Invisible hands behind oil prices

Praveen Jaiswal Vice President (Operations & HR) Lanka IOC PLC, Colombo

“There are 100 reasons for oil prices to rise...”, said Adam Sieminski, Deutsche Bank’s Chief Energy Economist.

“The only thing that will end this rally is a serious economic downturn”.

Demand is still expected to grow by more than 1 million barrels a day this year. Classical demand-supply studies tell us that if prices were to go up, then new supply or substitutes will come into picture.

What is happening today is that there is a fundamental change happening in the way oil is priced and the change is happening because we are transitioning from a buyers market to a sellers market.

As said by Jean Laherrere, a retired geophysicist and geologist “the problem is not with the tank but with the tap”. Geologists say “there’s no point recovering a barrel of crude if it uses more energy to extract than the barrel itself will produce”.

Admittedly, there is a persistent rise in global oil demand, but it is unreasonable to solely blame the market for the “oil bubble”, there are other “invisible hands” behind the crazy oil prices.

Oil supply and demand fundamentals do not look all that different than they did at $50 per barrel. Much-vaunted geopolitical risks are mostly the same, and the passage of time has likely diluted their influence on oil prices.

Although commercial stocks to confront any feared supply disruptions are somewhat lower, strategic reserves have grown and the traditional “obligation to serve” on the part of oil companies has clearly passed to governments. OPEC is bigger, but does not appear to be any more or any less disorganized, nor any less attentive to oil market conditions. What has apparently changed is everything else.

Non fundamental factors from outside the oil market have become a major contributor to oil price formation and at times appear to be the dominant factor driving prices upward.

Buying of oil in paper markets for reasons unrelated to oil market conditions has not only complicated oil market analysis, it has rendered much of the traditional approaches to international oil policy, by both consumers and producers, frustratingly ineffectual.

The economic and financial context in which oil markets operate has changed dramatically over the last four to five years, with oil prices being as much a result as a cause of those changes.

A chronically weakened dollar, a slowing US economy, a battered US real estate market and similarly punished global equity markets have made commodities such as oil a favoured “asset class”. Activity in derivatives markets has ballooned to become orders of magnitude larger than physical oil markets.

Even on the relatively limited regulated paper markets, volumes have topped an equivalent of 700 million barrels per day of daily futures trading and nearly 3 billion barrels of open interest in futures alone, with options and various other instruments like swaps, royalty trusts and various other oil-based paper products probably accounting for several multiples of that.

While some economists puzzle over the lack of visible consumer response to the price run-up, others see the potential for a quick response from a government “policy elasticity” of oil and says, “inflation is too high and interest rates need to go up” is a much greater threat to the economy and oil demand that marginal changes in buying and use patterns-not to mention much slower “life-style changes” - in reaction to higher oil prices.

But the opposite has happened as the US Federal Reserves continues to be more concerned about the economy than inflation and has kept rates low, helping the economy and supporting oil demand while hurting the dollar, both of which contribute to a higher oil price.

Currently topping the list of non fundamental factors is the threat of a US recession. Although high oil prices have obviously contributed to economic pain, the root cause is widely credited to the sub prime mortgage crisis that has percolated through domestic financial markets and spread overseas.

Massive losses in the US banking sector led to losses in stock market valuations that were quickly reflected in foreign markets. The double whammy on consumers’ wealth from a general erosion of real estate values and lower valuations of equity portfolios has pummeled consumer confidence.

US policy-markers have reacted with a low interest rate policy to keep the housing and banking sectors from collapsing, but at the expense of sharp erosion in the value of the US dollar. With oil mostly denominated in dollars, the indirect impact on oil markets has been an overwhelming factor in the recent upward course of oil prices.

A related driver for oil prices has been the unprecedented rise in the amount of money invested in oil futures and options and other derivatives, mostly independent of oil market fundamentals. Large volumes of cash from pension funds and other institutional investment groups have been moving into commodities as an alternative to equity and fixed income investments.

This is the result of rotation out of relatively unattractive near-term prospects for these investments. The combination of large funds inflow in general and the preferential position of commodity and oil investments have resulted in a massive increase in daily flows into paper oil that is unlikely to relent.

This flow is independent of the “passive long” investors that are betting on tight oil market fundamentals over the longer term as a direct result of oil market conditions driven by high demand growth and limited supply potential.

Under the broad label of the “China Thesis,” these investors see oil demand growth in China, India and other developing countries in Asia along with producing countries in the Middle East Gulf facing plateauing non-OPEC supply driven by maturing geological prospects and OPEC supply facing above-ground constraints, rising upstream costs and a reticence about bringing on capacity “too fast”.

Sub themes in the China Thesis include well-justified concerns about the adequacy of the global refining system forced to confront not only the escalating growth in developing-country demand, but also having to produce increasingly clean light-transportation fuels from lower quality crude oils.

The scariest aspect of the rise in oil prices is of fear of something going wrong, not because of something actually going wrong. Sometimes it’s natural (hurricanes) and sometimes man-made (Iran, Nigeria and terrorism).

In history, there was no bubble that never burst, be it stock or oil prices. Oil crises have caused at least two global economic downturns, one in 1973 and the other in 1979.

China and India now have been touted as the new engine of the world economy. Therefore, if the engine fails because of high oil prices, the global economy might stall along with it. One thing for sure is that irrational oil price rises will dampen the outlook for the global economy and that in turn, may yet make the bubble makers pay for what they have done.

Fundamental and Non-Fundamental Factors Contributing to High Oil Prices

Fundamental Factors

* Growing Demand

* Low Opec Spare Capacity

* Constrained Supplies

* Low Inventories vs. Risks

* Refinery Bottlenecks

* Tightening Product Quality Standards

* Crude Oil Quality Concerns Escalation

* “Passive Long” Investors

Non Fundamental Factors

* The US Economy

* US Monetary Policy/Weak Dollar

* Pension/Hedge Funds Inflows

* Weak Stock Markets/Asset Rotation

* Geopolitical Risks/”Fear Premium”

* “Peak Oil” Mentality

* Global Warming/Carbon Taxes

* Speculative Buying

* Political Pressure