One thing in particular from a short Reuters article caught my attention: "Crude oil prices rocketed to record highs above 135 dollars on Thursday, driven by growing concerns that energy supplies will fail to meet demand, analysts said." (emphasis mine)

Those four words - "driven by growing concerns" - are enough to convince me that speculation is playing some role in rising oil prices. Markets are often driven by rumor, and like all rumors, there's usually little substance to the ones that sway markets. The question then becomes how much substance is there behind these "growing concerns" of an energy crunch?

Supply/Demand & Peak Oil

On May 22, the Treasury and Energy Secretaries both publicly stated they believe rising oil prices are being caused by supply problems. The House of Representatives passed a bill two days earlier to sue OPEC for limiting supplies and price setting. Goldmann Sachs predicted on May 5 that prices could reach $200 per barrel over the next two years.

I've been all over the Energy Information Administration's site and can tell you with confidence: There is no shortage of oil! There isn't expected to be a shortage of oil in either the short- or long-term, according to EIA predictions. In their May 2008 Short Term Energy Outlook, consumption is projected to go down in the US for 2008, and both national and global inventories are expected to grow as supply is (barely) meeting demand through 2009. The long term outlook, as stated in their 2007 International Energy Outlook, says, "In the high price case, oil prices are projected to be $100 per barrel in 2030 ($157 per barrel on a nominal basis)." In fact, the supply/demand picture looks good enough that a law was just signed to halt shipments of oil to the national reserve, which is 97% full.

The theory of peak oil is being thrown around as well. I admit to not being an expert on the subject, but as I understand it, this is the idea that we'll have a Malthusian catastrophe because our dependence on oil wasn't mitigated twenty years before peak production. However, there's little agreement on when peak production occurred - or if it even has yet. The reasoning and logic behind this theory seem flawed to me. It requires one to accept the premises that no further oil fields will ever be tapped anywhere, that advances in technology will never make extraction or refinement more efficient then they are today, that energy alternatives will never be found or switched to, and that current trends in population growth and economics will continue as they have for decades. Before oil, this country was dependent on coal and whale oil - when is the last time you used a coal stove or fired up that whale-oil lamp? On top of all that, focusing on the finite nature of one resource fails to address the true problem: over-population in a closed system where all of the resources are finite.

I don't entirely dismiss "peak oil" theorists. I find their arguments about minor disruptions in supply having inordinate effects on economies, due to those economies' critical dependence on oil, particularly compelling. I have no doubt that if we don't start seriously looking for energy alternatives (with an effort on the order the moon mission), their worst scenarios have a high probability of occurring. Yet, the supply numbers simply don't support the idea that we've already hit global peak production, so this theory's effect on oil pricing should be minimal. At least it would be in an open and free market, where the truth would come out before a rumor caused such a large rise in price.

One last note of interest from the EIA site: The majority of oil the USA imports comes from non-OPEC countries, and has since 1994. However, in the future the situation will switch again - and for the entire oil-importing world, not just the USA. This means we'll be competing with the rest of the world for OPEC's oil! Keep those things in mind the next time you hear a Republicrat get on their soapbox and rail against OPEC or crow about having passed a bill to sue them.

Weak Dollar

The Federal Reserve has lowered interest rates and dumped tens of billions of dollars into the economy as a result of the sub-prime crisis. The Federal government continues to fund endless wars that mean budget deficits year after year. Have these things devalued the dollar enough to cause these kind of price surges? According to Ed Wallace at BusinessWeek, "The dollar has depreciated 30% against the world's currencies since 2002, while the price of oil has gone up 500%." Is this correct? I'm not sure where the 30% comes from - it's a "fuzzy" number to calculate - however in terms of buying power, it's fairly accurate. The price of oil is easier to verify - it was $25.03 per barrel in May 2002, and hit $135 per barrel this week, for a 539% increase. If supply, demand, and inflation were the only market factors involved, we would only be paying around $32.54 per barrel!

Speculation

Telegraph.co.uk reported on May 24:

On May 20, the Senate Committee on Homeland Security & Governmental Affairs held a hearing to ask "Are Institutional Investors contributing to food and energy price inflation?" Michael Masters, managing member and portfolio manager of Masters Capital Management, says we're experiencing a "a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant."

Other points he made include:

* Assets allocated to commodity index trading strategies have risen from $13 billion at the end of 2003 to $260 billion as of March 2008, and the prices of the 25 commodities that compose these indices have risen by an average of 183% in those five years.

* According to the CFTC and spot market participants, commodities futures prices are the benchmark for the prices of actual physical commodities, so when Index Speculators drive futures prices higher, the effects are felt immediately in spot prices and the real economy.

* In the popular press the explanation given most often for rising oil prices is the increased demand for oil from China. According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, Index Speculators demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!

* Index Speculators have now stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum, effectively adding eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve over the last five years.

