The man who would tighten the leash on oil traders
CFTC commissioner Bart Chilton confronts a market obsessed by 'tail risks'
On May 1, U.S. President Barack Obama broadcast a gripping late-night announcement: The mastermind of 9/11, Saudi Arabian terrorist Osama bin Laden, was dead – shot in a lightning raid by U.S. commandos. The following morning, global oil prices began to fall. By day’s end, the U.S.-traded crude oil benchmark, known as West Texas intermediate, had dropped to US$113.03 a barrel – just 36 cents lower than the prior close, but a clear psychological break in what had been a relentless, year-long ascent in prices. Within four days, traders had shoved oil below US$100 a barrel. Five months after that, prices tumbled another US$20 a barrel – in all, a 29 per cent decline from the 2011 peak, and a 52-week low.
Could one then safely infer that a commando had fired an unintentional double-shot – simultaneously killing bin Laden and puncturing a double-digit oil-price bubble inflated over the perceived security threat that he posed? I would be inclined to say yes. But not Bart Chilton, Washington’s self-styled oil trading policeman. With his trademark silver mane slicked straight back, Chilton, the most voluble member of the regulatory U.S. Commodity Futures Trading Commission (CFTC), suggests that attributing the price collapse to a terrorist’s death – even one of bin Laden’s stature – is a tad too simple. What about the influence of the U.S. dollar? Or the Arab Spring? Or oil traders themselves? “Given a certain strategy, they can move prices,” Chilton cautions.
The profession of oil trading generates odd reactions. Ordinary people who take for granted that the prices of stocks and bonds rise and fall along with investor sentiment will fervently reject the notion that oil prices are subject to the same influences. Chilton, one of five commissioners of the CFTC, an independent agency created in 1974 to regulate commodity futures and option markets in the U.S., will suggest that his agency restrict the size of a single trader’s bet, and find that “there are people out there who are violently opposed,” he told a United Nations audience in September. Some of that explosiveness seems to be a byproduct of the opaqueness of the work – oil trading may be among the least-understood of the world’s lucrative legal professions. Yet even for those who follow the subject, the year 2011 may go down as the most arcane in its history.
Back in the day, the job of the average oil trader was to reside either in New York or Houston, while fixating twice a year on the city of Vienna. In the Austrian capital, a dozen or so sheikhs and bureaucrats from the Organization of Petroleum Exporting Countries (OPEC) would gather to mull over how much oil to pump, and traders and analysts would obsess over their pronouncements, their verbal and physical tics, and any other grist for rumors on which they could trade for a couple of months: Does it look like the sheikhs are cutting production? You say they are cutting? What are they actually doing? They are going to be cheating. What are we seeing? You see the tankers – they are coming out, and they are full. See the waterline – it is low!
Curious, one might say, that such esoterica could result in serious global trading fortunes, created on the daily movement of cents in the price of a barrel. Yet it did, and we are not talking a tremendous distance of time – the era wound down just seven or eight years ago. Then the center of gravity in oil pricing began to shift. In 2003, some traders noticed an abrupt shrinkage in OPEC’s crucial cushion of production capacity – its ability to swiftly activate unused wells in the event of a supply disruption, such as a hurricane or a civil uprising. From 5.5 million barrels a day in 2002, OPEC’s surplus capacity more than halved the following year, to just two million barrels a day. Then it dipped further – to about one million barrels a day in mid-decade.
The main culprit was surging oil demand from the growing developing world, especially China. What particularly caught the eye of traders was that there was nearly no margin for error: Almost any loss of supply anywhere in the world would produce a global shortage, the crucial ingredient for a bull market, which was what was now unleashed. From an inflation-adjusted average of US$28.50 a barrel in 2002, oil was bid up to $44.81 in 2004, and $65.03 a barrel two years after that. So frenzied was the market that the definition of an oil trader – now front and center alongside OPEC as an influence on prices – widened to include pension funds, hedge funds, employee investment funds, and just ordinary investors, all seeking to get in on the bonanza. “I was one of the original bulls in oil. In fact, I was bullish before bullish was cool,” boasts Phil Flynn, a Chicago-based oil analyst.
As Flynn noticed, the new market participants helped to fundamentally shake up conventional notions of oil pricing. Investment and pension fund managers did not see oil futures primarily as a way to hedge against unforeseen circumstances, as many oil traders did, but solely as a financial instrument that could earn them money. As a result, oil trading and prices were no longer linked strictly by supply and demand, as they had been for decades. Instead, market participants were more centrally looking out for potential signs of unexpected events that could disrupt supply – what hedge fund managers call “tail risks events.” In 2008, such trading drove up the price to a record US$147.27 a barrel. Then arrived the biggest tail risk event of all – the near-collapse of the global economy. Now, the same traders who had pumped up the price rushed out of the market. On December 23, 2008, they bid oil prices down to an inter-day low of US$30.28 a barrel.
Which brings us back to the bin Laden assassination, and the question of why oil prices plunged the second half of 2011. If one were to compile nominations for the oil-trading tail risk event of the year, surely the Saudi’s killing would vie to top the list. But it would not win. Improbably, it would be edged out by a little city called Cushing. As it turns out, perhaps the most popular – and lucrative – bet in global oil trading for much of 2011 has not been threats to national security, but an obscure guessing game centered on this central Oklahoma city of about 8,700 people.
