Brent: Episode 1, Part 1 – Dr Adi Imsirovic

Neil: Hello and welcome to the Price of Everything, a podcast that aims to shine a light on pricing. The cost of commodities, that's energy, food and so on, is such an important part of our lives. But how are those prices actually calculated? Why do they move up and down quite so much? And what's next? The Price of Everything is the first podcast dedicated purely to how pricing works. My name is Neil Bradford and I'm the founder and CEO of General Index, which is the world's first technology-led benchmark provider. Together with my colleagues from around the world and some special guests, we'll be taking you through how some of the world's most important commodities come to be priced and what the future looks like for them in the age of climate change and the energy transition. Dated Brent is the world's most widely recognised price for crude oil. But why Brent? How did an oil field off the coast of Scotland become so pivotal in global oil pricing? My colleague David Ellwood explores the history. David: Brent is the world's most important oil benchmark, responsible for setting the price for over 70% of world exported oil. It is the most complex oil market in the world and the brand name of a benchmark that has reinvented itself many times since the 1980s. Well, hello everyone. My name is David Ellwood, and welcome to the Price of Everything. And this appraisal of Brent features in an excellent new book on oil pricing which came out during the pandemic, Trading and Price Discovery for Crude Oils: Growth and Development of International Oil Markets by Dr. Adi Imsirovic. I'm delighted to say that he joins me here now on the podcast. Adi, welcome to the Price of Everything. Adi: Hi David. Thanks for having me. David: Well, just a quick introduction, let me just tell my listeners a little bit about you. So Adi has over 30 years of experience in oil trading and academia. He's the former global head of crude oil at Gazprom Marketing & Trading. And taught economics at Surrey University in the UK for several years. He's now a senior research fellow at the Oxford Institute for Energy Studies. Now, why Brent? Why is Brent the first topic in this new podcast series? Well, as Adi says in his book, it's the world's most important oil price. Perhaps also the most famous oil price. And maybe we'd even go as far as to say that it's the most important price full stop. The Brent crude brand is as ubiquitous with oil as Coca-Cola is to fizzy drinks. It's integral to the daily working of the oil industry. And I guess it'll have been given a whole new audience in recent months as mainstream news outlets reported on the impact of Russia's invasion of Ukraine, rising fuel prices and their contribution to surge in inflation. Where the oil price quoted will most likely have been Brent. Over the next couple of episodes, we're going to explore Brent and the history of oil pricing. I'm thrilled that Adi's agreed to join us for our first episode, which we kind of loosely titled the History of Oil Pricing and the Background to Brent. Adi, if we were to try and wrap some dates around this, I think we're looking at starting, I'm going quite specific, 1859 and perhaps up to the 1870s and a little bit into the '80s, so we've got quite a breadth of time to cover with you. Obviously crude oil, we could go a lot further back, records tell us that Noah used it to seal his arc. The Babylonians waterproofed their roofs with crude oil or with some form of oil. And the Chinese have used it as a skin balm for years. And if we go to North America, well, the Native Americans, it was a treatment there for frostbite. But as I say, the story of the price of oil, and after all it is the pricing trends we are interested in specifically on this podcast, and the journey to Brent's dominance. And it's one that spans the last 160 years. And so today we are going to focus on the back story and look at what happened before the eyes of the oil world came to rest on the North Sea between the coasts of Scotland and Norway. And Adi, so in your book you trace the origins of the modern oil industry to a place more than 5,000 kilometres away from the North Sea, Oil Creek in Pennsylvania in the United States where the world's first commercial oil well was drilled in 1859. Now, perhaps describe to us what the market was like there. How was the emerging traded market around this nascent industry? Adi: Well, what I found very interesting was that the earlier days of the oil industry were extremely competitive, and the whole book is essentially looking obviously at the market. And as we all know, throughout the history of the oil industry, throughout the most of that period, the oil market hasn't been particularly competitive for various reasons. So I went back to the early days of the oil markets just to find out what actually happened, what went wrong, and why the market suddenly became uncompetitive from time to time. But it was really a fun journey. And doing the research was really interesting, going to the books written in 1870s and 1880s. It was really interesting to read. So I'll just obviously visit some snippets from that period. For example, the first market makers for oil and the first people to discover the oil price were actually speculators that were called dump men. And dump basically refers to any kind of vessel where you could put oil into. Very often it was when people run out of space, they would just dig a hole and just leave oil in the hole until they could use it. So the dump men of Oil Creek were actually the first