By
the last week of May, the world trade price of oil
had increased to nearly $42 per barrel. This was the
highest it had reached for some time, and it was increasing
despite the onset of summer (which typically implies
reduced oil prices). While in real terms this is still
well below the peak reached in the mid-1970s, which
triggered the famous worldwide stagflation, it is
still high enough to cause concern among both policymakers
and investors.
It must be noted that much of the increase in the
price of oil has occurred quite recently. As Chart
1 shows, from a low of $17.87 a barrel in February
2002, the average monthly price of crude imported
into the US rose to around $25 a barrel in May 2002
and fluctuated around that range till December that
year. It then rose sharply during the winter months
to touch $31.89 in February 2003, only to begin its
decline again to reach the $25 level by April-May
2003.
It is only after June 2003 that oil prices have once
again been on the rise, with the US import price climbing
to around $31 per barrel by February 2004. Even this
figure is way below the spot price of $42 recorded
at the end of May. Thus most of the increase in price
could have occurred only over the last three months.
Chart 2 provides the spot price of Brent Crude for
the February to April months as reported by the most
recent monthly oil market report (dated May 12) of
the international energy agency. This shows that Brent
Crude prices in spot markets rose from an average
of a little less than $31 a barrel in February to
$33.8 in March and then fell to $33.3 in April. Examining
weekly prices for five weeks up to the week ending
3 May 2004 suggests that the price increase that has
taken oil prices to record levels began in the week
ending April 26, with price during the week ending
May 3 averaging $36.1 per barrel.
Thus clearly there has been a surge in oil prices
during May. This sudden surge, coming in the wake
of a much slower increase over the previous three
months, suggests that trends warranted by supply-demand
balances have been significantly amplified by speculative
factors. The real issue under debate now is on the
relative role of these two factors - supply-demand
balances and speculation – in explaining the current
high price of oil.
A close examination suggests that demand supply balances
could not have contributed to the observed price trends
in world oil markets, despite a sharp increase in
global demand driven by a rapid rise in consumption
in the booming Chinese economy. According to the International
Energy Agency demand growth during 2004 is likely
to be the highest in 16 years, with global oil demand
expected to rise by 3.6 million barrels a day relative
to 2004. More than a third of this increase is seen
as being due to increased Chinese demand, with another
quarter contributed by North America.
At first glance, this rapid rise in demand appears
a problem since OPEC producers who are responsible
for 38 per cent of global demand, have little spare
capacity left. A range of factors have affected OPECs
capacity to keep pumping out oil in response to demand
increases. These include the Iran-Iraq war, the Gulf
war and the attempt by US-backed Venezuelan oil workers
in 2002 to topple the Chavez government by paralysing
the oil industry. These have not just effected crude
extraction but limited refinery capacity.
However, despite these setbacks, OPEC production is
estimated to have risen by 3.3 million barrels a day
between 2002 and 2004, which together with its recent
decision to expand supply by a further 2 million barrels
a day (reportedly the production in excess of quotas
that was already occurring) should be more than adequate
to match the increase in demand. To boot, non-OPEC
oil production, is estimated to have risen by 2.3
million barrels a day between 2002 and 2004, led by
a 1.7 million barrels per day contribution from the
countries of the former Soviet bloc.
In fact, the government of Saudi Arabia, the world's
largest oil producer (and the only OPEC country with
significant excess capacity at the moment) has actually
been trying for several weeks to ease prices downward.
It announced that it will pump more oil itself and
managed to persuade other OPEC members to raise the
group's production quotas by about two million barrels
a day, to ease any fears of supply constraints.
In sum, while the fact that OPEC producers are running
up against their capacity limits could have generated
fears that further rapid increases in demand may not
be matched by corresponding increases in supply, as
of now the oil market is hardly characterised by a
situation of unmet excess demand. However, this has
had only a limited impact on the markets. Instead,
most observers predict that oil prices will remain
high for the next few months at least, and possibly
even longer.
The key to understanding oil price increases, therefore,
is the role of the speculative factor. Most predictions
of where oil prices are headed are based on trends
in oil futures or derivative instruments that involve
a bet on the likely trend in oil prices. Long positions,
involving current access to the commodity held with
the intention of selling it later indicate that speculators
are betting on a price increase. This implies that
available stocks are being held back with future trade
at a profit in mind. To the extent that this affects
the actual demand-supply balance at any given point
of time, these expectations of a price increase tend
to get realised. This renders the price volatile as
well. For example, on Wednesday June 2, expectations
of an OPEC output increase resulted in a fall in US
benchmark crude futures of as much as $1.75 per barrel
to $40.58, from a record close of $42.33 in the previous
session.
A revealing development noted by most observers is
the presence of hedge funds and pension funds in the
market for oil futures. It must be noted that it is
not just what happens in oil markets that determines
speculative activity there. Recent months have seen
hedge and pension funds seeking new avenues for investment
because of losses being suffered in financial markets.
Long positions in commodities have increased because
of declines in Japanese and emerging market securities
prices and indices and the adverse consequences of
the dollar's rally. Many fund managers see oil as
a saviour in this context because profits from long
positions in oil derivatives have offset losses in
other markets.
They have been encouraged in this activity by recent
developments in Iraq and Saudi Arabia. Naturally,
the chief source of concern for some time has been
Iraq. It is not just that attacks on the export-oriented
oil pipeline in northern Iraq have constrained oil
exports from the occupied nation. Even in southern
Iraq (which provides around two-thirds of Iraq's oil
production) there have been attacks on oil production
and transport facilities. If the US military occupation
of Iraq was really all about oil, it should come as
no surprise to note that the difficulties, and indeed
failure of that occupation, will create uncertainty
and expectations of oil price rises in world markets.
