CHAPTER THREE
Marketing Oil
Oil’s startling career over the last 150 years – from a bit player in the lighting market to a ubiquitous fuel and feedstock – can be explained only in part by reference to its mercurial properties (its energy density, fluid character, and great abundance). The desire for oil – the great pull that draws crude to the surface at the rate of over 90 mmbd – has been manufactured over time. In this chapter, we explore how the dramatic growth of oil consumption in the twentieth century has rested on the standardization of oil products, the cultivation of new markets, and the creation of scarcity in the face of sometimes overwhelming abundance in order to secure the profitability of production. We examine how oil is bought and sold, and the reasons for increasing price volatility over the past decade.
Like measurements of blood pressure or temperature, oil prices are a “vital sign” of the economy, a core metric by which the capacity of the economic body for reproducing itself is assessed. Tracked through benchmark crudes at international exchanges and prices posted at local gas stations, the “price of oil” is one of a select group of metrics that inform the daily routines of many people on earth. The central place oil prices occupy in the public imagination reflects the tight link between the price of oil and economic growth and the proliferation of oil within social routines (particularly around mobility). It also reflects how localized events – from strikes and other stoppages to extreme weather and geopolitical conflict – translate into price signals that are rapidly transmitted around the world via an integrated global oil market (and vice versa). Swings in price cause value to “slosh” back and forth from one end of the oil production network to the other: a rise in oil prices distributes value away from consumers and toward producers, while a fall in prices increases the value of oil to consumers at the expense of producers. A good deal of the politics of oil centers on the strategies of producers and consumers to influence the distribution of value to their advantage and to exert a measure of control over price.
Pricing power has migrated over time, from multinational oil firms to the oil-exporting states of OPEC and more recently to the financial markets. As oil prices have become increasingly volatile, the question of who controls price and where pricing power now lies has sharpened. In practice, the volatility of oil prices is similar to that of many other commodities, yet oil is integrated into personal, corporate, and national economies like no other. For oil producers, high prices and volatility risk the possibility that consumers will switch from oil to cheaper, more reliably priced fuels. For oil consumers, volatile prices raise concerns about the security of supply and create a drag on economic growth, as in the US (see Figure 3.1), while the decreasing affordability of oil can leave poor consumers unable to access the energy services (such as heating and transportation) that oil provides.
A prolonged tightening in the oil market since 2002 appears to mark the end of an “Age of Plenty,” and a transition from an era in which demand for oil sets the bounds of supply to one in which oil’s availability is significantly constrained. Price volatility, the failure of high prices to drive sufficient new investment, and the influence of speculators on price formation powerfully suggest that the political institutions – like OPEC and the IEA – whose interactions have historically governed the price of oil are no longer effective. Both producers and consumers, it would seem, have lost the capacity to control oil’s price.
Figure 3.1 Oil price, volatility, and US recessions (1945–2011)
Sources: Federal Reserve Bank of St Louis (WTI monthly price volatility), and NBER (recession periods in gray).
Standardizing products
The modern economy of petroleum rests on a basic yet quite remarkable fact: the machines, products, and devices that consume oil do so without regard to wide geographical variations in the local availability and quality of crude oil. The unprecedented personal mobility that cars and airplanes provide, for example, arises from their ability to travel across vast swathes of space without loss of function. This fundamentally geographical experience – of freedom from local constraints imposed by the quality and/or quantity of resources – is a key part of the experience of modernity, whose icons are the automobile and airplane and other technologies of time-space compression. While we tend to think of enhanced mobility as a product of great design, a key aspect of the design of these machines is their optimization for very specific fuel inputs. Such narrow specialization in regard to inputs requires the production of an external world outside the machine that can continuously supply these inputs, if function is to be maintained. The “globalization” of travel and trade is underpinned by the simultaneous specialization and standardization of fuels. Standardization, then, is one of the essential conditions that makes the international economy of petroleum possible. At the end of the nineteenth century, the world’s largest oil company, Standard Oil, promoted itself by reference to this crucial aspect: initially, standardization assured customers using its fuel that kerosene lamps would be less likely to explode and set the house on fire.
