From the Archives
NEGATIVE. The word for this week is… NEGATIVE.
Although the first oil well was drilled in 4th century China using bamboo, it wasn’t until 2020 in America that oil prices went negative for the first time on record. In an absolutely wild week in the markets that broke CNBC’s charting system (see above), an oil-price futures contract went below $0 for the first time ever. As the WSJ put it:
“The fall was more severe for the front-month May contract, which made history by plunging into negative territory in the afternoon, a first in oil-futures-market data going back to 1983. It ended the day at minus-$37.63 a barrel, highlighting the dilemma facing energy companies. Producers in some parts of the world have to pay buyers to take oil away or store it.”
Now, whenever I hear or see people say that this is the first time that something has ever happened, my inner historian comes out as I try to find an example to refute this argument. However, I spent a good chunk of time this week trying to find an example of oil prices (or futures contracts in general) going negative, and I found nada. That is not to say an example doesn’t exist, but I couldn’t find one.
All this to say, subscribers to Investor Amnesia know that whenever a historical moment like this occurs in financial markets, this newsletter will provide the historical context. So please enjoy this week’s dive into all things oil markets with a sprinkling of futures contracts stretching back centuries. But first, a book recommendation:
For anyone looking to do some reading on the man most associated with oil (John d. Rockefeller), I’d highly recommend this book.
“The incredible tale of how ambitious oil rivals Marcus Samuel, Jr. and Henri Deterding joined forces to topple the Standard Oil empire.
Marcus Samuel, Jr., is an unorthodox Jewish merchant trader. Henri Deterding is a take-no-prisoners oilman. In 1889, John D. Rockefeller is at the peak of his power. Having annihilated all competition and possessing near-total domination of the market, even the U.S. government is wary of challenging the great “anaconda” of Standard Oil. The Standard never loses—that is until Samuel and Deterding team up to form Royal Dutch Shell.
A riveting account of ambition, oil, and greed, Breaking Rockefeller traces Samuel’s rise from outsider to the heights of the British aristocracy, Deterding’s conquest of America, and the collapse of Rockefeller’s monopoly. The beginning of the twentieth century is a time when vast fortunes were made and lost. Taking readers through the rough and tumble of East London’s streets, the twilight turmoil of czarist Russia, to the halls of the British Parliament, and right down Broadway in New York City, Peter Doran offers a richly detailed, fresh perspective on how Samuel and Deterding beat the world’s richest man at his own game.”
Now for the Sunday Reads!
I am VERY excited to share the 2 hour Real Vision special on financial history that I was asked to host. I had three absolutely fascinating conversations with well-known investors and pundits like Scott Nations, Jim Chanos, and Jim Grant.
While this is only available to Real Vision subscribers, you can get a 30-day trial for $1 and watch the video that way. Now I am obviously biased since I’m involved in the video, but for a 2 hour conversations with these esteemed guests, I think it’s an easy decision to cough up $1 !
“How does the impact of coronavirus compare to financial and economic crashes from the past? In the second episode of “Ahead of the Curve,” Real Vision takes viewers on a journey through the history of financial crises and crashes. History may not repeat itself, but understanding how we got here will help us understand where we are headed.
To that end, Jamie Catherwood of O’Shaughnessy Asset Management speaks to Scott Nations, president of Nationshares and author of “A History of the United States in Five Crashes,” Jim Grant, legendary financial reporter and founder of Grant’s Interest Rate Observer, and Jim Chanos, president of Kynikos Associates, famed fund manager, and master short seller. Nations breaks down the similarities between today and the Panic of 1907 and lessons from his book, Grant explains why the financial panic caused by coronavirus is reminiscent of the Panic of 1825, and Chanos shares his perspective on financial markets during previous crises.”
In a year of crazy oil prices and extreme volatility, it is important to understand the long-term drivers of prices and volatility. By using the longest crude oil price series available (1861 – 2008), the authors of this paper find three periods that include significant changes in the ‘persistence and volatility of price’.
- 1861 – 1878: Extremely high volatility and generally high prices.
- 1878-1972: Much less volatile period in which prices were also generally lower.
- 1972 – 2008 (Date of article): A second period of high volatility accompanied again by higher prices.
As an overarching point, the authors state:
“We argue that historically, the real price of oil has tended to be highly persistent and volatile whenever rapid industrialization in a major world economy coincided with uncertainty regarding access to supply.”
