Story of Crude Oil

By now it is becoming too obvious that theUnited States is playing the oil game all overagain. And this is the desperate gamble of acountry whose economy is neck deep introuble.Given this scenario, managing prices of oil iscentral to the US economic architecture.Expectedly, this gamble has been played in agreat alliance between the US government,US financial sector and the media.I have earlier written about:
The impending collapse of the US dollar onaccount of the inherent weakness in the USeconomy caused by its structural weakness as reflected in the subprimecrisis;
The repeated softening of the interest rates in the US that has thepotency to kill the US dollar; and
How the fall in the US dollar suits the US corporate sector, especiallyits omnipotent financial sector.Naturally, since the past few years, the US financial sector has begun to turnits attention from currency and stock markets to commodity markets.According to The Economist, about $260 billion has been invested into thecommodity market -- up nearly 20 times from what it was in 2003.Coinciding with a weak dollar and this speculative interest of the US financialsector, 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 indeedinteresting to note here is that unlike margin requirements for stocks whichare as high as 50 per cent in many markets, the margin requirements forcommodities is a mere 5-7 per cent.This implies that with an outlay of a mere $260 billion these speculatorswould 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 Londonand denominated in US dollar only. Naturally, it has been opined by expertsthat since the advent of oil futures, oil prices are no longer controlled byOPEC (Organization of Petroleum Exporting Countries). Rather, it is nowdone by Wall Street.This tectonic shift in the determination of international oil prices from thehands of producers to the hands of speculators is crucial to understandingthe oil price rise.Today's oil prices are believed to be determined by the four Anglo-Americanfinancial companies-turned-oil traders, viz., Goldman Sachs, Citigroup, J PMorgan Chase, and Morgan Stanley. It is only they who have any idea aboutwho is entering into oil futures or derivative contracts. It is also they who areplacing bets on oil prices and in the process ensuring that the prices of oilfutures go up by the day.But how does the increase in the price of this oil in the futures marketdetermine the prices of oil in the spot markets? Crucially, does speculation inoil influence and determine the prices of oil in the spot markets?Answering these questions as to whether speculation has supercharged thedemand for oil The Economist, in its recent issue, states: 'But that is plainwrong. Such speculators do not own real oil. Every barrel they buy in thefutures markets they sell back again before the contract ends. That mayraise the price of 'paper barrels,' but not of the black stuff refiners turn intopetrol. It is true that high futures prices could lead someone to hoard oiltoday in the hope of a higher price tomorrow. But inventories are notespecially full just now and there are few signs of hoarding.'On both counts -- that speculation in oil is not pushing up oil prices, as wellas on the issue of the build-up of inventories -- the venerable Economist iswrong.The finding of US Senate Committee in 2006In 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 marketspeculation in oil and gas prices. The report points out that large purchase of crude oil futures contracts by speculators has, in effect, createdadditional 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 thatthe 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 tospeculation!But the report found a serious loophole in the US regulation of oil derivatives trading, which according to experts could allow even a 'herd ofelephants to walk to through it.' The report pointed out that US energy futures were traded on regulated exchanges within the US andsubjected 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 OTCelectronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron into the Commodity FuturesModernization 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 togauge the extent of speculation in the markets and to detect, prevent, and prosecute price manipulation. In contrast, however, traders onunregulated OTC electronic exchanges are not required to keep records or file any information with the CFTC as these trades are exempt fromits oversight.Consequently, as there is no monitoring of such trading by the oversight body, the committee believes that it allows speculators to indulge inprice 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 thebeholder. In the absence of data, however, it is impossible to begin the analysis or engage in an informed debate over whether our energymarkets 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.The link to the spot marketsNow 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 theconsumption pattern. No wonder, a mere 3-4 per cent annual global growth has translated into more than a 40 per cent annual increase inprices 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 ifsupplies exceed demand by a substantial margin can any downward pressure on oil prices be created. In contrast, if someone with deeppockets picks up even a small quantity of oil, it dramatically alters the delicate global demand-supply gap, creating enormous upward pressureon 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, forthe past year and a half these reserves have doubled to more than 700 million barrels. Naturally, this build-up of strategic oil reserves by theUS (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 theUS government? Worse still, are they bordering on recklessness knowing fully well that if the oil prices fall the US government will be forced toa '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 350million 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 printingpresses 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 itsprediction.And, in the past three years alone the world has paid an estimated additional $3 trillion for its oil purchases. Oil speculators (and not oilproducers) 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 andthe link broken, oil prices cannot be controlled.