by Tom Bower
Guy Caruso, the head of the EIA, was the man in the middle of the two sides’ increasingly sterile arguments. Appointed by the George W. Bush administration in 2002 after serving for 12 years as an energy analyst at the CIA, Caruso had won star status by correctly forecasting the 1973 crisis, but he had also been involved in the mistaken CIA forecast in 1977 that Russia would become a net oil importer. Twenty-six years later, he acknowledged his misunderstanding, and disparaged the pessimism among the peak oil advocates, who relied on conservative, erratic and inconsistent data when so much depended upon price and technology. Russia had an abundance of oil — an estimated 250 to 300 billion barrels of reserves, of which 100 to 150 billion were recoverable — but extraction was fraught. The Russian slump in the early 1990s had been reversed with Western technology. The country contributed between 10 and 15 percent of the world’s production. Caruso predicted in 2003 that the world could rely on non-OPEC producers increasing their output from 40 million barrels a day to 54 million by 2025. Only production data, he said, was truly reliable. Annual production in 2021, predicted the EIA, would be between 48.5 billion and 78 billion barrels. Caruso’s forecast depended on the national oil producers expanding production; his optimism was shared by Peter Davies, BP’s chief economist. Pessimism in the industry, said Davies, an authoritative spokesman against peak oil, stemmed from weak demand causing less oil to be produced. Scientifically, he felt, there was no proof that the world was approaching “peak production.”
Caruso’s and Davies’s optimism was rejected by Peter Wells, a former BP engineer and peak oil believer, as “highly unlikely.” While OPEC producers, Wells argued, had failed to invest, and their spare capacity had fallen from 10 million barrels a day in 1987 to 1.5 million in 2004, the non-OPEC producers had also failed to replace depleted reserves. The result, he predicted, would be an oil-supply crisis that “can be expected to be acute after 2005,” causing actual shortages in 2007. Wells was supported by Jean H. Laherrère, a colleague of Campbell’s, who projected hitting the peak in 2010 at 33 billion barrels a year; by the IEA’s experts, financed by the OECD, who dated the peak as starting in 2012; and by Chris Skrebowski, the editor of Petroleum Review. Skrebowski reckoned that Venezuela’s oilfields were depleted, only clever tricks would recover oil from the fast-declining North Sea, and Russia could produce no new reserves, especially offshore. He predicted the peak starting in 2010 or 2011. That group questioned whether Caruso was clever enough to understand their arguments, and whether, as a Republican appointee, he withheld arguments that conflicted with the administration’s policies.
Besides the irreconcilable optimists, wishful thinkers, pessimists and alarmists who had provoked Hall to “get thinking,” he also noted the indisputable upheaval. Since 2001 Venezuela’s President Hugo Chávez had been gradually expelling the oil majors, initially by increasing their royalties to 30 percent; in Mexico, Vicente Fox’s stumbling failure to reform Pemex suggested a fall in production by another major supplier; China’s demands were increasing beyond anyone’s guess; the global economy was in the early stage of a boom; and in Washington there was disarray. The election of George W. Bush had been interpreted as an advantage for Big Oil, but like his predecessors, Bush had failed to formulate a coherent energy policy. Paralyzed and ignorant, the White House was suspicious of the CIA’s annual estimates of the state of the oil industry, but Bush rarely invited the presidents of the Big Four oil companies to the White House to hear their opinions. He could not change the laws governing the building of refineries although the newest had been built 30 years earlier, and he was unable to persuade Congress to permit drilling for oil off the coasts of Florida and California, or in Alaska’s wilderness. Fearful that oil supplies were peaking, energy secretaries spoke in terrified tones about their own weakness, dithered about strategy, toyed with dependence on Russia, and instinctively accused the producers of blackmail. Having studied all those patterns, Hall was sure that oil would eventually be priced far above $20. The uncertainty was whether his superiors would support his gamble against the whole industry. Fortuitously, he was asked by Bob Rubin, President Clinton’s former treasury secretary who had been appointed as a board member of Citigroup, to offer a presentation on oil to the bank.
