There are only two reasons to explain the price of oil: either as a reflection of fundamentals or as a result of financial speculation.
Increasingly, ever since oil breached $30 in 2003, there have been allegations that rising prices are attributable to the financialization of commodity markets. Such a perception implies that oil futures markets fail to facilitate price discovery and appropriate risk transfer. Since the advent of 2020, recent developments have added fuel to the fire.
Unearthing the source of oil returns is a murky business. Petroleum, by its nature, is usually crude, flammable, and typically difficult to extract from beneath the earth’s surface. Reeving systems are tackled with great craft by riggers, often offshore. OPEC is a well-known open platform for setting prices. Its members are quite refined and appear at least semi-transparent. Is OPEC+ fully culpable for the bulk of market volatility, or are there other parties shooting the well?
During the pandemic, the world witnessed the lowest oil prices in decades. However, a sharp rebound soon followed, which by July has pumped prices to their highest levels in six years.
Toward the depths of the short-lived slump, several places in the US saw gas prices drop below $1.00 — a price not seen at the pumps since 1979.
By April 2020, amid the first wave of global lockdowns, OPEC had exacerbated the excess supply by raising output some 1.7 million barrels per day, the most significant production jump since 1990. By May, this led to a near-record level of 535.2 million barrels of excess crude stockpiled in the US.
A perfect storm ensued. The COVID-induced demand obliteration, coupled with a torrent of supply and scarce storage space, resulted in a dramatic price plunge. The drop culminated in WTI crude trading at negative prices for the first time in history, reaching a record low of -$40.32 on the intraday futures market on April 20. Futures contracts would typically be “rolled over” by unloading them before the delivery date. In the case of WTI, unlike Brent crude contracts, which can be settled in cash, buyers of the WTI contract are expected to take delivery of physical oil barrels at the city of Cushing in Oklahoma.
However, with storage fast approaching total capacity in Cushing, no one wanted to take delivery of the expiring contracts. On April 20, the price difference between WTI and Brent exploded from a narrow spread of less than $10 to a dizzying chasm of $63. That astronomical spread implied the market was pricing in an enormous cost for taking physical delivery. Contract holders had to pay people to take oil off their hands.
Does a lack of storage fully explain why the US benchmark crude oil futures contract settled at negative $37 on that infamous 4/20/20? In a functioning market, actual oil users would be happy to have speculators pay them to take oil off their hands.
Storage shortages aside, the events of April 2020 point to a sizable excess of speculators in the futures market with no intention of buying actual crude at all. The market “worked to perfection,” CME chief executive Terrence Duffy said in the days following the crash. Did it? On the one hand, the fact that WTI futures have to be traded for actual oil at settlement means that the contract is inherently less prone to manipulation, at least in theory anyway. If an agreement settles in cash, its price doesn’t necessarily need to be set by any real underlying supply and demand dynamics.
That being said, futures markets don’t operate in a vacuum. Arbitrageurs can eventually step in to bring back some semblance of fundamental valuation into the market. So Duffy may have been correct in some sense that the market “worked to perfection” as price approached zero and converged with the fundamental physics of Oklahoma space-time. Still, it also highlights a presumed imbalance between the number of speculators and physical traders in the market.
Considering the high ratio of speculators relative to other market participants, what would ordinarily happen during periods when WTI futures are not trading dangerously close to zero? When tank capacity is adequate in normal trading conditions, would it be much less difficult to manipulate WTI than Brent? Did the events of April 2020 demonstrate the market’s efficiency, or did it simply unveil a dynamic that would otherwise go largely unnoticed? Moreover, could the price have been manipulated downwards on that infamous day?
Shooting the Well
A precious metals broker named Robert Mish was one investor caught on the wrong side of the oil trade that day. Fuelled by anger, Mish attempted to drill deeper into the reason for the wild price gyrations. Zeroing in on Vega Capital London, Mish and other claimants filed a case alleging that Vega had engaged in a “manipulative scheme” to drive down the price of the May 2020 contract.
The suit alleged that Vega sold May futures at a loss in order to crash the price at settlement, which was due the following day on April 21. That well-worn form of manipulation is known as “banging the close.” The Essex-based Vega traders had acquired a substantial volume of the contracts in advance. As a result, the alleged conspirators made a healthy profit of $500 million that day. But were those Essex Venga boys the real culprits, or were they mere scapegoats?
