Brent: Episode 1, Part 2 - 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: Thanks, Neil. I've been speaking with Dr. Adi Imsirovic, author of a new book on oil pricing. If you've not already listened to the first part, probably best to go check that out first. You'll find a link in the show notes. In this second part, we discuss the downfall of Standard Oil in the United States. And how the market swapped one monopoly for a whole series of international oil monopolies, interventionist governments, and pricing cartels. Okay, let's rejoin the conversation. They were growing into a position that, really, the only way for this to be broken up was for the state, for the government, to get involved. And we'll come to that just in a moment. But in parallel to... So whilst Standard Oil was hoovering up all of the markets, the domestic market in the US, around the turn of the 20th century, demand for oil was increasingly now coming from mobility. And we are seeing somewhat of a shift, or the roots of a shift, away from kerosene, with the internal combustion engine requiring fuel. Illumination was instead also being met by electricity. So the supply and demand dynamics, and you said that Standard Oil, or parts of their group, would've been tracking these trends. Well, I assume they would've seen these trends. And there was a tide as well, a growth in the international market, with more competition outside the United States. You described the Nobel Brothers and their work in Russia. So you've got competition and a market emerging outside the US. Whilst at home, they've grown so large that they need to be tamed. Perhaps, talk us through the dissolution of the trust, and what that spawns really, in terms of the legacy of Standard Oil? Adi: Well, typical of politics, to this day, there's so many parallels. And that's why we study history, David, because we can take so many lessons from those days. And based on my book, I've written quite a lot of papers and articles on energy transition in general, and lessons we should learn for general transition. In those days, politicians were late, as usual. By 1877, I think it was, Standard Oil controlled all the refineries in Cleveland, Pittsburgh, New York oil region, about 85% of the market, and later went to 95%. But they were actually dissolved, the trust was dissolved, in 1911, following passing of The Sherman Anti-Trust Act. Standard Oil was so big that it was broken into 30 companies. And some of these are household names, especially for us in the industry. Some of them, I'll just remind you, was Exxon, Mobil. Now, obviously, it's one company, but they were long time separate companies. Chevron, Marathon, Amoco, ARCO, Conoco, and many, many others. So basically, in 1880s, when Standard Oil controlled the US about 90% of all the production, 95% of all the refining, and when it was dissolved, actually it only controlled about 60% of each. Why? Well, all the monopolies crack at some stage because monopolies are associated with very high profits. So, you have new entrants. And you can try and keep entrants for a very long time, like Standard Oil did. But at some stage, you actually have to make some room for others, especially if they're more efficient. And Russia is a very interesting story as well. From 1860s, already, exports are becoming extremely important because everyone else finds that kerosene is quite useful for burning. Especially Europe and the UK was a massive market. So all of this is being sailed in the old sailing wooden ships and it's going in barrels to Europe. But quite early, competition appears in Russia because, as we know to this day, around the Tyumen region, there was oil and still is, of course. The interesting thing, and this is where I'm interested as an economist, is in 1873, Russia actually liberalised the oil industry. Up until then, they were selling it as a monopoly. The tsar was selling it. And what happens then, there's a massive inflow of capital into Russia. And later on, Russia was to become actually the biggest producer in the world as well. But, essentially, the characters that are really interesting are Nobel Brothers, a really, really interesting story. Obviously, we can't go into the details, but Ludwig, especially... Ludwig and Robert, Ludwig was also another genius. He actually constructed their first oil tanker that they used for kerosene. Later on, Marcus Samuel, of Shell fame, copied that, essentially just made it transatlantic. And launched his Murex, but we'll probably come to that point later on. They were investing a lot of money. They were ingenious. And, basically, started producing refining oil in Russia. Became major competitors of Standard Oil very, very quickly. Why? Well, essentially, the other character or the Rothschild family, also got into the oil business. And there was a railway built in 1883 from Batumi to Tbilisi, which is a port on the Black Sea. They basically opened the doors for Russian kerosene to come to Eastern Europe. So, essentially, that kerosene starts displacing Standard Oil kerosene in that part of Europe. And in fact, competition was, obviously, for this reason, because it was closer and it was cheaper. Labour, it was cheaper. Transportation was cheaper. That even Standard Oil agents now started buying this Russian kerosene to supply their own customers, it was like that. Later on, I mentioned Marcus Samuel and