Oil at US$100: The Great Price Fix

Oil at US$100: The Great Price Fix

If you walked into a home appliance store in 1950s America, it was guaranteed you’d walk out ripped off.

That’s because two giant manufacturers, General Electric and Westinghouse, effectively ran a cartel at the time.

For years, they conspired in secrecy, fixing the price of electrical parts in appliances to boost profit margins.

It took a long time for authorities to work out what was happening. In fact, they only stumbled on it by sheer accident.

What they found was one of the most bizarre stories of collusion you’re ever likely to come across.

It has stark parallels with what’s happening today in one of the most important sectors for global trade.

And it gives you a big clue as to where the money should flow over the next few years too.

Read on for the full story…

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The Tennessee Valley Authority (TVA) is a regional economic development agency operating in south-eastern United States.

The GE-Westinghouse conspiracy first began to unravel in 1959 when the TVA requested bids on a hydroelectric turbine generator.

Among a host of other bidders, GE and Westinghouse submitted near identical bids of $17.5 million.

They both lost out. The winning bid instead came from a British firm, which had submitted an offer of $12 million.

Incensed, GE and Westinghouse accused the TVA of endangering national security by selling to a foreign buyer.

The TVA issued a response claiming that prices for parts had risen more than 50% over the previous seven years. The average wholesale price of commodities had only increased 5%.

The price discrepancy and clash between the TVA and manufacturers aroused the curiosity of a Tennessee senator.

When authorities launched an official investigation, they sifted through the TVA’s internal financial records. And they happened upon a strange anomaly.

They noticed that up to 30 manufacturers had submitted the exact same bids for tenders. This was odd. The only way two companies are likely to make the same bid is if both of them know what the other is bidding.

And that’s precisely what was happening.

How not to price fix

As it turns out, company executives from across the industry would meet at restaurants or golf courses.

Once there, they’d decide on a winning bid. They’d then arrange a separate set of identical losing bids.

How did they decide who got to win the bid?

Companies basically stood in line and took turns at ‘winning’ business on a rotational basis.

They did this — if you can believe it — by tracking the phases of the moon. While they may have been strong believers in the powers of cosmology, we suspect they were probably just taking the mickey.

Few people were laughing when the scam was exposed.

They fleeced taxpayers out of US$1.4 trillion in today’s money.

Rightfully, the law doled out harsh punishments for those involved. Some 50 executives were ordered to pay massive fines, with nine GE and Westinghouse directors serving jail-time.

So, what did big business take away from this lesson in high-level collusion?

We suspect you already know the answer to that.

Institutionalising price fixing

Price fixing has come a long way since the 1950s.

In some industries, it’s become practically institutionalised.

There is perhaps no better example of this than the oil industry.

OPEC, as you’ll know, controls the bulk of the oil market, accounting for 60% of all traded oil.

Having control over a key commodity in any supply chain, as Westinghouse and GE illustrated, makes manipulating prices much easier.

OPEC does this chiefly by agreeing to set supply targets.

Saudi Arabia, its de facto leader, has a lot of influence in directing production policy. It controls the largest share of global oil supplies.

The Saudis are also preparing to launch what could be the biggest IPO in history. Saudi Aramco, the country’s giant state-owned oil firm, is expected to list sometime this year or next. Most likely it will be 2019.

Before it does, Saudi officials hope that the price of oil is at a certain (high) level. That’s because Aramco’s success in the market will in part depend on the oil price itself.

The Saudis can rely on both supply- and demand-side economics to push prices higher. Global demand for oil remains strong. Emerging market economies are driving this. And OPEC can keep cutting supply put even more pressure on prices.

According to Reuters, the Saudis are aiming for oil at $US100 a barrel in lead up to the IPO. That’s US$30 higher than current levels, with prices hovering around US$70 a barrel.

But higher oil prices won’t be the only factor at play in Aramco’s IPO success. Its balance sheet and oil reserve base will be just as important.

On that front, Aramco has few peers in the profitability stakes.

As you can see in the chart below, the company made a staggering $34 billion profit in the first half of 2017.

Source: Bloomberg

As for the reserve base, things are looking good there too.

Reuters reports that an independent audit of the company put its oil reserves at 270 billion barrels.

That surprised some observers, as Aramco had reported unchanged reserves of 261 billion barrel for three decades — despite being one of the most active oil producers in the world.

So Aramco is sitting on ample reserves. It has little debt. It operates at low production costs. And it’s one the most profitable companies in the world.

All in all, things look bullish for Aramco ahead of its IPO.

But it’s investors who should be most excited.

Assuming the Saudi’s achieve their desired US$100 a barrel target, there’s scope for oil prices to rise by 40% between now and the IPO.

For that reason, there’s no better time to be scoping out the energy market for the best oil explorers and producers on the ASX.

The market is gearing up for a major move higher.

The time to position yourself is now.

Until next week.


Jim Rickards Signature

Mat Spasic,
For The Daily Reckoning Australia