A Sea of Troubles, Part II
[Caveat lector- I’m not a petroleum scholar; my entire claim to knowledge is to have read a book or two on oil and having done a few months’ work at an agency dealing with commodities. ¡Cuidado!]
Oil is fascinating. A black, gooey, and inedible substance cursed with a terrible smell, it has somehow become the primary energy source behind our industrial society and the single most important commodity in the world. Wars have been won and lost over it, fortunes made and unmade, and the destinies of nations altered forever. Oil is power, and control of it is essential to both the companies and countries that deal in it. As Churchill wrote in 1911, despite the “sea of troubles” oil brings, “mastery itself [is] the prize of the venture”.
It’s this interaction between oil and politics that interests me most- how politics affects the way it’s produced, sold, and marketed. And so I’ve put down a pair of meditations on this topic, focusing on the relationship between companies and exporting nations. They’re best read together, but since they’re to be published in successive months, they can be read independently as well. And while they deal with oil specifically, many of these observations can be applied to commodities more generally, including “next-generation” commodities such as lithium and cobalt.
Part II: (Re)Integration?
“Just another commodity.” In a sense, that’s what oil is now. It’s traded just like any other commodity, like corn, copper, or cobalt.
The last fifty years of the petroleum industry have been defined by the shift in production structure towards national ownership of production. No longer do international oil companies produce the majority of the world’s oil via concession. Now, upstream assets are almost exclusively controlled by national oil companies (for reference, the “Big Six” supermajors- BP, Royal Dutch/Shell, ExxonMobil, Chevron, Eni, and Total- only control circa 4% of proven reserves).
This shift in ownership to exporting nations during the 1970s dramatically shifted the way oil is traded. The transfer of ownership rights to producing countries meant the transfer of sale rights to these governments, who didn’t exactly respect the sanctity of a contract all that much. Nonetheless, needing markets to sell their oil to, they negotiated long-term supply agreements with Western oil companies, in effect creating a looser sort of integration, bound by contract instead of ownership rights.
During the relative price stability of the mid-70s, these producers didn’t really have much reason to break their contracts. But when the spot (current) price of oil soared in 1979–81 due to the Iranian Revolution and its aftereffects, these producers simply invoked force majeure and shunted their production towards the spot market.
At one point in early 1979, Royal Dutch/Shell received a call from an exporting government, who claimed force majeure and cancelled their long-term contract. Hours later, they received another call from the same government, who had somehow “found” exactly the same amount of oil previously agreed upon, offering it back to Shell, except now at spot prices 50% higher than the contracted price.
The end result of this (amazingly, not illegal, due to sovereign immunity) mass breach of contract was to destroy the classic integrated structure of the industry, with most of the action shifting to the spot and the then-new futures markets. Before 1979, around 10% of total traded volumes was sold on the spot market; by 1982, more than 50% was sold via spot markets or was keyed to the spot price. Despite efforts to integrate by the producing nations, like Kuwait’s European downstream distribution network, Q-8 Oil (get it?), the industry is largely based around the same spot and futures market arrangement pioneered in the early 1980s. Neither producers nor consumers are bound to each other any longer.
While this system worked well in the 1990s, with relative political and economic and therefore price stability in most markets, it was upended by increasing financialization, the invasion of the oil industry by institutional investors through the trade in “paper barrels”. This intensified market volatility, with the resultant boom and bust dynamics seen in speculative bubbles- within a five-year span in the mid-2000s, the spot price of a barrel of WTI went from $25 to $145 and back down to $32. These insane gyrations have wreaked havoc on the economies of both producing and consuming nations. The 2007–8 spike to $140+ a barrel nearly destroyed the aviation industry, while the subsequent crash prompted economic and political crises in producing nations all over the world.
In addition to the instability created by financialization, the market has also suffered from the political upheavals of the last decade, from the destabilization of Libya to the implosion of Venezuela. Each has created significant constraints on available supply, with the supply crisis-in-aggregate averted largely due to the gargantuan new flows of shale oil from the US.
This instability is liable to get much worse. In the post-COVID era, we will see a far more dangerous and unstable globe. Given the current rate of vaccinations in the developing world and the progress (or lack thereof) towards averting climate change, the twin threats of COVID and climate change will continue to rip through the developing world, trailing economic and social destruction in their wake. Discontent will grow towards regimes already enfeebled by corruption, a lack of public trust, and stalling economic growth. Extremists and nationalists from all ends of the political spectrum will compete for power in angry and desperate societies, threatening civil discord within and aggressive foreign policies without.
The cumulative effect of mass political instability and financialization on a spot and futures-based commodities market that already enjoys little spare capacity through to 2030 will be a permanent state of pricing instability, given that commodities are disproportionately produced in developing countries. In times of supply disruptions, if there is little or no spare capacity available, which is the likely case in the event of mass instability, spot market participants are liable to panic buying as supplies and therefore today’s prices may not be available tomorrow. This dynamic creates a self-inducing panic, driving prices further up; yet the price must come down eventually, creating overall market conditions of increased volatility. This dire situation is further amplified by the financialization of the industry, as the generally increased volatility attracts more speculation and a higher number of market participants, further increasing price instability.
