When George Bush was inaugurated on January 20, 2001 the NYMEX near futures crude oil contract was $32.19/bbl (see also item 308). On September 10, 2001 (markets closed for 3 days because of 9/11), the price had declined to $27.63. In succeeding weeks, due to international cooperation and support, the futures price actually fell hitting a low of $17.72 on November 19, 2001.
During the first half of 2002, prices gradually rose returning to pre-9/11 levels and then continued to rise to inauguration levels in the runup to the Iraq War peaking at $37.78 on March 7, 2003 and then fell back and traded at the $30 +/- $2 through most of the rest of the year.
In 2004, prices rose steadily as insurgency and civil war took hold in Iraq and instability increased. The abuses at Abu Ghraib came out and the first and second battles of Fallujah took place. There was also the weather. In September, Hurricane Ivan hit the Gulf Coast and the following month prices spiked to $52-$55 in response. The futures price on the last day of trading for the year on December 29, 2003 was $32.52. On December 30, 2004, the last day of trading for 2004, the price was $43.45. 2004 is noteworthy because prices increased 33%, broke through the levels of the previous 3 years, and never returned to them.
In 2005, prices continued their rise and tested the $60 barrier in June before the price spikes in late August (to $69.81 on August 30, 2005, the day after Katrina made landfall) and late September (to $66.80 on September 21, 2005, 3 days before Rita came ashore). The contract ended the year at $61.04 (a 40% increase) on December 30.
In 2006, saber rattling against Iran by Bush sent prices over $70 in April. This was followed by the Palestinian civil war in June when Hamas threw Fatah backed security forces out of Gaza (item 191) and then Israel’s massive bombing campaign against Lebanon from July 12 to August 14. The peak for this period was $77.03 and occurred on July 14. After the ceasefire in Lebanon, prices began to fall and ended the year at $61.05 on December 29 almost exactly where they began the year. However for nearly 5 months during 2006 due to mostly avoidable events in the Middle East oil futures were trading at $10-$15 higher.
2007 was another critical year. It began with price manipulation of gasoline with refineries taken offline for accidents and maintenance forcing gas prices up. Early on crude oil futures actually declined which is what you would expect in the face of a downstream bottleneck creating a glut. Unfortunately, this was soon reversed as the Administration ratcheted up tensions with Iran on the basis of poorly substantiated charges that Iran was supplying Shia militias with a particularly lethal IED, the EFP (explosively formed projectile). Matters were not helped when a group of British Marines on a maritime patrol were seized by the Iranians. Yet even as these crises faded and gasoline prices eased, speculative pressure surged. In early 2007, some of the first mortgage lending companies went bankrupt as the subprime bubble prepared to burst. Even as the happy talk on Wall Street continued, the crude oil futures market was telling a very different story. This market had been jittery from March through May but in early June prices took off. The last time prices closed below $65 was on June 8. This spike in the crude futures market began a month before the two Bear Stearns funds went bust in July and two months before the subprime bubble officially blew up on August 9 when the French bank BNP Paribas froze withdrawals on 3 of its funds and created a worldwide financial panic (item 87). 2007 closed with the near futures contract at $95.98, a 57% rise for the year.
By mid June 2008, the futures price was at the $140 level, a 46% increase from the beginning of the year.
There are several things to say at this point.
Excess speculation results in price rises that can not be accounted for from the market fundamentals of supply and demand alone. As we saw above, a political crisis, a war, or a hurricane can threaten or cause supply disruptions, and temporary increases in futures prices result. But crises fade, wars end or fail to affect supply, weather related damage is repaired and, as concerns ease, prices should revert to at or near their previous levels.
Now there are some things which can raise the overall price as for example demand outstripping supply, but in the period 2004-2006 stocks of crude oil in the US were at record highs. So this wasn’t it. Inflation could do it but inflation has only become a concern in 2008 and that largely due to interest rate cuts in response to the subprime crisis. Devaluation of the dollar against other currencies could also be responsible. The dollar has fallen in value against many currencies, most notably the euro (item 307). Now if we were to assess the overall effect of devaluation, we would have to take into account not just the euro, the most extreme case, but a basket of the major currencies against which the dollar has lost less. But for the sake of argument, let’s not. Even if we said the dollar has lost 50% of its value since Bush took office and we increased future contract prices 50% accordingly, this would be $32 (the price at the time of Bush’s first inauguration) plus an extra $16 (the 50% markup). We would therefore expect the price to be around ~$50. To put it mildly, it’s not.
Looking back to when prices rose over and above their underlying costs and the factors of supply and demand, we can say excess speculation in the crude oil futures market began in 2004. Despite the accelerated rate of price increase and the sheer absolute size of it since the subprime fiasco hit in 2007, many in the media, the government, and the public remain in denial about the role of excess speculation. Even if speculation is admitted, a smaller and briefer impact is ascribed to it. The usual suspects are also blamed. It’s the oil companies’ fault or that of oil producers. While neither of these groups are “the good guys”, excess speculation is very much a creature of the financial markets and the major players in them: hedge funds, investment banks, index funds, and sovereign wealth funds.