his Murex in 1892. He launches that and goes through Suez Canal to Asia. Now, again, another parallel, late '90s, early '00s, they've got Asia as a major growing market. It becomes extremely important. And that's where all the competition is now happening. So the competition, you've got Marcus Samuel and his company. Marcus Samuel, again, another trader, makes a huge impact on the oil market. Another trader was Kessler or Royal Dutch. Royal Dutch was producing their own oil in what today is Indonesia, in Sumatra. And he brings another trader, Henri Deterding, that was actually at the time a Dutch trader in the region. Kessler dies earlier. Now, this is the quick story of Shell. Some people know it very well. But what I wanted to stress is that, first of all, it's interesting that these guys were all traders. The second thing is that there was a massive competition to Standard Oil. And Standard Oil tried to buy Royal Dutch and actually failed. And Marcus Samuel does that deal, but has to basically give control to Royal Dutch. And that split of 60/40 in favour of Royal Dutch was there to stay, with Shell Company, up until very, very recently. Then, also, on top of that, we have new sources of oil, new competition. William Knox D'Arcy is a Brit, who made his money in Australia, basically prospecting for gold. And invests a lot of that money into Persia, gets Persian concession. Later on, in 1909 or '10, production starts there. And then you have new sources in the Gulf of Mexico, California, mid-continent in the United States. And, of course, new companies come in. And, of course, that's where companies like Gulf Oil, Texaco, come from. And later on, they are internal competition to Standard Oil. David: You're starting to talk there about... It's another of the key themes through your book, which is that changing oil flows always impact pricing structures. From 1911, as you say, the Standard Oil trust is dissolved. 1911, of course, we're at the start of the decade of the First World War. You've described some of the early ventures there into the Middle East Gulf. The British government then, in 1913, they take a stake in what is now BP. But in that venture that you described, to try and secure the supply for the Royal Navy. And I know it's an oft-used phrase, but as we go through the war... And war is another key dynamic and a factor influencing trends. But, obviously, you quote that famous phrase, "How the allies floated to victory on a sea of oil." Talk us through now, we're heading now into the 1910s, into the 1920s. The domestic US markets have given way to... Standard Oil's trust's been split up. You've got the various components of it, some of them grow. Yes, they grow into what you describe as an international cartel of oil companies, sometimes with the state as a key or the main shareholder. And these will come to be known as the majors. Talk us through... I'm conscious of time, but in terms of... Talk us through this period now, from roughly the 1920s up to the Second World War. This is a period where the IOCs, the majors, start to dominate and have a real key role over price. Adi: I'm getting conscious of time. I'm just getting a little bit caught into the really niceties of history. There's so many interesting things to talk about as well. David: Well, everyone has to go and buy your book afterwards, that's why. Adi: Absolutely, absolutely. And the thing is, in my book, I'm trying to focus so much on the price and market, and price discovery not so much. Because, obviously, I'm not interested to write another book about the history of the industry. This is a really focused book on the price, and the markets, and development of the markets, plus a lot of economics behind it, as you just mentioned. Monopolies, why they happen, and we discuss that. And flows, and why do benchmarks and prices change? So I'll touch, based on these subjects, through a little bit of history as well. So, of course, one of the key things, when I was teaching energy economics at university, the first thing I would always say is, "The government policy is extremely important." And we can see here in the history of the oil markets as well. First of all, I think it's an interesting snippet that I'd found and discovered... Well, a couple of ones. When we were talking about Russia early on, I just need to mention that I found in one source, that Dmitri Mendeleev, the father of the periodic system of elements, was actually an oil consultant because he was a chemist. He was a chemist, he was consulting. Actually, he went to Philadelphia as well. He went to travel the United States,, and check the refining systems and advised the tsar as well. So that's interesting. The other interesting one was the role of the government, the British Navy. The parliament actually passed the majority ownership in BP, what it is now, that was Anglo-Persian then, two weeks... They were very fortunate timing. Two weeks before Franz Ferdinand got killed here in Sarajevo, where I am right now. So fortunate timing, and the First World War, then, was extremely important. It became obvious that the war was, essentially, totally based on oil. Later on, we'll see in the Second World War as well, becomes even more obvious when [inaudible 00:14:18], essentially, that one of the arguments there is that Hitler just wanted to get close to the oil fields. And the whole war was conducted