AN INTERNATIONAL ENERGY FORUM PUBLICATION 28 November 2013

IEF DIALOGUE INSIGHTSVIENNA, AUSTRIA | 28 NOVEMBER 2013

MAIN DISCUSSION TOPICS AND FINDINGS

INSIGHTS INTO PRICE FORMATION IN OIL MARKETS

INSIGHTS INTO PRICE FORMATION IN OIL MARKETS | VIENNA, AUSTRIA | 28 NOVEMBER 2013

TABLE OF CONTENTS

1. KEY INSIGHTS _____________________________________________________________________________ 2

2. BACKGROUND ____________________________________________________________________________ 4

3. THE OIL PRICE FORMATION PROCESS: CAN OIL PRICES BE WRONG? _________________________ 4

4. PRICE FORMATION, PRICE REPORTING AND PRICE REPORTING AGENCIES _____________________ 5

5. PRAs IN THE REGULATORY SPOTLIGHT ____________________________________________________ 6

6. “PAPER BARRELS” AND SPECULATION _______________________________________________________7

7. REVISITING 2008: POLICY, DISRUPTIONS AND FINANCIAL MARKETS ___________________________ 8

8. GUIDANCE FOR POLICYMAKERS ____________________________________________________________ 9

9. ADDITIONAL THOUGHTS ___________________________________________________________________10

10. ANNEX I: BACKGROUND INFORMATION ON PRAs ___________________________________________ 12

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1. KEY INSIGHTS

• Onewaytothinkaboutthefairor“correct”priceofcrudeoilistodefineitasthepriceatwhichbothbuyersandsellersinafreeandcompetitivemarketagreetocloseatransaction.Followingthislineofthinking,thevalueofcrudeisnever“wrong”ormispriced,andcurrentcriticismsoftheprocessofoilpriceformationareunwarranted.

• Asimplisticviewoftheworldwhereinthecrudeprice isneverwrongdoesnottakeintoaccount,however,informationalasymmetriesbetweenbuyersandsellers,herdbehaviour,effectsonthirdparties,marketbubbles,monopolisticoroligopolisticpractices,andothermarketexternalitieswiththepotentialtocauseadivergencebetweentheobservedoilpriceand theone that reflectsoil’s scarcity value. From thisperspective, prices can send thewrongsignalunlessappropriatemeasuresareimplemented.

• Price formationtakesplacethroughtheinteractionofnumerousbuyersandsellersintheoilmarket.Price reportingisperformedbycompaniesknownasPriceReportingAgencies(PRAs),which observe quoted prices from negotiations and prices referenced in closeddeals.

• WhilesomecharacterisePRAsaspassiveobserversofthepriceformationprocess,PRAscannotbeconsideredabsentfromthatprocess,asthepriceatwhichabuyerandsellercloseadealtodaymaywellbeinfluencedtosomeextentbythepricethataPRAreportedyesterday.Pricereportingisthusaninputintothepriceformationprocessforcrude.

• NewregulationstochangethecurrentpracticesofPRAshouldbeanalysedcarefullybeforeimplementingthem.Ifnotproperlycrafted,effortstoregulatePRAsmightengendergreatertransparencysurroundingPRApracticesatthecostoflesstransparencyregardingoilprices,asthePRAsmayreceivefewerinputsanddatapointswithwhichtowork.

• While there is apparent consensus amongpolicymakers thatmarkets should indeedbeastransparentaspossible,policymakersshouldbear inmindthattheavailabilityofmoreinformationcannot inandof itselfeliminatebuyer’s regretorseller’s remorse.There isadifferencebetweenmakingmarketstransparentandmakingmarketssafefromerrorsbybuyersorsellers.

• Broaderconsensusremainselusiveregardingtheimpactof“paperbarrels”onthecrudepriceformationprocess.

• Speculationhasbecomeabuzzwordusedtolaytheblamefor“excessive”oilpricevolatilityonfinancialinvestors,butspeculationitselfismoreoftenthannotpoorlydefined.

• Thereareclearbenefitsassociatedwiththerelativelyrecententranceoffinancialplayersincrude,includingthefactthattheyenhanceliquiditylevels.

• A“perfectstorm”seemstohavebeenbrewingin2008foroilprices.Thecombinationofdiesel fuel policies and limited refinery capacity,Chinesedemand, greater purchasesofChineseproductsdrivenbylowUSinterestrates,supplydisruptionsinimportantproducing

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countries,thinspareproductioncapacity,higherproductioncostsandthebeliefinthepeak-oiltheoryallmayhavecontributedtowardsfuellingtherisingpriceofcrudeoil.Whenthefuturebehaviourofthesefactorscameintoquestionasaconsequenceofthefinancialcrisis,greatervolatilityensued,leadingtothepricefallattheendof2008andriseagainin2009.

