Over a barrel
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Surging oil prices feed widespread panic and apocalyptic visions of a world without fuel. But it is not obvious whether speculation, rising demand or supply shortages are to blame. Daniel Ben-Ami examines the debate.
"To understand who he was, you have to go back to another time. When the world was powered by the black fuel. And the desert sprouted great cities of pipe and steel. Gone now, swept away. For reasons long forgotten, two mighty warrior tribes went to war and touched off a blaze which engulfed them all. Without fuel, they were nothing. They built a house of straw. The thundering machines sputtered and stopped. Their leaders talked and talked and talked. But nothing could stem the avalanche. Their world crumbled. The cities exploded. A whirlwind of looting, a firestorm of fear. Men began to feed on men."
"On the roads it was a white line nightmare. Only those mobile enough to scavenge, brutal enough to pillage would survive. The gangs took over the highways, ready to wage war for a tank of juice. And in this maelstrom of decay, ordinary men were battered and smashed."
Mad Max 2, the 1981 movie starring Mel Gibson, was based on a post-apocalyptic vision of a world with little oil. At the start the narrator described how a world based on oil usage had gone to war and collapsed. The film itself is centered on a besieged community, living by an oil well, surrounded by murderous renegades. The scenario, written by George Miller, was conceived in response to the oil crisis of the mid-1970s.
When crude topped $145 a barrel back in June similar anxieties were apparent. Prices for diesel and jet fuel rose even more sharply. There was a widespread fear that the surging oil price could stoke up inflation and do severe damage to the world economy. Obviously, sober commentators did not quite paint Mad Max-type scenarios but concern about the damaging effect of oil shortages were apparent.
Now that oil has fallen back to about $114 a barrel (at the time of writing) such fears have eased slightly. But concerns about energy shortages and rampant inflation have far from disappeared. In any case the oil price is still high by recent standards (see graph, page 14). Oil was only $50 a barrel in mid-January 2007 and in late 1998 it was trading at just over $10 a barrel. Even taking inflation into account its price in real terms has risen considerably.
In fact one of the strange characteristics of our age is that any movement in the oil price, in whatever direction, seems to prompt panic. Surging prices leads to anxious warnings about "peak oil" and running short of resources. Falling prices prompt concerns about the extensive use of fossil fuels and the danger of climate change. This cover story will focus on the trend towards higher energy prices rather than deal with the thorny issue of global warming (for an earlier cover story on the economics of climate change see Daniel Ben-Ami, "Climate of fear", Fund Strategy, December 11, 2006).
Although predicting with accuracy the exact movement of the oil price is almost impossible the main factors influencing its trajectory are straightforward: speculation, supply and demand. Although the relative importance of these factors can change over time they can all play an important role in principle.
It is also essential to recognise that supply and demand exist in relation to one another. A given level of supply can be high or low depending on the level of demand. The balance between the two is the most important variable to examine.
Other factors that are often discussed in relation to the oil price can generally be subsumed under one of these headings. For instance, a slowdown in the world economy is likely to lead to a reduction in the demand for oil. Geopolitical events, such as the war in Georgia, and natural disasters, such as hurricanes, can be seen as supply disruptions.
It is also necessary to distinguish between different sub-categories under the overall headings. Perhaps the most common confusion is between temporary shortages of supply, often caused by lack of investment in the necessary infrastructure, and chronic shortages. Supply shortages in the short or medium term does not necessarily imply the world is running out of oil. To understand these factors more fully it is necessary to examine each in turn.
Speculation The notion that speculation is the main force driving volatile oil prices has attracted some strange bedfellows. From politicians with little knowledge of the financial markets to financial experts; from left wing academics to right wing pundits. Oil producers, including the Organization of the Oil Producing Countries (Opec) and Venezuela's President Hugo Chavez, also frequently blame speculation for oil price volatility (see box, page 15). Both of the main candidates in the American presidential elections have attacked speculation in the oil market. Although they disagree on the solutions to the problem both have made public statements criticising the role of speculators. The House of Representatives has also passed a bill demanding a clampdown on oil trading by an overwhelming majority. No doubt many politicians of all shades see populist bashing of speculators as likely to bolster their electoral popularity.
