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
Exchange - and also off exchange, through bilateral over-the-counter (OTC)
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
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
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
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
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.
Chris Cook is a former director of the International Petroleum Exchange.
He is now a strategic market consultant, entrepreneur and commentator.