PMEX Crude Oil Futures

BRENT|WTI

September 2013

Pakistan Mercantile Exchange Limited

9 Floor, PRC Tower, 32-A Lalazar Drive, MT Khan Road, Karachi. Voice: +92 21 111 623 623, Fax: +92-21-5611263, 5610505 Email: info@pmex.com.pk, website: www.pmex.com.pk
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INTRODUCTION Crude oil is a mixture of hydrocarbons that exists in a liquid phase in natural underground reservoirs. Crude oil greatly varies in appearance depending upon its composition. It is usually black or dark brown. Petroleum is used mostly, by volume, for producing fuel oil and petrol both important primary energy sources. Aviation gasoline, motor gasoline, naphtha, kerosene, jet fuel, distillate fuel oil, residual fuel oil, liquefied petroleum gas, lubricants, paraffin wax, petroleum coke, asphalt and other products are obtained from the processing of crude and other hydrocarbon compounds. Almost all industries including agriculture are dependent on oil in one way or other. Oil & lubricants, transportation, petrochemicals, pesticides and insecticides, paints, perfumes, etc. are largely and directly affected by the oil prices. GLOBAL CRUDE OIL SCENARIO The upstream oil industry in its nature is an international market. The prices of oil are driven internationally and representative prices are quoted in US dollars. Almost all deals are priced in US dollars. Saudi Arabia, Russia, US, Iran and China are the top five oil producing countries. The world oil production in 2012 was 89.15 million barrels per day. The total proven oil reserves according to 2012 OPEC (Organization of Petroleum Producing Countries) estimates are around 1.48 trillion barrels, of which OPEC member countries hold around 72%. The given below data of world consumption and production shows that since year 2009 until 2011 the demand had slightly outpaced the supply but that trend ended in year 2012 when the production was more than the consumption. World Production & Consumption Year 2009 2010 2011 2012 Production Consumption Million barrels per day 84.58 84.76 87.07 87.36 87.34 88.56 89.15 88.88

In the global oil trade on the supply side OPEC plays an important role and on the demand side the economic growth & consumption patterns of top oil consuming countries play an important role. The top five countries with respect to production, consumption, import and export are: World Ranking of Countries Rank 1 2 3 4 5 Production(2012) S. Arabia(11.5) US (11.1) Russia (10.4) China (4.4) Iran (3.5) Consumption(2012) US (18.5) China (10.3) Japan (4.7) India (3.6) Russia (3.2) Import(2010) US (9.2) China (4.7) Japan (3.5) India (3.3) S. Korea (2.4) Export(2010) S. Arabia (6.8) Russia (4.9) Iran (2.4) Nigeria (2.3) UAE (2.1)

Numbers are in million barrels per day.

The Organization of Petroleum Exporting Countries (OPEC) OPEC is a major player of global oil arena. The current members of OPEC are Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, UAE and Venezuela. The OPEC countries produce about 41 % of the world's crude oil and its exports represent about 57% of the crude oil traded internationally. Therefore, OPEC can have a strong influence on the oil market, especially if it decides to reduce or increase its level of production. The OPEC member countries meet at least twice a year to co-ordinate their oil production policies in light of the market fundamentals, such as the likely future balance between supply and demand. The International Oil Pricing The crude oil is a most active internationally traded commodity. Oil prices are quoted in US dollars and almost all transactions are priced in US dollars irrespective of their production origin. Although the oil prices are widely influenced by the production decisions of OPECs member countries but the prices are not set by them. In today's complex global markets, the price of crude oil is set by movements on the two major international petroleum exchanges NYMEX and London based International Petroleum Exchange (IPE). The NYMEX and IPE have respectively been merged with Chicago Mercantile Exchange (CME) and Intercontinental Exchange (ICE). There are two major international pricing benchmark contracts, ICE Brent Crude Oil and NYMEX Light, Sweet Crude Oil futures contract (WTI).