The attacks on speculators are part of an ongoing debate that is raging in America. Michael Masters, a hedge fund manager, also attracted attention in May when he testified to the Senate's homeland security committee on how what he called "index speculators" were pushing up the oil price.
The following month the Commodity Futures Trading Commission (CFTC) set up a task force to examine the role of speculation in energy markets. Its interim report was published in July (see box, page 15) and the final version of the report is due in September.
Bill O'Reilly, a prominent conservative pundit on America's Fox News channel, has argued that: "Tough new standards should be imposed on the speculative oil market because this is a national security issue" ("Talk-ing Points: the oil war explodes", June 19, 2008).
But it was a radical British academic, in a letter to the Financial Times (FT) earlier this month, who put the basic case for speculation most clearly: "I had been wondering how defenders of the market were going to explain the recent fall in the oil price. A sudden drop of more than $30 in a month is hard to square with the official story, which is that the previous steep rise had nothing to do with financial speculation and was entirely caused by the changing balance of supply and demand" (Alex Callinicos, "Anybody's guess how oil price fell", FT, August 13, 2008).
The problem is that, although the volatility of the oil market might suggest that speculation is at work, it is not decisive proof. There are alternative explanations for the same phenomenon. In conditions where the difference between supply and demand is small a slight change in either variable can lead to big shifts in the price.
Professor Severin Borenstein, the director of the University of California Energy Institute, says: "the market is constantly trying to find out how supply and demand equilibrate". In tight market conditions: "small changes in beliefs in demand can lead to huge price changes. That's pretty basic economics". In his view speculators are simply reacting to changes in expectations rather than causing the price to move.
A more substantial argument for the importance of speculation is the mushrooming in the size of the futures markets in commodities, including oil, in recent years. This is true both for oil futures traded on exchanges, such as the New York Mercantile Exchange (Nymex) and over-the-counter (OTC) contracts (those negotiated privately off exchanges) (see bar chart, page 14).
However, although such figures could be taken to suggest that speculation is occurring they are not decisive either. It could equally be that those using the futures markets are hedging against volatility rather than creating it. In fact many of them may not be speculators at all - in the sense of those investing purely for financial gain. Some are likely to be firms of individuals hedging their exposure to oil price volatility. Even if such activity moves the futures price of oil it will not necessarily have a long-lasting effect on the spot price (for immediate delivery) of oil.
Much of the argument on whether speculation moves the spot price ofoil hinges on whether speculators have built up large inventories of oil. If such speculation is occurring it would be expected that, somewhere down the line, someone is hoarding physical oil.
Such hoarding could lead to temporary shortages, which would push up the price and help bolster the earnings of those betting on rising prices.
Most economists concede the point about inventories in principle but disagree about what is happening in practice. There is enough room for interpretation of the facts to still argue about the significance of speculation. Some point out that while inventory data for the developed countries is comprehensive, that for the developing world is lacking.
As Lehman Brothers, an investment bank, argued in a recent circular: "For oil, there are simply no credible data available for key aspects of the fundamental balance, such as the amount of Saudi Arabian spare capacity or the size of Chinese inventories" (Commodities Special Report, July 31, 2008). Others counter that China seems to be using as much energy as it can get at the moment. Its preoccupation seems to be feeding economic growth rather than hoarding oil.
Another variant of the inventory argument is what could be called the "in the ground" view. According to this theory there is no need for speculators to build up huge inventories because simply leaving oil in the ground is its functional equivalent. While this argument has some merit it is not about speculation in the sense the term is often used. It is more about oil producers limiting the supply of the commodity to keep the price up.