Standardization also underpins the basic exchange at the heart of market trade, both for crude oil and petroleum products. Light or heavy, sweet or sour, crude oil itself is a highly variable commodity. If buyers and sellers are to agree terms, this variability of crude presents a potential problem. Some guarantees of product quality and consistency – against the reality of variability – are needed if buyers are to be certain of what they are acquiring. In the very early days of oil, guarantees on product quality were obtained directly as buyers would sample the product prior to purchase. However, this requirement for direct knowledge limits the ability to buy oil sight unseen and constrains the pool of potential buyers. Getting oil to travel and reach a wide market, therefore, required a way of guaranteeing that the quantity and quality of the product would not vary but would be the same regardless of location. A first element of “standardization,” then, was around quantity, and the emergence of the 42 gallon (159 liters) Standard Oil Blue Barrel (bbl) as the unit of measurement for a material that changes volume with temperature and evaporates (changes in volume of up to 5 percent are acknowledged in large trades).
A second element of standardization of crude oil is around quality. Variations in density, viscosity, sulfur content, distillation temperature profile, and a number of other characteristics now define more than 200 different grades of crude, which are identified by the names of key oil fields. These variations are significant because they influence the range of products that can be won from crude through refining. Given this degree of natural variation, trade in oil is facilitated via a pricing system that ties prices to one of a handful of “benchmark” crudes. Variations in quality from these benchmarks then attract a premium or discount for any given crude, producing a spread of prices and price differentials that are themselves wrapped up into financial contracts and traded on the futures and derivatives markets.
Downstream from the refinery, standard-setting organizations play a significant role in creating conditions that enable trade in refined oil products. These include international organizations like ASTM International (formerly the American Society for Testing and Materials) and the International Organization for Standardization, military organizations like NATO and the US Air Force, national and regional standards (such as Europe’s EN228 standard for gasoline), as well as some corporate standards. These standards are fundamental to international petroleum sales. They enable buyers and sellers to understand quantity and quality without direct knowledge of the product, allow shortages in one area to be met by other sources of supply, increase competition among refineries and distributors, and help push for cleaner fuel standards. The significant role that environmental standards will play in making future fuel markets is exemplified by the EU’s Fuel Quality Directive, which has set specifications on fuels in the interests of protecting health and the environment since 1998. Expansion of the Directive to promote lower-carbon fuel sources, by assigning greenhouse gas values to different renewable and fossil fuels, has been vigorously resisted by unconventional oil producers (which would be given a higher greenhouse gas value) and most particularly by representatives from Canada’s bituminous sands industry. GHG emissions for bituminous sands throughout the entire supply chain can be 80 percent higher than some of the lowest GHG-emitting oil sources. A similar low-carbon fuel standard introduced by California in 2007 was challenged in court by the National Petrochemical and Refiners Association, but has remained in effect.1
Managing abundance
Scarcity is a central storyline in the unfolding drama of oil since the late nineteenth century. However, for much of the twentieth century, a primary issue for the oil industry was how to make oil scarce in the face of prodigious abundance so as to ensure profits from its production and distribution. Overproduction has dogged the oil industry for most of its history. This dynamic is now changing, however. Physical and institutional constraints on new supply have eroded spare capacity in the oil production network, while global demand for oil continues to grow. The result is a tightening of the oil market, heightened concerns about supply security, and increased price volatility. At the same time, higher prices for oil – and growing public concern about some of the products and by-products of crude oil production and refining – indicate the possibility of an alternative trajectory in which it is demand for oil that peaks, rather than supply, as part of a broader energy transition. There is already evidence for this alternative scenario within Europe, although both the scale of transition and the pace of change are limited relative to the growth in worldwide oil demand.
