Igor Ossipov, Casing Point13 september
Who Governs Global Oil Prices?
If we agree that diamonds, malachite and tantalite are a curse for D.R. Congo, then oil must be the penultimate stained Holy Grail of the entire world. It aids Middle Eastern dictators in their bids to be the last man on their thrones, causes thirsty states to indulge in most sinful actions, pushes profit-driven corporations to exploit an entire array of stakeholders and entices individuals towards corruption beyond all forms of humanity just so they attain a small nugget of this black gold. A successful gamble on the virtual roulette can grant ecstasy to a lucky few, but potentially cause misery for millions, as shifts in oil prices can adjudge the fate of an entire nation, as the invisible hand ushers across the modern oil bazaar. In all, in this post we explore the major question of the 20th and 21st century – “who manipulates the global oil prices?”
As now customary for ‘Casing Point’, my first few paragraphs will be a personal note and gratitude to those that assisted me in developing these ideas. In this post, I will be using some of the standpoints highlighted at this year’s IMEMO RAN event; the “Oil & Gas Dialogue” (26/04/13). As usual, I will offer additional links to expand our discussion. It is almost a cliché, but once again this topic is contested in academic literature, so I am sure we will not all agree on a same route, but even a directionless journey can be exciting!
I will be making a particularly strong emphasis on recent research by Prof. Andrey A. Konoplyanik, who in his book outlines the 'five stages' of oil market evolution. Now, these are quite arbitrary as an array of different time spans can be selected, but what makes his research standout is its inclusion of "transitional periods", which outline when the oil market transcended through its various stages. A less inclusive, yet still noteworthy analysis is by Prof. Yakov M. Mirkin; he only highlights three stages, but he outlines two factors behind shifts in oil prices. He sees the key reason being “fundamental factors”, but occasionally short-term “financial factors” also edge the market. For instance, just a couple of days ago we witnessed a financial factor in action, as China published its results for production output, for the past year. The results were better than anticipated (BBC, 2013), so it would have raised market moral and oil prices, as China is a major oil consumer and such “industrial production index” plays a major role as a financial factor. Moreover, this positive statistic would not only improve the Chinese economic performance, but also global GDP, which additionally raises investor confidence. I also took the liberty to translate Prof. Vitaly V. Bushuev’s chart into a more accessible English version (click here for my web-hosted diagram); please do have a look, so you could follow these shifts for yourself. Lastly, I am including a few technical pricing terms, if you are having difficulties with them, please feel free to leave a comment or just share your own thoughts!
Oil production is a millenniums old affair, possibly starting in China, but it is hard to say with certainty. However, the first stage of the oil market evolution occurred a great deal later from around 1928 to 1947. As one would expect, it was an uncompetitive physical type of market. It was dominated by seven oil majors, or the 'seven sisters', who reflected the global power balance – with USA and still Great Britain dominating this list. Today, many of the top Western oil companies draw their roots from these original siblings. In addition, oil contracts were then long-term, in the region of 25+ years, as it granted security for expensive investments, which required a lot of time to see returns. Essentially, prices evolved around a single-base structure, which meant they were relatively equal globally, quite consistent and the pricing mechanism used was cost-plus. Still, by 1947 to 1949 we experienced the first transitional period with prices splitting into two regions, while the neutral point of sale moved from Malta to New York, as US hegemonic prowess pushed on, alongside numerous other economic and political reasons.
The second stage occurred from 1947 to 1969, during this period the market was still uncompetitive and naturally there were elements of unfair pricing; as sisters still clinched the market tightly. At this stage, prices continued to be formulated by a cost-plus system for crude and now net-back for other petroleum products. Again, the seven sisters preferred long-term contracts and also used modern concessional tools to account for socio-economic factors. But, in 1969 to 1973 a major transitional period occurred as these majors started to negotiate with the OPEC alliance or 'cartel', with prices being linked evermore to national goals. Also, the two-regional system of the first stage remained, as prices depended on whether crude oil passed via the Gulf of Mexico or the Persian Gulf. In other words, the point of sale was vital.
