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But what is the alternative? Price dollars in oil, not oil in dollars! by Chris Cook


Friday, July 08, 2005

Former International Petroleum Exchange director, Chris Cook writes: A very strong case has been made by William Engdahl (the author of A Century of War – Anglo-American Politics and the New World Order) that the three principal goals of US foreign policy in the last 100 years have been energy security, energy security and energy security.

But it is becoming clear that the Iraq war — while aimed at reducing US reliance upon Saudi oil — may have unintended consequences in terms of changing the dynamics of the oil market generally and the Organization of the Petroleum Exporting Countries (OPEC) in particular.

When it is considered that the US, with 5% of the global population consumes 25% of global energy supplies, we see the sheer impossibility for China or India to begin to approach US levels of consumption within the existing global political and financial market settlement that has been maintained since Bretton Woods in 1944.

But what is the alternative?

The pricing of oil

There has been a growing realization on the part of major oil producers such as Iran and Saudi Arabia that oil is not priced in dollars but rather dollars are priced in oil. The reality underpinning this epiphany is the fact that oil has “value”, or “money’s worth” — in exchange for commodities, goods and services — whereas the financial object we are accustomed to think of as the “dollar” is merely a “claim over value,” or IOU issued by the US Federal Reserve Bank.

If we look at the current structure of the global energy market, we are conditioned to think that the “big bad wolf” is a “cartel” of OPEC members. However, the fact of the matter is that while there has indeed been a cartel extracting extraordinary profits from energy markets in recent years, this has consisted of intermediary investment banks and energy traders, who control the global market platform on which oil is traded and benchmark prices are set. In other words, the derivative tail has been wagging the oil market dog.

This is set to get worse, to the extent that a major trading disaster is only a matter of time – possibly as soon as this winter, if Goldman Sachs’ prognosis of a “super-spikes” to $100/barrel oil is realized. The reason for this is the fact that investment banks and oil companies have themselves now lost control of the price-setting process to a wall of hedge fund money under the control of star traders attracted by rewards beyond the dreams of avarice – as opposed to the pittance they were receiving with their former employers.

Hedge funds — as the Long Term Capital Management meltdown showed us in 1998 — are almost entirely unregulated, since there is no regulatory body with access to data in relation to their transactions (particularly “off-exchange”) or with the capability to take enforcement action over the offshore entities typically used by hedge funds.

Due to the lack of transparency in “off-exchange” trading, oil producers and consumers do not even know that they are losing — a phenomenon which J K Galbraith memorably described as the “bezzle.” However, while oil producers and consumers have now woken up to the bezzle, the problem they have is what to do about it. It has long been clear that a Middle Eastern benchmark oil price is a key part of the solution, and the creation and domination of such a benchmark has been the Holy Grail for the International Petroleum Exchange and New York Mercantile Exchange for some 15 years.

Whatever the benchmark and market mechanism, there are two functions which are generic to all markets: money, capital, commodities, energy, whatever. First, there is a requirement for a legally binding contract — “transaction registration”; second, there is the function of transfer of title against payment. Together these are thought of as “clearing and settlement”. These two functions constitute a natural monopoly and should therefore only take place in the context of an “enterprise model” (legal and financial structure) which is neutral both in terms of participation and absence of outside investors.

The requirement is therefore for an “Energy Clearing Union” comprising all market participant constituencies — whether producers, consumers or intermediaries — constituted as an “International Energy Trade Association” (”IETA”) and served by a consortium of providers of services such as communications, technology, risk management and so on. Such an IETA would not only have access to trading data both on and off-exchange but would also be in a position to impose standards of probity and market behavior with the threat of sanctions such as suspension — temporary or permanent — of the right to register transactions.

Bilateral transactions between IETA members would be subject to mutual guarantee, backed by suitable deposit or margin arrangements and/or a default fund. A risk management partner – rather than a central counterparty “Clearing House” – would manage the system and the risk. The outcome is a “Clearing Union” or “Guarantee Society”, as recently adopted by the Scottish Liberal Democrats as part of their policy to stimulate small and medium-size enterprises. Such a Clearing Union would be operated by a neutral consortium of service providers within a true partnership arrangement, with funding provided by the stakeholders themselves without recourse to outside investors. The Clearing Union concept is not a new idea within the oil market — at least one OPEC member has been advocating an OPEC Clearing Bank and associated investment institution for almost 20 years.

