The real reason why oil prices are rising - Interesting Read!!

The real reason why oil prices are rising

By now it is becoming too obvious that the United States is playing the oil game all over again. And this is the desperate gamble of a country whose economy is neck deep in trouble.

Given this scenario, managing prices of oil is central to the US economic architecture. Expectedly, this gamble has been played in a great alliance between the US government, US financial sector and the media.

The impending collapse of the US dollar on account of the inherent weakness in the US economy caused by its structural weakness as reflected in the sub-prime crisis;

The repeated softening of the interest rates in the US that has the potency to kill the US dollar; and how the fall in the US dollar suits the US corporate sector, especially its omnipotent financial sector.

Naturally, since the past few years, the US financial sector has begun to turn its attention from currency and stock markets to commodity markets. According to The Economist, about $260 billion has been invested into the commodity market -- up nearly 20 times from what it was in 2003.

Coinciding with a weak dollar and this speculative interest of the US financial sector, prices of commodities have soared globally.

And most of these investments are bets placed by hedge and pension funds, always on the lookout for risky but high-yielding investments. What is indeed interesting to note here is that unlike margin requirements for stocks which are as high as 50 per cent in many markets, the margin requirements for commodities is a mere 5-7 per
cent.

This implies that with an outlay of a mere $260 billion these speculators would be able to take positions of approximately $5 trillion -- yes, $5 trillion! -- in the futures markets. It is estimated that half of these are bets placed on oil.

Oil price hike: Govt can't save you: PM
Readers may note that oil is internationally traded in New York and London and denominated in US dollar only. Naturally, it has been opined by experts that since the advent of oil futures, oil prices are no longer controlled by OPEC (Organization of Petroleum Exporting Countries). Rather, it is now done by Wall Street.

This tectonic shift in the determination of international oil prices from the hands of producers to the hands of speculators is crucial to understanding the oil price rise.

Today's oil prices are believed to be determined by the four Anglo- American financial companies-turned-oil traders, viz., Goldman Sachs, Citigroup, J P Morgan Chase, and Morgan Stanley. It is only they who have any idea about who is entering into oil futures or derivative contracts. It is also they who are placing bets on oil prices and in the process ensuring that the prices of oil futures go up by the day.

But how does the increase in the price of this oil in the futures market determine the prices of oil in the spot markets? Crucially, does speculation in oil influence and determine the prices of oil in the spot markets?

Answering these questions as to whether speculation has supercharged the demand for oil The Economist, in its recent issue, states: 'But that is plain wrong. Such speculators do not own real oil. Every barrel they buy in the futures markets they sell back again before the contract ends. That may raise the price of 'paper barrels,' but not of the black stuff refiners turn into petrol. It is true that high futures prices could lead someone to hoard oil today in the hope of a higher price tomorrow. But inventories are not especially full just now and there are few signs of hoarding.'

On both counts -- that speculation in oil is not pushing up oil prices, as well as on the issue of the build-up of inventories -- the venerable Economist is wrong.

The finding of US Senate Committee in 2006
In June 2006, when the oil price in the futures markets was about $60 a barrel, a Senate Committee in the US probed the role of market speculation in oil and gas prices. The report points out that large purchase of crude oil futures contracts by speculators has, in effect, created additional demand for oil and in the process driven up the future prices of oil.

The report further stated that it was 'difficult to quantify the effect of speculation on prices,' but concluded that 'there is substantial evidence that the large amount of speculation in the current market has significantly increased prices.'

The report further estimated that speculative purchases of oil futures had added as much as $20-25 per barrel to the then prevailing price of $60 per barrel. In today's prices of approximately $130 per barrel, this means that approximately $100 per barrel could be attributed to speculation!

But the report found a serious loophole in the US regulation of oil derivatives trading, which according to experts could allow even a 'herd of elephants to walk to through it.' The report pointed out that US energy futures were traded on regulated exchanges within the US and subjected to extensive oversight by the Commodities Future Trading Commission (CFTC) -- the US regulator for commodity futures market.

In recent years, the report however pointed out to the tremendous growth in the trading of contracts which were traded on unregulated OTC (over-the-counter) electronic markets. Interestingly, the report pointed out that the trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron into the Commodity Futures Modernization Act in 2000.

The report concludes that consequential impact on account of lack of market oversight has been 'substantial.'

