Double, oil and trouble

May 23rd 2008
From Economist.com

The price of oil is beyond $130 a barrel. Where will it stop?

AFP/Shutterstock

THE price of oil may soon hit $200 a barrel—or so, at any rate, believes Shokri Ghanem, Libya’s oil minister. A few years ago such a prediction would have seemed absurd. But the price has doubled in the past year and has risen by 40% this year alone. It touched yet another record, of over $135 a barrel (before dipping slightly) on Thursday 22nd May. So more spectacular increases seem all too plausible.

The immediate trigger for the latest jump seems to have been an unexpected fall in American oil inventories. But stocks, although falling, are not particularly low: in America, they are only slightly below the average of the past five years. Supplies of petrol and other refined fuels are actually a little above average. And since demand for oil and petrol are falling in America, lower stocks are not as much of a worry as they might normally be.

Mr Ghanem’s explanation for this curious state of affairs is to blame speculators, who are investing ever more enthusiastically in oil futures. Many others share his view. Joe Lieberman, an American senator, points out that the value of investment funds that aim to track the price of oil and other raw materials has risen from $13 billion to $260 billion over the past five years. He blames these “index speculators”, for a big part of the commodity-price increases. He and his colleagues in the Senate are so worried that they are contemplating measures to curb the traders’ exuberance.

Yet few bankers agree that speculation has much to do with price rises. For one thing, indexed funds do not actually buy any physical oil, since it is bulky and expensive to store. Instead they buy contracts for future delivery, a few months hence. When the delivery date approaches, they sell their contract to someone who actually needs the oil right away, and then invest the proceeds in more futures. So far from holding oil back from the market, they tend to be big sellers of oil for immediate delivery.

That is important because it means that there is no hoarding, typically a prerequisite for a speculative bubble. Indeed, as discussed, America’s stocks and those of most other countries are at normal levels. If the indexed funds were indeed pushing the price of oil beyond the level justified by supply and demand, then they would be having trouble selling their futures contracts at such high prices before they matured. But there is no sign of that. In fact, until recently, oil for immediate delivery was more expensive than futures contracts.

Economic theory suggests that the future price is simply traders’ best guess of the shape of things to come. And traders seem to be very worried about the future. They recently pushed up the price of oil to be delivered at the end of 2016 to over $145 a barrel.

They seem to be motivated by the sobering realities of supply and demand, rather than reckless speculation. The output of several big oil exporters, such as Russia, Mexico and Venezuela, is declining. Yet none of those countries allows foreign investors unfettered access to develop new fields or increase production from existing ones. Many of the most promising areas for exploration, including Saudi Arabia, Iraq and Iran, are in effect off-limits to Western oil firms. Worse, the cost of developing new fields is rising almost as fast as the oil price. Cambridge Energy Research Associates, a consulting firm, believes it has more than doubled since 2000.

All this means that global oil production is growing only slowly. Global demand, meanwhile, continues to rise, thanks to an ever-increasing thirst for oil in fast-growing developing countries such as China and India. Their increased consumption is more than compensating for falling demand for oil in rich countries. In other words, the investors that Messrs Lieberman and Ghanem accuse of unfounded speculation may instead have concluded that the world will be short of oil for some time to come. Instead of hectoring speculators, perhaps Mr Lieberman should be hounding Mr Ghanem and the leaders of other oil-rich countries to allow foreign oil firms more access.