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Economics: Scapegoats
New York: June 09, 2008
By John R. Stephenson

High gasoline prices are like a punch in the gut! You are left staggered, wondering how come gasoline prices have been able to climb, so far, so fast. Surely, someone must be to blame! With the economy in the dumper and consumers hurting, politicians have been quick to find blame. Stuck for an explanation, politicians have found a possible scapegoat for high gasoline prices — greedy speculators who have been profiting from other people's hardship.


Members of the Organization of the Petroleum Exporting Countries ("OPEC") routinely blame speculators for high prices. According to Joe Lieberman, chairman of the Senate's Homeland Security Committee, "speculators are responsible for a big part of the commodity price increases." Big oil execs and the companies they represent are another easy target for lawmakers. The U.S. Congress is even contemplating a bill to allow American prosecutors to sue OPEC governments for oil market manipulation.

Politicians have also aimed their guns at "commodity index funds" that make money for their investors when oil prices rise. To bolster their case, they point out that commodity index funds have swelled from $13 billion in 2003 to over $260 billion today — a twenty-fold increase! From 2004 to today, oil prices have nearly tripled. Over the same period of time, the number of oil futures transactions on the NYMEX has also tripled, signaling to some that speculators are behind the run-up. They argue that all this "hot" money has supercharged the price of oil. But is this right?

Hardly. For starters, true speculators aim to profit from both rising and falling oil prices — hardly a one-way street. Not only that, but the so-called speculation is in the futures market (a paper market for the delivery of "future" oil) where no physical oil actually changes hands. When futures contracts mature, they are either settled with cash or the contract is sold to genuine consumers. Index funds are in a similar boat — they are active participants in the futures market. These funds buy contracts for delivery over the next month or so and then sell the short-term contracts to buy longer-dated contracts. All this buying and selling puts both upward, as well as downward pressure, on the oil futures market.

The most compelling argument against the role of index funds as manipulators of oil prices is their size. At some $260 billion in assets, index funds are less than half the market capitalization of ExxonMobil and a tiny fraction of the $50 trillion-odd annual transactions in the oil market.

The nickel market makes another case in point. In spite of strong investment flows into nickel, the price has fallen by over 50 percent over the past year. This suggests that there is no strong correlation between speculative activity and soaring commodity prices.

Also, true speculators tend to hoard physical supply in anticipation of higher future prices. So far, worldwide inventories are at their lowest level in twenty years, suggesting that no physical hoarding whatsoever is taking place.

At the end of the day, there really is only one buyer for crude oil — refineries. Should speculators push prices skyward, refineries will simply shut down rather than operate indefinitely at a loss. If this were the case, then prices for crude oil would fall rather than rally.

The likely reason for higher oil prices (and gasoline prices) has everything to with struggling supply and soaring demand, rather than greedy speculators. For the past several years, the world's oil production has grown only sluggishly. Meanwhile, demand, particularly from the developing world, has grown sharply, reducing any available slack in the system. This leaves the oil market at the mercy of even small disruptions in supply. Bad weather in the Gulf of Mexico or militants attacking a pipeline in Nigeria are enough to spark a sustained rally in the oil markets.

But not all crude oil is created equally. The price of oil that is quoted on NYMEX is for light (low viscosity), sweet (low sulphur) crude oil that can easily be refined into gasoline and diesel fuel for transportation. Heavy grades of crude oil by contrast, are most often refined into fuel oil, which is used mainly for heating. At the moment, diesel fuel is in short supply, while there is a glut of fuel oil on the market. Refining heavy crude oil into fuel oil is an expensive proposition, which many refiners simply won't undertake.

Iran is awash in heavy crude oil, which it has been unable to market. It is storing the heavy crude oil offshore in tankers moored at sea, in the hope that the market for heavy crude oil will improve.

A surge of nationalism in resource-rich countries such as Russia is making it increasingly difficult for multi-national oil companies to bring on additional supply. Not only that, but the most promising areas for oil exploration are also the most technologically challenging, areas such as: in deep water, the Arctic, or Canada's oil sands. But even if a major new discovery is made, it will take at least ten years or more to bring a major oilfield on after its discovery.

Making matters worse is the fact that half the world's population enjoys fuel subsidies. In Venezuela, a large oil exporting nation, the citizens enjoy gasoline prices of 5 cents a litre. Naturally, cheap domestic prices have caused citizens of these countries to guzzle, rather than conserve energy, putting increasing upward pressure on the world price for crude oil.

Figure 1: In a World of High Gasoline Prices, Not Everyone Pays!

Source: Morgan Stanley, The Economist

The high cost of subsidizing fuel prices has already caused many governments to consider lifting the domestic price of gasoline. Indonesia, Taiwan and Sri Lanka have all taken steps to raise the price of gasoline, while still keeping it far below the world market price. China, the second largest consumer of oil in the world, is unlikely to cut the gasoline subsidies of its citizens. Unlike many of the other Asian countries subsidizing fuel prices, China has a budget surplus and little public debt. The massive size of its economy means that it can afford to continue with its subsidies, the cost of which is estimated at less than 1% of gross domestic product (GDP).

Eventually, the world will adapt to higher oil and gasoline prices. It takes time for oil companies to bring on incremental production and for consumers to move out of the suburbs or to replace their gas-guzzling car. Already, there are some indications that high prices are curbing consumption in the West.

Eventually, the market for supply and demand will reach an equilibrium point. In the meantime, savvy investors looking to profit should consider an investment in oil producing companies. Their stocks are cheap on a relative basis and the demand for crude oil shows no sign of abating — regardless of what the politicians have to say.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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