The Quest: Energy, Security, and the Remaking of the Modern World

by Daniel Yergin

  Economic growth and financialization soon came together to start lifting the oil price higher. With that came more volatility, more fluctuations in the price, which was drawing in the traders. These were the nimble players who would, with hair-trigger timing, dart in and out to take advantage of the smallest anomalies and mispricings within these markets.

  This financialization was reinforced by a technological push. Traditionally, oil had been traded in the pit at the NYMEX by floor traders, wearing variously colored jackets, yelling themselves hoarse, wildly waving their arms and making strange hand gestures, all of which was aimed at registering their buys and sells. This system was called “open outcry,” and it was enormously clamorous.

  But around 2005 the importance of the floor traders began to decline rapidly with the introduction of the electronic trading platforms, which directly connected buyers and sellers through their computers. Now it was just push a button and the trade was done, instantaneously. Even the “button” was a metaphor, for frequently the trade was executed by a commodity fund’s algorithmic black box, operating in microseconds and never needing any sleep, let alone any human intervention once it had been programmed. The paper barrel had become the electronic barrel.11

  OVER THE COUNTER

  Futures contracts on commodity exchanges were only part of the new trading world. There were also over-the-counter markets, which did not have the regulatory and disclosure requirements of the futures market. Those who were critical of them dubbed them the “dark markets” because of this lack of regulatory oversight and transparency, and because they were suspicious of how they worked and of their impact. These were, after all, a form of financial derivative—a financial asset whose price is derived from one or more underlying asset. The cumulative risk and systemic impact of such derivatives could be very large because of their leverage, complexity, and lack of transparency.

  The over-the-counter off-exchange markets were the place for tailored, bespoke transactions where participants could buy oil derivatives of one kind or another, specifically designed to meet a particular market need or investment strategy. Banks became the “swap dealers,” facilitating the swapping of one security, currency, or type of interest rate for another between investors. They would then turn around and hedge their risks in swap deals on the futures markets. The over-the-counter market began to grow very substantially around 2003 and 2004. These markets had several attractive traits. It could be less expensive for hedgers to go to the over-the-counter market, as the costs might be lower and more predictable. They could make deals that were tailored to their particular needs and specifications and timing. For instance, someone might want to hedge jet fuel in New York Harbor, and WTI at Cushing was not a clear enough approximation in its pricing. It was also possible to do much larger deals without calling attention to oneself and thus prematurely forcing the price up or down, depending on the nature of the hedge.

  Overall, more and more money was coming into the oil market, through all the different kinds of funds and financial instruments. All this engendered increased activity, and more and more “investor excitement,” to borrow a phrase from Professor Robert Shiller, the student of financial bubbles and the explicator of the term “irrational exuberance.” Traders saw momentum in the market, which meant rising prices, and as they put money to work and prices went up, it added to the momentum, providing yet more reason to put more money to work, further fueling the momentum. And so prices kept going up.

  THE BELIEF SYSTEM

  There was method in all this momentum, a well-articulated belief system that explained rising prices. Or rationalized them. In his studies of bubbles and market behavior, Shiller refers to the common characteristic of what he calls “new era thinking”—the conviction that something new and different has arrived that justifies a rapid rise in asset prices in a particular market. New era thinking has been a consistent feature of bubbles—in stock markets and real estate and many other markets—going back to tulips in Holland in the early 1600s and the South Sea land bubble in the early 1700s. “A set of views and stories are generated that justify continuation of the bubble,” says Shiller. “But it’s not perceived as a bubble.” 12

  In the case of the oil market, an explanatory model, a set of new-era beliefs, took particular hold on the financial community with an almost mesmerizing effect. The beliefs came in the form of catechisms:That oil was going to be in permanently short supply (just the opposite of a decade earlier).

  That the world was running out of oil.

  That China was going to consume every barrel of oil that it could get its hands on—and then some.

  That Saudi Arabia was misleading the world about its oil reserves, and that Saudi production, the great balancer of world markets, would soon begin to decline.

  That the world had reached, or would soon reach, “peak oil”—maximum output—and the inevitable decline in output would begin even as the world wanted more and more oil.

  The last—“peak oil”—was the great unifying theme that tied all the rest together. As prices climbed, this view became more and more pervasive, especially in financial markets, and in a great feedback loop, reinforced bullish investor sentiment and helped to push prices up further.

  For all the above reasons together, it made sense, powerful sense, for prices to keep going up. That, after all, is what the most publicized predictions said would happen. Data that did not fit the model—for instance, an analysis of eleven hundred oil fields that failed to find a “peak” on a global basis—were disregarded and dismissed.13

  DOES PRICE ACTUALLY MATTER?

  At this point the oil world split in two. Some thought that prices did not matter, and some thought they did. Those who thought “not” worked on the assumption that prices would continue to go up, for all the reasons noted above, with little impact on consumers and on producers—and on the global economy.

