Print This Post
Could the Saudi Oil Meeting Matter?
What should we make of the Saudis call for the heads of state of oil consuming and producing countries - meaning all countries - to meet to discuss oil? Is it possible, as Mr. Market seemed to think this morning, that the Saudis would go to all that trouble for naught? Here’s what we know:
1. Such a meeting is unprecedented on at least two levels. The Saudis have never before stepped up to a global leadership role and there has never been a global meeting at such a high level (or any level, to my knowledge) to discuss oil. So the game’s afoot, as Sherlock would observe.
2. The current oil supply/demand crisis appears to be largely a function of two beliefs that have taken widespread footing in the oil markets: that there is a lack of light, sweet crude compared with growing demand for diesel and other refined fuels and there is a lack of refining capacity for the heavier, sour crude supplies that are not in short supply.
3. The Saudis are bringing on stream two new oil fields that produce light sweet crude, one this year with 500kb/d capacity, and a second one - Khurais - next year with 1.2 mb/d.
4. The Saudis are also bringing on stream substantial new refining capacity for heavier, less pure crude, as are the Indians and Chinese.
5. The Saudis super-giant field, Ghawar which yields about 5 mb/d, is old and some analysts believe it could be at the point of declining production. Part of the new Kharais project is an additional 4.5 mb/d of seawater injection capacity some of which is scheduled to boost the South Ghawar fields.
6. Industrial and political leaders in OECD countries are starting to transition the industrial economies away from dependence on oil for transportation.
7. The market has begun to put a high value on long dated oil as evidenced by a slight contango and much higher prices for long dated crude calls. Normally oil in the out years is priced lower than oil in the current periods reflecting the cost of money and the cost of oil storage, which is called backwardation. But now the high demand for oil in the out years is causing a gentle contango, meaning oil prices are starting to get higher in the out years than the near contract. Contango creates its own dynamics for higher oil prices by rewarding suppliers for selling later rather than selling sooner and thus taking some near-dated oil off the market.
8. An important support for oil prices is the falling dollar.
Putting these facts all together, we see an oil crisis caused by the market’s belief that supply is outrunning demand. This belief has taken hold just as Saudi Arabia is bringing vast new supplies to market and is bolstering the credibility of Ghawar, its present oil production backbone by adding new pressurization capacity. Moreover, the Saudis and others are getting closer to adding substantial new refining capacity that can sop up the heavy crude that today is in oversupply.
Thus the facts suggest that the Saudis have some opportunities to convince the oil market that prices have come too far given changing supply dynamics. If the Saudi argument can cause prices to drop, the Saudis could change the dynamics of oil trading for the next year or two, perhaps longer. This seems to be the possibility that underlies the Saudi call for a global conference on oil.
Why Now?
The fact that the proud Saudis, who have always guarded their privacy, are now volunteering to take the lead at this time underscores the importance of their desire for lower oil prices. Why? Their two goals are both threatened by the currently high price of oil. Those goals are:
1. Political peace. The Kingdom’s oil has given its rulers unprecedented influence and wealth. But their ability to enjoy it and to build a prosperous country is threatened by the possibilities of war in their neighborhood. KSA (Kingdom of Saudi Arabia) is surrounded by guerilla or national wars in Iraq, Lebanon, and Palestine plus an aggressive historical competitor, Iran. In fact, the Iranians’ nuclear ambitions might generate a pre-emptive strike that could reverberate into a threat to the security of the Kingdom. The Saudis would like to enjoy their good fortune in peace.
2. Longer term continuing strong demand for oil. High oil prices are pushing OECD countries to develop hybrid electric technologies that will eventually be cheaper than oil, thus threatening long term demand for oil. While the price of oil could go to astronomical levels in the short term, the longer term results might ironically result in much lower prices for oil perhaps 20 years from now, particularly given the world’s growing desire for a clean environment which could result in the social costs of burning fossil fuels becoming an explicit part of the price of oil via taxation.
Both Saudi goals are directly threatened by high and increasing oil prices. The high oil price enables Mid-East political instability by empowering Iran. Lower oil prices would reduce the power of Iran which is the chief source of all regional conflicts. It is Iranian intervention that fuels most opposition to the Iraqi regime, especially their support for Moktada al-Sadr. It is Iran that is chiefly fueling conflict in Lebanon. And it is Iran that is chiefly supporting Palestinian radicals. Lower oil prices would pressure the Iranian economy, possibly making the mullahs more likely to listen to the deals being offered by the U.S./E.U./Russia/China negotiators.
