by Tom Bower
Boarding his jet for the return flight to Moscow, Fridman felt flush. Oil prices were rising, and with more control over TNK-BP, his hopes of building an empire were no longer a dream. He now owned a $20 billion business that included a bank, a grocery chain and a telecom giant (he was simultaneously squeezing his Norwegian partner to secure control of their joint cell phone company), and after winning many battles he had prevailed over an international oil giant. The next step would be to appoint a new chief executive. He would go through the motions to seek an independent expert, but his ultimate objective — realized in 2009 — would be the appointment of himself. Unaware of the oligarch’s plan, Hayward returned to London feeling relaxed. The new agreement gave BP stronger legal protection right down the chain over all the subsidiary companies, and it could report record quarterly profits, up 56 percent to $8.6 billion, including 14 percent in dividends from TNK-BP. The outcome could have been so much worse. BP had retained its share of a profitable business. Its stake in Russia was safe, just as oil prices were booming.
Chapter Twenty-three
The Frustrated Regulator
THE COLD CONCENTRATION of oil traders across the globe evaporated in the spring of 2008. Frenzied speculation was changing the oil price during the course of a single day by dollars rather than the usual cents. On March 18, it rose by $3 to $109 a barrel as hedge funds and index speculators returned to the markets. The following day, it slipped back to $103. By May 1 it had soared through $120, having doubled in just nine months. Breathlessly charting the increases, radio and television bulletins reported the fate of the world’s lifeblood with the same emotion as eyewitnesses described an army marching toward Armageddon. During a brief pause, Fadel Gheit, a veteran oil sage based in an anonymous Wall Street tower overlooking the Hudson River, recalled the previous surge six months earlier. On November 21, 2007, prices on Nymex had nudged over $99, meriting special attention in the New York Times. In reality, taking inflation and the fall of the dollar into account since 1980, when oil was at $40, the price should have been $120. Oil was still cheap, but sentiment suggested the opposite.
Forecasting oil prices in an industry plagued by secrecy, inaccuracy and unexpected disasters, Gheit knew, was a fool’s game, yet regular uncertainty had once again been replaced by volatility. Convinced that the supply and demand of oil had not changed during those months, Gheit blamed speculators feeding scare stories to the markets and the media. Technical commodity experts using algorithmic models to eliminate risk had been joined by casino patrons. Index speculators had increased their investments by $55 billion during the first 52 days of the year. Over the previous five years, their investment had increased from $13 billion to $260 billion. With average profits during those years of 118 percent, more investors were betting on crude prices rising in the future. Those bets were directly influencing the daily “spot” price of physical crude.
Oil prices were no longer merely dependent on how much consumers would pay to suppliers, but in an eerie hiatus, traders and speculators were spreading uncertainty to fan the flames. Experts, responding to summonses from the television studios, confirmed the imminence of doom. One week after prices vaulted through $120, the doomsters’ fears were endorsed by Arjun Murti, the Goldman Sachs analyst famed for boldly forecasting in 2005 that oil would reach $105 a barrel “in a few years.” With oil at a record $122, Murti anticipated another “super spike.” Oil, he said, would hit $200 “within the next six to 24 months.” His opinion was endorsed by Chakib Khelil, the president of OPEC, and by T. Boone Pickens, who predicted $150 by the end of the year. Speculators, guessing that Pickens had wagered $1 billion on oil’s scarcity, assumed he was “talking his book,” but nevertheless began betting that the price would hit $200. Two weeks later, on May 21, the price had shot through $130. On that day, the directors of Nymex noticed, speculators held 849,472 contracts for 849 million barrels of oil, over 10 times the world’s daily production, and 18 times bigger than the “futures stockpile” in 2003. The sheer volume of money was forcing prices upward. This perfect storm, some suspected, was a conspiracy among speculators.