Even market experts, including those who have sometimes been branded as speculators themselves, take contrary views. Merrill Lynch, an investment bank, has decisively rejected the argument about speculation. Its study of the subject concludes that: "after analyzing the available data in detail, we find no link between spec activity and systematic price increases in commodity markets" (Global Energy Weekly, June 17, 2008).
Merrill's main argument is that supply and demand factors are the key factors in determining the oil price. However, Francisco Blanch, the head of commodities research at Merrill Lynch, argues it is important to recognise "a bit of a monetary phenomenon" that can contribute to rising prices. By creating a liquidity boom in emerging markets a lax global monetary policy increases demand for oil, which in turn affects the price. In effect there is a greater amount of money chasing a given number of barrels of oil.
Lehman takes a softer line on the speculator argument than Merrill. It concedes that, over the short run at least, speculation can have a substantial effect: "while prices must reflect fundamentals in the long run in the short run they can deviate considerably because of price inelasticity, informational imperfections and behavioral herding" (Commodities Special Report, July 31, 2008).
The CFTC's interim view is closer to Merrill than to Lehman (see box, page 15). After examining the data the American regulator concluded there was no sign that futures trading had pushed up spot prices. If anything, speculators would have benefited more from price decreases than increases in recent months.
It is also widely recognised that currency movements can affect the oil price. A weak dollar pushes up the oil price in nominal terms as it is normally priced in the American currency. But this effect is not enough to explain the extreme volatility experienced by the oil price in recent years.
At the least the case for speculation playing a key role is unproven. Extreme price volatility and the growth of futures markets do not in themselves prove that speculators are driving the market. While there is no doubt that many people are betting on the oil price, some on rises others on falls, they can be seen as responding to expectations rather than moulding them.
In any case, as will be shown, there is no problem explaining the fluctuations in the oil price in terms of supply and demand rather than needing to resort to speculation as an explanation.
Demand In many respects demand is the most straightforward of the key variables to examine. In broad terms the demand from the developed world is rising slowly while that from the developing world is increasing rapidly.
The reasons for the relatively stable demand from the developed countries is clear. First, their economies are growing relatively slowly. Since economic growth and the growth of energy use tend to be correlated it means that energy demand is not rising sharply. At the same time they have become more energy efficient. Therefore they are using less energy for each unit of output. A related development is the relative shift of industry - which tends to be more energy intensive than other economic sectors - to the developing world.
Developing countries, in contrast, are growing rapidly. For that reason alone it is not surprising that their energy use is rising rapidly too. In addition, their industrial output is rising in many cases. In China's case almost half of its GDP is accounted for by industrial output. In contrast in America it is just over 20% while in Britain it is almost a quarter of output.
The International Energy Agency estimated in its Medium-Term Oil Market Report (MTOMR) in July that oil product demand growth over the next five years will grow at an average annual rate 1.6%. Within this overall pattern the growth will largely be in the developing world:
"Demand growth remains heavily concentrated in developing countries, where total consumption will nearly reach parity with mature economies by 2015. Within the non-OECD [Organisation for Economic Cooperation and Development], growth is highly concentrated in three regions - Asia, the Middle East and South America, accounting for nearly 90% of global demand growth over the next five years. Of this, China and India account for almost half. By contrast, demand growth in OECD countries is expected to contract slightly over the next five years, albeit with modest growth continuing to be seen in the transportation sector."
This pattern points to a crucial distinction between demand levels and rates of growth. Although the growth is accounted for largely by developing economies the largest consumers are still in the developed world. America, for example, still consumes nearly three times as much oil as China, the world's second largest consumer (see table, page 13).
Considering China's population is more than four times that of America the level of American consumption per head is about 12 times that of China. Chinese consumption will grow as it becomes more affluent but it is still way behind America.
The slowdown in American economic growth has also played a key role in the recent dip in prices. American output is only growing slowly and consumers are reacting to high petrol prices by driving less as well as switching to smaller cars.