Lower oil prices would also help the King accomplish his second goal, taking the air out of the OECD’s efforts to develop alternative fuels for transportation. If the Saudis could move oil down to $120, then $110, then $100, and maybe even to $80 by the end of 2009, there might be very little left of OECD efforts to build electric public transportation and throw a lot of public funds into R&D for new battery technology, new cellulosic ethanol technology, and public electric refueling stations the way Israel and Denmark have already begun to do. Moving oil prices down would convince consumers and many executives that this past year’s high oil prices were really just a false alarm.
What Will the King Say?
The King certainly did not call this conference just to announce that they are putting another 200 kb/d on the market as was disclosed by the U.N. Secretary-General Ban Ki-Moon. That’s a big yawn, as today’s oil market has affirmed so surely the Saudi King did not go to the trouble of demanding a global audience just to say that. Something else must be going on.
First, the King must flesh out his vision of near term oil plenty, as described above. He will highlight the Kingdom’s major investments in new oil fields and new refining capabilities. He will pledge that all 1.7 mb/d of new Saudi light oil coming on stream over the next 12 months will be put on the market and sold to the highest bidder, even if that drives the price back down to $50. He will promise that the new saltwater pressurization capacity, not an asset that has been well noted, will keep Ghawar flowing at 5 mb/d for at least another decade.
Second, the King may call for a solution to above ground problems in Iraq and Nigeria, perhaps asking for the formation of separate Iraqi and Nigerian task forces made up of the Energy Secretaries of the major powers plus local officials in each country. The task forces would work to solve political and military problems in Iraq and Nigeria, allowing both Iraq and Nigeria to increase output by 2 mb/d each within two years, a goal that could realistically be accomplished if the political will were present.
On the demand side, the King might ask OECD countries to take some easy steps to reduce their demand for fuel inefficient vehicles perhaps through very high taxes on the purchase of automobiles that get less than, perhaps, 25 mpg. That is a very practical and potentially effective way to reduce global fuel use that the King could implement in his own country.
Is the King Working Alone?
The kicker in the Saudi oil event next Sunday might be a request that oil be priced in a basket of currencies, perhaps managed through the World Bank. This would be an effective way to stop oil from being traded as a tool to protect investors from a depreciating dollar. A decoupling of oil from the dollar might serve to strengthen the dollar, but it would certainly reduce the value of oil, if not immediately then over time assuming the dollar continues to weaken.
Whether or not the King makes such a dramatic request, I firmly believe that this conference is not his work alone and it did not spring to his mind in recent days. There have been a number of visits to the region by both President Bush and V.P. Cheney in recent months. They came away looking like weak beggars but I doubt that was the full story. I think they visited the King with a much more substantive agenda than simply to ask for higher oil production from the Kingdom. Decoupling the dollar from oil might have been a big part of it. Having the King initiate such a move - rather than a President proposing it - would save face for America - and have a better chance of succeeding because the sponsor would be more credible and likeable.
Whether the King asks for a decoupling of oil from the dollar or posits some other startling idea, it is clear that the King’s objective of lowering the price of oil and weakening the economy of Iran to pressure it on the nuclear issue and regional peace are goals that are also very near and dear to the hearts of the American government and, not so incidentally, the Israeli government. Giving the King of Saudi Arabia center stage in what is clearly a rehearsed script is a clever way of using one of the world’s most feared and respected leaders to do the heavy lifting.
Could it Work?
In the world of commodities, success leads to success. There are so many commodity investors who follow trends that when a trend gets started it achieves enormous momentum. The trend eventually alters the policies of commercial players in ways that sometimes reinforce the new trend. That is partly why the price of oil is now over $130 a barrel. The strong belief that oil prices can only rise has kept a certain amount of oil off the market and caused a certain group of oil users, like airlines, to be more aggressive in buying longer dated futures. Such actions, caused by a belief that oil prices will rise, tend to raise the near term price of oil further.
A trend becomes firmly ensconced when the traders not only recognize the trend but also think they understand the reasons behind it. So we now “know” that the growing demand for oil by Chindia and the oil exporting countries will overwhelm supply, which will be limited by Peak Oil and the Export Land Model.
