The Indian Economy Blog

June 3, 2008

Guest Post: On The Price of Crude Oil

V Anantha Nageswaran

What is interesting in Daniel Yergin’s FT piece is that he deftly sidesteps the question of predicting the future for oil price—near-term or in the long-term. In recent years, he has been proven wrong. His Cambridge Energy Research Associates (CERA) has been bearish on oil since 2004-05.

More important rather than interesting are his comments on the skyrocketing cost of everything from rigs, to ships to technical and skilled personnel. Clearly, for many reasons, the world needs to slow down. Central banks (or more precisely, governments) are unwilling to let that happen. The result is going to be more inflation (for a year or two) and less growth and eventual deflationary bust.

There is no dearth of commentary that predicts an imminent end to oil price. Usually, things happen unexpectedly, just as the rise of oil price itself to present levels. Now that every one and his dog is praying for or predicting a collapse in oil price, I wonder if it would happen now.

In any case, here are two samples of commentaries that call the oil price unsustainable:

In fact, John Hussman finds the contango in crude oil futures as heralding a big slump just as it did in 2006 when the price of oil dropped from around USD 80 to USD 55 per barrel.

He has exited his position in crude oil and has reduced his position in precious metals to 2%. How he proposes to reconcile that with his bearish stance on equities in the U.S.A is something that I have not been able to ask since I do not have his email address. Then, there are the comments by Mr. George Soros. He blamed it on speculators. One Michael Master in his testimony to the US Congress on the oil price spike. He has said that it is caused by index investors.

I do not recall hearing of him before this testimony. Suddenly, his name is everywhere.

It is not clear if these prognostications confuse wishful thinking for forecasts, for buried within its crevices, the Wall Street Journal carried an article on the oil producers shipping less crude than before.

This article refers to the rising consumption in Saudi Arabia and the rapidly declining export from Mexico. It is an interesting read and manages to finish on an optimistic note, somewhat inexplicably (i.e., that is falling oil price). Brad Setser makes an interesting point that this article was buried too deeply in the inside pages of WSJ than it deserved to. See this interesting post by Brad Setser.

Talking of inexplicable conclusions that did not flow from the discussions that preceded it, this paper by researchers by the Federal Reserve Bank of Dallas does the same thing. It argues, explains and convinces us that oil prices are justifably high. Then suddenly it concludes that sustaining triple-digit prices would be difficult.

It is funny and a different story that different people have different persons in mind for “speculators”. If you add them up, just about every one would be deemed a speculator while, of course, all those who invest in stocks that sustain Wall Street are fundamentally driven, analytical and rational.

I think America does not want to see the price of oil to drop so much that it angers the Sheikhs in the Arabian sands so much that they stop writing cheques for bankrupt Wall Street institutions.

See this article for confirmation on America speaking with forked or multiple tongues on this matter. And see this too.

The first line is a gem: “Hank Paulson, the US Treasury secretary, will invite oil producers to invest their petrodollars in the US while urging them to take steps to curb the price of oil in the medium term on a tour of the Gulf that begins on Friday”.

Once America has finished re-capitalising its financial institutions, it would not be averse to seeing the oil price collapse. In fact, it might even actively conspire to bring that eventuality about for biting the hand that fed them is part of longstanding Western tradition.

Geopolitical gains are not trifle if the price of oil continues to remain high, it would also put paid to any fledgling ambition of China (or even the distant India) to overtake America. At the very least, it would push the time-frame out by a few years and with some luck, few decades:

Credit Suisse’ s Dong Tao wrote in their “Emerging Markets Economics Daily” dated May 30, 2008 that Xu Xianchun, deputy director of the National Bureau of Statistics, has suggested that inflation might not peak until 2009 (p. 15).

The longer the oil stays elevated, the longer the persistence of inflation in China and the greater the policy challenge. In the meantime, more money would keep coming into China in search of appreciation.

Brad Setser estimates the rise in monthly reserves in China at USD 74 billions in April. Given that dollar appreciated in April, the actual sum could be about USD 82 billion, nearly a trillion dollar annual rate! There is no need to analyse this. China’s policy is totally and utterly rudderless. Brad Setser is way too polite on this one.

So, for what it is worth (you might be better off tossing a coin to decide), my forecast is that the price of crude oil would drop to about USD 110-115 or so. That is about it. It would then go back to 150 to drive one final nail into Asian economies, shower riches on West Asia and re-capitalise America. Then, once it has done its damage, the missile would be allowed to extinguish itself or burn itself out (pun intended).

