By Robert Campbell
NEW YORK May 15 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
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.
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
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.
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.
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.
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.
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.
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.
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?
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.
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.
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.
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'
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
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.
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.
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.
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.