It’s a bit premature to say that the price correction in oil and commodities generally is a harbinger of a reversion of much of the runup of this year; they were so overbought that some profit-taking was inevitable. But now that the bulls have finally met some strong headwinds, cautionary views are suddenly getting more respect.
John Dizard of the Financial Times has wryly noted:
The political reaction to high prices is most likely to lead to legislated changes in commodities markets regulation in the US and elsewhere. I am fairly certain that the changes will take effect after the coming decline in commodities prices.
I say decline because there always is one, and the late-stage political reaction suggests it is coming soon.
Indeed, although all may indeed not be well in commodities trading land, where insider information is legal and a so-called swaps loophole allows financial buyers to be classified as commercials, the investigation announced by the CFTC into possible speculation has the smell of a hunt for a few scalps to show to the public. From the Wall Street Journal:
The move Thursday by the Commodity Futures Trading Commission, including its unusual announcement of an investigation in progress, comes after crude-oil prices topped $130 a barrel last week and tested all-time highs….
“It’s important that people who are paying high gas prices understand the CFTC is on the case and that we’re closely monitoring and in this instance deeply investigating any potential abuse in this important energy market,” said Bart Chilton, a CFTC commissioner…..
Mr. Chilton, the CFTC commissioner, said regulators are looking at cases where traders have made simultaneous bets on unregulated and regulated markets, in particular in West Texas Intermediate crude-oil contracts. He said he wants to know “whether there’s any possibility for attempted manipulations as a result.”
Apart from its investigations into specific allegations, the CFTC said Thursday it will require more information in general from large traders. It wants to know about their bets in commodity-linked index investments as well as speculative trades that they are able to place via Wall Street dealers, often in large quantities.
Nevertheless, it does appear the CFTC has been less than forthcoming. An alert reader Juan pointed out that in reports on agricultural commodities trading, the CFTC published a supplemental report, the CIT, which broke out index speculators and showed their positions were severely imbalanced. A CFTC into oil trading (which predictably declared there was no speculation, using the superficial parsing of commercial versus non-commercial contract buyers) failed to provide the more detailed breakout. Looks a bit sus, no?
Note that one of the options under consideration is increasing margins to drive out speculative long buyers. The problem is while some of the recent entrants may be levered investors from other markets (anetodatal evidence suggests that some hedge funds, who are finding it difficult to get as much gearing as they once did from their prime broker, have moved into commodities because futures exchanges offer plenty of leverage), a large group, commodities index investors, seldom use leverage. Thus Mack Frankfurter says that an increase in margin requirements might produce perverse outcomes:
But as our analysis reveals using Dr. Spurgin’s model, the oil market currently indicates that there is a net hedging response where long hedgers are willing to pay short speculators excess premia to enter into a contract. As Michael Masters posited, the predominant long hedgers may very well be the commodity index funds. Yet it should also be noted that these same index funds will not be materially impacted by an increase in margin because they are fully-funded.
Hence, while the hedging response function may or may not be causing the market to steadily rise, it is prudent to err on the side of caution. If our thesis is correct, then raising margin requirements will result in a disastrous short covering rally.
At $135 a barrel per oil, we are beginning to see indications of demand destruction. It may in fact be the case that threats from Congress are already having a detrimental impact on the oil markets.
Note that Michael Masters, who contended in his Congressional testimony that committed long-only buyers like pension funds were contributing to rising commodity prices, did NOT recommend margin increases.
With some evidence in the US that gas use is declining even before the recent spike has worked its way through to the pump, more observers are coming to the point of view that high prices may be the cure for high prices. As John Authers writes in the Financial Times:
When will the oil price start to cause true macroeconomic pain? Once it does, it could create stagflation – something that is still not with us, given enduring strength in US manufacturing and growth in the emerging world. It will also, probably, reduce demand for oil and hence start to push the price down.
Other commodities have gone off the boil, with the S&P GSCI non-energy commodity index falling 13.5 per cent since mid-March while the energy index has gained 22.6 per cent. So attention now focuses on oil.
Even when adjusted for inflation, crude oil at $135 a barrel is more expensive than at the peak of the oil spike in 1980. That is an alarming statistic.
But Véronique Riches-Flores of Société Générale adjusts this by measuring the “oil burden” – the volume of oil consumed, multiplied by the average price and divided by nominal gross domestic product. This gives the proportion of the world economy devoted to oil and accounts for the way the world has reduced its reliance on oil since 1980.
The oil burden so measured has risen about 75 per cent during the past year, to its highest level in almost 25 years. This must soon have an economic impact if prices do not quickly reverse. But prices would need to reach about $190 before the burden regained its peak of 1980…..
