A glut of low-quality oil has resulted, hammering discounts against the higher-quality benchmark grades. OPEC members, who typically sell their crude at a monthly official selling price (OSP) announced about three weeks before the month begins, have been unable to cut prices fast enough to keep up.

"The rapidly changing crude values and volatile freight rates of recent months have highlighted the inherent problems of monthly term contract prices and the difficulty of increasing supply of long-haul sour crude from marginal supply sources," said Marshall Hall of EMC Energy Market Consultants.

By the end of the month, OSPs can be up to seven weeks behind market trends.

"If the price is a bit out of the market for a month or two then it doesn't matter much, but when it's several dollars out for month after month then it really starts to hurt," said a trader with an oil major.

DEEP DISCOUNTS

Traders warn that OPEC may have to price its low-quality crudes, which yield a lot of low-value fuel oil, at large discounts to benchmarks in New York and London until more refiners upgrade their facilities to handle it.

The trend has been clear from a succession of deep cuts to official selling prices by producers Saudi Arabia, Iran and Iraq in recent months, deepening discounts to record levels.

Iraq's state oil marketing arm SOMO last week took a first step toward firing up demand for its sour crude, telling customers it would consider revising its price formulas if market conditions changed after OSPs were announced.

Tweaking the oil price mechanism to better reflect market trends should make sour crude more competitive and encourage refiners to buy more, industry sources said.

"I'm skeptical about how the Iraqis will adjust prices," said one source. "But I'm sure they will sell more crude." SOMO has yet to inform traders how it will change prices, but one idea up for discussion is that it may offer retroactive pricing for cargoes, evaluating the final price based on a review of market conditions at the end of each month.

Iran has also shown willing to sell additional spot cargoes outside of the OSP mechanism, accepting offers linked to grades it does not typically use for pricing, traders said.

Non-OPEC member Syria last month revised its October OSP after buyers reacted angrily to the initial offer at what they saw as too high a price.

SAUDI RELUCTANT

One major buyer found the news of potential OSP reform less encouraging and did not expect the world's largest producer Saudi Arabia to follow suit, pointing to a failed attempt nearly 20 years ago by the kingdom to change its pricing mechanism.

In 1985, in an attempt to win back market share lost during a period of output cuts and high official selling prices, the world's largest exporter offered crude to refiners at netback prices that would guarantee refinery margins.

Other OPEC members also moved to netback pricing and boosted output, there was a glut of crude in international markets and crude oil prices fell sharply.

"This has painful memories for the Saudis," the buyer said. "They learned a very bitter lesson that if they went this way... then it opens them up to abuse."

Buyers also said that over the longer term, OSPs are as often below the market as they are over it, so that the cost to the refiner is neutral.

"If you take the peaks and the troughs over a year, it equals itself out," a buyer said.

"I'm skeptical about how the Iraqis will adjust prices," said one source. "But I'm sure they will sell more crude."