How Wall Street Controls Oil
And how OPEC will be the fall guy for $140 oil.
Control over oil markets, once the province of the major integrated oil companies and then OPEC, may now be shifting into the hands of Wall Street’s ubiquitous investment banks. Oil industry experts noted this unwelcome transition at an early December 2006 OPEC-EU meeting in Vienna. Producers clearly were not happy to see their ability to influence prices undermined. EU representatives were equally unhappy because the changeover might increase price volatility. Wall Street types, meanwhile, denied responsibility.
It has become clear in 2006 that one of Wall Street’s newest concepts—marketing commodities as an asset class—has altered world energy markets in a surprising fashion. In particular, the injection of cash into commodities by passive investors such as pension funds has created a rich financial incentive to accumulate inventories. Participants in physical energy markets (both oil and natural gas) have responded by putting away almost record amounts and building new storage facilities. The stocks amassed, in turn, have undermined the ability of oil exporters to control prices. OPEC ministers recognize that under certain circumstances the accruing stocks could precipitate a sudden, temporary drop in crude prices similar to the one observed in natural gas last spring.
At the same time, the stock and price rise threatens to raise political hackles. Legislators will no doubt
respond this spring with a spate of hearings and perhaps laws directed at an industry incorrectly accused
of hoarding.
Here I describe the latest development in the energy market twists and turns of the last three
decades. Its appearance has made the tools traditionally used to predict oil market fluctuations at least
temporarily obsolete.
A SURPRISING CHANGE
Those who watch oil markets closely were startled last June as oil prices and inventories simultaneously rose to unprecedented highs. The price rise itself was not a surprise. Nor was the stock climb to levels not observed since the 1998 shock. However, the two events occurring simultaneously caught the attention of many and for good reason: historically, high prices have been associated with low inventories and vice versa.
The surprising parallel increase in stocks and oil prices can be observed in Figure 1. There I compare
U.S. commercial crude stock levels from January 1986 through December 2006 with the spot price of WTI
[West Texas Intermediate, an oil pricing benchmark], which trades on the New York Mercantile Exchange.
For presentation purposes, stocks are graphed against the left vertical axis and prices against the right.
Control over oil markets may now be shifting into the hands of Wall Street’s
ubiquitous investment banks.
One the left vertical axis and prices against the right. One can note an unusual surge in stocks beginning in
January 2005 that matches the crude price rise from $45 to $74 per barrel.
The concurrent upsurge in prices and stocks was unusual by historical standards. In the past, inventories
of oil and other commodities moved counter cyclically with prices. Commercial users of commodities have
always been notoriously parsimonious. Indeed, few managers will risk tying up working capital to accum
mulate additional stocks, and oil companies have previously been very aggressive in minimizing inventories.
Crude for delivery in 2010 will pass $140 per barrel.
Moreover, no publicly traded company has reported holding speculative stocks.
On this occasion, however, the stock boost was driven by a profit motive rather than a speculative one.
Commercial firms were given the chance to gain by keeping stocks, and they responded by increasing their
holdings.
Wall Street provided the opportunity to benefit from adding stocks. For the last fifteen years, investment bankers have touted commodities as an asset class.
In the last two years, the idea gained recognition. Commodities were sold as an alternative to traditional bond and stock investments. Building on academic research at Yale and Wharton, analysts from Goldman Sachs, Deutsche Bank, Barclays, PIMCO, and other institutions have circulated papers that demonstrate how investors achieve useful diversification by allocating a small portion of their portfolios to ommodities. The diversification occurs because returns from commodities are negatively correlated with returns on equities or bonds.
Oil Storage Problem
Oil can no longer be held in open pits as it was in the 1930s. It must be kept in tanks or on
ships, and both have a fixed supply. As storage fills, the prices facility owners charge for it increase. The boost in storage costs drives down cash prices. Such an impact occurred in summer 2006 when cash prices in U.S. natural gas markets dropped by more than 60 percent to $4.50 per million Btu. In an even more extreme case, in September natural gas sellers briefly paid buyers in Great Britain to take gas. (The statement is correct. British firms paid buyers to take gas because storage was full.) Thus Wall Street’s commodity asset class innovation has the potential to destabilize energy markets thoroughly.
Control over oil markets may now beshifting into the hands of Wall Street’s
ubiquitous investment banks.
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Many pension fund managers have been convinced. Between 2004 and 2006, as much as $100 billion may have been invested in commodities. Figure 2, taken from a Goldman Sachs presentation, shows a rough estimate of the cash input from passive investors. One can see from the graph that financial institutions had marketed the idea as early as 1991. However, one can also note the idea only took hold in 2004.
