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"BrentGate" Will Be Larger Than the Libor Scandal

Here's a prediction: the Brent price fixing scandal will turn out to be larger than Libor. Energy prices ripple throughout the real economy and there will be not thousands but millions of angry punters ready to exercise a grievance if any of these allegations turn out to be true.

Here's a prediction: the Brent price fixing scandal will turn out to be larger than Libor. First indications are it may have been going on longer and its impact may both be as weighty and more direct. Energy prices ripple throughout the real economy and there will be not thousands but millions of angry punters ready to exercise a grievance if any of these allegations turn out to be true.

There are so many questions to be asked - and they will be asked, for sure, in the coming days. A story like this in the current economic environment is something like a perfect storm for BP, Shell and Statoil - for it is they who are under suspicion. So I'd like to get in early and put what I think are the three main questions are the table:

1) What is the scope and implication of these allegations if true?

2) How could it have happened?

3) What should happen now?

But first, a clarification. I'm calling this emerging story BrentGate as a working title because of the likelihood that the prices referred to are those of Brent in the North Sea. All three companies are active there, and these raids would make perfect sense given that just two months ago Platts, the agency whose prices are suspected of being manipulated, announced plans to adjust its assessment of Brent.

The Enormous Scope

The scope of impact of such price fixing, if proven, is enormous. Brent is a benchmark crude which sets the price of thousands of other grades of crude oil. Most of these other grades aren't even priced as absolute values in dollar terms, but rather relative to Brent or another benchmark such as West Texas Intermediate in the USA, or Dubai Light in the Middle East. Today, for example, Libya's 11 grades of crude oil and two million barrels a day are all priced against Brent. Sharara is sold at $1.50 more than whatever the spot price for Brent is, day by day, and Sarir (produced by BP, as it happens) at 60 cents less. Benchmarks are even embedded in upstream contracts, to determine the value of oil which is never traded on world markets at all. Shell and the government of Nigeria, say, might agree a formula under which the crude oil produced is valued against one or more benchmarks. This gives the government assurance of some approximation of market value in a case where an oil company is selling the crude to itself - one of its affiliates which are not 'at arm's length'.

Different crudes are worth different amounts because they vary greatly in the 'slate' of fuel products they can produce when refined. At one end of the spectrum, 'light' crude can produce a lot of gasoline (or petrol) with relatively little processing. At the other, heavier grades of crude may produce huge amounts of tar fit only for paving roads and hardly any high value gasoline unless it is passed through expensive hydrocracking processors to break longer chains of carbon down into shorter ones.

The system of benchmarking assumed its current importance in the 1970s when the rise of oil nationalism led to tbe break-up of the cartel of Big Oil who had run the industry for most of the previous century, and the creation of a spot market for oil which until then had mostly been traded in 'term' contracts of long duration between a limited numbers of buyers and sellers.

In order to serve as a benchmark, a grade of crude oil needs to be representative in two ways: in liquidity in the market, and in its own array of technical characteristics. Brent served this purpose well for decades.

How It Could Happen

The revision of the pricing assessment by Platts is the first clue as to how price fixing might happen. Production of the key crudes which make up Brent (itself a blend of several grades) has gone down in recent years as North Sea production fell more generally. This meant less actual trades of Brent itself in the market, and therefore fewer data points from fewer data sources to form an estimate of price on the spot market independent of interested parties.

The second element is the curious system Platts has used calls Market-on-Close. There are two loop-holes in this system which could be exploited. First, it is a snapshot of market activity within a half hour period every day, laying open the possibility of manipulating prices during that period. Secondly, the system not only accepts actual trades as input but also bids and offers which have not been fulfilled. There is clearly margin here for a seller, say, to post an offer price that's unrealistically high, or to make a bid that one never expects to fulfill.

But there's a broader picture here. Big Oil companies are often lambasted as the last industrial titans, with balance sheets, reach and turnover triggering pictures of fat, cigar-smoking arch-capitalists in the boardroom. But its an old paradigm. In the last 20 years those capitalists have turned into financiers and all aspects of the business have become as virtualised as every other economic sector. That's how BP gets to bring in Halliburton, TransOcean and a host of other companies as supporting cast when it has to face the music in a disaster like Deepwater Horizon. It holds the concession. Then contracts other companies to do most, sometimes all, of the actual work. When is an oil company not an oil company? When it's a security contractor, a bank, a derivatives trader or manipulator of stock market value.

BP led the move towards this model when under John Browne it became a major trader of energy products and derivatives. As Tom Bergin outlines in his excellent, and fair, biography of the last 30 years of the company, as financial markets were deregulated in the 80s and 90s, all kinds of options and futures contracts were developed around shipments of oil, like every other commodity. BP developed a strong trading department which used its knowledge of physical oil markets to speculate - oh, did I say that? trade - on these derivative financial products. They frequently, Bergin says, employed "squeeze" tactics, buying physical shipments of oil at higher than necessary prices in order to drive up the value of financial products based in that shipment that they held, to many times the value of the original physical commodity. You know, like the market trader who gets his pimply little cousin to stand in the front row and buy the first lot of lamb cutlets off the back of the lorry so all the rest pitch in. At one stage BP were earning more in profits from their paper trading than from all their refining and downstream distribution - gas stations and the like. If that sounds like the wild fantasy of an anti-globalisation radical, it's worth mentioning that Bergin is himself a former oil trader, who headed Reuters energy coverage, and has significant top-level access to all the key players.

What Should Happen Now

We are entering a new age of economics. We have seen too many market failures for the idea that Adam Smith's hidden hand can regulate life to be seen as anything more than an ideological prejudice. And this is particularly true around extractive industries and management of the world's increasingly stressed natural resources. We need a redefinition of what counts as public interest, as public goods in economic terms, and what economic policies are accordingly appropriate.

The consequences of volatility and opacity are too big to ignore. Somehow the functioning of commodity markets has to be reconciled with these broader public interests. Precisely how is hard to say. Making disclosure of price on all sales of over a million dollars mandatory at 12 months remove? Far enough on to not giveaway a company's current market position, short enugh to concentrate the minds of even the most rapacious traders? ("You will be caught, and probably while you're still in this job"). The digital economy allows all kinds of finesse and nuance to balance between the competing interests of commercial edge and public probity. Disclosures could be iterated, for example, with increasing detail - so that sales from last month are aggregated, but from last year are known trade by trade. And the elephant in the room is valuation of natural resource assets - Shell and ExxonMobil are just two of the majors that we know of who have adopted idiosyncratic approaches, at best, to the question of reporting how much oil in the ground they have title to.

These issues are too important to be left to the market and the discretion of the special interests who dominate the economic sphere.

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