Friday, January 04, 2008

Speculating on Oil Prices

The front-month benchmark light, sweet crude oil contract on the New York Mercantile Exchange (NYMEX) hit a record intraday high of $99.29 on November 21. As we started the year 2008 the expected has happened and the prices passed the magic three digit 100 dollar.

Many factors have been proposed to explain why oil prices have risen ten fold since the slump following the Asian crisis a decade ago. The widely quoted suspects are oil market fundamentals and speculators.

According to the oil market fundamentalists, the prices reflect the state of the market fundamentals (supply, demand and inventory levels). To them, factors such as eroding spare production capacity, refining bottlenecks, natural disasters, strikes, terrorist attacks, limited access to reserves, wrong timing of filling up the US strategic petroleum reserves, invasion of Iraq, instability in Nigeria, tensions over Iran, political crises in Venezuela, etc prevented supply from keeping up with the world’s ever increasing oil thirst.

Meanwhile, most producers were already producing near capacity for the first time in nearly 25 years to absorb the unexpected demand shock. Thus, the market has become very tight. Consequently, we have ended up with the current oil price dynamics, characterized by excessively high volatility and strong upward drift.

This may help explain part of the increase in the prices, but will not suffice to answer, for example, why prices have increased about 60 percent in the past 6 months. There were no significant changes in the market fundamentals in that period.

The oil market fundamentals are dead…long live the fundamentals

The market fundamentals become all silent when it comes to explain what has driven oil prices fall from $99.29 to below $90 a barrel despite an explosion and fire on a pipeline sending Canadian oil to the US Midwest refineries which cut US crude imports by 20 percent, despite an unusually large amount of drop in the US crude inventories ahead of the peak winter season, despite steep decline in imports notably on the Gulf Coast, despite more than 400 thousand barrels per day of shut in Abu Dhabi production for field maintenance, and despite no production increase decision on December 5 OPEC meeting. There are too many similar instances like that in the recent past which cannot be called exceptions. The reality does not fit the economic theory any more.

Instead of admitting that current crude oil prices are not justified anymore by the market fundamentals alone, the analysts start to look for other scapegoats. For example, when oil hit $85 on October 15, one of the frequently cited main culprit was Turkey-PKK tensions and fears of a Turkish military intervention in northern Iraq.

Moreover, every time when market fundamentals are not convincing, Energy Information Administration of the US Department of Energy and the International Energy Agency become more paranoid about supply and repeat their call on OPEC to increase its production and spare capacity. The facts, however, contradict with their claim. Most of the time in the past five years while global demand for oil has been increasing global oil supplies have increased by an even greater amount in absolute terms; global inventories have increased its record levels; and refineries have been working near full capacity. How would that be possible if there were crude oil shortage? Why the just-in-time style inventory management approach would end up with more inventories than five-year average?

When OPEC increased oil production the market fundamentalists this time argued that it is heavier and sour crude, which is not a remedy to bring down the price of light, sweet crude. Why should OPEC invest billions of dollars to create extra capacity in addition to their over 3 million barrels per day already idle, anyway? Instead, OPEC tries to send (often mixed) signals to futures market (by announcing production targets or by media appearances) in an attempt to change the course of direction. But the increase in the frequency of OPEC meetings, quota adjustments, and announcements has made speculative activity even more agile. What OPEC could do in order to get out of the blame game is to suspend production limits, to which its members do not obey anyway. In fact, OPEC better think of how to overcome the eroding export revenues because of falling dollar and work how to free oil prices and their currencies from the dollar, rather than focusing on how to feed immoral consumer insanity.

Speculators have fallen in love with oil

In reality, the price of oil is set by traders’ assessment of current and future factors that affect supply and demand of, not physical barrels, but paper barrels trading on the very liquid oil futures exchanges, mainly in New York and London, as well as off-exchange in exempt commercial and Over-the-Counter (OTC) markets offering the world’s leading oil benchmarks.

There are two types of players in the world paper oil market: Commercials and non-commercials. Commercial players are companies active in the business of producing or using crude oil (ie, active in cash market). They trade in futures contracts to offset or hedge the risks they face from price changes in the physical market. Non-commercial players (also called speculators) are financial institutions and trading companies. However, the distinction between commercial and non-commercial transactions is not clear anymore due to increasingly complex financial arrangements devised by hedge funds and other speculators to avoid public disclosures.

In practice, very insignificant number of contracts on NYMEX and InterContinentalExchange (ICE) result in physical delivery. Instead contracts are liquidated with offsets. Therefore the role of futures market as a hedging mechanism indeed is not correct. And yet, oil has become such a good business that even some financial players involved in oil trading got into the physical oil storage business. This means that they (for instance, Morgan Stanley and Goldman Sachs) not only invest on paper barrels but also in physical barrels.

Trading in paper barrels has grown significantly since 2000. At the ICE, average number of contracts traded daily (futures and options) increased from 50 thousand in 2000 to 285 thousand in 2007. Trading in NYMEX is more pronounced, average daily contracts traded increased from 158 thousand in 2000 to nearly 500 thousand in 2007. This means nearly 800 million barrels per day (a contract corresponds to 1000 barrels) of oil is traded in two futures exchanges. Note that average daily global production in 2007 is only 86 million barrels.

