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Author: 
Dr. Mohamed A. Ramady
Publication Date: 
Mon, 2008-05-26 03:00

Just when we are beginning to see the regional, or at least Saudi stock markets, settle down to a tighter trading range without erratic excesses, the oil markets seem to have been bitten by the bug of irrational exuberance.

It is unprecedented to see oil prices move up and down by more than $5 a barrel in the space of a few hours, without any basis in terms of supply and demand fundamentals. This is causing frustration from both suppliers and consumers. The former, mostly targeting OPEC producers are claiming rightly that their output and world supply is more than enough to meet world demand. The latter, represented by various governments with an eye on national elections and rising consumer anger, are demanding more output from producers.

The blame game and frustration from both sides is mounting, and all kinds of explanations are put forward to explain oil price rises. Each one has a certain grain of truth, but each does not explain the whole story of why oil prices have risen by more than a third in little more than a month.

The various explanatory causes range from the economic boom in the world’s largest developing economies, particularly China and India, or the unwillingness of OPEC to pump more crude (they have already stated that they will not do so in their forthcoming September meeting), or that the world has reached the dreaded “peak oil” stage, whereby the rate of oil depletion is not being matched by new finds.

And yet technology — and current high oil prices — are seemingly pushing back the date for “peak oil”, as the recent massive 33 billion barrel of new Brazilian offshore oil reserves has shown.

The upward march of oil prices is the result of a speculative frenzy of the sort that we only witnessed in the local stock market during 2006 and is symptomatic of the dotcom mania of the late 1990’s. Just like these two earlier markets, the current oil market is a massive exuberant bubble waiting to be popped. We might not be there yet, but it is certain as all bubbles have common characteristics. The first is that prices tend to move extremely rapidly. Who could forget those 10 percent plus daily movements in the fantasy trading world of the Saudi stock market, not so long ago? The second is that prices rise on the flimsiest of evidence or rumors to be more precise. The third is that any so-called evidence — or rumors — is justification for rushing into the oil market.

What next? Has the oil market forgotten past market bubbles and bursts? The anemic performance of the US dollar has contributed in part for the financial markets to hedge their returns by switching to oil futures. There is now irrefutable evidence to support the conclusion that a large amount of speculation in the current oil price markets has significantly added to prices. When conservative global pension funds join the fray, it just makes one think twice about another subprime market fiasco in the making.

As such, as far as the oil markets are concerned, the basic fundamentals no longer seem to matter. The fundamental equation for higher oil prices such as a stronger Asian market demand and a short run production and supply response are known and had been factored in by the markets. Rational markets — or efficient market hypothesis — would suggest that such factors have already been factored into oil prices.

The current irrational oil prices are extremely frustrating for leading OPEC price moderates. Saudi Oil Minister Ali Al Naemi publicly stated that the benchmark for oil should be around the $60 — $70 a barrel and that the Kingdom had done all it could to meet “real demand”, from “real customers.” This has fallen on deaf ears.

Politicians around the world are now waking up to this irrational price movement. In the UK, the Labor government is being urged not to implement the recent budgetary decision to increase petrol taxes by another 2 pence in October. In the USA, lawmakers unveiled a new energy package that would rescind $17 billion in oil company tax breaks and slap a 25 percent profit tax on firms that do not invest in new energy sources. Few are turning their attention to regulating speculative oil traders. The only way speculators can be tamed is by history to repeat itself, until the next exuberance bubble appears. Oil market speculators should take on board the recent 40 percent drop in wheat prices, which was the center of a frenzied speculative commodity market a few months ago.

As such, bubble markets are not rational in the long run, however, exuberant the players are. It is impossible to say how high the current oil price mania will go — some are saying $200 a barrel — others even more, but the bust will arrive, and that moment could be much nearer than many speculators may imagine. The erratic $5 a barrel movement in one day is a sign of nervousness and profit-taking. All it takes for a price blow out to take place are for a few more speculators to jump ship ...

(Dr. Mohamed Ramady is visiting associate professor, finance and economics at King Fahd University of Petroleum and Minerals)

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