By Chris Cook
As crude oil prices climbed back over US$80.00 per barrel during 2009 - after the dramatic spike to $147 and subsequent collapse to $35 - United States politicians and regulators were in no doubt as to who to blame.
They accused "speculators" such as exchange traded funds (ETFs) and hedge funds of manipulating oil prices through the use of futures and options contracts on the dominant exchanges - the New York Mercantile Exchange and the Intercontinental Exchange - and also off exchange, through bilateral over-the-counter (OTC) contracts.
But the truth lies elsewhere.
Introducing oil leasing
In 2005, Shell had a brainwave. It agreed with ETF Securities - a provider of exchange traded funds - that a new oil fund could invest directly in Shell's oil production. Whereas most ETFs that are exposed to the oil price use the oil futures markets, this initiative cut out the middlemen and all of the costs associated with maintaining a position in a futures market over time.
The outcome was that Shell borrowed dollars from the fund, while the fund borrowed, or leased, oil from Shell through forward sale agreements or otherwise. Everything was, and remains, above board and relatively transparent; but this innovative form of financial oil leasing appears to have been turned to other uses by other market participants.
Simply stated, producers have an interest in high prices. Cartels of producers have therefore often been created to openly manipulate prices by artificially supporting them. A classic example was the International Tin Council, which supported the tin price by buying tin - and stockpiling it - if and when the price fell to its "floor" price. Unfortunately, the high prices stimulated new production; eventually the ITC ran out of money; and the tin price collapsed in 1985.
In the late 1980s and early 1990s, Yasuo Hamanaka, a Japanese copper trader acting for Sumitomo Corporation, successfully manipulated the copper market not only for five years before someone blew the whistle, but even for another five years afterwards. The mechanism used was for investment banks to lend dollars to Sumitomo, which in return loaned copper through forward sales on the London Metal Exchange.
The only way to manipulate commodity prices is through the ability to secure supply. In the oil markets, funds, whether ETFs or hedge funds, are categorically unable to make or take delivery of the underlying commodity, and are therefore unable to manipulate the price. It is only "end user" producers and distributors, or the few traders with the capability to make and take delivery, who are in a position to manipulate oil prices, and in order to do so they require funding, or leverage.
I believe that it is macro manipulation by oil producers, funded by cheap money from investors, which has been the principal reason for recent movements in the oil price. The advantage producers have over oil traders is that producers are able to store their oil in the ground for free.
The Brent complex
More than 60% of global oil production is priced against the price of the United Kingdom's North Sea Brent, Forties, Oseberg, Ekofisk (BFOE) quality crude oil. Most of the rest is priced against the US West Texas Intermediate (WTI) price, but in the past 10 years, the WTI price has increasingly become the tail on the BFOE dog through "arbitrage" trading.
In order to support the global oil price, it would be necessary to secure supply through acquiring sufficient amounts of BFOE crude oil lifted each month. By the standards of the relatively few major market participants involved in the market, this is easily achievable if the funding is available.
As the credit crunch unfolded from late 2007, fund money began to pour into existing and new ETFs.
The zero bound
As short-term dollar interest rates fell to zero - "the zero bound" - investors switched their dollars into other assets, and particularly commodities, which also carry zero income, but which at least have intrinsic value, unlike the dollar or indeed any other "fiat" currency. We therefore saw simultaneous spikes in the oil markets, agricultural markets and metals markets - spikes that had nothing whatever to do with underlying supply and demand.
These rises in price continued until the destruction of demand created surpluses beyond global storage capacity, and prices thereupon collapsed as the bubble of leverage funded by investors deflated. The oil price collapsed to about $35 per barrel, and since short-term interest rates remained at 0%, the conditions were ripe for a repeat.
Banking on oil
What follows is necessarily speculative in the absence of hard evidence, but in my opinion, the 2008 "spike" was driven by one or more major commercial oil producers leasing and hence monetizing oil stored in the ground to one or more investment banks. In return, the banks collected and deployed fund money through opaque structured finance products or otherwise. Liberal helpings of hype in relation to oil shortages helped to inflate and support the market price.
In the course of a two-hour meeting in London in 2004, Kazempour Ardebili - who by then had been the Iranian representative at the Organization of the Petroleum Exporting Countries (OPEC) for some 18 years - explained that for almost all of that time he had been advocating an OPEC bank and an OPEC investment institution, but that this had never found favor with the Saudis.
Moreover, he looked back with nostalgia on the long periods of stability that pre-dated the development of the current market pricing structure. He pointed out that while high oil prices were in producers' interests, wild price swings destroyed Iran's ability to budget and invest.
The oil market in 2009 saw a rapid re-inflation from $35 to around $70 per barrel and the price has for several months been relatively stable within a range of $75 to $85. Commentators have suggested that perhaps $50 of that price is accounted for by supply and demand, while the balance is purely financially related.
It appears to me that Saudi Arabia - its participation is essential - could currently be playing the role of a central bank whose currency is crude oil, backed by the country's reserves of crude oil in the ground. Through extremely opaque market interventions by investment banking intermediaries, they could lend oil to the market - financial oil leasing - against dollar loans from investors in oil, and buy back their forward sales of crude oil in order to support the oil price within their chosen parameters.
The outcome - which has the effect of monetizing oil in the ground - is very similar to the way in which some governments maintain their currency more or less pegged to the US dollar and illustrates the reality that oil is not priced in dollars: dollars are priced in oil.
Whether or not it is in fact, as I suspect, macro manipulation by producers that accounts for movements in the prices of crude oil and oil products, and the flows and storage of crude oil and oil products, is a judgement I must leave to expert traders. But I am absolutely certain that the "speculator" investors blamed by US politicians and public for the movements in oil prices are not in fact responsible.
The oil market has been swinging dramatically between a lower boundary price, where an excess of supply means that, in a "buyer's market", sellers compete for sales, and the upper boundary of a "seller's market" price, where demand destruction kicks in.
According to an OPEC spokesman, the current market price is "perfect". If it is the case that the price is being financially supported at the "upper bound" within tighter pricing levels, then this is a fundamentally unstable position, where increasing supply of crude oil, or falling demand for products, would lead to a collapse - due to de-leveraging - similar to that in the tin market in 1985, and indeed, of the 2008 spike.
Although the interests of consumers and producers diverge in terms of price levels - with many in the US still convinced it is their oil that is under the Saudi desert - both have an interest in price stability. That is not the case for trading intermediaries - the middlemen - and particularly not for the investment banks that thrive on volatility and opacity, and for whom the only bad news is no news at all.
So, like a roll-on, roll-off ferry sailing in calm waters with water swilling about the car deck, I believe that the oil market will continue in a state of unstable equilibrium until it hits the next wave - which could be at any time - and the ferry overturns.
The current market architecture is fundamentally dysfunctional, and in my view a new settlement is both possible, and long overdue.