by Tom Bower
New technologies had revolutionized extraction rates. Old oil and natural gas fields were being rejuvenated. Shell had just reported that the proposal to import vast quantities of natural gas as LNG into America would be reconsidered. Using new technology, gas fields in Wyoming, previously regarded as redundant, had increased production by 9 percent in two years. New “tight gas technology” could release an extra 500 trillion cubic feet of natural gas, enough to satisfy American consumption for 20 years. The revolution affected every oil and natural gas field in the world, but was ignored in the frenzied reports that Qatar could not fulfill plans to double exports by 2011 to 77 million tons (20 percent of the world’s LNG) or meet the increasing demand for natural gas, which was destined by 2030 to overtake oil.
The hysteria drowned out those who maintained during the early summer of 2008 that there were ample supplies. Bowing to the mantra of irreversible shortages, speculators appeared to have grabbed control of oil from traditional traders. The number of contracts held by Nymex traders rose from 850,000 in 2003 to 2,700,000 in 2008. Like a herd, pension funds, index funds, hedge funds and investment bankers introduced an estimated additional $80 billion into oil trading. Even that statistic fueled further speculation. Everyone knew that the growth of the swaps was huge, but beyond that part of the OTC market regulated by Nymex, no one knew its size. The mystery in New York and London was the identity of the participants. The Washington Post would report that the CFTC had noted that Vitol, which boasted an annual $147 billion turnover, had traded contracts for 57.7 million barrels by June 2008, three times the USA’s daily needs, and at one point in July held a huge 11 percent of the futures market. Vitol stated that it was “not in the business of taking large positions speculating on the rise or fall of market prices,” but others were unsure. Many in Congress regarded Vitol’s activity as speculation rather than trading. “It’s dirty hedge money and even dirtier sovereign wealth funds,” suspected Ed Morse, the senior oil analyst at Lehman’s. Russians and Arabs were assumed to be playing the markets by taking a position and then releasing price-sensitive rumors to move the market in a profitable direction.
Commodity markets throughout history had experienced periods of boom and bust, but no oil trader had ever witnessed the sheer weight of money now being bet on oil. No one could predict the effect of hundreds of hedge funds promising 25 percent profits in oil against 3 percent from bank deposits, or accurately balance the dollar’s fall against rising oil prices. BP’s experts were particularly bewildered by the argument advanced by Sharon Brown-Hruska, previously a CFTC commissioner, that hedge funds were good for liquidity. There was no relationship, said the former regulator, between speculation and prices. Nymex agreed: “Hedge funds have been unfairly maligned,” said a spokesman, and “Simple answers are not supported by the available evidence.” Some traders believed that Brown-Hruska’s misunderstanding was profound. Hedge funds, insiders knew, were a one-way bet. Pouring money into the market — technically adding “liquidity” by betting long or short — meant that volatility had exploded. The hedge funds, BP’s traders believed, had pushed prices up by 20 percent, or at least $10, but, unable to pinpoint a guilty hedge fund, the traders and speculators blamed the national oil companies for forcing prices to rise by holding back oil.
Few across Washington could disentangle the contradictory opinions. Walter Lukken, the CFTC’s chairman, rejected any dishonesty among traders; Hank Paulson, now the US Treasury secretary, acknowledged that speculators might have a transitory influence, but said that in general they were just following the trend. Other finance ministers disagreed, but lacked any evidence. Their ignorance was shared by the EIA’s director Guy Caruso, who admitted having no reliable data about trading or noncommercial speculation, or about supply and demand. “It’s gone out of whack,” he confessed. “We’re not in a new paradigm where speculators rule, but it was a new situation when oil went over $90.” Ten percent of the price rise was due to speculation, he told a Senate hearing. Pinpointing 2006 as the moment predictions became unreliable, he explained, “We were too optimistic and high about the NOCs’ [national oil companies’] production. We thought more would be produced.” The optimistic predictions were influenced by the “difficult” political environment, in particular that of his employer, the US government. No one, he realized, had grasped the influence of the dollar’s decline, which had led speculators to “rush out of currencies into oil.” On Nymex, speculators were paying $100 for crude to be delivered in 2012.
