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World Oil Markets See New Norms Emerging
By Syed Rashid Husain
09/12/2011

Oil markets have travelled a long distance. $100 is the new norm. A few years back, when oil markets broke this psychological barrier for the first time, pundits were taken aback.

Producers were taken to task. The unusual was to impact the global economy - rather adversely - many asserted. That the global economy was able to sustain this high price and still make impressive growth in the intervening years is another story.

The new norm gave fillip to an altogether new, engrossing and interesting debate: What was driving the market to new heights? Were high oil prices the result of tight fundamentals or pure financial speculation - remained a major issue.

The world got divided in two distinct camps. Producers kept insisting that markets were beset with speculation and supply was not the issue. Flow of speculative dollars was keeping markets on boil. On the other hand, consumers kept asserting that fundamentals were mainly to be blamed for the woes of the market. Producers were subjected to severe pressure. Open the taps further, they were told.

Yet producers remained convinced that speculation was primarily to be blamed. In 2008, while the oil markets were scaling one peak after the other, Saudi Arabian Oil Minister Ali Al-Naimi did underline that speculation was the major culprit. And he had facts to back it.

With dollar under pressure, and global economy in tatters, fund managers were seen moving their money largely into commodities. And indeed oil remains the worlds’ largest traded commodity, crude remained a major attraction.

The bond and equity markets in the U.S. alone are valued at roughly $50 trillion, Minister Al-Naimi asserted in 2008. If money managers decided to reallocate a nominal one-half-of-one percent of those assets into the oil commodity, $250 billion influx of funds could be expected in the crude trade. And interestingly this small percentage equaled the value of the entire NYMEX WTI markets.

And after intense debate all these years, the diverging sides seem to be closing in on a sort of compromise. New studies are painting a more balanced view, blaming fundamentals, but crucially speculative activity too, for the rises, particularly over short periods of time. Financial activity in the futures market can significantly destabilize oil prices, a large number of pundits are now beginning to concede.

"In 2007 and 2008, destabilizing financial activity caused oil prices to respectively over- and undershoot their fundamental values by significant amounts," Ine Van Robays, of the Department of Financial Economics at Ghent University in Belgium, told the Commodity Futures Trading Commission (CFTC). However, she also underlined that financial activity in the futures market typically produces a short-term impact.

The agency is currently considering stricter position limits for energy, agriculture or metals derivatives, seeking to curb speculation and potential manipulation by hedge funds and other investors. It may vote soon on the controversial position limits proposal, which was introduced in January.

Her comments were backed up by David Frenk, research director for progressive watchdog group Better Markets. "Financial flows can and do dominate commodity price formation, not all the time, but enough of the time to make a real difference," he said.

Frenk said that financial speculation is excessive and is causing higher, more volatile prices than would otherwise be the case. He insisted that purely financial price increases of commodities needed to be stopped.

The European Central Bank too has just published a study saying that "some speculative and trend chasing behavior may have been adding to oil prices" since 2004.

The research paper ‘What is driving oil futures prices? Fundamentals versus speculation’ by Isabel Vansteenkiste builds a theoretical model to study the impact of traders buying and selling oil futures based on fundamentals and those following price trends.

After reviewing the January 1992 to April 2011 period, it concludes that "up to 2004, movements in oil futures prices are best explained by underlying fundamentals." Since then, however, the research notes that "regime switching has become more frequent and the chartist regime (speculative investment) has been the most prominent."

Late in August U.S. Sen. Bernie Sanders too said federal regulators should stop thumbing their noses at a year-old law and enforce limits on excessive speculation in oil markets. He cited secret data collected by the Commodity Futures Trading Commission, showing that Goldman Sachs, Morgan Stanley and other banks and hedge funds dominated oil markets in 2008 when prices rose sharply and topped $140 a barrel. The records - first made public by Sanders - shed light on the role of speculators at a time when oil prices were soaring. In the letter Sanders said the CFTC has been collecting this data for at least three years and called for an emergency meeting "to eliminate excessive oil speculation as soon as possible."

"While making this confidential information public may have upset Wall Street oil speculators, the American people have a right to know exactly what caused gasoline prices to skyrocket to more than $4 a gallon back in the summer of 2008," Sanders said. "Further, there is little doubt that the same speculators who caused gasoline and heating oil prices to unnecessarily spike in 2008 are playing the same games again in 2011. This is simply unacceptable and must not be allowed to continue."

However, certain authoritative voices continue to argue the role of speculators. University of California economics professor James Hamilton told the CFTC recently that the big picture driving the price of oil has been stagnating global production of crude in the face of big increases in world incomes and a spike in demand for oil products in emerging markets - not financial speculation.

"Sure it is fine to talk about (financial) speculation, but we should all be able to agree on the big picture that the real story driving the price of oil has been stagnating world supply in the face of a big increase in world incomes," Hamilton said.

Hamilton downplayed the impact of financial speculation by hedge funds and other traders on oil prices, insisting that market fundamentals are the key factor to consider when thinking broadly about the price of oil.

To back his conclusion, Hamilton pointed out that global production of crude oil, in millions of barrels of oil a day, in the past decade has stagnated, particularly between 2005 and 2009. He also cited International Monetary Fund data that showed global real gross domestic product increased 17.2% between 2005 and 2009, driven largely by growth in emerging economies.

"The big story is that global production of oil has stagnated and it is a very important event that everybody ought to be aware of and think about how this jives with tremendous demand for oil products in the emerging markets and fundamentals," he added.

The debate continues. Yet the pendulum is swinging - finally - the other way!

Source: Arab News, Saudi Arabia, September 11, 2011. Changes were made in keeping with the editorial policy of www.memrieconomicblog.org

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