The Oil Paradox
A worldwide slowdown won't end the oil price boom anytime soon.
Last week brought fresh evidence that the U.S. economy is slowing and may have slipped into recession. The news has not only dimmed expectations for world economic growth, but it has also hammered oil prices, which lost $15 from the $100 high just a month earlier. A year ago, more bullish thoughts lifted oil prices from the $50 level in January 2007. The question on policymakers' lips is whether a worldwide slowdown will bring an end to the boom in demand for oil and drive prices significantly lower. Although oil prices will eventually drop as new sources come online and biofuels and other alternatives take hold, crude price are likely to remain high and volatile for a while.
One reason is that today's oil market is precariously balanced between supply and demand. That's why small wiggles in expectations about how much oil the world economy will need, and how much supply is on hand, cause huge changes in price. Such gyrations explain why companies that are big oil users—such as airlines—owe their fortunes, increasingly, to how they manage their financial exposure to energy prices. Southwest Airlines, for example, is not just efficient in moving customers, but it is particularly notable for a string of good bets to hedge jet-fuel costs.
Oil is also not a normal commodity. A big part of today's high prices—and why they are still nearly double the level of a year ago, despite dark economic news—is that oil beats to backward economics. When the price of soybeans or steel rises reliably, farmers and steel millers boost output, and prices abate. When the price of oil rises, many suppliers do the opposite. This bizarre response comes not from the Organization of Petroleum Exporting Countries (OPEC), which is always in the news, but from the pernicious ways that oil wealth ripples through the societies that have most of the oil.
The most visible and worrisome effect of oil riches is the "resource curse." In poorly governed countries, oil wealth (and any other booty that is easily seized) actually impedes economic development because all politics is a struggle to loot the resource rather than to make long-term invests to improve human welfare. Governments that get easy money from natural resources don't need to rely so much on human productivity, which makes them less accountable to their populations. These factors explain why Venezuela, for example, is in perennial economic trouble despite having some of the world's greatest oil resources on its books. The current run-up in oil prices has allowed Hugo Chavez to bankroll a reckless foreign policy and has taken direct control over the country's oil fields. Having undercut Venezuela's oil company and scared away many of the most competent foreign investors, Venezuela's oil output is actually declining even though today's high oil prices would, in theory, make Venezuela's newest heavy-oil fields much more economically viable.
A similar story is unfolding in many other oil patches. Over the last few years, between 300,000 and 700,000 barrels per day of production in Nigeria has been offline due to local conflicts in the oil-rich Niger Delta, triggered in part by the fact that higher oil prices created stronger conflicts over how to allocate oil riches within Nigeria. Russia has had a harder time attracting investment in its oil fields because oil wealth has given the country a swagger that makes it less in need of outsider assistance.
Higher prices can also cause countries to hold back on oil production. When resources in the ground have greater value and state coffers are already bulging with earnings—this year, oil-exporting countries will earn about $800 billion—countries can afford to stretch their wealth further into the future. Several countries in the Persian Gulf have adopted policies consistent with this new view of depletion; gas-rich Qatar has gone the furthest, putting a moratorium on new gas projects for fear that it is exhausting the country's resources too rapidly.
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Posted By: wnnr2 @ 08/27/2008 1:08:56 PM
Comment: And here is the final part (4):
"Investment banks had been frustrated with the established exchange because they really were never able to get control of it," said Michael Greenberger, a law professor at the University of Maryland and a former staff member at the CFTC.
The most successful of the private platforms was InterContinental Exchange, or ICE, founded by Goldman Sachs, Morgan Stanley and a few other big brokerages in 2000. ICE soon opened a trading platform in London, allowing its founders to trade vast quantities of U.S. oil overseas without being subject to regulation.
The exemptions for swap dealers and the development of overseas markets allowed big brokerages to open the door for more hedge funds, pensions and big investors to move into commodities.
In the coming years, commodity investments by funds could grow to $1 trillion, veteran hedge fund manager Michael Masters said in testimony before the Senate earlier this year. In an interview, he said this trend could raise commodity prices for everyone in the coming years and "have catastrophic economic effects on millions of already stressed U.S. consumers."
Meanwhile, commodities have been good business for big Wall Street brokerages. Its commodity trades helped keep Goldman Sachs profitable during the credit crisis, said Richard Bove, a banking analyst at Ladenburg Thalmann.
"Business is lousy right now," Bowie said of Goldman Sachs. "Commodities and currencies are clearly the strongest business they have right now."
