Section 1 Hydrocarbon Resources Readings

Hydrocarbon Resources
Section 1.1 - Exploration and Production

- Peter A. Nolan and Mark C. Thurber. On the States Choices of Oil Company:
Risk Management and the Frontier of the Petroleum Industry

FREEMANSPOGLIINSTITUTEFORINTERNATIONALSTUDIES
ONTHESTATESCHOICEOFOILCOMPANY:
RISKMANAGEMENTANDTHEFRONTIEROFTHEPETROLEUM
INDUSTRY
PETERA.NOLANANDMARKC.THURBER
WorkingPaper
#99
December2010
PROGRAMONENERGYAND
SUSTAINABLEDEVELOPMENT

December 10, 2010 1 Nolan and Thurber, Working Paper #99

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


About the National Oil Company Research Platform

While the role of the state is declining in nearly every sector of world economic
activity, in hydrocarbons the pattern is quite different. State-controlled oil companiesso-
called national oil companies (NOCs)remain firmly in control over the vast majority of the
world's hydrocarbon resources. Some NOCs are singular in their control over their home
market; others engage in various joint ventures or are exposed to competition. PESDs study
on National Oil Companies focuses on fifteen NOCs: Saudi Aramco, NIOC (National Iranian
Oil Co), KPC (Kuwait Petroleum Co), PDVSA (Petrleos de Venezuela) , ADNOC (Abu
Dhabi National Oil Company), NNPC (Nigerian National Petroleum Corporation), PEMEX,
Gazprom, Sonatrach, CNPC, Petrobras, Petronas, ONGC, Sonangol, and Statoil.

These enterprises differ markedly in the ways they are governed and the tightness of
their relationship with government. NOCs also vary in their geological gifts, as some are
endowed with prodigious quantities of "easy" oil while others must work harder and apply
highly advanced technologies; some have sought gas, which requires different skills and
market orientation than oil, while others stay focused on liquids. These case studies explore
whether and how these and other factors actually explain the wide variation in the
performance of NOCs.


About the Authors

Peter A. Nolan is currently working as a Senior Advisor to Schlumberger Business
Consulting, providing guidance on the exploration business process and strategy
development. He recently retired from BP after a 36 year career in the petroleum exploration
business that also included leadership positions with a seismic company, a major UK
Independent, and BP. He has also served as a consulting professor at the Program on Energy
and Sustainable Development at Stanford University. In the first part of his career, Peter
managed a seismic computing center in the Netherlands which provided a sound base for
leading geoscience evaluations at a prospect and basin scale in many parts of the world. The
second half of Peters career has been dedicated to managing business development in many
countries including the Former Soviet Union and the Middle East and to developing business
strategies at both local and corporate levels. His current work interests include approaches to
assessing uncertainty and risk, the simplification of the apparently complex to aid strategic
choice and improving the exploration business process. Peter holds a degree in Geology
from the University of Southampton.

Mark C. Thurber is Associate Director for Research at the Program on Energy and
Sustainable Development at Stanford University. Mark's research interests include how
institutional factors affect the diffusion of technologiesboth large-scale, infrastructure-
intensive ones such as for resource extraction or central power generation as well as small,
highly-distributed ones like improved cookstoves or generators for the very poor. He also
studies the role of state energy enterprises in world energy markets, focusing on how the
corporate strategy and performance of such enterprises is shaped by government goals and
institutional environment. Mark holds a Ph.D. from Stanford University in Mechanical
Engineering (Thermosciences) and a B.S.E. from Princeton University in Mechanical and
Aerospace Engineering with a certificate from the Woodrow Wilson School of Public and
International Affairs. Before coming to PESD, Mark worked in high-tech industry, focusing
on high-volume manufacturing operations in Mexico, China, and Malaysia. This work
included a multi-year assignment in Guadalajara, Mexico helping to build up local
technological capability.


On the States Choice of Oil Company:
Risk Management and the Frontier of the
Petroleum Industry

Peter A. Nolan and Mark C. Thurber

1. Introduction

The record of events that describe the petroleum industry (Parra 2004; Yergin 1991)
and the analysis of these events (Adelman 1995; J acoby 1974; Kobrin 1984) provide a
context from which to draw observations about the drivers and evolution of the structure of
the industry. Private operating companies are seen to have been employed in the great
majority of instances for the exploration and early development of a new frontier petroleum
province, yet governments have often revisited those choices in favor of nationalization and
the transfer of petroleum assets to a state operating company. Most notably, in the early
1970s, nationalizations in a host of countries including all of the major developing world oil
producers left three-quarters of the worlds oil reserves in the hands of state-owned
companies. Control of a major part of the oil industry decisions on oil price, production,
and investment in reserves replacement passed from private enterprise to a small group of
producer countries.
Conventional wisdom holds that nationalizations are rooted in political motives of the
petroleum states, which perceive value in the direct control of resource development though a
state enterprise. State motives are inarguably important. At the same time, the argument
presented in this paper is that this motive to nationalize, whatever its cause, is in fact severely
constrained by both the significant risks associated with the creation of petroleum resources
and the capacity of the petroleum state to take these risks.
We argue that constraints of risk significantly affect a states choice of which agent to
employ to extract its hydrocarbons. Implicit in much current debate is the idea that private,
international oil companies (IOCs) and the state-controlled, national oil companies (NOCs)
are direct competitors, and that the former may face threats to their very existence in an era of
increased state control. In fact, IOCs and NOCs characteristically supply very different
functions to governments when it comes to managing risk. For reasons we will discuss, IOCs
excel at managing risk while NOCs typically do not. A third type of player, the oil services
company (OSC), does not take on the risk of oil exploration and development, but instead
supplies needed technology to both IOCs and NOCs. IOCs, NOCs, and OSCs will all
continue to exist because their distinct talents are needed by states seeking to realize the value
of their petroleum resources. However, the relative positions of these different players have


changed substantially over time, and will continue to do so, in response to the shifting needs
of oil-rich states.
Our hypotheses about the role of risk in shaping a states choice of agent for
hydrocarbon extraction are summarized in the decision tree of Figure 1. This diagram is a
stylized representation of how a rational state should choose its agentprivate or state
under different conditions; it does not, of course, imply that all states will actually make
rational choices. Private operating companies unsurprisingly are employed where oil-rich
states perceive no motive for direct control through a state enterprise (A). In the more
interesting (and common) cases where states do feel the need for direct control, private
companies may nevertheless thrive at the industry frontier, where risks are extreme and the
states capacity to shoulder these risks is low (B). State operating companies are principally
found in proven and more mature petroleum provinces where the risks associated with the
extraction of petroleum from developed fields are relatively small. However, they can also
thrive where the petroleum state has significant capacity to absorb risk (risk tolerance), or in
the rare cases where characteristics of the state-NOC relationship allow the NOC to develop
appreciable risk management capabilities.

Hi gh ri sk
of l oss
A
Pri vate operator
B
Pri vate operator
needed
but not wanted
C
Pri vate operator
not needed
Choi ce of
operator
State capaci ty for
ri sk
Ri sk
Si gni fi cance of
petrol eum and
moti ve for control
Low
Hi gh
Low ri sk
of l oss
Low
ri sk tol erance
Hi gh
ri sk tol erance

Figure 1 The central idea: Petroleum risk and the states capacity for risk can constrain state
choice of hydrocarbon agent.

Outcomes A and C in the decision tree are relatively stable, but outcome B creates an
inherent tension between the states desire for direct control and dependence on IOCs to


manage risk. In this situation, a significant alteration in either petroleum risk or in the states
capacity for risk can herald change. Over the multi-decade life of petroleum ventures, risks
and state capacity for risk do change quite profoundly, prompting corresponding changes in
the states choice of hydrocarbon agent. In some countries this has happened only once, in
others multiple times in some cases resulting in serial nationalizations.
In the next section of this paper we develop in more detail the hypotheses expressed
in Figure 1, exploring the nature and sources of risk in the petroleum industry, how these
risks change over time, the task of managing petroleum risks, and the variable capacity of
state and private companies to manage them. In section 3, we apply qualitative and
quantitative approaches to test the idea that risk significantly affects the states choice of
which agent to use for petroleum extraction. First, we review the events leading to the cluster
of nationalizations that occurred in the early 1970s and assess whether they were significantly
affected by considerations of risk. Second, we explore how well variation in risk and state
capacity for risk can explain changing ownership over time within a particular oil province
the UK and Norwegian zones of the North Sea. Third, we use data from energy research and
consulting firm Wood Mackenzie to quantitatively test our hypothesis about the key role of
risk, looking in particular at the case of oil and gas company exploration behavior. Finally, in
section 4, we assess our theory about the role of risk in light of the results of section 3 and
speculate about the roles for both private and state operating companies in the oil industry
going forward.

2. The constraint of risk
In this section we elaborate on the idea of Figure 1 that considerations of risk
significantly constrain a states options for using a state-owned entity to extract
hydrocarbons, even when motives of control militate in favor of such an approach. The term
risk has been used by different people to mean different things, which has sometimes
introduced ambiguity into discussions around the concept. Therefore, we begin this section
by presenting the definitions of risk and the related notion of uncertainty that will be used in
this paper before we proceed step-by-step through the logical flow of Figure 1.


2.1. Defining risk
We define uncertainty to be a state in which outcomes are not known. Uncertainty
can also be discussed in terms of degree, with uncertainty being smaller where more accurate
estimates of outcomes are possible. Risk exists where some of the possible, uncertain
outcomes involve a loss. Risk is higher when either negative outcomes are more probable or
the losses associated with these outcomes are higher. (Figure 2 illustrates this for petroleum
investments.)
The simplest type of risk-weighting for an investment simply multiplies the gain or
loss associated with a given outcome by the estimated probability of that outcome and then
sums over all possible outcomes (Megill 1988); in other words, it computes the expected
value of an investments profitability. However, two investments with the same expected
value of profitability can have widely different variances, with some investments being much
more exposed to large losses (or gains). For this reason, more sophisticated risk-weighting
approaches incorporate measures of an investors ability to tolerate a loss of a given size
(Lerche and MacKay 1999). Our discussion of petroleum risks in this paper is not
quantitative, but it incorporates the fundamental concepts above: that risk encapsulates both
uncertain outcomes and capital exposed to these uncertain outcomes; and that risk tolerance
is a key determinant of who can take on particular kinds of investments.
Risk can be managed in several main ways: by reducing ones stake in any one
investment, by taking on a diverse portfolio of projects to reduce the variance of overall
return on investment, and by using knowledge and experience to reduce uncertainty, arriving
at better determinations of the probabilities of different outcomes. This last idea merits
further unpacking. In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921)
divides probability estimates into those where the distribution of the outcome in a group of
instances is known (either through calculation a priori or from statistics of past experience)
and those where this is not true, the reason being in general that it is impossible to form a
group of instances, because the situation is in a high degree unique.
1
(Knight 1921 p233) As
Knight concedes, real-world probability determinations always lie somewhere on a
continuum between these idealized extremes of, on the one hand, a fully characterized
distribution of possible outcomes derived from perfect analogues to the present situation
(what Knight calls homogeneous classes) and, on the other, a completely unknowable
distribution associated with the absence of any analogues whatsoever that can provide
guidance.
2
A key part of skillful risk management is developing the most accurate possible

1
Knight suggests that these two canonical types of probability be referred to as risk and uncertainty,
respectively. However, we deliberately eschew Knights use of the terms risk and uncertainty in this
specialized way, believing it to be at odds with the common usage of these words and thus more confusing than
helpful. (Some authors resolve this dilemma by adding the modifier Knightian to indicate these specialized
meaningsfor example, Knightian uncertainty refers to the case where the distribution of outcomes is
unknowable.)
2
Knight (1921) writes on p225-226: There are all gradations from a perfectly homogeneous group of life or
fire hazards at one extreme to an absolutely unique exercise of judgment at the other. All gradations, we should
say, except the ideal extremes themselves; for as we can never in practice secure completely homogeneous
classes in the one case, so in the other it probably never happens that there is no basis of comparison for
determining the probability of error in a judgment.


estimates of probability even for relatively unique and unprecedented cases. Models of the
workings of physical phenomenaderived from accumulated experience and informed by
targeted data collection for the case at handcan be important tools for refining probability
estimates even in the absence of proximate analogues.

2.2. Petroleum state motives and choices
In the stylized decision tree of Figure 1, we concede as a starting point that political
considerations around resource control set the basic context that is then modulated by factors
related to risk. For the purposes of this paper, we make the following two principal
observations about state choices and state motives.
First, there is significant variation in how governments choose to involve themselves
in their respective oil sectors. Many petroleum states never seek to control their petroleum
industry through a state company. Others have periods of state intervention through a
national oil company but at some point revert to control through regulation of private
companies (e.g., the UK). In contrast, other petroleum states seek to nationalize their
petroleum industry as soon as they can achieve it and still others are serial nationalizers,
inviting private companies to invest in exploration and field development, then expropriating
developed resources, and, at a later date, repeating the cycle.
Second, governments that depend heavily on petroleum revenues typically express a
strong desire for direct control over their respective petroleum sectors. These states are prone
to seek mastery over all the key variables that affect their petroleum revenues: the pace of
investment, the rate of resource development, the government share of revenues, and of
course the price of oil. This mastery has often been pursued through the selection of a state
operating company. However, control of the factors that determine state revenue from
petroleum does not demand a state company. Licensing and contracts with private firms
offer a means to control the pace of investment and rate of development of resources. And, as
Adelman (1995) points out, setting a price floor through an excise tax supported by a
collective production limit by a producer cartel could influence oil price without the need for
a state operating company.
Whatever the real, or perceived, value of direct control through a state operating
company, the motive for control among the majority of the larger oil producer-states appears
paramount. This motive is, however, constrained by the inherent risks of exercising direct
control, as will be discussed in section 2.3. The capacity of a state to absorb hydrocarbon
riskits risk toleranceis essentially a question of how affected the government and the
economy would be by a shortfall in oil revenues relative to expectations or potential. For
example, Angolas MPLA government from 1976 through 2002 critically depended on oil
revenues to prosecute a civil war; the government had very little ability to accept risk that
these revenues would fall short of potential (see Heller, forthcoming). Countries like Kuwait
with small populations and substantial budgetary surpluses, on the other hand, are relatively
more able to tolerate the risk of underperformance.


2.3. The nature of petroleum risks
Uncertainty and risk are everywhere in the petroleum industry. In line with the
discussion in section 2.1, petroleum investment risks vary in magnitude as a function of both
uncertainty and capital invested (Figure 2). Exploration risks tend to be high because of their
geological uncertainty despite modest capital exposure. In contrast, field development risk is
high because despite reduced uncertaintyoil has been discoveredfield development
requires significantly greater capital. The magnitude of risk is also a function of the maturity
of the exploration and production program, with uncertainty decreasing as knowledge and
experience are acquired over time and as unproven (frontier) petroleum provinces are proven
commercially and eventually become mature.
Relevant uncertainties are not only geological but also related to future market
conditions. At the time of competition for hydrocarbon licenses, when future values are
being estimated, investors must also make judgments about future costs and future prices for
oil and gas produced. For the vast majority of oil today there is little or no risk associated
with connecting oil with a consumer, as most oil can be sold at the wellhead into a global
spot market. However, when this is not the case, investment in field development carries the
additional commercial risk that demand may not materialize or that necessary infrastructure
to connect supply to demand will not be available. We call this risk that hydrocarbons will
not be able to find or access customers market availability risk. Even today, despite the
existence of spot markets for liquefied natural gas (LNG), gas developments can still face
appreciable market availability risk, particularly because they require expensive infrastructure
and risky investments throughout the value chain. This risk can be especially pronounced in
cross-border projects. A converse market risk, supply risk, refers to the uncertainty that a
downstream investment, for example in a refinery, will receive a sufficient input stream of
hydrocarbons to run at capacity over a long period of time as needed to recover costs.


New province
exploration
New province
development
Tertiary Recovery
Proven province
exploration
Proven province
development
Extraction
Secondary
Recovery
Increasing capital at risk
I
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a
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u
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t
a
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t
y

o
f

o
u
t
c
o
m
e
Frontier
(High risk)
Proven
(Moderate risk)
Mature
(Low risk)

Figure 2 Relative risk of petroleum investments (illustrative).

Box 1 Frontier exploration uncertainties
A geological province is a large area, often of several thousand square kilometres, with a common
geological history. It becomes a petroleum province when a working petroleum system has been
discovered. A commercial petroleum system (or play) has several major components: a source rock
that has a rich carbon content and that has spent sufficient time at required temperatures to convert its
organic carbon to petroleum; a sedimentary reservoir rock with sufficient pore space to hold
significant volumes of petroleum and sufficient permeability to allow petroleum to flow to a well bore;
a non porous sedimentary rock that can be an effective barrier to petroleum migration; a structural
trapping mechanism that can combine a reservoir rock and associated barrier/seal rock in a trap to
capture and retain petroleum; and fortuitous geological timing such that that trap formation preceded
the migration of petroleum. Combinations of these variables that result in the trapping of significant
petroleum are rare. This is well illustrated by the USGS World Petroleum Assessment (USGS 2000)
which identified 937 geological provinces across the globe. Petroleum has been found in just 406 of
these provinces. According to the report, approximately 78% of the petroleum outside the US was
found in just 20 geological provinces, with about 50% in just five.


Frontier petroleum activities by definition are those characterized by the highest risk.
These can be conceptual oil and gas plays yet to be discovered and proved commercialin
other words, cases where only very imperfect analogues are available. The frontier can also
include hydrocarbons known to exist but which remain undeveloped because of the
significant risk involved in bringing these resources to market (e.g., shale oil and stranded
gas). Over many decades, the industry has seen the frontier progress from exploration and
development of onshore sedimentary basins through shallow offshore basins and into deep
and ultra-deep water basins today. Recent frontiers have included the challenge of deep
water as well as that of hydrocarbon activities in the former Soviet Union as it tentatively
opened to private investment. Emerging frontiers include the challenge of commercializing
vast resources of unconventional oils and gas, known to exist yet plagued by environmental
and technical uncertainties and high capital requirements. Another emerging frontier is
presented by the worlds large but aging oil fields, which require major new investments for
their redevelopment through tertiary recovery. The high-risk frontier always exists, but the
nature of its challenges changes over time.
As illustrated in Figure 3, risks change in a characteristic way over the lifetime of a
petroleum province. Frontier exploration is characterized by extreme uncertainty. The key
ingredients of success are poorly known (Box 1); probability estimates are likely to have
significant error. Each exploration well carries not only the uncertainty associated with the
specific prospect being drilled but also the uncertainty of the regional petroleum system. A
high probability of failure means that many wells might be drilled before success is achieved
or the attempt abandoned, and frontier wells can be expensive (a single deepwater well today
can cost more than $100 million).
The discovery of a petroleum field begins a process of appraisal and development.
Appraisal of a discovery involves drilling many new wells to confirm the extent and
properties of the reservoirs and fluids and also to determine whether the range of possible
outcomes can be attractive enough to warrant the much larger investment needed to develop
the field. The development of the initial fields in a new province is replete with technical
uncertainties that will affect the ultimate volume of oil that can be recovered and commercial
uncertainties that will affect the value of recovered oil (Box 2).
With the development of one or more commercial fields a frontier becomes proven.
Subsequent investments in proven provinces benefit from the data and knowledge acquired
during the frontier exploration and development phase. Uncertainty about the presence of
hydrocarbons and their character is much reduced, and accurate probability estimates are
more easily arrived at due to the existence of analogues from the same geological system that
can inform subsequent exploration or development activities. The associated reduction in
risk often prompts an influx of new entrant companies that were deterred when risks to entry
were high but are more able to invest in a lower risk environment. These new entrants can
include both state companies and smaller, independent private companies.


Finally, as a proven petroleum province is further developed, knowledge continues to
grow and uncertainty associated with these hydrocarbon activities is reduced still further.
Risks shrink accordingly, and a proven province becomes mature.
After substantial oil or gas has been extracted from mature fields, they can benefit
from investment in redevelopment. Two phases of redevelopment carry very different risks.
The first, secondary recovery, involves drilling additional producing wells and injecting
water or gas to maintain reservoir pressures if pressures have been depleted as oil is
extracted. Secondary recovery carries only moderate investment risk: New well positioning
is informed by the extensive reservoir and fluid information gathered during the fields
production history, and the supply of water (or sometimes gas) for injection is often low cost.
Investment in tertiary recovery, on the other hand, is potentially higher risk. Increased
recovery is achieved by injecting a stimulant to oil mobility in the form of chemicals or heat
into the reservoir. Tertiary recovery, like other frontier activities, requires the investment of
significant amounts of capital and, in contrast to secondary recovery, often has much more
uncertain outcomes. Increased knowledge from path-breaking tertiary recovery projects will
help reduce uncertainty and risk associated with similar projects in the future.


Box 2 Frontier development uncertainties
Field development at the frontier faces significant technical uncertainties. These include the properties of
reservoir rock, the fluids it contains, and the fluid dynamics within the rock. The reservoir rocks
porosity, its permeability, its homogeneity, its structure at field and pore scale all contribute to
uncertainty of both ultimate recovery and production rates. The reservoir at one location might be
vertically or horizontally connected to the fluids in the reservoir at another location. A reservoir might
be a single layer of sandstone at one location but made up of many more or less connected layers at
another location. Faults at a large or microscopic scale might significantly affect the fluid dynamics of
the reservoir. Fractures and pore space might be mineralized, restricting flow to a greater or lesser extent
or not at all.
Fluids in a reservoir might be oil or gas or a complex mixture of both. The oil will vary in its API
(specific gravity) and also its viscosity. Both oils and gases may contain many impurities (nitrogen,
carbon dioxide, and hydrogen sulfide are common). The pressure and temperature of the reservoir fluids
will depend on the depth of the reservoir, and this can affect mobility of hydrocarbons. Temperature and
pressure change as fluids are produced to the surface, which can cause the complex mixture of petroleum
to separate into liquids and gases, often resulting in there being significantly less fluid at the surface than
in the reservoir. Oil may have a gas cap above it in the reservoir, which may provide valuable energy
for pushing oil to the surface. An aquifer at the base of the reservoir might also serve as a key source of
energy (pressure) to move oil to the surface.
Uncertainties around each of these field variables translate into uncertainty in ultimate recovery
volumes; peak production from the field; the life of the field; well flow rates; the density of wells
required; required capacities of production, storage, and export systems; and when secondary and
perhaps tertiary recovery might ultimately be appropriate. Adding in the uncertainty of future costs and
future prices of oil or gas, the distribution of possible financial outcomes can be quite large.


I
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v
e
s
t
m
e
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t

r
i
s
k
Field maturity
Fronti er
Reserves creation
Major exploration and
field development
Proven/Mature
Reserves extraction
Field surveillance, maintenance
& Secondary Recovery
Fronti er
Reserves creation
Tertiary Recovery

Figure 3 Investment risk as a function of petroleum field maturity (illustrative).

Figure 3 emphasizes the extent to which risk in the petroleum industry is associated
with the creation of the reserves the relatively short time period required to find and
develop and where necessary create a market for produced products. By contrast, the capital
requirements and risks associated with the extraction of the fields petroleum are quite low
and the time required can span many decades. This dramatic shift in risk once major
exploration and development have been completed can alter the bargaining positions of the
petroleum state and any private operating company it employs in these initial phases. No
longer needing the risk management abilities of private operators, governments may review
their options and seek to increase their share of revenues and degree of control over
hydrocarbon resources. As Vernon (1971) put it in his study of petroleum nationalization, the
original bargain has become obsolete. (The threat in such cases of contract renegotiation or
in extreme cases outright expropriation represents a formidable risk for private oil companies;
however, this type of political risk falls outside of the scope of this paper because our
analysis focuses on the risks faced by a petroleum state and how they shape its choice of
petroleum agents, rather than on the risks faced by private investors.)
While hydrocarbon activities retain a frontier character, incentives to reduce
uncertainty and costs are enormous because such actions translate directly into value. By
contrast, there is much less leverage on value through efforts to reduce costs in mature
operations where costs are low relative to oil price. It is therefore unsurprising that petroleum
states with developed resources, which are characterized by low production costs, seek to
maximize their revenue by raising oil price rather than reducing cost as even herculean efforts
to improve project performance will have comparatively minor impact.


Together, these observations about the sources of risk and their change with time
suggest the following two expectations. First, agents that are able to most effectively manage
risktypically private companies, as we will discuss in section 2.5will provide more value
to resource-holding governments in frontier activities than in mature operations, as the
frontier is where costs are more significant relative to oil price. Even at the frontier,
governments can choose to employ an agent that might be less able to manage risks, like a
national oil company, but only at a potential cost to future revenues. Second, decreases in oil
price put a premium on risk minimization in a wider range of hydrocarbon activities,
effectively expanding the range of activities that are at the frontier; oil prices increases
have the opposite effect. One might therefore expect to see oil-price-dependent cycles in the
degree to which governments employ the private companies who are best able to manage
risk. In sections 2.4 and 2.5 below, we further explore the ways in which oil companies can
minimize risk as well as how capable the different types of companiesinternational oil
companies, national oil companies, and oil services companiesare of performing this
function.

2.4. The task of risk management in petroleum
Managing risk for a petroleum investor, be it a state or a private company, is about not
only maximizing the expected value of net revenue across all investments but also containing
its variance in particular, ones exposure to losses. Accomplishing this can be achieved by:
1) choosing projects with lower uncertainty, 2) investing in a portfolio of projects so that
uncertainties (if well-estimated) will average out, 3) measuring uncertainty better both to
identify projects with lower uncertainty and to provide confidence that revenue from a
portfolio of projects will converge to the expected value, and 4) reducing the capital exposed
to projects with high uncertainty.
Measuring uncertainty as accurately as possible, and progressively refining ones
estimates, is a central function of a petroleum operating company and the source of its
competitive advantage. Where the distribution of possible outcomes is well-understood due
to the availability of plentiful data from close geological analoguesthe type of situation
referred to by Knight (1921) as statistical probabilitythe measurement of uncertainty is
straightforward and a variety of players can function adequately. Where a petroleum
operating company truly distinguishes itself, by contrast, is in developing the best possible
probability estimates when close analogues are not available. As described in Boxes 3 and 4,
quantifying uncertainty in such cases requires investment in information (most often seismic
and well data) and skills in predictive modeling derived from study of geological processes
around the world and over many years. Predictive modeling integrates sampled data
informed by global analogues and a deep understanding of the geological processes at
workto predict a probabilistic distribution of hydrocarbons in place at all scales from a
petroleum province to a specific field. This process of predictive statistical modeling has
become the essence of both province-scale petroleum exploration (Lerche 1997) and
reservoir development.


The uncertainty estimates produced by statistical models allow determination of the
expected monetary value (EMV) of each investment (Rose 2001) and ranking of investments
by attractiveness. Assembling a portfolio of investments allows further reduction of risk
through diversification. To the extent that model predictions match the distributions of
outcomes that are actually observed in these investments, the net revenue from the portfolio
will converge to the overall expected value even though individual investments have highly
uncertain returns.
3
However, if major gaps in geological understanding lead to systematic
errors in these models that are reflected in investment choices, diversification will not
guarantee the expected overall return. The portfolio approach thus offers more risk
management value to petroleum operators with superior knowledge, providing yet another
motivation for companies to continually work at refining their geological understanding.
Mechanisms to directly reduce capital investment exposed to loss are also important.
One strategy is to take a less than 100% working interest in a project, sharing risk among
partners. States have sometimes reduced capital exposed to uncertain exploration outcomes
by mandating that they receive a carried interest in exploration ventures. Under such an
arrangement, states are not required to front any of the capital for exploration activities but
are given the option to take a share in an oil and gas field after the presence of commercial
reserves has been established.
Another way to reduce the capital exposed to loss is through engineering innovation
that drives cost reduction. Petroleum states focused on reducing risk create incentives for
innovation and cost reduction on the part of their petroleum agents. Such incentives can be
created by competitive bidding, benchmarking of performance, progress bonuses, variable
royalty structures, and other means.

3
As Knight (1921) writes on p233-234 of Risk, Uncertainty, and Profit, Now if the distribution of the different
possible outcomes in a group of instances is known, it is possible to get rid of any real uncertainty by the
expedient of grouping of consolidating instances.


Box 3 Managing exploration risk
Exploring for a new petroleum province, or a new play within this province, is essentially the
process of predicting the presence, characteristics, and location of the key elements needed to form a
petroleum province. Success in exploration depends on both geological observations (the data
samples) and the ability to construct geological models that incorporate all observations and make
useful and accurate predictions about both what might be found and the probability of finding it.
This process of observation, modeling, and prediction of what cannot be observed directly has always
been at the center of the exploration business. Well and seismic data are two of the more important
inputs that inform exploration. Cuttings from the drilling of wells provide rock samples that offer
information on the sedimentary formations penetrated and can provide micro-fossils useful for
correlation between wells and even across sedimentary basins. The use of remote tools in wells that
can measure the electrical resistivity of fluids in penetrated formations and measure the natural
radioactivity of the rocks in the well can provide clues to rock types and the fluids they contain.
Cores of rock from wells can provide the opportunity for direct rock measurements. Recording and
processing of reflected seismic (sound) waves enables the creation of maps of seismically reflective
surfaces which in turn can provide clues as to the depositional environment of the sediments, rock
types, and geological structure at depth. Stratigraphic data on rocks and their relationship with each
other that is obtained from even a limited number of wells can be combined with seismic information
to make extrapolations to a much larger area under the ground.
Geological models can be constructed that predict favorable combinations of source, reservoir and
sealing rocks in the subsurface and that consider the timing of trap formation relative to the timing of
petroleum generation and migration.


2.5. Company type and capacity to manage risk
We have discussed the nature of the risks associated with creating and extracting
petroleum reserves and considered approaches for managing them that can be employed by
companies and governments. In this section we consider how the distinctive characteristics
of state and private companies with respect to risk management offer governments a choice.
Governments can employ three broad categories of company: privately-owned
international operating companies (IOCs), state-owned (or state-controlled) national oil
companies (NOCs), and the various oil service companies (OSCs) that provide technical
services. While we are centrally interested in the choice between IOCs and NOCs as
operating companies, we will also consider the OSCs to highlight both their key role as
technology providers and their inability to absorb risk for a petroleum state.
Box 4 Managing development risk
Managing field development risk is once again about sampling and prediction, this time at a reservoir
rather than province scale and in the context of a specific development scheme. The objective at this
stage is to quantify and reduce uncertainties about the ultimate volume of recoverable petroleum and
the rate of flow from the field over time. Physical sampling technologies include the drilling of
appraisal wells to confirm the presence of petroleum at several reservoir locations, the sampling of
both rock and fluid properties at each of these locations, and the testing of wells to determine the flow
of oil or gas from the reservoir given local reservoir conditions. Seismic data, collected and processed
to provide a very high resolution three-dimensional image of the subsurface, is calibrated to well data.
In parallel with data collection a detailed predictive model of the reservoir is gradually built and
refined as new information becomes available to include the entire range of variables that might have
any material effect on the volume of recoverable petroleum or its rate of production. It is a model
with many dimensions and where the majority of variables, despite the high density of well and
seismic data, still carry considerable uncertainty. Analogous reservoir/fluid combinations from
development projects around the world will once again aid and constrain the predictive modeling of
the data. The remaining uncertainty that cannot be eliminated manifests itself in the form of changes
to estimates of recoverable reserves over the productive life of a field. Increasing computer capacity
has enabled ever more sophisticated simulations of the range of possible behaviors of the modeled
fluids within their reservoirs. These models can be applied to a variety of possible development well
configurations to investigate individual well productivity and longevity as petroleum migrates through
the reservoir pore space into hypothetical well bores cut either vertically or horizontally through the
reservoir. A development plan will be constructed based on a statistical reservoir model that predicts a
range of ultimate recoverable reserves and a range of potential production rates. Wells will be
designed and sited to recover the petroleum in the most economically efficient manner given proper
regard for safety and environmental considerations. If uncertainties remain high because of
irreducible complexity in the reservoir, then these uncertainties will be reflected in the options built
into the development plan, for example the provision for expensive extra space on an offshore
production platform that might or might not be required.


An important point to make at the outset of this discussion is that any company is
theoretically capable of pursuing any risk management strategy. J ust like an IOC, an NOC
would be free in principle to manage risk for its government by building a global portfolio of
investments around the world or by hiring or developing experts with outstanding capability
to quantify geological uncertainty. Indeed, as we will discuss later, the rare NOCs exist that
do just this. However, our point in this section is that the fact of being controlled by a state
rather than driven principally by profits characteristically causes an NOC not to develop risk
management skills on par with IOCs. In the case of OSCs, the salient point is that these
specialized companies occupy a particular, profitable market niche that involves providing
technology rather than managing hydrocarbon risk.

2.5.1. The International Oil Companies
Unlike NOCs, which can have a range of motivations and responsibilities depending
on state goals, IOCs are focused exclusively on profit maximization. The IOCs particular
talent for managing risk stems from this basic orientation. To maximize profits, an IOC must
succeed in competition with other oil operators across the globe. A private firm has to
compete for the opportunity to invest, compete to attract and retain intellectual capital, and
compete for risk capital. To win an opportunity to invest in exploration or development a
company must essentially promise value to the petroleum state that exceeds that offered by its
competitors. These promises are reflected in bids that are made more attractive to the state
through various mechanisms, such as non-refundable cash payments or the commitment to a
larger minimum work-program, which if successful promises economic growth and other
benefits to the state.
4
To create a more attractive bid without sacrificing profitability, a
company must be able to predict more value than any other bidder and ultimately to be
capable of delivering this value. A company must effectively see value that its competitors
cannot, such as more in-place petroleum, greater recovery potential, or even the potential of
future technologies to reduce costs. A company must get its predictions right more often than
it gets them wrong to achieve the long-term performance that enables the private firm to
attract risk capital and skills and, critically, to underwrite its promise of higher value to the
state.
The skills that a private operating company must develop to survive in the
marketplace thus naturally make it ideally capable of managing risk for a resource-rich
government. First, an IOC is driven by commercial incentives to refine its ability to predict
uncertain outcomes through application of the geosciences. Second, the company can
increase its profits by innovating engineering solutions that reduce capital placed at risk.
Third, because it is inherently driven to seek out the best opportunities all over the world, a
large IOC tends to develop a global portfolio of ventures. As long as project outcomes are
uncorrelated and the companys uncertainty characterizations are good, this portfolio
approach dramatically reduces the variance in the expected overall profitability for the IOC,

4
Which elements of a bid a host government prefers most depends on factors outside the scope of this study.
Some governments might prefer cash or direct payments to favored elites; others might seek visible work
programs that create jobs and votes.


allowing it to tolerate below-average financial outcomes, or even a total loss, in a particular
project. By shouldering all of the investment risk on such projects, IOCs can transform even
frontier projects from ventures that hold enormous risk for host governments into ones that
are nearly risk-free for the state.
IOCs have traditionally offered another crucial risk management function to resource-
rich governments: the ability to mitigate market availability risk by creating a bridge to
sources of demand for products that cannot be internationally traded. Investing upstream
without a market commitment or investing in the creation of a market without assured supply
would carry enormous risk. The development of stranded gas and its liquefaction for
shipment to dedicated international markets is one example. A private companys
willingness to invest private capital in development of oil or gas provides assurance to the
resource-holding government that the market is safe and to the market that supply can be
relied upon.
There is no reason in principle why NOCs could not also attract private capital to
projects that require cultivating a demand market, and indeed, a small number do. However,
there are several reasons why IOCs are typically better positioned to do this. First, the
market-driven track record of IOCs in maximizing returns helps more easily convince private
capital that IOCs can deliver in developing profitable markets for stranded oil or gas.
Second, connecting supply to demand around the globe requires a truly international focus
that is almost inevitably precluded to a greater or lesser degree by home country political
constraints faced by NOCs. Even Norways Statoil, among the most international and
market-driven of NOCs, faces domestic pressures that can distract from its international
activities (Thurber and Istad 2010).

