Making sense of oil pricing and price manipulation
By Stefanie Heerwig

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A shock wave recently hit the oil market as it came to light that the European Commission had raided offices by BP, Shell and Statoil to investigate whether the three European oil giants had colluded in reporting distorted prices to Platts and thereby manipulated the Brent benchmark. Since then investigations have even spread to the U.S., for a case that is as big as the Libor scandal, as papers like the Financial Times put it.

The thing is, as with Libor, the oil price rigging scandal not only hit the places closest to the epicenter but also shocked markets across the ocean. Oil trade is global as its accompanying financial trade in derivatives and futures. As an estimated 70 percent of crude oil is priced on Brent, and equally a vast amount of futures and derivatives are built upon the price of this black sweet liquid.

Not surprisingly, U.S. Based Prime International Trading Ltd. has filed a case against the oil giants over deliberately reporting "inaccurate misleading and false information regarding Brent crude oil prices to Platts." And the Senate Energy and Natural Resource Committee Chairman urged the Justice Department in a letter to investigate whether the alleged price fixing spilled over onto American shores.

But how could it even come that far? That was the first question that came to my mind when reading about the scandal. And, anyway, how does oil pricing work? As you might imagine answering these questions is not easy or even impossible. What I am therefore outlining below is just a tentative explanation without any conclusion and many open questions left in the end.

To start with, it might be important to know the Brent benchmark is not purely based on trade in the physical market, but also influenced by prices of futures and other exchange mechanisms on the financial market, which are in turn based on the physical commodity of Brent crudes (Yes, "crudes" not "crude" because Brent is not only based on one crude these days).

The prices oil companies like Shell, BP and Statoil report to Platts are based on their amount of physical trades, mostly forward contracts. And here is where one of the major loopholes in the assessment of the Brent benchmark already arises. Compared to the relative transparency in the stock market, traders are not obliged to report all transactions. They participate voluntarily and are able to selectively submit only trades that benefit their position, according to a recent report from the International Organization of Securities Commissions (Ioesco).

But this is not everything. One of the main problems with the benchmarking system of Brent is that the vulnerability for price manipulation has increased with the dwindling physical supply of Brent. This is why by 2007 Platts included three more crude streams into its benchmark, turning Brent into BFOE, which stands for Brent, Forties, Oseberg and Ekofisk. And just in March the agency reviewed its Brent pricing methodology again to increase its physical base once more. Because what can happen if the physical supply of Brent crudes is too small or not big enough is a so-called squeeze — a situation in which trades in the forward market exceed the actual amount of physical cargoes that can be loaded during that month, raising the price of that particular crude.

Yet, many think not only a lack of transparency and a physical squeeze have contributed to possible distortions of the Brent price, but also the financialization of the oil market have taken its toll on consumers at the gas pump. For instance, UNCTAD released a policy brief in 2012, in which it lays out that oil price fluctuations have not so much depended on developments in the real economy over the recent past, but the financial market (in which the volume of traded derivatives on commodity markets is on average 20 to 30 times larger than physical production).

The report shows, for example, that instead of following the fundamentals of supply and demand, oil prices coincided with the development in the European stock markets and rumors in the eurozone. As such, it concludes that:
"Due to the increased participation of financial players in those markets, the nature of information that drives commodity price formation has changed. Contrary to the assumptions of the efficient market hypothesis, the majority of market participants do not base their trading decisions purely and independently on the fundamentals of supply and demand; they also consider aspects related to other markets or to portfolio diversification to be important. This introduces spurious price signals into the market."
But there is always another side of the coin, and some experts also suggest there is a clear link between the price of futures and derivatives based on crude and its physical trade. For instance, the Oil & Gas Financial Journal says the exchange for physical mechanism (EFP) — another layer integrated into the calculation of the Brent benchmark — clearly links the Brent futures to the physical Brent trading. This is because it allows those holding futures to exchange those contracts at expiry for a cash value equivalent to physical barrels.

This still leaves several questions open and, of course, does not explain how exactly the price manipulation, if true, happened. This will be the work of the investigators. But it would be still interesting to know about how much the financial market has an impact on oil prices and whether it is actually possible to determine illegal price manipulations in all layers underlying the calculation of the Brent benchmark. There have been examples where major institutions like the Commodity Futures Trading Commission (CFTC) have had difficulties understanding the nature of commodity pricing mechanisms when researching an alleged case of illegal manipulation. Well, let's wait for the outcomes of the investigations for now.

Stefanie Heerwig is a research consultant in the energy sector. She has contributed to a series of papers on "oil-to-cash" and fossil-fuel subsidy reforms that are about to be published by the Center for Global Development, a Washington based think-tank. She holds a BA (Hons) degree in economics and politics from the University of London's School of Oriental and African Studies.