As the summer driving season begins many Americans will come face-to-face with one of the Bush administration's crowning achievements — the $4 gallon of gas. Like the subprime mortgage crisis, high gas prices and the related high prices of crude oil have made their way from the business pages to front pages of major newspapers. Yet, earlier this year CBS's Peter Maer asked Bush if he had any advice for the average American facing the prospect of $4/gallon gasoline. Bush, the former unsuccessful oil man, had not heard the prediction. "Oh yeah? That's interesting. I hadn't heard that," Bush said.
The Bush administration has presided over at least a 4-fold increase in the price of oil, from approximately $30/barrel on the day of Bush's inauguration to $134/barrel as of this writing. The man who headed Vice President Cheney's task force, Andrew Lundquist, is now a lobbyist representing several of the firms that that task force interviewed, including BP, Duke Energy, and the American Petroleum Institute. Citing "executive privilege" the administration has refused to release the task force's 170-page report to the press or the public. The Bush family has had an unusually close relationship with the Saudi royal family dating back at least to 1986 when "Poppy" Bush convinced the Saudis to limit oil production. In the current administration former Saudi ambassador Prince Bandar had such privileged access to "Junior" that he was given the nickname "Bandar Bush."
Earlier this month, Secretary of Treasury Paulson opined that "If you look at the facts, they show that the price of oil is about supply and demand." Ironically Paulson was on his way to Saudi Arabia, a key player in the OPEC cartel, which regularly increases or decreases the production of crude oil in attempting to protect its members' interests. At the G-8 summit meeting a week later, Secretary of Energy Sam Bodman, a former chemical industry executive with little energy-policy experience, proclaimed bravely that "there are relatively few things we can do short term," about the state of the oil market.
The steep increase in oil prices appears to have a variety of causes. One cause is, indeed, a steady increase in demand. According to Saudi investment firm Jadwa Investments, between 1997 and and 2002 demand for crude oil increased by 4.1 million barrels/day (mbd). From 2002 to 2007 demand increased by 8.1 mbd, with China responsible for approximately 50 percent of the increase. Over the same period US demand has increased by 1.2 mbd. Some analysts also suggest that the Bush administration's additions to the US strategic petroleum reserve have added as much as 10 percent to the light sweet crude price.
In 2008 and 2009, China, India, and the Middle East are expected to account for an even greater share of world demand for oil, while OECD demand is expected to continue to decline as the economies of developed nations continue to slow. Non-OPEC supply of oil has not met 2008 forecasts; the US, UK, Norway, and Mexico have reduced output. A decade or more of low oil prices has limited investment in new sources of oil. Some analysts have suggested that considerable investment is needed just to maintain current production levels, but even with higher prices, such investment has lagged. OPEC points to refining backlogs and costs, especially for lighter products, as contributing to upward pressure on oil prices. Refinery capacity is being added in Asia, however.
The increasing demand, minimal excess supply, and refining backlog make oil prices particularly sensitive to political events like the war in Iraq, political instability in Nigeria, and politicization of oil policy in Venezuela. Conditions also make oil prices more sensitive to OPEC production policies.
A factor which has recently attracted the attention of Congress, the media, and the public is the role of speculation in the oil market. The traditional role of commodities futures markets has been to help producers of seasonal commodities reduce the risk of changing prices over time. For instance, if a farmer whose crops won't be ready to harvest for another three months is concerned that the price for his harvest will decline during that time, he can sell a futures contract that expires in three months, and fulfill his obligation by delivering his harvest at that time. Regardless of price fluctuations in the interim, he will receive the contracted price for his crop.
On the other side of the futures market, a food processing company that uses the farmer's crop in its products may be concerned that the price will increase over the same three months. They might buy a futures contract at the current price, and fulfill their obligation by taking delivery in three months.
Futures markets exist on this basic model for a range of agricultural products, physical commodities (including metals, petroleum, etc.), and also financial instruments such as currencies, bonds, and market indexes. In the US, futures trading is regulated by the Commodity Futures Trading Commission (CFTC), an agency of the Department of Agriculture.
Speculators are a third category of participant in futures markets, after producers and consumers. The CFTC defines a speculator as someone who "does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes." Instead of taking delivery of a commodity, a speculator will typically "offset" one futures contract with a contract of equal size of the other side of the transaction. (Traditional hedgers may use this strategy, as well.) So for instance, someone who sold five February '09 Live Cattle sell contracts could cancel that obligation by buying five February '09 Live Cattle contracts. The offsetting trade could be made any time up to the last trading day of February '09. It is generally difficult to offset contracts in the months in which they expire, so speculators will try to make their offsetting trades before then. Also, expiration-month prices may move quite differently from prices of other futures months in the same commodity.
