A gas station in Oakland, California on June 17. Here we go again. (AP photo)

By Peter K. Ashton and Henry M. Banta
PKAshton@aol.com
henrybanta@aol.com

We are once again experiencing wild price fluctuations in the petroleum markets that threaten to repeat the frightful damage that was done last summer. This is coming at a time when the political machinery is in high gear to reform financial market regulation. The return of price speculation in petroleum demonstrates the problem confronting the reformers. We all think we have learned something about the damage rampant speculation can do to a market, even to the whole economy. We even think we know what to do to prevent future disasters. But do we know enough to avoid what happened to domestic gasoline prices last summer? One doesn’t have to be an alarmist to be concerned. 

The press, instead of merely expressing shock, should be reporting the whys and wherefores of this repetitive oil price spike syndrome. And among questions the press should ask are whether and how the financial leaders and experts in the Obama administration, so active these days, will get involved. To put it another way, what are they waiting for?

First, to understand the risk we need to review what happened to the crude oil market last summer. In January of last year the price of crude oil was about $90 a barrel. By July it had risen to $145 per barrel – a 66 percent increase in 162 days! Worse, it was more than double from the previous year. Spectacular as this price increase was, it was nothing compared with the drop back to $30.82 per barrel in just 120 days – a 380 percent change. This volatility in the crude oil price was reflected in the gasoline price which went from $3 per gallon to $4 then plummeted to $1.75 by the year end.

What was at work here? Economists and industry experts rushed to blame market forces: both long and short term trends in supply and demand, especially increased demand from China and India. But the degree of price volatility defied simple market based explanations.  As one expert noted, nothing happened in China or India to drive up prices a record $25 in a single day. Long term trends in supply and demand simply do not explain such violent price changes, either up or down. 

The most plausible explanation was the weakness of the dollar. And indeed it was a factor. World-wide oil transactions are denominated in dollars. As the dollar weakens against other currencies, buyers must pay more for crude oil to keep the sellers even. The fall in the value of the dollar in 2008 can explain some of the crude oil price increase, but by no means all. In 2008 the dollar never lost more than 7 percent of its value, a loss that cannot come close to justifying a 50 percent crude price increase. In short, what we are left with is an inescapable  conclusion that crude oil prices in 2008 were subject to a speculative bubble. 

This speculative bubble had serious consequences for U.S. consumers in the first half of 2008. About $60 of the $110 average price of a crude oil barrel can be conservatively ascribed to market fundamentals. The $50 that could not be explained added about $0.40 to the price of a gallon of gasoline. The total net cost for U.S. drivers was $27 billion.

In recent weeks prices have again become volatile. Crude oil spiked above $71 per barrel – an eight-month high. Gasoline prices have likewise shown a spike. Again the “market fundamentals” of supply and demand are offered as an explanation, and once again they have surface appeal. It is true that the International Energy Agency has revised its demand projections upward – now predicting a drop in global demand of only 2.9 percent, up from their earlier projection of a 3 percent drop. Also inventories of both crude oil and gasoline have shown a modest increase. Again there are concerns about increasing demand.  And the dollar has slipped a bit. 

But all these factors taken together do not justify such a sharp spike. The price movement is too fast and steep to be simply a matter of changes in supply and demand. What is most likely is that there is a perception on the part of speculators that the US economy is beginning to recover from the recession and they are betting on an increase in demand. This perception was reinforced by a general upward trend in commodity prices. The important point is that petroleum prices are extremely vulnerable to bouts of speculation. The risk of another costly speculative bubble is very high. The damage such speculative prices could do to a recovering economy makes the risk unacceptable.

There is no clear answer to what ought to be done. The sheer volume of money flowing in and out of commodity markets is troubling by itself. This is facilitated by investment vehicles such as exchange traded funds that are readily available to investors of all sizes. Making these less easily available and subject to strict margin requirements might help reduce the volatility of the market – on the simple theory that the smaller the herd, the less damage the herd behavior can do. Requiring large traders to report over-the-counter transactions to the CFTC would also help. In any case, for those who are busily rewriting the rules for financial markets, there is some work to be done. Hopefully we all can afford it.

Henry M. Banta is a partner in the Washington, DC, law firm of Lobel, Novins & Lamont. E-mail: henrybanta@aol.com

Peter K. Ashton is the president of Innovation & Information Consultants, Inc., an economic and financial consulting firm which specializes in the analysis of the petroleum industry. E-mail: PKAshton@aol.com

Comments

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It's the fundamentals, stupid. Posted by William T 06/19/2009, 07:18 PM Although it is entirely likely that the market "ran away with itself" in both directions over the last year, I think it's pretty clear that the underlying supply and demand do a pretty good job of explaining the prices. You have a market reaching limits of flexibility in the supply curve, coupled with shifts in the demand curve (in recent years related to the growth of world consumption, and in early 2009 the collapse of economic activity. Now it's starting to go back up). Small shifts in that demand curve can easily lead to large price changes because of the steepness of the production curve. The real problem for the future is that the production curve isn't going to shift any higher - if anything it is going to steepen and start to decrease (whether or not you believe in 'peak oil', production costs are increasing). So any kind of pressure from increases in demand is inevitably going to increase prices. Speculation may exacerbate the price movements, but fundamentally, the direction is up, and going to stay that way unless demand drops faster than production (ie collapse or mass conversion to alternative energy). Good luck to all long-distance commuters...

Fundamentals, My A-- Posted by Phil M 06/24/2009, 01:36 PM Currently the world is awash in oil. In the US they are paying for freighters to store it. Refiners have purposely lowered production to keep the price up. What is driving the price up is the enormous amounts of leveraged money in the commodities markets. Money is flowing from the pockets of regular Americans to the speculators because of this. Right when we need people to have money to spend and stimulate the economy it is drying up. Something needs to be done tohalt this act. Why are people allowed to by something which they can't use ? The options markets were intended to protect producers and users from severe price fluctuations. We need to return to this purpose.

Yes, there is an answer Posted by A Citizen 07/06/2009, 08:22 AM I can't believe I have to remind you scholars of recent history. last year there was on C-SPAN a Energy and Commerce Sub Committee hearing on rapidly inflating oil prices. There was a panel of four men who's job was oil marketing. They all agreed that oil price manipulation by hedge and pension funds was due to three factors. The Enron loophole The London loophole The Goldman Sachs loophole They explained these loopholes. In July of last year Sen. Reid brought to the floor of the Senate a bill to shut down these loopholes which the republicans blocked. Obama has now been President for five months and neither he nor Reid give this bill the time of day.I write my Congressmen and get zero response. Why are you and the media also sitting on your hands ?

Posted by ACitizen 08/29/2009, 03:00 PM I see the media is STILL sitting on their hands. If you listen to Bloomberg financial news for example you will hear industry people tell you that oil should only be $50. a barrel at most. I found out last week in that channel that disciples of Mark Rich in London are manipulating the market as the hedge funds did before the Crash. I email my Rep. and Sen. and get silence (they are Democrap). When is the media going to confront Congress on why they have not passed the legislation to close the Enron, London and Goldman Sachs loopholes. I'll be back in a couple of months to repeat my question to you again I am sure. Submit a comment - Jump to top of list