing model results to real market outcomes.
First, the model does not explicitly separate thermal from coking coal. 24 Though some coals can
switch between these markets making the distinction blurry at times, buying behavior in these
markets will differ under certain conditions. Most worth noting is that some demand for highquality material is likely less responsive to price movements than demand for thermal coal
because high-quality coking coal supplies are much tighter in China and internationally. We
suspect this accounts for a large share of Australian imports into China pre-2009 when CIF
prices for most Australian coals compared to Qinhuangdao coals were significantly higher.

24

In 2009 total coking coal imports were 34.5 Mt out of 126 Mt total imports.

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11

He and Morse, PESD WP #94

Second, by using the Qinhuangdao spot price to represent the Chinese domestic price, the model
does not take into account discrepancies between spot prices and term prices for power
generators in the Chinese market. Although in theory the two should be tightly correlated since
the deregulation of all coal prices in 2006 (spot was deregulated in 2002 but the NDRC still
directly capped term prices for power generators until 2006), this is not always the case in
practice. As evidenced by the June 2010 NDRC price cap on term prices, 25 China can in reality
have a two-tiered coal market under certain conditions. Thus if demand for import coal in the
power sector could replace either spot domestic coal or term domestic coal, it may be useful to
consider any price discrepancies between these two domestic markets as they will affect
arbitrage relationships. Though we argue that the current model capably represents Chinese
buying behavior in the aggregate, under certain circumstances modeling of power generators
buying behavior may be improved by using the NDRC capped term price as the domestic price
instead of spot. 26
Third, China announced that it would relax foreign exchange controls in June 2010, which has
led to minor RMB appreciation. Possible RMB appreciation going forward could increase
Chinas buying power for foreign coal and thus make imports more attractive. 27
Fourth, while the indicative energy-equivalent coal ton that we have created reflects differences
in energy content, the relationship of coal price to energy content may not always be linear (as
we have already discussed). Thus lower CV coals that are priced at a deeper discount coals may
present a greater arbitrage opportunity than our model indicates.
Fifth, while energy content is arguably the most significant variable impacting coal pricing, the
model does not reflect several key variables that can also impact price. Ash, moisture, volatiles,
sulfur, and other coal properties will also influence price. It is therefore important to note our
energy-equivalent coal ton should be broadly indicative of buying behavior but cannot capture
all variables that impact coal purchasing and pricing.

25

See NDRC: http://jgs.ndrc.gov.cn/gzdt/t20100625_356688.htm

This is complicated because even coal buyers that can acquire coal at below-market, government-capped prices
may still have to buy a fair amount of their supplies from the spot market. We estimate that 40-50% of coal supply
for key SOEs is under term contract (and thus impacted by the recent cap) and the remainder is purchased on the
spot market.
27
Albert Saputro and Adam Worthington of Macquarie Securities helpfully highlighted the importance of this issue
to us, which they have analyzed in their own research.
26

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12

He and Morse, PESD WP #94

Sixth, while we argue that Guangzhou is the best proxy to represent Chinas national import
behavior, other importing locations will witness slightly different arbitrage relationships that
might impact purchasing decisions. For instance, Shanghai is slightly farther from Indonesia and
Australia than Guangzhou while slightly closer to Qinhuangdao and Russia. This will increase
freight costs from the former two and favor coal shipped from the latter two.

3.6

Relevant External Factors Not Captured by ChinaCoalArb

Several macro-level factors that could impact coal imports should be noted.
First, there are technical limitations to imports that prevent a full switch to imports even if it was
clearly the most profitable option. Power plant boilers are designed to burn specific
specifications of coal, which is almost always domestic coal for energy security considerations.
However, power generators can blend imports and domestic coal supplies. For each boiler there
will be a technical limitation on the amount of blending that can occur. 28 Other industrial
applications, like cement or steel making, are likely also designed to burn domestic
specifications of coal and may not be able to fully switch to imports.
Second, import port capacity is also a theoretical limit on possible Chinese coal imports (one that
has not yet been tested).

