Platts Windows and Cash Settlements

Platts Windows and Cash Settlements

The “Platts window,” a metaphorical structure named after the influential provider of benchmark price assessments in various energy markets, consists of the final few minutes of trading, the period in the operation of an exchange when an aggressive player can have a big effect on the closing price.  A recent Wall Street Journal story focused on this window as it applies to the Singapore fuel oil market.

In the first quarter of 2016, one well-known trading house threw money at the close in Singapore with abandon. It bought 20.7 million barrels of fuel oil in Singapore’s Platt window for fuel oil prices. This, says the WSJ, was 44% of all the “window” buying that quarter and helps account for the fact that fuel oil prices in Singapore increased faster than those of either US traded crude or Brent crude. The increase was 7.5%, 3.5%, and 6.2% at those three locales.

The WSJ rather delicately suggested that the trader in question may be seeking an artificially high price in order to “benefit a separate position elsewhere” as in the derivatives world.  Yes, indeed it may.  Obviously anyone willing to do this takes a loss on the physical side, because it entails buying at a price higher than the commodity is worth.  The player has to be able to more than make up for that loss on the derivatives side to make the game worthwhile.

Cash versus Physical Settlement

The story raises the broader question of the distinctions among different sources of settlement, and how they may affect such a play.  Most futures contracts are settled by delivery of the commodity referenced. Still, some are settled by cash, and this is often done precisely in the hope of avoiding, or at least of complicating, market manipulation.  In 1995, for example, the International Petroleum Exchange [which of course has since become ICE Futures] claimed that the cash settlement of Brent crude oil futures “nearly eliminates the potential for squeezes.” The following year, the president of the Finnish Options Exchange said that the FOE had adopted cash settlement for paper pulp futures for the same reason, “the cornering element is not there.”

But that is less than the whole story. It is true that physical settlement plays readily into the conventional “squeeze” or “corner,” in which potential buyers of a commodity will have to buy it from the party who has cornered it, because at some point no other sellers at the relevant quantity or within the relevant time frame are available.  But it is cash settlement that plays most easily into the sort of arb strategy suggested by the WSJ story. For the simplest way for a trader to realize the derivatives gain that will compensate for the Platts-window purchasing is to ensure that it has entered into cash-settled swaps where the payoffs are determined by those Platts numbers.

Two Academic Views

Fifteen years ago, Craig Pirrong, in an article in The Journal of Business, made the case that cash settled contracts are more vulnerable to manipulation on the long side, and physically settled contracts are more vulnerable to manipulation to manipulation by the shorts. Thus, “an exchange’s contract choice for a given commodity depends on which problem is more acute.”

Later, Albert Kyle postulated what he called the “Modigliani-Miller Theorem of Cash Settlement.”  This was a formal proof that, given certain reasonable assumptions (assumptions less demanding than those that undergird the Black-Scholes theorem of option pricing, for example) it literally “does not matter whether a futures contract has cash settlement or physical delivery.” These are just “two different contract forms” which lead not only to the same pricing but to “precisely the same economic outcomes.”

 

 

 

 

 

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