* When Congress passed the Commodity Exchange Act in 1936, they did so with the understanding that speculators should not be allowed to dominate the commodities futures markets. Unfortunately, the CFTC has taken deliberate steps to allow certain speculators virtually unlimited access to the commodities futures markets. The CFTC has granted Wall Street banks an exemption from speculative position limits when these banks hedge over-the-counter swaps transactions. This has effectively opened a loophole for unlimited speculation. When Index Speculators enter into commodity index swaps, which 85-90% of them do, they face no speculative position limits.

* Additionally, the CFTC has recently proposed that Index Speculators be exempt from all position limits, thereby throwing the door open for unlimited Index Speculator "investment." The CFTC has even gone so far as to issue press releases on their website touting studies they commissioned showing that commodities futures make good additions to Institutional Investors' portfolios.

 

Pension fund managers at the hearing claimed their heavy investing in commodities is only having a minor influence on commodity prices. This flies in the face of reason, logic, and the CFTC claims that "when Index Speculators drive futures prices higher, the effects are felt immediately in spot prices and the real economy."

The CFTC - the government agency charged with regulating these markets - claims that prices of commodities aren't influenced by speculation. That would imply that commodities markets are self-regulating and that the CFTC isn't needed - so why are they being funded from public monies?

In response to suggestions made for increased regulation or increased call margins, the CFTC essentially claimed during this hearing that it's impossible to regulate all commodities trades and that increased regulation will reduce "transparency" in the markets. It must have been surreal to hear the National Farmers Union say in the same meeting: "Another example of the dysfunctional market is what happened in the cotton futures market when the price almost doubled in one day. When producers tried to market their cotton at the higher price, they were told there was no market for the physical commodity and the price collapsed shortly thereafter. We have yet to receive a satisfactory explanation from CFTC officials as to what caused this situation. Obviously it was not based upon market fundamentals and again farmers were precluded from being able to capture the higher prices."

Conclusion

Rising oil prices aren't being caused by dwindling supply, surging demand, or the devalued dollar. The physical supply is meeting the growing physical demand, and physical oil consumption is actually down in the USA due to the economy. The dollar, while losing value, has not lost 80% of it's buying power! I'm convinced the largest driving force behind rising oil - and all commodities for that matter - is speculation.

One of Masters' footnotes about the CFTC opening up the "swaps" loophole quotes minutes from a CFTC meeting:

"And that actually happened in 1991 with a particular swap dealer that was hedging an OTC transaction with a pension fund, and the swap dealer came to us, and we said, "yeah, that qualifies for a hedge exemption," so we granted a hedge exemption to the swap dealer. And in the years since then, we've done the same for other swap dealers, as well."

This is similar to the way the regulatory system broke down with the sub-prime crisis. One exception is made to the rule, and the next thing you know, everyone is lining up at the trough. It's a big Ponzi scheme, and whoever is holding these commodities when the bubble pops is going to be broke - while the ones who started it will be sitting pretty, quite a bit richer, and looking to their next criminal scam. This commodities bubble is going to hurt much more than the last couple of bubbles though, because the underlying physical commodities will prove to be much more sensitive to this wild speculation. I don't consume equities or bonds, or even the capital they represent, and can live just fine without them. Not so with commodities!

To add insult to injury, "We The People" will end up bailing them out, because Washington clearly isn't interesting in reforming the banking culture in this country. At the end of this week's Senate hearings, Lieberman agreed that speculators are having a disproportionate impact on commodity prices, and that he will convene another panel to close the "swaps loophole." It all sounded so hopeful until he referred to the Consumer First Energy Act of 2008 - which, on my initial reading, is aimed at punishing oil companies for their ridiculous profits and forcing them to pay for alternative energy research. These aren't bad ideas, but they don't address the root cause of rising oil prices, which is unlimited speculation in commodities futures by institutional investors. As a result, it will do as little to lower energy prices as the Farm Bill just signed into law will do to lower (working) Americans' grocery bills. Speculation will continue, because Washington can always roll out another tax rebate to placate us vulgar masses, right?

Until we do something to reform the banking community - specifically the investment banks - I believe we will continue to suffer through bubbles like this while investment bankers keep getting richer and fatter off the rest of the world's misery.

References:

Energy Information Administration

Financial Speculation in Commodity Markets: Are Institutional Investors and Hedge Funds Contributing to Food and Energy Price Inflation?

OPEC unhappy with oil price surge: El-Badri

Expensive oil due to tight supply: energy secretary

Paulson: oil demand/supply cause for price rise

House passes bill to sue OPEC over oil prices

Bush signs law halting oil shipments to reserve

Oil's perfect storm may blow over

There Is No Gas Shortage

Are Pension Funds Fueling High Oil?

Lieberman, Collins Say Commodities Market Speculation Contributes to High Cost of Food, Oil

Democratic Senators Unveil Consumer-First Energy Act Of 2008