After years of planning, the Dubai Mercantile Exchange (DME) opened for trading on June 1 with its flagship Omani crude futures contract. It’s a collaborative effort bringing together Tatweer, a unit of Dubai-government-owned Dubai Holdings, the New York Mercantile Exchange (Nymex) and the Sultanate of Oman.
The DME’s mission statement and declared rationale is to bridge the gap between international pricing mechanisms for sweet, or low-sulfur, crude and the Gulf’s more sulfuric (sour) oil, especially for trade with Asian oil buyers.
The price of sour crude from the Middle East is currently set in reference to inappropriate benchmarks — futures contracts for very different products traded on the world leading commodities exchanges, Nymex and London-based Intercontinental Exchange (ICE).
The idea of establishing a platform for setting its own benchmarks, enhancing profits, and managing risk in the trade of Middle Eastern oil is not new, it has just never worked before.
Part of Dubai’s goal as financial center
This dream to host the oil futures benchmarking is tied to Dubai’s goal of claiming the role of financial center between East and West through the Dubai International Financial Centre (DIFC). At its inception in 2002, the DIFC was labeled as tool to boost the contribution of the financial industry to the emirate’s GDP from 11% in 2001 to about 20% in 2010. While the DME makes reference to this target in documents on its website, it did not state how large a role the exchange aspires to play in this mission.
Being the center for sour crude futures trade could prove to be lucrative, given that the DME’s fees per trade are around $1. Brent (ICE) and West Texas Intermediate (Nymex), currently see daily volumes average around 150,000 trades.
The value of having a role in the futures contracts for Middle East oil was underscored by the ICE when it beat the DME to the punch by launching a similar contract on May 21 to directly compete with the DME. There is, however, a major difference in that the ICE sour crude contract is cash-settled whereas the DME’s contract is physically — actual barrels — settled and backed by the governments of regional oil producers. (Although only about 5% of physically-settled futures contracts result in the buyer actually taking the physical product).
High daily volumes are the backbone of a futures contract, which is essentially an agreement to buy a commodity later at a locked-in price. Therefore the 100 contracts, or lots, a trader buys on Monday at $68 each can be sold on Tuesday if the commodity’s price climbs.
Any futures exchange is, however, extremely volatile and contracts are traded quickly, often to maximize profit (as opposed to investors in the equities market who typically hold an investment for a longer period of time). Traders want to be able to get in and out of contracts at a moment’s notice.
This liquidity, however, is the element previous Middle East oil contracts have failed to grasp. Muted trader interest that kept liquidity low killed the first sour crude futures contract launched in Singapore in 1990. The flops that followed have either completely failed or traded in such low volumes they have not reached the status of a price benchmark.
A Nymex solo attempt at a sour crude contract, launched in 2000, only saw two days of trading but remained listed for a year. The DME partnership is Nymex’s fourth sortie into the sour crude futures arena, while the ICE is making its first dash into this market, although it did, however, acquire the International Petroleum Exchange in 2001, whose attempt at a Middle East crude futures contract had turned sour in 1991.
On the DME, contracts are traded for delivery two months in the future. In its first month of trading, 39,571 Oman crude oil futures contracts changed hands — the equivalent of nearly 40 million barrels. This was slightly lower than the rival contract launched by ICE, which saw over 50,000 futures contracts, equal to over 50 million barrels, trade in its first month.
In an attempt to avoid the plague of illiquidity that downed other contracts, the DME has instituted a market maker program. This common practice brings industry heavyweights (like traders and investment banks) to boost liquidity levels, offering cash incentives to increase daily trading volumes to the 20,000 mark, after which, according to the DME’s website, the program will tail off.
Still too early to tell
“The initial target figure mentioned by the DME was 20,000 lots per day and while volumes were reasonably promising to start with, liquidity has since declined to under 1,000 lots on some days,” commented Paul Young, executive oil pricing editor for Asia with the commodities pricing firm Platts. “But it’s still way too early to give an overall verdict on the success of the contract and the DME is launching new initiatives intended to improve liquidity.”
“The Asian market welcomes the DME as a more transparent benchmark for pricing purposes. I think liquidity level at this point remains an issue, but it is still early days for the exchange,” Victor Shum, a Singapore-based energy consultant with the firm Purvin and Gertz, told Executive. “I think the general sentiment seems to be, ‘Well, let’s take a wait and see attitude.’ I think the DME has the elements there to be successful. I think most traders would like to see rising liquidity.”
