Is the oil price rigged?

What's happened?

The European Commission last week launched what it called "unannounced inspections" ie, dawn raids on the offices of Shell, BP, Statoil of Norway, and Platts, as part of a new investigation into possible price-rigging in the oil industry.

Platts, a US-owned company whose London offices were raided last week, is the world's leading price-reporting agency, responsible for surveying the market of buyers and sellers each day and reporting the benchmark price for crude and oil products. All four firms said they were co-operating fully with the Commission's enquiries.

Meanwhile, this week there were signs that the enquiry is widening: Swiss-based commodities titans Glencore, Vitol, Gunvor and Mercuria all received requests for information from Brussels in connection with the probe.

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What have the oil firms done wrong?

Nothing has been proven, or even formally alleged. But the Commission says it's investigating concerns that "companies may have colluded in reporting distorted prices to a price-reporting agency to manipulate the published prices".

Also, it is worried that "companies may have prevented others from participating in the price assessment process, with a view to distorting published prices".

Despite the rash of headlines in the British press about Big Oil scheming to screw motorists at the pumps, the alleged manipulation of the benchmark could just as easily be downwards rather than up. The inquiry could last for months, and if evidence of market abuse is found, analysts expect an investigation lasting anything up to five years.

Why would you manipulate a price downwards?

To take a profit on derivatives or other trades related to that price. The core issue is that the Platts Brent benchmark has become the globally accepted basis upon which people trade all kinds of other grades of crude oil, as well as related derivatives and options.

Oil contracts might typically specify that the price of a particular product will vary over time in line with the Platts benchmark Brent price. In such a world, it obviously becomes possible and tempting to try and manipulate the benchmarks by misreporting trades in the direction that favours your options and/or futures positions. According to Tim Worstall in Forbes magazine, "it's exactly this that is being investigated" by the European Commission.

The prices that Platts and other price-reporting agencies publish each day underpin more than $2.5trn ($2,500bn) in wholesale physical and financial commodities markets. So if they can be manipulated by even a fraction, the potential gains are fantastically huge.

Why is Platts so dominant?

Mostly because it suits the market to have one major player that is widely trusted, even if some participants complain that it has become too powerful. ("They are everyone's favourite enemy," a trader told Reuters recently. "We can't live with them, but we can't live without them either.")

Platts has been a key source of data for the industry since at least 1923, when founder Warren Platt started the Platts Oilgram, a daily newsletter devoted to prices and market information. But since the mid-1980s, when the industry began using market prices instead of a system where they were set by big oil companies and the Opec club of oil-exporting countries, the importance of price-reporting companies and Platts in particular has surged.

These days, according to estimates provided by the oil firm Total, Platts dominates industry price reporting: among the pricing companies, its assessments underpin as much as 95% of crude trades and 90% of oil products and over-the-counter derivatives trades. It's also a highly lucrative business for its owners, McGraw-Hill: revenues have surged more than 40% in two years to $489m in 2012.

What does Platts say about the rigging rumours?

That it's fully aware of the danger of companies gaming the system and is permanently on the look out for it. If its reporters have any suspicions, they speak to traders and back-office teams before deciding whether individual trades truly reflect the market.

If they do suspect any bid, offer, or completed deal is intentionally manipulative or even merely unrepresentative, they have the discretion to exclude it from their calculations. And they can and frequently do ban companies from submitting quotes (known as "boxing" them).

According to Reuters, Platts believes it is this power that has at least partly triggered the current investigation, after a complaint from a Hungarian biofuel producer that Platts declined to admit it to the "market -on-close" window last year (see below).

As far as Platts is concerned, all necessary precautions are in place to protect the integrity of the system. Whether those precautions have been enough to stop oil firms and traders taking advantage remains to be seen.

How is the benchmark price set?

Each day, Platts stops accepting reports of the buying (bid) and selling (offer) prices for oil trades at 3.45pm, and observes market dealing in the half-hour 'window' from 4pm until the market closes at 4.30pm. It combines this information to publish a daily price.

This 'market-on-close' system is supposedly objective and provides representative prices; taking a snapshot at the close should result in a more 'current' price report than, say, the daily average would, especially when prices move quickly.

However, according to detractors, it is also more vulnerable to manipulation, since companies can in theory choose which deals they report in the 'window', and/or announce bids or offers that they don't intend to fulfil.