Understanding Oil Prices: A Guide to What Drives the Price of Oil in Today's Markets

by Salvatore Carollo

It’s a fair bet that most of what you think you know about oil prices is wrong. Despite the massive price fluctuations of the past decade, the received wisdom on the subject has remained fundamentally unchanged since the 1970s. When asked, most people – including politicians, financial analysts and pundits – will respond with a tired litany of reasons ranging from increased Chinese and Indian competition for diminishing resources and tensions in the Middle East, to manipulation by OPEC and exorbitant petrol taxes in the EU. Yet the facts belie these explanations. For instance, what really happened in late 2008 when, in just a few weeks, oil prices plummeted from $144 dollars to $37 dollars a barrel? Did Chinese and Indian demand suddenly dry up? Did Middle East conflicts magically resolve themselves? Did OPEC flood the market with crude? In each case the answer is a definitive no – quite the opposite in fact. Industry expert Salvatore Carollo explains that the truth behind today’s increasingly volatile oil market is that over the past two decades oil prices have come untethered from all classical notions of supply and demand and have transcended any country’s, consortium’s, cartel’s, or corporate entity’s powers to control them. At play is a subtler, more complex game than most analysts realise (or are unwilling to admit to), a very dangerous game involving runaway financial speculation, self-defeating government policymaking and a concerted disinvestment in refinery capacity among the oil majors. In Understanding Oil Prices Carollo identifies the key players in this dangerous game, exploring their competing interests and motivations, their moves and countermoves. Beginning with the 1976 oil embargo and moving through the 1986 Chernobyl incident, the implementation of the US Clean Air Act Amendments of 1990, and the precipitous expansion of the oil futures market since the turn of the century, he traces the vast structural changes which have occurred within the oil industry over the past four decades, identifying their economic, social and geopolitical drivers, and analysing their fallout in the global economy. He explores the oil industry’s decision to scale down refining capacity in the face of increasing demand and the effects of global shortages of petrol, diesel, jet fuel, fuel oil, chemical feedstocks, lubricants and other essential finished products, and describes how, beginning in the year 2000, the oil futures market detached itself almost completely from the crude market, leading to the assetization of oil, and the crippling impact reckless speculation in oil futures has had on the global economy. Finally he proposes new, more sophisticated models that economists and financial analysts can use to make sense of today’s oil market, while offering industry leaders and government policymakers prescriptions for stabilising the market to ensure a relatively steady flow of affordable oil. A concise, authoritative guide to understanding the complex, oft misunderstood oil markets, Understanding Oil Prices is an important resource for energy market participants, commodity traders and investors, as well as business journalists and government policymakers alike.

Genres: Business, Finance, Nonfiction

208 pages, Hardcover

First published January 1, 2011

Reviews

[Lars · Rating 2 out of 5]

A confusing, frustrating book, whose only merits are found in the author's unique and thought-provoking perspective. It is absolutely not a textbook, as the publisher and name would imply. Rather, it is a lengthy, emotionally charged op-ed, whose real title should be Pain at the Pump: Why Our Gas Prices are Broken and How to Fix Them or something similarly nonsensical.

Having read a number of books on the subject, this is the first time I have come across the idea that the crude markets are essentially delinked from the physical supply/demand balance. The author argues that the main driver in crude price formation is instead speculative activity in the financial markets. The mechanism by which this happens, as I understand him, is the link between ICE oil futures and the Brent reference price. Since the price of other oil grades are influenced by Brent, financial players can effectively manipulate global oil prices through their activities on the ICE. At the other end, markets for gasoline respond more closely to market fundamentals. Refiners, being stuck between artificially inflated crude price and more sober gasoline prices, are left unable to make a profit.

Though he has credentials from the oil industry, the author's style is essentially that of a crank. Every other sentence is an emotionally laden absolute about the wrongness of this and that. He drifts casually into a number of irrelevant asides, about nuclear power, Huntington's clash of civilizations, or any other topic that strikes his fancy. The book, only four years old at this point, is already dated and held prisoner to the transient concerns and debates of its time. With Brent lingering at sub-50 as we we speak, noone seems interested in blaming OPEC and muslims for high gas prices anymore. The author's rambling arguments against this now serve only to waste more of the book's ink.

At most points in the book, it is usually unclear who the author is addressing, or rather, who he is arguing against. Seldom are we invited to consider an actual perspective given by an actual person. Rather, the reader is simply told of a belief that is wrong, and then an opposite belief (the author's), which is right. In one brief flash of accountability, he mentions Merrill Lynch and other bank's exuberant 2008 predictions of $250+/bbl. oil, but moments like these are few and far between.

