After a phenomenal “spike” in oil prices to US$147 per barrel, the price has declined to just over $90. In the US this led to a “spike” to $4 per gallon of gasoline and placed energy prices right at the top of the US political agenda. Moreover, this political interest rapidly crossed the Atlantic since British trading of US contracts was believed to be instrumental in a speculative oil market price “bubble”.
In view of my background in energy markets – I was for several years director of compliance and market supervision at the International Petroleum Exchange (which is now ICE Futures Europe) – I was asked recently by the British parliament’s Treasury Select Committee to give evidence to them in relation to regulation of oil markets. Such an inquiry is a new direction for the committee, and following this initial hearing they decided to commence a full-blown Inquiry – in the finest US tradition – in October.
I told the committee – and their subsequent initial questioning that day of British regulators implied that my message was understood – that to follow the US approach to regulation of oil futures markets would be to try and solve today’s problems with yesterday’s tools.
The New York Mercantile Exchange (NYMEX) West Texas Intermediate (WTI) crude oil market price has become almost entirely irrelevant in the real world of physical and forward oil trading, which largely takes place, believe it or not, in Yahoo chat rooms. While NYMEX members still provide a massive pool of trading capital or “liquidity”, the inconvenient truth is that oil market pricing power has moved across the Atlantic to the price of North Sea crude oil.
The price of North Sea (Brent) crude oil is now the direct benchmark for over 60% of global crude oil pricing, and, through the mechanism of massive “arbitrage” trading between Brent and WTI, it also constitutes an indirect benchmark for most of the other 40%.
Most people – including virtually all mainstream press reporters – believe that it is the price of futures contracts that is used as a benchmark. In fact, it is the reported “spot” market price of “dated” Brent/BFOE (see below) cargo transactions that constitutes the direct and indirect benchmark for most global oil transactions. The massively traded ICE Futures Europe Brent/BFOE Crude Oil contract is merely a financial bet on these underlying prices, and these financial contracts are settled in cash, not oil.
For many years, the production of the Brent oil field has been in decline, and the production of other North Sea oil fields has therefore been amalgamated with it to ensure a sufficient number of transactions to give a credible benchmark price.
We now see four fields – Brent, Forties, Oseberg and Ekofisk (“BFOE”) – together supplying the BFOE “Brent” contract whereby 600,000 barrel “cargoes” of these qualities of oil may be bought and sold forward for eventual physical delivery.
The problem is that even this extended North Sea BFOE production is still only running at less than 70 cargoes per month, which is a total monthly production of little more than 40 million barrels. Even at $150 per barrel that represents a value of only $6 billion, and at current prices less than $4 billion.
Sitting on this base of physical trading is an off-exchange complex of price risk consisting of the simple forward BFOE contracts themselves, a host of derivative contracts, and an increasing number of “structured finance” transactions. It is estimated that in total, some $260 billion was recently invested in oil markets one way and another, and this pool of funds was superimposed as an inverted pyramid of risk on this relatively tiny base of physical crude oil.
Could these transactions have been instrumental in causing an oil market speculative bubble?
The answer is obvious: of course they could, and in all likelihood, they did. Unfortunately, because the transactions directly affecting the BFOE price took place off-exchange, not only does no regulator know, but none is in a position to know. Worse than that, even if regulators did know, there are no agreed market regulatory standards to enforce, and any offenders are for the most part smugly immune from enforcement action in offshore jurisdictions in any case.
Don’t shoot the piano player
As I pointed out to the Treasury select committee, to blame national regulators, such as the FSA in Britain and CFTC in the US, for problems of a global marketplace does not help, other than in providing a useful scapegoat. This is because the problem lies both in the global scope of the market and in its conflicted structure, where the interests of trading intermediaries or middlemen are diametrically opposed to those of end-user producers and consumers of oil and oil products.
In the absence of a new approach to market structure we will inevitably see repeats of the recent spike in oil prices as waves of hot money swill in and out of the market. In my opinion, that will inevitably lead, sooner rather than later, to a market meltdown – similar to the literally overnight collapse of the tin market in 1985 from $800 to $400 per tonne.
The conventional wisdom is that the “central counterparty” clearing houses of futures exchanges, which guarantee the performance of transactions, backed by a pool of capital and margin, are a strength of these markets.
In my view, they also constitute a single point of failure, where oil price risk is concentrated in exactly the same way that Fannie Mae and Freddie Mac were massively exposed to house price risk.
I made a presentation a couple of years ago in Lausanne to an audience of high-level security experts at a seminar covering the subject of economic terrorism. This fascinating seminar covered the subject of the susceptibility of global markets and commerce to acts aimed at causing economic destruction, rather than physical destruction and death.
I pointed out that current levels of gearing and risk, and the concentration of risk in single points of failure, together mean that the only difference between “economic terrorists” and proprietary traders such as hedge funds is motive. The former would destroy a market deliberately: the latter by accident.
While the oil market survived the recent storm surge of money, the inevitability of future waves of speculative money sweeping into the market, mean that an oil market meltdown is an accident waiting to happen.
Chris Cook is a former director of the International Petroleum Exchange. He is now a strategic market consultant, entrepreneur and commentator.
(Copyright 2008 Chris Cook – Reproduced with Permission)