Betting on oil

Print edition : October 08, 2004

IT is increasingly evident that speculative forces have played a role in making markets more volatile and completely out of sync with fundamentals that ought to govern prices in the market. After the Iranian Revolution in 1979, when oil prices shot up, Rotterdam became the centre of the spot market (markets in which oil is traded 24-48 hours before delivery). Since the 1980s, the bulk of the trade in oil has been in the futures markets, typically involving contracts for deliveries after 12 months. The principal oil futures markets are the New York Mercantile Exchange (NYMEX) and the London-based International Petroleum Exchange (IPE).

Although the trade in futures is defended on the grounds that it results in better "price discovery" and provides a hedge to cover risk, there are fears that it is a device for rampant speculation. Referred to as "paper barrels" each futures contract represents a transaction in 1,000 barrels. In 2003, betting in "paper barrel" contracts amounted to transactions involving over 100 billion barrels. In contrast, the total supply in 2003 was about 2.9 billion barrels. The traders transact a large volume of derivatives bets. Speculators purchase future contracts on the IPE and NYMEX exchanges; each single contract is a bet on 1,000 barrels of oil. More than 100 million of these contracts were traded on these exchanges in 2003, representing 100 billion barrelsl. A study conducted in 2000 showed that there was one underlying barrel of real oil that backed 570 "paper barrels" that were traded. Market sources have argued that in the oil market, which is characterised by relatively inelastic demand, if speculators bet long the piling volume of bets can actually result in even higher prices. In effect, betting activity on its own can cause prices to spiral.

Analysts argue that regulations governing trading in the oil exchanges actually facilitate speculation. For instance, a dealer in the IPE has to pay an up-front margin of a mere 3.8 per cent of the value of the trade. Thus, a speculator buying or selling a futures contract involving 1,000 barrels of oil at the price of $40 a barrel has to pay only $1,520 to get control of the contract. Thus, by making an investment of merely $1,520 the speculator gains control of 1,000 barrels of oil. If and when this happens on a massive scale, prices will move up incessantly. And, when many dealers want prices to move up, irrespective of what the market dictates through supply and demand, prices will go up because speculators want prices to go up further.

On May 14, contracts for Brent crude in the IPE amounted to 375 million barrels, the highest ever. This volume of trade is five times the global daily production. Although the Brent acts as the benchmark for crude oil prices in Europe, the production of Brent represents less than 0.5 per cent of world production. Energy analysts say that allowing the betting on Brent to set oil prices at a far broader level is much like allowing the tail to wag the dog. The situation is similar in the case of Western Texas Intermediate grade of U.S. crude, which acts as a benchmark for all oil trades in North America, although the sale of the grade of oil is only a fraction of the oil sold in the U.S. market. In the first quarter of 2004 there were 140,000 daily deals in the NYMEX, up from 50,000 four years earlier. Energy analysts say that speculative deals in the NYMEX account for one-third of all deals in the exchange.

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