Desperately seeking blame for oil prices
an a’political look at a universal problem

We’ve all engaged in the speculation wars as to the reason for oil prices’ astronomical rise in such a short time.  The four most common arguments are:

1:  questionable speculators activity
2:  decreasing supply and increasing demand - and peak oil theories
3:  Iraq or Middle East conflicts and terrorism
4: falling value of US dollar

I’m neither an accomplished economist, nor an oil expert.  But I’m one curious individual, so I set out to see if I could shed some light how just what to believe.  There’s considerable amount of data here (meaning long! a week’s worth!) but I’ll share my research on the four issues mentioned above… and my attempt to put it all into perspective…. sans politics. (the “gasps” abound, no doubt…)

To agree on a solution, we need to know the cause of the problem. 

The article that sparked my increased motivation and quest came from Australia’s Herald Sun yesterday, Speculators to blame, says OPEC”.

The monarch, who said Saudi Arabia would give $US1.5 billion ($1.57bn) to efforts to ease energy shortages in poor nations, told the 36-nation summit his country was “very concerned” about consumers worldwide.

He blamed increased oil consumption and taxes on fuel, but said: “Among other factors behind this unjust increase in oil prices is the abhorrent act of speculators acting for their own selfish interests”.

The most common thought on the speculators is that the buying frenzy is creating a positive feedback look, driving the prices artificially high and creating an economic bubble - much as was done with the housing prices in both the UK and USA. Along that line of thought, Congress is busy crafting legislation aimed at regulating speculators, while McCain has called for “thorough and complete investigation of speculators” to see if they’ve driven up oil prices.

Alan Reynolds termed this knee jerk reaction as a “witch hunt that’s clearly about oil” in an article that ran in the NY Sun June 20th, titled “Scapegoating the Speculators”, and was reproduced on the Cato Institute site.Reynold’s debates OPEC’s accusation. Speculators, purchase the contracts and sell those before their expiration date, in the hopes of making profits. Sometimes this entails betting the prices goes down instead of up. Or as he puts it, Guess wrong on the direction, and you lose money.

John Maynard Keynes (in The General Theory of Employment, Interest, and Money) offers this definition of speculation:

Speculation: The activity of forecasting the psychology of the market.
Speculative motive: The object of securing profit from knowing better than the market what the future will bring forth.

Keeping that definition in mind, Reynolds believes speculators are betting prices will be going down.

Purely financial speculators needn’t play futures at all. They can simply buy (or short) the exchange-traded US Oil Fund, which tracks the price of West Texas crude. And The Wall Street Journal reports that short interest in that fund is up 140 percent since January, outnumbering long bets by two to one.

Speculators, in other words, are increasingly leaning toward betting the price of oil will go down, not up. So they’re unlikely villains if prices do keep rising.

According to an excerpt from Martin Fridson, “Exactly What Do You Mean By Speculation?” Journal of Portfolio Management, Fall 1993, Reynold’s theory that current speculation is a bet that prices will be going down actually holds water.

Taking the debate a step further, Fridson suggested viewing speculation in the context of “Modern Portfolio Theory.” Building on the work of Harry Markowitz, William Sharpe, and others, Fridson concluded that “The common thread between speculation (as currently defined) and transactions that seem speculative, yet fail to satisfy all the established criteria, is that they are all bets against the consensus view.”

I think we can all safely concur that betting oil prices will decline is not the consensus…. Certainly speculative buying can inflate the real value of a product by simply increasing the demand for that product (which in this case is contracts only, not the delivery of oil) in the extreme.  However some competitive speculation often results in an efficient and healthy market.

As for the more logical idea of betting on further price increases, Reyolds counters with:

Yes, if the price of next month’s oil futures goes up, that can encourage producers to slow their sales on the spot market. And a higher price for next month’s oil can encourage refiners to buy more now rather than later. Both reactions could push the cash price up.