Verifiable facts embellished by rumors were stoking panic about catastrophic shortages: demand had surged, OPEC was refusing to pump more oil, supplies of non-OPEC oil were diminishing, biofuels were not prospering, the demand for electricity in the Third World was soaring, some nuclear power plants in Japan had faltered, LNG and coal had reached record prices, and the dollar was weak. Even a drought in Chile was blamed — the lack of water meant that a fall of electricity generated through hydroelectric dams required the country to use oil as a substitute. There was a general sense of despair — despite $300 billion spent every year, the supply of oil had barely increased in the previous five years. Pleas to OPEC to increase production were rebuffed. Mesmerized by their self-destructive decision in Jakarta in November 1997 to increase production by 10 percent, which prompted oil to fall to $9 a barrel, the OPEC producers preferred to keep prices high. Authoritative observers corroborated the foreboding about a new era. Despite Schlumberger using horizontal drills to tap western Siberia’s vast reserves, Russia’s oil production had fallen in April by half a percent, the first drop in 10 years. Leonid Fedun, the vice president of Lukoil, confirmed that Russia’s production had “probably peaked.” Saudi Arabia’s refusal to pump additional oil caused the banker Matthew Simmons to surmise that Ghawar was exhausted; an opinion dismissed by the Kingdom’s habitually secretive rulers, but partially confirmed by Sadad al-Huseini, the former head of production at Saudi Aramco. Saudi Arabia, al-Huseini revealed, had inflated its “proven” reserves by 300 billion barrels, and the old reservoirs in the Gulf — 70 percent were over 30 years old — were 41 percent depleted. OPEC, already supplying 44 percent of the world’s consumption, could not, he said, compensate for declining supplies from elsewhere. Matt Simmons predicted that oil production had peaked in 2005 at 85 million barrels a day, and was on a permanent decline to 60 million barrels a day by 2015.
Some facts were irrefutable. Production in Venezuela, Mexico and the North Sea was falling just as demand in China, India and especially Saudi Arabia and the Gulf states was rising. Guy Caruso, head of EIA, suggested that stocks of crude had fallen, that the world could not immediately produce more than 85 million barrels a day, and that prices could be high “for years to come.” BP’s statistics confirmed the shortage. In 2007, production of conventional oil had fallen by 0.2 percent to 81.5 million barrels a day, while consumption had risen by 1.1 percent to 85.22 million barrels a day. The gap was filled by oil produced from unconventional sources, including tar sands. Nevertheless, the balance of supply and demand appeared to be tilting over a precipice. The critical cushion to protect consumers from unforeseen calamities was shrinking, although experts disagreed over whether the gap was 300,000 or two million barrels a day. Across America and Europe, fuel and food prices rose, stock exchanges fell, airlines feared bankruptcy and politicians fretted. As usual, the Democrats in Washington berated Big Oil, and the Republicans berated the Democrats for preventing drilling offshore and in Alaska. Traders and speculators noted that despite talk of an emergency, there were no reports of queues of cars at empty gas pumps, or faltering electricity supplies, and that tankers laden with sour crude were anchored in the Persian Gulf waiting for customers. At the end of May oil prices slipped back to $120, but after a week’s lull the storm re-erupted on June 5. Israel threatened to bomb Iran, violence was reported in Nigeria, and the dollar fell further. Within 36 hours, oil jumped by $16.24 to $139.12 a barrel. For the first time, American motorists were paying over $4 a gallon for gasoline. Exploiting the hysteria while visiting France, Alexei Miller summoned the media to predict that oil would hit $250 in 2009, and natural gas prices would triple.
The speculators’ run appeared to be uncontrollable. Everyone was focused on the gap between the world’s actual production of about 85 million barrels of oil a day and the anticipated pressure from China, India and elsewhere
to immediately deliver an additional two million barrels a day. Over the following years, the experts anticipated that the world would demand 100 million barrels a day, and a plateau could be reached between 2015 and 2020. Doom merchants were swaying the markets. Their arguments appeared to be irrefutable: supplies from Russia would not increase above 10 million barrels a day, refineries across the globe were working at full capacity, and non-OPEC countries were producing less oil than expected. Although 250 companies had spent over $400 billion searching for oil during 2006, a remarkable 45 percent increase in one year, it would take at least eight years to produce an additional 20 million barrels a day, and in the meantime the certainty of permanent shortages was the expression of a potent and radical philosophy. The security of oil supplies, it appeared, could no longer be guaranteed by the fundamental economic commandment of supply and demand. Rather, prices were subservient to the decisions of the producing countries that controlled the oil. By withholding supplies, they could dictate the world’s fate. The advocates of peak oil were celebrating.
