Peak Oil News: Are Oil Prices Rigged?

Saturday, October 11, 2008

Are Oil Prices Rigged?


By Ari J. Officer and Garrett J. Hayes

We've all read that speculators are driving oil prices artificially high — a claim that gets more interesting in light of oil's recent fall below $115. But maybe we're looking at it from the wrong perspective. Suppose that major suppliers in the oil industry are these manipulative speculators.

Is it possible that oil prices are rigged? You bet. Here's how:

Just how would you raise prices if you were an oil supplier? Controlling the supply — as in the 1973 OPEC embargo — has become less effective with more sources of oil worldwide. And oil suppliers clearly cannot raise prices by controlling demand in the physical oil market; ultimately, they need to sell their oil, not buy it. However, with the market inefficiencies that we expose here, oil suppliers can regain the upper hand by artificially inflating demand using a different market. To understand this mechanism, we must take a glimpse into the future — the futures market, that is.

The price of oil reported in the news is actually the price of oil in the futures market. In this market, traders do not exchange physical barrels of oil, but instead trade contracts which obligate them to exchange oil at a quoted price at a specific date in the future, usually months in advance. Such a contract allows companies to hedge positions by locking in prices early. Airlines might buy futures contracts to reduce their exposure to rising fuel prices. Conversely, oil companies might sell futures contracts to assure a profit against future price drops. It's all about reducing risk and uncertainty. But what if oil suppliers were instead buying oil futures, compounding their own risk and reaping enormous profits from the explosion in the price of physical oil?

The futures market has become the public driving force in pricing oil. But the vast majority of oil consumed in the world is purchased through private deals, given the massive undertaking of physically delivering millions of barrels. However, a series of private deals cannot establish a market price. Because pricing in the futures market is transparent, in that trade activity is publicly available, it establishes the widely accepted benchmark for the price of oil. In other words, the futures market serves as the price discovery mechanism for the oil the world consumes.

Thanks to margin in the futures market, you can trade ten times more oil than you could otherwise afford. For only $9,000, you could control more than $140,000 of oil at recent highs.

All told, about one billion barrels of oil are traded daily through futures contracts at the New York Mercantile Exchange (NYMEX). This volume significantly overshadows the 80 million barrels of oil consumed each day worldwide. Yet this large volume of trading is misleading. Most of the trades are just noise: speculators going for quick profits, taking a position, and closing it out immediately.

A better measure of the size of a futures market is the open interest, the total number of outstanding positions. For contracts ranging from next month to a decade from now, there is a total of one billion barrels accounted for from the total number of outstanding positions. Interestingly enough, more than 30 billion barrels of oil are actually consumed each year. Despite all the volume, the claims realized through open interest pale in comparison to the actual consumption of oil. The futures market is much smaller than the real oil market. When you consider margin, the amount of money actually invested is even smaller. Indeed, one dollar invested in a long-term position in the futures market carries the leveraged weight of more than $300 in the physical oil market.

The point is, it would only take about $9 billion to control the entire long position in oil. That sounds like an enormous amount of money, but some of the major individual players in oil are bigger than the market itself: Sultan Hassanal Bolkiah Muizzaddin, of Brunei Shell Petroleum, is worth about $23 billion; Saudi Prince Alwaleed Bin Talal Alsaud is worth about $21 billion; Russian Vagit Alekperov of LUKoil is worth about $13 billion. No, we're not implicating any of these guys in market rigging; in fact the list of billionaires with that kind of swag is long. The point is that anyone in that category could clearly handle the risks of the oil futures market, and they might even be willing to take delivery on oil. With suppliers holding back their large stakes in oil before delivery, those speculators and hedgers on the other side (those who have sold oil) will need to pay higher prices to get out of their positions. Oil suppliers' ties to the oil market itself give them a unique advantage in cornering the market.

Why would these individuals or their companies risk their own money and reputations, should they be discovered? They don't need to. There's an anonymous investment vehicle — the hedge fund — with which they can even risk other investors' money for futures speculation. Although we're all affected by oil prices, we as oil consumers don't set the prices. Herein lies the problem. The futures market that serves as a price discovery mechanism for the physical oil market is open only to the elite. We trust these elites to determine the prices, but who are they? Who are the so-called experts? Hedge funds, oil companies, OPEC — the very people who profit from massive, consistent increases in prices. Notice a conflict of interest?

All an oil supplier would have to do to raise prices is buy up futures contracts.

It's not even that risky. Either the suppliers/investors risk an insignificant fraction of their gargantuan fortune, or they entice other investors to share the risk. With virtually unlimited resources and an actual tie to the underlying commodity, oil suppliers are in a far better position to accomplish this manipulation than, say, the Hunt brothers were during their attempt to corner the silver market in the 1970s.

It is in every oil supplier's best interest for prices to go up. Oil is a finite commodity. The world will eventually become more efficient and develop alternative energy sources. In the meantime, suppliers want to squeeze out as much profit as possible from their limited resources. Even if they know that the price of oil is too high (to the point of reducing demand) it is not in their interest to correct it. By setting prices in the smaller but more "trusted" futures market, oil producers realize multiplied gains on their physical oil sales.

Prices in the futures market — and, indeed, any real-life market on a standardized good — do not form where actual supply meets actual demand; they form where perceived supply meets perceived demand. Participants in the futures market merely represent the world around them. A veil has been placed over the public's eyes, and they accept this illusion of a fair price.

Unfortunately, the price set by the all-too-small futures market transcends oil to influence the entire American economy. Our oil-dependent economy is shaped by oil's arbitrarily determined price. In many ways, oil has become a pseudo-currency. Similarly, with oil traded internationally in U.S. dollars, the dollar is pegged against oil. While squeezing American industry, high oil prices also devalue the dollar. With the state of our economy reflected in the price of oil, it has become a new standard for valuing America. We are slaves to this black gold standard.

The American market system, purportedly a free market despite its flaws and gross inefficiencies, has opened this vulnerability. The oil suppliers may tighten the noose, but we tied it around our throats long ago. Hiding behind the wall of anonymity, the perpetrators profit and achieve their own ends, bringing down America in the process.

The futures markets is a closed book that needs to be opened beyond price transparency to participant transparency. After each contract has expired, NYMEX and other exchanges should reveal the participants in each trade. Tear down the wall of anonymity, and long positions will, we believe, connect back to oil suppliers, who should theoretically be sellers of oil, not buyers.

Is this vulnerability a reality? Is economics so wrong in applying its supply-demand theory that we might confuse corrupt manipulation with fair pricing? There's motive, opportunity, and greed at play. Why would we expect anything else?

Ari J. Officer studies financial mathematics at Stanford University. Garrett J. Hayes studies materials science and engineering at Stanford University