Those investing in commodities are not typical of other commodity market participants. They are not speculators. They do not trade frequently, and they do not sell short. Investors buy a diversified portfolio of commodities and hold on to it. Energy commodities, particularly oil, make up a large portion of the indexes because energy accounts for a large share of the economy.
Proponents of commodity investing recommend full collateralization of contracts. Although commodity futures are by definition margined transactions, commodity investors set aside the contract’s full value when they buy. Thus the purchaser of 1,000 barrels of crude will reserve $60,000 if oil sells at $60 per barrel. The money not used for margin is invested in a highly liquid instrument such as a Treasury bill.
The most widely quoted academic proponents of commodity investment (Gary Gorton and Geert Rouwenhorst) do not promise investors returns from price appreciation. Rather they demonstrate how a return can be earned as a result of markets normally being in “backwardation,” a condition that occurs when cash prices exceed futures prices. As they explain,
Keynes and Hicks postulated the theory of normal backwardation, which states
that the risk premium will, on average, accrue to the buyers. They envisioned a world in which
producers of commodities seek to hedge the price risk of their output. For example, a producer
of grain sells grain futures to lock in the future price of the crops and obtain insurance
against the price risk of grain at harvest time.
Speculators provide this insurance and buy futures, but they demand a futures price that is
below the spot price expected to prevail at the maturity of the futures contract. By “backward
dating” the futures price relative to the expected future spot price, speculators receive a risk
premium from producers for assuming the risk of future price fluctuations.
For illustration, I show in Figure 3 the forward price curve of oil on January 1, 2003. At that time, the first future settled for $31.68 per barrel and the second future at $30.50. If spot prices remained at $31.68 per barrel, the investor could count on making $1.18 per barrel in 30 days. Investors could earn an annual return of almost 60 percent if they repeated the exercise each month by “rolling” their investment into the next contract.
Gorton and Rouwenhorst examine data for a thirty-year period and show that a portfolio of commodities structured as described above would earn returns that match those from bonds and equities. They also show the returns are negatively correlated, implying that commodity investments help diversify
portfolios.
INTRODUCING “NORMAL CONTANGO”
The movement of passive investors into commodities shifted markets from backwardation to contango, the condition that occurs when futures prices exceed cash prices. Quite simply, energy markets today are too
small to accommodate the increased activity of investors seeking to buy commodities and still stay in backwardation. Producers who might sell futures to hedge the risk of a price decline generally do not do so, having been counseled by other representatives of the same investment banks that buyers of their equities did not want them to hedge. The consequence of this impasse was predictable. Futures prices rose relative to cash prices. As can be seen from Figure 4, the market shifted from backwardation on January 1, 2003, to contango by July 2006. (In Figure 4, the 2003 curve is graphed against the left vertical axis and the 2006
curve against the right because the price level in 2006 is roughly double that of 2003.) The change in the curve’s shape is remarkable.
Usually, markets become more backwardated as cash prices rise.
Inventory accumulation began once markets shifted into contango because it became profitable for commercial firms to add to stocks. In a contango market, a company acquiring stocks avoids the risk of a
price decline by hedging. Thus in July an oil company could acquire incremental oil for $76 per barrel and simultaneously hedge the volume by selling futures for $80 per barrel. This transaction— referred to historically as a “cash and carry”—nets the company a $4-per-barrel profit whether oil rises to $100 or
falls to $10. Not surprisingly, firms jumped at the opportunity. As noted above, both prices and inventories rose.
In theory, companies could acquire oil indefinitely. Prices could rise and stocks follow. However, at least one real impediment to this scenario exists: storage. Oil can no longer be held in open pits as it was in the
1930s. It must be kept in tanks or on ships, and both have a fixed supply.
As storage fills, the prices facility owners charge for it increase. The boost in storage costs drives down cash prices. Such an impact occurred in summer 2006 when cash prices in U.S. natural gas markets dropped by more than 60 percent to $4.50 per million Btu. In an even more extreme case, in September natural gas sellers briefly paid buyers in Great Britain to take gas. (The statement is correct. British firms paid buyers to take gas because storage was full.) Thus Wall Street’s commodity asset class innovation has the potential to destabilize energy markets thoroughly.
POLICY DILEMMAS
The emergence of high inventories and high prices and the possibility of a price collapse create dilemmas for OPEC and policymakers in consuming countries. For OPEC, the risk is obvious. Lawmakers in consuming nations seeking to reduce greenhouse gas emissions are also troubled by the prospect of low prices. Yet, there may be little they can do to ameliorate the situation.
OPEC’s problem concerns the price level. OPEC can and has cut oil production to squeeze stocks and raise
prices. In March 1999, Saudi Arabia led the organization in a program to reduce consumer inventories across the globe. Between mid-1998 and early 2001, global stocks shrunk by almost 700 million barrels. When they implemented this policy, OPEC officials predicted that prices would rise as stocks declined. Many doubted this, but by early 2001 prices had tripled from $10 to $30 per barrel.
