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Peak Oil, Speculators, Rising Demand Can’t Explain the Oil Price Bubble in July

Oil & Gas Pipelines in the Caucuses

In the winter of 2007, a cadre of foreign policy heavyweights gathered in the basement of the Ritz-Carlton in Washington D.C. to act out a hypothetical oil crisis created by a closure of the critical Baku-Tbilisi-Ceyhan oil pipeline, which links Europe and the oil-rich region of the Caspian Sea. The group, which included the retired Gen. John Abizaid, former Treasury Secretary Robert Rubin and State Department adviser Philip Zelikow among others, predicted that the closure would make oil prices nearly double overnight.

In the second week of August, the hypothetical actually happened when an alleged terrorist attack on the pipeline forced it to close for more than two weeks.

The result: oil prices fell.

And they kept falling when Russian tanks rolled into Georgia, threatening to assert control over a critical European oil and gas transport corridor. And they kept falling when Hurricane Gustav crashed into the Gulf Coast’s vital energy infrastructure.

“The Russian invasion of Georgia and Hurricane Gustav in the Gulf of Mexico should have pushed oil prices up,” said Fadel Gheit, a Managing Director and Senior Oil Analyst at Oppenheimer & Co. “Instead, prices fell. In fact, the day Russia invaded Georgia, oil prices fell five dollars even though they should have gone up five dollars.” After the first Arab oil crisis in 1973 sent the global economy into a decade long tail spin, the looming risk of supply disruptions has influenced the price of crude oil more than any other single factor. At least until recently.

In a little over a year, the price of crude oil nearly tripled, rising from roughly $50 a barrel in early 2007 to $147 in July. Unlike previous oil shocks, there was no Iranian Revolution or Arab-Israeli war to explain the precipitous rise. On the contrary, tensions in the Middle East seemed to be easing for the first time in years. The confrontation between the U.S. and Iran over nuclear weapons had finally ended after an intelligence report said Iran had ended its secret nuclear program in 2003. The surge in Iraq had reduced violence in Iraq. Still, oil prices soared and reached new record highs for several weeks on end. And then the surge suddenly stopped, sending oil prices into a slow decline that has yet to end.

“It was a perfect storm,” said Gheit. “The Federal Reserve was cutting interest rates. People were running away from the dollar as it lost value. Commodities were the safest place to store your money and oil is the safest of them all.”

In other words, oil futures markets have morphed into financial instruments first and foremost. The numbers bear this out. Nearly two billion barrels of crude oil were traded in early June, more than 22 times the size of the physical oil market. The two largest oil price spikes in 2008 followed Wall Street forecasts that oil prices would rise rather than reports about the state of supply or demand. While many attributed the rise to the roaring Asian demand, the Asian tiger hardly sprung into existence in a few short months. India and China began to grow rapidly more than a decade ago.

Hedge funds, pension funds, mutual funds and other institutional investors have sunk huge chunks of change into commodities markets in the last year because they seemed to be the only safe investment likely to appreciate. While the spike in oil prices may have been the most visible, prices across the entire commodities market exploded.

The emerging dynamics of oil price volatility were once reserved for rarified areas of high finance. For example, the value of the dollar has consistently pushed oil prices in the opposite direction. In other words, when the U.S. dollar starts to look unsafe, oil is the next best thing.

“Commodities prices have increased more in the aggregate over the last five years than at any other time in U.S. history,” said Michael Masters. “We have seen commodity price spikes occur in the past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today, unlike previous episodes, supply is ample: there are no lines at the gas pump and there is plenty of food on the shelves.”

That’s not to say oil prices should have remained low. On the contrary, prices seemed destined to rise - albeit far less precipitously. Declining production levels in the North Sea and higher than expected costs of finding and developing new fields. Still, these factors alone cannot explain the extreme rise in prices and market volatility. Neither can speculators.

Although they have become the hobgoblin-du-jour of America’s energy crisis, speculators are more of a symptom than the cause. Unlike most financial markets, the oil futures market is not a free market. “The oil markets are not free,” said Gheit. “They have always been rigged and continue to be rigged now. I have been in the industry for a long time and I’m absolutely convinced that I’m not smoking anything.”

In Gheit’s view, the real culprit for high oil prices are foreign governments and energy cartels hording the lion’s share of the world’s remaining oil and gas reserves. Speculators merely exacerbate the problem. If the market were free, Russia wouldn’t be kicking out foreign oil companies. Venezuela would not have nationalized its oil fields and OPEC would not exist.

The world has plenty of oil and gas to fuel humanity for decades, but a small number of governments control access to those resources. And those same governments need oil prices to stay high far more than the rest of world needs oil. Low oil and gas prices would bring Russia to its knees. Ditto Venezuela and the other members of OPEC.

“Hugo Chavez is not stupid,” said Gheit. “He knows prices will stay high the more he limits access to his country’s oil.”

In free markets, supply rises to meet demand. While many doubt that the world has enough oil and gas to satisfy the planet’s future energy needs, nearly everyone agrees that there is enough to keep supplies high and costs low in the near term future. The present predicament is first and foremost a political predicament. The free world has exhausted most of its cheap oil and gas and those who control the rest have every incentive to nurse them for every penny they’re worth. The trouble is that those who control the resources decide what they’re worth, which is why they might ultimately decide to use the oil futures market seems to do exactly that.

Sovereign wealth funds can simply pump a share of oil revenues into oil futures markets if they want to keep prices high. While institutional investors may have figured out to cash in on those prices, Joe 6-Pack hasn’t.

“No matter how many people are making money by speculating on oil prices,” said Gheit, “At the end of the day, someone has to foot the bill. Money does not come out of thin air. Someone has to pay. And it will ultimately be the tens of millions of people that are paying much more for gas now than they did a year ago.”

It is only a matter of time before those people start asking for answers. And if matters get too out of control, those answers could be so draconian that legitimately free markets suffer and not just fictious ones.
The trouble is that oil is not a financial instrument. The vast majority of people who live in developed countries depend on it in countless ways. To make matters worse, they have only a limited ability to reduce their consumption.

Oil futures were created so those who relied heavily on oil could offset the risks of supply disruptions by agreeing to pay a certain price in advance. In other words, by agreeing to pay a certain price at a future date,