Petromania: Black gold, paper barrels and oil price bubbles

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First published in Great Britain in 2009

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ISBN: 978-1-906659-77-6

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To Ele and Nessa, with love

Acknowledgements

Many oil industry experts are mentioned by name somewhere in this book, and it will become apparent that I agree with some and disagree with others. I would like to stress, however, that where there is such disagreement on my part, it is above all respectful disagreement. In this spirit I would like to thank all of the following people in particular for their freely-given time in discussing various issues with me, whether personally or in correspondence, whether i1.4n specific regard to the research for this book or in my day-to-day job as a journalist: Ed Morse, Daniel Ahn, Jeffrey Currie, Francisco Blanch, Colin Smith, Stephen Schork, Robert McCullough Jr., Christof Ruehl and Roger Bentley.

Very special thanks are due to Leo Drollas of the Centre for Global Energy Studies – unwittingly and unbeknownst to him (until now!) he is in a certain sense the godfather to this book. It was after a couple of hours spent in conversation with him in his London offices in January 2009 that I finally decided there was enough of a disjuncture between what actually happened with the oil price in 2008, and what an establishment consensus still persisted in saying had happened, to justify treatment of these issues at greater length. Mr Drollas himself is certainly not part of this establishment consensus, rather a proud outlier; and although I have not quoted him extensively in this work, this should in no way detract from the debt I owe him and the fact that it was he who first pointed me toward an extremely wide range of evidence backing up a stance I had already taken in early 2008 on a then significantly narrower base of evidence, bolstered by inference.

Speaking of my day-to-day job, I would also like to acknowledge various editorial colleagues at the Investors Chronicle who have taken charge of our news coverage from time to time over the past few years, all of whom have proved happy in that role to support and run with my own take on the oil markets. When we originally called the oil price as a bubble in May 2008, this placed us well outside the then-fashionable groupthink dominating the financial press. Thanks in this regard are owed to Graeme Davies, Oliver Ralph, Simon Thompson, John Hughman and Jonathan Eley.

Paul J. Davies and Chris Dillow were both kind enough to read and provide invaluable criticism, comment, and friendly encouragement on vast tracts of the manuscript as it emerged, and Andrew Adamson and Jack Cross also provided crucial help with the drafting. I am grateful to the team at Harriman House, particularly Stephen Eckett, Chris Parker and Suzanne Anderson, for taking this project on and seeing it through to completion in a very tight timeframe, in a very professional manner, yet in an ever-amiable and relaxed fashion throughout. It goes without saying that any simplifications, exaggerations, omissions and other errors still populating this text are my responsibility alone.

Last but certainly not least, it would never have been possible for me to steal the time in which to produce this book without a great deal of love, support and forbearance shown me by the two beautiful girls in my life, my wife Eleanor and daughter Nessa – to whom this book is dedicated, and for whom I promise to try to be (slightly) less boring and obsessional in future.

Daniel O’Sullivan

London, 2009

Preface

Petromania is an account of the spectacular boom and bust that occurred in the crude oil market through 2008, which saw oil breach $100 per barrel at the start of the year, clock an as-yet all-time high of $147 per barrel in July, but then collapse to $34 per barrel by Christmas – the wildest price movement ever seen in our most important global commodity, and one which wreaked havoc in the worldwide economy.

Contrary to arguments advanced by many commentators focusing on fundamental factors, this book argues that new forms of financial speculation which sprung up in commodity markets from the 1990s onwards were instead the key driving force behind this chain of events, now positively identified as a classic speculative bubble. No prior knowledge of the oil markets and their functioning is presumed, so it is hoped this text may also profitably serve as a basic primer on these subjects as well.

I have for the most part eschewed footnotes, but all of the key sources and texts can be found in the Sources & Bibliography section at the back of the book.

Introduction

A Shadowy History

2008 was the year the oil price made history not just once but three times. The world gasped as it breached the $100 per barrel threshold, for the first time ever, on the very first trading day of that year. We swooned as crude oil reached an all-time high, as yet unsurpassed, of $147 per barrel in early July. And when oil subsequently collapsed from that peak in its most precipitate dollar decline ever, to trade at $34 per barrel by Christmas ’08, people did not know whether to laugh or cry. Had all that suffering been for naught? Because make no mistake, no price matters more in this world than that of a barrel of crude oil. Along its way, the rampaging oil price had played havoc with livelihoods worldwide – affecting the poorest people in particular – whilst crippling and bankrupting businesses across the globe, destabilising developing world governments, and preventing developed world governments from cutting interest rates as swiftly as needed in meeting the most serious international economic crisis since the Great Depression.

