Reassessing the Brent Benchmark for Crude Oil

There is reason to believe that the Brent benchmark for global crude oil prices is being manipulated. This has serious implications for oil import dependent countries like India. The opaqueness of the price setting process makes it diffi cult to establish rigging, but it is in the interests of India and other large developing countries to bring out the real picture.

Akshay Mathur (mathur.akshay@gatewayhouse. in) is Head of Research and Fellow, Geoeconomic Studies at Gateway House, Indian Council on Global Relations, Mumbai.

The year 2013 has seen dramatic revelations in the manipulation of global benchmarks associated with interest rates (Libor), crude oil (Brent) and most recently with foreign exchange rates. All these can have a devastating impact on the global financial architecture. For India, there is nothing more significant than the manipulation of Brent, because it remains dependent on international markets for price discovery and oil imports for its daily existence.

On 14 May, the European Commission surprised the energy markets by announcing that it had launched investigations against several unnamed oil companies and price reporting agencies on the suspicion that they were manipulating the crude oil pricing benchmarks (European Commission 2013).
This development was followed by two significant lawsuits. The first on 24 May in New York by Prime International Trading, a Chicago-based trading company, against Shell, Statoil and BP alleging that “the defendants manipulated and restrained trade in both the physical (spot) Brent Crude oil market and the Brent Crude oil futures market” (Filip 2013).
The second, on 4 October, also in New York, by four traders associated with NYMEX, the world’s largest physical commodity futures exchange against the same three companies – BP, Shell, Statoil – along with six other oil producing and trading firms, for conspiracy to “intentionally manipulate Brent Crude Oil prices and the prices of Brent Crude oil futures”.¹
Issues of Credibility
The suit and the investigation raise serious concerns about the credibility of the global oil benchmarking architecture. A few years ago, this kind of inquiry would have been unthinkable. But earlier this year, after some major banks admitted to rigging Libor – the widely-used global benchmark for interest rates – every sacred benchmark should be subject to review.
For India, which imports 75% of its petroleum needs, this is especially significant. Platts, owned by New York-based McGraw-Hill, is one of only two major price reporting agencies in the world that assesses crude oil pricing benchmarks. The other is Argus, a prrivately-held London-based firm, currently also under the scanner. The method of assessing and buying oil is complex, and Brent is at the centre of it. Brent is used by nearly 60% of the world as a benchmark to price oil (Platts 2011). The only other major oil benchmark is the WTI (West Texas Intermediate) – for oil traded primarily in North America.
Brent is one of the three-component national benchmark called the Indian Basket which comprises Dated Brent (30.1%), Dubai and Oman (69.9%). The Dubai and Oman benchmarks are also assessed by Platts. As of September 2013, the Indian Basket was priced at $109.47 per barrel. This price point is used to estimate the cost of India’s crude oil import bill, which totalled $144 billion for 2012-13.²
Call for Investigations
Suspicions over the assessment of the price of oil have been rife for decades, as pricing grew ever more distanced from supply and demand. But they have gained momentum after the global economic crisis exposed the systemic risks of inter-linked markets. At the Seoul G-20 Summit in 2010, the leaders specifically requested the International Energy Forum (IEF), International Energy Agency (IEA), Organisation of the Petroleum Exporting Countries (OPEC) and International Organisation of Securities Commissions (IOSCO) to investigate “how the oil spot market prices are assessed by oil price reporting agencies and how this affects the transparency and functioning of oil markets”.³
After extensive research, the joint report of the energy and regulatory groups was published. Their assessment reflected the lack of a clear methodology that determines the price of oil or which estimates its impact on the global oil trade (IOSCO 2011).
In short, the pricing was indefinable.
All the allegations have yet to be proven. The price reporting agencies claim that their process is proprietary but accountable to their users. They also claim that they are providing transparency to an otherwise opaque physical market. This is true and the benefits of having a market-based system are obvious.
However, there are indications that their assessments could be subjective and that their methodology may be open to manipulation by the users of their system. In their lawsuit, NYMEX traders claimed that the price reporting agencies will not take action against the oil companies since they are their largest users, and thus a crucial source of revenue.
If the allegations are proven, the implications for consuming nations such as India could be serious. Even a 1% manipulation of the Brent price could cost India $480 million or Rs 3,000 crore annually based on purchases in the physical markets alone. This is equal to the total foreign development aid and loans India gives every year.Still, it is a conservative estimate assuming that Dubai and Oman were not manipulated and none of the other associated costs with hedging or transaction fees are included.
If the methodology is conclusively nebulous and the implications so serious, why is not more being done about it? Three reasons:
(1) The Global Benchmarking Process Is Difficult to Understand, Let Alone Protest or Penalise: It is not based on the physical market – supply and demand – alone or solely on the price set by OPEC. The benchmarking methodology that price reporting agencies use assesses the Brent using inputs from market participants such as oil producers, companies and traders via a complex and proprietary process.
The physical market – where the actual exchange of crude oil takes place – is itself quite opaque and has been so since the early 20th century when the “Seven Sisters” (the seven big oil companies) dominated the oil market. As the joint report of the energy amd regulatory groups explains, there is no obligation for the participants to report the transactions to the price reporting agencies like Platts and Argus, since the process is voluntary and unregulated. Even if they do, it is within a short 30-minute window and they can choose the volume and type of transactions to report. The agencies then analyse this based on the type of crude oil, location, volume, weighted averages, etc, to determine the pricing benchmark or the spot price. If the data is not representative, the agencies use their judgment.
