Nov 12, 2007
HIGH OIL PRICES
A bubble that's hard to prick
OIL prices are testing US$100 (S$144) a barrel, a key psychological threshold. Once over that hump, how much higher will the price go? Of course, given oil's limited supply and the world's expanding appetite, low-priced oil will never come again.
That, however, is different from another consideration: Whether current high prices are truly reflective of supply and demand, or are prices being pushed up to a significant extent by speculation? And if the latter, is there an 'oil bubble'?
The answer to that is wrapped up in arcane terms such as 'backwardation' and 'contango', which affect the prices of commodities, as well as in developments in the American prairie town of Cushing, Oklahoma. But more on this later.
In fact, an oil bubble may not necessarily be bad news. For if current prices reflect a bubble, there is the hope that the market will eventually readjust to equilibrium and there is the possibility of relief; it means the time for US$100 oil has not yet truly arrived. The oil bubble would be one whose pricking would benefit far more people than it would hurt.
The bad news is that if there is an oil bubble, it is unlike other bubbles - in Internet stocks, in properties and so on. An oil bubble would be more difficult to deflate.
That's because, unlike equities, oil is a much more complex trading class. Buyers and sellers are users and producers, but also large trading houses, hedge funds and institutional investors like pension funds. Although exchange- traded funds now allow retail investors to diversify into oil, the big moves depend far more on the large players than on the collective calculations of small investors. If this is a bubble, it's also one with more discipline.
Indeed, over the past three years, any number of analysts and economists have said that oil should be in the US$50 range, the US$60-plus level and so on. Yet it's remained stubbornly stuck on a steeper trajectory. In fact, here we are today, knocking on US$100.
Those who say oil is priced correctly point to China's increasing hunger for energy, India's demand for power and the US dollar's steep decline. Others might cite the correlation between oil and gold, which in recent periods has seen oil priced at 7.5-8 barrels to an ounce of gold. With oil just under US$100 and gold comfortably above US$800, you might well reckon that oil has legs yet.
But is Chinese and Indian demand, coupled with the weakness of the US dollar, enough to explain a more than threefold rise in oil's price since 2001? Is this justified under the calculus of demand and value? The week before the Sept 11, 2001, attacks in New York and Washington, oil was trading at US$28.
Terrorism, wars, civil unrest and weather uncertainties - all have been kneaded into prices as well. Yet have these resulted in enough of a consistent constriction in supply to justify prices of nearly US$100?
India's petroleum secretary, Mr M.S. Srinivasan, isn't likely to think so. He was reported by the International Herald Tribune last Friday as saying there are 'no supply constraints right now, and demand has not escalated out of control'. Mr Srinivasan has a suggestion for cooling the market: stop trading crude oil on commodity exchanges, which he believes contributes greatly to high prices. Do this much, and we'd see a 'drastic reduction' in the price of oil, Mr Srinivasan said.
His suggestion is unlikely to gain traction. For however much exchange trading contributes to speculative positions, it also provides price transparency. Without this, we'd have backroom brokering instead, which would more likely exacerbate the situation than help.
Yet Mr Srinivasan's frustration is understandable. And this can be seen in how prices have been bubbling up lately. Yes, demand is strong. No arguing. But the recent surge is also connected to how the premium in prices has shifted from later to earlier delivery.
Because of a complicated series of events, oil prices in the past several months are in a situation called backwardation. This means prices are higher for oil about to be delivered than for oil for later delivery. The opposite is contango, when prices are higher for future delivery than for supply sooner - reflecting the expense of storage and other carrying costs.
Until the middle of this year, conditions in the market were such that it was more profitable to buy lots of oil and hold it in storage tanks until later. But suddenly, it became more profitable to sell than to hold. The sub-prime mortgage crisis in the US, for one thing, has also made financing for holding oil more expensive.
So in backwardation, those who hold oil have an incentive to drain their tanks - kept in places like Cushing. This Oklahoma prairie town is one of the biggest storage sites for oil, with capacity possibly as high as 35 million barrels. Since 1983, Cushing has been the New York Mercantile Exchange's official delivery point for futures contracts in light, sweet crude, the global benchmark. So the market pays close attention to what happens in Cushing.
Maybe too much.
What the market has noticed is that the tanks in Cushing are down to perhaps 15 million barrels. Attention drawn to this decline in inventory is helping push up prices.
Yet, as Opec's head of petroleum market analysis, Mr Mohammad Alipour-Jeddi, has said: 'There is enough crude in the markets.'
Thus, it isn't a huge mismatch between supply and demand that's yanking up prices. Instead, backwardation is causing a draw-down of inventory, starting what's called a 'backwardation vortex'. By focusing on places like Cushing, the market has worked itself into a frenzy - whatever the real ability at the moment of producers to supply users.
Prices can be high in contango and oil investments profitable; but in backwardation there is an incentive to sell existing stocks, resulting in lowered inventories that spark market anxieties. As a result, some investors are reaping big profits and setting up conditions for even more gains.
Does speculation in oil amount to a bubble, then? Look again at the correlation between oil and gold.
Over a longer period of a half century, oil has been priced at 15 barrels to an ounce of gold. At gold's current price, that means oil should be in the mid-US$50 level. Sure, there's some wiggle room on the up side. But even then, there's going to be enough of a gap between the implied and actual price to suspect that oil's frothier than natural.
The question, in turn, is how do you prick this bubble?
Source: Straits Times
No comments:
Post a Comment