Not a big surprise to anyone is the fact that energy and food prices have steadily increased during the past year. Regular gasoline went up from around $2.40/gallon to ~$4.00/gallon (66% increase) over the one year period while food prices have gone up by more than 50% concurrently1.
Imagine the plight of the poor. For the bottom 20% of income distribution scale, food and energy costs are whooping 44% of their after tax income. Comparatively, food and energy costs are around 7% for households in the top 20% of the income distribution scale. However, it is estimated that poor households worldwide may pay nearly quarter of their income for energy costs---a 66% inflation consumes ~41% of their after tax income for energy expenses! In other words, they may be forced to make a difficult choice between energy and food. Therefore the energy inflation, we have seen over the last year, clearly has devastating effect on the world’s poor.
Currently, there is a renewed focus on the role of energy speculators2. In a town hall meeting at ElectraTherm, Inc. headquarters, President Obama said, "The attorney general is putting together a team whose job it is to root out any cases of fraud or manipulation in the oil markets that might affect gas prices, and that includes the role of traders and speculators."3 On the opposite end of the political spectrum, Republicans repeat the old mantra “Drill baby, drill!" Which is the truth? Let us explore this further.
In my view, the factors that influence oil prices can be broadly classified into the following categories:
1) Supply & Demand (e.g., increased demand from developing countries, natural disasters affecting the supply)
2) Risk Premium (e.g., Iraq war premium, Libyan unrest premium)
3) US Dollar Value Fluctuations
4) The Oil Production Peak
5) Excessive Market Speculation
Supply & Demand: The Energy Information Administration's (EIA) Petroleum Status Report provides information regarding the weekly supply/demand dynamics of petroleum products. The April 15, 2011 report clearly indicates that at 357.0 million barrels4, the crude oil inventories are at the upper limit of the average range for this time of the year and are 1.1 million barrels higher than the April 16, 2010 reserves4. Despite the continued glut in oil inventories, crude prices continued to march higher. Recently, President Obama said in a town hall meeting in Northern Virginia "It is true that a lot of what's driving oil prices up right now is not the lack of supply. There's enough supply." Clearly, supply and demand is not the cause for dramatic oil inflation.
Risk Premium: Instabilities and uprisings in oil producing nations result in uncertainties regarding oil supplies. Naturally, this translates into higher crude oil prices. The recent run up in oil prices accelerated with the revolt in Libya. However, this is not caused by a physical shortage of oil: Libyan output is only 2% of global consumption and only 2/3 of Libyan production capacity was lost. In other words, only 1.6% of the world's production was affected by the Libyan conflict. Other oil producing countries made up more than the difference by ramping up production. Based on the facts that the risk of Libyan civil war spreading to other Gulf oil producing nations does not appear high and the spare capacity of other oil producing nations is larger than it has been in years, the huge increase in crude oil prices since the start of the Libyan revolt look suspect.
U.S. Dollar Value Fluctuations: The declining dollar can explain only a fraction of the increase in oil prices. Therefore, we have to look elsewhere for the major portion of the price increase.
The Oil Production Peak: Although there is a big debate on the actual year we will be reaching peak oil production, there is a general consensus that this is not far off. This public awareness of Peak Oil added mid to long term supply uncertainty to the markets and pushed the average oil prices higher than the previous decades. There is no new information in this area during the last year. Therefore this cannot be the reason for the recent run up in the oil prices.
Excessive Market Speculation: The growing disconnect between oil inventories, the price of oil, and the strong relationship between oil prices and open interest oil future contracts (a proxy for speculative investments) strongly indicates that a significant portion of the current oil price is pure speculation. In my view, this time the turmoil that began in Tunisia and spread to Libya provided a perfect cover for speculators to run up oil prices.