Cushing is the home of WTI, the U.S.-traded benchmark. Oil pipeline and storage companies such as Calgary-based Enbridge Inc. and Tulsa, Oklahoma-based Magellan Midstream Partners, hold up to 48 million barrels of crude in gigantic tanks situated in Cushing, from where they are trans-shipped to refineries for sale to retailers. Yet the big bet on Cushing is not storage, but arbitrage. Historically, WTI sells at a premium to the world’s other major oil benchmark, the United Kingdom blend called Brent. But in the beginning of 2011, an unusual pricing phenomenon emerged in which the price of Brent was US$4 a barrel higher than WTI. And the spread began to widen further still, so much so that traders began to bet on the divergence – buying futures predicting a higher price (“going long”) for Brent, and a lower price (“going short”) for WTI. On Sept. 6, such trading helped to build the spread to a record US$26.87 a barrel.
While betting on the divergence, traders voiced a rationale for its existence – Cushing’s lack of sufficient pipelines to ship all its oil to refineries. But the highly suspicious Chilton saw the stuff of mischief in this picture: “What if someone moved a tankerful of oil to Cushing, and intentionally kept it bottled up there?” Chilton asked me. “What if this person said, ‘Well, we know we have a contract to deliver oil to a refinery somewhere, but you see, we just can’t get it out.’ But maybe he really could get some of it out. But he is blaming this big thing that everyone is talking about – the pipeline shortage – on why he can’t get his oil out.” In Chilton’s view, such a case could encourage a wider WTI-Brent spread. He does not say flatly that it has. But one gets the impression that it is such hunches that underlie Chilton’s drive to tighten the leash on traders.
This is in addition to the Ben Bernanke trade. This is a recent fashion in which oil traders speculate on the actions of the chairman of the U.S. Federal Reserve. They specifically bet on whether Bernanke will apply a certain arcane tool – called “quantitative easing” – that is thought to inordinately impact the price of oil. Ben Bernanke trade enthusiasts note that, three days before the post-bin Laden plunge in oil prices, he announced an official halt to a three-year run of quantitative easing, leading such investors to flee and short the market. Did that impact prices? Probably.
And who can forget Greece, the free-spending southern European country whose unconventional economic practices threatened to sink the whole of the European Union? One consequence of the uncertainty was a revival in the fortunes of a much-trampled U.S. dollar, a turnaround that once again overlapped with the bin Laden assassination, and theoretically explained the plummet in oil prices. Three days after his death, there was a cessation in a 16-month slide in the value of the dollar against the Euro. Standard financial theory says that the dollar always moves inversely to the price of oil, so that one could find symmetry in the 2011 drop in oil prices, and a 12-per cent rise in the value of the U.S. greenback.
But all of these variables get Chilton’s head spinning. If the oil-trading world has shifted to an obsession with tail risks, he might shift strategies, because by definition there is no way to anticipate such an event. But Chilton instead sees salvation in turning all that off, and seeking a solution elsewhere – in the basics. In October, the CFTC agreed to restrict any single trader’s ability to dominate a set of futures – in most cases to 10 per cent of a single month’s trading. Regardless of the tail risk, no trader could attempt to corner the oil futures market. Chilton regarded that as a substantial achievement considering the pushback he got from lobbyists who insisted that traders have no impact on oil prices. Before the vote, he told me he would feel lucky if his colleagues voted for any “limits at all.”
In the fall, a New Canaan, Connecticut-based hedge fund stratigist named Peter Beutel started to worry. The Euro was hurting, natural gas prices were plummeting, and copper prices were at 14-month lows, all of which looked to Beutel like the onset of a double-dip recession. Which, if you are an oil trader, means possible freefall: Oil prices could plummet like 2008, to US$35 a barrel, he feared. “Right now I’d say there is a 65 per cent chance that we are going in that direction, whereas on Friday I would have called it a toss at 50-50,” Beutel told me in early October. “And if we keep doing this by Wednesday, I may be up to thinking it is an 80 per cent chance that we are going to be looking at markets collapsing.” Instead, in the subsequent days the oil price shot back up, along with the stock market. “The end-result is that confidence has been restored,” an exhausted Beutel told clients in an overnight note.
Yet, is it? A bit of arcane knowledge probably stored only in the hearts and minds of oil traders weighed heavily on Beutel, which was that the United States appears never to have had a robust economic recovery with oil priced over US$30 a barrel. “I am not sure it is really even possible,” he says, because “you effectively have this massive tax on consumers and businesses.” Beutel noted that in the 1980s, a sharp price decline simultaneously bolstered the U.S. economy and dealt a death knell to the Soviet Union: Moscow was producing 12 million barrels of crude oil a day when the price dropped from US$32 in 1985 to less than US$10 in 1986, “and that effectively swamped them at a time they were trying to compete militarily with the United States,” Beutel told me. “They couldn’t do it, and as those numbers started to be passed through the great Soviet machine, it basically unraveled. Well, you could make the same argument here as the United States is having these huge numbers that have been going through our system since 2008.” In other words, a monster tail risk event.