Shutting oil in: proration and spare capacity
Strange as it may seem in a contemporary context, the politics of oil has frequently centered on how to “shut in” production and limit the rate at which oil flows onto the market, so as to avoid the depressing effect of excess supply on price. The enormous volumes of oil brought to the surface during the US oil booms of the early twentieth century, together with a highly fragmented pattern of ownership that undermined efforts at coordination, overwhelmed regional markets and created major problems of storage, waste, and damage to property. The practice of “proration” (proportional distribution) was introduced, first in Oklahoma in 1915 and then in other states, with the aim of preventing oversupply and waste. In these states, a government agency allocated allowable production to individual producers in the name of resource conservation. Until the early 1970s and the exhaustion of US spare capacity, the Texas Railroad Commission effectively controlled the rate of US oil production and domestic prices through its proration of the most significant oil-producing state in the country. Although the official role of proration orders was resource conservation and the prevention of waste, its influence on price stability served the interests of large oil producers.2
The international oil markets presented a similar collective action problem of managing excess capacity to avoid potentially ruinous competition. From the 1920s onward, a series of agreements among the majors sought to contain the potential for “destructive competition” over supply while at the same time securing their upstream and downstream positions against a growing group of independent oil companies and alternative sources of supply (see Box 2.2). The “Red-Line Agreement” in 1928, for example, committed the oil companies that made up the Turkish Petroleum Company in Iraq – which included Anglo-Persian, Shell, Compagnie Française des Pétroles, Standard Oil of New Jersey, and Mobil – to a policy of not competing with each other for concessions within the boundaries of the former Turkish Empire. The same year, a secret agreement to carve up the international oil market among three of the majors sought to solve a problem of “excessive competition [that] has resulted in the tremendous overproduction of today . . . in which money has been poured into manufacturing [refining] and marketing facilities so prodigally that those now available are far in excess of those required to handle efficiently the world’s consumption.” Concluded at Achnacarry Castle near Fort William, Scotland, and known as the “As-Is” Agreement, this deal suspended international competition between Anglo-Persian, Standard Oil of New Jersey, and Shell throughout the world with the aim of stabilizing prices.
Although the “As-Is” Agreement was short-lived, Big Oil’s integrated production structures and “conservation” systems afforded these firms a measure of control over international prices for much of the first half of the twentieth century. As the center of gravity of production slipped away from the US and toward the Middle East, so these governance structures came under increasing strain. An unintended consequence of efforts by the international companies to preserve market share in the face of growing competition was the emergence of a new international system of proration controlled by producer states. The decision by the majors to cut posted prices galvanized the formation of OPEC in 1960. OPEC’s founders saw in the Texas Railroad Commission a model of how price stability could be achieved by allocating production among producers. Like proration in the US during the interwar years, the formation of OPEC occurred in a period of structural oil surplus and falling prices, and marked the beginning of collective action by producer states concerned about government revenues to regulate the balance of oil supply and demand. OPEC’s action to restrict oil supply in 1973 (in the context of US support for Israel in the Yom Kippur War and the decision to decouple the dollar from gold) demonstrated the capacity of nationalized oil producers to act together and, for oil-importing countries, raised the specter of supply shortages that continues to haunt contemporary discussions of energy security.3
Proration is fundamentally a question of who should bear the costs associated with maintaining the cushion of spare capacity. Far from being a dusty footnote to the history of oil, the issue of spare capacity is a live and contentious one. The failure of high oil prices to produce sufficient investment to restore a “normal” price regime raises the question of where new oil could come from and who should make the investments required. OPEC countries, which hold the bulk of the lowest-cost reserves, may not be willing to make these additional investments because their revenue needs can be met by higher prices. Other oil exporters – like Russia and Mexico – do not seem willing to shoulder the costs of building and maintaining spare capacity although by most calculations they have sufficient reserves to enable them to act as swing producers. Consumers also hold some responsibility for bearing the costs of ensuring a reliable supply and the capacity to buffer short-term disruptions. The “Age of Plenty” may have come and gone, but the critical issue of who bears the costs of bringing supply and demand into balance remains.
Soaking up supply: manufacturing a world fit for oil
The creation of effective demand for oil involved more than organizing its scarcity. It also required embedding oil use within the routines and patterns of daily life by building cities, highway systems and other transportation networks that required massive and sustained inputs of gasoline, diesel, and jet fuels. In the early twentieth century, it was not a given that automobiles would be powered by oil, and the association of cars with oil took a while to take hold. In 1900, 38% of US vehicles ran on electricity, 40% on steam, and 22% on gasoline, with the electric vehicle fleet peaking in 1912. By 1930, however, electric vehicles had been fully displaced by internal combustion engines in the US and Europe. In the US in particular, the actions of corporations, planners, and architects created forms of the built environment that ensured the “American way of life” was dependent on the availability of cheap gasoline. An alliance of automobile and oil companies conspired to replace electrically driven public transportation in American cities – the street car and electric train – with diesel buses. Between 1936 and 1950, for example, the electrically driven tramcar lines in more than 45 major American cities were purchased by bus companies like National City Lines and its subsidiary Pacific City Lines – formed in the early 1930s and funded by General Motors, Standard Oil of California, Phillips Petroleum, and Firestone Tire – only to be shut down, leaving oil-powered transportation in their place. By the late 1950s, 90% of US tramlines had been closed. V8 engines – initially designed for boats and mounted on aircraft – became a “must” for any decent American car after World War II: the largest, Cadillac’s 8.2 liter displacement V8 500, averaged 8 mpg in the city. These powerful and profligate engines were largely gone by the mid-1970s following the first oil crisis and did not make a major comeback before the arrival of SUVs in the late 1980s.4
Broader forces were at work too. The availability of credit enabled individuals to purchase comparatively large homes on dispersed, suburban lots and the automobiles to travel between them and work, while also enabling city and federal governments to construct an infrastructure of bridges, tunnels, urban freeways, parkways, highways, and airports. In short, consumption practices were laid down in the postwar years that ensured a massive throughput of raw materials, and of oil products in particular.