2.5.2. The National Oil Companies
The characteristic feature of an NOC is its need to respond to government goals aside
from pure profit maximization. The exact shape and function of an NOC can thus vary
widely depending on how the government wants to control and benefit from the oil sector.
Some IOCs serve regulatory functions in the oil sector (as, for example, in the case of
Angolas Sonangol), some become broader development agencies (as in the case of
Venezuelas PDVSA), and some play the role of administrative vehicles for state
participation in oil (Nigerias NNPC has this character to a large extent). Many NOCs have
operational activities of some kind, but very few are pure hydrocarbon operators. As tools of
government, NOCs invariably have a soft budget constraint to some extentthey are never
exposed to the risk of takeover or bankruptcy that would threaten a private enterprise that
makes unsuccessful investments. On the other hand, NOCs are exposed to political pressures
to a greater degree than their privately-owned brethren. These basic conditions under which
NOCs operate have fundamental implications for their ability to manage risk as hydrocarbon
operators.
First, the close linkages between an NOC and its government can impede the NOCs
ability to raise risk capital or execute other transactions to manage risk, although such


obstacles can sometimes be overcome. Full state ownership precludes equity swaps that
might allow an NOC to manage risk by diversifying its assets abroad, but partial privatization
can be perceived by governments as weakening their control over the oil sector. Companies
funded entirely from government budgetary allocations can face legal constraints on their
ability to raise debt on international marketsMexicos Pemex was in this situation until the
PIDIREGAS scheme was developed to allow it to raise risk capital against the strength of
Mexicos sovereign debt rating (Stojanovski 2008). Most NOCs remain dependent on their
own cash flow or government balance sheets to finance their exploration and development
projects. This means that a national oil company is putting state rather than private capital at
risk; thus risks that the NOC incurs are, in effect, risks to the state.
Second, the relative absence of competitive pressures on the national oil company
reduces its incentives to develop the strong risk management capabilities that would be
essential to survival in a more competitive environment. NOCs generally have a soft budget
constraint and are granted special advantages in their home territory, commonly including a
preferential position in the upstream or a monopoly over product sales at home. Lacking
strong commercial incentives to do so, NOCs can therefore lag both in development of
capability to make accurate geological predictions and in innovation (technological or
organizational) that would reduce cost and thus capital at risk. In some cases, the lack of
competitive pressures can actively encourage NOCs to take technology risks that IOCs might
avoid as imprudent. For example, its monopoly position at home and soft budget constraint
probably encouraged Petrobras to be more aggressive at investing in technology-intensive
offshore exploration and development than it would have been if the state were not implicitly
underwriting these efforts (De Oliveira, forthcoming). Risk taking does not imply risk
management on behalf of the state.
Third, both political pressures and their privileged domestic position tend to
encourage NOCs to stay at home rather than diversifying abroad to reduce overall risk.
Petrobras initial partnerships with IOCs and efforts overseas were not politically popular in
Brazil (De Oliveira, forthcoming). Norways political leadership would probably not have
been amenable to an overseas role for Statoil before the 1990s, and the NOC must still
weather periodic criticism at home for its activities abroad (Thurber and Istad 2010). A more
significant factor in most cases, though, is the simple fact that, as long as plentiful domestic
resources remain available, an NOC has every incentive to operate on its home turf where it
is not exposed to full competition. This is the main reason why only a minority of NOCs
have developed any substantial international portfolio. Those that have internationalized in
the face of declining domestic resourcessuch as ONGC, CNPC, and Petronasare
employed by host governments that in any case no longer have a pivotal need for managing
the risks associated with extraction of domestic hydrocarbons.
As discussed above and elsewhere in this volume, governments have many goals
beyond managing their exposure to petroleum development risks, and it is the real or
perceived ability of NOCs to serve these goals that explains their existence despite
characteristically weak risk management capabilities. An NOC in theory offers the state
more direct control over resources, including the ability to pursue a depletion policy (rate of


production target) that would be in conflict with maximizing return on investment. An NOC
can be used to furnish a wide array of public or private goods, such as employment, financial
benefits for elites, fuel subsidies, or development services. Host governments might
encourage their NOCs to operate overseas if that yields projects and supplies that are thought
to improve the countrys energy security.
At the same time, recognizing the weaknesses of their NOCs at risk management and
the sparse inherent incentives for improvement, states do pursue various strategies to try to
squeeze more performance out of their state oil companies. These strategies, which are
treated in detail by David Hults (forthcoming), can include the introduction of some
competition in the home market to benchmark performance.

2.5.3. The Oil Service Companies
A closer examination of what a third entity, the oil service company (OSC), does can
help clarify the frequently misunderstood distinction between technology and risk
management functions in the petroleum industry. Oil service companies design and provide
the physical equipment that IOCs and NOCs alike use to explore, develop, and produce oil
and gas. They are essential vendors, but their roles are focused and limited. The role of the
oil company, whether state or private, is to know whereto explore and what to develop; the
role of the oil service company is to provide the technologies that will be used to explore and
develop. An oil company might, for example, predict the location of a potential reservoir, but
it is the drilling equipment provided by the oil service companies (OSCs) that physically tests
the prediction. Unlike operating companies, OSCs do not make predictions or promises
about the outcome of an exploration or production venture and do not invest shareholders
capital in highly uncertain outcomes. The OSCs supply technology but do not assume risk on
behalf of a hydrocarbon state.
While the major oil companies formerly developed and owned significant oil
exploration and development equipment, today most such technology functions are
outsourced because oil companies gain little competitive advantage from keeping them in-
house. IOCs compete by convincing oil-rich states of their ability to manage risk, whereas
OSCs compete by convincing IOCs and NOCs that they offer better tools to enable the oil
industry to take on the next frontier challengeto go farther and to do it at a lower cost.
As long as resource-rich countries remained dependent on IOCs for both risk
management and technology services, they had little prospect of developing state-controlled
operating companies. OSCs have played a key role in enabling the development of NOCs by
making state-of-the-art technology available to any prospective operating company, even
though IOCs retain their advantage in managing risks at the frontier.


2.6. Risk and the states choice of agent
Returning to the basic thesis expressed in Figure 1, we expect that the differences
discussed above in the characteristic abilities of different hydrocarbon companies to manage
risk will constrain a rational states choice of agent. In Figure 4, we represent this idea as a
set of outcomes according to risk and the states capacity for risk, considering only the case
of states that have a strong motivation for direct control over hydrocarbons.
For high-risk (frontier) ventures in countries with low risk tolerance, the expected
agent in petroleum is a private operating company (IOC), as shown in the lower right
quadrant of Figure 4. In the most risky frontier activities like exploration, IOCs will most
likely bear all of the risk for the state. Once the basic commerciality of a frontier play has
been established, states might choose to participate on an equity basis in its development,
with the IOCs willingness to risk private capital providing an important signal to the state
that development risks are acceptable and the investment is a good one.
For high-risk ventures in a state that that can tolerate risk (upper right quadrant of
Figure 4), for example because state revenues are diversified or the government already has a
substantial budget surplus, the outcome is often a sector where NOCs dominate as operators
and the state takes all of the investment risk. China and several of the large Middle East
producer states fall into this category.


NOC Operates
High State Equity
NOC Operates
High State Equity
IOC Operates
1. Little or no state equity
participation in exploration
2. Possibly significant state equity
participation in development
Ri sk
Low
(e.g., reserves extracti on)
Hi gh
(e.g., reserves creati on)
State
Capaci ty
for Ri sk
Low
Hi gh

Figure 4 The choice of operating company and state participation when the state desires
direct control.

Once reserves are created, markets are available, and risks are low, then NOCs can
thrive as operators (left half of Figure 4). This situation is characteristic of mature provinces
where extraction and maintenance activities dominate. Even so, there may remain cases with
significant IOC involvementfor example where institutional weakness and a dearth of
technical capability in a country preclude development even of a rudimentary operational
NOC that can competently contract technology functions to OSCs. The result might be a
national oil company that has no operational role but instead seeks technical service
agreements with private companies.
As discussed in section 2.3, oil price can play an important role in shifting the
boundary between high-risk and low-risk ventures for resource-rich states. When oil prices
rise, minimization of uncertainty and cost becomes a less important part of assuring the
desired revenue collection, and resource-rich governments also tend to be more flush with
cash that they can pour back into oil (and non-oil) activities. Under these circumstances, a
governments desire for direct control of hydrocarbons is less constrained by considerations
of risk, and an NOC is more likely to be the agent of choice. When oil prices drop, on the
other hand, governments wishing to maximize revenues will be more likely to need the risk-


minimizing talents of IOCs, which in general can offer lower costs and improved odds of
success in resource development. Such a dynamic could in theory lead to a kind of
backward-bending supply curve for oil, in which higher oil prices actually decrease the rate
at which hydrocarbons are found and extracted worldwide.

3. Testing the idea that risk constrains state choice of oil company
This section of the paper uses three complementary approaches to test the proposition
that risk is a significant constraint on state choice of agent in oil. First, we take a high-level
look at the most important structural change the industry has seenthe widespread
nationalizations of the early 1970sto see if changes in risk over time had an important
influence on events. Second, we examine the effect of risk on state choices of operating
company for the particular case of the North Sea, where within one province the behavior of
two different countries can be compared. Third, we use exploration well data from Wood
Mackenzie to statistically test whether specific frontiers are preferentially explored by private
companies as would be expected according to our hypothesis. In particular, we consider
exploration in deep water and in sectors that have not had a previous discovery. We also use
the same data to test for the expected effect of pricethat higher prices result in more use of
national oil companies and lower prices in more use of private companies.
In none of these cases do we expect to find a deterministic effect of risk on outcomes;
as we have discussed before, there are simply too many different factors that can affect the
states choice of agent. However, we do expect to see risk emerge as an observable
constraint on state choices in hydrocarbons.

3.1. The nationalizations of the early 1970s
In the early 1970s several countries, including all the major producing countries in the
developing world, chose to fully or partly nationalize their oil industries and replace private
oil companies with national operating companies. Unlike earlier and more isolated
nationalizations of private company oil positionsnotably in Bolivia in 1937 and Mexico in
1938which had only modest impact on the industry as a whole, the events of the early
1970s marked a transformation of the structure of the international oil industry. To examine
how the constraint of risk influenced these events, we need to look at several factors: the risk
characteristics of the emerging international oil industry as WWII drew to a close; the players
in the industry and the tools they used to manage these risks; the consequences for the
petroleum producer states; and the actions these states took to seize control. Our analysis
draws upon the excellent documentation and interpretation of these events by Adelman
(1995), J acoby (1974), Kobrin (1984), Parra (2004), and Yergin (1991).
As oil began to emerge as a key fuel, the United States, Russia, and China were able
to transition from indigenous coal to indigenous oil. However, the major industrial countries


of Europe and the Far East were faced with the need to import virtually all of their oil. At the
same time, virtually no indigenous markets were available to absorb the oil that was being
discovered in the Middle East and elsewhere. This mismatch created a pressing need to
connect emerging oil provinces with markets abroad. Risks were high not only in oil
exploration and development but also in bringing this oil to new consumers. At this stage, no
one knew what hydrocarbons might be found, where they would be found, or what it would
take to build the infrastructure to transport oil produced in the Middle East, Venezuela,
Indonesia, or other oil provinces to markets in Europe or J apan. Market risks ran in both
directions: Upstream development was extremely risky without a stable long-term market,
and market development was risky in the absence of assured supply.
For all the appeal of potential oil revenue, oil-rich countries had low capacity to
accept the massive geological and market availability risks in the nascent oil industry. They
did not in general have the financial capacity to put the requisite capital at risk themselves,
nor did they possess sufficient domestic technical capacity to form a state-owned agent that
could manage geological risk. (The few countries that eventually developed NOCs with
some risk management talents, notably Norway and Brazil, focused early in their petroleum
eras on building indigenous technical capability in oil.) As a result, all of these new producer
states chose to employ private companies to take on the risks of exploration, initial
development, and, critically, the creation of markets for their petroleum. Only a few major
international corporations had the know-how and financial risk tolerance required for such an
undertaking: American companies Chevron, Exxon, Gulf, Mobil, and Texaco; Britains BP;
Anglo-Dutch company Shell; and Frances CFP. These companies faced the challenge of
finding and developing sufficient petroleum in the Middle East, and later Africa, to support
and underwrite vast investments aimed at meeting the rapid growth in demand for petroleum
products from Europe and the Far East. Refineries, petrochemical plants, distribution
systems, and retail outlets as well as ports, infrastructure, and tanker fleets had to be financed.
The major international companies evolved several strategies for managing the
considerable risks of investment in this cross-border oil business: concessions, upstream joint
ventures, and vertical integration from supply to consumers. Very large and very long-term
concession agreements with producer states, which were to persist until the early 1970s,
reduced risk by aggregating geological opportunities and allowing cost recovery over a long
period. J oint ventures between oil companies helped spread the political risks of having
concessions in a few politically unstable countries. Vertical integration helped keep upstream
and downstream investments in harmony, infrastructure at capacity, and consumers content
and growing in number. The massive downstream investments required to build refineries
and oil transport infrastructure, which were significantly more capital-intensive even than
upstream exploration and development, made vertical integration particularly important at
this stage of industry development. Without being able to ensure oil supply sufficient to run
downstream infrastructure at full capacity, the oil companies would not have been confident
in their ability to achieve an adequate return on their downstream investments. Although the
major companies werenot a cartel in any formal sense, vertical integration and shared
upstream J V positions ensured that they shared knowledge and in effect made upstream


decisions within a common interest, further reducing their risk. None of these risk
management tools were available to the producer states at this phase of oil industry
development.
The risk management strategies of the private oil majors were successful: The
necessary investments were made in developing oil supply and delivering it to consumers,
and the international oil business grew at an unprecedented rate. However, the producer
states perceived this to be somewhat at their expense. Private companies were making all the
decisions about investment in exploration, whether and when to develop a discovery, and
what production levels to take from each field. The producer states were left with no strategic
control over critical factorsincluding the rate of investment and rate of productionthat
affected the revenues upon which they increasingly depended. They could increase taxes but
only on what was produced. These states therefore had a strong motive to wrest control of
the decisions affecting oil revenues from the private companies. However, they were
constained in their ability to do this by their limited capacity to accept risk or to apply the risk
management strategies being used by the private oil companies.
The risks of oil operations began to decline as the industry developed. By the late
1950s the big fields had been found and developed in the key Middle Eastern countries (Iran,
Iraq, Kuwait, and Saudi Arabia), significantly reducing upstream risk. Transport and refining
infrastructure was in place, and the market for petroleum products was growing rapidly.
However, the major oil companies still controlled access to customers, creating a residual
market availability risk that still precluded effective nationalization by producer states. The
inability of Iran, despite formal nationalization of its oil sector in 1951, to gain de facto
control over its hydrocarbons illustrated how this market availability risk still gave the major
oil companies the upper hand in their negotiations with oil states.
It was the entry of new companies into the international oil business that ultimately
helped provide competitive access to oil markets, reducing market availability risks
sufficiently for nationalization of a countrys oil sector to be feasible. The rapid growth and
profit potential of the international oil industry proved a strong attraction to new entrants,
especially once exploration and development risks had fallen and solid demand for oil had
been established. More than 300 private companies and 50 state-controlled companies
entered or significantly expanded their activities in the international oil business between
1953 and 1972 (J acoby 1974). These included American oil independents in search of
lower-cost oil supplies for their downstream positions in the United States as well as
companies owned by oil-consuming states that wanted security of supply (Parra 2004). The
new entrants pursued oil exploration and development in the already-established provinces of
the Middle East and also in new areas in Africa, helping supply stay ahead of demand even in
a rapidly growing market. Import controls imposed by the United States after 1957 meant
that the US-based independents had to find alternative markets in Europe and the Far East for
their crude. As a result, they contributed substantially to the rapid growth of refining
capacity in industrial countries of Europe and the Far East and began to create an open
market for the trading of crude oil. With infrastructure in place, increasingly open markets,
and a multiplicity of both suppliers and consumerswhat J acoby (1974) called an effective


market for oilupstream investments carried reduced market availability risk and
downstream investments carried reduced supply risk. In theory, the risk management role of
the major oil companies had become less important.
Our simple model of Figure 1 predicts that nationalizations could have been expected
as soon as geological and especially market availability risks had declined in this way by the
early to mid 1960s. However, in reality there was there was some delay before widespread
nationalization actually occurred. The nationalizing trend of the 1970s was indeed enabled
by reduced geological uncertainty and the ready availability of markets, but its exact timing
was affected by other factors. In particular, we speculate that the declining oil prices in the
1960s, themselves the result of increased competition in the oil industry, may have had a role
in affecting state perceptions of risk and re-directing state focus temporarily away from
nationalization. As discussed in section 2.3, lower oil prices effectively increased the risk
that overall revenue would fall short of government targets, placing a greater premium on
minimizing hydrocarbon and market availability risks by employing IOCs. At the same
time, these states turned to cartelization as their own means of reducing the risk to their
revenues. The OPEC cartel was formed in 1960 and made progressively stronger efforts to
control price through coordination. At the outset the OPEC states remained reliant on the
major oil companies to set the price of oil. By 1971 their bargaining position had improved
to the point where they were sharing decisions on price with the major companies. By 1973
their position was sufficiently strong that they could unilaterally set prices above what would
be sustainable in a free market, supported by the coordinated withholding of production
(Adelman 1995). Nationalization before an effective cartel agreement on production restraint
would have opened the door to competition between producer states and depressed crude
prices further. However, once an effective cartel was in place to deal with the price risk to
state revenues, nationalization could follow.

3.2. The North Sea
The North Sea provides an opportunity to examine how two countries, the UK and
Norway, chose their hydrocarbon agents to manage risks within essentially the same
petroleum province. The evolution of hydrocarbon policy in these two countries over the
course of North Sea petroleum development is well-documented by Bowen (1991), Nelsen
(1991), and Noreng (1980). Much of that history is consistent with what our theory would
predict about how risk constrains government actions. At the same time, differences in the
British and Norwegian approaches at particular junctures illustrate that risk is not the only
factor that influences government decisions on hydrocarbon licensing.
Until 1959, with the discovery of the very large Groningen gas field in the
Netherlands, there had been very few discoveries of hydrocarbons of commercial value in
onshore Europe. Once Groningen was known to exist, the major oil companies began
lobbying to open the North Sea for exploration on the theory that the Groningen-like
formations might extend offshore. Norway and the UK had a classic frontier province on


their hands: The geology of the North Sea was promising but it remained highly uncertain
whether commercially viable reserves would be found. Because massive investments in
exploration would be needed to prove out the province, this uncertainty translated into
substantial risk.
As Figures 1 and 4 would predict, both the British and Norwegian governments
avoided equity or operational participation in the early exploration and development of the
North Sea. Instead, after a process of demarcating political boundaries and putting in place
requisite legislation in their respective countries, the British and Norwegian Governments
sought to entice the private oil industry to take on the risks of establishing the new province.
Both governments allowed private companies to bid for exploration and production licenses.
In the UK, the licenses on offer covered not only the southern basin of the North Sea, which
was believed to offer the potential for gas in Groningen-like formations, but also extended
into the main areas of the North Sea.
5
Both countries took a remarkably similar approach to
exploration licensing, with nearly identical license sizes, incentives for exploration of the
more frontier areas, relinquishment requirements, work programs, and commercial terms
(Nelsen 1991). (We note that, since the Norwegian civil servants in charge of petroleum
explicitly sought to learn from their British counterparts, as discussed by Thurber and Istad
(2010), this similarity of approach was to some extent the result of deliberate imitation.
6
)
The results of this initial exploration licensing round emphasized the central role of
risk in several ways. First, exploration blocks perceived to have less uncertainty regarding
the presence of hydrocarbons were, unsurprisingly, more likely to receive bids. The vast
majority of the blocks near the known gas formation of Groningen were licensed, whereas
few of the blocks in the more remote Central North Sea and none of the blocks in the more
remote Northern North Sea were bid for. Second, companies shared risk by bidding in
consortia. For example, over half of the initial licenses issued by Norway were awarded to
partnerships of more than one company (Norwegian Petroleum Directorate 2010). Third,
licenses were concentrated among the most established oil companies, reflecting their
superior ability to manage the risks of frontier exploration. In this case these frontier risks
were associated with both geological uncertainty and uncertainty that suitable technologies
for offshore operations in harsh conditions could be developed.
Uncertainty was gradually reduced over time as discoveries followed the early license
rounds in both Norway and the UK. In 1965 the West Sole gas field was discovered, which
confirmed expectations that the Groningen-like gas extended into the southern basin under
the North Sea. The pace of exploration was slower in the more frontier areas of the Central
North Sea and the Northern North Sea. In total 14 wells were drilled in the UK sector of the
Central North Sea before the first modest oil discovery, the Montrose field, was made by
Amoco in December 1969. The first major oil find (Ekofisk) in the Central North Sea was
made in Norwegian waters by Phillips in December 1969, although its size was not

5
This first round of UK licenses covered virtually the whole of the offshore continental shelf from the Dover
Strait to the northern limits of the Shetland Islands (Bowen 1991).
6
This example implicitly points to a driver of government policy that falls outside of our simple theory about
risk and desire for control: the way that governments can be influenced by the actions of other countries.


appreciated at the time because of the fields geological complexity. The discovery of the
giant Forties field by BP in December 1970, however, left no doubt as to the commercial
potential of oil in the North Sea. J ust a few months later, in J une 1971, another exploration
well operated by Shell discovered the Brent field in the far north of the province. These three
large oil discoveries, once established to be commercial, essentially proved a major new oil
province and significantly reduced the risks associated with any further exploration and
development in the central and northern parts of the North Sea system.
These decreasing risks were reflected in the fourth UK license round, held in J une
1971, which attracted a great deal of competitive attention from exploration companies. Four
times more companies made applications than in any of the first three license rounds. The
high level of exploration commitments made in these next bidding rounds, which reflected
rising confidence and falling risks, yielded a string of significant discoveries in both the
Central North Sea and Northern North Sea areas. In just a few years, by 1977, the discovery
rate (measured in barrels found per well drilled) was already in decline in UK waters (Bowen
1991). The province was entering a more mature phase characterized by much higher
activity levels and reduced volumes discovered per well.
As expected according to Figure 4, both countries shifted to a more participatory
approach to hydrocarbon development as risks declined. Increased state involvement was
intended to provide the government with more information about operations and greater
influence over key operational decisions. In Norways second license round in 1969, state
participation was mandated, in a number of cases in the form of a carried interest in
exploration blocks. Carried interest meant that the state held an option to participate in
development and production activities in the event of a discovery that was determined to be
commercially viable. As discussed earlier, this kind of provision meant that the state took
none of the risk of failure from exploration or appraisal wells and only participated in
development where remaining risks were effectively underwritten by the willingness of the
operating company to invest private capital in the project.
During the 1970s, as risks continued to fall, both countries expanded their direct
involvement in hydrocarbon activities through the creation of national oil companies
initially, to manage the states equity share in development investments, and later, to take on
operatorship of new exploration, development, and production licenses. Norway led the way
in nationalizing resource holdings, creating national oil company Statoil in 1972, not long
after the size and commercial viability of the Ekofisk field had been established. The
company initially served as the investment vehicle for state participation in petroleum, and by
1974 it was being given a minimum 50% carried interest in all new exploration blocks. The
government also increasingly took steps to help Statoil develop into an operator, reserving
highly prospective blocks for the NOC as well as granting licenses to experienced
international companies with the provision that they relinquish operatorship to Statoil a
specified number of years after the commencement of production (Thurber and Istad 2010).
Britain moved more slowly than Norway but eventually followed suit in creating a
national oil company. A 1974 white paper announced the governments determination to


build up production as quickly as possible and assert greater public control over national
hydrocarbon interests, using carried interest provisions to avoid government exposure to
exploration and appraisal risks. The vehicle for this new state interest was the British
national oil company BNOC, which was formed in 1975 and given the right to acquire up to
51 percent of produced petroleum at market prices.
After tracking each other from the outset of North Sea petroleum activities through
the 1970s, British and Norwegian policy clearly diverged in the early 1980s. Britain ended
its state participation in oil field developments and began the process of full privatization of
both the national oil company (BNOC) and the national gas company (BGC). Norway made
no such reversal of policy and continued to assert state control of the oil sector through its
national oil company.
The ideas about risk presented here cannot entirely explain why Britain reversed
course and privatized its state industry, emphasizing that risk is far from the only determinant
of outcomes. The UKs larger economy and population made oil and gas a relatively less
disruptive force and, in line with Figure 1, may have reduced the perceived imperative to
exert direct control over petroleum development. However, it is also likely that other factors
internal to Britains politics during those years were important. The UK may simply have
had a lower political tolerance for government intervention in the economy. Britain had
dithered on whether to create a national oil company in the first place, remaining content with
the initial licensing system well into the 1970s. However, OPECs success in dramatically
raising oil prices in 1973 and the perception that oil companies were reaping extra-normal
profits had generated political impetus towards nationalization. Additional momentum in
favor of creating a British national oil company was generated by Labours election victory in
1974, which ousted a more market-oriented conservative government. However, the political
will behind direct national control over hydrocarbons could not be sustained when oil prices
tumbled in the 1980s, and Britain privatized BNOC and the state gas company (BGC) and
reverted to the model that had existed until the early 1970s: government regulation of
competing private firms. Even in Norway, political factorsnotably including the accession
of a Labour government in 1971had important influence over the exact timing of Statoils
creation, the form it took as a 100%-state-owned enterprise, and its eventual partial
privatization in 2001 (Thurber and Istad 2010).

3.3. Global patterns of oil and gas exploration, 1970-2008
Data on exploration wells around the world from energy research and consulting firm
Wood Mackenzie provide an ideal means of testing the hypothesis that risk is an important
driver of industry structure. We examined two possible frontiers: exploration in deep water,
which is characterized by massive capital requirements and significant technological
uncertainty, and exploration in areas where there have been no previous discoveries, for
which capital requirements may be lower but geological uncertainty is high. We also tested


the possibility, proposed in section 2.3, that oil price might be an important determinant of
whether NOCs or private firms predominate in hydrocarbon activities.
The specific hypotheses that we tested were the following:
Hypothesis #1: Governments will preferentially use national oil companies for exploration in
high price environments, where risk minimization is less important.
Hypothesis #2: Governments will preferentially use their national oil companies in onshore
or shallow-water exploration, where risks are lower than in deep water.
Hypothesis #3: Governments will preferentially use their national oil companies in territories
where previous discoveries have already been made, rather than in territories where no
previous discoveries have been made and risks are therefore higher.

We used the following linear regression model to simultaneously test these three
hypotheses:
NOCFRACTION
ijt
=
0
+
1
*PRICE
t
+
2
*NOFINDS
jt
+
3
*WATERDEPTH
jt
(Eq. 1)
Where:
NOCFRACTION
ijt
=Fraction of exploration wells spudded in country i and basin/sector
combination
7
j in year t which are operated by the national oil company of country i.
PRICE
t
=Average of Brent oil price (2008 US$) for 5 years prior to year t, normalized by
highest price during entire time period (1970-2008).
NOFINDS
jt
= 0 if a commercial discovery has been made in basin/sector j prior to year t
1 if no commercial discovery has been made in basin/sector j prior to year t

WATERDEPTH
jt
=Average water depth of wells completed in basin/sector j in year t and
two prior years, normalized by the 90
th
percentile water depth of offshore wells drilled in that
year worldwide. The 90
th
percentile water depth frontier is shown in Figure 5; however, note
that for the purposes of the regression model, the frontier value used for normalization is not
allowed to decline below the previous high, as the frontier depth is intended to reflect
knowledge about deepwater operations accumulated up to that point.

7
A basin is a geological depression that could contain hydrocarbons. The Wood Mackenzie PathFinder
database further divides basins into sectors, typically according to region within the basin although sometimes
based on other distinctions like whether an exploration area is onshore or offshore. For the purposes of this
analysis, the basic geological unit we characterize is the basin/sector combinationthe inclusion of the sector as
well as the basin enables us to better resolve differences in characteristics of the area being explored. Our
analysis dataset includes a total of 400 basin/sector combinations.


0
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W
a
t
e
r
D
e
p
t
h
o
f
9
0
t
h
P
e
r
c
e
n
t
i
l
e
O
f
f
s
h
o
r
e
E
x
p
l
o
r
a
t
i
o
n
W
e
l
l
(
m
e
t
e
r
s
)
YearWellSpudded

Figure 5 Water depth of the 90
th
percentile offshore exploration well worldwide that was
spudded in the given year. (In other words, 90% of offshore exploration wells were in
shallower water.) Data source: Wood Mackenzie PathFinder (2010).

The basic logic of this model is that NOCFRACTIONthe fraction of wells in a given
basin/sector operated by the home countrys NOCis a proxy for the states choice of
whether to employ an NOC or IOCs. Clearly, there are many factors besides an explicit state
choice that could influence this fraction. A state may not have an NOC, for example, or a
state may desire to employ an IOC to explore in a given area but find that IOCs are not
interested. However, our assumption is that over the long run states can put in place policies
(including the establishment of an NOC) and create incentive structures that will favor either
NOC or IOC exploration activity. Thus, the value of NOCFRACTION should at least
implicitly reflect state choices. Because we are focusing on the degree of risk a state is
willing to accept, we chose to examine the fraction of wells operated by the home NOC. The
decision to employ the home NOC as an operator entails more risk (but may also be
perceived to afford more control) than simply taking an equity share in an IOC-operated
exploration well.
Oil price expectations were represented in a simple-minded way by averaging the
Brent benchmark price for the previous five years.
8
Averages of one and three years were
also tried; they unsurprisingly showed similar (though noisier) regression results compared
with those presented in Tables 1 and 2.
NOFINDS is a dummy variable that in a coarse way groups exploration areas into
putative geological frontiersthose with no previous commercial discoveries as classified by

8
A futures price might have been more appropriate in theory, but the oil derivatives market did not develop
until the 1980s. We are doubtful in any case that the use of a futures price would have added significant value
to the analysis.


Wood Mackenzieand areas that should have lower geological uncertainty because a
previous commercial discovery has been made in the specified basin/sector. A sophisticated
case-by-case analysis of the geological uncertainty faced by each exploration well along with
its potential upside would have been a superior approach to characterizing risk, but such an
approach was not feasible for this kind of large-sample regression.
WATERDEPTH is intended to capture the challenge and risk posed by the
characteristic water depth in a given basin/sector. Because the frontier has advanced over
time as shown in Figure 5, this variable is normalized by a measure of the frontier water
depth in a given year.
Our analysis dataset included all exploration wells in Wood Mackenzies PathFinder
database, except those in China and Russia,
9
that were spudded between 1970 and 2008.
China and Russia were specifically excluded because of known data gaps for these countries
which could introduce systematic error, for example because wells with international
participation were more likely to be recorded than those without international participation.
With these two nations removed, a total of 89 countries were covered by the sample.
The full data table for 1970 through 2008 had a total of 8602 observations, with each
observation representing a basin/sector in a given country in a given year. As part of creating
the data table, it was necessary to classify every company operating a well over the sample
period as either an IOC or an NOC in each year, and also to identify the home country of a
given NOC in order to distinguish its operations at home from those abroad.
10
This
classification was performed based on a variety of sources, including the case studies in this
volume, the World Banks 2008 survey of national oil companies (World Bank 2008), and
company websites. Companies with majority state ownership were considered to be NOCs,
as were those for which the government was a minority shareholder but retained control
through special shareholding arrangements. Operating companies that were partnerships
between the home NOC and other private companies or foreign NOCs were generally not
classified as home NOCs, with the rationale that the other companies could be providing all
of the expertise in risk management for the partnership.
To test the three hypotheses above, an ordinary least squares regression was
performed on the data, using robust standard errors to account for heteroskedasticity. Results
are shown in Table 1, first for the entire sample period (model 1) and then for the periods
1970-1979, 1980-1989, 1990-1999, and 2000-2008 in models 2-5, respectively.
Interpretation is simplified by the fact that price has been normalized to 1 at its highest value
in the sample period (in 1984) and water depth is normalized to 1 at the frontier in a given
year, as measured by the 90
th
percentile water depth worldwide. Thus, for example, the

9
The exclusion of Russia and China turned out to have only a minor effect on regression results.
10
In a study that is focused on measuring the effect of state ownership per se on company performance, it might
make more sense to distinguish only between majority-state-owned and majority privately-owned companies,
irrespective of where the company is operating. In this work, however, we are focusing on a states choice of
whether to use its own NOC to develop domestic resources or to rely on outside companies, be they private or
owned by other states. Therefore, it was more logical to draw the line between the home NOC and any other
operator.


constant term in Table 1 (e.g., 0.218 for model 1) represents the expected fraction of NOC-
operated wells at zero price and zero water depth (e.g., an onshore sector), for an exploration
province that has already seen a commercial discovery. If the average price for the last five
years is at its maximum value, on the other hand, model 1 predicts the fraction of NOC-
operated wells will be 0.065 higher. If the water depth of wells drilled in the region over the
past three years (including the current year) is exactly at the 90
th
percentile frontier for the
current year, model 1 predicts the fraction of NOC-operated wells will be 0.136 lower.

Table 1 Regression results for coefficients of the independent variables in equation (1) and
their statistical significance.

Model 1, covering the entire period from 1970 through 2008, supports hypothesis #1
(higher oil price increases the likelihood that states will use NOCs for exploration) and
hypothesis #3 (states tend to use their NOCs to a lesser degree for exploration in deeper
water). The coefficient for NOFINDS in model 1, on the other hand, is not statistically
significant, meaning that overall there is no support either positive or negative for hypothesis
#2 that states are less likely to employ NOCs in territories where no previous discoveries
have been made.
The breakdown by time periods in models 2-5 reveals a more complicated picture.
The hypothesis that states will preferentially employ companies other than their NOCs in
deeper water is strongly borne out for the period from 1970 through 1989, but the effect
disappears for the later periods. All of the price effect for the period from 1970 through 2008
is accounted for by a large price coefficient from 1990 to 1999. A statistically significant
though smaller effect associated the presence or absence of previous commercial discoveries
also emerges for 1990-1999, although in the opposite direction to that expected by hypothesis
#2. We will discuss each of these findings in turn.


The finding that states preferentially avoided employing their NOCs as operators for
deeper water wells between 1970 and 1989 is the most unambiguous and strongly supported
by our regression. Figure 6, which plots the fraction of wells operated by NOCs at different
depths relative to the frontier in the time period from 1970 to 1989, clearly illustrates this
effect.
0
500
1000
1500
2000
2500
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
N
u
m
b
e
r
o
f
S
e
c
t
o
r
s
i
n
D
e
p
t
h
C
a
t
e
g
o
r
y
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r
a
c
t
i
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f
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e
l
l
s
O
p
e
r
a
t
e
d
b
y
H
o
m
e
N
O
C
19701989
FractionofNOCOperatedWells
NumberofSectors

Figure 6 Fraction of exploration wells operated by home NOC as a function of the water
depth of the basin/sector relative to the frontier (columns), along with the sample size for
each depth bin (line). Since the frontier is defined by the 90
th
percentile water depth in a
given year, depths of greater than 100% of the frontier are possible. Data source: Wood
Mackenzie PathFinder (2010).

Further analysis (including inspection of the raw data table) suggests that the
disappearance of the deepwater effect on NOC vs. IOC operatorship since 1990 is due almost
entirely to the influence on the results of Brazils Petrobras and Norways Statoiltwo
NOCs that have developed substantial skill at operating and managing risks in deep water. In
Table 2, we re-run the same regression models as in Table 1, but removing Brazil and
Norway from the dataset. When we do this, the strong preference against NOCs in deeper
water is roughly consistent across all four time periods. This result suggests that Petrobras
and Statoil have truly become IOC-like in their ability to operate and shoulder risks for
their respective governments in deep water, which is not a surprise in light of the findings of
Thurber and Istad (2010) and De Oliveira (forthcoming).


Table 2 Regression results for coefficients of the independent variables in equation (1) and
their statistical significance, this time excluding Brazil and Norway from consideration.