We have seen numerous instances of “price discovery augmentation” play out in other futures markets throughout history. Squeezes, corners, and misrepresentations are as old as the futures markets themselves. Since the late 1800s, attempts to maintain fairness in futures trading have failed. In 1908, Theodore Roosevelt sought to cap large shorts to curb wild price gyrations in futures markets. Roosevelt referred to the more nefarious speculators as “bucket shops.” He expressed that there should be steps taken to “prevent at least the grosser forms of gambling in securities and commodities, such as making large sales of what men do not possess and ‘cornering’ the market.” Roosevelt went as far as to suggest that the Federal government should forbid “the use of the mails, telegraph and telephone wires for mere gambling in stocks and futures, just as it does in lottery transactions.” In the age of algorithmic trading, it’s hard to envision a ban on internet trading any time soon. On a note more immutable to all eras — thirty bills were introduced following TR’s call to action, but none were passed.
Not all was bleak in 1908. Roosevelt conceded that “the great bulk of the business transacted on the exchanges is not only legitimate but is necessary to the working of our modern industrial system.”
Today, the boundaries between “bucket shops” and captains of industry are increasingly smudging. Fast forward 105 years from TR’s statement, in 2013, major oil giants such as Shell, BP, and Statoil were raided by the European Commission on suspicion of manipulating Brent prices. The raid was soon followed by a class action initiated by injured parties, including Morgan Stanley and other energy traders.
These manipulations were made possible due to loopholes in the Platts benchmarking process. Platts regularly publishes benchmark prices that are used to determine the cost of crude for refineries.
Unlike stock exchanges, where all trades are a matter of public record, Platts data aggregates what oil traders report to Platts. Companies like Shell, BP, and Statoil report their physical trades, mainly forward contracts.
What’s more, oil traders are not even obliged to disclose all transactions. Instead, they participate voluntarily, as was highlighted by an International Organization of Securities Commissions report in 2013.
As an aside, Platts’s parent company, McGraw Hill, and its Standard & Poor’s credit rating subsidiary were sued by the DOJ for their role in the mispricing of derivatives leading up to the financial crisis of 2008.
The European Commission investigation did not lead to any convictions or fines, although the EU updated its Benchmarking Regulations in 2016. The regulations took effect in 2018, with a two-year transitional period until January 2020. As for their enforcement, will it be heavy and sour or light and sweet?
Calculating Brent prices is a complex process that has evolved over the years, now incorporating five different oil fields. This year, Platts planned to add US WTI and make sweeping changes to how Brent spot prices are calculated. However, in March 2021, Platts announced the deferral of changes so as “to allow for further consultation with traders.”
Unlike other spot markets, Brent has an inherent “forward” component. The closest-to-delivery forward contract (reported by the traders) is what determines the spot market known as “Dated Brent.” These spot prices actually reflect ten days to a month forward. Brent traders have the option to use contracts for difference (CFD) for hedging or speculating. Those CFDs are swaps that track the difference in Dated Brent forwards and Brent forwards with a longer horizon. Traders use CFDs to manage the basis risk between physical markets and financial markets. CFDs remain key to the complex Brent system. Due to the limited size of the forward market, CFDs also serve as a crucial link between Dated Brent and futures markets.
According to Adi Imsirovic, a senior research fellow at the Oxford Institute for Energy Studies, the industry was in an uproar about the proposed changes because they would “likely undermine and possibly destroy the forward Brent market. The whole plethora of derivatives contracts would probably change or disappear.”
The below table calculated by Imsirovic and his Oxford colleague Bassam Fattouh in 2019 illustrates the limited players involved in the Brent price-setting process:
Source: Contracts for Difference and the Evolution of the Brent Complex (Imsirovic and Fattouh, 2019) – https://www.oxfordenergy.org/
Captains of Industry
According to Bloomberg, a happy trio of big friendly oil giants — BP, Shell, and Total — trade almost 30 million barrels of oil and other hydrocarbon products each day. That volume equates to the entire daily production of every OPEC member combined. Shell alone trades roughly 12 million barrels per day. Those numbers represent physical trading. Derivative volumes are much larger again.
In 2016, Shell bought roughly 70% of the cargoes of North Sea crude available for a particular month, triggering wild price gyrations while squeezing out other traders. By contrast, the Hunt brothers’ acquisition of 69% of all silver contracts on COMEX in 1980 was widely considered malicious market cornering (which was perhaps a reasonable allegation).
