The End of the “Paper Oil” Era
No. 1 2009 January/March

The world community has entered a period that will determine the
future development of the economy and, possibly, the entire
arrangement of the global system. Manifestations of the crisis are
wide-reaching and multifaceted, while the unstable situation makes
forecasting barely possible. Dynamical systems theory experts link
such phenomena to the “points of bifurcation,” at which the smooth
trajectory of development ends and the system’s behavior undergoes
a restructuring, the results of which are hard to predict.

Some weighty disproportions, underestimated interconnections and
risks that were not embraced by an in-depth analysis or were simply
hushed up have come to the surface. The crisis makes it easier to
rethink the situation, as the dominant paradigm, which could
scarcely be called into question in conditions of economic growth,
is getting weaker.

The structure of economic ties that took shape in the past
decades has serious inherent inconsistencies. The widespread
conviction that the expanding global economy is stable by virtue of
its scale and diversification of the participants’ interests is
creaking at the seams. The towering imbalances of world trade and
U.S. deficits aggravate the general situation, but market
participants cannot assess the situation adequately or counteract
to it using the available instruments (hence the abrupt
fluctuations of exchange rates). As a result, market participants
often act relying on feelings (sometimes strange even for
professional market analysts) that easily grow into panic.

This uncertainty has objective reasons, as various sectors of
today’s financial and economic system are interconnected and, more
often than not, the same players drift from one sector to another –
together with their capital. Many macroeconomic indicators have
become unpredictable, aggravating the risks of projects with long
payoff periods. The entire situation forces even long-term
investors to shift the focus onto short-term positions in a bid to
compensate for their losses (real or anticipated).

It is only now that market players are becoming aware of the
scale of the risks, as until very recently risks could be hedged by
a variety of inexpensive tools. Offers of such tools came not only
from private investors but also from the government, as one saw in
the case of real estate market mechanisms. The crisis as such was
largely a result of underrated risks.

Thus, any investor who moves to the short-term market and
becomes a purely financial speculative player there (even including
pension funds) expects to get short-term profits. A market of this
kind generates many financial instruments, but the abundance of
financial instruments does not guarantee large profits anymore, as
the number of players and the resources drawn have grown
several-fold in recent years.

Shares are the simplest of all instruments, and the inflow of
money to that market began to be felt about ten years ago, as a
result of which the stock market started moving in a steady upward
trend. However, its integral growth at rates considerably higher
than those of economic growth could not continue forever. Slow
growth irritated professional market traders, who had become
accustomed to windfall profits.

Naturally, points of growth do exist, but a search for them
entails the difficult task of looking for objects of capital
investment and serious risks. The desire to make life easier first
brought about an influx of investment in hi-tech companies, however
that sector later crashed. Then the sizable growth of the Chinese
and Indian economies bolstered by unbalanced exports of their
products – to the U.S. in the first place – raised the efficiency
of many companies and pushed their stock prices up, but this growth
had petered out by 2006 and 2007 as well, and the oil market turned
out to be a good sector for investment.

Objective uncertainty stemming from insufficient data on proven
reserves in major oil-producing countries – especially in Saudi
Arabia – and a sharp overall decrease in exploring for new deposits
amid a steady demand for oil fueled fears that a shortage of oil
was already possible in the foreseeable future. This facilitated
the rise of a long-term tendency for growth in oil prices and a
steep increase in the activity of financial investors in the oil
exchange instruments sector.

Thus a new bubble – an oil-related one this time – formed. In
the less than two years that preceded the peak of oil prices in the
summer of 2008, the presence of financial investors on the oil
market had grown several-fold and they accounted for 80 percent of
all transactions. These investors did not need oil as a commodity
and did not have it themselves. They carried out transactions with
what is known as “paper oil” – with the aid of exchange instruments
linked to the oil market. Remarkably, claims were made that the
considerable dominance of paper deals over real transactions with
oil was a sign of a mature market and that it provided the
necessary liquidity and an objective price for this commodity.

However, life does not support these theses. In reality, the
market is volatile and this fully conforms to the interests of the
vast majority of players. Moreover, market participants are
interested in keeping this volatility at a high level. (It should
be noted, though, that volatility per se does not guarantee a
victory. A more favorable situation is when the market is moving in
a direction that can be predicted by the market participant.) The
modern information society has mechanisms that allow it to push
masses of players towards supporting a certain trend. The list
includes well-targeted rumors, ignoring some information (“the
market has swallowed it already”) and over-emphasizing other
information, as well as proliferation (usually under the aegis of
respectable institutions – more often than not, financial ones) of
ostensible forecasts, which, in fact, are indicators of the
predominant vector in market development.

