Monday, February 2, 2009

The Oil Price Swings

Supply and Demand
81% of world energy supply is generated from fossil fuels with 35% from oil and 21% from gas. The world energy demand is naturally forecasted to surge to a new height as highly populated developing countries like China and India are going to need every energy supply they can find to answer to the increasingly growing demand. On the 11th of July 2008, the price of crude oil just skyrocketed to $147 per barrel. The price of oil jumped $25 in a single day on September 22.

If you think such an increasing trend of oil prices is caused by the surging demand, then you have absolutely got it wrong. Dead wrong. Because no supply-and-demand theory can justify for such a humongous increment. In fact, the largest price increase in history occurred during a time when actual demand was going down and actual worldwide supply was going up. Just after three months when the oil prices hit record high, this commodity which was theoretically priced according to supply and demand came crashing down along with the stock market. The evidence is clear. Speculation has taken over supply-and-demand’s role in driving oil prices, erratically.

How Oil is Traded?
Since decades ago, oil has been bought and sold on the commodities futures market alongside steel, coffee and sugar, for example, the New York Mercantile Exchange. It is traded by brokers who buy and sell contracts to deliver these commodities at a certain price at some date in the future. This system is created so that sellers can know the worth of their goods in advance and the buyers can lock in the best price to purchase. However, investors do not deliver the oil. Before delivery, investors sell oil for more than they paid to buy it. Investors will buy several thousands barrels of oil at a low price for example, $45 and then sell them when the price hit $100 per barrel.

Who are the buyers?
All sorts of large institutional investors. Pension funds, endowments, hedge funds and of course, Wall Street investment banks like Morgan Stanley and Goldman Sachs are putting money in the futures markets. The amount of money these investors placed in the commodities markets went from $13 billion to a staggering $300 billion.

Oil: ExxonMobil or Morgan Stanley?
Morgan Stanley. Some argue that ExxonMobil is not the largest oil company. It’s Morgan Stanley. Morgan Stanley does not own or control oil wells or gas stations but it buys and sells petroleum products through subsidiaries and companies it controls and has the capacity to store and hold 20 million barrels. Other than Morgan Stanley, Goldman Sachs owns a refinery and control 43,000 miles of pipeline and more than 150 storage terminals.

In 2000, US Congress deregulated the futures market by granting exemptions for complicated derivative investments called oil swaps. Deregulating the oil future market is important to eliminate controls placed on speculators. A deregulated market in oil futures allow speculators to have the ability to drive the price of energy products in any way they wanted to take it. Enron traders were able to drive the price of electricity up to as much as 300%.

The Oil Bubble
When Congress finally threatened new regulations, the oil bubble began to burst. Oil prices began to fall drastically with the bankruptcy of Lehman Brothers and the near collapse of AIG. They have heavily invested in the oil markets and when they fall, the speculators were looking for a way out. Approximately $70 billion came out of commodities futures from these index funds. The price of crude oil dropped more than $100 a barrel or 75% when the gasoline demand reduced by just 5%.

Speculation is really hurting the economy but on the other hand, it can be an effective money-making vehicle. With promises by Obama to seriously look at deregulations, hopefully the commodities markets will stabilize in the near future.

Source: Some figures were taken from CBS 60 Minutes: The Oil Price. Watch the video for more details.


Julie said...

Oil did not trade as a commodity until 1984 when Bush was in office. Anything intrinsic to our country's national security, should not be traded. Period.

Trading on the commodities exchange, is a disincentive for the oil companies to maintain their infrastructure and a constant supply of said commodity. They MAKE money when there is a disruption in supply, if it is traded. If it was NOT traded, a disruption would cause them to lose money. This should be a nobrainer......

Edwin Si said...

thx for ur comment