Monday, May 27, 2013

Key Issues to Understanding the Flawed Oil Pricing System

Following the news earlier this month that some of the world's major oil companies may have manipulated the Brent oil prices, some energy observers noted that it was a bomb that was waiting to explode. On May 14, 2013, the European Commission launched an investigation on BP, Statoil and Shell on suspicion of their involvement in manipulating oil prices since 2002. A U.S. commodity trading house, Prime International, filed a class-action lawsuit in New York against these companies on May 24, 2013. The scandal also involves one of the major independent oil price reporting agencies (PRAs), Platts, which collects and reports key international benchmarks on a regular basis. The prices that Platts reports provide grounds for long-term contracts, futures contracts, and derivatives and spot market transactions. Information that Platts provides to its subscribers, which range from oil companies to traders to banks to futures exchanges and governments, is used to help set prices for derivatives contracts and physical delivery of oil worth billions of dollars. According to the French oil company Total, “as much as 80 percent of all crude and oil-product deals are linked to reference prices including those published by Platts.” Even a minor mistake in price reporting carries significant implications on the energy markets. Several issues should be pointed out about PRAs and the energy market that may help understand the current mess.

First, some reporters immediately drew parallels between PRA oil pricing and the Libor-rigging scandal of last year. Libor, which stands for London Interbank Offered Rate, is a collection of rates designed to gauge the cost of borrowing between banks. Libor rates are used as benchmarks for nearly $10 trillion in loans and close to $350 trillion in derivatives. But comparing Libor-rigging to the oil price scandal is wrong. PRAs compete with each other for accuracy of price reporting, which is their bread and butter. Loss of credibility and reputational damage to their reporting would put them out of business. Unlike banks, they are not tied to energy trading apart from reporting about it. The key point on PRAs is they receive pricing information, everything from offers, bid and transactions, from energy market participants (i.e. buyers and sellers) purely on a voluntary basis. In other words, market participants are not required to share their trading data, but if and when they do so via PRAs, the latter must verify the accuracy and correctness of the data they receive.

Second, a lingering criticism of Platts has been its use of a market-on-close (MOC) methodology. Under the MOC mechanism, Platts establishes a time window and only trades transacted within this window are utilized to assessing the price of oil. According to Bassam Fattouh's seminal study of the oil pricing system, “the main criticism of the MOC methodology is that the Platts window often lacks sufficient liquidity and may be dominated by few players which may hamper the price discovery process.” Critics also point out the paucity of volumes traded within the Platts window, which is arguably not representative of the larger volume of trade taking place outside the window. As Fattouh argues, Platts favored the MOC methodology over what it previously used – the volume-weighted average of oil prices– believing that MOC most accurately reflected time sensitivity of assessed prices. However, there is no regulatory authority to oversee the behavior of PRAs or to address any dispute over PRA price assessments.

Third, given the varying levels of transparency between and within various layers of oil benchmarks, whether it is Brent, WTI or others, the current system of oil price discovery is quite imperfect. It will be interesting to see whether allegations of collusion among suspected oil companies to manipulate the Brent oil prices will bear evidence. A proof of such allegations is likely to result in evaluations of potential regulatory measures against market manipulation and a review of current methodologies used by PRAs to discover prices as well as transparency and accuracy of their assessment of energy prices.

Lastly, the current market-based system of oil pricing has existed since the 1980s, with oil prices set by the “market” and PRA reporting on prices based on their assessment of physical and financial transactions. Despite the known imperfections of the existing system, market participants (oil producers, oil companies, traders, refiners, financial actors, etc.) and governments have been hesitant to change it. It is highly unlikely that this system will be replaced with something else. But changes to PRA reporting methodology and transparency, which have come under increased scrutiny in recent years, might occur over the long term.

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