Analysis: Trading activity on DME Oman's forward curve begins to dry up

Singapore — Trading activity on several latter-month contracts of Dubai Mercantile Exchange's flagship 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.

"It's problematic that the Saudi switch [to DME Oman] hasn't done much for DME volumes," research associate at Oxford Institute for Energy Studies Adi Imsirovic said. "It's quite evident that Asian refiners are quite happy for now with just hedging Dubai and not the Oman part of their exposure."

"People are a lot more interested in liquidity than basis risk. If they get plenty of liquidity in second or third month Dubai, they'll just hedge on the Dubai curve and not worry about the Oman-Dubai spread, unless the Oman liquidity in these months improves," he said, referring to companies' exposure to DME Oman or Platts Oman that are both commonly used by Middle East exporters to price their crude.

Focus on liquidity in DME Oman's forward curve has grown, especially after Saudi Aramco adopted the contract in its crude price formula for Asian customers in late 2018. Both Saudi and Kuwait now sell their crude to Asian customers using the monthly average of Platts Dubai and DME Oman as the basis of its price formula. Previously, both producers used monthly average of Platts Dubai and Platts Oman.

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.

Dubai futures financially settle on S&P Global Platts cash Dubai assessments. Some Middle East crude oil assessments published by Platts compete with DME Oman in the Asian oil benchmark space.

'Unhedgable' risk

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, and therefore accounts for much of the trading volumes and open interest in this market.

While the market has had only limited options and incentives to manage their exposure to DME Oman prices, market participants have faced relatively low basis risk 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, traders and refiners 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.

"From [a] trading [point of view], having DME Oman [exposure] is such a hassle," a crude oil trader with a Middle East producer said. "It's a risk that is basically unhedgeable."

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, traders 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.

"Leaving aside the volumes, volatility around the expiry at month end is something DME still needs to focus on," said Imsirovic.

Changes in liquidity incentives

Just a month before the DME Oman M6 stopped trading, DME highlighted a 172% growth in forward curve trading in the January-October 2019 period, according to a statement on its website in November 2019. In July last year, the exchange said forward curve volume had reached 208,997 contracts in the second-quarter versus 143,703 contracts traded in Q1 2019.

"The increase in liquidity along the forward curve allows for customers to better manage price movements during these times of high volatility," DME's managing director Raid Al-Salami said in the statement then.

Platts first reported in July 2019 that much of the growth in trading volumes at the back end of the liquidity curve was driven by incentives the exchange offered to beef up volumes: http://plts.co/D93T30qSvWB

While a combination of factors may have led to the recent slump in trading at the back end of the DME forward curve, market participants highlight changes in the incentives program as a key reason.

In an email response to Platts on June 18, DME did not elaborate on the reasons behind the recent fall in liquidity on the forward curve or its implications, but pointed out that "liquidity schemes are common practice among exchanges".

"In fact, we believe every exchange in the world runs liquidity incentive schemes. We believe DME Oman Marker Price volumes are underpinned by the highest percentage of commercial activity among the major oil futures benchmarks," a spokesperson for the DME said in the email.

Full details of DME's latest incentive program remain unclear, although one trader, who previously traded DME forward month contracts to profit from the liquidity enhancement program, cited reduced payouts detailed in a January 30 email from the exchange to clients as an example of cuts in the incentives.

"They changed the payout. The more I traded the lesser I get. So [I] could not break even," the trader said. Since then, his firm has stopped trading the DME forward-month contracts because of the lower payouts, he said.

In the January 30 email, a copy of which was seen by Platts, a DME executive said the revised LEP scheme for February comprised a $50,000 pot for front month Globex OQD contract and a separate $20,000 pot for Months 2/3/4. The scale of reward would be determined by the percentage of LEP volume executed by each participating party, the email indicated.

In the June 18 response to Platts' queries, DME denied the accuracy of the above-mentioned incentives, without elaborating on the LEP scheme or the January 30 email cited by Platts. The DME spokesperson said the exchange was in no position to disclose details of any private contractual arrangements.