Saturday, January 26, 2008

Efficient Markets? How Noise Drives Prices

By Peter McKenzie-Brown This week was remarkable. It began with the Americans twisting Saudi arms so they would increase oil production. Nervous that there might be spigots that could actually be opened, oil prices dropped off their lofty levels. Then a decline on global stock markets was greatly exacerbated by the squeeze forced on France’s Société Générale by a rogue trader.

The Martin Luther King holiday market closures compromised an orderly unwinding of those futures contracts, and the decline in the markets turned into a meltdown. Not knowing that the actions of a 31-year-old rogue had precipitated the collapse, the Fed’s Ben Bernanke flooded the world with cash by precipitously slashing key US interest rates. The markets were also flooded with rumours of a severe US recession impending – one that would take the world with it. Fearing a crash in demand, the price of West Texas Intermediate briefly dropped to its lowest level in three months. Then reality began to intrude: the Saudis don’t have a lot more oil they can produce, and geopolitics, rising demand and historically tight supply still govern the price of oil.

The chart illustrates two things. First, it shows the trading range of oil (the space between the red and green lines) during the last six years. Second, it shows an extended breach in that trading range – essentially, three months of trades above the red line. What used to be resistance has now become support. I consider it highly significant that oil prices popped up after touching their three-month low.

In the future, oil is likely to trade above the red line. One of the great things about technical analysis of this kind is that it is a way of imposing order (straight lines) on a market riven by noise (jagged lines.) However, technical analysis is not an excuse for not understanding what decisions help form the jagged lines of day-to-day trading. Oil prices are governed by a highly sophisticated market – one that can quickly balance innumerable pricing factors to establish appropriate prices for oil, but so doing creates endless charts of jagged lines. Herein I present my perception of how that market developed and of the major factors influencing it. As a Canuck, I will deal with the matter from a Canadian perspective.

The Background: As oil became a vital factor in western life during the twentieth century, exploration for the stuff – a new industry – found more than the world could consume. In response, big companies set prices for the oil they controlled overseas, while governments and regulators in the US helped create a parallel environment in which America’s huge domestic oil industry could prosper from higher prices. By 1970, these different policies had created a global pricing environment in which oil produced in the United States cost $3.18 (U.S.), while oil produced overseas only fetched $1.30 (U.S.)

This situation received a severe blow in 1973 when OPEC began to act as a cartel – an organization committed to keeping prices higher than the market would ordinarily allow. They were so successful that OPEC’s member states made price control the organization’s primary purpose, and for more than a decade a statement from OPEC was enough to give world energy markets the jitters. The energy crises of the period were possible because the world was no longer awash with oil. In particular, production in the United States (then the world’s largest producer) had begun to decline.

The Western world needed new supplies, and the volumes required were only available from OPEC members. This period culminated with the Iranian Revolution of 1979-80, which brought panic to oil markets. Dubai oil prices rose from about $2.00 (U.S.) per barrel in 1972 to $36 (U.S.) in 1980. All this was far more traumatic a generation ago than the rapid oil price increases of the last ten years. The reason is that – at least, in relative terms – oil then played a much larger role in the world economy.

Spot and Futures Prices: The market responded dramatically, and predictably, to these painful price increases. Consumers used less oil while producers pumped more. OPEC soon lost the ability to keep prices high. Then, in 1986, Saudi Arabia, an OPEC leader, flooded the market with oil in an effort to re-establish market share. As a result, prices plunged. Dubai oil dropped to $13, and fluctuated around that level for more than a decade. It did not move decisively upward again until 2000, when tight oil supplies began to squeeze prices higher. Aided by the convergence of computer and telecommunication technology and by increasing competition among global oil producers, the world’s response to these three “price shocks” – the price spikes of 1973 and 1980-1981 and the price collapse of 1986 – was to create a sophisticated global energy market.

After much turmoil, this market, which now accommodates innumerable buyers and sellers, imposed a laissez-faire discipline on the matter of global oil pricing. In this market, petroleum prices take the forms of “spot” and “futures” prices. Spot prices represent what traders charge for oil for immediate settlement – usually, delivery within two days. Futures prices are prices for delivery of oil at a certain date in the future – as soon as one month, as far into the future as nine years – at specified prices. Driven by a global network of traders working around the clock (except weekends and holidays), spot trades take into account the needs of refineries and a constant stream of geopolitical and economic data.

The markets are more strongly influenced by information about how much crude oil inventory is in America’s stockpiles than by OPEC statements about how much oil they are going to produce. News about hurricanes and other extreme weather events also figure into price calculations. So do rumours and worries about conditions in the world’s large economies. 

The world’s energy traders bring uncountable resources, facts, needs, expectations and beliefs about the future into their collective trading decisions. This interplay of intelligence and knowledge creates a group mind capable of processing extraordinary amounts of information as it establishes global prices. Charts of spot prices changing minute by minute can be found on numerous web sites.