Hall owed his continued employment in the Citigroup to Rubin. In 1998, Salomon-Phibro had been bought by the Travelers Group, which later that year merged with Citicorp to form the world’s biggest bank. Based by then in a squat office building in Westport, Connecticut, an hour by train from Manhattan, Hall could have been in Siberia as far as Sandy Weill, his ultimate boss and the joint chairman of Citigroup, was concerned. Indeed, if Weill had had his way, Hall’s operation would have been closed down after Citicorp bought Salomon Brothers. He was unimpressed by its lackluster profits even in the good times. “Cents rather than dollars,” he said, unconvinced about a bank actively trading commodities, and especially oil. Traders, in Weill’s opinion, were an aberration. Jamie Dimon, the president of Citi, had until his departure in 1998 agreed. Initially, Weill limited Phibro’s exposure to risk; then, still dissatisfied, he ordered Hall to liquidate the operation. Hall had found a buyer at the time that Bob Rubin joined Citigroup. Unlike Weill, Rubin had been involved in Goldman Sachs’s development of J. Aron, and he understood the profitable advantages of trading commodities. Rubin also acknowledged Hall’s reputation. He had been around for longer than others, and although he lacked the conviction and the finance to copy Morgan Stanley’s and Goldman Sachs’s operations, in recent years he had earned profits as a trader. Rubin ordered Hall to stop the sale of Phibro and address a group of Citi executives.
Hall’s theme was the world running out of oil. “I’ve dug into the facts,” he told his audience, “and saw that supply will not meet demand.” He intended, he said, to bet against the oil majors and his rival traders. “It’s a three- to four-year bet,” he explained. “It’s not a question of ‘if’ but ‘when.’” Oil prices, he thought, would head toward $100 a barrel. “Everyone else,” he said, “is behind the curve.” That included Morgan Stanley, which, he explained, believed that the network of tankers, storage and billions of dollars of hedged oil contracts provided invaluable intelligence about the future. “Advanced intelligence is bogus,” said Hall. “Customers don’t tell the brokers their intentions. Those close to oil can lose more than the consumers. The flow of funds is more important than customers.” Morgan Stanley, he could have added, had risked much more than Phibro. To earn $2 billion profits, the bank owned assets worth $25 billion. The risk involved in that 10 percent return included being left with the liabilities if the investors crashed. He concluded with the critical challenge: “If my thesis is right, the bet will perform the same as buying oil at ‘spot’ but with less risk. So if I buy at $30 and the price goes to $120, I’ll earn 400 percent profit. But if I wait until the price hits $120 and then rises to $200, my profit will not be as interesting.”
Citi’s chief economist disagreed. “As prices rise,” he argued, “so will supply to meet demand.” Shortages, he explained, could not last forever, because rising prices would drive investment in high-cost production, and demand would eventually decrease. He echoed Peter Davies in believing that the pessimists were guided by weak demand, which meant that less oil was being produced, rather than that peak production was imminent. Hall’s reply was scathing. “It’s nothing to do with price. It’s geology. The world’s running out of oil.” Economics, he argued, would be turned on its head. “No one will want the oil when the prices get too high.”
Hall’s argument, carefully based on Hubbert and his disciples, won Rubin’s support. “No one paid any attention to the economist,” said Hall on his return to Connecticut. “I hate going to New York.” Hall had mastered the commodity and the market, read the literature, spoken to the right people, and was ready to stake about $1 billion in margin calls. He would buy oil two to five years in advance. Since the market was in backwardation, oil was cheaper in the future than on
the instant “spot” market. Holding 90 percent of Phibro’s “book,” or positions, he wanted to bet against the world, particularly the banks, rather than the oil majors.
