How financial speculators manipulated the oil and energy markets - China Dialogue

How financial speculators manipulated the oil and energy markets

For more than a decade speculators have manipulated energy markets, forcing up the price of oil and the subsidies that go with it.

Fossil fuels are the most subsidised commodity on earth. Government spending to reduce the price of oil, gas and coal – through tax-breaks, giveaways, price controls and other methods – rose to US$409 billion in 2010, six times more than the US$66 billion allocated for renewable energy, according to figures released last year by the International Energy Agency (IEA).

In an age when the world is supposed to be weaning itself off carbon-intensive energy sources, why is this happening? Much of the blame can be laid at the door of the speculators whose market manipulations have made oil-prices volatile and high over the past decade. Here lies the solution too: get a handle on the speculation, and the need for hand-outs all but disappears.

Why are fossil fuels subsidised?

The key rationale for subsidising fossil fuels is that energy is an essential commodity for every household, and governments need to make it affordable for all. Nearly two thirds of fossil-fuel subsidies go towards reducing the energy cost of the poor and the middle class in emerging economies. These include subsidies that China and India hand out through a leaky distribution system to their middle classes. And they also include the subsidies doled out by oil producers Saudi Arabia and Venezuela to their populations, so heavy they keep fossil-fuel prices lower than those of water and create high and wasteful consumption.

Read more: Can the US and China bring oil prices in line?
Also: Why lower oil prices hold the key to renewable energy

Globally, in fact, fossil-fuel subsidies have a poor record of helping the very poor: the IEA estimates that just 8% of aid reached the poorest 20% of each country’s population in 2010. Kerryn Lang of the International Institute for Sustainable Development, a Geneva-based non-profit studying global subsidy patterns, said that many subsidies tend to be detrimental because they cause distortions in the economy, create vested interests and are subject to misuse.

Apart from the US$280 billion given mostly in developing nations to lessen the energy cost of the poor, the enormous global subsidy bill for 2010 included US$125 billion given by OECD (developed) and OPEC (oil-producing) nations directly to oil majors to boost production.

When oil was stable

State support to the fossil-fuel industry has grown over the last decade in line with a rise in the price of crude and market volatility. Back in 1970, the price of crude oil was around US$3.5 per barrel, close to the production cost. The Yom Kippur war between Israel and a coalition of Arab states in 1973, followed by an oil embargo on western countries, and the Iraq-Iran conflict, pushed prices up to US$30 a barrel by 1981. But afterwards, oil prices steadily dropped for nearly two decades due to creation of adequate reserve capacity of oil by western economies to offset the once too often reduction in supply from the Middle East.

Even the Kuwait-Iraq Gulf war of the 1990s, which witnessed massive refinery burning and oil-field blasting, failed to trigger a sharp upsurge in fuel prices. While oil consumption went up by 6.2 million barrels per day from 1990 to 1997, energy prices were stable despite wars and hurricanes, snowstorms and refinery disruptions.         

The Enron era

Then Enron arrived. The politically connected US corporation would singlehandedly change the rules of the game in energy supply. In 1996, California’s energy trading laws were deregulated and the future markets were allowed unrestricted trading following hard lobbying by Enron. The regulatory changes permitted energy traders the privilege of doing business in closed-door, private exchanges and exempted energy swaps from regulatory oversight, the key concepts behind its web-based transaction system, EnronOnline.

This started a sequence of high-level demand manipulations which finally resulted in the Californian energy crisis of 2001, when power prices rose by up to 20 times and blackouts were rampant, even though consumption in the state was just 28 gigawatts against a generating capacity of 45 gigawatts. Energy traders took power plants off line for maintenance ahead of peak demand to create artificial shortages, causing the price spikes in California’s energy spot market.

Strategies to manipulate the market – given names like Fatboy, Death Star and Ping Pong by traders – became the norm. Megawatt laundering, where power was bought cheaply, flipped out of California to an intermediary and then resold to the state at an inflated price, was rife, as was roundtrip cross trading – the constant buying and selling of a particular commodity to inflate transaction volumes and raise prices. After the Enron scandal broke and the regulators started investigations in the United States, the energy traders who had scented profits shifted base to London.

Among the early movers was Jeffrey Sprecher of Western Power Group, who had purchased the Atlanta based Continental Power Exchange in 1997. Sprecher reportedly presented his business plan for online energy trading to the then commodities chiefs at Morgan Stanley and Goldman Sachs – John Shapiro and Gary Cohn – as well as British Petroleum and Shell, all of whom agreed to do business with the start up in return for equity stakes. Other European banking and oil-trading giants like Deutsche Bank, Societe General and Total were later roped in to make the “cartel” complete.