In early December 2006, Saudi Arabia’s oil minister Ali Al-Naimi commented that global inventories were rising again. He fretted that prices might come under pressure.
Other OPEC members stated more explicitly that production cuts were needed to reduce world stocks by 100 million barrels. There is a problem with this thinking, however. OPEC cannot make inventories decline by cutting output. A reduced oil supply might induce those holding stocks to sell and take profits. Alternatively, they might decide not to sell, in which case consumption would have to decrease. In this second scenario, crude oil prices would need to increase between 10 and 20 percent to balance the market. This would bring crude back to the summer peaks of nearly $80 per barrel. Of course, a crude price hike is just what those marketing commodities as assets seek. More investors and more money would pour into commodity indexes, much of it into oil. The incentive to hold stocks would strengthen and inventories might build despite OPEC’s production cut.
The process will end when storage fills. Then OPEC will need to reduce output further or risk prices falling
precipitously. We could very well observe a price decline and OPEC attempts to arrest it. During 2007, I suspect we will see an oil price surge followed by a rush of cash into commodities. Forward prices will be bid higher.
Crude for delivery in 2010 will pass $140 per barrel. Stocks will rise further while Congress and the press accuse oil companies of hoarding. Then buyers will realize at some point that they have no place to put the oil and prices will tumble. The history of commodity market cycles suggests the decline could be spectacular. Single digit prices are possible, although probably only for a day or two.
As an EU official said privately, “The market has been destabilized.”
◆
Quite simply, energy markets today are too small to accommodate the
increased activity of investors seeking to buy commodities and still stay in
backwardation.
In an even more extreme case, in September natural gas sellers briefly
paid buyers in Great Britain to take gas.
But an updated version may be required if Harold Vinegar and his colleagues get their way. Dr Vinegar, the former chief scientist of Royal Dutch Shell, is at the centre of an ambitious project to turn Israel into one of the world's leading oil producers.
Israel Energy Initiatives, where Dr Vinegar is chief scientist, is working on projects to extract oil and natural gas from oil shale from a 238sq km area of the Shfela Basin, to the south and west of Jerusalem.
Oil shale mining is often frowned upon, not least by the environmental lobby, as a dirty process that is both energy and water-intensive. IEI believes that its technique will be cleaner than that of other operators because the oil will be separated from the shale rock up to 300m beneath the ground. Water will be a by-product of the process rather than being consumed by it in large volumes.
According to Dr Vinegar, Israel has the second-biggest oil shale deposits in the world, outside the US: "We estimate that there is the equivalent of 250 billion barrels of oil here. To put that in context, there are proven reserves of 260 billion barrels of oil in Saudi Arabia."
The marginal cost of production, IEI estimates, will be between $US35 and $US40 per barrel. This, Dr Vinegar points out, is cheaper than the $US60 or so per barrel that it costs to extract crude from inhospitable locations such as the Arctic, and compares with $US30-$US40 per barrel in some of the deepwater oilfields off the coast of Brazil.
"These Israeli deposits have been known about, but have never been listed before. It was previously assumed there was not the technology to deal with it."
According to Dr Vinegar, IEI, which is owned by the American telecoms group IDT Corp, hopes to begin production on a commercial basis by the end of the decade, with a view to producing 50,000 barrels per day at the outset. This would be a fraction of the 270,000bpd consumed daily by Israel, but would be a significant step towards making the country energy-independent.
Dr Vinegar estimates that, with one barrel of oil comprising 42 gallons, each tonne of oil shale contains approximately 25gallons.The extraction process involves heating the rock underground, using electric heaters, to approximately 325C, the level at which the carbon-carbon bonds in the rock start to "crack". The oil produced by the process is light and easily refined to a range of products, including naphtha, jet fuel and diesel.
The project is attracting serious interest from outside investors. In November, 2010, an 11 per cent stake in Genie Oil & Gas, the division of IDC that is the parent company of IEI, was acquired for $US11m ($11.05m) by Jacob Rothschild, the banker, and Rupert Murdoch, chairman of News Corporation, parent company of The Times. Genie's advisory board includes heavyweight figures such as Michael Steinhardt, the hedge fund investor, and Dick Cheney, the former US vice-president.
Dr Vinegar said that an appraisal now under way would be followed by an 18-month pilot stage. Among the issues this will address will be concerns raised by environmental groups, including an examination of IEI's claims that the process does not require excessive use of water or energy. Reassurance will also be sought that a local aquifer, which is several hundred metres below the shale deposits, will not be contaminated by the work.
Assuming that these early stages are completed successfully, a demonstration phase would then take place over three to four years, during which the work completed in the pilot phase would be continued on a larger scale. Only then would the commercial operations begin. Dr Vinegar said that, by this stage, up to 1000 people would be employed on the project, many of them specialist engineers from outside Israel.