Another area of doubt is the role of subsidies in the developing world….Most notably, Chinese consumers are only paying about 10 per cent more for oil than they were 12 months ago, while JPMorgan research suggests consumers in Egypt, Indonesia, Malaysia, Mexico and Vietnam are buying petrol at an even bigger discount than in China.
Demand for oil, and therefore oil prices, could now depend on the future of those subsidies.
Ambrose Evans-Pritchard in the Telegraph argues that the days of many of those subsidies are numbered:
One by one, countries across Asia and the Middle East are being forced to abandon price controls on fuel and energy, bringing hundreds of millions of consumers face to face with the true market cost of oil. The effect has already begun to chip away at world demand and may ultimately trigger a slide in crude prices.
Egypt – the most populous Arab state – has raised petrol prices by 40pc, despite protests in Cairo. Sri Lanka lifted diesel and petrol prices by 25pc over the weekend. India may have to follow soon to prevent its trade and budget deficits climbing to dangerous levels. “The situation is alarming. We need to stem the rot,” said India’s energy secretary, MS Srinivasan.
Indonesia has raised petrol prices by 33pc in order to restore fiscal discipline (subsidies are 3pc of GDP). Taiwan has mooted a 20pc rise, and Malaysia is to peel back controls. While China has so far resisted calls for price freedom, the policy is becoming unsustainable. Analysts predict a change in tack after the finish of the Beijing Olympics at the end of August….
The number of miles driven by Americans fell in March at the steepest rate ever recorded. Oil use in the OECD club of rich states has been falling for more than two years.
Stephen Jen, currency chief at Morgan Stanley, says half the world’s population now enjoys fuel subsidies of one sort or another. Petrol costs 5 cents a litre in Venezuela, 12c in Saudi Arabia, 64c in China, $1 in the US, and $2.16 (£1.10) in Britain. It is heavily subsidised in Mexico, Iran, central Asia and the Gulf states.
The result has been to encourage promiscuous use of fuel. It has masked the underlying rate of inflation in emerging markets, and flattered the economic growth rate.
Mr Jen says the game is largely over. “The subsidies will need to be rolled back, especially for governments with fragile fiscal positions. They face a stagflationary shock,” he said.
Michael Waldron, an oil analyst at Lehman Brothers, said the bullish case for oil over the next year or so rests on an ever narrower group of countries – essentially China and the Gulf states.
“Are they really enough to support oil prices at this level? Inventories are building up at 600,000 barrels per day [bpd] across the world,” he said.
Lehman Brothers estimates that supply will average 86.2m bpd in the second quarter, while demand slips to 85.6m. The surplus will widen to 1m bpd later in the year as new oil comes on stream from Brazil, Azerbaijan, Kazakhstan and the Sudan. The US Energy Information Agency expects US output to rise by 400,000 bpd by the winter.
A cyclical correction as the global economy slows would not necessarily invalidate the Peak Oil theory. There can be powerful ups and down with an upward “supercycle”, even if the world is gradually running out of fossil fuels.
Reader Michael provided us with more detail on the crunch in India with the story, “Oil firms are weeks away from bankruptcy“:
There was no diesel for a day at a gas station in north India recently. The public sector oil companies are slowing down the issue of new gas connections to households. The private sector oil companies are closing down petrol pumps and exporting petrol and diesel. Kerosene is not easily available in the public distribution system; the open market rate is around Rs 30 a litre when the official rate is under Rs 10.
If you think these are isolated events, think again. A fuel shortage looms ahead of the nation as the oil companies rapidly head towards bankruptcy.
With international crude oil prices hovering around $129 a barrel, the country’s three oil marketing companies – IndianOil, Bharat Petroleum, and Hindustan Petroleum – are collectively looking at losses of Rs 200,000 crore this year. These losses belong to the budget, but finance minister P Chidambaram doesn’t want his own copybook ruined. If these numbers were added to this year’s Union budget, Chidambaram’s fiscal deficit – the borrowings needed to finance government expenditure – would bloat from a fictitious 2.5% of gross domestic product (GDP) to more than twice that figure.
Under the subsidy sharing formula designed by the government, the Oil & Natural Gas Corporation (ONGC), the country’s main oil producer, along with gas pipeline company GAIL is supposed to share one-third of the oil marketing companies’ losses. But ONGC’s turnover for 2007-08 will be around Rs 65,000 crore – one-third of the projected losses. Loss-sharing can thus wipe out ONGC as well.