A rational energy policy

It was instructive to hear the response at an industry event last June of both a panel of senior energy traders and their audience when asked for an assessment of the likely success of emissions trading. “Slim to zero” was the consensus of both, and even more telling was the analogy from the floor: “If you want to keep a donkey healthy you don’t take care of what comes out of it, you take care of what goes in.”

We do not have to look beyond the structure of the limited liability company to realize what the problem is with emissions trading. It is not necessary to make any ethical or moral judgment with respect to “the Corporation”, merely to observe that the managers of GasCo Inc or Oilco Plc are likely to be held to account by their shareholders if they fail to minimize costs and maximize shareholder value.

A levy on non-renewable energy would affect the costs of global intermediaries in a way that they would find more difficult to pass on and is therefore not in the interest of investors. This “externalization” of costs is the reason why the more canny oil companies and conglomerates have been assiduously promoting and lobbying for the emissions trading concept. The embarrassing fact is that if emissions trading could actually work, energy intermediaries would not support it.

An “Energy Clearing Union,” on the other hand, while not necessarily in the interests of investors is certainly in the interests of the planet. In particular, it could form the cornerstone of a rational global energy policy as an alternative to fundamentally unworkable emissions trading schemes. Since all energy transactions would be registered, it would be easy to apply a suitable levy that could then form the basis of an “Energy Investment Fund” that would fund investment in:

Existing and future non-renewable infrastructure, to ensure the most efficient possible utilization of these finite resources

Renewable energy

Energy-efficient and eco-friendly housing and infrastructure

IETA would increase the oil price with a levy of (say) $20/barrel above the market clearing level, and with the excess, acquire and develop the capital assets of all existing oil intermediaries while utilizing their expertise as development partners with incentives made up of a share in any gains in energy efficiency for which they are responsible.

A money based upon value

While an “Energy Clearing Union” provides the means for a rational energy policy, it still treats the symptom rather than the disease. In order to address the real problem, we need to re-examine the monetary unit itself. It is possible to conceive of a global “petro-dollar” — based upon a set amount of energy — which would be capable of fulfilling a role as a genuine alternative to the dollar as a global means of exchange.

J M Keynes put forward at Bretton Woods 60 years ago an “International Clearing Union” coupled with a new monetary unit he called the “Bancor”. Unfortunately, what we got is a “central bank-centric” monetary system configured around the World Bank/IMF and the Bank of International Settlements where the monetary units we use are essentially debts created by central banks and issued into circulation by banks as loans.

We take for granted that we need banks to create credit but perhaps do not realize that this bank-created credit constitutes the bulk of our money supply. The effect of a monetary unit created as a debt is that — to take the UK as an example — more than 97% of all money in circulation has come into existence through the creation of loans (two-thirds of them in respect of mortgage loans secured against property) by “credit institutions” such as banks and building societies.

However, when credit institutions create money through a loan, they do not create the money necessary to repay the interest on that loan. So the simple and inexorable mathematics of compound interest on the loans backing our money drives the unsustainable imperative for economic growth at the heart of our malaise. We also take for granted that banks are entitled to charge interest on the credit they create. A new website,  which links would-be borrowers together with would-be lenders essentially on a peer-to-peer basis, does for banks what Napster did for the music industry — it dis-intermediates them. But the Guarantee Society or Clearing Union goes further than this: credit is granted bilaterally and interest-free, and the only costs to the system user are the administration/accounting costs and a share of any defaults. Furthermore, there is no reason why transactions in a “Clearing Union” need be settled in central bank-issued money, since users may quite simply agree that they will accept “money’s worth” in (say) energy or commodities instead by reference to a value unit.

While banks, credit unions or ratings agencies may be the managers of the system and credit creation in this model, banks would no longer be able to charge us for their use of our credit. Some commentators, notably Susan George and George Monbiot, are advocates of an “International Clearing Union” as a solution. However, while an “International Clearing Union” is undoubtedly capable of being part of the solution, it is also necessary to address the nature of the monetary unit itself so that we may achieve a global monetary unit based upon “value” — such as an absolute amount of energy — rather than its antithesis — the Fed-issued Dollar.

An International Energy Clearing Union could provide a platform both for a new and rational energy policy and — in conjunction with new energy investment institutions — for a global monetary system based upon value rather than the US dollar. This would literally “reverse the polarity” of money to base it upon value, rather than upon a claim over value created by a bank out of thin air.

The existing system is approaching a crisis point, and a new alternative is emerging. A revolution is approaching — albeit a silent one — and when it is over we will wonder how it could ever have been otherwise.

A former director of the International Petroleum Exchange, Chris Cook is now a strategic market consultant, entrepreneur and commentator. You may email him at

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