Caruso’s confession exposed the administration’s impotence. He was accused of misunderstanding markets. His worship of supply and demand and denials about speculators’ influence had guided congressional policies. Overnight, his status was washed away. “The EIA is behind the eight ball,” complained a congressman. The agency was following, not leading. “The EIA is always lowballing.” Blinkeredly, the EIA and the administration had allowed speculators to run up prices toward the same peak as 1973, and became powerless to exert any influence. The confusion sparked heated accusations in Congress on May 21, 2008. Carrying out the familiar routine of lashing oil-company bosses to prove to constituents how their pain was shared, Dianne Feinstein, the Democrat senator for California, snapped at Stephen Simon, a senior vice president of Exxon, during a heated hearing, “You rack up record profits and apparently have no ethical compass about the price of gasoline.” Her repeated demands for “energy independence,” “security” and more oil at lower prices willfully ignored the fact that oil was priced globally, far beyond America’s control. Even ExxonMobil, the mightiest corporation, had been exposed as a pygmy in the face of the hurricane. The big six oil majors controlled just over 5 percent of oil reserves, and access to another 30 percent through partnerships with the national oil companies. The remaining two thirds was beyond the West’s access. The existence of ExxonMobil’s $40 billion bank deposit was evidence of Tillerson’s doubts. If oil prices could move $10 within one day, how could he justify committing billions to a project over 20 years? The crisis exposed the oil majors as minors. No one in America or Europe could apparently exercise any control over oil. Fearful of bankruptcy, the airlines’ knee-jerk reaction was to hedge their fuel bills for the future at over $100. They risked being among the biggest losers if oil prices tanked.
By June, with billions of dollars ceaselessly churning through the markets, the dispute over whether the oil producers or the speculators dominated the markets had become irreconcilable. Even the traditional players — Morgan Stanley, BP and OPEC — were only marginally influencing the market. As prices rose, there was anger that anonymous fund managers and traders were the dogs setting prices, while Saudi Arabia appeared as the reactive tail. Governments were immobilized, unable to plan. A chorus screamed abuse of the free market and appealed to governments to intervene. “Competition is crazy,” John D. Rockefeller used to moan. “It’s ruining us.” Now the free movement of prices was creating a clamor for controls and a windfall tax. “Outside of satanic cults,” said Republican senator John McCain, “these people have the worst PR of anybody in the world.” Manipulation, he suspected, could have been effortlessly crushed if BP and other stakeholders in Cushing had unleashed unlimited crude into all the pipelines. Prices would have fallen, but the owners had decided against it. Some commentators were now stating that they had lost faith in capitalism and markets. Others took comfort in the fact that while the financial players could introduce volatility, their influence in the markets was limited to less than 90 days. In BP’s opinion, it was laughable to suggest that oil prices could be manipulated from Cushing.
A notable voice of sanity was Lehman’s Ed Morse. Under pressure for contradicting Murti by forecasting that prices would fall “perhaps violently” in early 2009 to $80, he said, “The mania is a self-fulfilling momentum driving a misconception of a shortage. The 130-year cycle of oil has not disappeared.” High prices, he predicted, would depress American consumption, and Saudi Arabia’s increased production
would restore sanity. “The best cure for high prices,” Neal Shear at Morgan Stanley told a worried investor, “is high prices.” The speculators, financier George Soros told a Senate commerce committee, were inflating a bubble into a “super bubble” superimposed on a naturally rising market. Data produced by Barclays bank in June suggested that sentiment rather than facts was influencing prices: only 2 percent of the “long” positions, reported Nymex, was owned by speculators without seeking ownership, so no physical oil was being held back from the market. Speculative bets, agreed the CFTC, had fallen by 48.5 percent. The regulators did not realize that index fund managers were compelled by internal rules to sell their future contracts as prices rose. Contrary to the politicians’ jargon, some speculators were actually dumping oil. Beyond the politicians’ understanding, more critical events were unfolding.
