by Tom Bower
The impetus for the change was BP’s discovery of oil in the North Sea. Before the discovery of the Forties field in 1970, few experts had believed that any riches would be found under the gray water. The surprise breakthrough fired a stampede, akin to a gold rush. Among the biggest reservoirs was “Brent,” discovered in 1971 beneath 460 feet of water, which would provide 13 percent of Britain’s oil and 10 percent of its gas. Developed by Shell across 10 fields and 13 platforms, the reservoirs were 9,400 feet below the seabed, and the oil was piped 92 miles to Sullom Voe, a terminal in the Shetlands, using unique technology. In 1976 Shell’s experts estimated that production would end in the mid-1980s, and on that basis the oil companies were allowed to take the oil cheaply, without paying special taxes. But as the North Sea reserves’ true size became apparent and their productivity was extended for at least a further 35 years, the British and Norwegian governments imposed punishing taxes just as on other national oil companies, and reaped the same consequences of the oil majors refusing to search for new oil.
Initially the North Sea produced about 24 tankers of oil every month. As production increased, a few American refineries switched to the “light and sweet” North Sea crude and abandoned Saudi Arabia’s heavy “sour.” Although the quantities of this oil were small, their effect on the market was significant. After 1976, North Sea production was controlled by the British and Norwegian governments. To avoid oil shortages in Britain and to thwart profiteering, the government agency BNOC (British National Oil Corporation) intervened at the taxpayers’ expense to undercut OPEC prices, and directed that crude should be sold only to refineries. In the early 1980s these restrictions were breaking down, and North Sea oil was leaking onto the “spot market,” attracting dealers in London and New York. Although the quantities traded were small, the free market of Brent oil became the price-setter or benchmark for oil produced in North Africa, West Africa and the Middle East. The Saudis complained of chaos, but the traders loved the opportunities for speculation. BP and Shell fixed Brent prices, and using BP’s oil and information, Andy Hall began trading Brent oil aggressively. Both oil companies had to accept that the market had become opaque.
To introduce transparency into the “forward” market while controlling prices, Peter Ward, Shell’s senior trader and the self-appointed guardian of the Brent market, formalized in 1984 the idea of “15-day Brent.” On the 15th of every month the oil majors were assigned a cargo of 600,000 barrels of Brent crude at Sullom Voe for delivery the following month. At that point, once the oil major named the day for delivery, the Dated Brent could be traded, and speculation started. “Forward” meant a standard paper contract to physically deliver oil at an agreed destination but in an unregulated market beyond the exchanges in London, New York and Chicago. Tankers carrying 600,000 barrels of oil were sold and resold 100 times before reaching a refinery. Ward believed he had created an orderly market at fixed prices. He had not anticipated that Hall and others would profit by legitimately squeezing rival traders. As the oil traveled across the North Sea, it was bought and sold by traders playing a dangerous game — buying more Dated Brent than had been sold, knowing that others had sold more than they had bought, in the expectation of eventually balancing their books. Since the quantity of Brent oil available every month was limited, Hall could profit by buying large quantities for future delivery, hoping that rival traders would eventually be compelled to buy from him at a premium price. Squeezing the market — compelling rival traders needing the oil to fulfill their own contracts to buy at his price — added uncertainty and volatility to prices. As the Dated Brent was sold to refiners, the price of the 15-day Brent rose because there was less on the market, rewarding the squeezer. In that topsy-turvy world, Hall perfected the squeeze, attracting charges of price manipulation. The squeeze, Hall knew, was not illegal. On the contrary, the British system invited speculators to buy large quantities of Brent for future delivery, despite the fact that Hall’s tactics precipitated a 15-year battle to draw a line between aggressive dealing and manipulation of the annual $30 billion trade.
As the spot market grew and prices moved depending on disruption of supplies, Hall became a substantial participant in the “futures market” for the sale of oil—taking advantage of regulated trade on an exchange. His advantage over other traders was BP’s own information. Only BP knew how much oil would be piped from its Forties field through its own pipeline to the terminals at Hound Point. Working with Urs Rieder, a Swiss national at BP’s headquarters in London, and under the supervision of Robin Barclay, BP was not only anticipating how prices would vary, but was actually causing the market to change. That power transformed the company’s image. Buoyed by BP’s constant participation in the physical market, Hall traded uncompromisingly against smaller competitors. Leveraging the market to the hilt was not illegal, but entrepreneurial. Rieder’s move from BP to Marc Rich strengthened the relationship between Hall and the American trader. To outsiders, BP had become the elite of traders. BP’s traders were a special breed, stamped by pedigree and lifelong friendships. Not only were they numerically astute, they were also internationalist, aware of historical, religious and cultural tensions dictating the price of oil. Among them, Hall shone as the head boy of a new school.