But if the price starts moving down, that trend will also need a plausible rationale. The Saudis could provide that rational at their conference by convincing people that so much more crude is coming on the market in the next few years that, given a slowing global economy and steps being taken to bolster Ghawar’s production, there will be more oil on the market than there is demand for it.
That idea by itself might not be strong enough to overwhelm the present up-trend in oil prices. What, then, might get the price of oil going down? How about a concerted shorting of oil futures by the Saudis, the U.S. and - maybe - the Israelis. And/or London, Mr. Bush’s most recent stop. If such a scheme worked, the participants would actually make money on their futures bets. At the worst it would only cost them some money in a worthy effort. If central bankers are allowed to manipulate currency markets when they need to, why can’t their counterparts move the oil market when that is necessary for global stability?
If the market’s fear of higher oil prices were replaced by a fear of lower oil prices we could see $80 oil in another six months. Certainly the slowdown in OECD growth rates caused by the credit and housing crises provides a ripe environment for a reversal in the price of oil. If such a trend were started by a concerted international intervention in the futures markets and then kept in motion by a fundamental rational and a series of international actions put into motion by the Saudi oil conference, we could indeed see oil prices trending down for the next 12 - 18 months.
No Slam Dunk
The other side of this argument was offered in my two previous essays, Behind the U-Turn in Oil Prices and a follow up and expansion on it, High Oil Prices Start to Work. Is It Enough? where I pointed out two risks to a lower oil price scenario. One is the risk of a military action against Iran if it fails to halt its nuclear program. My guess is that Bush is now allowing diplomacy to have a robust chance to succeed. If it does not succeed, my guess is that military action may well be undertaken after the election, particularly if Obama is elected. Such a likelihood would be enhanced if oil prices have declined in the meantime and Iran still refuses to yield on nuclear weapons.
The other major argument against lower oil prices is the knowledge that new oil fields coming on stream will become increasingly scarce after 2010. Since a field takes about 6.5 years from discovery to first oil, we can now know nearly all the new fields scheduled to produce through 2014. The bulk of such scheduled fields come on stream in 2008 and 2009. Of course slippage is increasingly likely. Nonetheless, if oil does get cheaper for the next 18 months - or even if it simply fails to rise - global economies can be expected to recover their growth rate by 2010, just as oil from new fields is becoming scarce.
In any event, we can be fairly sure that oil will become extremely scarce by 2013. That is a known risk suggesting higher prices longer term. Other risks include
- further violence against oil production in Nigeria
- rapidly increasing costs for oil exploration and production resources including both labor and capital equipment,
- the possibility that if the Saudis try to force down oil prices other OPEC countries will withhold supplies to keep prices high.
It’s a Dialectic, Stupid
The bottom line, in my view, is that there is substantial uncertainty about the direction oil will take in the short run. For the next 18 months or so there will be strong forces at work on both sides of the oil market. If the Saudis (and their co-conspirators) do their utmost to lower prices and such efforts fail, the markets will be increasingly confident on the bullish side for oil prices. If the Saudi’s succeed, it could be a long way down for the price of oil.
In this environment, it seems dangerous to take a bold stance in either direction unless you are a professional oil trader and are constantly watching and listening. The wisest course for an individual investor may be to step aside from the oil market for a while and let the dialectic play out. The oil market has been generous to investors for the past four years. This could be a good time to protect the profits one has already realized rather than to aggressively seek more gains.
That said, if the price of oil does recede for a while, the stock market itself would be helped, although not particularly oil stocks. It would be a better environment for shipping and oil services and drilling companies rather than the E & P’s (exploration and production companies).
Tags: peak oil energy investments
Print This Post
20 responses so far ↓
1 L Jakus // Jun 16, 2008 at 4:32 pm
That’s quite an elaborate analysis of what would be a very complex plan.
However, I sense that neither the Bush nor Saudi administrations have the ability to carry off something that complex and far reaching.
I also sense that in Saudi Arabia, as in the United States, as in Aramco as in most large companies, the people towards the bottom who really know what’s going on don’t what to tell the people at the top what they don’t want to hear — which in this case would be that the old Saudi fields are running dry and that the new fields are no great shakes, these last ideas provided by Matthew Simmons, i.e., Twilight in the Desert, and the “peak oil” discussion in general.