But they would also cause oil inventories to rise. [Mata Note: Keep this inventory... aka stock on hand = less demand, translating to more supply available to sell... in mind for info about China further down.] And rising inventories always bring the price back down. Yet US oil inventories appear modest at present - so there’s little evidence that speculation had much to do with recent prices (aside from one-day spikes from scary rumors or news).

Economic bubbles and artificallyinflated prices can, as we again know with the housing markets, lead to quick, and possibly steep declines. The steepest decline would, of course, be recognized as a crash… which is George Soros prediction.Sorosis one of those, along with OPEC, that blame speculators.

There are few western media publications that do not blame speculators. But because I can see Reynold’s legitmate point, I’ll have to put the speculators in the “contributing to the problem” column. But I don’t see it as the primary driving force.

This seques us easily to the supply and demand argument. It cannot be questioned that the world is increasing it’s consumption (demand), so that only leaves us with the supply question. Is oil output sufficient for the demand?

Again we find a mixed bag. The Saudis insist they have enough oil to sustain needs for decades to come, and capitulated to US demands on the second request. They did, however, refuse the 1st request from GWB just a month earlier, saying it wasn’t a supply issue since no customers were asking for more oil.

The US was not alone in putting pressure on OPEC. British PM Brown flew to the summit with the same request… pump more. See OPEC chief dismisses Brown’s call to boost productions as “irrational”And like the Saudi’sfirst meeting with GWB, they refused. Cost of living in the UK has risen to a 16 year high of 3.3%.

Yet is it irrational? And if so, why the change of heart by the Saudis?

According to MarketWatch on June 19th, China’s reduction of subsidies, which precipitated their price hike to consumers, resulted in oil prices down $4.75… all based on “concern” for a slowdown in demand.

Translation? The Chinese nailed their population with a hefty price increase instantly following removing subsidies. The market anticipated the Chinese, not an affluent people, would decrease their demand which would increase available supply of marketable oil on the world market.

Note: The assumption of more available oil supply because of less Chinese demand resulted in drop in barrel prices.

But that oil per barrel price didn’t last when reality set in, and they didn’t see the Chinese running in droves from the pump.

Oil rose by more than $4 a barrel today as dealers reassessed their view about a fuel price increase in China announced by Beijing earlier this week. After a $5 fall yesterday, speculation that Chinese demand might rise pushed the price of both US and Brent crude above $136 a barrel, within sight of the record of just under $140 a barrel briefly reached earlier in the week.

The Chinese found themselves in the real shock and awe price moment. The government had been holding the prices down (for 8 months) with price caps until they were forced to remove them by the state-owned oil companies who had been functioning in the red for selling to China at a loss. Prices jumped 18% virtually overnight. Add’l pressure was put on China by foreign governments who argue that subsidised Chinese fuel is keeping global prices high.

What about the other 93% of the worlds current oil reserves, owned or controlled by governments? Are their subsidies also affecting oil prices?

Also an issue is the oil output declines by the state owned oil reserves. The absence of private investors in state owned oil producers - and the inability for a socialist country to improve it’s own production output with dwindling public funds - factors heavily in their decline of oil production. This is a situation that, as their economy declines with their oil income, they become another China - dependent upon oil production that runs in the red…. until it can’t any longer.

All these factors and events make me believe that supply vs demand is not meriting the attention it deserves by Congress and the western media.

As a side bar to supply/demand, comes the peak oil debate… or, per the liberal site, The Oil Drum, the limitations of natural production of oil by Mother Nature. But even these environmentalists admit oil’s still prevalent. They just claim it will be cost prohibitive to pump it.

Also on the same site, and from another very liberal/environmental source, the APSO, is a guest post by Rembrandt Koppelaar, Chairman of ASPO Netherlands.Mr. Koppelaar offers a very valuable lesson when reading about peak oil reports. Ala how do they figure “decline” - net or gross - when reading media reports and source material?

Gross decline rate - the drop in production that would occur if oil companies would not try to halt declines, or the natural decline level. Decline can be halted by introducing new techniques / workovers / drilling more wells and so forth.