Considering all of the evidence in Tables 1 and 2 together, it is difficult to find any
support either positive or negative for the idea that states might preferentially use IOCs to
explore regions that have not seen previous commercial discoveries and are therefore riskier.
Several explanations for this are possible. First, it may be that the presence or absence of a
prior commercial discovery in a basin/sector is simply too coarse and imperfect a measure of
geological risk. Second, this measure says nothing about the potential upside of a territory
with no previous discoveriesit may be that IOCs stay away from a basin/sector with no
previous discoveries precisely because they do not consider it to be very prospective. Third,
a countervailing factor that could cause NOCs to explore virgin territory even if there have
been no previous discoveries is the simple fact that it is on their home turf. (As will be
discussed further in section 4.1, NOCs in some cases might have incentive to pursue local
exploration precisely because the state is shouldering the risk.) Fourth, even if the region is
not highly prospective and uncertainties are high, capital outlays can be relatively low in the
case of onshore exploration wells, meaning that the risk might be tolerable for certain states.
At first glance, the price effect in model 1 of table 1 seemed to confirm our hypothesis
that high oil prices effectively reduce state risk and the need to employ IOCs. However,
further inspection reveals that the price effect is almost entirely associated with the period
from 1990 to 1999, although when Brazil and Norway are excluded in the analysis of Table
2, a statistically significant though smaller effect is also observed between 1970 and 1979.
Figure 7 suggests that the strong price effect in the 1990s might actually come from the
correlated decrease in the overall fraction of NOC-operated exploration wells and the oil
price over this period. Because this correlation could be random, we view the implications of
the analysis for hypothesis #1 as inconclusive. At the same time, one could plausibly make
the broader argument that the flurry of privatizations in the 1990s was related in part to the


decrease in oil prices and price expectationsin line with our argument about risk effectively
being higher in low price periods.

0
10
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100
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U
S
$
)
A
v
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r
a
c
t
i
o
n
o
f
W
e
l
l
s
NOCOperated
Fraction
Last5 YearsAvg Price
LastYearPrice

Figure 7 Average fraction of exploration wells operated by NOCs from 1970 through 2008,
plotted alongside the Brent benchmark oil price for both the previous year and for the average
of the previous five years. Data sources: Brent oil prices from BP (2009); NOC-operated
fraction of wells derived from Wood Mackenzie PathFinder (2010).

While our statistical analysis was unable to conclusively demonstrate a price effect on
states preferences for NOCs or IOCs, and it also failed to discern an effect based on our
simplistically-defined frontier of territories without previous discoveries, it did find clear
support for the thesis about risk and state choices in patterns of exploration as a function of
water depth. At the same time, it is important to point out that the model of equation (1) only
explains a small percentage of the overall variation in the states choice of an NOC or IOC.
The model showed the most explanatory power for the period from 1970 to 1979, but even
then the R
2
was only about 0.05the result not only of the coarseness of our ability to assess
risk but also the fact that risk is but one constraint on the choices of the state. The simple
regression model in this section did not attempt to characterize the other major dimensions in
the framework of Figure 1the states relative desire to control petroleum and the capacity
of a given state to take on risk. In addition, there are likely to be a whole host of other
idiosyncratic drivers of state choices, including the characteristics of different political
systems.


4. Conclusion
The central argument in this paper is that industrial structure, defined by a states
choice of private or state operating company, is to a significant degree a function of just three
variables: the petroleum states motive for direct control through a state company, the
inherent risks of doing so, and the capacity of the state to take these risks. Both state-owned
and private companies can in theory manage risks for the state, but the very nature of the
state-owned company as a tool for government goals beyond the commercial tends to make it
a poorer risk manager than its private counterparts. Governments thus have strong incentives
to employ private companies in cases involving high risks or in situations where they have
little or no desire for direct control of the sector and can achieve state goals through industrial
regulation. But these latter settings are rare in the major petroleum provinces; more common
is an acute interest in control with a highly varied exposure to risk and equally variable
capacity to manage it.
In section 3 of this paper, we considered the success of this basic model in predicting
how the agents most commonly employed by hydrocarbon states shifted as the oil and gas
industry developed; which kinds of companies Norway and the UK chose to find and extract
North Sea oil and gas; and whether different kinds of exploration frontiers (deepwater and
virgin territory) would be preferentially occupied by state or private companies. Broadly, the
outcomes in these cases supported our thesis that private companies play a central role as risk
managers at the frontier; however, other factors also emerged as having some bearing on the
state choice of hydrocarbon agent.

4.1. The influence of non-risk factors on agent choice
Political factors can play a particularly important role in what kind of company the
state employs in oil and gas and the exact timing of when the state involves itself directly.
For example, this factor appears to be relevant in explaining why the UK privatized its
national oil company BNOC relatively quickly after its formation whereas Norway preserved
Statoil as a fully-state-owned company for much longer and has left it as a majority-state-
owned entity to the present day. In some cases, NOCs may be difficult to privatize or
dismantle even after the risk environment has changed such that an IOC would be a more
logical choice for a state. Leaders may value the ability of an NOC to provide private
benefits to elites or broader public benefits that help them retain their legitimacy among the
population.
Political considerations and the non-hydrocarbon benefits of NOCs likely explain
many mistakes in which states persist in employing a state operating company even when it
is unable to adequately assess or manage the risks the state will be exposed to. Mexico and
Venezuela today are two countries that retain state companies in the face of mounting risks to
state investment intended to open new frontiers in these countries. Other mistakes may


instead be cases in which the state is able to tolerate the risks involved in frontier activities, at
least for the time being. For example, Indias national oil company ONGC compiled a
woeful performance record in exploration activities (Rai 2010), but these failed investments
may not have loomed as large in a diversified economy like Indias as they would have in a
state like Nigeria in which oil revenues are critically needed to close the state budget. (And
in any event, the Indian government in recent years has attempted to benchmark and improve
ONGCs performance, including through the introduction of competition.)
The Indian example may also reflect the ironic outcome that NOCs can end up taking
on significant risks, even if not prepared to adequately manage them, precisely because they
are gambling with state money. This is likely part of the explanation for why IOCs did not
systematically emerge in section 3.3 as the dominant explorers in hydrocarbon basins without
previous discoveries. As discussed in section 2.5.2, Petrobras was likely more aggressive in
taking on the technological risks of offshore development than it would otherwise have been
because the state was shouldering the risk of failure. Similarly, Statoil was free to take a
more long-term approach to research and development than commercial players because of
its implicit support from the state. As Statoil has progressively separated from the state,
notably through partial privatization in 2001, it has appeared to move toward a more
commercial mode of managing technology development and risk (Thurber and Istad 2010).
As the Petrobras and Statoil cases demonstrate, state support for capability
development within national oil companies can in rare instances lead to long-term benefits
for the state, even if it does result in sub-optimal risk management in the short term. It can
also lead to NOCs eventually developing some risk management skills themselves. As
suggested by the results of section 3.3, Petrobras and Statoil by the 1990s were able to play
an IOC-like role for their respective governments in taking on the risks of deepwater
exploration. Their development of risk management capabilities within these NOCs was
facilitated by the atypically limited demands of their host states for non-hydrocarbon
functions.
A final factor that emerged as a qualification to the basic framework of state agent
choice was the effect of oil price. By altering the relative contribution of produced quantity,
production cost, and selling price to net revenue for the state, price changes effectively shift
the location of the frontier by making given resources more or less economic. We expect
lower price environments to place a greater premium on the risk management skills that IOCs
bring to the table. As discussed in section 3.3, decreasing oil price in the 1990s did broadly
track a decrease in the use of NOCs in exploration, although further work would be needed to
confirm a causal result. Another way of thinking about price fluctuations is as an
independent source of revenue risk to the state that private companies are not able manage on
its behalf. The significance of price risk may help explain the observation in section 3.1 that
oil-rich states turned to cartelization before nationalization, even after the geological and
market availability risks of the oil industry had been substantially reduced.


4.2. Industry structure and the next frontier
With such a large share of the worlds petroleum reserves under the control of state
companies today, it is often suggested that the days of the private operating company are
over, and that state companies and oil service companies will increasingly control oil in the
future. Based on the theory of risk and the structure of the petroleum industry that we have
described here, we are skeptical of such arguments, for several principal reasons. First, the oil
service companies do not compete with private operating companies. Rather, they perform
fundamentally different roles, with only the private operating companies managing risk as a
fundamental part of their business models. Second, most state companies are not well
equipped to manage extreme risks on behalf of their respective governments. Because of a
lack of competitive pressures at home, their responsiveness to government goals beyond the
commercial, and other domestic political factors, only the rare NOC can accumulate the
necessary elements of risk management such as strong geosciences capability, the ability to
innovate while holding down costs, and a global portfolio of investments. Third, there will
remain a new high-risk frontier to be conquered as long as there is a petroleum industry. That
being said, the changing nature of the frontier will have implications for the opportunities
available to private operating companies going forward.
Previous frontiers have largely been about exploration and development in new
geographies, and the private operating companies, of all sizes, have become skillful at
managing these risks. We can see that major new exploration geography is limited: The
industry has already explored accessible onshore basins, offshore basins, and now deepwater
basins. Todays frontier opportunities mostly do not involve new geography per se, but like
all frontiers they are characterized by high uncertainty and massive capital requirements.
Todays frontiers encompass vast volumes of unconventional oils (for example, tar sands,
only 20 percent of which can be extracted with todays surface mining technology) as well as
unconventional gas in tight sands, in tight shale source rocks, as coal bed methane, and in
hydrates. Even conventional natural gas development can retain a high-risk character due to
the capital intensity of gas transport infrastructure, the complex and frequently cross-border
value chains associated with gas, and the requirement that reliable demand be established at
prices that can enable cost recovery. For this reason, IOCs continue to dominate in the gas
arena. Other frontiers include exploration in ultra-deep waters, particularly where mobile salt
provides a substantial obstacle to the identification and mapping of drillable prospects, as
well as exploration of the remote Arctic with its challenges of both static and mobile ice.
Success at these frontiers will depend, as always, on the ability to manage risk
through the development of increasingly accurate measurements of uncertainty. It will
require the use of innovative data collection methods and accumulated geological knowledge
to make skillful predictions of exploration or development outcomes even when an absence
of precedent makes these outcomes seem unknowable. It will also demand continual
innovation to reduce capital cost. Several broad uncertainties exacerbate the risks of todays
frontiers, notably those around climate policy and the direction of future oil pricesthe latter
being a function in part of how large resource (and spare capacity) holders like Saudi Arabia


might try to use production rates to influence oil price so as to undercut any emerging threats
to petroleums dominance.
Because of this ongoing need for risk management at the frontier, the role for private
operating companies in the petroleum industry will not disappear; of course, there is no
guarantee that these companies will be able to maintain or expand their current share of the
market. More certainty in both climate policy and oil pricethe latter created, for example,
by taxation to create oil price floors in consuming countriesmight help in reducing the
market risks that private companies are unable to manage themselves, and thereby assist these
companies in venturing out more aggressively into new frontiers.
State companies will continue to thrive where there are low-risk and low-cost
hydrocarbons to manage. Whenever risks become higher or cost performance becomes more
critical to state revenues, their dominance is likely to wane at least for the moment. One
high-risk activity on the horizon for oil-rich governments with maturing resources is the
redevelopment of large maturing fields through tertiary recovery. Other frontiers that are
closed today for political reasons may open as a result of political change, as has occurred in
Iraq, or when the true risks of investment and the limited ability of the state to absorb risk are
better understood, as in the case of Mexico deep water or Venezuela extra-heavy oil.
It may be that more NOCs over time will follow the lead of Statoil and Petrobras in
starting to develop a global portfolio and competitive risk management capabilities.
However, in most cases this only seems to happen when domestic resources begin to
dwindle; until this point, governments tend to ask NOCs to fulfill too many ancillary goals,
while NOCs find themselves too comfortably sheltered at home to become truly competitive
at managing risk.

November 16, 2010 43 Nolan and Thurber, Working Paper #98

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Schuster.

Section 1.3 Crude Oil Market Dynamics and Pricing
- Bassam Fattouh. An Anatomy of the Crude Oil Pricing System
1

An Anatomy of the Crude Oil Pricing
System

Bassam Fattouh
1

WPM 40

January 2011

1
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.
2

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

3

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
4

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
5

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

6

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
7

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 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.
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
8

price in these markets improve the price discovery process? Such key questions remain heavily under-
researched 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
9

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
10

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.

11

1. Introduction
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. But what is really meant by the
market price or the spot price of crude oil?
The concept of the market price of oil associated with the current pricing regime has often been
surrounded with confusion. 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. In the current system, the prices of these
crudes are usually set at a discount or a premium to a benchmark or reference price according to their
quality and their relative supply and demand. However, this raises a series of questions. How are these
price differentials set? More importantly, how is the price of the benchmark or reference crude
determined?
A simple answer to the latter question would be the market and the forces of supply and demand for
these benchmark crudes. But this raises additional questions. What are the main features of the spot
physical markets for these benchmarks? Do these markets have enough liquidity to ensure an efficient
price discovery process? What are the roles of the various financial layers such as the futures markets and
other derivatives-based instruments that have emerged around the physical benchmarks? Do these
financial layers enhance or hamper the price discovery function? Does the distinction between the
different layers of the market matter or have the different layers become so inter-linked that the
distinction is no longer meaningful? And if the distinction does matter, what do prices in different
markets reflect? It is clear from all these questions that the concept of market price needs to be defined
more precisely. The argument that the market determines the oil price has little explanatory power.
The above questions have assumed special importance in the last few years. The sharp swings in oil prices
and the marked increase in volatility during the latest 2008-2009 price cycle have raised concerns about
the impact of financial layers and financial investors on oil price behaviour.
2
Some observers in the oil
industry and in academic institutions attribute the recent behaviour in prices to structural transformations
in the oil market. According to this view, the boom in oil prices can be explained in terms of tightened
market fundamentals, rigidities in the oil industry due to long periods of underinvestment, and structural
changes in the behaviour of key players such as non-OPEC suppliers, OPEC members, and non-OECD
consumers.
3
On the other hand, other observers consider that the changes in fundamentals or even in
expectations, have not been sufficiently dramatic to justify the extreme cycles in oil prices over the period
2008-2009. Instead, the oil market is seen as having been distorted by substantial and volatile flows of
financial investments in deregulated or poorly regulated crude oil derivatives instruments.
4

The view that crude oil has acquired the characteristics of financial assets such as stocks or bonds has
gained wide acceptance among many observers but is disputed by others.
5
Many empirical papers

2
For a comprehensive overview, see Fattouh (2009).
3
See, for instance, IMF (2008), World Economic Outlook (October), Washington: International Monetary Fund;
Commodity Futures Trading Commission (2008), Interagency Task Force on Commodity Markets Interim Report
on Crude Oil; Killian and Murphy (2010).

4
See, for instance, the Testimony of Michael Greenberger before the Commodity Futures Trading Commission on
Excessive Speculation: Position Limits and Exemptions, 5 August 2009. Greenberger provides an extensive list of
studies that are in favour of the speculation view.
5
See, for instance, Yergin (2009). Yergin argues that the excessive daily trading has helped turn oil into something
new -- not only a physical commodity critical to the security and economic viability of nations but also a financial
asset, part of that great instantaneous exchange of stocks, bonds, currencies, and everything else that makes up the
world's financial portfolio.

12

examine whether the price behaviour of commodities mimics that of financial assets and whether
commodity and equity prices have become increasingly correlated.
6
However, the nature of
financialisation and its implications are not yet clear in these studies. 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.
One important aspect of financialisation often highlighted is the increasing role that expectations play in
the pricing of crude oil. In the case of equities, pricing is based on expectations of a firms future
earnings. In the oil market, expectations of future market fundamentals have increasingly been playing an
important role in oil pricing. According to some observers, if there is large uncertainty as to what the
long-term oil market fundamentals are, or if perceptions of these fundamentals are highly exaggerated and
inflated, then the oil price in the futures market can diverge away from its true underlying fundamental
value causing an oil price bubble.
7

However, unlike a pure financial asset, the crude oil market also has a physical dimension that should
anchor these expectations 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 deals are
transacted at spot prices, these prices reflect existing supply-demand conditions.
In the oil market, however, the story is more complex. To begin with, 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. More
importantly for this paper, though many oil prices are observed on screens and reported through a variety
of channels, it is important to understand what these different prices really mean. Thus, although the
futures price often converges to a spot price, it is important to analyse the process of convergence and
understand what the spot price really means in the context of the oil market.
Unfortunately, little attention has been devoted to such issues and the processes of price discovery and
price formation in oil markets remain under-researched. While this topic can be linked to the current
debate on the role of speculation versus fundamentals in the determination of oil prices, it goes beyond
the existing debates which have recently dominated policy agendas. This paper offers a fresh and deeper
perspective on the current debate by analysing how oil prices are discovered in the current international
pricing system, by identifying the various layers relevant for the price formation process and by

6
See, for instance, Tang and Xiong (2010) who find that commodity prices (more specifically the commodity
indices GSCI and DJ-UBS), world equity indices, and the US dollar have become increasingly correlated.
Silvennoinen and Thorp (2010) also find an increasing degree of integration between commodities and financial
markets especially since the late 1990s. They find that factors such as lower interest rates and corporate bond
spreads, US dollar depreciations and financial traders open positions can explain commodity returns volatility. In
contrast, Bykahin, Haig and Robe (2010) find that the relation between commodity and US equity returns did not
witness any significant change in the last decade or so. This even applies to periods when markets have witnessed
extreme returns. Gorton and Rouwenhorst (2004) find that commodity futures returns are negatively correlated with
equity returns and bond returns. This can be explained in terms of the different behaviour of commodities and other
asset classes over the business cycle.
7
See, for instance, Jalali-Naini (2009).
13

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 main purposes of this paper are to analyse the main features of the current crude oil pricing system;
to describe the structure of the main benchmarks currently used namely Brent, West Texas Intermediate
(WTI) and Dubai-Oman; to clearly identify the various financial layers that have emerged around these
physical benchmarks; to analyse the links between the different financial layers and between the financial
layers and the physical benchmarks; and then to evaluate how these links influence the price discovery
and oil price formation process in the crude oil market. The paper is divided into seven sections. Section 2
provides a historical background to the current international pricing regime analysing the major
transformations in the oil market during the last 50 years or so, and the different pricing systems that have
been associated with the various market structures. Section 3 discusses the main features of the pricing
formulae that constitute the basis of the market-related crude oil pricing system. Section 4 discusses the
role of oil pricing reporting agencies in the current oil pricing system. Sections 5, 6 and 7 analyse the
three widely used benchmarks in the international oil pricing system Brent, WTI and Dubai, describing
their physical base, and analysing the financial layers that have emerged around these physical
benchmarks. Section 8 evaluates the links between the physical benchmarks and financial layers and
draws the main implications on the oil price formation process. The last section offers some conclusions.

14

2. Historical Background to the International Oil Pricing System
The emergence of the current oil price system cannot be understood in isolation from previous ones. It has
emerged in response to major shifts in the global political and economic structures, changes in power
balances, and economic and political transformations that fundamentally changed the structure of the oil
market and the supply chain. This chapter discusses the major transformations in the oil market during the
period 1950-1988 that led to the emergence of the current international oil pricing system.
The Era of the Posted Price
Until the late 1950s, the international oil industry outside the United States, Canada, the USSR and China
was characterised by the dominant position of the large multinational oil companies known as the Seven
Sisters or the majors. The host governments did not participate in production or pricing of crude oil and
acted only as competing sellers of licences or oil concessions. In return, host governments received a
stream of income through royalties and income taxes.
Each of the Seven Sisters was vertically integrated and had control of both upstream operations
(exploration, development and production of oil)
8
and to a significant but lesser extent of downstream
operations (transportation, refining and marketing). At the same time, they controlled the rate of supply of
crude oil going into the market through joint ownership of companies that operated in various countries.
The vertical and horizontal linkages enabled the multinational oil companies to control the bulk of oil
exports from the major oil-producing countries and to prevent large amounts of crude oil accumulating in
the hands of sellers, thus minimising the risk of sellers competing to dispose of unwanted crude oil to
independent buyers and thus pushing prices down (Penrose, 1968).
The oil pricing system associated with the concession system until the mid 1970s was centred on the
concept of a posted price, which was used to calculate the stream of revenues accruing to host
governments. Spot prices, transfer prices and long-term contract prices could not play such a fiscal role.
The vertically and horizontally integrated industrial structure of the oil market meant that oil trading
became to a large extent a question of inter-company exchange with no free market operating outside
these companies control. This resulted in an underdeveloped spot market. Transfer prices used in
transactions within the subsidiaries of an oil company did not reflect market conditions but were merely
used by multinational oil companies to minimise their worldwide tax liabilities by transferring profits
from high-tax to low-tax jurisdictions. Because some companies were crude long and others crude short,
transactions used to occur between the multinational oil companies on the basis of long-term contracts.
However, the prices used in these contracts were never disclosed, with oil companies considering this
information to be a commercial secret. Oil-exporting countries were also not particularly keen on using
contract prices as these were usually lower than posted prices.
Thus, the calculations of the royalty and income tax per barrel of crude oil going to the host governments
had to be based on posted prices. Being a fiscal parameter, the posted price did not respond to the usual
market forces of supply and demand and thus did not play any allocation function (Mabro, 1984). The
multinational oil companies were comfortable with the system of posted prices because it maintained their
oligopolistic position, and until the late 1960s OPEC countries were too weak to change the existing
pricing system.
The Pricing System Shaken but Not Broken
By the late 1950s, the dominance of the vertically integrated companies was challenged by the arrival of
independent oil companies who were able to invest in upstream operations and obtain access to crude oil
outside the Seven Sisters control. In the mid 1950s, Venezuela granted independents (mainly from the

8
In 1950 the majors controlled 85% of the crude oil production in the world outside Canada, USA, Soviet Russia
and China (Danielsen, 1982).
15

US) some oil concessions, and by 1965 non-majors were responsible for 15% of total Venezuelan
production (Parra, 2004).
9
Oil discovery in Libya increased the importance of independents in oil
production, for the Libyan government chose as a matter of policy to attract a diverse set of oil companies
and not only the majors. In 1965, production by independents in Libya totalled around 580 thousand b/d
increasing to 1.1 million b/d in 1968 (Parra, 2004). Competition with the majors also appeared elsewhere.
In the late 1950s, Iran signed two exploration and development agreements in the Persian Gulf offshore
with non-majors and in 1951, Saudi Arabia entered into an agreement with the Japan Petroleum Trading
Company to explore and develop Saudi Arabias fields in the Neutral Zone offshore area.
10
Crude oil
from the Former Soviet Union also began to make its way into the market. The discovery and
development of large fields in the Soviet bloc led to a rapid growth in Russian oil exports from less than
100,000 b/d in 1956 to nearly 700,000 b/d in 1961 (Parra, 2004).
While these and other developments led to the emergence of a market for buying and selling crude oil
outside the control of the Seven Sisters, the total volume of crude oil from US independents and other
companies operating in Venezuela, Libya and the Gulf offshore remained small. Furthermore, the growth
of Russian exports came to a halt after 1967 and production levels declined in 1969 and 1970 (Parra,
2004). These factors limited the scope and size of the market and by the late 1960s the majors were still
the dominant force both in the upstream and downstream parts of the oil industry (Penrose, 1968).
Nevertheless, competitive pressures from other oil producers were partly responsible for the multinational
oil companies decision to cut the posted price in 1959 and 1960. The US decision to impose mandatory
import quotas which increased competition for outlets outside the US was an additional factor that placed
downward pressure on oil prices. The formation of OPEC in 1960 was an attempt by member countries to
prevent the decline in the posted price (Skeet, 1988) and thus for most of the 1960s, OPEC acted as a
trade union whose main objective was to prevent the income of its member countries from declining.
The Emergence of the OPEC Administered Pricing System
Between 1965 and 1973, global demand for oil increased at a fast rate with an average annual increase of
more than 3 million b/d during this period (BP Statistical Review 2010). Most of this increase was met by
OPEC which massively increased its production from around 14 million b/d in 1965 to close to 30 million
b/d in 1973. During this period, OPECs share in global crude oil production increased from 44% in 1965
to 51% in 1973. Other developments in the early 1970s, such as Libyas production cutbacks and the
sabotage of the Saudi Tapline in Syria, tightened further the supply-demand balance.
These oil market conditions created a strong sellers market and significantly increased OPEC
governments power relative to the multinational oil companies. In September 1970 the Libyan
government reached an agreement with Occidental in which this independent oil company agreed to pay
income taxes on the basis of increased posted price and to make retroactive payment to compensate for
the lost revenue since 1965. Occidental was the ideal company to pressurise: unlike the majors, it relied
heavily on Libyan production and did not have much access to oil in other parts of the world. Soon
afterwards, all other companies operating in Libya submitted to these new terms. As a result of this
agreement, other oil-producing countries invoked the most favoured nation clause and made it clear that
they would not accept anything less than the terms granted to Libya. The negotiations conducted in
Tehran resulted in a collective decision to raise the posted price and increase the tax rate.
In September 1973, OPEC decided to reopen negotiations with the companies to revise the Tehran
Agreement and seek large increases in the posted price. Oil companies refused OPECs demand for this
increase and negotiations collapsed. As a result, on 16 October 1973, the six Gulf members of OPEC

9
This share though declined from 1966 onwards.
10
The volume of oil produced from these concessions did not constitute a serious threat to the majors, but the
conclusion of the agreements led to other host governments exerting pressure for better terms in their existing
concessions.
16

unilaterally announced an immediate increase in the posted price of the Arabian Light crude from $3.65
to $5.119. On 19 October 1973, members of the Organization of Arab Oil Producing Countries (less Iraq)
announced production cuts of 5% of the September volume and a further 5% per month until the total
evacuation of Israeli forces from all Arab territory occupied during the June 1967 war is completed and
the legitimate rights of the Palestinian people are restored (Skeet, 1988, quotations in original). In
December 1973, OPEC raised the posted price of the Arabian Light further to $11.651. This jump in price
was unprecedented. More importantly, the year 1973 represented a dramatic shift in the balance of power
towards OPEC. For the first time in its history, OPEC assumed a unilateral role in setting the posted price
(Terzian, 1985). Before that date, OPEC had been only able to prevent oil companies from reducing it.
The Consolidation of the OPEC Administered Pricing System
The oil industry witnessed a major transformation in the early 1970s when some OPEC governments
stopped granting new concessions
11
and started to claim equity participation in their existing concessions,
with a few of them opting for full nationalisation.
12
Demands for equity participation emerged in the early
1960s, but the multinational oil companies downplayed these calls. They became more wary in the late
1960s when they realized that even moderate countries such as Saudi Arabia had begun to make similar
calls for equity participation. In 1971, a Ministerial Committee was established to devise a plan for the
effective implementation of the participation agreement. OPECs six Gulf members (Abu Dhabi, Iran,
Iraq, Saudi Arabia, Qatar, and Kuwait) agreed to negotiate the participation agreement with oil companies
collectively and empowered the Saudi oil Minister Zaki Yamani to negotiate in their name. In October
1972, after many rounds of negotiations, the oil companies agreed to an initial 25% participation which
would reach 51% in 1983. Out of the six Gulf States, Saudi Arabia, Abu Dhabi and later Qatar signed the
general participation agreement. Iran announced its withdrawal early in 1972. Iraq opted for
nationalisation in 1972. In Kuwait, the parliament fiercely opposed the agreement and in 1974 the
government took a 60% stake in the Kuwait oil company and called for a 100% stake by 1980. 100%
equity participation in Kuwait was achieved in 1976 and Qatar followed suit in 1976-77.
Equity participation gave OPEC governments a share of the oil produced which they had to sell to third-
party buyers. It led to the introduction of new pricing concepts to deal with this reality (Mabro, 1984). As
owners of crude oil, governments had to set a price for third-party buyers. The concept of official selling
price (OSP) or government selling price (GSP) entered at this point and is still currently used by some oil
exporters. However, for reasons of convenience, lack of marketing experience and inability to integrate
downwards into refining and marketing in oil-importing countries, most of the governments share was
sold back to the companies that held the concession and produced the crude oil in the first place. These
sales were made compulsory as part of equity participation agreements and used to be transacted at
buyback prices.
The complex oil pricing system of the early 1970s centred on three different concepts of prices: the
posted price, the official selling price, and the buyback price. Such a system was highly inefficient as it
meant that a buyer could obtain a barrel of oil at different prices (Mabro, 2005). Lack of information and
transparency also meant that there was no adjustment mechanism to ensure that these prices converge.
Thus, this regime was short-lived and by 1975 had ceased to exist.

11
As early as 1957, Egypt and Iran started turning away from concessions to new contractual forms such as joint
venture schemes and service contracts. In 1964, Iraq decided not to grant any more oil concessions (Terzian, 1985).
12
Nationalisation of oil concessions in the Middle East extends well before that date. Other than Mossadeghs
attempt at nationalisation in 1951, in 1956 Egypt nationalised Shells interest in the country. In 1958, Syria
nationalized the Karatchock oilfields and in 1963 the entire oil sector came under the government control. In 1967,
Algerisation of oil companies had already begun and by 1970 all non-French oil interests were nationalized. In
1971, French interests were subject to Algerisation with the government taking 51% of French companies stakes
(Terzian, 1985).
17

The administered oil pricing regime that emerged in 1974-75 after the short lived episode of the buyback
system was radical in many aspects, not least because it represented a complete shift in the power of
setting the oil price from multinational companies to OPEC. The new system was centred on the concept
of reference or marker price with Saudi Arabias Arabian Light being the chosen marker crude. In this
administered pricing system, individual members retained the OSPs for their crudes, but these were now
set in relation to the reference price. The differential relative to the marker price used to be adjusted
periodically depending on a variety of factors such as the relative supply and demand for each crude
variety and the relative price of petroleum products among other things. The flexibility of adjusting
differentials by oil-exporting countries complicated the process of administering the marker price. In the
slack market of 1983, OPEC opted for a more rigid system of setting price differentials, but it was
unsuccessful.
The Genesis of the Crude Oil Market
Equity participation and nationalisation profoundly affected the structure of the oil industry. Multinational
oil companies lost large reserves of crude oil and found themselves increasingly net short and dependent
on OPEC supplies. The degree of vertical integration between upstream and downstream considerably
weakened. Oil companies retained both their upstream and downstream assets, but their position became
more imbalanced and in one direction: the companies no longer had enough access to crude oil to meet
their downstream requirements. This encouraged the development of an oil market outside the inter-
multinational oil companies trade. However, during the years 197578, OPEC countries remained
dependent on multinational oil companies to lift and dispose of the crude oil and initially sold only low
volumes through their national oil companies to firms other than the old concessionaires. Thus, at the
early stages of the OPEC-administered pricing system, the majors continued to have preferential access to
crude which narrowed the scope of a competitive oil market.
The situation changed in the late 1970s with the emergence of new players on the global oil scene.
National oil companies in OPEC started to increase the number of their non-concessionaire customers.
The appearance of independent oil companies, Japanese and independent refineries, state oil companies,
trading houses and oil traders permitted such a development. The pace accelerated during and in the
aftermath of the 1979 Iranian crisis. The new regime in Iran cancelled any previous agreements with the
oil majors in marketing Iranian oil: they became mere purchasers as with any other oil companies. In
Libya, there was a switch away from the main term contract customers, including majors, to new
customers primarily governments and state oil corporations. Other OPEC countries followed suit soon
afterwards.
During the 1979 crisis, spot crude prices rose faster than official selling prices. The long-term contract
represented an agreement between the buyer and the seller that specified the quantity of oil to be
delivered while the price was linked to the OPEC marker price. These contracts obliged producers to sell
certain quantities of oil to the majors at the marker price. This meant that oil companies would have been
able to capture the entire differential between official selling prices and the spot prices by buying from
governments and selling in the spot market or through term contracts with other companies having no
direct access to producers. This was unacceptable to producers and governments started selling their
crude oil directly to third-party buyers (Stevens, 1985). Faced with a large number of bidders, small
OPEC producers such as Kuwait began to place an official mark-up over the marker price. By abandoning
their long-term contracts, the producers had the freedom to sell to buyers who offered the highest mark-up
over the marker price.
13
The result was that the majors lost access to large volumes of crude oil that were
available to them under long-term contracts. This had the effect of dramatically worsening the imbalance

13
Saudi Arabia was a major exception to this behaviour. They maintained their long-term contracts with the four
Aramco concessionaires (Exxon, Chevron, Texaco and Mobil) who continued to obtain oil at the OPEC official
price and enjoyed what their competitors referred to bitterly as the Aramco advantage.
18

within oil companies and reduced the degree of integration between downstream and upstream with the
latter becoming only a small fraction of the former.
Faced with this virtual disruption of traditional supply channels, multinational oil companies were forced
to enter the market. This had a profound effect on oil markets as de-integration and the emergence of new
players expanded the external market where buyers and sellers engaged in arms-length transactions. The
crude market became more competitive and the majority of oil used to move through short-term contracts
or the spot market. Prior to these developments, the spot market had consisted of a small number of
transactions usually done under distressed conditions, for the disposal of small amounts of crude oil not
covered by long-term contracts.
The Collapse of the OPEC Administered Pricing System
The decline in oil demand in the mid 1980s caused by a worldwide economic recession and the growth in
non-OPEC crude oil production responding to higher oil prices and taking advantage of new technologies
represented major challenges to OPECs administered pricing system and were ultimately responsible for
its demise. New discoveries in non-OPEC countries meant that significant amounts of oil began to reach
the international market from outside OPEC.
14
This increase in supply also meant an increase in the
number and diversity of crude oil producers who were setting their prices in line with market conditions
and hence proved to be more competitive. The new suppliers who ended up having more crude oil than
required by contract buyers secured the sale of all their production by undercutting OPEC prices in the
spot market. Buyers who became more diverse were attracted to these offers of competitive prices. With
the continued decline in demand for its oil, OPEC saw its own market share in the worlds oil production
fall from 51% in 1973 to 28% in 1985.
Under these pressures, disagreements within OPEC began to surface. Saudi Arabia used to lose market
share with every increase in the marker price and hence opposed them while other OPEC members
pushed for large increases. At times, disagreements within OPEC led to the adoption of a two-tiered price
reference structure. This emerged first in late 1976 when Saudi Arabia and UAE set a lower price for the
marker crude than the rest of OPEC.
15
It was repeated in 1980 when Saudi Arabia used $32 per barrel for
the marker while the other OPEC members used the per barrel marker of $36. Thus, two new concepts
were introduced: the actual marker price which was fixed by Saudi Arabia and the deemed marker price
which was fixed by the rest of OPEC (Amuzegar, 1999).
It became clear by the mid 1980s that the OPEC-administered oil pricing system was unlikely to hold for
long and OPECs or more precisely Saudi Arabias, attempts to defend the marker price would only result
in loss of market share as other producers could offer to sell their oil at a discount to the administered
price of Arabian Light. As a result of these pressures, the demand for Saudi oil declined from 10.2 million
b/d in 1980 to 3.6 million b/d in 1985.

In 1986 and for a short period of time, Saudi Arabia adopted the netback pricing system to restore the
countrys market share.
16
Soon after other oil exporting countries followed suit. The netback pricing

14
This process began well before the 1970s. The North Sea attracted oil companies from the early 1960s and the
first rounds of leasing were awarded in 1964 and 1965. In 1969, oil was found in the Norwegian sector and in 1970
a major find (the Ekofisk field) was confirmed. In the UK sector, Amoco found in 1969 some oil but it was deemed
to be non-commercial. In 1970, BP drilled the exploratory well that found the Forties field. One year later, Shell-
Esso discovered the Brent field (Parra, 2004). It is important to note that all these major discoveries preceded the
large rise in oil prices. Seymour (1990) shows that half of the increase in non-OPEC supply over the 197585 period
would have materialised regardless of the level of oil prices.
15
This two-tier pricing system lasted until July 1977 when Saudi Arabia and UAE announced acceptance of the
price $12.70 for the marker crude.
16
For a detailed analysis of the netback pricing system and the 1986 price collapse, see Mabro (1986).
19

system provided oil companies with a guaranteed refining margin even if oil prices were to collapse.
17

Under this system, refineries had the incentive to run at a high capacity leading to an oversupply of
petroleum products. Lower product prices pulled down crude oil prices and caused the collapse of the
crude oil price from $26.69 on 1 July, 1985 to $9.15 a barrel on the 21 July, 1986.
18
Out of the 1986 oil
price crisis, the current market-related oil pricing system emerged. However, the transition did not occur
instantaneously. In 1987, Saudi Arabia reverted back to official pricing for a short period of time, but its
position was untenable as many other oil exporting countries have already made the switch to the more
flexible market-related pricing system. The date as to when Saudi Arabia explicitly adopted the pricing
formulae is not clear but it might have occurred sometime in 1987 (Horsnell and Mabro, 1993). This
opened a new chapter in the history of the oil market which saw OPEC abandon the administered pricing
system and transfer the pricing power of crude oil to the so-called market.

