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The oil price Conundrum

Shebonti Ray Dadwal is Consultant at the Manohar Parrikar Institute for Defence Studies and Analyses, New Delhi. Click here for detailed profile
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  • October 24, 2008

    As the saying goes, everything that goes up had to come down. The same holds true for the price of oil, which has seen a slide of around 55% in just three months. At one point of time there were even predictions that prices would reach $200 a barrel. However, currently, the price of oil has dropped to $68 a barrel, from a high of over $147 in July this year. But the question is how and more importantly, why did this happen, and in such a short time.

    First, oil is perhaps one of, if not the most, politically sensitive commodity, with almost any political issue immediately impacting on its price. However, apart from geopolitical issues, several other factors influence oil prices as well, which could include issues as diverse as weather conditions, the state of US inventories, demand-supply imbalances, both in terms of crude as well as refined products, value of the US dollar, etc. Nonetheless, the current freefall has taken everyone by surprise given that with winter in the western hemisphere round the corner, creating an annual increase in demand, oil prices have continued to fall.

    What are the reasons? But before analysing the current oil price behaviour, let us first see why there was such an unprecedented rise in oil prices in the first place before the fall, as it were.

    Simply put, it was a combination of factors, including, commodity market speculation, the fall in value of dollar, increasing demand and lack of spare capacity. However, it was speculation that was mainly responsible for the unprecedented highs that were observed three months ago. A US Senate Permanent Subcommittee on Investigations report noted, “there is substantial evidence that the large amount of speculation in the current market has significantly increased prices.”1

    But how was this rampant speculation allowed to go on without being regulated? As the US Subcommittee on Investigations reported, till recently, US energy futures were traded exclusively on regulated exchanges, which are subject to extensive oversight by the CFTC. But with the recent growth in trading of contracts on over the counter (OTC) electronic markets (as against regular futures contracts), which are exempted from US Commodity Futures Trading Commission (CFTC) oversight (thanks to a provision inserted at the behest of Enron and other large energy traders in the Commodity Futures Modernisation Act of 2000), large financial institutions, hedge funds, pension funds and other investors began pouring in billions of dollars into the energy commodities markets, mainly to hedge against a weak dollar. This in turn created a huge demand for oil (and gold), not by producers or consumers of oil but from speculators, thereby driving up the price for future delivery of oil.2

    Part of the reason for this diversion by speculators to energy commodities was due to the expectation that the growing imbalance in demand and supply would increase further oil prices, due to a combination of growing demand, lack of timely investment in producing or discovering new oil, depletion in spare capacity in producing states and fall in the value of the US dollar. Between January 2002 and the first half of July 2008, the USD lost nearly 45% of its value. According to some analysts, over the same period, the dollar-denominated price for the OPEC reference basket (WTI was $10 more expensive, and Brent $8) rose from $18.42/barrel to $137.57/barrel, that is, an increase of almost 650%.3

    However, following the downturn in the US economy due to the sub-prime crisis, which gradually spread to the rest of the world, setting off alarm bells in the global financial markets, the demand for oil started coming down. In fact, in its monthly report in October, the International Energy Agency (IEA) cut its global oil demand forecast for 2008 by 240,000 barrels per day on the basis of worsening economic conditions in the developed nations and said that demand would drop further in 2009 by 440,000 b/d. The IEA now expects global oil demand to total 86.5 mbd in 2008 and 87.2 mbd in 2009.

    Around this time, the US Federal Reserve’s anti-inflation policy which was initiated over a year ago, started paying off and from May on wards, the dollar began rallying. Also, the huge purchases of futures contracts which pushed up oil prices, provided an incentive for oil companies to buy and store oil, on the expectation that prices would continue its upward spiral. This, in turn, saw a substantial growth in oil inventories, particularly in the US. At the same time, with higher oil prices, investment in oil exploration and development also saw renewed vigour, with an expected increase in surplus capacity.

    Hence, a combination of these factors set off a rollback in prices, with speculators now scrambling to liquidate their positions due to the declining value of the securities they held. The more they sold their contracts, the more prices spiralled downwards. Moreover, banks were coming under increasing pressure to reduce their lending due to their low reserve margins, as well as concerns that hedge funds were not good risks.

    So how low are oil prices expected to fall? Those that are expecting prices to go back to the pre-2002 $20s, they are likely to be in for a disappointment. An alarmed OPEC has already begun preparing to cut production -- the first time in almost two years -- to stem a price collapse. Ministers of the 13 member nations gathered in Vienna, to decide on how deep the cuts should be, with predictions that a 1 to 2 mbd of cuts could be agreed upon. Though in the past, OPEC production cuts have not succeeded in stemming the price from falling, this time round it may succeed as Russia has agreed to cooperate with the cartel to stablise prices. Moreover, as the global economy weakens, and the price of oil begins falling, international oil companies will once again reduce investments in E&P, leading to the earlier situation which saw supplies and spare capacity dwindling again. Hence, though as of now, it seems unlikely that oil will reach the heights witnessed earlier in the year, it is equally unlikely that oil prices will go below $60 a barrel. Only time will tell.