IMF and Oil Prices

International Monetary Fund released its most recent World Economic Outlook in September 2011. The economic growth forecasts in this outlook, like any other of its past outlooks, are used by all prominent institutions as a crucial input for making oil demand forecasts. For instance, in early October, the IMF’s downward revision of GDP forecasts was interpreted by traders as a sign of a slowdown in oil demand growth.

IMF uses its own interpretation of oil prices for making its economic growth forecasts. Note that throughout its World Economic Outlook with oil price the IMF means “simple average of spot prices of U.K. Brent, Dubai Fateh, and West Texas Intermediate (or WTI) crude oil.”

Historically, WTI has traded at a premium of a few dollars, because it is a lighter and sweeter variety of crude oil. Starting from 28 October 2011 this has changed. For more than once year now Brent has been trading at a premium to WTI. The Brent-WTI spread blow-out from a few dollars to nearly $30 in early September. Of course this development has brought the WTI price as an international price benchmark under scrutiny. The IEA, for instance, switched to Brent price in its monthly Oil Market Reports. Now, more and more people mean Brent price when they talk about world oil price.

The IMF says in its WEO that “Historically, WTI has traded at a premium, because it is a lighter and sweeter variety of crude oil. If this anomaly continues, use of the WTI price as a price benchmark will increasingly come under scrutiny.”  It also says that current futures prices imply that markets expect WTI to be priced at a discount to Brent through 2016.

 If this is the case what is the point for the IMF to continue using an “average” oil price. Using an average price would make sense if the price series that were averaged followed more of less the same path. This is not anymore the case. So, is it meaningful to average the three benchmark crude prices?

By using this “average” oil price the IMF makes a number of assertions that are simply not backed up by the facts. Chapter 1 of WEO makes a blunt remark with saying that “During the second quarter of 2011, oil prices briefly rose more than 25 percent above the levels that prevailed in January 2011. It is hard to determine the extent to which prices were driven up by stronger demand or by lower supply.”

Note that the IMF undermines the role of speculators. IMF further states that “global macroeconomic factors explain a large and broadly stable share of commodity price fluctuations. If noise trading (and destabilizing speculation more generally) had become more important, commodity price volatility should have increased.” How can you justify it if you plot average petroleum spot price (an equally weighted average of WTI, Dated Brent, and Dubai Fateh) against Net Long Noncommercial Positions in Crude Oil in NYMEX? How do you see it if you use an average oil price? More importantly, does it make sense?

The race between WTI and Brent (actually between NYMEX and ICE) for being a representative global crude oil benchmark price continues. Non commercials are more and more attracted to the Brent market's stronger calendar spread structure as well as stronger price momentum. Does this race today make sense?  As I mentioned above, many institutions including the IEA switched to Brent as world oil price benchmark. This is despite the fact that WTI production may be increasing while Brent has peaked and is dwindling. When the new pipeline between the US and Canada is completed, more oil will be flowing to Cushing, the WTI contract's point of delivery. The pipeline connection problem to supply Midwest refineries will most probably be solved in the future. In the mean time, Will we see then a switch back to WTI price? 

 Isn’t this a market distortion? How long will we remain silent to casino capitalism for having a very strong influence on the price of a commodity that affect every one of us. How long will we play the three monkeys that financialization of oil markets has had nothing to do with the oil price movements in the past few years? (And yes, in this post I am biased).

Nuclear Power vs Oil for Navy Surface Ships

Congressional Budget Office release a report entitled “The Cost-Effectiveness of Nuclear Power for Navy Surface Ships” in May 2011.

All of the US Navy's aircraft carriers and submarines are powered by nuclear reactors; its other surface combatants are powered by engines that use conventional petroleum-based fuels. In recent years the US Congress has shown interest in powering some of the Navy’s future destroyers and amphibious warships with nuclear rather than petroleum based fuel.

The argument now spreading out that the Navy could save money on fuel in the future by purchasing additional nuclear-powered ships rather than conventionally powered ships. Those savings in fuel costs, however, would be offset by the additional up-front costs required for the procurement of nuclear-powered ships.

