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February 28, 2006

Is the IOB DOA?


The Iranian oil bourse: theory and reality

by Ann Berg

If you're waiting for the Iranian oil bourse (IOB) the proposed euro-based petroleum futures exchange in Tehran to overthrow the global dollar-based economy, don't hold your breath. Establishing a futures-trading mechanism to compete with the powerhouses of the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE) for the oil trade is as probable as U.S. energy independence in our lifetime.

Futures exchanges were created to allow buyers and sellers of particular goods to transfer forward price risks. That remains their function today. Think of a futures contract as a proxy, similar in function to a coin it is something you hold until you can exchange it for the "real good" at a future time.

Futures contracts standardized agreements between buyers and sellers are not stocks or bonds. Stocks and bonds are issued by corporations, governments, or other entities to secure financing. Investors usually buy them from broker/dealers blessed by the Securities and Exchange Commission, an agent of the federal government.

Why does this matter? Stock exchanges do not create and guarantee the products they trade. Futures exchanges do.

Creating futures contracts is a tall order. Minimal conditions for contract success include a liquid underlying market, minimal state intervention, enforceable property rights, and a framework for dispute settlement. Balancing the advantages between long and short is critical to design.

So imagine the IOB creating a futures contract settled by actual physical delivery (like the NYMEX contract) and answer this: would a Persian Gulf contract favor the long futures holder (such as China, the second largest oil importer in the world) or the short seller and deliverer (in this case, the Iranian government)?

And what if there were a repeat voluntary or involuntary of the 1973 oil embargo?

In such a case, not only would China's long oil contracts become worthless, but reduced Iranian supply would likely double the cost of obtaining the physical oil on the open market.

In addition, China would have the headache of figuring out what to do with a $40,000 per day tanker in the straits of Hormuz. Triple whammy.

Can't happen? Oil futures did not exist until 1983, so they have not experienced a jarring event like a major embargo. But this is exactly what did happen in the grain markets when Jimmy Carter declared a grain embargo on the Soviets in 1980. Grain companies that had hedged large grain sales to the USSR were left holding the bag on long positions in futures, physicals, and ocean freight.

The IOB could, of course, design its contracts to be cash settled like the Brent Crude oil contract traded on the ICE. But who would dictate and manage the settlement price except a committee of Iranian government officials? Who would arbitrate disputes over settlement prices?

The clearing house for any exchange guarantees its financial integrity. The clearing house safeguards against default among its various clearing members by collecting (and remitting) deposits in accordance with contract settlement prices and members' net long and short positions. It also has the power to demand additional funds, order liquidation, transfer positions, and suspend trading.

The clearing house, however, is funded by its members, which are mutually at risk in case of default. To date, the IOB is mum about capital requirements of clearing membership. Its clearing operation, described by one of its creators, former IPE director Chris Cook, as "a new partnership-based synthesis of bilateral trading between users combined with a collective guarantee," sounds as if the traders are not responsible for coming up with the dough in case of default some other "risk/treasury partner" is.

How many oil traders are going to feel confident trading an untested oil contract through an untried clearing mechanism?

When Turkey established its futures exchange (TURKDEX) last year, it had the wisdom to choose an SEC and UK capital-markets-approved intermediary, Takasbank, to operate its clearing function, and it required all members make adequate capital contributions to its guaranty fund.

Most writers enthusing about the potential of the IOB are underestimating the enormous challenge of creating a functioning futures exchange with international participation. And even if the embargo scenario is of low probability, it is unclear how the IOB would prevent the appearance of market manipulation when the state controls the production and distribution of the product.

The ultimate question is, who's going to take the other side of the trade some speculator in Peoria?

(Of course, that's not possible, since the U.S. prohibits trade and investment with Iran.)

Bottom line: if a euro-based oil futures market succeeds, it will happen at the established exchanges that already have deep liquidity and a large customer base. The oil trade in futures and physicals may indeed one day switch to the euro because of growing fault lines in the dollar, but not because of the creation of an Iranian oil bourse.

 

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Ann Berg has spent a 30-year career in commodities and capital markets as a trader, consultant, and writer. While a commodity futures trader and Director of the Chicago Board of Trade, she advised foreign governments, NGOs (the United Nations, World Bank), think tanks (Catalyst Institute), and multinational and foreign corporations on a variety market-related issues. She was also a frequent conference speaker at international derivatives markets forums. In recent years, she has contributed articles to several commodities/capital markets publications, including Futures Magazine, Traders Source, Financial Exchange, and the Financial Times editorial page. Berg is also an artist. She is currently working on a body of work entitled The Unknown Unknowns – The Things You Don’t Know You Don’t Know, which explores U.S. national security policy.

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