New consumption norms and practices took on a geographical expression – in the spatial segregation of home and work that led to urban sprawl, the growing connectivity of urban settlements in national space via smooth rolling highways and air travel, and in the micro-geographies of the home that became structured around new products and materials – and locked in demand for oil. The reworking of urban space around the automobile has been widely studied: in extreme cases like Los Angeles, as much as two-thirds of urban space is given over to the car. Such patterns were key parts of the postwar consumption landscape in oil’s major markets. Automobile ownership and suburbanization created conditions of mass consumption for oil and its products, not only in North America but also in Europe and increasingly in Latin America and Asia via a model of “development as modernization,” in which transportation, personal mobility, and consumption feature strongly. These globalized practices and the landscapes they produced could soak up the abundance of production that exploration and oil-field development was bringing to the market in the 1950s and 1960s. A powerful alliance between automobile manufacturers, oil companies, construction firms, and the state was created in many countries, which lobbied to produce new consumption landscapes that, in turn, reproduced their social power.
In mature markets, many of the conditions under which oil first established its dominance as a fuel no longer hold. Oil prices are higher, alternatives to oil (such as gas for heating and power generation) are more widely available and increasingly cost-competitive, and many governments have raised the level of taxation on fuels considerably. Further, consideration of the environmental, health, and development impacts of oil has begun to appear in decisions about oil consumption in a way that it never did in the mid-twentieth century. As a result of price trends, efficiency gains, and government policies on climate and energy security, demand for oil has already peaked in the OECD. In many of these economies, oil has exited the power sector altogether, replaced by the expansion of coal, gas, nuclear, and renewables, while its role as a domestic and industrial heating fuel has also been squeezed by gas and electricity. In practice, demand destruction takes the form of retooling urban landscapes, transportation systems, and industrial machinery to disembed oil from its current incumbent position. The transportation sector, in particular, has underpinned growth in oil demand for the last 30 years and is currently the primary driver of demand in Asia. Given this tight connection between demand growth and transport, improvements to the efficiency of transportation combined with investment in alternatives to car and air travel will be particularly significant for reducing aggregate demand. The IEA has identified the potential for a worldwide demand side peak in the (unlikely) event that governments commit to maintain carbon dioxide levels at below 450ppm.5
Squeezing crude: new products from oil
Owners of crude oil sought to expand markets for oil by developing new products from the remarkable raw material at their disposal. In effect, this involved squeezing crude oil harder – via more sophisticated refineries and cracking techniques – so as to extract from crude a greater range of products and services. The progressive development of thermal cracking techniques in the early twentieth century allowed refineries to break down long hydrocarbon chains of low value into more volatile (i.e. short chain) products that could be sold at higher prices. The subsequent development of catalytic cracking allowed production of higher-quality and more specialized products, such as high-octane gasoline, which enabled oil products to reach further still into industrial, military, and domestic applications.