Figure 1 shows how extraordinary this price blow-out was in terms of what has gone before since the turn of the 21st century (through the 1990s prices were even lower, around $20 per barrel). For a physical commodity such as crude oil there are always physical market fundamentals to consider in any account of price movements. And as we shall see, there were many and indeed still remain many who feel that supply and demand fundamentals justified the wild appreciation in oil prices seen in recent years. Yet whenever such a spectacular boom and bust in any asset price is observed over such a short timeframe, an inescapable suspicion is that it was above all the product of a speculative bubble inflated by investors – as defined by Yale economist Robert Shiller, ‘a situation in which temporarily high prices are sustained largely by investors’ enthusiasm rather than by consistent estimation of real value.’(Irrational Exuberance, Robert Shiller, 2nd ed., 2005, p. xviii (Princeton University Press, 2005).

Figure 1: 21st century oil prices, the story so far [Source: Thomson Datastream]

This book is overwhelmingly concerned with establishing that the actual physical fundamentals of oil supply and demand patently failed to justify crude oil prices at the levels they achieved in summer 2008, but that activity on the part of speculative financial investors was instead the major driving force behind this phenomenon. The arguments entertained both for and against this proposition will range across many aspects of the global oil industry and the globalised financial markets, but we can make a modest start here and now. For if a picture tells a thousand words, our chart here also furnishes immediate and very eloquent support for the bubble theory.

The shaded band below the actual peak of the oil price in Figure 1 sketches the matching shape of one of our more notorious speculative bubbles of recent years: the Nasdaq tech stock/dotcom share boom in the US which peaked in March 2000 before its own spectacular bust.

Perhaps no two investment propositions could be more different than crude oil and the boom-era Nasdaq. One is the physical product of a classic, grimy, old economy business focused around costly and dangerous real world engineering projects in often inhospitable environments; the other was a basket of dotcom internet retailing, biotech, new media and other similarly weightless members of a supposed new economy. Yet as Figure 1 indicates, both the oil price and the Nasdaq 100 shared a strikingly similar trajectory through the crucial period spanning their most rapid appreciation and subsequent abrupt collapse.

This is more than just a matter of resemblance from a distance. Figure 2 details this uncanny coincidence in tighter focus (and without the Nasdaq vertical axis offset used in Figure 1 for ease of presentation). It clearly shows how closely the two markets shadow each other as they move through their respective zeniths, years apart.

Lest those rightly wise to the tricks of statistical presentation begin to question this startling parallel, it should be stressed – no axis-shifting or otherwise underhanded data transformation is required to draw this graph. It is simply a fact that, although separated across time, space and underlying investment assets, both the Nasdaq 100 and the oil price gained, gained again more rapidly, and then dropped precipitately through near-enough the same percentages in three distinct phases over the same number of weeks in their respective boom to bust cycles. We shall examine an extended version of this chart later, but what can better explain this coincidence other than some unfolding logic of speculative bubbles, an underlying algebra of investor herding common to all such episodes? The spectacular rise and fall of the oil price certainly looks like a speculative bubble, if recent history is any guide.

Figure 2: Two bubbles [Source: Thomson Datastream]

Does it matter if the oil blow-out was indeed a genuine speculative bubble, a fragile ‘naturally-occurring Ponzi scheme’ to use Robert Shiller’s terminology, demonstrating dynamics of the type described variously both by Shiller and the late Hyman Minsky, another major theorist of speculative excess? That is, was it merely a self-referential feedback loop of ever-higher valuations, only ever justified on the basis of the next herd of investors buying into the latest this time it’s different story? And if so, so what? Who cares that some made fortunes while others lost their shirts in the sort of investment craze which is, after all, now widely recognised as an all-too-periodic visitation upon our market-based variant of economic development? So what if the petromania of 2008 now takes its place in the historical parade of previous investment manias, including such celebrated episodes as the Dutch tulipomania of the 1600s, the Mississippi Scheme of early 1700s France, and the roughly coincident episode in England – which bequeathed us the usage by which we now tend to identify similar market phenomena – the South Sea Bubble?

