Commodity price benchmarks are wrong as often as 27% of the time


By Lananh Nguyen and Isaac Arnsdorf
Bloomberg News
Wednesday, October 9, 2013

Commodities traders who buy and sell as much as $5.67 trillion of raw materials a year say the benchmark prices for everything from oil to iron ore to gasoline are wrong as often as 27 percent of the time.

In a Bloomberg News survey conducted during the past eight weeks, 85 traders and analysts said they have little confidence in the assessed prices of crude, metals and iron ore. Regulators, including European Union Competition Commissioner Joaquin Almunia, may examine commodities markets, having already increased investigations of manipulation of benchmarks for interest rates, derivatives, foreign exchange and oil.

Five years after the global credit crisis prompted more regulation of banks, benchmark prices for hundreds of commodities are determined through surveys of anonymous traders who may have a stake in the outcome of the assessments. Unlike stock prices, available in real time at regulated exchanges for all investors to see, many raw materials that go into food, clothing and power are bought and sold in private.

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"There will be growing pressure for more regulation," David Wilson, director of metals research and strategy at Citigroup Inc. in London, said by phone Sept. 3. "Commodities markets have traditionally been a backwater that only specialists would have been involved with. Clearly these markets haven't changed with the times."

While prices for stocks, bonds, and currencies are set by actual trades on exchanges, benchmarks for coal, iron ore, fertilizer, gas and some metals are determined by journalists. They establish the prices by collating data on available bids, offers and trades as well as phone and e-mail surveys. Those assessments are often used to determine payments in long-term contracts between buyers and sellers.

Bloomberg surveyed analysts and traders of energy, metals, iron ore, carbon and power. They were granted anonymity so they would give their unguarded opinions to the question: "How many times out of 100 instances do you estimate the assessed benchmark price for the main commodity you trade is unrepresentative of the true level?"

The mean answer was 27 and the median was 20. Crude benchmarks were the least representative in markets where more than five respondents gave answers, followed by oil products, metals and iron ore. Agricultural commodities had the greatest accuracy, according to the survey. About 270 people were contacted. Most of those who declined to give answers said they couldn't quantify how frequently prices were inaccurate.

"The survey shows there is clearly a concern that others could be using these price-making mechanisms to bias the price up or down depending on their interests," Shaun Ledgerwood, a senior antitrust consultant at the Brattle Group who formerly worked at the U.S. Federal Energy Regulatory Commission, said by phone Sept. 30. "However, from the traders' perspective, no other mechanism provides as reliable a source of information."

The responses represent a fraction of the thousands of commodities and energy traders in the world. The 10 largest investment banks employ almost 2,300 people across trading, structuring, sales and research publishing, according to Coalition Development Ltd., a London-based research company.

The system of price benchmarks in the oil market "isn't broken," Ian Taylor, president and chief executive of Vitol Group, the world's largest independent oil trader, said in an interview at the Oil & Money conference in London Oct. 1. Some prices are hard to assess because there aren't enough trades, he said.

"We occasionally don't like the price quotations but we don't think it's fair to say you can't trust them," Taylor said. "There's a logical reason that they are what they are, and you can't say they're demonstrably wrong."

Published benchmarks provide more transparency than would exist without them, and there are no alternatives, Ehsan Ul-Haq, a senior market consultant at Walton-on-Thames, England-based KBC Energy Economics who has almost 20 years of experience in the oil industry, said by phone Oct. 1.

Assessments in spot markets contrast with exchange-listed futures ranging from crude oil to corn, which trade almost around the clock and are publicly disclosed. More than 2,000 commodity contracts trade on bourses worldwide, according to data compiled by Bloomberg based on listings by the CME Group Inc. and IntercontinentalExchange Inc.

Ensuring the accuracy of benchmarks has gained urgency as the global commodities market surged. World trade in agricultural, mining products and fuels swelled to $5.67 trillion in 2011 from $1.34 trillion a decade earlier, according to the World Trade Organization in Geneva.

The International Organization of Securities Commissions, the Madrid-based group representing regulators from more than 100 countries, set tougher guidelines for publishing benchmarks in a July 17 report, including making prices based on "observable" deals where possible.

Banks, traders and benchmark publishers could be fined for failing to follow rules aimed at reducing the potential for rate-rigging, according to EU rules proposed Sept. 18. While prices would have to be based on real transaction data, those underpinning the commodity markets may be allowed special treatment because of their "sector-specific characteristics," the plans show.

Regulators say they aren't convinced of the integrity of commodity assessments. The EU's probes will probably spread to raw materials, Almunia, a vice-president of the European Commission, said on the EU assembly's website May 28.

"We have started with the financial sector, now we are in the energy sector, and probably in the raw materials or in other cases we will need to pay attention also," he said.

Almunia's comments came after antitrust authorities opened a probe into manipulation of oil prices. EU investigators searched the offices of Platts, the unit of New York-based McGraw Hill Financial Inc. that assesses the price of Dated Brent, the benchmark for more than half of the world's crude. Authorities also raided BP Plc (BP/), Royal Dutch Shell Plc (RDSA) and Statoil ASA (STL), and sought information from Vitol Group, Gunvor Group Ltd. and Glencore Xstrata Plc. (GLEN)

Spokesmen for BP, Shell, Statoil, Gunvor and Glencore declined to comment, as did a spokeswoman for Vitol.

The Federal Trade Commission is investigating oil prices, mirroring Europe's inquiry, two people familiar with the matter said in June. The FTC is looking at the impact that possible manipulation of the benchmark could have on physical and derivative oil markets in the U.S., a person who asked not to be named because the matter is confidential said in July.