Eager to lead the public outcry, British Prime Minister Gordon Brown joined Bush in accusing Saudi Arabia of manipulating prices by cutting production between March 2006 and April 2007 by about a million barrels a day. OPEC’s control over oil supplies, declared Brown, was “a scandal” and he appealed on May 19 to European governments to break OPEC’s “stranglehold” on world economic growth. When Saudi Arabia summoned an emergency OPEC meeting in Jeddah on June 22, Brown decided to fly to the Kingdom for the day to publicly berate the producers for holding the world for ransom and demand that they pump more oil. Chakib Khelil, head of OPEC, was perplexed. Brown, he told his aides, was “irrational and illogical,” preferring to ignore the high taxes he himself had imposed on oil, and his request for more oil was “simplistic.” Khelil was convinced that “The demand for oil is exceeding the supply of oil, not just now but in the medium- to long-term future.” Others felt that Khelil’s explanation, while possibly true, was equally too simplistic. A complicated matrix of events, partly related to diesel, was also influencing the price increases.
Demand for diesel, manufactured from light sweet crude, had escalated during 2008. The Chinese government ordered diesel to be stockpiled to prevent any shortages during the Beijing Olympics, and European motorists, responding to tax incentives, were switching from gasoline. Because of limited refining capacity in Europe and Asia, the extra supplies were bought in America. The extra demand coincided with a fall in the supply of light sweet crude. New violence in Nigeria had reduced production, and the US Department of Energy chose that period to buy 30,000 barrels of light sweet every day to refill the Strategic Petroleum Reserve. Compounding the shortage, at the same time America’s refineries were obliged to implement the regulations introduced by President Clinton in January 2000 to reduce sulphur in diesel. Overnight, the number of refineries able to produce diesel under the new regulations was reduced, and the production of diesel from sour crude fell. The unexpected bottleneck in the refineries would have been avoided if America’s refineries had all been owned by the major oil companies, which could have pooled their knowledge through their trade association. Instead, scattered among diverse independents, there was no nerve center to warn the government about the consequences of Clinton’s laws. All those unrelated circumstances overturned normality.
Customarily, in summer diesel was cheaper than gasoline, but now for the first time tight supplies not only pushed diesel prices up, but also increased the price of light sweet crude. As the price of WTI rose on Nymex, the Saudis automatically increased the price of their sour crude. Since few refineries had the capacity to process sour into low-sulphur diesel as required by American and European environmental regulations, OPEC countries were producing about four million barrels of excess sour crude every day. A complication was also distorting prices, especially between WTI and Brent, because the amount of crude flowing through Cushing was fast declining, artificially increasing the price of Brent oil — a distortion that the Saudis would remove in October 2009 by abandoning Nymex’s prices as a benchmark for their crude oil and use instead a new index developed by Argus. Gordon Brown was oblivious, and his welcome in Jeddah on June 22 — he was the only non-OPEC leader to attend the meeting — was cool.
Brown’s high taxes had hastened a sharp fall of investment in the North Sea, an 8 percent annual fall of production and declining discovery of new fields. Although about 20 billion barrels of oil remained there, the cost of extraction had risen from $5 to $16 a barrel, making further prospecting unattractive, dramatically cutting the number of new wells and halving to 15 years the fields’ lifespan. Unwilling to acknowledge his own responsibility for the fall in production, Brown had theatrically summoned an international oil summit in London, inviting President Bush, Hugo Chávez and Muammar Gaddafi. He had also convened all the North Sea operators to meet in Aberdeen. In front of the television cameras, he urged them to increase production and find new oil immediately. How, wondered al-Naimi, did he imagine that new North Sea oil, if it existed, could be produced in less than four years? Brown, he decided, was not a serious player but a dupe who believed the warning of Shokri Ghanem, the chairman of Libya’s national oil company, that “Prices have nowhere to go but higher. OPEC is reaching its peak production and there is no more that countries can produce. We are squeezing the rocks as hard as we can.” Al-Naimi knew there was a surplus of Saudi sour crude in storage in the Gulf and no buyers. Brown returned to London claiming credit for the Saudi agreement to increase production by 500,000 barrels a day, but still no wiser about why, despite increased supply, prices were heading toward $140 a barrel. Ten years earlier, crude had sold for $10.