2 Simon // Jun 16, 2008 at 4:41 pm
Great analysis. Thank you Jim. The only thing that niggles me after two mins reflection is the possility that an Obama admin would use military action in the middle east for any reason. I’d place more weight on possible action before the election, but not much. Another possibility is for Israel to act unilaterally either before or just after the election. These are dreadful thoughts but while in the swing if America could be seen as being forced to “lend a hand” to a situation seen as being initiated by Iran and involving Israel that may have a deciding effect if the election was at all close.
3 Don Hejtmanek // Jun 16, 2008 at 5:13 pm
Jim I believe that the Saudies could very well short oil for a short term gain, and then reverse the trade to capture the upside gain. The only fly in the ointment is supply. I do not believe they have the oil reserves to supply the market. Once oil comes down in price, what comes next, consumption. Once oil goes back to $3 out come the SUVs. Also would not China with its imense dollar surplus buy up all the spare capacity for the future? Seems logical to me.
4 Robert Essian // Jun 16, 2008 at 5:47 pm
Jim, wow! We have been doing nicely and feeling real good… then this….I am one of those who hang on your words as extremely insightful and re-assuring. Assuming you are correct how will that play out in the natural gas plays. For example a company like CHK.
5 cwduke // Jun 16, 2008 at 6:12 pm
Thanks for your excellent analysis of a very complex problem.
I differ on the option that an Obama administration would launch any type of military action reqardless of the provocation .
It is going to be interesting to see if the Saudis can actually lift production as much as they say.
Also I think the other OPECers might actually reduce their own production to keep the prices high realizing that it going to worth more in the future.
If I remember correctly Matt Simmons mentions the two Saudi fields as being very difficult to produce and never living up to expectations in his 2005 book, Twilight in the Desert.
6 Phil Tucker // Jun 16, 2008 at 6:30 pm
Very thoughtful analysis, but you left out demand destruction in a framework of increasing economic weakness in the developed economies, later to be followed by the developing economies. I suspect significantly more weakness in demand as resources are allocated elsewhere [ food, water, medical, utilities], some substitution and an unexpected short-term pop in non OPEC production. Much later — 2015 or later — pricing power moves completely to the OPEC producers. We still have some time.
7 JAY GALLENTINE // Jun 16, 2008 at 8:02 pm
WHO SHOULD I TRUST, BOONE PICKENS, MATTHEW SIMMONS, JIM ROGERS, ALI SAMSAM BAKHTIARI, CHARLEY MAXXWELL, JOHN OLSON, SENATOR BARTLETT, STEPEN LEEB, ART SMITH, ETC, OR THE ARABS? I THINK I WILL GO WITH FORMER! WE ARE PAST PEAK, AND THEY CAN PLAY THEIR GAMES OF DECEIT, BUT I PUT MY MONEY ON HIGHER CRUDE PRICES, MUCH HIGHER PRICES FOR THE FUTURE.
8 Jack be Nibble // Jun 16, 2008 at 10:31 pm
Rocket Science
None needed here!
The King is moving away from Iran.
9 paultaut // Jun 16, 2008 at 10:42 pm
My estimate is that you are right on many counts.
I disagree on strenght in the dollar as a result. My thoughts go to a vast supply of dollars currently buying oil. With the removal of this implicit demand, I can only see the dollar dropping, like a ton of bricks.
The other is the WTI, Brent contracts insitsu. How will they be removed from the scene?
The fact that one uses 4.5 million in water to get 5 million out only means that this field is close to capitulation. The costs to keep supply steady are escalating.
Meanwhile, will the other MidEast countries back the Saudi effort or just view the entire effort as an attempt to permanently take over Leadership of OPEC?
Personally, I think this Summit will be an effort to provide consuming nations with a dose of reality. Oil output cannot keep up with demand. Please reduce consumption since reserve capacity no longer exists at the present time.