Regulators around the world have tried to make the financial system safer and more transparent in the five years since the collapse of Lehman Brothers Holdings Inc. As they examine markets that remain opaque, they uncovered attempts to rig the London interbank offered rate, or Libor, referenced in contracts valued at about $600 trillion. Royal Bank of Scotland Group Plc, UBS AG and Barclays Plc were fined a total of about $2.5 billion since June 2012.

Those probes are continuing. Last month, U.S. prosecutors charged three former ICAP Plc (IAP) employees with manipulating Libor, and the London-based interdealer broker was fined $88 million in a five-year international probe of rigging of benchmark interest rates.

Authorities are also investigating manipulation of ISDAfix, a benchmark in the $379 trillion market for interest-rate swaps. Almunia said Oct. 7 on the EU's website that he is examining possible irregularities in currency rates following a Swiss probe into whether banks colluded to manipulate the $5.3 trillion-a-day foreign exchange market.

Libor and ISDAfix are part of a suite of financial benchmarks that underpin about $1 quadrillion of assets and trades, almost 14 times global economic output in 2012.

Royal Bank of Scotland passed a currency trader's instant message records to U.K. regulators after concluding the communications may have been inappropriate, according to two people familiar with the matter. RBS uncovered the chats after opening an internal probe following a Bloomberg News report in June that traders at some of the world's biggest banks may have sought to manipulate benchmark foreign exchange rates.

RBS, Deutsche Bank and Citigroup are among firms reviewing e-mails, instant messages and phone records of their foreign-exchange employees for evidence of potential manipulation, according to three people with knowledge of those probes. Spokesmen at all the firms declined to comment.

Requiring that commodity-price benchmarks be set by observable deals may backfire should traders decide it's safer to avoid participating in assessments, said Clare Hatcher, a consultant at London-based law firm Clyde & Co.

Methods for pricing commodities evolved over as long as 130 years and gained acceptance in part by providing more information to the market than was previously available.

For crude oil and refined fuels, Platts publishes the names of companies, prices, delivery ports and other transaction details. It assesses prices through bids, offers and transactions made by phone, instant message or online during prescribed times, known as the market-on-close process, which subscribers to the service can see.

The process began in 1992 and is used for selected products, such as Dated Brent crude, that have industry-agreed specifications. More than 60 percent of the world's internationally traded crude oil was priced against Dated Brent as of May 2011, according to a report by Platts at the time.

Before market-related pricing systems were adopted in the late 1980s, oil prices were set by large multinational companies and later by the Organization of Petroleum Exporting Countries, according to the Oxford Institute for Energy Studies.

In other markets, such as coal and iron ore, transaction details are published when buyers and sellers agree to provide them. Platts reporters discuss bids, offers and deals with participants to determine daily prices. In the absence of verified deals, reporters use information such as bids and offers and related prices in other markets. Judgment is used to exclude data that don't follow Platts procedures or are considered out of line.

"In all of Platts' data-collection processes for its assessments, our aim is to bring transparency to price discovery by publishing as much detailed and meaningful information as possible," Kathleen Tanzy, a New York-based spokeswoman for the company, said in an e-mailed statement Oct. 4. "In our oil and oil products assessments, the degree of transparency our market-on-close price assessment process provides is unparalleled, identifying all data by company name."

Sugar, coffee and cocoa are determined in private negotiations, with prices set at a certain amount above or below exchange-traded futures. In these spot markets for prompt deliveries, reporters call traders and brokers and then publish the values in news articles.

In Platts's experience, there is always someone who doesn't agree with a price assessment, perhaps because the market moved against his or her position, Tanzy said. Platts assessments reflect market value as determined between buyer and seller in the open market and reported to Platts, she said in a previous e-mail.

Platts gave the EU a presentation outlining its market-on-close assessment, Tanzy said, declining to provide details of the meeting.

The company is an independent party with no financial stake in whether prices rise or fall, Jorge Montepeque, global director of market reporting, said in a July interview.

Argus Media Ltd., a competitor of Platts, hasn't been involved in the EU investigation and won't speculate about scrutiny of oil or other markets, Seana Lanigan, a spokeswoman for the London-based company , said in a July 26 e-mail. Argus is implementing the principles for oil-price reporting recommended by IOSCO, she said.

"In 40 years we've never had any serious complaints or legal action about our price assessments," Adrian Binks, chairman and chief executive of Argus, said by phone Oct. 4. An external review of Argus's process will be published in the next month, he said.

Bloomberg LP, the parent of Bloomberg News, competes with Platts, Argus and other assessment companies in providing market news and information.

Even for gold, with its pricing system that has lasted more than 90 years, it would be "naive to discount the possibility of price manipulation," said Mark O'Byrne, director at brokerage GoldCore Ltd. in Dublin. In the spot market, transactions between banks are reported by participants directly to news organizations. Prices used by mining companies for hedging are published by London Gold Market Fixing Ltd. Five banks carry out fixings every morning and afternoon to set benchmark prices.

The China Iron & Steel Association, representing iron-ore buyers from the world's largest importing nation, said in May it was skeptical about Platts prices because of the unknown size of the deal samples.

Metal Bulletin Ltd. will probably hire an outside auditor to review its process for pricing iron ore and steel, London-based Managing Director Raju Daswani said June 6. Published benchmarks provide more transparency than would exist without them, Daswani said by e-mail Oct. 4.

CRU Group, a competitor, said June 5 it hired a third party to review how it collects steel prices. The results will be published to data providers, Glenn Cooney, head of operations, said by e-mail Oct. 4.

"You can't regulate a handshake, a one-off contract between producers, shippers and consumers," Andrey Kryuchenkov, a London-based analyst at VTB Capital, a unit of Russia's second-largest lender, said in an e-mailed response to questions Sept. 4. "How do you define manipulation? When an Australian miner shakes a hand with a giant smelter in China and they agree on a term price?"

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