Speculators "provide liquidity" (cash) in commodities markets, which benefits traditional hedgers particularly in the market for contracts relatively far into the future where there are relatively few traders (hundreds vs. hundreds of thousands for short-dated contracts). A 1996 EIA study found that so-called noncommercial traders (meaning market participants such as speculators who aren't suppliers or consumers of oil) tended to follow price trends rather than set them, but could contribute to instability in the market by moving large sums of money between markets (for example from the commodities market to the currency or bond markets).
More recently, some speculators have adopted strategies unrelated to short-term supply and demand, while others have made large bets on small price movements to try to cover losses in other markets. As in the mortgage crisis, the effect of the funds movement is amplified by the amount of "leverage," i.e. how much of the invested money has been borrowed.
The price at which commodities trade in the physical market (as contrasted to the futures market) is referred to as the "spot" price. In general futures prices tend to approach the spot price as the futures contract expiration date approaches. The spot price can vary from the futures price at expiration because of additional costs: storage, delivery, and the convenience of immediate access to the commodity. In the physical market, the price of most transactions is set based on contracts between suppliers and users. When in 2005 OPEC abandoned its self-enforced "trading band" price calculation, it became standard practice to reference spot prices for oil to prices in the futures markets. Futures contracts on crude oil from the North Sea, referred to as Brent, are used to price global daily oil production; contracts for West Texas Intermediate crude oil are used as a benchmark for US oil production, and as a basis for trading oil futures in the US.
As of May 2008, futures market prices 1-18 months into the future were in what traders term "backwardation," meaning that the spot rates are higher than futures prices. This would normally indicate that the market expected prices to decline, yet oil futures have been settling higher over time. For instance, in February 2007 oil futures settled at $59/barrel, in January 2008 at $92.93, and in March at $105.42. Oil producers employing traditional hedging revised futures prices upward in anticipation of increased marginal costs (the cost of creating each additional unit of output). This increase was echoed and amplified by speculators, and, because spot prices are now referenced to futures prices, affected the spot price as well.
A June 2006 report by the Permanent Subcommittee on Investigations of the US Senate Committee on Homeland Security and Governmental affairs concluded that:
The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil to be delivered in the future in the same manner that additional demand for the immediate delivery of a physical barrel of oil drives up the price on the spot market. As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand
for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum.
In the traditional commodity hedging scenario, with commodity suppliers and producers having inverse needs, finding partners to take the other side of futures transactions was relatively straightforward. The large influx of money buying futures contracts (betting that prices will increase) has "distorted the historical relationships," George Zivic of Almanac Capital told CNN. Analyst Peter Beutel went further. "We want to see them out, they have no respect for our markets at all," he said. Yet, in Beutel's view, the real culprit is not the speculators or fund managers, but the Federal Reserve, which has been steadily cutting interest rates to help credit markets recover from the subprime mortgage crisis.When interest rates decline, it is common for investors to look to physical commodities as a hedge against inflation. "The Fed tipped their hand," Beutel said. "[The big funds] were basically told by [Fed Chairman Ben] Bernanke that this is where the money is."
The Senate report restated the CFTC's central role in regulating commodity markets:
A key responsibility of the CFTC is to ensure that prices on the futures market reflect the laws of supply and demand rather than manipulative practices or excessive speculation. The Commodity Exchange Act (CEA) states, "Excessive speculation in any commodity under contracts of sale of such commodity for future delivery . . . causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity." The CEA directs the CFTC to establish such trading limits "as the Commission finds are necessary to diminish, eliminate, or prevent such burden."
Yet, the report found that "[a]t the same time that there has been a huge influx of speculative dollars in energy commodities, the CFTC's ability to monitor the nature, extent, and effect of this speculation has been diminishing."
Under the Bush administration CFTC staffing reached the lowest level in its 33-year history. The agency does not have a permanent chair; current head Walter Lukken has been serving as "acting" chair since September 2007. Lukken told the Washington Post "We could hire an extra 100 people and put them to work tomorrow given the inflow of trading volume. We are doing the best we can in difficult circumstances"
The Senate report noted, "there has been an explosion of trading of U.S. energy commodities on exchanges that are not regulated by the CFTC." One key weakness in the CFTC's ability to do its job is that a whole class of commodities trades, called "futures lookalike trades," were exempted from CFTC oversight by the Republican majority 106th Congress, "at the behest of Enron and other large energy traders...." The report notes "The only practical difference between futures look-alike contracts and futures contracts is that the look-alikes are traded in unregulated markets whereas futures are traded on regulated exchanges."
