LONDON (Reuters) - Britain’s Financial Services Authority (FSA), still reeling from its failure to prevent manipulation of Libor and other failures of supervision in the run up to the financial crisis, should heed calls to open an investigation into the oil market to ensure it remains free from distortion.
Several prominent analysts and news organizations have drawn parallels between Libor and the potential for manipulation of oil prices.
While many of the comparisons are highly misleading, they are not going to go away, and need to be confronted head on.
Much of the criticism has been focused on the potential for market participants to manipulate oil price assessments published by price-reporting agencies, through the submission of false information and selective reporting of deals.
At the request of the G20, the International Organisation of Securities Commissions (IOSCO) has been conducting a review in the agencies which has been quite critical of the current system, not always fairly (“Consultation on the Functioning and Oversight of Oil Price Reporting Agencies” March and June 2012).
But the critics are missing the point. In the case of the flagship Brent benchmark, the real concern is not in how prices are assessed, but the declining amount of production that underpins Brent price assessments and the futures contract -- especially during the summer when field operators undertake maintenance, or when unexpected problems cause output to plunge.
The falling volume of output and the dwindling number of cargoes available for trading each month makes Brent prices much more vulnerable to distortion than before -- whether or not anyone tries to manipulate them.
There is no evidence anyone has deliberately tried to manipulate the Brent contract recently. But there is plenty of evidence prices have de-linked from the broader oil market because of local issues [ID:nL6E8IHHA6]. And falling volumes in the underlying physical market should always be a red flag in futures markets for participants, exchange operators and regulators alike.
Any benchmark, whether in oil or another commodity, is an uncomfortable mix of global/representative factors and local/specific ones.
In the case of Brent, the problem is that local/specific factors are increasingly playing a more important role than the global/representative ones. To the extent that Brent prices continue to be employed as a benchmark, that sends an increasingly misleading signal.
In the last 12 months, Brent prices have been driven by local supply problems (such as production problems in the Buzzard field) and the recently implemented free-trade agreement with South Korea (which gives UK-produced crudes a small but significant price advantage when sold in South Korea).
Brent’s behavior would not matter except for the fact Brent futures are used as a reference or benchmark for a much bigger set of transactions in other grades of crude oil worldwide, and therefore influences the price of oil and refined products around the world. It is Brent’s use as a benchmark which raises troubling comparisons with Libor.
In Libor’s case, many of the rates quoted each day had become purely theoretical, because the banks were not actually borrowing from one another in the market, certainly not at many of the maturities being quoted. It was the theoretical nature of the rates that made so vulnerable to distortion and even manipulation.
In the case of Brent, things are not nearly as bad. There is still some production, and cargoes are still being bought and sold each day. But the volumes are much smaller than in the past.
At present, the Brent contract is based on the cheapest to deliver of four crude streams (Brent, Forties, Oseberg and Ekofisk). In a bid to improve physical liquidity, Platts, the price reporting agency which publishes the most influential assessment, has already extended the number of days in the assessment window to 25 from January this year.
Platts has said that it is also considering adding two more crude streams (Denmark’s DUC and Norway’s Troll) to the Brent basket [ID:nL5E8GHF5A].
Yet Platts has ended up caught in an impossible position. It has sought to change the physical basis of the assessments to safeguard their integrity and maintain underlying liquidity. But it has run into a tangle of competing viewpoints and vested interests from the industry -- parts of which still deny there is any problem.
When the agency has pressed ahead and made changes to its assessments, it has been criticized for not taking sufficient account of the views of other stakeholders. The pricing agencies were upbraided in IOSCO’s consultation report for imposing changes in methodology and benchmark assessments unilaterally.
IOSCO observed: “PRAs have been criticized for imposing the market methodologies that influence the way the industry trades. That is, traders who wish their transactions to be included in an assessment methodology must deal in a manner and time that meets the particular methodology.”
Later the report claimed “users (of price assessments) believe they are forced to continue to suffer unsatisfactory decisions made by a particular PRA, since that is preferable to exposing themselves to basis risk in the market.”
At times the agencies have appeared damned if they make changes and damned if they don‘t. They are being blamed for a problem which is not of their own making.
In the Libor scandal, one of the main problems was that no one took responsibility for investigating the problem and coming up with a solution, even after the potential problem was highlighted in the media some years ago.
Responsibility for Libor (which was not really a market at all towards the end) was fragmented among different regulators, different countries, the sponsoring trade association, index compilers and the banks themselves, ensuring that no-one took responsibility.
Something similar is true in Brent, with responsibility split between the price assessors, futures exchanges and the FSA. The physical market itself is not regulated. The futures exchanges are self-regulating. And the FSA has broad oversight over how the exchanges conduct their business as recognized investment exchanges.
Unless one organization takes overall responsibility for ensuring the market continues to work properly the Libor problem could be repeated.
The only organization which has the authority and resources to take on the role is FSA and its successors -- which have a statutory responsibility to maintain confidence in the UK financial system, which includes derivatives markets regulated in London.
The FSA should claim jurisdiction because the Brent benchmark is used to settle oil futures contracts on a UK-regulated recognized investment exchange. The rules governing recognized investment exchanges and the admission of new financial instruments to trading give the FSA power to act (“Recognition Requirement for Investment Exchanges and Clearing Houses” Regulations 2001, and FSA Handbook REC 2.12.2A, 2007).
In the Libor case, the FSA, the Bank of England and others failed to pay sufficient attention to the early warning signs.
In Brent, it is important the FSA takes a proactive approach. The regulator should launch an investigation to examine the implications of declining physical output, reassure the market the current benchmark and futures contracts are sufficiently liquid, or insist on changes if there is an actual or threatened distortion of prices.
The outcome of an inquiry may well be a clean bill of health. But it would be much better to hold an open and thorough investigation to resolve them, than deny the need for one now, then run the risk of being forced to hold one later if something goes wrong.
Editing by William Hardy