Uncertainty and politicians’ gestures encouraged more speculation. On June 26, 2008, the oil price shot above $140. Shares fell, gold hit a record $915 an ounce and reports mentioned “fear in Wall Street and Washington.” The world, sages warned apocalyptically, was on the edge of a new oil shock. Shell, Marathon, ConocoPhillips and Lukoil locked themselves into trading short at prices between $120 and $140. Lord Meghnad Desai, a British economist, noting that $260 billion was invested in commodity markets, mostly in oil, compared with $13 billion five years earlier, wrote that not only speculation was driving up prices. Influenced by the testimony to the Senate on May 20, 2008, of Michael Masters, a former Goldman Sachs fund manager, Desai was convinced the problem was caused by a shortage of crude oil, which would continue unchanged for another 12 months. Looking for culprits, some observers in Congress of the market frenzy, ritually suspicious about manipulation, repeated their conviction of Big Oil’s conspiracy to “talk up peak oil” and “talk down supplies” in order to push prices up. Those considering themselves more sophisticated seized upon ICE as the menace. For them the unregulated exchange in London, perniciously undermining Nymex, a properly policed market, was the obvious culprit.
The absence of American supervision over ICE in London irked regulators in New York and Washington. No one trusted the low-caliber officials employed by the British Financial Services Authority (FSA). Oil traders, with similar disdain for the CFTC’s staff, were accused of distorting the market by trading one position on ICE and the opposite one on Nymex in New York. Denied information, the CFTC could not confirm that speculators in London were squeezing prices in America. “To date,” it reported, “there is no statistically significant evidence” that speculation had influenced prices. Unknown to the CFTC, on one day in July Vitol owned a massive 11 percent of all the oil contracts traded on Nymex. Contrary to its official position as a trader, much of that huge position was purely speculative, and placed through ICE. When this was discovered, it contradicted Vitol’s statement in May denying any speculation. The “London loophole,” thundered Democratic senator Joseph Lieberman, was a blank check for the manipulators. Convinced that traders were arbitraging between Nymex and ICE to manipulate prices and even commit fraud, the politicians demanded that the CFTC supervise American citizens trading on foreign markets. Yielding to the outcry, the CFTC limited Americans speculating on WTI prices in London.
Any satisfaction that move caused was brief. Only 15 percent of WTI contracts were traded out of New
York. Frustrated by the global nature of the oil trade, senators thrashed around seeking powers to compel traders to stop speculating. None could explain the distinction between a hedge fund and an airline protecting its commercial interests. Confused that prices on ICE were identical to Nymex’s, and unable to name a single speculator, the senators, led by Carl Levin, demanded power to order American traders to limit trading in London or to ban speculation altogether. James Newsome, Nymex’s president, was worried — especially because his rival, ICE’s founder Jeff Sprecher, appeared relaxed. His criticism of ICE risked backfiring on Nymex. The politicians’ threats, Newsome realized, were exaggerated, and none understood one likely consequence. Nymex’s profitable trade would simply move from New York to London, the natural trading place for the Middle East because of the time zone, the laws and the financial environment. Only ICE would benefit, and Nymex would lose its lucrative income. The facts were ignored, and a flurry of bills was announced to ban speculators.
Immune to the bewilderment in Washington, Andy Hall was counting his profits. Going in and out of the market since his original bet in 2003 had notionally earned Phibro over $2 billion in profits. The losers were mostly banks, although even they had made healthy profits, albeit by taking greater risks. Hall had enjoyed the market of a lifetime. His envious rivals spoke of him “shooting the lights out over the profits.” Of course, Hall had not anticipated in 2003 that high demand for diesel — but never a shortage — would spook the market, but he knew the value of trading on ignorance. In his small way, he had squeezed the world. Quietly, he decided to call it a day. Oil had hit $140 a barrel. Recession, he believed, was looming. “The whole thing is in danger of collapsing,” he realized. “If the fundamentals suck, it’s no use being ‘long.’” The time had come to part with the herd. “There’s no point in standing in front of an oncoming train.” Over just two days Phibro anonymously offloaded contracts worth more than $1 billion. Hall’s personal profit was at least $125 million, but the credit crunch, triggered in part by oil speculation, would sting Phibro. Citibank would need government funds to survive, and in summer 2009 Hall’s $100-million pay supplement would be frozen as a result of Washington’s edict banning bank employees from receiving bonuses. Blissfully unaware of the position to come, in summer 2008 Hall noted, “In liquid markets, it’s easy to sell off.” The buyers, he believed, would be burned; but even he did not anticipate the speed of the turn.