in that way. But, essentially, we have this post-colonial period that's very important, where the British Foreign Office plays a major role. And together with the Germans, muscles in BP, or Anglo-Persian; Shell; and Deutsche Bank into the Turkish Petroleum Company. And we're talking about Ottoman Empire, which controlled most of the Middle East. And they muscle in, later on, after the war, the German portion, or ownership, goes to France. But this whole thing is about the government's new colonial relationship with the producers. The Turkish sultan basically transfers most of the profitable land into his own account. And there's another whole story of Mr 5%, or an Armenian called Gulbenkian, who was a banker. These are all very interesting stories. But back to our story was that the first Red Line Agreement between the French and the British, the Red Line agreement, was just the first monopoly agreement. It clearly divided the world, gave it on a silver plate to the oil companies, and made sure that they don't compete. It was basically an agreement into which the Americans later on muscle in as well, with the help of the US State Department. So the American companies also get an equal share. It was interesting, also, that in those days, Britain is still a power, but a very weak one, especially coming out of the Second World War. And it was best described, that weakness, in the 1944 Anglo-American Oil Agreement. That agreement was never really ratified by Congress, it was not. But, essentially, it became obvious that that was the first attempt ever to regulate oil globally, between those two powers. But the key in that one, for us here, is that, in that agreement, it granted the open door policy to the Americans. So the American companies could actually come into the Middle East and start exploring. So very soon, we have Bahrain concession being discovered. Oil is discovered by Chevron, again, with the help of State Department. Interesting story as well there was that Texaco comes in because most of that oil is marketed in the East. But there's a lot of competition where Chevron was very weak, so they bring in Texaco. So Texaco and Chevron now have half ownership of that concession. But Texaco gives shares the marketing in Asia with Chevron through new company called Caltex. And that's the origin of, obviously, Caltex in the East. Later on, we have in '38, we discover [inaudible 00:17:41], that's Exxon, big fields in Saudi Arabia, Ghawar, the biggest field in the world. And then, the four big American companies muscle in, Chevron, Texaco, Exxon. Keep saying ExxonMobil because, now, when you say ExxonMobil, because one company now. And those four partners create the Aramco, and that's where Aramco originally comes from. Very often in the industry, you say Aramco partners, that we refer to these four companies. Just to cut the long story short, now, when we have BP, Shell, we have American companies. They essentially work together. Later on, they're called, obviously, Seven Sisters. But the interesting way they do it, there's no, essentially, price. These companies, essentially, together have joint ventures. Their Russian supply, together, they're using a number of rules, which I go into detail in the book. I won't bother you now. But they essentially make sure the market is always well supplied, that no oil goes outside their integrated systems. And they introduce, now, the key to the book is pricing. Pricing was very, very much discriminatory to pricing. It has some interesting historical origin, of course. For a long period of time, US was a major exporter. So, actually, at the time, about 60% of the market was all the US oil. So it was natural that the price would be US based, US Gulf. So it was Gulf price plus pricing. But, of course, during the war, it was the British Auditor General that was going through the accounts. They were buying fuel from BP for British Navy. So here's this British Navy loading fuel oil in AB from the Abadan, from the Abadan Refinery in Persia. And being charged a price in the US Gulf, plus some invisible, non-existing freight from the US Gulf. David: Phantom freight, I think you call it, right? Adi: Exactly, phantom freight. So we have these discriminatory pricing that, over time, had to change. But then, even when they move, they start posting prices in the Persian Gulf. They simply use the prices from US Gulf. Again, they're getting massive profits. Because, on average, at the time, I think production cost in Bahrain was about 15 cents a barrel. And production cost in the US was over a dollar. So, again, it was discriminatory. And it was with Marshall Plan that it all becomes a little bit obvious. Obviously, Marshall Plan is another way to enhance the role of US companies in the Middle East. Britain and France come out weak after the Second World War, but they're held by the Americans. And a lot of oil comes from the Middle East. So it became obvious that pricing has to be tweaked again. Again, I'll cut the long story short, but they set a UK as an equalising point. So you take a US Gulf plus freight, minus freight from the Gulf. And then, after '48, when US actually starts importing oil, again, that point moves to the US Gulf. But, now, becomes to use Gulf minus pricing. So it's a whole mess. The pricing system is broken. Even though these are not market prices, they're just used for tax