Their full conclusion, however, states:
“We argue in this paper that a long-term view is essential to understanding the dynamic behavior of oil prices. We show that shocks to the oil market have had remarkably different effects on the real price of oil across historical periods, but not because of their origin on the supply or the demand side, rather because of the ability (or lack thereof) of key players in the market to restrict access to supplies. In other words, it is the consequence of demand and supply factors that determines the effects of shocks to the oil market. With effective restrictions on access to excess supplies, growth shocks can generate oil prices that are both highly persistent and, through an endogenous storage response, highly volatile. On the other hand, without these restrictions, the same growth shocks will be quickly accommodated, and will not lead to increased persistence or volatility. In this regard, it is immaterial whether the growth shocks originate on the demand or the supply side.
The literature is focus on the extremely persistent and volatile post-1973 period can therefore be misleading: throughout most of the history of oil, the ability to restrict access to supplies was actually sorely lacking, with the oil market showing remarkable flexibility and relative price stability as a result. This held true even in years when oil supply or demand were experiencing great upheavals, such as during World War II and the postwar re-building of Europe. The history of the oil industry shows that shifts in industry structure can occur quite quickly; the structural breaks in price behavior associated with these shifts are testimony to their importance.”
The political component of oil markets is nothing new. In fact the United States wielded political influence and sought to exert financial pressure through oil during World War II. The below summary of the linked article comes from NBER:
“The United States and Britain imposed oil embargoes of various degrees against Spain for several reasons. Foremost among these was the Allies’ desire that Spain remain neutral throughout the war. They also hoped that sanctions would discourage Spain from allowing German spies to operate in Spain, that Spain would withdraw its “volunteer” troops fighting alongside the Germans on the Eastern front, and that Spanish Dictator Francisco Franco would rein in his nation’s virulently pro-Axis press. Not least, the Allies wanted Spain to halt its exports to Germany of crucial raw materials, particularly tungsten, which was used in armor-piercing shells. The Allies also feared Spain’s re-exporting petroleum products, especially aviation fuel, to the Germans. By analyzing month-by-month and product-by-product shipping records in the Spanish Archives, Caruana and Rockoff track the Allied economic pressures on Spain throughout the war. In doing so, the researchers identify three phases of sanctions. They also determine that the effectiveness of each phase depended largely on the goals of the nations imposing the sanctions and on the degree of accord between those nations.
To begin with, fearful of a pro-Axis Spain possibly capturing Gibraltar and other strategic Mediterranean sites, Britain enacted a program at the outset of the war whereby shippers in every port around the world had to obtain clearance from the British consul for every shipment to Spain. Royal Navy inspectors who maintained a blockade around Spain enforced certification of cargo. The Americans, who at that time were still neutral in the war, protested the British action at first. But the United States eventually began to cooperate with it. With the fall of France in June 1940, the British asked the United States to halt its considerable oil exports to Spain, and the Americans complied.
Spain panicked, the researchers report, fearful for its transportation systems, fishing fleets, and industries. The country had no other access to oil, and appeals to Germany, which was concerned about fueling its war machine and industries, were of no avail. Franco was forced to seek accommodation with the Allies, and in return for an allotment of oil that amounted to about 80 percent of Spain’s consumption before the Spanish Civil War, Franco acceded to the Allied demands for neutrality.
This “First Embargo” held until the latter half of 1941, when Germany invaded Russia and Franco announced that Spanish “volunteers” were to fight alongside German forces. A second phase of sanctions, which the researchers called “the Squeeze,” included a one-third reduction in Spain’s allotment of oil, and American demands that its inspectors be allowed on Spanish soil to monitor the importation and consumption of oil. The Americans also wanted Spain to recall its troops from the Russian front. The British were less enthusiastic about these demands, worried that they might interfere with Britain’s crucial imports of iron ore and potash from Spain. For its part, Spain swallowed the humiliating conditions imposed on it, but delayed withdrawing its troops from the east until October 1943 – and even then did not recall all of them.
In addition, Spain’s press remained avidly pro-Axis, and Spain was allowing straying German planes to land and refuel on its territory, while Allied planes were impounded and their pilots interned. Most importantly, Spain was still supplying tungsten to both the Nazis and to the Allies. As a result, the Allies in January 1944 imposed a “Second Embargo.” This phase, the researchers say, proved the least effective. On the one hand, Spain paid lip service to the demands placed on it – such as withholding tungsten from Germany — but turned a blind eye to the smuggling of the ore to the Nazis. On the other hand, the United States and Britain differed on how hard to press Spain, with the British deeply concerned about its investments in that country and about its post-war trade relations. Churchill and Roosevelt were soon at loggerheads over Spain, and at one point the British even threatened to “go their own way” on the oil issue. Churchill, in a clever turn of phrase, told Roosevelt that the Americans, with their lack of concern about long-term British interests, were acting like “an elephant in the garden.” The Allies made efforts to smooth over their differences, but the Second Embargo, according to Caruana and Rockoff, at best achieved only part of the Allies’ goal.
