By Robert Campbell
NEW YORK, May 14 (Reuters) - The vulnerability of physicalcrude price assessments to manipulation is an open secret withinthe oil industry. The surprise, perhaps, is that it tookregulators so long to open a formal probe.
Nevertheless, the revelation that the European Union raidedthe offices of oil majors BP, Shell and Statoil on Tuesday inconnection with an investigation into alleged oil pricemanipulation has sent shockwaves into the broader market.
Price assessments underlie most of the oil and refinedproducts traded worldwide. Only a fraction of the world's oil istraded on a true spot basis. But these limited numbers of spottrades are used to assess the daily value of crude oil andvarious refined products at key trading hubs worldwide. Theseassessments in turn are used to settle longer-term salesagreements.
Only the most financially strong firms could contemplatetaking on the risk of doing most of their business on a spotbasis due to the price risk they would take on.
Exxon Mobil Corp, which is renowned in the oil industry forits refusal to trade financial products, is probably the onlyenergy firm truly able to take on this risk and this is due moreto its vertically integrated business that allows it to offsetregional price swings internally than to its financial strength.
Everyone else relies to some extent or another on so-calledterm deals, lasting weeks or months, that are usually indexed toa public price assessment published by one of the major pricereporting 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 moderncommodity businesses possible. Term deals based on priceassessments allow end-users, traders and suppliers to hedgetheir price exposure as they see fit, reducing an individualbusiness's vulnerability to price volatility.
For instance a petrochemical firm contracts for delivery ofnaphtha, the raw material for ethylene, at a set premium ordiscount to a daily price assessment.
The petrochemical firm can then hedge its exposure tofluctuations in the daily price assessment by taking out anoffsetting swap contract with a large bank, trading house or oilmajor, paying its counterparty a fixed premium in return foroffloading the price risk.
PAPER-PHYSICAL EQUIVALENCE
All of this is possible through the simple fact thatexposure to the price of oil can be obtained or offset by eitherphysical or "paper" barrels. That is to say if a company is longcrude oil and short a financial product based on the price ofcrude oil, it is market neutral.
Thus banks have a big role in commodity markets. Even ifthey never touch the black stuff, pump fuel or hire a tankerthey can take on exposure to oil prices. By and large theseexposures are set off against different clients with mostprofits coming not from price exposure but rather the spreadbetween long and short positions sold to different clients andassociated fees.
Or they can do what the oil majors and traders do: tradeboth physical and financial products. Physical long positionscan be offset with paper positions. Moreover, there is no rulethat market participants have to be market neutral. Manyfrequently make directional bets on outright prices or on theprice spreads between various products.
It is this paper-physical equivalence that is at the heartof the modern oil trade that is frequently misunderstood by laypersons. And it is likely at the heart of any allegedmanipulative practices in the oil market because the notionalvalue of many companies' paper position is substantially greaterthan their physical oil market position.
From late 2001 until the end of 2002 I worked as an oilprice reporter at Argus in London. During that time it was notuncommon to hear suggestions that certain traders were allegedlytrying to "push" price assessments in a direction that favoredtheir positions. These accusations usually came from othertraders whose own positions perhaps lay in another direction.
Why push the physical market around? Because it determinesthe value of a company's paper position. Rival traders wouldoften suggest that some market participants were deliberatelytaking a loss on physical trades to ensure a profit on a muchlarger paper position.
Indeed, in the less liquid refined product markets thevolume of spot trade can be so small that losses on physicalpositions could be tiny while the corresponding profits on apaper position could be substantial. In many jurisdictions, thepractice, sometimes referred to as "jamming the physical," isnot itself illegal.
The fundamental problem is that physical spot markets in oilare illiquid. There can be days where there are no public trades or where bids and offers fail to coincide due to limitations ofproduct specifications, timing and other factors. With only ahandful of firms participating in the market there are only afew potential trades a day.
Reporters would also frequently hear that deals had beenconcluded on a "P and C" basis (private and confidential) so nopricing was available. And even when trading information wasdisclosed, sometimes the whole story wasn't there. On otheroccassions aggressive traders would berate reporters to try andget more influence over the daily assessment. Sometimes thedaily price was more a matter of a judgment call than aconclusion drawn from plenty of evidence.
One of the first lessons taught to new reporters on the oilprice reporting beats is the challenge in understanding whetheror not bids or offers on the sale of a fuel cargo werereflective of the broader market.
A trader could, for instance, bid for the delivery of acargo of jet fuel into a harbor with restrictions on the draftof tankers. The price for such a delivery ought to be higherthan the overall market due to the difficulty in fulfilling theorder. But by how much? And what if it was the only public bidgoing? What did that make the "broader market" price?
Or perhaps another trader might offer a cargo of fuel at aparticularly attractive price. Why so cheap when compared toyesterday? It might turn out that the tanker carrying the cargowas an older vessel that was not acceptable to most buyers.
More simply a large company with good market intelligencewould probably have a good idea where potential sellers wouldhave cargoes available. Thus a shrewd trader could, on slowdays, lodge aggressive bids for cargoes that had no hope ofsucceeding but which would end up playing a role in determiningthe daily price assessment.
To combat these practices oil price reporters are encouragedto develop as many sources as possible with oil traders atvarious firms to get as good a handle as possible on the dailystate of the market. Still, the disparity of access to marketinformation generally means that the media is among the last tolearn about market developments.
Platts, the only PRA to be directly drawn into this week'sEU probe, says its current methodology, in place in Europe since2002, is aimed at stamping out mischief by traders by makingassessments more rules-based and less reliant on reporters'judgment.
Experienced price reporters can often ferret outskullduggery but PRAs often face talent retention problems dueto pay, working conditions and opportunities elsewhere. It isnot uncommon for price reporters to become oil brokers ortraders. But oil brokers and traders almost never move in theother direction.
Thus, both Platts and Argus operate with disclaimersstating, essentially, that anyone who uses their priceassessments when conducting business does so at their own riskand they make no warranty to the accuracy of these prices.
Thomson Reuters, my current employer, which competes withboth Platts and Argus in providing data and news to the energymarkets, operates on a similar basis. Prices and information wedisseminate about the market are for indicative purposes only.
Yet at the heart of the system are two assumptions. One isthat firms will be honest in their dealings with the media, theother being that a competitive market makes it difficult for anyone actor to dramatically move prices in one direction for toolong. As the Libor scandal has shown these sorts of assumptionsrest on shaky ground.
Individual oil traders operate under a system of incentiveswhere outsized rewards are conferred largely based on theprofitability of a trading book, not for accuracy in reportingtrades to price reporting agencies. Since paper trades can behugely profitable, forcing even tiny moves in physical pricesthat are imperceptible to ordinary consumers to benefit paperpositions must be tempting.
