Murky oil dealings to stay beyond regulators' reach

LONDON (Reuters) - Record oil prices have prompted calls to tighten regulation of oil futures exchanges, where politicians have blamed speculators for driving up prices.

But the multi-trillion dollar unregulated over-the-counter markets in physical oil and related derivatives potentially pose a bigger challenge.

"I believe there is a loophole here because no one looks at it," said Chris Cook, an energy market consultant. "And there is no transparency in the market."

Regulators are being asked to grapple with the OTC market in oil, but face a difficult task.

Its size is hard to estimate as there are no detailed statistics.

The Bank for International Settlements estimated the OTC market in commodity derivatives at $9 trillion at the end of 2007, up by nearly a fifth from the end of June 2007.

The BIS data does not give any breakdown for oil.

One senior executive at a UK investment bank estimated that the OTC market is 10 to 15 times bigger than futures markets.

Others in the industry say it is hard to make a precise assessment.

"If you take the view that firms that do stuff on the OTC/physical markets and hedge on the futures markets, you would think there would be at least an equivalent OTC market to the futures markets, plus any proprietary and speculative interest," said one senior executive at a U.S. investment bank.

"So you would have to say the OTC would be bigger."

The OTC markets are closely linked to futures.

"What is often overlooked is that a lot of the risks in the OTC markets are offset in futures markets," said Lawrence Eagles, of the International Energy Agency.

"Much of the trading that goes on is related to risk management in different derivatives, so you cannot look at a single part or a single exchange, you have to look at the whole to give a clear picture of what is going on."

OTC markets, which also include physical oil trading, encompass a range of energy-related products used for risk management, proprietary trading or investment.

OTC forward contracts in oil, for example, enable companies to buy and sell oil privately between themselves for future delivery outside the institutional framework of an exchange.

Price swaps allow firms to exchange price risk without involving the physical delivery of any oil.

The participants include oil and energy companies, trading firms, investment banks and hedge funds.

EXCHANGE CLEARING

Some OTC derivatives in oil are cleared on regulated exchanges, which makes them more transparent.

Oil swaps, for example, can be cleared on the ICE Futures Europe (ICE.N) exchange and the New York Mercantile Exchange.

Exchanges want to do more clearing to boost revenues.

"The trend is towards more OTC instruments being cleared on regulated exchanges like NYMEX and the ICE," said Christopher Bellew, of Bache Commodities.

"Clearing OTC business on exchanges reduces counterparty risk which is attractive these days," he said, referring to greater concerns over credit risks after the credit crunch.

In the credit markets, a number of exchanges, including Eurex (EXIA.PA) in Europe and CME Group in the United States are making a push to boost clearing services for OTC derivatives.

But in oil, investment banks may be reluctant to move over entirely to more standardised contracts that can be cleared on exchanges as tailor-made OTC products earn them more money.

Politicians in Europe and the United States have blamed speculators for contributing to oil's surge to record levels above $147 a barrel earlier in July.

A U.S. government task force this week said supply and demand factors not speculation were behind oil's rise.

But the debate over speculation continues.

The European Union finance ministers have asked the European Commission to look at the oil markets, including derivatives and issues such as speculation.

A UK Parliamentary panel last week asked Britain's financial regulator to shed more light on the OTC energy markets by producing some data.

A bill in the U.S. Senate that aims to rein in energy market speculation, would require institutional traders to give regulators more details on unregulated over-the-counter deals.

"There has to be a balance between the level of supervision and transparency and market functioning," said Eagles, who said there was a danger that if regulations were overbearing, this would push more trading towards less transparent areas where there is less opportunity for oversight.