3.7

Model Results

Figure 7 displays the results of the arbitrage model. We compare arbitrage relationships to total
monthly imports in order to demonstrate the relationship. The left axis indicates the price
advantage on a $/ton basis of import coals landed in Guangzhou compared to domestic coals
landed in Guangzhou. Negative values indicate a profit advantage for domestic coals and
positive values indicate a profit advantage for imports. The right axis indicates million tons of

28

From interviews with coal and power experts at Yudean Group in Guangdong. This is a complex engineering
issue which we will not address in detail here as there are multiple variables that impact blending ratios at coal
plants, though we do want to note that some blending limitations may exist.

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13

He and Morse, PESD WP #94

national coal imports by month. Figure 8 displays the only arbitrage relationships in greater

50

18

ImportPriceAdvantage USD/metricton

16
30
14

10

MillionTonsImports

detail (weekly basis).

12

10

Russia
Indonesia

10
8

Australia
QHDNEWC

30

QHDINDO
QHDRUS

4
50
2

70

0
May10
Apr10
Mar10
Feb10
Jan10
Dec09
Nov09
Oct09
Sep09
Aug09
Jul09
Jun09
May09
Apr09
Mar09
Feb09
Jan09
Dec08
Nov08
Oct08
Sep08
Aug08
Jul08
Jun08
May08
Apr08
Mar08
Feb08
Jan08
Dec07
Nov07
Oct07
Sep07
Aug07
Jul07
Jun07

Figure 7 Arbitrage relationships drive Chinese coal import patterns. Note: All arbitrage values are the
CIF Guangzhou from Qinhuangdao minus CIF value of imported coals. Source: McCloskey, Reuters,
AXS Marine, Shanghai Shipping Index, authors analysis.

5 August 2010

14

He and Morse, PESD WP #94

45.00

ImportPriceAdvantage USD/metricton

35.00
25.00
15.00
5.00
5.00
15.00
25.00

QHDNEWC

35.00

QHDINDO

45.00

QHDRUS

55.00
65.00
75.00

Apr10

Feb10

Dec09

Oct09

Aug09

Jun09

Apr09

Feb09

Dec08

Oct08

Aug08

Jun08

Apr08

Feb08

Dec07

Oct07

Aug07

Jun07

Figure 8 Weekly arbitrage values from 2007 show the dramatic shift in the relationship of domestic to
international coals. Note: All arbitrage values are the CIF Guangzhou from Qinhuangdao (QHD) minus
CIF value of imported coals. Source: McCloskey, Reuters, AXS Marine, Shanghai Shipping Index,
authors analysis.

The results explain the dramatic shift from China importing 40.4 Mt in 2008 to importing 126 Mt
in 2009. Prior to the fourth quarter of 2008, international coal prices were disadvantaged
compared to domestic coal prices. In summer 2008 Australian and Russian imports were out of
the money against Qinhuangdao by as much as $65/t and $30/t respectively. While minor
amounts of Australian material was still imported likely specific qualities of coking coal not
readily available in the Chinese domestic market Chinas imports were negligible because
importing wasnt profitable. The partial exception to this description is Indonesian coal, which
came in and out of the money against Qinhuangdao in Southern China. This can be attributed to
two primary factors, both of which give Indonesia competitive advantage exporting into China.
First, Indonesias geographic proximity to Chinese markets means that it pays a smaller freight
penalty than Australia and Russia (assuming Russian material is delivered into South China,

5 August 2010

15

He and Morse, PESD WP #94

which in reality it may not always be). Second, Indonesian FOB prices were historically slightly
lower than Australian and Russian on an energy adjusted basis. Thus as freight and domestic
and international coal prices fluctuated, import windows opened for Indonesian coal in Southern
China.
At the end of 2008 this historical relationship of domestic to international coal changed
dramatically. In the wake of global recession, the historical relationship of domestic to
international coals in Southern China inverted and a massive arbitrage opportunity arose. By late
2009, Indonesian coal was as much as $40/ton more profitable than domestic coal, Australian
coal was as much as $29/ton more profitable, and even Russian coal which suffers from a huge
rail transport penalty to move coal from central Russia to eastern ports was pricing into
Southern China against domestic coal at $40/ton better than Qinhuangdao. Imports skyrocketed,
cresting in winter 2009-2010. International prices have since recovered and the arbitrage
window began to close by summer 2010.
This model therefore provides credible explanation of Chinas coal import behavior and explains
Chinas record imports in 2009. We conclude Chinas coal buying behavior follows the logic of
a cost minimizer and Chinas coal imports will fluctuate according to the arbitrage differentials
between domestic and international coal prices.

