Oil Speculators Finally Face Their Day of Reckoning

In March 2005, Goldman Sachs warned that the oil market was in the early stages of a “super spike,” and predicted that oil prices could soon rise to $105 a barrel.1 At the time, the price of a barrel of oil stood at $57.

Then, in early September, Hurricane Katrina temporarily damaged U.S. oil refineries and offshore platforms in the Gulf of Mexico. The hurricane’s impact on the oil industry amounted to an average of 1.3 million lost barrels of oil per day until the platforms and refineries came back on line. Prices hit $70 a barrel, and many alarmists warned of soaring oil prices, gasoline shortages, and an economic collapse.

If oil prices reached $100 a barrel, analysts predicted the impact on the economy would be huge. According to William Hummer, chief economist at Wayne Hummer Investments, “The economy would slow to a crawl. We’d have a return to stagflation, that cliche from the 1970’s. We’d see a huge cutback in driving. The sacrifices would be severe. It would be another blow to the airlines and the whole transportation sector.”

But, as we’ll discuss, the rise in oil prices over the past two years is not due to the increase in demand, nor is it caused by a shortage in the oil supply. Instead, prices have soared because of speculation in the oil market.

It’s true that the world’s demand for oil has increased somewhat. According to The New York Times,2 it went up by more than 2 percent per year over the last two years, which is twice the average annual increase for the past decade.

In the U.S., demand for oil has risen to 20 million barrels a day. Meanwhile, China’s growing economy is expected to increase its demand to 7 million barrels a day by 2007, up from 2 million barrels a day 20 years ago. As we will discuss in Trend #4, China is building 50,000 miles of a new superhighway to connect nearly 250 cities with populations of more than 200,000.

But the global growth in demand should not present a problem when we consider the supply side. There is an abundance of evidence that proves that there is absolutely no shortage of oil.

Even after the increased demand in the U.S. and China, the world is still producing more oil than it is consuming, according to the International Energy Agency. In fact, during the first half of 2005, surplus oil production was greater than at any time since 1998, when a barrel of oil sold for about $20.

Furthermore, the OECD reports that the world’s developed nations presently hold crude oil inventories of 5.32 billion barrels. That is up 2.6 percent from last year’s level. Moreover, crude inventories throughout the developed world are increasing at a rate of 1.3 million barrels per day, which is well in excess of the five-year average increase of 420,000 barrels per day.3

In the U.S., according to the Department of Energy publication This Week In Petroleum,4 crude oil inventories are above historical averages. Furthermore, inventories even increased during August, when they typically drop, and they were 15 percent above their year-ago level.

According to a report by Chief Investment Strategist Brian S. Wesbury and Senior Economist Bill Mulvihill of Claymore Advisors, oil inventories tend to rise in late winter and early spring, peak later in the spring, and then drop during the summer driving season. Yet, in late August, oil inventories held 323 million barrels, roughly 11 percent above their historical average.5

The nation’s Strategic Petroleum Reserve, holding about 700 million barrels of crude oil, was filled completely in early September. The government halted its purchases for the reserve, releasing about 82,000 barrels of production a day for commercial use.

As a result, when Hurricane Katrina shut down much of the Gulf region’s oil production in early September, the U.S. actually had plenty of inventory to replace the lost production. And yet, oil prices still rose to $70 a barrel after the hurricane hit.

This makes it clear that the oil market is being driven by speculators, who are accumulating crude oil under the assumption that prices will keep going up. Otherwise, they would sell their oil, and inventories would drop during the summer, as they typically have in other years.

This is the only possible explanation for the high prices of oil in recent months. Even before the hurricane, the price of crude oil had doubled to $66 a barrel, from $33 a barrel in January 2004.

Milton Ezrati, Senior Economic Strategist for Lord, Abbett & Co., offers the following argument to support his conclusion that speculators are behind the oil price increases.

The New York Mercantile Exchange processed about 320,000 light sweet crude future contracts a day in July. Since the Exchange estimates that only about 170,000 contracts a day are necessary for the normal conduct of the oil business, Ezrati concludes that some 46 percent of those contracts came from purely financial sources. In other words, they were speculative.6

This recent record contrasts sharply with earlier years. In 2002 and 2003, for example, purely financial interests in oil futures amounted to only 3.5 percent of all contracts. In 2004, the number was higher, but still stood at only 20 percent.

As Ezrati explains, the significance of this growth in speculative interest should not be underestimated. So far in 2005, one day’s speculative interest in oil contracts has averaged an amount equal to seven days of American oil consumption or about 9 percent of the total crude inventory of all other countries combined.

According to Amy Jaffe, an energy research specialist at the Rice University’s James A. Baker III Institute for Public Policy, one reason speculators have become so aggressive is because President Bush has been hesitant to interfere with the free market. By contrast, during the 1990s, oil traders knew that the Clinton Administration would be more likely to intervene, so they sold oil when prices went higher than longer-term supply-demand relationships would support.

Now, as Jaffe told the Seattle Times,7 speculators believe that Bush won’t intervene, so they have not felt compelled to sell because they are not afraid that prices will fall. However, the fact that the President released 1 million barrels per day in response to hurricane Katrina shows that this assumption may not hold up much longer.

Moreover, it’s clear that, based on the fundamentals, speculation can’t push prices up much further than it already has.