According to America's Federal Highway Administration traffic volumes on all roads and streets was 4.7% down in June 2008 compared with June 2007. The fall in American demand is, at least in the short term, more than enough to offset the rising demand from the developing world.
Charles Dumas, the head of the World Service at Lombard Street Research, says: "The US is overwhelmingly the most important story". He estimates that American demand has fallen by about 5%. "There's clearly a lot of oil saving going on," he says.
Michel Waldron, an energy markets analyst at Lehman Brothers, takes a similar view. He describes demand data from America as "very bearish". The decline in demand from America alone "completely wipes out China and the Middle East" in terms of their increase in energy use. In addition it should be remembered that Europe and Japan are also flirting with recession.
The demand situation in relation to oil is the simplest element of the equation. It has risen steadily in recent years and is likely to continue to do so. Developing economies will account for the bulk of the growth although the absolute levels of consumption in the developed world remain much higher.
Supply If the demand situation for oil is relatively straightforward the supply position is the opposite. Fundamentally different forms of supply problems are unhelpfully lumped together in much of the discussion. Indeed, it is confusions over supply that account for many of the misconceptions in the oil discussion.
In broad terms it is possible to distinguish between three types of supply problems. First, there are short-term supply problems including geopolitical factors and natural disasters. Second, are shortages that result from lack of investment in the infrastructure exploration, production or processing of oil. Finally, many argue that there are absolute constraints on oil production as the resource runs out - the discussion of "peak oil" is a common form this argument takes. Often in the discussion the second kind of constraint, shortages that result from lack of investment, is mistaken for absolute shortages of the resource.
The impact of geopolitical tensions attract a lot of attention but, at least in relation to the oil price, they are rarely as important as assumed. Risingtensions between Israel and Iran, culminating in the news that the Israeli air force was rehearsing an attack on the Islamic Republic, probably helped push oil prices up to their June highs. However, it is likely oil would have risen strongly even if the Middle East was at peace.
It was striking that the Russian incursion into Georgia in August had little impact on the oil price despite the former soviet republic being a centre for oil trans-shipment. Its facilities include the Baku-Tbilisi-Ceyhan (BTC) pipeline - although this was temporarily shut in early August after an explosion in its Turkish section - and the Black Sea export terminals of Batumi, Poti and Supsa. However, the dip in global demand for oil seemed to make the markets less anxious about possible disruptions in supply in the Caucasus.
Natural disasters can also have some impact on oil supply. For example, a bad American hurricane season or another earthquake in China could send up oil prices in the short term.
However, the main causes of supply disruption tend to be more mundane. They are generally rooted in a lack of sufficient investment in supply capacity. Although some investment is always taking place it is often insufficient to keep up with rising demand. Berkeley's Professor Borenstein says: "there has been a lot of supply response but there's also been a lot of supply diminution". In general terms the supply from Opec is remaining buoyant while that from many non-Opec countries is declining.
This is certainly the view taken by the IEA's MTOMR: "A detailed study of non-OPEC decline rates conducted earlier this year (already factored into our 2008 projections in the monthly Oil Market Report) found that average non-OPEC decline rates for mature fields over the past 10 years have been relatively constant at around 7.5% per year. Incorporating the result of this study into the five-year forecast, together with some adjustments to assumed OPEC field decline rates suggests that global net decline for the forecast (the implied decline level for the entirety of base year production) rises from 4% per annum in last year's MTOMR to 5.2% this year. Put another way, over 3.5 mb/d [million barrels per day] of new production is needed each year just to hold world production steady."
Jonathan Waghorn, an energy fund manager at Investec, points to many non-Opec countries in which the supply of oil and gas is static or declining. These include Britain, Mexico, Nigeria, Norway and Russia. Meanwhile, there is insufficient investment taking place to find replacements.
"The industry needs to go out and find more oil on a daily basis," he says. "We're not finding the stuff and it's declining faster than we expected."