14 Comments »

  1. [...] Anantha Nageswaran takes us through the varied opinions on the why and what of oil price rise. There is no dearth of commentary that predicts an imminent [...]

    Pingback by Crude opinions | DesiPundit — June 3, 2008 @ 2:40 pm

  2. Wouldn’t letting oil rise to 150 damage the prospects of McCain ? A better solution is to let Israel attack Iran, get US drawn into that war. That should help the Republicans, while satisfying the objectives listed above. ( The idea of Israel attack on Iran is picked from Prof Roubini’s site)

    Comment by barbadkatte — June 3, 2008 @ 2:57 pm

  3. [...] 1. IE Blog has two superb posts on price of crude oil- On The Price of Crude Oil, Upsetting Oil Pricing [...]

    Pingback by Assorted Links « Mostly Economics — June 4, 2008 @ 9:56 am

  4. The rise of the price of oil changes nearly everything in the US economy because we got very use to cheap oil. So the revenue of many businesses could be much less because the cost of production/transportation was less. But now, if their revenue is the same their production/transportation has increased so their profits are dropping or disappearing for some. An article I read analyzes how this effects Americans. Its called Oil at $200 Would Mean What?. Its really interesting.

    Comment by PaulHunt — June 4, 2008 @ 6:26 pm

  5. Lets not get into this tunnel vision and limit ourself to purposeless fabrications of bi-directional ulterior-motives that US had with regards to oil (ex: ”US allowing high gas prices to recapitaize weakened wallstreet” is such a wild fictional content on this blog that forced me to go beyond my usval restraint) . Forward looking platform with facts (not fiction) driving our discussion, certainly filled with constructive criticism is what we need look at this blogs for and from. Analysis has to be done to educate and inspire the reader, not to entertain him. Facts, data and analysis is what a micro/macro economic analysis is meant to be.

    American innovation historically is at its best when there is an underlying capitalistic incentive and urge to innovate for that specific cause. Painfully high gas prices at the pump definitely is good for the globe in the long-run considering vast amount of brain-trust redirected towards finding an alternative to oil.

    ~$4 billion USD pumped into outcome-driven research in alternative fuels by venture capital over the last 18 months would be a game changer going forward.

    Look at these Capitalism-driven innovations transforming our lives around computing, healthcare and energy, if you need living and breathing exampes of ground breaking innovation:

    Automotive-class LithiumIon from A123 getting us a car from GM and others in the next 12 months with <70centsPerGallon (compare that to $5).

    Blockbuster biological drugs from Amgen and Genentech (ex Herceptin) literally rewriting the cancer survival rates every month.

    ShrinkWrapping a transistor from the size of a hand to 1/100 th size of a single red blood cell (using 45nm Hafnium) by intel.

    Commercial production of cellulosic ethanol (ethanol from gas, husk or wood) based on proven Fischer-Tropsch process (instead of expensive enzymes) by range fuels.

    Comment by Siva Moturi — June 15, 2008 @ 1:23 pm

  6. One of the reasons for the acceleration in oil prices is definitely the futures market. With the slide of the dollar against other currencies, investors (whoever they may be) are using oil as a hedge. Investing in oil futures is a great hedge against inflation as well.

    The relatively low initial margins required to play oil futures has definitely had its effects on oil prices. It would be interesting to see oil price behavior if margin money was increased by the clearing houses.

    Comment by Nikhil Nayak — July 11, 2008 @ 8:53 pm

  7. Excerpt from Business Week: “Astonishing” drop in demand

    Analysts say that while oil traders have been betting on surging demand from developing countries such as India and China, reduced demand in the U.S. is now sending bearish signals the markets can’t ignore. Moreover, Energy Dept. data released July 16 showed a 3 million barrel jump in U.S. crude inventories, to 296.9 million barrels; analysts had expected a decline. Moreover, U.S. demand for energy products has fallen 2% from the same period last summer, according to a four-week average federal regulators release weekly. “I think this is a precursor to a much bigger sell-off,” says Peter Beutel, president of Cameron Hanover, an energy risk-management firm in New Canaan, Conn. “It’s very possible we have seen the worst this [price surge] is going to do to us. The tide is starting to change.”

    Fingerman points to the 5% drop in U.S. gasoline demand from the same time a year ago as evidence of a “structural shift in the car economy.” He points to the sharp sales declines for large vehicles at General Motors (GM) and Ford (F), as well as wider use of public transport.

