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	Vol. 229 No. 8
ARTHUR BERMAN, CONTRIBUTING EDITOR, bermanae@gmail.com

The high price of oil

There is no clear connection between oil futures speculation and oil price. I wrote that in an earlier version of this column. While I believe that supply and demand are the main causes of high oil price, oil futures speculation may play some role. Let me explain.

Oil producers and consumers buy and sell oil futures contracts to guarantee a future price as a hedge against price change. The distinction between speculative (Non-Commercial) and legitimate (Commercial) traders by the US Commodity Futures Trading Commission (CFTC), however, seems somewhat arbitrary, or at least imprecise. A futures position is considered commercial by the CFTC if the trader intends to take physical delivery of oil. In contrast, a speculator uses futures positions solely with the intent to profit from change in the value of oil. How does the CFTC know if a trader buys futures contracts to manage price risk or is in it only for the money?

A futures contract requires that a buyer take the other side of the option that a seller offers. Simply taking a position in an oil futures contract should not affect the price of oil, but maybe it does if a large enough position is taken.

The most confusing aspect of the way the CFTC reports non-commercial or speculative positions involves what it calls “spreading.” This means that a trader takes an equal position in both long and short oil futures contracts. This does not strike me as a speculative strategy. The problem is that spreading accounts for about 60% of all the speculative positions reported by the CFTC. As CFTC Director Walter Lukken recently stated, “I think what would be admitted is that our data could be improved.”

Based on this accounting, the percentage of speculative trades has increased from below 20% a decade ago, to more than 30% in the past three years, but it is certainly not 70% as claimed by some in the Congress. There is a fair correlation between oil price and speculation (r2=0.67), but it may reflect only the strong trend of rising oil prices (an auto-correlation of oil price has an r2=0.83). It is worth noting that the percent of speculative trades decreased during the period of greatest oil price increase after 2006. Despite all the uncertainties in determining what constitutes a speculative trade, however, I cannot deny the correlation.

Initially, I did not think that a correlation existed because of my choice of data. I compared year-over-year (YOY) oil-price change (a derivative) with the percent of speculative trades in a given year (a variable). That gave a zero or negative correlation. Recognizing my error in comparing unlike quantities, I compared YOY change in number of speculators to YOY change in oil price (both derivatives). That gave me an inverse correlation-more speculative trades correlated with lower oil price. When I finally compared average price with average percent of speculative trades (both variables), the correlation emerged. The lesson is to be careful about what statistics you use and believe.

The case for supply and demand as the main cause for oil price increase is strong, but not categorical. Like oil futures data, this is due partly to the way that oil production and consumption are reported. I used the BP Statistical Review of World Energy June 2008 as my primary source. When I examined historical supply and demand I found that worldwide consumption has exceeded production since 1980. How can that be? Among other things, it is because the data does not include ethanol and biodiesel fuels as production but does count it as consumption. Also it does not account for refinery gain, the volume increase that results from addition of hydrogen to crude oil (about 2 million bopd). In addition, all of these agencies have consistently overstated demand in recent years, and have had to issue frequent updates to correct these errors.

With those qualifications in mind, it does appear that demand growth currently exceeds supply growth, and is an important factor in oil price. In 2007, production from many important exporting countries declined. These include Saudi Arabia (-4.1%), Mexico (-5.5%), the UAE (-2.3%), Kuwait (-2.1%), Venezuela (-7.2%) Norway (-7.7%), Nigeria (-4.8%) and Indonesia (-4.9%).

World oil demand has increased more than 27% since 1980 (from 61.8 to 85.2 million bopd). China’s consumption has increased more than 3 million bopd since 2000, accounting for 35% of total world demand growth. Other key contributors to demand growth since 2000 include the United States (11%), Saudi Arabia (7%), India (6%), Canada (4%) and Iran (4%). Uncertainty about growing demand unquestionably influences traders’ thinking these days.

The disproportion of the recent rate of increase in oil price to changes in the supply and demand balance is sometimes cited as evidence that supply-demand fundamentals are not causing high oil prices. This view ignores that oil price has increased every year in the last decade except 2001 by an average of 25%, and rapid increases are not limited to the last few years. The disproportion in price may be explained by demand inelasticity (it takes a long time before demand adjusts to price change), but the problem remains.

Some analysts blame high oil prices on the weak US dollar. Theoretically, a weak dollar only means that a barrel of oil costs more in the United States and in countries that base their currencies on the US dollar. Nevertheless, the US is the world’s largest economy, and when the dollar has rallied in recent months, oil prices fell.

The truth is that there is no simple explanation for high oil prices. There are many causes that may be inter-related, and perception of future supply and demand imbalance is as important to price as a real imbalance. I believe that the price of oil is high mainly because demand is increasing faster than supply, but other factors like commodity speculation may also be important.

There are no quick or easy remedies for high oil prices. I doubt that the US Congress’ focus on oil futures speculation will affect the price of oil very much. Increased regulation of the CFTC will cause investors to move their business to other exchanges and cash markets outside the US. The only good news about high oil prices is that demand in the US has decreased nearly 5%, or about 1 million bopd, since January 2008. High oil price is the most effective way to promote conservation and reduce greenhouse gases. Decreased demand should also lead to somewhat lower prices.