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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.
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