In this Crisis, what became of the oil?

Source: BP Statistical Review of World Energy, June 2007 (download complete report).

Source: Makhnovitch, http://www.terredebrut.org

 

A few months ago the big news were the disproportionate/enormous increase of the oil price. As the need for transport is an established part of our life, this increase was justified in every possible way.......especially as far as the supply was concerned, and with this............came the crisis, and it has shown the strength of the demand in this market.

 

The purpose of this article is to show that there is another protagonist in the oil market, and that is the credit, specially the leverage of the speculators.

During these few months the oil has shown us a spectacular increase followed likewise by a spectacular fall. What can we learn from this exceptional situation?

 

First: that we should not listen to the fortunetellers or the ones that exaggerate. The oil did not reach 200 USD as the Iranian Minister of Oil, Gholamhossein Nozar, announced on the 8th of May this year to the IRNA, the official Iranian new agency: "If the current conditions remain the same, a period when oil is supplied at $200 a barrel is not out of the question,''. The same week, when the oil price reached 123 USD, a report from Goldman Sachs also considered it possible that the oil price would surpass the 200 USD barrier. Let us then remember that its price reached 147 USD and that in this moment it is about 40 USD. If we are not to believe the exaggerations regarding the increase, neither should we believe that the oil price will fall to 20 USD as in 2001.

 

The second thing we should learn, is that usually a lot of allegations without basis are made, e.g. that the oil is coming to an end, and therefore the price increase was so huge, as we supposedly are in a "zenith of oil production" also called "oil peak" by e.g. M. King Hubbert (Hubbert Curve) or C.G. Campbell.

 

We do not know how much oil is left on our planet, and probably the last barrel will never be extracted (too expensive). The extraction cost of the last barrel would be exorbitant (economists call it marginal cost), and probably nobody will even try.

 

On the other hand, the supply is only one part of the explanation. The demand also plays an important role. We will now dedicate a few lines to study the possible explanations to the increase and subsequent decrease.

 

The world consumes approximately 86m barrels per day. In order to know whether the demand grows or falls, it is important to study the average price. This number is influenced by the price paid and the vicissitudes of the extraction; hurricanes like the recent Gustav or Ike that affected the Mexican Golf. All oil and gas production in this area was closed down by the storm, and so were the oil ducts, ports and channels. It is also affected by strikes, wars, producers' collusions, transport and refineries, and of course by taxes. The demand depends on the climate, e.g. during a cold winter the demand increases, and vice versa.

 

In the past when new producer countries came up (boosting the supply), the price was clearly reduced. This is shown in the following diagram: a historical and real price fall of crude oil. Likewise, when a political-military event takes place (the Gulf war, the invasion of Iraq, etc.) an exponential increase of the crude oil price is produced. The first chart is from British Petroleum and it shows, in a long time scale, how the events of the world affect the price.

 

The diagram ends just prior to the last escalation up to 147 USD and the following drop. One of explanations of the decrease of the current price it the reduction of the demand caused by the present international economic crisis. However, the consumer might not see this, as the price increases faster when the oil goes up, than it decreases when the crude oil falls.

 

The current price is to a great extent determined by future expectations that are evaluated by the speculators, with market operations that in have become very sophisticated in the latest years with all kinds of new derivatives.

 

Consequently a new factor, the speculation with easy access to credits is what explains a large part of what we have seen during the last months (I have to emphasise that I am not against "speculation" in its positive sense. What I think is wrong are the credits with leverage without regulation that can be 500 times the investment made by one agent only). This credit capacity explains to a large extent the rise and subsequent fall. With the crisis and later the credit rationing, the escalation of prices stopped abruptly. It is a fact that when you buy on credit, with such a high leverage, and in large volumes, it will end up producing alterations in the market, no matter how big and deep it might be. When the global funds enter with a lot of liquidity in the oil market, they will inevitably have some influence -even though it might be only temporary- moving it away from the fundamentals of its price.

 

The excessive leverage ought to be regulated. Yes, regulated! The market we have, is not free (nor should it be so), as the venerable Professor Fuentes Quintana used to say in his lectures on public finances, we live in a social market system, whether the ideologists like it or not. A "free" market works within a set of rules, it is regulated or self-regulated, because if the rules are not observed, the market will stop to work efficiently.

 

The future expectations are now acquiring increasing importance. This and the above mentioned leverage tools provoke an expansion of the volatility of the prices and also in the speed of the negotiations in the market (24 hours a day, 7 days a week).

 

There exist three factors (detailed further down in the text) in the leverage of the operations of buying or selling of futures adding volatility to the price. (According to Robger Pirog, this is normally seen in the inflexion points, i.e. when a bull market changes to bear market, or vice versa. From "World oil and its effect in oil price", CRS Report for Congress (09/06/2005)). The goods in question are converted to a "commodity", token of interchange, that substitutes other financial tools, which to a certain degree is the case of gold, and it is affected by foreign exchange rates when it is converted to an internationally operated commodity.

 

During the last years when the negotiated volume has been increasing, oil became more attractive to speculators owing to the immediate liquidity. The operations in futures and the management of stocks determined the oil prices in the short term. US Commodity Futures Trading Commission confirms that 71% of the oil market is controlled by speculators. These speculators will try to foresee the changes in the demand, mostly because of the incipient growth in the less developed countries like China and India.