In the third stage, we see the golden age of OPEC, from around 1973 to 1985. At first, the market was incredibly uncompetitive with renowned oil shocks, but with time this still physical market began to shift towards its now relatively competitive features. We saw pricing shift towards shorter contracts and then physical spot markets emerged, also OPEC started dealing via officially listed prices. It used the net-forward pricing mechanism and spot prices in case of immediate contracts. At that stage the invisible hand pounded its fist on the global crude market, leading to demand/supply evermore taking precedent in how prices are formed. In regards to the seven sisters, their muscle diminished as time passed and they were restructured at the end of the third stage. This was a big global reshuffle as during the 1960s these powerhouses sold around 85% of the global crude oil – much more than modern OPEC at around 40%. Again, the third stage was followed by a transitional period of 1985 to 1986, as Saudi Arabia pushed for the net-back mechanism across not only petroleum products, but also crude oil. Saudis also began to reject officially manipulated prices by OPEC. We essentially see how net-forward is rejected in favour of net-back and crude oil is for the first time linked to NYMEX exchange (New York, USA). Also, in 1986 oil futures come into play, as global exchanges begin trading specifically in oil with specialised units.
In the fourth stage from 1986 till about 2004 physical crude oil trade is established fully and paper traded crude oil formulates to a mature extent. In essence, crude oil is commoditized. Prices are determined on stock-exchanges on specialised trading floors [oil exchanges]. In an unprecedented fashion physical producers no longer wield the ultimate control over the market; it is now the oil hedges who manipulate prices and market behaviour with vast currency reserves. Now, prices are determined via net-back which is based on futures, and financial banking/trading mirrors the oil exchange. The reason for this rests on the fact that financial personal and investment bankers moved into oil; under their expertise the market takes new shape. Unfortunately, this also leads to investments going towards the paper market, which creates a major lack of real investment into physical production. If we recall, 2000s see major price rises as natural production halts. At this point demand/supply make the ball roll, but it is heavily correlated with expectations of brokerage players.
The current fifth stage takes place somewhere between 2004 and today, with both the physical and paper oil markets being near full competitiveness. A monumental shift of commodization is replaced with financialisation, as sheer volumes of trade of virtual oil shadows the relatively minor physical production. At this point, globalization takes full swing as IT technologies and newly fashioned financial products enlarge crude oil from a resource based material to a global financial asset, which is available on tap for a wide range of professional, but also unfortunately to less professional investors. To apply a bit of slang and a technical term, as the Dyson Hoover commercial goes there is 'no loss of suction' as the “vacuum cleaner effect” draws everyone in. Today, oil is a financial structure, although a relatively small one in comparison to other financial products. Still, this does not mean it is less appealing, as many view it as being a real hit; if it was a record it would have collected numerous platinum records. Yes, real events and capacity still influence the oil market, but speculators provide a limitless spur of liquidity. We see even ports, which are key selling points, linking their prices to oil based on futures and demand for oil is based on derivatives/net-back. If we break down oil pricing structures we see that physical producers and their decision making only adds a fraction to the end value of crude, as another fraction is added by in house specialised oil speculators and then by less specialised financial institutions or global investors who are not part of the oil industry per se, but need a safe harbour to rip the benefits of their vast liquid assets. I would describe this situation as a rainbow-effect as rising liquidity in the global economy was followed by rising oil prices and it all crashed in 2007-2008 financial implosion with steep fall in prices for oil the next few years. As markets snail towards recovery, we see prices slowly increase.
The most traditional superpower in oil is undisputedly Saudi Arabia, with its physical market still dominating to a big extent. It also wields substantial power in OPEC, so it can use this cartel for its own means to a reasonable degree. We even have a very ambiguous 'fair price' policy set by the Saudis, whereby essentially oil is priced at a level that allows this behemoth to break-even financially. As Saudi Arabia relies quite heavily on oil for its budget, we typically need around $90-100 per barrel for prices to be deemed fair. As anyone knows, who may have stumbled across a business section of any media outlet, reserve levels and production capacity of Saudi Arabia/OPEC, play a big role in global oil prices. This 'fairness element' is an interesting one, as it is in fact a double-edge sword, if it prices oil too highly by lowering production [which is not instantaneous, as markets must firstly adjust], it also leads to alternatives being more appealing. It would be wrong to suggest that emergence of USA shale oil boom was due to Saudi Arabia/OPEC pricing policy, as it was more to do with speculation, but still, as prices increased to all time highs US local producers decided to jump on the bandwagon. I doubt that the US will be able to overtake Saudi Arabia and Russia as some reports argue by 2017-2020, but potentially we could see this giant becoming a physical superpower, as well as being a virtual one, as the next paragraph will discuss.
