By Gary M. Vasey, Ph.D., General Manager, Europe
and Patrick Reames, Vice President, Trading & Risk Management

An article by Ralph Nader caught my eye this week. In that article he makes the case, with very little evidence, that speculators are to blame fair and square for the high and increasing price of crude oil. It's the sort of piece you would expect from a politician, especially one not overly fond of the oil and energy industry. It's also an example of the true level of ignorance of anything and everything energy amongst politicians and the media. It's why we don't actually have a coherent energy policy—because the industry simply isn't well understood by the people with high profile names or magazines that like to sound off about the issue.

The point that he makes—that speculators are to blame—is worthy of hard analysis. It's almost certain that the current price of crude oil reflects some level of premium due to speculation but the source of that speculation and the mechanism by which speculation moves prices might be a small surprise to many. Most folks like to blames hedge funds and big banks. Hedge funds are an easy culprit because they are not in a position to defend themselves due to how they are governed on the one hand and so as to preserve their strategy on the other.

However, what really lies behind the rise of crude oil, and commodity prices in general, comes down to a combination of factors and is not just about market speculation. This is why Ralph Nader deserves to be called out for his story on crude prices. He has an axe to grind and, unfortunately, many, if not most folks may believe him.

Let's take another look at some of the factors driving the price of crude oil.

The Fundamentals
It's best to start with the fundamentals because it is, despite Mr. Nader's and others opinions, the reason why speculators got interested in oil in the first place. This apparently gets forgotten by the media and our politicians. One of the first myths to explode is that there is adequate supply. There is not. Supply and demand have been tight for several years now. One only has to inspect data from various organizations like the EIA and IEA to understand that. Two million barrels per day of oversupply may sound like an awful lot of crude oil but, the US alone consumes around 20 million barrels of crude oil on a DAILY basis.

What just isn't understood but is very, very important is that not every barrel of crude oil is the same. No, an increasing amount of the stuff is what is called heavy, sour crude oil. What buyers seek is light sweet crude oil. Why? Because it is more costly to process heavy, sour crude and, more importantly, there is much more limited refinery capacity that CAN process heavy, sour crude oil. So what we have is both supply/demand tightness and a lack of refining to handle heavy, sour crude oil.
According to reports by Lehman Brothers, this situation may last through the end of this decade. A study by that bank suggests that more refining capacity is on the way, particularly in the Middle East and Asia. Much of it will be built adjacent to fields producing heavy, sour crude meaning that it can be processed into usable product ready for export. But for now, even if Saudi Arabia can add 500,000bbls per day of supply, it isn't much use because it's heavy, sour crude that can't really be readily processed due to lack of refining capacity. OPEC points to the fact that its members can't sell all the oil they have to offer because it's the wrong kind!

What put us in this mess in the first place was the rapid growth in demand from Asia and the U.S. Don't rely on my word for it - just read the report by the World Energy Outlook that the IEA issued late 2007 on the future of supply and demand. It isn't pretty reading. But, as the price of crude rises demand should fall. But, in fact, the strength of demand from developing and developed countries alike has actually meant that only now, in recent months, have we seen any sort of demand response at all and that is reflected in a small drop in gasoline consumption in the US and crude oil use in Europe. Frankly, the strength of demand has been pretty robust and the expected demand response simply hasn't occurred as quickly as might be expected. Why is that?

The Impact of the U.S. Dollar
Yes, oil along with many other commodities is priced in U.S. dollars. The U.S. dollar has nosedived over the last two years, with the Federal Reserve trapped between a rock and a hard place. The U.S. economy, as a result of the credit crisis, is in tatters and every indicator suggests that it is headed towards a long shallow recession. In an attempt to spur the economy, the Fed has reduced interest rates several times. The problem is that many other nations are not following the Fed's lead on interest rates. One thing that is now different is the existence of a Euro Zone in which European nations have adopted a common currency and their Governments given up some fiscal control to the independent European Central Bank. It (The ECB) remains adamantly focused on fighting inflationary pressure and recently raised interest rates squeezing the dollar further. In short, the "Mighty Dollar" is simply no longer so mighty. In fact, with a worsening banking crisis in the United States, the dollar has just this week reached a new historical low versus the Euro.

