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Wednesday 14 November 2012

Energy pricing: the market is manipulation



As an oil industry whistleblower, I know the energy sector is even more flawed than this week's exposé of gas prices reveals
north sea oil
'The real problem lies not with gas, but crude oil – which is suffering perhaps the greatest market manipulation the world has seen.' Photograph: Getty Images
The Guardian's investigation into the alleged "Libor-like" fixing of UK gas prices was doubly ironic for me. The first irony is that, as director of compliance and market supervision of the International Petroleum Exchange (now ICE Futures Europe) in the 1990s, I was heavily involved in the development and legal architecture of the gas-market contract that has now allegedly been manipulated.
The second painful irony is that in 2000 the Guardian published detailed allegations made by me on very similar micro-manipulation of the International Petroleum Exchange's Brent futures contract-settlement prices. This systemic manipulation was so pervasive that traders referred to the on-exchange profits they made at the expense of the manipulators – who profited "off-exchange" – as "grab a grand".
Unfortunately, I described the manipulation as "systematic" – taken to mean that some of the players were routinely manipulating the price most of the time – rather than "systemic", where most of the players manipulate the market some of the time. On this basis the commissioner appointed to investigate my allegations rejected them, and in finest whistleblower tradition my reputation was destroyed: I lost my livelihood, home and marriage. Had the crude oil market been properly investigated at that time, subsequent oil market history would probably have been very different.
One thing I have come to realise since my failed attempt at whistleblowing is that the short-term trading exposed this week is only part of the problem. The malaise runs much deeper. If you want to find out who really has an interest in rigging the market, ask who benefits from medium- and long-term high commodity prices: it's the producers, stupid. From De Beers' diamond hoarding to coffee-grower cartels, if the history of commodity markets tells us anything it's that if producers can find leverage to support commodity prices, they will.
The real problem in the energy market lies not with gas, but crude oil – which is suffering perhaps the greatest market manipulation the world has seen. This is due to financialisation of markets which began in crude oil about 12 years ago, but only became significant from around 2005 onwards. From the mid-90s, a new type of investor entered the markets as investment banks created new vehicles – index funds, exchange traded funds and so on – which enabled investors to invest directly in equities, precious metals; commodities generally and above all, in energy, with a view to "hedging inflation". Rather than speculatively taking a risk in search of a profit, they sought only the return of their capital, and the preservation of the value of their investment relative to dollars, sterling and so on.
To understand what happened to oil, we just need to look at the Enron scandal. The fundamental scam perpetrated here was based on an ancient financing method known as "prepay". Quite simply, this occurs when producers sell their product at a discount for cash now, with delivery later. So via intermediary banks such as JP Morgan and Citigroup, Enron were able to opaquely obtain "off-balance sheet" financing disguised as commodity trades of which Enron's investors and creditors were blithely unaware.Essentially, Enron was borrowing dollars and lending commodities.
A similarly opaque prepay technique has been responsible since 2005 for the inflation of two oil market bubbles. The first – a private sector bubble – culminated in July 2008 in a spike to $147 a barrel, and then a collapse to $35, causing great pain to producers used to high prices. At this point key producers – facilitated by friendly investment banks – resorted to prepay to finance themselves, and a public sector bubble was rapidly inflated during 2009.
In my analysis, the US and Saudis then hit upon a strategy that loosely "pegged" the oil price against the dollar within an agreed trading range, keeping prices relatively stable. But this trick only worked until early 2011, after which Fukushima and supply shocks in Libya and Iran have caused more turmoil.
I believe that there is now virtually nothing holding the oil market up, and that when (not if) Iran reaches an accommodation with the US on terms similar to those spurned by Dick Cheney in 2003, we will see the oil market price fall, possibly dramatically.
I have been warning for some time that risk-averse investors – whose very presence in the market causes the inflation they wish to avoid – are taking a much higher level of market risk than they appreciate. If I am correct, this will – sooner rather than later – give rise to the next Great Regulatory Disaster.
Perhaps worse than this, and particularly relevant to my work on financial market resilience, there is a significant risk of the sort of discontinuity in market price that took place in the tin market in 1985 when the market price collapsed overnight, from the price level supported by producer cartel stockpiling of $8,000 a tonne to the much lower price of $4000 a tonne, which reflected the influx of new low-cost tin supply.
The presence in the market of middlemen who have an interest in volatility and opacity means that we have now reached a stage where market manipulation is no longer an aberration: the market is the manipulation.
So what can be done? In the long term, crude oil prices can only go up, and many would argue that for the sake of the environment it is essential that carbon fuel prices are set at levels at which demand is low. The problem then is how best to distribute interationally and domestically the surplus value thereby created, in particular in investment in renewable energy, and above all in the cheapest energy of all – energy savings.
This will require a new (in fact very old) – and non-toxic – type of market architecture, and the good news is that this are already emerging as the current market paradigm approaches its end.

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