• All in all, when assessing the oil market’s performance and transparency in 2008, thecrudeoilpriceformationprocess—thoughnotperfect—appearstohavefunctionedbetterincomparisonwiththefarlargercreditandinterestratederivativesmarkets,asoilpricesexperiencedacorrectionlinkedtofundamentalsinashortertimespan.

• Moreandbetterqualitydataonrefinerycapacitiesandinventories,especiallyinnon-OECDcountries,mighthavehelpedtomitigatethevolatilityin2008byreducinguncertaintyinthemarket.

• Policymakers should ensure that they have a comprehensive understanding of how toaddressandalleviatepotentialshortagesorbottlenecksofrefinedproducts,notablydiesel,gasolineandgasoil.

• Hightaxesonvehicularfuelsmeanthatthefuelsdonotaccuratelyreflecttherealvalueofoilandthecostsofproduction,andthusinhibittheconveyanceofpricesignals.Subsidiestendtohavethesameeffectonpricesignals.

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2. BACKGROUND

Theprocessthroughwhichworldoilpricesaredeterminedhasevolvedoverthelastfewdecadestowardsgreaterdecentralisationandcloserinteractionbetweenphysicalandfinancialmarkets.Anincreasingnumberofactorsparticipateinthedailymatchingofsupplyanddemandbids.Thisprocessanditsoutcomesarescrutinisedonadailybasisbypolicymakers,companies,consumers,institutionalinvestors,hedgefundmanagers,journalists,andmanyotherplayers,whoareaidedbyadvancedtechnologyandcommunicationstools.

Totheextentthatthecontemporaryprocessofpriceformationisefficient,ithelpsinthediscoveryofthetruevalueofthelastunitofoiltraded(themarginalbarrel),sendingimportantsignalsfortheallocationofresourceslinkedtoproductionandconsumptionalike.Butiftheprocessisinefficient,wherebyobservedpricesfailtoreflectfullytheinterplayofdemandandsupplyforces,itcanleadtoamisallocationofresourceswithrelatedcoststosocietyandglobalenergysecurity.

Considering the importanceof price formation to the healthy functioning anddevelopment ofworldoilmarkets,theInternationalEnergyForum(IEF)organisedaThought-LeadersRoundtableonPriceFormationwiththegoalofbetterunderstandingtheefficiencyandtransparencyofoilpricediscovery.Asmallgroupofprofessionalsrepresentingthepublicandprivatesectors,energyexchangesandPriceReportingAgencies(PRAs)gatheredinViennaattheinvitationoftheIEFforahalf-dayofinformaldiscussions.ConversationsrevolvedaroundtheprocessofpriceformationinoilmarketsandtherolethatPRAsplaytherein.Discussantsexchangedviewsontherootcausesofpronouncedoilpricevolatilityin2008andonenergy-relatedpolicyandregulations.

Theroundtableyieldedanumberofinsightsandtouchedonsomechallengingquestions,whichremainopenforfurtherdiscussionandanalysis.Giventhevolumesofliteratureandmediareportsthathavebeenwrittenonthetopicofoilpriceformation,andgiventhelimitedtimethatroundtableparticipantshadfortheirdiscussion,thisnoteisnotintendedtobeacomprehensivereference.Instead,it ismeanttohelpshedsomeadditionallightonwhatiswidely-acknowledgedtobeacomplexphenomenon.

Theusualbut importantdisclaimerapplies to thisas toall IEFdialogue reporting:noneof theinsightspresentedhereinshouldbeinterpretedasthespecificpositionoftheIEFonthissubject,norcantheybeattributedtoanyindividual.Theyarosefromtheinformalexchangeofideasamongtheroundtableparticipantsandarepresentedhereincondensedform.

3. THE OIL PRICE FORMATION PROCESS: CAN OIL PRICES BE WRONG?

Theprocessofoilpriceformationhasdrawngreaterscrutinysincemid-2008,whenthepriceofabarrelofWTIreacheditsmostrecentpeakofUS$147,plummetedtoaroundUS$30inDecemberthatsameyear,andsubsequentlyrosetotheUS$70rangeinJune2009.Whatcausedpricestochangesodrasticallyoversuchashortperiodoftime?Wastheoilmarketunabletopricecrudecorrectly?Wereoilpricessendingthe“wrong”signalstocrudebuyersandsellers?

The IEFThought-LeadersRoundtablebeganwitha somewhatphilosophicaldiscussionon theaccuracyofpricesignalsintheeyesofmarketactors,andonthequestionmanycrudeexpertsandpolicymakersareregularlyasked:“Whatisthefairpriceofcrude”?

