Highlighted by a report published by the Oxford Institute for Energy Studies, much of the crude market is opaque, meaning most transactions are hidden from the public. This incites the need for an independent assessment of market conditions, which subsequently falls upon price reporting agencies. The most popular being Platts and Argus. These private entities identify the price level of a crude benchmark, such as Brent or WTI which then form the base of long-term contracts, spot (over-the-counter) transactions and futures contract prices. These financial products form a web of trading that constitute the crude oil paper market. Within this market, traders with stakes in the industry exchange these products, and by doing so, send price signals to other interests, which are captured by the price reporting agencies who then adjust their price.
The incentives for not leaving a paper trail in oil transactions has significant appeal to individual interests. One may look no further than a Berne Declaration Investigation involving the Congolese state refining company and the son of their President who used a Geneva based oil trading firm to embezzle funds out of the country’s treasury. As such, much of the oil traded out of Switzerland, the UK and New York is hidden from public view. This makes it particularly difficult to observe in real-time the true price of oil. To overcome this challenge, price reporting agencies (PRA’s for short) have invested their resources and reputation into providing a unitary number.
In the same report, the author identifies 3 inter-related dimensions to assess the role the PRA’s have in determining crude oil’s price. First is a methodology for price assessment. It is important to note that no two agencies have the same method for determining its price, so that each agency may produce a different number for the same benchmark. When millions of barrels are traded in single transactions, even small differences between PRA calculations can have large impacts on revenues. Second, the pricing process must be efficient. A good assessment must be fast enough to calculate quickly so as to provide regular updates, but also pack as much information as possible so as to be descriptive. Third, PRA’s must have internal measures to protect the integrity of the standard. Given the monumental sum of government revenues that are based off of the price of oil, the PRA must have checks and balances in play to marginalize massive incentives to engage in collusion. Once a PRA’s price estimate is generated, they form the base of long-term contracts, spot transactions and futures/options contracts.
Unlike traditional views of commodities markets, where its price, and associated financial products are based purely on the physical market, crude oil, through its pricing mechanism is also influenced by trading in its paper market. Once crude is represented in electronic form, mostly all barriers to arbitrage, (the act of buying a cheap product in one location to sell in an area where its price is higher) are evaporated. Thus regional fluctuations in demand can be anticipated. Futures pricing also gives a means to hedge against the risk of the price changing, so that the overall level of supply can be judged. This makes these markets a good source of information on the fundamentals themselves. As Horsnell and Mabro, authors of ‘Oil Markets and Prices: the Brent Market and the Formation of World Oil Prices’ wrote, “price reporting does more than provide a mirror for oil markets; the reflection in the mirror can affect the image itself.”
The pricing of crude oil operates in a way many wouldn’t expect. Prices are not determined in any traditional way. The majority of transactions are hidden from public view, so that its true price is not instantaneously observable. To compensate for this calamitous truth, we rely on price reporting agencies to calculate an accurate price. The information used by these agencies to come to this number extend beyond compiling averages based on the relatively few observable trades, but derive itself from oil’s paper market; a market which derives its price from the PRA’s. In an era where a gargantuan sum of interest is focused the price of a barrel of oil, perhaps some of that attention ought to be diverted into understanding how the price even comes into existence, especially since the price of oil, to a large extent, influences overall market volatility.