Buyers and sellers of oil have been forced to adjust to unprecedented volatility as Covid-19 caused demand destruction on a scale never seen before. This has highlighted the need for regional benchmarks to have deep and liquid forward curves, allowing physical oil market participants to effectively hedge their risk.
Forward curves define the price at which an oil contract for future delivery can be concluded today, and are used for many reasons. These include refiners locking in their cracking margins and buyers and sellers of oil managing the risk of price fluctuations from the time an oil contract is agreed to when the physical oil is delivered months later.
Most Middle East oil sold to Asia is priced basis the Platts Dubai benchmark, either by itself or alongside Platts Oman or DME Oman. Crude oil from Oman and the Emirates of Dubai is priced basis average of DME Oman alone. Exchange-listed Dubai futures financially settle on S&P Global Platts cash Dubai assessments.
Focus on liquidity in DME Oman's forward curve has grown, especially after Saudi Aramco adopted the contract in its crude price formula for Asia in late 2018. Both Saudi and Kuwait now sell their crude to Asian customers referencing the monthly average of Platts Dubai and DME Oman. Previously, both producers used monthly average of Platts Dubai and Platts Oman.
Trading activity on several latter-month contracts of DME Oman crude futures has come to a sudden halt in recent months, even as more Middle East producers began using the contract to price crude sales to Asia.
The DME Oman sixth-month, or M6, contract stopped trading at the end of December, around the same time Kuwait announced plans to begin using DME Oman alongside Platts Dubai for pricing its crude starting February. Similarly, the M5 and M4 contracts last traded in February and March, respectively, according to daily trading volumes reported by the exchange.
The sudden shortening of the DME Oman forward curve suggests the contract's appeal as a hedging and risk management tool remains limited despite recent increase in its use for pricing Middle East crude.
The lack of interest in forward month Oman derivatives stems from the well-established market practice where the forward curve for Dubai futures is widely used as the primary hedging instrument for Asian firms managing exposure to Middle East oil.
Companies with exposure to oil pricing against Platts Dubai/Oman or Platts Dubai/DME Oman commonly hedge their risk on the Dubai forward curve, taking on the basis risk that may arise from the spread between either of the Oman prices versus Dubai.
This basis risk has been relatively low in the past given the narrow spread between Platts Dubai and DME Oman prices. DME Oman's premium over Platts Dubai averaged about 44 cents/b last year and 35 cents/b in 2018.
This year, however, oil traders and refiners in Asia have balked as this basis risk has ballooned with the spread widening sharply to average about $1.55/b year-to-date. DME Oman's premium over Platts Dubai surged to as much as $6.56/b in April.
With the slump in trading volume for latter-month contracts, DME Oman's open interest -- the number of outstanding contracts -- on the forward curve months starting M2 has plunged further. On the last trading day of May, total open interest on DME Oman contracts stood at 14,270 lots, while open interest on the forward curve from M2 (August) contract onwards was at 140 lots.
In comparison, open interest for the Dubai 1st Line Futures on ICE on the same day stood at just under 239,000 lots for contracts starting from June 2020, according to ICE data. On the Dubai forward curve, open interest for contracts starting August 2020 onwards was just under 133,800 lots.
Besides the low volume and open interest on its forward curve, market participants cite the volatility in the DME Oman contract around expiry as a key reason the contract is not used for hedging or risk management. Instead, it is used primarily as a platform to buy physical barrels of Oman crude.
During volatile periods, market participants require regional oil benchmarks that are transparent and allow for effective risk management underpinned by deep and liquid forward curves.