Some controversy remains as to whether speculation or fundamentals were behind the spectacular rise in the oil price in 2008, or for that matter the rise in the oil price during the last 6 months. The dissention can partially be traced to academics like myself, who have been careless in our explanations of this issue. For instance, even in my textbooks (2000,2007) I failed to note that the speculators in question are not like the ladies and gentlemen in the neighbourhood betting shops in Sydney (Australia), nor the young lads who used the alley behind my home in Chicago as the site for an occasional game of dice.
Instead, a majority of the professionals speculating on oil resemble those in front of the screens in the film Wall Street, and they have comparable educations. Most of them really and truly understand the dynamics of oil markets, and if they don't they are encouraged by their superiors - at e.g. investment banks and other financial institutions - to find another line of work. They also do not call themselves speculators! The few whom I encountered in Singapore and Sydney called themselves traders. In my textbooks I referred to their activities as proprietary trading.
In my course on oil and gas economics at the Asian Institute of Technology (Bangkok), I discussed two oil price escalations. One 'about' 1981, when the Shah said goodbye to Iran; while the next was in l990-91, during the run-up to the Gulf War. Last year I concentrated my attention on the approach of the oil price to $147/b. This breathtaking escalation began in 2008, somewhat earlier than when I gave a long lecture on the oil price at the Ecole Normale Superieure (Paris), just prior to which I read several articles by a journalist in Le Monde, Jean-Michel Bezat, who had some very bad news to present his readers about the intentions of King Abdullah where the supply of oil was concerned. Among other things, His Majesty said that when there were new discoveries, they should be left in the ground for the children (les enfants) of the Kingdom.
Let's look at these upward oil price movements. The first mentioned above raised the price several hundred percent before it swung back, and if you examine a plot of oil prices it is quite obvious that it was a 'spike': it jumped up and fell back in a very short time. The second was also a spike of about one-hundred percent.
The third price rise was not a spike. It was a sustained price rise that continued for several months. What about the behaviour of speculators on these occasions? In the two spikes some of them made a lot of money, but the smart ones did not try to prolong their windfalls. This is because they knew that there was a great deal of easily obtainable oil in the crust of the earth, and in addition oil producers possessed considerable spare capacity. It has also been claimed - though not by reliable sources - that there was considerable 'cheating' by OPEC producers. The price had to fall.
Things were different in 2008. There was still a large amount of oil in easily exploitable deposits, but its owners had no intention of producing it given prices and price expectations - nor would you if you had been in their place. In fact, as I argued in my Bangkok lectures, they might not have increased their output at any price. On that occasion there about two million barrels per day (= 2mb/d) of spare capacity, with most of this in Saudi Arabia. In these circumstances speculators, anti-speculators, neighbourhood betting syndicates, moonwalkers, day-trippers or anybody with an urge to make some quick cash went long in oil (by which I meant that they tended to purchase oil futures, which are also important for pricing physical oil). This was the period when the billionaire investor T. Boone Pickens predicted that oil was on its way to $200/b, and he might have been correct if the macroeconomic-financial market meltdown had not commenced. It was also clear at a fairly early stage that this (outrageously) high oil price could bring about a macroeconomic disaster.
Here we have the reason why President Bush visited Saudi Arabia in May (2008), and requested some assistance from King Abdullah. The well known outcome of that episode was that his host graciously thanked him for his concern and wished him a safe flight back to Washington.
That brings us to the bottom line in the fundamentals versus speculation dispute: logically, if X depends on Y, and Y depends on Z, then X also depends on Z. To the extent that the oil price is influenced by speculators, and speculators obtain their clues from fundamentals (e.g. demand, reserves, OPEC policies), then what weight speculators exert on the price is mostly due to fundamentals. Mostly? Well, that is a figure of speech, since there are undoubtedly a few speculators who play 'hunches' instead of fundamentals, but they tend to have a minimum of 'juice' in this very complicated market, even if occasionally a few of them are lucky.
In his testimony before a congressional committee, Michael Masters took what was virtually a sacred oath that speculators were responsible for the big oil price upswing in 2008. He was probably right, though his logic was very different from that in the above discussion, where the point is that the price rise originated with fundamentals in which demand threatened to outrun supply, and to which speculators reacted. Mr Masters seemed to be in favour of banning or limiting speculation, which would be something like banning the musical background in a Fred Astaire or Gene Kelly film.
OPEC weighed in on the discussion by claiming that speculation was behind the price rises, although to my way of thinking OPEC's supply policy is perhaps the cornerstone of today's oil market fundamentals. Even if Mr Masters and his distinguished interrogators did not understand this rather unique situation, intelligent speculators did.
It also needs to be stressed that the decision makers at OPEC know - as I also know - that without speculation market liquidity could plummet, which in turn could - could, not would - lead to a situation of the kind shown in a French TV film last year, in which mules (or horses) were seen pulling luxury automobiles. I am not suggesting that OPEC movers and shakers are thrilled at this prospect, but if the oil price exceeded $300/b - i.e. the price that oil reached in that French film - those gentlemen would probably find the change in Paris street scenes more than tolerable during the lovely vacations that they might be inclined to take in that magnificent city. And finally, it should be noted that a partial or full reduction in speculation would have drastic consequences for the hedging of (oil) price risk - a hedging by consumers and producers of physical oil. If Mr Masters had been aware of this, and what it would mean for future investment and production in the oil sector, he might have tried to be less dramatic in his condemnation of speculation.
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Bezat, Jean-Michel (2008). Petrole: le pouvoir a changé de camp. Le Monde (20, Mai).