– John Kemp is a Reuters columnist.  The views expressed are his own –

The record differential between the front-month and more liquid second-month contracts at expiry last week once again raised pointed questions about whether the NYMEX light sweet contract is serving as a good benchmark for the global oil market, or sending misleading signals about the state of supply and demand.

The expiring January 2009 contract ended down $2.35 on Friday at $33.87, while the more liquid February contract actually rose 69 cents to settle at $42.36 - an unprecedented contango from one month to the next of $8.49.

Criticism of the contract is not new, and past calls for reform have been successfully sidelined. But with policymakers taking a keener interest as a result of wild gyrations in oil prices this year, and a continued focus on regulatory changes to improve market functioning in future, there is at least a chance changes will be adopted as part of a wider package of futures market adjustments.

AN UNREPRESENTATIVE PRICE

During the surge to $147 per barrel earlier this year, OPEC repeatedly criticized the NYMEX reference price for overstating the real degree of tightness in the physical market and causing prices to overshoot on the upside.

While rallying NYMEX prices seemed to point to an acute physical shortage and need for more oil, Saudi Arabia could not find buyers for the 200,000 barrels per day (bpd) of extra oil promised to U.N. Secretary-General Ban Ki-moon or the 300,000 bpd promised to U.S. President George Bush in June.

Bizarrely, rather than acknowledge there was something wrong with the reference price, some market participants suggested Saudi Arabia should increase the already large discounts for its physical crude to achieve sales in a market that clearly did not need the oil, and was not paying enough contango to make storing it economic (contango is where the futures price is above the spot market).

The NYMEX WTI price may have achieved unprecedented media fame as a result of the “super-spike”, but a futures price to which producers and consumers were paying ever larger discounts for actual barrels was clearly not a good indication of where the market as a whole was trading.

Now the market risks overshooting in the other direction. Intense pressure on the front month in recent weeks has more to do with the contract’s peculiarities (in particular storage restrictions at the delivery point) than a further deterioration in oil demand or a market vote of no-confidence in the 2.2 million barrels per day further cut in oil production announced by OPEC at the end of last week.

The collapse in NYMEX prices nearby risks exaggerating the real degree of oversupply  and demand destruction, sending the wrong signal to producers and consumers about the wider availability of crude in the petroleum economy.

DOMESTIC PRICE, GLOBAL BENCHMARK

The NYMEX contract is for a very special type of crude oil (light sweet) delivered at a very special location (Cushing, Oklahoma) in the interior of the United States. It is not representative of the majority of crude oil traded internationally (most of which is heavier and sourer) and delivered by ocean-going tankers.

These specifications made sense when the contract was introduced as a benchmark for the U.S. domestic market.

U.S. refiners have a strong preference for light oils, for which they were prepared to pay a premium, because of their much higher yield to gasoline. The inland delivery location, centrally located and near the main Texas oilfields, rather than one on the coast, made sense for a contract that tried to capture the “typical” base price for crude oil paid by refiners across the continental United States.

But these specifications make much less sense now the NYMEX price is increasingly used a benchmark for the global petroleum economy, in which light sweet crudes are only a small fraction of total output. Just as NYMEX prices sent the wrong signals about physical oil availability on the way up, distorting the market and triggering more demand destruction than was really necessary, they now risk sending the wrong ones on the way down.

Earlier this year, the problem was a relative shortage of light sweet crude oils at Cushing, while all the extra barrels being offered to the market by Saudi Arabia were heavier, sourer crudes that could not be delivered against the contract. Moreover, extra Saudi crudes would have arrived by ship, and the pipeline and storage configurations around Cushing would have made it difficult to deliver them quickly against the contract.

Financial speculators were able to push NYMEX higher safe in the knowledge Saudi Arabia could not take the other side and overwhelm them by delivering physical barrels to bring prices down. The resulting spike exhibited all the characteristics of a technical squeeze:  tight contract specifications ensured there could be shortage of NYMEX light sweet inland oils even while the global market was oversupplied by heavier, sourer seaborne ones.

