Oil prices again reached an all-time high, reaching an intra-day high of $123.79 Wednesday. The weekly IEA report showed that crude oil and gasoline inventories had gone up significantly more than predicted. The crude oil inventory was up 5.65 million barrels, or 1.8 percent, to 325.6 million barrel, about four times more than what analysts had been predicting. Gasoline also showed a greater than expected increase, while distillates like diesel were lower.
Many analysts are surprised at the current spike in oil prices since many of the factors which were thought to contribute to the rise in oil prices had reversed. The US Dollar has rallied against the Euro over the past two weeks as the Fed has signaled an end to the current interest rate cuts. The supply situation has improved. Even the rebels in Nigeria signaled a willingness to end attacks if former President Jimmy Carter agrees to mediate.
Why the Spike?
The spike in oil is being attributed to a report from Goldman Sachs which discussed the current supply and demand situation. The report noted that while oil supply growth and spare capacity is limited, the demand from emerging economies of India and China shows no sign of slowing down. The report says that it is likely that we will see a major spike in the price of oil, as high as $150-$200 in the next 6-24 months as rampant speculation about supply-demand mismatch creates a bubble and pushes oil prices to stratospheric levels. The report goes on to suggest that speculators are doing the rest of the world a favor, by accelerating the price increase, which will force governments to act and reduce the demand, leading to a subsequent decline in oil down to $75-$100 level.
One reason why Goldman's prediction might come true is that a lot of emerging markets like Indian/China, which are the growth drivers on the demand side, have fuel subsidies in place. As a result the increase in the price of crude is absorbed by their government and not passed on to the end consumer. Unlike the developed world, there little price elasticity in the demand for oil in these countries. The governments are already worried about inflation and are reluctant to pass on the increase in oil prices to deter demand growth.
Price Discovery: Speculators versus Hedgers
The commodities futures markets were originally designed to assist large consumers and producers to hedge the risk of massive price movements due to unforeseen circumstances. They are valuable tool which allows corporations to manage risks and plan their budgets, without worrying about day to day gyrations in the commodity markets.
As growing demand from emerging economies led to a rally in commodity prices, a number of new vehicles have emerged which allow investors to invest in commodities without accessing the futures market. Many of these funds are in the form of ETFs which offer exposure to specific commodities. In the case of crude oil, there are at least two funds (USO, OIL) which are directly linked to the price of crude.
Unlike actual consumers and producers of oil, the money invested in these ETFs is purely speculative. These ETFs are long only products and they do not take short futures position. Though there were always speculators in the commodity markets, the ease of access which the ETFs provide means that universe of investors who can now speculate (on the long side) has increased substantially. Financial advisors now increasingly tout commodities as a contra investment class with an inverse relationship to the US Dollar (and consequently the US economy).
The huge amount of speculative money invested in the commodity market is creating an imbalance in the price discovery process. A process designed to be driven by supply and demand of the underlying commodity is now being controlled by speculative money betting on uni-directional price movement.
Margin Requirements: Pennies to the Dollar
An aspect of the commodity futures market which may not be obvious to the average person on Main Street is that, it takes very little money to speculate in the commodity futures market. A NYMEX crude oil contract corresponds to 1000 barrels of oil (corresponding to $123,780 of total oil value) but requires just $9788 in initial margin! So you could call a futures broker, deposit $20,000 and start speculating on thousands of barrels of crude oil.
The low margin requirements were designed to allow commercial users to hedge their exposure without the hedging becoming a financial drain. However, they also expose the market to manipulation and rampant speculation.
Black Box Trading and Technical Levels
As the money chasing commodities has grown, a large group of investors including hedge funds are trading in the commodity markets. Many of these groups use sophisticated algorithms programmed into computers to trade. These techniques, often called black-box trading, execute trades without direct human intervention. They study the price action, especially around key technical levels which are considered resistance (against upward movement) or support (against downward movement). If the price breaks through a support level it is likely to go down further; similarly if it breaks through resistance, it is likely to go higher.
One commonly used technical indicator is daily pivot points which are derived from the previous day's high-low-close values. These levels act as support and resistance levels. For example, for Wednesday May 07, 2008 from low to high were (S2:119.407, S1:120.533, PP: 122.67, R1:124.793, R2:125.927). After the bearish IEA report, crude oil fell rapidly but rebounded right at the S1 level. The low for the day was 120.54, right at the S1 level! Later during the day the price hung around the PP point of 121.647 before spiking up after 1:00PM.
