Speculators' day out

Print edition : October 08, 2004

Rampant speculation, rather than demand or supply factors, is fuelling the oil price in the international market which has caused panic across the world.

ZOOMING oil prices have caused widespread panic across the world. Although oil prices have fallen from the peak level of almost $50 a barrel on August 20, they still remain at their highest in over two decades. Given that oil markets are virtually synonymous with energy supplies, governments, central banks and consuming industries have reacted with panic. Meanwhile, nations as varied as India, China and the United States have undertaken efforts to build a strategic stockpile of oil supplies. And, trigger-happy central banks, generally prone to use the stick of interest rates against the slightest hint of inflation, have threatened to use them to counter the latest "oil shock". The ramifications of higher interest rates could have potentially devastating consequences for world economic performance, which is already faltering. Energy market pundits, who have a field day during an "oil shock", are divided on the seriousness of the threat posed by the higher prices. The pundits of gloom say that a major world energy crisis is round the corner. Those advocating a business-as-usual scenario argue that the world will bounce back from this crisis, just as it did from every previous one since the 1970s.

Although there is no doubt that oil prices have set a scorching pace in the last three years, and have been extremely volatile, the current price levels have to be seen in the context of long-term price movements. Although prices are apparently at their peak now, accounting for inflation enables a more accurate comparison with the price levels in the past. For instance, oil prices at their historic peak of $39 a barrel in February 1981 would actually be about $73.50 in terms of current money values. That is substantially more than the price of about $44 prevailing in mid-September. Although prices today are high when compared to the long-term price of about $30 a barrel, several questions remain unanswered. How far is the current upsurge in oil prices linked to market fundamentals, particularly demand and supply? And, how much has speculation in the market contributed to the dramatic increase of oil prices by over 40 per cent in the past year?

Market players attribute the sharp increase in prices to various factors. The rapid flow of oil from Iraq, which the markets expected to materialise after the U.S. occupation, has simply not happened. The gathering momentum of the Iraqi resistance has targeted oil installations and virtually stopped exports of crude. In any case, this would have amounted to only one million barrels a day (mbd), which is only a fraction of world crude output, which is in excess of 80 mbd. The markets also point to the rapid increase in oil consumption in China, fuelled by rapid economic growth. In fact, China has overtaken Japan as the second biggest consumer of oil after the U.S. The market has also speculated on shortages arising out of constraints in sources as varied as Russia (because of the clampdown by the tax authorities on Yukos, a major oil producer), Nigeria and Venezuela at a time when the demand for oil has been booming in the U.S., China, India and other markets.

On August 3, Purnomo Yusgiantoro, president of the Organisation of Petroleum Exporting Countries (OPEC), said prices were at "crazy levels" when prices in the New York market breached the $44 a barrel mark. OPEC, he said was powerless to cool the markets because there was no room to increase supply by its 11 member-countries (including Iraq). Later, in August, Yusgiantoro said that crude oil production by OPEC 10 - excluding Iraq - was close to 30 mbd, with an additional one mbd as standby capacity. He also promised that capacity additions would be possible, but only over the following 18 months. OPEC output in July was about 29 mbd with 27.5 mbd by OPEC-10 and the remaining by Iraq. Yusgiantoro said that "geopolitical tensions" and rampant speculation in the oil futures markets were responsible for the "over-inflated prices".

The latest (August) monthly Oil Market Report of the International Energy Agency (IEA), which primarily represents the interests of the advanced industrialised oil-consuming nations, terms the oil market as being afflicted by "irrational exuberance". It observed that although the demand-supply balance was "tight", the market had been "living with greater uncertainties for quite some time now". In fact, it pointed out that there was enough "buffer" to cope with "potential supply disruptions". The Report asks: Even if the market is tight and uncertain, and oil infrastructure may be less than desired, do these factors justify an oil price of $45 a barrel?

According to the IEA, the global demand for oil was 79.6 mbd in 2003 and it was expected to increase to 82.2 mbd in 2004. However, this does not give an accurate picture of the situation. Demand in the second quarter of 2004 increased at the rate of more than 5 per cent, the highest in the last six quarters. Demand has been particularly strong in the U.S., which was the biggest consuming nation, accounts for one in four barrels consumed in the world, and in China. The scorching pace of the Chinese economy during the last calendar year, and the stockpile that it is building currently are believed to have contributed to the higher Chinese demand, which increased from 4.7 mbd in 2001 to 5.9 mbd in the third quarter of 2003.

Since then demand has registered a more modest increase. The IEA points out that the "soft-landing" of the economy planned by Chinese authorities, and the restrictions on truckers in China are likely to result in demand slowing down in 2005. The Indian Oil Corporation, India's leading refiner, expects crude oil imports to rise to 11 per cent in 2004-05 as demand rises by nearly 4 per cent. India's crude oil import bill is expected to increase by rise 50 per cent to $27 billion this fiscal year.

After the September 11 attack, the Bush administration resolved to maintain the Strategic Petroleum Reserve (SPR) at 700 mbd. By March, the SPR held 647 mbd of oil. At an average fill rate of about one million barrels a day, which amounts to about 1 per cent of the U.S. demand of crude oil, it would take another six months for the SPR to reach its target. There has been criticism that the U.S. government has proceeded with the build-up programme even as oil prices have soared. The latest figures released by the IEA show that while demand in the second quarter of 2004 was 81.1 mbd, supply from all sources amounted to 82.3 mbd. While this does represent a tight situation, the point is whether this slim mismatch warrants the magnitude of price increases seen in recent weeks. For some time now, international oil market watchers have been arguing that the speculative forces have played a crucial role in pushing prices beyond levels warranted by "market risks" associated with supply constraints in one corner of the world or other - be it because of Yukos in Russia, or the war in Iraq or the unrest in Nigeria.

In the first 90 days of 2004, oil prices leapt by more than $7 a barrel, when the gap between supply and demand was about 2 mbd, according to data released by the IEA. Oil market commentators say that this price increase does not represent a normal or rational response to a supply problem. The problem is that since oil, the most important energy resource, is so basic to economies and societies across the world, its demand is relatively inelastic to price, at least in the short term. Thus, a minor shortfall in supply can trigger a relatively disproportionate increase in prices. This would be understandable because this is what often happens in commodity markets.

The collapse of the stock market a few years ago, the fall in interest rates, and fewer opportunities to bet on currencies have caused speculative adventurers to focus their attention on commodity markets, particularly oil. Hedge funds and other financial players are active in the futures contract market for oil. The peculiar features of oil, its relatively low elasticity of demand, and its strategic importance offer advantages that other commodities do not offer speculators. After all, when oil prices touch $50 a barrel, there may be buyers who may see it fit to buy at that price rather than wait to see prices touching $60 a barrel. In short, its volatility is what makes oil an ideal betting medium for speculators. The collapse of financial markets worldwide has caused hedge and pension funds to move into the markets for commodities like oil. The herd behaviour of such entities has caused further instability in the oil market. In recent months OPEC, for long the favourite punching bag of the media whenever oil prices rode high, has hit out at the way dealers in the market are marking a premium for oil in various part of the world. In fact, analysts have quantified the risk premium at between $5-10 a barrel. Although both OPEC and the IEA have said that demand is likely to be matched by supply, there are fears that in the run-up to the winter season, when oil demand typically peaks, prices could hit even higher levels if the speculative forces have their way.

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