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Onewaytothinkaboutthefairor“correct”priceofcrudeoil(oranyothergoodorservice)istodefineitasthepriceatwhichbothbuyersandsellersagreetocloseatransaction.Followingthislineofthinking,thevalueofcrudeisnever“wrong”ormispriced,becauseifoneorbothpartiesdonotthinkthepriceisfair,notransactionwilloccur.Thisperspectiveassumesthatnumerousbuyersandsellersactintheirrespectivebestinterestsinfreeandcompetitivemarkets.Fromthisadmittedlysimplisticpointofview,onemightarguethatthereislittleaboutcurrentoilmarketpriceformationthatrequiresfixing.

Yetcrudepriceformationisnotasimplesubject.Asimplisticviewoftheworldwhereinthepriceisneverwrongdoesnottakeintoaccountinformationalasymmetriesbetweenbuyersandsellers,herdbehaviour,effectsonthirdparties,marketbubbles,monopolisticoroligopolisticpractices,andotherso-calledmarketimperfectionswiththepotentialtocauseadivergencebetweentheobservedoilpriceandtheonethatreflectsoil’sscarcityvalue.Fromthisperspective,pricescansendthewrongsignalunlessappropriatemeasuresareimplemented.

4. PRICE FORMATION, PRICE REPORTING AND PRICE REPORTING AGENCIES

When attempting to better understand how prices are determined and disseminated, it ishelpful to startbydistinguishingbetween theprocessofprice formation (alsoknownaspricediscovery)andtheprocessofpricereporting.Priceformationtakesplacethroughtheinteractionofnumerousbuyersandsellersintheoilmarket.Itiswhatstandardeconomictextbooksdescribeastheinterplaybetweensupplyanddemandinthedeterminationofthepriceofanygood.PricereportingisperformedbycompaniesknownasPriceReportingAgencies(PRAs),whichobservequotedpricesfromnegotiationsandpricesreferencedincloseddeals.

Whileparticipants in the IEFThought-LeadersRoundtablewere familiarwith theworkofPRAs,some readersof thisnotemaybe less so.1 In short, PRAsareprivately-ownedpublishersandinformationprovidersthatreportoilpricesinphysicalandsomederivativeoilmarkets.SomePRAsrelyoninterviewswithmarketactorstogaininsightsintopricelevels.PRAssharethepricestheyassesswith their customers,who include thebuyersandsellers transacting in thephysicaloilmarket.

BuyersandsellersmaychoosewhetherornottoincorporatedatafromPRAsandnumerousothersourcesintotheirdecisionmatrices,butgiventhecomplexitiesofphysicalcrudemarkets,someactorsunderstandablyrelyonsecondarysourcesofinformation,includingpriceassessmentsandbenchmarkoilprices,toguidetheirdecision-making.

PRAsassert that theyare improving transparency incrudemarkets,and that theypublish theirviewsof themarkets just as anyoneelsemay. If observersquestion their assessmentsof themarketprice,thenthoseobserversarefreetoexplainwhytheythinkthePRAsmayhavemissedthemark.PRAswouldfindithardtostayinbusinessiftheywereconsistentlyprovidinginformationthat isnotcredibletotheircustomers.Companiesthatpurchasetheirservices,whetheronthedemandorthesupplyside,aretechnicallyfreetostopdoingso.Itisthecase,nonetheless,thattheindustryhasevolvedtothepointwherethepracticeofrelyingonPRA-referencedcontracts

1 For reference, Annex I includes background information on PRAs as described in an October 2011 Joint Report by the International

Energy Agency (IEA), IEF, International Organization of Securities Commissions (IOSCO) and the Organization of the Petroleum Exporting

Countries (OPEC) presented to G20 Ministers (hereafter referred to as the 2011 Joint Report).

One way to think

about the fair or

“correct” price of

crude oil (or any other

good or service) is to

define it as the price at

which both buyers and

sellers agree to close

a transaction.

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limitscompanies’options,astakingtheirbusinesselsewherewouldentailacomplexprocessofrestructuringandpotentialrenegotiationofmanycontracts.

WhilesomecharacterisePRAsaspassiveobserversofpriceformation,PRAscannotcategoricallybeconsideredabsent fromthatprocess,as thepriceatwhichabuyerandsellercloseadealtodaymaywellbeinfluencedtosomeextentbythepricethataPRAreportedyesterday.2

Pricereportingisthusaninputintothepriceformationprocessforcrude,andthequalityofthisinputisofparamountimportance.IfPRAsprovideunbiasedinformationtobuyersandsellers,itwillhelpmarketactorsdiscovertherightpriceforatransaction.Butiftheinformationisbiasedinsomeway,theprocessofoilpriceformationislikelytoincorporatethatbias.Theefficiencyofpricesignals,inthesensethattheyreflecttheopportunitycostofthemarginaloilbarrel,wouldthereforedecrease.

