Sustainable Finance & Energy Security

Phillip Bruner | | November 2012

Issue:Competition over resources

The link between volatility in financial markets and volatility in energy prices is poorly understood. Nevertheless, it is possible to understand certain aspects of the relationship between the two. First, we know that as cheap and easy access to conventional fossil fuel supplies diminishes due to rapidly rising demand in the majority world, the process of extracting resources from remaining reserves (or ‘provinces’) is prone to what the Industry Taskforce on Peak Oil and Energy Security has called ‘peaky behaviour’. The so-called peaky behaviour of lesser-known provinces is erratic and naturally less predictable than the usual behaviour of known provinces. This matters a lot in the case of oil extraction, as price stability in oil markets is predicated on understanding and making informed guesses about the rate at which oil can be brought to market.

As access to predictable supply declines and new sources are sought offshore in the deep seas, among Arctic ice or onshore in untapped kerogen rock, the ability of retailers and speculators to understand the oil market is hindered by an added layer of uncertainty. Experimenting with new methods of extracting oil lacks a historical track record, which normally provides a more stable framework for making sound decisions about supply and demand management – decisions which oil companies, traders and regulators are usually adept at making. Industry professionals must now cope with attempts to acquire a more nuanced understanding of the impact which erratic rates of extraction can have on oil markets. They must also cope indirectly with volatility in consumer demand for oil-based products.

Financing an oil shock?

Volatility in financial markets, due to unsustainable lending practices and the rise in use of exotic trading instruments, affects consumer demand for everyday products, particularly in oil-importing nations such as the United States and Britain. Because oil is the lifeblood of the modern industrial economy on which all businesses in the supply chain depend, when oil prices increase, so too do the prices of mainstay consumer goods. In the West, we are dependent on our thriving oil-driven economies, where the transport of goods and services are very closely linked to oil prices. So when global oil prices rise or fall, foreign and domestic businesses transfer the added costs downstream to consumers who feel the impact. Or, in cases where the added expense cannot be borne by consumers, businesses may either attempt to reduce wages or absorb the price shocks internally, which can lead to downsizing and layoffs. When the prices of consumer goods increase, we also use more of our income to pay for oil-derived products, and as a result our spending on other goods and services declines. This means that demand for many types of non-essential goods and services drops, including holiday travel, dining out, new cars, computers and more expensive homes. These impacts have a compound effect on prospects for a speedy economic recovery, making it more difficult for growth to be restored post-crisis and threatening longer-term stability.

Betting on volatility
It may be a coincidence that at the height of the most recent stock market crash in July 2008, oil prices skyrocketed to $147 dollars per barrel. However, it wouldn’t seem so on the basis of an article in the Guardian published one month earlier, in which billionaire hedge fund manager George Soros , predicted that the price of oil had become a bubble that could trigger a stock market crash. On 3 June, Soros informed the US Senate commerce committee that oil had been ‘pushed to its $135 a barrel mark’ – at that time a record high – by a ‘new wave of speculators’. Soros claimed that the doubling in the price of oil from 2006-08 was partly due to investment institutions, such as pension funds, channelling money into indexes that link to the cost of crude. Soros proceeded to warn the committee that, “there could be very serious consequences for global stock markets if the institutions suddenly began betting on a fall in the oil price.” Finally, he compared the speculative pressures being forced by institutional investors on oil prices in 2008 with the stock market crash of 1987, which was partly caused by a sudden rush of money into portfolio insurance – which institutions used to hedge themselves against a fall in share prices. According to Soros, institutional investors have been engaged in propping up one side of the market so as to give them sufficient weight to unbalance it if so decided. “If the trend were reversed and the institutions as a group headed for the exit as they did in 1987 there would be a crash”, he said.

A more recent example of energy market manipulation on a regional scale is that of Barclays’ involvement in manipulating California power markets. The U.S. Federal Energy Regulatory Commission has recently proposed a total $470 million fine on Barclays for its actions – the largest ever by the agency – revealed partly on the basis of communications by four traders at Barclays’ West Coast power desk. The trading activity allegedly took place over two years from late 2006, in which the team exchanged messages explaining how they would ‘crap on’ prices in one market in order to profit in another. The traders stand accused of having wilfully manipulated energy prices, i.e. ‘driving up or down physical power prices to make money with their financial swap positions’. Their actions, if proven true, may have resulted in losses for other traders amounting to $139 million, netting Barclays gains upwards of $34.9 million.

Unsustainable finance and the threat to energy security?
The critical importance of predictable access to reliable energy supplies to meet electricity and fuel demand have been well documented in previous articles published by contributors. Economic recession, while potentially offsetting oil demand, could stand to make diminishing supplies last longer, buying time for other alternative clean energy sources to comprise a wider portion of overall generation. But economic recession also has another more subtle impact on energy production – it rattles investor confidence in innovative technologies that might otherwise stand to make oil-dependent economies more energy secure. Currently, a hot debate is raging in the UK and US on the future of conventional oil and gas, as well as nuclear energy, in curbing global demand for fossil fuels. This added uncertainty deters renewable energy investments while forecasts for economic recovery remain dismal. General volatility in financial markets, fuelled by irresponsible lending and trading practices, has an effect on oil prices as well, which further stifles economic growth. While the complexity of global markets demands wider investigation into the causes and effects of finance in relation to oil prices, evidence of market manipulation is unsettling. A sustainable and secure future, where a wider energy mix has been developed to meet rising demand, will no doubt require a more sustainable financial system which can service the real needs of citizens.

Phillip Bruner is Founder of the Green Investment Forum and a guest lecturer in global political economy at the University of Edinburgh

Image source: Heatingoil


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