[Marxism] Oil Prices

[bauerly@xxxxxxxx]

FUTURES PRICES DETERMINE PHYSICAL OIL PRICES

A number of high-profile economists, like Paul Krugman, have recently been
making the argument that trading in oil futures can't really influence the
price of physical oil because it doesn't remove any oil from the market. Here's
a classic statement of this argument by Jon Birger, a staff writer from Fortune:

Here's a suggestion: The next time a Congressional committee wants to hold a
hearing on how "speculators" are driving up oil prices, each committee member
should first be required to demonstrate - preferably in their opening remarks -
a basic understanding of the mechanics of futures trading.

Even better, they should be required to explain in detail how it is that
investors who never take delivery of a single barrel of crude - and thus never
remove a drop of oil from the open market - are causing record high oil
prices.Source
I will now provide that explanation, and in the process show that both Krugman
and Birger are grossly misinformed about the way physical crude is actually
priced in the global oil market.

Most crude oil is traded based on long-term contracts, and the prices in those
contracts are set by a system known as "formula pricing". In this system, the
price of delivered crude is set by adding a premium to, or subtracting a
discount from, certain benchmark or marker crudes, namely: West Texas
Intermediate (WTI), Brent and Dubai-Oman. Generally, WTI is used as the
benchmark for oil sold to North America, Brent for oil sold to Europe and
Africa, and Dubai-Oman for Gulf crude sold in the Asia-Pacific market (Source1,
Source2).

Originally, the benchmark prices were spot prices, but over time problems began
to arise due to the depletion of the benchmark crudes:

In the early stages of the current oil pricing system which emerged in the
period 1986-88, crude oil was priced off the spot market quotations of these
benchmarks (namely dated Brent, spot WTI and Dubai) as assessed by oil
reporting agencies such as Platts and Petroleum Argus. In the last few years
[i.e. since the early 2000s] however, there have been some serious doubts about
the ability of the spot physical market to generate a price that reflects
accurately the margin of the physical barrel of oil. One of the main problems
is that very little actual trading occurs in these crudes which makes the
process of price discovery very difficult.Source
The rapidly declining size of spot markets for the benchmark crudes led to
chronic problems with speculators cornering those markets with a technique
called the "squeeze":

Low volumes of crude oil available for spot trading make price discovery
problematic and increase the vulnerability of markets to squeezes, distorting
prices and undermining market confidence. A squeeze refers to a situation in
which a trader goes long in a forward market by an amount that exceeds the
actual physical cargoes that can be loaded during that month. If successful,
the squeezer will claim delivery from sellers who are short and will obtain
cash settlement involving a premium. It is true that all markets are prone to
squeezes and in the last few years there have been occasions on which the Brent
market was subject to successful squeezes. But it is also true that it is easier
to squeeze thinner markets.Source
The Brent spot market in particular was plagued by frequent squeezes in the
early 2000s, and this is well attested to by numerous sources here, here(pdf),
here, here, and here etc.

Here's an interesting tidbit on the subject:

Dated Brent, which acts as a price marker for many international grades, is
physical crude traded on an informal market, rather than a regulated futures
exchange. This lack of regulation poses problems for oil producers and
consumers seeking a fair price, said Robert Mabro, director of the Oxford
Institute for Energy Studies and a leading Brent expert.

"There are regular squeezes in the Brent market," Mabro said. "In the trading
community, people are fed up. This general view that you can do whatever you
like in an informal market is okay, as long as you regulate the market a bit.
But if it's a free-for-all, you're back to the cowboy age."

A typical Brent squeeze involves a company quietly building a strong position in
short-term swaps called contracts for difference, or CFD's, for a differential
not reflected in current prices. The company then buys enough cargoes in the
dated Brent market to drive the physical crude price higher, which boosts the
CFD differential, Mabro said.

The company may lose money on the physical side, but it's more than compensated
from profits on its offsetting paper position in the short-term swaps market,
Mabro said.

"The whole trick is to collect more money in CFDs than you lose on the physical
squeeze," Mabro said. "People seem to do it in turn. It depends on who's smart
enough to move in a way that nobody notices until it happens."Source
To deal with this problem, many key oil exporters shifted away from the spot
market, and began to use futures prices as the benchmark in formula pricing:

The declining liquidity of the physical base of the reference crude oil and the
narrowness of the spot market have caused many oil-exporting and oil-consuming
countries to look for an alternative market to derive the price of the
reference crude. The alternative was found in the futures market. When formula
pricing was first used in the mid-1980s, the WTI and Brent futures contracts
were in their infancy. Since then, the futures market has grown to become not
only a market that allows producers and refiners to hedge their risks and
speculators to take positions, but is also at the heart of the current
oil-pricing regime. Thus, instead of using dated Brent as the basis of pricing
crude exports to Europe, several major oil-producing countries such as Saudi
Arabia, Kuwait and Iran rely on the IPE Brent Weighted Average (BWAVE).11 The
shift to the futures market has been justified by a number of factors. Unlike
the spot market, the futures market is highly liquid which makes it less
vulnerable to distortions. Another reason is that a futures price is determined
by actual transactions in the futures exchange and not on the basis of assessed
prices by oil reporting agencies. Furthermore, the timely availability of
futures prices, which are continuously updated and disseminated to the public,
enhances price transparency.

[11] The BWAVE is the weighted average of all futures price quotations that
arise for a given contract of the futures exchange (IPE) during a trading day.
The weights are the shares of the relevant volume of transactions on that day.
Specifically, this change places the futures market, which is a market for
financial contracts, at the heart of the current pricing system.Source(pdf)
As you can see, Krugman and Birger are profoundly confused about the way the
international oil markets actually function. Futures aren't a paper bet on the
direction of prices determined by some independent process. Futures themselves
*determine* the price of most physical oil traded today. The futures price (+
or - the differential) literally *is* the price of oil.

-----

Further information on this topic is available in The Oil in the 21st Century:
Issues, Challenges and Opportunities, Ch. 3 "Origins and Evolution of the
Current International Oil Pricing System" (P. 41-100) and in Petroleum
Refining: Separation Processes, Ch. 3 "International Oil Markets" (P. 77-114)

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