Technical Levels: Fuel for Manipulation?
The commitment of traders report indicates almost 30% of the open futures interest in crude oil is from speculators and traders, and not commercial hedgers. And unlike commercial hedgers where the long/short interest is balanced (with short interest about 4.5% higher), the speculators are net long (with short interest about 15% less than the long interest).
When a market has a lot of speculative interest, traders (and black box algorithms) closely watch key technical levels. An entity which is interested in moving the market in a particular direction can provide support at the key technical levels. For example, Wednesday if the price had fallen meaningfully below 120.54, it may have reduced the speculative excess and oil may not rallied to a new high.
Since the futures market determines the price of oil, intervention in the futures market at specific price points can have a leveraged effect to entities which profit from higher crude oil prices. You would expect oil exporting entities to sell future contracts to hedge. However the same entities can also go long futures at key technical levels and provide an upward support to the market, with speculators taking care of the rest. For example, buying futures around the 120.54 level yesterday would have provided the support needed to boost the market higher after the bearish report.
Case for Intervention: An Economic War
We have a situation where the tradable production of a commodity is controlled by a handful of nations. A significant number of these countries are aggressively opposed to the United States and would cheer if America suffers. As the world's largest consumer of energy, high oil prices are a tax on the United States.
Further we have an open futures market, where anybody can speculate with very little financial outlay. To add fuel to the fire, we have a strongly bullish investment sentiment, with investors pouring in funds into the long side. All it takes is support at key technical levels and the speculators will take the market higher.
In my opinion, this is the perfect storm. Countries which are not amicable to US interests have a vested interest in keeping oil prices high. This comes at a time where the US banking and economic system is under stress. Higher energy prices are likely to break the back of the already stretched US consumer. Oil exporting countries also know that insatiable demand from the emerging economies will always provide a support to oil prices, and will make up for any reduction in demand from the US.
We are fighting an economic war where the parties are fighting with different rules. On side we have the free markets of the US; on the other side we have the world's most powerful cartel. We need different weapons to fight this war; traditional free markets dynamics will take too long to come into equilibrium. During this period, the average American will suffer, while we ship wealth to countries not amicable to American interests.
How to Intervene?
Though a lot of observers understand the problem, there are no easy answers to this situation. I have certain ideas which can reduce some of the speculative froth while still allowing an active futures market for commercial hedgers.
1. Commercial Hedgers vs. Speculators: A clear demarcation between commercial hedgers who take possession of the physical commodity, and speculators can result in different rules for two classes. The ability of speculators to influence the market price will be reduced by significantly increasing margin requirements (e.g. by 5x) for non-commercial entities.
2. Strategic Petroleum Reserves: The whiff of government intervention can take the wind out of speculators, and the SPR can be a valuable tool in sending that message.
a. The SPR can be used as a reserve to sell futures contracts against. Since commodity prices are driven by technicals, intervention at key points can have a leveraged affect. How would the price action been if the key technical levels were taken out by some well time selling after the bearish inventory report?
b. The government can declare that they will use the SPR as a price control mechanism; reducing purchases if the oil spikes up, and in extreme cases even release supply if needed.
3. OPIC (Organization of Petroleum Importing Countries): The US should work with the emerging economies of China and India which are being blamed for the speculative fervor to create a formal union of countries which import oil.
a. The US should impress upon the governments of these countries to aggressively reduce subsidies for petroleum products to reduce the growth in demand and provide incentive for more efficient consumption of oil. Since these countries are large net importers of oil, high oil prices are not in their interest.
b. Collaborative Bidding and Exploration: Currently companies from India and China are in a fierce competition with each other when they bid for exploration rights for different emerging fields. Instead of competing with each other which bids up the price, the US should lead efforts to form a block which bids together and shares technology for more efficient exploitation of existing energy resources.
c. Energy Efficiency: The US should encourage exchange of technologies which result in more efficient utilization of existing energy resources.
4. Gas Guzzler Tax: Current tax policies encourage small businesses to purchase gas-guzzling vehicles which they can depreciate quickly. This is a regressive tax policy which discourages energy efficiency. The tax policy should be changed to encourage the purchase of more efficient vehicles and penalize gas-guzzling vehicles.
Disclosure: Author holds both long and short equity, options and futures positions in crude oil and oil related industries.