Oil Price Rise: Demand - Supply - Speculation

The growth in the price of oil is generally viewed as due to three, fundamental factors: rising demand [especially from Asia]; constrained supply or delivery interruptions and; the weak dollar. Let’s examine each factor:

1) World demand in the 1st quarter of 2003 was 78.4 mb/d and by the 1st quarter of 2008 it was 86.6 mb/d. That equals 2.0% average growth per year for five years. [source: International Energy Agency - Monthly Oil Market Report - Summary of Global Oil Demand, p.11, 04/10/03 and p.1, 04/11/08]. Two percent average growth in demand can hardly be described as huge, large, or even robust. But over the same time period the increase in West Texas Intermediate [WTI] oil price was 78% per year, on average. Further, oil demand from Asian countries [China, Taipei, Korea, Japan, Malaysia, Indonesia, India] using UN Joint Oil Data Initiative was 19.704 mb/d in Jan.2007 and 19.138 mb/d in Jan.2008 for a 2.8% decline.

2) Saudi Arabia noted recently [May, 2008] that no buyer of oil is being turned away; other producers claim that the world is awash in oil. There is an ample supply of oil for consumption; while some premium for a supply disruption is built-in, it’s magnitude is subject to your judgment. IEA Oil Market Report data shows world oil supply at 80.71 mb/d Jan.07 and 82.67 mb/d Jan.08. That is a shortfall in Jan.07 of 5.19 mb/d and for Jan.08 of 3.93 mb/d. Which makes for a reduction in shortfall of 24%. But four million barrels per day in world supply shortfall, being taken out of inventory is equal to just 1.3% of U.S. inventories at 306.8 m/b, as of May 30, 2008 [this is all within margin-of-error]. While inventory builds might not be taking place, there is no inability to meet the demand for oil.

3) Comparing oil priced in the Euro and the USD you find that oil costs America 60% more, in U.S.dollars from 2002 to present; a stronger dollar would go a long way toward bring down the USD price of oil.

We can obviously discount a demand growth of only 2% per year as the main factor. The weakening USD is a major cause; but what is feeding the balance of oil price growth? No oil buyer has been told to, “Come back next week with your tanker.” If the UN-JODI is to be believed then demand by the top 30 nations declined 1.8% from Feb.2007 to Feb.2008. But over the same time period the price for oil increased 59%. Given that demand is modest to declining, according to the reporting-agencies, and the supply of oil is always available, what can account for this pricing disjuncture? Especially when Carl B.Weinberg [chief economist, High Frequency Economics] notes that, “many analysts are now thinking that fundamentals support a price of $70 to $80 a barrel [“Coming: Cheaper Oil and a Stronger Buck,” Barron’s, Mar.24, 2008].” While the statement [June 6, 2008] by Israeli Transportation Minister Shaul Mofaz, “If Iran continues its nuclear arms program we will attack,” does not calm the oil market, it is a transitory event. The answer lies in the commodities futures, index market.

The traditional futures-market participants, commodity buyers and producers, trade oil in order to manage the risks of rising or falling prices in their own businesses. But there is another category of participants in the oil market. It is those who began to view physical oil merely as a financial asset within a portfolio; these are the institutional-investors or index speculators.

Hiding as commercial accounts, thru a Commodity Futures Trading Commission exemption to avoid speculative position limits, these institutional-investors use commodities index-futures to hold positions in oil. But not as traditional buyers of oil would, but as financial speculations. This feeds the demand side, without ever, actually demanding oil. Eighty two percent (82%) of WTI futures [net increase from 01/01/03 to 03/12/08] was purchased by institutional-investors [Testimony of Michael Masters before the Committee on Homeland Security and Governmental Affairs, U.S. Senate, p.3, May 20, 2008].

He further notes that Index Speculators “never sell” their positions but, “roll their positions by buying calendar spreads.” True, their positions are closed but then they are continuously reopened. According to Michael Masters the increase in institutional-investor position's on WTI futures increased 539% over five and one-quarter years [102% per year on average]. Momentum in price attracts attention and so more and more institutions enter trades, ratcheting the price upward. How can experts claim that such an influx of non-traditional buyers into index-futures, at this magnitude, does not effect spot prices?

