No. 3, 2009

Open oil and petroleum product trade in Russia: initial results

The Russian government first mulled the idea of establishing a commodity exchange to trade in oil, gas and petroleum products back in the 1990s. The point is that Urals oil production in Russia by far outstrips that of Brent, but Brent is traded in the ICE Futures marketplace and is a benchmark indicator of the global energy market while Urals crude was not present in any commodity exchange. The idea of an oil exchange has come to materialize only lately. Currently, efforts are underway to create an organized petroleum product market in Russia on the basis of the St. Petersburg International Commodity Exchange and Moscow's Interregional Oil and Gas Exchange.

Getting off the ground

The establishment of oil exchanges in Russia was prompted by a speech made by then-President of Russia Vladimir Putin on May 10, 2006 when he said the following in his state of the nation address to the Federal Assembly: "The real convertibility of the ruble largely depends on its appeal as an instrument used for settlements and savings. In this respect, we still have to do a great deal. In particular, the ruble should become a more universal instrument for international settlements and gradually expand its zone of influence. For these same purposes, it is necessary to organize an exchange trade in oil, gas and other commodities in Russia with settlements in rubles. Our commodities are traded on world markets. Why are they not traded in our country?"

In October 2006, during a meeting between the President of Russia and the Governor of St. Petersburg, Valentina Matviyenko, a decision was made to accommodate the oil exchange in St. Petersburg.

On June 5, 2007, the Russian government passed a resolution on Measures to Arrange for the Purchase and Delivery of Oil and Petroleum Products through Commodity Exchanges. The document explicitly provided for government support for the operation of oil exchanges. In particular, it was insistently recommended that budget fund recipients (first of all, the Defense and Agriculture ministries) buy at least 15% of oil and petroleum products for their needs on this trading floor.

In April 2008, a closed joint-stock company, Saint Petersburg International Commodity Exchange (SPBICEX), was founded by Russian oil majors Transneft, Transnefteprodukt, Rosneft, Gazpromneft, Zarubezhneft, Surgutneftegaz, large trader and transport companies Sovcomflot, Russian Railways, and also VTB, Sberbank and Gazprombank. The SPBICEX was intended to trade in petroleum products and eventually switch over to export operations by expanding the product range to include oil, metals, construction materials, grain and mineral fertilizer. The exchange was set to come on stream in 2009, with up to 300 million rubles invested in launching petroleum product trade.

In June 2008, the Economic Development Ministry, the St. Petersburg city administration, the New York Mercantile Exchange (NYMEX) and the Expertica company signed cooperation agreement on establishing an international commodity exchange in St. Petersburg. The document provided for defining a group of interested Russian and foreign companies and setting up relevant bodies to establish the exchange; approving the constituent documents, budget and management structure; working out a general business plan; registration of a joint-stock company in St. Petersburg for the conduct of commercial operations; and obtaining the required licenses and permits.

The agreement also stipulated the movement of trade in REBCO (Russian Export Blend Crude Oil) futures, currently traded on NYMEX, to St. Petersburg. This move was expected to solve problems with contractual physical deliveries of oil and liquidity.

As a result of all these measures, the first real trading at the SPBICEX took place only on September 23, 2008 and the first results were summed up already on September 29. "A total of 2,800 tons of petroleum products were sold, including 1,900 tons of aviation kerosene and 900 tons of diesel fuel. Nineteen exchange deals were made," the exchange press office said. On the exchange, average weighted prices of these products stayed within a narrower range than on the over-the-counter market. Transnefteprodukt acted as a commodity controller of the deals while settlements were effected by the Settlement Depositary Company.

In March 2009, Rosneft and TNK-BP launched trade in petroleum products at the SPBICEX. In April, they were joined by Surgutneftegaz and Gazpromneft. In May, Russia's largest oil producer LUKOIL started trade in light petroleum products at the exchange.

The St. Petersburg trading floor is expected to trade in petroleum products for the domestic market at the initial stage and eventually switch over to export trade by expanding the range of products to include metals, construction materials, grain and mineral fertilizer.

Moscow rival

At about the same time, operations on a similar competitive commodity exchange began in Moscow. The Interregional oil and gas complex exchange (MBNK) launched regular trade in gasoline and aviation kerosene in August-September 2008.