He added: "Funding is not needed for the pilot and demonstration, although once we were getting to 50,000 barrels per day, we would want to have a partner. We have been approached by all the majors."
Dr Vinegar said that the project still faced a number of hurdles: "There is a geological risk: Is the resource there? What is the risk to the aquifer? We have no doubts here, and in particular that the resource is there and is of good quality, but the pilot can prove these things.
"Then there is the technological risk: Can we drill long horizontal wells and can the heaters be placed in them? And can they last?
"And finally there is the economic risk, what the price of oil does. But I think the price is going to continue rising, to the extent that, by 2030, we will be at around $US200 per barrel."
To that, there can be added a fourth potential risk for the project: whether it is capable of overcoming criticism from the environmental lobby to win popular support. This, perhaps, is the greatest challenge facing Dr Vinegar and his colleagues.
There’s an old joke that when Moses was leading the Israelites out of Egypt, he made a wrong turn and missed all the oil. Well, it turns out that neither Moses nor G-d, made a mistake. Israel is on its way to becoming a energy Goliath.
What is less well-known, but even more dramatic, is the work being done on this country’s oil shale. The British-based World Energy Council reported in November 2010 that Israel had oil shale from which it is possible to extract the equivalent of 4 billion barrels of oil. Yet these numbers are currently undergoing a major revision internationally.
By Mark Anderson
“Crude oil is the real ‘currency’ of the world,” said Lindsey Williams at a gathering of the Midwest Concerned Citizens group in Kansas City on July 22. But Americans will never hear about huge oil and gas reserves in the United States, which, if ever tapped, would bring today’s fuel prices at least as low as $1.50 per gallon and make America more energy independent.
As a Baptist missionary in the 1970s, Williams said he rubbed elbows with members of the world’s power elite—who boasted of detailed 30-year and 50-year plans to control the flow of oil and information.
A huge quantity of crude oil and natural gas exists under Gull Island, located in the waters of Prudhoe Bay in Alaska, says Williams. He cited key British Petroleum memoranda and related the statements of upper echelon oil officials who told him that Gull Island would be kept under wraps, limiting domestic supplies so Americans would someday see prices hit up to $10 a gallon at the pump.
“Every issue in the world today relates to crude oil,” said Williams. The U.S. occupation of Iraq and the saber rattling about attacking Iran fit into the crude oil matrix.
Iran is being targeted because it’s one of several countries that want to use their own currencies for oil sales, rather than using the U.S. dollar. Williams told AFP that any country that doesn’t want to “play ball” with the U.S. government and the financial and oil interests is, in essence, put on a hit list.
The United States, he said, learned that Iran intended to form its own bourse and not use the dollar for oil sales. Therefore, the notion that Iran is a menacing “almost-nuclear” country was trumped up, presented as fact via the corporate media and Iran is now in the crosshairs.
Other nations wanting more independence from U.S. meddling include Norway, Venezuela, Nigeria, Bolivia, Sweden and Russia.
The 30-year plan, which was first proposed three decades ago and is nearing fruition, included smug assurances from oil officials that the United States will triple its crude-oil usage and alternative fuels will not be allowed to gain enough ground to make a difference. They also noted that all foreign oil production will be scaled back to the United States and that Americans soon will pay $4 to $5 a gallon at the pump and could pay as much as $7 to $10 down the road.
In the early 1960s crude oil was selected as a tool of world control, Williams said, adding, “What we pay at the gas pump is a form of taxation.” The American consumer’s dependence on crude oil thus far has enabled people from foreign oil-producing nations to buy T-bills (U.S. treasury notes) in order to support the U.S. national debt and continued deficit spending. The need to support that debt puts the U.S. government in a bind, forcing Americans to remain dependent on foreign oil.
Williams, as a chaplain in 1970 when the trans-Alaskan oil pipeline was finished, ministered among the pipeline workers. However, as time passed he made a favorable impression with the top brass and was asked to improve worker-company relations. Next thing he knew, he said he was sitting at meetings of the World Bank, the International Monetary Fund and various meetings of oil executives over a three-year period.
He told AFP that the IMF-World Bank acts as a middleman between oil producing nations and refineries. In so doing, they set oil prices, he said.
The big event in that three-year period was in 1977 when an Atlantic Richfield oil executive told him, “We have just drilled into the largest pool of oil in North America—[and] in the world!”
That pool was Gull Island. It was said that there was enough natural gas to supply America for 200 years. But to this day, “not one drop” of that oil has been released to American refineries, Williams said.
Williams said the executive had warned him that the Gull Island find was highly classified. Do not repeat any of this, he was told. Obviously, that warning did not stop him.