Price Discovery, or Modelling?

Paul Hardy. Image Credit: NSI

"Price discovery is the overall process, whether explicit or inferred, of setting the spot price or the proper price of an asset, security, commodity, or currency. The process of price discovery looks at a number of tangible and intangible factors, including supply and demand, investor risk attitudes, and the overall economic and geopolitical environment. Simply put, it is where a buyer and a seller agree on a price and a transaction occurs."

Price modelling is a wholly different function whereby, through algorithms and suppositions, the company tries to estimate where the market should be. The problem comes when modelling pretends to be discovery.

It can lead to wrong business decisions and wrong assumptions as to the performance of a particular buyer. The spot market of any commodity is based on a number of factors, including:

1. Location
2. Availability of logistics
3. Economies of scale
4. Notice period
5. Quality
6. Market trend
7. Macro-economic factors
8. Competitor pricing
9. Arbitrage between ports
10. Whether the supplier is long or short on product
11. Route to market

This is why price modelling is notoriously hard to get accurate.

This year has seen the rise of a number of companies offering price modelling and benchmarking via digitalised platforms. The premise seems to be to make the market transparent and to report accurately on it. These aims are perfectly in line with what we see as brokers. The efficacy of these platforms will depend on how accurate the modelling is.

There does seem to be a certain amount of muddying of the water where price modelling masquerades as discovery. Price discovery is labour intensive and requires a significant amount of trust in the people who deliver it. It involves the gathering of specific market prices from real suppliers taking into account the channel in which the business is worked e.g. there is a different price whether buying direct from the supplier or via an intermediary.

The easy way to judge whether the platform is using modelling or discovery is to assess how much resource is being devoted to the gathering of prices. Secondly, what is the 'real world' experience of those gathering the prices? Are those companies in the market and fixing business? Lastly, are the claims 'too good to be true'? It is then simple to judge where and if the lines have been blurred.

When modelling poses as discovery it throws in a number of challenges. Primarily, the buyer faces the possibility of being benchmarked against an increasing number of imperfect indexes. From our side the buyer and the management need accurate data and need to buy 'on the market', not below or above a fictitious model.

The solution to the problem is greater trust between the counterparties and a transparent way of working. If you can see the prices of all the available channels in the market and monitor over the course of the enquiry how those prices have evolved you can be sure you are achieving price discovery. This may sound as if I am espousing self-benchmarking. Far from it, I would encourage all of our owners to use various indexes as they see fit. What I am saying though, is you cannot create your own benchmark of modelled prices and then assess your own performance against the price you set. I am not a betting man but will wager you will end up performing well against your own artificially set benchmark.

Someone said to me the other day: "The numbers don't lie, it comes down to who presents them." Those of you doing the job on a daily basis know 'discovery' whether you are a buyer, broker, trader or supplier. It then comes down to how transparent and open you choose to be with the reporting of the market or what margin you want to make.