According to Shell Oil president John Hofmeister, the “proper” range for oil should be somewhere between US$35 - US$90 a barrel. Based on that statement and assuming it’s more or less accurate, what do you think we should make of the current oil price of US$130 - US$140 per barrel? How much of the spectacular rise in oil is due to speculation? That is important to determine as excessive speculation could basically drive prices much higher than its real demand-supply equilibrium.
Open interest in WTI oil futures has been growing exponentially at 18% per annum since 2001, thanks to the entry of non-commercial players. The entry of more non-commercial players and speculators generally mean they would be on the long-side of the futures and options.
Many reasons are being cited for the oil price boom – speculation, fundamentals, dollar weakness, fuel subsidies, inflation, low interest rates. All factors are playing a part at some time or another, with different factors dominating at various times.
But one factor stands out as the biggest culprit – SPECULATION.
Spike in speculation
According to Michael Masters, index speculators are the primary cause of the recent price spikes in commodities. This is not selective information to back my view as he heads a highly respected fund management company – Masters Capital Management.
He recently (May 20, to be exact) delivered a testimony before the Permanent committee on “Investigations committee on homeland security and governmental affairs” to the US Senate. Hence his testimony carries a lot of weight.
Masters talked about the resurgence of several groups over the past five years who he deemed as newcomers to the “commodity speculation scene”. They are corporate and government pension funds, sovereign wealth funds, university endowment funds and other institutional investors. Collectively, they constitute the largest share of outstanding commodities futures contracts than any other group.
Masters refers to them as “index speculators” because they distribute their allocation of dollars across 25 key commodities futures according to popular indices, namely the S&P Goldman Sachs Commodity Index and Dow Jones AIG Commodity Index.
The rising interest in commodities was largely based on the assumption that historically, commodities have no correlation to fixed income and equities. It has to be noted however that while previously the futures market may have been relatively “not big enough” to provide this kind of diversification, this has not been the case over the last 10 years.
As at end 2003, assets allocated to commodity index trading stood at a whopping US$13bil. As of March 2008, that figure has ballooned to US$260bil! Obviously, something highly significant has happened here with equally significant consequences.
The culprits
Some political leaders have pointed their fingers at speculators as the primary culprits for driving oil price by more than 50% over the last 12 months alone. In my opinion, they are correct, partially.
The new index speculators are not your average in-and-out trading outfits. Collectively, these funds have stockpiled (long on inventory via the futures market) 1.1 billion barrels of petroleum. It’s not like they are actually going to take delivery of these oil barrels, but their stockpiling is tantamount to hoarding 1.1 billion barrels from the real market place. If real supply is constant, one can imagine what the 1.1 billion long positions will do to oil futures prices if they are rolled over.
Apart from index speculators, a huge number of long-only commodity funds and plethora of dedicated commodity ETFs have entered the scene in the past five years. A quick glance at Nasdaq will be able to give you an idea on the rising emergence of ETFs. Essentially, they are long players, trying to cash in on investors interest on a prolonged commodity bull run. But are they really interested to consume these commodities? NO.
Joining the bandwagon
Lending a great deal of support to index speculators are, unsurprisingly, investment banks. Swaps loophole exempts investment banks like Goldman Sachs and Merrill Lynch from reporting requirements and limits on trading positions.
The loophole allows pension funds (or any other aforementioned funds) to enter into a swap agreement with an investment bank, which can then trade unlimited numbers of the contracts in futures markets.
Even more interesting is that the WTI crude oil futures traded on ICE in Europe are exempt from regulatory action! ICE (Intercontinental Exchange) operates global commodity and financial products including the world’s leading electronic energy markets and soft commodity exchange.
Amidst all these hoopla, it would appear that Opec, which is traditionally everyone’s punching bag, is probably an innocent party to this catastrophe, this time around.
According to market estimates, the actual costs incurred in producing the most expensive oil is only around US$70-US$80 a barrel; the rest of the current oil price represents the market’s risk premium plus speculation. Note, that assumption is based on the high end of the cost spectrum and most are produced at a much lower cost.
Rising trend
You have heard this before: according to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels – an increase of 920 million barrels.
Over the same period, Index Speculators demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!
Bearing in mind that commodity futures markets are much smaller than capital markets, these substantive funds will have a far greater impact on commodity prices.
In 2004, the total value of futures contract outstanding for all 25 index commodities was US$180bil. In 2004, index speculators poured in US$25bil into these markets – a significant 14%. It would be safe to assume that the sums being ploughed into the commodity futures markets in the ensuing years to present is much higher.
Rising trend means index speculators are making a lot of money. The run attracts momentum players. Typically, rather than take their profits and run, index speculators tend to stay on because the allocation is a diversification bet not a straight out investing bet. They are more likely to reinvest their compounded gains and even more due to profit-motivated demand thinking.
Psyche of speculators
Index speculators are different from traditional speculators. The latter will trade, take their profits and run. The former prefers to keep the long position and generally, never sell. Instead of providing liquidity, index speculators are actually draining liquidity. Even if Opec promises to release more oil now, it would probably not dent the rally by much.
If index speculators weren’t a group but an individual, regulators would be on his back like a hawk and he’d be hauled up for attempting to corner a market. Masters highlighted to the US Senate that it is most important to close the loophole in the Commodity Exchange Act 1936 which exempt investment banks from speculative position limits when these banks hedge OTC swaps transactions.
According to Masters, almost 90% of index speculators effectively enter into commodity index swaps and face no limits on their positions. To puncture the oil price bubble, and yes, it is a bubble, Masters recommended that pension funds be forbidden from using commodity index replication strategies.
He added that the swaps loophole should be plugged immediately, thus causing all speculators to face position limits. In all likelihood, if the recommendations put forth by Masters or moves similar to that are put into action, the oil price bubble may be punctured.
Judging from market developments in recent weeks, it may be wrong to assume that “nothing will be done” by the US lawmakers soon.
We will find out – very soon.
p/s photo: Leah Dizon
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