5. PRAS IN THE REGULATORY SPOTLIGHT

TheroleofprominentPRAsintheoilmarket,suchasPlatts,Argus,andICIS,drewmoreattentioninlightofthevolatilityofcrudepricesin2008.Policymakers,regulatorsandanalystsalikewantedtoknowifthemethodologiesthePRAswereemployingweresoundenoughtoreflectwhatwasactuallytakingplaceinthephysicalmarket,andiftheywererobustenoughtofilteroutanyattemptsatmanipulation. In its2012reportPrinciples for Oil Price Reporting Agencies, IOSCOidentified“commonvulnerabilitiesthatcould,ifnotaddressedbyappropriatecontrolsandpolicies,resultinanassessedpricethatisanunreliableindicatorofthephysicaloilmarketvalueitisintendedtoreflect”.3IOSCOpointedtothepossibilitiesof“selectivereporting”and“opacityandvariationsinassessmentmethodologies”astherootcausesoftheperceivedvulnerabilities.

Asdiscussedintheroundtable,thoughPRAshaverecentlycomeundertheregulatorylens,relatedregulatorychangesshouldbeanalysedcarefully.Growingscrutinyand lengthening regulatoryreachmayleadsomedatasubmitterstobecomelesswillingtosharedataaboutoilpriceswithPRAs.Largemarketparticipantsmayconsiderprohibitingtheiremployeesfromtalkingtoanyoneaboutanytransaction,asthepathofsilencemaypresent fewerpotential legalentanglements.Ifnotproperlycrafted,efforts to regulatePRAsmight ironicallyengendergreater transparencysurroundingPRApracticesbut lesstransparencyregardingoilprices,asthePRAsmayreceivefewerinputsanddatapointswithwhichtowork.4

Discussantsattheroundtableunderscoredtheimportanceofregulatorsnotconflatingthegoalofgreatertransparency(whichimpliesshuttingdownavenuesforpotentialmarketmanipulation)withtheobjectiveoferadicatingmarketrisk.Whilethereisapparentconsensusamongpolicymakersthatmarkets should indeed be as transparent as possible, policymakers should bear inmindthattheavailabilityofmoreinformationcannotinandofitselfeliminatebuyer’sregretorseller’sremorse.Marketsbynaturecannotprovidefullcertaintytoparticipantsregardingoutcomes(even

2 The point was raised in the 2011 Joint Report cited in Footnote 1 that the Platts that the Platts eWindow may be characterised by some

experts as a trading platform, thereby service as an avenue for price discovery. The report recommended additional analysis to reach a

conclusion on the matter.

3 The G20 Leaders’ Cannes Summit Final Declaration (2011) states “Recognising the role of Price Reporting Agencies for the proper

functioning of oil markets, we ask IOSCO, in collaboration with the IEF, IEA and OPEC, to prepare recommendations to improve their

functioning and oversight to our Finance Ministers by mid-2012”; Principles for Oil Price Reporting Agencies, page 6.

4 This sentiment was also reflected in Point (viii) of the 2011 Joint Report, referenced in Annex I.

While some

characterise PRAs as

passive observers of

price formation, PRAs

cannot categorically

be considered absent

from that process

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with insurance andother hedging instruments to protect against risk), especially in a dynamicprocessofprice-discovery.

On the international level, a robust and sustained dialogue among regulators in differentjurisdictionscan facilitatecross-borderpolicycoordinationand toensure that the “rulesof thegame” are clear to the private sector. One example of this type of coordination is illustratedthroughtheG20-mandatedrecommendationsfromIOSCO.5IOSCOcontinuestoworkwithPRAsandinternationalorganisationsincludingtheIEA,IEF,andOPECtodeepenthediscourseamongnumerousstakeholdersandmarketactors.Nevertheless,generalconcernswereraisedregardingpossible“regulatoryoverlap”,whereinmultipleregulatorsmaysetdifferentpoliciesforasinglejurisdictionthatcouldcomplicatethefunctioningofmarkets.