In less than two months from now, some oil companies will be plain and simple broke as they exhaust their borrowing limits of Rs 90,000 crore. They have already notched up borrowings of around Rs 70,000 crore when their combined net worth is just over Rs 54,000 crore. The only reason they are still able to borrow is because they are owned by the government, and governments are not expected to default.
By early July, they will simply have no cash to run their business and some of them will find it difficult to pay staff salaries. “It is like a time bomb ticking away. If the prices of petro-products are not increased immediately, they will just sink without a trace,” top industry sources said.
What is worse, global suppliers of crude and petro-products are not going to honour contracts unless money is paid upfront, which means the country could be looking at a frightening scenario of a fuel shortage.
Losses on the sale of diesel, petrol, liquefied petroleum gas (cooking gas) and kerosene are already Rs 550 crore a day. What has been especially worrying is the alarming rise in the consumption of diesel. Sources say that diesel consumption has grown 25% since January this year. With world prices of the fuel closer to $160 per barrel, imports will soon have to be reduced.
Private sector refiners like Reliance and Essar are exporting diesel because it is not viable to sell in the local market. Reliance Petroleum has closed down all its 1,432 gas stations.
A spokesman for Essar Oil said the company continued to operate its 1,000-and-odd outlets, but at a reduced scale. According to him, both petrol and diesel are retailed at roughly Rs 9 more than the public sector companies. Clearly, few people will buy fuel when the state oil companies are giving them the same stuff cheaper.
However, the public sector oil companies cannot continue to bleed indefinitely. If they are unable to buy any more diesel abroad due to a shortage of cash, user industries like power, shipping, transport (rail and road) and telecommunications could face a crunch. There could be havoc if the crisis extends to petrol, LPG and even a fuel like kerosene, which is used in the aviation sector.
Masters may not be such a disinterested party as he claimed:
Looks like $200 oil should take care of global warming. Hail to the people who wanted market forces to solve the global warming problem.
Bogus. The CFTC sees manipulation and speculation in the energy markets, yet in the silver market they see no sign of manipulation. Observers have reported that the bullish speculation in oil is only 1/3 the bearish speculation in silver. Yes, the big boys are allowed to keep the price of silver low by playing games in the paper silver markets…
From Ted Butler: “For the COT of 5/25/04, the eight largest traders were net short 180 million ounces of silver futures. At the recent extreme on 3/11/08 they held more than 400 million ounces short.” I think that’s like 6-9 months of the world’s entire silver output, yet the CFTC is perfectly fine with it. Move right along…
So why is the CFTC so schizophrenic in their analysis? Why can they see manipulation in energy, where the supply demand problem is obvious as Matt Simmons and Boone Pickens have shown; yet the CFTC blindly ignores the obvious problem in the silver market??
No wonder there are so many conspiracy theories out there. Somethin’ smells bad.
The fact that it is only now that foreign governments are bringing “hundreds of millions of consumers face to face with the true market cost of oil” really needs to be brought to the attention of the US public and policymakers. While improved energy efficiency remains an important goal for the US, the lack of incentive for consumers in these other countries to be more energy efficient has obviously been an important driver of demand. I expect that foreign demand will drop off sharply as these subsidies are eliminated, relieving demand pressure and thereby some of the price pressure.
Anon @ 10:50 –
“So why is the CFTC so schizophrenic in their analysis? Why can they see manipulation in energy, where the supply demand problem is obvious as Matt Simmons and Boone Pickens have shown.”
That’s just it…the cftc doesn’t “see” manipulation in energy. I’m not sure where you see them acknowledging this.
What they are doing is investigating it – as they should be doing with ALL commodities (including silver).
Back to Yves:
“oil trading failed to provide the more detailed breakout”
I’m wondering if this has anything to do with the “enron loophole?” Although that has recently been closed, i wonder what the timeline is for when they WILL show it.
Also, my favorite line from the WSJ article from above was from Paul Pantano, “a Washington lawyer who represents many energy traders”:
“Commercial parties and speculators are operating in a market where the rules about what is considered manipulative conduct versus legitimate trading activity are not very clear.”
Wow. Does this mean traders don’t even know if they were cornering the markets? Or is this pre-emptive, in defense of traders that knowingly did?
NYMEX is increasing margin requirements on oil futures. Also some other contracts. See their press release at
Strong relationship between increase in living standards and oil usage. Seems the emerging third world rapid growth is really based not on fundamentals but oil subsidies. Shock and awe await these countries.
The decouple theory is really based on how long these gov’t can keep up these subsidies, good luck!