Nonstopdrivel
14 years ago
This author points out that speculators are part of the solution, not the problem, and that the real issue facing the market right now (ignoring for the moment supply issues) is hedging by vertically integrated oil companies.

Can the Oil Market Be Manipulated? 
by KENT MOORS PH.D. | published MAY 27TH, 2011

On Tuesday, May 24, the U.S. Commodity Futures Trading Commission (CFTC) sued two companies on charges they manipulated prices for crude oil and oil futures at the height of the recession.

The case – filed in Manhattan's U.S. District Court – is called U.S. Commodity Futures Trading Commission v. Parnon Energy Inc.

It actually charges two related companies with manipulating the pricing in West Texas Intermediate (WTI) crude between the fourth quarter of 2007 and early in 2008. They are California-based oil logistics company Parnon Energy and London oil trader Arcadia Petroleum – both affiliates of the closely held Cypriot company Farahead Holdings Ltd.

(Remember, WTI is the benchmark crude traded on NYMEX in New York.)

The suit alleges that the companies acquired stockpiles of crude, issued call and put options on the long and short positions developed to mimic a market shortage, and profited enormously from what the CFTC says amounts to a fictitious, "artificial," price increase.

And it is reviving the question of whether the price of crude oil can be manipulated.

The companies lost on the sale of the crude oil itself (the "wet" barrels of actual commodity) they had stockpiled. But, according to the filing, they gained more than $50 million in profits from the derivatives (the related "paper" barrels).

The alleged activity occurred during the early part of a run up to historically high oil prices of $147.27 a barrel (by the second week of July in 2008). The companies charged, however, were trading, and making profits, when the price for crude was well under $100.

The civil lawsuit further contends that the companies stopped the practice when they were apprised of a CFTC investigation.

Now, the Commission regards this alleged conduct as an unwarranted manipulation of pricing -for both a physical commodity and the derivatives based upon it.

The companies, of course, will claim that their actions amount to normal operations of supply and demand.

However, given a number of precedents, the respondents will have some difficulty in sustaining that position…

After all, several years ago, BP plc (NYSE:BP) tried to claim the same thing, when a couple of affiliated traders cornered the propane market and then began increasing prices. And although the oil major never admitted to any wrongdoing, it still paid a fine of almost $400 million.

The same result probably awaits Parnon/Arcadia/Farahead, along with two company officers also named in the civil suit.

The Real Question Is Whether Such Manipulation
Can Actually Determine Direction and Price


Taking a $50 million profit from paper transactions is one thing… but when compared to the daily trading in oil futures and options the amount is insignificant – it's positively minute.

Certainly no one can suggest that amassing an oil stockpile like the one documented in this case could actually control the crude oil market. Even creating a bottleneck through artificial means (controlling access to transit volume at a strategically located port, for example) could not result in more than a temporary impact on market pricing.

Conspiracy theory buffs aside, this may be the way players manipulate for a short-term, localized profit.

Yet the sheer size of the suppressed inventory (on the one hand) and the avalanche of derivative paper (on the other) that it would take to control the market in this way renders such a strategy impossible. Even if a series of traders could pull it off, it makes for an unwieldy tool and a very obvious group of culprits.

Traders, speculators, shippers, and logistics providers cannot artificially manipulate the broader market this way. However, producers might…

A More Troubling Development

I have had an interest in tracking oil companies (for crude) and refineries (for oil products) trading in their own volume over the past 11 years.

As I noted last week (in "Oil Inventories, Speculation, and Hedging," May 20), anecdotal evidence is already emerging that vertically integrated oil companies (VIOCs) – those controlling the upstream/downstream process from field to refinery through retail outlet – were unusually active recently in trading in near-month futures contracts in their own product.

This occurred both when crude oil and gasoline prices were rising (through close on April 29) and thereafter, as crude plummeted almost 15% and gasoline over 13% as of the end of trading on May 6.

Hedging is certainly required in such volatile periods. And the VIOCs will insist that is what they were doing.

Yet an even more troubling development may be brewing with the activities of the huge state-controlled producers in OPEC and Russia. These two sources alone account for almost 58% of all crude oil available in daily trading. That certainly accounts for the "wet barrel" side of the equation.

And for the "paper barrel" side?

Take a look at where more of the investments are directed these days… from these countries' sovereign wealth funds.

That combination dwarfs anything that might come out of a courtroom in Manhattan.

Sincerely,

Kent


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Nonstopdrivel
14 years ago

Inventories, Speculation, and Hedging
After the End of Cheap Oil
 

by KENT MOORS PH.D. | published MAY 20TH, 2011

The downswing in oil prices over the past two weeks has once again introduced supply/demand questions… while, at the same time, renewing suspicions that speculation is the cause of oil pricing instability.

Discussion of the supply/demand question usually gravitates to the "peak oil" debate: how much oil is left, and when the markets will conclude that over 50% of the total supply has been exhausted.

This latter consideration has become a mainstay of the debate. That's because it cuts to the core of how traders view the relationship between available supply… and price.