Net Decline rate - the drop in production that occurs when the efforts by oil companies to halt decline are included.

Koppelaar has lots of charts and pictures to entertain. He even points out that between 2001 and 2006, there has not been a decline in the “liquids” production. But what is the most important point to take away from informative post is the fact studies upon which many rely (like Congress…..) are:

1: dealing with existing oil fields and not necesarily future oil fields
2: perhaps not taking into account that the oil supply is not being drained, but is requiring more drilling to extract the still existing oil
3: as our technology improves, the “cost prohibitive factor” becomes less relevant

Because of the vagueness and disclosures on most links about peak oil, I’m going to say that peak oil - in the context of the doom’n'gloom apocolyptic end to oil available - is a highly debatable subject…. all which can change depending on technology, and exploration and development of new oil fields.

That said, I’ll put supply and demand into a “definitely a factor” column.

As for refining - it is a separate issue known already to affect US prices. Our prices at the pump are in direct response to our refinining limitations and interruptions… i.e. hurricanes/Mother Nature damaging for our coastal refineries, and federal mandates forcing different mixtures twice a year. Refining is definitely an issue, but one that comes into play between the price per barrel and the gas pump. But it is always worth noting that the head of OPEC cites refining limitations as a factor of the price per barrel.

Oddly enough, many of the articles morph right from the supply/demand issue into the conflicts/terrorism effect. But not in the direction most would think.

The Saudis (only) agreed to increase oil output at the summit - despite their claims “no one was asking for more oil”. Yet still the prices surged in the wake of that announcement, with light sweet crude at over $135 and $136 a barrel the following days. (Note: light sweet crude is the least expensive to refine). Why?

Terrorism… but not Iraq. The hotbead area directly affecting prices is one where the US has no military conflict - Nigeria’s sweet crude fields that remain under constant and deliberate assault from Emancipation of the Niger Delta (MEND) since their formation in March 2006.

Nigeria is the world’s eighth largest oil exporter and the fifth largest supplier of crude to the US. MEND’s recent sabotage of pipelines and other oil facilities has so far shut off over a fifth of the country’s oil output, steadily driving up world oil prices.

The above quote was from 2006, however their terrorists antics, designed to slice away at Nigeria’s oil income, remains an ongoing influence today. Again, from the CNN article just yesterday, about prices rising in the wake of the Saudi output increase:

Oil prices rose Monday as investors shrugged off Saudi Arabia’s pledge to increase its oil production if needed, focusing instead on disruptions to Nigerian supply and heightened Middle East tensions.

snip

Royal Dutch Shell PLC said Friday that it cannot meet contractual obligations to export oil from a Nigerian oil field following a militant attack Thursday. Nigerian oil workers also reportedly decided to strike at a Chevron Corp. facility beginning Monday.

But oil prices might find some relief from Sunday’s announcement by Nigeria’s main militant group that it would halt attacks starting at midnight Tuesday. The Movement for the Emancipation of the Niger Delta declared a unilateral cease-fire, saying elders in the restive southern region had asked the fighters to allow peace efforts to go ahead.

The group’s attacks have sliced about one quarter from Nigeria’s normal oil daily oil output, helping buoy crude prices in international markets.

“The market will see if indeed that cease-fire holds for a bit of time,” Shum said.

Unlike “concern” about attack on Iran oil fields, which has not happened, Nigeria’s conflicts are real… not speculation. This again sidles right back into the supply/demand argument. When looking at the terrorism/war effects on oil, it was an interesting trip thru memory lane in the media.

From a Feb 2007 Vanity Fair article by Sebastian Junger - “Blood Oil: Politics & Power” - Nigeria figured prominently even prior.