In a 2008 article, F. William Engdahl presents a case to substantiate his hypothesis that perhaps 60% of the price of oil is pure speculation.5 In this regard, another interesting read is a 2008 article entitled A Few Speculators Dominate Vast Market for Oil Trading written by David Cho, a Washington Post Staff Writer.How did we let a handful of speculators control the oil markets and set the prices for one of the most important commodities?
There are two kinds of participants in the commodities markets: 1) users who hedge against future fluctuations and take delivery of the oil (e.g. end users such as airlines, trucking companies, farmers and petroleum refiners) and 2) speculators, who never take delivery but make money by placing good bets (e.g. hedge funds, financial firms, big banks, and investors).
In theory, speculators are supposed to make the market more efficient by bringing liquidity to the market. However, a gaping loophole in Government regulation of oil derivative trading resulted in excessive speculation causing either sudden/unreasonable fluctuations or unwarranted changes in the price of oil.
Before 2000, US energy futures were traded exclusively in regulated exchanges within the United States (e.g. NYMEX) subject to extensive oversight by the Commodity Futures Trading Commission (CFTC). This oversight included ongoing monitoring to detect and prevent price manipulation or fraud. Because of this the oil users (e.g. airlines, trucking companies, etc.) held the majority (~63%) of crude oil futures, while speculators accounted for the minority of the futures contracts.
However, the Commodity Futures Modernization Act of 2000 contained a provision that was inserted at the behest of Enron and other large energy traders. This provision exempted the trading of energy commodities by large firms on Over The Counter (OTC) electronic exchanges from CFTC oversight. This resulted in tremendous growth for the trading of contracts that look and are structured just like futures contracts, but which are traded on unregulated OTC electronic markets. According to an analysis by the House Energy Committee’s Subcommittee on Oversight and Investigations, by 2008, the speculators held majority (~65%) of the crude oil futures and oil users accounted for the minority---those proportions had basically flipped!
The situation got even worse and made things ripe for oil price manipulations. In January 2006, the Bush Administration’s CFTC permitted the Intercontinental Exchange (ICE) to use its trading terminals in the United States to trade US crude oil futures on the ICE futures exchange in London. The CFTC has no jurisdiction over the trading of these contracts, thus opening the way for the present unregulated and highly opaque oil futures speculation.
“The CFTC's ability to detect and deter energy price manipulation is suffering from critical information gaps, because traders on OTC electronic exchanges and the London ICE Futures are currently exempt from CFTC reporting requirements. Large trader reporting is also essential to analyze the effect of speculation on energy prices.”---states the Senate report.6
Because of favorable legislation and very low margins that are required to invest in the futures markets, speculators turned to oil futures (going long on oil while shorting the dollar). There is plenty of evidence that commodity trades helped the financial firms in Wall Street profit during the credit crisis. In fact, some analysts argue that in the coming years, commodity investments by funds could grow to $1 trillion. This kind of excessive speculation would result in much higher commodity prices for everyone in the coming years, having catastrophic economic effects on millions of already distressed consumers.
Consumers can be protected while at the same time excessive speculation can be reduced, if the US works with UK to institute the following: 1) limiting the size of the bets that speculators can make; 2) increasing the margin requirements on futures contracts significantly; 3) requiring some level of physical delivery of the oil; 4) eliminating the Enron loophole, and bringing all the futures market under the control of CFTC with significant increase in its oversight personnel and enforcement budgets.
Obviously, both big Wall Street firms and banks don’t want this. The question is does the President Obama and the Congress do the right thing?
1. Please note that rising energy prices is one of the contributing factors for the food inflation.
2. According to the Commodity Futures Trading Commission (CFTC), a speculator ‘‘does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes."
4. These figures of crude inventories exclude our Strategic Petroleum Reserves.
6. United States Senate Premanent Subcommittee on Investigations, 109th Congress 2nd Session, The Role of Market speculation in Rising Oil and Gas Prices: A Need to Put the Cop Back on the Beat; Staff Report, prepared by the Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs, United States Senate, Washington D.C., June 27, 2006.
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