Under such circumstances of restricted supply growth and strong demand it is the marginal producer that determines the price. In other words it is the price needed to produce the final increment of oil to satisfy market needs. Waghorn estimates that the current marginal producer requires a price of about $100-$110 to produce oil.
But Waghorn does not see oil reserves as necessarily in terminal decline. He points out, for example, that the oil contained in the Canadian tar sands is equivalent to the reserves of Saudi Arabia.
Robin Batchelor, an energy fund manager at BlackRock, takes a similar view. He points out that there are plenty of reserves in the world but they are often in places where oil companies are either unwilling or unable to invest. "You've got to look at where the reserves are," he says. "A lot of them are off limits".
Leonardo Maugeri, a senior executive at ENI, an Italian oil company makes an even more basic point. Much of the world remains underexplored or unexplored in relation to its oil producing potential. In his book, The Age of Oil, he writes: "We are very far from having an acceptable knowledge of subsurface oil resources, and there is plenty of evidence that a huge potential for future oil production exists".
It is also important not simply to look at the crude oil supply in isolation from other forms of energy. For example, since the accident at the Three Mile Island power station in Pennsylvania in 1979 no atomic reactors have been built in America. If America had invested in other forms of energy the demand for crude oil would probably be lower. Other countries have also seen protests against coal-fired and hydroelectric power stations on alleged environmental grounds.
Overall, the supply constraints on oil are of a temporary rather than permanent nature. They are the result of a reluctance to invest sufficiently to build up new capacity rather than an absolute shortage of oil in the ground.
Ultimately, supply and demand must be understood in relation to one another. But all those who favour human advancement should welcome rising demand as it is closely tied to economic growth.
Expanding economies are in turn a pre-condition for lifting the mass of humanity away from the scourge of poverty. The challenge then is to bolster all forms of supply so that cheap and plentiful energy can be available to all.
Speculation or fundamentals?
Three recent key reports have disagreed on whether speculation or fundamental factors explain the surge in oil prices. More are in the offing.
America's Commodity Futures Trading Commission (CFTC) Interim Report on Crude Oil (July 2008)
"The Task Force's preliminary assessment is that current oil prices and the increase in oil prices between January 2003 and June 2008 are largely due to fundamental supply and demand factors. During this same period, activity on the crude oil futures market - as measured by the number of contracts outstanding, trading activity, and the number of traders - has increased significantly. While these increases broadly coincided with the run-up in crude oil prices, the Task Force's preliminary analysis to date does not support the proposition that speculative activity has systematically driven changes in oil prices."
Report available at www.cftc.gov. The final report is due in September.
International Energy Agency (IEA) Medium-Term Oil Market Report (July 2008)
"While recognising that speculation can have a day-to-day impact on price moves, the fact that all producers are working virtually flat out and that there is no sign of any abnormal stockbuild gives a strong indication that current oil prices are justified by fundamentals."
Report available from the IEA for a fee.
The Organization of the Petroleum Exporting Countries (Opec) World Oil Outlook 2008 (July 2008):
"There is certainly enough supply, and there is ample investment. All of this points away from the direction of high prices. Clearly, elements other than supply and demand fundamentals are at play.
"The first element is related to the fall in the value of the dollar in relation to other currencies. For example, it went from 1.3 dollars per euro in August 2007 to around $1.6 in June 2008. This represents a significant weakening.
"Another element driving oil prices relates to the role of regulated oil futures and unregulated over-the-counter (OTC) exchanges. The trade in paper barrels has expanded dramatically in recent years."
Report available at www.opec.org.
The International Monetary Fund (IMF) is also conducting an investigation into the oil price surge. It is due to report to the annual meetings of the IMF and World Bank in October.
Sources and further information
Some key reports on the oil industry are not publically available but there is a huge amount of material that is accessible. Sources and references include:
Books/reports
Websites
on energy in America and worldwide.