17
It involved a general formula in which the price of crude oil was set equal to the ex post product realisation minus
refining and transport costs. A number of variables had to be defined in a complex contract including the set of
petroleum products that the refiner could produce from a barrel of oil, the refining costs, transportation costs, and the
time lag between loading and delivery.
18
These figures refer to First-month Brent. Source: Petroleum Intelligence Weekly (PIW)
20

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 long-
term 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.
21

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
P
x
= P
R
D
where P
x
is the price of crude x; P
R
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

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.
-10.00
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+4.00
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+8.00
+10.00
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0
Arab Super Light-50 Arab Extra Light-37 Arab Light-33
Arab Medium -31 Arab Heavy-27
22

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).
23
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

Figure 2: Differentials of Term Prices between Saudi Arabia Light and Iran Light Destined to Asia
(FOB) (In US cents)

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
-0.50
-0.40
-0.30
-0.20
-0.10
0.00
0.10
0.20
0.30
0.40
0.50
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24

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)

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.
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Saudi Arabia
Light-33.0
Saudi Arabia
Arab Medium-3.5
Saudi Arabia
Arab Heavy-27.6
25

Table 1: Main Benchmarks Used in Formula Pricing

Asia Europe
US
Saudi Arabia Oman and Dubai
BWAVE from Jul.'00, Dated Brent
Until Jun.'00
ASCI from
Jan.2010, WTI
until Dec.'09
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
ASCI from
December 2009 ;
Previously WTI
Iraq (Basrah
Blend)
Oman and Dubai Dated Brent
ASCI from April
2010, Previously
WTI Second
Month
Nigeria

Dated Brent Brent
Mexico (Maya
Blend)

Dated Brent x0.527
+ 3.5%HSFO x0.467
- 1%FO x.25
+ 3.5%FO x0.25
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.
26

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

Source: Petroleum Intelligence Weekly

Figure 5: Price Differential between WTI and ASCI ($/Barrel) (ASCI Price=0)

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.
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-1.00
...
1.00
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8.00
ASCI WTI vs ASCI
27

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 index
28
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.
28

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 P-
Plus
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 5 <1 <1
Number of Different Spot
Buyers per Cal Month
26 27 7 10 3 5
Number of Different Spot
Sellers per Cal Month
24 36 6 9 3 6
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
29

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.

30

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 market-
related pricing system in 1986
30
, 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 Jean-
Marie 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.
31

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 30-
minute 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).
32

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 Entire Day (Argus) Window % of Total
LLS 0 446,920 0%
WTI Diff to CMA 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 0 40,044 0%
Poseidon 0 73,857 0%
SGC 0 22,100 0%
Bonito 0 9,140 0%

37,843 1,637,768 2.31%
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.
40
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.
33

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
34

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 non-
repeatable 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
35

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.
36

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 pre-
designed 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
See Argus (2010), Argus Guide to Crude and Oil Products Markets, January.
54
BP Website: https://www.icmmed0ty.com/fps/content/brochure/brochure.asp?sectionid=1

37

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

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)

1986 1987 1988 1989 1990(a) 1990(b) 1990 1991 1992
Brent System 885 791 734 503 450 320 396 450 547
Ninian System 346 302 373 374 366 345 357 324 309
Total Blend 885 791 734 503 450 665 540 773 856
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.
4 2
1
23
1
4
53
5
1
35
2
10
2
2
3
38
1
31
AGIP (ENI) Amerada HESS BGGROUP BPPLC
CHALLENGER CHEVRONTEXACO CNR DANA
DYAS EXXONMOBIL ITOCHU LUNDIN
MARUBENI MITSUBISHI PALACE E&P SHELL
STATOIL ASA TFE
38

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.
39

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 Brent Oseberg Ekofisk
API 44.1 32.6 38.1 37.7 37.5
Sulfur Content
wt.
0.19 1.44 0.42 0.23 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.
58
For instance on May 25 2010, Forties was assessed at $67.57-67.59, Oseberg at $68.49-68.52, Ekofisk at $68.29-
68.32, 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.

40

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 25
th
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).
41

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 5
th
of the preceding month. The loading programme was then organised and
finalised by the 15
th
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 10
th
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 22
nd
and 24
th
of July in which he can load the oil into tankers. The seller has to
nominate the buyer at the latest by the 1
st
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 5
th
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.
42

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

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.

0
100,000
200,000
300,000
400,000
500,000
600,000
0
2
4
6
8
10
12
14
Jul-07 Dec-07 May-08 Oct-08 Mar-09 Aug-09 Jan-10 Jun-10
Participants Liquidity (b/d)
43

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

Sales (b/d) Purchases (b/d)

2007 2008 2009 2010 2007 2008 2009 2010
Arcadia 0 0 0 0 485 0 0 0
BP 23,786 3,005 13,699 29,545 25,243 273 10,959 12,662
Chevron 0 273 274 0 0 273 0 0
ConocoPhillips 18,447 11,749 12,329 32,143 6,311 5,464 12,329 29,545
Glencore 0 0 274 0 0 546 548 0
Hess 0 0 9,315 37,338 0 0 10,137 20,779
Hetco 0 0 822 7,143 0 0 1,096 974
Mercuria 12,136 12,842 64,658 79,545 13,107 24,863 54,247 89,286
Morgan
Stanley 0 0 274 28,896 0 0 3,014 19,805
Noble 0 0 548 6,494 0 0 822 5,844
Phibro 46,602 19,126 25,479 23,377 36,408 23,770 36,164 14,935
Sempra 15,534 18,306 13,151 8,766 18,447 19,672 13,699 7,792
Shell 34,951 62,022 125,205 91,883 46,117 32,787 73,151 75,000
StatoilHydro 0 273 0 0 0 0 0 0
Total 0 0 0 649 0 0 0 2,273
Totsa 31,068 16,667 53,425 62,987 61,650 28,962 108,767 83,442
Trafigura 0 0 0 16,234 0 0 0 10,714
unknown 0 273 0 0 0 273 0 0
Vitol 68,447 12,842 48,219 56,818 43,204 20,492 42,740 108,766

252,978 159,386 369,681 483,828 252,979 159,383 369,682 483,827

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 15
th
day of the contract month, if such
15
th
day is a business day. For instance, a December contract will expire on the 15
th
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.

44

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.
45

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 25
th
May, the price of Dated
BFOE reflects the price of delivery for the period between the 4
th
of June and the 15
th
of June (11 days).
On 26
th
May, the price of Dated BFOE rolls forward one day to cover the period between the 5
th
and 16
th

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

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.
0
10
20
30
40
50
60
70
80
90
1986 1987 1988 1989 1990 1991
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
46

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)

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

Sales (b/d) Purchases (b/d)

2007 2008 2009 2010 2007 2008 2009 2010
Addax 0 0 411 0 0 0 740 812
Arcadia 23,301 4,918 4,658 14,448 6,553 10,109 6,575 17,208
Astra 0 0 0 0 2,427 1,298 0 0
BNP Paribas 0 0 548 5,519 0 0 2,192 4,221
BP 26,214 55,601 74,085 76,948 43,083 37,432 24,397 75,010
Cargill 485 1,913 411 0 485 4,918 274 1,136
Chevron 17,233 26,093 70,699 84,659 43,811 47,541 53,863 73,195
Chinaoil 0 0 0 0 0 0 1,233 0
0
200,000
400,000
600,000
800,000
1,000,000
1,200,000
1,400,000
1,600,000
47

ConocoPhillips 485 10,410 23,041 33,766 728 24,863 28,630 60,065
Glencore 1,456 1,940 14,219 24,968 485 4,372 9,863 26,299
Gunvor 0 7,240 13,151 3,571 1,942 5,464 3,836 1,299
Hess 971 273 2,192 22,240 0 0 2,192 17,532
Hetco 0 0 0 3,571 0 0 1,096 974
IPC 0 273 2,055 325 0 1,481 3,068 1,786
Iplom 0 0 548 0 0 1,093 548 1,136
Itochu 0 546 7,671 7,253 0 6,126 11,041 10,844
JP Morgan 9,223 11,380 9,153 7,792 1,456 29,358 54,973 14,935
Koch 33,010 36,284 23,556 3,247 11,165 37,205 34,849 32,305
Lukoil 971 13,798 28,559 24,513 485 7,049 20,411 21,753
Maesfield 0 0 1,644 1,136 0 0 0 1,623
Marathon Oil 0 0 0 0 11,408 9,699 548 6,494
Masefield 0 273 1,233 3,247 0 3,825 685 0
Mercuria 34,345 46,809 59,726 79,471 31,311 68,415 99,841 117,156
Merrill Lynch 1,942 4,781 1,918 1,299 7,646 4,645 0 0
Mitsubishi 0 0 0 0 0 0 3,014 0
Mitsui 0 273 0 0 1,456 546 0 0
Morgan Stanley 20,388 24,317 57,882 100,487 20,146 17,760 51,238 88,377
Murphy 0 0 0 0 0 410 0 0
Natixis 0 0 42,033 19,968 0 0 36,849 27,110
Neste 971 4,372 2,740 0 0 3,005 822 1,623
Nexen 1,942 4,577 4,003 6,951 2,427 2,691 5,189 11,685
Noble 0 0 822 14,286 0 0 548 8,442
OMV 1,485 0 14,562 28,545 0 5,787 36,995 48,880
ORL 0 1,093 0 0 0 2,186 0 0
Petraco 0 820 1,644 974 0 1,735 2,192 0
Petrodiamond 0 0 0 1,948 0 0 822 0
Petroplus 5,583 3,825 1,918 0 1,942 0 1,644 0
Phibro 20,146 48,656 68,923 82,867 36,772 52,117 34,400 50,487
Pioneer 0 0 0 0 0 0 137 0
Plains 0 2,732 0 0 0 0 2,466 1,299
Preem 0 0 685 0 0 0 3,562 0
Sempra 971 7,978 9,644 2,273 4,854 15,929 15,616 2,922
Shell 47,694 131,929 132,079 149,221 52,699 39,727 83,995 129,545
Sinochem 0 0 0 1,136 0 273 603 974
Sinopec 0 0 1,932 2,597 0 0 2,800 1,867
Socar 0 0 0 25,000 0 0 0 9,091
Sonatrach 0 0 274 974 0 0 7,260 8,279
Standard Bank 0 0 932 5,575 0 0 548 5,195
Statoil 6,796 2,186 8,630 108,224 4,369 273 8,630 118,130
StatoilHydro 14,563 77,945 59,233 0 6,796 54,781 61,863 325
Totsa 19,782 23,087 45,260 25,974 14,078 46,325 47,397 60,575
Trafigura 971 16,940 29,315 27,955 3,641 13,798 28,877 32,649
Unipec 8,738 7,377 4,521 8,955 0 12,432 29,170 11,578
Valero 1,456 546 1,096 0 9,951 14,208 19,726 54,545
Veba 0 0 0 0 0 1,093 0 0
Vitol 36,044 58,579 132,060 245,692 15,049 49,795 112,447 98,214

339173 641772 961675 1259585 339172 641772 961674 1259585
Source: Argus
48

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 19
th
March 19 for loading on 21
st
-23
rd
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. 19
th
-23
rd
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 19
th
-23
rd
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.
49

19
th
of March stood at $79.53 while the CFD for the week 19
th
-23
rd
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 19
th
-23
rd
April (say 22
nd
of April) i.e. when the cargo
is being loaded, the refiner sells the Forward May contract. On the 22
nd
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 Dated Brent BFOE MAY
Loss/Gain CFD
Loss/Gain CFD
19/04/2010 83.19 83.53
0.2(83.19-83.53)
-0.068
20/04/2010 84.74 84.86
0.2(84.74-84.86)
-0.024
21/04/2010 84.47 84.62
0.2(84.47-84.62)
-0.03
22/04/2010 84.64 84.78
0.2(84.64-84.78)
-0.028
23/04/2010 86.49 86.43
0.2(86.49-86.43)
0.012
Total
Loss/Gain

-0.138

The refinerys final position as of 23
rd
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
(23
rd
of April 2010)
Price Paid for the Cargo
(Average Dated Brent over the period April 19-April 23) 84.706
Gain on Forward Position 5.25
Loss on CFD -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 19
th
-23
rd
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 19
th
-23
rd
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.
50

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 21
st
May, the 10-21 day cargoes refer to 6
th
-17
th
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.
51

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.
73
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.
52

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.
53

Table 8: US Oil Production by District

2004 2005 2006 2007 2008 2009
U.S. 5,419 5,178 5,102 5,064 4,950 5,361
PADD 1
(East Coast) 19 23 22 21 21 18
PADD 2
(Midwest) 435 443 458 470 538 591
Kansas 93 93 98 100 108 108
North Dakota 85 98 109 123 172 218
Oklahoma 171 170 172 167 175 184
PADD 3
Gulf Coast) 3,016 2,804 2,838 2,828 2,699 3,121
Louisiana 228 207 202 210 199 189
Texas 1,073 1,062 1,088 1,087 1,087 1,106
Federal
Offshore
(PADD 3) 1,453 1,282 1,299 1,277 1,152 1,559
PADD 4
(Rocky
Mountain) 309 340 357 361 357 357
Wyoming 141 141 145 148 145 141
PADD 5
(West Coast) 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
California 656 631 612 594 586 567
Source: EIA Website

Table 9: Operable Refining Capacity by District
2004 2005 2006 2007 2008 2009
U.S. 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
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
54

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)

2004 2005 2006 2007 2008 2009
PADD1 (Total) 1,549 1,605 1,497 1,495 1,421 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 460 469 493 574 790 601
Canada 87 88 105 126 151 148

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.
55

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 25
th
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

Source: CME Group
0
2000000
4000000
6000000
8000000
10000000
12000000
14000000
16000000
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
56

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)

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
460127
20991
4
0
50000
100000
150000
200000
250000
300000
350000
400000
450000
500000
N
o
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-
1
0
F
e
b
-
1
1
M
a
y
-
1
1
A
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57

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/d
77
(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)

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 22
nd

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 three-
day window between the expiration of the monthly NYMEX WTI contract and the deadline for
completing the shipping arrangements (i.e. between the 22
nd
and 25
th
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 26
th
of February, the physical front month becomes April which can then be linked to the
April WTI futures contract.

77
Argus (2009), Argus US Crude Prices Explained, 24 September.
78
In our example, the physical month extends in our example from 26
th
January through February 25
th
.
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
450,000
58

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.
59

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)

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 supply-
demand 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.

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60

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

Source: Petroleum Intelligence Weekly

Most Latin American producers
85
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.

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61

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
62

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)

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.
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63

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 inter-
month 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

Notes: Spread deals include Dubai one-month spread, Dubai two-month spreads, and Dubai-Brent and Dubai-WTI
Spreads.
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64

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)

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.
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65

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

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
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66

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 spread
95
, 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.
93
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.
67

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

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 31
st
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.

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68

Figure 23: Volume and Open Interest of the October 2010 Futures Contracts (Traded During
Month of August)

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.

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69

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).
70

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
71

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

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.
-2500
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1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
OECD Non-OECD
72

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

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 EIA
103
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
BP (2010), BP Statistical Review of World Energy, June.
103
EIA (2010), International Energy Outlook 2010, US Energy Information Administration, Table A.5.
28%
18%
54%
Composition of Saudi Exports in
2002
US
Europe
Others
15%
10%
75%
Composition of Saudi Exports in
2009
US
Europe
Others
73

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.
74

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).
75

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 11
th
and 21
st
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 22
nd
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.

76

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

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.
-1.8
-1.6
-1.4
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
01 Sep 11 Sep 21 Sep 01 Oct 11 Oct 21 Oct
$
/
b
l

French refinery
strike begins
Strike
officially
ends
Ice Brent=0
77

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.

78

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 decision-
making 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.
79

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
80

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).
81

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Section 1.5 - Liquefied Natural Gas
- PriceWaterhouseCoopers. Todays LNG Market Dynamics
How are todays
LNG market dynamics
challenging its historic
conventions?
PwC I 3
Now, more than ever, stakeholders in Liqueed Natural Gas
(LNG) projects need to understand not only market trends
in terms of supply and demand, but also the trends that are
inuencing LNG contracting and prices. This is particularly
important for Australian projects, because the AsiaPacic
could emerge as the benchmark region for a global LNG
market, with Australia delivering both long-term secure
supply as well as valuable swing supply to Asian customers.
Global consumption of LNG deed the global nancial
crisis and a fall in global demand for natural gas by growing
more than 8% in 2009, a year of unprecedented growth in
liquefaction and regasication capacity.
Australian LNG projects continue to develop at a record
pace. Their proximity to the major energy consuming nations
in Asia endows a shipping advantage over more distant LNG
suppliers and a lower carbon footprint. The unprecedented
quantum of new LNG project developments, capital
expenditure and new players in the market is transforming
LNG from a supplier-to-buyer and point-to-point long-
term contract market to one that is more nimble and able to
respond to supplydemand imbalances.
Core to the LNG market are pricing mechanisms that are
inconsistent from one region to the next. This begs the question:
Is LNG so different from its petroleum brethren that it will not
evolve into a market in its own right? Given Australias increasing
presence in the LNG market, it will play a major role in shaping
the direction of these developments. This shaping of the market
will bring challenges and opportunities for Australian projects.
This thought leadership paper rst addresses the fundamentals
playing out in the global LNG market, then investigates
complexities and trends around contracting and pricing. The
paper considers the implications for Australian projects and
their potential to inuence the future development of the global
LNG market.
Introduction
PwC I 5
1. LNG market outlook
LNG market fundamentals predict
supplydemand imbalances. Can
Australia play a role as swing producer
in the AsiaPacic?
LNG projects are characterised by relatively large capital
investments and long development lead times. Abundant
sources of gas are stranded in regions of low or modest
consumption, such as the Middle East, East Africa and the Asia
Pacic. Supply is mostly distant from the major markets of East
Asia, Europe and North America (Figure 1). These consumer
markets are characterised by strong seasonality, driven by the
need for summer cooling and winter heating. One of the key
outcomes of this geographical mismatch between supply and
demand has been a relatively high level of gas value differences
between supply and demand centres. Value differences for gas
between markets are much higher (often exceeding several
hundred percent of the commodity value at the domestic supply
source market) than in other hydrocarbon markets, such as
crude oil (where value differences between regions track in the
region 25%). The value difference between global gas markets
was at its highest when there were only a few LNG suppliers
some 10 years ago. However the rapid increase in the number of
liquefaction plants and LNG receiving terminals will narrow the
LNG market value gap by increasing competition for supply and
delivery options.
Figure 1: LNG suppliers and customers, 1Q2010
Import Markets
Stranded Gas
Global movements of contracted LNG have grown more than
three-fold from around 80 Mtpa (million tonnes per annum) to
260 Mtpa in the past 10 years. This has been accompanied
by equally dramatic growth in the number of customers and
regasication terminals. Global regasication capacity is now in
excess of 500 Mtpa, which is nearly double the capacity of just
ve years ago, according to The International Group of Liqueed
Natural Gas Importers (GIIGNL).
Market expansion is one factor that is bringing a moderating
inuence to the value differences between LNG markets.
However, there are other factors, potentially more far-reaching,
that are inuencing potential value differences between the
global gas regions. As the industry matures, advances in
technology are facilitating diversication of gas supply sources
and more efcient methods of production along the entire supply
chain, including:
7%
7%
66%
5%
22%
LNG
Non LNG
CSM
FLNG
Unconventional gas, such as coal seam methane (CSM)
CSM will be an important new source of gas for LNG
production when proposed Australian projects are
developed. The rst is expected to come onstream in 2012.
Floating LNG (FLNG)
FLNG production vessels can liquefy and store gas and feed
LNG into ships directly, with minimal pipeline infrastructure
and no onshore facilities. Due to their mobility, they can make
economically viable some smaller stranded gas discoveries.
Modular liquefaction
Modular construction of major liquefaction plant units and
supporting components allows less costly LNG liquefaction
infrastructure to be developed faster and more efciently.
Onboard regasication
Some newer LNG supply vessels can regasify and feed
natural gas directly into customers pipelines, obviating the
need for receiving terminals in some situations, and making
possible delivery to multiple sites from one vessel.
These trends are lowering capital and operating costs, as
well as reinforcing market trends towards greater exibility
and efciency, and less variability between projects. Although
resisted by some of the larger producers that argue that LNG
is different due to technical and safety issues associated with
trading, the makings of an LNG spot market has emerged in
the past few years. The overall trend, in response to technical
developments and market dynamics, is towards lower costs and
more efcient means of delivering gas from the wellhead and
ultimately into the demand centres.
Looking forward
The immediate outlook for global LNG demand is for supply to
exceed demand over the next couple of years. This prediction
by energy analyst, EnergyQuest, is based on the substantial
liquefaction capacity coming into production in Qatar, together
with new projects in Indonesia (Tangguh), Russia (Sakhalin),
Yemen, Australia (Pluto), Algeria, Nigeria, Angola and Peru. At
the same time, LNG demand from the United States is expected
to fall, largely due to the growth in shale gas production.
The additional supply will gradually be absorbed as demand
increases with the recovery of the global economy. It is not clear
whether this period of slower overall global energy demand
growth is temporary or more structural in nature. Uncertainty
has delayed some LNG project nal investment decisions (FIDs),
contributing to a projected LNG supply shortfall around 2014.
As with other large energy infrastructure developments,
oversupply can be common; rather than a shortage, because
capacity is built in anticipation of demand. There is a further
surge in supply likely from around the middle of the decade as
new projects already in construction or front-end engineering
and design come into production. This may well create a surplus
in the global market post 2015.
Looking local
New projects and expansions in Australia and Papua New
Guinea (PNG) will be signicant contributors to new supply.
Capital expenditure in the region is expected to total more
than A$340 billion (including over A$20 billion for PNG LNG)
from now until 2015. Australian investment is dominated
by the giant projects competing to supply growing Asian
energy requirements. More than 90% of the projected capital
expenditure in Australia is directed at export LNG markets rather
than domestic gas developments, and FLNG and CSM are
emerging as sizeable new market segments (Figure 2).
Figure 2: Australian LNG projects by technology, share of
cumulative capital expenditure 201015
Note: Non LNG is domestic gas
Source: ABARE list of major minerals and energy projects 2009; The
Australian Financial Review; PricewaterhouseCoopers
Implications for Australian projects
Australian projects face the immediate challenge of
securing contracts for large volumes in an oversupplied
market. There will be pressure for more favourable buyer
terms as competition to contract supply intensies.
Australian projects taking supply to the market in the
medium term should be able to take advantage of market
opportunities created by a predicted shortfall in supply
around 2014.
CSM projects will be challenged with developing
gas resources so that they are available in time for
commissioning of LNG plants; they are able to manage
any quality differences that impact gas value; and they can
meet the competition for LNG supply agreements.
PwC I 7
2. LNG contracting trends
Will the global LNG market evolve
towards common supply contracting
and pricing terms?
Contracted volumes of LNG have increased exponentially over
the past 10 years, as LNG production capacity has expanded to
meet global demand. At the turn of the century, nearly 2.7 billion
tonnes of LNG were sold or committed for sale in 85 contracts.
By 31 March 2010, this had more than doubled to nearly 5.8
billion tonnes in 198 contracts (Figure 3).
The rapid upswing from 2002 to 2010 reects recent rapid
market growth for contracted LNG. At the same time, a large
number of contracts will be expiring as sources of supply are
depleted, with new contracts continually being written to replace
them. However, given the signicant pipeline of potential new
projects and the importance of securing contracts to reach FID
and completion, it is surprising that contract volumes fall away
as rapidly as they do from around 2018.
Shorter term contracts:
Are they here to stay?
The market is accommodating shorter term contracts; tenure as
low as one year or less (Figure 4). However, these contracts tend
to cover smaller volumes (Figure 5). The number and volume of
contracts are still dominated by longer term sales arrangements,
but the shorter term market is evolving.
As LNG markets mature, producers are more condent in the
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MT p.a
Contracts in IQ2000 Contracts in IQ2010
Figure 3: Global LNG contract volume by year of delivery,
1Q2000 and 1Q2010
Source: Bloomberg
Figure 4: Global LNG contract duration by number of contracts,
1Q2000 and 1Q2010
Source: Bloomberg
Figure 5: Global LNG contract duration by volume,
1Q2000 and 1Q2010
Source: Bloomberg
0%
20%
40%
60%
80%
100%
0 1 0 IQ2 0 0 0 IQ2
10 years 10-20 years 20-50 years
0%
20%
40%
60%
80%
100%
0 1 0 IQ2 0 0 0 IQ2
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scope for future contracting, and this may favour shorter term
contracts as well as partial contracting (with or without volume
swing options). However, projects struggle where too much
uncontracted volume exists, making it more difcult to secure
project nancing. This is less of an issue when the project
sponsor has a broader portfolio of LNG supply and can readily
manage any mismatch in supply and buyer agreements. These
same companies may be reluctant to lock in to long-term supply
16
63
43
120
0
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Europe Asia/Pacific
4
29
Americas
Number of contracts
IQ2000 IQ2010
Figure 6: Global LNG contracts by import region, 1Q2000 and 1Q2010
Source: Bloomberg
Figure 7: Global LNG contract volume by year of delivery and export
region, 1Q2000
Source: Bloomberg
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Europe Asia/Pacific Middle East Africa Americas
Figure 8: Global LNG contract volume by year of delivery and export
region, 1Q2010
Source: Bloomberg
Europe Asia/Pacific Middle East Africa Americas Non-specific
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contracts at unfavourable terms if they expect tightening in the
LNG market in the future. The increasing relative importance
of Atlantic markets (Europe and Americas), where most spot
contracts are negotiated, may be another contributing factor
(Figure 6).
In 2009, some LNG cargoes destined for Europe were diverted
to the AsiaPacic region, and some major Asian customers
took smaller spot LNG supply to take advantage of market
conditions. These represent tentative steps towards a global
spot market responsive to regional price differences. Some
of the reasons behind these price differences are discussed
below. More frequent inter-regional trade is also being facilitated
by more exible shipping (eg onboard regasication), and the
removal of destination restrictions from some contracts under
pressure from customers in a buyers market.
From the supply side, the emergence of the Middle East as a
signicant exporter has introduced signicant new competition
for Australian LNG suppliers. (Figures 7 and 8).
The Middle East has been the most active contracting region for
LNG supply in recent times, but Australia dominates the Asia
Pacic region in LNG contracting as other supply arrangements
wind down.
As more companies in more locations enter the market on
both sides of the negotiating table, more diverse contracting is
evolving. In the very early days, the norm was a supply contract
for all projected volume to a xed delivery destination and at a
xed price, perhaps with a price index escalator (or a pricing
band to put limits around price where crude oil indexation was
used). Although some of these contracts are still in existence
today, more recent contracts tend to include more complex
arrangements, such as price averaging to reduce volatility. Price
banding and delivery destination restrictions are less common,
and terms, such as options on additional cargoes, are more
common.
PwC I 9
East and west gas prices: Will they
converge?
Prices in most LNG contracts are linked to an energy index.
Crude oil indexes were used initially because oil was a mature
market that facilitated ease of benchmarking and price risk
management. As gas markets have developed, different indexes
have been adopted in demand regions with actively traded gas
markets (Table 1).
Benchmarking LNG contract prices against these different
indexes has resulted in different prices being paid for LNG and,
hence, systematic arbitrage spreads between regions. These
spreads have widened in recent years.
Although there are no published series for traded LNG spot
prices, for the markets where there is direct gas indexation
for LNG, it is possible to compare spot prices for natural gas.
The difference between those markets can be signicant, as
reected in the domestic gas markets in Europe and Canada
where the price gap averaged US4.50/GJ in 2009.
For regions using oil indexes, it is also possible to estimate the
extent of price differences by applying the different indexes to
typical contract terms. For example, a typical contract price in
the AsiaPacic region is determined by a formula similar to the
following:
LNG price = (gas/oil parity factor) x JCC + beta + S-curve
gas/oil parity factor is usually in the range 0.140.18 because
gas contains approximately 67 times less energy value than
oil
JCC is the Japanese Crude Cocktail index
beta is simply a pass-through of known transport costs
S-curves, which place a band around the price with a cap
and oor, are becoming a thing of the past as suppliers and
customers increasingly manage these risks separate to
supply contracts.
The gas/oil parity factor and the index are the main terms for
negotiation. If energy value were the only determining factor
in the relative prices of gas and oil, then LNG prices based on
different indexes would be about the same. However, oil markets
are diverging from gas markets, and their relativities are different
in different regions (Figure 9).
If oil was priced consistently at parity to gas, these ratios would
be the same, at around six times. However, in North America,
the ratio has increased in recent years to more than 12 and in the
United Kingdom it has oscillated around a factor of 10, implying
that oil is priced higher than would be explained by its energy
value alone (Figure 10). The indexes used in LNG contracts
in different regions have diverged over recent years and are
expected to diverge further, based on futures market values.
Figures 9 and 10 do not show actual LNG contracted prices;
rather they show equivalent spot market values based on price
Region Common Indexes Commodity

East Asia China,
Japan, Korea,
Taiwan
JCC (Japan Crude
Cocktail)
Crude oil
Continental Europe Various Combination
of crude oil, oil
products and
other energy
commodities
United States,
United Kingdom
NBP (National
Balancing Point)
Henry Hub
Domestic gas
Table 1: Price indexes for LNG contracts by demand
Figure 9: Crude oil/natural gas price ratio, North America and
United Kingdom, 19962014
Source: Market prices converted to US$/mmbtu
0.00
2.00
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Historical Future
Brent/NBP Gas WTI/Gas Henry Hub Energy Parity
Figure 10: Equivalent spot market values based on price indexes,
19962014
Source: Market prices converted to gas equivalent using an oil/gas
energy ratio of 6:1
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Historical Future
JCC Brent Gas Equiv. WTI Gas Eqiv. UK Gas US Gas
indexes and how these diverge from the anticipated parity
energy caloric value. They demonstrate how different indexes
can create large differences in the LNG prices actually paid to
suppliers.
LNG contracts in the AsiaPacic region that are price-
referenced using crude oil have generally delivered much higher
prices than LNG contracts priced on natural gas in the United
States and the United Kingdom. LNG contracts priced on a mix
of energy commodities would fall somewhere between the two
extremes. Even though both sides of the North Atlantic link LNG
prices to natural gas price indexes, when the formula is applied
to prices from the futures markets, LNG contract prices in the
United Kingdom display a higher forward price outlook than in
the United States.
Over a period when other sources of energy market arbitrage
are diminishing, this systematic LNG arbitrage value stands out.
It goes some way to explaining the ow of LNG cargoes from
the Atlantic Basin to the Pacic Basin in recent years. It is also
leading to pressure from both buyers and sellers to change the
way contract prices are indexed. As natural gas markets develop
and risk management options improve, crude oil indexes
become less relevant. After the extreme volatility in crude oil
markets over several years, both buyers and sellers of LNG are
looking for greater stability in pricing. If crude oil is sidelined as
an acceptable index, the question arises whether worldwide gas
markets are sufciently well developed to provide both a suitable
index and risk management opportunities. The other option is to
price LNG off LNG!
Some market participants are taking steps to reduce uncertainty
further by calling for the development of a standardised LNG
contract. Although negotiating power shifts between buyers and
sellers depending on whether there is oversupply or a shortage,
uncertainty is a challenge for all market participants.
Is standardisation the future for LNG
contracting?
The Association of International Petroleum Negotiators (AIPN),
a not-for-prot member organisation of 2200, has as one of its
core tasks, the development of model contracts. In 2009, it
released its AIPN Model LNG Master Sales Agreement (MSA)
for spot sales of LNG where transportation is provided by
the seller on an ex ship basis. The MSA covers the following
components:
contract term
sale and purchase obligations
product quantity and delivery tolerances
pricing terms
payment and invoicing
credit support
taxes, duties and charges
transportation unloading
measurement and testing

force majeure
dispute resolution.
These components demonstrate the complexity of LNG
contracts, which also reect physical parameters, such as
product quality and the customers specic delivery needs.
Nevertheless, the AIPN created the model MSA to facilitate
the creation of a more efcient LNG secondary market, and
encourage trading and arbitrage of LNG cargoes (see www.aipn.
org). Although the LNG spot market is very much in its infancy,
the availability of an accepted standard contract may accelerate
its development. As the market matures, the emergence of a
secondary market is a natural part of its evolution. However,
despite technological developments towards greater exibility,
LNG production, distribution and consumption remain
technically challenging relative to other energy sources, such as
crude oil. Therefore, there may be a limit to the extent to which
LNG can be freely traded on spot terms.
Implications for future LNG pricing

Australian LNG projects that are indexed to petroleum
mostly delivering into Asia have been enjoying
relatively high prices; but, how long will this last? When
capacity comes onstream from 2015, will Asian buyers
reject contract prices indexed to crude oil and look for a
closer relationship with the Atlantic basin?
Less than full contracting of LNG plant may compromise
nance, which may not be available if all capacity is not
committed. The challenge is to strike the best balance of
contract terms for the individual project parameters.
The degree of support for transparency in LNG global
pricing through a standardised index is mixed. Support
will grow with increasing exibility in the market and
additional facilities and market participants.
Arbitrage opportunities; exible delivery terms, greater
production and delivery efciency; and standard form
agreements should facilitate the development and
potential acceptance of a more liberal LNG market. The
question arises whether the LNG market will evolve into a
market unto itself or always remain a submarket of other
energy markets.
Consolidation of price indexes used for LNG contracts
will only happen if a competitive market is fostered,
and support is provided by the industry at large for its
development. Surprisingly, an international spot market
for LNG could provide further impetus for a single
international spot gas market index!
Will the LNG market of 2020 behave in much the same
way as the crude oil market of 2010? Will the AsiaPacic
region provide the benchmarks for indexes? Is this an
opportunity for Australian LNG stakeholders to play a
leading role in the global LNG market, delivering both
secure long-term contracted supply and spot volumes
on demand?
pwc.com.au
2010 PricewaterhouseCoopers. All rights reserved. PricewaterhouseCoopers refers to
PricewaterhouseCoopers or, as the context requires, the PricewaterhouseCoopers global
network or other member rms of the network, each of which is a separate legal entity.
Section 1.6 - Unconventional Products
- Deutsche Bank. Oil and Gas for Beginners: A Guide to the Oil and Gas Industry
- Michael Toman, Aimee E. Curtright, David S. Ortiz, Joel Darmstadter, Brian Shannon.
Unconventional Fossil-Based Fuels: Economic and Environmental Trade-Offs
Europe United Kingdom
Oil & Gas Integrated Oils

9 September 2010
Oil & Gas for
Beginners
A guide to the oil & gas
industry

Lucas Herrmann, ACA
Research Analyst
(+44) 20 754-73636
lucas.herrmann@db.com
Elaine Dunphy, ACA
Research Analyst
(+44) 207 545-9138
elaine.dunphy@db.com
Jonathan Copus
Research Analyst
(+44) 20 754-51202
jonathan.copus@db.com

Deutsche Bank AG/London
All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local
exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche
Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm
may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single
factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1.
MICA(P) 007/05/2010
Industry Update

The basics of the 'Black Stuff'
Deutsche Bank's overview of the global
oil & gas industry. Structured in three
parts, this layperson's guide includes
details on the workings of the oil & gas
industry, key oil producing countries and
a summary of the assets and portfolios of
the leading European and US oil & gas
companies.

