A Word about Oil Prices

There is a great deal of discussion about why global oil markets are engaged in yet another price feeding frenzy. Some claim it is simply supply and demand. Others point out that both "supply" and "demand" can be manipulated in many ways. Others point to international tensions in the middle east, particularly Iran. Yet others point to Wall Street and blame the bankers. And not just a few in the US are pointing fingers at Barack Obama's broad agenda of energy starvation as being a significant factor in price increases. But where does the truth "lie?"

A speculator purchasing vast futures at higher than the current market price can cause oil producers to horde their commodity in the hopes they'll be able to sell it later on at the future price. This drives prices up in reality -- both future and present prices -- due to the decreased amount of oil currently available on the market.

Investment firms that can influence the oil futures market stand to make a lot; oil companies that both produce the commodity and drive prices up of their product up through oil futures derivatives stand to make even more. Investigations into the unregulated oil futures exchanges turned up major financial institutions like Goldman Sachs and Citigroup. But it also revealed energy producers like Vitol, a Swiss company that owned 11 percent of the oil futures contracts on the New York Mercantile Exchange alone [source: Washington Post].

As a result of speculation among these and other major players, an estimated 60 percent of the price of oil per barrel was added; a $100 barrel of oil, in reality, should cost $40 [source: Engdahl]. And despite having an agency created to prevent just such speculative price inflation, by the time oil prices skyrocketed, the government had made a paper tiger out of it. _HSW: Oil Speculation and Oil Prices

Inflation Adjusted Crude Oil Prices
As you can see from recent history, oil price shocks are nothing new to global markets. In fact, as you can see from the chart above, oil prices are not yet back to last April's (2011) highs -- the most recent price scare.

What about oil futures and oil prices? Many people suggest that if oil futures speculators do not take delivery of oil contracts, that they cannot influence the real price of oil. But that is not necessarily the case:

A speculator betting on a single futures contract will have no effect on the market. A speculator with a sizable amount of capital to put to work however, can purchase a stake that is sizable enough to sway the market, and is considered the major factor in how oil futures raise prices.

As speculators purchase on rumor rather than fact, a speculator purchasing a large amount of futures at a price that is higher than the market value of oil currently can lead to the hoarding of the commodity by producers in the hopes that the commodity can be sold for a higher price in the future.

As the supply of oil is reduced by these actions on the part of the producer, this leads to a realized increase in the price of the commodity both in the present as well as the future. An investment firm as well as oil producers stand to make a huge profit, as an estimated 60% of oil’s per barrel price is the result of speculation on the part of investment firms and other major players. _HowtoTradeStocks

Large scale, coordinated oil speculation would appear to be one way in which "oil demand" can be manipulated so as to drive up prices. There are several other ways in which this can be done, and we will look at some of those in later postings.

Those who think that oil speculators do not actually take delivery of oil may be in for a bit of a shock to discover that speculators have periodically stockpiled oil -- then strategically released stockpiles -- for some time.

The oil-storage trade is a trading strategy where oil tank owners and companies that lease storage buy oil for immediate delivery and hold it in their storage tanks, then sell contracts for future delivery at a higher price. When delivery dates approach, they close out existing contracts and sell new ones for future delivery of the same oil. The oil never moves out of storage. Trading in this fashion is only successful if the forward market is in "contango", that is if the price of oil in the future also known as forward prices are higher than current prices or spot prices. Storing oil became big business in 2008 and 2009,[1] with many participants—including Wall Street giants, such as Morgan Stanley, Goldman Sachs, or Citicorp—turning sizeable profits simply by sitting on tanks of oil.[2]

It has been estimated that one in twelve of the largest oil tankers are being used for the storage, rather than transportation of oil,[3] and that if lined up end to end, the tankers would stretch out for 26 miles. _Wikipedia

The actual proportion of tankers and oil depots used for speculative purposes is likely to fluctuate over time, according to prices and price-manipulating opportunities.

There is a great deal riding on oil prices. Hedge funds, pension funds, university endowments, foundations, big money NGOs, and more, are betting on oil prices going higher. The risk involved is significant, but with the deteriorating value of the dollar and the general stagnation in global economies, opportunities for significant returns on investment seem to be few and far between, the past few years.

While many analysts are scratching their heads as to how oil prices could increase in the absence of any clear increase in natural (as opposed to artificial) demand, Al Fin energy analysts believe that several concurrent factors are in play:

1. Russia is far more than a bystander in the current price runup More here
   
   International tensions tend to create a "defensive demand," a type of artificial demand which involves stockpiling oil in anticipation of future reductions in supply. Russia is best situated of all nations to both ramp up international tensions -- either directly or via proxies -- then to profit in several ways from a runup in energy prices.
2. OPEC has an interest in driving up the global price of oil as high as can be sustained by the markets.
3. National oil companies in many oil-producing countries neglect their oil production equipment and their oil fields, leading to artificial reduction in production and supply due to Oblomovism.
4. Official policies of "energy starvation" on the part of the US Obama administration and other western nations, leads to artificial reduction of supplies.
5. The rapid buildup of the "infrastructure to nowhere" better known as the "Great China Bubble" has led to an artificial demand surge. The Chinese government appears to be engaged in "doubling down" on this policy, despite early warning signs of impending turbulence.
6. The progressive decline in the value of the dollar creates an inexorably upward trend in oil pricing.

There are many more factors involved, of course. But it is enough to understand that the causes of the current oil price runup are many and varied.

What are the counter-vailing forces, seeking to drive oil prices downward again? The most significant force in the short-term is the desire of speculators to take profits. Once investors decide the house of cards is due for yet another inevitable collapse, the rats will get out while the getting is good.

In the intermediate term, demand destruction eventually sets in -- even in emerging nations, BRICs, and third world nations. But demand destruction in the advanced worlds of the North America and Europe never truly went away after the price runup of 2007-2008. And such demand destruction in North America and Europe is likely to add to the general economic doldrums both there and in exporting nations such as China.

In the longer term, high oil prices stimulate increased production of oil, increased exploration for new oil, better technologies for recovering more oil from existing fields, and better technologies for producing economical substitutes for crude oil. All of these price-stimulated supply increases put downward pressure on oil prices.

The entire dynamic is complex, with several opposing and reinforcing factors in play. It is best to expect to be surprised, and to be prepared, in case you are.

Cross-posted from Al Fin blog