In the first half of the twentieth century, oil and petrochemicals largely replaced coal tar as the foundation of chemical engineering. The nascent plastics industry – which had its roots in organic materials (e.g. cellulose) and coal tar from the 1850s onward – became firmly affixed to oil and petrochemicals by the mid-twentieth century, particularly via the polymer technologies and thermoplastics to which they gave rise. In the 1950s and 1960s, and following crash programs for the development of synthetic rubber in the US, the petrochemical industry began seeking new markets by manufacturing substitutes for natural products. Plastics began to replace traditional materials in a range of applications – including metals, wood, and glass. Low-density polyethylene (LDPE), for example, developed commercially by Monsanto in 1945, enabled products like the “Sqezy bottle” and the replacement of glass containers for liquids such as shampoo. Both Tupperware and Lycra were introduced in 1949, the former made from low-density polyethylene and the latter from polyurethane. The plastics and chemical industries, seeking new markets for products developed for military applications in World War II, began marketing a suite of new products that included pesticides, fabrics, and household utensils, tying oil and oil products ever more tightly to daily life. The search for new products and markets continues, but the petrochemical sector has been confronted with a range of environmental and health challenges since the 1960s. Plastics, in particular, have acquired a bad reputation due to their environmental persistence and potential health impacts. Bisphenol A, for example – which is used to make polycarbonate plastics – is now banned from some products in Canada and the European Union, while several countries and municipalities now either ban or tax plastic bags. Environmental and health concerns have seen oil products replaced by other materials in some applications (e.g. packaging), constraining demand growth in some markets.6
The end of abundance or a new beginning?
The long-term trend has been for oil supply to grow in pace with the expansion of demand, with only relatively short-term interruptions. Between 2002 and 2012, however, a “supply gap” emerged. Rapid growth in Asian economies meant market fundamentals pushed prices higher, yet higher prices initially failed to bring forth sufficient new supply from conventional sources to rebalance the market. Some analysts interpreted this “demand overhang” as evidence of the “peaking” of conventional oil production and that the volume of conventional oil pulled from the ground each year would only decline. Others have seen market tightening as evidence of insufficient investment by IOCs and NOCs, and as an adjustment to new unconventional sources, rather than a fundamental geological constraint. There is agreement, however, that high and volatile oil prices since 2002 are not a temporary phenomenon but mark “the end of cheap oil” and a significant shift in the nature of the resource base. Although oil prices have fallen from over US$100 in the early 2010s, they continue to be high by historical standards. When adjusted for inflation, the average oil price prior to the first oil shock was US$25 per barrel (1946–1972) and US$32 (1986–2002) prior to the last oil boom, while “low prices” in the wake of the most recent boom hover around US$40–50. Increasingly, the gap between supply and demand is being made up by unconventional sources, which have production costs that are three to four times as high as conventional oil. The volatility of prices and their departure from historic norms of around US$25 provide a daily indication that established mechanisms for regulating the availability and affordability of oil no longer seem to be working.
Oil markets and shifts in pricing power
For much of the twentieth century, the mechanism for allocating oil among consumers and distributing it along the production network was quite unlike a market. Oil prices were set by oil producers until the mid-1980s, first by a small number of vertically integrated companies that controlled the bulk of world production until the late 1950s, and then by the governments of key oil-exporting states which linked their prices to the benchmark Arabian Light Crude. It has only been since the 1980s that a large, functioning market for oil has developed in which prices are “discovered” through the interaction of buyers and sellers, rather than being set by producers. Technologies of electronic trading rapidly expanded this “spot market” (with contracts for delivery within days), which became an important source of liquidity in the oil market as well as the reference point for oil sold through long-term contracts. As the amount of oil passing through spot markets has fallen over time, so the financial futures markets have eclipsed the spot market and now have a leading role in establishing oil prices. Prices are now set by a “paper” market in which trading behavior is closely linked to other financial markets and only weakly tied to physical supplies of oil.
Producer pricing and the emergence of a consumer counterweight
For the first half of the “Age of Plenty,” the price of oil (outside the Soviet Union and China) was effectively set by the integrated majors. The majors’ control of upstream operations provided a means to regulate the flow of oil onto the market, while rapidly growing demand provided a context that contained inter-firm competition. Trade in oil in this period was dominated by “horizontal” exchanges among the majors (for which prices were never disclosed) and by “vertical” trades between the subsidiaries of an individual firm, the latter often using transfer pricing techniques to reduce overall tax liabilities. In short, oil markets were very thinly developed and the bulk of the world’s international oil movements took place within the structure of the multinational oil firms that dominated production. The concept of “posted prices” played a key role in keeping this administrative system together. These prices were set by the majors, rather than determined by open-market transactions, and were used as the basis for calculating the taxes and royalties the majors would pay to the reserve-holding states in which they held their concessions.