For conspiracy theorists and free market skeptics his arguments hold obvious appeal. I guess this is why this book has so many four- and five-star ratings: since they already agree with him, these readers accept (or choose to ignore) the author's lack of structure and rigor. If you, like me, are on the fence, I guarantee you will find him completely insufferable by the end.

I recently read Oil 101, written by former oil trader Morgan Downey. Aside from being a much better reference and guide to the oil markets than this book, I note that it did not mention anything about crude markets being a function of speculative activity and has its feet planted firmly in the supply/demand perspective. I also asked two professional oil market analysts about the author's ideas and they both gave me a confused shrug in response. Their view, representing what I find to be the mainstream view in the financial sector, is that the impact of speculation is there, but that it constitutes a small part of price formation.

Of course, the author is very well aware that his view is outside the mainstream: he argues that the supply/demand perspective is a self-fulfilling prophecy since the financial players publish influential analyses and make trading decisions based on it which then in turn influence the price through the aforementioned mechanisms. And for what it's worth, Downey completely missed the shale revolution in his book, instead displaying a peakish concern over oil prices escalating indefinitely into the future. Oil 101 was, I presume, written before the massive price crash and subsequent price spike from late 2008-2013, which in my opinion is the best evidence Carollo has in favor of his theories.

We now have a situation where crude prices have dropped significantly over a short period of time. The conventional explanation given is oversupply caused by a glut of US unconventionals. If, as the author argues, crude markets are indeed delinked from supply/demand, then blaming oversupply would be incorrect, or at least insufficient in explaining the decrease. I am quite curious as to whether Carollo's theories have any explanatory power when it comes to these latest developments. As Kahneman says in Thinking, Fast and Slow, the best test of a theory used to explain the past is to see whether it can be used to predict the future.

I'll run the numbers myself sometime over the coming months, see what I come up with, and update this review when I have done so. For the time being, however, my view on this book is very negative, especially in light of its short length and hefty price tag. Not recommended.

[Sara · Rating 5 out of 5]

"We are all OPEC": a call for co-ordination over the resource commons

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The book leads you gradually from the macro down to the micro view of oil resource management, taking a historical perspective and uncovering both the industrial and finanicial nitty-gritty behind our peaceful fuel tank fill. By the time you get inside the mind of the trader who is busy hedging their purchase of a Brent-21-days contract for 600,000 barrels of oil, you'll be convinced that Adam Smith was a sociopath. Mind that the author is no marxist, or autonomist, but an oil industry practitioner who's seen his business overhauled by the rise of finance in the 1980s and the use of war in the Middle East as a continuation of co-ordination with other means. Above all, he's witnessed the failure of the oil industry in the West to catch up with the new environmental regulation, because the 'invisible hand' of micro decisions left to its own devices leads only to inaction and to prisoner's dilemma solutions even to politically important problems.

As the widely misunderstood Hardin said, there is no technical solution to the problem of the commons, but only a political and ethical one. OPEC co-ordination, which drove Thatcher crazy, is therefore regretted here as a responsible way of dealing with the macro and long-term implications of oil pricing. OPEC has foregone its co-ordinating role since 1988, when it pegged the prices of all crudes to the financially driven price of the Brent in London. The ever swinging price of oil is the cause of never ending violence in countries like Nigeria, and lack of much needed structural investments in the downtream operations in the US, which both lead to bottlenecks, pressure on prices thus fostering further financial speculation.

Cause for hope is an episode of successful co-ordination driven bottom up at the beginning of this century, when Platts, a publisher specializing in oil trade publications, spearheaded a movement to change the Brent forward market, which was set to cause - through a practice called 'squeezing' - to cause dramatic episodes of predatory speculation. The publisher succeeded and the market rules were changed (which of course did not prevent the Brent futures reaching the level of $144 in July 2008).

[Said AlMaskery · Rating 5 out of 5]

this book is a must for a big category of audience. It simply gives a brief history of oil and oil prices. The visualization through graphs and diagrams is very relevant. The building of the case was very structured.

Oil prices is not anymore a factor of supply and demand, its not even about the physical amount being traded world wide. It is now the speculation of finance traders that sets the prices. The author patiently and structuraly explains how, through time, this was allowed to happen.

[Chris Mcmanaman · Rating 5 out of 5]

This is what I expect of a Wiley Finance book. Many of the series are not up to par with this book.