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9 September 2010 Integrated Oils Oil & Gas for Beginners
Page 226 Deutsche Bank AG/London
Canadas Oil Sands
A huge unconventional resource
Canadas oil sands represent the largest single undeveloped, discovered, oil resource
globally. All told, an estimated 143bn barrels of recoverable oil lie in the sand, water and clay
of Northern Alberta. These reserves are second in size only to Saudi Arabia and 50% greater
than those of Iraq. Moreover, with an estimated total resource of as much as 2.5 trillion
barrels, huge potential exists for technological improvements to further enhance the extent to
which this resource can ultimately be recovered.
Figure 346: Of 2.5trillion bbls, 143bn are
recoverable and 6bn produced to date

Figure 347: Oil sands mean Canada has
reserves second only to Saudi Arabia
Proven
6%
Tot al resources
94%
Produced
4%
Commercial
28%
Undeveloped
68%

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Bn bbls
Convent ional Oil Sands
Source: BP Statistical Review, Wood Mackenzie

Source: BP Statistical Review June 2010
Three locations, two principle extraction techniques
Oil sands represent heavy and thick deposits of bitumen-coated sand. They are found in three
different deposits in northern Alberta; Athabasca; Peace River and Cold Lake, which extends
into neighbouring Saskatchewan (see map). In contrast with conventional crude oil which
flows naturally or is pumped from the ground, the bitumen from oil sands must be mined or
recovered in situ (i.e. the bitumen will be extracted in place rather than mined and extracted
subsequently). The Athabasca deposit which is the largest of the three has the highest
concentration of developments, a feature which in large part reflects the fact that it is the
only one shallow enough to be suitable for surface mining. This can be done at depths of up
to 75 metres. However, at depths of greater than 75 metres mining becomes uneconomic
and alternative in-situ methods are required. Two methods of in-situ extraction are used;
steam assisted gravity and drainage (or SAGD) and cyclic steam stimulation (CSS). Of these,
SAGDs higher recovery rates mean it is by far the most frequently used.
Of the current reserves base 80% are expected to require in-situ extraction. However, of the
reserves attributed to current projects around two-thirds will be exploited by mining.
This is not crude oil it is low value bitumen
Compared with conventional production methods, the oil sands are very capital intensive and
expensive to extract requiring significant energy. This is particularly true of the in-situ
processes which require a mscf of natural gas for every barrel of bitumen recovered. The
bitumen produced is also not suited to the North American refining market, its very low API
(under 10) requiring specialist refineries. Consequently it sells at a substantial ~$25/bbl
discount to WTI. Most of the current mines therefore have invested in expensive upgraders.
This second and separate process takes the bitumen and upgrades it to create a lighter
product with similar characteristics to conventional crude oil. The resulting synthetic crude oil
or syncrude as it is commonly termed, sells at a similar price to WTI.
An estimated 143bn barrels
of recoverable oil lie in the
sand, water and clay of
Northern Alberta.
Deutsche Bank AG/London Page 227
Given all of this it is perhaps surprising that the oil sands should be the subject of such a
wave of investment. However, high oil prices aside, in an era of political uncertainty Canada
represents a haven of stability. Moreover, the fiscal terms available have proven by and large
attractive and largely stable with the Alberta authorities encouraging investment. This,
together with the outlook for production is discussed further in the Countries section.
Figure 348: Canadas Alberta Home to the oil sands and the location of the three key
deposits
Hudson Bay
Nunavut
CANADA
UNITED STATES OF AMERICA
Arctic Ocean
Northwest Territories
Yukon
Beaufort Sea
Victoria
Island
B
affin Island
GREENLAND
(DENMARK)
British
Columbia
Alberta
Saskatchewan
Manitoba
Ontario
Quebec
USA
Alaska
Pacific Ocean
Athabasca
Oil Sands
Cold Lake
Oil Sands
Peace River
Oil Sands
Wabasca
Oil Sands
130W 140W 150W 160W 170W
120W 110W
110W
100W
90W
90W 80W
70W 60W 50W 40W 30W
40N
50N
50N
60N
60N
70N
130
W
140
W
160
W
170
W
50W
30W
40N
0 500 1,000 250
km
Source: Wood Mackenzie
Methods of Extraction Mining
About 10% of the Athabasca oil sands, accounting for an area of c.3,400km, are covered by
less than 75 metres (250 feet) of overburden making them readily accessible for mining. The
overburden consists of 1 to 3 metres of water-logged muskeg on top of 0 to 75 metres of
clay and barren sand, while the underlying oil sands are typically 40 to 60 metres thick and sit
on top of relatively flat limestone rock.
The oil sands are mined using truck and shovel methods, 100 ton power shovels lifting the
sands into 400 ton trucks for transport to an ore preparation plant. Here the untreated oil
sands are crushed and mixed with hot water and caustic soda to create a slurry before
moving on to an extraction facility where it is agitated. The combination of hot water and
agitation releases bitumen from the oil sand and, by allowing small air bubbles to attach to
the bitumen droplets, the bitumen floats to the top of the separation vessels as a froth which
can be skimmed. After some further treatment to remove any remaining water and fine
solids, the bitumen is then diluted with lighter petroleum (typically naphtha or paraffin) to
allow it to flow (this can require as much as 40% dilution) after which it can be transported by
pipeline as low value, dilbit for upgrading.
Overall, around 90% of the bitumen can be recovered from sand with about two tons of tar
sands required to produce one barrel (roughly 1/8 of a ton) of oil. Separate to the extracted
bitumen, the remaining tailings are then thickened by dewatering before being returned for
reclamation with the warm water recovered re-entering the extraction process. The diluted
bitumen or dilbit is then transported via pipeline to an associated upgrader. At the present
time, all of the Alberta mining projects have associated upgraders although several un-
integrated projects are in planning or underway.
Figure 349: Canada Oil sands Mining projects existing and planned
Project Status Start-up Reserves
(mbbls)
Peak
(kb/d)
Capex
(US$m)
Main Participants Method
Suncor Mine Onstream 1967 3,182 287 36,351 Suncor Energy* (100%) Mining with Upgrader
Syncrude Onstream 1978 6,507 600 67,304 Syncrude JV (See note below) Mining with Upgrader
Foster Creek Onstream 2001 1,788 210 8,566 Cenovus Energy* (50%), COP (50%) SAGD no upgrader
Christina Lake Onstream 2002 1,534 218 8,184 Cenovus Energy* (50%), COP(50%) SAGD no upgrader
AOSP Onstream 2003 3,671 370 50,486 Shell* (60%), Chevron (20%), Marathon (20%) Mining with Upgrader
Suncor SAGD Onstream 2004 2,431 229 21,479 Suncor Energy* (100%) SAGD with upgrader
Long Lake Onstream 2008 1,693 144 24,764 Nexen* (65%), OPTI (35%) SAGD with upgrader
Horizon Project Onstream 2008 2,294 162 21,027 Canadian Natural Resources* (100%) Mining with Upgrader
Planned
Kai Kos Dehseh Development 2010 900 80 4,500 Statoil* (100%) SAGD no upgrader
Kearl Development 2013 3,541 220 19,221 Imperial Oil* (71%), ExxonMobil (29%) Mining no upgrader
Sunrise Development 2014 3,000 200 11,316 Husky Energy* (50%), BP (50%) SAGD with upgrader
Fort Hills Probable 2019 1,940 160 12,007 Suncor Energy* (60%) Mining with Upgrader
Source: Wood Mackenzie Pathfinder. * denotes operator Note Syncrude JV comprises COST (36.74%), Imperial Oil (25%), Suncor Energy (12%), ConocoPhillips (9%), Nexen (7.23%), Murphy Oil (5%), Nippon Oil (5%)
Methods of Extraction In-situ
At depths of greater than 75 metres the mining of oil sands is no longer economic.
Alternative approaches which involve heating the subsoil to enable the bitumen to flow are
then used. At the present time there are two main in-situ methods used, SAGD and CSS
although alternatives using either solvents instead of steam (Nexens VAPEX) or in-situ
combustion (ISC), which uses oxygen to promote combustion and generate heat, are also
being trialed.
The oil sands are mined
using truck and shovel
methods
At depths of greater than 75
metres the mining of oil
sands is no longer economic
Steam Assisted Gravity and Drainage (SAGD)
The gravity drainage idea was originally conceived by Dr. Roger Butler, an engineer for
Imperial Oil around 1969. However, it wasnt really until the development of directional
drilling that the economics associated with SAGD improved to the point that it became
financially viable. SAGD involves drilling two parallel horizontal oil wells in the oil sand
formation. The upper well injects steam and the lower one collects the water that results
from the condensation of the injected steam and the crude oil or bitumen. The injected steam
heats the crude oil or bitumen and lowers its viscosity which allows it to flow down into the
lower wellbore. The large density contrast between steam on one side and water/hot heavy
on the other side ensures that steam is not produced at the lower production well.
The water and crude oil or bitumen is brought to the surface by several methods such as
natural steam lift where some of the recovered hot water condensate flashes in the riser and
lifts the column of fluid to the surface, by gas lift where a gas (usually natural gas) is injected
into the riser to lift the column of fluid, or by pumps such as progressive cavity pumps that
work well for moving high-viscosity fluids with suspended solids.
SAGD tends to result in the recovery of around 60% of the original oil in place (OOIP).
Cyclic Steam Stimulation
CSS is a common enhanced oil recovery technique, accidentally discovered by Shell while it
was doing a steam flood in Venezuela and one of its steam injectors blew out and ended up
producing oil at much higher rates than a conventional production well in a similar
environment.
Also known as the Huff and Puff method, CSS consists of three stages: injection, soaking
and production. Steam is first injected into a well for a certain amount of time to heat the oil
in the surrounding reservoir to a temperature at which it flows. This persists for many weeks
with the steam soaking the subsoil sands before the process is halted. At this time the
wells are turned into producers, at first by natural flow (since the steam injection will have
increased the reservoir pressure) and then by artificial lift. Production will decrease as the oil
cools down, and once production reaches an economically determined level the steps are
repeated again.
The process can be quite effective, especially in the first few cycles. However, it is typically
only able to retrieve approximately 20% of the OOIP. As a result, it has given way to the use
of SAGD as a preferred method of extraction with only three founding projects now using
CSS as their primary means of extraction Cold Lake, Peace River and Primrose/Wolf Lake.
Figure 350: Diagrammatic representation of Cyclic
Steam Simulation (CSS)

Figure 351: Diagrammatic representation of Steam
Assisted Gravity Drainage (SAGD)

Source: Courtesy of Shell

Source: Courtesy of Shell
SAGD involves drilling two
parallel horizontal oil wells
in the oil sand formation.
The upper well injects steam
and the lower one collects
the water that results from
the condensation of the
injected steam and the
crude oil or bitumen
CSS consists of three
stages: injection, soaking
and production.
Figure 352: Canada Oil sands Projects and start up dates (all Athabasca except those shaded)
Project Status Start-Up Reserves
(mmbbls)
Peak
(kb/d)
Capex
^(US$m)
Partners Method
Primrose/Wolf Lake Onstream 1983 951 120 4303 CNR* (100%) CSS/SAGD no upgrader
Cold Lake Onstream 1986 900 165 5203 Imperial Oil* (100%) CSS no upgrader
Peace River Onstream 1986 109 13 897 Shell* (100%) CSS no upgrader
Hangingstone Onstream 1999 380 35 2255 Japan COS 75%; Nexen 25% SAGD no upgrader
Foster Creek * Onstream 2001 1788 210 8566 Cenovus Energy* (50%), COP (50%) SAGD no upgrader
Christina Lake * Onstream 2002 1534 218 8184 Cenovus Energy* (50%), COP (50%) SAGD no upgrader
MacKay River Onstream 2002 563 68 4179 Suncor Energy* (100%) SAGD no upgrader
Suncor SAGD Onstream 2004 2431 229 21479 Suncor Energy* (100%) SAGD with upgrader
Joslyn Onstream 2006 889 100 11986 Total* (75%), Oxy(15%), INPEX (10%) SAGD/Mine with upgrader
Tucker Onstream 2006 347 30 1875 Husky Energy* (100%) SAGD with upgrader
Surmont Onstream 2007 890 111 4354 ConocoPhillips* (50%), Total (50%) SAGD no upgrader
Long Lake Onstream 2008 1693 144 24764 Nexen* (65%), OPTI (35%) SAGD with upgrader
Horizon Project Onstream 2008 2294 162 21027 Canadian Natural Resources* (100%) Mining with Upgrader
Kai Kos Dehseh Development 2010 900 80 4500 Statoil* (100%) SAGD no upgrader
Kearl Development 2013 3541 220 19221 Imperial Oil* (71%), ExxonMobil (29%) Mining no upgrader
Sunrise Development 2014 3000 200 11316 Husky Energy* (50%), BP (50%) SAGD with upgrader
Fort Hills Mine Probable 2019 1940 160 12007 Suncor Energy* (60%) Mining with Upgrader
Source: Wood Mackenzie Pathfinder. *Encana and COP established a JV with COP taking an upstream interest in the Encana fields but offering scope for upgrading of bitumen at two COP facilities ^ CAPEX costs are shown in
2010 terms
Upgrading
Because of limited demand for bitumen itself in North America, the bitumen output from the
oil sands needs to be upgraded if it is to find a market. Consequently, many of those involved
in the production of the tar sands have invested in complex upgrading refineries designed to
break down the long chain bitumen carbon molecules into shorter, lighter chains more
representative of crude oil. In the first stage of the upgrading coking or hydro-cracking is used
to break up the heavy hydrocarbons. The second stage, hydro-treating, uses hydrogen to
remove impurities, namely sulphur. Depending upon the technology chosen and the capex
spent upgraders can be designed to produce differing API crudes with different sulphur
content.
The scale of the cost should not, however, be underestimated. In 2007 when making a
regulatory application to build a new 400kb/d upgrader, Shell indicated that the total project
would cost as much as $27billion i.e. $67,500/flowing bbl. This compares with the estimated
$15,000/flowing barrel cost of a green-field refinery. In 2008 Statoil withdrew its application
for an upgrader on its Leismer project. It initially planned to spend $4bln on an 80kb/d
upgrader, increasing this capacity to 243kb/d in subsequent phases for a total cost of $16bln.
However, it subsequently found the costs to be too prohibitive. Similarly, both the upgrader
and the upstream development of Totals Northern Lights project were postponed due to the
overheated cost environment in Canadas oil sands industry.
Because the majority of the large mining projects have associated upgraders, around 70% of
the oil sands production is sold in North American markets as synthetic crude oil or syncrude.
This can readily be refined within North American markets. Nonetheless, as production from
often smaller SAGD developments builds, so the volume of untreated diluted bitumen is also
expected to increase significantly.
This represents both an opportunity for refiners but also a potential threat to the tar sands
industry. To the extent that investment in expensive cokers and hydrocrackers is made
across North American refineries, it represents a good opportunity to capture a significant
proportion of the value of the tar sands barrel. This is a strategy that companies such as BP
The bitumen output from
the oil sands needs to be
upgraded if it is to find a
market.
are looking towards as a way of benefiting from the growth in production from Canadas oil
sands. However, if this investment is not made, the resulting surplus in bitumen production is
almost certain to see an increase in the discount to WTI at which dilbit currently sells, so
placing further potential pressure on the economics of an already very costly process.
Figure 353: Expected output of syncrude and bitumen from Canadas Oil Sands 2000-
2015E
0
500
1000
1500
2000
2500
3000
3500
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
2
0
1
5
2
0
1
6
2
0
1
7
2
0
1
8
2
0
1
9
2
0
2
0
kb/d
Syncrude Bit umen
Source: Wood Mackenzie GOST
Costs The highest marginal cost barrel on the globe
Although there are no exploration or finding costs associated with oil sands production, the
energy intensity of the projects combined with the sheer scale of the facilities required for
the production of bitumen means that the fixed capital and variable operating costs of their
production are amongst the highest in the world.
Before the global economic crisis gathered pace in 2008, the pace of growth in activity in the
oil sands drove dramatic cost inflation in the industry with the estimates for expenditure on
many projects at least doubling from first inception. In particular, with so many companies
looking to expand production the local labour force has been overwhelmed with the
population of Fort McMurray, the unofficial centre of the industry, growing annually at a rate
of just below 10%. This exorbitant cost inflation coupled with the global economic crisis and
the subsequent crash in oil prices in 2009 saw a significant decline in the number of final
investment decisions taken on oil sands projects in Canada. Even with some level of cost
deflation since then, Wood Mackenzie still estimates that the breakeven oil price required for
a SAGD project is $65/bbl, while mining projects require nearer $90/bbl (discounted at 15%).
The very heavy, upfront capital costs associated with doing business in the oil sands are thus
a high feature that not surprisingly, weighs very heavily on the internal rates of return that
these projects can achieve. However, because of the very large reserves associated with
most developments, at around $7-8 per upgraded barrel the DD&A cost is not dissimilar to
that seen in many other parts of the oil industry.
The DD&A charge is, however, as nothing when compared with the variable operating costs
associated with extracting an oil sands barrel. At comfortably over $20 per upgraded barrel
there can be little doubt that the oil sands represent amongst the highest marginal cost
barrels in the world. Not least amongst these costs are those for natural gas given that for
every barrel produced under the SAGD process at least 1mscf of gas will be required.
Cost inflation in recent years
has been dramatic
Indeed, even an upgraded mined barrel requires around 0.75mscf per bbl of production given
the energy requirements of the upgrader (0.5mscf/bbl). Add to this the costs associated with
diluting the bitumen for transport and the pipeline costs themselves, and it soon becomes
very clear that the oil sands need high crude prices to prove economic.
In the table below we have used Wood Mackenzie estimates of full cycle project costs to
estimate the fixed and variable costs per barrel of production over a range of different
projects. The analysis emphasizes that on average, the full cash costs for a mined, upgraded
barrel runs at around $30/bbl with the more recent projects looking at something nearer
$40/bbl. Of this the variable component stands at $25/bbl. Remove the upgrader and the full
costs per barrel fall by almost half to $20/bbl. However, this reduction in cost is achieved for
a c$25/bbl reduction in end market price.
For SAGD projects the upfront capital costs are cheaper with DD&A running at a modest $5-
8.50/bbl against nearer $11/bbl for those from a mined barrel with upgrader. At an average
$18/bbl the variable costs of production are, however, even higher than those of a non-
upgraded mine a feature which in large part reflects the even greater energy-requirements of
the SAGD process (namely the gas required to produce steam).
Figure 354: Fixed, variable and full cost estimates for a range of oil sand facilities
Project Reserves
(mmbbl)
Capex (US$m) Opex (US$m) DDA ($/bbl) OPEX ($/bbl) Full cost
($/bbl)
Jackfish 588 2949 10372 5.02 17.64 22.65
Kearl 3541 19221 42625 5.43 12.04 17.47
Average Mine no Upgrader 5.37 12.84 18.21
AOSP 3671 50486 126035 13.75 34.33 48.08
Fort Hills Mine 1940 12007 25991 6.19 13.40 19.59
Horizon Project 2294 21027 57176 9.17 24.93 34.10
Suncor Mine Project 3182 36351 101887 11.43 32.02 43.45
Syncrude Project 6507 67304 210641 10.34 32.37 42.71
Average Mine with Upgrader 10.64 29.65 40.29
Christina Lake 1534 8184 22767 5.34 14.84 20.18
Foster Creek 1788 8566 30848 4.79 17.25 22.05
Hangingstone 380 2255 6761 5.93 17.77 23.70
Kai Kos Dehseh 900 4500 14893 5.00 16.55 21.55
Orion 185 1020 2682 5.50 14.48 19.98
Surmont 890 4354 15348 4.89 17.24 22.13
Average SAGD no Upgrader 5.09 16.43 21.52
Long Lake 1693 24764 29676 14.63 17.53 32.16
Suncor SAGD Project 2431 21479 60191 8.83 24.76 33.59
Sunrise 3000 11316 48865 3.77 16.29 20.06
Tucker 347 1875 5585 5.41 16.11 21.52
Joslyn 889 11986 18472 13.48 20.78 34.26
Average SAGD with Upgrader 8.54 19.47 28.02
Source: Wood Mackenzie Pathfinder, Deutsche Bank estimates

On average, the full costs for
a mined, upgraded barrel
runs at around $30/bbl with
the more recent projects
looking at something nearer
$40/bbl
Gas to Liquids (GTL)
An expensive alternative to LNG
Gas-to-liquids technology represents a means of converting natural gas into liquids. Energy
and capital intensive, the process offers the potential to convert large reserves of stranded
gas to higher value, high purity, synthetic liquids namely diesel, naphtha and lubricant base
oils which can be transported to consuming markets. Based on a catalytic chemical reaction
called the Fischer-Tropsch process, the chemical process at its most basic represents the
addition of single carbon molecules to create carbon chains, the lengths of which can, to
some extent, be determined by altering the conditions through the conversion process.
Because of the very high associated costs, GTL is unlikely to prove economic at oil prices
below $40/bbl. However, at high oil prices the process creates far greater value than the
main alternative for gas monetisation, LNG. At this time, only two companies, SASOL and
Shell have technology proven to work on a commercial scale.
Background
In the 1920s, two German scientists Franz Fischer and Hans Tropsch sought to discover an
alternative source of liquid fuels in petroleum-poor but coal-rich Germany. They discovered
that by combining carbon monoxide with hydrogen (collectively entitled syngas) in the
presence of either an iron or cobalt catalyst at high pressures and temperatures, they could
create longer chain, liquid, carbon molecules (synthetic petroleum) which could be used as
fuel. Moreover, the fuel produced contained no sulphur, aromatics or other impurities all of
which enhanced engine performance. For countries in need of transport fuels but lacking in
access to crude oil, their process became an important alternative source of supply. Indeed,
by the time of World War II Germany was producing over 125kd/d of synthetic fuels from 25
plants. Similarly, the process was used by South Africa to meet its energy needs during its
isolation under Apartheid, with the South African energy company, SASOL, becoming the
global leader in the commercial application of Fischer-Tropsch technology for the production
of high quality diesel fuels albeit predominantly using coal as a source of carbon.
Today, GTL represents the potential for those countries with substantial, low cost, stranded
gas resources to monetise their gas and diversify their sources of revenue by producing high
value, transport fuels and lubricants rather than LNG or other low value-added base chemicals
such as methanol.
Figure 355: The GTL process straightforward addition chemistry removes the need
for a refinery. But very commercially and technologically challenging
Product
Upgrade
LPG
Kero/Diesel
(plus specialties)
Naphtha
Syngas
Generation
H
2
CO
O2
Air
Separation
Air
Fischer
Tropsch
(cobalt
catalyst)
Gas Gas
Processing
+ +
Pre-Treat - -
Natural Gas
C5+, LPG & (Ethane)
H
2
S, CO
2
, H
2
O, other
Hydrogen
Remove impurities and
longer chain gases
Use of hydro-cracking to
crack wax and create
desired chain length
Mix syngas with liquid wax
slurry such that it diffuses
into it and creates more wax
No sulphur, no aromatics,
high performance fuels
CH
4
Source: Deutsche Bank
Gas-to-liquids technology
represents a means of
converting natural gas into
liquids
Commercial GTL plants are limited
Although it is now almost 90 years since the discovery of the Fischer-Tropsch process, the
commercialisation of GTL remains very much in its infancy. To date, only three plants are
operating commercially, Petro SAs 22.5kb/d in South Africa, Shells 14.7kb/d Bintulu plant in
Malaysia and SASOLs 34kb/d Oryx facility in Qatar (where teething problems deferred full
output to mid-08). Shells giant Pearl GTL facility is due to commission at the end of 2010 and
is expected to ramp up slowly over a 12-18 month period.
Figure 356: GTL today: Still an emerging industry
14 700 bpd
Malaysia SHELL
Existing GTL (gas)
22 500 bpd
South Africa
(Petro SA)
34 000 bpd
Qatar SASOL
Planned GTL
140,000 bpd
Qatar SHELL
34,000 bpd
Nigeria SASOL-
CVX
The low number of GTL plants reflects several factors:

Capital costs: The capital costs associated with constructing GTL facilities remain
substantial. In part this reflects the inability of companies to find benefit from improved
reactor economics. Given the extremely explosive and challenging conditions under
which these operate, increasing reactor capacity has proven very difficult. Consequently,
projects operate in batch mode, each unit having a capacity of around 8kb/d using Shells
fixed bed technology or 17kb/d using SASOLs slurry process (but which produces a
lower value end product slate). To build a commercial plant with significant output is thus
extremely expensive with Shells Pearl GTL plant expected to cost around $80k per
barrel of capacity.
Figure 357: Costs per b/d of the three
planned GTL projects

Figure 358: Estimated IRR (%) and NPV
at different oil prices Shells Pearl project
0
10000
20000
30000
40000
50000
60000
70000
80000
90000
Oryx Pearl Escravos
US$/bbl

0
10000
20000
30000
40000
50000
60000
70000
$40 $60 $80 $100 $120
NPV Full Cycle ($m) NPV Remaining ($m) NPV Start-up ($m)
IRR 10.5% IRR 27.0% IRR 23.4% IRR 19.8% IRR 15.9%
NPV $m


Energy intensity: GTL is a very energy intensive process. Overall, around 40% of the
energy value of the natural gas used in the process is lost, with extensive associated
production of carbon dioxide. For example, Shells Pearl GTL facility is expected to
require 1.6bcf/d of gas or the oil equivalent of 270kboe/d to create 140kb/d of oil
products. This contrasts with the production and shipping of LNG, the major alternative
for stranded gas, which results in energy usage of a far less material 13% during the
liquefaction process and through boil-off during shipping to its final destination, and an
oil refineries consumption of around 7% of its crude oil feedstock.
The commercialisation of
GTL remains very much in
its infancy
Figure 359: About 40% of the gas entering the GTL process is consumed within it
relative to only 13% for LNG.
GTL Energy Balance LNG Energy Balance
A GTL plant incurs:
Carbon losses of around 30%, due to the extensive production of carbon dioxide and water. Optimal
carbon efficiency of ~75 % may be achieved (depending upon slate)
Energy losses of over 40%, which is primarily associated with the production of synthesis gas, which
is energy intensive. The process looses significant energy in its generation of water, a major by-
product. Optimal energy efficiency of ~65 % could be achieved
LNG value
87%
Shipping
losses
2%
Liquefaction
loss
11%
Losses
40%
LPG
1%
Diesel
42%
Naphtha
17%
Source: Wood Mackenzie; Deutsche Bank

Technology: With the exception of Shell, SASOL and Chevron (through access to
SASOLs technology via the SASOL-Chevron JV), none of the major oil and gas
companies has technology that has been proven on a commercial scale. Although Exxon,
BP and Conoco all claim to have GTL technology, it is unclear at this time whether their
technology is sufficiently advanced to be capable of applying to a large scale,
commercial facility. This has been emphasised following decisions by Conoco and
Marathon in recent years to abandon planned Qatari GTL projects and Exxons more
recent 2007 decision not to proceed with a planned 154kb/d GTL facility, again in Qatar.
In part this doubtless reflects the rising capital costs associated with these ventures.
However, it is also almost certainly indicative of the huge technical risks associated with
operating and constructing a world-scale GTL facility, using technology that is often
unproven. This was highlighted in 2007 when SASOLs Oryx plant suffered significant
start-up teething problems despite SASOLs industry leading expertise in GTL and CTL
(Coal to liquid) markets.
Figure 360: GTL plants on stream and planned
Name Company Location Start-up Capacity (b/d) Comment
Mossgas Petro SA South Africa 1993 22,500 Producing
Sasolburg SASOL South Africa 1993 2,500 Producing
Bintulu Shell Malaysia 1993 14,700 Producing
Alaska BP USA 2002 300 Pilot
Oklahoma Conoco USA 2002 400 Pilot
Oryx SASOL Qatar 2007 34,000 Teething issues
Planned
Pearl GTL Shell Qatar 2012 140,000 Huge cost
Escravos SASOL-Chevron Nigeria 2012+ 34,000 Delayed
On hold/cancelled
Tinrhert GTL Under bid Algeria n.a. 36,000 Postponed (cost)
Palm Exxon Qatar 2012+ 154,000 Cancelled (costs)
n.a. Conoco Phillips Qatar 2010 80,000 Cancelled
n.a. Marathon Qatar 2010 120,000 Cancelled

Oil price: Because of the substantial capital costs of the process and its poor energy
efficiency, the GTL process is rarely economic unless the price of crude oil is high. As
illustrated by the previous figures, based on our estimates a new full cycle GTL plant
being considered today would require an oil price near $40/bbl just to break even and an
oil price nearer $55/bbl to achieve a return nearer typical industry standards. Historically,
the expectation that oil prices were likely to trade at around a $20/bbl band has meant
that the economics around GTL made little commercial sense.
There are positives
Yet despite the costs and the technical challenges, at high crude oil and product prices GTL
represents a substantial opportunity for those countries with substantial gas resources at
their disposal to establish a very profitable and value creating revenue stream. Although the
breakeven costs are high, because of the absolute scale of the investment and the resource
being monetised at oil prices above US$40/bbl the NPV of the project is substantial.
For example, we estimate that where Shells Pearl project would create little more than
$0.5bn of NPV at $25/bbl oil on an $18.5bn investment, at current oil prices nearer $75/bbl
the project would create value of almost US$29bn over its full life-cycle.
For the resource holder GTL also offers the potential to reduce its dependence upon
international gas prices and gain greater exposure to the higher value oil products, not least
diesel and lubricants, so diversifying its risk. Equally, for the integrated oil company, the high
quality of the output slate offers the opportunity to market a high performance, differentiated
fuel that because of its purity (no sulphur, no metals) burns more cleanly and with limited
particulate emissions.
Figure 361: Difference between product slate of a refinery and Qatari GTL projects
with no low value fuel oil produced the GTL slate is of far greater value
Traditional Crude Slate Shell GTL slate Sasol GTL slate
Raw material Crude oil Natural Gas Natural Gas

Process Refinery

Product slate Product slate Product slate
LPG 3% 3% 3%
Naphtha 7% 28% 26%
Gasoline 27% 0% 0%
Middle distillate 40% 54% 71%
Fuel oil 21% 0% 0%
Lubricants/waxes 2% 15% 0%
An uncertain future at this time
GTLs future role in energy markets is thus likely to depend heavily on the direction of future
oil prices and the extent to which technology can bring down the associated capital costs. In
the near term, however, its role in energy markets is likely to be determined more than
anything by the success or otherwise of both SASOL and Shells development projects. If
technologies are proven here and costs contained at budgeted levels, considerable
enthusiasm could follow. In its absence, however, GTL is likely to play only a niche role in
energy markets for some time to come.

GTL represents a substantial
opportunity for those
countries with substantial
gas resources at their
disposal to establish a very
profitable and value creating
revenue stream
Coal Bed Methane
Exactly what it says on the label
While natural gas is perhaps most commonly associated with oil, it also occurs with coal.
Coal bed methane (CBM, also referred to as coal seam gas) is simply methane found in coal
seams. It is generated either from a biological process as a result of microbial action or from
a thermal process as a result of increasing heat with the depth of the coal. Whereas in a
natural gas reservoir such as sandstone the gas is held in the void spaces within the rock,
methane in coal is retained on the surface of the coal within the micropore structure. Often a
coal seam is saturated with water, with methane held in the coal by water pressure. Release
this pressure and it allows methane to escape from the coal.
A substantial resource
During coalification large quantities of methane rich gas are generated and stored within the
coal on internal surfaces. Because the coal has such a large internal surface area it can store
surprisingly large volumes of gas perhaps six or seven times those of a conventional gas
reservoir of equal rock volume. In addition, much of the coal and thus methane lies at shallow
depths making wells easier to drill, whilst exploration costs are low given that the location of
many of the worlds coal reserves are well known.
Figure 362: Geographical location of coal bed methane resources around the world (Gas-initially-in-place estimates)
USA 200 TCF
Current Prodn 4.3bcf/d
Australia 250 TCF
Current Prodn 0.6bcf/d
Europe (France & UK) 50 TCF
Current Prodn NA
China 660 TCF
Current Prodn neg
Indonesia 270 TCF
Current Prodn NA
India 25TCF
Current Prodn NA
Source: Wood Mackenzie Unconventional Gas Tool, Deutsche Bank estimates
Although scientific understanding of, and production experience with, coal bed methane is in
the early stages, it is believed to represent a very substantial resource of natural gas. In the
US alone, US Geological Society estimates suggest that as much as 700TCF of CBM
resources are in place, of which perhaps near 200TCF could prove economically recoverable.
Australia is another country with considerable CBM resources (c.250TCF) that has seen a lot
of interest by IOCs in recent years, particularly for CBM to LNG projects. Perhaps the most
interesting region, however, is China where Wood Mackenzie estimates there are some
660TCF of commercial CBM gas reserves, yet the industry is in its infancy with only the
Qinshui region producing any CBM gas (and at less than 20mscf/d this is negligible). Given
Coal bed methane (CBM) is
simply methane found in
coal seams
the countrys growing appetite for gas we suspect there will be significant investment in
developing its CBM resource in future years.
Extracting CBM
Several methods exist for extracting CBM. The focus of most extraction techniques is,
however, to reduce the pressure of the coal stream and the water within it, predominantly by
releasing a large volume of water and fracturing the coal seam. Since CBM travels with
ground water in coal seams, extraction of CBM involves pumping available water from the
saturated coal seam in order to reduce the water pressure that holds gas in the seam. CBM
has very low solubility in water and readily separates as pressure decreases, allowing it to be
piped out of the well separately from the water. Water moving from the coal seam to the
well bore encourages gas migration toward the well.
Figure 363: Extracting Coal Bed Methane/CSG

Figure 364: Conventional gas production profile vs. CSG


As illustrated above, the production profiles of CBM wells are typically characterized by a
negative decline in which the gas production rate initially increases as the water is pumped
off and gas begins to desorb and flow. Both production and ultimate recovery rates from
each well are highly variable due to the heterogeneous nature of coalbeds. On average a
typical CBM well recovers anything between 0.2 and 7BCF of gas, with production rates
varying from less than 1mscf/d to up to 7mscf/d.
The extraction of CBM gas requires drilling significantly more wells than would be typical for
a conventional gas project due to considerably lower permeability in the reservoir which
limits flow rates. For example, the conventional Pluto gas project in Australia requires a total
of 7 wells (flow rates of c.120mscf/d per well) compared to some 1500 wells for the
Fairview/Roma CBM project (flow rate of 1mscf/d per well). While this would seem cost
prohibitive at first glance, the fact that CBM is found in shallow, onshore beds means the
wells are typically faster and less complicated to drill than those for many conventional
projects. Indeed in Australia rigs are now truck mounted for ease of logistics, a move that has
resulted in the cost per CBM well falling from more than A$5mln to nearer A$1mln.
Moreover, production and processing facilities for CSM gas are relatively simple, and thus
more cost beneficial when compared to those of conventional gas facilities.
Environmental pros and cons
CBM does, however, produce very large volumes of high salinity water, the disposal of which
represents a significant challenge given the toxic impact of salt water on vegetation. More
positively, however, through capturing methane that may otherwise find its way to the
earths atmosphere it holds the potential to significantly reduce global methane emissions.

