Volatility reigned for crude oil pricing during the financial crisis. So what factors led to it and could it happen again?
PUTTING THE pieces together in the aftermath of the global economic meltdown that led to a precipitous rise and fall in crude oil prices can be a daunting task.
Market analysts tussle and argue vehemently about the primary and secondary causes for the volatility, making great entertainment for audiences of talking head shows. Many castigate hedge funds and money managers as gamblers, having no business handling crude oil market contracts.
Some have even called into question the West Texas Intermediate (WTI) benchmark as a proven pricing mechanism for crude oil, as hindsight shows that investment money can override basic economics. Speculation has no place in the oil business, they say.
Others, meanwhile, consider speculation vital to market vigor. Global geopolitical energy expert and University of Houston professor Michael Economides, says there was no rational economic reason for either $150/bbl or $40/bbl oil.
"Headlines rule the oil business," says Economides. He says several events in 2004 tripped oil's fiscal unpredictability.
First, the Iraq war and the Abu Ghraib prison scandal escalated panic in the oil market. "The fear factor went through the roof in the Middle East," Economides says.
The second event was in Russia, when the government, led by president Vladimir Putin, took over Yukos, the country's largest oil company, an event Economides considers the "swindle of the century."
The third event was when Venezuelan president Hugo Chavez threatened to, and eventually did, seize control of the country's oil assets.
But what may have started more than five years ago now has certainly escalated to serious threats to the global economy.
A pair of studies commissioned by the US-based energy exchange CME Group showed that the volatile pricing of crude oil in 2008 through 2009, which nearly topped $150/bbl, then plunged to under $40/bbl within a span of eight months, was because of supply and demand fundamentals during a turbulent time, and not overt manipulation.
RUSH TO A SAFE HAVEN
In the midst of the financial crisis, the market experienced a massive rush to commodities with real value. Crude oil was no exception, as trading volumes on the energy exchanges exceeded historical levels, and have continued to do so as recently as early February.
A panic sell-off in the equity markets triggered a record number of crude oil futures contracts being traded on February 5. According to the CME Group, crude oil futures reached a new daily volume record on that day, when 1,121,751 contracts traded, surpassing the 1,092,509 contracts traded on June 6, 2008.
"A lot of people didn't understand what the market was trying to say," says Phil Flynn, analyst at US-based futures broker PFGBEST. "The oil market was acting as a safe haven from what they perceived as US bank failures."
Without the oil markets as an alternative vehicle to trade on, Flynn says the crisis could have been a lot more severe. "People put their money in commodities to protect themselves against falling values," Flynn explains.
But understanding price fluctuations can be difficult for the consumer and general public to comprehend. It was no surprise to anyone in the market that the oil price shock of 2008 brought on threats to "limit oil speculation" by trade associations, US congressional leaders and the U.S. Commodities Futures Trading Commission.
Suspicions of veiled manipulation in the crude oil markets were, in fact, overblown, according to the studies, commissioned by the CME Group as a means to facilitate understanding of crude oil pricing during the global financial crisis.
STUDY ON VOLATILITY
In his study titled An Evaluation of the Performance of Oil Price Benchmarks During the Financial Crisis, professor Craig Pirrong at the University of Houston, Texas, US, concluded that movements in crude oil futures after the collapse of Lehman Brothers in September 2008 echoed realities in the physical market where oil is bought, sold and stored.
"The collapse in demand caused by the acute worldwide economic contraction made it optimal to increase sharply the amount of oil in storage," Pirrong said.
WTI crude's record run-up hit its pinnacle on July 11, 2008 at over $147/bbl, but collapsed to around $33/bbl by the winter in North America as demand for petroleum products deteriorated and storage levels escalated.
"First-month WTI's performance was affected more acutely by the financial crisis," Pirrong said, indicating that the front contract acted as the harbor for market volatility and reaction.
Such volatility had some market players criticize WTI as an inaccurate indicator of the global oil benchmark, paralleling buying and selling crude oil as a game of poker, and the exchange systems as Las Vegas casinos.
The second CME study called into question the accurate representation of WTI and its trading hub of Cushing, Oklahoma, US, as a viable benchmarking product.
But Kenneth Miller, vice president at US-based energy consultancy Purvin & Gertz, led a study on WTI released in January 2010, stating that the 2008 highs and lows were no different from historical volatility as a result of many political, economic and natural events.
Events such as hurricanes Katrina and Rita in 2005 and the invasion of Kuwait by Iraq in 1991 resulted in spiking petroleum prices. The study affirmed the role of WTI as a benchmark and proved that it remains a central plank of the energy markets.
According to Mike Davis, director of market development for the global InterContinental Exchange (ICE), an effective benchmark is globally representative and reflective of underlying economics. ICE's benchmark crude oil - Brent - like WTI, trades on a global electronic scale.
With its wide acceptance by the industry as a representative, WTI's (as well as Brent's) standardized terms and conditions come as the grade is openly and actively traded by a critical mass of varied parties.
"People prefer to stick with benchmarks they know," Davis says.
Some analysts grumbled at the CME studies and the ICE's stance, blasting their arguments as "biased."
"It makes it clear that the price of crude oil does not reflect what is actually happening on the ground," says Hamza Khan, analyst at US-based consulting firm The Schork Report. "It's like the hen asking the fox for directions."
But speculation in itself is not a bad thing, as markets need risk-takers. If you offer people a chance to make money, they will take that chance. Too many players in the market, however, may be burdensome.
Trading a crude oil contract now presents that opportunity to more people. And that chance is not just limited to players in the downstream and refining sectors.
Even rap moguls are trying to tap into the lucrative market as seen by the creation of oil and gas exploration firm Bronald Oil, started by the founders of New Orleans-based hip-hop music publisher Cash Money Records.