Answer: they cannot. The pricing signal that index-speculators are sending to the spot market is a false signal. Their financial demand is only for oil futures, not barrels of oil. For persons to claim it is really the huge demand [2% per year + marginal decline] or supply disruptions [that never happen] is to be otherwise engaged. When oil commodities futures index prices rise the spot price must also increase to avoid contango. The degree of self-interest in this issue is very high; what that will mean for financial reform is left to the cynicism of the reader.

Comments

[uberneocon:]

The latest CFTC report shows speculative open interest net SHORT about a quartet of a million WTI contracts and options; how does this square with the "hoarding" thesis? The WTI market was in contango a few weeks ago, i.e., every forward roll would have resulted in a loss, not exactly a path to riches.

2008 Jun 08 06:53 AM

[Reinko:]

Nice article, since I read that Masters file a lot of what I already suspected got some hands and feet.

What I don't understand is the next quote from the above article:

According to Michael Masters the increase in institutional-investor position's on WTI futures increased 539% over five and one-quarter years [102% per year on average]. Unquote.

In my world a 539% increase over 5.25 years equals to 42.37% year on year.

For the rest: A good article!

2008 Jun 08 08:26 AM

[Sylvanus:]

Dear Sir,

All oil is not the same. WTI (West Texas Intermdiate) is a light sweet crude oil. This is ideal for producing gasoline. It is easy to refine. Heavy sour crudes are less desirable, few refineries in the world are able to handle them and produce high grade, less polluting products. Just as Anthracite coal (almost gone) and low sulfur coals command a premium price over lignite (low grade coal), crude oil such as WTI, North Sea, Tapis, and Nigerian crudes set the benchmark and heavy crudes (Saudi and Iranian for example are discounted at a lower price.

The refineries problems include fouling of the heat exchangers, additional unit operations (hydrotreatment) to remove sulfur components, cracking, and alkylation. All of which add to the cost of refining to produce high quality products. These also increase the maintenance costs and mean additional downtime (reducing capacity utilization).


Stringent environmental requirements, such as in California mean that Asian and European products can not be imported. Due to Diesel demand in Europe there is no surplus production. Heating oil in the northeastern US, has a higher sulfur content than what is allowed in diesel fuel. No new refinery has been built in the US during the past 30 years. Any wonder that fuel supplies at the pump cost more.

Speculation has been blamed for the rise in fuel prices, but hedging activities in the futures markets are used to lock in low prices for organizations such as airlines. British Airways reported a profit of 1.5 billion dollars this year. But now expects to pay an additional 2.0 Billion dollars in the coming year despite hedging. The oil futures market is in Contango, which means oil contracts for 6 months and longer are priced higher then the current spot prices (physical oil for immediate delivery). Hence hedging has been made more difficult.

Oil consumption is directly correlated with real growth in a country's GDP. World oil supply has not increased over the last three years, but the World total GDP has been increasing 3% per year.

Oil is also priced in dollars and dollars are necessary to buy oil, the so-called Petrodollars. OPEC countries and Sovereign Wealth funds have been and are recycling petrodollars. trade surpluses, etc. for US Assets, such as US treasuries, CitiGroup, CDO s, CDS.
Rockefeller Center, ..., Lehman Bros. and Bear Stearns, thereby propping up the US dollar. The ultimate cause of the weak dollar is US debt (now equivalent to 160% of US GDP) and the Federal reserve policies increasing the money supply.

On the fundamentals, increasing demand, and slowly declining supply, oil will be more costly. To think otherwise, is merely wishful thinking.

Best regards,

Publius

2008 Jun 08 10:28 AM

[Sylvanus:]

On Jun 08 10:28 AM Sylvanus wrote:

