Myth-makers caught short in oil speculation
By R M Cutler
BRUSSELS - As in military science there is the danger of "fighting the last
war", so in economic science there is the danger of puncturing the last bubble.
This is especially hazardous when what one has is not, in fact, a bubble. Then,
the myths of such a bubble are what need puncturing. So it is today with oil
prices, which this week hit a record US$139.89 a barrel.
Is demand actually decreasing in India and China? No, demand is still rising;
it is the rate of increase of demand that is declining, and also not by much.
Or, perhaps, is oil a hedge against dollar weakness? "The dollar," said
Canadian Finance Minister Jim Flaherty at the Group of Eight (G-8)meeting of
his colleagues last weekend in Osaka, "is a market currency." And "one does not
interfere with a market currency".
The G-8 finance ministers basically admitted there was not much they could do
about the recent worldwide increases in the price of oil, which has more than
doubled from a year ago, or, for that matter, other commodities. All that they
could bring themselves to do was to commission a study from the International
Monetary Fund to determine what effect speculators may be having on oil
supplies.
So are oil prices in a "bubble" manipulated by speculators, as American
financier George Soros told a US Senate committee earlier this month? Soros is
not hands-on enough today to be accused of venting frustration at having to
cover massive shorts as the price of a barrel shot close to $140 towards the
end of the first week of the month. (He retired from day-to-day fund management
some time after his September 1982 coup against the British pound.) Indeed, he
warned in that same testimony that he does not consider himself an expert on
the oil market and stays away from it. Clearly, his finesse at hedging remains
unimpaired.
In fact, hedging is not so far from the heart of the matter. The US futures
exchanges may alter their reporting format in the foreseeable future so as to
separate futures contracts for delivery from those typically canceled and
renewed for the following month, which practice creates statistics that some
think inflates reported oil demand. This matter is at the center of the
successful negotiations last week by the US Commodity Futures Trading
Commission (CFTC) to close the "London loophole".
The "London loophole" consisted of trading on the Intercontinental Exchange
(ICE), the leading electronic exchange for futures and energy contracts, that
did not have to be reported to the CFTC.
The CFTC has also set up an interagency task force to study developments in
commodity markets, including the role of speculators. In the US, members of
Congress, who have held a series of hearings looking into what is driving
energy prices to record levels, are pressing the CFTC to increase oversight of
the fuel market.
ICE chief executive Jeff Sprecher told Bloomberg News that his figures reveal
not speculators but rather hedgers - "this rapid influx of commercial users"
buying contracts now for real future deliveries in order to avoid future price
increases - as the driving force in oil pricing today.
Nor did Soros fail to mention that fact in elliptical fashion, although media
reports did fail adequately to stress the second half of his pull-quote: the
bubble that he saw, he said, "is superimposed on an upward trend in oil prices
that has a strong foundation in reality" (emphasis added). Last week,
the Financial Times of London noted one indicator of this "strong foundation in
reality" when it reported that refiners are paying record premiums for
high-quality crude oil to produce diesel and gasoline, something that they
would hardly be doing in the absence of strong demand in the physical oil
market.
Any discussion of oil prices and the complex chain that links unrefined oil to
products bought by consumers must also include reference to the large worldwide
complex of middlemen who follow the instant-to-instant demand for the dozens of
refined petroleum products available. Refiners tweak their valves to produce
whatever gives them the greatest margin at the moment, based on orders from
those middlemen who are in direct and indirect contact with end buyers. The
people who do this operate on the basis of contract prices for delivery of
physical goods, not oil that exists only in paper contracts.
In the aftermath of Hurricane Katrina, in late August 2005, which struck a
vital oil production and refining region of the US, the press was rife with
true and correct reports about shortages of refinery capacity. US Gulf Coast
region refinery capacity before the hurricane was just over 8 million barrels
per day, representing no less than 47.4% of total US capacity (not to mention
being home to over a quarter of federal offshore crude oil production), and
9.9% of world refinery capacity at the time. This continuing shortage has not
been recently emphasized.
The post-Katrina reports on refinery shortages appeared mostly in the North
American media market and dealt mainly with US retail products. The specialized
global financial press noted that this phenomenon of refinery shortages was
worldwide. World refining capacity as a multiple of world oil demand had
dropped from 111% in 1990 to 103% in 2004. As it takes an absolute minimum of
three years to get a new refinery up and running, and the US Congress did not
get around to passing a bill giving greater incentives to refinery construction
until 2007, this American situation has not changed much.
On a worldwide scale, of course, available statistical series compiled
variously by governments, industry and international agencies differ slightly
among themselves, and estimates are continually being fine-tuned. But the
overall consensus appears to be that, even if global demand grows less quickly
because of an economic downturn, still by 2010 the key capacity/demand ratio is
very unlikely to exceed 104% by much, if any. This is not really enough slack
to make up for natural disaster outages, maintenance downtime and the like.
The Financial Times suggests, probably correctly, that a fixation on oil
futures prices in New York and London is responsible for relative inattention
in the continuing shortage in refinery capacity. That refining shortage is
surely one reason why the oil markets basically shrugged off Saudi Arabia's
announcement, a few days ago, that it would increase production by 200,000
barrels per day after having increased it by 300,000 a few months ago.
Another reason for lack of response to the Saudi move was skepticism that the
announcement would (or even could) be matched by deeds. The Paris-based
International Energy Agency expects to publish towards the end of this year its
first survey of reserves based on field-by-field estimates for the 400 largest
fields worldwide, which are together responsible for about two-thirds of world
production and, of course, a number of the largest of which are in Saudi
Arabia. Prominent press leaks over the past few weeks foretell a conclusion
that these reserves are significantly lower than once thought.
The view that high oil prices are due to a shortage of refining capacity in
industrialized nations was supported this week by the United Arab Emirates Oil
Minister Mohammed al-Hamli.
"There are not enough refineries to meet growing demand," Hamli told the Gulf
News daily, according to a Reuters report on Tuesday. "A shortage of refineries
is one of the main reasons behind the increasing prices as a result of the
policies adopted by industrialized nations not to invest in new refineries due
to environmental concerns, while the sector needs substantial new investments."
None of this is to say that oil prices may not fall in the future, and even
fall importantly. Possibly prices will spike still higher, and then appear to
crash, relatively speaking. But it is hard to keep an unsubstitutable commodity
down for long.
R M Cutler (rmc@alum.mit.edu and http://www.robertcutler.org)
is a Canadian international affairs specialist.
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