USA, as the centre of virtual paper market influences prices substantially, as volumes of financially traded oil exceed physically produced units. As we see, derivatives are a major element, as well as the capacity of liquidity in the US and inevitably the global dollar economy (which changes if the FED alters its monetary policy – for example, it is now considering ending its quantitative easing policy by around 2014). Also, other financial factors play a role, for instance the recycling of foreign exchange surpluses; the historic example is the one from 1973 when Richard Nixon cancelled control over capital flows to make recycling of the US dollar easier, but several years later a major oil shock occurred following monetary instability even before financialisation of oil took place. However, the most clear cut example of changes within financial rules or perhaps their absence is the cancelation of the infamous Glass-Steagall Act (1999). In hindsight, this was a monumental mistake by President Clinton, as its cancelation now made it legal for financial and investment banks to emerge. Naturally, speculation has thrived and liquidity ploughed into virtual oil markets. I recommend reading the book by Philip Arestis, who I had the pleasure of meeting, to understand quite the extent of this suicidal move. To add more salt to an open wound, oil specific legislation like the Commodities Futures Modernization Act resulted in lowered controls over oil futures. Moreover, in typical fashion of regulatory capture by vast lobbying, the 'vanguard' of oil markets, the Commodity Futures Trading Commission, lowered its oversight over oil major’s operations. What does the world hold in stall for us? I guess we will have to see how the 2010s Dodd-Frank Act, which came into force in 2011, performs and if it mitigates the emerged problems. Still, on the bright-side, we only have to wait for 7-10 years, as that is about how long a typical recession takes to roll-in!
USSR had a very modest impact during the first three stages of the evolutionary track, as it was a 'price taker', rather than a 'price maker'. An entire range of reasons were behind this and some of them mirror insofar as modern Russia. A major factor was its geographical location, as it was too far from the centres of oil consumption at the time and many of the major customers did not fall within geopolitically acceptable lines of this power. However, the main reason for USSR and now Russia being a price taker is the fact that neither wielded reserve capacity. Hence, it could not lower or increase its production to influence global prices, even if it produces sufficient amount out of the total global production. Moreover, USSR’s absent and Russia’s still underdeveloped financial mechanisms do not allow for a similar position that is held by the US, as the virtual oil superpower. As Vaitheeswaran (2007) puts it, Russia has been then and is now a “free rider, pumping without restraint in order to take advantage of the high prices”, but this leaves no room to manoeuvre, nor could it as it holds relatively minor amount of global oil reserves – which are depleting quickly.
Russia may have emerged from the ashes of USSR, but it was far from a Phoenix as during 4-5 stages it once again had little sway – obviously Russia makes the most oil in the world, occasionally swapping places with Saudi Arabia for the top branch, but the Saudis wield OPEC which allows them to work more or less as a unit. In a way the situation has worsened as during the 1-3 stages oil markets were undeveloped, so being a price-taker still gave time to catch up, now the mature market has less scope for revolutionary drives. Russia practically makes no impact on the financial market of derivatives. In fact, I attended a talk two years ago by Gazprom’s stock trading arm in London, albeit I appreciated that it was staffed by young and eager professionals, it was evident that the arm was just starting out; while other traders have a long history and connections. As any broker knows, information and connections is a diamond in the rough. Russia must alter and improve its banking sector, as otherwise its institutions cannot pressure oil prices in the desired direction. If we recall, Cyprus was used by Russians because it had a western know-how and relatively easy access. As Russian home grown banks simply cannot provide the needed services (see my interview with Prof. Richard Sakwa). As typical for the world, first comes the financial system and then comes the oil trading floors, this is perhaps partially the reason why the Russian oil stock market has not took-off, as it only deals with small volumes and prices tend to be high.
