Petroleumworld`s
Opinion Forum:
viewpoints on issues in energy, international
politics & civilization.
Easter
Feature
What's
Really Driving the Price of Oil?
By
Beat Balzli and Frank Hornig
The price of crude oil has doubled, from $50 to $100, within
months. The increase cannot be attributed to the fundamental
data, which have hardly changed. And the looming recession
ought to drive the price down. So why is oil getting more expensive?
Pumps in Oklahoma are less important to the price of oil than pension-fund
managers.
Cushing is the kind of place where you'd expect to see a cowboy ride around
the corner and tie his horse to a rail in front of the Buckhorn Bar. This sleepy
town of 8,000 on the Oklahoma prairie comes complete with a main street that
could double for a set in a Western. Its biggest attractions include a defunct
train station and a run-down movie theater, where the price of admission is
$1.50.
Robert
Felts, a friendly old man who works for the Cushing Industrial
Authority, likes to show visitors
the historic oil
pump in the middle of town. He tells the story of how, in 1912,
a giant oil field was discovered nearby that placed Cushing
on the map and showered it with more than two decades of prosperity.
Up to 50 million barrels of oil bubbled out of the ground each
year in those days. "Our refineries could hardly keep
up," says Felts. To solve the problem, the oil barons
of the day had large storage tanks installed in the surrounding
prairieland.
There isn't much to talk about besides oil in this small Oklahoma town. But
reports on the situation in Cushing get global markets moving at 10:30 every
Wednesday morning. That's when US government officials publish a figure that
reflects the amount of oil stored in the hundreds of tanks which now stretch
for miles along the horizon.
Located at a key intersection in the North American pipeline
system, Cushing is home to the largest oil storage facility
in the United States. Oil traded on the New York Mercantile
Exchange literally changes owners here in Cushing. If the tanks
are full, prices sink. But if levels in these tanks fall, prices
rise. A rule of thumb for traders: Supply and demand control
the market.
Normally, at any rate. But in recent months the conventional
wisdom has flip-flopped. Within a year the price of a barrel
of crude has doubled, from $50 to last week's high of $100.
Nothing seems impossible now. Some analysts see prices rising
to between $120 and $150, which would have dramatic consequences
for the world economy.
Similarly spectacular price developments have only occurred
four times in the last few decades: in 1973, when the Organization
of Petroleum Exporting Countries (OPEC) imposed an embargo
for the first time; in 1979, as a consequence of the Iranian
revolution; a year later, when Iraq invaded Iran; and in 1990,
when Iraq invaded Kuwait.
Which leads to one the most provocative questions being asked
about the world economy today: Why are oil prices soaring again?
It's All Speculation
There are plenty of answers. Some hold the crisis in the Middle
East and constantly growing demand in China responsible. Others
blame producing countries for keeping the oil spigot half-closed.
But
none of it's very convincing. "Supply and demand cannot
explain the high prices," says Fadel Gheit of Oppenheimer & Co.,
a leading commodities analyst. Like many in his profession,
Gheit believes financial investors are
driving up prices. He's reminded of the Internet bubble around the turn of
the millennium. According to Gheit, oil is also seeing "excessive speculation" at
the moment.
OPEC
arrives at the same conclusion. "The fundamentals
are right," says OPEC President Mohammed al-Hamli. In
fact, the cartel has expected excess supply on markets since
early February -- a result of the American economic crisis.
This excess supply would normally cause the price per barrel
to fall. Instead, dealers have now broken through the magic
$100 threshold for the second time in only a few weeks.
The mood is festive among oil barons, who seem to be unimpressed
by global recession fears. Exxon Mobil recently reported its
profits for 2007: $40.6 billion, a record for the world's largest
energy company, and in international economic history. A company
has never made so much money in a year.
Enormous amounts of money are currently changing hands in
the business of oil contracts. With the American real estate
debacle infecting ever larger segments of the capital markets,
from stocks to bonds, investors are seeking alternatives worldwide.