Based on their study of “the Spanish Experiment,” Caruana and Rockoff conclude that the outcomes of sanctions can be hard to predict, because the factors that influence outcomes are so diverse. The researchers also maintain that, “the choice of goals that can be monitored effectively is an important determinant of whether goals can be achieved.” Finally, Caruana and Rockoff state emphatically: “Cooperation among the countries imposing sanctions is critical for success.”
After everything that’s gone on in this area of markets in 2020, however, this is a good opportunity to review the long-term relationship between oil prices and equities.
‘This paper examines the relationship between US crude oil and stock market prices… [using] a monthly data set from 1859 to 2013. Our sample period begins at the time usually identified as the modern era of the petroleum industry, which links to the drilling of the first oil well in the US at Titusville, Pennsylvania in 1858. The early part of the 20th century saw the major international oil companies capturing control of the pricing of crude oil, This control continued until OPEC established its dominance with the nationalization of domestic oil industries in OPEC countries. That effect control by OPEC saw its initial success in the first oil price shock of 1973. Since then, OPEC’s power waxed and waned over time.’
‘We find that the natural logarithms of SP500 stock market index and the WTI crude oil price series exhibit non-stationary behavior. Moreover, these two series prove co-integrated, leading to our estimation of the MS-VEC model. We find that the high-volatility regime more frequently exists prior to the Great Depression and after the 1973 oil price shock caused by the OPECs. The low-volatility regime occurs more frequently during the period of time from the end of the Great Depression to the first OPEC oil price shock, where the oil markets fell largely under the control of the major international oil companies.’
Although the Chicago Board of Trade was not opened until 18148, the history of derivatives stretches much further back.
“Contracts for future delivery of commodities spread from Mesopotamia to Hellenistic Egypt and the Roman world. After the collapse of the Roman Empire, contracts for future delivery continued to be used in the Byzantine Empire in the eastern Mediterranean and they survived in canon law in western Europe. It is likely that Sephardic Jews carried derivative trading from Mesopotamia to Spain during Roman times and the first millennium AD, and, after being expelled from Spain, to the Low Countries in the sixteenth century. Derivative trading on securities spread from Amsterdam to England and France at the turn of the seventeenth to the eighteenth century, and from France to Germany in the early nineteenth century. Circumstantial evidence indicates that bankers and banks were at the forefront of derivative trading during the eighteenth and nineteenth centuries.”
In fact, there is evidence of a derivative contract involving oil prices existing in 1750 BC:
“A tablet from 1750 BC provided a slave trader with funding and insurance. At the time when the contract was written, he received 204 2/3 qu of oil in the measure of Shamash. In return, he had to deliver healthy slaves from Gutium after one month, with an option of paying 1/3 mina 2/3 shekels of silver instead of delivering slaves.
‘204 2/3 qu of oil in the measure of Shamash, to the value of 1/3 mina 2/3 shekels of silver, as the price for healthy slaves from Gutium, Warad-Marduk son of Ibni-Marduk has received from Utul-Ishtar the troop-commander on the authority of Lu-Ishurra son of Ili-usati. Within one month he shall bring healthy slaves from Gutium. If he does not bring them within one month, Lu-Ish(k)urra son of Ili-usati will repay 1/3 mina 2/3 shekels of silver to the bearer of this tablet. Before (four witnesses whose names are listed). Month Ab, sixth day, year in which King Ammisaduqa, etc.’
“This contract provided the slave trader with capital to procure slaves from Gutium. The option to pay 1/3 mina 2/3 shekels of silver limited his loss if he was not able to buy slaves at a price that made the transaction profitable. It also provided insurance against all other hazards of the slave trade, including the risk that the slaves fell ill, they ran away, etc. The counterparty agreed to this transaction if the price of 1/3 mina 2/3 shekels of silver for 204 2/3 qu of oil exceeded the spot price of oil by an amount that was sufficient to adequately compensate for supplying the initial loan of oil and for the risks inherent in the slave trade. The cuneiform tablet gave the slave trader the option to pay silver to the bearer of the tablet. This suggests that the holder of the tablet could transfer the contract to a third party.”
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