In a normal market, pricing – whether for paper barrels (futures contracts) or wet barrels (actual consignments of oil) – is primarily based on the price of the next available barrel. It is, therefore, a forward-looking process, based less on where the price has been than on where traders conclude the price is going. (These are forward contracts and deliveries, after all.)

In a supply-constricted market, however, the focus changes to the price of the most expensive next available barrel.

Why? Because the normal process of pricing being determined by the interchange between supply and demand only works if there is reserve supply and an ultimate cap on demand expansion.

Price usually serves as the barometer of both – higher prices enticing both increasing production and declining use; lower prices discouraging marginal increases in extraction, but prompting additional use. (Declining energy prices always result in rising consumption.)

But when a concern emerges over how much supply can be brought onto the market in a given time frame, the dynamic changes…

Now the uncertainty of satisfying market demand will gravitate the price to higher levels, reflecting competition for the available supply. In this situation, a trader needs to peg the trade to the highest price; otherwise, he or she cannot guarantee access to volume.

We are not (yet) in a supply-constricted situation.

Additionally, I want to emphasize – again – that we are not in, nor are we approaching, a peak oil environment, either. (See "Why This Is Not A Peak Oil Crisis," March 4, 2011.)

There is plenty of oil left. The problem surrounds the end of cheap oil.

The new oil coming online is more expensive to extract, process, transport, and refine. As we move into an accelerated tapping of unconventional sources (such as oil sands, shale, heavy oil, and bitumen), the cost factor increases even more.

OK, so that provides us with one indication of why prices (until recently) have been increasing.

But if the essential culprit is not availability, then is it speculation?

Why Speculation Is Actually Necessary

In a normally balanced market, speculators tend to offset. Even when the presumption is that the price will be moving up or down, there is still an offsetting factor in the trading process.

Speculators are necessary to allow trade. (I have discussed this before, as well. See "2011 Energy Prices and the Speculator's Role in Trade," December 28, 2010.)

If I want to make a transaction, I need somebody on the other side prepared to take a financial risk. I need, in short, somebody interested in making money off of the transaction – not a party needing to buy or sell the actual oil (more on that in a moment).

Speculators add liquidity.

And they tend to take the more extreme positions in trade – both to increase the return potential to them and to provide adequate leverage for exercising a series of options to manage their own risk, thereby narrowing the range of risk for others.

Occasionally, a market can heat up or cool down to the extent that the positions taken by speculators may have an impact greater than usual. However, even in such situations, the existence of the speculative element more reflects – rather than produces – the market effect.

This is important, because current political rhetoric from inside the Beltway finds it very convenient to blame the speculator for the run-up in prices.

One proposed solution is to restrict the speculation in New York.

Changes in margins, contract volume, and the like may well be in order. But attempting to restrict futures contracts only to those who have an interest in the underlying wet barrels – i.e., actual buyers or sellers of the crude – will simply move the speculation to markets beyond U.S. control.

Not a good idea for a market already dependent on other countries for upwards to two-thirds of daily oil needs…

It also merely accentuates what I do regard as the primary cause: hedging.

Why Hedging Is A Valid Exercise, Too

It allows providers and recipients of both crude oil and oil products to protect their bottom lines from undesirable changes in prices.

They will do so by either counter-positioning consignments or taking options (which essentially do the same thing).

However, the parties are not the same in each case. With crude oil, the provider is a production company, while the recipient is a refinery. In the case of oil products, the provider is a refinery, with the recipient a wholesaler (or "jobber").

Leaving hedging as the only, or primary, arbiter of price, will bring us back to the situation that prompted creation of futures contracts in the early 1980s. They were designed to open up markets to more participants and effectively wrestle the determination of price from the hands of a few very large international oil companies (the famous "Seven Sisters").

These days, returning to hedging as the way to set pricing once again allows a few players to dictate prices.

Today, however, the main participants are not international majors, but national oil companies – Saudi Aramco, Petróleos de Venezuela (PDVSA), other OPEC members, or Russian Rosneft.

The market price would not be determined by thousands of smaller end users, but by huge producers bent on maintaining higher prices.

Nonetheless, the larger vertically integrated oil companies (VIOCs) – those who control the process from wellhead to refinery to retail outlet – would still benefit if hedging were the only solution.

The refinery remains the lynchpin in the entire process. Those who control refinery capacity control the pricing in the regional and local markets they serve.

Anecdotal evidence is already emerging that VIOCs were unusually active in trading in near-month futures contracts in their own product – both when crude oil and gasoline prices were rising through close on April 29 and thereafter, as crude plummeted almost 15% through close on May 6.

Does this improve either the pricing picture or the demand-side concern hitting the average consumer at the pump?

I think not.

Sincerely,

Kent


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Wade
  • Wade
  • Veteran Member
14 years ago
Gee, we read the same junk mail/investment newsletters, too. :)

And do not be conformed to this world, but be transformed by the renewing of your mind, that you may prove what is that good and acceptable and perfect will of God.
Romans 12:2 (NKJV)
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