‘Crude mania’ creates oil price bubbles
A veteran dealer explains why oil markets are prone to price bubbles
A typical headline asked: is oil headed for $200? Crude “mania” sends oil beyond US$125, said another. What was happening when prices leaped? Did anyone know? Did anyone care?
No one knows where oil is headed. Nor can anyone predict where oil prices will go even though they claim to know and sound like they do. Don’t believe them. There was no rational reason it hit those lofty prices. Crude mania is what it was.
The NDP’s Peggy Nash wanted to summon oil executives to Ottawa to answer questions about oil prices. This might have embarrassed the executives (because of their atrocious salaries) and won her some support from those who don’t know any better but it wouldn’t have changed anything. The fact is that no one in Canada or the United States – oil companies, politicians, banks or financial experts – has the power to do anything about oil prices.
Executives of the major oil companies, answering to the U.S. Senate, say that the “market” sets the price. This answer is particularly evasive. What is the market? Is the market some uncontrolled, green swarm of greenbacks floating around looking for a price to land? Saying the market controls the price absolves them from the responsibility for controlling or setting the price.
There is a famous and apt quotation from author Upton Sinclair: “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”
Why did the price of crude oil hit $135, and briefly go higher? Why are prices half that now? Let’s take a look at how prices are really determined and what can be done about it.
Is the price based on cost of production? Some stakeholders, in order to justify their “take” from the high price, will tell you that new production is costly to extract and replace with new reserves. Oil sands production is high-cost. Yes, it is a lot more costly than some conventional production but that is not the answer to why crude oil prices went so high.
So what is the market? Webster has several definitions but the one that best describes the crude oil marketing business is: “the area of economic activity in which buyers and sellers come together and the forces of supply and demand affect prices.”
Sounds pretty logical and simple, doesn’t it? You assume that a seller actually possesses oil and wants to sell it. You also assume that the buyer actually has a need for the oil and wants to buy it. That is not necessarily so. In fact, there are more barrels of crude oil sold every minute of the day by people and companies who have no direct involvement in the crude oil producing business. What do you think Enron’s main business was? They built and lost an empire which traded in crude oil and other energy products. They also attempted to control the market. They made it appear that either the supply of crude oil was increasing or decreasing or that the demand was increasing or decreasing. They did this through various manipulative means to cause the apparent supply-demand ratios to change and hence the price of crude oil. And you better believe someone kept on trying to do that. There is now a move to close a gap in U.S. market regulation that has become known as the Enron Loophole, which is an exemption created at the request of the firm it is named after.
It seems like everyone is convinced that it is supply and demand that is setting the price. That is shading the truth. The fact is that it is not about the traders forecasting what prices will do when there is a threat of a hurricane or a threat of a political uprising in an oil-producing country. It is, in fact, the anticipation of how other traders will react to such news.
The price of crude used to be based on fundamentals. When demand increased and the Organization of Petroleum Exporting Countries withheld supply from the market, the price went up and lineups for gasoline lengthened. Now, the remote anticipation of a supply or demand change affects the price immediately – not when it actually happens.
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