||Vol. 228 No. 1
|PERRY A. FISCHER, EDITOR
High oil prices�who�s to blame? The lady on the talk-radio show introduced me as an oil price expert. Besides the fact that was not true, it violated my basic world view that, in most cases, there are no experts, certainly not in the realm of predicting oil prices.
So, when she asked me, �Who�s to blame for these high oil prices?�
I answered, �No one really knows. It�s complicated.�
A wise man would leave it at that, so I�ll continue.
Through my vast education via the popular press, the Internet, and being in a position that occasionally finds me in proximity to an �expert,� I�ve formed some educated guesses as to what is making oil prices high. Also, a report (S. Prt. 109-65) was issued by the US Senate Permanent Subcommittee on Investigations in late June 2006, and virtually ignored by the press. Chaired by Minnesota Republican Norm Coleman, the 52-page bipartisan report is remarkably blunt.
First on the list of causative factors are former President Bill Clinton and the 106th US Congress. In December of 2000, �at the behest of Enron and other large energy traders,� as one of their last actions, a small change was slipped into the Commodities Futures Modernization Act of 2000. This change effectively meant that large oil and gas traders could trade US energy commodities on unregulated, Over-the-Counter electronic markets without any record or oversight of those transactions, such oversight formerly preformed by the Commodities Futures Trading Commission (CFTC). The Large Trading Reports, together with price and other volume information, once formed the cornerstone of the CFTC�s ability to detect �concentrated and coordinated positions that might be used to attempt [market] manipulation.�
A second cause occurred in early 2006. The Intercontinental Exchange (ICE) began allowing traders to use its terminals in the US, to trade futures contracts in energy products produced and delivered in the US on its ICE Futures exchange in London. These trades also bypass some of the reporting requirements of the CFTC. As much as a third of all US crude oil futures now trade via the ICE.
So, does this mean that the market is definitely being manipulated? Well, there�s an old country saying, �If you don�t know, just say so.� And I don�t know. But if history is any indicator, we�d be foolish to rely on the good and honorable intentions of�well, at least some of whom are no more than�gamblers.
A third factor is volume. Markets tend to generate derivatives�and ever more rapidly. These products can be �look alike� futures, or they can be funds or funds-like. Oil contracts are generally sold in 1,000-barrel contracts, making it, traditionally, a game for corporations or rich men. Through derivatives, �mom & pops� and even school teachers are playing the futures markets through fund managers. All of this results in increased futures volume.
There�s an old saying among traders: �Volume (usually) precedes price.� That is what�s going on here. The volume of US oil futures contracts has nearly tripled since January 2003. It is mostly non�hedged, purely speculative money. While another saying, �Volume provides liquidity to markets,� is also true, it has a limit. No one seems to know exactly how much of the oil traded is real; but surely, when the volume of speculative �paper� is above 90% of all trades, we are well beyond providing liquidity, and into the bubble-making, pure gambling, and market-crashing realm�something that the CFTC is supposed to help prevent. It goes to the very core of how markets are supposed to function, and what overseers, such as the CFTC, are supposed to do.
Intuitively, when someone who produces oil wants to sell it to someone who uses oil, the price they arrive at has validity. But when we reach the point when nearly all trades are between people who have no interest, let alone ability, to produce or use oil, price validity has a different connotation, to which markets are appropriately blind. Intuitively, a market that, in the extreme case, exists almost purely for the purpose of �providing liquidity,� is a strange market indeed. One report (S. Keshan) said that commodities traders are making quintuple what they were making in 2000. And the Center for Responsive Politics says that the big Wall Street firms have given $300 million to politicians over the last five years.
The Senate report estimated that $20�25 of the price of a barrel of oil was caused by the speculative bubble. It�s worth noting that nearly all futures markets have experienced a huge volume increase in recent years�not just oil. No one seems to know why, exactly, but part of it is due to liberalized markets, especially in the US. Estimates by a respected economist are that investment in commodity index funds went from $15 billion in 2003 to $80 billion today.
A fourth part of the puzzle, and one that I think has some merit, is that high oil prices are due, in part, to weakness in the dollar vs. almost all other currencies. For one thing, the run-up in futures volumes coincides with the dollar�s weakness over time. And don�t forget the obvious: The price of oil hasn�t gone up nearly as much in other currencies as it has in dollars. In 2001, a $28 oil barrel cost 32 euros ($1 = 0.88�). Today, a $60 barrel cost only 45 euros ($1 =1.33�). That�s a 41% increase measured in euros, but it�s up 114% in dollars. And oil is traded in dollars.
Previous supply and demand indicators aren�t working. It used to be that when gas or oil storage levels were high, prices would fall, and vice versa. Over the past two years, oil and gas inventories have grown, with OECD countries near a 20-year high, and US oil stocks haven�t been this high since May 1998. Some of us remember May 1998�the beginning of the steepest and deepest decline in oilfield history.
Despite all the press about the surge in Chinese demand in 2004, high prices have dampened world demand into historically mediocre increases. Lee Raymond, former chairman of ExxonMobil (Nov. 9, 2005), and BP�s head John Browne (May 6, 2006) have both said plainly that supply and demand fundamentals are not driving prices. Finally, the EIA forecasts the present 1.5 to 2 million barrels a day supply surplus to grow to 3 to 5 million barrels a day within three years.
The fifth element is what I call the �Matt effect.� You can�t sell that many books about Saudi production crashing, make that many speeches, be quoted widely in the press, and have no effect. And yes, Matt Simmons is mentioned in the Senate report. If oil prices do start to fall...well, maybe he�s got another book left in him to write.