To assess the relative costs of using nuclear versus conventional propulsion for ships other than carriers and submarines, the Congressional Budget Office (CBO) developed a hypothetical future fleet, based on the Navy's shipbuilding plan, of new destroyers and amphibious warfare ships that are candidates for nuclear propulsion systems. Specifically, CBO chose for its analysis the Navy's planned new version of the DDG-51 destroyer and its replacement, the DDG(X); the LH(X) amphibious assault ship; and the LSD(X) amphibious dock landing ship. CBO then estimated the life-cycle costs for each ship in that fleet—that is, the costs over the ship's entire 40-year service life, beginning with its acquisition and progressing through the annual expenditures over 40 years for its fuel, personnel, and other operations and support and, finally, its disposal.

CBO compared lifecycle costs under two alternative versions of the fleet: Each version comprised the same number of ships of each class but differed in whether the ships were powered by conventional systems that used petroleum-based fuels or by nuclear reactors.

Estimates of the relative costs of using nuclear power versus conventional fuels for ships depend in large part on the projected path of oil prices, which determine how much the Navy must pay for fuel in the future. The initial costs for building and fueling a nuclear-powered ship are greater than those for building a conventionally powered ship. However, once the Navy has acquired a nuclear ship, it incurs no further costs for fuel. If oil prices rose substantially in the future, the estimated savings in fuel costs from using nuclear power over a ship's lifetime could offset the higher initial costs to procure the ship.

In its January 2011 macroeconomic projections, CBO estimated that oil prices would average $86 per barrel in 2011 and over the next decade would grow at an average rate of about 1 percentage point per year above the rate of general inflation, reaching $95 per barrel (in 2011 dollars) by 2021. After 2021, CBO assumes, the price will continue to grow at a rate of 1 percentage point above inflation, reaching $114 per barrel (in 2011 dollars) by 2040. If oil prices followed that trajectory, total life-cycle costs for a nuclear fleet would be 19 percent higher than those for a conventional fleet, in CBO's estimation.

To determine how sensitive those findings are to the trajectory of oil prices, CBO also examined a case in which oil prices start from a value of $86 per barrel in 2011 and then rise at a rate higher than the real (inflation-adjusted) growth of 1 percent in CBO's baseline trajectory. That analysis suggested that a fleet of nuclear-powered destroyers would become cost-effective if the real annual rate of growth of oil prices exceeded 3.4 percent—which implies oil prices of $223 or more per barrel (in 2011 dollars) in 2040.

The amount of energy used by new surface ships—particularly those, such as destroyers, that require large amounts of energy for purposes other than propulsion—could also be substantially higher or lower than projected. Employing an approach similar to that used to assess sensitivity to oil prices, CBO estimated that providing destroyers with nuclear reactors would become cost-effective only if energy use more than doubled for the entire fleet of destroyers.


The use of nuclear power has potential advantages besides savings on the cost of fuel. For example, the Navy would be less vulnerable to disruptions in the supply of oil: The alternative nuclear fleet would use about 5 million barrels of oil less per year, reducing the Navy's current annual consumption of petroleum-based fuels for aircraft and ships by about 15 percent. The use of nuclear power also has some potential disadvantages, including the concerns about proliferating nuclear material that would arise if the Navy had more ships with highly enriched uranium deployed overseas. CBO, however, did not attempt to quantify those other advantages and disadvantages.

The CBO analysis sounds good enough but not complete because of two reasons.

First, in my opinion an oil price of $223 in 2040 is rather conservative. Many analysts probably will not share my view but this is what I believe. The CBO oil price forecasts is close to the Energy Information Administration’s high case oil price forecast as indicated in its Annual Energy Outlook released in April 2011 (see figure 13).

Second, using direct cost of oil does not make much sense in such an analysis. It would have been more appropriate to use Fully Burdened Cost of Fuel (oil). After all, it is the FBCF that matters, not the average price of imported oil to US refineries used in the CBO analysis.

Oil prices have become hostages of speculation

My deepest condolences to the people of Japan.

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).

According to the oil market fundamentalists, the prices reflect the state of the market fundamentals (supply, demand and inventory levels). 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.

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.

Recent Experience

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.

And yet oil prices rose and fell (as much as $10 per barrel on 24 February, for instance) though the situation in the physical market looked no more settled or chaotic than it has. Well, look at this then: WTI options reached a record 324,655 contracts on February 23, surpassing the previous record of 294,411 contracts set on Jan. 31. ICE Brent Crude futures set a daily volume record of 821,857 contracts on February 24?

What can be done ?

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.