by Tom Bower
Considering all those variations, Littlejohn calculated the Saudi oil price by averaging the price of a basket of crude oils including Alaskan, WTI and Brent. Taking into account the amount of sulphur in Saudi oil and the freight costs from the Gulf, he would “netback” the price for delivery in New York to the cost for the customer at the terminal in Saudi Arabia. Littlejohn would hate to be accused of trying to influence prices. His unspoken quest was to discover the amounts of oil in storage in America, Asia and western Europe. If he could successfully manage the inventories of oil in the West, Saudi Arabia could influence prices over the long term.
Both Laney Littlejohn and Jorge Montepeque were aware of another complication. Crude oil prices were no longer solely dependent on supplies from the OPEC countries, the US and the North Sea, but were also influenced by the prices of products refined from oil, or the other way around. Trades of jet oil, kerosene, heating oil, diesel and the dozens of types of gasoline for cars sold “over the counter” by refineries to customers and between traders either in the future or for “spot” were all influenced by crude prices, and vice versa. The market was a vast, self-adjusting balancing act, reported by Platts and Argus. The principal users of those two agencies were the oil majors and traders, especially Glencore, Vitol and Trafigura. Registered in Switzerland and with offices across the globe, the secrecy surrounding the privately owned traders inevitably attracted suspicion.
Unlike the standardized Nymex quotation for the price of light sweet crude at Cushing, there was a vast variety of deals between the traders. Jet oil refined in Europe and sold to the US was priced differently from jet oil refined in Singapore and sold to Japan, or on a tanker heading from Rotterdam to Mexico, or from a refinery in Malaysia to Tokyo. The same jet fuels produced in America were priced differently depending on the refinery and which pipeline was used to transport it around the country. Even dishonest traders needed to know what prices their competitors had agreed to on a permutation of deals, and their only sources were Platts and Argus. The simplicity of Platts’s and Argus’s pricing exposed the market to unscrupulous traders.
In the early days, Platts employed 15 reporters in the USA, London and Singapore to telephone traders every day to discover the prices of their latest deals — the bids, offers and final contracts in every region. The work was not arduous. The Platts reporters asked simple questions, but, handicapped by the traders’ superior knowledge and their occasional intention to manipulate the market, they had to rely on the information given to them by the traders. If only a few people were trading, creating an “illiquid market,” the traders could easily hoodwink young reporters and secure profits on contracts based on Platts’s report of a price. Good reporters tried to filter out the lies and balance out the assertions to establish whether the trader had simply invented a contract to be reported by Platts in order to increase his profits. “Some traders talk their books to manipulate the prices,” grumbled a Platts executive. “Traders conspire to pull the wool over our eyes,” agreed another Platts reporter. “We’re fighting against distorted images in the market,” declared Montepeque, who to his staff was the only barrier between honesty and dishonesty. “The best liar,” said a Platts reporter, “is the trader who tells you the truth 95 percent of the time, slipping in one lie for his own purpose.” An experienced reporter, Montepeque hoped, would “discount what he thinks is a phony price.” But “interpreting” the market among the 20 traders of oil products and 15 traders of crude in America was chancy. Nevertheless, even the best manipulator could only fool the market for a couple of days. Beth Evans was one of the few Platts reporters feared by traders. If she suspected a trader of committing “hanky-panky” or making “five o’clock daisy chains” in the Brent market, she delighted in “wiping him out.” “Death by Beth” was the fate of a trader nailed by her disapproval. Her anger was especially aggravated by British traders playing games on Thanksgiving Day, when the US market was closed, to manipulate unrealistic prices.
