The vulnerability of physical crude price assessments to manipulation is an open secret within the oil industry. The surprise, perhaps, is that it took regulators so long to open a formal probe.
Nevertheless, the revelation that the European Union raided the offices of oil majors BP, Shell and Statoil on Tuesday in connection with an investigation into alleged oil price manipulation has sent shockwaves into the broader market.
Price assessments underlie most of the oil and refined products traded worldwide. Only a fraction of the world's oil is traded on a true spot basis. But these limited numbers of spot trades are used to assess the daily value of crude oil and various refined products at key trading hubs worldwide. These assessments in turn are used to settle longer-term sales agreements.
Only the most financially strong firms could contemplate taking on the risk of doing most of their business on a spot basis due to the price risk they would take on.
Exxon Mobil Corp, which is renowned in the oil industry for its refusal to trade financial products, is probably the only energy firm truly able to take on this risk and this is due more to its vertically integrated business that allows it to offset regional price swings internally than to its financial strength.
Everyone else relies to some extent or another on so-called term deals, lasting weeks or months, that are usually indexed to a public price assessment published by one of the major price reporting agencies (PRAs) such as Platts, a unit of McGraw Hill , or Argus Media, a closely-held British firm.
Why do this? The short answer is that it makes modern commodity businesses possible. Term deals based on price assessments allow end-users, traders and suppliers to hedge their price exposure as they see fit, reducing an individual business's vulnerability to price volatility.
For instance a petrochemical firm contracts for delivery of naphtha, the raw material for ethylene, at a set premium or discount to a daily price assessment.
The petrochemical firm can then hedge its exposure to fluctuations in the daily price assessment by taking out an offsetting swap contract with a large bank, trading house or oil major, paying its counterparty a fixed premium in return for offloading the price risk.
PAPER-PHYSICAL EQUIVALENCE
All of this is possible through the simple fact that exposure to the price of oil can be obtained or offset by either physical or "paper" barrels. That is to say if a company is long crude oil and short a financial product based on the price of crude oil, it is market neutral.
Thus banks have a big role in commodity markets. Even if they never touch the black stuff, pump fuel or hire a tanker they can take on exposure to oil prices. By and large these exposures are set off against different clients with most profits coming not from price exposure but rather the spread between long and short positions sold to different clients and associated fees.
Or they can do what the oil majors and traders do: trade both physical and financial products. Physical long positions can be offset with paper positions. Moreover, there is no rule that market participants have to be market neutral. Many frequently make directional bets on outright prices or on the price spreads between various products.
It is this paper-physical equivalence that is at the heart of the modern oil trade that is frequently misunderstood by lay persons. And it is likely at the heart of any alleged manipulative practices in the oil market because the notional value of many companies' paper position is substantially greater than their physical oil market position.
_0">From late 2001 until the end of 2002 I worked as an oil price reporter at Argus in London. During that time it was not uncommon to hear suggestions that certain traders were allegedly trying to "push" price assessments in a direction that favored their positions. These accusations usually came from other traders whose own positions perhaps lay in another direction.
Why push the physical market around? Because it determines the value of a company's paper position. Rival traders would often suggest that some market participants were deliberately taking a loss on physical trades to ensure a profit on a much larger paper position.
_2">Indeed, in the less liquid refined product markets the volume of spot trade can be so small that losses on physical positions could be tiny while the corresponding profits on a paper position could be substantial. In many jurisdictions, the practice, sometimes referred to as "jamming the physical," is not itself illegal.
_3">The fundamental problem is that physical spot markets in oil are illiquid. There can be days where there are no public trades or where bids and offers fail to coincide due to limitations of product specifications, timing and other factors. With only a handful of firms participating in the market there are only a few potential trades a day.
_4">Reporters would also frequently hear that deals had been concluded on a "P and C" basis (private and confidential) so no pricing was available. And even when trading information was disclosed, sometimes the whole story wasn't there. On other occassions aggressive traders would berate reporters to try and get more influence over the daily assessment. Sometimes the daily price was more a matter of a judgment call than a conclusion drawn from plenty of evidence.
_5">One of the first lessons taught to new reporters on the oil price reporting beats is the challenge in understanding whether or not bids or offers on the sale of a fuel cargo were reflective of the broader market.
_6">A trader could, for instance, bid for the delivery of a cargo of jet fuel into a harbor with restrictions on the draft of tankers. The price for such a delivery ought to be higher than the overall market due to the difficulty in fulfilling the order. But by how much? And what if it was the only public bid going? What did that make the "broader market" price?
_7">Or perhaps another trader might offer a cargo of fuel at a particularly attractive price. Why so cheap when compared to yesterday? It might turn out that the tanker carrying the cargo was an older vessel that was not acceptable to most buyers.
_8">More simply a large company with good market intelligence would probably have a good idea where potential sellers would have cargoes available. Thus a shrewd trader could, on slow days, lodge aggressive bids for cargoes that had no hope of succeeding but which would end up playing a role in determining the daily price assessment.
_9">To combat these practices oil price reporters are encouraged to develop as many sources as possible with oil traders at various firms to get as good a handle as possible on the daily state of the market. Still, the disparity of access to market information generally means that the media is among the last to learn about market developments.
_10">Platts, the only PRA to be directly drawn into this week's EU probe, says its current methodology, in place in Europe since 2002, is aimed at stamping out mischief by traders by making assessments more rules-based and less reliant on reporters' judgment.
_11">Experienced price reporters can often ferret out skullduggery but PRAs often face talent retention problems due to pay, working conditions and opportunities elsewhere. It is not uncommon for price reporters to become oil brokers or traders. But oil brokers and traders almost never move in the other direction.
_12">Thus, both Platts and Argus operate with disclaimers stating, essentially, that anyone who uses their price assessments when conducting business does so at their own risk and they make no warranty to the accuracy of these prices.
_13">Thomson Reuters, my current employer, which competes with both Platts and Argus in providing data and news to the energy markets, operates on a similar basis. Prices and information we disseminate about the market are for indicative purposes only.
_14">Yet at the heart of the system are two assumptions. One is that firms will be honest in their dealings with the media, the other being that a competitive market makes it difficult for any one actor to dramatically move prices in one direction for too long. As the Libor scandal has shown these sorts of assumptions rest on shaky ground.
_15">Individual oil traders operate under a system of incentives where outsized rewards are conferred largely based on the profitability of a trading book, not for accuracy in reporting trades to price reporting agencies. Since paper trades can be hugely profitable, forcing even tiny moves in physical prices that are imperceptible to ordinary consumers to benefit paper positions must be tempting.