Explanation of the decoupling between physical and paper oil markets


A few days ago, Saudi Arabia shocked oil gamblers after it raised oil prices for its largest market, Asia, in the midst of one of its biggest oil crashes this year. State producer Saudi Aramco increased its key Arab Light crude for Asian customers by $2.80 a barrel from July to a premium of $9.30 a barrel over the Oman/Dubai regional rates, bringing it just below the record premium of $9.35 a barrel in May came.

Aramco claimed it continued to see strong crude demand from customers in Asia, the country’s largest market, as well as extremely strong refining margins.

The rise in the country’s official selling price (OSP) came just hours before the futures market spiraled into a tailspin, with Brent and WTI both crashing nearly 10% on Tuesday. In fact, benchmark Brent futures are down 11.3% just two days after the price hike, ostensibly due to weak demand and fears of a recession.

On some level, Saudi Arabia’s “insane” decision to raise prices in this environment seems logical.

After all, refining margins have run amok, with profits from making a barrel of gas oil at a typical Singapore refinery hitting an all-time high of $68.69 on June 24. , it’s still nearly 4x higher than last year’s $11.83 and a whopping 550% above profit margin at the same time in 2021.

But the fact that the physical crude oil market (bullish) does not seem to match the futures market (bearish) suggests that there is a serious discrepancy between the two.

Decoupling physical versus paper market

At this point, it is important to distinguish between the physical crude oil market and the crude oil futures market.

Physical (also known as spot) market prices are determined by supply and demand of physical crude oil. Here, traders buy oil from the producer and sell it to the refinery for immediate delivery. Physical buyers and sellers have an instant pulse in the market and can instantly feel whether it is well stocked or not.

Futures prices, on the other hand, are determined by the supply and demand for raw futures positions. Futures markets provide traders with a means of betting on rough prices at certain points in the future, and also allow physical market participants to hedge their position, thereby minimizing risk.

The ongoing decoupling between physical crude and futures markets can mainly be attributed to mounting fears of a severe economic slowdown that could curtail demand for oil.

“A growing number of analysts expect many of the world’s leading economies to experience negative growth in the coming months, and this will drag the US into a recessionFawad Razaqzada, a market analyst at City Index, told Bloomberg.

Related: The One Resource That Won’t Stop Rising

Months of declining liquidity, in addition to heavy technical selling and hedging activity by oil producers, have all contributed to the sell-off of oil futures. However, the main driver has been concerns about a possible recession and an overly aggressive Fed, which have undermined the idea that oil prices are a means of hedging against inflation.

Recession fears may have pushed some investors out of oil trading as an inflation hedgeGiovanni Staunovo, an analyst at UBS Group AG, told Bloomberg.

Last month, Federal Reserve officials decided to maintain an aggressive regime of rate hikes in an effort to cool inflation and prevent it from becoming entrenched, even if that means slowing the U.S. economy. According to the minutes of the June 14-15 policy meeting of the Federal Open Market Committee, the central bank plans to raise interest rates by 50 or 75 basis points at the next meeting is scheduled for July 26-27, just after an increase of 75 basis points in June – the largest in nearly three decades. Indeed, it is June’s massive surge that fueled the ongoing oil price sell-off, meaning the oil bulls may not get a much-needed reprieve anytime soon.

And now the million-dollar question: Will other oil producers take their cues from Saudi Arabia?

Saudi Aramco does not disclose the pricing formula it uses to establish its OSPs; however, experts believe it is quite a technical process that takes into account refining margins, the relative price between Oman/Dubai and Brent, and the actual volumes sought by refining customers.

The big problem with using a technical process to determine your OSP, as the Saudis do, is that the price can’t quickly adjust to the highly unusual conditions in today’s global oil market.

Lower Brent prices will encourage refineries in Asia, which can easily change crudes, to buy more oil from suppliers such as West African producers, including Angola and Nigeria, at that price relative to the global benchmark. Furthermore, Asian refiners unscrupulous about buying heavily discounted Russian Urals will also disembark, leaving Saudi and Middle Eastern crudes less attractive at that price.

By Alex Kimani for Oilprice.com

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