by Tom Bower
During those early days of July 2008, Walter Lukken, the CFTC’s director, sought to disprove his agency’s critics. Despite his limited resources, and still convinced that prices were rising because of shortages of all crude oils rather than speculators, he became involved in the blame game, looking for scapegoats. Convinced by a tip-off, Lukken believed that malicious traders were spreading false rumors that Cushing was empty, reporting false data about oil stocks and holding back tankers to push prices higher. His belief in the possibility of a conspiracy revealed his agency’s limitations. Experienced traders knew that the stocks in tanks and pipelines were constantly changing, data was always history, forecasts were frivolous, and holding stocks in tankers was hugely expensive. Psychology was critical, but rumors could only influence prices for hours, perhaps a few days, but no longer. Understanding the oil market still seemed to be beyond the regulator’s grasp.
On July 11, US light sweet crude oil hit $147.50 a barrel, a record high. How long, bystanders wondered, would it be before the price soared through $150? On the trading floors, uncertainty emerged. The spike coincided with banking collapses and talk of recession. Traders and speculators paused. By the end of the day, the price had fallen to $144. Sharp movements had become normal, but nevertheless a change of nearly $4 within five minutes was nerve-racking. “Volatility is only your friend if your positions are right,” an experienced New York trader murmured. “All traders think they know how to make money, but not all know when to switch from a rising to a falling market.” His aggressive rivals at Morgan Stanley, he suspected, were “floundering in oil.” In fact, their model of balancing their positions was withstanding the strain, and they would earn good profits despite some inevitably bad bets. Sensing imminent catastrophe, a handful of sharp investors placed an apparently losing bet. For a mere $1.80 they bought options to sell oil to banks and other traders in November at prices of around $100 a barrel. If the actual price in November was below $100, the difference would be pure profit. On July 14, few traders at the major institutions imagined oil falling anywhere close to $120. Over the following week, prices seesawed around $145, and in the next week they began to slide to $130. As some spoke about a “temporary correction,” the signs of a profound crash emerged. The SemGroup in New York filed for bankruptcy protection on July 22, citing $2.4 billion in losses from trading energy futures and OTC derivatives. At the beginning of August, the price was down to $120.
Many did not believe it was the end of the boom. During August, hedge funds were buying back in on the dip. At Morgan Stanley, losses were mounting in the infrastructure — the oil tankers and oil storage complexes. As the market swung into backwardation — oil prices being lower in the future — it made no sense to store oil. Morgan Stanley’s tankers were empty, and the leasing costs were cash down the drain. On August 20, oil was down to $114. Michael Witnner, global head of oil research at Société Générale in London, predicted that the bottom in 2008 would be $105, and oil would rise in 2009 to $120 because “supplies are tight.” Unseen by the traders and analysts was a change in demand for refined products that was about to cause havoc.
One source of healthy profits for traders, especially Vitol’s and Glencore’s, was playing a technical arbitrage called the “distillate-to-petrol spread.” Traders would bet that diesel prices — contrary to the usual summer season, when refineries produced more gasoline for motorists — would remain high. But unexpectedly, in August demand for diesel dived and prices fell. Only later would all the reasons become apparent: in the post-Olympic weeks, China stopped importing diesel along with other fuels, and began consuming its stockpile; the American government stopped filling the Strategic Petroleum Reserve; Russia invaded Georgia; and general consumption slid as the recession grew. Suddenly, diesel and light sweet crude were abundant. “The market’s changed,” said one trader. “With swings like this, someone’s lost a lot of money.” The hedge funds that had bought into the market on the dip took a hit. Vitol was rumored to be among the losers on jet fuel, dropping $500 million. “They’re so toxic, they eat their own,” observed a rival. The EIA, which had predicted in June that gas prices in August would be $4.15 a gallon, was speechless as they fell to $3.69. Although consumption in the West had been falling for over a year, the IEA, based in Paris, still predicted that overall oil consumption in 2008 would rise by 1 percent to 89 million barrels a day. The average in fact would be 85.8 million barrels. Tantalizingly, subsequent research would suggest that speculators had not unduly influenced markets. As the hedge funds were buying, the more passive pension funds were selling. The markets were operating perfectly. Yet misjudgments about the panic had sparked a lust for regulation, especially for “forward” contracts. Suspiciously, while the CFTC, acknowledging the research, would abandon regulating “forward” deals, European regulators appeared determined to impose costly rules despite the threat of trade moving to Switzerland, to New York or to Dubai. Politics threatened to corrupt reasonable protection.