10 dennis // Jun 17, 2008 at 4:04 am
What a great analysis! For USA coal to electric including electric automobiles provide an out. Coal—>>methanol too. But the greenies have a death grip on Washington DC lawmakers and block coal due to CO2. Global warming is a lie and will beggar America
Natural gas is also a way out for us
Dennis
11 Robert Essian // Jun 17, 2008 at 5:16 am
OK Jim, I slept on your last artical and woke up feeling a little better about things this morning. The old Grandma statement went something like this, “sleep on it, it’ll become clearer in the morning”. So true. I became interested in the stock market and in particular clean alternate fuels. I stumbled across the Peak oil theory as a result. I’m a believer. However, I am pulling for higher oil prices (without demand distruction) and a stressed out citizen base for two reasons. One I want a new and vibrant community that stops consuming so much of the stuff that harms our world around us. I want all of us to remember how these rescent spikes in oil hurt all of us and really does nothing but show us our future if we don’t stop consuming so much of this stuff. I want my family, most of all my Grandson’s to live in an environement of peace and relative tranquility. For my second reason it’s purely economics. I’ve worked hard all my life and I want to add some real wealth so I can retire, hang out with my girlfiend of 35 years and golf with any of my 12 siblings. So I hope Jim that to some degree you are right about this meeting on Sunday and a correction is made in the market place so people around the world have some hope going forward and that our transition to the better future is a slow and less painful process. We all will do well financially in the energy plays and the world will have time to figure these things out and to start to make the changes necessary. This of course is if the politicians actually come together for the good of all humanity and not their special interests. I think I’ll go call my Grandson now…I’m in need of some lovin’ PEACE!
12 paultaut // Jun 17, 2008 at 5:16 am
Nat. gas has to rise another 10% or more before LNG shipments start coming our way. And we still rely on Gulf of Mexico nat. gas far, far too much.
Even if its only a delay, tankers waiting to unload or skirting a storm, oil will go up if it looks like A Tropical Storm may enter the Gulf. Previously meaningless supply disruptions now create havoc somewhere and the world as a whole feels it.
13 Jim // Jun 17, 2008 at 5:36 am
Jim, I think that you just answered your June 10, 2008 post - $4 per gallon appears to be high enough to cause sufficient disruption and some action. We opened our wallets last summer and smiled as we filled up. Not this summer.
14 Jim // Jun 17, 2008 at 5:42 am
Jim, I think that you just answered your June 10th post - $4 per gallon is sufficiently high enough to cause some change. Last summer we just smiled when we opened our wallets and filled up. Not this summer.
15 Ed // Jun 17, 2008 at 4:41 pm
What about speculators . . . Check out this article:
PERHAPS 60% OF TODAY’S OIL
PRICE IS PURE SPECULATION
by F. William Engdahl
May 2, 2008
The price of crude oil today is not made according to any traditional relation of supply to demand. It’s controlled by an elaborate financial market system as well as by the four major Anglo-American oil companies. As much as 60% of today’s crude oil price is pure speculation driven by large trader banks and hedge funds. It has nothing to do with the convenient myths of Peak Oil. It has to do with control of oil and its price. How?
First, the crucial role of the international oil exchanges in London and New York is crucial to the game. Nymex in New York and the ICE Futures in London today control global benchmark oil prices which in turn set most of the freely traded oil cargo. They do so via oil futures contracts on two grades of crude oil—West Texas Intermediate and North Sea Brent.
A third rather new oil exchange, the Dubai Mercantile Exchange (DME), trading Dubai crude, is more or less a daughter of Nymex, with Nymex President, James Newsome, sitting on the board of DME and most key personnel British or American citizens.
Brent is used in spot and long-term contracts to value as much of crude oil produced in global oil markets each day. The Brent price is published by a private oil industry publication, Platt’s. Major oil producers including Russia and Nigeria use Brent as a benchmark for pricing the crude they produce. Brent is a key crude blend for the European market and, to some extent, for Asia.
WTI has historically been more of a US crude oil basket. Not only is it used as the basis for US-traded oil futures, but it’s also a key benchmark for US production.
‘The tail that wags the dog’
All this is well and official. But how today’s oil prices are really determined is done by a process so opaque only a handful of major oil trading banks such as Goldman Sachs or Morgan Stanley have any idea who is buying and who selling oil futures or derivative contracts that set physical oil prices in this strange new world of “paper oil.”
With the development of unregulated international derivatives trading in oil futures over the past decade or more, the way has opened for the present speculative bubble in oil prices.
Since the advent of oil futures trading and the two major London and New York oil futures contracts, control of oil prices has left OPEC and gone to Wall Street. It is a classic case of the “tail that wags the dog.”
