The Ponzi game of Madoff has resulted in the disappearance of more than $50 billion causing obvious pain to the rich. But the poor have suffered even more since some of the philanthropies helping them are also the victims.

The Madoff scandal has become a cause celebre. However an unprecedented transfer of wealth of $2.2 trillion from oil importing countries to oil exporting countries during 2004-08 has attracted hardly any attention. It is difficult to estimate the harm caused by such a gigantic flow of wealth to fight hunger in poor countries, world prosperity and international peace. How could oil prices reach a historic high of $147 per barrel in July 2008 in a short time, similar to the first two oil shocks without any kind of oil disruption? Who were the villains behind this oil price carnage?

Was this caused by the invisible hands of the free market sending signals to the world to get ready for the end of the oil era and to change over to alternate energy sources as was wrongly perceived during the earlier such price volatility during 1979 to 1987? Or was it because of the price manipulation by the oil cartel OPEC cooperating with the international oil companies? Or was it caused by the Wall Street speculators? An objective analysis of the world oil market shows that this spectacular wealth transfer was caused by the greedy companies like hedge funds, investment banks, etc which are not related to oil sector.

Control has shifted from OPEC to futures

Fig. 1 shows the crude oil price increase during the second oil shock caused by the Iran-Iraq war (the first shock was caused by the Iranian revolution and fall of Shah in 1979). It was the time when the oil market was not affected by paper barrels. Multinational oil companies and OPEC were in control and their production decisions affected the market. Market factors like the imbalance in supply and demand to a great extent determined the oil pricing though OPEC did play some role in preventing the oil prices falling to marginal cost.

It was only in 1983 futures markets for crude oil were introduced. It was preceded by heating oil and gasoline futures market. But the kind of volatility witnessed during the current oil price carnage was absent.

Factors behind the price increase of 1979-81and then sudden price drop in 1986 were well-known and indisputable. Iranian revolution and Iran-Iraq war had reduced OPEC surplus production capacity and in the absence of reliable statistics on world crude oil supply/demand there was the perception of shortage resulting in a lot of panic buying. Though Europe and Japan had strategic storage, US had just started to build strategic petroleum reserves. As demand started to fall, OPEC was unable to reduce production because of the cheating by most members. When Saudi Arabia, which was taking the full brunt of defending the price, announced its policy of increasing production based on netback pricing, prices fell to single digits. There have been no such factors behind the recent price increases or sudden price drops as shown in the Fig. 2.

As crude prices were going up, factors that were given to explain were: Niger delta fight disrupting oil production in Nigeria (it continues even now); Venezuela's crude production drop as a result of Chavez's nationalisation of oil companies and disruption in crude oil production as a result of firing of PDVSA's top management (Venezuela's crude production still remains low); Russia's production decline (it is continuing to decline); trouble caused by jihadi terrorism in Saudi Arabia (this has not only not disappeared, but is actually getting stronger); oil disruption in Iraqi production from time to time as a result of bombing of oil pipelines carrying crude oil to Mediterranean port (situation in Iraq has certainly improved); fluctuation in dollar value, etc.

If we look at world oil supply and demand during 2003-08, it shows that there was adequate oil production and most of the factors explained to describe the relentless price increases did not have any impact. Table 1 shows a fairly balanced oil supply scenario.

Throughout this period (2003-08), OPEC has never been able to produce at its maximum capacity. World oil spare capacity, which was greater than 5 million barrels per day in 2003, fell to around 3 million to 3.5 million barrels per day during subsequent years.

A zero sum game

When Dow Jones goes up or down, wealth transferred from those who buy stocks to sellers of stocks is not very significant and it is not a zero sum game unlike the futures market. When oil prices go up and down, gains or losses on the future markets are a zero sum game. For every winner there is a loser. Thus, when oil prices went up to $147 some winners were long on futures or options. But the amount of money transferred between losers and winners is insignificant in relation to what their greed has done to world oil industry.

One cannot rule out the possibility that some OPEC countries may be involved in oil speculation. Even if they lose some money in the futures market when futures fall, they would have earned far more by selling wet barrels. Since there is no transparency in the futures market, especially in the International Petroleum Exchange of UK compared to NYMEX, it is not possible to know the real players in futures market. Some analysts have estimated that more than 70 per cent of futures activities are controlled by non-oil sector related players which is a far cry from 1980s when oil futures market started.

