Middle Eastern NOCs have long faced a twin challenge of ever more competitive markets in their traditional East of Suez backyard and the need to squeeze out more revenue from their production. From Oman’s decision in the mid-2000s to make its crude freely tradeable in the spot market to the move several years later by Abu Dhabi’s Adnoc to charge a premium for lifting destination restrictions on some of its cargoes, they have been constantly changing their business models to try to capture greater value from their crude sales.
Covid-19 has served only to reinforce the importance of East of Suez, as refining margin weakness forces more closures in the West. So, is the time ripe for more traditional producers such as Iraq to shake-up their marketing strategy?
Middle East spot market
As the end of the year approaches, the region’s NOCs will be drawing up their annual term contracts with customers—predominantly Asian refiners. Typically sold on a destination restriction basis—a tool to allow producers to set discriminatory pricing by region and prevent any regional imbalances from emerging—term contract barrels provide producers with security of supply and guarantee refiners with a medium-heavy baseload.
Despite this, the past decade has witnessed the growth of a healthy Middle Eastern free-on-board spot market, helping underpin the development of price discovery mechanisms and their underlying benchmarks. Oman’s mid-2000s removal of destination and resale restrictions on its crude was first mover, allowing its export grade to underpin the establishment of an exchanged-traded medium-sour crude futures contract (DME Oman).
he UAE followed its lead in having destination restrictions removed from its key grades, initially Upper Zakum and later Murban—a light sour grade with similar qualities to North Sea Forties and the US WTI Midland export grade, both of which compete with Murban in the Asian refining space.
Adnoc’s logic was relatively straightforward: by removing destination restrictions on crude cargoes in exchange for a premium to the official selling price (OSP)—typically $0.11-0.19/bl—these cargoes would not only remain attractive for customers but also allow the NOC to capture additional value from the higher sales price. For term lifters, destination-free cargoes provide optimisation benefits and the ability to ship grades either east or west into their own refining systems, economics permitting.
While Saudi Aramco still markets its crude via term contracts with destination restrictions, it has conducted spot sales for its crude held in storage in Asia—a tool designed to capture market share and optimise flows.
Another avenue of innovation has been greater willingness by Gulf NOCs to trade third-party barrels, a strategy designed to capture value from arbitrage flows and enhance the competitiveness of their overseas storage and downstream footprint. Given many have international downstream expansion ambitions, this is a trend set to grow over the next decade.
For more conservative producers like Iraq, attempts to develop a more competitive marketing strategy have been less smooth and illustrative of the challenges Middle East producers face in a more competitive market.
In effect, Iraq’s crude marketing evolution can be broken down in three separate stages.
The first involved Iraq’s launch of a new crude grade in 2015, Basra Heavy—a decision prompted by the deterioration in quality of Iraq’s flagship crude grade, Basra Light.
From 2012 onwards, as Iraqi oil production ramped up, production of heavier crude streams, particularly West Qurna 2 and Halfaya, was not matched with a build-out of segregated crude storage facilities or professional blending. This led to volatility in the API of Basra Light—in April 2014, for example, the API fluctuated between 28.07° and 32.37°.
Basra Heavy was an attempt to solve this issue. Its launch faced initial resistance from term lifters due to higher-than-expected OSPs. But, after industry consultation, state oil marketer Somo adjusted the OSP and pushed the grade onto the market with the support of several IOCs, particularly BP. Iraq’s production growth and exports from 2014 onwards were supported by a basic strategy: discounting Asia-bound OSPs relative to other grades of similar quality in order to win market share.
Iraq’s marketing journey kicked off a second phase in 2016. Against a backdrop of sour crude tightness driven by Opec+ cuts, Iraq got a taste of the tradeable value of its crude by allocating a greater share on the spot market—either via DME auctions (where it sold in 2mn bl parcels) or cargo sales via the S&P Global Platts’ market-on-close process.
Along with increased spot sales, Iraq also sought to emulate its regional peers in establishing trading joint ventures (JVs). One JV was with Russia’s Litasco—trading around 2-3mn bl/month of Basra Light—and the other with China’s Zhenhua Oil—a JV designed to expand Iraq’s footprint among China’s teapot refiners. These customers were important given the growing import quotas allocated to them and their poor credit profiles (meaning higher prices due to increased counterparty risk premiums).
But the strategy shake-up proved temporary. By 2018, Iraq ended both its relationship with the DME and Platts and its trading JVs. Somo’s affairs came under parliamentary scrutiny and the trading accounts of the JVs saw financial investigations.
Since 2018, the main plank of Iraq’s marketing strategy has been to clamp down on the resale of its crude by term lifters and instead issue direct private spot tenders—often one spot cargo/month—in the market. Its aim is to capture the profits previously earned by traders, having previously turned a blind eye to illicit cargo resales by term lifters as a way to capture greater market share.
As a large secondary spot market for Basra Light had developed, it made sense for Iraq to seek to play a more active role. But, while its move has proven relatively successful, several factors suggest the time may be ripe for another shake-up.
Firstly, the unprecedented scale of April’s Opec+ deal has supercharged sour crude tightness, helping raise the spot differential of medium-sour Basra Light against the OSP. This has incentivised Somo to sell greater volumes via spot tenders in recent months.
But the structural shift of oil flows to East of Suez markets, especially since the pandemic moved west, highlights the need not just to take low-hanging fruit of a premium price. At the same time, Iraq must balance this with maintaining the underlying competitiveness of its crude in a crowded market.
One strategy could be to emulate Adnoc and introduce greater optionality to term lifters, for example, by charging a premium to have cargoes ‘unrestricted’. Iraq would then move with the market, rather than trying to control it.
Iraqi crudes can already leverage a strong user base, delivering into almost every major refining demand centre. Such a move would allow Iraq to capture direct value from a secondary market already in operation.
Second, weaker demand elsewhere due to Covid-19 has enhanced Chinese pricing power, particularly the growing role of the Shanghai Exchange (INE), where Basra Light (along with Oman and Upper Zakum) is a key deliverable grade into the medium-sour contract.
In particular, Iraq should pay attention to the prospect of Chinese buyers simply purchasing Basra Light cargoes directly from INE rather than an external seller. It should also monitor the growing prospect of INE as a re-export destination.
Beyond ensuring the competitiveness of Iraqi crude, other challenges also loom in the next decade. Iraq’s production profile is set to get heavier from 2020 as more oil comes from the Mishrif reservoir (24–28° API, 4pc sulphur). At the opposite end of the spectrum, growing volumes of lighter crude from the Yamama formation are set to emerge, primarily from Russian producer Lukoil’s West Qurna 2.
The increasing complexity of Iraq’s production profile will increase the need for segregated tanks, automatic blender technologies and infrastructural flexibility, especially if Somo advances on its plans to launch a new Basra medium grade.
Ahmed Mehdi is an independent petroleum consultant.