In June 2014, the price of Brent crude began to fall.  It had been trading above $100 per barrel since 2011, but events in June 2014 lead to a sharp drop in the price.  On the 19th of June, the oil was trading at over $115 per barrel and then began to drop rapidly reaching just over $55 per barrel by year end 2014, a drop of over 50% in 6 months.  The blame was quickly placed on Saudi Arabia, Kuwait and other OPEC members.

International media called it a price war launched by Saudi Arabia and supported by OPEC members in order to crush/drive-out American shale oil producers from the market.  Shale oil production began to rise rapidly from 2007 and oil industry experts claimed that it was hurting OPEC producers.  Below are some of the news headlines in 2014 and 2015 from the major international media:

BBC: “Why is Saudi Arabia using oil as a weapon?” – December 3, 2014

CNN: “The story behind Saudi Arabia’s oil games” – December 31, 2014

Bloomberg: “Saudis’ Oil Price War Is Paying Off” – February 27, 2015

Wall Street Journal: “Gulf Oil Producers Ramp Up Price War” – September 14, 2015

The Guardian: “OPEC bid to kill off US shale sends oil price down to 2009 low” – December 7, 2015

In the months following the fall in the price of oil, the story developed into a Saudi-OPEC price war with American shale oil producers combined with slowing demand for oil in developing countries, especially China.  A slowdown in China and India meant that rising production from OPEC would only push the price of oil lower unless oil producers cut production.  Though this is partially true, it does not explain the full story.  A closer look at the oil price history and a different story develops.

brent-crude-chartFigure 1: Price of Brent Crude Oil from April 1991 to September 2016.  Source: Thomson Reuters.

Figure 1 shows the price of Brent crude oil from April 1991 to September this year.  Points 1 to 5 in the chart need explanation because this is where the true story develops.

Point 1

From 1991 to the middle of 2004 the price never traded above $40 per barrel.  This 13-year period included the end of Iraq’s invasion of Kuwait, the Asian Financial Crisis, the Russian Ruble Crisis, the Dotcom bubble, the September 11 terrorist attacks on America, the US war in Iraq and Afghanistan and many more events that financial experts would say could have caused the price of oil to rise rapidly, but it didn’t. Why?

There was also rising demand for oil from emerging markets, such as China, India and Brazil, while supply of oil was rising at a slower rate.  There was no major American shale oil production at this time.

Point 2

In late 2004 the price of oil rose above $40 per barrel and continued to rise to an astronomical level of $143 per barrel by July 2008.  Industry experts said this rapid rise was due to a rapid increase in global demand driven by emerging markets growing appetite for oil combined with the slow rate of global oil production.  This would be believable if emerging markets started to grow rapidly in 2004, but they were growing rapidly since 1999 and China in particular was growing at record rate for much longer.  The rise in the price of oil to a price the world had never seen didn’t make sense to associate it only with a rapid rise in demand.  There was something else driving the price of oil higher.

The answer can be found in financial derivatives.  When the story of derivatives was added to the story of oil everything starts to make sense.  In 1999, financial regulators in the US loosened regulation of financial derivatives after being lobbied heavily by the big banks.  Trading in derivatives was relatively small at the time, but they were extremely lucrative/profitable for banks that issued and traded them.  Global derivatives trading quickly grew from a few trillion dollars to over $100 trillion in a few short years.


Derivatives Definition:

Derivatives are defined as hedging instruments that are used to protect against financial loss of an asset, currency or commodity, but the underlying derivative is not at asset itself.  It is simply a promise, an insurance contract or a bet from one financial institution to another or to an investor to pay out in the event the derivative bet becomes true, such as a drop in the value of a bond whereby an investor seeks to be reimbursed for the loss of the bond’s value.  A majority of derivatives are based on interest rates and foreign currencies. Only a small portion of financial derivatives are based on commodities, such as gold and oil.


Prior to 2004 there were no oil derivatives.  The launch of oil derivatives gave banks and speculators a new financial instrument with which they can use to play the price of oil.  The small size of oil derivatives compared with interest derivatives meant that it was more volatile and easier for peculators to be able to move the market in oil.  Though derivatives do not directly invest in oil, they are linked to price movements in oil meaning that trades in oil support the derivative contracts and their trading.

As a result of the growing interest in speculating in commodities and oil, the market for derivatives grew faster and faster as the price of commodities and oil continued to rise.  Industry experts and international media justified the rising prices of commodities and oil on growing economies and increased demand ignoring completely the effect derivatives had on the market.

