Memorandum submitted by Alan Barton
THE PRICE OF OIL
As long ago as 1997 worrying trends in oil pricing
began to show themselves. Since the start of the oil business
in the late 19th century the natural law of supply and demand
had determined the value of this extraordinary hydrocarbon at
any moment in time and this appeared not to be the case any longer.
With the advent of new technologies in the early
80s it became possible to establish oil futures exchanges and
transmit electronically live prices for months ahead from the
exchange to screens in offices worldwide. The earliest and most
significant of these was the Mercantile Exchange in New York,
closely followed by what became it's satellite, the International
Petroleum Exchange in London.
The effect on the oil business itself was dramatic
in that the price on the screen more or less set the price in
the physical market but with it came another more destabilising
development. Computer programmes had been written to use past
market data to define market trends and to use this "sign
language" to develop trading strategies. The finance houses
concerned saw this technology as being applied to the new commodity—oil.
This meant that the oil price could be set without any reference
to the situation in the physical oil business itself.
These trading strategies became known as Technical
Analysis and the conditions existing in the real world as the
Fundamentals. So diverse were the two that the editor of the house
magazine of the IPE, the Pipeline, decided that it would be appropriate
to publish a piece on Technical Analysis versus Fundamentals.
I wrote the section on Fundamentals but at my request it did not
bear my name because of the possible conflict of interest with
my employers.
My item, copy of which is attached, set out
a brief history of oil pricing with particular reference to OPEC,
of course, and the perils of Technical Analysis. My final paragraph
prophetically expressed concerns about the effects these changes
would have and my view that the possible result could be "unjustifiable
price increases for consumers". This, of course, is exactly
what happened.
Over the last few years there has not been any
problem with the availability of oil and this cannot be why we
have seen such an exorbitant increase. Prices of around 100 dollars
per barrel are symptomatic of a crisis in supply that has simply
not existed. The main reason fo this unnatural paradox has been
that large international financial institutions came to see in
the oil futures markets the possibility of big profits by trading
in this new and largest "commodity" in the world. There
was no need to have any knowledge whatsoever of a barrel of oil
itself, the main game being to profit from price movements, up
or down, the objective being to buy and sell, or the other way
round, in order to gain from the difference. The absolute price
was not really relevant. Furthermore, additional change ("volativity"
is the technical description) could be generated by building into
the price the possible effect of events which may or may not take
place in the future such as military actions, strikes, adverse
weather, etc. Hence the going price, ultimately paid by the consumer,
includes a differential for the possible effect on supplies which
have not taken place and might never occur. On top of this there
has been an explosion in the growth of derivatives for all types
of oil deals that are freely available in the unregulated OTC
(over the counter) market.
A house of cards has been created.
Meanwhile, today OPEC sits on the fence. When
asked about the huge increase in price they say it is due to "speculators".
In fact they are telling the truth in that the OPEC power on pricing
has been overtaken by the forces of the futures market. Most members
are happy to receive the greatly enhanced income although the
largest ones, especially Saudi Arabia, are probably concerned
about the long term effect of the resulting damper on demand,
the boost it provides to renewable alternatives and the way it
scrambles the economics on long-term investments. It is possible
that the bigger OPEC countries would be willing to accept a price
around 30 dollars.
The wave spreads to other forms of energy especially
natural gas where prices are linked to oil by formulae contained
in the contracts. The oil and gas companies reap staggering profits
and when questioned simply point to the "market". For
most of the oil companies this is hiding behind a falsehood. They
know that the "market" is not the real market at all
and that the price is set by a few financial "traders"
pushing buttons in New York but they are happy to quietly make
their billions without any blame. Some of them assist in the process
using futures in a big way for hedging, thereby providing liquidity,
the lifeblood of the futures market. One huge oil company does
not use futures at all preferring to ride the waves while another
speculates in it and has received many fines for price fixing.
For the gas companies these immense profits are truly windfalls.
While not part of the primary reason for the price inflation they
are well aware of it and how they benefit by association with
a pricing system they know to be unreal. In a letter published
in the Daily Telegraph a year or so ago the author who
I happen to know is a highly experienced gas man, pointed out
that the true landed cost of gas in the UK was between 10 to 20p
per therm versus a wholesale price at the time of 67p.
The political effect is even more disturbing.
The massive flow of petrodollars has revitalised Russia and given
countries, many unfriendly to the west, increased financial muscle
to use as they see fit. One of the reasons the US attacked Iraq
was not about oil itself (Iraq never interfered with the flow
of oil to the US and other western markets) but the money it generated
for Saddam. The imposition of sanctions did not stop this and
huge sums continued to be transferred illegally back to Iraq by
oil traders, mostly American, some of whom were unmasked after
the invasion and prosecuted with at least one jail sentenced passed.
Iran, a long standing price hawk in OPEC, which
is currently at odds with the west over nuclear matters, and the
backing of terrorists has been gifted for years huge increases
in oil revenues.
It is so ironic that the country where the damage
is the greatest, the USA, has it's source at home on it's doorstep—the
"Merc" in New York.
Action can and must be taken to change the situation
if only for the sake of national and global economies. Furthermore,
unless steps are taken an escalation of conflict in one form or
another appears inevitable.
March 2008
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