Gamblers at futures market pushing up petrol, diesel prices

Time has come to question the economic benefits of having oil futures market. Despite adequate spare capacity and absence of any major supply disruption, 2011 will end as the year of the highest average crude oil price of about $111 per barrel.

2011 also is the year, when the spread between two benchmark crude oils  Brent and West Texas Intermediate (WTI) was the highest. The unusual spread between two benchmark crude oils whose production accounts for a small percentage of the total world oil demand has resulted in giving wrong price signals to international oil market.  

Economists claim that futures market helps to ‘discover’ the price of a commodity as well as manage risk of the price movement. On both these counts, crude oil futures market seems to have failed. Since the introduction of the oil futures market in 1983, price volatility has increased significantly. In addition, the oil futures market has resulted in transferring huge amounts of wealth from oil importing countries to oil exporting countries by pushing prices higher. In 2011 alone revenues of Opec will be about $890 billions.

Even in the absence of any futures market, international oil industry did not have any problem in discovering oil prices. For a very long time till the first oil shock of 1973, the so called posted prices set the crude oil prices. During that time the international crude oil trading was done mostly on a long term basis. While crude oil prices were based on a posted basis by the oil companies, product prices were based mostly on spot basis influenced by the market forces.

Predominantly three markets namely Rotterdam, Mediterranean and Gulf Coast markets gave pricing signals to the spot product markets. It is the interaction between spot product market and the posted crude oil which determined the movement in oil prices.

Before the first two oil shocks of 1973 and 1978 there was criticism that ‘seven sisters’ controlled the oil pricing. Some claimed that it was such a firm grip on supply/demand of the oil industry which might have resulted in less volatility. There is certain amount of truth in such a claim. Only for few years Opec was able to control the pricing. Later the invisible hand of the market determined the price based on supply/demand. During that time the price volatility was manageable. However once futures market started to give pricing signals to oil market, volatility has increased considerably.

Historic maximum

Historically, the differential between US produced WTI and North Sea Brent reflected mostly the transportation cost of moving Brent to the gulf coast in the US. The US was crude short.

Since North Sea was crude surplus from where Brent was moving to the US, WTI historically was able to get a premium of $1.50 to $2.00 per barrel reflecting the transportation cost. However this relationship started to change. Recently WTI has been discounted from Brent.

WTI discount reached a historic maximum of 28/bbl in October thanks to speculation in futures  market. Currently it is around around $10/bbl. The price for Indian imports of crude oil is based on Brent. As a result India ended up paying more for its imports.

When the futures market started, WTI traded in NewYork Mercantile Exchange (Nymex) did serve as a benchmark for the global crude oil trading. But today 70 per cent of the crude oil prices use Brent traded on Intercontinental Exchange (ICE) in London as the benchmark. WTI has lost its benchmark status even for the US in recent months. Still trading of WTI futures on Nymex has not come down.  Still the media in the US and even the rest of the world while quoting the daily change in oil prices refer to WTI and not to Brent.

Since 2008,  some feeble voices have started to raise some inconvenient questions about the usefulness of having futures market to discover oil prices.

But it has not gained any strength to be heard by the policy makers. IEA and Opec held two workshops to discuss relationship between physical and financial trading in Europe. In the US, the government is trying to tweak the futures trading to reduce the impact of speculation.

But no one dares to pronounce that emperor has no clothes to convey the message that futures trading has resulted in higher oil prices and we need dramatic reform of the futures trading.
 
In early 1990s crude oil price was less than $30/bbl. Forecasts made by most experts during those years predicted that crude oil price would be $30 to $35 per barrel for 2010 to 2015. In reality 2011 will end up with the highest average crude oil price. Why did the forecasts go wrong? Quantum jumps in crude oil price during the first two oil shocks was mostly because of the unexpected disruption in crude oil production. But for Libyan unrest there has been no such production disruption to drive crude oil prices higher in 2011.

The world oil supply/demand has been fairly balanced with adequate surplus capacity to get over any small supply disruption. The fact that the oil price has been considerably higher than the marginal cost of production can be attributed to the speculative trade in the futures market.

Today the futures market has become a huge gambling casino generating billions of earnings for the owners of the markets and dealers.

The gambling that is taking place may be a zero sum game for those who play there. However their gambling has unnecessarily resulted in higher world crude oil price. This in turn has transferred billions from oil importing countries to oil exporting countries.

During the last eight years Wall Street speculators might have been responsible to transfer more than five trillion dollars of wealth from oil importing to oil exporting countries. It is high time that steps are taken to reform the futures market. At G-20 meeting our economist prime minister should take the lead.