ENERGY PRICE MANIPULATION? - June 8, 2008
  

Energy prices have been multiplied by factors of 3-6 times in less than a decade. Is it just a matter of growing demand and supply uncertainty? Or, have various energy products become another form of speculation? Is illegality and price manipulation at work?

HISTORY OF ILLEGALITY, AN INVITATION TO MANIPULATION
 
The United States Commodity Futures Trade Commission, (CFTC), has just launched a formal investigation into energy price manipulation. It is curious for an institution that less than a month earlier responded to the US Congress that it found no evidence that speculation was the cause for dramatic price increases. It is not as if there had been no precedent of illegal price manipulation, including US Government enforcement procedures: From more recent cases such as Enron and British Petroleum, criminal and civil liability has been assessed to corporations and individuals, and under significantly much less dynamic conditions.

Speculation is at least in part at work. Recent price spikes do not reflect a basic underlying change in market conditions, but at most expectations of future events. Uncertainty has not become more uncertain! Rather, it is speculators seeking to exploit and even further the uncertainty to drive prices up and reap sure profits. Although only a thin line, speculation though does not translate into illegality, at least according to current definitions of the law. Nonetheless, whether illegality can be ultimately evidenced or not, there is something curious and potentially culpable about a system where now the trades are 10X the amount of real product that is actually available in the market. This is an indication of speculation and an invitation to manipulation and illegality as the “paper demand” for product is the driving force, by a factor of 10, over actual consumption.

THE CASE FOR FREE MARKETS

The futures market derives its credibility by presumably providing hedging opportunities for producers. Producers can lock in some of their selling price through the futures markets, and thus commit to more rational production goals.

Some energy companies, including Exxon/Mobil, have recently asserted reluctance to commit to new production deeming that current prices would not be sustained. That was when petroleum was around $50-75 per barrel only a couple of years ago. Most energy producers assumed petroleum prices below $50 when reaching recent production decisions. What is not clear is to what extent futures markets have been employed by such producers to hedge. Much of actual production, petroleum reaching markets from new drilling, is still years away from when the project is initiated making hedging options shallow or unavailable. Most of the trading in the futures market though occurs in the near months when hedging options are no longer so plausible, at least for producers.

Hedging through futures markets also takes into consideration only one part of the equation. Production and drilling costs have also been rapidly rising, thereby making previous production price hurdle rates obsolete.

Regardless, three conclusions can be reached:

 
- Energy companies, producers, drillers, servicers, refiners, have not suffered due to any perceived

   uncertainty and are reaping record revenues and profits.
- Speculation appears to far exceed hedging activity within the futures market, especially in the near

   months.
- Hedging options seem to have had minimal impact on future production. The perceived long term price of

   energy appears to be the most critical factor, along with costs and availability of drillers and servicers.

THE COMING CRUNCH?

Rocketing energy prices are attributed by some to ever rising global demand, already realized and expected. Supply interruptions, though, have been relatively minor, especially after the initial disruptions in Iraq, despite presumed threats. Simply stated, there is no shortage now, but only an expectation of ever growing demand especially due to China, India and other rapidly developing economies.

The “crunch,” inadequate supply to meet the demand, is almost certain in the future. The same is the case for many or most commodities, from grains to water. Nonetheless, current supply meets current demand, and the crunch is still several years away. So, why these price explosions now?

REVOLVING RATIONALE

Speculation does not stand naked as a rationale. The bite of energy prices is so onerous that the profit motive cannot justify current speculation and presumably extortionist prices. A merry-go-around of reasons for high prices continues to be trotted out. First, it was an alleged lack of refining capacity, in the US, that was show cased as the reason for high prices for gasoline but also oil. Currently, though, oil refineries actually have sliced a bit of capacity utilization.

Then, weather and hurricanes were to blame. However the last couple of years have been relatively tame in weather disruptions and temperature extremes.

