Oil Prices Are Rigged? It Just Ain’t So! By Robert P. Murphy

This article is copied from the June 2009 publication of The Freeman: Ideas on Liberty, a flagship publication of the Foundation for Economic Education and one of the oldest and most respected journals of liberty in America. For almost 50 years it has uncompromisingly defended the ideals of the free society. Enjoy.

Even though oil prices have fallen and quieted the price-conspiracy mongers, you can bet that when prices go up again, they will be back in force. It happened last time. For example, in an article for Time last August, Ari Officer and Garrett Hayes ask, “Are Oil Prices Rigged?”. Our cynical authors—who are Stanford graduate students in financial mathematics and materials science/engineering respectively—answer in the affirmative, but their arguments are shockingly ignorant of how markets work.

Officer and Hayes admit up front that oil speculators aren’t the ones manipulating oil prices. Rather, they blame the oil producers for rigging the market, allegedly through the use of futures contracts:

The price of oil reported in the news is actually the price of oil in the futures market. In this market, traders do not exchange physical barrels of oil, but instead trade contracts which obligate them to exchange oil at a quoted price at a specific date in the future. . . . Such a contract allows companies to hedge positions by locking in prices early. . . . It’s all about reducing risk and uncertainty. But what if oil suppliers were instead buying oil futures, compounding their own risk and reaping enormous profits from the explosion in the price of physical oil?

An interesting possibility, to be sure, except for one nagging problem: If an oil producer is buying a futures contract from himself, that is equivalent to taking future supply off the market. To use a simplistic example, suppose a major producer estimates that he can sell 100,000 barrels of January 2010 oil at $90 per barrel or raise the price to $100 per barrel if he restricts his output to 75,000 barrels. The authors want to argue that he has a third option: “selling” 100,000 future barrels at $100, holding the price up himself by entering the futures market and snatching up those excess 25,000 barrels of January 2010 oil.

But in this third approach the producer is still extracting the same deal from his actual customers: They are giving him $100 each for 75,000 barrels of January 2010 oil. Since the producer himself bought the other 25,000 barrels, it is rather irrelevant that he received a high price for them; he can “pay himself” $100 a piece, if it makes him feel rich, but that still leaves him just as wealthy—and with just as much oil—as if he had simply cut his January 2010 output to 75,000 barrels. The existence of the futures market doesn’t give our producer any more ability to gouge his customers than his ownership of the oil in the first place gives him.

Final Consumers Have the Final Word

There is no getting around this basic fact, try as the authors might to bring up subtleties of the futures market.

They argue, for example, that only “Hedge funds, oil companies, OPEC—the very people who profit from massive, consistent increases in prices,” have access to the futures market. From this they conclude that, “we as oil consumers don’t set the prices.”

That’s simply untrue. Hedge funds can’t force refiners to buy more oil than they want to at a given price. If the “fair” price of oil, as determined by the “fundamentals” of supply and demand, is $80 per barrel, but the greedy hedge funds and OPEC buy up futures contracts and push the price up to $120 per barrel, then there will be a glut. That is, more physical barrels of oil will come to market than the actual end users will purchase. Oil inventories would grow larger every day, as producers kept pumping more oil than consumers burned.

Incidentally, this outcome is certainly possible. For example, if a group of rich speculators foresaw an imminent attack on Iran, they could rush to buy up oil futures. This would push up the futures price, which would lead producers to lower current output and devote more of their finite supply to the future (where the new demand was). The reduction in current supply would drive up the spot price, forcing consumers to economize on oil in the present.

Maybe High Prices Aren’t Such a Bad Thing

Let’s carry this scenario just a bit further. Suppose the speculators were really convinced that war with Iran would happen within a few months and that the price of oil at that time would skyrocket to $200 per barrel. Then the speculators would continue buying futures contracts, so long as the futures price were below $200. Oil producers would be overjoyed at this incredible demand, and would gladly sell more and more futures contracts. At some point, the producers would realize that they had promised as many barrels in future months as they could physically pump. Then it would become profitable to pump oil in the interim and physically warehouse it.

Thus the speculators’ actions would a) drive up the spot price of oil to cause consumers to restrict their use of oil in the present, and b) induce stockpiling of oil. Notice that these effects are exactly what we want to happen. If the speculators were right and war broke out, the spot price would not jump as sharply because it would have been pushed up already. The larger stockpiles of physical oil would help ease the crunch when Iran stopped exporting.

Pumping Out Evidence to the Contrary

To return to the Time article, the authors have spelled out a mechanism through which rich institutions could push up the price of oil. But they haven’t followed out the implications of their thesis and checked to see whether this was actually happening. Unfortunately for their claim, oil inventories have been fairly constant over the last several years, and—most damning of all—world oil production increased from 2007 through 2008, exactly the period when prices skyrocketed. (See my article “Oil Speculators: Bad or Good?” for more details.)

To repeat: Consumers still decide how many barrels they want to buy at a given price. If outside parties push up the price (and they can, if they are willing to risk enough money), then consumers will buy fewer barrels. Therefore, if the high price of oil were due to manipulation, we would observe either a restriction in output and/or accumulating inventories. We see neither.

In reality, all prices are determined by supply and demand, properly defined. Outside investors with lots of money can certainly influence prices, but there are always risks. Funds that had large “long” bets on commodities took a bath as oil fell from its July 2008 high of $145 down to well below $50 a few months later. Futures markets allow producers and consumers to hedge against needless risk by locking in prices, and they allow speculators with superior foresight to improve the allocation of resources over time. Our Time authors think they’ve shown that the oil market is rigged, but it just ain’t so!