By the late 1950s, the percentage of oil entering world markets under the majors’ control was slipping. The growing role of Soviet oil exports and the increased role of independents (such as Occidental in Libya and the five independents that were part of a US-led consortium to reactivate Iran’s oil industry after the coup in 1953) meant that a market for oil emerged outside the structure of the majors. Competition among suppliers for market share led the majors to sell oil to refiners at a discount, creating a growing gap between posted prices for crude and the actual prices for which oil sold. When the majors moved to cut posted prices in 1959, reserve-holding states reacted by forming OPEC. The initial decision of reserve-holding states to defend posted prices evolved over time into a strategy of equity participation (i.e. nationalization), which gave governments control over a proportion of oil output. This further undermined the majors’ control over upstream production, and transformed governments from landlords into hawkers of equity oil. It marked a decisive shift in control over the world market from the major international companies to oil-exporting states.7
With the formation of OPEC, the power to set prices remained with producers but shifted from European and American companies to the governments of oil-exporting countries. Like the system of posted prices operated by the majors, the OPEC system was an administered one. Individual oil-exporting states set an official selling price for their crudes, with these prices linked to the “reference price” of Saudi Arabia’s Arabian Light. The tightness of this linkage would be tested over time – and particularly in the period of falling prices in the early 1980s – but the basic idea replicated the majors’ model of producer collaboration with the goal of containing the threat of potentially ruinous competition for market share. OPEC members demonstrated their power to withhold supply and drive changes in price (both up and down) during the 1970s.
In an effort to wrest some control over price and supply security back from producers, the major oil-consuming countries set up the International Energy Agency (IEA) in 1974 as a counterweight to OPEC. Created on the initiative of US Secretary of State Henry Kissinger within the structures of the OECD, the IEA directed its members to cooperate in order to address “their vulnerability to the new economic power of the oil-producer countries.” The IEA’s brief has broadened over time, but its core function remains as an oil-importers’ club that faces OPEC across the oil market: however, although membership has expanded, the IEA does not include the countries experiencing fastest growth in demand (such as China or India), with the OECD proportion of global oil consumption falling from 71 percent in 1970 to 48 percent in 2015, and expected to be below 40 percent by 2035. In contrast, China now represents about 13 percent of world demand, and large buyers like Sinopec can at times dominate daily physical oil trading. The principal mechanisms at the IEA’s disposal are a system of emergency petroleum reserves covering 90 days of imports, an agreement to share these among members in an emergency, and advocacy of governance structures for oil that rely on market allocation and which promote investment in new supply.8
Market prices and the search for price stability
The current system for determining the price of oil is market based. Its origins lie in the tension between OPEC and the IEA over the power to control price, and it stepped from the margins of the oil trade in the 1980s with the collapse of the OPEC-administered system of pricing. Between 1986 and 1988, with its market position heavily eroded by competitive discounting by other OPEC members, Saudi Arabia – the anchor point of OPEC reference prices – moved to a market-based system of price determination, with other producers following suit. The essence of the current system is that oil prices are not set administratively by producers but emerge out of the interactions among buyers and sellers. These interactions take place either via the spot market or, increasingly, via the market in oil futures, with prices fluctuating over the course of a single day rather than being set for relatively long periods of time (up to a year or more under an administrative system).
