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Mon 1 Jan 2007 10:22 AM

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DME: Dubai’s first oil souk

Oil trading will gain more local relevance as soon as the Dubai Mercantile Exchange opens for business

The Dubai Mercantile Exchange (DME) and Oman’s Ministry of Oil and Gas look set to create the Middle East’s first physically linked sour crude oil futures contract. The pioneering energy commodities exchange will be based in the financial free zone of the Dubai International Financial Centre (DIFC) and will benefit from the region’s vast hydrocarbon reserves, as well as its historical role in pricing Middle East crude oil.

It is the DME’s first contract with Oman and aims to address the inherent weaknesses in the price discovery and price transparency of Middle East crude. It follows an analysis of the benefits and implications of such a contract by the DME’s working group comprising Oman’s Ministry of Oil and Gas, the Ministry of Finance, Petroleum Development Oman and the New York Mercantile Exchange (NYMEX).

“Together we looked at everything from the well-head, to compliance, to clearing, so that we familiarised ourselves with the whole process,” explains Gary King, CEO of the DME.

Oman is one half of the benchmark for over 12 million barrels per day (bpd) of Middle East oil exports to Asia, alongside Dubai crude, and will adopt forward pricing of its crude oil based on the daily settlement price of the DME’s Oman Crude Oil Futures Contract.

“This is one of the most significant developments in the Middle Eastern oil market for years, addresses industry needs, and is entirely appropriate given Oman’s role in pricing the region’s crude oil,” said Omani oil minister, Mohammad bin Hamad bin Seif al-Rumhy.

The Middle East is the world’s largest hydrocarbon region but has yet to develop a transparent futures contract. This is a derivative instrument, which allows trading of a commodity in the future. West Texas Intermediate (WTI) and Brent are two types of crude used as global benchmarks in oil pricing and comprise the underlying commodity of the New York Mercantile Exchange’s oil futures contracts.

The DME is regulated by the Dubai Financial Services Authority (DFSA), and is a joint venture between NYMEX, the largest physical commodity futures exchange in the world and the investment company, Tatweer, a member of Dubai Holding.

“Oman’s current oil export price mechanism is retroactive. We’re creating an international exchange, which is locally developed, but with a global reach. Our exchange offers a producer who adopts retroactive pricing the chance to look back at what’s happened in the market over a given period and adjust the price to take into account market variables, such as how other crude oil prices have changed relative to each other. This is called look-back,” said King.

“These are sweet crudes which have very low levels of sulphur and little similarity with the oil that is being produced in the Gulf. There isn’t a futures contract for Middle East crude oil. This creates a real gap in the market place for companies seeking price transparency, price discovery and the ability to hedge their price exposure. We took it upon ourselves, after speaking with the industry, to develop this new benchmark,” said King.

Risk management has always been the main problem when buying crude oil in the Middle East, as unforeseen market variables make it difficult to manage price exposure. Previously, companies based in the region have had to hedge themselves with another commodity such as WTI or Brent. This can pose a risk as they don’t have any resemblance to what’s going on in the Middle East.

Trading on the DME will allow traders to reduce their risk by bringing their pricing closer to the product they are buying. “When you make the transition to forward pricing, if you are trading on the exchange, you know what the price of that commodity is going to be. Someone who’s buying oil in the future can manage price exposure by buying or selling futures to offset their physical position,” added King.

By switching to the futures contract, the DME is providing an incentive for trading on the exchange to traders, refiners and producers who buy more than 700 000 bpd of Omani crude. This is made particularly attractive in the early days of the contract by way of a three-tiered membership programme. The DME will also offer members its Market Making Programme, a service whereby selected companies on the exchange floor bid offers on the screen. This gives liquidity to the DME, something that King describes as the lifeblood of an exchange.

“Liquidity allows customers to see the true price of crude. When you have liquidity you have a number of constituents comprising buyers and sellers. That market place sets the value. This is what is meant by true price discovery or price transparency and allows for fair value as determined by the market,” says King.

One of the hallmarks of the DME is that it enables physical delivery of oil. This creates a convergence in price between the paper contract and commodity, which is trading 23.5 hours a day.

“The fact that you can take physical delivery means that there is a tie between the paper and physical. We have aligned ourselves with the Sultan of Oman because we recognise the importance of having the physical crude underpinning the contract,” said King.

The fact that the Dubai International Financial Centre houses a series of trading hubs and stations on an exchange floor is another cornerstone of the project. A settlement will be reached at the close of business every day, the average of which will determine the oil price. The official selling price (OSP) will be based on the settlement of the DME.

“We want to have a diverse energy community on the floor. You can’t ignore the human element. Trading floors are immensely exciting places to be as they are a window to the exchange. We want it to become Dubai’s first oil souk,” said King. The DME has established spread contracts which trade differentials between different products, enabling companies to trade arbitrarily between different crude oils. The Omani oil minister has said that the ministry will support the DME by using it as the pricing method “so long as it performs well and guarantees fair prices that match those of the global markets.”

This is a challenge Gary King feels the exchange is up to. “We have a very strong regulatory background here, as well as a world class regulator and firm internal controls by way of compliance procedures and market surveillance. We also have our partners at NYMEX who bring considerable expertise in the running of exchanges.”

The DME plans to trade in other commodities and has already announced its collaboration with Emirates to explore the development of the world’s first physically delivered jet fuel futures contract.

“There has never been a jet fuel futures contract so this will be another first. It is something the airline industry and refiners has said to us they want. We are already offering a unique product to our customers who trade on the DME,” said King.

When asked about expanding beyond Oman, King alluded to various plans already in motion. “We’re not going to be a one or two contract exchange. This is going to be an international exchange on an international platform. We have a pipeline of other projects we’re developing and are hoping to make numerous announcements in the coming months. We see the Oman project as the first of many and we aim to trade similar volumes to that of Brent and WTI within the next few years. This is feasible due to the physical oil base in the Gulf.”

Completion of the exchange floor is said to be imminent and will be the world’s first commodity exchange based around energy.

This is one of the most significant developments in the Middle Eastern oil market for years. Mohammad bin Hamad bin Seif al-Rumhy

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