Is there any way to restore some semblance of stability to the market? Perhaps the answer is a return to the past- to integration. In its classic form, the integrated oil company drilled, pumped, refined, and marketed its own oil, secured by concession from the producing country. That last bit is key. The concessionaire company physically owned the oil (at least in part), from unextracted reserves underground all the way up until the point of sale. It sold oil between its subsidiaries at internal rates, unconnected to the spot market. And as for the exporting nation, the company would pay it an agreed-upon rate per barrel, thus locking it into a sort of long-term sale agreement (sometimes without an actual sale, since the company might own 100% of the concession).
First and foremost, integration very definitely secures supply. Formal corporate ownership of the oil, at least in part, makes it very difficult for the producing country to simply re-sell oil on the spot market in contravention of contracts, fixing a supply at a given price. This not only directly secures supply and price, but also removes barrels from the spot and futures markets. With lower traded volume and less market participants scrambling for barrels, the price becomes less volatile and less attractive to speculators, counteracting the speculative pressures created by financialization.
Secondly, integration also brings increased political stability. Stable and predictable revenue inflows help exporting governments not only conduct long-term budgeting and planning, but also limit the effects of being petro-states. Countries with high levels of oil exports (but really any natural resource exporting state) find themselves becoming petro-states, where a very large slice of the economy is fed by government oil export revenues. Naturally, when the oil price surges, government revenues balloon. However, electorates being short-sighted, the result is popular demand for a spending spree. But when price inevitably falls, the electorate nevertheless demands their now sky-high entitlements, and will oust whoever cuts expenditure in reaction to changed circumstances. The result is predictable- large deficit spending or high inflation, both of which place developing economies in serious jeopardy and risk civil unrest and the stability of governments.
Having a concession agreement with an international oil company gives governments a critical excuse allowing them to resist the demands of the populace. They can simply point to the concession agreement and say it is out of their hands, avoiding over-commitment and preserving domestic stability. Increased political stability in exporting governments in turn improves pricing stability, reducing spot market volatility.
All this begs the question- why should concession-based integration be any more durable than long-term contracts, which were broken with such ease in 1979–81? Simply put, it’s far easier to break a purely commercial contract in which one controls the goods to be exchanged than to interfere with the assets and individuals of a foreign company. Nationalization and embargoes, two of the most prominent tools used by producing nations to achieve their goals, are inherently high-profile and immensely damaging to foreign relations. This is especially important to commodities producers, given the companies who deal in commodities are disproportionately American, British, Russian, or Chinese- not states you want to antagonize.
It’s true that in the past, integration agreements have been altered through political pressure to achieve a higher price than that agreed upon, such as during OPEC’s unilateral decision to quadruple the posted price in December 1973. Pricing restructurings are certainly less disruptive to foreign relations than outright nationalization and embargoes. Yet it’s arguable that producing nations have learned the lessons of the last 60 years. Venezuelan oil minister Juan Pablo Pérez Alfonso, co-founder of OPEC and one of the principal proponents of ever-higher oil revenues, eventually came to refer to oil as “the devil’s excrement” precisely because of these destabilizing petro-state dynamics. His countryman, two-time president Carlos Andrés Pérez, followed a similar path, going from exuberantly hailing “magical liquid wealth” in the 70s to soberly concluding a decade later that “an [oil] price spike is bad for everyone, but worse for developing countries that have oil- it is a trap.” Stability, in the end, is what’s most important for national prosperity.
And even if these producing nations decide to “adjust” the agreements by increasing prices, the fact remains that these products are not sold on the open market, and therefore still remove barrels and buyers from the speculative frenzy, counteracting the pressures created by financialization.
But while (re)integration might well be a boon for all parties involved (with the exception of traders and speculators), the world has changed. The companies no longer exclusively exercise that magical mastery and mystique of technology, know-how, logistics, markets, and capital. The only places where a 1950s-style concession with “50–50” profit-sharing but 100% company ownership might be tenable are those on the very fringes of development, like Somalia, Afghanistan, or the DRC.
Any concession arrangement under present circumstances should be more of a mechanism to guarantee integration and stability for both companies and countries, rather than a method for companies to extract commodities at preferential rates, and for which stability comes as a nice bonus. That era is long over. Something like a 75–25 ownership split and 99.9% of profits going to the producing country should be more than sufficient to provide that integration mechanism.
Furthermore, the financialization of the industry and the development of spot and futures and markets are not to be ignored. While volatile and unstable, these markets respond to market forces in ways that the original concession agreements did not. For example, the terms of the famous Aramco concession, as revised in 1950, went largely unchanged until 1971, despite the real price of oil roughly halving in that 21-year span. Perhaps, then, a five-year moving average or a similar formula should be the basis of calculation, allowing for both some degree of stability as well as responsiveness to overall market conditions.
As the Shah of Iran once put it, “the conditions of the year 1951 do not exist anymore”; the age of concessions, in their classic form, is dead and buried. And while the diversification of energy sources and the existence of government-controlled buffers and reserves (e.g. the US Strategic Petroleum Reserve) may well prevent excessive market volatility, in the face of a dangerous and unstable new world, perhaps a revised form of the concession system deserves another look.