 

The expectations influence both on the supply and the demand, sometimes strengthening - sometimes compensating - the tendency of the other.

 

How does the dollar affect the oil price? First, on the supply side it implies that the producer country receives dollars for the barrels, with which it can import products. If the dollar price falls, in relative terms the purchase power of the barrels is less than the country's "no-dollar" importations. That is why the producers are interested in a higher dollar price, specially if their importations are bought from commercial partners outside the dollar area.

 

From July 2007 to July 2008, the oil price doubled, from 70 USD to 140 USD, compared to a 1.5% increase in the demand.

 

A factor that evidently explains this increase is the price is speculation that changed with the regulations imposed by the Security and Exchange Commission (SEC, a Northamerican organism for regulation of the financial markets). After 15 July it prevented the speculators from selling shares, without having them at their disposal. As expressed by Fernando López D'Alesandro (in "Vaivenes del petróleo", published in the Energy Supplement no. 78 of the newspaper La Diaria, Montevideo, on 26 September, 2008): "The massive sales at the NYMEX (New York Mercantile Exchange) of both fuels and oil futures, made the hot money go down, which added to the lack of credits, a direct product of the subprime crisis, also slowed down the speculation. Masters Capital Management, one of the main investment funds, published a report short ago, in which they affirm that the speculators have retired 39,000 million dollars from the futures' market during the last two months".

 

This was reflected especially by the by the bank shares (that have been declining during two years), so it was impossible to maintain short positions of these shares. As a lot of the speculators felt obliged to buy in order not to disobey the regulation, they left the market in which they were, i.e. the oil market (long positions), and as a result of this, the volume of contracts for oil futures fell to its lowest point in the last one and a half years.

 

The OPEC should be mentioned in the context of the sudden growth and decline of the price. If it is true that they are advocating a stable price, then it must be concluded that this group of countries was incapable of restraining the price escalation. Neither do they now exert much influence to reduce the production significantly with the purpose of increasing the price. In the past, when OPEC controlled more than 75% of the crude oil extraction, they had a certain control over the market, but now, when they represent less than 40%, their role has diminished as you can see in the second diagram.

 

 The "stock factor" or oil inventories factor is a variable influenced by net demanding countries, like  USA, with their so-called “strategic reserves”, and the offerors that pretend to control the price. This is confidential information and the increase or decrease of the reserves are reflected in the short term price expectations. In the latest report from "Crude Oil Inventories" we are informed of an accumulation of the raw material, superior to the average of the year. On the supply side should be mentioned that only 13 countries in the world control 85% of the total oil reserves known.

 

On the other hand, we always talk about the price in nominal terms, not real terms. As we ought to in order to compare seriously and see the impact, which by the way is completely distorted by taxes.

 

The partial justifications for the price are only valid in retrospect, as an example can be mentioned China's oil demand (as justification for the spectacular increase). As we have seen, China is not immune against the global crisis we experiment, the oil depends on the global demand and however diversified this is, it follows a pattern, there are no "free travellers", in the end all depends on all.

 

The economic crisis in USA and Europe is obviously a factor that has slowed down the prices. Together they consume 35% of the world's oil and the financial crisis, with its social consequences, has produced a reduction of the demand. Is it possible to confirm that this will decide the future? No, not if there exist substitute consumers. Brazil, Russia, India and China will continue to increase their GDP at different speeds. As example, if they grow at an average of 5% during the next 14 years, they will double their GDP and in all probability their oil demand will increase. This would imply that the oil price is no longer conditioned by the demand of USA and the European Union.

 

On the supply side the producers face a different problem with each increase or decrease of the price. According to Deutsche Bank, Iran and Venezuela need an oil price higher

than 95 USD in order to balance their investments, while Russia requires a price of 75 USD. These numbers collide with producer countries where it is much cheaper to extract the oil, like Saudi Arabia or Libya, where the balance is reached with a price of 50 USD per barrel.

 

On the other hand, the investment in installations to extract crude oil from deep waters requiring special and costly techniques and which, sometimes, only are profitable when the oil price is more than 100 USD according to the calculations of different analysts. Considering other high cost project, like the oil-deposits Kashagan in Kazakhstan, Sakhalin II in Russia and the tar sands in Canada and Venezuela, are under doubt seen in light of the present prices.

 

Finally, I would like to express my wish to learn from what we have experimented since July, the oil market has got a new element that explains its past irrational exuberance: the speculation with highly leveraged credits. This is not the end of the story, the fundamental reasons of the real supply and demand will always prevail over the temporary financial speculations, but it should be remembered that it is necessary to regulate a market if it has to work well.

 

Really, I do not know what will happen for certain with the oil price in the future. With the crisis it seems like we are going to have a period with restrained prices. However, I am sure we are going to see a future economic recovery, and with China as being already today the second largest importer of crude oil, the price will most probably go up again, but preferably without the irrational exuberance of July. The prices should give us information and an ordered solution to the real supply and demand. The regulators should learn the lesson that of such a rapid increase and decrease, caused by the leverage of the speculators. If they don't, we, the final consumers will pay the folly.