Speculation? What speculation?
The French government’s report on “Oil Price Volatility” which appeared last month is a welcome blast against oil market speculation. It is questionable, though, whether its recommendations will have the desired effect.
The ‘Report on oil price volatility’, commissioned by the French Minister for the Economy, Christine Lagarde, and published last month by a working group chaired by Jean-Marie Chevalier, professor at the Paris Dauphine University and Director of the French Centre of the Geopolitics of Energy and Raw Materials (CGEMP) (see France declares war on oil speculators), is to be commended for the concerns it raises about oil price speculation. Its three basic suggestions – improving information flows through the International Energy Forum (IEF) and the Joint Oil Data Initiative (JODI), the development of a European oil strategy and much better regulation of financial market involvement – are, in theory, to be welcomed. The trouble is that they may not be very effective.
Excellent as are both the IEF and JODI initiatives, in which producing and consuming countries cooperate and exchange oil market data, it is not entirely obvious that more real numbers on stocks or production would really make much difference. After all, nobody took the slightest notice of the stock figures of the International Energy Agency in early 2008, when they were on their way to being the highest on record. Also, accurate figures are no guarantee of intelligent response. When in June 2009, the US Energy Information Administration announced that oil demand would be 1.8 million barrels lower in that year against 2008 for the second month running, oil futures prices rose substantially on the grounds that demand must have bottomed out! Counter-intuitive thinking seems to be the name of this game.
Equally, it is by no means obvious that a European strategy for oil supplies – apart from the risk of introducing a command economy – would make too much difference either. It would certainly be fun for reporters watching it created. Chevalier also criticised the oil price reporting services of Argus and Platts. That looks like shooting the messenger: if anybody is making any money from oil prices, it isn’t the Argus and Platts price reporters. A price reporter is a good thing to have been, preferably for as short a time as possible.
What about greater regulation of the paper barrel market? Well, a good start would be an end to the over-the-counter market, reduced anonymity and far greater transparency as to who is holding what, not least because it would give the professionals a good opportunity to point the finger and laugh. But if you really want oil futures to genuinely reflect the true demand for oil, somehow the paper barrel market has to be limited to those who actually trade in oil. This would not necessarily exclude big players like Goldman Sachs and others. It would however guarantee that those involved actually knew something about the fundamentals, or indeed something about oil. Whether this will ever happen? Don’t hold your breath.
Of course there are those who would argue that the fantastic oil price volatility of recent years is not a speculative bubble at all. Just days before the oil price started to come down from its height of $144 a barrel in July 2008 investment bank Merrill Lynch blissfully announced: ‘In our view, the fundamentals of supply and demand have been disrupted, resulting in a price hike of essential commodities including grains and energy. There is no link that establishes speculation has contributed to the exorbitant rise in commodities prices.’
What a surprise then that three months later the masters of the universe at Merrill announced a $7.9 billion exposure to bad debt and forecast that oil prices would drop as low as $25 a barrel in 2009!
Wagging the dog
There is, in fact, overwhelming evidence that the ‘oil paper barrel market’, at roughly 35 times the physical barrel market, is greatly increasing price volatility. A tail, designed to stabilise future prices for operations like airlines, is now wagging the dog to such an extent that those with a legitimate reason for hedging, like those airlines, are now pulling out of the system.
Consider the events of 2008. Over that year oil consumption fell by 0.6% or 420,000 barrels per day (bd) – the biggest fall since 1982. US oil demand was falling by at least as much as that of China was rising and that rise was rapidly slowing down. Opec meanwhile increased production, early in the year and there was no shortage of refinery capacity; in fact it was growing. Commercial stocks as defined by the OECD in March 2008 were around 2.5 billion barrels, or near the top of the entire range since 2003. And what happened? Well, the crude price went to a staggering $144 a barrel in July 2008.
It could be argued of course that only halfway through the year did we realise that the down-turn in the economy would have an effect on oil demand, and a sudden burst of neural brain activity in that one week in July told us to shout: “Sell!”
Well sorry. The world recession was stomping towards us like a rogue elephant from early 2007. New Century Financial, the US’s largest sub-prime lender, went dramatically bust that April. Bear Stearns warned that two of its hedge funds had gone belly-up in July 2007. At the time, the Chairman of the Federal Reserve, Ben Bernanke, warned that the US sub-prime disaster would cost at least $100 billion. In August, the European Central Bank poured €95 billion into the banking system and then – finger in the dyke – added a further €108 billion a few days later.