In the coming months, swap dealers expect to have yet another venue for oil speculation. The CFTC has stated it would not stand in the way of trading in U.S. oil contracts overseas in Dubai. Goldman Sachs and Vitol are among the major investors in this new exchange.
© 2008 The Washington Post Company
Posted By: wnnr2 @ 08/27/2008 1:06:42 PM
Comment: I'm sorry to have repeated the post on part 2 . It appeared not to take originally. HERE IS PART 3:
Victoria Dix, a spokeswoman for Vitol, declined to answer questions. The firm, through Dix, released a statement that stated only that it had not been contacted by the CFTC about the reclassification of its business and that its trading status remained unchanged. CFTC officials said they do not typically contact firms that are reclassified.
On its Web site, the firm says it has $100 billion a year in revenue and describes its thriving global energy-trading business.
For most of the past century, regulators put limits on financial actors to prevent them from dominating commodity exchanges, which were much smaller than the bond or stock markets. Only commercial operations, such as farms, airlines, manufacturers and the middlemen that handle their trading activities, were allowed to buy nearly unlimited quantities. The goal was to allow these businesses to minimize the effect of price swings.
The first major change to this regulatory framework occurred in 1991, when Goldman Sachs, through a subsidiary called J. Aron, argued that it should be granted the same exemption given to commercial traders because its business of buying commodities on behalf of investors was similar to the middlemen who broker commodity transactions for commercial firms.
The CFTC granted this request. More exemptions soon followed, including one to the Houston-based energy trader Enron.
"When the CFTC granted the 1991 hedging exemption to J. Aron (a division of Goldman Sachs), it signaled a major shift that has since allowed investors to accumulate enormous positions for purely speculative purposes," said Rep. Bart Stupak (D-Mich.) Now, he added, "legitimate businesses that hedge and take physical delivery of oil are being trampled by the speculators who are in the market purely to make profit."
A second turning point came when Congress passed the Commodity Futures Modernization Act of 2000. The law formally allowed investors to trade energy commodities on private electronic platforms outside the purview of regulators. Critics have called this piece of legislation the "Enron loophole," saying Enron played a role in crafting it.
In the months after the act was passed, private electronic trading platforms sprang up across the country, challenging the dominance of NYMEX.
© 2008 The Washington Post Company
Posted By: wnnr2 @ 08/27/2008 1:01:21 PM
Comment: And here is part 2:
CFTC documents show Vitol was one of the most active traders of oil on NYMEX as prices reached record levels. By June 6, for instance, Vitol had acquired a huge holding in oil contracts, betting prices would rise. The contracts were equal to 57.7 million barrels of oil -- about three times the amount the United States consumes daily. That day, the price of oil spiked $11 to settle at $138.54. Oil prices eventually peaked at $147.27 a barrel on July 11 before falling back to settle at $114.98 yesterday.
The documents do not say how much Vitol put down to acquire this position, but under NYMEX rules, the down payment could have been as little as $1 billion, with the company borrowing the rest.
The biggest players on the commodity exchanges often operate as "swap dealers" who primarily invest on behalf of hedge funds, wealthy individuals and pension funds, allowing these investors to enjoy returns without having to buy an actual contract for oil or other goods. Some dealers also manage commodity trading for commercial firms.
To build up the vast holdings this practice entails, some swap dealers have maneuvered behind the scenes, exploiting their political influence and gaps in oversight to gain exemptions from regulatory limits and permission to set up new, unregulated markets. Many big traders are active not only on NYMEX but also on private and overseas markets beyond the CFTC's purview. These openings have given the firms nearly unfettered access to the trading of vital goods, including oil, cotton and corn.
Using swap dealers as middlemen, investment funds have poured into the commodity markets, raising their holdings to $260 billion this year from $13 billion in 2003. During that same period, the price of crude oil rose unabated every year.
CFTC data show that at the end of July, just four swap dealers held one-third of all NYMEX oil contracts that bet prices would increase. Dealers make trades that forecast prices will either rise or fall. Energy analysts say these data are evidence of the concentration of power in the markets.
CFTC leaders have argued that speculators are not influencing commodities' prices. If any new information arises during the agency's examination of swap dealer activity, officials said they would report it to Congress.
"To date, the CFTC has found that supply and demand fundamentals offer the best explanation for the systematic rise in oil prices," CFTC spokesman R. David Gary said, reading a statement that had been crafted by agency officials. "Regardless of their classification . . . the CFTC's market surveillance group scrutinizes daily the positions of all large traders, both commercial and non-commercial, to guard against market manipulation."
© 2008 The Washington Post Company