market makers, the first traders. And the important thing for me and you and all of us who are in the oil market is that price discovery. And they were the ones who were actually discovering the price of oil. They relied on better knowledge than others because they would travel around the region, they would talk to producers. And when there was excess supply of oil, especially for the smaller producers that did not have agreement with refineries and so on, these smaller producers, some of them would very quickly run out of storage and they needed to offload the oil. And then the dump men would come in, and like today's market makers, if you want to buy for example an oil derivative, you'll probably call a bank or call a broker and they would find somebody for you. They would basically give you a price. And they were extremely useful at the time because then you would know where the price of oil was and what price you could sell it at. And then later on it gets also even more interesting as the oil production increased, transportation was always a very, very big problem. So the big great breakthrough and invention were actually the gathering lines that would take oil from the well to the railways. Where they would transport it further on. So these gathering lines were actually quite useful because you could actually deliver your oil. If you're a producer, you deliver oil into a gathering line and you get a receipt, a ticket essentially. So those first tickets were actually then because they would only be approved of ownership and had no price or anything on it, they would just say thousand barrels, David gave to Ali, into the gathering line, could then be traded. So these tickets were actually usually be issued for a thousand barrels at a time. Interestingly enough, that's the route and probably the main reason why now the oil trades in thousand barrel lots still to this day. They would be for spot delivery, regular so-called 10 day delivery and future delivery. And they could be traded. So people started trading them in the Oil City. They were trading basically next to the railway station. And they would just exchange these certificates. And interestingly enough, some speculation was quite a favourite pastime of many of the citizens of Oil City and so on. And at the same time, what's quite interesting was the development and commercialisation of the telegraph. And as the first exchange is developed, then telegraph really helped that because you could actually be in various parts of the town, use telegraph to get the information and have prices, know prices exactly where they were. So that enabled then exchanges to be opened in other places outside the Oil City in places like Bradford, Pittsburgh, New York, Philadelphia and so on. So anyway, it was a really fun time. There were a lot of brokers. First brokers were established in '68. They were representing refineries. The trade was quite significant, the volumes, David, were quite big. In fact in the Oil City, the exchange there in, I think it was summer 1882, they actually set up a clearing house. And very soon after setting up the clearing house, I think it was in October the clearing house was set up, and then a month later, a record volume of oil traded these certificates of 18 million barrels. So these are big volumes. Now, this is a big size. We're talking about serious price discovery. David: But you're also describing a market that if a trader from nowadays was to be dropped back in history, there's lots of elements of this industry that they'd recognise. Adi: Absolutely. Like a lot of refineries, pretty much in those days, all the oil was either traded on the exchanges or based on the exchange prices. So big refiners, later on we'll come to probably chat about Standard Oil, the infamous monopoly, they were for years buying oil based on the exchange prices. They would take high, low and average them. And actually if you think about it, that's how refineries buy oil now pretty much, they will take your publication or any other assessment and they will just average it out over a period of time, high, lows or close or something like that. Very, very similar. David: We might come, I'm sure we'll come to reflect later on perhaps why or the opportunity that the industry lost, given up almost, well, perhaps a hundred years of progress to go back. But we'll come to that later. I just want to touch on, one of the things you mentioned in the book is the first, I think it's important to draw here because we have a view, we are looking forward to the evolution of the Brent price, and you have the first example around this time of a forward market being developed as well. Which is a key characteristic of the Brent price. That was, I think you described a gentleman called Jacob Vandergrift, a bit of a river captain and a pioneer oil producer. So this was an era of individuals as well. This was a time for people with ambition and with skill and capability who were starting to put and influence the infrastructure of the industry. Adi: Absolutely. And the obvious two characters that filtered through and become the key characters, in fact one of them, please, these days, people talk about Rockefeller, but Rockefeller and his right man, Henry Flagler, I think is unjustly missed in a lot of these conversations. We all know about Rockefeller, but actually not many people know about Henry Flagler, who was instrumental in creation of Standard Oil. And actually later on, funnily enough, Flagler was also pretty much founder of Florida. He founded Florida East Coast Railway, founded