  Those who believed that prices still mattered were pretty sure that the impact would be felt, though perhaps not immediately. But rising prices would eventually do what they always did—encourage more supply, more investment, stimulate alternatives, while damping down demand. They also feared that rising prices would have a wider cost in terms of reduced economic growth or even recession, which in turn would also bring down demand.

  Yet that latter position seemed to be losing the argument. On the first trading day of 2007, WTI had closed at $61.05. A year later, on the first day of trading, January 2, 2008, oil briefly hit $100 and then slid back. A month later it really broke through $100. And kept going. The oil fever that had struck Cushing, Oklahoma, after 1912 was coming back in 2008 in the form of a global epidemic that was sweeping the planet. 14

  It was in the last part of 2007 and around the beginning of 2008 that the forces driving the oil price up shifted decisively from the fundamentals into something else—“hyperappreciation in asset prices.” Or what is more colloquially known as a bubble.

  “GOING TO EXPLODE”

  Even the biggest, most sophisticated institutional investors were embracing commodities. In February 2008, CalPERS, the California State retirement fund, the largest pension fund in the United States, announced that it now deemed commodities part of a distinct asset class. As a result it was going to increase its commitment to “commodities” as much as sixteenfold. “The actual importance of the energy and materials sector we believe is going to explode,” CalPERS’s chief investment officer had previously explained.

  Gasoline prices in the United States finally broke through the $3 a gallon barrier in February 2008 and headed higher. By April 2008, 70 percent of Americans described higher gasoline prices as a financial hardship and blamed “greedy oil companies for” “gouging the public.” A month later gasoline breached $4 a gallon. The public was agitated and enraged; gasoline prices dominated the news; they looked to become an issue in the presidential campaign. They had already become a subject of a host of congressional hearings. In a deliberate replay of the poli
tical theater that had followed the 1973 oil crisis, oil company executives were summoned to congressional hearings, made to raise their right hands and put under oath, and then interrogated for hours. But now the executives were no longer alone. Fund managers and executives from the financial industry were also called to testify. The Commodity Futures Trading Commission, which regulates futures, was charged with assessing whether new controls on speculators were required.

  Still the drumbeat of predictions continued, as though casting and recasting a spell. A Wall Street analyst predicted that the coming superspike made $200 oil “increasingly likely” within the next two years.

  That forecast struck terror into the heart of the airline industry, which was reeling from the effects of the surge in jet fuel, made even worse by constraints in the refining system. “Scary” was the one-word reaction of David Davis, Northwest Airlines’ chief financial officer at the time. “We kept saying to ourselves that the price had to fall back, but it kept going up. The market was looking for any opportunity to take the price up.”15

  “YOU NEED BUYERS”

  In the middle of May—with oil prices now the top domestic political issue in the United States—President George W. Bush went to Saudi Arabia. There at a meeting at the ranch of Saudi King Abdullah, Bush talked about the risks to the world economy of rising prices. He urged the Saudis to lift output to help cool the fever. He did not get the answer he wanted. The Saudis had already upped production by 300,000 barrels per day but were having trouble finding customers. “If you want to move more oil, you need a buyer,” said Saudi petroleum minister Ali Al-Naimi. After the meeting, the president’s national security assistant Steven Hadley ruefully commented, “There is something going on in the oil market that is much more complicated than just turning on the spigot.” There was no relief after Riyadh. The price of oil kept going up. “One concern that has prompted traders to bid up oil prices,” reported the Wall Street Journal from Jeddah, “is Saudi Arabia’s long-term production capacity. Some analysts believe the kingdom’s best fields could hit a production peak in the years ahead.”

  At almost exactly the same time, one of the most prominent Wall Street oil analysts added to the fever with a report declaring that a “structural re-pricing” of oil—reflecting long-term expectations for shortage of oil and “continued robust demand from the BRICS”—meant a “structural bull market” on top of the “super cycle” that would take prices “to ever-higher levels.” The surge continued. By the end of May, oil prices had hit $130. New cars sales in the United States were plummeting.16

  “OIL DOT-COM”

  A few contrarian voices on Wall Street warned that these prices had become seriously divorced from reality. Edward Morse, a veteran analyst, in a paper titled “Oil Dot-com,” wrote: “As during the dotcom period, when ‘new economy’ stocks became popular, a growing band of Wall Street analysts who are significantly raising” their forecasts were “partially responsible for new investor flows, driving... prices to perhaps unsustainable levels.” He continued: “We are seeing the classic ingredients of an asset bubble. Financial investors tend to ‘herd’ and chase past performance.... But when peak prices hit, they are also likely to fall precipitously. That’s the way cyclical turning points always occur.” But the analysis could only go so far. “Getting that timing right is the difficult part,” he added.

