The Hindu Business Line : Why have oil prices gone crazy?

The volatility in oil prices could be the outcome of a widening demand-supply gap, oil companies under-playing production, and the fact that the world is nearing peak oil. Equally, it may be triggered by speculative activity, though it could well be the other way around, says ALOK RAY.

Why are oil prices heading straight north, with no signs of stabilising? Experts hold divergent opinions about what has been causing the rapid price rise in recent times. Currently, many fingers are pointing at the speculators in the oil futures market. In addition, there are the usual suspects — OPEC not raising production to meet rising demand; big oil companies colluding to raise prices; increasing political uncertainty in West Asia; falling dollar; Chinese stoc kpiling oil after the earthquake and before the Olympics, and so on.

But, first, a look at the more fundamental factors. A theory is gaining ground that the world may be fast approaching the ‘peak oil’ point.

According to a report by Earth Policy Institute, since 1984, world oil production has gone beyond all new discoveries, and by a widening gap. An additional problem is the aging oil-fields. The world’s 20 largest oil-fields were all discovered between 1917 and 1979, and the annual output from these fields is falling by 4 mb/d (million barrels a day). Offsetting this decline with new discoveries, or with more advanced extraction technologies, is becoming increasingly difficult.

Oil production

Geological knowledge and technology have improved enormously in the past 30 years. So, it is unlikely that major fields are yet to be found. Even if more oil can be extracted from sea-shales, tar-sands and deeper sea beds, that would be feasible only at sharply rising costs.

A recent study by the German-based Energy Watch Group, after analysing country-specific detailed data and projections, has concluded that world oil production has already peaked. The group projects it will decline by 7 per cent a year, falling to 58 mb/d in 2020. However, this pessimistic scenario is not shared by all experts. For example, the International Energy Agency (IEA) and the US Department of Energy are each projecting world oil output in 2020 at 104 mb/d.

Many people do not know that Russia — not Saudi Arabia — is currently the largest producer of oil. Unlike the Saudi rulers, the Russian President, Mr Vladimir Putin, has no reason to keep the US in good humour. If anything, he may try to twist the market to put Americans in trouble, if an opportunity arises.

Oil from Saudi oil-fields is also highly vulnerable in that half of the production comes from one field, two-thirds of oil goes through one processing plant and is shipped through two terminals, one of which was the target of a failed terrorist attack in 2002. Needless to add, Iran and Venezuela (two other major oil producers) — mainly because of the highly belligerent attitude of US administration to these regimes — would also be happy to see US in trouble.

Added to all this are the disturbing Iran-Iraq-Israel scenarios and the steadily rising demand for oil because of the increasing prosperity in China, India and the oil producing countries. Clearly, demand is quickly overtaking supply at going prices, along with rising uncertainty in the global oil market. Hence, market sentiment in favour of a long-term upward trend as well as sharp spikes (due to any temporary supply disruptions) for the price of oil is not difficult to understand.

Bio-fuel impact

The US strategy of turning corn into ethanol following massive subsidisation by the US Government, is also coming under increasing fire. Despite attempts by the US administration to downplay its impact on sharply rising global food prices, many experts (including at FAO and the World Bank) believe that this is an important factor contributing to recent food price inflation.

Some scientists are even questioning whether production of ethanol uses up more energy than it saves and, may, in fact, worsen the impact on environment. All these may slow down the search for alternative bio-fuels in the years to come.

The problem with oil is that it takes a long time (many years) to increase production — especially refining capacity — even when prices are remunerative. This is unlike the rise in the prices of an agricultural crop such as corn. A rise in the relative price of corn would increase the acreage under it at the expense of other crops such as wheat, even within a year.

That is not the case for oil. Some companies/countries may even have an incentive to reduce production (by keeping oil underground for later use/sale) when prices rise, if they believe prices would be more remunerative in the future.

There are also differences on the demand side. A rise in the relative price of corn would quickly switch demand away from corn to other substitutes. No such substitute exists for oil. Many people would switch to more fuel-efficient cars (such as hybrids or smaller vehicles) but that would be done mostly when they buy their next car and as more such cars appear on the market.

Demand-supply gap

Some would switch to other energy-saving options, using public transport when they believe that high oil prices are not a temporary affair. The effect of the doubling of the crude price has also been muted in many countries (like India) as the governments have passed on the burden to consumers only partially.

So, a given demand-supply gap in the oil market immediately pushes up the price much more than a similar gap in many other commodity markets. However, the response of both supply and demand to price (the so-called elasticities of demand and supply) will be higher as time passes. The same demand-supply gap in the oil market would imply a lower price level in the longer run — say, in five years.

Yet, that does not fully explain why prices should be rising so fast — doubling over the last 12 months. Some analysts (and politicians, including prominent US Congressmen) are, therefore, pointing to large-scale speculative activity in oil as a possible accomplice, if not the main culprit.

Their theory: After losing money in the housing market, big hedge funds and investment banks are now pouring money into commodity markets, including oil, which are much less regulated than stock markets. They are not buying or hoarding actual oil — and, hence, do not have to incur the cost of storage.

Speculation

Instead, they are buying oil futures with borrowed money at low interest rates – that is buying papers that entitle the holder to get oil after, say, three months, at a price negotiated today. These papers are traded on commodity exchanges, just like company shares in a stock market.

If the price of oil is rising in the market, and some investors believe that prices would go on rising, investor X should be able to sell the paper to investor Y at a higher price and make profits. Y, in turn, will sell the paper to Z at an even higher price later, and so on.

An asset bubble may thus be created. But at some point the bubble will burst and many people will lose money. It is speculative betting involving a risk and no sure profits. So, to increase the chances of making profits as long as possible, these investments banks need to sustain the market hype that prices will go on rising at a fast pace. Some suspect that a few investment banks are deliberately creating a panic in the market by projecting (through their “expert” studies) that the price of oil may even go up to $200 per barrel in the near future. Given the demand-supply fundamentals in the oil market, as described above, and the general trend of rising oil prices in the past few years, many people would be willing to believe this.

According to The Economist, the number of transactions involving oil futures on the New York Mercantile Exchange the biggest market for oil, has almost tripled since 2004. The price of oil has also tripled over the same period. However, such a correlation does not prove the causality. Questions remain on whether speculation is causing rising prices or rising prices are attracting more speculators. It can be both — one reinforcing the other and creating a self-fulfilling prophecy. But, at this point of time, nobody knows for sure.

(The author, a former Professor of Economics at IIM Calcutta, is currently a Visiting Professor at University of Pittsburgh, US. He can be reached at alokray15@yahoo.com)

Related Stories:
Rising crude prices fuel futures trade
Oil prices: Correction on cards
Petroleum product prices — Getting the real message
Strategy to stave off oil crisis