6. “PAPER BARRELS” AND SPECULATION

Inaddition to thegrowingscrutinyof thePRAs, the roleplayedbyfinancialactors in thepriceformationofcrudehasgainedmuchattentioninrecentyears,andkeydifferencesbetweenthephysicalandfinancialmarketsforcrude(thelatterrepresentingtheso-called“paperbarrels”)areworthhighlighting.Thefinancialenergymarketsarebasedonthephysicalmarkets,asderivativesarefinancial instrumentsbuiltuponunderlyingenergyassets. In thefinancialorpapermarket,liquidityishighandthereisinprinciplenolimitorconstraintontradingvolumes,asparticipantscanbuyorsellanynumberofcontracts.Thephysicalmarketisinherentlylimitedbythesupplyofcrudeavailableforsale.Someperceivethatthephysicalmarketcanconstrainthefuturesorpapermarket,whileothersdonotseelimitsfromthephysicalmarketimposedonthefinancialmarket.Ifthefinancialmarketweretodisappeartomorrow,therewouldstillbeamarketpriceinthephysicalmarket.

Debates persist among market actors, academics and experts regarding the role that paperbarrelsplayintheprocessofpriceformation.Thedegreeofinfluencethatfinancialactorsexertinthemarkethavebeendiscussedatmanyroundtablesandfora.TheIEA,IEFandOPEChavetodateheld three jointworkshops focusedon the interactionsbetweenphysicalandfinancialmarketsforenergy.Participantsinthemostrecentjointworkshop,whichincludedabroadrangeofexperts,“expressedtheviewthatderivativesandphysicaltransactionsbothplayaroleinoilpricediscovery”.6Yetdespitethisfinding,broaderconsensusremainselusive,andtheimpactofpaperbarrelsonpriceformationremainsatopicofdebate.Forsome,thepaperbarrelsarenothingmorethananexpressionofthefinancialisationofenergymarkets;butforothers,theyclearlyinfluencecrudepricesandmoreover,arevehiclesforpotentiallymanipulativetrading.

Speculationhasbecomeabuzzwordusedtolaytheblamefor“excessive”oilpricevolatilityonfinancial investors,but speculation itself ismoreoften thannotpoorlydefined.7Marketactors’decisions regardingstorage levelsor theuseof financialhedgingmechanisms,bothpotentialtoolsinaprospectivespeculator’sarsenal,maywellbeguidedbycommercialorprecautionarymotives,notnecessarilybymanipulativeintent.Arefinerymighthavereasontoexpectasupplydisruptiontooccurinthenearfutureandthusmightbuycrudeforphysicalstoragetocompensate

5 The G20 Leaders’ Cannes Summit Final Declaration (2011).

6 Joint IEA-IEF-OPEC Report on the Workshop “Interactions between Physical and Financial Energy Markets”, held on 21 March 2013 in

Vienna; Page 4.

7 “The Role of Speculation in Oil Markets: What Have we Learned So Far?” by Bassam Fattouh, Lutz Kilian and Lahan Mahadeva (2012).

Debates persist

among market actors,

academics and

experts regarding the

role that paper barrels

play in the process of

price formation.

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foranexpectedlossinfeedstock,ortolockinapriceforfuturedeliveryusingfinancialmarkets.Somemightdefinethisactivityasspeculation.Othersmightlabelthatawisebusinessmoveinlightofon-goingmarketuncertainty.

Isiteasiertoidentify“excessive”speculation?Itwouldhavetobedrivenbynon-commercialandnon-precautionarymotivesforincreasingstorage,ofthetypethatismuchmorecloselylinkedtoeffortsatmarketmanipulation.Insuchacase,physicalcrudeinventorybuild-upwouldbelargeandevenobservable,regardlessofthenumberofpaperbarrelcontracts.Evenso,it ishardtodistinguishthemotivesbehindinventorybuild-up.Ananalyticallyusefuldefinitionof“excessive”inthiscontextiselusive,andisprimarilyinfluencedbyone’sperspective.

Despite concerns regardingpossible speculation, there are clear benefits associatedwith therelatively recent entranceof financial players in crude, andmorebroadly commoditymarkets.Perhapsthemostprominentamongthemisthattheyenhanceliquiditylevelsandhelphedgersfindcounterpartiesfortheirtrades.

7. REVISITING 2008: POLICY, DISRUPTIONS AND FINANCIAL MARKETS

Afterdiscussingtheprocessofpriceformation,theroundtableparticipantsshiftedtheconversationtothemuch-debated2008crudepriceshock,wherethebackendofthecrudeoilfuturescurve(up to fiveyearsout)demonstratedvolatility levels typically characteristicof the frontend.Forthemostpart,pricelevelsatthebackendofthecurvearedeterminedbythemarginalcostofproduction,whilelevelsatthefrontendaredrivenbyheadlines.Regardlessofwhichpartofthecurveoneanalyses fromthe2008-09period,onepoint isclear: therewasnosingle factor toexplainthepricevolatilityduringthatperiod.Thisrealisationshouldcomeaslittlesurprisegiventhecomplexnatureofoilmarkets.