3.8

Drivers of Arbitrage Inversion in 2009

Analyzing causes of the dramatic inversion of the historical relationship between Chinas
domestic coal market and the international coal market provides a more detailed understanding
of the market conditions that caused this shift, and thus enables coal market observers to examine
how likely these conditions are to carry forward. We argue that in the wake of the global
financial crisis of 2008 seven principal drivers caused the inversion of historical price
relationships of international to Chinese coal prices.
First, the macroeconomic impact of the global financial crisis was comparatively smaller on
China than many other coal consuming nations. Chinas GDP growth rate was 9.6% in 2008 and

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16

He and Morse, PESD WP #94

9.1% in 2009, declining by only 0.5%. 29 By contrast, real global GDP growth was estimated to
be a negative 2.1% in 2009. 30 This meant that Chinese macroeconomic activity sustained a
comparatively high level of energy demand relative to other coal importing economies. And in
China energy means coal.
Second, after the global financial crisis Chinese domestic freight prices remained higher than
international freight prices, giving imports an advantage over domestic coal. Figure 9 shows
Chinese domestic freight compared to international freight rates as a percentage of their prefinancial crisis levels. 31 This meant that the freight component of the delivered price of imports
decreased relative to its domestic counterpart.
Third, international FOB prices declined more than Chinese domestic FOB prices when
measured as a percentage of their pre-financial crisis levels. Figure 10 illustrates this trend. This
shift, combined with the relative freight advantage, in put imports at a significant advantage to
domestic coal.

29

Both are numbers after adjustment announced by China National Bureau of Statistics.
http://www.stats.gov.cn/tjdt/zygg/sjxdtzgg/t20100702_402654527.htm
30
World Bank global outlook:
http://web.worldbank.org/external/default/main?theSitePK=659149&pagePK=2470434&contentMDK=20370107&
menuPK=659160&piPK=2470429
31
We chose September 2008 as the pre-financial crisis point, as equities markets began their precipitous drop in that
month and Lehman Bros filed for bankruptcy. For a history of the performance of the S&P 500 see Bloomberg:
http://www.bloomberg.com/apps/quote?ticker=SPX:IND

5 August 2010

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He and Morse, PESD WP #94

NewcastletoShanghai

140%

QinhangdaotoShanghai

120%

KalimantantoShanghai

100%

Vostochny(RUS)toShanghai

80%
60%
40%
20%
Jun10

May10

Apr10

Mar10

Feb10

Jan10

Dec09

Nov09

Oct09

Sep09

Aug09

Jul09

Jun09

May09

Apr09

Mar09

Feb09

Jan09

Dec08

Nov08

Oct08

Sep08

0%

Figure 9 Cost of freight indexed to pre-financial crisis levels in September 2008. Source: Shanghai
Shipping Index, AXS Marine.

120%
Qinhuangdao

110%

Newcastle

100%

Vostochny

90%

Kalimantan

80%
70%
60%
50%
40%
30%
20%
May10

Apr10

Mar10

Feb10

Jan10

Dec09

Nov09

Oct09

Sep09

Aug09

Jul09

Jun09

May09

Apr09

Mar09

Feb09

Jan09

Dec08

Nov08

Oct08

Sep08

Figure 10 FOB coal prices indexed to pre-financial crisis levels in September 2008. Source:
McCloskey, Reuters.

5 August 2010

18

He and Morse, PESD WP #94

Fourth, the relative strength of Chinas domestic coal prices was largely due to a series of
regulatory events in key production regions that curtailed supply and supported prices.
Consistent with national coal mining policies, Shanxi province embarked on a major campaign
of mine consolidation. The government began a program of closing small mines or
consolidating them into larger mines and implementing more rigorous safety standards. The
targets of that program are shown in Table 3. The result was a shut-in of traditional supply that
supported prices. There is evidence in summer 2010 that the program was not completely
successful and that government officials may re-implement similar measures. 32
Table 3 Mining consolidation targets in Shanxi.
2008 Target

2009 Target

2010 Target

Mine number

2600

1053

1000

Average mine size

300,000 ton/yr

900,000 ton/yr

900,000 ton/yr

Number of firms

2200

130
4 at 100 million scale
3 at 50 million scale

100

Source: Government of Shanxi.