Hall’s casualties included Tom O’Malley, Marc Rich’s successor at Philipp Bros. Shrewd, intriguing and charismatic, O’Malley possessed an instinctive understanding of oil trading, bending rules but, unlike Rich, not breaking them. Profiting from the oil industry’s inefficiency and the market’s ignorance, he occasionally exported cargoes of oil from America’s West Coast to the East Coast merely to boost prices on the West Coast, but he was occasionally stung by Hall’s squeeze when he was contracted to supply Brent oil in New York. To enhance his business and remove the competitor treading on his toes, O’Malley offered Hall a job. Simultaneously, Hall also received an offer from Marc Rich. At the climax of his negotiations with O’Malley, Hall asked for the terms and conditions of his employment and a company car. “Terms and conditions,” snapped O’Malley, “is BP bullshit. You come to Philipps to become rich.” Hall’s resignation from BP in summer 1982 was regarded as a bombshell in London. Rising stars and potential board members never left the family.
Combined, Hall and O’Malley were feared as “crocodiles in the water,” and became notorious for analyzing markets, buying large, long positions in Brent oil, and holding out if there was insufficient volume until rivals screamed for mercy. In the Big Boys’ game, a rival trader’s scream was an invitation to squeeze harder. Philipp Bros., or Phibro, was good at squeezing, because there were large numbers of small traders — at least 50 in the US alone. To outsiders, Phibro personified the separate world inhabited by oil traders. “You’re ignoring the rule, ‘Don’t steal from thy brethren,’” London trader Peter Gignoux complained. The British government’s remaining control over North Sea oil prices crumbled as Phibro aggressively traded primitive derivatives and futures against rival traders. The “plain-vanilla swap” compelled the customer either to take physical delivery of the oil or pay to cover the loss.
For the first time, global oil prices were influenced by traders speculating as proprietors, regardless of the producers or the customers. The OPEC countries, especially Saudi Arabia, hated their game, and even Shell was displeased that their precious commodity created profiteers and casualties. In 1983 the market became murkier when Marc Rich remained in Switzerland and escaped facing criminal charges including tax evasion. Despite the scandal, Phibro and others continued to trade with him and Glencore, his corporate reincarnation in Zug. Phibro’s aggression invited retaliation. During that year, Shell took exception to Phibro squeezing Gatoil, a Lebanese oil trader based in Switzerland. Gatoil had speculated by short-selling Brent oil without owning the crude. Subsequently unable to obtain the oil to fulfill its contracts because Phibro had bought all the consignments, it defaulted on contracts worth $75 million. Refusing to bow out quietly, Gatoil reneged on the contrac
ts and sent telexes to all its customers blaming Hall’s squeeze. Shell’s displeasure was made clear at the annual Institute of Petroleum conference in London, where every trader was warned not to attend Phibro’s party featuring Diana Ross. “A puerile idea to boycott our party,” scoffed Hall, furious that the “clubby clique of traders around Gatoil and Shell obeyed and we were on the other side.” Shell levied a $2-million charge, and Phibro paid.
Michael Marks, the chairman of New York’s Mercantile Exchange, Nymex or the Merc, attempted to put an end to the chaos in 1983. Dairy products had been traded on Nymex since the market was established in 1872; Maine potatoes were added in 1941; and later traders could speculate on soya beans, known as “the crush.” Marks introduced trading of heating oil, an important fuel in America, and crude oil futures, dubbing the price spread “the crack.” The reference for prices was the future delivery of West Texas Intermediate (WTI, America’s light sweet crude oil) to Cushing, a small town of 8,500 people including prison inmates in the Oklahoma prairies. Several oil companies were building nine square miles of pipelines and steel container tanks in Cushing as a junction linked to ports and refineries in the Gulf of Mexico, New York and Chicago. Prices quoted on Nymex, based on those at the Cushing crossroads, rivaled those at London’s International Petroleum Exchange, trading futures in Brent and natural gas delivered in Europe. Instantly, the last vestiges of Saudi Arabia’s stranglehold over world prices were removed. With the formalization of a futures market, OPEC’s attempt to micromanage fixed prices was replaced by market forces. The fragmented market became more efficient, but also murkier. Dictators producing oil were unwilling to succumb to regulators in New York, Washington and London. Instead of sanitizing oil trading, Nymex lured reputable institutions to join a freebooting paradise trading oil across frontiers without rules. “I wish we were regulated,” one trader lamented. “Why?” he was asked by Peter Gignoux. “So I could tweak the rules.”