The focus of most extraction
techniques is to reduce the
pressure of the coal stream
and the water within it
Tight & Shale Gas
Huge potential resource
Recent years have seen a huge surge in interest in developing tight and shale gas reserves,
particularly in the US. Not only are these resources by and large based in energy hungry
OECD countries (i.e. access to both resource and end-market), improvements in technology
that have improved productivity and reduced costs coupled with a steadily increasing gas
price has rendered the exploitation of these vast resources economic. Moreover, a drive to
reduce dependence on volatile oil producing regions and increase consumption of more
environmentally friendly sources of energy has also stood in favour of the development of
these unconventional gas resources. So what exactly is tight gas or shale gas?
Tight gas is gas that is trapped in reservoirs (often sandstone) that have low porosity and
permeability (typically less than 0.1millidarcy). It is known as a non-conventional resource
since simply drilling a conventional well through the middle of such reservoirs will not result
in enough gas production to make the well economic.
Shale gas is similar to tight gas, the key difference being that the rock is shale. Shale is the
earths most common sedimentary rock, rich in organic carbon but characterised by ultra-low
permeability. In many fields, shale forms the seal that retains the hydrocarbons within
producing reservoirs, but in a handful of basins shale forms both the source and reservoir for
natural gas.
Figure 365: Tight and Shale Gas gas-in-place reserves at an estimated 11688 TCF represents a vast resource
USA 7286 TCF
Current Prodn 25bcf/d
Europe 2017 TCF
Current Prodn NA
China 1569 TCF
Current Prodn 1.3bcf/d (tight)
Africa (Algeria, SA) 816 TCF
Current Prodn NA
Source: Wood Mackenzie Unconventional Gas Tool, Deutsche Bank estimates
Global resources of tight and shale gas are vast with Wood Mackenzie estimating almost
12000TCF of initial gas to be in place. However, despite these vast reserves of tight/shale
gas around the world, its development has only come to the forefront in recent years as a
commercially viable and reliable source of gas. Steadily increasing US gas prices since the
Tight gas is gas that is
trapped in reservoirs that
have low porosity and
permeability
turn of the century made previously uneconomic tight gas reservoirs more financially
appealing. Moreover, operational improvements that lowered well costs and improved
productivity have also played a big part; techniques such as horizontal drilling, multi-lateral
well completions, fracturing and acidising all increase well productivity dramatically. A key
advance was the evolution in the 1990s from using large volumes of sand based propellant
during fracturing (i.e. expensive) to slick-water fracturing which uses greater volumes of
water and far less propellant.
Nonetheless, the US remains the only region to have significant production levels (25bcf/d or
4.3mb/d 43% of total US gas production). With recoverable tight gas reserves in the US
estimated to be at least 200-500TCF (33-38bn boe) compared to oil reserves of 28bn bbls, it
is clear that if gas prices remain above $3/mmbtu there remains the potential for strong
tight/shale gas production. Indeed Wood Mackenzie estimates that production of tight and
shale gas in the US will almost double between 2009 and 2020, with the majority of growth
coming in shale gas production.
Figure 366: North America gas supply/demand
0
10
20
30
40
50
60
70
80
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
bcf /d Conventional Shale Tight CBM
Piped Imports LNG import s Demand
Extracting the gas
Both tight and shale gas are typically difficult to extract given the rocks low permeability,
however, once flowing the gas tends to flow clean i.e. without any liquid content. As with
CBM, tight and shale gas production is characterised by a high initial flow rate (referred to as
the initial production or IP rate) after which production tends to decline steeply with the
remaining gas produced very slowly over time. Expected ultimate recovery (EUR) of the gas
in place is typically only 20%, much lower than conventional gas plays. However, recovery
rates are continually improving with advances in completion and horizontal drilling. IP and
EUR rates can vary widely by play with shale plays in the US Barnett for example averaging at
a 30 day IP rate of 2.4msc/f and an EUR of 2.7BCF per well compared to up to 15mscf/d in
the Haynesville with EURs of up to 6.5BCF.
Vertical drilling is typically used in the initial or pilot-testing phases of an emerging shale/tight
play given the lower cost of coring and drilling vertically. However, once the play is deemed
to be commercially viable based on early testing, almost without exception wide-scale
development is undertaken using horizontal drilling (explained below). In most cases, a
successful well requires hydraulic stimulation. When completing a well, an operator will
commonly perform numerous staged fracture jobs along the lateral leg of the wellbore that
which is in direct contact with the producing zone. In each frac stage, fluid and proppant
(grains of synthetic materials or sand used to prop pore-space open) are hydraulically
pumped into perforations that are punched into a section of the formation. After each stage,
a plug is set and the process is repeated moving up the wellbore. While the theoretically
ideal completion would involve the maximum possible smaller frac stages so as to contact
the maximum amount of rock in the wellbore that quickly becomes cost-prohibitive. While
every gas play is different and completion methods can vary widely between operators, we
most commonly hear about lateral lengths of 3000 to 6000 feet with fracs performed every
500-700 feet.
Some technical lingo
Horizontal drilling: in a horizontal well, a vertical well is deviated to drill laterally so as to
expose the wellbore the the maximum amount of the shale formation as possible. This is
well suited to tight/shale gas exploitation as in many instances the naturally occurring
fractures in the rock are oriented vertically so a horizontal well effectively intersects there pre-
existing fractures thereby increasing potential production rates.
Fraccing: a procedure used to improve reservoir effective permeability. Fluid (such as water
or acid) and propellant (such as sand) are pumped at high pressure into the reservoir. The
result being that the reservoir rock fractures with the propellant effectively wedged inside the
fractures thus keeping them open and allowing the gas to flow (also known as fracturing).

Figure 367: Typical Flow rates of a tight/shale gas play

Figure 368: Shale Gas in the US by play
Barnett Shale Type Curves
-
0.50
1.00
1.50
2.00
2.50
3.00
0 12 24 36 48 60 72 84
Production Month
m
m
c
f
d
C R t d W d M k i
Tight gas and shale gas wells exhibit rapid initial
decline rates, but can then produce for up to 30
years


Source: American Association of Petroleum Geologists (AAPG)
Economic at current gas prices?
With rig rates dramatically reduced due to the fall in drilling activity during the financial crisis
and given improvements in drilling efficiency and completion techniques, US tight and shale
gas reserves can now break even at gas prices as low as $3/mmbtu (from between $4.50-
8/mmbtu but 3 years ago). This means that many projects are competitive with both
conventional piped gas and with LNG imports. Moreover, given the ready supply of gas and
the strong likelihood that production volumes are set to significantly increase in the future, it
is likely that unconventional gas will set the marginal price of gas in the US for the
foreseeable future.
The same cannot be said however for the rest of the world where exorbitant drilling costs
require a gas price nearer $7-10/mmbtu. While drilling costs have fallen considerably in the
US (for example average well costs in the Barnett have fallen from near $7-8mln per well in
the 1980s to todays $2-3mln per well) we cannot extrapolate this performance to the rest of
the world, particularly Europe where it currently costs between $20-25mln to drill a single
well. Not only are the plays geologically more challenging, but Europe also has a number of
other impediments such as limited supply of key services, lack of necessary infrastructure,
language barriers and stricter environmental regulation and land access rights (Europe is
geographically smaller and more built up vs. the location of unconventional gas reserves in
the US). Below we present Wood Mackenzies most recent assessment of well costs and
break even gas prices around the world. This highlights the challenging economics of
developing unconventional gas plays outside the US in most other regions.
Figure 369: Well costs vs. breakeven prices for shale
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
0.00 5.00 10.00 15.00 20.00 25.00
P
o
s
t

t
a
x

b
r
e
a
k
e
v
e
n

(
U
S
$
/
m
c
f
e
)
Tot al well cost (US mn)
Predominantly US unconvent ional gas
plays
Source: Wood Mackenzie Unconventional Gas Tool
Despite the high costs involved, large industry players continue to commit both financial and
human capital towards evaluating the potential of international unconventional gas assets.
Recent licensing rounds in Romania and Poland saw a significant up-tick in the level of
companies tendering for acreage, with the focus being on those areas which are believed to
contain significant gas reserves. We expect increased investment in the evaluation of these
resources over the coming years.
Environmental pros and cons
Finally, as with CBM there are a number of environmental considerations with tight/shale gas.
While gas is environmentally cleaner to burn than oil, there are concerns over the impact
current extraction techniques (in particular fraccing) could have on the surrounding
environment. The main concerns include the mishandling of solid toxic waste, a deterioration
in air quality, the contamination of ground water from use of chemicals and the migration of
gases and hydraulic fracturing chemical to the surface. The US Energy Policy Act of 2005
exempted hydraulic fracturing from regulation under the Safe Drinking Water Act. However,
the FRAC Act 2009 (not yet legislation) makes calls for the practice to be regulated and for
energy companies to disclose what chemicals they are using in the fraccing process.

Section 1.7 - Global Gas Price Formation
- International Gas Union. Wholesale Gas Price FormationA Global View of
Price Drivers and Regional Trends?
Wholesale Gas Price Formation
- A global review of drivers and regional trends
International Gas Union (IGU)
News, views and knowledge on gas worldwide
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:
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
fndings 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 beneft 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
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 Pacifc ...............................................................................................................................................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
June 2011 | International Gas Union 3
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.
4 International Gas Union | June 2011
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 defnitely infuenced 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 infuenced 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.
In periods of ample gas supply, prices have delinked with
gas becoming signifcantly 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.
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 refned 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.
With respect to the latter debate, Non-OECD countries already
supply high shares of the European and Asian OECD member
countries gas demand, and the gas fows 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 refects
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 fnal 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
Regulation
below cost
26 %
Oil price
escalation
20 %
No price
1 %
Netback from
final product
1 %
Regulation
social and
political
9 %
Regulation cost
of service
3 %
Bilateral
monopoly
8 %
Gas-on-gas
competition
32 %
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.
The second biggest category in 2007 was Regulation below
cost (see Chapter 4 for defnitions) 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 Pacifc OECD countries was 20%.
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.
The share of gas transactions at prices refecting 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.
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 frst 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 fuctuated around higher
averages volatility appears to have been roughly constant
during the 2000s.
Some short term price volatility is part and parcel of gas-on-
gas 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 signifcantly
dampens the impact of oil price fuctuations. 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 fndings 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 fgure 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

Gas-on-gas competition
Bilateral monopoly
Netback from final product
Regulation cost of service
Regulation social and political
No price
North America, UK
Continental Europe,
Developed Asia
Continental Europe
Bilateral monopoly
No price
Select Non-OECD
2008
2020
R
u
s
s
ia
,

C
h
in
a
? Select market segments
Select Non-OECD
Select Non-OECD
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 effcient 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 effciency, 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 Pacifc 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.
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 2007-
08 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 fnancial 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
Pacifc 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
beneft of oil indexed pricing as Russia is negotiating netback
prices based on Western European border prices with its near
neighbours.
The netback from fnal 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 diffcult 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
signifcant 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 refect 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.
2. Introduction
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 fuctuations; 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.
These differences between gas and oil are becoming less
pronounced:
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 frst 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 non-
OECD 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 signifcantly
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
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 diffcult 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 frst
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 identifes 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 briefy 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 effcient levels.
Chapter 9 addresses this issue of gas price volatility. Since the
turn of the decade, gas prices have not only fuctuated 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 refected 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 fexible 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.
Study object is wholesale
border or hub price
formation
Hub price
Border or DES (LNG) price
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
Citygate
price
Small
end
user
prices
Wellhead
price
Large end user prices
FOB price (LNG)
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 infuenced by taxes and by local supply
and demand conditions refecting 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.
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
fnancial information in charge of gas supply but where one
can still fnd 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 defne 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 feld to plant transportation costs)
and liquefaction costs, but not shipping and regasifcation
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 signifcant 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 refect 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
signifcant 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
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 regasifcation, shipping and liquefaction
costs have been deducted from the end user price, and is as
such a key indicator of project feasibility
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.
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.

Competitive markets
Short to medium term supply and demand drivers
Even modest short term gas supply or demand disturbances
may boost or depress prices signifcantly. 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.
There are many examples of gas demand spikes leading to gas
price spikes. Such spikes may occur because of temperature
fuctuations. 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).
Chart 3.1: Iberian Peninsula: Hydro reservoir levels and LNG
imports
Iberian Peninsula: Variations in hydro reservoir
level and LNG imports, March 1999 - June 2008
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Business cycles affect gas demand especially industrial gas
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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
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3. Gas price drivers
Examples of accidents or commercial / political supply cut-offs
driving price spikes are harder to fnd. 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.
The Russian-Ukrainian gas conficts 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 confict occurred at a time when these
prices had already increased signifcantly. The dip in Russian
gas supply may have only marginally aggravated the price
spike. The latter confict 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 fuctuating
around a steadily declining trend during the fnal quarter of
2008 and into 2009 (Chart 3.3).
Chart 3.3: North European gas hub prices
Source: WGI
North European gas hub prices
Weekly averages, autumn-winter 2008-09
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Long term supply and demand drivers
Gas prices in competitive markets fuctuate 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
Long term supply side drivers
Chart 3.4: Long term marginal supply cost curve (illustration)
Volume
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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.
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 defnition sloping upwards and
are normally becoming steeper as more supply is brought into
the picture. However, new gas discoveries and technological
progress can fatten 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
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 fnancial 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 fnancial,
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 fscal 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
infation 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 effciency improvements, meaning
progress that happens by itself, so to say, not because of
political signals
Policy measures to make car manufacturers produce more
fuel effcient 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
fuctuations 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 fexibility of their
fuel using equipment. The more dual fring 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 confdence
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.
Today, with a growing share of world gas supply going to fre
gas power plants, the coal price level is becoming another
important reference.
Chart 3.5: US natural gas and oil prices
Sources: US DOE EIA
US natural gas and oil product prices
Monthly averages, January1999 - December 2008
0
5
10
15
20
25
30
J
a
n

9
9
J
a
n

0
0
J
a
n

0
1
J
a
n

0
2
J
a
n

0
3
J
a
n

0
4
J
a
n

0
5
J
a
n

0
6
J
a
n

0
7
J
a
n

0
8
U
S
D
/
M
M
B
t
u
US Gulf Coast No. 2 Heating Oil
US Gulf Coast Residual Fuel Oil 1,0% Sulfur
Henry Hub
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 obser-
ved in early-mid 2008, or has the fnancial crises defated pri-
ces 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 brid-
ging 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.
Chart 3.6: US gas consumption
US gas consumption: History, EIA's 2009
reference projection
0
100
200
300
400
500
600
700
800
1
9
9
0
1
9
9
3
1
9
9
6
1
9
9
9
2
0
0
2
2
0
0
5
2
0
0
8
2
0
1
1
2
0
1
4
2
0
1
7
2
0
2
0
2
0
2
3
2
0
2
6
2
0
2
9
B
c
m
Source: US DOE EIA: Annual Energy Outlook 2009
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 fulfl 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.
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 refned 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 simplifcation 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 infuence Continental
European and Developed Asian contract prices. Long term
import contracts always have some offtake fexibility. If spot
prices fall signifcantly 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 fexible import
contracts, so the infuence 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 defned so as to include both operating, depreciation
and fnancial costs and a return on investments, but they may
as well be defned 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 fnancing 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, refecting 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 conficting 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 infation, 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
Gas imports
becoming possible
Gas imports
becoming possible
Gas exports
becoming possible
Gas exports
becoming possible
P
domestic
P
international
> 1
P
domestic
P
international
< 1
P
domestic
P
international
> 1
P
domestic
P
international
< 1
Incentives to grow imports => increased
competition in domestic market => domestic prices
depressed towards international level
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
If high domestic prices reflect high costs, countrys
gas not competitive in world markets => no exports
take place
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 defcits. 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
benefciaries 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
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 diffcult
to defne and support.
Chart 3.8: Challenges of price regulation
Price riots,
accommodating
leadership
Drive to shift
domestic fuel use
from oil to gas to
sustain oil exports
Low incomes, drive
to support domestic
gas intensive
industry
Higher cost
of new
domestic
production
Incentives to
contain domestic
gas demand to
enable gas
exports
Exposure to
world gas price
fluctuations
Time
Price
Growing
dependence on
imported gas =>
We propose to distinguish between the following gas pricing
mechanisms:
Gas on gas competition
Bilateral monopoly
Netback from fnal product
Regulation on a cost of service basis
Regulation on a social and political basis
No pricing
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 fxed
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.
Chart 4.1: Pricing under gas-on-gas competition
Price
Demand
P
1
Volume
Supply =
Marginal Cost
Average
Cost
V
1
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
4. Key gas pricing mechanisms
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 infation 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
Price
Demand
P
1
P
2
P
3
Volume
Supply =
Marginal Cost
Average
Cost
V
1
V
3
V
2
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 feld 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 fnal product means that the price received by the
gas supplier refects the price received by the buyer for his fnal
product. For instance, the price received by the gas supplier
from the power sector may be set in relation to, and allowed to
fuctuate 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 refecting 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 felds with gas caps or gas-condensate
felds, 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 proftable. 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.
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 fnance transportation and distribution costs cross-
subsidising 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.
Chart 4.3: Pricing under regulation
Price
Demand
P
1
P
5
P
4
Volume
Supply =
Marginal Cost
Average
Cost
V
1
V
4
V
5
Bilateral monopoly, netback pricing,
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.
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 signifcant gas resources dispersed in large
numbers of felds typically saw the development of com-
petitive 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 sel-
lers 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 compa-
nies, and US gas prices have as a rule been determined com-
petitively by supply and demand. For decades prices were
very low, refecting 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 fx 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 frst 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 frst 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 com-
panies 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 frst
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 exemplifed
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 frst 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
5. Origins of individual pricing mechanisms
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 frst to mid-sized industrial and
commercial buyers, and then to the entire gas market.
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 effciency boosting effects of increased
competition. However, prices were also infuenced 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.
Continental Europe
The market value pricing principle that dominates in Conti-
nental Europe originated in the Netherlands. The Groningen
feld 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 year
2
.
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 feld
cheaply, thus giving away value. Delaying its development
seemed an equally unattractive option. There was a percepti-
on 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.
Specifcally, 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
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.
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.
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 Pacifc
Japan was a 2 bcm a year gas market until 1970 when im-
ported (Alaskan) LNG entered the fuel mix. Import growth
accelerated in the 1970s and 1980s in response to the frst
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 reser-
ves around 1970.
The Asian countries that do not have signifcant 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
frst initiated discussions on potential LNG imports, they had
to emphasize long-term security of supply to make sure that
they would be able to fulfl 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 refected in the
history of LNG pricing as well.
In 1969 when LNG was frst imported into Japan, and through the
early 1970s, the price was fxed. 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
2
BP Statistical Review of World Energy, 2008
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 fxed pricing system was acceptable
to Japanese LNG buyers as well.
After the frst oil shock in 1973, however, the oil price surge
left the price of LNG signifcantly 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, codifed 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 unmodifed, 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 diffculties securing
the economics of their LNG projects. In order to cope with that
problem, the LNG pricing formula was modifed 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:
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 con-
stant 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 foor or ceiling
Modified price formula
85-90% indexed to oil
Old price formula
Oil Parity
LNG price
$/MMBTU
Oil price
$/BBL
LNG indexed to oil with no floor, ceiling
In Japan, LNG was introduced in order to reduce an at that
time excessive dependency on oil. Japanese power companies
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 foors and ceilings as
an extension of the S-curve mechanism.
Chart 5.2: LNG pricing with S-curve
?
low oil
price zone
LNG price
$/MMBTU
Oil price
$/BBL
?
high oil
price zone
kink-
points
LNG indexed to oil: S-curve

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
Regulated gas pricing may mean cost of service based pricing
as well as political pricing where costs may be considered but
generally play second fddle 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
side by side with households and vulnerable industries benefting
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 effciency 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 felds 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 suffcient
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 fxed 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 signifcantly.
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 refecting 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,
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, fared or at best reinjected.
Though faring 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 effciently 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 intensifed 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.
OECD area
After 6 to 7 years of gas price fuctuations around a rising
trend, by mid 2008 there was broad agreement across OECD
countries that prices had shifted up on a permanent basis
(Chart 6.1). The fnancial crisis in the autumn of 2008, the
steep oil price and spot gas price declines towards the end
of the year and the outlook for oil linked gas prices to come
down in 2009 have highlighted the risks of jumping to con-
clusions. There will likely be many revisits to the question of
the structural or cyclical nature of gas price movements in the
2000s. Will permanently higher supply costs restore prices
to USD 10 or 12 per MMBtu once the crisis peters out and
demand picks up? Or will the price history of the frst three
quarters of 2008 prove to be a one-off event?
Chart 6.1: Gas border and hub prices
Source: PIRA
Gas border/hub prices
Monthly averages Jan 1997- Dec 2008
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Henry Hub
NBP
Europe contract
Japan contract
Prices frmed in the 2002-08 period for two main reasons:
Gas supply-demand balances tightened, affecting prices
through gas-on-gas competition,
Oil prices went up, affecting gas prices in Europe and Asia
through the price clause in European and Asian gas import
contracts, and gas prices elsewhere through the substitution
mechanism, i.e., by raising the price thresholds where consumers
can save money by switching from gas to competing fuels.
Gas market tightening became an issue in late 2000 when US
prices quadrupled. US gas demand increased by more than 4%
in 2000, and the power sectors dash for gas promised further
growth. US gas production had been fat for some years, but
few had bothered to look for structural reasons; consumption
had also been fat so there had been no need for more supply
than was available at the prevailing prices. In 2000, however,
it became clear that the surplus production capacity that had
ensured low prices through the 1990s was gone. The US gas
supply curve had steepened and prices responded accordingly
to the increase in demand.
Prices reverted to the USD 2-3/MMBtu range in late 2001
thanks to weather and other circumstances that wiped out the
previous years demand growth, but started to climb again in
2002, and Henry Hub peaked at close to USD 14/MMBtu on
a monthly average basis in the wake of hurricanes Katrina
and Rita in the autumn of 2005. Following a period of relative
normality Henry Hub in the summer of 2008 again touched the
USD 13-14/MMBtu range, this time because of a combination
of factors including high demand, record high oil prices, a lack
of LNG for the US and below average storage levels. Indigenous
production has however staged an unexpected recovery with
high prices and new technology making shale gas and other
unconventional gas economic.
Continental European gas buyers had after 2007 to cope with
the impact of sharply rising oil prices. Gas import prices more
than doubled between June 2007 and January 2009.
The UKs growing gas import dependence and recurrent need
to compete with other importers for supply constitute a strong
link between UK and Continental European gas import prices.
Thus the NBP price was by mid 2008 forecast to climb at an
even faster pace than Continental prices to ensure British
competitiveness during the winter.
Because of the averaging and lagging nature of the gas priceoil
price link, Asian import prices are like Continental European
import prices less volatile than US and Northwest European
hub prices. They have also on balance been 1-2 dollars per
MMBtu higher than US and European prices. This relationship
has however become less clear cut since 2005. Asian buyers
still tend to pay more for their supply than other buyers, but the
differences have recently narrowed somewhat and occasionally
the relationships have reversed.
Chart 6.1 does not show the wide range of prices paid for spot
cargos by Japanese, Korean, Spanish and other buyers that
for various reasons have needed to top up their term imports.
Asian buyers in early-mid 2008 frequently offered USD 15-20/
MMBtu for additional supply (Chart 6.2).
Chart 6.2: Japanese LNG import prices
6. Recent gas price developments
Japanese contract prices in 2004-08 fell out of line with spot
prices due to the S-curve formulae typical for Japanese LNG
import contracts. These formulae fatten the LNG price-oil price
curve above and below certain oil price levels. The upper level
is typically around USD 30 a barrel which was considered a
robust price at the time of contract signature but corresponded
to only 20-25% of spring-summer 2008 oil prices. The levels
are not set in stone most contracts state that buyers and sellers
should get together and negotiate new terms if it appears that
the existing ones no longer refect market realities. However,
buyers have ways to put off settlements, and many have done so.
With respect to new contracts, Asias main LNG suppliers
in 2008 took advantage of the prevailing market tightness to
demand price parity with crude oil. A JCC price of USD 150/b
would then translate into an LNG price of some USD 25-26/
MMBtu. Asian LNG buyers resisted full parity with no S-curve
protection against extreme oil prices as a basis for long term
contracts. As of early 2009 full parity seems some time off.
There is evidence that S-curves are beginning to regain their
popularity with sellers fearful of crude oil prices in the USD
30-40/b bracket and LNG prices in the USD 5-6/MMBtu range.
The global fnancial crisis hit spot gas prices in the autumn of
2008, reducing Henry Hub from more than USD 12/MMbtu in
June to around USD 5,50/MMBtu by end December, and the
NBP price from USD 12,90/MMBtu in September to around
USD 8,20/MMBtu three months later (Chart 3.1). Long term
contract prices held up through 2008 but were by early 2009
caught up by tumbling crude and oil product prices and looked
set to plummet in the second and third quarters.
Independently of the fnancial crisis, US gas prices have since
2007 fuctuated in a range making US buyers unprepared to
compete with Asian and European buyers for spot LNG. The
US has since the beginning of 2006 experienced a boom in
unconventional gas production which, in combination with
fat demand, has allowed for declines in both piped gas and
LNG imports and still left the country with adequate gas in
storage. Since unconventional gas is relatively costly to produce,
prices lower than those prevailing by the end of 2008 may be
unsustainable. The number of gas rigs in operation is already
down in response to the July-December 2008 price downturn.
Whether the US gas supply-demand balance will drive, and
sustain, a price recovery any time soon is however equally
questionable.
A wide range of possible development paths for US gas production
is adding to the uncertainty whether oil and gas prices world
wide will decline even further, remain depressed for a long
time or recover fairly quickly. This confusion refected the
impossibility in the midst of a crisis, with no distance to the
subject matter, of forecasting its depth and duration.
However, it needs to be remembered that:
Gas prices are still robust in comparison to those prevailing
as recently as in 2003,
The gas price levels of 2007 and early-mid 2008 pointed
towards demand destruction on a signifcant scale; the price
decline has dampened if not eliminated this risk,
Gas development costs have exploded leaving a fair share
of future supply marginal at early 2009 prices,
Though a world wide economic setback will dampen cost
infation,
The cyclical component of this infation (booming raw
material, engineering service and skilled labour prices)
will not disappear overnight,
The structural component related to the oil and gas
industrys turn to developments in more remote locations,
deeper waters and harsher climates will not disappear at all.
Thus, while the jury is still out, it seems a fair hypothesis that
gas prices will recover perhaps not in the medium-short term
to levels comparable to their recent peaks, but to levels that will
support continued growth in supply and demand.
Rest of the world
Prior to the fnancial crisis gas prices increased also outside
the OECD area, though not everywhere, and certainly not at
uniform rates.
Central and Eastern Europe and the FSU countries that rely on
Russian gas have had to undertake major price adjustments.
Soon after the break-up of the FSU, the Central and Eastern
European countries that had come to rely on cheap Russian and
Central Asian were presented with similar price formulas as
those underpinning Western Europes Russian gas imports. More
recently the other FSU republics have had to cope with similar
sea-changes in the pricing of Russian gas, although different
countries have been granted different transition periods and were
still by 2008 paying signifcantly different prices (Chart 6.3)
Chart 6.3: Gazprom prices
The Russian-Ukrainian dispute over gas prices, transit tariffs
and payment arrears that has received special attention due to
Ukraines role as transit country for nearly two thirds of Russias
Source: Spiegel International Online
gas exports to Europe. Ukraine by 2005 paid a nominal price of
USD 50 per 1000 cubic metres or USD 1,38/MMBtu for Russian
gas. Russia raised the gas price frst to USD 160/1000 cm and
then to USD 230/1000 cm. Ukrainian payment problems have
on two occasions in 2006 and again in 2009 led Gazprom
to cut its supply of gas to Ukraine and indirectly to Europe. An
agreement concluded in January 2009 commits Ukraine to pay
the European standard price minus 20% in 2009, and the full
European standard price from 2010 onwards, against receiving
market based transit tariffs for the roughly four ffths of Russias
gas exports to Europe that transit Ukraine. The fnancial crisis
will lower Russias oil linked export prices but will evidently
also reduce the importing countries ability to pay.
Gazprom continues o adjust the existing agreements with CIS
countries step by step in order to move to contractual terms and
conditions and pricing mechanisms similar to those effective
in the European countries beginning from 2011. Finally export
prices will refect fuel market conditions and the prices of the
best alternatives to gas.
Russia is also implementing domestic price reform. Although
quite impressive in nominal terms (Chart 6.4), the price
adjustments made between the mid 1990s and 2005 only kept
up with infation. Gas became steadily cheaper compared to
oil and coal. Gazprom reported a loss of USD 25 billion on its
domestic sales between 1999 and 2003. Concerns about the
sustainability of Russias gas balance with prices that favoured
rapid consumption growth but did not generate the funds needed
for the development of the next generation of giant gas felds,
were raised.
Chart 6.4: Russian regulated gas prices to industry
Source: CERA
Russia: Average regulated gas price for industry
In 2006 the government responded by presenting a plan to increase
prices to industrial consumers to parity with European border
prices adjusted for transportation costs, by 2011. Observers noting
the strains that exposure to world level gas prices would put on
the Russian economy, greeted the timeline with scepticism, and
the oil driven escalation of European border prices that started
in 2007 made the reform pace required by the 2006 plan even
faster. The government in mid 2008 acknowledged all this by
postponing the deadline for full alignment of domestic industrial
prices with export netback prices, to 2014-15, and announcing
a revised schedule for the 2008-11 period according to which
prices will increase by 25% in 2008, 25% in 2009, 30% in
2010 and 40% in 2011.
The fact that Russian industrial and residential consumers in
2008 paid only USD 1,89/MMBtu and USD 1,44/MMBtu
3

(net of VAT) for gas indicates that the country has a long way
to go to reach parity in netback terms with European prices.
The Russian governments embrace of this pricing principle
probably inspired and has in turn been bolstered by the Central
Asian republics more aggressive pricing of their gas sales to
Russia. Back in 2000 Gazprom typically paid a border price of
around USD 40/1000 cm, or USD 1,10/MMBtu, for Turkmen and
other Central Asian gas. In the frst half of 2008 Turkmenistan
received USD 130/1000 cm or USD 3,59/MMBtu for its gas.
At the same time the heads of Turkmenistans, Kazakhstans
and Uzbekistans state oil and gas companies announced that
from 2009 on Gazprom would need to pay the price of gas on
Europes eastern border netted back to the delivery points for
Central Asian gas on Russias southern border.
In addition to raising regulated prices, the Russian government
is encouraging growth in the hitherto tiny part of the gas market
with unregulated prices. A gas exchange is established and
placed under Gazprom subsidiary Mezhregiongas. It remains
embryonic, and exchange prices have to date not differed much
from the regulated prices. However, it is a start.
The leading Asian Non-OECD economies, China and India, share
a desire to boost gas consumption, and a need to complement
indigenous gas production with imported gas supply. Both
countries already have pockets of domestic gas demand ready
for international gas prices. Market growth requires however
the active participation of the power sector and key industries
used to burn cheap coal or price regulated domestic gas. The
diffculties of accelerating gas penetration in such an environment
have stimulated indigenous gas E&D in both countries. Recent
discoveries may enable a more gradual alignment of Chinese and
Indian prices with the Japanese and Korean import prices that
defne the alternative costs to suppliers but will not eliminate
the need for price reform.
3
Gazprom reports on its home page regulated prices in 2008 at RUB 1690 per 1000 cubic
metres for industrial consumers and RUB 1290/1000 cm for households. The average RUB/
USD exchange rate in 2008 was 0,04039.
Chart 6.5: Select Chinese gas prices
Source: ICIS Heren China Gas Markets
Select Chinese gas prices
December 08 / January 09
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prices,
industry:
Retail
prices,
households:
Ex-field
prices:
LNG
prices:
Chinese gas prices are regulated by central and provincial
authorities and have traditionally varied across locations and
sectors. In late 2005 a nation-wide price reform the frst in
eight years was implemented, and in late 2007 the government
announced further price hikes (with special, subsidised rates
remaining in place for the fertilizer industry). As of 2008 ex-
feld prices were in the USD 4-5/MMBtu range, the ex-terminal
price of imported LNG USD 17-18/MMBtu and retail prices
between USD 5,50 and USD 22,50 per MMBtu depending on
location and customer class (Chart 6.5).
Chinas willingness to pay todays market prices for imported
LNG was long in doubt. CNOOCs contracts for NWS and
Tangguh LNG were signed under the buyers market conditions
that prevailed in the early 2000s and lay down DES prices in the
USD 3,00-3,70/MMBtu price range refecting oil price ceilings
of USD 25 and USD 38 per barrel respectively. However,
CNOOCs and Petrochinas more recent deals with Petronas,
Woodside and Qatargas are comparable to the established Asian
importers recent contracts, with the Chinese side accepting
Qatars 2008 insistence on crude oil parity pricing. The Chinese
buyers presumably hope to make expensive LNG marketable
through blending with much cheaper indigenous gas.
In India gas supply has three components, each of which is
priced differently. Gas produced by the state oil companies
ONGC and OIL is subject to the so-called Administrated Price
Mechanism (APM). In 2006-07 this gas made up about 65%
of total supply. The APM price is indexed to a basket of fuel
oil prices in such a way that the markets segments eligible for
APN gas in 2008 paid wholesale prices in the USD 2,00-2,40/
MMBtu range plus transmission and distribution charges and
taxes. Customers in the northeast paid less as part of a regional
support policy package. Gas produced by private companies
is sold at negotiated prices with no linkage to oil and no caps;
recently prices have varied between USD 3,50 and USD 5,70
per MMBtu. Finally, regasifed imported LNG is sold at prices
set on a cost plus basis and subject to government approval.
As China, India signed its frst LNG import contracts with
RasGas II at a time when buyers had the upper hand. Thus
Petronet between 2004 and 2009 received Qatari LNG at a
constant price of USD 2,53/MMBtu. From 2009 the price will be
linked to oil, but for several years the pass-through factor will be
much lower than normal for newer contracts. India has not since
20XX signed any long term LNG import contracts refecting the
2008 price environment and also the outlook for rapid growth
in indigenous Krishna Godavari basin gas production. But
Indian buyers have at times been active in the spot market.
Also in Latin America, countries experiencing gas demand
pressure and relying on imported gas for signifcant shares of
their supply, are struggling to cope with increasing prices of
internationally traded gas.
One example is Brazil where gas prices in nominal USD terms
increased signifcantly in 2003 and again in 2005. An attempt in
2004 to boost market growth by freezing prices was abandoned
due to its negative impact on E&D. The price of locally produced
gas jumped from about USD 3/MMBtu by mid 2004 to USD
10/MMBtu by late 2008 (Chart 6.6).
Chart 6.6: Brazilian gas prices
Source: Petrobras
Brazilian gas prices
Commodity + transportation, 1st quarter '02 - 3rd quarter '08
0
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Indigenous
Imported
Power sector rate
In 2006 Brazil which sources more than 40% of its gas supply
from Bolivia, was presented with a request for a 120% increase
in the price of Bolivian gas. La Paz based its claim on, among
other things, the steep increase in international gas prices
between 1999 when Bolivia started selling gas to Brazil, and
2006. Eventually, the two countries settled for a smaller increase,
but the episode showed how international gas prices can enter
intra regional gas price negotiations as benchmarks without the
exporting country having the option to export gas outside the
region or the importing country having the option to import gas
from outside the region, i.e., without the international prices
having any real signifcance as alternative costs to any of them.
Argentinean producers receive only about USD 1,50/MMBtu
for indigenous gas. This low price refects decisions made in
the wake of the Argentinean economic crisis in the beginning
of this decade. It is about one ffth of what Argentina pays for
Bolivian gas and is not encouraging gas E&D, which is one
reason why Argentinean gas production has stagnated and
shortage problems have emerged.
In March 2008 the government authorised higher prices for
gas produced from new, remote or tight felds with above
normal development costs. But this so-called Gas Plus plan
does not introduce new pricing principles, it only amounts to
a modernisation of the cost plus approach.
Several Latin American countries have opted for LNG as a
means to reduce their dependence on piped gas imports from
their neighbours. Exposure to the volatility of world LNG prices
apparently seems a lesser evil than the risk of supply cut-offs
in the event that the upstream country needs the gas for itself.
Petrobras in 2008 commissioned terminals at Pecm in Cear
and at Baa de Guanabara near Rio de Janeiro. Both terminals
are LNG tankers modifed for onboard regasifcation and will
operate mainly during the Brazilian winter season. Argentinas
Enarsa in 2008 commissioned a terminal of the same type at
the port of Bahia Blanca, 400 miles southwest of Buenos Aires,
partly in response to warnings that Bolivia would not be able
to meet is supply commitments to Argentina in 2008-09. In
Chile construction of one terminal at Quintero near Santiago
and another at Mejilloners further north is ongoing with a view
to commissioning in 2009-10, partly in response to the risk of
Argentinean gas supply shortfalls.
Venezuela also practices price regulation. Since 2001 private
producers have been allowed to sell gas directly to end-users,
bypassing PdVSA, but because of limited access to PdVSAs
pipelines the state company remains the main market for private
gas. Moreover, the Ministry of Energy and Petroleum caps prices
at levels supposedly refecting Anaco or Lake Maracaibo hub
costs and transportation costs but clearly refecting other, political
and social considerations as well. As importantly, maximum
prices are quoted in Bolivares, and provisions for adjusting
them in response to infation and changes in the exchange rate
did not prevent a signifcant drop in the dollar value of gas in
the Venezuelan local market between 2000 and 2004.