  Morse did not sway many people. Some of his clients did not merely disagree ; they literally shouted at him that he was wrong. The price continued its sharp ascent. Ever more money flooded into the market on the premise that prices would climb still higher. “Perhaps the biggest ramification of current oil prices is the stoking of fears over ‘peak oil,’ ” said one petroleum industry publication. “This mindset has spurred investors to buy.” 17

  “IT NEEDS TO STOP”

  There seemed no respite. High gasoline prices—combined with the imminence of Memorial Day and the opening of driving season—infected the entire nation with a virulent case of road rage. That made it an “ideal time,” said the New York Times, “for Congress to show its solidarity with angry American motorists.” At one hearing, a congressman bluntly told oil company executives, “You are gouging the American public and it needs to stop.” Another announced that the industry should be nationalized outright.

  At a hearing on the other side of Capitol Hill, a senator asked the empanelled oil company executives, “Does it trouble any of you when you see what you are doing to us?” One executive tried to frame a reply: “I feel very proud of the fact that we are investing all of our earnings. We invest in future supplies for the world, so I am proud of that.”

  “You,” snapped another senator, “have no ethical compass about the price of gasoline.”18

  CHINA IN 2014

  In other parts of the world, high prices were seen as a boon. Every year in June in St. Petersburg, during the white nights, when it is light even at midnight, the Russian government hosts its own version of Davos—the St. Petersburg Economic Forum. The setting is the sprawling modernistic Lenexpro congress center that juts out into the Gulf of Finland and looks toward the Baltic Sea. In June 2008 Russia was booming from the high oil and natural gas prices, which was reflected in the buoyant atmosphere of the forum. Wall Street may have been showing signs of growing distress. But, seen from St. Petersburg , that was only further reason for the global financial markets to become more anchored in Russia and the other BRICs.

  Over coffee between one of the sessions, the head of a very large commoditiestrading firm was asked why he thought prices were still going up. He had a very clear explanation: As markets generally do, he replied, the oil market was anticipating what would happen in the future. In this case, it had pulled forward into 2008 the prices that would be associated with China’s huge oil demand in the year 2014. It just seemed so obvious.

  A few days later, the head of one of the world’s largest state-owned energy companies declared that oil would hit $250 a barrel in the “foreseeable future.” Were that to happen, a leader of the travel industry said in reply, the airline industry would collapse and would have to be nationalized. Otherwise there would be no planes in the air.

  On June 15, oil prices reached $139.89. The airline industry certainly had its back against the wall. In earlier years, fuel prices had been about 20 percent of operating costs; now they were up around 45 percent, bigger even than labor costs. Bankruptcies seemed inevitable—the only way out.19

  JEDDAH VERSUS BONGA

  On Sunday, June 22, a hastily organized conference involving 36 countries convened in Jeddah, Saudi Arabia, at the invitation of King Abdullah. The Saudis, among others, were acutely concerned with what oil prices would do to the demand for oil and to the world economy, in which they had a very significant stake.

  To open the conference, King Abdullah and British Prime Minister Gordon Brown entered, side by side, to the music of a military band. But there was little harmony. The producers blamed the prices on “speculators” and said that there was no shortage of crude oil. The consuming countries blamed the prices on a shortage of crude oil. The Saudis announced that they would put another 200,000 barrels a day into the market if they could find buyers. But that would take time. The next morning the price in Singapore opened higher than it had closed in New York the previous Friday.

  Within hours of the Jeddah meeting, a dramatic reminder of the physical risks to supply shook the market and added to the widespread anxiety. One third of Nigeria’s production was already shut in by violence and criminal attacks. But surely it was thought, the new multibillion-dollar offshore projects were secure from assault, insulated from violence by their distance from land. That sense of security was misplaced.

  Members of MEND, the Movement for the Emancipation of the Niger Delta, moving fast in heavily armed speed boats, evaded such security as there was and launched an attack on Bonga, the most prominent of all the platforms, 70 miles from the shore. They managed to climb onto the platform, but they we
re repelled before they could blow up the computerized control room. It was a close call, and a very scary one. The Bonga attack sent new shockwaves through the market. In an e-mail to journalists, a spokesman for MEND warned, “The location for today’s attack was deliberately chosen to remove any notion that offshore oil production is far from our reach.” Bonga trumped Jeddah and prices continued to go up.20

  The physical market had turned. Although hardly recognized, the demand shock was over. World oil demand was going down and supply was increasing. Spare capacity—the gap between world capacity and world demand—was beginning to widen. But none of that seemed to matter. Prices continued to rise. “I kept staring at my Bloomberg , looking at the prices all the time,” recalled the CFO of Northwest Airlines. “It was unbelievable.”

  And it was all happening very fast. “This is like a highway with no cops and no speed limits, and everybody is going 120 miles per hour,” lamented one senator, citing a Wall Street analyst, at a hearing on June 25. By the beginning of July, prices exceeded $140. Prediction after prediction reinforced that conviction, as the crescendo of incantations about higher prices reverberated around the world.21

  BREAK POINT

  In truth, the gears had already started to grind in the other direction. The break point was at hand. Prices did matter after all. They mattered economically—and, as the public’s ire and fear rose, they mattered politically.