Grappling with rising prices of crude oil
http://www.hindu.
Atul Aneja
The exact role played by speculators in pushing up oil prices has come under greater scrutiny after the Jeddah conference.
The Jeddah conference of oil producers and consumers, which concluded on June 22, brought into sharp focus the role of speculators behind the recent surge in oil prices. The conference exposed deep divisions between oil producers and leading industrialised nations over the causes behind what has been described as the third oil shock. King Abdullah bin Abdul al Aziz of Saudi Arabia was outspoken in his criticism of oil speculators at the conference. Following the lead of the world’s largest oil producer, the rest of the members of the Organisation of Petroleum Exporting Countries (OPEC) amplified its line of argument.
The United States aggressively countered the assertion by oil producers. Ahead of the meeting, U.S. Energy Secretary Samuel Bodman stressed that it was not speculation, but the supply shortages in the wake of surging demand that had pushed up the prices to their present highs. Key western allies such as Germany backed Washington’s position. It was evident that the industrialised world wanted to steer the global energy debate on soaring prices from the role that speculators had played to expansion of output, from which western oil companies could stand to benefit.
Without adopting a confrontational stance, India’s position on the price increase stood out for its clarity, forthrightness and pragmatism. Finance Minister P. Chidambaram targeted speculators for causing the recent spurt in prices. “Respectfully, we reject the suggestion that rising demand is the cause of spiralling oil prices. Surely, demand and supply dynamics cannot explain what has happened over the last 12 months. How is it that the oil prices were $70 a barrel in August 2007 and how is it that they have doubled when there has been no dramatic change in demand?” Mr. Chidambaram added that the current pandemonium in oil prices lay in “unregulated over-the-counter (OTC) markets and futures trading in oil.”
Notwithstanding the rift between the OPEC and buyers in the West, the exact role played by speculators in pushing up prices has come under greater scrutiny after the Jeddah conference. While the entire picture on the modus operandi of speculators is still being pieced together, there is sufficient information to conclude that they have played a key role in escalating prices dramatically in just over a year.
Speculators neither own nor use oil. Instead they provide capital which is used for trading in oil futures in the hope of making a profit at a later date. The speculator enters into a contract in the “futures market” for the purchase of oil on a specified future date. The implications of this practice over the last one year have been enormous.
Leading players
Billions of dollars have been pouring into the commodity futures markets lately. Large financial institutions, hedge funds and pension funds have pumped huge volumes of capital in these markets. Goldman Sachs, Citigroup, J.P. Morgan Chase, and Morgan Stanley are some leading firms in the U.S. that have been involved in the oil trade.
Money has also been flowing into what are called commodity index funds. These funds are linked to a basket of several commodity futures. According to Goldman Sachs, nearly $85 billion pension funds and mutual funds have been invested in the commodity index funds. Not surprisingly, the communiqué issued at the end of the Jeddah conference singled out the need for greater transparency in the functioning of index fund activity.
The large inflow of funds into oil futures has coincided with the fall in the value of the dollar. As the dollar tumbled and the housing mortgage crisis in the U.S. began to bite, investment in oil emerged as a favourite avenue for securing speculative gains. With the influx of massive amounts of capital, oil in the futures market rose higher than current prices. This increased the demand for oil in current trading. Oil companies began to purchase extra oil at current prices. The surge in demand, linked to perceived trends in the futures market, generated an upward pressure on current prices.
It is not surprising that despite high oil prices, the demand for oil is continuing to rise. Fearing even higher prices, oil companies have begun to hoard oil. Crude oil inventories in the U.S. are at their highest in eight years.
Despite its obvious impact, the exact measure of escalation in oil prices caused by speculation in the futures market has been hard to gauge. It is estimated that speculation is behind nearly 60 per cent increase in the price of oil. A U.S. Senate subcommittee report of June 2006, “The role of market speculation in rising oil and gas prices,” observed that “there is substantial evidence supporting the conclusion that large amount of speculation in the current market has significantly increased prices.”
In the past, U.S. energy futures were traded exclusively through regulated exchanges such as the New York Mercantile Exchange. The Commodity Futures Trading Commission (CFTC) — a regulatory authority established by Congress on financial futures — monitored the transactions to prevent excessive speculation and other manipulative practices.
However, the Senate report made a significant observation. It noted that, “in recent years, however, there has been a tremendous growth in the trading of contracts that look like futures contracts, but which are traded on unregulated OTC electronic markets.” The removal of the OTC electronic exchanges from monitoring by the CFTC was anchored in the Commodity Futures Modernisation Act of 2000. It is alleged that large energy traders were the driving force behind this legislation. Another provision was added by the Bush administration in January 2006, which further removed oil futures trading from the CFTC’s surveillance ambit. It allowed U.S. crude oil futures to be traded on the Intercontinental Exchange futures. A leading operator of electronic energy exchanges, ICE is based in London.
Consequently, it is not CFTC, but the U.K. Financial Services Authority which, so far, has exercised exclusive authority over the functioning of the ICE Futures exchange. As a result, speculators in the U.S. trading in crude oil, gasoline and heating oil futures can bypass the U.S. regulatory mechanisms, by avoiding trading through NYMEX. Instead, they can route their transactions through the ICE Futures exchange.
It is evident that geopolitical tensions in West Asia have been overplayed as a factor behind the recent surge in prices. The fear of a possible war in the world’s energy heartland has coincided with excessive speculation, causing prices to gallop. The prospects of a war in the region, and the possible disruption it would cause to global oil supplies, have been used for expanding production capacity significantly. It has been said that already the gap between the total current supply potential, including the spare production capacity that countries like Saudi Arabia possess, and the growing energy demand in the world has been narrowing down alarmingly.
However, at the Jeddah conference, Saudi Arabia’s Oil Minister Ali Al Naimi emphasised that the expansion of supplies was not a problem. He pointed out that from July, the Kingdom would produce 9.7 million barrels a day. Production capacity would be raised to 12.5 million barrels by the end of 2009. A further 2.5 million barrels could be added through production in some of the new giant fields, raising capacity to a mammoth 15 million barrels a day.
As the role of unbridled speculation in the surge in oil prices becomes more evident, the international energy community has begun to consider ways to tackle it. At the Jeddah conference, Mr. Chidambaram called upon “producers — especially OPEC — and consumers to wrest control over oil trading from the hands of speculators.” He advocated the adoption of a “price band mechanism” that would work with the direct involvement of producers and consumers. OPEC, however, rejected the call on Monday saying the market is the best judge.
The pernicious impact of speculation on oil has also become part of the U.S. domestic debate. Members of the campaign team of U.S. Presidential hopeful Barack Obama have criticised the law which prevents the CFTC from fully overseeing the oil futures market and investigating cases of excessive speculation.
Despite some glimmer of hope, achieving lasting success will not be easy as powerful vested interests are involved in keeping alive speculative trading in oil.
BigGains !!
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