The year 2008 is remembered as the crisis year that saw Fannie Mae and Freddie Mac go down, followed by Lehman Brothers and a host of others. Then, everything else to do with financial markets went topsy-turvy. Not unrelated but relatively less commented on was the simultaneous swing in oil prices that saw Brent touching $147 a barrel in the summer and then dropping to $40 in November of the same year.
Oil had seen swings earlier, too, but this one had a much larger connection with the financial world that is often inadequately explained. Financial analysts dissecting the reasons for such a play rarely tell the full story, choosing to throw the dart on the growing demand from India and China. An engineer by training and an advisor with Eni, Salvatore Carollo has successfully attempted to unravel the mystery. Understanding Oil Prices, part of the Wiley Finance series, explains the complicated world of oil pricing in the context of 2008 and debunks the classic demand-supply theory to explain why oil prices go awry. Carollo comes with the insider’s perspective that gives the book a critical view of how the financial markets dabble in oil. He tells a story that is refreshingly different from the standard one of oil geopolitics. He starts with how oil prices were benchmarked to those set by American oil companies, covers the formation of Opec and explains how the Saudi attempt to have a net-back value system gave way to the creation of the Brent standard.
Recounting the slipping of control of the oil market out of the hands of Opec countries to London and Wall Street, Carollo explains how Brent futures moved away from the purpose of imparting transparency to a market that operated purely for financial purposes using the analogy of cherry and tomato stickers. “The market of oil stickers is a market that is almost totally independent from the real oil market, with bodies operating there and dominating it (controlling it and manipulating it) that normally have no relationship with or interest in the oil industry,” says Carollo.
Brent, which was born to support the trading operations of the oil companies, has seen a tenfold increase in volumes, causing “complete disruption in the internal dynamics of oil”. Interestingly, during 2008-09, about $51,000 billion was traded on the futures market, 27 times more than the physical market and six to seven times more than the entire world production of crude. Carollo, in fact, questions the logic of calling the Brent quotation the price of crude oil.
In the chapter on global oil flows, the author explains how the dependence on crude oil is a necessity imposed by nature though the dependence for finished products is a strategic and economic choice of nations. The United States, for instance, decided to depend structurally on the procurement of refined products coming from other geographic areas. “Dependence for finished products on other refining countries is an economic and strategic choice that provides benefits if well managed and monitored as time goes by, but that can also become a heavy burden if it slips out of control and becomes a strategic limitation.” He has lucidly explained how the dynamics of product prices and crude oil play out in the light of heavy taxation through charts and figures.
Finished products have also seen prices drift away from the world of crude owing to the increasing demand for better quality vehicular fuel. Environmental concerns on setting up refineries, on one end, and adopting better fuel by law have added another dimension to the already complex world of product prices. Carollo, however, does not go into much detail on this and confines it to the fourth chapter, leaving the reader seeking more.
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The chapter on the European refinery crisis captures the dynamics of crude and finished product markets. Carollo shows how the crude market adapted itself to that of products, even as the financial market led to a substantial transfer of most of the refining margin from the refiner to the financial investor. He mentions the creation of excess refining capacity in China and India in passing but does not elaborate on the impact this development may have on product prices.
A must-read for anyone who wants to understand the real story behind oil prices, Carollo concludes with an unexpectedly half-hearted assessment of the political equilibrium governing oil politics. He draws a parallel between the confrontation between Islam and Christianity to what is happening in the world of oil. Interestingly, though, he uses an Aesop’s Fable to explain how the oil companies have delegated the management of their company’s risk to the financial fund managers, making them, as a result, “true masters of the business”.
UNDERSTANDING OIL PRICES
Salvatore Carollo
John Wiley & Sons
168 pages; Price Rs 3,933