Even if a European Commission investigation into alleged manipulation of reported energy prices comes to nothing, it highlights a strange marketplace. In the global energy trade, billions of dollars change hands on the basis of "best guess" benchmarks. More is at stake than fines for rogue traders. As with Libor, the energy market is based on voluntary disclosures of imperfect information - a dangerous way to set prices.
The EU is trying to determine whether oil traders conspired to distort the prices of crude and refined products reported to Platts, one of several price reporting agencies (PRAs) that make money shining a light into murky commodity markets. The EU hasn't identified the specific markets it is investigating, and so far there are no allegations of impropriety. But BP, Statoil and Shell, which are cooperating with the probe along with Platts, operate across wide swathes of the energy market, including Brent crude, the benchmark that acts as a reference price for roughly two-thirds of the global oil trade.
Physical energy markets are immense and sprawling: oil trading, for example, involves hundreds of different products, each with its own peculiarities, which change hands in many places around the world. Market participants include producers, traders, banks and customers such as refineries or utilities. Trades are mainly conducted over the counter, so transactions aren't reported automatically, as they would be on an exchange.
That's where the PRAs come in. Platts and its competitors practice a form of journalism. Their employees compile reports of bids, offers and completed transactions and draw conclusions about prevailing market prices.
The results, which are published daily, are no more than an imperfect snapshot. No trader is under any obligation to report trades; participation is voluntary. There may be no reported transactions in some less liquid markets, so the reported price is only an estimate. The process is sophisticated, but it's still guesswork.
Platts and its allies argue that the system's checks and balances, which include giving reporters leeway to discard trades that don't meet internal guidelines, limit the potential for abuse. That's true, but market participants may still be tempted to cheat. After all, a trader with oil to sell would gain if a fib told to Platts about market strength or weakness moved the reported price by a few cents.
For holders of complex hedged positions of several products, small price moves can be very profitable. But traders might struggle to sustain a price-rigging conspiracy. Even if two traders colluded one day, they might well be on the opposite sides of a trade the next.
If there has been cheating, the impact would extend far beyond physical markets. Many long-term energy supply contracts are based on prices referenced to Brent or other PRA benchmarks. The influence extends into derivatives, too. ICE uses a sampling of PRA data to set the cash settlement of Brent crude futures, for example - although it doesn't disclose which specific companies' numbers it uses. Many over-the-counter derivatives also rely on PRA soundings.
It's difficult to estimate the financial impact of any possible wrongdoing. The EU talked up the "huge impact" of even "small distortions of assessed prices" and mentioned the potential harm to "final consumers". That sounds exaggerated. As with the Libor manipulation, any distortions are likely to have been tiny, temporary and not in one direction.
More likely is a large number of almost invisible customer losses and a small number of fairly chunky gains for individual traders. Still, as banks have learned in the Libor scandal, the lack of massive damage offers no protection against bad publicity and large fines.
The PRAs may be able to dodge the worst. The EU has concerns that "companies may have prevented others from participating in the price assessment process". That suggests Platts' editorial process may come under some scrutiny. But unlike the Libor banks, PRAs don't place trades themselves. Ultimately they are just information brokers for trades between consenting adults. And they can always offer new safeguards to make cheating harder.
Whatever happens in this investigation, the current system of energy pricing, which relies on a combination of real and hypothetical transactions, still has some uncomfortable echoes of Libor, where rates are set entirely on the basis of reports. These pricing mechanisms are both convenient and deeply flawed.
The convenience accounts for the system's success. The use of quasi-prices to set real prices works fairly well, and even a cloudy view of an opaque market is better than total ignorance. The flaw is that so many transactions depend on so little information, gathered from people who may have reasons not to be entirely candid. It is peculiar, to say the least, to build a multi-billion dollar market on such a crude artifice.
