Speculative bubble

Published : Jul 04, 2008 00:00 IST

The Senate Homeland Security and Governmental Affairs Committee of the United States hearing testimony on whether speculation in the commodities market by institutional investors and hedge funds is contributing to food and energy price surges, in Washington, D.C., on May 20.-JAY MALLIN/BLOOMBERG NEWS

The Senate Homeland Security and Governmental Affairs Committee of the United States hearing testimony on whether speculation in the commodities market by institutional investors and hedge funds is contributing to food and energy price surges, in Washington, D.C., on May 20.-JAY MALLIN/BLOOMBERG NEWS

Just as in the case of major foodgrains, deregulation of financial markets has had a significant role in affecting global oil prices.

IT may seem hard to believe now, but for more than half a century, world oil prices have not moved much around the average figure of U.S. $27 a barrel in 2007 price terms. The occasional shifts away from this average have been few, and the periods of oil price spikes were relatively short, the most notable being the shocks induced by the Organisation of the Petroleum Exporting Countries (OPEC) in the 1970s.

Between the mid-1980s and 2003, the real price (that is, adjusted to inflation) of crude oil on the major international trading exchanges was typically less than $25 a barrel. The recent rise in the price of oil began in 2004, when it became evident that the United States-led invasion of Iraq was going to be ineffective in securing Iraqs oil reserves for the U.S. However, even then the price rise was substantial without being a surge. It is really only in the past year that the global oil price has behaved like a runaway horse, breaking all speed limits and previous barriers.

In the three years between January 2004 and April 2007, the oil price in nominal dollar terms increased by around 2.3 times, to $65 a barrel. But in the period between then and early June this year, that is just 14 months, the price more than doubled again, to reach a peak of $139 a barrel on June 6 before coming down slightly to $132 on June 10. A price of around $100 a barrel in 2007 prices would be equal to the maximum achieved in the post-Second World War period, in 1980. So the global price of oil is now higher in real terms than it has been since the 1920s. And the rate of increase of oil prices in the past year has been the fastest ever recorded. Also, there seems to be no ceiling in sight: some market analysts have gone on record to predict oil prices of $150-200 per barrel by the end of the year.

This has already spawned a mini-industry of explanations as to why this has happened. And, just as in the case of global food prices, the various explanations reflect not so much the clear empirical evidence as the interests of those presenting them. Thus, it is common for policymakers and commentators in the developed world to argue that the current high oil prices are essentially the fault of the developing world: a combination of supply cutbacks by OPEC and increased demand from the rapidly growing economies of China and India.

However, both of these factors, while they may at some point in future play a role in changing the long-term conditions of the world oil market, have next to nothing to do with the most recent increase in oil prices over the past year. But to understand this, it is necessary to consider each of the most commonly advanced arguments in turn.

Most of the explanations deal with supply conditions. One argument that has been around for a while is that of peak oil the position that global oil reserves are running out, and may have already peaked or will shortly peak. The most extreme proponents of this position also believe that more investment in exploration will do little to change this imbalance and, therefore, the world must learn to shift to alternative forms of energy, whether fossil-based or renewable. In this perception, the current spike in price is simply the inevitable effect of more than a decade of denial, which is making the inevitable adjustment that much sharper and more painful. However, for this to be true, it should be reflected in growing imbalances between actual consumption of oil and global supplies. But this is not the case, as will be evident below.

Then there are those who note the more proximate effects on supply of particular political and economic trends. The continuing instability in Iraq continues to affect its production and exports of oil. Recent terrorist attacks in Nigeria have reduced drilling and production in that country. Production is falling in Venezuela because of ageing oil fields. Tensions in West Asia, whether because of fears of an Israeli attack on Iran or continuing conflicts in Palestine, are also said to have an impact on oil supplies and, therefore, prices.

A slightly different argument posits that the falling value of the U.S. dollar affects oil supplies because the oil trade is generally denominated in dollars. This makes producers prefer to keep the oil in the ground rather than extract it to be paid in depreciating dollars.

However, this argument is flimsy, not only because it is not essential to denominate the trade in dollars, but because there is no real evidence that the fall in the U.S. dollar is linked to suppliers behaviour. Indeed, it may be more likely that the causation may be the other way around that rising oil prices cause dollar depreciation by pushing up the U.S. import bill.

The most ridiculous of the supply-side arguments is the one that blames OPEC for the current situation. This view is more common than might be expected: Prime Minister Gordon Brown of the United Kingdom has railed against the scandal of the continuing market power of OPEC and the U.S. Congress is actually trying to bring a lawsuit against OPEC for cartel-like behaviour and price manipulation! This remarkably stupid move ignores that fact that since the 1980s, OPEC has not fulfilled the basic requirement of a cartel: a mechanism to enforce quotas upon its members.

In fact, today OPEC is more like a club of some oil producers, rather than a cartel that is in command of world oil supply. It controls only about 40 per cent of the world oil production, compared with 70 per cent in the early 1970s. And it has been remarkably inefficient in imposing any kind of production quota on its members, who have happily increased or decreased their production as they wished. Most of its members are producing exactly as they would if OPEC did not exist. And in any case, OPEC has been around for nearly more than five decades, and for most of that period the world oil price has been around $27 a barrel.

The argument appears even more foolish once it is known that the slight decline in global oil supply in April 2008 (compared with a year ago) is entirely because of non-OPEC oil exporters, since the supply from OPEC countries was actually higher by 1.7 million barrels a day. In any case, the Oil Minister of the largest OPEC producer, and indeed the worlds largest oil producer, Saudi Arabia, has already announced that any demand for extra production capacity from consumers will be immediately met. So it is somewhat bizarre to blame the current high prices on OPEC.