However, this picture is not complete. In the past few years, large financial institutions, hedge funds, pension funds, and other investment funds have been pouring billions of dollars into the unregulated over-the-counter market electronic markets. How many contracts are traded there? Nobody knows!

What we know more or less is that according to the Bank for International Settlements, the notional outstanding value of all types of OTC derivatives contracts exceeded $500 trillion at the end of June 2007, ten times more than that of in 1996. And cost of replacing all open OTC contracts at the prevailing market prices (gross market value) was over $10 trillion at end June 2007. Unfortunately it is not possible to know the share of oil in that total.

Oil prices have become hostages of speculation

In the past, big consumers and producers were affecting the price behavior. Today, through their money game well-capitalized speculators mostly drive prices away from fundamentals, which have become disconnected from fundamentals. Thanks to the invisible hand of casino capitalism and globalization, trillions of speculative dollars change hand each day worldwide, looking for lucrative returns in the world markets. Many heavy speculators have considered oil market as a haven, especially after the turmoil in credit markets. This influx of large speculative trading injects volatility into global markets. Since speculators make money by betting on prices they love volatility.

Consequently, current and future fears, concern, worries and perceived risks on nearly everything which has a slight link to oil have become the main drivers of market sentiments. By playing up many of those psychological factors (especially by mispresenting peak oil phenomenon as if it means running out of oil) the mainstream media meanwhile have helped creating the risk premium. If speculators want to take the prices higher, the least they can do is to exaggerate any situation so that risk premium increases. Keep in mind that bad news are quickly reflected in price, especially in the short term. Therefore, any rumor, gossip, breaking news headline and announcement contribute to the tension in the market. Under such conditions, what John Maynard Keynes’ term called "the animal spirit" for market sentiment takes the stage and trade becomes much more news headlines driven.

Speculators are part of the chain, not the anchor

Expectations and theory have repeatedly failed to align with the reality. It is mainly because besides oil market fundamentals, the oil prices are driven by a set of stochastic processes including the circumstances specific to the US market, expansionary monetary policies, the dollar depreciation, global financial liquidity and geopolitical developments. Therefore it is not the data on fundamentals, which are pathetically poor, but the perceptions of dominant players on the market that set the oil prices and their likely direction.

Due mainly to their flawed reasonings and disputed assumptions, almost all forecasts by reputable agencies were proven to be wrong in the past years mainly. They were focusing solely on the market fundamentals but were overconfident on supply growth but over pessimistic on the effect on growth. Besides, they failed to see the effect of dollar devaluation (as the dollar is loosing its status as the preeminent international currency); they oversaw the fact that demand has become more price inelastic; they overlooked the impact of exchange rates; and they ignored the effect of monetary and fiscal policies. Not surprisingly, today oil market behaves irrationally and dominant players take advantage of it.

What next?

We are witnessing a structural shift in the pricing of oil thanks partly to relatively soft market fundamentals. It is not easy to guesstimate the ceiling but costs to maintain long term conventional and unconventional global oil production capacity (especially in OECD countries) will hint the floor on oil prices. Replacing conventional oil with costlier substitutes will not be a remedy.

In a decade time, even if a major global economic meltdown takes place (which is highly likely, deep but maybe relatively short lasting) both peak oil will hit and many oil producing nations will have to reduce exports to supply their rapidly growing domestic consumption. End result: oil prices in the long term will be determined only in three digits.

Until then many factors in international financial markets including whether hot money will continue to be accumulated in the oil market will continue to influence the prices. Also much will depend on developments in the Middle East, Russia, and Nigeria. The fate of dollar is still open. Many important central banks may join the Fed in cutting interest rates next year. All these will continue to put additional pressure on prices and volatility is likely to remain a permanent future.

It is extremely hard to explain movements in oil prices in the short to medium terms. A return to $20 oil price environment, an average up to 2000 is unlikely. In the next couple of years, if physiological factors influencing traders’ expectations recedes and demand growth moderates, oil might fall temporarily to the low $50s range a barrel and may stabilize at $70. But there is no escape from resuming its upward advance. One sure thing is that the rally to $100 oil is not over.

For the moment it seems that the only effective remedy of high oil prices is higher prices. Unless consumption reacts to high prices in terms of a demand destruction it is natural that prices remain high. That is why, instead of blaming on China and other developing countries, people in the West and their parrots should first blame on themselves. The gasoline in the US is still less than half of the prices in Europe. The Americans have to learn to save out of their income, we all have to learn to drive less and have to get used to three digit oil prices.

Time has come to free oil prices from speculators. There seem to be two simple but politically impossible solutions: close down futures exchanges, ban or restrict non-commercial’s paper barrel trading, and oblige physical delivery rather than cash settlement.

Time also has come to question the representativeness of the WTI and Brent crude benchmarks for the world’s internationally traded crude oil. Their combined output, corresponding to only one percent of global oil production, is declining. For example, the number of Brent cargoes is getting smaller as production goes down, making the market easy to be squeezed. The world needs a better crude oil benchmark, a food for thought particularly for the Turkish and Middle Eastern policy makers.

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