Oil was still soaring upwards when the Federal Reserve was offering further billions at the end of the year. It continued upward in April 2008 as the IMF announced that the credit crunch would cost the world economy over $1 trillion. Meanwhile, the US Commodity Futures Trading Commission (CFTC) revealed that one unnamed NYMEX participant had crude futures contracts amounting to 460 million barrels, or around five and a half times global daily production just before the price collapse.
Needless to say, the price collapse did show up a few things. The SemGroup LP, an energy ‘specialist’. announced $3.2 billion in losses. This was blamed on “unauthorised speculative oil trading” by the chief executive officer. Rather plaintively, they explained that the man had not concentrated his positions on just one month, but in several, all of them unhappily in deep doo-doo. Needless to say, the word ‘speculative’ is always twinned with unauthorised’ when the mistakes are exposed. When it works it is not speculation; when it doesn’t it is ‘unauthorised’.
Movers and shakers
But is there any obvious explanation for the failure of the paper barrel community to realise that real crude oil demand was beginning to fall as early as late-2007 and that, as they waited on the tracks, there was a train coming?
Unhappily there is. From around 2004 onwards, the upper echelons of the international banking community had been preoccupied with the lucrative business of securitising debts: bundling them up, selling them on, sharing them out and paying themselves high fees for doing so. In theory this was a mechanism for distributing risk, but since the actual and individual risks were getting progressively buried ever deeper in the paperwork, increasingly nobody knew what they were.
Around early 2006, it began to occur to some of these movers and shakers of this particular and peculiar business that these collateralized debt obligations (CDOs) – particularly those in the mortgage market – contained a considerable of quantity of ordure. Equally, the process of piling up small quantities of ordure into ever-larger quantities of ordure, did not magically transmute the stuff into gold.
By 2007, many in the market realised the danger and began to pull out. The CDO market peaked in 2006 at $520 billion and than began to fall to only $61.9 billion in 2008.
However if there is a golden rule in this community, it is that you cannot stand still. Year on year the investment results have to go higher. If it was the case that the sub-prime mortgage business was shot, there needed to be an alternative place to put the money. And what better place to put it than in commodities? After all, we all know that “peak oil” is just around the corner, don’t we? OK, it may not be quite going to happen next week, but the long-term outlook is pretty bullish for oil, isn’t it?
Similarly, the community comforted itself with the old salesman’s hope about China: what if they all buy one? The idea that demand growth in China might be offset by the discovery that US and European demand might have reached a plateau was a bit too sophisticated. And at least oil and copper had a slightly more solid feel to them than a package of un-performing mortgages.
Yet if it was the commodity “oil” the financial community wanted for their new portfolios, this did not mean they wanted to store the sticky stuff. Even if physical spot trading and buying tanker loads was a possibility, it was clearly easier to enter the futures market, where you owned oil apparently, but did not actually have to handle it, smell it or look after it in anyway. It was a “virtual” world of oil. As a result, whereas the volume of general futures contracts on the NYMEX rose by a mere 27.3% between January and October 2007 compared to the same period of the previous year, the volume in oil futures increased by 79%.
The good thing about the paper barrel market, is that it is infinitely expandable. There is never a physical shortage. And you don’t have to dirty those Gucci shoes in the unpleasant business of digging the stuff up. You don’t even need storage capacity. All you need is some other sucker to come along and sit at the poker table. Hence, of course, the simple idea that this market hurts nobody but its participants. The players stub out their cigars, swill down their brandy and sweep up their chips, ready to start another session on the following day, with the market cleared.
This would, naturally, be true if the participants were merely gathered around the table betting on whether it will be raining outside at 2.00 pm precisely next Thursday. The problem for the financial community is that few investors would be happy with putting their money in “rainfall futures”. It smacks too much of – perish the thought – gambling. The futures market needs the legitimacy of being actually attached to something physical to reassure the investor that he is in fact investing in something.
The paper barrel market thus needs the physical market. And it probably needs the physical market considerably more than the physical market needs it. After all, the paper market was created – perfectly legitimately – to give oil users the opportunity to hedge against abrupt price increases that would affect their ability to operate and make a profit. However, are we now saying that those physical users are so addicted to hedging against price increases that they need to hold positions equivalent to 35 times the total global consumption of oil? Perhaps everybody should start to hedge against the price of gasoline at the local pump. It might just justify this statistic.
Big dirty pond
The defence that the paper barrel market does no harm because it does not affect the ‘real’ price of crude is absurd for a number of reasons. If it does not affect the real price of crude then what on earth is it for? Then, the argument that the global oil market is too big to be manipulated is simply untrue.