On June 23, 2005, a group of high-ranking government officials were convened in a ballroom of the Four Seasons Hotel in Washington, D.C., to respond to a simulated crisis in the global oil supply. The event was called “Oil ShockWave,” and it was organized by public-interest groups concerned withenergy policy and national security. Among those seated beneath a wall-size map of the world were two former heads of the C.I.A., the president of the Council on Foreign Relations, and a member of the Joint Chiefs of Staff. The scenario they were handed was this:

Civil conflict breaks out in northern Nigeria—an area rife with Islamic militancy and religious violence—and the Nigerian Army is forced to intervene. The situation deteriorates, and international oil companies decide to end operations in the oil-rich Niger River delta, resulting in a loss of 800,000 barrels a day on the world market. Since Nigerian oil is classified as “light sweet crude,” meaning that it requires very little refining, this makes it a particularly painful loss to the American market. Concurrently, in this scenario, a cold wave sweeping across the Northern Hemisphere boosts global demand by 800,000 barrels a day. Because global oil production is already functioning at close to maximum capacity (around 84 million barrels a day), small disruptions in supply shudder through the system very quickly. A net deficit of almost two million barrels a day is a significant shock to the market, and the price of a barrel of oil rapidly goes to more than $80.

What follows is almost comical considering today’s reality of oil at over $135 per barrel. Talk of how the US could sustain $80 per oil almost “indefinitely”, but that demand would decline. The Oil ShockWave panel suggested a scenario of near “simultaneous” terrorist attacks on oil supplies worldwide that could “easily send prices to $120 a barrel, and those prices, if sustained for more than a few weeks, would cascade disastrously through the American economy.”

Slowdown in the economy, yes. Evidently not quite disastrous… but certainly, if unable to stablize prices, ultimately could be disastrous not only for the US economy, but the global economy. The US marketplace is, afterall, the centerpiece for most of the world’s goods. When we can no longer afford to “go to the mall”, the effect will be felt like a shot heard round the world.

What I found was most interesting was Junger stated the last two US recessions were spiked by 1: an increase in oil prices and 2: unrest in Nigeria.

Because Nigerian oil is so vital to the American economy, President Bush’s State Department declared in 2002 that—along with all other African oil imports—it was to be considered a “strategic national interest.”

Even today, on The Oil Drum, Nigeria is raised as the main issue for terrorist disruption of the world’s oil supply.

On the heels of this weekend’s Saudi Oil summit, Nigerian production has dropped to the lowest level in 25 years. This was in part because militant attacks shut in as much as 345,000 barrels per day of Nigerian production in the past few days. The Nigerian militant group MEND (Movement for the Emancipation of the Niger Delta) has demonstrated a continuing ability to interrupt production from Nigeria’s mature, onshore fields. However, the future promise of Nigerian oil is not onshore. Rather, it is the 1.25 million barrels per day of offshore production scheduled to come on line in the next 6 years. Analysts previously believed these offshore facilities were out of MEND’s reach.

The beauty of this particular post and source link is that offshore production… by someone, and hopefully private firms… can promise a more stable supply of Nigeria’s crude. But is anyone addressing this?

As for the rest of the Middle East conflicts? Israel vs “fill in the blank” has been going on for half a century. The US has been present in Saudi since the early 90s. In short, nothing has caused this much of a steady, sustained and leap of pricing. In light of this history and the constant state of middle eastern unrest for centuries, I’ll place conflicts and terrorism effect into possible, but not as likely column, and Nigeria’s situation under the supply/demand column.

Which bring us last to the falling of the US dollar. Certainly this decline affects more than just oil in the US economy, and the decline did not start with the rise in oil prices.

In 2007, the US trade deficit was “$708.5 billion, which is $1.6 trillion in exports minus $2.2 trillion in imports. The deficit improved by $50 billion in 2007, thanks to higher exports, a result of the declining dollar. (Source: U.S. Bureau of Economic Analysis, “U.S. International Trade in Goods and Services,Exhibit 1″, March 11, 2008).” fast source here w/links to spreadsheets)

Again, contrary to the US citizens common belief, this is not attributable to Iraq war debt. The deficit is divided into two categories - petroleum related and consumer products. Together these categories equal 87% of the total national debt.