Speculating about oil prices had been transformed by the major players. The growing popularity of “swaps” and over-the-counter (OTC) contracts, developed during the 1990s to reduce and spread the risk assumed by energy providers, merchants and traders, had become frustrated by the limitations of trading and pricing through reporters and the existing exchanges. Brokers crying out on the floor of the Nymex exchange in New York represented traditional traders buying oil for immediate delivery and speculating about future prices. After 1983, the “spot” trade had extended into “swaps” in the OTC market. “Swaps” were perfect for two traders to agree a deal specifying a range of variables including the price, location and specification of products, which was unavailable on Nymex. Not only was the agreement customized to suit the two traders, but there was no commitment actually to deliver the oil or natural gas, merely an agreement to pay the difference in price on the day the swap expired. In effect, “swaps” were trades in price, not in oil itself, and were used by both speculators and traders to protect or hedge their positions, reducing or spreading the risk. The final price would be calculated against Nymex’s. In 1990, traders demanded that regulatory authorities acknowledge that the trade was legitimate and their agreements were enforceable. Responding to those demands for unhindered growth, the CFTC agreed in 1991 that complex derivatives could be bought and sold using borrowed money or on margin calls. Under pressure from the traders and bankers, in 1993 Wendy Gramm, the head of the CFTC, announced that the regulator would not exercise its authority over the “spot” trade or over swaps or “forwards” on the OTC market, the equivalent of Nymex’s “futures.”
As the trade expanded, the OTC traders speculated on the price of oil, natural gas and electricity free of any controls, and simultaneously expressed dissatisfaction with Nymex. “Nymex has too many shenanigans on the floor,” complained one of the leading bankers pioneering the OTC trade. “No one’s policing the brokers. They are greedy and rigging the market.” The traders believed Nymex’s brokers were deceiving their clients about the prices on the floor for their own profit. Equally unacceptable was the iron grip imposed by Enron. Electronic trading of energy swaps was only possible through Enron-on-line, a facility that allowed Enron’s own traders to see every bid and deal made by rival traders and major energy corporations, and to adjust their own prices accordingly. The expanding “voice-brokering” community trading swaps acknowledged its own inefficiency. Trading by telephone calls and telexes was time-consuming, and Enron-on-line proved the advantage of electronic trading.
John Shapiro of Morgan Stanley wanted a neutral exchange and a genuine market to trade customized “swaps” electronically 24 hours a day, a facility Nymex’s directors refused to provide. After securing the agreement of Tim O’Neill at Goldman Sachs, Morgan Stanley sought the agreement of BP and Shell to establish the Intercontinental Exchange (ICE), an electronic exchange or bazaar to be used by major oil producers and traders on their own terms. The oil companies’ response was positive. Like the banks, they scorned Nymex’s floor traders as compromised, and Platts reporters as “kids two years out of college who can be easily outwitted by those knowing the business and can’t be relied on to get today’s price.” Nine other major market-makers agreed in 2000 to share ownership of ICE, trading “swaps” using a computer in Atlanta. Their deals, the founders agreed, would be settled by using the average of Nymex’s prices on the day. Motivated by their desire to be free of Nymex, the founders successfully argued that since only large corporations were participating, they did not require regulation or government protection from misconduct. Subscribers trading through ICE would be able to avoid US regulators.
Jeff Sprecher, ICE’s first chief executive, was keen to establish the new market. In 2001 he bought the limping International Petroleum Exchange in London, which traded futures in Brent and natural gas delivered in Europe, and merged it with ICE. ICE’s subscribers were now further removed from American regulators. By trading WTI in London, the newly named “ICE Futures,” an exclusively electronic exchange, was nominally supervised by the British Financial Services Authority, an understaffed, underfunded and inept regulator. That encouraged aspiring speculators to trade oil. Rapidly, ICE’s footprint spread across the world, attracting over 1,000 OTC spot traders and 440 futures traders using 9,300 active screens. The explosion was noted by the regulators in Washington and London, and was ignored. Asian and the Middle Eastern traders were using ICE by hedging oil derivatives (CFDs), although the identities and honesty of those influencing prices beyond the regulators’ knowledge was unknown. The ignorance was compounded by the exceptional complications introduced into oil trading by investment fund managers, bankers and speculators.
The new complexities did not deter Andy Hall. As he began taking long positions, he believed that prices could only go in one direction if the market became the epicenter of craziness. Over several months he bought call options on Nymex and “swaps” from the banks, not least from Goldman Sachs, which owned a stash of Mexican oil. “We’re easing our way in,” he told his staff, “to prevent the market moving against us. At the end of several months, he had invested the first $1 billion for the delivery of oil over the next three to five years.
