Oil is the biggest commodity market and influences every aspect of our lives but getting a handle on the price of oil is a difficult exercise, almost absurd in its complexity and sometimes dangerously opaque. The world needs more benchmarks to reflect local energy markets and it needs more transparency about how those benchmarks are derived.
For most purposes there are only two prices that matter today. The Brent price is based on the trade of cargoes of crude produced from several oil fields in the North Sea, including the eponymous and rapidly depleting Brent. West Texas Intermediate (WTI) is based on the trade in crude delivered by pipeline from Texas oil fields to terminals at Cushing, in Oklahoma.
For decades, price reporting agencies, such as Platts and Argus, have monitored the trading in cargoes of crude oil, notified to them by oil companies. More recently, huge futures markets – ICE in London and NYMEX in New York – have been built on Brent and WTI.
It's a financial superstructure erected over the physical trade in barrels. These markets are huge, many times the value of the underlying trade in barrels of oil that fuel our planet. This reflects not just our liking of gambling – pension funds and hedge funds are big players in these markets – but also the extent to which the price of energy affects growth in the global economy.
All this is fine, as long as the huge inverse pyramid of forward buying, hedging and betting touches ground every day in reference to a reliable daily price, one based on a real transaction in which an oil refiner bought a cargo of oil. It's not just speculators who want to know the price of Brent. The North Sea crude is used as a benchmark to price oil produced out of wells from Nigeria to Eastern Siberia.
Brent's popularity as a benchmark has been growing at the expense of its rival WTI. The two benchmarks once traded more or less in tandem with Brent priced at a $1 (U.S.)-a-barrel discount to WTI, reflecting the latter's position in the world's biggest oil market. However, in the past year, a glut of crude at WTI's delivery point at Cushing has widened the discount to more than $20, provoking nasty comments about WTI's usefulness. Critics see a landlocked American benchmark compared with Brent's more global status. This week, the biggest commodity index, S&P GSCI, adjusted its oil component to take more account of Brent and less of WTI, reflecting a shift in influence.
So, which oil price matters? The answer is both and other oil prices as well. Oil is not gold: It is not really fungible, the crudes differ in quality and accessibility, and the underlying trade in barrels is often opaque or even non-existent. Brent may be popular but it is hardly transparent. In order to settle the Brent futures contract, the ICE exchange makes reference to daily prices in the physical oil market assessed by agencies such as Platts.
Unfortunately, the output of the oil fields used to price Brent is in rapid decline. On some days no trades are reported and the journalists who staff the agencies have to make assessments based on historic trades. Maintenance at oil platforms and shutdowns reduces the volume further. Moreover, there is no obligation for oil companies to notify their trading to Platts and it is no surprise that there are frequent accusations of price squeezes and other hankypanky as the barrels in the North Sea are drained to a dribble.
If you thought this was an odd way to run an oil market, you might have a point. However, you would need to assume that someone was "running" this market. A recent investigation commissioned by the G20 into oil price reporting found lots of problems in oil pricing but came to no conclusion, mainly because there is no mechanism to force the regulation of a trade that is global, voluntary and mobile.
We need good reference points to price useful things, such as wheat or copper. More than any other thing we need to know the price of energy and oil is still our best reference point. However, we suffer a delusion in believing that there should be one global price for oil, a commodity of variable quality and one which can be in huge surplus or deficit at the same time in different parts of the world.
North America is being rapidly transformed from a major oil importer into a potential exporter. Huge amounts of infrastructure must be built to make this happen. It is no wonder, then, that the price of WTI is volatile. What we can be sure of, however, is that its importance as a benchmark can only increase, not diminish.
Meanwhile, more than half of the world is is pricing its energy on the basis of a tiny trade in a very scarce oil blend in Northwest Europe, a market in large energy deficit. If you thought that neither WTI nor Brent alone currently adequately reflected global energy supply and demand, you would be on the right track. We need other oil benchmarks and indexes but the Gulf oil exporters are strangely reluctant to rally together and form a transparent market. Unsurprisingly, China, a rapidly growing oil consumer and Russia, a major exporter, are both keen to develop their own respective oil trading benchmarks but we can only wonder whether either would enjoy the confidence of foreign investors.
We don't know what the global price of oil is and that is because there isn't one. In the end, the only price that matters is the one that consumers have to pay. What they want to know is that the price they are quoted is always transparent and verifiable and we are not quite there yet.
Carl Mortished