Shapiro, who has since retired as head of commodity trade at Morgan Stanley told Business Week “At that time, Wall Street firms and energy companies were looking for a competitor to the deregulated exchange of EnronOnline. Jeff was very smart to realise that he had to give away a lot of equity.” This laid the foundation for the world’s most powerful trading alliance of big oil and big banks, working behind the closed doors of Sprecher’s deregulated ICE commodity exchange, where they – as stakeholders – could make their own laws.

Energy trading spurted at ICE soon after Enron’s collapse, when Sprecher acquired the International Petroleum Exchange in London and started crude-oil trading at ICE futures. They initially traded Brent crude (North Sea Oil), which constituted just 15% of global stocks, but whose physical supplies and prices could be fully controlled by the ICE trading coalition. Using similar practices to those seen in California – creating artificial shortages and round-trip trading between members – they caused prices to spike and created unprecedented volatility for the next decade.

British laws help build big oil cartel

A series of films by CBS News
investigating the speculative oil bubble of 2008, which interviewed everyone from Dan Gilligan, president of the Petroleum Marketers Association of America to the Saudi oil minister, points to extensive speculation in the commodity futures market as the source of the problem. Senators Carl Levin and Dianne Feinstein have been trying to respond to this by plugging the regulatory gap known as the “London loophole”, which permits speculative trading without regulatory oversight in the ICE Exchange, but so far ICE backed by the Wall Street Banks, oil majors and UK laws, has managed to evade closer scrutiny.

As the reports by CBS showed, cartel members, who controlled the supply chain from pipelines to refineries, restricted physical supplies to raise prices. Morgan Stanley became one of the largest oil traders with 450,000 subsidiaries trading oil from its humungous tank farms, or oil depots, while planned maintenance outages and supply shortages at thousands of kilometres of pipelines owned by Goldman Sachs and other members kept oil panic and prices high. This was a repeat of the plan that led to the California energy crisis, though much more sophisticated in execution and more widespread, with trading data from the commodity exchanges not available for scrutiny.

The high profitability of trading at the ICE deregulated exchange soon attracted the big Swiss commodity traders, like Glencore, Vitol and Trafigura, who controlled large parts of physical supplies of African and Dubai crude oil. Soon, oil volatility became a global phenomenon, disconnected from real supply and demand.

The 2008 oil-price spike to US$145 a barrel reportedly came as consumption of oil was falling and supply was on the rise. Global banks channeled hundreds of billions of dollars from pension funds into oil speculation, making the real consumer and retailer look like a flea on an elephant’s back.

The peak oil myth

Oil supply today is no longer “peaking”, thanks to new technologies like horizontal drilling, which have augmented supplies from new and existing wells. But that has not stabilised prices as you might expect. Nor has the entry of cheaper shale gas as an energy substitute affected prices outside of the US.

Rather, supply-chain manipulations by Big Oil and Big Banks have kept the prices of  crude well over US$100 a barrel for months, making feasible the entry of expensive and carbon-intensive sourcing like the oil production from the “Tar sands of Canada”. While oil from Saudi Arabia takes less than US$10 to drill, Canadian tar-sands oil has a production cost of US$60 per barrel. This highly carbon-intensive source would not be viable if the price of crude oil had not been pushed so high.

Last year, when oil prices shot up to over US$120 a barrel, actual consumption of oil fell by over 5% and new supplies grew by 8%. Panic caused by Arab unrest, supply-chain manipulations and the diversion of liquidity to revitalise banks saw oil prices move up despite falling demand. Given the current situation between Iran and Israel and the unsolved Syrian crisis, more volatility in crude is expected early next year if the strife escalates after the US elections.

Forbes reported in February
that speculation in crude oil may have added as much as US$23.39 to the price of a single barrel, nearly a quarter of the current price. If such speculation were curbed, subsidies for fossil fuel could be nearly negligible. The immense task of controlling billions of high-speed trading transactions at the futures market, 95% of which are not related to physical trading but affect pricing, makes a mockery of regulators, who are either incapacitated or co-opted into the system.

So what can be done? The Financial Transaction Tax proposed by the European Commission, which proposes to tax every monetary transaction and is bitterly opposed by London, could to some extent curtail the problem. This because it would be unviable to indulge in multiple trading rotations and pay tax every time, while the tax-linked system would also automatically help to trace the source of any such round-trip trading transactions.

Meanwhile, the United States and China have devised methods by which they are buying crude oil at a cheaper price than the rest of the world. These methods are not regulatory in nature but are market-based techniques to risk-manage volatile markets. Can the rest of the world follow their lead and limit speculation?

Next: Can the US and China bring oil prices under control?