If this vector is clear to a majority of players, then the
market is ready to move in this direction and investors are ready
to get revenues from it, even though the movement may overstep the
boundaries of long-term assessments and fundamental indicators.
This is how bubbles are formed.

Assessments of a financial agent’s success are based entirely on
short-term indicators, so the agents assess the items for their
investments against short-term indicators as well. Since the
problem of uncertainty persists, investors have to assume higher
risks camouflaged as market instruments.

The crisis has pushed the risks still higher. Previously there
was an obvious global tendency (“the main line”) suggesting that as
markets grew, consumption also increased. This was bolstered by the
relevant instruments of growth, such as large-scale inexpensive
loans and equally inexpensive insurance schemes.

Yet commercial forecasting becomes impossible when the number of
risks rises above a crucial point. This triggers a sharp decline in
activity and prolongs the crisis. Imagine that acute and
conspicuous elements of the crisis have been eliminated. What is to
be done with the vagueness surrounding the price of credit
resources, exchange rates and, last but not least, the market
demand for commodities? The latter has begun to influence even
traditional mass commodities like oil and gas.

How does one subdue entropy? In the first place, we must analyze
specific markets, mechanisms and interests of the participants, and
if the analysis reveals that a given market does not correspond to
the tasks it is expected to resolve, then we must modernize that

The main criterion of market analysis is the availability of
stabilization mechanisms. If the tasks are long-term, then we must
have mechanisms capable of overcoming the propensity for short-term
deals and short-lived benefits, gregariousness, timidity, and other
deficiencies of existing markets.

Let us look at some concrete examples.


The history of the crude oil market is reviewed in detail in an
array of publications (see, for instance, “Putting a Price on
Energy.” International Pricing Mechanisms for Oil and Gas, 2007).
Market instability and the phenomena pertaining to it have also
been a topic of discussion (Alexander Arbatov, Maria Belova,
Vladimir Feygin. “Russian Hydrocarbons and World Markets.” Russia in
Global Affairs, No. 1, January/March 2006; Vladimir Feygin. “The
Price Swingboard.” Global Energy, October 2008 – Russ. Ed.).

As the oil market began to develop along the liberal model and
saw a sharp inflow of financial players, price establishment turned
into a separate business for the relevant “professionals.” This
business only requires a monetary resource. The commodity is
separate from the business and the people involved can guess the
correlations between supply and demand only through tentative signs
– rumors, expectations, statements – and sometimes by individual
parameters, such as changes in the reserves of oil and petroleum
products in the U.S. The participants are inclined to overstate the
significance of some factors, partially due to scarce information
and partially because they have a material interest in rocking the
market. For the very same reason, they are interested in
coordinating their behavior to a large enough degree and are not
interested in unlimited competition. If the market is rocked by
only one or a few participants, it requires sizable financial costs
and is risky.

The direct involvement of commercial players in this process is
insignificant (at any rate they are almost never present on the
market under their own names). Their efforts were much more
noticeable earlier when the market was smaller. It is well known,
for instance, that British Petroleum was fined for attempts to
manipulate the market.

In the current crisis, the involvement of financial investors on
the oil market is diminishing, but those who have stayed behave in
the same way, or delicately coordinate their efforts. The forms of
coordination may differ, but the essence remains unchanged, since
financial players make profits on it.

Oil is a special commodity. Many other commodities are also
susceptible to price leaps and falls, but oil prices draw much
greater attention and this issue is far more politicized. When
prices were high quite recently, producers of oil and other vital
energy resources would say that their commodities would continue to
become ever more expensive and that it would even be possible to
buy up the economies of developed countries with dollars gained
from oil, gas, steel, etc. They would even claim that world markets
should work according to the rules established by producer

There are a number of opinions out there today claiming that an
oil price of $30 to $40 per barrel is acceptable during the crisis
period and producer countries should not act selfishly, keep their
appetites in check and make sacrifices so that the world economy
get out of this crisis. Yet such prices mean a mortal blow to the
economies of many oil-dependent countries, like Nigeria or
Venezuela. So would it be justifiable to get out of the crisis at
their expense? One of the compromise solutions suggests that
countries should renounce defending extreme positions: claiming
that justice is being established on the international market, and,
adversely, interpreting the essence and results of the existing
balance too broadly. As we have said earlier, modern markets do not
resolve long-term issues. Attempts to create long-term instruments
for oil and gas markets were made in the past when long futures
were considered in this capacity. But neither their reliability –
in essence they prolonged the tendencies that took shape in the
sphere of short-term futures – nor the volumes traded could turn
them into instruments of investment. Another example was the
efforts made in Britain to use futures for the market entry price
at terminals in order to justify investment decisions: in the final
run, the Transco company acknowledged this practice as faulty.

