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How Oil is Actually Priced: Be Worried
A recent article published in the Asia Times by former oil market regulator Chris Cook and posted below argues that all oil prices take their clues from the Brent spot price, a price that could be easily manipulated. Cook therefore believes the prices of all traded oil contracts, including WTI itself could suddenly decline in a way similar to the decline in mortgage backed securities that are highly leveraged to the relatively small amount of bad mortgage debt written over the past few years.
Cook states that the U.S. WTI contracts are linked by strong arbitrage trades to the European Brent/BFOE futures contracts which in turn are priced directly off the spot cash market for shipload quantities of oil in Europe. Thus, he says, virtually all futures prices depend on the European spot market. Unfortunately, this spot market is very thin and thus subject to manipulation which could either be intentional or accidental based simply on speculative greed. Cook claims that $260B of contracts including “structured products” rest on a base of only $4B of actual cash trades. In other words, he suggest that at some point oil could become like tulips were in the 17th century.
Adding to his alarm is the fact that the cash trades do not take place on any exchange. There are no records of which trades are done by which individuals. Even if the individuals were known, there is no regulatory mechanism in place to monitor or control the fairly small quantity of oil-for-cash trades.
Mr. Cook foresees the return of rabid speculation to the oil pits and fears it will result ultimately in a collapse. Whether such fears are justified or not it seems reasonable that there should be more transparency and oversight of the spot oil market than what apparently exists.
Sep 19, 2008 
SPEAKING FREELY
Oil market collapse waiting to happen
By Chris Cook
Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.
After a phenomenal “spike” in oil prices to US$147 per barrel, the price has declined to just over $90. In the US this led to a “spike” to $4 per gallon of gasoline and placed energy prices right at the top of the US political agenda. Moreover, this political interest rapidly crossed the Atlantic since British trading of US contracts was believed to be instrumental in a speculative oil market price “bubble”.
In view of my background in energy markets - I was for several years director of compliance and market supervision at the
International Petroleum Exchange (which is now ICE Futures Europe) - I was asked recently by the British parliament’s Treasury Select Committee to give evidence to them in relation to regulation of oil markets. Such an inquiry is a new direction for the committee, and following this initial hearing they decided to commence a full-blown Inquiry - in the finest US tradition - in October.
I told the committee - and their subsequent initial questioning that day of British regulators implied that my message was understood - that to follow the US approach to regulation of oil futures markets would be to try and solve today’s problems with yesterday’s tools.
The New York Mercantile Exchange (NYMEX) West Texas Intermediate (WTI) crude oil market price has become almost entirely irrelevant in the real world of physical and forward oil trading, which largely takes place, believe it or not, in Yahoo chat rooms. While NYMEX members still provide a massive pool of trading capital or “liquidity”, the inconvenient truth is that oil market pricing power has moved across the Atlantic to the price of North Sea crude oil.
Brent benchmark
The price of North Sea (Brent) crude oil is now the direct benchmark for over 60% of global crude oil pricing, and, through the mechanism of massive “arbitrage” trading between Brent and WTI, it also constitutes an indirect benchmark for most of the other 40%.
Most people - including virtually all mainstream press reporters - believe that it is the price of futures contracts that is used as a benchmark. In fact, it is the reported “spot” market price of “dated” Brent/BFOE (see below) cargo transactions that constitutes the direct and indirect benchmark for most global oil transactions. The massively traded ICE Futures Europe Brent/BFOE Crude Oil contract is merely a financial bet on these underlying prices, and these financial contracts are settled in cash, not oil.
For many years, the production of the Brent oil field has been in decline, and the production of other North Sea oil fields has therefore been amalgamated with it to ensure a sufficient number of transactions to give a credible benchmark price.
We now see four fields - Brent, Forties, Oseberg and Ekofisk (”BFOE”) - together supplying the BFOE “Brent” contract whereby 600,000 barrel “cargoes” of these qualities of oil may be bought and sold forward for eventual physical delivery.
The problem is that even this extended North Sea BFOE production is still only running at less than 70 cargoes per month, which is a total monthly production of little more than 40 million barrels. Even at $150 per barrel that represents a value of only $6 billion, and at current prices less than $4 billion.
Sitting on this base of physical trading is an off-exchange complex of price risk consisting of the simple forward BFOE contracts themselves, a host of derivative contracts, and an increasing number of “structured finance” transactions. It is estimated that in total, some $260 billion was recently invested in oil markets one way and another, and this pool of funds was superimposed as an inverted pyramid of risk on this relatively tiny base of physical crude oil.
Could these transactions have been instrumental in causing an oil market speculative bubble?
