The fundamentals are no more in control of the market. New factors have emerged in the process — much beyond the grip of the traditional market players — impacting heavily on the global oil prices.
And the transformation has been rapid — taking place before our eyes — over less than a decade.
On Dec. 10, 1998, crude oil futures settled at a low point of $10.72 on the New York Mercantile Exchange. However, the situation began to turn in early 1999. Hugo Chavez became President of Venezuela. Within the OPEC, Venezuela was until then a known quota buster, making all OPEC’s calculations meaningless in real sense.
However, with the induction of the leftist Hugo Chavez in Caracas, things started to change in real sense. Chavez realized the importance of enhancing coordination within the group and promised better cooperation and greater compliance with the output quota. He also realized that Saudi Arabia has a key role to play in stabilizing the crude markets. He therefore endeavored to improve ties and foster closer cooperation with Riyadh at all levels.
And thus when in March 1999, OPEC ministers agreed to cut production again, the group stayed in sync. Prices began to climb and closed the year above $25. Ever since it has been an uphill and bumpy ride altogether.
It was during this period that financialization of the oil markets started to impact, rather significantly, the crude markets. The fastest-growing bet in the oil market today is that the price of crude will double to $200 a barrel by the end of the year. Options to buy oil for $200 on the New York Mercantile Exchange rose 10-fold over the past two months to 5,533 contracts, a record increase for any similar period, a Bloomberg report said. The contracts, the cheapest way to speculate in energy markets, appreciated 36 percent since early December as crude futures reached a record $100.09 on Jan. 3.
While analysts at Merrill Lynch & Co. and UBS AG still insisting the slowing US economy will lead to the biggest drop in prices since 2001, the options show some traders expect oil to rise for a seventh straight year.
“One hundred dollars a barrel is actually 14.9 cents a cup, so we’re still talking about oil being remarkably cheap,” said Matthew Simmons, the chief proponent of the peak oil theory and the chairman of Simmons & Co. International, a Houston-based investment bank. Inventories “are tight as a drum and I don’t see how we get out of this box,” he said in a Bloomberg television interview last week. “Demand clearly isn’t starting to slow down.”
World consumption will rise to 87.8 million barrels a day this year, 2.1 million more than in 2007, or about the same amount that Nigeria supplies, according to the Paris-based IEA. Demand from China alone will increase 5.7 percent to 8 million barrels a day as imports expand to support an economy that’s likely to grow 11 percent, the IEA said. Oil suppliers are straining to increase production. Speculators don’t require prices to rise all the way to $200 to make money from options since they can sell the contracts on to others as their value rises.
And in the meantime, while the markets were undergoing tremendous structural transition, finding oil in the ground was getting harder too. In fact with the structural changes in the crude market, it is now a lot easier to buy oil on paper.
The New York Mercantile Exchange started round-the-clock electronic trading of its main crude benchmark in September 2006 and improved access to previously restricted energy trading markets. Financial institutions created new vehicles for making bets on the price of oil without having to manage futures holdings.
All of this has helped attract a flood of new money that has literally transformed oil trading. The oil markets were once dominated by physical traders — firms that needed to take delivery of the crude oil to run through refineries or trade with partners. Most of the new market entrants have no interest in ever taking delivery of a barrel of oil.
The new money came from hedge funds seeking profits in sharp oil price moves, pension funds seeking diversification and a hedge against inflation, and Wall Street commodity desks helping financial investors make sophisticated bets and risking their own capital.
The number of oil futures bets outstanding on Nymex has thus quintupled since 2001. Because oil has been rising at the same time, the dollars at stake in the main oil futures benchmark, not including options, rose from roughly $7 billion in 2001 to more than $145 billion, calculates Ben Dell, energy analyst at Sanford C. Bernstein & Co.
As this surge of money chased a slowly growing number of barrels, prices sprinted upwards. And there is little to indicate that the conditions created by these financial commodity traders will push prices down anytime soon.
Market norms have changes, have gone more sophisticated, rather complicated. It is no more just the empirical demand-supply equation controlling the market prices. There are factors much beyond the fundamentals, impacting the market. Indeed OPEC has a point too and this needs to be heeded too in the right quarters, before measures to correct the situation are taken — if at all possible.