High oil prices and speculation

This is from a Philippine paper. Although this is in a Philippine paper and discusses the effect of increased oil prices in the Philippines the author is based in Saudi Arabia. He makes the interesting point that perhaps a considerable amount of the increase in oil prices is due to speculation rather than other factors often cited.








COMMENTARY
The threat of oil prices


By Louie de Leon
Philippine Daily Inquirer
First Posted 11:39pm (Mla time) 01/03/2008


Undeniably, crude oil price levels have shot up considerably since the start of the year.

Some say the reason is the geopolitical tensions in the Middle East and in other parts of the world, which raise concerns about the security of oil facilities. But Iraq is more secure now than it was two years or even a year ago. But still, oil prices started to spike up during the latter part of the first quarter of 2007. If Iraq is safer now, as George W. Bush says, shouldn’t oil prices be going down instead of up? On the other hand, Iran is just as confrontational toward the United States today as it was last year, and no major war has erupted since January to warrant a 100-percent increase in oil prices.

If geopolitical tensions alone explain the oil price hikes, why didn’t prices shoot up just as fast in 2006 when Israel bombed Lebanon for more than a week, and many oil-producing Arab countries threatened retaliation?

Is the increase, then, due to increasing demand and shrinking supply? That the demand for oil is going up is undeniable, but that begs the question: whether the magnitude of the demand for oil in the United States and in China and India, as well as in other East Asian tigers has increased 100 percent to warrant a meteoric rise in the prices of oil. And I don’t think either that the world’s oil supplies have been so drastically depleted to warrant the doubling of oil prices.

At the recent OPEC meeting, oil ministers of Kuwait and Saudi Arabia said oil supplies were adequate and they saw no need to increase output, as this could lead to an oversupply in the market. Accusing these oil producers of manipulating the prices is an all too easy explanation. If the accusation were true, wouldn’t the United States, the United Kingdom and other European countries by now have led some political protests such as an embargo or a UN resolution?

Indeed, geopolitical uncertainties and demand-and-supply concerns are contributing to the rise of oil prices. However, the sharp increases in prices are being driven by factors inside the oil markets themselves.

In the spot market, or what commodity traders call the “wet market,” where there is physical delivery of the traded commodity, oil prices are not fixed. Oil prices are fixed in the futures market, where “paper barrels” are traded; this may entail no actual deliveries until several years from now. The futures market is where speculation is rife.

Speculative attacks are fueling the increase, since the price of oil, as a physical commodity, is fixed in the market using oil futures, the primary buyers of which are investors, hedge funds, investments banks, among others. The great unwinding in the US housing market and the increasing liquidity in the world financial system have sent large sums of “hot money” circulating in the world equities, currency and commodities market in search of “investment” instruments that would yield the highest return. And oil is one of those instruments, gold being another. Fortunately, unlike oil, gold price changes have no effect on the daily life of ordinary Filipinos and, hence, have caught little of our attention.

The global economy is driven by an unforgiving capitalism fueled by greed, in which the Philippines is just a bit player. And the Philippines has very little control over this trend. This reminds me of what the former French Prime Minister Edouard Balladur said: “What is the market? It is the law of the jungle, the law of nature. What is civilization? It is the struggle against nature.”

World commodities and capital markets are jungles too big for the Philippines to struggle against. I would like to suggest an article written by Prof. Giacomo Luciani of the Gulf Research Center of Geneva, titled “Global Oil Market Needs Fundamental Reforms.” Another interesting read on this analysis is Alan Greenspan’s “The Age of Turbulence.”

I think Luciani summed up brilliantly the threat of oil prices when he said: “In the long run, demand will slow down, expectations will reverse and prices will decline; but a lot of economic damage may be done in the meantime.”

Louie de Leon is a credit analyst based in Saudi Arabia.