Black Gold, Devil’s Excrement

It matters greatly, as the list of charges already laid against the high oil price underlines. No other commodity can affect the world economy the way oil can – certainly not copper, gold or platinum, other important commodities which also experienced astounding price blow-outs through roughly the same period. Yet through 2008 they were not the topics of conversation around the water cooler, or on radio talk shows, or TV news reports, in legislative hearings held by elected politicians, or at inter-governmental summits. Whereas oil most definitely was centre stage across all. The reason is simple. At the dawn of the 21st century, over a hundred years since combustion engines first shattered the bucolic peace of our forefathers, the old-fashioned, literally prehistoric, black, slick, smelly liquid hydrocarbon fossil fuel known as crude oil remains our industrial lifeblood, and therefore the single most-traded commodity worldwide both in terms of volume and value.

Fuel products derived from crude oil drive our transport on land, sea and in the air – while also firing a good portion worldwide of our electrical power generation capacity. Meanwhile materials derived from crude oil and its associated natural gas both underpin the ubiquitous use of plastic throughout our industrialised society, and also provide us with a plethora of synthetic fibres to clothe us in evermore imaginative materials. Ever since the then-dominant British naval fleet made the momentous decision to switch its boilers from coal-fired to oil-fired at the beginning of the 20th century, access to and control of supplies of crude oil has determined the weightiest of foreign policy decisions made by states, and decided the outcome of wars fought between them.

The incredible wealth oil can bring to those who control it has funded the rise of fabulously rich dynasties around the world, from the original US oil barons of the early 20th century to the Gulf sheikdoms of the contemporary Middle East. However, these riches also mean corruption, crime and violence are frequently inextricably intertwined with the production and exploitation of oil. It is now common to refer to the resource curse afflicting developing countries such as Nigeria, endowed with significant oil resources but lacking the requisite governance structures to check the potential for embezzlement, bribery, thievery and outright armed conflict, both inter-state and civil, that the promise of such resources can awaken in people. Oil is indeed commonly known as black gold, but it has also famously been described as ‘the devil’s excrement’ – by a one-time president of oil producer cartel OPEC, no less (former Venezuelan oil minister Juan Pablo Perez Alfonso, speaking in 1975).

A high oil price enriches some countries, but also spells relatively higher costs across practically the whole gamut of business activity worldwide. It brings an increased risk both of knock-on inflation in the economy, yet also recession due to there being less cash to spare in oil-importing countries for other goods and services. Together these two outcomes spell stagflation, the term coined in the 1970s following the oil shock, an embargo by Arabian oil producers in protest at Western support for Israel that signalled a new heavyweight status on the global stage for OPEC. Much as it might pain us to admit it, nothing matters as much to the smooth functioning of our society as our supply of crude oil, and no price is therefore more important to us than the price of crude oil.

Follow the Money

Whoever can influence the oil price wields enormous power over the direction of our globalised economy – which is exactly what this book is about. Yet this is a tale played out a million miles from the swamps of the Niger Delta, or the snows of the Russian Far North, or the deep water offshore of Brazil, or the heat of the Arabian Desert. This is a tale played out on computer screens across the world, shouted hoarse across City trading pits, and buried in the annual statement of returns from your own pension fund. For the truth is that, as with so many other spheres of modern life, the globalised financial investment sector has effectively colonised the oil market as a prime source of speculative return.

As a result, many people are worried that the price of this most crucial commodity of all now dances to the tune of investment manager sentiment, herded in and out of short-lived trends, subjugated to trading expectations regarding comparative yields across asset classes that also include equities, bonds, currencies, precious metals and other commodities. In the worst-case scenario, this financialisation of the oil market causes the price to lose touch with the actual underlying physical fundamentals of supply and demand. And certainly, this is what the evidence collected here suggests happened over summer 2008.

For many, it seems economically suboptimal – not to say morally unfair – for the self-serving investment strategies of a well-paid transnational financial elite to dictate wild gyrations in the oil price. It rides roughshod over the common interest that the vast majority of people worldwide share in enjoying relatively stable energy costs. Yet this is the natural outcome of the particular way we have organised our market-capitalist economy to date – and ultimately, changing this state of affairs is a political question. It was one which many politicians themselves became very interested in as fuel prices rocketed skywards through early 2008. In the US in particular, public opinion on the matter forced a series of legislative hearings that sat across many months in both Houses of the US Congress. The testimony offered and evidence submitted to these hearings loom large in this tale, as do the responses engendered from US market regulators.