It naturally makes the process discretionary and therefore open to possible manipulation.
This exploitable process would be easy to isolate and fix had this physical markets-based process not been inextricably linked to the financial markets. Bassam Fattouh at the Oxford Institute of Energy Studies, found in a 2011 study that oil prices are actually “co-determined” by the physical and financial markets (Fattouh 2011). He explains how indications from the futures markets influence the physical markets, muddling the process of price discovery.
Other studies have found that the futures market prices can also be used directly by the oil producers to make a sale or to adjust their production targets, thus letting the financial markets influence the physical market in a roundabout way (OECD 2013).
No one fully understands the complexity of these linkages. This became obvious when a workshop conducted in 2011 by the OPEC, IEA and IEF (also at the behest of the G-20) concluded that there is “no consensus on a single theory over the role of speculation, on how it may influence oil price formation, nor on a consistent explanation about the mechanics or causal relationships in price formation”.⁴
The influence of the futures market has even overshadowed the OPEC pricing system, limiting their role mostly to production planning. Some OPEC members such as Saudi Arabia, Kuwait and Iran now just use the futures market to price their oil (Fattouh 2007).
(2) The Pain of Increasing Prices Is Felt Mostly by the End Consumers in Price-Taking Countries: India, like most developing countries, is a “price-taker”, in that it has to accept the prices set by the international markets. Not only does it use a global benchmark (Brent) for purchasing crude oil, but also a global benchmark (FOB AG Price for Gasoil 0.05% Sulphur) for selling petrol, the refined product.⁵ Both these benchmarks are assessed by price reporting agencies and are largely correlated. If the price of oil was manipulated upwards, the profitability of oil companies in India – the price of petrol minus the price of crude oil – is unaffected, since both prices move in the same direction with usually similar magnitudes. But the price that consumers pay will be higher.
Indian oil companies and the Indian government have historically borne the brunt of price increases, since retail prices have been regulated. According to the Petroleum Planning and Analysis Cell of the Ministry of Petroleum and Natural Gas, the government’s total subsidy burden for 2011-12 was Rs 1,61,029 crore. But this is changing quickly as petrol prices in India are already linked to global benchmarks and diesel will be soon. Thus, any price increase now will directly affect consumers at the pump.
(3) Most Participants Believe They Are Sufficiently Hedged against Any Surprise in the Markets: Paradoxically, as the price assessment process gets more complex, participants are engaging more in the financial markets to hedge against ambiguity and uncertainty. Some of this hedging is done by the oil companies to guard against business risk – a legitimate and innovative instrument offered by the financial markets.
The rest is just speculation. This is true for “price-making” and “price-taking countries”. The same OPEC-IEA-IEF workshop admitted that “during periods of financial turbulence, financial players may become liquidity consumers due to their own financial distress, with a convective flow of risk back towards commercial hedger”. It is an eerie reminder of the attitude that caused the sub-prime crisis in the United States. Recall that the hedging giant AIG was the first to be bailed out.
Recognising the severity of this global issue, G-20 leaders asked IOSCO, OPEC, IEF and IEA at the Cannes meeting in 2011 to follow up on its joint report and recommend steps for improving the system. In 2012, the group published guiding principles for price reporting agencies, but its adoption has been uneven and ambiguous.
India, specifically, but also China and South Africa, should also be equally concerned about the possibility of oil price manipulation since they are large consumers. Like India, China is deregulating its oil prices gradually, and directly connecting to these now-disputed global benchmarks (Lan 2013). Their consumers will also directly feel the pain of rising prices.
If existing institutions are not reformed, the monopoly may just have to be broken by the “price-taking” emerging countries. For instance, BRICS accounted for 22% of global oil consumption. Mexico, Indonesia, Japan, South Korea and Thailand add another 14%. These countries can promote new price reporting agencies and new exchanges with better transparency and regulations. Such alternatives are already being experimented in other sectors.
The BRICS Development Bank was launched earlier this year to provide an alternative multilateral financing institution and private enterprises from India, Malaysia, South Africa, Brazil and Portugal recently announced the launch of a new credit rating agency called ARC to break the monopoly held by three global giants – Moody’s, S&P and Fitch.
India produces and refines oil too. It can estimate the cost of exploration and refining with accuracy and can leverage its experience to launch alternative price discovery methods. Russia, a large non-OPEC producer, can promote its own oil benchmark Eastern Siberian-Pacific Ocean (ESPO) by improving transparency, reporting and reach. After all, the BFOE (Brent, Forties Blend, Oseberg and Ekofisk), the crude oil fields on which Brent is based, produce only a fraction of global oil production.
Indian commodity exchanges already provide a futures market for trading Brent and want to be global leaders in price discovery. The industry is waiting for the Forward Markets Regulation Amendment Bill 2010 to be approved by Parliament. It will strengthen the regulatory authority of the Forwards Markets Commission, the department that currently oversees the derivative markets. It may also allow banks and mutual funds to participate in the future markets if the recommendations of the Standing Committee of Parliament reviewing the bill are accepted. That will add heterogeneity and volume to the exchange-based trades.
For now, all eyes are focused on the swiftness and efficacy of the American and British law enforcement agencies investigating the allegations. It is necessary for the existing benchmark architecture to correct itself, restore confidence and mitigate the systemic risk of manipulation of a vital resource like crude oil. It is also necessary for other options to develop and mature. Here the emerging nations, especially BRICS, can lead the way.