Can the Oil Market Be Manipulated?

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On May 24, the U.S. Commodity Futures Trading Commission sued two companies on charges they manipulated prices for crude oil and oil futures at the height of the recession. The case – filed in Manhattan's U.S. District Court – is called U.S. Commodity Futures Trading Commission v. Parnon Energy Inc.

It actually charges two related companies with manipulating the pricing in West Texas Intermediate (WTI) crude between the fourth quarter of 2007 and early in 2008. They are California-based oil logistics company Parnon Energy and London oil trader Arcadia Petroleum – both affiliates of the closely held Cypriot company Farahead Holdings Ltd. (Remember, WTI is the benchmark crude traded on Nymex in New York.)

The suit alleges that the companies acquired stockpiles of crude, issued call and put options on the long and short positions developed to mimic a market shortage, and profited enormously from what the CFTC says amounts to a fictitious, "artificial," price increase. And it is reviving the question of whether the price of crude oil can be manipulated.

The companies lost on the sale of the crude oil itself (the "wet" barrels of actual commodity) they had stockpiled. But, according to the filing, they gained more than $50 million in profits from the derivatives (the related "paper" barrels). The alleged activity occurred during the early part of a run up to historically high oil prices of $147.27 a barrel (by the second week of July in 2008). The companies charged, however, were trading, and making profits, when the price for crude was well under $100.

The civil lawsuit further contends that the companies stopped the practice when they were apprised of a CFTC investigation.

The Commission regards this alleged conduct as an unwarranted manipulation of pricing -- for both a physical commodity and the derivatives based upon it.

The companies, of course, will claim that their actions amount to normal operations of supply and demand. However, given a number of precedents, the respondents will have some difficulty in sustaining that position.

After all, several years ago, BP plc (NYSE:BP) tried to claim the same thing, when a couple of affiliated traders cornered the propane market and then began increasing prices. And although the oil major never admitted to any wrongdoing, it still paid a fine of almost $400 million.

The same result probably awaits Parnon/Arcadia/Farahead, along with two company officers also named in the civil suit.

The Real Question

Taking a $50 million profit from paper transactions is one thing, but when compared to the daily trading in oil futures and options the amount is insignificant – it's positively minute.

Certainly no one can suggest that amassing an oil stockpile like the one documented in this case could actually control the crude oil market. Even creating a bottleneck through artificial means (controlling access to transit volume at a strategically located port, for example) could not result in more than a temporary impact on market pricing.

Conspiracy theory buffs aside, this may be the way players manipulate for a short-term, localized profit. Yet the sheer size of the suppressed inventory (on the one hand) and the avalanche of derivative paper (on the other) that it would take to control the market in this way renders such a strategy impossible. Even if a series of traders could pull it off, it makes for an unwieldy tool and a very obvious group of culprits.

Traders, speculators, shippers, and logistics providers cannot artificially manipulate the broader market this way. However, producers might.

A More Troubling Development

I have had an interest in tracking oil companies (for crude) and refineries (for oil products) trading in their own volume over the past 11 years. As I noted last week (in "Oil Inventories, Speculation, and Hedging"), anecdotal evidence is already emerging that vertically integrated oil companies (VIOCs) – those controlling the upstream/downstream process from field to refinery through retail outlet – were unusually active recently in trading in near-month futures contracts in their own product.

This occurred both when crude oil and gasoline prices were rising (through close on April 29) and thereafter, as crude plummeted almost 15% and gasoline over 13% as of the end of trading on May 6.

Hedging is certainly required in such volatile periods. And the VIOCs will insist that is what they were doing. Yet an even more troubling development may be brewing with the activities of the huge state-controlled producers in OPEC and Russia. These two sources alone account for almost 58% of all crude oil available in daily trading. That certainly accounts for the "wet barrel" side of the equation.

And for the "paper barrel" side? Take a look at where more of the investments are directed these days from these countries' sovereign wealth funds. That combination dwarfs anything that might come out of a courtroom in Manhattan.

Disclosure: None

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