Montepeque’s attempt to sanitize the system was resented by Littlejohn. “Jorge Montepeque is full of shit,” he said. “There is no evidence of wrongdoing, but a lot of people bite on it.” Montepeque was undaunted. Like the oil producers and oil majors, he knew that Littlejohn hated being told how to run his business, but some traders enjoyed flouting the rules. Prices offered to Platts on a P&C basis — private and confidential — were suspected of manipulation. “These traders,” said Montepeque, “want a fantasy world of secrecy.” “Game playing” had become endemic. “Resetting has to be done,” said Montepeque, because “the oil trade is impenetrable for outsiders.” He set out to create a transparent market with new rules for the messy trade in oil products — diesel, jet oil, gasoline and kerosene — being sold in different specifications, in constantly changing time zones, with freight prices influenced by pipelines and tankers heading toward dozens of destinations. Technically the traders were dealing in “swaps” on the OTC market or “futures” on Nymex.
The market’s opacity suited Glencore, Vitol, Trafigura and others dealing on the margins in terms of market share. Marc Rich had reincorporated his company in New York as Clarendon, but once it had become notorious for lying, manipulation and secretly breaking sanctions to trade oil with Iraq, a group of his former employees decided in 1993 to break with Rich and the past by reestablishing the business in Switzerland as Glencore, which developed into the world’s largest commodities trader, with annual revenues in 2008 of $152 billion. The successor company remained a colossus among mineral traders.
Playing “the basis game,” certain traders and private corporations expanded their operations from beyond mere trading of petroleum products to renting pipelines, refineries and tankers for crude oil. Like scavengers in the African desert, ensuring oil was loaded and delivered for the best prices, traders crisscrossed the globe to dusty backwaters where they would wait endlessly for meetings that could lead to an offer to buy or supply cargoes of oil that the majors felt compelled to ignore. Refineries in eastern Europe, the Balkans, Colombia, Nicaragua, Ecuador and South Korea, blighted by shortages of money or shunned by the oil majors because their credit was deemed to be unreliable, were vulnerable to higher-priced cargoes.
In the aftermath of the Kuwait war, it was reported that some unnamed traders had noticed that vast amounts of crude oil, contaminated with sand and salt water, were lying on the desert, in the salt marshes and in damaged oil wells. At no cost, traders obtained the oil for treatment in Very Large Crude Carriers (VLCCs) anchored offshore. After decontamination the crude was sold to refineries in Brazil and Tanzania, and a power station in Pakistan. The generators in the Pakistani power station, clogged up with sand and bitumen, had to be closed down. Several refineries in eastern Europe, especially in Romania, discovered after refining crude that it did not match the specifications in the bill of lading. Private detectives found that during the tankers’ passage through the Suez Canal, the original loads of top-quality Iranian crude had either been transferred to another tanker or had been piped into a storage tank and replaced by inferior oil, which was undetected by the staff on the quay at the Romanian refinery. Unlike the major oil corporations, the Romanians had carelessly failed to employ an assayer to test the oil before acceptance. By the time the damage had been discovered, and the refineries’ products — gasoline, diesel and heating oil — were discovered to be inferior or even worthless, so many shipments had been mixed together that it was impossible to determine for legal purposes whether the supplier was responsible for the culpable load.
In that sketchy world of squeezes and deception, the arrival of the bankers Morgan Stanley as oil traders shifted the balance. Under John Shapiro’s direction, Morgan Stanley’s oil business based on Sixth Avenue in Manhattan had grown from two traders in 1984 to 40 in 1990. Diversification meant greater risks and higher profits. Until 1990, the bank had predominantly dealt in crude oil, and did not fully understand the complexities of trading the refined products manufactu
red by the world’s 620 refineries, each calibrated for different requirements in summer and winter. Among those recruited after March 1990 was Olav Refvik, a Norwegian employed by Statoil who revolutionized the bank’s philosophy. In the volatile period after the Gulf War started in August, Refvik and Shapiro shifted the bank’s emphasis from providing risk management for customers and primarily financing the trade of crude oil to risking money by trading products. Serious profits, Shapiro and Refvik realized, could be made by taking positions, or propriety trading, on the price of the so-called middle distillates — heating oil, diesel and jet fuel — where the “crack spread,” or profits, were healthy.