The answer is obvious: of course they could, and in all likelihood, they did. Unfortunately, because the transactions directly affecting the BFOE price took place off-exchange, not only does no regulator know, but none is in a position to know. Worse than that, even if regulators did know, there are no agreed market regulatory standards to enforce, and any offenders are for the most part smugly immune from enforcement action in offshore jurisdictions in any case.
Don’t shoot the piano player
As I pointed out to the Treasury select committee, to blame national regulators, such as the FSA in Britain and CFTC in the US, for problems of a global marketplace does not help, other than in providing a useful scapegoat. This is because the problem lies both in the global scope of the market and in its conflicted structure, where the interests of trading intermediaries or middlemen are diametrically opposed to those of end-user producers and consumers of oil and oil products.
In the absence of a new approach to market structure we will inevitably see repeats of the recent spike in oil prices as waves of hot money swill in and out of the market. In my opinion, that will inevitably lead, sooner rather than later, to a market meltdown - similar to the literally overnight collapse of the tin market in 1985 from $800 to $400 per tonne.
The conventional wisdom is that the “central counterparty” clearing houses of futures exchanges, which guarantee the performance of transactions, backed by a pool of capital and margin, are a strength of these markets.
In my view, they also constitute a single point of failure, where oil price risk is concentrated in exactly the same way that Fannie Mae and Freddie Mac were massively exposed to house price risk.
I made a presentation a couple of years ago in Lausanne to an audience of high-level security experts at a seminar covering the subject of economic terrorism. This fascinating seminar covered the subject of the susceptibility of global markets and commerce to acts aimed at causing economic destruction, rather than physical destruction and death.
I pointed out that current levels of gearing and risk, and the concentration of risk in single points of failure, together mean that the only difference between “economic terrorists” and proprietary traders such as hedge funds is motive. The former would destroy a market deliberately: the latter by accident.
While the oil market survived the recent storm surge of money, the inevitability of future waves of speculative money sweeping into the market, mean that an oil market meltdown is an accident waiting to happen.
Chris Cook is a former director of the International Petroleum Exchange. He is now a strategic market consultant, entrepreneur and commentator.
(Copyright 2008 Chris Cook.)
Tags: peak oil energy investments
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15 responses so far ↓
1 KV // Sep 29, 2008 at 2:38 pm
Bubblicious!
With $650 Billions in the cash market, we just wait inflation to take over, and then oil might be cheap at $2oo+
2 paultaut // Sep 29, 2008 at 2:53 pm
I’ve been using Brent for years but not in the manner described above.
Brent plus shipping cost should equate fairly closely to WTI, I do not have a clue as to what the going rates are but have been using $3 because 30 years ago the cost was $1.50.
If Brent trades at or above WTI for any lenght of time I just assume oil inventories will decline regardless of weekly guestimates.
Brent has the same problem as WTI, there isn’t a lot of it and its production is in decline.
3 paultaut // Sep 29, 2008 at 3:02 pm
One other thing, Mr. Cook seems to acknowledge the decline in production but seems to also think that this lack of “liquidity” will also lead to an implosion of price. To me, this seems rather contradictory.
4 Pat // Sep 30, 2008 at 7:43 am
One thing I miss in all talk about higher oil prices say $200 + is that high prices would correct themselves by leading to deep recession and lower use of oil and then lower prices…. can someone with more knowledge tell me why oil bulls do not seem talk much about this issue.
5 Bruce // Sep 30, 2008 at 8:10 pm
Hey Jim.
Do you have some insights into how biofuels works regarding pricing that you can share with us?
6 robert essian // Oct 1, 2008 at 4:42 am
Jim, your sight was one of the first ones I found when I decided to take contol away from my broker and assume full responsibility of my finances. I have not been disapointed.
I read the article above on the heels of another article by Don Coxe (Sept 10th “Global Portfolio Strategy”.
So many spins and turns are becoming so complex that it challenges the mind to get wrapped around some of their complexities.
I would find it truly rewarding if the crude oil situation was in fact just a supply and demand issue.
I’m finding that manipulation by all forms of governments, speculators and all other invisble entities may play a more important roll in determining the price of this stuff.
So when I express that I’m behind the curve I’m assuming you and many of your very knowledgable respondants probably know this and I just need to catch up.
To finish I’ll have to stay with what I know and that’s the fundamentals. If I lose, I lose. I suspect we will all lose…Without rules there is only caos…Peace
7 KV // Oct 1, 2008 at 6:00 am
RE - I hope you would not mind if I interject to your note to Jim.
Doing investing for yourself is fundamnetal to your survival. Brokers, financial advisors, and others have eye on your assets not whether it grows! They would scalp you from 2% to 10% of your assets and you don’t even know it.