Oil, with its supposedly straightforward market rules and ever-rising
prices, seems to be a perfect tool for spreading risk and maximizing
profit. But many investors will have a rude awakening when
they realize that an investment in oil, though it may look
different, is no less a gamble than other types of investments.
"I
trade in news"
The
New York Mercantile Exchange, or NYMEX, is the central arena
in the game of trading in commodities like oil. For
100 years traders here, at the southern tip of Manhattan,
on the banks of the Hudson River, have traded in commodities
like butter, cheese and potatoes -- until they recognized,
in 1978, that oil was the future.
The trading floor at the NYMEX looks like a Roman arena. Traders, standing
in the galleries, shout and gesticulate and perform an almost archaic ritual.
When two agree on a deal, they write the basic numbers on a piece of paper
and toss it into the center of the stage, where a sturdy-looking exchange employee
stands, wearing protective glasses so that the flying wads of paper don't accidentally
injure his eyes. By the time he picks up one of these pieces of paper and stamps
it, many barrels of oil will have already exchanged owners.
"I trade in news," says Chris Motroni, 29. He earns
his money as a small, independent trader on the NYMEX, with
smaller trades and a lot of self-confidence. "The prices
will increase to $115," he says. Motroni loves the mood
on the trading floor, where both his father and his brother
have also worked. But they got out of floor trading long
ago.
The same holds true for the big players, the banks, hedge
funds and pension funds, which all trade by computer nowadays.
Business on the NYMEX has exploded. The world consumes 86 million
barrels of oil a day, but trading volume is 15 times as high.
The difference represents bets on future price developments.
The
traders' activities have generated sharp criticism,
even in the US Congress,
not exactly famous as an enemy of the oil industry. A congressional hearing
in December went by the blunt title: "Speculation in the Crude Oil Market."
The
upshot of all this trading is that speculators now hold up
to 45 percent of all oil contracts -- three times
as many
as at the turn of the millennium. "Prices are being distorted," says
Senator Carl Levin, the ranking Democrat on the Permanent
Subcommittee on Investigations, which is investigating the
speculative trading
of oil futures. If supply and demand were the only factors,
the price of oil would be at least $20 lower.
How could this have happened?
One of the world's 10 largest energy trading companies, Mercuria,
is headquartered on Place du Molard in Geneva, Switzerland.
From here, 70 employees analyze the market, dealing with such
factors as tanker routes and inventory levels. Thirty billion
dollars per year flow through the company's accounts.
CEO
Daniel Jaeggi, a former futures trader for Goldman Sachs,
knows exactly how the business changed
in the late 1990s. "The
big pension funds began to diversify their investments, increasingly
putting their assets in oil," he says. The pension funds,
according to Jaeggi, became the "driving factor in the
market."
Wall
Street banks were only too happy to service this demand,
and Goldman
Sachs was at the head of the pack. "They invented a
new commodities index that also included oil," says
Jaeggi. The new index was wildly successful, and the more
major investors
put money into it, the more oil contracts Goldman bought
and the higher the prices went. An enormous market force
had been
created.
Everyone jumped into the game. Morgan Stanley, Deutsche Bank
and many other financial giants dramatically expanded their
trading volume in oil contracts. Investment banks like Goldman
even established their own oil reserves, acting as if they
were energy companies like BP. They hoped to gain better insight
into market events.
As a result, the trading volume in crude oil has almost tripled
in the last five years, while demand for the liquid itself
grew by only 1.9 percent per year.
Goodbye to Supply and Demand
Once upon a time, all that counted in the oil business was
production volume and consumption in the industrialized nations.
Those days are gone. Oil is now part of every well-structured
portfolio -- as was the case, until recently, with those abstract
securities meant to enable the investor to secure a slice of
the American real-estate boom.
But nothing is like it was on the commodities markets. Nowadays even the most
insignificant piece of news -- like the nonviolent encounter between US warships
and Iranian speedboats in the Strait of Hormuz in January -- can send oil prices
on a roller-coaster ride.