In early September, the oil producers were apprehensive. Igor Sechin was seeking explanations for why oil had fallen 30 percent to $106, and whether the Saudi announcement that it should be $80 was reliable. In Venezuela and Iran, the governments were dismayed, but consoled themselves that $80 was still a good price. For months they had pleaded their helplessness to stop rising prices, but between November 2006 and January 2007 they had cut production by 1.5 million barrels a day to push prices higher. Now they resolved to stop prices falling. Meeting on September 9 in Vienna, the 11 OPEC ministers welcomed Sechin to their discussions, and agreed to cut production to keep prices at $100. On the same day, stock markets across the world plunged, and the banking crisis appeared uncontrollable. The specter of the oil ministers debating how to control prices at the beginning of a global recession suggested exceptional artlessness.
On October 28, Mohamed bin Dhaen al Hamli, the UAE’s minister for energy, addressed about 1,000 oil experts at the annual Oil and Money conference in London. “There are no smiles this year,” he admitted. “We are in an unhealthy position.” He glanced at Abdullah bin Hamad Al-Attiyah, the Qatari minister of energy, who agreed, “We have lost control of the market.” Al Hamli continued, “I am confused. I am seeing collapse everywhere. Low oil prices are dangerous for the world economy.” Oil was at $62, well below the $80 that OPEC had agreed four days earlier in Vienna would sustain their economies. Saudi Arabia and the Gulf states could survive if prices fell lower, but Venezuela, Iran and Algeria were suffering, and everyone suspected prices would continue to fall despite OPEC’s cuts in production. Wistfully, al Hamli recalled the mood four months earlier: “Before, everyone made money and it was very exciting for all of us.” That was not a sentiment shared by most of his audience, especially those relieved that gasoline prices in America had fallen to $2.59 a gallon. Oil markets, they knew, always assume different forms, making manipulation by producers and consumers impossible beyond the short term. “We’re producing oil,” continued al Hamli, “and no one is buying it. We are in a crisis period for new projects.” Demand for oil had in fact fallen faster than anyone could have imagined, to just 81.8 million barrels a day, the fastest decline since 1982, and was unlikely ever to return to its former levels in the Western economies.
Graphs produced by Philip Verleger showed that the 2008 price spike was unlikely to be repeated for another 20 years. Al Hamli voiced the universal regret of all the oil producers at having refused to accept deals offered by the oil majors when the price was $80. Their revenge on the West had been short-lived. Hugo Chávez was caught between exulting in the crisis of capitalism and resolving its repercussions on Venezuela’s economy as production fell to the lowest level in 20 years and he confiscated exploration equipment worth billions of dollars. Financial meltdown hit Dubai and Russia first. Dubai could rely on neighboring states to underwrite its debts, and Putin could draw on Russia’s wealth fund to prevent the country’s immediate slide toward bankruptcy. In the longer term, Putin�
�s narrow nationalism concerning Russia’s oil and natural gas was determining the world’s financial stability. In common with other presidents of oil-producing countries, Putin had resisted investing past profits to improve the industry. Leonid Fedun, the vice president of Lukoil, estimated that Russia would need to invest $300 billion over the following eight years just to keep production at its current level. Instead, Lukoil, bolstered by appropriating Yukos’s assets and relying on Khodorkovsky’s diminishing legacy, was mirroring the country’s general decline. Russia’s output, Putin knew, could have grown by 12 percent every year to 14 million barrels a day by 2008, but because Western investment had been deterred, it was hovering around nine million barrels a day.
In the midst of plummeting oil prices, Russia’s falling production was not uppermost on Putin’s agenda. But he could not ignore Gazprom’s financial crisis. Alexei Miller, who only months earlier had swaggered across the globe, confessed that Gazprom was heading toward a huge deficit, and was unable to fund new exploration or the construction of pipelines. For a start, the dividend would need to be cut and the contracts for natural gas with the Caspian states renegotiated. Gazprom’s plight was replicated across the world. Everywhere big projects were being canceled. In Canada, the tar sands were no longer economic; the North Sea was unattractive for new drilling; and Petrobras in Brazil calculated that offshore production would be loss-making if oil fell under $40. Even Beijing’s technocrats were scrabbling to unwind long-term, self-destructively high contracts to supply oil at inflated prices.