In practice, the “market-based” process of price discovery is a much less pure process than it sounds. First, only a comparatively small (and declining) proportion of trade in oil actually passes through the spot market: in 2010, trades for immediate oil deliveries on the spot market accounted for only around 3.5 percent of global crude production. Far more oil changes hand via long-term (1–2-year) contracts, although those contracts are typically based on a formula that references the spot market price. Second, market pricing revolves around a handful of “benchmark crudes” that make up the spot market. The prices of these benchmark crudes – such as West Texas Intermediate, Dubai-Oman, or Brent/Forties/ Oseberg/Ekofisk (BFOE) – serve as reference points against which the prices of other crudes are determined by the application of a differential. Benchmark crudes are also important because they are used as a price reference point in contracts for a whole series of non-oil transactions (such as the sale of oil derivatives and tax payments to governments). Third, the “price of oil” quoted on the nightly news is not an actual price revealed through trade but an “assessment” made by a price reporting agency such as Platts. This is because buyers and sellers in the spot market sell their oil “over the counter” in direct deals and do not disclose their prices (unlike the futures market where prices are visible). Price-reporting agencies use a combination of market knowledge and information about specific deals to “identify” prices and, as a result, these agencies play an important (and contested) role in the operation of the spot market.9
The “thinness” of spot markets and their limited liquidity mean oil prices have instead become increasingly linked to the trade in oil futures. The volume of trades and the number of market actors are much greater in these “paper” markets for oil. Initially a way of hedging against price swings in the physical oil trade – and regarded by conventional economic theory as a source of market stability – paper markets for oil have become progressively disconnected from the trade in physical oil, and are now a relatively autonomous force with significant influence on the price of oil and on the investment strategies of oil firms. The first oil futures contract – for heating oil – was offered on the New York Mercantile Exchange (NYMEX) in 1978, followed by the introduction of a futures contract for West Texas Intermediate in 1983. An extensive market in oil futures, options, and sundry other oil-related derivatives has since emerged, centered on the NYMEX and the InterContinental Exchange (ICE) in London. The scale of this market has grown rapidly since the late 1990s: the number of open futures contracts on the NYMEX and ICE rose from 149,000 in 1994 (daily average) to just above a million in 2009 – contracts equivalent to over a billion barrels of oil. Similarly striking is a parallel growth in so-called “over the counter” trades which occur off-exchange: as much as 90 percent of swaps and options trading in oil can occur this way. The volume of over-the-counter trades for all commodities is estimated to have increased eighteenfold between 1998 and 2007. Not only has the size of these “dry barrel” markets increased, but the volumes of oil that change hands each day through futures and derivatives contracts can be many times larger than the number of “wet barrels” brought to the surface and circulated through the oil production network: by 2009, the annual trading volume of crude oil futures was nearly eight-and-a-half times world oil production.10
A shared goal of oil importers and exporters within this market system has been price stability and the prevention of “price shocks.” These are experienced by consumers as sharp spikes in the price of oil that erode value; and by oil exporters as sudden changes in revenue flows (both up and down) that can have disruptive effects on economic development. Furthermore, sustained high prices – and/or a high degree of price volatility – can also undermine the market for oil as consumers switch to alternative fuels or invest in improvements in efficiency that reduce demand. This interest in perpetuating markets for oil attenuates the urge of oil producers to raise prices, and underlies cooperation between OPEC and consuming countries. A manifestation of this shared interest in price stability was the introduction in 2000 of an OPEC price band of US$20–28 per barrel: if prices fell outside this band, OPEC would take action to expand or rein in production. Significantly, this band was deemed “unrealistic” by OPEC in 2005 and suspended when oil had been trading at over US$40 per barrel for a year or so. The continued growth in prices and the apparent inability of either OPEC or the IEA to restore equilibrium indicate how pricing power has slipped out of the hands of both oil producers and consumers, and the growing influence of financial traders in oil markets.
Volatility, speculation, and the limits of the market
Crude prices rose from US$18 per barrel at the start of 2002 to US$145 in July 2008, fell to US$34 in December that year before recovering to US$128 in March 2011, and then bottomed out at US$26 in January 2016. The causes of this volatility have been widely debated. While high prices are linked to “market fundamentals” and a structural imbalance between supply and demand that emerged around 2002, the recent volatility in oil appears to be linked to the increased influence of financial activity in the markets for oil futures and derivatives (see Figure 3.2). Structural conditions of growing demand, limited spare production capacity, and political instability in oil-exporting regions create ample opportunities for financial speculation, and a range of non-oil-related actors has entered the futures markets for oil to take them up. These so-called “noncommercial traders” do not enter the futures market to hedge against price risk as they neither produce oil nor consume it. Attracted to oil as an asset class, noncommercial traders enter the futures market to make a financial bet on oil: they speculate on oil price movements and oil derivatives as an alternative to real estate or stocks and bonds. The volume and significance of “noncommercial” traders in oil markets increased sharply after 2004: the volume of open contracts on NYMEX attributable to noncommercial traders grew from less than 20 percent in 2000 to more than 40 percent in 2008. The growing “financialization” of oil markets and the much greater liquidity of the derivative “paper” barrel market relative to the spot market have occurred at a time of rising prices and increased market volatility. To some observers, volatility and uncertainty over price are now endemic to the oil market. While any causation between financialization and high oil prices is contested, financialization has clouded the role of the futures market in price discovery and contributed to growing uncertainty about the relationship of price to physical oil supply.11
Figure 3.2 Futures and options contracts for oil and other commodities (1993–2010)
Source: Authors, based on Bank of International Settlements Quarterly Review data.
