It was the hot topic of last summer (when oil prices were racing to record highs), but the debate over whether speculators are really to blame for oil’s volatily has somewhat fallen off the agenda since the price of crude came crashing down.
Opec, of course, have always maintained it was indeed the speculators’ fault (not theirs). Unsurprisingly, perhaps, it is Opec secretary general, Abdalla el-Badri, who is planning to revive the debate at Davos this week. He plans to do so in a panel he is featuring in alongside oil big wigs Tony Hayward of BP and Ilham Aliyev, president of oil exporting nation Azerbaijan.
As Bloomberg reports on Wednesday:
Jan. 28 (Bloomberg) — OPEC wants U.S. regulators to curtail oil trading by hedge funds and speculators who helped make last year the most volatile in crude oil trading. Abdalla el-Badri, secretary-general of the Organization of Petroleum Exporting Countries, is seeking rules to “limit the level of speculation” by investors who buy oil without planning to use it.
Oil surged 46 percent in the first half of 2008 to a record $147.27 only to plunge by the end of the year, prompting OPEC to make its biggest ever supply cuts. “OPEC has repeatedly called for the need to reduce the role of excessive speculative activity in the market,” el-Badri, who will attend this week’s World Economic Forum in Davos, Switzerland, said in an e-mailed response to questions. “Today, it is impossible to know who is actually buying and selling oil futures.”
However, as the article also points out, the trouble is that the Commodity Futures Trading Commission (CFTC) is still divided on the matter. Their data, for example, show that net long positions held by speculators (eg non-commercial traders) peaked at 115,145 contracts in March. They switched direction in July to a net-short position which reached 52,984 contracts by mid-November.
As the debate continues, FT Alphaville would like to redraw attention to the enlightening testimony given last year by Chris Cook, a strategic market analyst and former director of the International Petroleum Exchange (who happens to have advised Iran on creating its own alternative oil bourse too).
Chris Cook, as referenced in this Oil Drum interview, has long focused his work on how intermediaries manipulate the oil markets. As Oil Drum explains:
As a result of the realisation of how the intermediaries were making the market more volatile than it needed to be, making money at both the producer and consumers expense, Cook wrote to the governor of the central bank of Iran proposing the creation of a Middle Eastern Exchange with its own benchmark price.
The Iranians liked the idea, the Saudis however couldn’t support it due to US connections. After 9/11 the Saudi’s withdrew their objections and in May 2004 Cook was invited to Iran’s central bank to give a presentation setting out how an oil exchange might operate. Cook and his consortium got the contract to put it together. Difficulties arose however since the Oil Ministry didn’t want transparency in the oil market, the current system not withstanding its flaws was making the Iranian elite lots of money.
Of course, since that interview was published in 2006 we’ve seen the birth of the Dubai Mercantile exchange and its DME Oman Crude Oil Futures Contract and in February 2008 the Iranians launched the first phase of their Iranian Oil Bourse vision in the form of an exchange trading polyethylene – the ultimate aim being the trade of an alternative (and liquid) oil contract priced in euros not dollars.
But back to Chris Cook’s testimony. His critique was very much focused on contract deliverability. As he explained (our emphasis):
Oil futures markets are essentially an overlay on the underlying “physical” market, and futures contracts are bets on the future price which allow risk to be transferred between those wishing to “hedge” price movements in the physical market, and those prepared to take on that price risk.
In excess of 60% of global crude oil is priced by reference to the “benchmark” price of North Sea “Brent” quality crude oil—now in fact “BFOE” (Brent, Forties, Oseberg and Ekofisk qualities). But the actual benchmark price is not that of the ICE Futures (formerly IPE) Brent crude oil contract. This contract is not deliverable, and is merely a financial contract settled in cash on expiry against an index price. The massive open interest in this contract has no more effect on the physical oil price than I would if I made a bet with a friend in relation to oil prices.
Physically deliverable contracts are not as straightforward as those settled in cash, and it is the (deliverable) NYMEX West Texas Intermediate (“WTI”) contracts—particularly those traded in London on the ICE Futures platform—which are particularly exercising the US Senate and Congress.
The fact of the matter is that deliverable futures contract prices converge on the physical market price upon the expiry of the contract—not vice versa. Speculative position limits are entirely irrelevant except in relation to trading in the “spot” contract month approaching expiry. Even then, limits would only be useful from the point of view of preventing defaults and ensuring orderly deliveries.
In any case, no exchange broker/clearing member would dream of allowing clients to keep positions open in the “spot” delivery month who did not have the capability to make or take delivery of the relevant commodity. In six years of managing overall trading and deliveries in the IPE Gas Oil contract deliverable in Amsterdam, Rotterdam, Antwerp (“ARA”) neither I nor, as far as I know, the regulator (SIB/FSA) or the London Clearing House which actually took the financial risk, ever seriously considered the use of position limits of any type.
