Mid-July marked the first anniversary of the credit turmoil born of subprime mortgages. But taking top billing with this crisis was an unprecedented rise in commodity prices, most spectacularly that of crude oil. Like actors on a stage, their roles were intertwined, with the script written by global investment banks, hedge funds and central banks.
One vehemently debated question has been the role of precisely these financial institutions in the run-up of these prices. The rise in crude prices, with the benchmark Brent rocketing up from $52 per barrel in July 2007 to over $145 in July 2008, was as dramatic as the fall over the past month, now down to under $115 a barrel, a drop of over $30 in a month. So this kind of movement is quite clearly the handiwork of speculators, right? No way could perceptions of demand-supply imbalances have caused this kind of movement.
The testimony of Michael Masters, a hedge fund manager, before a US congressional committee provided some evidence that speculation is driving, or at least contributing massively, to the rise in commodity, particularly oil, prices. The essence of what he testified was as follows. ?Index speculators? had increased their assets allocated to index trading strategies from $13 billion at the end of 2003 to over $260 billion in March 2008. The prices of the 25 commodities that comprise these indices have risen an average 183% in those five years. Since 2003, open interest?the total number of outstanding futures contracts?in the NYMEX crude futures market has risen from a 10-year average of 440,000 to around 1.4 million.
China?s annual demand for petroleum has increased from 1.9 billion barrels to 2.8 billion barrels over this period, an increase of 920 million barrels. Over the same five-year period, index speculators? demand for oil futures increased by 848 million barrels, almost equal to the increase in the Chinese demand. In fact, index speculators have stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum, effectively adding eight times as much oil to their stockpile as the US has added to its Strategic Petroleum Reserve.
The contrarian view (at least its theory) was laid out, among others, by Paul Krugman, one of the most respected economists. He suggested that, if speculation were to cause a rise in prices, there would have to be a corresponding rise in inventories. This argument will be immediately obvious to all economics undergraduates who have studied downward sloping demand curves and upward sloping supply curves, with the equilibrium price determined by at their intersection. Any price above this equilibrium (which balances supply and demand) will lead to supply being higher than demand, and consequently, inventories. And given that inventories have remained at or below seasonal averages, and are falling, supporters of this theory have concluded that speculation must not be having an impact on prices.
Of course, detractors of this theory point out that normal laws of supply and demand don?t work in the oil markets. Opec is a cartel and doesn?t respond to price signals. Increasing oil production, even at existing oilfields, takes time. Emerging markets like India and China control prices at the pumps and thereby distort demand. Nevertheless, there should have been some response in inventories. There has not.
A substantiation of the ?fundamentals? hypothesis was provided by a recent report of the interim task force (ITF) headed by the US commodities market regulator, the Commodity and Futures Trading Commission, and comprising, among others, the Federal Reserve Board, Securities and Exchange Commission, Federal Trade Commission and the US Treasury. The inferences, no, the conclusions were unequivocal. The ITF?s preliminary analysis ?does not support the proposition that speculative activity has systematically driven changes in oil prices?. They use both publicly available information as well as aggregations of confidential surveillance data to support their inferences.
They find that commodity swap dealers have held roughly balanced long and short positions in the crude oil market over the last year and actually held a net short position over the first five months of 2008. That is, swap dealers? futures positions would have benefited more from price decreases than from increases. Moreover, any upward price pressure exerted by the long positions of swap dealers? commodity index clients has largely been offset by the short positions of the dealers? other clients. In addition, changes in the positions of swap dealers and non-commercial traders often followed price changes, suggesting that they were responding to new information and not driving prices higher.
If the ITF is correct, there will be a steady rise in crude prices over the years. The chart above will let the reader judge how much of an impact the imbalance between global supply and demand has had on oil prices. Whatever your conclusion, the true story of global oil will have an overwhelming impact on India. For the sake of our continued growth, we had better adjust to this reality.
?The author is vice-president, business & economic research, Axis Bank. These are his personal views.
The author thanks Rituparna Banerjee for inputs