BRENT: ICE Brent Crude Futures is currently the worlds largest crude oil futures contract in terms of volume. As the average North Sea crude oil output is currently around two million barrels per day (bpd) and the Brent-Forties-Oseberg-Ekofisk (BFOE) basket comprises an approximate one million bpd (around 700k bpd during the 2012 summer maintenance period), making it the largest underlying physical market of any comparable traded and transparent benchmark. Approximately two-thirds of the worlds traded crude oil uses the Brent complex, which includes ICE Brent futures with its deep liquidity and far-reaching forward curve, as a price benchmark. Many national oil producers and other participants around the world price crude at a differential to Brent, depending on the crude grade. Factors such as Brents accessibility and reach as a seaborne crude, production, adaptation to changing global economics in the oil market, stability and geographic location have consolidated Brents global benchmark position and contributed to physical participants, such as international airlines and oil producers in Asia, adopting Brent as a primary hedging tool. WTI: NYMEX Light, Sweet Crude Oil futures contract is the world's second most liquid forum for crude oil trading, and the world's second largest-volume futures contract trading on a physical commodity. Because of its excellent liquidity and price transparency, the contract is still used by many as a principal international pricing benchmark. Price difference between Brent & WTI: The Brent-WTI spread, the difference between the prices of Brent and West Texas Intermediate (WTI) crude oils, has narrowed considerably over the past several months. The spread, which was more than $23 per barrel ($/bbl) in mid-February, fell to under $9/bbl in April, and has ranged between $6/bbl and $10/bbl since then. The narrowing of the spread is supported by several factors that have: Lowered Brent (North Sea) prices because Brent-quality crude imports into North America have been displaced by increased U.S. light sweet crude production, reducing Brent-quality crude demand. Raised WTI (Cushing, Oklahoma) prices because the infrastructure limitations that had lowered WTI prices are lessening.

Before 2011, Brent and WTI crude oil prices tracked closely, with Brent crude oil prices typically trading at a slight discount to WTI crude oil, reflecting delivery costs to transport Brent crude oil and Brent-like crude oil into the U.S. market, where they competed with WTI crude oil. In early 2011, this longstanding relationship began to change, and since then, WTI crude oil has priced at a persistent discount to Brent crude oil. Increased U.S. light sweet crude oil production combined with limited pipeline capacity to move the crude from production fields and storage locations, including Cushing, Oklahoma, the delivery point for the Nymex light sweet crude oil contract, to refining centers put downward pressure on the price of WTI crude oil. More recently, expansions in U.S. crude oil infrastructure have eased the downward pressure on the price of WTI. Since mid-2012, significant pipeline takeaway capacity has been added at Cushing, enabling crude oil to flow to and from the trading hub more easily. Other pipeline and rail projects have also been completed, making it possible to move barrels from production areas, such as Texas and North Dakota, to refinery centers without passing through the hub. Even U.S. East Coast refineries, which historically have relied on Brent crude oil and Brent-like crudes, can now access U.S. light sweet crude oil. U.S. crude that moves by rail is replacing Brent crude oil and Brent-like crude oil imports into the U.S. East Coast, putting downward pressure on the price of Brent crude oil and narrowing the differential versus WTI crude oil. The future of the Brent-WTI price spread will be determined, in part, by the balance between future growth in U.S. crude production and the capacity of crude oil infrastructure to move that crude to U.S. refiners. The International Energy Agency (IEA) reported that planned maintenance in the North Sea oil fields this summer will reduce production, adding upward pressure to Brent prices and potentially widening the Brent-WTI spread. In its June 2013 Short-Term Energy Outlook, EIA forecast the Brent-WTI price spread to average $11/bbl in 2013 and decline to an average $8/bbl in 2014.

Factors Affecting International Oil Prices Current supply in terms of output, especially the production quota set by OPEC. The OPEC cartel provides 57% of oil traded internationally. Oil reserves, including what is available in U.S. refineries and what is stored at the strategic reserves International economic growth, particular from US and developing Asian nations influence the oil demand. New developments in alternate energy technologies i.e. shale oil, solar, etc. During summer forecasts for travel. During winter weather forecasts are used to determine home heating oil use. Potential world crises in oil-producing countries can also substantially influence oil prices. Almost all oil deals worldwide are priced in US dollars. Therefore the weakening and strengthening of US dollars also affect oil prices. In the recent years the speculative trading and investments form commodity funds have also become a factor that has the potential to influence oil prices.

PAKISTAN The energy sector has a vital role in Pakistans economy. The sector by far attracts the highest foreign direct investment and raises substantial revenue for the exchequer. However at the same time high imports of crude oil and petroleum products affect the balance of payments adversely. Until 1999 the oil and gas sector was tightly controlled by the government. Since early 2000 a pro-market reform process was started. Oil and Gas Regulatory Authority (OGRA) was established to regulate the sector. Under the current pricing regime of petroleum products, prices are revised every fortnightly based on the international pricing. Pakistans total crude oil reserves are around 264 million barrels. In FY 11 Pakistans total production of crude oil was 24 million barrels while imports of crude oil were 49.6 million barrels. The total petroleum product consumption in FY11 was 18.8 million tonnes. Pakistan spends a substantial amount on the import of crude oil and other petroleum products. In FY 11 Pakistan imported crude oil of worth US$ 4.69 billion and petroleum products of worth US$ 8.51

billion. Pakistan imports most of the crude oil and petroleum products from Middle East and Iran. Consumption Pattern of Petroleum Products The transport sector is the largest user of petroleum products (47 percent), followed by power (43 percent); industry accounts for about 7 percent, and the balance is used in other sectors.

