Are Oil Prices Rigged?

Time.com ^ | Friday, Aug. 22, 2008 | Ari J. Officer and Garrett J. Hayes

[300magnum]

We've all read that speculators are driving oil prices artificially high — a claim that gets more interesting in light of oil's recent fall below $115. But maybe we're looking at it from the wrong perspective. Suppose that major suppliers in the oil industry are these manipulative speculators.

Is it possible that oil prices are rigged? You bet. Here's how:

Just how would you raise prices if you were an oil supplier? Controlling the supply — as in the 1973 OPEC embargo — has become less effective with more sources of oil worldwide. And oil suppliers clearly cannot raise prices by controlling demand in the physical oil market; ultimately, they need to sell their oil, not buy it. However, with the market inefficiencies that we expose here, oil suppliers can regain the upper hand by artificially inflating demand using a different market. To understand this mechanism, we must take a glimpse into the future — the futures market, that is.

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, usually months in advance. Such a contract allows companies to hedge positions by locking in prices early. Airlines might buy futures contracts to reduce their exposure to rising fuel prices. Conversely, oil companies might sell futures contracts to assure a profit against future price drops. 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?

The futures market has become the public driving force in pricing

[chrisj6]

Ya, I think I did...yours came up by default for some reason. Sorry about that. I’m new to this site.

[Bishop_Malachi]

Chrisj6,

Maybe we are talking past one another. I shall still argue that I got your point. I just don’t agree with your conclusions. I’ll try to put the oil market in perspective as best I can. Speculation in oil futures adds almost nothing to the price of oil because futures trading is a zero sum game. It is like a poker game in which money is won only by others loosing. At the end of the game the same amount of money is on the table; it has merely changed hands.

Perhaps most importantly, the total amount of speculative trading (that is, hedge funds, etc) is only a tiny fraction of total contracts bought and sold by producers and refiners. Therefore, their impact could not possibly be large when you realize that annual world oil sales total about $3.4 trillion dollars. Your arguments about how small the futures markets are, undermines the very thesis that they have a powerful influence over prices.

The actual sale of oil takes place in a global auction in six major centers around the world, which are logically the major refining and distribution centers, in which thousands of trades take place simultaneously. These are completely free markets and are not “rigged” simply because it is not possible to rig them. The market is simply too large and diversified for that to happen. Keep in mind that in these auctions there are actual sellers who have oil to sell, mostly government-owned oil companies. Most of the buyers are independent oil companies, primarily refiners. A unified manipulation is possible only in the wildest of conspiracy theory.

The actual sale of oil does not take place by means of futures contracts, but rather spot market contract sales. These contract sales can be for immediate delivery, or delivery at a future time, in which case they are called forward contracts. What distinguishes forward from futures is that forward are binding commitments to make and take delivery. With futures actual delivery almost never takes place. Contract sales are for “cargoes,” that is ship or barge loads of oil or in some cases amounts delivered via pipeline.

So, what is the futures market ultimately all about? Its about hedging one’s bets on future price. Futures serve as a price signal about where the price is likely headed, and most importantly for actual oil traders, futures trading serves the function of leveling out both gains and losses; in other words futures trading actually stabilizes prices for traders. To blame those who speculate with futures is plain wrong.

And finally, I’d like to clarify BobbyT’s point about Ford. What he meant was that Ford shareholders obviously want to make money in the stock market, but the Ford Corporation itself cannot affect it’s own quarterly profits by simply tikering with stocks. The stock values are based on the P/E ratio, book value, etc. not visa-versa.

Anyway, I’m worn out. Have a nice day.