So how is it possible to make up for the shortcomings of the
market that stem from player shortsightedness and interest in
coordinated moves, including those that go beyond the limits of
reasonable price corridors? Using the language offered above, what
are the stabilizers of the market? The answer for today is clear:
as regards the crude oil market, it is OPEC (or possibly OPEC in
cooperation with other producers) that is making efforts – albeit
tough ones – towards harmonizing supply and demand.

Further prospects for normalization involve modification of the
mechanisms of crude oil trading. It is important to return to the
fundamental principle of price formation as a balance of supply and
demand, rather than a balance of market derivatives. This is
possible if more trading floors are opened and producers bring the
amounts of crude subject to sale (for instance, 10 to 15 percent of
their sales over a coordinated period of time). Trading will be
done as a price auction for the real amounts of supplies.

The impossibility of selling the stated quantity of products at
the prices that would satisfy the suppliers will mean the
excessiveness of the amounts offered or of the prices quoted. As in
other places, the sellers and consumers of commodity batches will
have an opportunity to change their offers, tap mutually acceptable
terms of transactions or reject them. Technical issues – and they
are many – can be resolved as well. This practice may lead to a
sharp growth in market transparency and information awareness by
the participants. Naturally it will influence the behavior of
petroleum exchanges that will adjust their role to the new
conditions on their own.

Of course, if producers (with the involvement of consumers and
the minimum possible brokering) assume this approach as a
guideline, problems of a different kind may appear. It is good when
a traded commodity has wide accessibility and is homogeneous, and
market participants abound on both sides. As for oil, its
homogeneity is quite relative (it has several basic brands). But
what about its abundance?

It is obvious that natural factors and the principle of state
sovereignty over natural resources also play a significant role.
When oil prices “went off scale” and OPEC claimed that there was an
abundance of oil on the market, developed countries apportioned all
blame to “resource nationalism.” Their claims suggested that
state-run companies in producer countries are inefficient,
reluctant (or unable) to run a sufficient number of projects, and
thus they create a shortage in oil supply. The producers, on the
contrary, made assurances that they were doing their best to
develop production capacity, including reserves, yet they could not
catch up with growing demand. Remarkably, OPEC again said quite
recently that it is implementing new projects in this crisis amid
rapidly falling oil prices, and that it had set for itself a task
of restoring the required level of reserve capacities.

A few simple questions arise. Do multinational corporations,
which are not run by the state, create sufficient reserve
production capacities? Which factors (except market ones, like the
influence of consumer countries) can stimulate them to expand these
capacities? Why has all the talk about a malicious OPEC died down
now that demand has begun to shrink?

There is another question: Do producers have a duty to fill up
the market with their resources amid such conditions? It appears
that, generally, the answer is no.

And how will the liquidity of the markets be guaranteed? The
answer is in a natural way – that is, by providing sufficient
amounts of the commodity and a sufficient number of trading
participants, along with due observance of the principles of
openness (for commercial participants interested in transactions of
the type that will be effectuated on these floors).

If this is the case, a chance will appear that the volatility of
prices will diminish sharply and stabilize within a fundamental
corridor (the upper limit of which marks the possibility of a
changeover to other energy resources). This will require that
market players understand that they should moderate their behavior
to a certain extent. It will also require their mutual
responsibility for the market’s long-term stability (particularly
in creating reserves and modest expectations of state support for
alternative energy projects – see below for a discussion of this
new sector).

Synchronized steps may be needed to interact in investment
processes, as the shortcomings of the oil market have the largest
noticeable impact on investment decisions – they are likewise a
basis for durable stability in the oil and gas industry.

Governments acting in a reasonable union with private businesses
and using market instruments have a significant role in the
process. This does not imply “socialization,” which has become a
scarecrow thanks to some analysts. Yet if the purely financial
market has failed to create reliable instruments for long-term
projects like nuclear and hydropower plants, it is impossible to
shun the role of the state. That this should not be confined to
government investment only is another story. For instance, it would
be reasonable to issue long-term maturity bonds for private
investors in such projects that would have reliable guarantees,
including the profitability of these projects exceeding that of
secure deposits.