A June 2006 US Senate Permanent Subcommittee on Investigations report on “The Role of Market Speculation in rising oil and gas prices,” noted, “…there is substantial evidence supporting the conclusion that the large amount of speculation in the current market has significantly increased prices.”
What the Senate committee staff documented in the report was a gaping loophole in US Government regulation of oil derivatives trading so huge a herd of elephants could walk through it. That seems precisely what they have been doing in ramping oil prices through the roof in recent months.
The Senate report was ignored in the media and in the Congress.
The report pointed out that the Commodity Futures Trading Trading Commission, a financial futures regulator, had been mandated by Congress to ensure that prices on the futures market reflect the laws of supply and demand rather than manipulative practices or excessive speculation. The US Commodity Exchange Act (CEA) states, “Excessive speculation in any commodity under contracts of sale of such commodity for future delivery . . . causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity.”
Further, the CEA directs the CFTC to establish such trading limits “as the Commission finds are necessary to diminish, eliminate, or prevent such burden.” Where is the CFTC now that we need such limits?
they seem to have deliberately walked away from their mandated oversight responsibilities in the world’s most important traded commodity, oil.
Enron has the last laugh…
As that US Senate report noted:
“Until recently, US energy futures were traded exclusively on regulated exchanges within the United States, like the NYMEX, which are subject to extensive oversight by the CFTC,including ongoing monitoring to detect and prevent price manipulation or fraud. In recent years, however, there has been a tremendous growth in the trading of contracts that look and are structured just like futures contracts, but which are traded on unregulated OTC electronic markets. Because of their similarity to futures contracts they are often called “futures look-alikes.”
The only practical difference between futures look-alike contracts and futures contracts is that the look-alikes are traded in unregulated markets whereas futures are traded on regulated exchanges. The trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron and other large energy traders into the Commodity Futures Modernization Act of 2000 in the waning hours of the 106th Congress.
The impact on market oversight has been substantial. NYMEX traders, for example, are required to keep records of all trades and report large trades to the CFTC. These Large Trader Reports, together with daily trading data providing price and volume information, are the CFTC’s primary tools to gauge the extent of speculation in the markets and to detect, prevent, and prosecute price manipulation. CFTC Chairman Reuben Jeffrey recently stated:
“The Commission’s Large Trader information system is one of the cornerstones of our surveillance program and enables detection of concentrated and coordinated positions that might be used by one or more traders to attempt manipulation.”
In contrast to trades conducted on the NYMEX, traders on unregulated OTC electronic exchanges are not required to keep records or file Large Trader Reports with the CFTC, and these trades are exempt from routine CFTC oversight. In contrast to trades conducted on regulated futures exchanges, there is no limit on the number of contracts a speculator may hold on an unregulated OTC electronic exchange, no monitoring of trading by the exchange itself, and no reporting of the amount of outstanding contracts (“open interest”) at the end of each day.”
Then, apparently to make sure the way was opened really wide to potential market oil price manipulation, in January 2006, the Bush Administration’s CFTC permitted the Intercontinental Exchange (ICE), the leading operator of electronic energy exchanges, to use its trading terminals in the United States for the trading of US crude oil futures on the ICE futures exchange in London – called “ICE Futures.”
Previously, the ICE Futures exchange in London had traded only in European energy commodities – Brent crude oil and United Kingdom natural gas. As a United Kingdom futures market, the ICE Futures exchange is regulated solely by the UK Financial Services Authority. In 1999, the London exchange obtained the CFTC’s permission to install computer terminals in the United States to permit traders in New York and other US cities to trade European energy commodities through the ICE exchange.
The CFTC opens the door
Then, in January 2006, ICE Futures in London began trading a futures contract for West Texas Intermediate (WTI) crude oil, a type of crude oil that is produced and delivered in the United States. ICE Futures also notified the CFTC that it would be permitting traders in the United States to use ICE terminals in the United States to trade its new WTI contract on the ICE Futures London exchange. ICE Futures as well allowed traders in the United States to trade US gasoline and heating oil futures on the ICE Futures exchange in London.
Despite the use by US traders of trading terminals within the United States to trade US oil, gasoline, and heating oil futures contracts, the CFTC has until today refused to assert any jurisdiction over the trading of these contracts.
Persons within the United States seeking to trade key US energy commodities – US crude oil, gasoline, and heating oil futures – are able to avoid all US market oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the NYMEX in New York.
