The surprise is that it took so long to open an oil price probe

The vulnerability of crude oil price assessments to fixing is an open secret, writes Robert Campbell.

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 EU 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 few 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, 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 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 petrochem 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.

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. 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 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.

Formerly, it was not uncommon to hear suggestions that certain traders were allegedly trying to “push” price assessments in a direction that favoured their positions.

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.

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.

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.

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’ judgement.

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 move prices in one direction for too long.

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.