calculations. And the problems, they try and keep them stable so everyone is happy. And later on, when essentially they realise that they have to drop those prices, then they start tweaking freights, rather than using... I think it was called US Marine Committee or whatever freight rates. They were long-term averages. They use spot rates, because spot rates are lower, to keep the prices stable. And then, when the spot rates change, they don't do anything anyway. They keep prices posted, prices stable. So, anyway, it's a monopoly, total monopoly situation. Prices don't exist. There's no markets. The only price that's there, basically, is the price to use for tax calculations, to pay the taxes to the producing countries. And all is done through something called Pool Association, or As-Is Agreement, that was agreed between three majors, Exxon, BP, and Shell in Achnacarry in Scotland, or As-Is Agreement. And the idea is to pool the resources to minimise the costs. And the companies literally work together very, very closely as a very efficient, excellent monopoly. Again, the Rockefeller price is set by them, or posted, thus like Rockefeller, and that's it. There's no markets. There's no, really, prices to speak of. David: We keep discovering, through your book, no system lasts forever. And as we head now quickly into the second half of the 20th century, what we have... So the majors start to see their position challenged. There are discoveries being made elsewhere, noticeably in Libya. And you describe how over, say, from 1946, when there were, aside from the majors, there were, say, nine independent oil companies. And by 1970, there were 81. So through that, it captures quite nicely the majors' dominance. Their hold on the market was disrupted. And, also, you've got other geopolitical themes through this time as well. The rise of the pushback against the post-colonial communism, the nationalisation and revolution. And it feels like it doesn't do it justice to gloss over this period with some quite broad brush strokes. But we can revisit this at a future date, perhaps. Just describe to us, quite quickly then, in terms of just this sweep? As we're heading now into the 1960s, we see the rise of the Nations-State in the Middle East. And OPEC emerges as a challenger, and as a vehicle for pricing. Adi: Yeah. Very quickly, I think we saw the independent companies, like I mentioned in the United States before, the US National Security Council actually allows oil companies income tax to be credited against the US tax. So, actually, basically, they can just pass on the extra costs. Because of the threat of communism, the governments, especially US and UK, allow the producing countries a lot more leeway in increasing those having higher prices, or actually higher percentage of taxes, coming out of production. Because that's a simpler way, rather than go to the Congress. You just give them high price to the Shah of Iran so he can buy weapons from you and so on. So, basically, that's the other balancing side. So, essentially, we are having these... Most big changes in any energy industry, or in most other industries as well, happen when there is an excess supply. We've had that with gas with LNG just recently, three or four years ago. Basically, you get increase in market participation. We had Great Depression as well, let's not forget that. And after the Great Depression, we have weakness in the market. So now, we have also oil coming from other places, let's not... You mentioned Libya, Algeria, and so on. But you have Russia as well. The production grows a lot, to four million barrels very, very, very quickly. And then, you have a new breed of populous leaders like Gaddafi, [inaudible 00:25:53], NASA, Tariki, and Alfonso within OPEC, and so on. And they are basically pushing for more and more, in a tight market, as the market slowly tightens, they're pushing for more participation. First participation, but essentially, that later on leads, also, to nationalisation of the oil industry. I think what I'm going to do, as I'm going very quickly, I have to mention the key thing for OPEC. And this transition from oil companies to OPEC. That was, in 1958, in Cairo, there is the first Arab Petroleum Congress. It's extremely important. It's important because OPEC, with producing countries, become aware, in various presentations, that actually oil companies are making a lot more money elsewhere. They think they're getting 50/50 tax arrangements, but oil companies are then charging pipelines, that they're making money on the downstream and so on. And the other thing, they have this American advisor called Hendrix, who basically argues that under US, UK, and French law, actually producing countries can change their concessions, if they're not in their best public interest. On the sidelines of that agreement, far more important, is that representatives of Saudi Arabia, Kuwait, Egypt, Syria, Iran, and Venezuela, sit down and talk about the future of the oil industry, as far as producing countries are concerned. And they reach so-called Mahdi Agreement, in which, basically, their agreement has no legal value or anything. But it's extremely important because they express their aspirations that the producing countries need to increase their shares of revenues. They need to support prices because of tax. They need to be consulted before posted prices are