cities of Miami and Palm Beach. He had the money and ambition and was not shy even from these huge projects. So, the story of the two of them is quite interesting. And the other story that's not very often mentioned is that, we'll probably mention a few other individuals later on, is the role that traders actually had. Because Rockefeller and Henry Flagler were merchants, they were traders, they were not geologists or traditional oilmen. They were basically trading various commodities, including kerosene. And then in the process realised there's a lot of money in kerosene. And then they started basically, they moved into that business and it was a thriving market. David: Plus we should just note for listeners, so kerosene was the main final product that was being produced for illumination. Adi: Oh yeah. Thank you for that, David. Essentially in those days, illumination was the killer app for the oil industry. So, it was very important, of course, lighting is very, very important. And in those days a lot of rural areas where kerosine was quite easy to transport. And when it burnt, it burnt quite much better than a lot of other oil that were used like whale oil. And whale oil was also very expensive. Not to mention that what we currently see as a horrible dirty oil industry effectively saved the whales, which is very important to point out to a lot of people. So anyway, that was interesting. The other interesting thing with them, before we move on maybe to, if you let me, talk a little bit about Rockefeller and Standard Oil, was that it was the first oil shock, was obviously not in 1973. The first oil shock happened between 1860 and '62. And the oil prices were trading in 1860s around $20 a barrel. It was quite expensive. It was a difficult process. But then as technology improved, there was basically an oil rush. The prices collapsed to about 10 cents a barrel. So that's basically the first oil shock. And it was good for the oil industry because obviously made the kerosene a cheap product. And technology, I think the other important thing is the oil industry basically just borrowed technology from whiskey distillation, including the barrels. The first barrels were whiskey barrels, as we all know. And technology was simple. So in his autobiography, Rockefeller says, and I used that for one of my chapters, basically it was so simple that the butcher, baker and the candle maker were all getting involved into refining. So in 1866, Cleveland has over 50 refineries. I don't even know whether they could count it because all those refineries are very small. And even Rockefeller and Flagler's first refinery was about 500 barrels a day, and it was considered sizable. David: So we've been through a period here where there's a relatively free market where you've got standardisation that's emerged, the first exchanges, and they dominated as the main price setting venues for about 20 years between- Adi: Yeah, a good 20 years. David: The 1870s to the mid 1890s. Now I'm jumping a little bit ahead because I guess the history of oil that you described through your book is, if nothing, not a catalogue of power grabs of governments and individuals and companies seeking to wield control over pricing. And perhaps the first and most audacious happened in January, 1895 when one oil company, you've mentioned their name, Standard Oil, issued a particular notice to the crude producers. Perhaps you can tell us a bit about what was going on there and what was so audacious about it. Adi: By that time, Standard Oil obviously established itself. So let's start from the end. In 1890, I keep saying 19, in 1895 Ceep Agency, which was the sole agent for purchases of crude oil for Standard Oil, basically they bought the company and they served all the interests of Standard Oil. One day came out, it was in January that year, 1895, came out basically and posted a notice on their office saying that from that day, Standard Oil, or Ceep Agency on behalf of Standard Oil, is no longer going to trade or make transactions via the exchanges. And that they would post their own prices rather than use exchange prices. And I obviously have the notice in my book, I'm just paraphrasing it now. Essentially what they're saying, they're saying, we are big enough, we are strong enough, we're essentially a monopoly that we don't have to take your prices and exchange prices, IE, third party independent market prices. We are just going to set the price what we think is the right price. They obviously didn't set them particularly high. And one study that I mentioned in my book basically says, that was by Brown and Pineridge, they say that the prices in that period following that notice might have fallen as much as 40%. David: So it's quite interesting, you described how they just in a sense did what Luther did in Wittenberg in the 16th century and nailed his thesis to the door of a church. And here we've got another momentous moment in history where I suppose a company rather than an individual, has similarly put a post ... I suppose today ... they have to do it at a door there or on a notice board. Today we do it on social media or somewhere else or send an email. But quite a transformational moment for the industry. Adi: It's a huge moment because following the notice, very quickly, all the exchanges folded. Maybe we'll come back to that later on. But Standard Oil was that big and that dominant, controlled at one stage 95% of all the refining in the US. They were so powerful they could do it. And basically they decided to, they became what we call in economics a monopsony. They