In 2008, OPEC Secretary General Abdullah al-Badri stated that paper market for oil of 1.35 billion bpd is 15 times more than the world oil consumption of 86 million bpd. Some reports also suggested that futures speculators related to major oil producers, such as Sultan Hassanal Bolkiah Muizzaddin of Brunei Shell Petroleum, Saudi Prince Alwaleed Bin Talal Alsaud and Russian Vagit Alekperov of LUKoil might have contributed to price volatility.

Today, unlike pre-1983, when world oil prices were determined by Rotterdam or Gulf Coast or Middle East wet barrels, they are decided by non-oil industry actors who are indifferent to supply/demand changes or OPEC spare capacity or inventory changes. However, these factors are often mentioned to explain the price movement, but their impact is little as shown earlier. For all practical purposes, it is the chartists and speculators who decide the price movement and not the actual market fundamentals underlying the market supply/demand forces.

With great anticipation, oil futures market waits for weekly changes in the US oil and gas inventory reports every Wednesday and Thursday as though the fate of the world oil market hangs on their revelations. The US oil industry is a dominant force with US demand accounting for more than 25 per cent of the world oil demand, but the weekly changes in such inventory numbers are at best random. Over the medium term, trends in inventory movement and also their absolute levels may have some impact on prices. But their weekly movement should have no influence on the daily or weekly price movement. Weekly changes do not signal any possible surplus or deficit in oil production or refinery runs for prices to move dramatically.

It is this irrationality on the part of futures dealers which moves the market sentiment and not what oil producers or refiners or oil marketers or customers predict. More detailed IEA's monthly Oil Market Report which gives a more comprehensive report of world oil supply/demand has less impact on oil market. This can be partly attributed to the difficulty in getting credible statistics. The real truth may be that it is not available on a weekly basis for futures dealers to speculate. For futures market, a month is eternity and monthly data has no use, which is really ironical.

Futures market for oil has failed

Figures 3 and 4 show the transfer of wealth between major oil importing and exporting countries, while average price of oil prevailing during those six years is depicted in Fig.5. The increase in prices and the volatility during 2003-2008 is far greater than the one observed during 1979-2006.

Futures market is supposed to reduce volatility and also discover the 'right' price for the commodity to bring supply and demand in balance. Oil futures market has failed in both these objectives. One may legitimately argue that futures has been playing a critical and useful role in discovering prices for many important commodities like wheat, corn, many metals… for decades and oil market is not any different.

Unfortunately, oil is not like any other commodity. During the last 50 years, it has become clear that oil is a political commodity which has been used as a weapon by some of the OPEC countries. Iran and Venezuela are openly threatening to use their oil production as political weapons. Just this year, Russia used gas supplies to Ukraine as a political weapon though there was some commercial justification in demanding higher prices. Despite many predictions of the imminent collapse or death of oil cartel, it is able to control production.

In comparison to all other commodities because of the multiplier effect of oil on the world economy, oil has far-reaching impact. For example, prices of wheat or corn on futures market have no cascading impact on the price of wheat in India, China or several African countries. But it is the oil futures market which has direct and indirect devastating impact on most of the oil importing and exporting countries. When prices go up, the poor oil importing countries often face civil unrest; and when the prices go down, the oil exporting countries, whose economies have been misgoverned like Venezuela, Nigeria, and Russia, face potential civil unrest.

The recent volatility in oil prices, which is more or less a replay of 1979-87, should be a lesson for the world community to learn from and bring some order to oil market to avoid such oil price carnage in the future. For oil importing poor countries of Africa and India, this has been a disaster. Even developed countries, now facing the financial meltdown, are indirect victims of oil price volatility. Easy money, which was ploughed back into them by oil rich Middle East countries looking for high returns through sovereign and hedge funds, might have led to the financial irresponsibility on the part of some of their financial companies.

Monte Carlo Casino with high status...