In January 2006 the Bush administration's CFTC allowed the Intercontinental Exchanged (ICE), "the leading operator of electronic energy exchanges," to use its terminals in the US to trade US futures contracts on the ICE Futures exchange in London. Previously the ICE Futures exchange had traded only European energy contracts. Now it would trade West Texas Intermediate futures on an exchange regulated exclusively by the UK Financial Services Authority. In April, ICE allowed US traders to trade gasoline and heating oil futures on the London futures exchange, using terminals in the US. Despite the fact that traders in the US were trading US crude, heating oil, and gasoline futures contracts, the CFTC had "not asserted any jurisdiction over the trading of these contracts."
Persons within the United States seeking to trade key U.S. energy commodities — U.S. crude oil, gasoline, and heating oil futures — now can avoid all U.S. market
oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the NYMEX in New York.
The report noted further that so-called "Large Trader Reports" are essential to the CFTC's ability to "deter price manipulation" and analyze the effect of speculation on prices. ICE Futures are exempt from any CFTC reporting requirements. Moreover, ICE's filings with the US Securities and Exchange Commission (SEC) state that the firm's trading system performs a "price discovery function," This means that, rather than following price trends as the EIA study found in 1996, speculators can now directly affect prices in the cash market for commodities traded on ICE Futures exchange (thereby affecting US energy prices).
At the time the report was written, oil was trading at approximate $70/barrel, of which an estimated $20-$25 was due to "speculative purchases of oil." Analyst F. William Engdahl has suggested that as much as 60 percent of today's price of oil could be due to the effect of speculation. According the EIA's June 2008 figures, OECD commercial inventories were above their 5-year average, and US consumption is expected to shrink by 290,000 barrels/day. As Engdahl says, "The large influx of speculative investment into oil futures has led to a situation where we have both high supplies of crude oil and high crude oil prices."
On May 20, CFTC chief economist Jeffrey Harris told the Senate that the CFTC had found that speculation was not the cause of recent spikes in energy prices. Rather, he said, prices were being driven "by powerful economic fundamental forces and the laws of supply and demand."
A few days later, Marc Cooper of the Consumer Federation of America called the CFTC reaction to rising oil "the regulatory equivalent of the FEMA's response to hurricane Katrina," Cooper suggested Congress "Just fire the commissioners and clean the problem up." "Americans are suffering needlessly due to the [energy price] bubble," he said.
In late May, as oil prices hit record highs, the CFTC apparently reversed its opinion and announced it would ratchet up its oversight of energy futures trading, including:
- An agreement with Britain's commodities regulator, the Financial Services Authority (FSA), to gather information on large positions of the benchmark West Texas Intermediate (WTI) contract.
- A proposal to eliminate commodity trading limit exemptions from investment banks such as Goldman Sachs (GS) and Morgan Stanley (MS).
- An investigation of the crude oil trading market dating to December, 2007. The Wall Street Journal also reported that the CFTC was expanding an investigation into alleged short-term manipulation of crude oil prices through the Platts price-reporting system. (The CFTC would not confirm the probe's existence, Platts declined comment.)
Then on June 17, 2008 ICE Futures announced that it would impose permanent position and accountability limits for some of its US-traded crude oil contracts. The CFTC also announced that it would require "Large Trader Reports" and similar account limits from other foreign exchanges. Critics described the actions as too little, too late. "There's smoke here, and the CFTC hasn't wanted to look if there's a fire," University of Maryland professor and former CFTC commissioner Michael Greenberger told the Post.
A fourth factor affecting the price of oil is the value of the dollar relative to other currencies. The French bank BNP Paribas has calculated that a 1 percent depreciation of the dollar leads to a greater than 1 percent increase in oil prices in the long term and a 0.89 percent increase in oil prices in the short term. Roubini Global Economics describes the effect of the dollar on oil prices as follows:
- As the dollar weakens, oil becomes cheaper in non-USD currencies, raising the purchasing power of non-US consumers who in turn demand more oil.
- Oil exporters who price their oil in USD hike prices to offset the fall in revenue and purchasing power against non-US trading partners from currency valuation changes.
