By Dr. Hans Black
Interinvest Review & Outlook
Since hitting a low of $33 per barrel last December, crude oil prices have doubled recently to almost $70 per barrel amid growing speculation of a recovery in the global economy. The rise in oil is prompting several market participants to bet on further price increases in the months ahead.
While the global economy may indeed have seen its worst days, the recent run-up in oil prices appears to have little fundamental underpinning. There is scant evidence that demand for oil products is actually increasing. U.S. refinery capacity utilization is running at less than 85%, well below the long-term average. Motor fuel demand has been waning in recent weeks after spiking in late May due to what were probably seasonal factors. On the supply side of the equation, stockpiles of crude oil have been relentlessly expanding. According to the U.S. Department of Energy, crude inventories have increased to 347 million barrels from 283 million barrels at the beginning of the year. With the summer driving season about to wind down, the focus of market participants will soon shift to heating fuel supplies. Distillate supplies are currently running at 163 million barrels, substantially above where they were at the start of each of the last two heating seasons.
Once again, speculation appears to be at work in the oil markets just as it was in the run-up to $145 per barrel last year. This time, however, the move in crude prices is catching the attention of regulators. The new chairman of the Commodities and Futures Trading Commission (C.F.T.C), Gary Gensler, is seriously considering placing trading limits on energy speculators. Last week, the C.F.T.C. began a series of hearings on the subject, and based on the tone of the testimony, regulation appears inevitable.
Back in June 2008 we warned that extreme volatility in the commodity markets would begin to mobilize lawmakers into reining in excessive speculation. We argued that institutional flows were overwhelming the commodity markets, thus distorting prices. Moreover, the exemption from position limits granted to swap dealers was facilitating growing streams of capital into commodity-based investment and trading strategies, hence helping to feed the frenzy in prices. After looking into these issues last year, the C.F.T.C. concluded that oil and other commodity price swings were the result of supply and demand factors. However, the agency is now taking a fresh look at the data upon which it based its conclusions, calling last year's examination "deeply flawed."
To be sure, the about face by the C.F.T.C. is partially motivated by the change in politics in Washington. Also, there is a certain amount of scapegoating taking place with speculators serving as a convenient target. Even so, there is growing evidence that the oil market is broken.
Prices have become hostage to capital flows and the unrelenting willingness of investors to gain exposure to oil as an asset class. Given that rising oil prices are a tax on consumers and businesses, crude has historically moved inversely with stock prices. This year, however, the price of oil has moved in almost perfect lockstep with the stock market. Expectations of rising demand stemming from tentative signs of a global economic recovery are commonly held out as the main reason for oil's increasingly positive correlation to stock prices. However, if this were the case, should not natural gas, another commonly used fuel, also be rising? Instead, the price of natural gas has been languishing near its cycle low of $3.50 per million British thermal units for the past several weeks. The divergent price performance of oil and natural gas, two fuels that are both amply supplied in the marketplace, speaks volumes about the extent to which money flows may be pushing the price of the former higher.
Not surprisingly, the trading community is pushing back against the idea of greater regulation. It regularly warns that true price discovery will be compromised by the burden of excessive regulation and that the markets remain deep enough to accommodate rising investors flows. The facts do not seem to support these arguments. Although oil is the world's most important commodity, the reality is that the oil futures market is relatively small. For example, there are currently 1.14 million contracts of open interest in oil on the New York Mercantile Exchange. At the current price of crude, each contract is worth approximately $65,000, giving the entire market a notional value of nearly $75 billion. Multinational oil companies have market capitalizations that comfortably exceed this amount including the world's largest oil company, Exxon Mobil, which is worth $350 billion or nearly five times as much. So much for deep markets!
In many ways the effort to curb speculation is just a sideshow for the even more incendiary issue of market manipulation. Thin markets, unfortunately, become fertile ground for foul play. Attempts to corner markets have already occurred with other commodities such as copper.
The regulatory crackdown by the C.F.T.C. will represent an important step towards rendering oil and other commodity markets more transparent. The agency will be releasing data later this month, which is expected to show that current rules are inadequate in preventing traders and institutions from amassing concentrated positions in the market. Such revelations may cause investors to rethink whether oil and other commodities have risen to unjustifiably high levels this year. Investors have used the rise in oil and base metals as a signal that the global economy is entering a reflationary phase. A reassertion of the fundamentals that pares back commodity price gains could reintroduce the specter of deflation, an outcome that is more consistent with the numerous headwinds currently facing the global economy.
Editor's Note: Dr. Hans Black is editor of Interinvest Review & Outlook, P.O. Box 51462, Boston, MA 02205. Monthly, 1 year, $125. www.interinvest.com.