How did they do it?
- Low margins. The amount you need to put down on a futures contract is only 5%-7% of its face value. This means that for every dollar invested, $15 to $20 of futures contract could be purchased.
- Paper demand. Most excess speculators never take possession of a single teaspoon of oil. They simply make a bet that the price of oil will rise. They are buying a contract, a financial instrument, not the oil itself. When it comes time to settle up, they sell the contract and pocket the profit or flip it and buy a new contract. Because no oil actually changes hands, these are called “paper” barrels. Oil futures market, however, have no way of distinguishing the demand represented by these paper barrels from that of real consumers of oil, such as refiners. Thus in addition to real demand, this paper demand adds pressure to prices as if it were real.
- The Enron exception. Through its political pull with politicians like then Senator Phil Gramm (R-TX), Enron was able to insert language into the Commodity Futures Modernization Act of 2000 exempting energy trading companies from oversight by the Commodities Futures Trading Commission (CFTC), the government watchdog agency, in the over-the-counter (OTC) market for “futures-like” instruments.
- London-Dubai loophole. In January 2006, the Intercontinental Exchange (ICE) with the blessing of the CFTC (via no-action letters) began allowing American traders to trade futures contracts on oil produced and consumed in this country on foreign terminals in the UK thus circumventing reporting requirements to the CFTC regarding large trader activity and speculation caps. (ICE also has an OTC component.) NYMEX joined with the Dubai Mercantile Exchange to launch a similar venture in May 2007.
- Swaps dealer loophole. Under a 1993 CFTC rule, swaps dealers, investment banks like Goldman Sachs and Morgan Stanley, were given the same status as traditional futures traders like oil companies and airlines as long as they were considered to be hedging a “legitimate” risk. This allowed large financial funds to enter into swaps contracts with investment banks. A swap contract is essentially an agreement between two parties in which the first party agrees to pay the second a fixed rate of interest on an agreed upon amount, and the second party agrees to pay the first a variable rate on the same amount. The actual principals offset each other so it’s really a mechanism to convert a fixed rate into a variable rate. The trick is that the investment banks use the money they receive to buy something that has a variable value, in this case crude oil futures which they have access to and the funds do not. This has been yet another way for large amounts of outside capital to enter into and distort the operation of the futures market in crude.
- An ineffectual CFTC. This agency is supposed to regulate futures markets, but in this most anti-regulatory of Administrations, it has given away so much of its authority that it has no idea what is going on in the “dark markets” created by ICE and the Enron exception and no real interest in doing anything about it.
- Political inaction. On June 27, 2006 (while Republicans were still in the majority), the Senate Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs issued a report investigating excess speculation in energy futures markets. Legislation for better reporting to the CFTC was proposed but died and disappeared. It bears repeating most of this problem and the reasons for it were known more than 2 years before it came to the attention of most of the public in 2008, and nothing was done by either Congress or the Administration during that whole time. If action had been taken in 2006, most of the current damage to the economy and pain to individual Americans could have been avoided.
- Injected liquidity. When the subprime bubble burst, the Fed and central banks around the world made hundreds of billions of dollars of liquidity available to financial markets to shore them up. Essentially none of this liquidity was used to help out homeowners with subprime mortgages, those with near subprime mortgages, those who had been encouraged to borrow against the inflated value of their houses only to see that value drop, and those few home buyers who were still out there. Instead cheap money was made available to financial markets which used it to facilitate excessive speculation in among other things, crude oil futures. It is we through our governments who are financing the speculation which is hurting us so.
In addition, the Fed repeatedly cut interest rates which also made money cheaper to borrow for those who could. These cuts fed into the speculative craze as investment moved back and forth between crude oil and the dollar. When the dollar weakened, the action moved into crude oil. When it strengthened, the action moved the other way. Speculators were able to profit from both ends.
As with the subprime bubble before it, the current bubble in crude oil and crude oil futures was as foreseeable as it was avoidable. Those who had the responsibility to know and act, knew but did not act. They continue not to act, and now they pretend not to know.
In an August 21, 2008 story in the Washington Post, the CFTC found in an audit of one privately held Swiss company Vitol that at one point in July this company alone held 11% of all NYMEX crude futures contracts. On this basis, the CFTC that has resisted the whole notion of excessive speculation estimated that 81% of futures contracts were held by speculators, and that this number could increase as more information came in from other large traders. It is almost impossible to overstate the effects of excessive speculation on everything from the economy, to global terrorism, to a resurgent Russia driven by the greed of a relatively small number of financial houses and an ideologically clueless CFTC.