In late October 2008, few imagined the oil price dipping below $60, but on November 14 WTI slipped beneath $55. OPEC announced a cut of another four million barrels a day, and traders spoke about chartering tankers for peppercorn amounts to store oil and profit when prices inevitably returned to $60 in March 2009. Just before Christmas, oil fell below $34. That was good news for the handful of astute investors who had bought options for $1.80 in July, betting that oil would fall below $100. Most of the difference between $34 and $100 was pure profit. In New York, schadenfreude greeted King Abdullah of Saudi Arabia’s pronouncement that he favored an oil price of $75. Since July, Saudi Arabia had cut production by 20 percent. The king resembled King Canute as he lamented the market’s unprecedented volatility. On January 7, 2009, oil rose to $50. Two days later, the low was $39. Natural gas followed the dive. With some self-congratulation, Shell had started pumping LNG into tankers at Sakhalin 2, but supplies from Indonesia and Qatar meant the world was unexpectedly awash with LNG, and prices crashed from $13 per British thermal unit to $4. As Richard Fuld, the former chairman of Lehman’s, had once observed, “Markets rise arithmetically but then collapse geometrically.”
In these unprecedented conditions, only those with unusual courage would make predictions, but a principal purpose of the EIA in Washington and the IEA in Paris was to forecast the future. The divergence between the two undermined their credibility. The EIA prophesied that oil’s average price until 2015 would be $57; the IEA said it would be $100. “The era of cheap oil is over,” announced the OECD agency, warning that underinvestment between 2008 and 2015 would cause an energy crunch in 2030, with oil at $200. In 2007, the IEA had suggested that oil would be $108 in 2030. Within one year it had doubled its prediction on the grounds that the world was heading for a shortage even if oil rose to $70. “The current global trends in energy supply are patently unsustainable,” said the IEA’s experts, predicting that output would fall by 6 percent if current investment was maintained, but more probably by 9 percent. The scenario favored by the IEA and oil peakists pictured the recession ending, the oil “shortage” returning and prices soaring. The crash had exposed an alternative scenario: there was no shortage of oil, but there were restrictions to the development of existing reserves, limited finance to find new fields and bottlenecks in refineries. Leadership could solve all these problems, but competing interests prevented the major oil companies from thinking beyond their own profits.
On February 3, 2009, after touching $37 and lower in some markets, oil was priced at $40, and most of the majors admitted they were in trouble. ConocoPhillips revealed that it had paid $34 billion too much for companies with oil reserves over the previous three years. Assets worth $10 billion would need to be sold immediately and expenditure cut, albeit that its investment in exploration was low. BP acknowledged that unless oil rose to between $50 and $60 most of its investments would be unprofitable, albeit its 2009 cash costs would be reduced from $32 billion to $28 billion, and its investment to $20 billion. Shell, like BP, would acknowledge that its profits would fall from the 2008 peak, but it would try to sustain its $32 billion investment program in 2009 (Shell’s profits for 2008 were $31.3 billion, 14 percent higher than 2007; BP’s were $25.6 billion, up 39 percent). Only ExxonMobil, with record profits of $45.2 billion in 2008, pledged that there would be no change to its five-year $125 billion investment program, and unlike the other majors it even bought back $7 billion worth of shares. But, in the broader picture of 85 million barrels of oil being supplied every day across the globe, ExxonMobil was insignificant. In 2008, the corporation invested $26.1 billion to produce oil and spent $35.7 billion to buy back shares. Compared to Chevron’s $22.8 billion investment, ExxonMobil paraded the virtue of conservatism just as the crash reconfirmed that the oil majors were minnows. Vulnerable to blackmail, stricken by falling prices, unable to influence markets and controlling just 5 percent of the world’s oil, they were squeezed by the national oil producers, and forced to survive by their wits. Strong only in marketing gas from the pumps, their fate depended on acquisition, and each merger constricted the investment to find more oil. Shell and BP planned to squeeze costs by more staff cuts. Uncertainty, instability and speculation about prices had been a bonanza for the traders but a disaster for economies. Their profits in 2009 would slide by about 70 percent. The “crisis” was about not diminishing oil supplies, but a potentially destructive fall in demand.