Adopting financial instruments used by metal and foreign exchange dealers, Morgan Stanley would agree, for example, to guarantee the price of jet fuel for an airline in Chicago three months in the future. To protect itself from risk because of the inevitable change in oil prices, the bank would simultaneously buy another product, perhaps heating oil in Europe. Since the general price of jet fuel and heating oil, allowing for different specifications, would rise or fall simultaneously, the bank’s profit was earned by “arbing on the difference in price,” not by delivering the fuel. By protecting against price movements, or “hedging” relative prices, the bank offered customers the opportunity to protect themselves against every contingency.
Oil trading had fundamentally changed. First because the derivatives introduced liquidity or money into the market, and second because the market for oil products would eventually influence the price of crude oil, including OPEC’s. Gradually, speculation among traders and the banks undermined OPEC’s overwhelming power to control the world’s oil prices. Morgan Stanley was becoming an intellectual powerhouse, “trading around the book.” As the bank entrusted more money to Shapiro and the oil traders, Olav Refvik, regarded by one industry insider as “a piece of work with a very aggressive DNA,” became known for “not being shy about an outsize bet, risking a big loss for a big profit.”
Shapiro’s success hurt Goldman Sachs. The founding team was blamed for failing to take risks and build the business. “They liked it when traders earned profits, but couldn’t take the pressure of losses,” noted Charlie Tuke. “They were so frightened of making the wrong decision that they were prevented from making the right decision.” The new managers, Lee Vance and Frank Bosens, restructured the operation to take risks and follow Morgan Stanley’s practice of making a market for anything and anyone. By then, those using Morgan Stanley’s sophisticated methods of trading included BP and Shell. Their trading operations enjoyed a unique global footprint.
Establishing an advantage over rival traders depended upon possessing better information about events that would influence oil supplies and price movements. Noting how Marc Rich had earned his fortune by anticipating wars during the 1970s, every trader had sought unique sources of information to outwit his rivals. BP was becoming the industry’s most aggressive trader. Since its expulsion from the Middle East and Nigeria, the company had focused more effort than others on trading from London, Cleveland and Singapore. BP’s strength was its physical presence in every product and every region — producing, refining and marketing oil. This meant that BP’s traders — employed on short-term contracts and paid bonuses to encourage aggression — received invaluable intelligence about shortages, surpluses and calamities. “A lot of people have lost money betting against BP, and made money following BP,” said Peter Gignoux, a London trader. Even the best rival traders were by comparison working in a vacuum. “In trading you are either everywhere or you die,” said Gignoux. “BP’s culture was aggressive and arrogant, trading as a big name. Only when their conduct was so outrageous were they punished.” During the 1990s, BP had often been suspected of manipulating prices of Alaskan and Brent oil. In June 1997, Trevor Butler and three other BP traders were finally accused of “front-running” Brent: Butler was selling small parcels of oil at a high price and then, having established a closing price on the futures market, selling a huge amount on BP’s behalf at the high price. Inevitably, prices would subsequently fall. Both BP and Butler were found culpable. BP was fined £125,000 by the IPE, and Butler was ordered to pay costs. “It’s called ‘Grab a Grand,’” said one of the defending lawyers, who described manipulation as “systemic.” The punishment of BP would be noted by rival traders as merely symbolic. Although BP issued a statement promising to “review our procedures,” no one believed the company would behave less aggressively in future.
