3. Valuation and pricing
As we have seen, more than half of all commodities bought and sold around the world are not traded directly on the market, against an openly marked price. This is for two reasons. The first is that a lot of the trade is conducted within the same large business groups between related parties, as the jargon has it. The second is that many commodities are sold against benchmark prices, but with a premium or discount attached to them. The broader concept, then, which often determines price is valuation: how do related parties create a valuation which controls the price paid?
Because sub-soil resources are public goods in most of the world (with the notable exception of the United States), valuation often enters contractual terms between a producing company and a host government. Because trades with related parties will create a valuation that is liable to taxes, the primary contract will seek to determine what the rules are for such a valuation. It can do this with different degrees of specifity. Sometimes, for instance contractual language will simply state that a commodity must be priced by comparison with an “appropriate” basket of similar commodities. But other contracts actually provide precise formulae against a specific benchmark or benchmarks, and even a broader range of indices, such as the US consumer price index.
Key then is the use of benchmarks.
Oil - Global Market, Benchmarks
Although the spot market developed later in oil than in minerals, the volume of trade is so great that benchmarks in oil are the most significant and widely used of any commodity. Globally, three grades of crude have predominated: Brent, out of the North Sea, West Texas Intermediate in the United States, and Dubai Crude in the Middle East.
Each grade of crude oil has a couple of physical characteristics that make it more or less valuable: the first is how heavy or light it is on a scale established by the American Petroleum Institute. Every crude oil in the world has an API grade, and weight is quite literally what is being measured. With Brent, or other lighter grades, for example, there are normally 7.3 barrels to a tonne, whereas with a “heavier” grade might yield less than seven barrels per tonne. But the weight is also a proxy for what is called “the slate” - the balance of different end products which one kind of crude oil can produce in comparison with another. A light crude will produce more petrol, and feeder stock for plastics, while a heavier one will produce a lot more tar, and other lower grade products. A crude is also said to be either sweet or sour, which relates to the amount of sulphur in it - which has to be removed before it can be processed into usable end products.
The balance of crudes available to a particular refining market can mean that refineries optimise for particular grades. Which in turn means that although a light, sweet grade of crude will always be more valuable than a sour, heavy one, the differential may not always be stable.
And in fact, the differentials between Brent and WTI themselves have varied massively over the last 10 years, as the accompanying graph suggests, from periods where they were almost equal to others where they were $20 per barrel apart.
Benchmarks need to be revised from time to time to check they are still fit for purpose. For example, a crude oil that was once “thickly” traded may deplete over time until the number of trades decreases to a point where it can no longer provide reliable market data, since the fewer the trades, the more vulnerable trades are to being gamed. In 2013, Brent came under scrutiny after it was suggested there were so few trades that the benchmark was liable to manipulation in the trading window quoted by Platts energy news agency. These allegations were not proved, but came at a time when it had already been “diluted” by production in other North Sea fields - Forties, Oseberg and Ekofisk - after production in the Brent field itself had significantly declined.
Gas - Regional Markets, Benchmarks
Gas is radically different to oil in the sense that there is no global market because of transportation issues. Gas must either be piped, or cooled to minus 180 degrees centigrade so that it forms a liquid. But both options require prohibitively expensive - and vulnerable infrastructure. As a result there are effectively three regional markets with widely quoted prices: North America, Europe, and Asia. And as the graph above, derived from BP’s Statistical Review, there are massive differences, and these differences have grown in recent years. The regional markets have sharply diverged since shale gas was developed in the USA, driving prices down there, and forcing a separate price point for gas, whereas in Asia, at the other end of the spectrum, gas prices are still partly linked to oil prices - as all gas prices were historically.
Iron and steel
Iron ore prices were mostly fixed in closed meetings between producers and consumers - major steel manufacturers - until as recently as 2010. Although there was a spot price, it was typically higher than that of larger deals.
Gold and silver
Gold is perhaps the oldest commodity, and for a long time was the most transparently traded in its capacity as actual money. But in recent years there have been price fixing issues in the primary market known as the “gold fix” run between major banks. In 2014, the UK bank Barclays was fined for seeking to control the price of gold in this market to limit its own exposure in a derivatives deal. Even the World Gold Council, the representative body of leading producers, announced a study into whether the system should be reformed and in 2016 China announced it was setting its own gold fix. A similar fix system for silver dated back to the late nineteenth century but petered out in the 2000s.
Coal, like oil, is less fungible as a commodity than it appears. There is a vast difference in quality between browncoal, anthracite, and coking coal, and also the fact it is a bulk commodity means transportation costs are significant, which in turn can accentuate regional price differentials.
The availability of short-term physical supply is a key factor influencing trading, and this in turn is influenced by stocks of two kinds: strategic reserves held by or on behalf of governments, and commercial stocks held by companies.
The International Energy Agency was created as a kind of consumer answer to OPEC in the aftermath of the 1970s oil price crises and embargoes. Gathering in most of the world’s major oil consumers, member states committed to building strategic reservoirs of petroleum to cover at least 90 days of imports. So in the United States, government-held reserves are at about 730 million barrels, equivalent to three months of oil imports. All of the IEA’s 28 member states have fulfilled this requirement. Other countries have recently developed their own strategic reserves, notably China.
In addition there may be commercial stocks held in a commodity, by producers seeking to influence price, or to hedge against volatility. In the diamond trade, De Beers exercised monopolistic control for over a century with market share reaching almost 90% as late as the 1980s. Key to this control was the maintenance of a large stockpile of diamonds which allowed the company to keep prices on a continuous upward curve, but to force any independent sellers out of the market by flooding it if necessary. In the last quarter century that has been diluted by first Russia, and then new mines in Australia and Canada selling their output independently of De Beers.
In oil the amount of commercial storage also plays a significant role in determining price. Traders in New York regularly use overflights of huge storage tanks at Cushing Point, Oklahoma with resonance technology that can detect how empty or full the tanks are, and therefore how much short-term physical liquidity there is. The volume of pipelines in the United States also guarantees that at any one time there will be a significant amount of oil in flow between the upstream and midstream refining facilities. These features are also found on the European market, but to a lesser extent.