In the first opening lines of this post it was mentioned that oil prices, or oil in general, can decide the fate of nations. In all fairness, Russia has been on a rollercoaster of a journey with much of its recent history being linked with this semi-precious resource. If we recall [see Smith (2009) for the statistics in 2007 prices] the 1973 OPEC actions following the US support for Israel led to an explosion of oil prices, as these increased from $12 to $53 in a matter of four months. Just about a decade later Iran’s political turmoil and Iran-Iraq war shocked the world with pricing ballooning to $95 per barrel by 1981. However, by 1986 prices took a sharp nose-dive to a mere $21 per barrel. At this point USSR collapsed, partially due to its economic machine being heavily reliant on petrodollars, sending more than 300 million people straight below the poverty line. In early 1990s newly established Russia started to stabilise, but was quickly offset as oil prices plummeted to just $12 per barrel by December 1998 as the Asian Financial Crisis took grip. As millions lost their savings via ruble devaluation and non-existent social support it was the lowest point a state could reach in this shocking limbo. In the years following the financial crash prices increased to a low $30 per barrel and over time catapulted to over $140 just prior to the now global financial recession. If not for the vast financial reserves accumulated in the years prior to it, Russia would have once again plummeted down the abyss. A question now stands for policymakers, how to avoid another collapse in the more than likely future recession. As we know, the problem lies in the fact that petrodollars derived by OPEC and now Russia cannot be easily spend by the actual producers, as their economies are not well developed to use the vast inflows of liquidity without inflationary repercussions. As a result, this huge liquidity is invested back into the large developed economies that also tend to be the actual consumers of oil. It is an incredible carrousel or a resource curse, except people that fall of it, are real and sometimes an entire nations can come off the horse. I am particularly interested in how BRICs manage to overcome the current state of financial affairs, as the recent announcement for a $100 billion reserve fund seems like a right step forward, but effectiveness will be in the small print and in action.
A major problem is that other nations hold the vaccine to this problem, but it is not in the interests of the US to change the system. If we look at the recent GDP statistics we see USA has recovered quicker than any other major economy. A lot will depend on how the new legislation holds in the US, like the Dodd-Frank Act. If we look at the statistics for manipulators, its frankly shocking. Cambridge Energy Research Associates (CERA) highlight that from 2008 there were no changes within expenses of exploration or production of BRENT crude. Based on 1st quarter of 2012, all the costs associated to produce a barrel of BRENT account for $53 per barrel or just 45% of the average market price at the time when oil was traded at around $90; this means that the rest is primarily speculation. In the modern era of oil trade, financialisation is vastly overpowered. For instance, OPEC’s excess capacity is currently at a massive 4 million barrels which is an equivalent of huge Chinese production of crude oil. Yet, we see prices trading at around $90-100 per barrel. If we compare this historically, the last time OPEC had such capacity; prices were at around $30 per barrel. As it seems, the golden era of stable prices for oil has long ended ($10-20 per barrel consistently from 1874 to 1974), just quite how much volatility we will experience now, only time will tell.
I want to end this post with an article I came across a few days ago, it puzzled and to be honest shocked me quite a lot. I think many British people value charities and the notion of charitable giving. However, the recent charitable event by Prince Harry and The Duke of Cambridge, has at least for me overstepped the red line. The two young princes were playing on the stock exchange in the bid to raise money for charity and William said: "Bloody hell, was that a billion?!" I realise this was just a PR stunt for the royals and much of it was a bit of fun, but since when did it become morally and ethically justifiable to essentially gamble for the name of charity? I am by no means a socialist, nor does my upbringing suggest that I ought to be one, but if we recall what has happened in 2008, which is not a distant memory, many lost and persist to lose their entire worldly possessions due to a small circle of brokers who got it seriously wrong. I find this quite disturbing that socialisation of the modern public is moving towards a state whereby we justify for something to be gambled to such an extent - yet we frown upon people that go to normal casinos. To end on a frank note, if not for these economic swings and roundabouts due to absence of good regulation, most people would not need charity, yet, we relatively recently let in another industry into the global casino with little gambling limits and about to invite its friend (gas).
P.S. while writing this post I was considering doing a mirror post for oil's alternative, natural gas, but it soon became apparent that this will not be viable in the short margins of blogging. In the case of gas there are just too many caveats and political edges. I must be honest, my questions to Prof. Jonathan Stern during our relatively recent meeting did not go down to well, as I think he did not wish to indulge too much into shale gas production and its future. However, I am still going to strongly recommend his incredibly detailed book on gas pricing - The Pricing of International Traded Gas.
Thank You for Reading & I hope You've Enjoyed this Post!
M.A. University of Kent & Higher School of Economics, Oil/Diesel Broker and RIAC Blogger.