The roots of the new mood had evolved after President Bush’s State of the Union address on January 31, 2006. “America,” admitted the president, “is addicted to oil [from unstable parts of the world].” “This country,” he urged, “[should] dramatically improve our environment, move beyond a petroleum-based economy and make our dependence on Middle Eastern oil a thing of the past.” Some economists had predicted before 2006 that once prices passed $50 a barrel, a recession was inevitable. During July and August 2006, oil hit $75. In Washington, OPEC’s control over 77 percent of the world’s remaining proven reserves — 922 billion out of 1,200 billion barrels — was reason for apprehension. OPEC had abandoned the $22–$28 price range set in March 2000, and by allowing prices to triple, its members had, by some calculations, earned an additional $720 billion by 2006. Saudi Arabia’s motive was regarded in Washington as greed. The Kingdom was spending billions of dollars to accommodate the huge growth of its population, probably over 6 percent annually. Naturally, the new buildings and infrastructure required extra revenue, but the Saudis’ conduct aroused suspicions after prices fell below $60 in October. “Oil prices can’t rise forever,” commented Oil & Gas, the industry’s journal. BP’s review for 2006 would show that the world’s demand for oil during that year had grown by just 0.7 percent, half the average for the past decade, and oil consumption in Western countries had declined.
Just as the journal was published, prices fell on October 20, 2006, to $55, and OPEC cut its output by 1.2 million barrels a day. There was little doubt in Washington and London that OPEC was manipulating prices. “The cartel,” declared Congress’s Joint Economic Committee in early November, “is the single greatest cause of market instability as it fans market fears with intermittent quota and output cuts to extend the price surge.” Saudi Arabia was no longer producing oil to finance luxury foreign trips for the extended ruling family or to balance its own finances, but was endangering its customers. Few questioned America’s decision to exclude Iran’s huge reserves from the market. Rather, Washington blamed the producers, and alighted on a new culprit.
President Bush, briefed by the collective wisdom of the oil industry, accused China of tilting the balance. OPEC’s ruse, American politicians were convinced, was intended to profit from China’s surging demands, although the country’s consumption was unquantified. China’s state agencies had aggressively bought oil in Sudan, Iran and Burma, all countries excluded from America’s orbit, and had invested in 27 oil projects in 14 African countries, including $2.3 billion for a 45 percent stake in Nigeria’s deepwater Akpo field. African governments were reassured by China’s noninterference in their internal affairs, in marked contrast to America’s moralizing, although China’s $8 billion pipeline to transport Sudan’s oil to the Red Sea would be protected from rebellious tribesmen by Chinese soldiers. More threatening, in Bush’s opinion, was China’s response to America’s threat to oil supplies in the event of a conflict between China and Taiwan or Japan. Fearing that America’s warships could blockade the Straits of Hormuz and Malacca to prevent 80 percent of China’s oil imports, China planned a “Strings of Pearls” strategy, building naval bases for a new fleet in Pakistan, Burma and Thailand.
To head off the Chinese challenge, Bush warned President Hu Jintao during his visit to the White House in April 2006 against attempting to “lock up” global oil supplies. His admonition was ignored. In November 2006, about 40 heads of African states, including those of Angola, Sudan, Congo Brazzaville and Equatorial Guinea, were invited to visit Beijing for a China–Africa forum. After contracting to buy Saudi oil, China began building a refinery dedicated to sour crude. That same month, the oil price rose from $58 to $60 a barrel, and Bush openly accused China of provoking a price surge. Traders found many other reasons to explain the increase: oil stocks were being sold, Big Oil had failed to invest, oil nationalism, Russia’s untrustworthiness after the Ukraine crisis, and the unreliability of LNG, nuclear power and tar sands as alternative sources of energy; but Andy Hall highlighted China’s increasing demand and OPEC’s cut in production.