NYMEX (New York Mercantile Exchange) traders are required to keep records of all trades and report large trades to the CFTC enabling it to gauge the extent of speculation in the markets and to detect, prevent, and prosecute price manipulation. In contrast, however, traders on unregulated OTC electronic exchanges are not required to keep records or file any information with the CFTC as these trades are
exempt from its oversight.

Consequently, as there is no monitoring of such trading by the oversight body, the committee believes that it allows speculators to indulge in price manipulation.

Finally, the report concludes that to a certain extent, whether or not any level of speculation is 'excessive' lies entirely in the eye of the beholder. In the absence of data, however, it is impossible to begin the analysis or engage in an informed debate over whether our energy markets are functioning properly or are in the midst of a speculative bubble.

That was two years back. And much water has flown in the Mississippi since then.


Now to answer the second leg of the question: how speculators are able to translate the future prices into spot prices.

The answer to this question is fairly simple. After all, oil price is highly inelastic -- i.e. even a substantial increase in price does not alter the consumption pattern. No wonder, a mere 3-4 per cent annual global growth has translated into more than a 40 per cent annual increase in prices for the past three or four years.

But there is more to it. One may note that the world supply and demand is evenly matched at about 85 million barrels every day. Only if supplies exceed demand by a substantial margin can any downward pressure on oil prices be created. In contrast, if someone with deep pockets picks up even a small quantity of oil, it dramatically alters the delicate global demand-supply gap, creating enormous upward pressure on prices.

What is interesting to note is that the US strategic oil reserves were at approximately 350 million barrels for a decade till 2006. However, for the past year and a half these reserves have doubled to more than 700 million barrels. Naturally, this build-up of strategic oil reserves by the US (of 350 million barrels) is adding enormous pressure on the oil demand and consequently its prices.

Do the oil speculators know of this reserves build-up by the US and are indulging in rampant speculation? Are they acting in tandem with the US government? Worse still, are they bordering on recklessness knowing fully well that if the oil prices fall the US government will be forced to a 'Bears Stearns' on them and bail them out? One is not sure.

But who foots bill at such high prices? At an average price of even $100 per barrel, the entire cost for the purchase of this additional 350 million barrels by the US works out to a mere $35 billion. Needless to emphasise, this can be funded by the US by allowing it currency printing presses to work overtime. After all, it has a currency that is acceptable globally and people worldwide are willing to exchange it for precious oil.

No wonder Goldman Sachs predicts that oil will touch $200 to a barrel shortly, knowing fully well that the US government will back its prediction.

And, in the past three years alone the world has paid an estimated additional $3 trillion for its oil purchases. Oil speculators (and not oil producers) are the biggest beneficiaries of this price increase.

In the process, the US has been able to keep the value of the US dollar afloat -- perhaps at an extra cost of a mere $35 billion to its exchequer!

The global crude oil price rise is complex, sinister and beyond innocent economic theories of demand and supply. It is speculation, geopolitics and much more. Obviously, there is a symbiotic link between the US, the US dollar and the oil prices. And unless this truth is understood and the link broken, oil prices cannot be
controlled.

Ban of Commodity Futures: Is it justified? KARVY

Futures trade in agriculture commodities had another bad day on 7 May 2008 with FMC announcing suspension of futures trade in four commodities namely chana, soy oil, potato and rubber for four months that is till 6th September. Government has already de-listed four major commodities like wheat, rice, urad and tur in January – February 2007. Government was under pressure from various political parties for last few weeks to impose ban on futures trade in essential commodities, alleging futures trading is responsible for sharp rise in prices. Inflation remained above 7% for four consecutive weeks from March onwards.

Commodity futures provide platform for farmers, traders, exporters and other corporates to hedge their positions. Speculators provide liquidity in the market with active participation. Prices of any commodity follow its own fundamentals and price manipulation by few traders is not possible if it is perfect market.

Supply-Demand mismatch
Prices of agriculture commodities especially edible oils, chana and rubber rose sharply in the past six months. Soy oil prices gained by about 35% with in short span of in five months (October 2007 and February 2008) and touched Rs.740 per quintal in domestic markets. Domestic prices moved up sharply tracking global prices especially CBOT and MDEX. At CBOT, prices gained by about 47% during same period. Global Soy bean output has declined by 7 percent to 220 million tonnes in 2007-08 against 237 million tonnes in previous year. Edible oil seeds production has also declined to 390 million tonnes compared to 408 million tonnes in last year. Major fall in soy bean output was in US with decline of around 20% in this season. Short fall in global output of soy bean and shifting large chunk of agriculture produce for bio-fuels led to sharp gain in prices of all the edible oils.