Petroleum Sector Structure Pakistans petroleum sector operates under the Ministry of Petroleum and Natural Resources which is responsible for dealing with all matters relating to petroleum, gas mineral. The Oil & Gas Regulatory Authority (OGRA) regulates the sector and pricing of all petroleum products are determined by OGRA. We can broadly explain the structure of petroleum sector through the following diagram.

Oil Exp & Production Cos

Pakistan Petroleum Sector

Refineries

OMCs

Consumers

Crude and Petro Products Imports

There are around eleven oil exploring and producing companies are operating in Pakistan and they are producing around 66 thousand barrels per day. There are seven refining companies with refining capacity of 13 million tonnes per annum are operating. In the oil marketing sector twelve OMCs are operating with over 60% share of PSO.

Indigenous Production & Crude oil Processed by Refineries Year 2008 2009 2010 2011 Production 3.43 3.22 3.18 3.22 Processed 11.97 11.00 10.10 10.00

Processed figures include imports. Unit: million TOE

IMPORT OF CRUDE OIL

Unit: Qty. in Tonnes (Value in Million US$ Year Refinery BYCO PRL NRL PARCO TOTAL: 2007-08 Qty 790,760 849,852 2,223,469 4,559,532 8,423,613 Value 551 568 1,519 3,104 5,742 2008-09 Qty 875,233 1,304,743 2,317,995 3,562,684 8,060,655 Value 496 596 1,172 1,980 4,244 2009-10 Qty 632,732 979,604 1,711,581 3,564,378 6,888,295 Value 351 552 956 1,992 3,851 2010-11 Qty 491,922 929,885 1,927,662 3,308,563 6,658,032 Value 329 638 1,306 2,413 4,686

IMPORT OF PETROLEUM PRODUCTS

Unit: Qty. in Tonnes Value in Million US$ Year PRODUCTS 100/LL HSD High Sulphur F. Oil Low Sulphur F. Oil Motor Spirit TOTAL: 2007-08 Qty. 121,499 4,507,873 3,921,425 346,906 127,386 9,025,089 Value 123 3,863 1,914 200 106 6,206 2008-09 Qty. 253,024 4,395,427 5,077,096 248,637 9,974,184 Value 162 2,862 2,022 151 5,197 2009-10 Qty. 606,163 4,394,888 5,600,120 576,929 11,178,100 Value 419 2,725 2,579 422 6,145 2010-11 Qty. 802,971 3,777,500 5,597,137 1,063,590 1,129,689 12,370,887 Value 723 3,063 3,121 628 971 8,506

Exports of Crude oil & Petroleum Products FY 08 Qty Value Crude Oil Petroleum Products 1,337,338 1,210 FY 09 Qty Value 1,211,731 823 FY 10 Qty Value 1,449,972 1,107 FY 11 Qty Value 1,573,255 1,530 -

Qty in TOE, Value in million US$

PETROLEUM PRICING REGIME IN PAKISTAN The price deregulation process was initiated in 2000, when the government adopted a market-based price framework. FO prices have been completely deregulated since July 2000, while the HSD market was partially deregulated in 2002. Retail prices of other products are regulated in accordance with the price framework set by the government and comprise import parity price (IPP), allowable margins (OMC margin, freight margin, and dealer's commission), and taxes (petroleum levy/surcharge, sales tax). Prices are adjusted every fortnight in accordance with changes in international market prices. Import Parity Price (IPP) Import Parity Prices are calculated as to reflect as closely as possible the "true" cost of imports and are based on a 15 day average Arab Gulf C&F prices plus a number of incidentals.