In 1982, Phibro had faced an unusual problem. The profitable commodities business was handicapped by a lack of finance. Its solution was to buy Salomon Brothers, the Wall Street bank, and begin issuing oil warranties. Manhattan was shocked at a commodities trader owning an investment bank. Overnight, Hall and O’Malley were established as super-league players among oil traders, yet Hall was upset. “Traders and asset managers don’t mix,” he announced. “I don’t want to be part of a bank.” Phibro moved to Greenwich, Connecticut, to be as far from Salomon as possible, operating as a hedge fund before hedge funds became widespread.
Across Manhattan, Neal Shear, a pugnacious gold trader at Morgan Stanley, had watched Hall’s success with interest. Recruited in 1982 from J. Aron & Co., a commodities trader owned by Goldman Sachs, to start a metal-trading business to compete with his former employer, Shear envied the easy profits Hall and Rich were making. Compared to gold, he realized, oil trading was much more sophisticated and profitable. Without transaction costs or retail customers, and blessed by general ignorance about differing prices in Cushing and elsewhere in America, traders could pocket huge profits. In economists’ jargon, oil trading was “an inefficient market.” Shear’s business plan was original: “Our concept is not to be long or short but flat, to profit from transport, location, timing and quality specifications.” Initially he wanted Morgan Stanley to copy and compete with Hall and Rich, but Louis Bernard, one of the bank’s senior partners, understood that the rapid changes in oil prices guaranteed better profits than speculating in foreign exchange. On Morgan Stanley’s model, the volatility of oil prices could be 30 percent, while in the same period foreign exchange could move just 8 percent. Investment bankers who had traditionally offered their clients the chance to manage risk in foreign currencies could make much more by offering them the chance to manage, protect and hedge crude prices against the risk of price changes. In 1984 Bernard hired John Shapiro, a trader at Conoco, and Nancy Kropp, a trader employed by Sun Oil, to trade crude. To ensure a constant stream of information about the market’s movements ahead of its rivals, the bank leased a few oil storage containers from Arco in Cushing. Hour by hour the traders in New York would be aware of whether there was a surplus or a shortage of WTI in Oklahoma, which determined prices on Nymex. Shapiro invented oil options, explaining the new idea to the oil industry at its annual conference in London in 1985. “We’re not taking speculative positions,” he explained. “This is defensive, as a hedge, leaving Morgan Stanley to manage the residual risk. We’ve no desire to do an Andy Hall.” Andy Hall had also “invented” oil options, offering to the public the chance to invest in the oil trade. In the same year, by a different route, Goldman Sachs established another group of oil traders.
As the gold market deteriorated in 1981, J. Aron & Co., a conservatively managed precious metals dealer, had been sold to Goldman Sachs for $30 million, although the rumored price was $100 million. Goldman Sachs’s partners had only agreed to buy what one called a “risk-averse pig in a poke” because they assumed that Phibro’s purchase of Salomon’s must be clever, and Aron would give them additional international experience to earn a slice of the commodities trade. Three years later, 30 Aron metal traders were ordered to start trading oil. Under the leadership of Steve Hendel, Charlie Tuke and Steve Semlitz, they were to rival Morgan Stanley. Among their new ventures was speculating in heating oil contracts. By offsetting any order to buy or sell heating oil for future delivery, the bank earned its profit on the arbitrage regardless of future prices. “Arbing on the difference in price” depended on whether the speculator took a bearish or bullish view, but the risk was taken by the customer. The bank’s books were nearly always balanced. Whenever an order to buy was booked, the bank’s traders made sure that the order for the future was fulfilled by finding a supplier. In those early days, neither Goldman Sachs nor Morgan Stanley was a proprietary trader betting on the price, and they were blessed that British banks were either too sleepy or too small to compete.