BP’s use of “embedded optionality” — simultaneously trading paper and physical oil products, and monitoring activities at refineries to improve the flow of information about the business and mitigate the risk if it needed to store or supply oil — was also adopted by Morgan Stanley after the insolvency of Wyatt, an oil storage terminal in New Haven, Connecticut, in 1991. This would normally have been followed by the bank selling the assets at firestorm prices, but John Shapiro and Neal Shear spotted an alternative strategy of “going back to basics.” After Wyatt was bought from the administrator, Morgan Stanley agreed to lease the terminal to store and supply four million gallons of heating oil and diesel every day to customers in the area. The physical ownership of oil gave the bank the flexibility to simultaneously trade real oil and speculate in “paper” oil, knowing that if a deal turned sour, it could avoid the risk of “having its feet held to the fire,” and take delivery of physical oil. Shapiro had tested the idea in Oklahoma in 1986, and it worked. “Being in the physical business tells us when markets are oversupplied or undersupplied,” he argued. The bank’s traders were no longer the tail, but had become the dog. “I’m getting squeezed out by Wall Street’s invasion into our territory,” Phibro’s Andy Hall complained.
Like all the traders, Hall had greeted the Iraqi invasion of Kuwait on August 2, 1990, as another opportunity for profit. Two oil producers at war and the prospect of a shortage provoked speculation. Prices rose during the first day from $21 a barrel to $27, and later hit $40. Unseen by the public, the traders were deploying their ruses and skills to make fortunes. None had taken into account the effect on the industry’s image.
The oil majors’ spontaneous hike of gasoline prices in the United States aroused public anger, and demands for a repeat of the windfall profits tax of the 1970s. None of the oil majors or the traders had anticipated that soon after the invasion Saudi Arabia would begin to recommission 146 old wells and drill 51 new wells, increasing production by 29 percent to 8.5 million barrels a day. Traders had not calculated that Saudi Arabia’s spare capacity would compensate for the absence of Kuwaiti oil, or that stocks from America’s strategic petroleum reserve would be released. Their expectation of a war premium evaporated. In early January 1991 oil prices fell back to $21 after Allied air raids on Iraq ended the threat to supplies. “Wall Street is ankle-deep in blood,” smirked one trader in London. Andy Hall’s speculative positions were hammered, and he withdrew from trading physical oil, concentrating on trading derivatives for high-percentage profits. He was relieved, like other traders, to be shielded from the growing conviction among the American public that Big Oil was profiting from US soldiers dying in the Persian Gulf.
Protestors shouting about “blood for oil” and recalling Rockefeller’s price-fixing cartels sought an explanation for the continuing high price of gas. Although the world was awash with low-priced oil, gasoline’s price rise in the US following the invasion in August from $1.19 to $1.54 per gallon had not been reduced by early January. By contrast, the oil majors’ profits, opaque at the best of times, had soared. Exxon’s had risen by 300 percent, Mobil’s by 45 percent, Shell’s by 69 percent and Amoco’s by 68 percent. All those profits, said critics, would have been higher if the companies had not used adroit bookkeeping to write off capital values, add to their reserves and settle tax disputes. One note in small print in Exxon’s accounts embodied the seemingly disparate threads linking the public’s dislike of Big Oil. At the end of 1990 it became apparent that Exxon had reduced its
liability for taxation by setting off some costs caused by the Exxon Valdez disaster in Alaska against taxes. That calamity, and the reaction of Lawrence Rawl, the chairman, further damaged the industry’s credibility.
Rawl had been telephoned at 8:30 a.m. on Good Friday, March 24, 1989, and told that the Exxon Valdez, a 900-foot tanker, had hit the Bligh Reef while maneuvering through Prince William Sound. By daybreak over 10 million gallons of Alaskan crude oil had leaked out of the tanker and was edging toward 1,100 miles of pristine coastline. Rawl was told that the tanker’s captain had failed an alcohol test, and admitted, “You know it’s going to be bad, bad, bad.” By afternoon, he said, “I knew we were in a ditch pretty deep.” Instead of flying to Alaska, he was persuaded to stay in New York. Even Exxon’s chairman could be held on a chain by the corporation’s lawyers. “You’ll get in the way,” he was told. “We’ve said everything that there is to say.” His absence, the corporation’s refusal to immediately admit liability or offer remorse, and the background to the incident fueled public loathing of Exxon and Big Oil.
