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The oil bubble, fueled by speculators

When speculators are in play, things rarely make sense.

Take crude oil, for example.

Just a few months ago, the upward trend of the price of the greatest commodity in human history seemed unstoppable. After it hit $100, it quickly crossed $110, $125, $140… analysts left and right were fighting to be the first to predict the next psychological “barrier”.  Many were confident that, by year’s end, we will surely see prices of $200 and even $250 per barrel.

Few had the cool heads to sit down, do their homework and see that things didn’t make sense at all!

Economics love the supply and demand rule. It’s simple – you have only two variables to work with: when they are not in equilibrium, price goes up or down. How complicated can it be?

Actually, it can be very complicated… especially when speculators come into play. The fact that there is little regulation on the commodity exchanges (one example is the UK-registered, Atlanta-based International Commodity Exchange (ICE)), empowers speculators to affect the price of a specific commodity by a disputably big margin. Because of the lack of adequate regulations and reporting requirements, domestic and international financial institutions and hedge funds do not have to disclose many of their hedge positions, hence the influence of those transactions on the global commodity market can be often murky and much more profound than ever suspected.

Just last week, the U.S. Commodity Futures Trading Commission came out with a report that pretty much admitted that it can’t measure the volume generated specifically by speculators. The same commission estimates that at this time, more than half of the traders on the New York Mercantile Exchange are not in the oil business themselves—think financial institutions who do not “work” with use energy contracts for mostly for hedging purposes.

While having a certain amount of speculators on any market is a good thing, as they often help to provide much needed liquidity, too many speculators tip the fine balance between supply and demand and can make the price of a precious commodity fluctuate with tremendous margins.

Here are some recent events on the oil market that are probably the biggest evidence about how much speculation has affected the world commodity prices.

SUPPLY AND DEMAND

According to a report by the U.S. Energy Information Administration, the global demand for oil has risen only slightly from 85.78 mil. barrels per day in the first quarter of 2007 to 85.85 m.b. per day in the first quarter of 2008.

On the other side of the equation, supply has gone up relatively quite a lot – from 83.96 m.b. in Q1, 2008 to 85.38 m.b per day.

The supply shortage in Q1 of 2007, when the crude oil was around $60 a barrel was only 1.82 m.b. per day, while in Q1 of 2008, when the shortage was only 0.47 million barrels a day, crude cost around $105 and was on its way up sharply.

I know many here will say that the US Dollar value adversely affects the price of oil. While that’s absolutely correct (oil is traded mostly in $US and oil producers and traders seek to recuperate losses from the devaluation of the greenback when it goes down, by seeking a higher price for the crude), the dollar went down only about 19% against the other major currencies between March 2007 and March 2008.

All else constant, the price of crude oil should have been around $71, not $105 at the end of Q1, 2008.

Yet, as more investors pored money in the commodity markets, the price of oil and other commodities skyrocketed into the stratosphere.

TIME TO BURST ANOTHER BUBBLE

As some investors started thinking that the upward swing may be over, the domino fell.

Many investors started to pull out in order to realize the profits that they have made on paper. As money started flowing out of the commodity markets, the price of oil plummeted. With increasing losses, investors and speculators started pulling out, hedge funds ran out of cash, financial firms ran out of steam, the markets were in panic mode. That is, speculators were in a panic mode. Traders were quick to say that the freefalling crude oil prices are because of dwindling demand on the world markets.

Really.

Here are a few more recent examples of a market that doesn’t make sense!

When hurricane Gustav formed on Monday, August 25, 2008 it wasn’t even yet clear if it would enter the Gulf of Mexico, the heart of U.S. oil production. However, the market was full of uncertainty and hungry for news that would reverse the downward trend of oil. Surely, a low pressure in the Caribbean is all it needed – crude went up from $114 to $118 per barrel. Yet, when Gustav intensified to a devastating Category 4 and was now absolutely clear that it would cross the oil fields in the gulf, right through the middle of it all, the price… stayed put.

Oil companies haven’t even begun to assess the damage to its local infrastructure, when the word on the exchange was that everything was all right with it, so the price went down from $115 to $109. Oh, by the way, the dollar fell against the Euro that week (once again – weaker $US should indicate stronger crude oil prices).

Why is this happening? I think the answer is “lack of information and transparency on the commodity markets”. Without knowing for certain how much of the created demand for contracts is driven purely by speculation, many traders do not know what to expect when the tiniest threat to supply happens. They try to secure their deliveries and drive the price up. Meanwhile, speculators have surely realized the bubble burst and are looking for any way to recuperate from their losses and use any spike of the price to pull out even more positions.

This brings us to last weekend’s paradox.

Ike, landing as a Category 2 hurricane, hit Texas right at the heart of the U.S. oil refinery center – Houston. As expected, gasoline prices went up dramatically, once again flirting with, or exceeding the $4 mark. By Sunday, September 14, 2008, the world was that the refineries fared better than expected and crude processing could be restarted very quickly.

The price of crude oil fell!!!

Now, here’s the problem with this picture: oil refineries refine crude oil into usable products – gasoline, heating oil, asphalt, etc. If oil refineries are down, these end products naturally become more expensive (supply goes down, price goes up). However, the price of crude oil should slide down, since there will be less facilities to refine crude, hence the demand for crude would fall.

And when OPEC recently said that it will curtail production to counter the falling price of oil, the price of crude on the world markets reacted accordingly… by coming down even further.

Many analysts continue to boast decreasing world supply as the reason for the falling price of crude. While this may be the case, did supply go down so much that it would merit a more than 30% price drop in just a few short months?

Like it or not, oil and other basic commodities are too important for today’s global economy and their prices inevitably affect everyone. Such a critical part of the world’s business machine should not be left without oversight as it could derail every effort to correct its course. New set of regulation on the commodity markets that will make them a lot more transparent than they are right now (and they are currently as transparent as a mirror in a steam room) is urgently needed, otherwise bubbles will eventually form, especially when regulations elsewhere put an increasing pressure on financial firms to play by the rules, hurting all of us in the process.

All bubbles eventually burst. That’s why they are bubbles. I would personally suspect that crude would go down below $90, possibly even below $80, but that is ultimately irrelevant. We should use this break from the soaring prices to create new regulations to safeguard against repeating history, as well as to find alternatives to oil as soon as possible. Yes, that could save the environment in the process, but either way, at some point, all oil will be pumped out of the ground (at this rate of extraction, and it will surely speed up anyway, estimates are that we have enough oil to last us only between 50 and 150 years) and then, there will be no more oil to charge for it, let alone buy it.

Oh, and by the way, that could save the environment too.

P.S. When this article was written, price of oil continued to slide and is now around $95.

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