Do Crises Tear the Fabric of Oil Trade?

In 1990, Iraq invaded Kuwait, touching off an economic, financial, diplomatic, and military crisis associated with a tremendous spike in oil prices and recession in OECD and oil-importing developing countries. But was the Gulf Crisis a disruption? Did it affect the fabric of oil trade? To examine this question, this paper examines the changing role of international trade intermediaries (ITIs, often referred to as “trading companies”) in the oil market. ITIs connect buyers and sellers, serving as the glue that holds many commodity markets together. Oil trading companies have attracted harsh scrutiny form policymakers as a result of allegations regarding their role in the United Nations’ Iraqi Oil-for-Food Program, but minimal scholarly attention. The paper takes advantage of a unique microdatabase on the Brent market. Produced in the U.K. North Sea, Brent Blend is by far the most widely traded crude oil in the international market. Participants in the Brent market are diverse, with the largest traders falling into two categories. The first comprises “industrial MNEs”—companies active in the business of producing or refining crude oil. The second category comprises financial houses and trading companies. This diversity provides an opportunity to test hypotheses regarding behavioral differences across types of companies and geographic origin, before, during, and after the crisis.

The oil crises of recent years lie behind much of the concern and interest regarding energy issues among policymakers, the media, and the public. Starting with the "Energy Crisis" and oil embargo of the early 1970s and continuing to today's high oil prices and conflict in the Middle East, oil shocks have been a prominent and dramatic feature of the international economic landscape. These shocks have been followed by recessions in the United States and other industrialized nations, as well as oil-importing developing countries. In his 2006 State of the Union Address, President Bush acknowledged that oil as an energy source is prone to instability and shocks when he pronounced America "addicted to oil."

When Iraq invaded Kuwait in 1990, it touched off an economic, financial, diplomatic, and military crisis, which triggered a tremendous spike in oil prices and recession in OECD and oil-importing developing countries. But was the Gulf Crisis a market disruption? In other words, did it affect the fabric of trade in the world oil market?

To answer this question, RFF's 2005–2006 Gilbert White Fellow Robert Weiner focuses on the changing role of international trade intermediaries (often referred to as "trading companies") in the oil market. In "Do Crises Tear the Fabric of Oil Trade?" (DP 06-16), Weiner finds that the crisis diminished the role intermediaries played in petroleum sales – both during the crisis and after.

Oil crises have attracted considerable attention from researchers and policymakers, but the literature on their effects tends to focus on macroeconomic and financial consequences – for example, unemployment, recession, and poor stock-market performance. By focusing on the role of intermediaries in the Gulf crisis, Weiner illuminates the less widely explored microeconomic aspects of oil crises.

Intermediaries work as "middlemen," connecting buyers and sellers in international trade and serving as the glue that holds many commodity markets together. Along with national oil companies, these intermediaries have come to complement (and is some cases replace) the so-called Seven Sisters that dominated international oil trade from the 1920s until the early 1970s. But although they have attracted harsh scrutiny from policymakers for their role in the United Nations' Iraqi Oil-for-Food Program, intermediaries have received limited attention in the research literature.

   
"Do Crises Tear the Fabric of Oil Trade?" takes advantage of a unique database of individual sales transactions in the Brent market. Produced in the U.K. North Sea, Brent Blend is by far the most widely traded crude oil in the international market. The database is unusual in that it identifies the terms of each crude oil transaction, as well as the buyer and seller of each cargo traded. Terms of individual transactions are not typically available to researchers, despite their enormous size. (For example, at $50/barrel, a single transaction involving a 1-million-barrel tanker cargo involves a transfer of $50 million.)
The database is generated by a daily trade-press survey of oil traders. Participants in the Brent market are diverse, with the largest traders falling into two categories. The first comprises oil companies, including majors (Exxon, BP, etc.), other integrated petroleum companies, producers, refiners, and national oil companies. The second category comprises financial houses and trading companies – Wall Street banks, commodity traders, and Japanese general trading companies (sogo shosha). This diversity provides an opportunity to test hypotheses regarding behavioral differences across types of companies before, during, and after the crisis.

Weiner finds that the Gulf Crisis indeed affected patterns of oil trade. These patterns changed significantly during the crisis, with intermediaries playing a smaller role than before in serving as counterparties to the large oil companies that produce and refine the commodity. Moreover, while the crisis ended as abruptly as it had begun, and oil prices declined sharply to pre-crisis levels, the status quo ante was not restored. The temporary shock to the oil market had lasting effects on market participants, especially oil trading companies. One possible explanation is that lightly capitalized trading companies were seen as less creditworthy after the crisis than before.

Intermediaries continue to be important in world oil trade, notwithstanding predictions of their demise as a result of improved information systems. Some intermediaries have entered upstream or downstream segments of the industry; the reason for others' survival is hard to pinpoint, given the paucity of data. The dominant role played by trading companies as purchasers of Iraq’s oil exports during the UN Oil-for-Food Program, and the extensive diversion of funds designated for humanitarian aid suggests the usefulness of ongoing research into their role and behavior in international oil trade.

Further Readings: "Do Crises Tear the Fabric of Oil Trade?" is part of an ongoing research stream by Weiner examining microeconomic aspects of the oil market. In “Default, Market Microstructure, and Changing Trade Patterns in Forward Markets: Case Study of North-Sea Oil” (Journal of Banking and Finance, 1994), he examines default by trading companies during the price collapse of 1985–1986, when prices fell from $30/barrel to $10/barrel in a few months – a shock that damaged the economies of oil-exporting countries and regions of the United States. The paper finds that despite predictions that defaults would disrupt the market itself, trading survived, with minor structural changes.  Two papers focus on whether speculators exacerbate or even cause price volatility. Much of the blame for today's high and volatile prices has been laid at the feet of speculators, especially hedge funds, yet supporting evidence and analysis tends to be scarce. Speculation in International Crises: Report from the Gulf (Journal of International Business Studies, 2005) examines speculation during oil crises, finding that it played more of a stabilizing role during crises than at other times, exactly the opposite of the view widely held in industry and policy circles. Do Birds of a Feather Flock Together? Speculator Herding in the World Oil Market (RFF Discussion Paper 06-31, 2006) examines herding behavior by oil-market speculators, finding that it cannot contribute much to oil-price volatility.