You are here:

The oily truth

Created:
9 June 2008
Written by:
Simon Thompson

I have been studying the dynamics fuelling the surge in the oil price in great detail over the past few weeks for a very good reason: my expectation of a US pre-election rally (Presidential Profits, 30 May 2008). However, it seems inconceivable that stock markets will make much progress if the oil price continues its relentless march skywards. Therefore, it is important to understand what is behind this year's price surge.

Advertising

Supply...

It may be obvious, but we do have a supply problem that is leading to an incredibly tight oil market. Not only does the global oil industry rely heavily on a few giant and declining oilfields for its supply - one in five barrels of global oil output is pumped from a field that is more than 40 years old - but not a single new discovery in the past three decades has been capable of producing more than 1m barrels of oil per day. So with global oil consumption increasing rapidly, driven by fast growing Asian and emerging market economies, the oil industry has faced an uphill battle to increase production enough to maintain the equilibrium. It's a balancing act that is not going to get any easier for four specific reasons.

...demand...

First, the US may be the biggest consumer of crude, but China is not far behind. Chinese oil consumption doubled between 1994 and 2003 and is forecast to double again by 2010 - at which point the International Energy Agency (www.iea.org) predicts that the country will be the world's largest consumer of energy. To complicate matters, fast-growing emerging economies have been subsidising fuel costs so that the full impact of the spiralling oil price is not being felt by consumers. So even though crude oil as more than doubled in the past 12 months, Chinese consumers are only paying around 10 per cent more for their fuel than a year ago. They are not alone. Indian state oil companies face losses of over £25bn this year as a result of similar subsidies. In turn, this is exacerbating the tightness in the oil market, since it artificially buoys demand. Indeed, IEA forecasts that Asia will account for 70 per cent of incremental global oil consumption this year.

The second reason lies with Russia and Saudi Arabia, the two largest oil producers. It would appear production in the former has peaked - it actually fell in April - while the latter has decided not to expand output next year beyond the 12.5m barrels a day capacity of its fields. So the supply side has just got a lot tighter.

Thirdly, there has been a flood of money into commodity-index tracker funds which have increased 21-fold in size to $290bn (£148bn) in the past five years. True, these funds are long-term holders of oil, but they have added to demand at a time when the commodity is scarce enough above the ground.

...and speculation

However, the most compelling reason why the oil price has shot up to such stratospheric heights has little to do with subsidies, commodity index funds and emerging markets. No, there is potentially something sinister at play.

Mr William Enghadi, associate of the Centre for Research on Globalisation (http://www.globalresearch.ca), has uncovered widespread speculation by institutional investors buying oil on margin. In a paper, "More on the real reason behind high oil prices", Mr Enghadi notes: "A conservative calculation is that at least 60 per cent of today's crude oil price comes from unregulated futures speculation by hedge funds, banks and financial groups using the London ICE Futures and New York NYMEX futures exchanges and uncontrolled inter-bank or Over-The-Counter (OTC) trading to avoid scrutiny. US margin rules of the government's Commodity Futures Trading Commission (CFTC) allow speculators to buy crude oil futures on NYMEX by having to pay only 6 per cent of the value of the contract. At a price of $138 per barrel, that means a futures trader only has to put up about $8 for every barrel. He borrows the other $130. This extreme leverage of 16:1 helps drive prices to wildly unrealistic levels and offset bank losses in sub-prime and other disasters at the expense of the overall population".

The numbers seem to back this up. Charles Stanley Stockbrokers estimates that "oil speculators have amassed 1.1bn barrels of oil, more than eight times the amount added by the US to its strategic reserve, making them the largest single influence on oil-related commodity futures trading". The broker adds: "The CFTC has gone as far to deliberately sanction this bubble by allowing US investment banks exemption from speculative position limits when hedging OTC swap deals....knowingly building a loophole in existing rules enabling financial institutions access to unlimited and unregulated speculative excess."

So if Mr Enghadi is correct that unregulated speculation and profiteering by financial institutions is the true reason why the oil price has shot up, then the question is how long will the regulators turn a blind eye?

The clampdown looms

We may not have to wait long to find out, because I suspect that "official intervention" into oil futures trading, and specifically higher margin requirements, is getting nearer by the day, driven by political pressure from the US, the world's biggest consumer of oil. This would dampen speculative trading and take some of the froth off the oil price as traders deleverage positions. In turn, that would be seen as a major positive for equity markets spooked by $139 a barrel oil. So, if like me, you are looking for the catalyst for a pre-election US stock market rally, it would pay to keep a close eye on the oil markets.

MORE FROM SIMON THOMPSON...

For more of Simon's columns, see his IC home page...

Or have your say using the Your Opinion form.

Simon is the creator of the Bargain Portfolio, which you can track on the IC website.

Get Simon's column as soon as it's published using IC Desktop Alerts. They're FREE and the software only takes a few minutes to install. Click here for more.

  • Back to top

Products and Services from Barclays Stockbrokers.

The UK’s No.1 Stockbroker

Stocks and Shares

Contracts for Difference

Financial Spread Trading

Gilts and Bonds

Funds Market

FX

Education Centre

Trading Simulator

Advertorial Feature

Take control of your investing with CFDs

Have you ever watched a move in the markets that you saw coming, but you weren't able to exploit?

by Dominic Picarda

Advertorial Feature

Spread your risks with spread trading

With so many big moves in the world's financial markets, there have seldom been more opportunities around for spread traders. Isn't it time you joined them?

by Dominic Picarda