Takingacloserlookatthe2008experienceandwhatitimpliesforthepriceformationprocess,onefundamentals-basedexplanationraisedattheroundtablepointstolegislationcoveringdieselfuelashavingplayedakeyroleintheoilpriceincrease.Priorto2008,EuropeanandUSpolicymakershadrequiredrefinerstolowerthesulphurcontentofdieselfuels.Thechallengethereinwasthatmostrefinerieslackedthecapacitytoproducethenewly-mandatedlowsulphurfuelsfromheavysourcrudes.Toproducethelowsulphurdiesel,therefineriessoughtlightsweetcrude(suchasWestTexasIntermediatecrude),whichtightenedthesupply-demandbalanceofWTIanddrovepriceshigher.Theoilindustryeventuallyrespondedbybuildingnew,sophisticatedrefineries,butittooktimeforthemtocomeonstream.

Demandsidedrivers thatmayhavefuelledtherise inconsumptionto2008includeeconomicgrowthinChina,whichwasapparentlystockpilingdieselfuelaheadofthe2008SummerOlympics.Moreover, strong demand for China’smanufactured goodsmeantmassive volumes of diesel-poweredtrucksmovinggoodsfromportstofactories,andthenbringingfinishedgoodsbacktoports.TheUStruckingfleetwasgoingstrongaswell,andadditionaldemandpressurecamefromlowUSinterestratesthatwerefuellingtherealestatemarket. Onthesupplyside,disruptionsinIraq,NigeriaandVenezuelathataffectedtheirabilitytobringmoreoiltothemarketplayedapartinsendingcrudepriceshigher.Atthesametime,productioncostsintheoilindustrywerehigherthaninpreviousyears(deep-wateroilwasthenewfrontierandtheunconventionalsrevolutionhadnotyetrealiseditspotential).Vocaladvocatesofthepeak

Regardless of which

part of the curve one

analyses from the

2008-09 period, one

point is clear: there

was no single factor

to explain the price

volatility during that

period.

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oiltheorymayhavealsoplayedapartinsupportingexpectationsofrestrictedsupplyinthefuture.

Insum,a“perfectstorm”seemstohavebeenbrewingin2008foroilprices.Thecombinationofdieselfuelpoliciesandlimitedrefinerycapacity,Chinesedemand,greaterpurchasesofChineseproductsdrivenbylowUSinterestrates,supplydisruptionsinimportantproducingcountries,thinspareproductioncapacity,higherproductioncostsandthebelief inthepeak-oiltheoryallmayhavecontributedtowardsfuellingtheriseincrudeoilpricesbymid-2008.Whentheeconomiccrisishitharder, itaddeduncertainty to these factors,causingashift inexpectations for futuredemandandoilpricesfelltowardstheendofthatyear.Oncetheseexpectationsstabilisedandsomegrowthresumed,pricesincreasedyetagainin2009,andhavedisplayedmuchlessvolatilitysincethen.

Someexpertsattheroundtablepositedthatfinancialactorslikewisecontributedtothisvolatility.ProponentsoftheroleofpaperbarrelsasdriversofmarketpricespointtothefactthatpensionfundsandotherassetmanagershadbeenencouragedtobuyoilasahedgeagainstaweakeningUSdollarandbecausetheyweresearchingforanon-correlatedassettobalancetheirportfolios.By one estimate, pension funds in OECD nations had around US$18 trillion in assets undermanagementpriortotherecentfinancialcrisis.Anallocationofjust5%ofthattotaltotheflatendofthecurvecouldhaveimpactedpricesindeed.

To this day, believers in the physical barrels or fundamentals-based explanation continue todebatetherootcauseofthe2008volatilitywiththosewhobelievepaperbarrelsplayedamajorrole.Themarket fundamentalssideof thedebateremainsscepticalabout the influencepaperbarrelsmayhavehadonthepriceofcrude.Afterall,purchasingfinancialinstrumentstiedtooilforfuturesaleisnotthesameasstoringbarrelsofoilinadrivetoraiseprices.Atightsupply-demandbalancemay be causedby demandoutpacing supply, not necessarily by inventory build. Butsinceadrasticrise,fall,andriseagainofoilpricestookplaceinarelativelyshortperiodoftime—withoutcorrespondingshiftsinshort-termfundamentalstoexplainthefullcycle—proponentsofthepaperbarrelsexplanationpointtoadifferentexplanation,oneinwhicheitherdrasticchangesinexpectationsormanipulativeintentplayedasignificantrole.