were the sole buyer, almost the sole buyer. And they're buying at prices they thought were right. But how did they manage to get that is a really interesting story in itself. And I think that's where Flagler is forgotten quite a lot. He was an expert on transportation and railways. And actually, as I said earlier on, he founded the Florida East Coast Railway later on. And had a lot of good contacts. In those days, I mean, there were actually many ways, David, that period reminds me when I read about it, when I researched it, reminded me so much of late nineties here, a period that we've lived through, with the internet companies. And simply legislation was trying to catch up with transformational technologies like the railways. And Flagler and Rockefeller used railways to become a monopoly. And the way they did it was that railways were not properly regulated. The reason was that laws and regulations existed at state levels, but obviously railways crossed them. So it was in many ways, I don't want to go too much into detail, it's in the book with some references as well, but it was a wild west, and you could actually, bigger players could cut deals with railroads. And after agricultural commodities, oil was becoming the most important commodity to be transported. And while some passenger traffic was somehow regulated a little bit, it was this [inaudible 00:21:23] transportation that wasn't. Now from early days, the first thing that Rockefeller and Flagler did were, they had a partnership of course, what they decided, they borrowed a lot of money. So they leveraged, seriously leveraged their positions. And it handsomely paid off. They also invested that money very well, very wisely. They actually bought depots, they bought rail tanks. They invested money into production, refining process. And to this day, Exxon, which is what then was Standard Oil, they boast themselves of their excellence in refining. And they are, from day one, I think Flagler and Rockefeller had some of the best processes, refineries and actually investing money into the efficiency of the whole process. Now, transportation was extremely expensive. In many cases transportation of oil and product, IE, kerosene, was half of overall costs of oil. So they realised that the way to actually be more competitive than the others was to invest a lot of money into railways. But unfortunately, apart from the efficiency, and Rockefeller and Flagler were very, very good managers, as I said, their processes were efficient; and for many reasons, the company would've succeeded anyway because of all that excellence. But Flagler was not a straight player either. He was a poker player with a few cards up his sleeves always. So what he did was he would cut these deals with railways in such a way that they would cripple his competition. And they were doing that quite blatantly. So railways were given discounts, rebates, and drawbacks. Now, the drawback is probably something not many people have heard of. But drawbacks were really, really nasty. Essentially what a drawback is, you sit down with the railway and you say, okay, you give me a discount first relative to my competitor. So I'll pay say a dollar a barrel, and my competitor will pay a £1.50. And I've got the actual numbers in the book, but I'm just now paraphrasing it. Not only that, but I'm so powerful, I'm so important to you that I want 50 cents from what you charge my competitor to give back to me. So those are the drawbacks. So they were basically killing their competition. At the time I mentioned the prices collapsed as well. So what happened was that you had excess capacity in refining. Then they started, then they came up with something which they called Our Plan. And Our Plan was basically to borrow even more money to incorporate the company and then to start buying. But cleverly, they started buying biggest competitors first, like Clark Payne & Company and some others. So very, very quickly due to their efficiency, due to they had their own rail cars, due to these nasty deals with railways, they bought out their competition. And in Cleveland where originally their refinery was, within a period of three months, they bought 22 out of 26 refineries. They basically bought everyone. And the company was so set up, coming back to your point, David, how it reminds us very much of what we have today. At the time, in their heyday, major oil companies have their trading arms, like VPOI or Stuss Co, Shell and so on. Standard Oil had that already a long, long time ago. They had something called National Transit Company. The job of their company was essentially to monitor the market, to do analysis of supply and demand, and then to advise the executive committee which then issued order whether to buy oil or not at the prevailing prices, what price to set and when. So they essentially had a fantastic whole set up as a company. But because of that nasty dealing that they did through the railways and getting rid of a lot of competition, I think that trust, later on they incorporated into a trust, the name trust in the US remains once synonymous with monopoly and abuse of power. David: That's a good place for us to pause and bring the first part of episode one to a close. In the next part, I'll be asking Adi about how the oil trade grew outside the United States as we continue to explore the history of Brent, the world's most important oil price benchmark. Thank you for listening to The Price of Everything, a new podcast from General Index. To continue listening, click on the link in the show notes for part two right now.