Normally, most of the players in the futures markets are industry players – largely shippers and refiners – who simply are planning ahead. After all, why purchase crude oil at the last second and risk that none will be available when one can purchase a futures contract that will ensure delivery in, say, September? If August rolls around and it turns out you do not need all the crude you in effect pre-purchased, one can simply sell the extra futures contract and buy a new contract for October delivery. In essence, it's the industrial equivalent of keeping a spare can of gasoline in your garage.

But there are other players in the futures markets, too: investors who have no intention of ever taking delivery of any shipment. Instead, they play the market in a bid to profit from price fluctuations. Such speculators used to be marginal players, but right now there are a lot of these folks. Some estimates put them at more than two-thirds of total traders by volume. Part of this jump is thanks to the subprime lending mess. When the mortgage market cracked in late 2007, many who made their living trading mortgage securities and property fled into the energy markets.

Defenders of speculation claim that anything that increases the number of participants will increase efficiencies and lower prices in the long run. Detractors of speculation assert that – as with any other market – when more money chases after a set amount of product, prices rise. And in this case, unnecessarily so.

Not to muddy the waters, but both are right – and wrong. The more market players there are, the less likely it is shocks will occur and the less severe those shocks will be. Large, deep markets tend to iron out disruptions due to sheer size. At the same time, when a large proportion of the market players do not actually ever intend to receive the product, the result is indeed a price overhang.

This raises two questions: how big of an overhang, and what to do about it?
Some of those testifying before Congress projected that without speculators the price of oil would fall by half in a month. While Stratfor certainly senses that speculators are having a demonstrable impact, we have a hard time believing the oil issue is that simple.

If Saudi Arabia makes good on its weekend pledge to increase oil output, global spare production capacity will slide to less than one million barrels per day, a historic low. Add in remarkably robust resilience from China and the United States and a price crash seems a stretch, even though a price moderation is certainly possible (and even likely) with the right mix of regulation. Oil is scarce, oil is needed, oil has no obvious substitutes, and there is nothing that anyone can do to bring more of the stuff onto the market quickly. That is a perfect storm for expensive crude, and no amount of regulatory change is going to alter this bottomline.

Yet some level of regulation is imminent for two reasons, one structural, the other political.

Structurally, speculators serve a crucial function under normal circumstances. When stock markets hit ridiculous highs, the exuberance of speculators overwhelms the system and quickly forces a market spike to become a market collapse (think the April 2000 dot-com crash). These collapses predominantly hurt only speculators and force some much-needed rationality into the system. But in strategic commodities such as oil or food, price spikes can wreak havoc on society.

And when that happens, regulators cut in. Regulation makes the system more inefficient, but so does out-of-control speculation. Unless it is very bad regulation, however, it does not stop the forces of supply and demand from functioning. A market with runaway speculation, on the other hand, can do that.

Politically, there is more going on in the U.S. than simply crude going for more than $130 a barrel, gasoline at $4 a gallon, and a summer driving season only just underway. The United States is in full election mode, neither candidate has a vested interest in defending the status quo, and there are 300 million Americans out there who are getting fed up with prices that make the Hurricane Katrina aftermath look cheap. Taking some sort of action on energy is a political no-brainer, and 'speculators' are the perfect faceless foe. Congress and both presidential candidates are in the mood to act – and act quickly.

The trick will be to hit the right balance, and that is no sure thing. If it were, it would have been done ages ago. Futures trading is an essential leg of energy markets, and finding a way to separate those not actually interested in getting hold of the black gooey stuff from those who do will not be simple. Any regulation that fails to do just that won't just hurt speculators, it will disrupt the global energy network. And if that were to happen, $130 a barrel would look cheap indeed.

II
Saudis' gameplan

The long-awaited Jeddah Oil Conference on oil supplies was held (June third week) and yielded the long-expected answer. The Saudis are going to increase oil supplies by the amount floated last month, and are prepared to increase supplies even more if there is demand for more product, which they do not see at this time. The subtext of the meeting was simple. Oil prices are not the result of insufficient supply or extraordinary demand. Supply and demand are pretty much balanced. Therefore, $135 a barrel for oil does not represent a problem to be solved; it represents a reasonable price for crude.

It doesn't take a rocket scientist to understand the Saudi view. Making a $135 a barrel is better than making a $100 a barrel, and beats the hell out of making $50 dollars a barrel. In some cases, countries that buy oil might have non-economic leverage to use against oil producers. In the case of Saudi Arabia, the most important exporter, there is not much that can be done. On the contrary, the Saudis have the leverage.

The only country that could use political leverage against the Saudis is the United States, and at the moment the United States is more dependent on the Saudis politically than the other way around. The Saudis are critical to two major strategic U.S. initiatives: stabilising Iraq and the Israeli-Palestinian talks. The Saudis are not involved in these matters for Washington's benefit, but Washington is benefiting. There are no non-economic threats the United States could make, assuming it would really want to bring down oil prices.

The fact is that the United States is benefiting geopolitically from higher oil prices. Certainly it is putting significant pressure on the U.S. economy, but nothing compared to the pressure being placed on China. The United States figures that while it can get cheap goods from China and elsewhere in the world, the weakening of China's global position certainly does not cause the United States much grief. And the role the Saudis are playing in stabilising the Middle East is also to the United States' benefit. Relieving geopolitical pain in return for increasing economic pain sometimes makes sense. But the truth is that it really doesn't matter what Washington thinks about higher oil prices. They are a reality, so Washington might as well get the benefits.

From Saudi Arabia's point of view, there are three issues it must consider in determining how much oil to pump.

First, the Saudis want to maintain demand. They do not want to lead the world into a global recession, since that would reduce demand and decrease prices. They are clearly watching the global picture carefully, and we would think that what they are seeing is that any further increase in oil prices would lead to a serious recession. They are indicating that they will try to increase production so that oil prices don't go any higher and perhaps increase production in the face of softening demand, allowing prices to go down a bit. Oil markets are acting as if this were the case, but the Saudis are too smart to pay much attention to the day-to-day fluctuation of oil markets.

Second, the Saudis have limits on what they can produce. In the short term, their productive capacity has some give in it, but it is not infinitely elastic. They need to be careful not to max out capacity. There has been much discussion of peak oil – the idea that the Saudis have peaked out in their oil supply. If that's true, then they need to get the maximum price for every barrel produced. It could be argued that keeping prices high even in the face of global depression, if it could be done, would be the optimal long-term strategy for the Saudis. If peak oil is true, then the Saudis need to maximise the total revenue captured, not quarterly or annual revenue.

But the Saudis need to be aware of the third variable: alternative sources of oil and alternative energy supplies. The higher the price of oil goes, the more incentive there is to use previously uneconomic sources of oil and find other energy sources. This is not something the Saudis, or other oil producers, want to see happen. Over the long term, to the extent that they can control prices, the Saudis and others want the highest possible price that precludes significant investment in alternatives. That isn't easy to calculate or to do, but it is their goal.

Thus, what the Saudis want is the highest possible price. The Jeddah conference affirmed that, but it also seemed to understand that the term 'possible' is complex and flexible. If we can extract any meaning from this conference, it would appear to be that the Saudis do not want to see a major break in prices, but are probably wary of seeing the price going much higher and might prefer moderately lower prices to achieve their ends. But it is not clear to us that the Saudis really have that much control over markets, so their finely tuned wishes and reality might not be connected.

Courtesy: Stratfor

top