How Wall Street Controls Oil: And How OPEC Will Be the Fall Guy for $90 Oil

By Verleger, Philip K., Jr. | The International Economy, Winter 2007 | Go to article overview

How Wall Street Controls Oil: And How OPEC Will Be the Fall Guy for $90 Oil


Verleger, Philip K., Jr., The International Economy


Control over oil markets, once the province of the major integrated oil companies and then OPEC, may now be shifting into the hands of Wall Street's ubiquitous investment banks. Oil industry experts noted this unwelcome transition at an early December 2006 OPEC-EU meeting in Vienna. Producers clearly were not happy to see their ability to influence prices undermined. EU representatives were equally unhappy because the changeover might increase price volatility. Wall Street types, meanwhile, denied responsibility.

It has become clear in 2006 that one of Wall Street's newest concepts--marketing commodities as an asset class--has altered world energy markets in a surprising fashion. In particular, the injection of cash into commodities by passive investors such as pension funds has created a rich financial incentive to accumulate inventories. Participants in physical energy markets (both oil and natural gas) have responded by putting away almost record amounts and building new storage facilities. The stocks amassed, in turn, have undermined the ability of oil exporters to control prices. OPEC ministers recognize that under certain circumstances the accruing stocks could precipitate a sudden, temporary drop in crude prices similar to the one observed in natural gas last spring.

At the same time, the stock and price rise threatens to raise political hackles. Legislators will no doubt respond this spring with a spate of hearings and perhaps laws directed at an industry incorrectly accused of hoarding.

Here I describe the latest development in the energy market twists and turns of the last three decades. Its appearance has made the tools traditionally used to predict oil market fluctuations at least temporarily obsolete.

A SURPRISING CHANGE

Those who watch oil markets closely were startled last June as oil prices and inventories simultaneously rose to unprecedented highs. The price rise itself was not a surprise. Nor was the stock climb to levels not observed since the 1998 shock. However, the two events occurring simultaneously caught the attention of many and for good reason: historically, high prices have been associated with low inventories and vice versa.

The surprising parallel increase in stocks and oil prices can be observed in Figure 1. There I compare U.S. commercial crude stock levels from January 1986 through December 2006 with the spot price of WTI [West Texas Intermediate, an oil pricing benchmark], which trades on the New York Mercantile Exchange. For presentation purposes, stocks are graphed against the left vertical axis and prices against the right. One can note an unusual surge in stocks beginning in January 2005 that matches the crude price rise from $45 to $74 per barrel.

[FIGURE 1 OMITTED]

The concurrent upsurge in prices and stocks was unusual by historical standards. In the past, inventories of oil and other commodities moved countercyclically with prices. Commercial users of commodities have always been notoriously parsimonious. Indeed, few managers will risk tying up working capital to accumulate additional stocks, and oil companies have previously been very aggressive in minimizing inventories. Moreover, no publicly traded company has reported holding speculative stocks.

On this occasion, however, the stock boost was driven by a profit motive rather than a speculative one. Commercial firms were given the chance to gain by keeping stocks, and they responded by increasing their holdings.

Wall Street provided the opportunity to benefit from adding stocks. For the last fifteen years, investment bankers have touted commodities as an asset class. In the last two years, the idea gained recognition. Commodities were sold as an alternative to traditional bond and stock investments. Building on academic research at Yale and Wharton, analysts from Goldman Sachs, Deutsche Bank, Barclays, PIMCO, and other institutions have circulated papers that demonstrate how investors achieve useful diversification by allocating a small portion of their portfolios to commodities. …

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