Fifth, the traditional negotiations for term coal contracts between coal producers and power
generators, which in 2008 allocated 1.1 Bt of coal (40% of Chinas total coal consumption that
year), broke down in 2009 when an agreement on price could not be reached. This led some coal
buyers that would otherwise have purchased domestic coal to look overseas.
Sixth, Chinese national policy on resource use facilitated increased imports. The so called Two
Markets, Two Resources 33 policy encourages coal buyers to import coal when the economics
justify it.
Finally, temporary factors in China like weather interruptions of transport and weak hydro
generation due to droughts contributed to higher domestic coal prices.

32

Research by Macquarie Securities in June 2010.

Two Markets, Two Resources is a Chinese term reflecting a strategy to encourage Chinese company and Chinese
industry Walking Out of the country to explore both domestic markets and international markets.
33

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He and Morse, PESD WP #94

There are a number of long term factors that will determine price relationship of Chinese coal to
international coal. Several forthcoming studies from Stanford address a set of key issues and
reforms that will impact Chinas domestic market such as the coal power conflict and resulting
policy and market reforms, the possible vertical integration of Chinas coal and power industries,
the consolidation of coal producing into larger mines, the adoption of more efficient power
generation technologies, and the construction of major coal-power bases that will produce over
100 Mt/year each. 34
4

Conclusions and Implications for the Global Market

Once a largely isolated coal market, China now plays a central role in determining global trade
flows and prices. Understanding Chinese import behavior under current and future market
conditions is therefore imperative for any analysis of the global coal trade. We have put forward
a theory of Chinese import behavior based on arbitrage relationships between China and the
global market and proved that theory in the ChinaCoalArb model.
Our findings indicate that China is a cost minimizer in the international market that will import
heavily when the price is right as it was in 2009 due to a confluence of circumstances we have
described here and largely rely on domestic coal when imports are unattractive.
The nature of Chinese demand for international coal is therefore fundamentally different from
India, the other source of dramatic demand growth in international coal markets. India is
structurally short coal because demand growth (mainly for power) has outstripped domestic coal
supplies. China, on the other hand, is now the worlds largest coal arbitrage trader. This means
that the relationship between Chinas domestic coal price and the international coal price will be
one of the key factors in determining global trade flows in the coming decade as China could just
as easily buy 15-20% of internationally traded coal as it could buy very little.
Chinas role as worlds largest coal arbitrageur has a hugely significant implication for the global
coal market: it links the international price of coal to Chinas domestic price. Chinas buying
and selling activity on the margins of its massive domestic coal market bring domestic and
global prices closer to parity (though at present not to complete parity). In other words, what

34

Forthcoming studies from PESD Stanford by Huaichuan Rui, Kevin Tu, and Yu Yuefeng address these issues.
See http://pesd.stanford.edu.

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He and Morse, PESD WP #94

happens in the mines of Shanxi will impact the price of power in Munich. The unique politics
and economics of the Chinese coal market are now therefore by necessity the politics and
economics of the global market, and whether or not China imports coal in a given year, the
China factor will increasingly define how the world sells, buys, and uses coal.

Acknowledgments
The authors would like to thank a number of people who made this analysis possible. Our
colleagues at PESD, including Frank Wolak and Mark Thurber, as usual provided invaluable
insights. We also greatly benefitted from discussion with many people in the coal and financial
industries. The Macquarie Securities team, including Adam Worthington, Yeeman Chin, Jon
Windham, Albert Saputro, shared their own insightful analyses of these issues for which we are
quite grateful. Bart Lucarelli also helped sharpen many of the ideas here. Stu Murray of London
Commodity Brokers, who is unmatched in his insight into Chinese buying behavior, shared his
experiences with us. Thanks also to many Chinese scholars and analysts, includingYang
Xianfeng, Li Hongjun, Hu Pingfan, Cai Guotian, Wu Lixin, Zhang Guoqiang, Wu Wenhua, Li
Hong, Gao Shixian. Finally, thanks to Kathy Lung and Sunny Wang for their support.

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