Hall’s rivals were unaware of his plans. “Andy,” said one of his awestruck competitors, “doesn’t speak to people. He distills the salient points out of the essence from reading, which with hindsight is brilliantly obvious, but hidden by specious and wrong ‘facts.’” No one within that small community doubted that Hall embodied “the perfect combination of immense intellect and off-the-scale commercial brilliance.” None of his admirers was aware that the basis of Hall’s mammoth bet was an old, controversial and, to some, discredited theory.
The slow increase in the demand for oil reinforced Hall’s conviction that supplies were peaking and prices would rise. The number of identifiable speculators was limited. The principal players on ICE, especially the banks — Morgan Stanley, Goldman Sachs, Lehman’s, J.P. Morgan and Barclays Capital — rightly resisted being tarnished as price fixers or a cartel. But beyond New York, in the Middle East, Russia and Asia, were anonymous traders blessed with privileged information and anxious to ride a rising market, not least by occasionally introducing erroneous facts into the media to enhance their profits.
Their paper chase was noticed by some in Congress. Oil prices at the end of 2002 had unexpectedly risen from $18 to $40 a barrel. On February 12, 2003, despite nervousness about war, terrorism in Saudi Arabia and environmental extremism, Anne-Louise Hittle, a senior director of CERA, predicted that the price was likely to fall. She believed OPEC would resume setting prices, and huge supplies of oil would flow from Iraq. Staff employed by the Congressional Permanent Subcommittee on Investigations were unconvinced. “Gas prices: how are they really set?” was the committee’s question. The world, the investigators puzzled, was not short of oil, yet storage tanks were at record lows, and prices were at a 12-year high. The committee collected evidence that traders in London and New York were manipulating crude prices. But the situation remained inscrutable. The impenetrability of ICE, the investigators admitted, made supervision impossible. “There are defects in the market,” the senior investigator noted, but could offer no solution to the puzzle.
The beneficiary would be Andy Hall. The confirmation of his judgment was the news in January 2004 that Shell had grossly overstated its oil reserves. Reading reports about the exaggeration, Hall smiled: “The fiasco confirms my suspicion that the IOCs can’t replace their reserves.”
Chapter Sixteen
The Downfall
IN 2000, SHELL’S executives were surprised when the Securities and Exchange Commission (SEC), the American regulator, published on its website new guidelines to the oil companies about reporting the assessment and the value of their r
eserves. Until then, Shell and all the oil companies had defined their reserves according to the SEC’s Rule 4-10, which required “reasonable certainty” that the oil would be produced. There had been no prior discussion about the SEC making any changes to rules that had originally been commissioned by Congress in October 1973, after the Arab–Israeli war. Mindful of America’s vulnerability to oil scarcity, President Nixon had launched “Project Independence” to plan for energy security. At a time when the US imported 30 percent of its oil, it made strategic sense to know just how much oil America could produce domestically. The SEC was the agency that applied rules, finally approved in 1978, that assessed how much oil existed at the bottom of vertical wells in Texas, Louisiana and Oklahoma, the principal locations of America’s reserves. The definitions were written to protect competing mineral rights within 40-acre sites, and ignored seismic data. Since then, judging reserves had become more complex than had been conceived in 1973. Experts could give differing but justifiable estimates dependent on their interpretation of 3D seismic images, the extent of horizontal drilling and the depth of the wells beneath oceans. Even the definition of oil had changed to include Canada’s tar sands, Venezuela’s oil in the Orinoco and liquids extracted from coal. The SEC was also operating in a different environment. By 2001, America’s share of the world’s proven reserves had fallen from over 65 percent to 17 percent, and the country was importing 60 percent of its consumption. Over 80 percent of the world’s oil and natural gas was controlled by non-American national producers. Just 10 percent of the world’s reserves and 40 percent of the production of oil and gas, deposited mostly outside the US, was controlled by the major oil companies. Although the majority of these were non-American companies operating in foreign countries, they were quoted on the New York Stock Exchange and governed by the SEC rules.