The impact of the weak dollar is to constantly help drive up commodity prices including crude oil in the United States. However, for many other nations, the rise in crude oil prices has been less dramatic than that in the United States. This point can readily be observed in Figure 1 below which clearly shows dollar based consumers paying as much as a $50/bbl premium versus the Euro based consumer. Perhaps, this, in part, explains why a significant demand response has been late arriving. Although gasoline consumption in the United States has experienced a year over year decline recently as many Americans are reducing leisure and non-essential driving, crude price increases have not had the global impact on consumers that has been experienced by those in the United States. In all likelihood, any significant demand response will not occur unless, or rather until, the United States and global economies slow in response to recent economic events.

In recent months, crude oil and other commodities have become a hedge against inflation. Just as gold has always been the place to be in times of a weaker dollar, oil is now the place to be when inflationary trends set in. Many investors are imagining an economic perfect storm—a weakening dollar increasing prices on imported goods and services, combined with accelerating crude price increases (driven in part by that weakening dollar) leading to sharply higher prices for domestically produced goods. In these conditions, tying oneself to crude helps offset the impact.

As we stated above, the Fed is between a rock and a hard place right now. It needs to address inflation but it also has to keep an eye on the overall economy. Unfortunately, its growing more apparent that the balancing act that has been Fed policy is unsustainable.

The weakness of the U.S. dollar then has had a very definite and quite large impact on the price of crude oil and this little to do with speculators!

And Speculators?
It's so easy to blame hedge funds and other "speculators." It's so easy to blame lack of oversight and regulation. But the evidence really seems to suggest that these funds are not directly to blame. In fact, through the first several months of this year, as crude oil prices rose over 40 percent, hedge fund returns were lackluster. The Gardner Energy MacroIndex® (www.macroindex.com) is an index based on the performance of energy hedge funds. True, it reflects hedge funds in energy across the space from equity long/short through debt and including commodity trading, but it was actually in negative territory until the last two months and as of the end of May, was up just 1.42 percent for the year. Yes, it is true that a small number of funds have performed extremely well but the vast majority just are not focused on the very risky strategy of directional crude oil trading. In fact, the evidence for speculation in oil markets is weak at best. In recent months, the CFTC data has shown that speculators are making up much less of the market.

So what is happening? Energy and commodity markets have changed dramatically and one of those changes is just how easy it is for any investor to place money in those markets using a variety of instruments that are relatively liquid and tradable. The evidence now suggests that investment in the growing number of Indexes across the space is the real speculative factor in energy and commodity markets. Investment in these commodity Index funds creates a positive feedback loop and the better the performance the more money comes in. It becomes a self-fulfilling prophecy. These Indexes are essentially a long-only strategy and their investors are actually—yes—You and I through pension funds, endowment funds and so on. We are to blame for speculation because WE are the speculators. Mr. Nader—I hope you don't have money in a pension or endowment fund!? The pressure and the flow of money have been accentuated by the concept that commodities provide a hedge against inflation.

Summary
Exactly what is driving crude oil prices is a very complex study. Yes, speculation is involved but it wouldn't be if the fundamentals didn't point to higher prices in the first place and it wouldn't be if equities were a more attractive investment than commodities for example. In other words, blaming speculation gets us nowhere because, in doing so, we are focusing only on a symptom while ignoring the much larger issue confronting our, and subsequent, generations—natural resource availability. It is the fundamentals of supply and demand, and the various markets reactions to those fundamentals, that must be understood in order for us to take the actions necessary to fend off a crisis that is otherwise inevitable. As we have stated before, what is ultimately required is a comprehensive energy policy that founded in and recognizes the finite nature of the commodities on which the United States and world has grown dependant.

With all of this in mind, UtiliPoint is proposing to undertake an exhaustive study, seeking to further clarify and define the driving forces behind crude oil prices. We hope this study will help to illuminate the realities of the market and, potentially, reduce the amount and level of volume of the uninformed voices seeking to shape the issue in support of political agendas.

We are currently seeking sponsorship for the study. If you or your firm might be interested in becoming a sponsor, please contact us for a study prospectus.

i What's Really Driving the High Price of Oil? Ralph Nader, May 28, 2008, Counter Punch Magazine

The above article appears on www.utilipointeuropeblog.com and is a recent IssueAlert from UtiliPoint. You can subscribe to IssueAlert here