A short-term cure had been successfully applied by Ali al-Naimi, the Saudi oil minister, who had carefully delivered soundbites before the 153rd OPEC meeting in Vienna in May, with the result that oil had risen that week to $68 a barrel and was expected to rise further. Speculators, switching away from equities and the weakening dollar and into commodities, were driving prices up. Last year’s villains had become al-Naimi’s Good Samaritans. At $70 a barrel, the oil companies could afford to continue investing. Steady production to maximize resources was the obvious solution. The obstacle was the oil majors’ inability to fashion a sensible relationship with the national oil companies.
Corrupt and inefficient, the national oil companies were allowing production to diminish. Impatient with the lengthy timescale involved in producing new oil, their countries’ leaders contemplated the pleasures of permanent high prices. They ignored the lesson of the 130-year cycle, that oil producers are more dependent on consumers than the opposite. While Saudi Arabia learned the advantage of stability, states like Iran, Venezuela and Algeria dismissed history. Lee Raymond, John Browne and Phil Watts had failed to seduce the leaders of most of the oil-producing states into understanding the advantage of stability, and their successors have done no better. Only President Putin appeared to reflect on the recent lessons and on Gazprom’s falling income, squeezed by disadvantageous contracts. In June 2009 the Russian government asked Shell to develop Sakhalin 3, a coup for the beleaguered company, and a parallel offer on another site was made to Total of France. Exxon and the other American oil companies were excluded from Russian deals, albeit that in September, ExxonMobil was included among the oil companies invited to meet Putin in Salekhard, a remote Siberian oil town, to hear the president offer new terms for Western investment. But ExxonMobil would struggle to benefit from the president’s promise of a new era. The backwash of the Yukos negotiations still rankled.
In common with other oil producers, the Russians were bewildered by the statistics. Over the previous months economists employed by Goldm
an Sachs had issued a succession of contradictory forecasts, suggesting first that oil would slump to $30 a barrel, then that it would stay at $55, then in June 2009 that it would surge to $70, and then toward $95. The bank was reflecting the confusion at the IEA. On June 11, 2009, the agency had announced, as oil hit $73 a barrel, that prices would rise further although demand had fallen since 2008. Less than three weeks later, on June 29, IEA forecast that in the future demand would drop sharply. In 2014 the world would need 84.9 million barrels a day rather than, as previously predicted, 89 million. Prices inevitably fell toward $60 a barrel. The volatility reflected incompatible pressures: fear of peak oil, uncertainty about whether new reserves could be developed, the weakness of the dollar and the development of renewable energy. OPEC was an immediate casualty, followed by the forecasters.
The solution to the deadlock between the disputing interest groups could be the Arctic. Just as North Sea oil undermined OPEC in the 1980s, oil from the Arctic could trigger an era of surplus oil and animate cooperation. At least 100 billion tons of hydrocarbons can be extracted from the Arctic, although the technological obstacles are considerable and the starting cost will be at least $20 billion. Only four Western companies possess the skills — ExxonMobil is not among them. So far, two suitable drill ships have been built, both under contract to Shell. Alaska took three years to master. The Gulf of Mexico has so far taken 40 years, and its exploration is still handicapped by a myriad of obstacles. But extracting oil off Brazil’s coast has confirmed that no technical obstacle is insuperable, if the finance is available. Drawing on that new technology, the Arctic riches will eventually be released, despite Russia’s attempts to establish territorial ambitions. In that unusual battleground, Russia has neither the financial nor the technical ability to execute the task. The fate of Arctic oil will depend on the oil majors repudiating their former cowardice. As the pressure of the price crash has eased during 2009, the chairmen have had time to conduct an autopsy on the past hectic months and consider the shrinkage of their corporations. Their salvation could be brought about by renegotiating their relationship with the governments of the oil-producing countries. Weakened by the collapse of prices, those governments could be encouraged to sign more reasonable contracts in order to expand production, reducing the risk of instability over the remainder of the century.