The trade deficit by category was:

$293 billion for petroleum related products,
$328 billion for consumer products,
$193 billion for all other goods,
$107 billion in surplus for services.
(See spreadsheet in Google Docs)

In a Cleverwithcash.com article,discussing subprimeloans, the US dollar and oil prices, they point out that both China and Japan are financing a great part of the US debt, holding US Treasuries. Their economy is effectively tied to ours.

To we laymen, on the surface it appears to be a bottomless feeding frenzy cycle… As US Dollar goes down, oil prices go up. As oil price increases, the US trade deficit goes up further for our petroleum related products, causing a lower dollar.

Yet why is it that Europe is also suffering from the interminably high prices with their Euro? According to Martin Feldstein,:

Because the oil market is global, with its price in different places virtually identical, the price reflects both total world demand for oil and total supply by all of the oil-producing countries. The primary demand for oil is as a transport fuel, with lesser amounts used for heating, energy, and as inputs for petrochemical industries like plastics. The increasing demand for oil from all countries, but particularly from rapidly growing emerging-market countries like China and India, has therefore been, and will continue to be, an important force pushing up the global price.

The thinking behind the question of whether oil would cost less today if it were priced in euros seems to be that, since the dollar has fallen relative to the euro, this would have contained the rise in the price of oil. In reality, the currency in which oil is priced would have no significant or sustained effect on the price of oil when translated into dollars, euros, yen, or any other currency.

Feldstein (a professor of economics at Harvard, former Chairman of President Reagan’s Council of Economic Advisors, and President of the National Bureau for Economic Research) concurs that while the decline of the dollar doesn’t affect the rise in oil prices, the rise in oil does contribute to the deficit… which affects the dollar’s value. Thus, it is a separate issue to be reckoned with for the overall health of the US economy, and our continuation as the quintessential, coveted market globally. Based on this, I’ll place the falling dollar into the “not applicable” column for oil prices.

Which brings me at long last to digest all I’ve learned in the past week. A tenative summary about a very complex subject… one truly beyond most of us, and most certainly me. But in light that we have a Congress about to intercede, and media proclaiming they “know”, it behooves us all to have a more informed perspective. I hope this does that for you, as it did for me.

Of the four categories, it appears the most influential on oil prices is the oil supply/demand theory, peppered by refining. It is, however, not the lone culprit. Added to that is a degree of speculation and their effects… in theory and practice, perhaps not long term.

We’ve eliminated the falling dollar as an issue and, other than Nigeria (under supply/demand now), terrorism.

But the solution is as multifaceted as the problem … how to best address supply and demand, avoid legislation that is counterproductive to traditional speculation benefits, and not worsen our national debt with prohibitive trade laws.

Can Congress take off their blinders and abandon their standard tunnel vision? Truly, it’s not their strong suite. Their habits are to find somewhere/someone to assign blame, and reap legislative punishment on that declared scape goat. This is, per WSJ’s Keith Johnson, what they have planned.

In his article “Saudis or Speculators? Oil-Price Finger-Pointing Heats Up”, Congress is set to parade a list of witness that will give the elected elite exactly what they want to hear to push forward their proposed legislation on speculators.

Among the experts: Oppenheimer and Co. oil analyst Fadel Gheit, who famously and furiously blames speculation for the bulk of the price increase, as well as Michael Masters, a Virgin Islands-based fund manager who doesn’t hesitate to point the finger at colleagues. He noted in previous congressional testimony that in the last five years, speculation in crude futures has increased almost as much as physical demand for oil in China, another favorite bete noir. Other energy experts set to testify include speculation alongside a weak dollar, “peak oil” and relentless demand growth as a part of a “perfect storm” that explains today’s high oil prices.

They may convince the nation, after all the western media demonization, that they are correcting the situation. But after all I’ve read, I can’t help but believe they are missing the pulse of the problem. And that does not bode well for us, Joe Blow citizenry.