Oil warning lights on as price surges

PUBLISHED : Tuesday, 03 November, 2009, 12:00am
UPDATED : Tuesday, 03 November, 2009, 12:00am

There are times when it is hard to understand the mysterious ways of markets, unless you see the players as hyper-reactive children with a short memory and little capacity for careful thought responding to the latest piece of gratification or denial.

The obvious example is the stock market. Wall Street last week reacted to the news of positive United States third-quarter growth by rising 2 per cent, blithely ignoring all the clearly obvious caveats that growth was boosted by the 'cash for clunkers' incentives and it is proving to be a jobless recovery. Surely enough, the next day, US data showed a dip in consumer spending in September and Wall Street duly dived.

Oil prices moved similarly, rising above US$80 a barrel on prospects of a return to real growth, only to shed US$2.50 a barrel when the poor news of consumer spending hit home.

But, in the case of oil, there are reasons for real worry that prices may again go sharply higher than are warranted by global economic growth and the balance of supply and demand, because oil prices are vulnerable to a multiple whammy effect: extreme market nervousness; pricing in a weak and weakening US dollar; the increasing role of speculative traders; the emergence of oil as a - more useful - store of value and speculative play alongside gold; and the failure of world leaders to get to grips with substantial issues of global use of energy.

Arguments have raged in academic and political circles about what exactly caused oil prices to soar so rapidly last year, from US$92 a barrel in January to a record high of US$147 on July 11, before collapsing dramatically and equally quickly to below US$40 in December.

One theory is based on the 'peak oil' claim advanced by M. King Hubbard that the world is running out of oil. The problem with this is that Hubbard claimed in the early 1970s that oil output would peak in the mid-1980s and then fall to 35 million barrels a day by 2000. But world oil output was 75 million barrels a day in 2000 and climbed to more than 86 million barrels last year.

'Peak oil' is rather like the boy who cried 'wolf'. The wolf did eventually come. But it makes claims about a trend rather than about prices over a short time. It does not fit easily either with the rise in prices or with their subsequent drop, which was not brought about by any sudden discovery of new oil.

Market fundamentalists argued the surge in oil prices was due to normal supply and demand forces. In the Osaka meeting of Group of Seven finance ministers last year, then US treasury secretary Henry Paulson insisted there was no evidence the rise was being driven by speculation; he blamed it on supply and demand.

Unfortunately for the aficionados of market forces, global demand for oil fell slightly in the first half of last year to 86.5 million barrels a day, while oil production actually rose to 86.8 million barrels a day. You would have expected the oil price to fall, not rise, other things being equal.

One important new factor in the world oil market is the increasing financialisation of oil. Mohsin Khan, in a paper for the Peterson Institute for International Economics, noted that in 2002, the average daily trading volume of oil futures was four times the daily world demand for physical oil. By last year, daily trading in paper barrels had reached 15 times the physical demand for oil.

It is too easy to leap from the massive jump in futures trading in paper oil to conclude that some of the sharp price rise must have been speculative. Economists at the International Monetary Fund said, with Paulson, that there was no conclusive proof. Khan thinks otherwise and comments that oil inventories are incomplete. China does not report inventory data, and US figures do not include 'oil at sea' in tankers. He also notes a surprisingly close relationship between prices of oil and gold, a highly speculative commodity, with oil rising faster than gold.

Another factor is that leading oil producers see US$70 to US$75 as a benchmark price for oil that is 'fair' for both consumers and producers.

This year, Britain's Gordon Brown and France's Nicolas Sarkozy expressed concern about 'damaging speculation' and called for an investigation into oil futures trading. The US Commodity Futures Trading Commission says 20 per cent of traders on the New York Mercantile Exchange are non-commercial; read: speculators. Forecasts are that demand will rise 1.5 per cent as global growth picks up. Speculators will have an increasingly upper hand, especially during unexpected interruptions to supply.

Prospects for the medium term to 2030 are more worrying. The British Energy Research Centre recently reported 'more than two-thirds of current crude oil production capacity may need to be replaced by 2030' and noted the world's 10 largest oil-producing fields are in decline.

Yet investment, both in upstream and downstream oil, is falling below surging demand. There has been talk of curbing demand by cleaner and greener use of energy. But no global agreement is in sight.

For all the great hopes of new sources of oil, so far only 13 million of the 85 million barrels a day comes from non-conventional sources.

The lessons of all this are: New investment is urgently needed, new oil sources will be expensive and speculators are poised to make a killing.