Africa and the Middle East are lagging the other Non-OECD
regions in reforming their domestic gas prices. In Algeria and
Libya, Sonatrach and NOC provide gas to big industrial and
power sector customers at prices that are not publicly available
but apparently low by international standards. Algeria also has a
signifcant number of smaller scale, residential and commercial
customers, and Sonelgaz in 2006 supplied these customers at
a fraction of what Mediterranean European residential and
commercial gas consumers pay. In Egypt, EGAS purchases
gas from various upstream consortia at a price linked to oil but
until recently capped at a low oil price; for the 2006 licensing
round EGAS put the maximum gas price at USD 2,57/mcf for
oil prices at or above USD 22/b. However, warnings from key
upstream players that EGAS needed to pay more to enable
companies to cover escalating costs and sustain E&D in 2007
brought results with BP and RWE managing to negotiate a
ceiling of USD 4,84/mcf. At the same time hikes in select end
user gas prices were announced, refecting government worries
about its fuel subsidy burden as well as with the sustainability
of the pace of growth of domestic gas use.
In Nigeria, as yet the only signifcant gas producer south of
Sahara, select industrial customers reportedly pay prices that
cover supply costs, but the countrys biggest gas user, state
power utility PHCN, in 2005 paid only a reported 11 US cents
per MMBtu.
Nigerian authorities in 2008 presented companies looking for
opportunities in Nigerian LNG with a request to get involved
also in domestic gas and power supply. A new Gas Master
Plan promises efforts to turn the currently badly mismanaged
domestic gas and power sectors into attractive targets for foreign
investment. However, the plan remains short on specifcs on key
preconditions like domestic gas price reform, and the current
political situation in Nigeria does not bode well for consistent
implementation of policies to fx the countrys problems.
The Middle East has seen even fewer attempts at domestic
gas price reform. In many Middle Eastern countries gas has
historically been considered a free good, and as high oil prices
have boosted national oil company and state revenues across the
region, the appetite for fuel subsidy cuts that one could detect
in the late 1990s has waned.
Iran has kept domestic gas prices low with the purpose of
encouraging substitution from oil products to gas wherever
possible, and also for social and political reasons. The reporting
on Iranian end user gas prices is not particularly consistent.
The highest estimate available from Facts puts the prices
charged to different market segments in the USD 0,20-1,00/
MMBtu range (Chart 6.7).
Chart 6.7: Iranian gas prices
Source: Facts Global Energy
Iranian domestic gas prices, 2007-09
0,00
0,20
0,40
0,60
0,80
1,00
1,20
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Fuel subsidies represent a major burden on the Iranian budget.
But with oil being more valuable than gas, and with NIOC
struggling to sustain Irans oil exports, until spring 2008 no
one suspected the government of planning gas price reform
initiatives.
Nevertheless, in May 2008 government offcials did announce a
plan to hike domestic gas prices to encourage energy conservation
and free up gas for exports.
Apparently the announcement which could be related to
Turkmenistans decision to double the price of Turkmen gas
to Iran included neither details on the planned extensiveness
of the reform nor a timeline, and it remains to be seen whether
and when adjustments with suffcient bite to have an impact
on demand patterns, will be enacted.
Saudi Arabian gas sales prices are not public but are presumably
consistent with the gas purchase price announced in 2003 in
the context of the gas opening, of USD 0,75/MMBtu at the
inlet to the Saudi Master Gas System, minus a tariff for use
of this system for onward transportation. Saudi Arabia sticks
to its policy of offering cheap gas to attract investments in
petrochemical and other gas intensive industries, even in the
face of a gas shortage so severe that power plants intended to
run on gas recently have burned crude oil instead.
7. Current extensiveness of individual
pricing mechanisms
Introduction
This section considers current practice with respect to wholesale
contract price formation for both pipeline gas and LNG. We
proceed from a mapping of current pricing mechanisms around
the world, not only for gas traded internationally, but also for
gas produced and consumed within countries. IGU members
have provided data for almost 100 countries, and Nexant have
collated and analysed them. The mapping of price mechanisms
was frst undertaken for the year 2005 and was repeated for
2007. This section reports largely on the 2007 results with some
comparisons against the 2005 results.
We focus as noted on wholesale prices. Wholesale prices
can cover a wide range of prices. The only prices which are
clearly not included are the prices of gas to end users. In traded
markets, such as the USA and the UK, the wholesale price would
typically be a hub price (e.g. Henry Hub or the NBP). In many
other countries, where gas is imported, it could typically be a
border price. The more diffcult cases are countries where
all gas consumed is supplied from indigenous production,
with no international trade (either imports or exports) and the
concept of a wholesale price is not recognised. In such cases
the wholesale price could be approximated by wellhead prices
or city-gate prices. Generally the wholesale price is likely
to be determined somewhere between the entry to the main
high pressure transmission system and the exit points to local
distribution companies or very large end users.
The initial data collection was done on a country basis. The data
were then collated to a regional level using the standard IGU
regions shown in Chart 7.1. Most of the regions are defned
along the usual geographic lines, although the IGU includes
Mexico in North America, and divides Asia into a region
including the Indian sub-continent plus China, called Asia, and
another region including the rest of Asia plus Australasia which
is called Asia Pacifc.
Chart 7.1: IGU regions
North America
Latin America
Africa
Europe
FSU
Middle East
Asia
Asia Pacific
IGU regions
Data for each country were collected in a standard format. As an
example, a data collection form for the UK is shown in the chart
below. Individual country gas demand may be supplied from any
one combination of three sources indigenous production, pipeline
imports and LNG imports (storage is ignored for the purpose of
this analysis). For each of these three sources separately data
was collected on what percentage of the wholesale price for that
category is determined by each mechanism. In some countries,
one single mechanism was found to cover all transactions and
that mechanism, therefore, was allocated 100%. In many cases,
however, several mechanisms were found to be operating, in
which cases estimates were made of the percentages for each
price mechanism. The only constraint is that the total for each
source of gas must add up to 100%.
Information was also collected on wholesale price levels in
2007 and 2005. This covered the annual average price and the
highest monthly average price and lowest monthly average
price. All prices were converted to $/MMBtu. A comments
section was included to identify and acknowledge the source
of the information and any other useful information.
All data in the IGU study on gas volumes for consumption,
production, imports and exports is taken from the IEA database,
supplemented where necessary by the US Energy Information
Administration and any specifc country and/or regional
knowledge.

Chart 7.2: Data collection form
Data Collection Form
Country
Region
Volumes 2007: BCM
Pipeline LNG Pipeline LNG
91.4 72.4 28.0 1.5 10.4 0.0
Oil Price Escalation
Gas-on-Gas
Competition
Bilateral Monopoly
Netback from Final
Product
Regulation: Cost of
Service
Regulation: Social
and Political
Regulation: Below
Cost
No Price
Not Known
Total
Comments
Completed By
Estimated 2007
Wholesale Price
Range ($/MMBTU)
Average High Low
$5.89 $10.57 $3.35
100.0%
United Kingdom
Europe
Consumption Production
Imports Exports
Wholesale Price
Formation
Imports
Pipeline LNG
Domestic Production
76.5%
100.0%
100.0%
100.0%
23.5%
Mke Fulwood - Nexant
The EU Energy Sector Inquiry found that in the UK around 40% of long term contracts use a market
based gas price index as the escalator. The remaining 60% predominantly use oil price indexation with
some inflation element. However, les than 40% of domestic UK production is under long term contract
with the other 60%being traded on the spot market and therefore automatically priced on the NBP index
(source for this information was an OIES study on the UK gas market updated for recent data from IEA
and Heren). It is thought that all pipeline and LNG imports are priced against the NBP. UK imports
pipeline gas from Norway, Netherlands, Belgium and Germany and LNG from Trinidad, Qatar, Egypt
and Algeria.
100.0%
Data Collection Form
Price Formation Mechanisms
Types of Price Formation Mechanism
In preparation for the initial data collection exercise for 2005,
a series of discussions were held at the PGC B2 sub group
meetings on the range of different types of possible price
formation mechanisms.
It was decided to use for categorisation purposes the eight
wholesale pricing mechanisms outlined above. For the remainder
of this section the following abbreviations will be used:
GOG Gas-on-Gas Competition
OPE Oil Price Escalation
BIM Bilateral Monopoly
NET Netback from Final Product
RCS Regulation Cost of Service
RSP Regulation Social and Political
RBC Regulation Below Cost
NP No Price
NK Not Known
In addition to categories 1-8 it proved necessary to have a not
known category for those instances where no information was
found on how a particular component of gas consumption in a
particular country is priced.
Results
Format of 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:
Indigenous production (consumed within the country, i.e.
not exported)
Pipeline imports
LNG imports
Total imports (pipeline plus LNG)
Total consumption (indigenous 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.
In terms of the presentation of results, the World results will be
considered frst, followed by the Regional results for the separate
regions North America, Latin America, Europe, Former Soviet
Union, Middle East, Africa, Asia and Asia Pacifc.
As well as collecting information on price formation mechanisms
by country, information was also collected on wholesale price
levels in each country. These results on a country and regional
basis are also presented together with an analysis of price trends.
World Results
Before considering the results on price formation mechanisms,
the regional patterns of consumption and production will be
considered. The discussion of the results on price formation
mechanisms will show comparisons between 2007 and 2005
for the World and where relevant for regions but there is an
additional sub-section which explains directly the reasons for
the changes.
World Consumption and Production
In 2007 total world consumption and production was of the
order of 2,980 bcm. Chart 7.3 below shows the distribution of
world consumption.
Chart 7.3: World gas consumption 2007
World gas consumption 2007
North America
27 %
Latin America
4 %
Europe
18 %
Former Soviet
Union
23 %
Middle East
10 %
Africa
3 %
Asia
5 %
Asia Pacific
10 %
2,982 bcm
Sources: BP, IGU
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 infuence on the results
on price formation mechanisms at the World level. The Middle
East and Asia Pacifc will also have an important, but smaller,
infuence.
With respect to world gas production, the largest consuming
region North America was largely self-suffcient in 2007.
The Former Soviet Union was a net exporter, principally to
Europe, which was a net importer. Asia Pacifc 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-suffcient.
Chart 7.4: World gas production, 2007
World gas production, 2007
North America
26 %
Latin America
5 %
Europe
10 %
Former Soviet
Union
28 %
Middle East
12 %
Africa
6 %
Asia
5 %
Asia Pacific
8 %
2,988 bcm

Sources: BP, IGU
Concerning imports by pipeline (both intra- and inter-regional),
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 signifcant. In the other regions,
pipeline imports are all intra-regional.
Chart 7.5: World pipeline gas imports, 2007
World pipeline gas imports, 2007
North America
18,4 %
Latin America
2,0 %
Europe
52,1 %
Former Soviet
Union
23,0 %
Africa
0,2 %
Asia
0,4 %
Middle East
1,4 %
Asia Pacific
2,4 %
710 bcm
Sources: BP, IGU
With respect to gas exports via pipeline, the Former Soviet Union
in 2007 accounted for some 46% of the world total. Africa,
meaning in this case Algeria, is also a signifcant exporter to
Europe, while any trade in the Asian and American regions is
intra-regional.
Chart 7.6: World pipeline gas exports
World pipeline gas exports, 2007
North America
18,4 %
Latin America
2,0 %
Europe
24,3 %
Former Soviet
Union
44,9 %
Middle East
1,1 %
Africa
6,4 %
Asia
1,8 %
Asia Pacific
1,0 %
710 bcm
Sources: BP, IGU
LNG imports are dominated by Asia Pacifc principally
Japan, Korea, and Taiwan, with Europe being the second largest
importing region. When compared with the LNG Exports chart,
much of the Asia Pacifc trade is intra-regional, but the region
also imports signifcant quantities from the Middle East, while
Africa and Latin America (Trinidad) are key exporters to Europe
and North America.
Chart 7.7: World LNG imports, 2007
World LNG Imports, 2007
North America
10,3 %
Latin America
0,6 %
Europe
23,5 %
Asia Pacific
59,5 %
FSU 0,0 %
Africa
0,0 %
Asia
6,1 %
Middle East
0,0 %
225 bcm
Sources: BP, IGU
Chart 7.8: World LNG exports, 2007
World LNG Exports, 2007
Africa
27,2 %
Asia
0,0 %
Asia Pacific
38,5 %
Latin America
8,0 %
Europe
0,1 %
Middle East
25,7 %
FSU 0 %
North America
0,6 %
225 bcm
Sources: BP, IGU
Price formation: Indigenous production
Chart 7.9: World price formation 2007 indigenous production
World price formation 2007:
Indigenous production
Oil Price
Escalation
5 %
Gas-on-gas
competition
36 %
Bilateral
monopoly
1 % Netback
1 %
Regulation
COS
4 %
Regulation
social/political
14 %
Regulation
below cost
38 %
Not known
0 %
No price
1 %
2,048 bcm
Indigenous production, consumed in own country, accounted
for just over 2,000 bcm in 2007, slightly less than 70% of total
world consumption. The two largest price formation categories
were GOG accounting for some 36% mainly in North
America, UK in Europe and Australia in Asia Pacifc and
RBC accounting for 38%, largely the Former Soviet Union
and Middle East with some in Africa. RSP at 14% is spread
through all regions apart from North America. RCS, at 4%, is
principally in Africa and Asia. There is a small amount of OPE
in Europe and Asia. Compared to 2005 the changes have been
minor marginal increases in GOG and RBC.
Chart 7.10: World price formation 2005 indigenous production
BIM
4 %
Regulation
below cost
34 %
Regulation COS
4 %
Netback
1 %
Regulation
social/political
16 %
No price
2 %
Not known
0 %
4 %
Gas-on-gas
competition
35 %
1,940 bcm
Price Formation: Pipeline Imports
Pipeline imports at 710 bcm account for some 24% 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. Compared to 2005, there
have been increases in GOG and BIM at the expense of OPE.
Chart 7.11: World price formation 2007 pipeline imports
World price formation 2007: Pipeline Imports
Bilateral monopoly
27 %
Gas-on-gas
competition
26 %
Oil price
escalation
47 %
710 bcm
Chart 7.12: World price formation 2005 pipeline imports
World price formation 2005: Pipeline imports
Gas-on-gas
competition 22 %
Oil price
escalation
55 %
Bilateral monopoly
23 %
660 bcm
Price Formation: LNG Imports
LNG imports at 225 bcm account for some 7,5% of total world
gas consumption. Internationally traded LNG is largely dominated
by OPE into Europe and Asia Pacifc. GOG is mainly North
America with some spot LNG cargoes into Europe and Asia
Pacifc, while the small amount of BIM is in Asia refecting
the LNG cargoes to India. Compared to 2005, GOG has gained
signifcantly at the expense of OPE, largely refecting the increase
in spot LNG cargoes.
Chart 7.13: World price formation 2007 LNG imports
World price formation 2007: LNG imports
70 %
Bilateral monopoly
3 %
Gas-on gas
competition
27 %
225 bcm
Chart 7.14: World price formation 2005 LNG imports
Gas-on-gas
competition
13 %
Bilateral monopoly
4 %
83 %
190 bcm
Price Formation: Total Imports
Total imports at 935 bcm account for some 32% of total world
consumption. 53% is OPE with Europe (pipeline mainly) and
Asia Pacifc (LNG) dominating. GOG is both pipeline and LNG
imports, with BIM largely intra-Former Soviet Union pipeline
trade. GOG and BIM have gained signifcantly at the expense
of OPE comparing 2007 and 2005.
Chart 7.15: World price formation 2007 total imports
Gas-on-gas
competition
13 %
Bilateral monopoly
4 %
83 %
190 bcm
Chart 7.16: World price formation 2005 total imports
World price formation 2005: Total Imports
Oil price
escalation
62 %
Gas-on-gas
competition
20 %
Bilateral
monopoly
18 %
850 bcm
Price formation: Total consumption
The respective shares of total world consumption for each price
formation mechanism refect 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 just under 40% 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), Middle
East and North America (in Mexico, where Pemex refneries
and petrochemical plants use gas as a free feedstock).
Compared to 2005, GOG and RBC have increased their respective
shares, largely at the expense of OPE and RSP.
Chart 7.17: World price formation 2007 total consumption
Total consumption
Gas-on-gas
competition
32 %
Regulation below
cost 26 %
20 %
Netback from final
product 1 %
Regulation cost of
service
3 %
Regulation
social/political
9 %
No price
1 %
Not known
0 %
Bilateral monopoly
8 %
2,982 bcm
Total Consumption
Regulation below
cost
23 %
22 %
Gas-on-gas
competition
32 %
Regulation cost of
service 3 %
Bilateral monopoly
8 %
Netback from
final product
0 %
Regulation
social/political
11 %
No price
1 %
Not known
0 %
2,790 bcm
Regional results
In presenting the World results all 5 identifed categories
Domestic Production, Pipeline Imports, LNG Imports, Total
Imports and Total Consumption were reviewed and analysed,
and also compared with 2005. At the regional level not all the
categories will be relevant, for example, there may be little or
no LNG imports into a region, and there may be no material
changes from 2005. The data and charts presented for each
region, therefore, will differ depending on the relevance of each
consumption category, and any changes since 2005.
North America
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 7.1: North America consumption and production 2007 (BCM)
USA 652.9 545.9 108.9 20.7 22.0 1.2
Canada 94.0 183.7 13.2 107.3
Mexico 54.1 46.2 8.8 2.5 1.6
Total North America 801.0 775.8 130.9 23.2 130.9 1.2
Exports
Country Consumption Production
Imports
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 signifcant amounts from the Middle East and Africa.
Chart 7.19: North America price formation 2007 total consumption
North America price formation 2007:
Total consumption
Gas-on-gas
competition
98,7 %
No price
1,3 %
800 bcm
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
consumption, related to feedstock for petrochemical plants,
fuel for equipment in refneries and plants and for secondary
oil recovery. This gas is not priced and has been allocated to
the No Price category.
Latin America
Table 7.2: Latin America consumption and production 2007 (BCM)
Argentina 44.1 44.8 1.9 2.5
Bolivia 1.8 13.5 11.7
Brazil 22.0 11.3 10.0
Chile 4.4 2.0 2.4
Colombia 7.7 7.7
Dominican Republic 0.6 0.6
Ecuador 0.3 0.3
Peru 2.7 2.7
Puerto Rico 0.7 0.7
Trinidad 20.9 39.0 18.2
Uruguay 0.1 0.1
Venezuela 28.5 28.5
Total Latin America 133.6 149.8 14.3 1.2 14.2 18.2
Imports Exports
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
intra-regional 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 half of Brazils.
Latin America consumption at 134 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 two 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 competing suppliers (GOG),
as are power generators in Trinidad (BIM). NET is in Trinidad
where gas is provided to Methanol plants. Compared to 2005
the main changes are increasing shares of GOG (in Argentina)
and OPE (in Brazil) at the expense of RSP.
Chart 7.20: Latin America price formation 2007 total consumption
Latin America price formation 2007:
Total consumption
Regulation
social/political
48,2 %
Regulation cost of
service
8,0 %
Netback from final
product
11,4 %
Bilateral monopoly
4,7 %
Gas-on-gas
competition
8,3 %
19,5 %
134 bcm
Chart 7.21: Latin America price formation 2005 total consumption
Latin America price formation 2005:
Total consumption
15 %
Gas-on-gas
competition
2 %
Bilateral monopoly
7 %
Netback from final
product
9 %
Regulation cost of
service
5 %
Regulation
social/political
60 %
Regulation below
cost
2 %
125 bcm
Europe
Table 7.3: Europe consumption and production 2007 (Bcm)
Austria 8.9 1.4 7.5
Belgium & Luxembourg 16.9 19.3 3.2 4.5
Bosnia-Herzegovina 0.4 0.4
Bulgaria 3.1 3.1
Croatia 3.1 2.0 1.1
Czech Republic 8.9 0.3 8.6
Denmark 5.0 10.4 5.3
Estonia 1.0 1.0
Finland 4.3 4.3
France 43.2 1.0 29.1 12.6
FYROM 0.1 0.1
Germany 82.7 14.3 83.7 16.4
Greece 4.0 2.9 0.8
Hungary 11.8 1.3 10.5
Ireland 4.8 0.6 4.2
Italy 84.9 9.7 71.5 2.4 0.1
Latvia 1.6 1.6
Lithuania 3.8 3.4
Netherlands 37.2 64.5 18.9 50.1
Norway 4.3 89.7 86.1 0.1
Poland 13.7 4.3 9.3
Portugal 4.2 1.9 2.3
Romania 16.4 11.6 4.8
Serbia & Montenegro 2.3 0.2 2.1
Slovakia 5.9 0.1 5.8
Slovenia 1.1 1.1
Spain 35.1 11.0 24.2
Sweden 1.0 1.1
Switzerland 2.9 3.0
Turkey 35.1 30.6 6.0
United Kingdom 91.4 72.4 28.0 1.5 10.4
Total Europe 539.2 283.8 369.8 53.0 172.7 0.1
Imports Exports
Europe is highly dependent on imported gas both by pipeline
and LNG. Of the largest consumers, only the UK produced the
majority of its gas requirements, and this situation is rapidly
changing. Norway and the Netherlands provided a signifcant
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 signifcant quantities of
LNG were also sourced from West Africa and the Middle East.
Out of the total European consumption in 2007 of 539 bcm,
only 117 bcm (22%) was produced and consumed within the
country and half of this was in the UK market. The chart below
shows the price formation mechanisms for this indigenous
production with GOG at 44% and OPE at 35% dominating.
This was in the UK, where some of the older contracts still
retain key elements of OPE, but also in the Netherlands and
Italy where domestic production 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. NP was in
Norway refecting reinjected gas.
Chart 7.22: Europe price formation 2007 indigenous production
Europe price formation 2007: Domestic
production
Regulation
social/political
13,6 %
No price
2,8 %
Regulation cost
of service
2 %
Bilateral monopoly
0,9 %
Netback
0,6 %
35,2 %
Gas-on-gas
competition
45,2 %
123 bcm
The situation for total imports (both pipeline and LNG, comprising
424 bcm or 78% of total consumption) is markedly different,
with OPE dominating at 82%. GOG at 16% is predominantly
the UK, plus Ireland, but also in other major European countries
where trading hubs are developing and in Spain, refecting spot
LNG cargoes. The BIM category (2%) is largely accounted for
by imports into the Baltic States (Estonia, Latvia and Lithuania)
and Bulgaria from Russia.
Chart 7.23: Europe price formation 2007 total imports
Europe price formation 2007: Total imports
82,4 %
Gas-on-gas
competition
15,5 %
Bilateral monopoly
2,0 %
424 bcm
In total, at 540 bcm, Europe accounts for around 18% 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 72%. GOG is largely the UK market, plus the developing
trading hubs in continental Europe. Compared to 2005, GOG
has gained at the expense of OPE as trading hubs developed
and spot LNG cargoes increased.
Chart 7.24: Europe price formation 2007 total consumption
Europe price formation 2007: Total
consumption
72,2 %
Regulation
social/political
3,0 %
Bilateral monopoly
1,8 %
Gas-on-gas
competition
22,0 %
No price
0,6 %
Regulation cost of
service
0,4 %
540 bcm
Netback from
final product
0,1%
Chart 7.25: Europe price formation 2005 total consumption
consumption
79,1 %
Regulation cost of
service
0,3 %
Netback
0,1 %
Bilateral monopoly
1,6 %
Gas-on-gas
competition
15,5 %
Regulation
social/political
2,7 %
No price
0,6 %
540 bcm
Former Soviet Union
Table 7.4: FSU consumption and production 2007 (BCM)
Armenia 2.1 2.1
Azerbaijan 8.3 10.3 0.0 2.0
Belarus 20.8 0.2 20.6
Georgia 1.7 1.7
Kazakhstan 13.3 29.6 7.2 15.2
Kyrgyzstan 0.8 0.0 0.8
Moldova 2.8 0.1 2.7
Russian Federation 481.5 647.0 68.1 233.7
Tajikistan 0.7 0.0 0.6
Turkmenistan 23.5 72.3 0.0 48.8
Ukraine 69.8 20.6 59.2 5.1
Uzbekistan 50.6 65.3 0.0 14.7
Total FSU 675.9 845.5 163.0 0.0 319.5 0.0
Imports Exports
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. Russia is
also a major importer of gas, together with Ukraine.
At 675 bcm the Former Soviet Union accounts for around 23%
of world consumption. All imported gas is priced on a BIM
basis. The dominant price formation mechanism, however, is
RBC in Russia, Turkmenistan, Uzbekistan and Kazakhstan.
However, this situation in Russia, at least, is beginning to
change 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. Compared to 2005 RBC has increased its share,
in part due to changing consumption patterns within the region.
Chart 7.26: FSU price formation 2007 total consumption
FSU price formation 2007: Total consumption
Gas-on-gas
competition
1,1 %
Bilateral monopoly
24,1 %
Regulation below
cost
72,7 %
Regulation
social/political
1,6 %
No price
0,6 %
675 bcm
Chart 7.27: FSU price formation 2005 total consumption
Gas-on-gas
competition
1,1 %
Bilateral monopoly
24,1 %
Regulation below
cost
72,7 %
Regulation
social/political
1,6 %
No price
0,6 %
675 bcm
Middle East
Table 7.5: Middle East consumption and production 2007 (BCM)
Bahrain 11.5 11.5
Iran 111.8 111.9 6.1 6.2
Iraq 2.5 2.5
Israel 0.7 0.7
Jordan 2.4 0.2 2.4
Kuwait 12.6 12.6
Oman 10.9 24.1 1.0 12.2
Qatar 20.5 59.8 0.8 38.5
Saudi Arabia 75.9 75.9
Syria 5.3 5.3
United Arab Emirates 43.2 49.2 1.8 7.6
Total Middle East 297.3 353.7 10.2 0.0 7.9 58.2
Exports
Imports
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.
Middle East consumption at 297 bcm accounts for around 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
trades from Egypt to Jordan and Oman to the UAE. Chart for
2005 is not shown as there has been almost no change.
Chart 7.28: Middle East price formation 2007 total consumption
Middle East price formation 2007: Total
consumption
Regulation below
cost
80,3 %
Not known
0,8 %
Regulation
social/political
14,2 %
No price
1,3 %
Bilateral
monopoly
3,4 %
297 bcm
Africa
Table 7.6: Africa consumption and production 2007 (BCM)
Algeria 24.4 83.0 34.0 24.7
Angola 0.8 0.8
Egypt 32.0 46.5 2.4 13.6
Equatorial Guinea 1.3 2.7 1.4
Ivory Coast 1.3 1.3
Libya 5.2 15.2 9.2 0.8
Nigeria 14.8 35.0 21.2
South Africa 2.2 2.2
Tunisia 4.3 2.5 1.3
Total Africa 86.3 189.2 1.3 0.0 45.6 61.6
Exports
Imports
Excluding its export trade, Africa has virtually no traded gas,
with only Tunisia importing some gas from Algeria via the
pipeline to Italy.
In terms of consumption, Africa is the smallest region at 86
bcm, or 3% of total world consumption. Wholesale prices are
highly regulated, with RBC accounting for just over half, in
Egypt and Nigeria. RCS is predominantly Algeria and RSP in
Libya and South Africa. The OPE category refects the only
traded gas with Tunisia importing from Algeria. Compared
to 2005 RBC has increased its share largely at the expense of
RCS, refecting changing consumption patterns.
Chart 7.29: Africa price formation 2007 total consumption
Africa price formation 2007: Total
consumption
Regulation cost of
service
29,8 %
Regulation
social/political
9,0 %
Regulation below
cost
54,2 %
Oil price
escalation
5,0 %
No price
0,9 %
Netback
1,1 %
86 bcm
Chart 7.30: Africa price formation 2005 total consumption
consumption
Regulation below
cost
48,2 %
Regulation cost of
service
32,6 %
Regulation
social/political
11,2 %
Oil price
escalation
5,7 %
No price
1,1 %
Netback
1,2 %
75 bcm
Asia
Table 7.7: Asia consumption and production 2007 (BCM)
Afghanistan 0.2 0.2
Bangladesh 16.3 16.3
China 67.3 69.3 3.9 3.0
China Hong Kong 3.0 3.0
India 40.2 30.2 10.0
Myanmar 4.8 14.7 9.9
Pakistan 30.8 30.8
Total Asia 162.6 161.5 3.0 13.9 12.9 0.0
Imports Exports
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
signifcantly from both indigenous resources and imports.
Asia accounts for just over 5% of world consumption at 163
bcm. Regulation of wholesale prices is widespread. RSP at
51% is predominantly China and India, RCS in Pakistan and
RBC in Myanmar. OPE at 12% is in Bangladesh and LNG into
China. The BIM category is Indian LNG imports, and private
gas production in India, plus Hong Kong imports from China.
GOG is spot LNG cargoes into India. Compared to 2005, RSP
and RCS have declined with OPE, GOG and BIM gaining, in
part refecting changing consumption patterns.
Chart 7.31: Asia price formation 2007 total consumption
Asia price formation 2007: Total consumption
12,1 %
Gas-on-gas
competition
3,4 %
Bilateral monopoly
11,4 %
Regulation cost of
service
18,9 %
Regulation
social/political
51,2 %
Regulation below
cost
3,0 %
163 bcm
Chart 7.32: Asia price formation 2005 - total consumption
12,1 %
Gas-on-gas
competition
3,4 %
Bilateral monopoly
11,4 %
Regulation cost of
service
18,9 %
Regulation
social/political
51,2 %
Regulation below
cost
3,0 %
163 bcm
Asia Pacifc
Table 7.8: Asia Pacifc consumption and production 2007 (BCM)
Australia 25.1 40.0 20.2
Brunei 2.9 12.3 9.4
Indonesia 33.8 66.7 5.4 27.7
Japan 90.2 1.4 88.8
Malaysia 28.3 60.5 1.8 29.8
New Zealand 3.7 4.0
Philippines 3.4 3.4
Singapore 7.2 7.2
South Korea 37.0 2.6 34.4
Taiwan 11.8 0.9 10.9
Thailand 35.4 25.9 9.9
Vietnam 7.7 7.7
Total Asia Pacific 286.5 225.4 17.1 134.1 7.2 87.1
Exports
Imports
After Europe, Asia Pacifc 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.
At 286 bcm, Asia Pacifc accounts for just under 10% of total
world consumption. Over 50% of gas is imported by countries.
OPE at 52% is the largest category and comprises LNG imports
into Japan, Korea and Taiwan, pipeline into Singapore and
domestic production in Thailand. GOG is Australia and spot
LNG trade. BIM is mainly imports into Thailand and some in
Indonesia and New Zealand. RSP is the majority of wholesale
gas in Indonesia and Malaysia. RCS is Vietnam. Compared
to 2005, GOG and OPE have gained shares, principally at the
expense of RSP.
Chart 7.33: Asia Pacifc price formation 2007 - total consumption
Asia Pacific price formation 2007: Total
consumption
51,9 %
Gas-on-gas
competition
16,3 %
Bilateral monopoly
7,6 %
Regulation cost of
service
3,0 %
Regulation
social/political
19,3 %
Not known
1,9 %
286 bcm
Chart 7.34: Asia Pacifc price formation 2005 - total consumption
consumption
50,4 %
Bilateral monopoly
8,1 %
Regulation cost of
service
2,9 %
Regulation
social/political
24,8 %
Not known
2,0 %
Gas-on-gas
competition
11,8 %
280 bcm
Wholesale Prices
As well as collecting data on price formation mechanisms the
IGU study also collected information on wholesale price levels
in 2007. As noted in the Introduction, the results here should
be treated as broad orders of magnitude, since the defnition 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.
Chart 7.35: World average wholesale gas prices by region
World: Average wholesale prices by region
2007
$0,00 $1,00 $2,00 $3,00 $4,00 $5,00 $6,00 $7,00 $8,00
Middle East
Former Soviet Union
Africa
Latin America
Asia
Total world
Asia Pacific
North America
Europe
$/MMBTU
The chart above shows a snapshot of price levels for 2007.
From year to year, wholesale prices can change signifcantly, as
discussed below. 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 Pacifc. 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 Turkmenistan is missing with
over 10 bcm consumption. The highest wholesale prices in 2007
were found in the LNG dependent countries in Asia Pacifc
(South Korea and Taiwan). These were followed by a whole
host of European countries headed by Belgium and France, and
then North America. 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 plus Argentina and Venezuela.
Chart 7.36: World average wholesale gas prices by country
Average wholesale prices by country 2007
$0,00 $1,00 $2,00 $3,00 $4,00 $5,00 $6,00 $7,00 $8,00 $9,00 $10,00
Nigeria
Iran
Uzbekistan
UAE
Saudi Arabia
Qatar
Oman
Bahrain
Argentina
Venezuela
Kuwait
Kazakhstan
Egypt
Russian
China
Trinidad
Algeria
Malaysia
Belarus
Bangladesh
Pakistan
India
Australia
Ukraine
Indonesia
Thailand
Romania
Brazil
United Kingdom
Canada
Mexico
Spain
USA
Poland
Italy
Japan
Netherlands
Germany
Turkey
Hungary
France
Belgium
Taiwan
South Korea
$/MMBTU
Countries over 10 bcm annual
Consumption
World average
$4.50
An alternative way of analysing the data is to categorise by price
formation mechanism. The highest wholesale prices are OPE
followed by GOG. 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 fnal products almost all Trinidad and some in Norway.
The result for BIM is largely impacted by the lower levels of
wholesale prices in intra-Former Soviet Union trade.
Chart 7.37: Wholesale prices by price formation mechanism, 2007
Wholesale prices by price formation
mechanism 2007
$0,00
$1,00
$2,00
$3,00
$4,00
$5,00
$6,00
$7,00
$8,00
OPE GOG BIM NET RCS RSP RBC TOT
$
/
M
M
B
T
U
The charts above are for 2007 only and present, therefore,
only a snapshot of price levels. The chart below shows prices
over time for Henry Hub and NBP (both GOG markets) and
Germany, Spain, Japan/Korea (all OPE markets) and for Russian
exports to Former Soviet Union countries (BIM). In 2005 GOG
prices were above OPE prices but since 2006 GOG prices have
generally been below the OPE market prices. Through the
1990s Henry Hub / NBP prices were generally below Japan/
Korea, Germany and Spain prices. Prices of Russian exports
to Former Soviet Union countries have very recently started to
rise as Russia moves towards more market pricing.
Chart 7.38: Wholesale price trends 1989 - 2008
Wholesale price indicators
0,00
2,00
4,00
6,00
8,00
10,00
12,00
14,00
16,00
18,00
20,00
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Henry Hub NBP Germany Spain Jap/Kor Rus to FSU
The next chart simplifes the last one, using specifc countries
as proxies for different price formation mechanisms. Countries
are weighted together using their annual gas consumption as
the weights. GOG is the weighted average of UK and US (US
only prior to 1997); OPE is the weighted average of Germany,
Spain, Japan and Korea; and BIM is Russia exports to Former
Soviet Union countries. The oil price (WTI) is also shown as
the black line, converted to $/MMBTU. It is clear here how
GOG prices dropped below OPE prices from the beginning
of 2006. OPE prices would appear to track oil prices pretty
closely for much of the period, although the sharp increase in
oil prices from the beginning of 2007 was only partly passed
through into OPE prices with a lag, and the recent falls have
not yet been translated into lower wholesale prices. In the case
of Japan and Korea the effects of the S curve clauses in the
LNG contracts, may be responsible for the wholesale price not
fully refecting the rise in oil prices.
Chart 7.39: Wholesale price trends by price formation mechanism
1989 - 2008
mechanism
0
5
10
15
20
25
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/
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GOG OPE BIM WTI
UK/US prices
Ger/Sp/Jap/Kor prices
Russia exports
to FSU prices
Oil Price
Changes between 2005 and 2007
Details of the 2005 price formation mapping, were in part
included in the Results section but full details are contained
in Appendix 1. Changes in the relative importance of the dif-
ferent price formation mechanisms can occur either because
of differential growth in consumption between countries or
because price formation mechanisms themselves change.
The table below shows the growth in consumption by region
between 2005 and 2007.
Table 7.9: Growth in gas consumption 2005 to 2007
2005 2007 BCM %
North America 768.8 801.0 32.2 4.2%
Latin America 125.7 133.6 8.0 6.4%
Europe 534.6 539.2 4.6 0.9%
Former Soviet Union 593.8 675.9 82.1 13.8%
Middle East 276.6 297.3 20.7 7.5%
Africa 75.1 86.3 11.2 14.9%
Asia 134.7 162.6 27.9 20.7%
Asia Pacific 279.3 286.5 7.2 2.6%
Total World 2,788.5 2,982.3 193.9 7.0%
Region
Consumption Changes
World gas consumption grew by 7% between 2005 and 2007,
with faster than average growth in the Former Soviet Union,
Africa and Asia. The RBC price formation category is relatively
more important in these regions so, other things being equal, the
share of RBC might be expected to rise between 2005 and 2007.
The charts below show the changes in the volumes attributable to
each price formation mechanism and the changes in percentage
shares. It appears that the share of RBC has risen between 2005
and 2007, both in absolute volume terms and in its percentage
share.
Chart 7.40: Changes in wholesale price formation mechanisms
2005 to 2007
Volume changes in wholesale price formation
mechanisms between 2005 and 2007
-40
-20
0
20
40
60
80
100
120
140
OPE GOG BIM NET RCS RSP RBC NP NK
B
C
M
Percentage changes in wholesale price
formation nechanisms between 2005 and
2007
-3,0%
-2,0%
-1,0%
0,0%
1,0%
2,0%
3,0%
4,0%
OPE GOG BIM NET RCS RSP RBC NP NK
P
e
r
c
e
n
t

