Crude shock: Stop treating oil market as a huge gambling casino

May 16, 2020 6:11 AM

Oil futures markets need serious reform, or even wholesale junking, given the volatility they engender hurts many stakeholders.

It is time we develop such a stable pricing mechanism, and stop treating the oil market as a huge gambling casino.

West Texas Intermediate futures (benchmark crude for the US oil trading) closed negative $37.63 per barrel on April 20, creating shock waves. Without exception, all journalists discussing this referred to it as historic. But they did not explain why it has made history.

Not only the crude price went up the next day to $8.91, within few days it has gone above $20— same as it was before the so-called negative price Armageddon. Based on subsequent price movement, the negative price is an aberration. In reality, it is a failure of the futures market (FM). But, to the CEO of CME group that owns the New York Mercantile Exchange, “it was the Oil Futures Market working to the perfection.” Since, it is a key source of revenue for the CME Group, one cannot expect an unbiased assessment from him.

Even more shocking, none of the economists commented on the negative price as though it was not a concern. According to economic theory, FM is an efficient way of “discovering price”. And, if the price went negative, it must be right and normal.

Now is the time to question the gospel truth of discovering price through FM for oil, a strategically important commodity. Can we have alternative ways of determining price that are fair to both exporting and importing countries? Or, can we at least reform FM to limit these to serious traders? This way, the event of negative price can indeed become “historic”.

In 1978, after the second oil price war, oil prices had jumped up by 300%; NYME, which was banned from dealing in potato futures, introduced oil futures. In succession, came FM in gasoline, crude, natural gas and options, and all kinds of derivatives. In short, Wall Street speculators developed an elaborate ecosystem to build a grand casino. While oil FM is similar to Vegas casinos, there is a big difference.

In casinos, while some gamblers win, most gamblers lose—the house always win. Similarly, while the owners of FMs like CME always earn money, it is a zero-sum game for participants. For every loser, there is a winner. However, the price volatility (negative price) may result in non-participants (oil exporters and importers) losing or winning billions of dollars.

During the last two major price wars (1986 and 2014), there was huge volatility caused by speculators, thanks to the FM. It had far-reaching impact on the world economy and geopolitics. One of the arguments to support FM is that it causes less volatility compared to the pricing regime before 1978.

If one excludes the periods when neither the Texas Railroad Commission in the US market nor, later, major oil companies in the international market oversaw pricing decision, there was no such volatility. Even during these times of “control”, supply and demand fundamentals influenced prices through spot prices in the Rotterdam and Mediterranean markets.

The oil industry seems to be the only that undergoes dramatic changes when prices fall. Still, it is a mystery that the World Bank, the IMF, the UN—interested in strategies to help developing economies—have not studied the problem of stabilising oil prices. There are, however, hundreds of policy papers on the impact of petroleum subsidy on climate change and how it distorts economies. But, not one study focuses on ways to stabilise the oil market.

The collapse in oil prices may have precipitated the collapse of the Soviet Union, loss of oil revenues may also have helped bring the Iran-Iraq war to end in 1987—these are the only the pleasant outcomes. On the other hand, civil-war situations in several OPEC nations (Nigeria, Iraq, Iran, Venezuela, Libya, etc) brought about or exacerbated by volatility could have been avoided. Similarly, oil prices going above $100 led to riots in importing countries.

Price collapse can result in bankruptcy of oilcos, affecting millions of livelihoods. Talented professionals may seek employment in other sectors. Unfortunately, economists believe such collateral damages are worth paying so that “free market can discover prices through the futures market”.

When the FM discovered $147 per barrel in July 2008, or it reached a low of negative $40 per barrel in April 2020, what kind of pricing signal did it send to oilcos in terms of future investment? Will any oilco base its investment decision by looking at futures market for oil in 2030? In fact, when futures market was first introduced, major oilcos and OPEC did not participate.

One reason cited to justify FM is hedging. For airlines, there may be some justification for hedging for six or eight months. However, with a better system, like posted price or some modified system, hedging may not be necessary.

In the long history of oil, only when supply and demand was controlled, there was price stability. It is time we develop such a stable pricing mechanism, and stop treating the oil market as a huge gambling casino.

 

The author is former manager, Conoco, and former board member of the national oil company of Georgia. Views are personal.

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