Chana prices also have gained by more than 30% in the last six months due to lower output concerns. Production of rabi chana 2007-08 estimated below 50 lakh tonnes compared to 58 lakh tonnes in previous year. Carry forward stocks are almost nil. Prices were trading at one year low of Rs.2000 per quintal during end of 2008 and lower estimates led to sharp rise in prices towards Rs.3000 per quintal in last 4-5 months. India imported more than 1.2 million tonnes of pulses in 2007-08 and failed to keep prices low as import prices ruled high. India annually produces about 13-14 million tonnes of pulses and this output almost stagnant for last 15 years. Consumption is rising every year with increasing population. India is largest importer of pulses and import about 2-3 million tonnes.

Rubber prices have gained by 23 percent in the last four months in domestic markets. Rubber global production is 9.89 million tonnes in 2007 compare to 9.68 million tonnes in 2006, while, consumption has increased to 9.73 million tonnes in 2007 from 9.21 million tonnes in 2006. India has produced about 8.25 lakh tonnes in 2007-08 compare to 8.53 lakh tonnes in previous year. Increasing demand for rubber in global markets and strong crude oil prices led to sharp rise in prices in recent past.

Potato prices fell from recent high of Rs.650 levels to Rs.450 with in span of one month with increasing arrivals. Output estimated at 28-29 million tonnes in 2007-08 higher from 25 million tonnes in previous season. Higher arrivals and lack of demand pulled down the prices of potato. Few state governments including West Bengal provided intervened in spot markets to support the prices.

Government measures
Government took various measures to control the rising prices of food commodities. It reduced import duty on refined edible oil from 40-45% to zero percent in March 2008 to control the rising prices of edible oils. India import about 50% of total domestic requirement and is price taker in global markets.

Price movement especially in Malaysia and US has direct impact on domestic markets. Edible oil prices have marginally come down in the past one month after Government reduced import duty on edible oils. Soy oil prices fell by Rs.150 per quintal with in span of one month. Apart from reducing import duties on edible oils, Government also directed states to strictly impose the stock limits on food grains and pulses.

Various states including Maharashtra, Andhra Pradesh and Delhi conducted raids on stock hoarders to bring out the excess stocks. This led to panic selling of pulses in spot markets and led to sharp fall in prices of most of pulses. Chana prices fell from recent high of Rs.3000 levels towards Rs.2300 with in one month period.

Impact of recent Government measures
In spite of taking these many measures, inflation remained high and touched 42 month high of 7.61% for week ending 26th April. Prices of most of agriculture commodities fell in the past few weeks as a result of Government intervention and also declining demand at higher levels apart from fall in prices of edible oils in global markets. However, higher prices of non-agriculture commodities like steel and cement remained high boosting inflation further.

Outcome of Abhijit sen committee report
Abhijit sen committee was constituted in March 2007 to study the impact of futures trade on agriculture commodity prices. it submitted report on 29th April 2008 to Government. It found no evidence of futures trade affecting the spot prices of agriculture commodities. His statements was, "I don't think one can say anything conclusively whether futures impacted prices," after submitting the report to Agriculture department. It recommended continuation of futures ban on wheat, rice, urad and tur, but not recommended any fresh ban on any commodities.

Is suspension justified?
Now big question arises as to what was the need for suspension of futures trade in four agriculture commodities when prices of edible oils have already eased and they are largely influenced by global factors rather than domestic factors.

It is strange that soy bean is left out from this list and Soy oil, a biproduct of soy bean has been suspended.

Chana prices have already fallen by 20% in last one month and what was the need to suspend futures rather than improving supply.

Potato prices are already trading at one year low and farmers are affected due to lower prices. Those who are demanding imposition of ban on futures trade in agriculture commodities are themselves providing support price to potato in West Bengal. Now it is very difficult to understand in what way Potato prices caused the inflation.

Volumes in rubber futures are almost nil in exchanges and there is no question of speculation increasing the prices with such low volumes. Also one should understand that Rubber and Soy oil are internationally traded commodities and domestic prices move in tandem with the international prices. Now it is important to watch for how long the disparity is maintained given the supply- demand mismatch across the world.

Various sections of people have criticized this decision of Government and real market players have lost confidence in futures trade. This includes representatives of various organizations of exporters, importers, processers etc. All these participants were using exchanges to hedge their positions. Now that in most of the rural areas NCDEX prices have become the bench mark, the farmer and small trader community will be deprived of better price discovery mechanism. Since Chana and Soy oil future contribute almost 35% of total Agri futures volumes, the future of Commodity derivatives market will be under threat.