In Westport, Connecticut, insiders said that Andy Hall calculated his bets had earned Phibro about $1 billion since 2003. On a winning streak, he was certain that rising demand would push prices up further. The market, he believed, was going in his direction; this was not the time to separate himself from the herd. “The trick,” he reminded his staff, “is to run in the same direction when the herd’s right.” In Congress and Westminster, some politicians were convinced the market was being manipulated. The uncertainty was whether it was traders, the national oil companies or shady officials employed by the governments of the oil producers who were secretly speculating against the market. Was there a genuine oil shortage, or was it contrived? Was Hall, like other speculators, driving or following the market? However much the politicians demanded answers, Hall could not answer that question. The spotlight for explanations switched to the regulator, principally the CFTC monitoring contracts for the future physical delivery of oil.
The unknown in 1996, as oil prices seesawed, was whether speculators, contrary to the CFTC’s founding wisdom, were inflating prices beyond the normal boundaries of supply and demand. Prices and profits had soared, prompting politicians’ criticism of the oil majors and demands for windfall taxes. The CFTC could not answer President Clinton’s questions about the oil majors or the speculators. To reinforce the regulator, Clinton appointed Brooksley Born, an accomplished derivatives lawyer, to chair the CFTC. Unlike her tame predecessors, Born was a suspicious outsider, uncertain whether traders and the major producers were manipulating prices by inventing “dangers” and rumors to exaggerate fears and increase their profits. Finding the proof, she knew, would require Herculean efforts.
A deliberate smokescreen concealed the over-the-counter (OTC) trade, the intense sale and purchase, or “spot trade,” of physical oil for immediate or future delivery. Known also as “swaps,” the OTC market had been deregulated in 1993 by Wendy Gramm, a laissez-faire economist and the wife of Senator Phil Gramm. Appointed chairman of the CFTC by President Reagan, who called her “my favorite economist,” Wendy Gramm, like her husband, believed that capitalism blossomed with as little registration, record-keeping and regulatory supervision as possible. After resigning from the CFTC in 1992, Gramm became a director of Enron, and the company contributed to Phil Gramm’s election campaigns. In sharp contrast, Brooksley Born favored speculation to stimulate the markets with cash, but wanted powers to prevent abuse. Too many major oil companies were buying “look-alike” OTCs from the banks so as to avoid the regulators. In 1996 the deregulatory atmosphere had encouraged one trader employed by the Japanese bank Sumitomo to mount a fraud trading copper futures on the London Metal Exchange and OTC copper “swaps,” while in America, Bankers Trust had caused the multinational corporation Procter & Gamble to suffer huge losses through the sale of interest rate “swaps,” and Orange County in Califo
rnia had become insolvent as a result of speculating on OTCs. By 1998, oil had become intrinsic to the OTC explosion. Many transactions were finalized by telephone conversations, with little committed to paper or e-mails. Vitol, Glencore and other traders spent millions of dollars gathering intelligence, but finding evidence even of normal trading was hard. Even if records existed, it was very difficult for the CFTC to obtain access to their computers and paperwork in Switzerland to scrutinize their “swaps” trade.
Challenging the oil magnates was beyond the CFTC’s expertise and power. Fearing a crash, Born had deterred Enron’s lobbyists, who were seeking approval to start trading energy derivatives on the OTC market. But in the remaining markets, although speculators were borrowing increasingly huge sums to trade swaps on the OTC market — much more than permitted by Nymex — this was beyond the regulator’s supervision except in cases of fraud and manipulation. “It’s so opaque,” Born told her staff as they watched helplessly from the sidelines. “No one knows anything about this market, and we don’t have any tools to police it.” Multibillion-dollar investment funds like Long Term Capital Management in New York were speculating with unknown amounts in OTCs. Born wanted to reform the CFTC into a savvy, independent regulator, but her task was complicated. To reverse Wendy Gramm’s liberalization required congressional approval for new regulations. Although the CFTC was only answerable to Congress and not the Treasury, Born circulated a “concept release” in April 1998 on OTC derivatives to several Washington politicians, including Bob Rubin, the Treasury secretary, and Alan Greenspan, the chairman of the Federal Reserve. Getting their support to extend the CFTC’s authority over the “swaps loophole” was politically critical.