> All oil is not the same. WTI (West Texas Intermdiate) is a light
> sweet crude oil. This is ideal for producing gasoline. It is easy
> to refine. Heavy sour crudes are less desirable, few refineries
> in the world are able to handle them and produce high grade, less
> polluting products. Just as Anthracite coal (almost gone) and low
> sulfur coals command a premium price over lignite (low grade coal),
> crude oil such as WTI, North Sea, Tapis, and Nigerian crudes set
> the benchmark and heavy crudes (Saudi and Iranian for example are
> discounted at a lower price.
>
> The refineries problems include fouling of the heat exchangers, additional
> unit operations (hydrotreatment) to remove sulfur components, cracking,
> and alkylation. All of which add to both the capital costs and the cost
> of refining to produce high quality products. These also increase the
> maintenance costs and mean additional downtime (reducing capacity utilization). <br/>
>
>
> Stringent environmental requirements, such as in California mean
> that Asian and European products can not be imported. Due to Diesel
> demand in Europe there is no surplus production. Heating oil in
> the northeastern US, has a higher sulfur content than what is allowed
> in diesel fuel. No new refinery has been built in the US during
> the past 30 years. Any wonder that fuel supplies at the pump cost
> more.
>
> Speculation has been blamed for the rise in fuel prices, but hedging
> activities in the futures markets are used to lock in low prices
> for organizations such as airlines. British Airways reported a profit
> of 1.5 billion dollars this year. But now expects to pay an additional
> 2.0 Billion dollars in the coming year despite hedging. The oil
> futures market is in Contango, which means oil contracts for 6 months
> and longer are priced higher then the current spot prices (physical
> oil for immediate delivery). Hence hedging has been made more difficult.
>
>
> Oil consumption is directly correlated with real growth in a country's
> GDP. World oil supply has not increased over the last three years,
> but the World total GDP has been increasing 3% per year.
>
> Oil is also priced in dollars and dollars are necessary to buy oil,
> the so-called Petrodollars. OPEC countries and Sovereign Wealth
> funds have been and are recycling petrodollars. trade surpluses,
> etc. for US Assets, such as US treasuries, CitiGroup, CDO s, CDS.
>
> Rockefeller Center, ..., Lehman Bros. and Bear Stearns, thereby propping
> up the US dollar. The ultimate cause of the weak dollar is US debt
> (now equivalent to 160% of US GDP) and the Federal reserve policies
> increasing the money supply.
>
> On the fundamentals, increasing demand, and slowly declining supply,
> oil will be more costly. To think otherwise, is merely wishful thinking.
>
>
>

2008 Jun 08 10:43 AM

[Paul Killinger:]

It bears saying once again... A major reason for the skyrocketing price of oil is the absolute hammerlock the Greens have on our Congress, which has placed 85% of U.S. oil and gas reserves off limits to new exploration. This self-imposed boycott is what's driving oil prices, not speculators. It's NOT speculating when you're betting on a SURE THING...!

On a happier note, I finally found a copy of Vaclav Klauses' "Blue Planet in Green Shackles." This is the book exposing the Green terrorism being visited upon us driving our entire self-imposed energy crisis that no American economist had the brains or guts to write.

2008 Jun 08 11:14 AM

[maximax:]

What are all these politically motivated comments on the oil market doing here that are of no interest to investors/speculators, written by people who do not understand what they are talking about (see Sylvanus comment for better info), and funnily enough, these articles are always followed by comments like "good article". yeah right. good for what? short sighted agendas? This is not a lobbying site. And paulk8756 - your 85% claim has already been discredited elsewhere on this site. Get a life. Go somewhere where you cannot cause any damage.

2008 Jun 09 05:23 AM

[jjason:]

I agree that paulk and Sylvanus should go post somewhere else...like the bathroom mirror.

The authors point is exactly what Phil Davis wrote last week. Phil's article explains how the speculation IS affecting the spot price.

Another article to read is " Greenberger's testimony - I Banks Control the Energy Markets" by Anthony Schneider also on SeekingAlpha and has links to testimony by Professor Michael Greenberger who used to work at the CFTC. Greenbergers report is titled "Energy Market Manipulation and Federal Enforcement Regimes".

William, thanks for the article. You are right.

2008 Jun 09 05:11 PM

[mixter:]

Maximax doesn't seem to comprehend that our idiot politicians greatly influence business operations which determine which stocks will be better investments.

And, 85% of our outer continental shelf is off limits not only to drilling, but to exploration as well.

If you don't think the "Dim-wit-o-crats" have had an adverse effect on our energy situation, you are not very smart!

The "greenis weenies" will take the US down if they have their way.

2008 Jun 29 01:21 PM

[Manish Agarwal:]

I am not against commodity market and the way analyst who has never seen crude in their life operates in future market. I am against the faulty mechanism of commodity market where trades can be done without having inventory in reality. There are no price check mechanism present where we can stop the trade for few hours if prices are rising above certain limit as it is in stocks which we call as circuit filter. Sufficient inventory should be there in exchange so trade can be settled by delivery and see how the stupidity of speculation will end in near term.

Feb 18 02:05 AM