True supply and demand existed only when you and are living in bunch of tribes and we traded goods, properties and believe it or not brides for peace!
Today, there is no supply and demand; just theories, about monies, gold, oil, corn, politics - keeping people dumb. We do not educate, so everything is complex, and we inherently good at heart, we trust in big building, three piece suits etc.
Unfortunately, nobody ever is in front of the curve. Take a look $700 B bill - which I think is necessary - that will require legal interpretation to prove that acts by many were not according to law. Pass what you may, Paulson and company will do what they planned.
With rules, it is an organized chaos.
Here is my unsolicited views:
Be less emotional! Do not lose, or keep losses to minimum! Do not involve politics or God when dealing with money, and count, or compute numbers all the time! Keep portfolios so that no single company is >2% in portfolio, take profits, and help others understand this! Why? The darn thing makes you smart, and you only give up a bit or two to the sharks, and survive to be a big fish!
We live with sharks!
8 robert essian // Oct 1, 2008 at 7:27 am
KV, thanks for that.
The emotional part of this for me lies in the adrenaline rush I get from new and informed information.
I absolutely am hooked and wish I spent more of my time as a young man REALLY involved with this.
I have learned so much and intend on spending many more hours doing the math, reading charts and researching. I know no other way.
I have no doubt to the value of my holdings as we go forward,
So Jim don’t get upset with me about staying on message (he has every right)…How about those Cubs (My brother managed them)…Peace.
9 paultaut // Oct 1, 2008 at 8:59 am
Go Cubs Go Sorry Jim, but like all perceptions Hope is all that can go on without logical accessories.
Pat: Oil Bulls know that regardless of the depth of the Recessions, Oil will continue to be used and disappear. And all that can possibly happen is that the inevitable is postponed.
This Recession will pass and a recovery will again strain supply. This is also inevitable. Unfortunately for us, the current crisis is Financial. Oil projects which would have helped increase Supply have been shelved or postponed, no financing.
I am talking only about the Developed Nations. If a reduction of Growth from 11% to 8% is called a recession in China, I would gladly accept it in the US. Not China or India, nor the Middle East or Brazil will wallow in what we call a recession. This is half of the worlds’ population.
10 robert essian // Oct 1, 2008 at 11:21 am
The way it looks from here is supply will be just in time no matter the situation.
Worse of course if above ground issues like Jim has stated with Iran, Russia, Venezuela, Nigeria.
Below ground issues like Mexico and the North Sea. Not to mention OECD countries are past Peak and heading down the depletion road of what looks to be more than 5% plus per year.
At some point in the very near future we will have to commit to an infrastructure plan that will ramp up energy use or we are really in trouble. Fact is an electric economy has to happen or we are heading for the dark ages.
Pun intendent.
Costs for energy will rise and continue to do so until the United States, the largest energy user relieves the demand issue around the world and at home by completing the electrical transmission, wind and solar projects.
If not then this financial issue will seem small in comparison.
I honestly see no other way.
I believe Obama see’s this for our future, will have the majority to make it happen should he be elected.
If elected though he has committed to pulling out of Iraq and my concern based on a previous gentlemens comments on this sight is that you can forrget about Iraq’s oil because unrest will prevail. What’s the risk premium on that? I would think very high.
Here’s hoping the Senate and the House don’t get their feelings hurt from now until Thursday…PLEASE…Peace
11 eddel // Oct 1, 2008 at 12:09 pm
Demand and supply will eventually rule in the longer term. Manipulators are short term. Stay cool through the roller coaster. Buy assets while they are cheap, and hang in as inflation begins to take over.
12 paultaut // Oct 1, 2008 at 12:22 pm
Personally, I think we are found under carnal knowledge either way.
Bush has a higher approval rating than Congress. To me that translates into a shift in both House and Senate back to the GOP. Obama’s “Change” will die on the Vine without Congressional Support.
The true government in Iraq is held my that nations’ Imams. What they say goes. Outside of the Kurds, there are 2 separate and highly contentious groups. Sunni and Shiah, they may unite against a common foe but only for the duration.
I firmly believe that Iraq will be broken up into 3 states whenever the US leaves, 2 if the bloodbath which has been a long time coming occurs.
Think in terms of the Hatfields VS the MCoys?, but extend it to include the entire country.
13 hughowens // Oct 13, 2008 at 8:16 am
Simply superb article by Chris Cook. Thank you Jim. The comments were for the most part disappointing, irrelevant and off message.
14 Rob Brinkman // Oct 22, 2008 at 3:32 am
Oil is going back to $40-$50. Easy money.
15 Rob Brinman // Dec 17, 2008 at 2:15 pm
Oil under $40. Time to cover and reshort higher on a deadcat bounce.
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