OIL PRICES CRUDE AWAKENINGS by osi33942

VIEWS: 7 PAGES: 1

									                                    The Big Issue



                                OIL PRICES: CRUDE AWAKENINGS
                                The fluctuating price of oil is a global hot topic. Professor Paul Stevens, a senior
                                research fellow for Chatham House, explains some of the influences on price.


                                S
                                        ince January, crude oil prices have risen to record highs.         The paper market then fails to reflect real physical supply and
                                        Although they have come down in the past month, calls              demand. This arises partly because money managers, although
                                        continue for governments to do something about it.                 smart people, do not always understand oil markets. For example,
                                However, this requires understanding the cause, in a world of much         when asked why they are pushing up oil prices, they may reply
                                misunderstanding. The accused include excessive demand from                “because there is a shortage” – and when asked why they think there
                                developing countries, refinery shortages and speculators.                  is a shortage, they may reply “because the price is rising”.
                                    Crude oil markets can be divided into two segments – one for               However, each time such a disconnect has been realised, the
                                physical barrels, where producers sell and refiners buy physical oil,      price has adjusted accordingly. At the end of 2006, prices fell
                                and the futures market, where paper promises are made to                   quickly, and by almost $30 a barrel, when markets realised that oil
                                exchange oil in the future.                                                was not in short supply. Subsequently, prices rose to new record
                                    Players in this second market are often divided into two               heights in the wake of an OPEC cut in physical production.
                                sections – ‘commercial’ and ‘financial’ investors. The latter are              Since the start of 2007, another disconnect has emerged. Money
                                often referred to as ‘speculators’, although I believe the reality is      managers have poured into the futures market, not only because of
                                more complex: when people talk about ‘speculators’, they think of          unattractive alternatives, but also due to the powerful perception
                                investors who move in and out of the market on a short-term basis,         that there is a current, and immediate, physical shortage of oil. This
                                thriving on price volatility. In essence, they are accused of pushing      behaviour can be self-perpetuating. If investors believe the price
                                prices up and down, without any basis in the real, physical                will rise, they will invest, and so the price rises. Once on this
                                demand and supply for the underlying commodity. While they                 treadmill, it is difficult to get off without major losses, and so many
                                may exist, in reality, a growing role has been played by portfolio         will try to talk up prices further to cover their exposure.
                                managers and hedge funds, or ‘money managers’, who look for                    However, OPEC has increased production again, and the
                                long-term investments. This group sees commodities in general as           physical market is currently quite comfortably supplied. There are
                                an asset class.                                                            no immediate queues out there for crude oil, and inventories are at
                                    In part, recent growth in this investment has been triggered           normal levels. Since the start of July, the futures market has again
                                because there are limited alternatives – government bonds are              realised this disconnection, and there has been a sharp adjustment
                                unattractive and equity markets in freefall. It is, therefore, driven by   down in prices.
                                the long-term expectations of investors as to the future price of the          However, if talk of an impending ‘oil supply crunch’ captures the
                                underlying commodity. Whether this constitutes ‘speculation’ is            imagination of money managers, or if geopolitics rears its ugly
                                merely a semantic argument.                                                head again, then prices may rise once more. Financial investors,
                                    Links between the two markets are complex – in this, they are          thus, can accelerate or decelerate existing price movements, based
                                no different from any other financial market. Perceptions about            on their expectations of what is going on in the physical market –
                                surpluses or shortages of physical barrels inform behaviour, which,        and these may be correct or incorrect.
                                in turn, can influence the futures price. The paper market does not              Ultimately, the market punishes those who base financial
                                set the price for crude oil per se, but it can provide signals and                                            investment on incorrect
                                indicate a starting point for                                                                                      assessments of the underlying
                                discussion.                                                                                                         physical market. There is,
                                    In general terms,                                                                                               therefore, no reason to limit
                                perceptions about the real                                                                                           the many advantages a
                                supply and demand for the                                                                                             functioning futures market
                                underlying physical                                                                                                    brings to commercial
                                commodity come first, and                                                                                               participants – for example,
Illustration: David Lyttleton




                                investors jump on the                                                                                                    the possibility to hedge
                                bandwagon. However,                                                                                                       and to ensure future
                                also like any other                                                                                                      deliveries at prices known
                                financial market, the                                                                                                    today – by restricting the
                                futures market has, on a                                                                                                   access to financial
                                number of occasions,                                                                                                         investments in
                                misread signals.                                                                                                                crude oil. I




                                06 Issue 3 2008 BP MAGAZINE

								
To top