c
h
a
n
g
e
In addition to the RBC category increasing its share, the GOG
category also increased its share. These categories gained largely
at the expense of the RSP and OPE categories. The changes
can be explained as follows:
The increase in the RBC category of 130 bcm (2.9% increase
in share) was mostly as a result of the faster consumption
growth in the FSU, particularly in Russia. Some 110 bcm
out of the 130 bcm refects consumption growth, with only
the balance of 20 bcm refecting changes in price formation
mechanisms (largely in Russia);
The decline in the RSP category of some 24 bcm, largely
refects changes in price formation mechanisms in Brazil
(towards OPE), Argentina (towards GOG), lower domestic
production in Ukraine (which is all RSP) and declining
consumption in Malaysia (again all RSP);
The increase in the GOG category of some 100 bcm and the
decline in the OPE category are largely related. The switch
to GOG away from OPE refected relatively more spot LNG
cargoes to Japan, Korea, Taiwan and Spain, together with
increased spot volumes in Europe delivered from trading
hubs in Belgium, France, Germany, Italy and the Netherlands
together with a decline in production from traditional long
term contracts in the UK. The decline in the OPE category
was partly offset by the change in Brazil towards OPE and
consumption growth in Asia, particularly LNG imports into
China.
Overall much of the change in relative importance of the different
price formation mechanisms 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.
In respect of the levels of wholesale prices, the average wholesale
price was little changed between 2005 and 2007 - $4.50 per
MMBTU in 2007 against $4.53 per MMBTU in 2005. However,
as the chart below shows, in every price formation category,
apart from GOG, prices rose, sometimes signifcantly. In GOG
prices declined as a consequence of the falls in the USA and
the UK from the peak levels in 2005.
Chart 7.41: Changes in wholesale price levels 2005 to 2007
nechanism 2005 & 2007
$0,00
$1,00
$2,00
$3,00
$4,00
$5,00
$6,00
$7,00
$8,00
$9,00
$
/
M
M
B
T
U
2005 2007
Conclusions
In 2007 just under 70% of the worlds consumption of gas
comprised of domestic production consumed within that country,
with no trade across international borders. Some 24% was
traded through pipelines and some 7.5% LNG. The wholesale
price formation mechanisms are largely very different for
internationally traded gas compared to gas which is produced
purely for domestic consumption.
Table 7.10: World price formation 2007 total consumption
(BCM)
OPE GOG BIM NET RCS RSP RBC NP NK TOT
North America 0.0 790.3 0.0 0.0 0.0 0.0 0.0 10.7 0.0 801.0
Latin America 26.0 11.0 6.3 15.2 10.7 64.4 0.0 0.0 0.0 133.6
Europe 389.9 118.6 9.7 0.7 2.0 16.0 0.0 3.3 0.0 540.2
Former Soviet Union 0.0 7.2 163.0 0.0 0.0 10.6 491.1 4.0 0.0 675.9
Middle East 0.0 0.0 10.2 0.0 0.0 42.2 238.6 3.8 2.5 297.3
Africa 4.3 0.0 0.0 0.9 25.7 7.8 46.8 0.8 0.0 86.3
Asia 19.7 5.5 18.5 0.0 30.8 83.3 4.8 0.0 0.0 162.6
Asia Pacific 148.6 46.7 21.7 0.0 8.6 55.3 0.0 0.0 5.5 286.5
Total World 588.5 979.4 229.4 16.8 77.8 279.6 781.4 22.6 8.0 2,983.4
20% 33% 8% 1% 3% 9% 26% 1% 0% 100%
Total Consumption
Region
World price formation 2007: Total
consumption
Gas-on-gas
competition
32,8 %
19,7 %
Regulation below
cost
26,2 %
Netback
0,6 %
No price
0,8 %
Not known
0,3 %
Regulation cost of
service
2,6 %
Regulation
social/political
9,4 %
Bilateral monopoly
7,7 %
2,982 bcm
The chart above illustrates the overall results at the world level,
while the table looks at the breakdown by region.
The largest price formation category is GOG at 33%, 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 Pacifc, Australia and spot
LNG cargoes;
The OPE category at 20%, is generally only found in
internationally traded gas, which is mainly pipeline and
LNG in Europe and LNG in Asia Pacifc;
Together the GOG and OPE categories, which could be said
to refect an economic or market value of gas, account
for over 50% of total world consumption;
Wholesale price regulation, which covers 3 categories
RCS, RSP and RBC, accounts for 38% of total world
consumption, but is only found in domestic gas production
and not internationally traded gas. The RBC category in
2007 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 recent price increases,
which would mean that most of the market may be moving
from the RBC category, probably to the RSP category;
The RSP category, at 9%, 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 Pacifc, imported gas into India and Thailand
and partly domestically produced gas in Indonesia.
In respect of wholesale price levels in 2007, the chart below
shows that price levels were generally higher in the OPE markets
of Asia Pacifc and Europe, followed by GOG, predominantly
in the USA and UK. 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 lower levels of wholesale prices in intra-Former Soviet
Union trade.
Chart 7.43: Wholesale prices by price formation 2007
mechanism 2007
$0,00
$1,00
$2,00
$3,00
$4,00
$5,00
$6,00
$7,00
$8,00
$
/
M
M
B
T
U
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.

Parts of the world are in transit between gas pricing mechanisms.
Others are trying to fx problems with their existing mechanisms
without plunging into the unknowns of all-out system reform.
Yet others do not envisage signifcant 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.
Sellers, buyers and regulators preferences with respect
to retaining, adjusting or replacing pricing mechanisms are
infuenced by a number of factors:
Relative effciency 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
Effciency arguments are typically heard from proponents of
gas-on-gas competition based pricing. Only when gas prices
are allowed to refect gas supply and demand will the socially
optimal amount of resources fow 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 frm 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 frst 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
less volatile, refecting the way the indices are defned. With
gas prices set to refect the average of oil prices over a period
of time many months prior to delivery, short term peaks and
troughs are automatically smoothened out.
However, apart from the fact that price volatility to many actors
represents opportunities rather than problems, it might not be
very diffcult to shape the price clause in a contract based on
gas indexation so as to obtain the same smoothening effect.
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 beneftted from record
high prices feel the pinch. On the other hand, raising domestic
fuel prices too quickly might boost infation 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
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 effcient alternatives.
Continental Europe
With respect to Continental Europe, the EU commissions
electricity and gas liberalisation agendas refect 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 benefts to the
consumers. In any event, it is argued, the incumbents need to
be exposed to competition to stay effcient.
Specifcally, 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 infuence, and
because views on the optimal extent of regulation of economic
life, and the proper infuence 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-on-
gas 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 signifcant 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 refned products are vast, liquid and well
understood by everybody involved.
Thus, while there has been considerable movement on the grid
access issue, there is for the moment strong interest in retaining
oil linked pricing. European gas market players have also put
up a strong fght 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-on-
gas 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
0 %
10 %
20 %
30 %
40 %
50 %
60 %
70 %
80 %
90 %
100 %
1974 1980 1990 2000 2004
Others
Hydro
Nuclear
Gas
Oil
Coal
1974: Oil
share 25%
2004: Oil share 4%
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 infation, to coal or to electricity (the
spark spread) will likely continue to coexist for many years.
Asia Pacifc
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 mar-
ket based pricing is for the time being not an option other than
for spot cargos anyway since the OECD Pacifc gas markets
are characterised by limited competition and have no gas hubs.
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
cheap LNG, but since Indonesias supply challenges became
manifest their main interest has again been to secure volumes.
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
frst step towards a level playing feld and real competition.
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 foor offering protection to the seller if
oil prices should become too low came under pressure. The
fnancial 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 Pacifc 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 fnancial 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 foors, other times as ceilings.
Chart 8.2: Asian LNG importers spot purchases
Established Asian LNG importers' spot
purchases, 1995-2007
-
5
10
15
20
25
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
B
c
m
Tai wan
Korea
Japan
Source: PIRA, defning spot purchases as including contracts up to four years
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
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 fnd
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 fnancial 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 defcits 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
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.
In the late 1990s when oil prices dipped below USD 10 a
barrel and the oil exporters ran up record trade and fscal
defcits, 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 fscal
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 fow 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
2,5% a year in this period imports and exports nearly doubled
between 1992 and 2008.
Continental Europes interfacing with other market structures
has considerably modifed 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
fat 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.
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 liquefed 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 regasifcation terminals, and Canada,
Chile, Croatia, Poland, Singapore, the Netherlands, Germany,
Indonesia have all taken steps to enter this segment of the
global gas market.
Chart 8.4: LNG imports and exports by country
LNG exports by country
1964-2007
0
50
100
150
200
250
1
9
6
4
1
9
6
8
1
9
7
2
1
9
7
6
1
9
8
0
1
9
8
4
1
9
8
8
1
9
9
2
1
9
9
6
2
0
0
0
2
0
0
4
B
c
m
Norway
Eq. Guinea
Egypt
Oman
Trinidad
Nigeria
Qatar
Australia
Malaysia
Indonesia
Abu Dhabi
Brunei
Libya
US
Algeria
LNG imports by country
1964-2007
0
50
100
150
200
250
1
9
6
4
1
9
6
8
1
9
7
2
1
9
7
6
1
9
8
0
1
9
8
4
1
9
8
8
1
9
9
2
1
9
9
6
2
0
0
0
2
0
0
4
B
c
m
Mexico
China
I ndia
Dom.Rep.
Puert o Rico
Port ugal
Greece
Turkey
Taiwan
Sout h Korea
Germany
Belgium
I taly
USA
Spain
Japan
France
UK
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 infuences 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-fll 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 frm 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 confict 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 frst 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 frst 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
LNG contract prices are linked to the oil price, spot purchases
were apparently priced on an Atlantic basin netback basis,
though they could also refect 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 Pacifc 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 regasifed 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
fexible portion of LNG the volumes purchased by portfolio
players, the volumes available from liquefaction plants after
contractual commitments have been fulflled, 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 fexible
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 frst half of this decade forecasters expected rapid
growth in LNG exports and imports. This optimism refected 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 fexible 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 fve liquefaction
projects took fnal 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 fexible 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:
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 fscal 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.
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 fnancial crisis.
How quickly the fexible, 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 fexible 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
fexible LNG over a decade (a doubling of the fexible 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
fnancial 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 frst place, there were signs that the prices
in 2007 and the frst 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).
Sponsors probably also noticed that US LNG demand was not
developing as expected in the early 2000s.
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
open seasons for new regas terminals, that got the globalization
debate started.
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, fexible LNG would fow 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 fred 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 flled 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 fow
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 frst 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
Jan 97 - Oct 08
35
37
39
41
43
45
47
49
51
53
ja
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US monthly LNG imports
Jan 97 - Oct 08
0
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Trend line
Trend line
Source: US DOE EIA
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
US LNG imports
DOE/EIA's forecasts 2000-2009
0
1
2
3
4
5
6
7
1
9
9
7
2
0
0
0
2
0
0
3
2
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2
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2
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2
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2
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2
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2
7
2
0
3
0
T
c
f
2000
2005
2006
2007
2008
2009
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 signifcant 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 foor 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 suffcient 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 refect 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.
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 monthly LNG imports by supplier
0
500
1000
1500
2000
2500
3000
j
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Trinidad
Qatar
Norway
Nigeria
Eq. Guinea
Egypt
Algeria
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 fexible
enough to quickly accommodate any loss of fexible 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.
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 unifed pricing. The latter would mean
that a vital globalisation and unifcation driver would disappear
from the scene with the result that the processes might take
much longer.

General
In general terms, price volatility refers to the frequency and
amplitude of price fuctuations. In fnancial 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 prin-
ciple be used to discuss all kinds of fuctuations.
There is a strong popular perception that gas prices fuctuate
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 fuctuations
Henry Hub next month delivery
contract price
Jan 94 - Dec 08, daily basis
0
2
4
6
8
10
12
14
16
18
1
3
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NBP spot price
Jan 97 - Dec 08, monthly basis
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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
fuctuated 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
Henry Hub next month delivery contract price
Annual means, highs, lows
0
2
4
6
8
10
12
14
16
18
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
U
S
D
/
M
M
B
t
u
Source: US DOE EIA
Chart 9.3: Henry Hub standard deviation
Standard deviation of daily observations
0,00
0,50
1,00
1,50
2,00
2,50
3,00
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
U
S
D
/
M
M
B
t
u
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 log-
normal basis using the form
Return(t) = ln(Price(t)/Price(t-1)).
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 diffcult to see any clear
trend in volatility over the 1994-2007 period (Chart 9.4).
Chart 9.4: Henry Hub daily returns
Daily returns, January 2004 - December 2008
-50 %
-40 %
-30 %
-20 %
-10 %
0 %
10 %
20 %
30 %
40 %
1
4
.
0
1
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9
4
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.
0
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1
4
.
0
1
.
0
8
Source: US DOE EIA
What effects price volatility has on the affected markets and
economies is also a controversial issue.
9. Price volatility
In the 1980s and 1990s oil price volatility was much debated.
Many politicians and market actors recommended producer to
consumer cooperation to dampen price fuctuations. 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 study
5
examined the allegations that oil price
volatility had boosted infation 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 fexibility for consumers
and producers
The study failed to fnd 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.
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 fngers are pointed at commodity trading techniques
resulting from time to time in waves of speculative gas sales or
purchases. The public is also occasionally fred 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
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 fexibility of supply
S
Volume
Price
D
11
D
21
P
2
P
1
If the market at the
outset is at A, with
plenty of flexibility on
the supply side, an
increase in demand
from D
11
to D
12
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.
A
B
D
12
D
22
Price volatility and the flexibility of supply
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 fexibility of demand
Volume
Price
D
1
P
1
P
2
If the market is
at A when
supply shifts
from S
1
to S
2
,
then if demand
is flexible (the
D
1
curve)
prices only
increase by
P
1
, whereas
if demand is
inflexible (the
D
2
curve)
prices increase
by P
2
.
A
D
2
S
1
S
2
Price volatility and the flexibility of demand
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 fuctuations.
5
Philip K. Verleger, Jr.: Adjusting to Volatile Energy Prices, Washington DC 1993
Gas exchange prices refect 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 fuctuations.
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 effciency impro-
vements, 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 pur-
chases within the limits set by their fexibility to switch to
alternative fuels. Typically, power sector gas demand declines
as generators switch from gas to coal or oil-fred capacity,
while industrial gas demand declines as frms relying on gas
for process heat switch to oil products and frms 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, be-
cause of effciency considerations and also since environmen-
tal 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 uncon-
ventional 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 felds. Aggregate
additional production is not expected to be signifcant.
As for demand, prolonged periods of high gas prices reduce
power sector gas needs by encouraging investment in alterna-
tive (typically coal fred) 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 build-
ing insulation, double glazing and more effcient 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 felds 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 feld 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 fexibility to switch from
alternative fuels to gas. Typically, power generators bring unused
gas fred capacity on line at the expense of coal fred capacity.
Industrial gas demand is unlikely to change.
Prolonged periods of low gas prices would strengthen the case
for new investment in gas fred 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
refected 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 felds 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 insuffcient
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.
Volatility of oil indexed prices
In Continental Europe and Asia gas prices are as noted
indexed to oil prices depend on imported gas to satisfy
signifcant portions of their needs. This gas typically travels
signifcant distances from the well-head to the city-gate.
Importantly, the indices are not crude or product spot prices,
which are highly volatile, but rolling price averages typically
ironing out fuctuations 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) signifcantly 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 refect 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 confrms 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 confned to the existence of contract
re-openers. Whether triggered by the buyer or the seller, re-
openers can result in signifcant re-basing of the underlying
contract price.
Chart 9.7: Standard deviations of monthly observations of
sample of gas prices
Bilateral monopoly
No price
North America, UK
Continental Europe,
Developed Asia
Continental Europe
Bilateral monopoly
No price
Select Non-OECD
2008
2020
R
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C
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Select market segments
Select Non-OECD
Select Non-OECD
Source of price data: PIRA
Volatility and LNG
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 mate-
rial shift inside the LNG portion of gas supply from long term
contracted to fexible LNG would imply further commoditi-
zation of gas and different volatility patterns across countries.
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 frst place are arrested.
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 fexible 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.
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
fexibility 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 fexible
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 fnancial investors, and does as such
imply a risk of speculative booms and busts.
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
0,00
5,00
10,00
15,00
20,00
25,00
2007 2010 2015 2020 2025 2030
U
S
D
/
M
M
B
t
u
Crude oil - IEA imports
Gas - US imports
Gas - Japan LNG imports
Gas - European i mports
Source: IEA: World Energy Outlook 2008
The split of gas transactions by price formation mechanism
could however change signifcantly 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 signifcant 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 beneft from oil indexation when oil prices
are suffciently low for suffciently long to make oil linked
gas cheaper than spot gas. Sellers of course beneft 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 benefts over time. Oil driven
gas price rallies like the one in 2007-08 that led to signifcant
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 fnancial crisis, the recession and the consequent
drop in gas demand nearly everywhere have forced gas suppliers
to signifcantly 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 infuenced 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.
10. Towards further changes in the extensiveness
of individual pricing mechanisms?
Oil indexation will in any event not disappear any time soon,
for several reasons.
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.
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
0
50
100
150
200
250
300
350
400
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
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2
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0
2
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2
0
2
5
b
c
m
Still, the existing body of oil linked contracts considerably
reduces the maximum pace at which a shift towards, e.g., gas
indexation could proceed.
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.
Gaining acceptance for alternative pricing models will likely
take longer in Asia than in Europe.
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.
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.
Chart 10.3: Japans, South Koreas and Taiwans contracted
gas supply
Japan's, South Korea's and Taiwan's
contracted gas supply, mid 2008
0
20
40
60
80
100
120
140
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
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b
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m
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 signifcant 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 frst to the second and
third pricing principle.
6
Including deals at HoA or MoU level as well as frm sales and purchase contracts
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, infation and the popularity and leeway of the incumbent
government need to be constantly considered.
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 felds
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 refect 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 beneft 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
Bilateral monopoly
No price
North America, UK
Continental Europe,
Developed Asia
Continental Europe
Bilateral monopoly
No price
Select Non-OECD
2008
2020
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Select Non-OECD
Select Non-OECD
Format of 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:
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 frst, followed by the Regional results for the separate
regions North America, Latin America, Europe, Former Soviet
Union, Middle East, Africa, Asia and Asia Pacifc.
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.
World Results
World Consumption and Production
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
Latin America
5 %
Europe
19 %
Former Soviet
Union
21 %
Middle East
10 %
Africa
3 %
North America
27 %
Asia
5 %
Asia Pacific
10 %
2,790 bcm
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 infuence on the results
on price formation mechanisms at the World level. The Middle
East and Asia Pacifc will also have an important, but smaller,
infuence.
The Chart on the next page shows World Production by region.
The largest consuming region North America was largely
self-suffcient in 2005. The Former Soviet Union was a net
exporter, principally to Europe, which was a net importer. Asia
Pacifc 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-suffcient.
Appendix 1
Price Formation Mechanisms 2005 Survey
Chart A2: World gas production 2005
World gas production 2005
North America
26 %
Latin America
5 %
Europe
11 %
Former Soviet
Union
28 %
Middle East
11 %
Africa
6 %
Asia
5 %
Asia Pacific
8 %
2,785 bcm
With respect to imports by pipeline (both intra- and inter-
regional), 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 signifcant. In the other regions,
pipeline imports are all intra-regional.
Chart A3: Pipeline imports 2005
World gas production 2005
North America
26 %
Latin America
5 %
Europe
11 %
Former Soviet
Union
28 %
Middle East
11 %
Africa
6 %
Asia
5 %
Asia Pacific
8 %
2,785 bcm
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 signifcant exporter to
Europe, while any trade in the Asian and American regions is
intra-regional.
Chart A4: Pipeline exports 2005
Pipeline exports 2005
North America
18,8 %
Latin America
2,6 %
Europe
23,4 %
Former Soviet
Union
44,8 %
Africa
6,7 %
Asia
1,8 %
Middle East
0,9 %
Asia Pacific
1,0 %
663 bcm
Chart A5: LNG imports 2005
LNG imports 2005
Europe
25,2 %
Asia Pacific
61,6 %
Latin America
0,5 %
North America
9,5 %
Asia
3,2 %
190 bcm
LNG imports are dominated by Asia Pacifc principally
Japan, Korea, and Taiwan, with Europe being the second largest
importing region. When compared with the LNG Exports chart,
much of the Asia Pacifc trade is intra-regional, but the region
also imports signifcant quantities from the Middle East, while
Africa and Latin America (Trinidad) are key exporters to Europe
and North America.
Chart A6: LNG exports 2005
LNG exports 2005
Latin America
7,4 %
Middle East
23,0 %
Africa
24,1 %
Asia Pacific
44,5 %
North America
1,0 %
190 bcm
Price Formation: Domestic Production
Chart A7: World price formation 2005 indigenous production
Gas-on-gas
competition
36,3 %
Regulation below
cost
33,6 %
4,4 %
Regulation
social/political
15,6 %
Netback
0,7 %
Regulation cost of
service
3,6 %
Bilateral monopoly
3,7 %
Not known
0,4 %
No price
1,7 %
1,940 bcm
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 Pacifc 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 Pacifc. There is a small amount of OPE in Europe
and Asia.
Price Formation: Pipeline Imports
Chart A8: World price formation 2005 pipeline imports
World price formation 2005: Pipeline imports
54,8 %
Gas-on-gas
competition
22,4 %
Bilateral monopoly
22,7 %
660 bcm
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.
Price Formation: LNG Imports
Chart A9: World price formation 2005 LNG imports
83,0 %
Bilateral monopoly
3,7 %
Gas-on-gas
competition
13,4 %
190 bcm
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 Pacifc. GOG is mainly North
America with some spot LNG cargoes into Asia Pacifc, while
BIM is in Asia refecting the LNG cargoes to India.
Price Formation: Total Imports
Chart A10: World price formation 2005 total imports
World price formation 2005: Total imports
61,1 %
Bilateral monopoly
18,5 %
Gas-on-gas
competition
20,4 %
850 bcm
Total imports at 850 bcm account for some 30% of total world
consumption. 60% is OPE with Europe (pipeline mainly) and
Asia Pacifc (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
consumption
Regulation below
cost
23,3 %
Gas-on-gas
competition
31,4 %
21,7 %
Regulation
social/political
10,9 %
No price
1,2 %
Not known
0,3 %
Netback
0,5 %
Bilateral monopoly
8,2 %
Regulation cost of
service
2,5 %
2,790 bcm
The respective shares of total world consumption for each price
formation mechanism refect 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 refneries and petrochemical
plants use gas as a free feedstock).
Regional Results
In presenting the World results all 5 identifed 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
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)
USA 629.8 511.8 104.2 17.9 20.3 1.8
Canada 91.4 185.9 10.1 104.2
Mexico 47.6 39.2 10.1 0.0
Total North America 768.8 736.9 124.5 17.9 124.5 1.8
Imports Exports
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
Gas-on-gas
competition
98,8 %
No price
1,2 %
770 bcm
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
consumption, related to feedstock for petrochemical plants,
fuel for equipment in refneries and plants and for secondary
oil recovery. This gas is not priced and has been allocated to
the No Price category.
Latin America
Table A2: Latin America consumption and production 2005
(BCM)
Argentina 40.4 45.6 1.7 6.8
Bolivia 2.1 12.4 10.4
Brazil 19.9 11.4 8.8
Chile 8.5 2.0 6.5
Colombia 6.8 6.8
Dominican Republic 0.3 0.3
Ecuador 0.3 0.3
Peru 1.5 1.6
Puerto Rico 0.7 0.7
Trinidad 16.3 30.3 14.0
Uruguay 0.1 0.1
Venezuela 28.9 28.9
Total Latin America 125.7 139.2 17.2 0.9 17.2 14.0
Imports Exports
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 intra-
regional 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
14,8 %
Gas-on-gas
competition
1,6 %
Bilateral monopoly
6,7 %
Netback
9,5 %
Regulation cost of
service
5,4 %
Regulation
social/political
59,5 %
Regulation below
cost
2,5 %
125 bcm
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.

Europe
Table A3: Europe consumption and production 2005 (BCM)
Austria 10.0 1.6 8.7
Belgium & Luxembourg 16.6 18.0 3.0 4.4
Bosnia-Herzegovina 0.4 0.4
Bulgaria 3.0 2.9
Croatia 2.7 1.5 1.2
Czech Republic 8.5 0.2 9.5
Denmark 5.0 10.4 5.3
Estonia 1.5 0.7
Finland 4.0 4.2
France 45.8 1.2 36.2 12.8
Germany 86.2 15.8 90.7 9.8
Greece 2.8 2.3 0.5
Hungary 13.2 3.0 10.8
Ireland 3.9 0.6 3.1
Italy 78.7 12.1 71.0 2.5
Latvia 1.8 1.2
Lithuania 3.3 2.9
Netherlands 39.5 62.9 23.0 46.8
Norway 4.5 85.0 79.5
Poland 13.6 4.3 10.2
Portugal 4.2 2.6 1.6
Romania 17.3 12.1 6.3
Serbia & Montenegro 2.2 0.3 1.9
Slovakia 6.6 0.2 6.4
Slovenia 1.1 1.1
Spain 32.4 0.2 11.6 21.9
Sweden 0.8 1.0
Switzerland 3.1 2.8
Turkey 26.9 0.9 22.2 4.9
United Kingdom 95.1 87.5 14.7 0.5 9.7
Total Europe 534.6 299.7 367.4 47.6 155.4 0.0
Imports Exports
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 signifcant
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 signifcant 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.
Chart A14: Europe price formation 2005 indigenous production

Europe price formation 2005: Indigenous
production
Gas-on-gas
competition
47,0 %
No price
2,8 %
Netback
0,6 %
Regulation cost of
service
1,2 %
Bilateral monopoly
2,0 %
34,7 %
Regulation
social/political
11,6 %
124 bcm
Chart A15: Europe price formation 2005 total imports
Europe price formation 2005: Total imports
92,4 %
Bilateral monopoly
1,5 %
Gas-on-gas
competition
6,0 %
415 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.
Chart A16: Europe price formation 2005 total consumption
consumption
79,1 %
Bilateral monopoly
1,6 %
Gas-on-gas
competition
15,5 %
Regulation cost
of service
0,3 %
Regulation
social/political
2,7 %
No price
0,6 %
Netback
0,1 %
540 bcm
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.
Former Soviet Union
Table A4: FSU consumption and production 2005 (BCM)
Armenia 1.7 1.7
Azerbaijan 8.9 5.3 4.5
Belarus 18.9 0.3 20.1
Georgia 1.5 0.2 1.5
Kazakhstan 19.6 23.3 11.6 7.6
Kyrgyzstan 0.7 0.0 0.7
Moldova 2.5 0.1 2.5
Russian Federation 405.1 598.0 25.6 229.0
Tajikistan 1.4 0.0 1.4
Turkmenistan 16.6 58.8 0.0 45.2
Ukraine 72.9 19.4 55.3 2.5
Uzbekistan 44.0 55.0 0.0 12.4
Total FSU 593.8 760.5 124.8 0.0 296.7 0.0
Imports Exports
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
Bilateral monopoly
29,1 %
Regulation below
cost
65,1 %
No price
2,8 %
Regulation
social/political
3,0 %
595 bcm

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.
Middle East
Table A5: Middle East consumption and production 2005 (BCM)
Bahrain 10.7 10.7
Iran 102.4 100.9 5.8 4.3
Iraq 2.5 2.5
Israel 0.7 0.7
Jordan 1.6 0.3 1.3
Kuwait 12.3 12.3
Oman 9.2 19.8 1.4 9.2
Qatar 18.7 45.8 27.1
Saudi Arabia 71.2 71.2
Syria 6.1 5.4
United Arab Emirates 41.3 47.0 1.4 7.1
Total Middle East 276.6 316.6 8.5 0.0 5.7 43.5
Imports Exports
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.
Chart A18: Middle East price formation 2005 total consumption
Middle East price formation 2005: Total
consumption
Regulation below
cost
80,4 %
Regulation
social/political
14,8 %
No price
1,3 %
Not known
0,9 %
Bilateral monopoly
2,6 %
275 bcm
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
Table A6: Africa consumption and production 2005 (BCM)
Algeria 23.2 88.2 39.1 25.7
Angola 0.8 0.8
Egypt 25.8 34.6 1.1 6.9
Equatorial Guinea 1.3 1.3
Ivory Coast 1.3 1.3
Libya 5.8 11.3 4.5 0.9
Nigeria 10.4 22.4 12.0
South Africa 2.2 2.2
Tunisia 4.3 2.5 1.8
Total Africa 75.1 164.6 1.8 0.0 44.7 45.5
Exports
Imports
Excluding its export trade, Africa has virtually not traded gas,
with only Tunisia importing some gas from Algeria via the
pipeline to Italy.
Chart A19: Africa price formation 2005 total consumption
consumption
Regulation
social/political
11,2 %
Regulation below
cost
48,2 %
Regulation cost of
service
32,6 %
No price
1,1 %
5,7 %
Netback
1,2 %
75 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 refects the only
traded gas with Tunisia importing from Algeria.
Asia
Table A7: Asia consumption and production 2005 (BCM)
Afghanistan 0.2 0.2
Bangladesh 14.2 14.2
China 45.7 50.0 3.1
China Hong Kong 3.1 3.1
India 38.1 32.1 6.0
Myanmar 4.1 13.0 8.9
Pakistan 29.3 29.3
Total Asia 134.7 138.8 3.1 6.0 12.0 0.0
Exports
Imports
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 signifcantly from both indigenous
resources and imports.
Chart A20: Asia price formation 2005 total consumption
10,5 %
Bilateral monopoly
6,8 %
Regulation cost of
service
21,8 %
Regulation
social/political
57,9 %
Regulation below
cost
3,0 %
135 bcm
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.
Asia Pacifc
Table A8: Asia Pacifc consumption and production 2005 (BCM)
Australia 26.8 40.3 14.9
Brunei 2.4 11.5 9.2
Indonesia 37.5 73.8 4.8 31.5
Japan 79.0 5.1 76.3
Malaysia 39.3 59.9 1.8 28.5
New Zealand 3.5 3.8
Philippines 3.0 2.9
Singapore 6.6 6.6
South Korea 33.7 0.5 30.5
Taiwan 10.7 0.8 9.6
Thailand 29.9 23.7 8.9
Vietnam 6.9 6.9
Total Asia Pacific 279.3 229.2 15.5 116.4 6.6 84.0
Exports
Imports
After Europe, Asia Pacifc 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 Pacifc price formation 2005 total consumption
consumption
Gas-on-gas
competition
11,8 %
Bilateral monopoly
8,1 %
Regulation cost of
service
2,9 %
Regulation
social/political
24,8 %
Not known
2,0 %
Oil price
escalation
50,4 %
280 bcm
At 280 bcm, Asia Pacifc 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.
Wholesale Prices
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 defnition 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.
Chart A22: Wholesale prices by region 2005
World: Average wholesale prices 2005
$0,00 $1,00 $2,00 $3,00 $4,00 $5,00 $6,00 $7,00 $8,00 $9,00
Middle East
Former Soviet Union
Latin America
Africa
Asia
Total World
Asia Pacific
Europe
North America
$/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 Pacifc. 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.
Chart A23: Wholesale prices by country 2005
Average wholesale prices 2005
$0,00 $1,00 $2,00 $3,00 $4,00 $5,00 $6,00 $7,00 $8,00 $9,00 $10,00
Iran
Nigeria
Uzbekistan
Saudi Arabia
Qatar
Argentina
Venezuela
Kazakhstan
Kuwait
Egypt
Russian Federation
Belarus
Ukraine
Trinidad
Malaysia
India
Algeria
China
Pakistan
Australia
Bangladesh
Brazil
Romania
Indonesia
Thailand
Spain
Italy
Germany
Turkey
Poland
Austria
Hungary
Belgium & Luxembourg
Netherlands
Japan
United Kingdom
France
South Korea
Canada
Mexico
Taiwan
USA
$/MMBTU
Countries over 10 bcm
Annual Consumption
World Average
Chart A24: Wholesale prices by price formation mechanism 2005
mechanism 2005
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$3,00
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$5,00
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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 fnal 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.
Chart A25: World price formation 2005 total consumption
consumption
Regulation below
cost
23,3 %
Gas-on-gas
competition
31,4 %
21,7 %
Regulation
social/political
10,9 %
No price
1,2 %
Not known
0,3 %
Netback
0,5 %
Bilateral monopoly
8,2 %
Regulation cost of
service
2,5 %
2,790 bcm
Table A9: World price formation 2005 total consumption (BCM)
OPE GOG BIM NET RCS RSP RBC NP NK TOT
North America 0.0 759.4 0.0 0.0 0.0 0.0 0.0 9.4 0.0 768.8
Latin America 18.7 2.0 8.4 11.9 6.8 74.8 3.1 0.0 0.0 125.7
Europe 426.6 83.4 8.7 0.7 1.7 14.4 0.0 3.5 0.0 539.1
Former Soviet Union 0.0 0.0 172.9 0.0 0.0 17.6 386.6 16.6 0.0 593.7
Middle East 0.0 0.0 7.2 0.0 0.0 40.6 221.5 3.6 2.5 275.3
Africa 4.3 0.0 0.0 0.9 24.5 8.4 36.2 0.8 0.0 75.1
Asia 14.2 0.0 9.1 0.0 29.3 78.0 4.1 0.0 0.0 134.7
Asia Pacific 140.8 33.0 22.6 0.0 8.0 69.3 0.0 0.0 5.6 279.3
Total World 604.6 877.9 228.9 13.5 70.3 303.2 651.4 33.8 8.1 2,791.7
22% 31% 8% 0% 3% 11% 23% 1% 0% 100%
Region
Total Consumption
The chart above illustrates the overall results at the world level,
while the table looks at the breakdown by region.
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 Pacifc, 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 Pacifc;
Together the GOG and OPE categories, which could be said
to refect 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 Pacifc, imported gas in India and
Thailand and partly domestically produced gas in Indonesia.
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 intra-
Former Soviet Union trade. In 2006/7, however, GOG prices
have declined to below comparable OPE prices.
Chart A26: Wholesale prices by price formation 2005

mechanism 2005
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International Gas Union
Offce of the Secretary General
c/o Statoil ASA
0246 Oslo
Norway
Telephone: + 47 51 99 00 00
Fax: + 47 22 53 43 40
Email: secrigu@statoil.com
Website: www.igu.org
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IGU members
IGU
The International Gas Union is a worldwide non-proft
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 organi-
sation covers all aspects of the gas industry, including
exploration and production, storage, LNG, distribu-
tion and natural gas utilisation in all market segments.
IGU promotes technical and economic progress of
the gas industry emphasising environmental perform-
ance worldwide. For more information, please visit
www.igu.org
Sponsored by:

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Section 1 Hydrocarbon Resources Readings

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Hydrocarbon Resources

Section 1.1 - Exploration and Production

Region Common Indexes Commodity

measurement and testing

Implications for future LNG pricing

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