But the relative success of Iraqi opponents of US
occupation, who have continued to disrupt oil supplies
from that country, is not the only source of apprehension.
In the past months, there have been several attempts
by insurgents to attack energy targets inside Saudi
Arabia, and some of these have been at least partly
successful. There is no reason to believe that these
attacks will reduce or be eliminated in the near future.
Partly for this reason, Saudi Arabia has not been
able to calm the energy markets with promises of more
oil output, as it had successfully managed in the
past.
Of course, this increase in violent attacks against
oil facilities in different parts of the Middle East
is no accident, but is related directly to the US
military occupation of Iraq and its general geopolitical
strategy in the region. The Bush regime sought to
establish its control over world oil resources (and
to underline thereby its control over the world economy)
through aggressive military intervention. Paradoxically
(but perhaps predictably), it has succeeded in diminishing
its control and creating more uncertainty on the future
of the oil economy.
In the event, terrorist attacks in May in Khobar aimed
at the facilities of oil firms and at foreign personnel
linked to the oil industry (that killed 22 foreign
oil workers) spurred rumours that there is a strong
possibility that Saudi Arabia's production capabilities
may be severely damaged if not crippled. This in turn
is expected to affect oil supplies enough to generate
shortages. There are three presumptions involved here:
first, that security at Saudi oil installations can
easily be breached; second, that foreign personnel
are crucial to Saudia Arabia's oil industry; and,
third, that production elsewhere cannot increase to
make up for any shortfall in supply from Saudi Arabia.
As many observers and players have been at pains to
point out, none of these is necessarily true. Ali
al-Naimi, the Saudi Arabian oil minister, reportedly
dismissed negative perceptions about oil supply security
in the kingdom after the attack in Khobar when he
said: "This paranoia about terrorism in the world
that all of the oil establishments are at risk, that
is not true. I tell you very confidently that the
oil establishments in Saudi Arabia are very, very
secure. They are protected very, very strongly to
prevent anything from happening to them.''
He also made clear that there is no shortage of local
expertise if the need arises: ''when something happens,
even when it is not close to the establishment, what
happens is that people have the perceptions that this
will lead to employees running away. We have the human
resources that are capable and educated and we have
the best petroleum companies in the world. How to
convince those pundits, analysts and traders is the
problem," he reportedly said.
But in a market driven by rumour, the herd instinct
and a desperate search for profit, the Khobar attack
was enough to drive prices to record levels. While
estimates of the impact of such speculative activity
on the part of financial investors on oil prices vary,
some analysts suggest that it could have contributed
as much as 10 dollar increase in the price per barrel.
That is, almost all of the recent increase in prices
is seen as the result of speculative activity.
Needless to say, spokespersons for finance have been
quick to deny all this. Hedge fund managers repeatedly
dismiss views that speculators have been a leading
force in pushing prices to record levels. And, Robert
Collins, president of Nymex, the principal exchange
for oil futures, said: "While it is true to say
there is a great deal of hedge fund activity in the
futures exchanges, those markets are ultimately driven
by the fundamentals of the cash/spot markets in which
(hedge funds) barely operate."
However, the numbers are clear. Price increases are
not warranted by the prevailing supply-demand imbalance
and hence must be speculative; more so because even
the OPEC announcement that output would be increased
has not had an adequately calming effect on the oil
market.
If oil prices do continue to rule high, this in turn
will generate inflationary pressures, which have already
been evident in the US. Given the obsession of financial
markets with inflation control, it is not surprising
that they view this with trepidation. Even in India,
the question of how to deal with rising world oil
prices, and the extent to which they should be passed
on to Indian consumers, has already become an issue
for the new government.
But oil prices are especially significant in US politics.
The United States is the world's biggest consumer
and importer of oil, consuming roughly one-quarter
of the world's petroleum. Already by March the US
trade deficit rose sharply to a record $46 billion
in March, and about half of the increase was accounted
for by increased payments for oil imports. The US
oil import bill figures for April and May are likely
to be much worse.
US consumers are the most pampered in the world, used
to low petroleum prices for their cars in particular,
and usually there is a direct political fallout when
they have to pay more for this item. Petrol prices
in the US have gone up by more than 50 per cent this
year already, and there are rumblings amongst the
electorate about having to pay well above $2 per gallon.
President Bush, up for re-election later this year
and already taking a battering on his aggressive military
and foreign policy, can ill afford this additional
source of national discontent.
But the real problem is that price increases driven
by speculative activity hits the oil importers hard,
without delivering the benefits to oil exporters in
full. A conservative estimate by the International
Energy Agency suggests that a $10 per barrel increase
in oil price (say from $25 to $35) if sustained over
a full year, transfers income from oil importers to
the beneficiaries of the price to the tune of $150
billion or 0.5 per cent of global product. But with
global demand placed at over 81 million barrels per
day, the actual transfer could be as much as double
that amount.
A large chunk of this transfer would be from developing
country oil importers. The impact of such a transfer
on their balance of payments cannot but be damaging.
In the emerging markets like India and China with
large foreign exchange reserves, such a transfer would
drain their reserves, making them extremely vulnerable
to any decision of foreign financial investors to
withdraw their investments. Put otherwise these countries
lose both ways: they loose if financial investors
choose them as investment destinations, since this
results in an increase in reserves, an appreciation
of the currency, a worsening balance of trade, and
increased external vulnerability. They loose even
more if financial investors choose to move out of
paper assets into oil in search of better profits,
because that both increases their import bill as well
as reduces their reserves because of capital outflow,
threatening a financial crisis. Speculation in oil
does adversely affect richer nations like the US,
EU and Japan. But it can have devastating effects
on poorer oil-importing economies. In the final analysis
it is only the speculators who win in a world of dominant
finance.