The falling US Dollar has been a real factor contributing to rising prices in the United States. However, energy prices have risen by several factors beyond the quantitative fall of the dollar. In fact as the dollar has steadied, even slightly recovered over the last couple of months, energy prices raced ahead unbridled to new records.

Paradoxically, as the US economy has slowed and the global economic environment has become more uncertain in the immediate term, energy prices have continued upwards. Maybe the cause is not in the fundamentals, but prices are being driven by the financial and commodities market environment. The sharp declines in stock prices and real estate has encouraged investors to pour money and speculation into commodities. Funds indexed to commodity prices could be an especially precarious combination with pure speculation: In anticipation of more passive investors piling into these index funds, more aggressive investors will jump in before to be the first to exploit further anticipated investor demand, regardless of actual supply/demand fundamentals. It can become and has a vicious cycle.

"FOREIGN OIL"

Only a few years ago, the argument was that “Foreign Oil,” a code name that American politicians used to rely upon to blame Arabs with energy exports, was the villain. It became a rallying cry for everything from Alaska drilling and ethanol to militarism and xenophobic exclusion. However, this time OPEC is not such a credible scapegoat, even while oil producing countries reap record profits. OPEC is not responsible for setting these high prices, well its not so relevant official rates, and member states are not curtailing production, but generally to the contrary. Anyway, oil producing states, like companies, will look to maximize revenues at these high prices by producing at or close to capacity.

"THE TREND IS YOUR FRIEND"

George Soros, earlier this week, testified before the US Congress on high oil prices and speculation. George had made his fortune in speculating in currencies. He was not there as the subject of an inquiry, but rather a source of insight. Many of the patterns seen in the currency market are also evident in the commodities markets.

As in currency and other financial markets, commodity markets are subject to the dominant flow of trends. More successful investors identify and jump behind the dominant trend. It is a form of herd mentality, or maybe in this case, we can use the analogy of a piranha feeding frenzy, with oil consumers as the prey. Of course, you want to be at the front of the line going in and coming out, less your capital becomes the meal. There does not need to be a conscious coordination or “conspiracy” to move the herd. All it takes is the leaders to set the course.

When Goldman Sachs recently predicted that oil prices would continue to spurt to further record levels such amounted to a clear setting of the course by the herd leader. The rationale and its validity in fundamental analysis are largely irrelevant as long as the lead speculator can move the market with its loud projections or silent action.

If you have the market weight of a Goldman Sachs, you can make the prediction and have it become a self-fulfilling prophecy.

WHAT WILL IT TAKE TO REVERSE THE TREND?

What Goldman, and others, has done here is not illegal. Should it be illegal, is a different issue. Regardless, I’m not certain how such action could be criminalized or evidenced? However, there are other factors that can influence the flow of the herd and the appetite of the piranha. And, sooner or later, the trend will be reversed, but when and after what traumatic consequences for the energy consumer, economy as a whole and the development of alternative and reusable energy.

The report that US regulators were investigating for price manipulation brought about a sudden decline in prices. After a few days though, the still dominant trend has been reestablished, and new record prices were breached. There was no dramatic event to reestablish the dominant trend, while a variety of rationale was offered with degrees of limited validity.

The current US Administration had to at least appear to act to confront rising prices. It has not been terribly impressive though, since many suspect that this Administration is not inclined to deny its supporters in the oil industry or perhaps it favors current price conditions as encouraging lower consumption and new alternatives, or at least new drilling.

The trend up has to come to an end, sooner or later. The current course will inevitably lead to a deep global recession and send prices plummeting. That would be a double whammy to global consumers: Today, they cannot afford the prices to purchase. Tomorrow, they would not have the jobs or income to buy gasoline at even sharply lower prices. It is as if speculators in the energy markets are playing chicken with the global economy. However, it is the economy that would crash first, but with everyone the loser, except the speculators at the front who would have gorged and gotten out before becoming the meal.

BLOWING UP THE PIPELINE!