Shell was again fined $30 million for manipulating natural gas markets between 2000 and 2002. Soon after, US regulators slapped them on the wrist again with $300,000 for other misconduct involving oil futures between 2003 and 2004. Then in 2007, BP belatedly landed on the bandit list, coughing up over $300 million to settle charges for manipulating US propane markets.
In 2020, the US unit of the world’s largest independent oil trader, Vitol, agreed to pay more than $160 million to settle allegations that it conspired to pay bribes to Latin American officials and separately attempted to manipulate two Platts benchmarks.
Paper or Plastic
Before the 2013 Brent fixing revelations came to light, a UNCTAD 2012 policy brief concluded that wild price volatility is due to financialization rather than developments in the real economy. UNCTAD highlighted the growing distortion of typical seasonal trends, as well as a strong correlation between commodity prices and broader financial markets. For example, following the Eurozone bank recapitalization agreement in late June 2012, the Brent oil price rose 7% in one day and WTI by 9% — an event unrelated to oil dynamics. In addition, the volume of traded derivatives on commodity markets is usually 20-30 times larger than physical production, making prices easier to move with more leverage. These findings led the UN body to conclude that the “price discovery market mechanism is seriously distorted.”
CFTC regulations enforced by CME put limits on position sizes. However, traders who claim to be engaged in hedging, risk management, or spread positions can exempt themselves from position limits. CFTC has rarely ever intervened during market disruptions. Instead, they typically allow the exchanges to sort out their issues internally. For example, when the Hunt brothers attempted to corner the silver market from 1979 to 1980, CBOT and COMEX were slow to raise margin requirements and cap position sizes. COMEX eventually suspended all silver trading and forced longs to liquidate their positions — a move that pushed the billionaire brothers into bankruptcy.
Aside from the snaking pipelines and unapologetically imposing rigs, physical demand and supply still play a significant role in setting futures prices. After all, oil is integral to the greasing of our economic wheels. The pandemic has created conditions amenable to a surge in oil prices. As society becomes vaccinated, the economy should react like a shale well injected with a high-pressure concoction of slickwater, releasing a build-up of trapped hydrocarbons. On the other hand, could the delta variant and the burden of high fuel prices disrupt the demand narrative? In financialized markets, the forward-looking demand narrative is often more relevant than the demand itself. As Keynes said, “in the long run, we’re all dead.”
“The long-run” expiration date for oil assets is fast approaching. Society will inevitably shift toward sustainable energy. The Glasgow summit in November should be interesting. Ahead of the climate conference, carbon credit futures are booming. The cost of carbon in the EU has more than doubled in two years to €58. Former Bank of England Governor and UN special envoy on climate action, Mark Carney, has said carbon prices are “well short of the estimated $80 to $100 a ton needed by the end of this decade to keep us on track to net zero.” The EU subsequently leaked a proposal for a carbon border tax. The US, UK, and Canada are also considering levies against carbon-intensive goods. India’s Environment Minister, Prakash Javadekar, expressed concerns about how this could impact emerging economies. “We’re suffering from climate change which was caused by the reckless emissions for hundreds of years by the developed world,” Javadekar stated. It may also be worth noting that national emissions targets exclude fossil fuel exports. For example, the US exported 6.06 million barrels of oil to China in April — equivalent to 2.61 million metric tons of CO2. Those exported molecules are excluded from US emissions figures.
In a recent FT article, Kempen Asset Management made an attention-grabbing headline, claiming that if the price of indirect scope-3 carbon emissions were to reach $75 per tonne, global equity markets could fall by as much as 20%. While click-bait statements may lack crucial macroeconomic nuances, Kempen did raise a valid point. The cost of carbon is a risk for corporate earnings, particularly in emerging markets. On the other hand, governments redistribute their tax takes, so it’s not as straightforward as Kempen suggests, although still a potential risk overall. In any case, will more companies choose to hedge the price of carbon?
On a better note for oil, the cost of alternative energy sources, especially solar, has dramatically increased. This solar storm has led to fewer homeowners and businesses switching their traditional gas guzzlers for more eco-friendly alternatives. Several environmentalist groups have even opposed utility-scale solar farms and windmills, citing copper and EV supply issues. The environmentalist groups also questioned the ethics of battery mineral supply chains.