For a start, the oil market is not just one big dirty pond, where one crude is just like another. According to Energy Intelligence’s Oil Industry Handbook, there are some 160-odd types of crude. At a variety of different API and different characteristics, it is simply not the case that these individual crudes can be put into any old refinery anywhere. While most refineries have some flexibility, processing – for example – most heavier crudes is a specialised job.
In addition, over 50% of these crudes are traded on long-term contracts with a nod towards current physical spot deals for pricing adjustment. Most Middle Eastern oil is traded on such contracts. Many other producers sell on contract to traders, who in turn sell spot.
In fact, a considerable part of the 82 mbd (million barrels per day) of oil produced actually does not come on the international market at all, but is used by national oil companies (NICs), or indeed by the majors for their own needs. A rough estimate would suggest that only around 40 mbd is actually exported into the global market.
The net result is that the oil market that is subject to trading is much smaller than if first appears. It is halved by the internal needs of the producers and then halved again by the contract market. It is also further reduced by the physical problem of matching merchant refiners with the crude they can actually process. The spot market that creates the marginal price is consequently not the totality of the market, but much smaller. The point where this physical spot market impinges on the futures market is even smaller still.
Take for example the people who genuinely need to hedge against price increases for large amounts of crude; independent merchant refiners for example. Such people, who buy in the physical spot markets, do need to project their prices forward into the future. Should his traders end up with unexpectedly expensive crude for, say 50,000 barrels, the refiner’s hedging positions will, at minimum, compensate him financially for the increase in price, or at maximum and, probably unexpectedly, deliver compatible quantities of the real thing.
(Physical delivery is extremely rare, estimated in 2002 at about 5%, but probably much lower now. This is obviously something of a blessing for all those involved. Apart from dirtying their shoes, anyone holding paper barrels worth about four times the world’s daily oil production would obviously have a pretty hard time if somebody demanded the physical letter of the contract!)
Prior to the invasion of the paper barrel market by those looking for a place to put their money as the sub-prime market appeared ever more risky, our refiner’s 50,000 barrels would have indicated a relatively small pricing blip on the scheme of things for the professional oil watchers. Sure enough, the price reporters would have reported that the futures market was in ‘contango’ or ‘backwardisation’ meaning that prices looked like going higher or lower next month.
However as the invasion of paper barrels proceeded, the refiner’s hedge started to gain the status of holy writ, amplified into the equivalent of a major event, say a social upheaval in Nigeria. Besides, with more and more money piling into the market, the new entrants found it more and more difficult to find anybody with real knowledge of the physical spot market who wanted to hedge. These people became extremely rare. In effect the market grew ever larger on the basis that the financial community was dealing more and more with itself. As more money floated in, so the price rose since nobody was going to enter the market betting on a much lower price and there were less and less ‘real’ hedgers to tell them what was really happening. Market ‘sentiment’ took off.
The result was an oil price roughly double what it should have been with regard to the fundamentals and that was bound to collapse. In defence of those stuck in front of computer screens all day, it has to be said that it is very difficult to stop a party when it is at full steam. The City of London and New York is now littered with people who say they saw the general crash coming, but were reluctant to say so, not least because they wanted a few more days to correct their positions and in any case felt powerless to do anything about it. With credit freely available and screens saying ‘contango’ far into the future, it was mighty difficult to stop.
So why don’t the oil majors in particular complain about the antics of the paper market? They don’t because they actually operate in the real world. If the world is prepared to believe that the oil price really is $144 a barrel then bully for them! Let’s get down to the pump and widen our refinery margins by jacking up the price of gasoline. Speculation? What speculation?
In the end the consumer pays the bill. Still, as the paper barrel market distorts the price signals in the real market, oil companies are hurt too: not only are they faced with rising costs, they are also finding it increasingly difficult to make rational investment decisions.
As John Kemp of Thomson-Reuters has written: “Excessive volatility undermines the function of price signals by making it harder for producers and consumers to differentiate real long-term signals from the mass of short-term movements (noise). It imposes real costs in terms of resource misallocation when producers and consumers get it wrong and these costs are not trivial.”
It will be very interesting to see what the international community – for example the world’s energy ministers meeting in Cancun, Mexico under the auspices of the IEF at the end of this month – is able and willing to do to tackle the problem.
|Chris Cragg is commentator and energy editor of European Energy Review. See also his article “Regulating Energy Futures”, which appeared in the August 2009 edition of Platt’s Energy Economist (no. 334).|