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Are Oil Prices Rigged?

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KAREN BLEIER / AFP / Getty

We've all read that speculators are driving oil prices artificially high — a claim that gets more interesting in light of oil's recent fall below $115. But maybe we're looking at it from the wrong perspective. Suppose that major suppliers in the oil industry are these manipulative speculators.

Is it possible that oil prices are rigged? You bet. Here's how:

Just how would you raise prices if you were an oil supplier? Controlling the supply — as in the 1973 OPEC embargo — has become less effective with more sources of oil worldwide. And oil suppliers clearly cannot raise prices by controlling demand in the physical oil market; ultimately, they need to sell their oil, not buy it. However, with the market inefficiencies that we expose here, oil suppliers can regain the upper hand by artificially inflating demand using a different market. To understand this mechanism, we must take a glimpse into the future — the futures market, that is.

The price of oil reported in the news is actually the price of oil in the futures market. In this market, traders do not exchange physical barrels of oil, but instead trade contracts which obligate them to exchange oil at a quoted price at a specific date in the future, usually months in advance. Such a contract allows companies to hedge positions by locking in prices early. Airlines might buy futures contracts to reduce their exposure to rising fuel prices. Conversely, oil companies might sell futures contracts to assure a profit against future price drops. It's all about reducing risk and uncertainty. But what if oil suppliers were instead buying oil futures, compounding their own risk and reaping enormous profits from the explosion in the price of physical oil?

The futures market has become the public driving force in pricing oil. But the vast majority of oil consumed in the world is purchased through private deals, given the massive undertaking of physically delivering millions of barrels. However, a series of private deals cannot establish a market price. Because pricing in the futures market is transparent, in that trade activity is publicly available, it establishes the widely accepted benchmark for the price of oil. In other words, the futures market serves as the price discovery mechanism for the oil the world consumes.

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