The only way that prices will continue to rise is if some sort of supply disruption occurs. Such scenarios might involve terrorists’ attacks disabling Saudi facilities, or open hostilities between the U.S. and Iranian forces in the Persian Gulf, either of which have a 10 percent or less near-term probability.

While not probable, a serious disruption of production at one of those crucial choke points could cause prices to rise even further. For instance, Saudi Arabia produces more crude oil than any other country. It has the largest oil reserves, with more than 260 billion barrels. It is the only country that has the capacity to increase its output if there was actually a shortage in the world oil supply. And it has been the target of several attacks by Al-Qaeda in the last two years. If terrorists succeeded in disrupting Saudi Arabia’s oil supply, the impact would be felt throughout the developed world, perhaps kicking prices temporarily above the $100 per barrel price.

But barring such dramatic supply disruptions, the speculators will have to come to grips with the fundamentals and face reality. At that point, there will be a steep drop in oil prices.

The good news is that, if any event or series of events combined to drive up oil prices beyond $100 a barrel, the market would react. Demand would drop sharply, because people would use their cars less and make other adjustments to use less oil until prices declined.

Looking forward, we foresee three forecasts based on this trend:

First, through the end of 2005 and much of 2006, oil prices will remain in the $60 to $70 a barrel range. High fuel prices will continue to hurt the demand for gas-thirsty vehicles like large SUVs and luxury cars. In August 2005, sales of smaller SUVs increased, while sales of gas-guzzling Chevrolet Suburbans fell by 25 percent, and sales of Ford Expeditions dropped by 40 percent, according to The Chicago Tribune.8 High fuel prices will also cut into the resale value of used cars in these categories. At the same time, demand will grow for hybrid and electric cars. We’ll see an increase in people seeking to telecommute or live closer to their workplace; as long commutes become more costly, at $3 to $4 a gallon, it will simply become too expensive to drive a 50-mile round-trip to work. This is likely to increase revenues for those selling home office equipment, videoconferencing technology, and broadband services. For the near term, jet fuel costs will stay high, dealing yet another blow to the troubled airline industry. But, as we’ve noted, only the unlikely occurrence of an extended supply disruption on a very large scale would drive prices significantly above $70 per barrel.

Second, rather than hurting the U.S. economy, high oil prices may actually drive more consumer spending and economic growth. Since the 1970s, energy has become a much smaller factor in the U.S. economic equation. More importantly, when oil prices go up, oil-producing countries typically invest their windfall profits in hedge funds. Those funds buy American assets, such as mortgage-backed securities. As a result, U.S. consumers gain access to more cash through home-equity loans and refinanced mortgages, and their spending helps the economy to grow. “Until the market corrects it, housing price wealth creation will provide a powerful offset to the impact of higher oil prices on U.S. consumer spending,” says Sal Guatieri, senior economist at BMO Financial Group.9

Third, within 12 to 18 months, fundamentals will take over and force prices back to the range of $35 to $45 per barrel. Today, worldwide drilling activity is at the highest level in more than a decade. The Cambridge Energy Research Associates consulting firm, known as CERA, predicts that global oil production capacity will increase sharply for the rest of the decade. As reported in The Wall Street Journal,10 this will lead to an excess supply of between 6 million and 7.5 million barrels a day. CERA’s analysis concluded that the world’s production capacity could increase by 16 million barrels a day by 2010. As a consequence, prices will drop below $40 a barrel.

References List :
1. The Seattle Times, April 5, 2005, “Oil-Market Contrarian Sees Price Bubble Ready to Burst,” by Brad Foss. ⓒ Copyright 2005 by The Seattle Times Company. All rights reserved. 2. The New York Times, September 4, 2005, “Katrinas Shock to the System,” by Jad Mouawad. ⓒ Copyright 2005 by The New York Times Company. All rights reserved. 3. To access Milton Ezratis commentary “Oil Again,” visit the Lord Abbett & Company website at:www.lordabbett.com/usa/insights/insights.jsp 4. To access the article “Good New and Bad News,” visit the Energy Information Administration website at: Tonto.eia.doe.gov/oog/info/twip/twiparch/050824/twipprint.html 5. To access the article “Oil Bubble?” visit Claymore Advisors website at:Research.claymore.com/docs/Oil%20Bubble%208-29-2005.pdf 6. To access Milton Ezratis commentary “Oil Again,” visit the Lord Abbett & Company website at:www.lordabbett.com/usa/insights/insights.jsp 7. Seattle Times, September 1, 2005, “U.S. Oil Reserves Released; Price, Shortage Fears Rise.” ⓒ Copyright 2005 by The Seattle Times Company. All rights reserved. 8. Chicago Tribune, September 4, 2005, “Fuelish SUVs Not Foolish, Many Say,” by Rick Popely. ⓒ Copyright 2005 by Tribune Company. All rights reserved. 9. Agence France Presse, August 18, 2005, “U.S. Economy, So Far, Shrugs Off Oil Surge.” ⓒ Copyright 2005 by Agence France-Presse. All rights reserved. 10. The Wall Street Journal, June 22, 2005, “Oil Capacity to Rise, Not Peak, Report Says.” ⓒ Copyright 2005 by Dow Jones and Company, Inc. All rights reserved.