Now the opposite problem is occurring. Crude stocks at Cushing have doubled from 14.3 million barrels to 27.5 million since mid-October. Stocks around the delivery point are at a near-record levels and approaching the maximum capacity of local tank and pipeline facilities (https://customers.reuters.com/d/graphics/CUSHING.pdf).

As a result, the market has been forced into a huge contango as storage becomes increasingly expensive and difficult to obtain, ensuring the expiring futures trade at a substantial discount.

But Cushing inventories are not typical of the rest of the U.S. Midwest (https://customers.reuters.com/d/graphics/PADD2_EX_CUSHING.pdf) or along the U.S. Gulf Coast (https://customers.reuters.com/d/graphics/PADD3.pdf), where stock levels are high relative to demand but nowhere near as overfull as in Oklahoma.

Once again the problem is geography. Coastal refiners have responded to the downturn by cutting imports of seaborne crude, limiting the stock build. But the inland market is the destination for some Canadian crudes that have nowhere else to go, and the pipeline configuration means they cannot be trans-shipped to other locations readily.

Light sweet crude has been piling up in the region, with refiners choosing to deliver the unwanted excess to the market by delivering it into Cushing.

NEW GRADES, NEW DELIVERY POINTS

The easiest way to make NYMEX more representative would be to widen the number of crude grades that can be delivered, and open a new delivery point along the U.S. Gulf Coast. Both reforms would link the contract more tightly into the global petroleum economy.

NYMEX already permits some flexibility in delivery grades. Sellers can deliver UK Brent and Norwegian Oseberg at small fixed discounts to the settlement price, and Nigerian Bonny Light and Qua Iboe, as well as Colombia’s Cusiana at small premiums.

In principle, there is no reason the contract cannot be modified further to allow a wider range of foreign oils to be delivered at larger discounts to the settlement price.

More importantly, NYMEX could open a second delivery location along the Gulf Coast, increasing the amount of storage capacity available, and linking it more closely into the tanker market.

If prices spiked again, a coastal delivery location would make it much easier for Saudi Arabia to short the market and deliver its own barrels into the rally. By widening the physical basis, it would also make it easier to support the market by cutting international production and avert a glut trapped around the delivery location.

So far, the market has continued to resist change. But there are signs policymakers might enforce one.

Earlier in the year, Saudi Arabia strongly hinted western governments should look at reforming their own futures markets rather than call for production of even more barrels of oil that could not be sold at the prevailing (unrealistic) price.

Naturally, some of the reform impetus has ebbed along with prices and demand. But policymakers continue to show interest in structural reforms, as was evident at last week’s London Energy Meeting, and there is an increased willingness to challenge unfettered market dynamics.

It is still possible the incoming Obama administration might force contract changes as part of a wider package of reforms designed to improve the functioning of commodity markets, reduce volatility and send clearer, more consistent price signals to the industry and consumers.

For previous columns by John Kemp, click here.

– John Kemp is a Reuters columnist. The opinions expressed are his own –

China’s decision to link domestic fuel prices indirectly to the international crude oil market, subject to a price cap, while hiking the consumption tax on gasoline and diesel and phasing out a variety of road tolls and other fees shows Saudi Arabia’s worst fears about high prices and demand destruction are starting to come true.

It seems likely to confirm the kingdom’s determination to see prices stabilize around $75 per barrel, well below recent price peaks, and far below the level sought by some other OPEC members, as well as international oil companies and advocates of alternative energy.

China is among the world’s most inefficient users of energy, measured in terms of BTUs consumed per dollar of GDP produced.

Since China’s economy is one of the largest and fastest growing, and heavily reliant on imported crude oil, China has been hit harder than any other country by the recent surge in oil and energy prices.

Rising energy prices have worsened the country’s terms of trade, and threaten the viability of much of the industrial base (including the power-intensive steel and aluminum industries).

