The Reason for High Oil Prices

The rise in oil prices has become a very pressing issue. Certainly, nobody has to be reminded that crude is now hovering just below $80 per barrel, while gasoline has surpassed $3 per gallon on average around the nation.

The widely accepted explanation for oil prices' recent steep climb is strong demand. We are told that the global economy is firing on all cylinders, and that China and India have emerged as major consumers. In addition, we are told that supplies are tight; that the margin between what is produced and what is consumed on a daily basis has never been narrower; and furthermore, that major new discoveries of oil are few and far between.

These explanations certainly sound plausible, and perhaps we can even attribute some portion of the price rise to them. A closer analysis, however, shows that they are not sufficient to explain the full extent of the increases.

The speculation problem
A new report released last month by the Senate Permanent Subcommittee on Investigations concludes that market speculation has played a role in the rise of oil and gas prices. It points a finger not only at commodity funds and hedge funds, but also at large institutional investors such as pension funds and mutual funds, which have become major participants in the energy markets over the past several years.

The investigation found that an estimated $60 billion has poured into regulated U.S. oil futures markets in the past few years. While this sounds like a lot (and it certainly is), the amount that has gone into non-regulated exchanges overseas is inestimable. Therein lies the problem.

The Commodity Futures Trading Commission oversees all futures trading on U.S. markets, and it's constantly monitoring the positions of large speculators. However, the CFTC has no jurisdiction over exchanges that are outside the U.S. or in the murky over-the-counter market where billions of dollars of contracts are traded all the time. This leaves the oil markets subject to price manipulation or price distortion as a result of speculative money flows that cannot be regulated or monitored. One excerpt from the Senate's report reads as follows:

As an increasing number of U.S. energy trades [occur] on unregulated, OTC electronic exchanges or through foreign exchanges, the CFTC's large trading reporting system becomes less and less accurate, the trading data becomes less and less useful, and its market oversight program becomes less comprehensive.. A trader may take a position on an unregulated electronic exchange or on a foreign exchange that is either in addition to or opposite from the positions the trader has taken on the NYMEX, and thereby avoid and distort the large trader reporting system. Not only can the CFTC be misled by these trading practices, but these trading practices could render the CFTC weekly publication of energy market trading data, intended to be used by the public, as incomplete and misleading.

Despite this, some "experts" still contend that high oil and gas prices are uniquely an issue of supply and demand. Let's examine those arguments.

The limits of traditional thinking
First, we'll have a look at the demand side. According to the Energy Information Administration (a bureau of the Department of Energy), the daily global consumption of crude oil has climbed by 22% in the past 16 years; however, the price of crude has increased nearly eightfold. Gasoline demand in the same period is up about 44%, while the traded futures price of gasoline has increased sixfold. Clearly, the amount by which the price has risen seems to exceed the degree by which demand has grown.

The exact opposite is true, when you look at the growth in futures trading. Activity on the NYMEX alone has increased by more than 1,000% since 1990, and the total combined volume of global trade in energy derivatives has increased exponentially. While actual, physical demand has indeed been rising over these years, it simply cannot compare to the growth rate of futures and derivatives. Unfortunately, the market does not differentiate between the two sources of demand, so speculative demand is just as important as demand tied to actual physical consumption.

It's also important to understand that the numbers from the EIA are global demand numbers, and therefore include the impact of China and India and other emerging economies. Many oil bulls rely almost solely on the China rationale to justify current prices, yet it doesn't hold up to the test. Obviously, I'm not saying that China hasn't been a factor -- it just hasn't been enough of a factor to push crude to the prices we're seeing now.

On the supply side, the arguments are equally weak. At the present time, inventories of crude oil in the United States are at an eight-year high, and OECD inventories of crude are at a 20-year high. Yet prices continue to climb. In the past two years, as the price of crude has nearly doubled, U.S. inventories have increased by more than 70 million barrels (not including the Strategic Petroleum Reserve). The domestic gasoline supply has remained constant; however, imports have doubled in the past two years, making up the difference.

Any honest assessment of these numbers should lead to the inescapable conclusion that supply and demand factors alone cannot explain the large run-up in price we've seen thus far. And I haven't even discussed OPEC output and capacity growth (both have increased), the quiet return of Iraqi output to pre-war levels, and the lack of any major supply disruptions. If anything, these have been bearish factors for oil, not bullish ones.

When the market breaks down
The big problem now is that speculation has gotten so out of hand that it is distorting the very mechanism by which the market allocates supply. For example, a commodity that is in tight supply will normally exhibit a spot price that's higher than futures prices, since consumers are willing to pay up to obtain supplies that have suddenly become scarce. In turn, higher spot prices act as an inducement to producers or inventory-holders to sell their inventories into the market now, rather than hold them and realize a lower price at some future point. Selling inventory into the marketplace alleviates the shortage.

What we see happening now in oil is exactly the opposite. Despite all the talk of supply tightness and a concomitant 700% run-up in the price over the past seven years, spot prices for crude remain below futures prices all the way out to January 2009! It seems speculators are buying oil and holding it for the purposes of financial gain, in such huge quantities that it precludes the normal price relationship from occurring.

With the price curve as it is, an incentive is created to hold oil in inventory rather than sell it into the marketplace, and this creates a vicious circle: the more oil held in inventory, the more spot prices remain weak relative to futures, and the more investors want to hold it in inventory. The bottom line is that supplies are held off the market exactly at a time when they should be brought on.

Therefore, all the talk in the world about what will stop the price rise is moot if we fail to see it as a consequence of speculation, not supply and demand. Hopefully, the Committee's report will bring some relief. I have to say I'm not very hopeful, because the remedies suggested seem meek. I hope I'm wrong -- for the sake of consumers and the U.S. economy, I hope I'm doubly wrong.

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Fool contributorMike Norman is the founder and publisher of The Economic Contrarian Update and a Fox News business contributor. He is also a radio talk show host for the BizRadio Network.


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