Gary King, DME’s chief executive office emphasized the contract’s innovative elements when giving his outlook on the contract’s future. “We decided to align ourselves with a Middle East oil producer,” King told Executive a few days before the June 1 launch. “No one’s ever done that before.”
King said market research revealed customers who wanted a physically delivered contract and not the traditional cash-settled contracts and the contract launched in May by ICE. This offers a direct link between the paper market of the futures contracts and the physical commodity. In a bid to meet what King described as market demand, the DME set out to find a producer to partner with for the physical delivery.
Oman announced before the contract’s launch that it would base the price of all of its crude on the DME contract price, starting this month. In late June, in a move apparently timed to offer one last burst of good PR before the launch, the Dubai government, which essentially has about a one-third stake in the bourse, made the same announcement regarding its oil contracts two days before trading began.
Government backing from producer nations for the contract will certainly help lend it credibility, but the exchange has only rallied two middle-weights — Oman and Dubai — in a region of heavy-weights, John Sfakianakis, chief economist with Saudi Arabia’s SABB bank, told Executive.
Oman has 5.5 billion barrels of oil, according to estimates from the U.S. government’s energy information agency. That’s the second lowest level of reserves of the six Gulf Cooperation Council countries behind Bahrain with less than one billion barrels.
The agency’s figures estimate the UAE has 97.8 billion barrels, but UAE government websites put Dubai’s share near 4 billion in 1991. Abu Dhabi sits on an estimated 94% of the nation’s reserves.
Some are being left out
“I’m a little bit skeptical because Abu Dhabi should be a natural participant in this,” said Sfakianakis said. The DME has approached other regional producers, but came back scant on direct commitments.
“We’ve talked to all of them, and I think the proof is as we go forward, the goal is to get the contract accepted as regional benchmark and overall the ultimate goal is to get it accepted as a global benchmark,” King said in an interview the day the exchange opened.
“I think what’s accepted is that it’s important to get first three contracts trading, demonstrate they trade in a robust fashion, that they’re liquid and that you get effective price discovery,” he added, referencing the two cash settled futures contracts that are spreads between the Oman crude price and the prices of WTI and Brent.
But what of Saudi Arabia, the 800-pound gorilla, which holds the second-largest oil reserves in the world? “At the moment you can safely say that Saudi Arabia is not involved,” Sfakianakis said.
An exchange of their own
Given the goals of other GCC nations to power up their own financial hubs, it is possible that bigger producers have not shown the urge to commit to the DME sour crude contract, because they would like to run a benchmarking exchange themselves .
One contender is Qatar’s IMEX, which has just appointed its first CEO. The exchange has been rumored to look longingly at sour crude contracts, in addition to jet fuel and liquefied natural gas futures. IMEX, just like DME, is not yet letting on what futures it plans to introduce in the coming months.
Competitive pressures notwithstanding, Dubai’s financial services sector is an undisputed pillar for the economies of both the emirate and the GCC, now and in future. The question is if it will be the Gulf’s sole central financial market place. According to numbers released in June by the Dubai Chamber of Commerce and Industry, finance in 2006 contributed to about 10% of the emirate’s rapidly expanding GDP — and thus would have to significantly outpace other growth sectors within Dubai if it really is to supply 20% of the emirate’s GDP in the next decade.
The DME’s immediate concerns will be for developing its products and client base beyond the discounts it offered traders in the startup phase. Since early 2006, there’s been talk of a jet fuel futures contract, and King has said in interviews during the DME launch that this could be running by year’s end. He added that the exchange is keen on trading other commodities but was reluctant to give details.
“The market doesn’t take prisoners. We’re holding most of those ideas close to our chests at the moment,” he told Dow Jones on June 1.
Diversifying or bringing other producers on board or simply securing pricing agreements would be a boon for the nascent exchange, but is not an absolute make or break necessity. In the end, analysts argue the market is ready for change, but is there room in the market for two or more sour crude contracts?
“Not really,” says Michael Davies, senior analyst with the London-based futures brokerage firm Sucden. “At this early stage, there needs to be a focus on one.”