Notwithstanding this flurry of legislative interest, however, one year on there has yet to be any concrete action taken to control the financial sector influence on the oil price which drove this chain of events. This is also despite the previously avowed intent of new US president Barack Obama to rein in such speculation in the oil market, a pledge he made when campaigning for office. In mid-June 2009, the White House unveiled a package of proposed regulatory reforms for the financial sector, intended to ensure that the widespread institutional failings that caused the global credit crunch, its attendant banking crisis and the economic catastrophe we are now enduring can never happen again. Re-regulating financial sector interest in the commodity markets, however, is markedly absent from these proposals. Even though White House spokesman Robert Gibbs told reporters, ‘I don’t think the President’s concern has changed,’ he admitted he did not know if speculation in oil markets would be dealt with in further proposals.

It is easy to see why such steps have slid down the presidential to do list. The priority for the world’s most powerful man right now is stabilising the global financial markets at large. And while commodities such as oil are an important part of this panorama, attention is fixed instead on a whole other vista of market failure, the delinquent peddling of sub-prime mortgages. The resulting toxic asset infection was spread by the virus of securitisation and similar credit derivatives throughout the length, depth and breadth of the banking sector worldwide, and remains as yet largely unresolved. Significant as it is, the dramatic oil price spike of summer 2008 risks becoming the other, forgotten financial excess of the late noughties – overshadowed by the all-encompassing fallout from that more obvious bubble of our times, the worldwide real estate boom-and-bust.

That would be unfortunate, as the lessons we can derive from studying the petromania of 2008 are needed right here, right now. Incredible as it may seem so soon after the oil price collapse in late summer 2008, the financial forces which blew that bubble are at work once again, stoking the next flare-up in oil, even as physical market fundamentals look at least as unsupportive as they did last year, and possibly more so. Oil doubled from its Christmas 2008 low, to around $70 per barrel in mid-2009, and investment bank cheerleaders are once again pencilling-in forward estimates of $95 per barrel for mid-2010. Triple digit price forecasts will probably be in vogue once more by the time this volume has gone to print. Back in the real world, however, politicians and economists warn that this unchecked and patently illogical price appreciation is undermining recovery prospects across the wider economy. Following its initial appearance in summer 2008, petromania may well come to be characterised by recurrent outbreaks of the fever. Understanding how it progresses is at least half the battle in tackling it.

1: The Ascent

‘At first, as in all these gambling mania, confidence was at its height, and every body gained.’

Charles Mackay, The Tulipomania in Extraordinary Popular Delusions and the Madness of Crowds (1841)

1.1 The Triple-Digit Threshold

Global markets opened 2008 in a jittery mood as January 2, the first trading day of the New Year, saw leading share indices stumble in turn across the time zones. While the main equity boards in Hong Kong, Frankfurt, Paris and London would all close down more or less a percentage point, the real upset was in New York where, following the release of particularly weak US manufacturing data, the Dow Jones Industrial Average was heading for a 1.7% drop – its worst first-day percentage performance since 1983. Yet elsewhere in the city, another market was about to breach a more momentous threshold. Shortly after noon, a commodity broker working on the floor of the New York Mercantile Exchange (NYMEX) became the first person in history to pay $100 for a barrel of crude oil.

Stephen Schork, a former longtime Nymex trader who now edits the daily energy market analytical newsletter The Schork Report, remembers the exact moment: ‘I was on the telephone with a journalist and I think the bid in the market was around $99.30 or $99.40, so he was asking me When do you think we will see $100? And as soon as he asked that, a $100 print went on the board and I said, Yep, right now I think we’ll see it…’

The trade immediately made headlines worldwide. As the reporter’s interest shows, crude oil’s rapid appreciation, from around $60 per barrel a year earlier, was already big news, and that first hundred dollar deal on Nymex – the exchange the wider world looks to for its benchmark oil price – was immediately controversial. Not just because the new era of triple-digit oil prices it heralded was feared both by ordinary citizens struggling with sky-high fuel costs, as well as economists and governments concerned at how appreciation in such a ubiquitous industrial cost input was stoking global inflation. More immediately, there were questions regarding the legitimacy of the transaction and whether it should stand in the trading record.

Those physically present in the Nymex exchange could see the agreed $100 price printed up on the board over the open-outcry bear pit, where