The other argument popular in the North relates to demand and suggests that the voracious demand for oil in China and India which in turn is fed by heavy state subsidies that keep the domestic prices of fuels down is responsible for the recent price surge. On the surface, this argument appears plausible, but once again it is fallacious.

It is true that Chinas demand for oil, in particular, has been increasing rapidly, but it still accounts for less than 8 per cent of global consumption, and India for less than 3 per cent. The current obsession with subsidies ignores the taxes imposed on petroleum prices that affect retail domestic prices. In fact, despite recent increases, the U.S. still has among the lowest domestic prices of fuel in the world, substantially lower than Indias even in nominal terms. Relative to per capita GDP (gross domestic product) or actual purchasing power, the domestic retail prices of oil and oil products in India and China are many multiples of the prices prevailing in the U.S. So the subsidies leading to excessive fuel consumption are much more prevalent in the U.S. than they are in India or China.

In 2007, import demand from China and India together increased by 8.7 per cent, but import demand from the other five large importers (U.S., Japan, Germany, France, Italy) actually fell by 2.6 per cent. As a result, demand for oil from the top 10 importing countries actually declined by 0.5 per cent. Even so, the global oil price increased by 170 per cent!

The scenario appears to be similar in the current year. According to projections of the Energy Information Administration of the U.S. government, OECD (Organisation for Economic Cooperation and Development) oil demand will contract for the third successive year in 2008. While non-OECD demand growth in 2008, led by China and West Asia, will remain reasonably strong at 3.7 per cent, aggregate global demand will increase by only 1.2 per cent. Supply is expected to be approximately the same as the previous year, at around 86 million barrels per day. Yet in the first five months of this year, global oil prices have increased by more than 140 per cent.

From all this it is quite evident that the straightforward explanations based on real demand and supply are simply not useful in understanding the current price hike. Rather, the price for this very physical commodity, this universal intermediate, is now determined in the virtual world. In other words, speculative forces, operating especially through the commodity futures markets, are driving the current oil price surge.

Just as in the case of other primary commodities, financial deregulation has played a role in allowing this to happen. Two major international exchanges are crucial to this process. The New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE) in London control futures contracts on two of the most widely traded grades of oil: West Texas Intermediate and North Sea Brent. This becomes a benchmark for spot prices of actually traded cargo. For the past few years, the oil market has been operating in what is known as contango, meaning that futures contracts for oil are priced higher than oil directed to spot delivery.

As futures prices keep rising, they push up spot prices as well, regardless of the ground situation with respect to actual consumption and actual supply.

The problem is that the futures market is largely unregulated, because of the growth of OTC (over the counter) electronic markets that were allowed in the early years of the decade in the U.S., and because the ICE in London is also not subject to regulation. As a result, this has led to a process so opaque only a handful of major oil trading banks such as Goldman Sachs or Morgan Stanley have any idea who is buying and who selling oil futures or derivative contracts that set physical oil prices in this strange new world of paper oil (F. William Engdahl, https://www.globalresearch.ca/ index. php? c ontext = va & aid=8878).

The problems with such unregulated markets have been evident for some time now. In June 2006, a U.S. Senate Permanent Subcommittee on Investigations published a report on The Role of Market Speculation in Rising Oil and Gas Prices (the Levin-Coleman Report). This was largely ignored by the media and, indeed, by U.S. policymakers, but its findings have great relevance today.

Some of its conclusions are worth quoting in detail: There is substantial evidence supporting the conclusion that the large amount of speculation in the current market has significantly increased prices [because of] a tremendous growth in the trading of contracts that look and are structured just like futures contracts, but which are traded on unregulated OTC electronic markets.

As a result, the report noted, there has been a significant reduction in the possibilities of market oversight. With respect to crude oil, the influx of speculative dollars appears to have altered the historical relationship between price and inventory, leading the current oil market to be characterised by both large inventories and high prices.

Because it is so unregulated, it is not even possible to figure out who the major players (and therefore major beneficiaries of the oil price rise) are, but it is clear that oil producers are not benefiting much even as oil consumers suffer. It may well be that, in addition to financial institutions that have specialised in commodity futures trading, large transnational banks that have burnt their fingers in the U.S. housing market and desperately need to recoup their losses are entering this market and driving up prices to make quick speculative gains.

There is some evidence of the involvement of large players in this market. Goldman Sachs and Morgan Stanley are the two leading energy trading firms in the U.S. Citigroup and JP Morgan Chase are major players and also fund numerous hedge funds that speculate. In the past five years, investment in index funds tied to commodities has grown from $13 billion to $260 billion. Hedge funds, investment banks, pension funds, and other professional investors increasingly direct their financial resources into oil and other commodities.

This is supposed to create a hedge against inflation, but of course it ends up contributing to it. Such speculation has become the most profitable form of financial activity as well. According to HSBC, commodity- and energy-weighted funds topped the list of best performers in the financial markets in the past three months, generating on average more than 30 per cent annual returns even as other hedge funds suffered losses.

There has been some belated and minimalist policy action against this tendency. On May 30, responding to much criticism, both NYMEX and ICE London tripled margin calls for their contracts, forcing traders to deposit more money when investing. It is after that that the price per barrel of Brent Crude oil fell from $139 to $132, suggesting that it may have had a minor impact in curbing extremely speculative activity.

So, just as for major foodgrains, the deregulation of financial markets has had a significant role in affecting global oil prices. Therefore, it is likely that the current oil price spike reflects a speculative bubble. If so, like all bubbles, it will eventually come to an end. Of course, this bursting of the bubble may take longer than could be expected remember that the U.S. housing bubble carried on for several years but even so it is essentially transient. This means that policies in developing countries must also factor in this possibility, especially before trying to pass on the adverse effects of the oil price hike on to the working people.

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