The central government has made reductions in energy consumption per unit of output a top priority.
Policymakers have used investment controls and other administrative measures to try to limit the expansion of energy-intensive industries aimed at producing primarily for export.

At the same time, export taxes have been introduced on a wide range of low-value added semi-manufactured products (such as unwrought aluminum) and VAT rebates scaled back to encourage the manufacturing sector to concentrate on exporting higher value-added items in which energy is a smaller fraction of the overall unit cost.

But efforts to increase energy efficiency have been only partially successful, because the government continued to hold prices for gasoline, diesel, thermal coal and on-grid electricity below international levels, using a combination of price controls and subsidies. The government’s strategy for improving energy efficiency came into conflict with the priority on economic and social stability.

Extensive price controls and subsidies largely insulated households and businesses from the rise in international oil and energy prices, blunting the incentive to improve energy efficiency.

Eventually, the rise in global oil prices became overwhelming. The resulting pressure on the current account of the balance of payments and need for growing subsidies to the country’s oil refiners forced the government to raise administrated gasoline and diesel prices almost 20 percent earlier this year.
One welcome effect of the rise in oil prices and the decision to increase domestic gasoline and diesel charges was that it sharpened incentives for energy efficiency considerably.

But as the economy has slowed sharply and international oil prices have tumbled, the government has come under pressure to cut fuel charges.

Instead, the National Development and Reform Commission (NDRC) has introduced a carefully integrated package of measures designed to provide short-term economic relief while maintaining the pressure for greater energy efficiency in the medium term.

By linking domestic prices indirectly to the international oil price, NDRC has ensured that consumers and businesses will benefit from the current easing in the oil market, helping stabilize the economy, but that domestic prices will move up again if the market picks up, reducing the subsidy burden and maintaining market-based incentives to limit energy consumption.

More importantly, the government has taken advantage of the (possibly temporary) reduction in oil prices to introduce a (probably permanent) increase in the energy consumption tax.

The key point is that the consumption tax is not linked to variations in the oil price and will sharpen the incentives for using energy more efficiently at any level of international prices.

In effect, China has started to emulate the successful conservation strategies used in Europe and Japan, where heavy fuel taxes have spurred the use of much more fuel efficient vehicles and much lower energy consumption per unit of output than in the United States and the rest of the world.

Europe and Japan took advantage of relatively low oil prices during the late 1980s and 1990s to raise substantial excise taxes on the consumption of gasoline and diesel. China’s decision to boost the consumption tax on gasoline and diesel looks like it could be the first in a series of phased increases over time, similar to the United Kingdom’s “fuel duty escalator.”

OPEC has long complained about the massive “wedge” these fuel taxes have driven between the pump prices paid by motorists in Western Europe and the net revenue which oil exporting countries actually receive for their crude, but they are widely cited as the most effective conservation strategy.

Saudi Arabia expressed consistent concerns that the recent surge in oil prices would lead to the long-term loss of demand even if prices subsequently fell back. Those fears are now being realized.

China’s decision to raise the fuel consumption tax is one of a number of measures adopted around the world to promote conservation and aimed at the volume of oil consumed for any given level of prices.

It is consistent with the massively increased bio-ethanol blending requirements introduced in the United States last year designed to displace oil consumption.

By pushing energy conservation to the top of the policy agenda, the frenzied escalation in oil prices during 2006-2008 is set to have long-lasting effects, even if prices eventually stabilize at much lower levels. President-elect Barack Obama has made clear that improving energy efficiency and cutting dependence on oil imports will be a top priority in the next four years.

Neither the incoming Obama administration, nor top planners in Beijing, will quickly forget the harsh lessons about reducing energy dependence taught in the last two years, even if prices now settle much lower.

China’s decision to raise fuel taxes will increase Saudi Arabia’s determination to stabilize prices at a much lower level than most other members of the organization are comfortable with, to try to limit the long-term damage to oil demand.

The kingdom’s worst fears about the long-term damage wrought by high and volatile prices are now being realized.

For more columns by John Kemp, click here.