So, according to Chris Cook, the issue of price volatility stems purely from the machinations of the physical markets, which are – to all intense and purposes – still dominated by large producers like BP, Shell, Total etc, the intermediary oil trading firms like Glencore, Vitol and a few big investment banks, namely Morgan Stanley and Goldman Sachs (via its J. Aron trading name). Hedge funds and passive index funds are therefore largely irrelevant.
This becomes a growing concern as the dominance of the non-deliverable Brent contract increases and the likes of the deliverable WTI contract follow increasingly in its footsteps (rather than lead). As Cook explains (our emphasis):
If there is a problem in the oil markets, it lies in contracts made in respect of the underlying physical market. Moreover, the problem does not lie in WTI—which, through massive arbitrage trading is now the tail to the Brent dog — but in the aptly named “Brent complex”. The decline of production in the Brent field during the 1990′s led to endemic manipulation via “squeezes” of the “Brent 15 Day” forward market and eventually in 2002-04 to the current BFOE contract.
But note here that even now, only about 70 BFOE cargoes of 600,000 barrels each are being produced monthly to a total value of maybe $6 billion at current prices. By all accounts there is of the order of $260 billion of speculative money invested in oil markets—much of it in funds based upon indices such as the GSCI. While much of this figure probably relates to the notional value of open futures contracts, it will be seen that the amount of money available to anyone interested in playing games in the BFOE market dwarfs the actual value of crude oil production of this crucial benchmark quality.
The financial market commentator, Henry Liu, recently had this to say in “Asia Times” in relation to oil trading: “But now … oil in the ground can be more valuable than oil above ground because it can serve as a monetizable asset of rising value through asset-backed securities (ABS) in the wild, wild world of structured finance (derivatives). So while there is incentive to find more oil reserves to enlarge the asset base, there is little incentive to pump it out of the ground merely to keep prices low … ” It is here, in that “wild, wild world” of the relationship between oil producers and investment banks, that any problem must lie.
So, as Chris Cook goes on to say, he believes the problem of “manipulation” (if there is any) does not lie with the passive speculators, the hedge funds or even Opec, rather with the cartel that both producers and consumers are exposed to via the effective duopoly of NYMEX and ICE Futures. And here’s the clincher:
I am sure both take very seriously their duties as regulated markets in relation to trading “on exchange”. However, the regulatory issues do not arise from what their membership and customer base are doing on exchange, but from what they are doing “off exchange”. In a global market place, national regulators are faced with two main problems. Firstly, they do not have access to the necessary market data to regulate market standards of behaviour. Secondly, even if they did, they have no effective means of enforcement on trading intermediaries scattered and for the most part incorporated and operating “offshore”.
Hmm, what could that mean? “Offshore ” intermediaries operating “off exchange” in the physical markets?
Well, a clue comes in the CFTC’s decision last year to reclassify one particular physical market operator Vitol into a non-commercial trader from a commercial one. Of course, Vitol itself still disagrees with that verdict, seeing itself as a wholesome commercial trader.
But Cook’s point is apt – unless you’re a speculator who can physically move barrels around yourself (by operating in the OTC markets), your position is unlikely to influence the price very much. Hence his conclusion that:
… regulated futures markets should be as transparent as possible, and that limits on positions—which in my view, and that of other witnesses—need not be prescriptive—are only of any regulatory benefit where contracts are deliverable, and then only in the proximity of contract expiry in order to ensure orderly contract performance.
Finally, I confess I was almost sorry for the Financial Services Authority, who were sent away to do their homework and return to the Committee with satisfactory information in relation to transactions in the physical and “OTC” markets which is where—as I stated—the evidence of a bubble, if there is one, must lie.
The problem for the FSA is that this data is for the most part inaccessible—because the relevant market participants are unregulated, offshore, or both—or accessible only with difficulty by interrogating intermediaries.
So to really get a grip of the market Cook advises oil consuming nations to create a global “market transaction registry” to be held in the neutral hands of a “Custodian”. He says the outcome of this would enable regulators globally to access the data they require to enforce agreed market standards both on and off-exchange. Perhaps this is the sort of thing Messrs. el-Badri, Hayward and Aliyev should really address when they discuss the subject at Davos?
Related links:
Vitol ‘not in the business of speculation’ – FT Alphaville
‘Unprecedent’ inflows into oil ETFs – FT Alphaville
Select Committee on Treasury – Regulation of the oil markets minutes – House of Commons