Speculation, not fundamentals driving oil prices
Over the years oil pundits have learnt one hard lesson that it is impossible and even risky to predict oil prices.
But Wall Street financial trading firms were boldly forecasting that crude oil price will reach or exceed $100 in 2011 even before the Egyptian revolution. Some firms which even predicted that they may even exceed the historical high price of $147/b reached in 2008.
The revolution in Egypt may affect no more than 3.5 million barrels per day (MMBD) of world crude oil moving through Suez canal and SUMED pipeline in the worst case. Since oil inventory is more than adequate and shipping capacity is in surplus, any disruption will have little impact. Still, soon after the revolution prices did exceed $100. Some even predicted that it may exceed $200. Later they came down a bit. Currently there is a lot of renewed interest to find out what factors actually drive the oil prices — speculation or fundamentals?
Fundamental factors affecting oil prices are: demand for petroleum products influenced mostly by economic growth, production of crude oil, policies of OPEC to limit oil supply, oil inventory levels, refinery capabilities, shipping tonnage, supply disruption because of civil war, terrorism, strikes, etc. All these fundamentals do not justify the current high oil prices.
In fact, if prices were determined purely by free market economy, they should have been below $50 to $60 barrels based on marginal cost of oil production. The long term oil price forecast made only five years back for 2020 by Energy Information Administration (EIA) of the US was less than $50 per barrel. Forecasts made by International Energy Agency (IEA) and most oil experts were no different. There have been no dramatic changes during these five years to affect oil prices.
The latest IEA oil market report estimates 2011 world oil demand to be around 88.8 MMBD which is 1.4 MMBD higher than in 2010. With OPEC having more than 5.6 MMBD surplus capacity, there should be no problem in meeting such a small increase in demand even if there is some minor disruption in Niger delta or Iraq or the above mentioned Egyptian revolution.
During the recent historic oil price increase it was argued that the shortage of light crude oil might have been the driving force behind high oil prices. With more than five years to upgrade the refineries, this apparent problem has been also solved as can be seen from the narrowing difference between light and heavy crude oils. Product and crude oil inventories are also at satisfactory level if not more than adequate. OPEC’s production ceilings are not strictly adhered. Every OPEC country produces over its target. In short the industry is supplied with more than needed amount of oil and also of the right quality. What does then drive the oil pricing?
It has become a fashion to correlate dollar value with oil pricing as though the former is a driving force. There have been times when there was good correlation between dollar declining and oil prices climbing. But this need not prove causation. However, in recent months, even when dollar has gone up, oil prices have climbed.
Greed
Another factor which is the driving force for higher crude oil price is the high level of speculation by the Wall Street traders who are treating oil as another asset like stocks, bonds, gold, etc for diversifying their investment to earn above average return. When crude oil prices reached a high in July 2008, outstanding futures and option contracts for oil were at maximum. Wall Street investors after being burnt by stock market, real estate bubble, and sub prime mortgage scam were diverting investment into oil market creating demand for paper barrels. At times paper barrels were more than ten times the average daily demand for oil. It is the same factor which has driven high oil prices after the fall of oil prices to $40 level in early 2009. It is in the interest of the wall street trading banks to hype the prices by predicting higher prices.
We need to question how and if the futures market serves the economy, oil market or the consumers. The usual answer given by the economists is that futures market helps discover the price and also helps the market participants to hedge their risks. These two should help the consumers since it would improve the efficiency. When we compare the market conditions prior to the implementation of oil futures trading to the current, a strong argument can be made that consumers have been taken for a ride by the speculators and their unintended beneficiaries are the oil exporting countries.
There have been some feeble moves by the US congress to regulate the futures market. However it may not be enough. Intercontinental Exchange (ICE) market which is regulated by the UK has no such regulations in comparison to the New York Mercantile Exchange (NYMEX) in the US. Unless there are strict regulations to keep the speculators out of the futures market we are going to see speculation driving the prices and not the fundamentals.
NYMEX and ICE have become huge sophisticated casinos attracting billions of dollars. Unlike Las Vegas casinos where bets result in zero sum game, price discoveries made by these markets result in transferring trillions of dollars from oil importing countries to oil exporting countries. It is high time that G-20 takes steps to put a stop to this gambling game.