Although the role of market speculation in driving the price of oil is disputed, what is clear is that price signals emerging from oil markets are not translating into the sort of changes one might expect with regard to oil demand and supply. Substantial rises in the price of oil since 2002 have neither caused aggregate demand to slacken nor have they generated significant growth in supply. Strong growth of Asian demand has outstripped recessionary effects in OECD markets so that demand for oil has continued to rise even while prices have risen sharply. On the supply side, the financial strategies adopted by many oil companies have prioritized shareholder dividends and buybacks over investment in production. It is widely recognized, for example, that high oil prices since 2004 have not translated into proportional increases in investment expenditure by major oil firms.
The “failure” of the normal market response mechanism to dampen demand and increase supply at a time of high prices raises questions about who now controls the oil market and illustrates the limitations of the market-based model of oil allocation that has dominated consuming countries since the 1980s. Some analysts suggest we may be on the cusp of a new price regime in which the price of oil is no longer set by the marginal costs of production (the cost of the last barrel necessary to meet demand). With its availability constrained, prices become separated from the costs of production, and it is the value to end consumers (rather than the marginal costs of production) that determines price. In the language of economists, oil ceases to be a commodity and becomes a strategic good. The growth of bilateral deals in the international oil market – such as China’s use of loans-for-oil as a complement to its equity oil positions (Box 3.1) – suggests that this may already be happening as consumers seek nonmarket mechanisms to “lock in” supplies. These deals effectively segment the international crude oil market and mean that “purchasing power is no longer enough of a guarantee for access to all oil flows.”12
Conclusion
This chapter has shown how the centrality of oil to modern life is not a natural state of affairs but has been assiduously produced through creative enterprise during the twentieth century. A vast range of markets for oil products developed as producers struggled with the problem of overproduction. For much of this period, oil supply was led by growth in demand and, in the face of surplus, producers devised various mechanisms to retain control over price. The inherent conflict between oil producers and consumers over the distribution of value takes the form of a struggle over price. The shift from high oil prices in the 1970s to low prices in the 1990s reflected a loss of pricing power by OPEC. Price volatility has increased substantially since 2002, raising the question of where in the production network pricing power now lies. High prices, like those of the last oil boom, are clearly to the advantage of oil producers yet, critically, pricing no longer seems to be entirely within their control. Producers still have the capacity to restrict the flow of oil onto markets, but most have sought to maintain market share in the face of the growing significance of unconventional oil supplies and sluggish growth in global oil demand.
During the run up to record oil prices over the last few years, some saw evidence of looming geological constraints and the imminence of “peak oil.” Others interpreted high prices as a function of underinvestment by oil companies and reserve-holding states, and political decisions (not physical limits) that set the conditions determining where and how oil reserves could be developed. We side with the latter as an analysis of where constraints on supply originate, and how investments in technology and infrastructure are shaped by political choices. The rapid development of unconventional oil resources in North America, and the sharp drop in the price of oil to which it (and the response of other producers) has contributed, highlights the limits of “peak oil” as analysis of contemporary oil politics. Tar sands and tight oil show how global oil demand can be met by expanding supply from unconventional oil resources, but also the necessary enabling conditions – limited CO2 regulation, corporate tax breaks, weak environmental legislation – and environmental and social consequences of doing so. Unconventional oil has high costs, both in relation to conventional oil and wider social and environmental values. The falls in price recently enjoyed by consumers are a consequence of a struggle for market share, in which conventional oil producers (in the form of OPEC) effectively give up some rent in exchange for a price environment that asserts their dominance in global oil supply vis-à-vis unconventional oil producers (and sustains expanding demand for oil overall). Consumers benefit in the short term, but falling prices distract attention – both analytically and politically – from one of the most significant effects of sustained high prices: demand destruction. In OECD economies, high and volatile oil prices over the last decade encouraged technological and cultural changes that have reduced the intensity of fuel use, demonstrating an alternative way to balance demand with constrained supply. Although moves toward demand destruction have been too small and too slow to be widely effective, they are promising because they seek to undo demand by disembedding oil from urban and transportation infrastructures. However, falling prices relieve consumers of this incentive and create political pressure, in North America and elsewhere, to expand domestic supply in the hope of locking in the gains of cheaper fuel.