Happy 150th, Oil! So Long, and Thanks for Modern Civilization -- From Wired Magazine, August 28th 2009

One hundred and fifty years ago on Aug. 27, Colonel Edwin L. Drake sunk the very first commercial well that produced flowing petroleum.

The discovery that large amounts of oil could be found underground marked the beginning of a time during which this convenient fossil fuel became America’s dominant energy source.

But what began 150 years ago won’t last another 150 years — or even another 50. The era of cheap oil is ending, and with another energy transition upon us, we’ve got to scavenge all the lessons we can from its remarkable history.

“I would see this as less of an anniversary to note for celebration and more of an anniversary to note how far we’ve come and the serious moment that we’re at right now,” said Brian Black, an energy historian at Pennsylvania State University and and author of the book Petrolia. “Energy transitions happen and I argue that we’re in one right now and that we need to aggressively look to the future to what’s going to happen after petroleum.”

When Drake and others sunk their wells, there were no cars, no plastics, no chemical industry. Water power was the dominant industrial energy source. Steam engines burning coal were on the rise, but the nation’s energy system — unlike Great Britain’s — still used fossil fuels sparingly. The original role for oil was as an illuminant, not a motor fuel, which would come decades later.

Before the 1860s, petroleum was a well-known curiosity. People collected it with blankets or skimmed it off naturally occurring oil seeps. Occasionally they drank some of it as a medicine or rubbed it on aching joints.

Some people had the bright idea of distilling it to make fuel for lamps, but it was easier to get lamp fuel from pig fat or whale oil or converted coal. Without a steady supply, there was no point in developing a whole system and infrastructure dedicated to petroleum.

Nonetheless, some Yankee capitalists from Connecticut were convinced that oil could be found in the ground and exploited. They recruited “Colonel” Edwin Drake, who was not a Colonel at all, mostly because he was charming and unemployed. He, in turn, found someone skilled in the art of drilling, or what passed for it in those days.

Drake and his sidekick “Uncle Billy” Smith started looking underground for oil in the spring of ‘59. They used a heavy metal tip attached to a rope, sending it plummeting down the borehole like a ram to break up the rock. It was slow going.

On Aug. 27, 1859, at 69 feet of depth, Drake and Smith hit oil. It was a big deal, but the Civil War stalled the immediate development of the rock oil industry.

“When the discovery happened, the few people who were there and not involved in the war, went around and bought all the property they could and had outside investors come in,” Black said. “But the real heyday of the development happened from 1864-1870. It’s that 11-year period when the little river valley was the world’s leading supplier of oil.”

The “little river valley” in western Pennsylvania earned the nickname Petrolia. Centered in the Oil Creek valley about one hundred miles north of Pittsburgh, the wells of Pithole, Titusville and Oil City pumped 56 million barrels of oil out of the ground from 1859 to 1873.

Suddenly, rock oil was everywhere. And cheap. Whale oil had always been a bit precious. A three to five year voyage would only yield a few thousand gallons of the stuff. In 1866, after the end of the Civil War, 3.6 million barrels poured out of the region. Daniel Yergin notes in his history of oil, The Prize, that as more people poured into the oil regions “supply outran demand” and soon the whiskey barrels that held the oil “cost almost twice as much as the oil inside them.”

Still, fortunes were being made and lost. Not just money, but energy, was flowing from underground. Some have estimated that for every unit of energy you invested sinking a well, you got back “more than 100 times as much usable energy.

Oil, people soon found, was uniquely convenient. To equal get the amount of energy in a tank of gasoline, you need 200 pounds of wood. Pair that energy density with stability under most conditions (meaning it didn’t randomly explode), and that, as a liquid, it was easy to transport, and you have the killer app for the infrastructure age.

In a world that only had a tiny fraction of the amount of heat, light, and power available that we do now, people came up with all kinds of ideas for what to do with oil’s energy: cars, tractors, airplanes, chemicals, fertilizer, and plastic.

Perhaps it’s not a surprising consequence of this innovation that at current consumption levels, Americans would blow through all the oil ever produced in Petrolia in less than three days.

The scale of the oil industry is astounding, but it’s becoming clear the world’s oil supply will peak soon, or perhaps has peaked already. People quibble about the details, but no one argues that oil will play a much different role in our energy system in 50 years than it did in 1959.

The search for alternatives is on. If that search goes poorly — as some Peak Oil analysts predict — human civilization will fall off an energy cliff. The amount of energy we get back from drilling oil wells in the middle of the Gulf of Mexico continues to drop, and alternative sources don’t provide usable energy for humans on the generous terms that oil long has.

But humans with an economic incentive to be optimistic become optimists, and the harder we look, the more possible alternatives we find. The big question now is whether the cure for our oil addiction will come with a heavy carbon side effect.

“Peak oil and peak gas and coal could really go either way for the climate,” Pushker Kharecha, a scientist with NASA’s Global Institute for Space Studies, said at least year’s American Geophysical Union meeting. “It all depends on choices for subsequent energy sources.”

Over the next 20 years, synthetic fuels made from coal or shale oil could conceivably become the fuels of the future. On the other hand, so could advanced biofuels from cellulosic ethanol or algae. Or the era of fuel could end and electric vehicles could be deployed in mass, at least in rich countries.

With the massive injection of stimulus and venture capital money into alternative energy that’s occurred over the past few years, the solutions for replacing oil could already be circulating among the labs and office parks of the country. To paraphrase technology pundit Clay Shirky talking about the media, nothing will work to replace oil, but everything might.

If history tells us anything, it’s that energy sources can change, never tomorrow, but always some day.

“What is required is to operate without fear and to take energy transitions on as a developmental opportunity,” Black said.