Let us now look at the specificity of the gas market – first of
all in Europe – from the point of view of the problems discussed

The gas industry needs long-term stability to an even greater
extent than the oil industry. Gas projects, including the
construction of appropriate infrastructures, require more capital
investment and have longer payoff periods. It is well known that
these factors contributed to the rise of a system of long-term
agreements on the European market with a sizable (70 to 80 percent)
share of take-or-pay obligations.

Why do the parties to them – suppliers and customers alike –
hold on to them? These agreements provide for the sharing of risks,
although they do not get rid of risks. Each party assumes the risks
it finds easier to assume considering the market situation,
experience, etc. The general principle is that the customer bears
the risks for supply volumes and the seller, for prices.

The customer under a wholesale contract is not the end consumer
of gas – he is an intermediary trader in fact, simultaneously
offering various services. He bears the risks for selling the
amount of gas stated in the contract and at prices specified in

These risks are limited when the market is developing and
consumption is growing. Gas then offers its natural advantages
(obvious for the consumer) and barriers obstruct access to the
market of the given customer (wholesale purchaser) for competitors.
The existing risks take the form of irrational taxation, inadequate
price formation in contracts or the rise of alternative
technologies and energy resources, as a result of which
competitiveness of supplies under an agreement (sometimes signed
for a period of more than twenty years) may change.

The risks get much higher, however, in the course of market
liberalization. These are regulation risks linked with the easing
up of unlimited competition on the purchaser’s traditional market
after it is opened. European gas market reform ideologists suffer
from a double consciousness. Initially, they hoped to get rid of
long-term contracts altogether (because that is how they understood
the goal of market reform – as a liberal competitive market), but
then they had to put up with these contracts and even recognize
their importance.

A need emerged at a new stage of reform (declared in early 2007
but still awaiting final endorsement) to decide on what mechanisms
would provide for the development of infrastructure in a situation
where the transportation and supplies of gas become separated from
each other. This problem still remains.

The proposals being drafted in Europe have been given the
nickname “a gas Gosplan,” an allusion to Soviet-era central
planning. These proposals have actually moved the decision-making
on investments (and this is the most painful problem for the gas
sector due to its high input-intensive nature) to the level of a
bureaucratic structure while leaving the obligations on investment
(and the relevant responsibility) to commercial companies
(operators of the gas distribution system). Meanwhile, long-term
agreements per se can serve as a basis for appropriate decisions
(for more details, see: Vladimir Feygin. “Towards a Global
Gosplan.” Mirovaya Energetika, No. 8 (44), 2007 – Russ. Ed).

Thus we again face the dilemma of choosing between ideal notions
about the market (which in practice result in monsters like the
“gas Gosplan”) or pragmatic decisions in the form of long-term
agreements allowing a successful sharing of risks by the parties
and laying the market groundwork for long-term development.

Do the long-term contracts have shortcomings? Yes, they do. For
instance, they do not take account of the seasonal nature of
production activity in the gas sector and the way prices are
formed. This shortcoming manifests itself especially vividly during
sharp oil price fluctuations, like what happened in the second half
of 2008 when gas became less competitive due to the delayed
factoring of the changes in oil product prices into the price
calculation formula. However, these and other weaknesses are easy
to analyze and correct, and contracts can be more flexible and
diversified as well.

Does the presence of long-term contracts mean that other forms
of contract relations on the natural gas market are not necessary?
It does not, of course. But can Europe do without long-term
contracts in a situation where gas is pumped over thousands of
kilometers and the risks of implementing projects are very high?
While previously theoreticians would try and convince everyone that
this was possible, the new situation on the financial markets makes
a negative answer all too obvious. So would it be more reasonable
to recognize reality instead of harboring a dislike for long-term
contracts and disassembling the structure of this market by
introducing mechanisms that restrict the participation of
suppliers, or promulgating the idea of a “New Energy Policy” (which
we will discuss below)?


Events related to the complex of problems concerning
environmental protection, energy savings and alternative sources of
energy have posed a serious challenge to the stability and
predictability of the energy sector.

Proponents of radical measures drafted demands to developed
countries to reduce greenhouse gas emissions by the middle of this
century. After that, the “horizon” of planning was brought forward
to more practical deadlines. Completion of the tasks was pegged to
2030 and, according to new scenarios, including those drafted by
the International Energy Agency (IEA), the volumes of emissions
must return to the current levels after a certain period of further
growth – resulting, in the first place, from the growth of
economies in developing countries.