All in all, when assessing the oilmarket’s performance and transparency in 2008, roundtablediscussantsnotedthatthecrudepriceformationprocess—thoughnotperfect—appearstohavefunctionedbetterincomparisonwiththefarlargercreditandinterestratederivativesmarkets,asoilpricesexperiencedacorrectionlinkedtofundamentalsinashortertimespan.Moreover,thepriceoffinanciallytradedcommoditieswasrelativelylessvolatilethannon-financialisedcommodities.

8. GUIDANCE FOR POLICYMAKERS

Shiftingtheconversationfromwhathappenedtowhatpoliciesmighthavehelpedmitigate2008’sups and downs, the ideas discussed during the roundtable focused on transparency, taxes,infrastructure,andrulesonproprietarytrading,amongothers.

More andbetter quality dataon refinery capacities and inventories in selectedmarketsmighthave helped tomitigate the volatility by reducing uncertainty in themarket. Some roundtablediscussantsnotedthat inventoriesaround2008werenotconsideredtohavebeenparticularlytight, but this begs thequestion: inventoriesofwhich countries? Weremarket actorsprivy tocomprehensivestocksdatafromnon-OECDcountries?

Some roundtable

discussants noted

that inventories

around 2008 were

not considered to

have been particularly

tight, but this begs the

question: inventories

of which countries?

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Fiveyearsafterthepriceswingsof2008,expertsattheThirdIEA-IEF-OPECSymposiumonEnergyOutlooks (Riyadh,2013) focusedonthe importanceof inventoriesoutsideOECDcountriesandhighlightedthefollowingpoints,amongothers:

• TheroleofOECDstocksandtheirforwarddemandcoverisnolongeranadequatebarometerforoilmarketconditions;

• Theabsorptivecapacityofnon-OECDconsumingcountries,especiallyinAsia,isnowakeytounderstandingoilbalances;

• Non-OECDstocksareincreasinglyimportanttothemarketbecausetheyrepresentarisingshareoftheoverallstockvolumes.8

• TheJointOrganisationDataInitiative’snon-OECDcrudeandproductstockdatahasamajorroletoplayinresolvinginconsistentsupply-demandbalances;

Theabove-mentionedpointswerelikelyrelevanttosomedegreefiveyearsago,andtheideathatbetterstocksdata--notablyfornon-OECDcountries--mighthavemitigatedthe2008volatilityunderscorestheneedforpolicymakerstoredoubletheircommitmenttogreaterdatatransparency.

Policymakersshouldensurethattheyhaveacomprehensiveunderstandingofhowtoaddressandalleviatepotentialshortagesorbottlenecksofrefinedproducts,notablydiesel,gasolineandgasoil.

Taxesonvehicularfuelsindevelopedcountries,especiallyEurope,representasignificantportionofthepriceconsumerspayatthepump.Hightaxesmeanthatthefuelpricesobscuretherealvalueofoilandthecostsofproductiontotheconsumer,andthusinhibittheconveyanceofpricesignals.Subsidiestendtohavethesameeffectonpricesignals,plusadverseeffectsonconservationandclimatechange.

Fromthefinancialmarketsside,discussantssuggestedthathadtheVolckerRule9beeninplace,itmighthavetamedsomepartoftheexcessivevolatilityasproprietarytradingisperceivedbysometohavehadahandinthemarketswings.

9. ADDITIONAL THOUGHTS

Moreworkonunderstandingtheinteractionbetweenphysicalandfinancialmarketswillbeneededtobetterunderstandtheprocessthroughwhichpriceschangedsoabruptlyin2008.Apossiblesynthesisoftheargumentsunderdiscussionmightbebasedonthehypothesisthat,whilelong-termoilpricetrendsaredeterminedbyfundamentals—thefactorsthatmovephysicaldemandandsupply--short-termvariationsareinfluencedbybothcurrentfundamentalsandexpectationsofthefuturebalancebetweendemandandsupply.Expectationsmightthereforecausetheshort-termoilpricetodivergefromitslong-termtrenduntiltherealityofphysicalsupplyanddemandconditionsforces a correction that brings prices in line with fundamentals. Without a clearly developedeconomicmodelandthesupportofevidence,however,suchasynthesisissuggestiveratherthanconclusive.

8 Excerpts from presentations by David Knapp of Energy Intelligence and Joel Couse of Total.

Complete presentations available at www.ief.org

9 Broadly defined, the Volcker Rule is intended to restrict banking entities from engaging in proprietary trading.

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Other subjects thatwere raisedbutnotdiscussed indepthduring the roundtablebecauseoftimeconstraints,eventhoughtheyarelikelytoinfluencetheprocessofoilpriceformationinthecomingyears,includethefollowing:

• TheoutlookforUScrudeexportpolicyaftertherevolutioninunconventionaloilandgas,andimplicationsonglobalcompetitivedynamics;

• TheformulationoftaxpolicyinEurope;• Fossilfuelsubsidies;• Theriseofelectronictradinganditspotentialimpactsonoilmarkets.