M2 Twin Turbo
Last but not least, inkjet-induced inflation could be a boon for commodity prices going forward. The US M2 money supply has skyrocketed from $15 trillion in 2019 to over $20 trillion today. So while central bank bazookas could cripple Main Street with Weimar-like inflation, the downwash from their kamikaze helicopters may be a tailwind for commodities. However, the media have already begun scrambling from the “great reflation trade” narrative due to one unmasked cough from Chairman Powell. What with central bank hawkishness, it remains to be seen how the trade will play out. In 2012, Harvard economist and New York Post columnist Kenneth Rogoff expressed his belief that “a moderate dose of inflation would be no bad thing.” So “don’t worry about it.” Rogoff followed his comments by adding that “a sustained burst of moderate inflation, say, 4% to 6% for several years, would reduce the value of debts by 27%.” Paul Krugman, the babbling champion of shell-game economics, might add that such inflation would need to be rapidly sprung on the public as “a surprise.” Because who doesn’t like the surprise of rising bread prices in the morning?
On the other hand, although the recent rift between the UAE and OPEC+ could spell higher prices in the short term, it may herald a breakdown in the cartel once again. The UAE supports a proposed OPEC+ supply increase but is seeking a review of baseline production references. The UAE contends that its baseline was initially set too low but was ready to tolerate the restrictions if the deal were to end by April 2022. The UAE has invested billions of dollars in infrastructure to boost capacity, but 30% of that capacity is lying idle under the current onerous OPEC+ agreement. The Emirates plan to eventually go green, meaning they need to pump more now to meet their strategic goals later.
In the short term, without unanimous agreement between all members, OPEC+ rules forbid them to push through changes to the current deal, meaning they cannot decide to pump more oil without the UAE. This deadlock has led oil prices to climb higher, with the expectation that a shortage could ensue.
Abu Dhabi’s recent bid to create a new global oil benchmark could signal the UAE’s long-term trajectory. The Brent benchmark’s dominance has been steadily diminishing, and WTI may not adequately represent prices outside of the US. Given the weaknesses of those benchmarks, Abu Dhabi is well-positioned to fill the void. The Gulf state is a thriving tourist destination and a cultural melting pot, home to people from all corners of the globe. Dubai signposts are often written in Arabic, English, Russian, and Mandarin. The UAE’s new Murban crude futures contract was launched on the ICE Futures Abu Dhabi (IFAD) in April. The exchange’s location between Asia and Western refineries further adds to its allure. The Emirates are poised to prosper. Tensions between the UAE and OPEC’s de facto leader, Saudi Arabia, were already building due to previous geopolitical disagreements. Could an Emirati rift from the pack trigger a price war similar to that of Spring 2020? As it stands, it seems more likely that the Saudis will recognize the UAE’s position and agree to the proposed revisions. At the same time, such a concession could prompt other OPEC+ members to seek similar adjustments. In any case, supply changes will not take effect immediately, while supply should increase in the months to come, regardless of the OPEC outcome.
New Lease Of Life
Additionally, Bank of America’s head of global commodities and derivatives, Francisco Blanch, optimistically expected US shale production to pick up, pending a favorable decision from the Biden administration. Unsurprisingly, that favorable decision did not materialize, as the Biden administration froze the sale of new leases. On the other hand, the administration has continued to approve drilling permits. It remains to be seen whether Biden’s policies will have any material impact on production. As oil creeps higher, more existing US wells come online. The cycle becomes self-defeating as more supply pushes down prices.
Meanwhile, Brent and WTI spreads have narrowed further, making US shale less attractive. The spreads are indicative of US demand set to outstrip supply. By July, the oil futures forward curve was at its steepest in over a year. However, crude stocks at Cushing declined to 38 million barrels by July 9 — a 22% decline since the same time last year. Despite this apparent scarcity, WTI futures fell from their highs. Notably, the elevated backwardation of 6-month WTI futures continues, meaning the front month is more expensive than the 6-month contract. This spread has narrowed since last week, yet still reflects expectations of higher prices now, followed by a flood to come. Presumably, the high backwardation is enticing sellers to draw down inventories to sell sooner rather than later. However, inventories at Cushing are still well above their 2018 lows.
It is said that PD Armour, an entrepreneur who made millions selling meat to the US Army during the Civil War, was once told that there was considerable short interest in pork futures and was asked why he did not comer the delivery. He is said to have replied, “to commit murder is very simple; the trouble is to bury the corpse.” He was referring to the difficulty in offloading commodities after a short squeeze without depressing prices. What about a long squeeze?