Point 3

In 2008 the price of oil, as well as other commodities, began to fall.  The price of oil fell at a record rate from $143 in July 2008 to $34 by year end, that is a 75% drop in 5 months, which has never happened in the history of oil.  The reason given for the drop was the Global Financial Crisis, which was sparked by the collapse of Lehman Brothers.  Again, the reason was only partially correct.  The Global Financial Crisis did cause many of the world’s economies to go into recession, thus, reducing demand for oil, but it does not explain such a rapid price drop in such a short time.

When we add in the derivatives story here again we see how the story starts to make sense.  The collapse of Lehman Brothers caused shock waves through financial markets worldwide.  International credit markets were frozen and banks stopped lending to each other because of lack of trust.  The major banks all feared that they may be the next to collapse.  This lack of trust and lending between banks cause the global derivatives market to come to a halt.  Derivatives after all are not transparent and are not traded openly on markets, meaning that their true pricing and value is not clear.  The market is traded from one bank to another.  One bank issues a derivative and another buys it and can trade it to another bank or investor.  Thus, if I believe that one bank could fail I will immediately stop buying and trading their derivatives.  Frozen credit markets and lack of trust meant that the derivatives market also stopped and with it oil and commodities came crashing down.

Point 4

The oil market quickly recovered and by early 2011 oil was trading above $100 per barrel again.  The international media attributed this to the global economic recovery and the return of the demand for oil.  However, what really recovered was the derivatives market.  Once governments and central banks in America and Europe bailed out their banks, trust and credit markets began to open up again and these banks went back to playing their same game.  Lucrative derivative trades took center stage again as big banks looked to capitalize on their new life thanks to bailouts.

Point 5

Then finally we come to where we are today.  The price of oil has fallen to new lows again, but has somewhat recovered from the low of $25 per barrel in January this year to over $50 per barrel today.  We are told that this price drop is due to the price war started by Saudi Arabia and supported by OPEC in order to drive out American shale producers.  This combined with the fact that emerging markets are slowing down.  While this is partially true, it does not explain the full story.

total-derivatives-chartFigure 2: Growth in global financial derivatives from 2001 to 2015. Source: Bank for International Settlements and the International Monetary Fund (IMF).

The blame this time for the fall in oil can be attributed to Basel III.  After the Global Financial Crisis, the Basel Committee, which is operated by the Bank for International Settlements in Switzerland came out with new rules for banks, which it had hope would fix some of the problems that caused the crisis, such as trading in derivatives.  While global financial regulators saw the dangers of derivatives and sought to increase their regulation, they have failed to this day to do anything about it.  The main reason is for fear of causing another panic and sparking another financial crisis.  The size of the global derivatives market scared them off as you can see in Figure 2.  Believe it or not, the size of the derivatives market is about seven times larger than the entire global economy.  How can this be?  Simply because derivatives at bets placed upon other bets with no underlying assets.  The market can grow exponentially, which is one of the key dangers.

The Basel Committee foreseeing that regulators may be slow to regulate derivatives placed some of its own restrictions on how banks trade derivatives.  Specifically, they increased the margin requirements for banks holding derivatives in order for them to be in compliance with Basel III.

The increased margin requirements meant that banks were forced reduced the size of their derivative holdings by January 2015.  Thus, banks began unwinding these holdings in the second half of 2014, which is when the price of oil started to fall.  In Deutsche Bank alone, it’s financial derivatives fell by over 12.7 trillion euros from 54.6 trillion euros in 2013 to 41.9 trillion euros in 2015 per the bank’s annual reports.  Compare this to the entire GDP of Germany which is 3 trillion euros and you can see the size of the derivatives problem.  According to the Bank for International Settlements, commodity derivatives have fallen over 45% from June 2014 to year end 2015.  For Deutsche Bank, commodity derivatives fell over 60% over the same period.

Conclusion

The claim that Saudi Arabia, Kuwait and other OPEC members are behind the fall in oil prices is false.  One of the main reasons for the fall in oil prices is due to the derivatives market, which has brought in mass speculation into oil and other commodities markets since 2004.  This in addition to the slowdown in global demand coupled with a rise in supply help explain the full story behind the fall in oil prices.  One more element that needs to be added to the mix is Basel III, which today is forcing banks to reduce the size of their derivatives holdings.  With all of these factors you will now have a more complete story behind the fall in oil prices since June 2014.

As the sell-off in derivatives continues, we expect the price of oil to remain low for many years.  We must also be prepared to handle oil prices in line with their historical trading range and not look back at $100 per barrel oil as where it should be trading.

Title image source: Photo 52035917 © Mary Wandler – Dreamstime.com

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