Setting Prices by Word of Mouth

For many raw materials, benchmarks are subjective
Iron ore mine at Mount Whaleback, Australia Photograph by John W Banagan/Getty Images

Prices for stocks, bonds, and currencies are set by billions of trades on public exchanges. Futures contracts for many commodities trade on exchanges almost around the clock. In contrast, deals for the delivery of commodities—raw materials such as coal, iron ore, fertilizer, gas, and some metals—are often made in private using benchmark prices determined by industry publications.

There are at least six price-reporting companies that cover energy and commodities markets. Their employees base their quotes on available bids, offers, and transactions as well as on phone calls and e-mails to market participants. It is a system that developed over more than 100 years. World trade in fuels and agricultural and mining products swelled to $5.67 trillion in 2011 from $1.34 trillion a decade earlier, according to data from the World Trade Organization. “Commodities markets have traditionally been a backwater that only specialists would have been involved with,” says David Wilson, director of metals research and strategy at Citigroup in London. “Clearly these markets haven’t changed with the times.”

Global regulators have tried to make the financial system safer and more transparent since the financial crisis. As they examine markets that remain opaque, U.S. and U.K. officials uncovered banks’ attempts to rig the London interbank offered rate, or Libor, by submitting false information during the rate-setting process. Libor is used as a reference rate in outstanding contracts valued at about $600 trillion. Those probes are continuing. Authorities are also investigating manipulation of ISDAfix, a benchmark in the $379 trillion market for interest rate swaps.

European Union Competition Commissioner Joaquín Almunia said on 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. Earlier this year, Almunia suggested the EU’s probes may spread to raw materials: “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.”

Commodities market participants have less than full confidence in benchmark prices. In a survey conducted from Aug. 12 to Oct. 4, Bloomberg News contacted 270 traders and analysts of energy, metals, iron ore, carbon, and power and asked them: “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?” Among the 85 responses, the mean answer was 27, and the median was 20. Crude benchmarks were the least representative, followed by oil products, metals, and iron ore. Agricultural commodities had the greatest accuracy, according to the survey.

The respondents represent only a fraction of the thousands of commodities and energy traders worldwide. Still, “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,” says Shaun Ledgerwood, a senior antitrust consultant at Brattle Group who formerly worked at the Federal Energy Regulatory Commission.

Whatever their flaws, published benchmarks provide more transparency than what would exist without them, and alternatives are lacking. “From the traders’ perspective,” says Ledgerwood, “no other mechanism provides as reliable a source of information.” The system of price benchmarks in the oil market “isn’t broken,” says Ian Taylor, president and chief executive officer of Vitol Group, the world’s largest independent oil trader. “We occasionally don’t like the price quotations, but we don’t think it’s fair to say you can’t trust them. There’s a logical reason that they are what they are, and you can’t say they’re demonstrably wrong.”

For crude oil and refined fuels, Platts, owned by McGraw Hill Financial, assesses prices through bids, offers, and transactions made by telephone, instant message, and online during prescribed times. Along with prices, it publishes the names of companies, delivery ports, and other transaction details.

Jorge Montepeque, Platts’s global director of market reporting, says the company is an independent party with no financial stake in whether prices rise or fall. “In all of Platts’s 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 company spokeswoman, said in an e-mail. “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.” 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, she said. Bloomberg LP, the parent of Bloomberg Businessweek, competes with Platts and other assessment companies in providing market news and information.

In markets such as coal and iron ore, transaction details are published when buyers and sellers agree to provide them. To establish sugar, coffee, and cocoa prices, reporters call traders and brokers and then publish the results in news articles.

Some pricing firms are reviewing their practices. Metal Bulletin, an independent research firm in London, may hire an outside auditor to examine its process for pricing iron ore and steel, says Managing Director Raju Daswani. CRU Group, another independent research firm, hired a third party to review how it collects steel prices. It will share the results with its data providers, says Glenn Cooney, head of operations.

Even in the gold market, which has a pricing system that’s lasted more than 90 years, it would be “naive to discount the possibility of price manipulation,” says Mark O’Byrne, director at brokerage GoldCore in Dublin. London Gold Market Fixing, which has five member banks, publishes prices used by mining companies for hedging. The banks confer every morning and afternoon to set benchmarks.

Because of the questions swirling around price-setting mechanisms, “there will be growing pressure for more regulation,” says Citigroup’s Wilson. But private markets will remain hard to police. “You can’t regulate a handshake, a one-off contract between producers, shippers, and consumers,” says Andrey Kryuchenkov, a London-based analyst at VTB Capital, a unit of Russia’s second-largest bank. “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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