The way oil futures market has functioned during 2003-08 and especially in 2008, resembles Monte Carlo Casino with high stakes. The society has no problem in banning gambling on moral grounds, and disallowing such casinos in many states and cities. But when the oil futures market games played by Wall Street speculators under the guise of meeting the economic objective of price discovery become actually gambling casinos, why should the society be silent spectators? In gambling, only those who are involved in such activities make or lose money. Unfortunately in this oil futures gambling game, as earlier shown, outsiders, specially the poor in developing countries, are the biggest losers. According to Business Week, funds invested in oil futures have gone up from $9 billion in 2000 to about $280 billion by 2008 before the bursting of the oil price bubble.

Focus on transfer of wealth to Middle East

The US Congress has spent far more time looking into the potential wrongdoings of major oil companies during this crisis, but has been blind-sighted by the ever increasing gasoline prices at the pump. On the other hand, they should have worried more about the tremendous transfer of wealth to import oil from the Middle East countries.

President Obama, like the previous the President, has vowed to gain energy independence by eliminating oil imports from the volatile Middle East countries to improve national security. While such a goal, though not achievable, is laudable, the Obama government should seriously consider the possibility of restructuring the oil futures market for a political commodity like oil to achieve energy security by regulating the roles of different players and also by insisting on greater transparency for all the oil futures market in other parts of the world. OPEC has shown interest to cooperate with oil importing countries from time to time, especially when oil prices are rock bottom. This may be the time for the US and developed countries to promote such cooperation more seriously.

For the US, it is better to go after the more achievable goal of bringing order to oil futures market to avoid the kind of volatility seen recently. This would encourage proper development of alternate energy sources to replace the Middle East oil like Tar Sands project in Canada, research efforts to develop renewable energy sources like cellulosic ethanol, thin film solar photo voltaics, wind energy, tidal energy, alternate fuels for transportation to replace gasoline and diesel, etc.

Lack of credible and timely data on world oil production, demand, refinery runs and inventory has further strengthened the speculators in their role of influencing price volatility. During the first two oil shocks, no monthly or quarterly world oil supply/demand reports were available. This resulted in oil industry building stocks to prevent any possible shortage. This, in turn, resulted in pushing oil prices higher than under normal market conditions without panic buying. Today, we have some information on oil market published on a monthly basis by IEA and some consultants though none of them has accurate information. It is in this area that the world community should work together to develop a system of collecting and disseminating information on oil market on a timely basis.

How oil prices were set?

A brief history of how the oil prices were set since the oil era began may be useful to understand the problems with the current pricing scenario.

Soon after the discovery of oil in the US, oil price used to fluctuate widely till Rockefeller managed to stabilise it through his monopoly power of controlling refining. Later, it was Texas Rail Road Commission which regulated oil production in Texas which brought stability to the market, till oil was discovered in huge quantities in the Middle East and Texas lost its dominating role.

Then the power to control oil market was taken over by the so called Seven Sisters–Exxon, Mobil, Texaco, Chevron, Gulf, Shell and CFP–through an informal cartel. Even after the formation of OPEC in 1960, multinational oil companies managed to control oil prices.

It was only from early 1970s, OPEC got into the driver's seat. But OPEC's regime lasted only till the end of 1980s. Since 1990, it is the oil futures market which is pretty much in charge of the oil market in determining the oil prices. Most of the crude oil prices are currently set by three marker crude oil prices prevailing on three different exchanges–the West Texas Intermediate on New York Mercantile Exchange; Brent on International Petroleum Exchange; and Oman on Dubai Mercantile Exchange.

However, during periods of surplus capacity, OPEC has been able to lend support for prices to remain at least by some margin above the marginal cost of production. But they are unable to control prices when market is tight as seen recently. Thus, for greater part of oil era, oil prices have been controlled not by market forces. But the recent control of oil market by Wall Street speculators have been a disaster to consumers in poor countries.

Now that crude oil prices are low and there are no indications of their going higher for some time, there is unlikely to be any effort to reform the current system by the world community. The US Congress, which has been looking at pricing power of the futures market, seems to have lost interest. The European Union and Japan have not taken any interest and abdicated their role to the US.

It should be developing countries like India and China which should take a lead to work with the western countries to regulate the market more strictly with the long term goal of replacing it with a new system which is fair to producers and consumers.