Thesefactorsaffectsupply,demandandpricepatterns,bothcurrentandexpected.Understandinghowtheyinteractwithotherfactorswillhelptoenrichandenhanceourcollectiveunderstandingofoilpricemovements.

Participants in the IEF Thought-Leaders Roundtable on Price Formation included Christophe Barret, Stuart Brooks, John

Brunton, Peter Caddy, Aldo Flores-Quiroga, Lu Feng, Zack Henry, John Mathias, Jorge Montepeque, Yasser Mufti, Neelesh

Nerukar,Hans-WernerPolzin,SimonSmith,NamatAl-Soof,GlenSweetnam,andDongFanWang.

The insights presented in this document are for general reference on the diversity of perspectives expressed during the roundtable

discussion. They should not be interpreted as reflecting the participants’ consensus nor should they be taken to represent the specific views

of the organisations that hosted the event, of the individuals who participated in the event, nor their employers. The purpose of the document

is to inform and generate dialogue.

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10. ANNEX I: BACKGROUND INFORMATION ON PRAs

Excerpts from the “Oil Price Reporting Agencies Report” by IEA, IEF, OPEC and IOSCO, presented to G20 Finance Ministers in October 201110

i. PRAsareprivately-ownedpublishersandinformationproviderswhoreportoilpricestransactedinphysicalandsomederivativeoilmarkets,andgiveaninformedassessmentofoilpricelevelsatdistinctpointsintime,evenwhennoactualdealshavebeentransacted.AwidevarietyofmarketparticipantsrelyonPRApricereports,suchaslargeoilproducers,smallerindependentproducers,refiners,tradersandtaxationauthorities.

ii. BenchmarkoilpricesassessedbyPRAsareusedasreferencesforawidevarietyofpurposes,includingthesettlementofphysicaltrades,standardised,overthecounterandexchange-tradedderivativecontracts,thepriceindexationofnaturalgascontracts,andtaxreferenceprices.ThedealevidenceonwhichPRAsassessbenchmarkpricesisonlyatinyfractionoftheglobalpetroleumtrade.

iii. Some PRAs rely heavily on interviewswithmarket participants to gain insights into price levels and othertransaction-relatedinformation.ManyindustryparticipantsandgovernmentssupplementPRAserviceswithadditionalsourcesofinformation,includingshipcharteringinformation,tanker-trackinginformation,andproprietaryconsultants’reports.

iv. PRAsattempttominimisethepossibilitythatmarketparticipantsusefraudulentorothermanipulativeprocedurestoinfluenceprices.PRAsarguethattheirmethodologiesandtheirjudgmentsareintendedtoweedoutquestionabletransactions, trades thatarenot truly “arm’s length”,andbidsoroffers thatdonot legitimately representmarketprices.However,PRAsoftencanobserveonlyonepartofatransaction,sinceoffsettingtransactionsneednotbereportedtoPRAsandthereisnoobligationonmarketparticipantstosubmitallrelevantdealsforconsiderationbyaparticularPRA.

v. ThemethodologiesusedbythePRAsshowconsiderablevariation.ThemethodsofreportingdatarangefromthealmostentirelysubjectiveapproachadoptedbyICIS(basedonthefirst-handextensivetradingexperienceofitsreporters),tothealmostentirelymechanicalapproachofAPPI(basedondatasubmittedinwritingtoanaccountingfirmbyapaneloftraders).ThetwomostsignificantPRAsintheoilmarket,ArgusandPlatts,useacombinationofmechanisticanalysisandjudgment.

vi. PRAsopenlydescribetheirmethodologiesindetail.OnindividualdaysthedifferentmethodologiesusedbythevariousPRAscancausethepricereportedbyonePRAtodifferfromthatreportedbyanotherPRAforthesamecrudebenchmark.ThereisnoevidencetosuggestthatthereisaconsistentupwardordownwardbiasofanyonePRA’sreporteddatacomparedwithanother.

vii. Withregardtomarkettransparency,PRAsfillanimportantroleofcollecting,collating,editinganddisseminatinginformation.IntheabsenceofPRAs,marketparticipantswouldhavetorelyonalternativesourcesofinformation.

viii. In termsof regulatingPRAs,manymarketactorsconsulted inconjunctionwith thepreparationof theJointReportexpressedtheviewthatbadregulationisworsethannoregulationatall.

10 The full report is available here: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD364.pdf