Last year saw the most extreme volatility of oil prices we have ever witnessed. There is a consensus now that this extreme volatility was not only due to supply and demand factors in the physical oil market, but exacerbated by speculation in the futures market. Extreme price volatility negatively impacts the economic interests of consumers and producers alike. As speculation on the upside remained untamed, at present shorting oil is exaggerating oil prices on the way down. This results in huge uncertainty about oil prices leading toward underinvestment in oil and even in renewables.
But aren’t current oil prices good news for consumers? Yes, in the short run they are. However, in the medium term there is a very serious risk that we are setting ourselves up for the next supply crunch and another round of price hikes once the world economy recovers. The reason is that the current level of oil prices is already causing the delay and postponement of many investment projects. In the upstream oil sector the largest producer Saudi Arabia is on track of fulfilling their commitment to expand capacity to 12.5 million barrels per day at the end of 2009 which the world has to duly acknowledge. This may result in an unprecedented high level of spare capacity later this year of 4.5 million barrels per day. As comforting as this buffer may seem, current oil prices are severely worsening the business case for “difficult” oil projects in areas where extraction costs are high and slow in coming down (e.g. oil sands in Canada and ultra-deep sea in Brazil, Angola).
Why is low investment a problem with oil demand declining in 2009? Firstly, because we need the majority of investment to compensate for the substantial decline of oil production from existing fields. Secondly, because once the world economy recovers, oil demand will rapidly pick up and will start growing significantly again, in particular driven by economic growth in Asia. As the lack of financing is becoming a justification for part of the lack of investment there is a need to de-link energy investments from the list of troublesome sectors and enable them so as to receive the necessary bank funding. Limiting investment in energy is myopic and could turn out to be detrimental. Realistic energy scenarios demonstrate that the world will need more oil for many decades, with renewables playing a useful complementary role at most.
What can be done about this excessive oil price volatility? It is impossible to eliminate volatility in the oil market. But we can do more to limit volatility through more transparency and better oversight. The Joint Oil Data Initiative (JODI), coordinated by the IEF (International Energy Forum), in which IEA (International Energy Agency) and OPEC (Organization of the Petroleum Exporting Countries) participate along with others, is already instrumental in providing market players with the best available monthly data on oil demand, supply and stocks at a global level.
Although significant improvements have been achieved, more is needed to improve completeness, quality and timeliness of data (e.g. stocks in India and China). In addition, the initiative underway at the IEF to build a database on global oil investment, will help the market to better understand the medium-term balance between supply and demand.
Regarding the paper oil market, we need to address the issue of transparency and the conflict of interest between paper oil traders and analysts working for the same companies.
The proposals of the International Task Force on Commodity Futures Markets should be rapidly implemented to increase transparency in trading in oil derivatives (including over-the-counter transactions) and to improve internationally coordinated regulatory oversight.
As useful as the paper oil market is for hedging existing fuel risks of companies, where it is used solely for massive speculative trading, one may want to consider introducing position limits as is currently under discussion in the US Congress legislation. Of course, the upcoming G-20 meetings are focused on bringing back confidence in the entire global financial system. However, we hope that the need of establishing better regulatory oversight on oil and other commodities trading is tackled at the same time, in the interest of a less volatile oil market which would benefit the world economy.
(John Sfakianakis is chief economist at Saudi British Bank (SABB) and Noé van Hulst is secretary-general of International Energy Forum.)