Time and again suspension of future commodities trade to tame the domestic inflation will dilute the basic objective of introducing futures trade in India. As this is just a suspension and not a complete ban, the reintroduction may not result in good volumes since the participants have already lost their trust in Government. To conclude the government should focus more on ensuring enough supplies in the market with measures such as enhancing productivity, better cultivation practices etc.

CRUDE OIL BUBBLE: IS IT A CASE OF " IRRATIONAL EXUBERANCE"?

The recent gravity defying surge in Crude Oil has attracted much attention and generated heated debate across the globe. A 99% annual appreciation in prices of world's principal source of fuel is bound to affect all countries and their inhabitants in a big way. The situation is even worse at MCX, India, where a depreciating rupee (against dollar) has further added momentum to the rally as a stronger dollar directly translates to costlier imports (read Crude Oil). In my previous posts in the same blog and numerous articles, presentations, lectures and private discussions, I had reiterated that the era of "Easy/Cheap" oil is over. However, the way the Crude Oil is scaling newer highs each day has put analysts across the world in a fix. It is not the $130 or $135 level which is alarming us but the speed with which these milestones are being achieved.

Market is equally divided between those who are seeing further upside and between those who are expecting a substantial correction in near term.

The reasons for a deeper correction/profit booking in Crude Oil are numerous.

There are many reasons to assume that market is overreacting to Oil bullish factors. What is being ignored is the fact that Commodity business is a cyclical one. Higher Crude Oil prices (or any other commodity) are self defeating as it directly translates into a reduction in demand as the consumers start cutting down on consumption or switches to cheaper alternative. Arjun Murti of Goldman Sachs who has to his credit many doomsday prophecies (including the recent Crude at $ 200 one) himself drives in a Hybrid car.

Many banks and investment firms have come out to defend the rise in oil prices, saying that it is based on fundamentals and that prices could rise much further. Analysts like Arjun Murti, Pickens, Guppy etc. and market movers like Goldman Sachs, UBS are constantly raising the projection levels in prices, thus sending the prices over the roof. While they go on saying this and prices continues to move upward, open interest in crude futures contracts has been moving steadily downward since a high of 1.58 million last July to 1.36 million now.

But aren't there fundamental reasons for this rise in oil prices? In some ways yes, demand from China and India is increasing, but at a slower pace than oil has gone up. The chief market strategist for one of the world's leading oil industry banks, David Kelly, of J.P. Morgan Funds, recently admitted something telling to the Washington Post, "One of the things I think is very important to realize is that the growth in the world oil consumption is not that strong." One of the stories used to support the oil futures speculators is the allegation that China 's oil import thirst is exploding out of control, driving shortages in the supply-demand equilibrium. The facts do not support the China demand thesis however. The US Government's Energy Information Administration (EIA) in its most recent monthly Short Term Energy Outlook report, concluded that US oil demand is expected to decline by 190,000 b/d in 2008. That is mainly owing to the deepening economic recession. Chinese consumption, the EIA says, far from exploding, is expected to rise this year by only 400,000 barrels a day. That is hardly the "surging oil demand" blamed on China in the media. Last year China imported 3.2 million barrels per day, and its estimated usage was around 7 million b/d total. The US , by contrast, consumes around 20.7 million b/d. That means the key oil consuming nation, the USA, is experiencing a significant drop in demand. China, which consumes only a third of the oil the US does, will see a minor rise in import demand compared with the total daily world oil output of some 84 million barrels, less than half of a percent of the total demand. The Organization of the Petroleum Exporting Countries (OPEC) has its 2008 global oil demand growth forecast unchanged at 1.2 mm bpd, as slowing economic growth in the industrialised world is offset by slightly growing consumption in developing nations. OPEC predicts global oil demand in 2008 will average 87 million bpd -- largely unchanged from its previous estimate. Demand from China , the Middle East , India , and Latin America -- is forecast to be stronger but the EU and North American demand will be lower.

Not only is there no supply crisis to justify such a price bubble. There are several giant new oil fields due to begin production over the course of 2008 to further add to supply.