With so much money at risk, it is also responsible to question to what degree some speculators, US and global, might engage to always turn the herd back in the upward direction. In old cowboy films, it only took a few gun shots. Will some devious speculator pay some Nigerian guerrilla group to blow up a pipeline just as oil begins to reverse? Will some terrorist organization become also a speculator with the ability to steer prices? Can a Latin American dictator steer the direction of prices as much by heated rhetoric as production cuts? Can a reasserted imperial Russia become the new political power broker applying energy to secure its agenda as well as setting price trends?

Some of the above possibilities are clearly illegal and most may be beyond the direct control of democratic governments and law authorities. However, a few measures may be considered before consumers are stripped bare and the global economy is crushed. For many, energy is less a discretionary item and more a necessity, to heat homes or get to jobs. Even for many energy producers, the current situation is untenable as crashing economies and prices could destroy demand for their product longer-term, either conventional or alternative.

Demand destruction for gasoline and other conventional energy products is already occurring, and in the US we are seeing demand drop by 3-5% so far. Some claim this is being offset by growing demand in the developing economies, where energy has been traditionally heavily subsidized. Nonetheless, the current trend in demand destruction in the US and western countries is largely irreversible as living and even “essential” usage habits are reforming and more efficient vehicles and engines are replacing the “cheap energy” guzzlers. As an example, GM has announced closings of many of its SUV production plants, although it will take some time for drivers to switch into new, more efficient vehicles.

OPTIONS TO CONSIDER
 
The current energy price spiral may be seen to be a good thing for alternative energy options. However, even then, there is only so much of a good thing. An economic collapse and bursting of the bubble will make some alternatives untenable, cutting profit and usage projections. Alternative energy options are most vulnerable when significant development and marketing capital still remains to be committed. A seesawing of prices is a high risk exercise for those who have to make decisions about viability and committing further capital.

A steady price of energy, less driven by speculation and more by supply/demand fundamentals is in the interest of most, except perhaps the speculator. Here are some options to consider in making prices steady, as well as reducing demand and increasing supply:

1. Increase alternative energy, but true alternatives, (Ethanol from corn is not very efficient, but driven by

    political rhetoric, while biofuel from waste is a more sound trade off. Also, switching agricultural

    production to ethanol or certain types of biofuel can have negative effect on hunger and global food

    situation).
2. Increase efficiency, always a good option.
3. Do not allow borrowing, “margin lending,” for speculators in the commodity, including energy markets.
4. Close the “Enron loophole” in US to prevent unregulated activity, manipulation or speculation, in non-US

    based markets.
5. Increase tax on speculative profits, even if not increasing taxes on oil company corporate “windfall”

    profits.
6. Discourage investors, by regulation, taxes or otherwise, from seeking fossil fuels and commodities as a

    source of return on passive investment.
7. Reduce subsidies for gasoline, especially in rapidly growing economies like China. Do not have their

    consumers become addicted as US users. (India and especially Malaysia have started such positive

    measures).
8. Subsidize efficiency and research in and development of alternatives.

THE BIG BITE

Energy is not a discretionary item for the overwhelming majority of retail and industrial consumers. Like food, it cannot become the prospecting ground for speculators. Nonetheless, the consumption and pricing for energy products will need to reflect and react to fundamental market changes. For the purposes of this article, we have lumped all fossil fuel energy, from natural gas to gasoline, into a generic. However, even among products there is a dynamics that also has to be allowed to adjust to market, demand, supply, efficiency, technology and environmental conditions. What is disconcerting though regarding the current trend in the energy markets is that all of the above, including the future of global economic health are being wagged by the speculative dog with the loud bark and big bite.
 

Muhamed Sacirbey

--------------------

Mr. Muhamed Sacirbey holds B.A. degree in history and J. D. degree from Tulane University in New Orleans. He also holds M.B.A. degree from Columbia University. Prior to becoming Bosnia’s Foreign Minister and Ambassador to the United Nations, he practiced as an attorney in New York City and worked for several years as an investment banker. He presently writes his book “A Convenient Genocide, in a fishbowl ” and is a commentator on human rights and political issues.

--------------------