Speculation is driving the price of oil

OIL&rsquo;S break through to $80 per barrel earlier this week was attributed to yet another bout of dollar weakness in forex markets, or a strong gasoline inventory draw-down in the US. But looking at the truly fundamental factors &ndash; the Organisation of the Petroleum Exporting Countries&rsquo; (Opec) spare production capacity standing at a whopping 5.5m barrels per day, global crude inventories still sky-high and a petrol-based product glut so severe that refineries are curtailing output &ndash; it is clear that only speculative pressure adequately explains fresh oil price hikes.<br /><br />Despite the evidence of last year&rsquo;s petromania, some still deny that speculation materially affects oil prices. CME Group, which runs the Nymex oil futures exchange and whose daily-traded front month contract sets the benchmark global oil price, recently objected to plans by US commodity futures regulator the CFTC to rein in financial sector speculation on that exchange. <br /><br />The CME Group argued new precautions were unnecessary because &ldquo;supply and demand &ndash; and not speculators &ndash; is the underlying cause of price movement in commodity markets&rdquo;. <br /><br />In contrast, while my book Petromania comprehensively documents all the fundamental factors influencing the oil price through its spectacular blow-out in 2008, I show that the phenomenon which saw crude oil charge to its all-time high of $147 in July 2008 yet crash to $34 by Christmas was a classic speculative bubble, caused by the financialisation of the oil markets. <br /><br />Just compare the oil price bubble of 2008 with an earlier obvious episode of speculative excess &ndash; the Nasdaq 100 bubble in the US which burst almost a decade ago. (See chart one, right.) Despite being separated across time, space and underlying investment assets, the movement of the oil price up to and through its peak into its precipitate sell-off last year uncannily matches the earlier progression of the now-notorious dotcom fever which crashed in early 2000. <br /><br />This chart also shows the sideways movement in the oil price over recent months &ndash; crude oil has seemed range-bound in a relatively tight $65-75 per barrel band since late July. One particular argument explaining why this has happened is market participants&rsquo; concern over the CFTC&rsquo;s intention to reform oil futures regulation, as announced on 21 July.<br /><br /><strong>POWERING AHEAD</strong><br />Recent indications are that these ambitions have been significantly watered down. Indeed, this may be why oil is now powering ahead again. The ongoing willingness of the financial investment sector to buy into oil prices &ndash; trading oil to satisfy their own concerns regarding dollar weakness and the bogey of inflation fears rather than giving any due regard to fundamental crude oil supply and demand factors &ndash; is certainly recognised as a key variable in near-term oil price forecasts by analysts. <br /><br />Societe Generale&rsquo;s global head of oil research Mike Wittner acknowledges that inflation/dollar concern on the part of financial sector investors is a key &ldquo;non-fundamental&rdquo; factor that needs to remain &ldquo;constructive&rdquo; in order for his $90 per barrel August 2010 oil price forecast to pan out. <br /><br />He also admits that the CFTC rethink could yet turn out to be bearish for the oil price in the coming months. Nevertheless, he judges that institutional investor appetite will remain firm enough for the oil price to continue to appreciate from here as, almost, a technical necessity. <br /><br />Wittner&rsquo;s reasoning is that as economic conditions improve over the coming months, the market will expect the oil futures curve to shift out of its current contango, a situation in which the price for current delivery of crude oil is cheaper than prices for delivery several months or years ahead. <br /><br />Regardless of the massive current spare supply buffer, if Opec manages to maintain current production quotas, then even a mild measure of economic recovery should still see crude inventories dropping over time. And conventionally, periods of falling inventories see a diminishing contango in the market, with the front month price narrowing the gap up to longer-dated prices and a resulting flattening of the futures curve. <br /><br />Wittner sees the five-year forward price, currently standing around $85 per barrel, as an anchor for what the &ldquo;appropriate&rdquo; price for oil actually is, and it is in relation to this five-year price that the front-month, the figure we all read in the newspaper, will rise. <br /><br /><strong>FAIR PRICE</strong><br />And Wittner is on firm ground here &ndash; the five-year forward oil price is often said to be more distanced from the short-run concerns that pull the front-month price up and down on a day-to-day basis. As such, the five-year price is considered by many as a good guide to what the market thinks the fair, underlying price for oil will be in the future &ndash; that is, a price level just rewarding enough to justify sufficient production. <br /><br />But don&rsquo;t be fooled by this comfortable convention. The five-year price is itself obviously subject to fluctuations and as such, is not a consistent estimation of future production costs of oil. After all, compared to the current price around the mid-80s, the five-year price was above $140 at the height of the oil boom, yet at the start of this year it was around $60. <br /><br />And the prediction that the curve will flatten as inventories drop could indeed, as Wittner forecasts, be fulfilled if the front month prices climb to match current long-dated prices in the coming months. <br /><br />Equally, however, the curve could show its &ldquo;correct&rdquo; flattening for a period of falling inventories if the five-year price declined from its current levels. But just how likely is that?<br /><br />Well, there is evidence that the current five-year price itself is in fact failing to fulfil its historic role, and is instead running far ahead of what might be thought to be the fair, underlying price for oil. (See chart two, below.) <br /><br /><strong>PLAIN VANILLA</strong><br />Developed by LCM Commodities analysts Ed Morse and Daniel Ahn, this chart shows the actual five-year forward Nymex oil price (as 60-month West Texas Intermediate) plotted against twinned producer price index (PPI) series (one plain vanilla and one dollar exchange rate-adjusted) for the US oil service sector &ndash; whose cost base determines the production costs for the large international oil companies.<br /><br />Strikingly, for a long period up to late 2007 the five-year forward price actually did match near enough what the PPI curves said it should &ndash; Morse and Ahn can actually describe a close fit from early 1994 onwards.<br /><br />From late 2007, however, it accelerates upwards into the towering peak and precipitous decline that mark the speculative oil price bubble of last year. Looking at the price since then, it is clear that despite some convergence around the turn of 2009, the five-year price has once more traded significantly ahead of where the PPI indicators say it should &ndash; which looks like the beginning of another bubble. <br /><br />In August, five-year forward oil was trading around $86, whereas the twinned PPI curves say it should have been between $57-59. This can be interpreted as the magnitude of the credibility gap between current five-year prices and what previous pricing patterns tell us they should be. And this is, perhaps, the gap between reality and current oil prices which we can put down to speculative pressures. <br /><br />When it comes to economic recovery, everything is &ldquo;relative&rdquo;. But here is another relative calculation &ndash; against the Societe Generale forecast for 2010 of global oil demand of 85.5m barrels per day, anticipated Opec spare capacity will still be at peak levels last seen around 2002, when the average price of crude oil was just $22.81 a barrel. <br /><br />That&rsquo;s how far removed we are from the already highly-questionable &ldquo;supply crisis&rdquo; argued as justifying $100-plus prices last year. Why is the oil price not acknowledging this?<br /><br />Petromania - Black Gold, Paper Barrels and Oil Price Bubbles, by Daniel O&rsquo;Sullivan, is published by Harriman House, priced at &pound;20.<br />