    Since the U.S. consumes a quarter of the world’s gasoline on a daily basis, lower U.S. demand has a “huge ripple effect” on the market, and that is starting to be reflected in prices, says Fingerman, who considers $80 oil possible by year’s end. “I think it’s the beginning of the end,” he says. “The fundamental data just keeps getting more and more bearish.” Another oil contrarian, Lehman Brothers (LEH) energy economist Edward L. Morse, sees oil in the lower $90 range by 2009. “The drop in demand (BusinessWeek, 7/16/08) has been astonishing, particularly in the U.S.,” Morse says.

    Comment by Nikhil Nayak — July 19, 2008 @ 11:14 am

  8. Futures market can be driven up only if there is demand-supply gap.
    Let me remind that for every buyer of futures there is a seller if the buyer is speculator. If not at the expiry speculator must take delivery which is not found true by CFTC. So the speculative buyer must square his position which will pull the price down if there is excess supply. If there is shortage it will short squeeze which will drive price higher.
    Economics 101 simply.

    Look for july 21st, 22nd. Expiry of current month futures. If the price remains at current level, we can safely assume that there is not enough demand at 147$/ barrel. Price on july 22nd is the real price as the current month futures expires. To get a better idea look at spot prices. Somebody is buying oil at 130$/barrel.

    To nikhil
    Since oil is the backbone of economy, reduction in oil consumption can be translated into recession for US (ie) demand drop for oil in US means recession for US. lly demand drop for oil from world will mean global recession.

    Comment by satish — July 19, 2008 @ 8:58 pm

  9. Satish,

    The Business Week article I refered to was more to point out that speculation in oil is a major factor in the current oil price scenario. The fact that US demand is going down is a result of high prices. What this has done is create a bad sentiment and is probably going to attract legislation on commodities trading. I believe this is going to result in less people taking positions on futures contracts.

    I have to clarify that the contracts for difference market or CFDs was on my mind when I made the initial comment. At the moment on the CFD market the initial margin is only 1%. Based on a 100 barrel contract of $13,600 of West Texas or Brent @ say $136/barrel, the initial margin is only $136. Also there is no time limit. CFDs have no time frame to closing out the contract. This is definitely an attractive place to be and in my opinion many of the institutional investors are right there right now.

    Comment by Nikhil Nayak — July 20, 2008 @ 7:01 pm

  10. Most crude oil price around the world are benchmarked to WTI. WTI has got
    expiry. So WTI crude must be lower if it cannot be used as a hedge at expiry. Supply must be really tight for speculators to benefit on upside.
    If we had 4mbd of spare capcity speculators will not dare to move price upside.
    CFD’s can work for stocks which has no depreciation. I dont know how it works for commodities.

    Comment by Satish — July 20, 2008 @ 8:41 pm

  11. Why do we need stop loss when there is no expiry which increases the counter party risk to infinite.

    Comment by satish — July 21, 2008 @ 11:42 am

  12. Getting back to the point of the price of crude oil: I don’t think that anyone doubts the assertion that there is more demand for oil than ever before. China and India alone are adding huge pressure to the demand alone. In that sense the assertion that market fundamentals are still driving oil prices high are still true.

    My point was that commodity market speculation especially the CFD market based on oil futures is possibly driving prices further still. The Intercontinental Exchange (ICE) based in London has recently been in talks with US counterparts to reign in some of it. It is being debated but the fact is when investors play the oil futures market with such instruments prices can be affected.

    Comment by Nikhil Nayak — July 22, 2008 @ 5:15 pm

  13. Very interesting post by Nageswaran.

    With Keneth Rogoff, ex-IMF chief economist, predicting further crisis in the US financial system which even the sovereign wealth funds from the arabs will be hard put to revive (http://www.informationclearinghouse.info/article20557.htm);can one expect the crude prices to drop below $100/barrel?

    Presently, the price is hovering around $115 with a 1 year forecast of $150.

    Comment by Curious — August 20, 2008 @ 11:22 pm

  14. I think its pretty clear now that speculation was playing a huge part in inflating oil prices. Even with hurricane Gustav and a bunch of other threats on the horizon the price of WTI has been dropping. I don’t believe even $100/barrel can be maintained. My guess is that WTI will drop below $90 in the next couple of months.

    For us here in India what is interesting to note is that the Indian oil companies do not source their oil from the North Sea or Texas. Still prices went sky high on “global cues” and they still are hovering at July levels. Even more interesting, I am told that Reliance reports prices of approx $88 on their balance sheet which could be a fair indication of what the real price is.

    Comment by Nikhil Nayak — September 4, 2008 @ 1:40 am

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