The situation in Cushing, meanwhile, can still keep traders
on their toes. Let's say fog cripples the port of Houston for
a few days, so not enough new foreign crude flows into American
pipelines. Supplies in the tanks in Oklahoma will sink, and
the supply bottleneck will drive up prices. Or imagine that
the McKee refinery in Texas -- a major oil buyer -- partially
shuts down after a fire. Crude reserves in Cushing will rise,
and prices will fall.
Strange price distortions are fairly normal. All the oil reserves
of the United States have long run higher that the five-year
average -- yet for historic reasons, prices on the commodities
exchanges are based solely on the levels in Cushing and the
type of oil stored in the tanks there, West Texas Intermediate.
"It's astonishing that a type of oil that is produced
at a level of only about 300,000 barrels a day serves as the
benchmark for the whole world," says Eugen Weinberg, an
analyst at Germany's Commerzbank. He even believes that market
players "attempt to influence" the key Cushing statistics "through
their targeted actions."
Classic models, on the other hand, hardly play a role anymore
in explaining the price of oil. The fact that relations with
Iran have eased a little, or that there has been cautious improvement
in Iraq, won't interest traders. They alternately attribute
price changes to the crisis in the Middle East, to winter,
to unrest in Nigeria and to exploding demand in China.
"None of this is new," says Fadel Gheit. "There
hasn't been peace in the Middle East since Biblical days. And
the conflict in Nigeria has also been going on for 40 years." Not
to mention the recurring return of winter.
Gheit
has been in the business for 30 years. He worked at Mobil
Oil and JP Morgan before moving to Oppenheimer.
He remembers
oil prices of $9 a barrel. In the hearings before the US
Congress, he served as a star witness of sorts, attesting
to the madness
of the speculators. "The traders use every excuse in the
book to drive up prices," he says, "it's pure hysteria." On
some mornings, when he arrives at his office in Manhattan,
London traders have driven up prices by $4 a barrel overnight,
perhaps because a pipeline burst somewhere in the world. "I
have a degree in engineering," says Gheit. "This
isn't heart surgery. It's a plumber's job, child's play." The
damaged pipeline was probably repaired even before Gheit
found out about it -- but after the traders made their profits.
The question is, how long can these galloping prices continue
without doing permanent damage to the US and world economies?
Rising prices for gasoline, heating oil and airline tickets
will increase inflationary pressures and stifle demand in the
short to medium term.
"In the end it's a straw that breaks the camel's back," says
Gheit, a native Egyptian. Or it's like a weightlifter hefting
weights, he says, until someone places a pencil on top and
he crashes to the ground.
"This is a bubble," he insists, "and
it will burst."
Beat
Balzli and Frank Hornig are
both journalists with SPIEGEL Magazine
Petroleumworld does not necessarily share these views.
Editor's
Note:This commentary was originally published by SPIEGEL,
March, 2008. Translated from the German by Christopher
Sultan.Petroleumworld
reprint this article in the interest of our readers.
All
comments posted and published on Petroleumworld, do not
reflect either for or against the
opinion expressed
in the
comment as an endorsement of
Petroleumworld. All comments expressed are private comments
and do not
necessary reflect the view of this website. All comments
are posted and
published without liability to Petroleumworld.
Fair use Notice: All works published by Petroleumworld are
in accordance
with Title 17 U.S.C. Section 107, this material is distributed
without
profit to those who have expressed a prior interest in receiving
the
included information for research and educational purposes.
Petroleumworld
has no affiliation whatsoever with the originator of this article
nor is
Petroleumworld endorsed or sponsored by the originator. Petroleumworld
encourages persons to reproduce, reprint, or broadcast Petroleumworld
articles provided that any such reproduction identify the original
source,
http://www.petroleumworld.com or else and it is done within
the fair use as
provided for in section 107 of the US Copyright Law. If you
wish to use
copyrighted material from this site for purposes of your own
that go beyond
'fair use', you must obtain permission from the copyright owner.
Internet web links to http://www.petroleumworld.com are appreciated.
Petroleumworld
03/20/08
Copyright ©2006
SPIEGEL. All Rights Reserved