Is that not elegant? The US Government energy futures regulator, CFTC opened the way to the present unregulated and highly opaque oil futures speculation. It may just be coincidence that the present CEO of NYMEX, James Newsome, who also sits on the Dubai Exchange, is a former chairman of the US CFTC. In Washington doors revolve quite smoothly between private and public posts.
A glance at the price for Brent and WTI futures prices since January 2006 indicates the remarkable correlation between skyrocketing oil prices and the unregulated trade in ICE oil futures in US markets. Keep in mind that ICE Futures in London is owned and controlled by a USA company based in Atlanta Georgia.
In January 2006 when the CFTC allowed the ICE Futures the gaping exception, oil prices were trading in the range of $59-60 a barrel. Today some two years later we see prices tapping $120 and trend upwards. This is not an OPEC problem, it is a US Government regulatory problem of malign neglect.
By not requiring the ICE to file daily reports of large trades of energy commodities, it is not able to detect and deter price manipulation. As the Senate report noted,
“The CFTC’s ability to detect and deter energy price manipulation is suffering from critical information gaps, because traders on OTC electronic exchanges and the London ICE Futures are currently exempt from CFTC reporting requirements. Large trader reporting is also essential to analyzE the effect of speculation on energy prices.”
The report added,
“ICE’s filings with the Securities and Exchange Commission and other evidence indicate that its over-the-counter electronic exchange performs a price discovery function — and thereby affects US energy prices — in the cash market for the energy commodities traded on that exchange.”
Hedge Funds and Banks driving oil prices
In the most recent sustained run-up in energy prices, large financial institutions, hedge funds, pension funds, and other investors have been pouring billions of dollars into the energy commodities markets to try to take advantage of price changes or hedge against them. Most of this additional investment has not come from producers or consumers of these commodities, but from speculators seeking to take advantage of these price changes. The CFTC defines a speculator as a person who “does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes.”
The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil for future delivery in the same manner that additional demand for contracts for the delivery of a physical barrel today drives up the price for oil on the spot market. As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum.
Perhaps 60% of oil prices today pure speculation
Goldman Sachs and Morgan Stanley today are the two leading energy trading firms in the United States. Citigroup and JP Morgan Chase are major players and fund numerous hedge funds as well who speculate.
In June 2006, oil traded in futures markets at some $60 a barrel and the Senate investigation estimated that some $25 of that was due to pure financial speculation. One analyst estimated in August 2005 that US oil inventory levels suggested WTI crude prices should be around $25 a barrel, and not $60.
That would mean today that at least $50 to $60 or more of today’s $115 a barrel price is due to pure hedge fund and financial institution speculation. However, given the unchanged equilibrium in global oil supply and demand over recent months amid the explosive rise in oil futures prices traded on Nymex and ICE exchanges in New York and London it is more likely that as much as 60% of the today oil price is pure speculation. No one knows officially except the tiny handful of energy trading banks in New York and London and they certainly aren’t talking.
By purchasing large numbers of futures contracts, and thereby pushing up futures prices to even higher levels than current prices, speculators have provided a financial incentive for oil companies to buy even more oil and place it in storage. A refiner will purchase extra oil today, even if it costs $115 per barrel, if the futures price is even higher.
As a result, over the past two years crude oil inventories have been steadily growing, resulting in US crude oil inventories that are now higher than at any time in the previous eight years. The large influx of speculative investment into oil futures has led to a situation where we have both high supplies of crude oil and high crude oil prices.
Compelling evidence also suggests that the oft-cited geopolitical, economic, and natural factors do not explain the recent rise in energy prices can be seen in the actual data on crude oil supply and demand. Although demand has significantly increased over the past few years, so have supplies.
Over the past couple of years global crude oil production has increased along with the increases in demand; in fact, during this period global supplies have exceeded demand, according to the US Department of Energy. The US Department of Energy’s Energy Information Administration (EIA) recently forecast that in the next few years global surplus production capacity will continue to grow to between 3 and 5 million barrels per day by 2010, thereby “substantially thickening the surplus capacity cushion.”
Dollar and oil link
A common speculation strategy amid a declining USA economy and a falling US dollar is for speculators and ordinary investment funds desperate for more profitable investments amid the US securitization disaster, to take futures positions selling the dollar “short” and oil “long.”
