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Putting Knowledge into Action

As the price of crude oil continues to rise inexorably calls for scrutiny and oversight of commodity markets increase. Both major US Presidential candidates have already partially blamed speculation for rising commodity prices and both have affirmed their view that something should be done. The question though is what exactly? I have argued until I am blue in the face that oil and commodity prices are rising because of a number of factors of which ‘speculation’ is only one. The evidence for ‘speculation’ is actually weaker now than it once was if you look at the CFTC data.

So what is driving the price of crude oil? That’s what a new study by Energy and Utilities analyst and consulting firm UtiliPoint International will seek to establish. In fact, UtiliPoint is seeking sponsors for this research project currently and a prospectus is available from me on request at gvasey@utilipoint.com.

Unfortunately, the price of crude oil is being driven, at least from my perspective, by several increasingly intractable factors which it would appear politicians can neither do anything about nor wish to address and those are as follows;

1. The fundamentals of supply and demand;
2. The relative weakness of the US Dollar;
3. The ease of access to commodity markets via indexes, exchange traded funds and other investment vehicles;
4. The global economy in general.

There are other factors but to my mind, these are the key ones.

When it comes to supply and demand inspection of the data shows that for the last several years supply and demand have been tight. I have read various journalists accounts of how there are 2 million barrels a day of spare supply but they are misleading their readers in making this assertion as a result of its banality. What they do not understand is that not all crude oil is the same. Much of the new supply (along with much of the oft quoted extra Saudi capacity) is heavy sour crude and while there may be quite of bit of it on the market, there is insufficient refining capacity geared up to process it. This is where the OPEC position regarding refinery capacity being to blame has some merit. However, according to analysis by Lehman Brothers, this situation will alleviate itself somewhat by the end of this decade as quite a bit of new refining capacity is planned, targeting heavy sour crude, in the Middle East and Asia particularly. As I have often stated, when supply and demand is tight, global events have a magnified impact on price formation. The fact of the matter – to use a politician’s favorite expression - is that oil markets are tight and that is helping drive prices higher.

The US Dollar continues to decline especially after the European Central Bank carried out its threat and lifted interest rates. The US Federal Reserve can’t move except to make muted statements regarding inflation and the desire for a stronger Dollar. And there is a circular story inherent in the US Dollar story too. That is that the lower the Dollar falls, the more commodity prices rise and the more inflationary pressure builds increasing pressure on the ECB and Fed to raise rates….or not and suffer the consequences.

Access to commodities for any investor is considerably easier than it once was. Commodities have emerged as an asset class – indeed, the only asset class with which money can be made and, in recent months, commodities have become a hedge against inflation. All of this has increased to amount of money coming into commodities and consequently this must have had an impact on prices – this is the ‘speculation’ factor that politicians and media folks love to point the finger at.
The global economy is a factor behind all of the above.

But, what goes up eventually must come down. What could drive prices down? Well, for one thing markets are very sensitive to ‘news’ right now and news is increasingly filtering through regarding demand destruction – not just in US gasoline markets but across Europe and elsewhere as global economies feel the strain of higher energy and natural resources prices. Another factor is actually liquidity. Over the last several years, all of the new action in oil and commodity markets has helped liquidity and transparency but at these price levels liquidity is and will continue to diminish. The first casualties of the liquidity problem are the physical players – the energy companies that move and manage the actual energy. They are finding it increasingly difficult (at a time when credit is already a market issue) to raise the capital required for margin calls and also to find the credit and collateral to trade. Increasingly, smaller physical players are being sidelined by this issue and it will spread.

In fact, high prices are a problem both in terms of magnifying the credit issue but also they increase risks. A small book keeping error that once would have caused nothing but a minor annoyance can now cost millions of Dollars. The risks have increased exponentially on the errors and omissions side too.
In a short article like this, justice cannot truly be done to the magnitude of this issue but my bet is that the price of oil will have to come down sooner or later and some of the evidence is suggesting sooner as opposed to later.