Oil prices have become hostages of speculation
Today oil market behaves irrationally and dominant players take advantage of it. I simply do not understand why media and many oil market analysts blame on market fundamentals for the increases in the oil prices again. It is in fact mostly speculators to be blamed. I still haven’t changed my position on that (see my previous post oil prices and speculator (2005), here (2006), here (2008), and also here, and here).
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.
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 anyway? Instead, OPEC tries to send (often mixed) signals to futures market in an attempt to change the course of direction. 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.
Speculators have fallen in love with oil
In the past, big consumers and producers were affecting the price behavior. Today, 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. This influx of large speculative trading injects volatility into global markets. Since speculators make money by betting on prices they love volatility.
In practice, very insignificant number of contracts on NYMEX and ICE result in physical delivery. Instead contracts are liquidated with offsets. Therefore the role of futures market as a hedging mechanism is largely not correct anymore.
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 markets offering the world’s leading oil benchmarks.
There are two types of players in the world paper oil market: Commercials and non-commercials. However, the distinction between commercial and non-commercial transactions is not clear anymore.
As there is no supply constraint in paper barrel market, trading in paper barrels has grown significantly since 2000. Take the average number of contracts traded daily and then divide the corresponding barrel equivalent to daily world oil production. I don’t want to go into the technicalities here but I just tell you that the amount of paper barrels traded daily is more than 15 times of the world’s daily oil production. And yet this is without taking into account of the OTC markets. (God knows how much oil is traded in there.)
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. 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. 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.
The recent turmoil across the Middle East and North Africa was a perfect catalyst for speculators. Oil prices have started to rise as domestic unrest grew and governments were toppled first in Tunisia and then in Egypt. Unrest in Tunisia had a limited impact on the prices because the country was not among the significant oil suppliers. Egypt is also not a significant supplier but what makes the country important is the Suez Canal and the Sumed pipeline. Although there was no disruption in oil flows in those transport channels worries of speculators pushed the prices up.
The rise in prices intensified since the start of violence in Libya. It simply sparked greater fears of contagion, especially to Saudi Arabia and Algeria. The possibility that world oil production could be curtailed has become the main worry although OPEC hinted that the block would increase supply should prices keep rising or should any real need in the market emerges.
Is the rise in oil prices justified? Look at the following facts:
Stockpiles at Cushing, Okla., are at a record high of over 40 million barrels. Kuwait, UAE, Nigeria and Saudi Arabia increased production which is estimated to be as high as 800,000 barrels per day, corresponding the loss of Libyan oil exports. There is over 5 million barrels per day of estimated OPEC spare capacity. Total OECD stocks are sufficient to cover 91 days of forward demand (1.6 billion barrels of government controlled and 2.7 billion barrels of industry stocks). And global demand is usually low in early months of the year.
I believe that, in today’s oil market, speculators do play an important role in determining the direction (if not setting) of the oil prices. It seems that the only effective remedy of high oil prices is higher prices. We all have to learn to drive less and have to get used to three digit oil prices.
Meanwhile, time has come to free oil prices from speculators. There seem to be four politically impossible or difficult solutions: close down futures exchanges, ban or restrict non-commercial’s paper barrel trading, put the position limits to especially of non-commercial traders, 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 less than five percent of global oil production, is declining.