For huge US or EU pension funds or banks desperate to get profits following the collapse in earnings since August 2007 and the US real estate crisis, oil is one of the best ways to get huge speculative gains. The backdrop that supports the current oil price bubble is continued unrest in the Middle East, in Sudan, in Venezuela and Pakistan and firm oil demand in China and most of the world outside the US. Speculators trade on rumor, not fact.
In turn, once major oil companies and refiners in North America and EU countries begin to hoard oil, supplies appear even tighter lending background support to present prices.
Because the over-the-counter (OTC) and London ICE Futures energy markets are unregulated, there are no precise or reliable figures as to the total dollar value of recent spending on investments in energy commodities, but the estimates are consistently in the range of tens of billions of dollars.
The increased speculative interest in commodities is also seen in the increasing popularity
of commodity index funds, which are funds whose price is tied to the price of a basket of various commodity futures. Goldman Sachs estimates that pension funds and mutual funds have invested a total of approximately $85 billion in commodity index funds, and that investments in its own index, the Goldman Sachs Commodity Index (GSCI), has tripled over the past few years. Notable is the fact that the US Treasury Secretary, Henry Paulson, is former Chairman of Goldman Sachs.
16 Robert Essian // Jun 17, 2008 at 7:12 pm
Jim, Wow! You opened up pandora’s box: I think I’ll sleep on this too…Ha!…I mean no disrespect… truly I don’t.
17 Krakatoa // Jun 17, 2008 at 10:36 pm
Thanks Jim. Really good analysis. I enjoy your article.
18 paultaut // Jun 18, 2008 at 4:09 am
5 years ago China was importing 4 million brls per day, today they are above 7 million. Indonesia used to export, now they import.
Buying Oil futures contracts can only drive the price of oil up if delivery is made and that oil is taken off the market. Otherwise, the contract is rolled over to the next.
So what I must be reading is that there are vast amounts of oil sitting in man made containers with millions of Brls. that have been taken off the market by hedge funds and other large institutions and this is the cause of the oil spike???? And it is all going to flood the market to drive oil prices down so that these hedge and insitutional funds can all go bankrupt.
Yeah, right.
19 rbblum // Jun 18, 2008 at 2:24 pm
Most of the cards are already on the table. In order to focus on what was presented in the article (Could the Saudi Oil Meeting Matter), the House of Saud is following a work-in-progrss script due to our current time in history truly being at a crossroads; transitioning from an oil based energy environment to a state that anything & everything goes regarding certain non-polluting, alternative energy sources - geothermal, wind, and solar.
With the oil price per bbl slipping out of the effective control of OPEC, the House of Saud will be presenting itself as a global leader calming global nerves, softening the spot price of oil from current upper price band as well as finding a globally accepted market price given a support of about $100 bbl per bbl that will extend their oil business interests within the less than stable OPEC organization.
Of course the visit by Bush with the Saudi’s lacked the usual political practice lacking transparency. But there are some issues that could be on a very short list, including pegging oil to the eruo and the US dollar as well as officially proclaiming the opening its new field with a 500kb/d capacity. The Bush administration will (impotently) call for a stronger US dollar and present a position to the US Congress to allow for the drilling of oil in US controlled regions. . . . in essence, there will be nothing new.
Even if there is no global recession, the House of Saud’s future is not guaranteed - dealing with their subjects underlying radical/militant behavior, competing with neighbors (Qatar and Dubai) for current and future international business interests, and not having the integrity of a large military/security force to defend its kingdom (House of Saud family members) from direct or indirect threats.
For the US, this is a presidential election year, so don’t look for any comprehensive energy plan until May 2009 at the earliest. But also remember to ‘be careful what you wish for’.
Even worse would be to witness any conflict with Iran which would likely bring Syria, Lebanon, Jordan, and Gaza into the fray with additional concerns from Pakistan, Afghanastan, Malaysia and Venezuela.
20 wynn // Jun 20, 2008 at 9:01 am
WOW look at the big brain on Jim!!!
this is great stuff to think about but gives too much credit to the administration for an attempt to get in front of the problem.
im still a proponent of the Earl Butz philosophy on commodities: “the only cure for high prices is high prices.”
the longer prices stay up the greater the fall when it comes and it will come in my opinion. i would just as soon see prices stay high and force changes in behavior.
Leave a Comment