Benchmark Pricing: Spot prices represent the business end of crude oil pricing, but futures contracts are the ones that truly set prices. As their name implies, futures contracts anticipate what prices will be in the future. Investors and speculators buy these contracts on major commodity exchanges, and spot traders use them as their main references as they negotiate prices.

Traders have developed many strategies using futures contracts. They are commonly used for financial speculation, but they also have practical business uses. Refiners can use them to secure the price they will pay for oil at certain points in the future, for example. To create futures markets, exchanges had to settle on particular kinds of oil to serve as benchmarks. The price of a barrel is highly dependent on both its grade (which is determined by factors such as its specific gravity and its sulfur content) and its point of delivery. In North America, the benchmark price on the New York Mercantile Exchange (NYMEX) is West Texas intermediate oil (WTI), delivered at Cushing, Oklahoma.

There are other benchmark crude oil contracts. Of these, the most important is Brent light, delivered at a port in the north of Scotland. Traded on the International Commodity Exchange in London, this oil contract essentially determines the price of oil in Europe and Africa. Oman oil, which is traded in Dubai, helps determine the cost of oil in the Middle East. The US government’s Energy Information Administration uses an entirely different approach to oil price calculations. It calculates the weighted average cost of oil imports (including oil from its biggest supplier, Canada) to determine the world oil price for the United States. Known as the Imported Refiner Acquisition Cost index, this is a lagging indicator. Instead of giving information about what prices are or will be, it describes what they have been.

Edmonton Par: Although Canada is a large and growing oil producer, we are a price taker rather than a price maker. Canadian prices are established by reference to the benchmarks of New York, especially, and of London. Those benchmarks are the price makers. The “real” price of oil is its spot price – the amount a buyer will pay for oil for real, immediate delivery. One important Canadian pricing standard is Edmonton light oil. How prices for that oil are established illustrates spot pricing in action. Initially, the price for Edmonton light is set by the companies – Imperial Oil, Petro-Canada, Shell and Suncor – with facilities at Refinery Row, near Alberta’s capital city.

Each morning they post the price they will pay for Edmonton light. Those prices closely track the most recent closing price for NYMEX futures contracts. The daily average of the prices offered by those four refiners is known as Edmonton Par, and it is the standard used for calculating oil prices in Western Canada. Foreign buyers (mostly located in Chicago) negotiate deals that take into account Edmonton Par, the futures price in New York, the spot price in Edmonton, the date the oil will be delivered, the difference in quality between Canadian light and WTI, the cost of transportation and the availability of competing supplies. As with other efficient markets, the price of Canadian oil reflects a balance of the needs and intelligence of many buyers and sellers.

Canada’s Split Personality: Global markets have had quite a big impact on the distribution of oil within Canada and across North America. In particular, they have helped determine which parts of North America use Canadian oil, and which use oil from the US and overseas. Refiners avoid the high transportation charges required to pipeline oil from Alberta to Toronto and points east. Instead, they buy oil from offshore Newfoundland or from international markets. That oil is delivered to ports in eastern Canada or to a pipeline terminal at the ice-free harbour in Portland, Maine. From those delivery points the oil is piped to major refining centres in Come-by-Chance, Nfld.; Saint John, NB; Montréal and St. Romauld, PQ; and Nanticoke, Ont.; and to smaller eastern refineries.

Oil from western Canada is another story. It is highly competitive from Vancouver to Sarnia, and in parts of the US West and Midwest. Many refiners in those areas have developed equipment designed to refine specific kinds of oil from Canadian producers. That specialized equipment is one part of the industrial infrastructure that has created secure markets for Canadian oil. Another is North America’s complex network of interconnected pipelines, which make delivery relatively easy.

In practice, Canada has a split personality in the matter of oil imports and exports, and this is mostly a function of our planet’s market pricing for oil. We are the seventh largest exporter of oil in the world, but also the seventh largest importer. In 2006, each day Canada exported 1,784,000 barrels of crude oil, mostly from the west. At the same time, however, we imported 849,000 per day into the east. Canada was thus a net exporter of 935,000 barrels of oil per day.

Because a great deal of our oil production is lower-quality heavy oil, in 2006 Canadian production on the whole sold for less than the $66 per barrel fetched by West Texas Intermediate. However, those net exports added more than $55 million per day to our trade balance with the world. The creation of a sophisticated global marketplace for crude oil coincided closely with the years in which Canada joined the big leagues of global oil producers and exporters. As we have seen, market pricing now suffuses the sector, and it has helped put the industry into its present form. An example is Canada’s decision to import oil for its eastern refineries while exporting oil from the west. In this instance and many others, efficient markets have helped create a cost-efficient industry.
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