Petroleum Bubbles

Yesterday Saudi Arabia hosted a forum of major crude producers to discuss production levels and the high price of oil that the American consumer is all too familiar with. The US Secretary of Energy, Sec. Bodman, remarked at the forum that energy prices are being driven by supply and demand – that the high cost of crude can be attributed to increased worldwide consumption and alleviated by increased production. Despite consistent statements by the Saudi oil minister, Ali al-Naimi, the Saudis agreed to increase July’s production levels and continue to increase production as needed.

Crude prices are remaining strong today – many observers are now pointing at attacks in Nigeria that have shut-in more crude than the promised Saudi production increase will deliver. But these attacks don’t explain how we’ve arrived at $135/b oil. Nor can supply and demand – market fundamentals – as Sec. Bodman pointed to yesterday adequately explain the near doubling of crude prices in less than a year. Likewise there have not been significant fundamental changes to the overall security picture that can account for the precipitous rise in crude prices in the last year. While all these factors have certainly contributed to the rising cost of crude, most notably in the increase from $35/b to the $70-75/b range, an additional factor has been driving the cost of oil for at least the last twelve months. That factor is speculation.

It is important to understand how speculation occurs and how it can influence price structures. I think often people are left with the impression that an oil company, say BP, owns oil fields, tankers, refineries and gas stations and is itself responsible for extracting the oil from the ground, moving it onto a tanker, shipping it to a refinery and turning it into gasoline. This leads people to believe that oil companies are fixing prices. Other times people believe that OPEC is responsible for all the oil in the world and can arbitrarily cut supply to increase price – this leads people to blame Saudi Arabia for high crude costs. The market, unfortunately, is much more complicated than either of those scenarios.

Basically, oil can be purchased as a future contract in 1000 barrel units with a particular delivery date, like July 1. These contracts are offered by the owners of the oil when it is extracted, owners like Saudi Aramco or BP or Iraqi National Petroleum Company or Big John’s Mom & Pop Crude. Futures are intended to be bought by refineries so that there is some stability in price between the time it is removed from the ground and the time - weeks later - when it arrives at a refinery to be converted into gasoline. These futures, however, can be purchased and resold by anyone. When a market is tight, as the oil market has been for the last several years, futures being purchased by outside entities that believe they can buy a future today only to sell it for a profit tomorrow artificially inflate demand and drive price up. These futures are subsequently sold to refineries at a price level that does not reflect the commodity’s fundamentals but that yields a profit to the intermediary. Given a sufficient amount of money and number of non-refining entities purchasing and selling futures contracts, this speculation can become the driving force behind price formation.

Welcome to the petroleum bubble. It’ll burst eventually, but it’ll take more than additional Arabian Heavy to pop it.