- Investors buy oil futures to hedge against imported inflation.
- Dollar pegging oil exporters import the US's loose monetary policy, encouraging economic growth and thus local demand for oil, particularly if these same countries subsidize the purchase of gasoline and other oil products. (Loose monetary policy refers to a central bank setting low short term interest rates, which makes borrowing money relatively inexpensive.)
As Clara Jeffery pointed out on MotherJones.com, on the day of Bush's inauguration, a barrel of oil cost approximately $30, and 32 Euros. Today that barrel costs approximately $134, or a little over 86 Euros. In percentage terms, that's a 346 percent increase of the price in dollars, but only a 168 percent increase in Euros. The difference is attributable to the decline in the value of the dollar vs. the Euro during Bush's time in office. While acknowledging the view of James K. Galbraith and others that federal deficits in themselves aren't necessarily bad, Jeffery argued that a large portion of the dollar's depreciation can be ascribed to the Bush Republican deficits, especially the tax cuts for the wealthy, and the war in Iraq. A quick check of historical oil prices in dollars and Euros reveals that the gap between prices in the two currencies accelerated after the US invasion of Iraq in 2003.
Energy companies benefit from a depreciating dollar, as the values of their domestic inventories increase in proportion to the dollar's fall. At the beginning of Bush's first term, Exxon-Mobil stock traded at less than $36 per share. Today Exxon-Mobil is trading at $85 per share, or an increase of 136 percent. During most of the period from 2001-2008, Exxon-Mobil stock appreciated at the same rate as the price of oil. By contrast, the S&P 500 index is nearly unchanged (or even somewhat lower) from 2001.
HuffingtonPost.com's Learsy summed it up in his headline this way:
"$4-a-gallon gas? Predictions surprise Bush" Seattle Times 29 Feb. 2008
Learsy, Raymond J. "Cheney Greets King Abdullah In SaudiLand With High Fives As Oil Sails Past $100 Per Barrel" HuffingtonPost.com 27 Mar. 2008
Learsy, Raymond J. "Hallelujah! Saudi King Abdullah a No-Show at White House State Dinner" HuffingtonPost.com 3 Apr. 2007
"Profile: Secretary of Energy Samuel Bodman" ABC News. 8 Feb. 2005
Learsy, Raymond J. "Our Treasury Secretary Pumps For OPEC"
Verleger, Philip K. Jr. Testimony The Permanent Subcommittee on Investigation of the U.S. Senate Committee on Homeland Security and Governmental Affairs. 11 Dec. 2007
Pineda, Mikka and Rachel Ziemba "Explaining the Oil Price Boom" RGE Monitor. May 2008
Dale, Charles and John Zyren "Noncommercial Trading in the Energy Futures Market" Petroleum Marketing Monthly. Energy Information Administration. May 1996
The Role of Market Speculation in Rising Oil and Gas Prices Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs. US Senate. 7 Jun. 2006
Engdahl, F. William "Perhaps 60% Of Today's Oil Price Is Pure Speculation" FinancialSense.com. 2 May 2008
"CFTC:ICE Futures Europe Agrees To Oil Contract Position Limits" DowJones. 17 Jun. 2008
Cho, David "Investors' Growing Appetite for Oil Evades Market Limits" Washington Post 6 Jun. 2008
Hargreaves, Steve. "Oil prices: Wall Street's game" CNNMoney.com. 16 May 2008
Jeffery, Clara "Why Are We Paying $89 A Barrel for Oil? (Answer: It's Not What You Think)" MotherJones.com. 17 Oct. 2007
Lilly, Scott Bush's Weak Dollar Center for American Progress. May 2008.
Leising, Matthew "Soros Says Record Oil Prices Result of 'Bubble'" Bloomberg.com. 3 Jun. 2008
Herbs, Moira "Oil Traders Face New Regulation" Business Week 9 Jun. 2008
Note: The main components of the price of gasoline are crude oil, refining costs and profits, distribution costs, retail markup, and taxes. Traditionally the price of crude oil has represented approximately 55 percent of the price of gasoline, although a 2007 study by industry analyst Tim Hamilton for the Foundation for Taxpayer and Consumer Rights found that, at least in California, gas prices increased even when the price of crude oil declined. This year, however, oil prices have risen faster than gasoline prices.
See also Paul Krugman's comment that focusing on speculation is a way of avoiding adapting to the need to reduce oil consumption.