Enverus Blog

Insights across the energy value chain

On July 19th, the U.S. Federal Reserve surprised the global financial world, particularly anyone interested in oil and gas prices.

Mr. Bernanke and company announced they might change a rule that lets banks own physical commodities.

The rule has been in place for the past decade.

It allows banks to own both physical commodities, like crude oil stored in tanks, ships and pipelines, while simultaneously trading financial products derived from those commodities.

The Aftermath

The very next day, on July 20th, the New York Times ran a front page story that raised questions about how banks might be using warehouses full of aluminum to manipulate prices. The U.S. Senate Banking Committee followed up with an extensive hearing on July 23rd that aired major concerns about the effect this practice might have on consumer prices.

On July 26th, JP Morgan Chase made the surprise announcement that it was exiting the physical commodity market. JP Morgan is the biggest bank investor in the natural gas storage business. The company leased about 25 billion cubic feet of natural gas in the first quarter of this year alone.

How could this affect the global oil and gas industry?

No doubt other players want to get into the game. For example, privately owned merchant trading group Freepoint Commodities announced they financed their first oil and gas deal the same day of the Senate hearing. There are likely analysts reviewing bank portfolios today who are looking for opportunities from divestment.

In a contango market (where the future price is higher than today’s price), many financial firms make money by holding physical crude in onshore tankers and offshore ships and selling future delivery for a higher price. The current crude market is in backwardation (where the future price is less than today’s price). This creates a perfect storm for some. The push for bank divestment and the current market reality might present opportunities to buy onshore storage at a discount.

Why does this matter to the public?

The central question driving the Federal Reserve’s review and the Senate Hearing is whether banks can use physical ownership of commodities to manipulate the price of financial derivatives of those products.

For example, let’s say you owned a bank that also owns a crude pipeline. In theory, you could possibly analyze crude flows and deduce that a particular crude futures product is likely to go up or down. You could then trade accordingly.

While this use of bank owned data is legal, U.S. Senator Jeff Merkley sees the practice as “a substantial conflict of interest.” He has urged the Federal Reserve to prohibit the practice.

How big a role do the banks play in crude pricing?

An internal Goldman Sachs memo from 2011 suggests investor speculation could account for about a third of the price of a barrel of oil. Following this logic, financial speculation, not the physical production and use of crude, could potentially swing the price of oil as much as one-third.

The Commodity Futures Trading Commission has estimated financial speculation can cost of the average American driver up to $10 every time they fill up. But speculation can both increase and decrease crude prices, independent of global supply and demand.

What is the historical relationship between oil and gas prices and financial speculation?

The West Texas Intermediate (WTI) futures contract was invented by the New York Mercantile Exchange (NYMEX). It allow buyers and sellers to hedge future crude prices. It was originally created in 1872 to trade butter and cheese futures, but the NYMEX was struggling by early 1970. Potato futures still traded, but even that was threatened when a physical potato delivery was too moldy to sell.

The 1973 Arab oil embargo created a global crude shortage shortly after the NYMEX WTI exchange was created. Trading in the contract quickly escalated as refiners sought to lock in crude supply during a time of enormous volatility. The modern crude futures market was born.

Banks began profiting from owning physical commodities in 2012. According to the London research company Coalition, banks gained more than $1 billion in revenue from commodity trading in 2012. Crude oil represented half of the total.

How can the world really know what crude oil is worth?

The price of anything is determined by how much a willing buyer will pay a willing seller. So, in the crude market the price is also determined by how much a refinery is willing to pay a producer when it wants to buy oil.

Certainly, financial derivative products like futures contracts create an efficient market for buyers and sellers to hedge volatile prices. However, real-time granular data that shows how much crude is produced, when and where its produced and how much will be produced in the future is the by far the best way to anticipate prices.

Drillinginfo can help with that. And you can take that to the bank.

Your Turn

What do you think? How much does commodities speculation affect global oil and gas prices? Should banks be allowed to hold physical commodities while also trading in derivatives of those products? If the practice is allowed to continue, what do you think is the best way to anticipate prices? Please leave your thoughts in the comments below.

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Tom Morgan

Tom Morgan is an Analyst for Drillinginfo. He has 20 years of experience practicing law with a focus on advocating for public policy to advance energy security and private property rights. Tom received his law degrees from Georgetown University and American University law schools. He hosts the weekly Drillinginfo Energy Minute, and you can find and connect with him on LinkedIn as Tom Morgan.