Ex-Refinery Prices Domestic refineries benefit from a protective duty (6-10 percent) on four main products namely HSD, Kero, LDO, JP-4, 24. Ex-refinery prices are equal to IPP for all products except the above four for which an element of 6-10 percent protective duty is embedded in the ex-refinery price. Inland Freight Margin The inland freight margin is set to recover the total primary freight cost for pipelines, rail and road transportation of petroleum products and to equalize prices throughout Pakistan. The margins account for the cost of freight from supply sources to the primary depots, and are averaged into a single freight margin in the price structure. The secondary freight (depots to retail outlets) has been deregulated and its cost is recovered from end-consumers by each OMC. OMC Margin and Dealer Commissions OMC distribution margins and dealer commissions are capped respectively at 3.5% and 4% of the maximum selling price (as set fortnightly). OMCs and dealers are allowed to provide discounts from the maximum selling price (that is, offer discounts on the capped margins) as part of a strategy to expand their market share. Taxation Petroleum levy/surcharges vary by product, and reflect the fiscal targets of the government, relative consumption volume, and socio-political considerations (kerosene and diesel are taxed at lower rates as compared to motor gasoline). Under the current pricing regime petroleum levy has been set at the rate of Rs.10 per liter on petrol, Rs.8 per liter on high-speed diesel, Rs.14 per liter on high octane, Rs.6 per liter on kerosene oil and Rs.3 per liter on light diesel oil. Subsidies Under the current pricing regime no subsidy is being given to the consumers. However under the influence of socio- political considerations the government sometimes comes under pressure to provide subsidies. In 2008 when crude oil prices were at its historical highs, GOP did not pass on the high prices to the consumers and took the burden on its own kitty. The government provided subsidy to the tune of around US$ 5 billion.

PMEX CRUDE OIL FUTURES Keeping in view the emergence of ICE Brent Crude Oil as the international pricing benchmark and also the import of crude oil by Pakistan is based on Brent Crude Prices, PMEX is in the process of listing another Crude Oil futures contract based on the ICE Brent Futures in addition to the already listed Crude oil contract based on CMEs WTI Futures contract. Futures are primarily used to mange the price risk of the underlying commodity. It transfers the price risk form those who are risk averse (hedgers) to those who are ready to take the risk (speculators). Both PMEXs Crude Oil Futures Contracts (Brent & WTI) are cash settled contracts in Pak rupee. However the price quotation is in US dollars which will provide the local market participants an international flare and ease of trading as the crude oil is not only quoted in US dollars but almost all intl deals are priced in US dollars. The key market players hedgers, investors and speculators play their important and due role for the success of any futures market. There are three broad segments of participants who will participate in the trading of Crude oil futures listed at PMEX 1. Existing Investors of Unregulated Forex Houses PMEXs first target for its crude oil futures is to attract those investors who are currently trading crude oil futures through unregulated forex houses. PMEX will provide them a safe, secure, transparent and convenient trading platform. Currently these forex houses transmit huge sums of foreign exchange to their foreign counterparts to enable their local investors to trade in crude oil or other commodities. As these houses are not regulated by any authority, at times they close their operations and disappear, depriving investors of their money. With the listing of this contract, PMEX will bring these investors under the umbrella of a regulated and documented marketplace and above all, foreign exchange outflows will reduce. We have been observing since the introduction of Gold, Crude Oil and Silver that a number of investors from these houses have shifted their trades to PMEX. The pace of joining a regulated marketplace by these investors will substantially increase with the availability of complete basket of commodities at PMEX. PMEX will be providing a service where needs of domestic stakeholders can be met from within the country as opposed to relying directly on foreign markets.

This is an important step towards the countrys self reliance and growth, namely the ability to fulfill needs from own resources from within the country as much as possible. 2. New Investors/Day Traders A large number of new investors are also interested to trade in crude oil futures as they do not want to trade through above described forex house. Trading through these houses is not only inconvenient but also carries a huge credit default risk. As such PMEX will be able to attract a large number of new investors/ day traders at its platform for crude oil trading. 3. Corporates Number of companies, both in public and private sector are exposed to price risk of crude oil or on the products derived form crude oil. Some of these companies are in the following sectors: Airlines Power generation Big transport companies Refineries Oil Marketing Companies

Most of these companies are interested to hedge their price risk volatility. At the moment public sector companies are not allowed to participate in hedging. The reason may be that no local rupee based hedging instrument was available. They are now interested to participate in the PMEX rupee settled crude oil futures. However their point of view is that once PMEX will list the crude oil futures then they would approach Ministry of Finance to get the permission for hedging. The private sector companies have no such regulatory requirements. We believe that a lot of interest from corporate sector will arise after the listing of Contract based on ICE Brent Crude Oil Futures at PMEX.

Appendix Sources: Pakistan Energy Year Book 2012 Oil and Gas regulatory Authority Ministry of Petroleum and Natural Resource Energy Information Administration- A US government agency

Crude Oil Units (average gravity)

1 US barrel = 42 US gallons 1 US barrel = 158.98 liters 1 tonne crude oil = 7.454 barrels 1 short ton = 6.65 barrels

Note: barrels per tonne vary from origin to origin