changed. They want to get more involved into pipelines and refining because that's where the money is. They need to establish national oil companies. And they need to coordinate these policies. So this Mahdi Agreement becomes, essentially, a roadmap, for decades to come. And OPEC will follow those ideas. So the key for us, me and you, in terms of price and pricing, to get back to the book, pricing structure made no sense. And the problem was that, when the major oil companies, when they had to reduce posted price in a weak market, either they would take a hit themselves and they would pay higher taxes. Or they would just pass it on to the producing countries by reducing those prices. And, of course, they were hugely dependent on that oil revenue. So at one stage, to cut the long story short, after a couple of reductions by BP and, now, Exxon, on September the 14th 1960 in Baghdad, Venezuela; and Saudi Arabia; Iran; Iraq; and Kuwait set up OPEC. That's it. So cutting through the story, I'm making it simple, but the important thing is, first, 10 years of OPEC, OPEC virtually does nothing. They have a lot of aspirations, there's a lot of talking, but they do very, very little. David: And they come into their own really in the 1970s. War, again, is a function of the geopolitics at the time. You have, let see, the Arab-Israeli War in '73, and there's a price war. And, really, almost for the next... From '73 to the mid '80s, the OPEC and the NOCs, they're fighting another transformation in the market, which is the emergence of the spot market. And as we draw things to a close, I wonder if you could just say a few words on that? Because the emergence of the spot market is, obviously, key to the story of Brent and the evolution of that as a price benchmark. Adi: Yeah, absolutely. There's no trading in oil, as I mentioned. Everything is within the integrated systems. And the '70s are the key. We'll also cut through that one as quickly as possible. I think it's important to say that, throughout most of the 1970s, OPEC in, at least my opinion... It's slightly controversial. But it was, in my opinion, it was riding the market, not controlling it. Because, OPEC, they had no way to control the price. You can control the price through quotas, through balancing supply and demand. They were not doing anything. And we saw the demand was increasing, prices were going up. And they were, basically, just increasing those prices. I think the key comes after, by the late '70s, OPEC is, pretty much, by the end of 1970s, OPEC's in charge of their own resources, output, and prices. But they still have no mechanism. Only in '82, OPEC actually starts setting ceilings and quotas. And they don't have a need because their demand is growing so much. And I spent quite a bit of time, I'm not going to do it now, on very, very silly policies of consuming countries, particularly in Europe and the US, with price freezes and so on. Very important for what we are doing now, but maybe in some other talk. What we are doing with gas, a bad idea because demand was increasing significantly. And supply was actually being tailed, especially in the United States. United States stops being any great help in terms of oil supply because their own production is falling. So I think, in terms of emerging of the spot market, what becomes policies of nationalisation, in places like Iran, for example, BP loses their own concession, is forced to go into the open market to find that oil. A number of so-called independent companies are being picked off by people like Gaddafi and an Algerian revolutionary government. They're, basically, being picked off and played one against the other. But those independent companies, partly to do with the US policy of import quotas, they have this stranded oil. And this oil has to find a place somewhere. So, actually, we start seeing the beginning of the spot market. And, of course, after the Iranian revolution '79, what we see actually is emergence from the spot market. And serious spot prices being more or less an indicator of where the posted prices of OPEC should be going. And OPEC is, basically, just following the market, riding it, as I said, rather than setting it up. David: Adi, we could talk for a whole other hour, I think, on this. And I'm sure, I think that means that we have to invite you back, if you're willing, at a later date. But that was a really mammoth effort, a tour de force, taking us through over 100 years of oil pricing history. So thank you very much for joining us. I just want to give a reminder to our listeners that Adi's book, Trading and Price Discovery for Crude Oils, published by Palgrave, is available in all good bookstores and online distributors. To our listeners, if you'd like to engage with anything we've been discussing, you can join in the conversation on Twitter and LinkedIn, by using the hashtag GX Price of Everything, GX Price of Everything. I'll be back next time with more special guests, when our journey through the story of Brent crescendos, and we explore the North Sea discoveries in the 1970s, and the proliferation of trading in London in the '80s. So just leaves me to say, Adi, thank you very much again. It's been a pleasure to have you. And to our listeners, we look forward to having you back next time. But until then, you've been listening to the Price of Everything, a new podcast from General Index. Goodbye.