These scenarios suggest a giant leap in the field of energy
efficiency; a steep growth in the use of renewable sources of
energy; an increased share of atomic energy; and the broad use of
CCS (pre-combustion carbon capture and storage) technologies, which
the industrial sector still uses on a narrow scale. This means that
by 2030, global consumption of basic hydrocarbon resources – crude
oil, natural gas, and coal – must return to current levels.

When oil prices were high, developed countries were constantly
worried about insufficient investment in the energy sector. It is
appropriate to ask IEA experts now what reaction they expect to
hear from the producers of energy resources or investors if the
forecasts show that the solution to global climate problems can
make the results of investment totally unnecessary already in the

The European Commission issued in mid-November 2008 a voluminous
package of documents on the so-called New Energy Policy (NEP). It
aims to promote practical steps under the previously stated
20-20-20 targets – that is, a 20-percent reduction in greenhouse
emissions, a 20-percent increase in energy efficiency and an equal
simultaneous increase in the share of renewable sources of energy
by 2020. From the very start these elegant objectives were not
propped up by well-calculated measures, which means they remained
political statements of intentions.

The new package of documents on the NEP incorporates – along
with various proposed measures – the results of research on various
scenarios for energy consumption in EU countries, conducted at the
European Commission’s request. Apart from the basic scenario (which
does not bring in the 20-20-20 goals), it also includes an
alternative scenario (that of the NEP) that reaches two out of the
three goals (but predicts an increase in energy efficiency by 13 to
14 percent against the proposed 20 percent). Along with this, total
consumption of energy in the EU is expected to decrease by 2020,
while gas imports will either grow slightly or go down a little
(the calculation is made against 2005).

Europeans aired assurances during the first discussion of the
document held at the EU’s initiative in Moscow last November that
this is not a forecast-type document. This apparently should sound
like a call to stay away from taking its provisions too seriously.
No wonder. Even a superficial analysis of the scenario shows that
the quantities of imported gas featured in it are smaller than the
total amounts of gas put in the agreements with major supplier
countries. This either means that the contracts signed earlier will
not be implemented under certain scenarios or the authors of the
forecast simply did not bother with such “trifles.” The second
option looks more likely.

One way or other, this is the first time ever that a package of
official EU documents has planted a bomb under the basis of
cooperation with energy resource suppliers – first of all with
Russia. Such “scenarios” – to say nothing of possible practical
policies on them – push risks in the energy sector to a markedly
new level.

U.S. President Barack Obama has also said that the development
of alternative energy and new energy technologies are among the
priorities for his administration. One can expect more active steps
by the U.S. in designing collective actions for the post-Kyoto
period. The U.S. Congress is already discussing bills on tougher
measures against greenhouse emissions. But as U.S. energy sector
experts analyze realistic ways to resolve these tasks, they
themselves draw the conclusions that natural gas is destined to
play the main role as an ecologically safe and efficient energy

It appears that an analysis will eventually be needed of why the
conclusions drawn by U.S. and EU experts differ so vastly.

Another dimension of the problem relates to the possibility of
amassed governmental investment in developed countries in
alternative sources of energy, as well as in the energy and
energy-saving technologies in general. The progress of these
technologies, equipment and methods is interesting and important
for all countries. Otherwise, the human race will inevitably run
into a shortage of energy resources or the cost will become
unaffordable. But if the efforts made in order to rapidly break
away from dependence on hydrocarbons entail massive state
subsidizing, producers will have the right to ask questions about
whether this approach frustrates the balance of interests of the
sides and the principles of energy security. An analogy with fair
trade principles, which are coordinated between countries in the
format of the World Trade Organization, naturally comes to mind

* * *

Financial markets will no longer operate as they did before and
it is obvious that a change in the regulatory model is needed. This
will influence the mode of functioning of commodity markets as

If one imagines that the objective reasons behind the current
crisis have been eliminated, the critical mass of risks standing in
the way of a reversion to the trajectory of rapid development
remains the same. There is a need for mechanisms to increase
predictability and reduce the risks that take the form of an
irresponsible inflating of volatility and overblown short-term
interests. They naturally include interstate instruments, the
build-up of public awareness and non-confrontational interaction
among the parties to the process. Stabilization mechanisms can
vary, but the mutual understanding of their acceptability is highly

It is important that state interference be restricted,
especially during the period that follows an acute crisis phase,
and not only in producer countries.

A rejection of coordinated steps is fraught with confrontational
and catastrophic scenarios, such as mass refusals by producers to
supply sufficient volumes of resources to the market when prices
are very low or attempts to prevent such or similar development
scenarios by unconventional methods (such as the use of force) –
unless the elimination of problems and unilateral approaches become
a universal goal.