The world's single largest oil producer, Saudi Arabia is finalizing plans to boost drilling activity by a third and increase investments by 40 %. Saudi Aramco's plan, which runs from 2009 to 2013, is expected to be approved by the company's board and the Oil Ministry this month. The Kingdom is in the midst of a $ 50 billion oil production expansion plan to meet growing demand in Asia and other emerging markets. The Kingdom is expected to boost its pumping capacity to a total of 12.5 mm bpd by next year, up about 11 % from current capacity of 11.3 mm bpd. In April this year Saudi Arabia 's Khursaniyah oilfield began pumping and will soon add another 500,000 bpd to world oil supply of high grade Arabian Light crude. As well, another Saudi expansion project, the Khurais oilfield development, is the largest of Saudi Aramco projects that will boost the production capacity of Saudi oilfields from 11.3 million bpd to 12.5 million bpd by 2009. Khurais is planned to add another 1.2 million bpd of high-quality Arabian light crude to Saudi Arabia 's export capacity.

Brazil 's Petrobras is in the early phase of exploiting what it estimates are newly confirmed oil reserves offshore in its Tupi field that could be as great or greater than the North Sea . Petrobras, says the new ultra-deep Tupi field could hold as much as 8 billion barrels of recoverable light crude. When online in a few years it is expected to put Brazil among the world's "top 10" oil producers, between those of Nigeria and those of Venezuela .


In the United States, aside from rumors that the big oil companies have been deliberately sitting on vast new reserves in Alaska for fear that the prices of recent years would plunge on over-supply, the US Geological Survey (USGS) recently issued a report that confirmed major new oil reserves in an area called the Bakken, which stretches across North Dakota, Montana and south-eastern Saskatchewan. The USGS estimates up to 3.65 billion barrels of oil in the Bakken. These are just several confirmations of large new oil reserves to be exploited. Iraq , where the Anglo-American Big Four oil majors are salivating to get their hands on the unexplored fields, is believed to hold oil reserves second only to Saudi Arabia . Much of the world has yet to be explored for oil. At prices above $60 a barrel huge new potentials become economic. The major problem faced by Big Oil is not finding replacement oil but keeping the lid on world oil finds in order to maintain present exorbitant prices. Here they have some help from Wall Street banks and the two major oil trade exchanges—NYMEX and London-Atlanta's ICE and ICE Futures.

Moreover, the argument that Crude Oil is tracking a weaker dollar doesn't hold true anymore. Euro has corrected sharply from its high of 1.6018 against the dollar. Signs of slowdown are being identified in Eurozone as well and ECB's Trichet has come under pressure to review his tight monetary policy. On the other hand recently released US economic indicators and have been largely mixed and point towards relative stabilization of Housing and labor market. Moreover with commodity prices going over the roof, US Federal Reserve may soon return to the policy of Inflation targeting. Interest-rate futures show the Federal Reserve may start to raise U.S. borrowing costs by the end of the year as the economy recovers and inflation accelerates. Earlier, seven interest-rate cuts by the Fed since September sent the dollar to an all-time low against the euro in April, boosting gold and other commodities.

Moreover, Crude Oil being a political (and strategic) commodity, we may very well see intervention from US on the issue of high prices. Entire global economy, especially that of US is under strong pressure due to Crude Oil induced inflation. Recently, the US House of Representatives overwhelmingly approved legislation allowing the Justice Department to sue OPEC members for limiting oil supplies and working together to set crude price. Already, President Bush in his recent trip to Gulf has pressurised Saudi Arabia, the most influential OPEC member to increase the Crude Oil production by 300,000 million barrels per day. Also, if recent indications are to be believed, U.S. Government is soon expected to force regulators to raise margin requirements under current market conditions, specifically with respect to the oil markets. This could have a dramatic downward effect on prices. (Remember silver and the Hunt Brothers in 1980.) In April 2008, U.S. Sen. Byron Dorgan, a North Dakota Democrat, told Congress, "There is an orgy of speculation in futures markets. This is a 24-hour casino with unbelievable speculation." He and others in Congress have been raising the idea of changing margin requirements that traders must pay up front in order to engage in oil speculation. Dorgan said stock speculation requires a 50% margin, but commodities like oil demand a much lower threshold, just 5% or 7%.

No doubt, Crude Oil, being in limited supply, is fundamentally strongest commodity around. But the way the recent spike has pushed the prices of the liquid gold has raised many an eyebrow and in coming days we may expect a substantial correction. Though a break below $100 is certainly not anticipated and too far fetched, a correction to the tune of $ 20 from current levels cannot be ruled out. However, traders should refrain from taking a short position arbitrarily and should wait for the confirming trend. Like any other market analysts, I too have faith in the old adage "Market is always right" and "Trend is your friend".

Courtsey:salmanspeaks.co.nr