The non-profit partnership MBNK was established in 2002 by a number of gas producers with the participation of the Russian Gas Society and the Union of Independent Gas Producers. Apart from Rosneft, the partnership's participants include domestic oil and gas producers TNK-BP Holding and NOVATEK, and also the Airport Fuel Supply Trading House. Various organizational obstacles have prevented trade in petroleum products on the exchange over all these years, even though the need for this trade was highlighted by both officials and market participants.

"From August 5, a pilot project for trade in petroleum products was launched on the exchange," said Valery Yazev, deputy chairman of the Russian State Duma and chairman of the MBNK Exchange Council. "The first trading session offered aviation kerosene for sale; a total of 2,160 tons of kerosene worth 60 million rubles were sold. The next trading session involved the sale of diesel fuel and gasoline, apart from aviation kerosene. On September 2, a total of 5,800 tons of petroleum products were sold. The lots offered for sale are of a small size, but may be it is just as well because oil prices are falling and buyers are afraid of concluding large-scale contracts."

As a result, pilot trade proved to be a success, following which weekly operations were launched. From October 2, they are held twice a week: on Tuesdays and Thursdays. In October, about 30 companies from Eastern Siberian and Central regions participated in trading.

In the next 18 months, MBNK plans to increase petroleum products sales to 2 million tons and trade volumes to 30 billion rubles a year. The exchange is so far oriented to the domestic market and does not work with futures contracts, but it cannot be ruled out that these mechanisms would be used in the future.

The first results

Both oil and gas exchanges, which started their operations simultaneously in September 2008, continue to move in the same direction. The terms and conditions offered to market participants are similar while differences are of technical nature. It is not surprising therefore that the exchanges hold the same market share. A small volume of trade is their major problem as less than 1% of total petroleum products are offered for sale in open trade. It is obvious that the results of deals with such insignificant trade volumes cannot serve as price indicators for the entire market.

The volumes of exchange trade in petroleum products are small primarily because fuel market participants have not displayed any special interest in this kind of trade so far. Retail gasoline prices in Russia break down as follows: about 30% are companies' operating costs for production and refining, 20% are profits (moreover, these profits apply to the production chain, from oil wells to filling stations) and about 50% are excise duties and taxes. Oil producing companies receive a steady 20% in profits without help from commodity exchanges, as the system of trade in the oil sector has long been established. Therefore, they are likely to join a new trading floor, only if domestic demand is created, at least within the scope of government orders (through the system of procurement for government needs and national monopolies).

There are also some legal obstacles that impede the development of the commodity exchanging market.

Experts say that clearing transactions should be put on a firm legislative basis, including clearing transactions to register commitments linked with the delivery of goods. For example, commodity exchanges do not act as a party to a transaction; in real fact, they only help buyers and sellers to make deals. Correspondingly, commodity exchanges currently cannot provide reliable guarantees to market participants for the fulfillment of transactions. If one party defaults on its obligations, the other party can only count on bringing the case to a court of law. Court proceedings can take a lot of time and will not necessarily be successful for the complainant party. The law on Commodity Exchanges and Exchange Trade adopted in 1992 does not regulate liability of the parties for failure to honor the terms of a transaction. Experienced lawyers would be able to delay court proceedings for long by taking advantages of loopholes in legislation.

Cash collateral is one of the measures to guarantee the fulfillment of transactions. For example, IOGE traders would make a guarantee deposit accounting for 5% of the transaction amount. Since, however, deliveries take several days (and sometimes several weeks), the price may change more than 5% and in this case, a guarantee deposit will fail to cover potential losses in full.

Experts also say that Russia has not yet developed a full-fledged mechanism to regulate the futures market (the market of derivative financial instruments) and the system of taxation for operations performed on this market (VAT is charged only upon expiry of a futures contract and the commencement of the procedure for its settlement).

Experts likewise stress the need for an improved regulation of the issue, registration and circulation of double warehouse warrants (VAT excluded) for standard goods, allowing for their use in exchange trade. Measures to combat price manipulation and the performance of transactions based on insider information have long been overdue as well. Finally, it is necessary to stipulate the option of holding tenders to procure goods for government and municipal needs with the help of exchanges as electronic trade operators.

Despite the existence of a series of problems, government officials remain optimistic over the future of exchange trade in oil and petroleum products. The concept of commodity exchanges in Russia provides for the development of both the spot and futures markets of oil and petroleum products. The Russian government believes that exchange trade would help create price indicators reliably reflecting the market dynamics while the Economic Development Ministry hopes that the principal trading floor for major price indicators would be selected before this year is out.