In 1985, to profit from the “cash and carry possibilities” of heating oil and crude, Goldman Sachs’s traders also acquired storage containers in Cushing and New York. The two American investment banks had become players in physical and paper oil. Oil prices, they realized, were determined not only by demand, but also by supply and international events. In that jigsaw, they traded only if they had the edge. Recognizing that accurate prediction of prices was impossible, the traders did not bet on prices going in a particular direction, but traded on the volatility itself as Brent fell from $30 a barrel in December 1985 to $9 in August 1986. Fast and furious, dealers traded huge volumes even to earn just half a cent on a barrel. The watershed in their trading — before computer models had eradicated the club atmosphere — was the formal introduction of derivatives (“Contracts for Difference”), allowing traders to own huge “paper” positions to influence the market. Bankers, oil traders, the oil companies and the OPEC producers were plotting against each other to master and manipulate the market. The trade in futures, or “paper barrels,” was as much a banking business as an oil trader’s speciality.
1986 was the beginning of oil’s Goldilocks years. Survivors of the crash were destined to earn fortunes because of the volatility of prices. Regardless of whether these went up or down, the traders could profit. During the boom in the 1970s, oil prices had soared fivefold, and pundits had predicted $100 a barrel. In the mid-1980s, Sheikh Ahmed Zaki Yamani, the Saudi oil minister, became worried that high prices would encourage the West to search for alternative sources of energy. In that event, he anticipated, the floor for oil prices would be $18. Others including Matt Simmons, a Houston banker, predicted a crash. “Stay alive till ’85” became the mantra of groups characterized by Simmons as “insular and unreliable” for failing to understand the effect of the growing excess capacity. Contrary to their expectation, oil prices had fallen despite the Iran–Iraq war. Falling prices appealed to President Reagan. According to rumors, in 1985 he urged King Fahd of Saudi Arabia to flood the world with oil in order to des
troy the Soviet economy; at the same time, Margaret Thatcher ended BNOC’s monopoly in the North Sea, deregulating prices of Brent oil. During December 1985, Simmons’s pessimistic forecast began to materialize. Prices were falling from $36 as Saudi Arabia flooded the world with oil, and they fell further as unexpected surpluses of oil from Alaska, the North Sea and Nigeria were dumped on the market. Traders in the speculative Brent market played for huge profits as prices seesawed. The value of 44 to 50 tankers carrying 600,000 barrels of crude oil every month from the North Sea terminals to refineries assumed global importance among the 50 players — oil companies, banks and traders. All crude oil in the world beyond America was priced in relation to Dated Brent, the benchmark of oil prices. Two traders fixing a future price for oil produced in Nigeria would base their contract on the price of Brent on the material day in the future. By squeezing the price of Dated Brent, traders could directly influence the price of crude sold by Nigeria, or Russia, or Algeria. Fortunes could also be made by manipulating the market prices of other oils across the globe based on Brent.
In that hectic atmosphere, a group of traders regularly met at the Maharajah curry house off Shaftesbury Avenue in central London to agree to joint ventures to reduce risk and decide what price they would bid for Brent. In the era before the computerization of the markets, the traders, unable to know at an instant the price of oil elsewhere in the world, relied on gossip and trust, knowing that rivals would pick their pockets whenever possible. The atmosphere in the curry restaurant was akin to a club where “everyone was prepared to screw but not kill.” Over 50 percent of the trading market was governed by self-interest rather than laws. “Can you break a law when laws don’t exist?” asked one club member rhetorically. Unscrupulous traders seeking to achieve the desired price on a Dubai contract would try to squeeze the price of Brent oil on that day. Shrewd traders noticing a rival taking up a perilous position would step aside to avoid a crash. The unfortunates who screamed “help” could expect assistance, but at a price. The hostility was not tarnished by malice. Those meeting in the restaurant were deal junkies playing for pennies on each barrel, and at the end of the day they jumped into their Porsches to party and celebrate all night with Charlie Tuke before starting to trade at 6 o’clock the following morning. Among the reasons to celebrate was the crash of Japanese trading companies in London. In previous years, their traders had been paid commission on turnover and not profits, and were thus keen to accept any contract. Those traders were known as “Japanese condoms” because they would be left holding all the contracts. As oil prices fell in the mid-1980s, the Japanese traders had been forced to pay huge sums to the London traders before their companies closed. “Hara-kiri all round,” toasted the profiteers, enjoying in that helter-skelter era the fierce competition by rival markets in New York and Chicago to attract their trade.