Not only are the lunatics in charge of the asylum and George W Bush in
the White House, speculators have taken control of the commodities
markets and the fundamentals of supply and demand don’t support the
present oil price.

While crude nudged above a record US$71 a barrel overnight, US oil
inventories are running at eight-year highs. While most of Australia’s
media is concerned about the petrol price causing the sky to fall, OPEC
is worried about a sudden and very sharp fall in oil prices.

Yes, there are some contradictions in the system. The easy temptation
is to just blame the obvious immediate excuse for the present price
spike – tension over the coincidence of radical, unpredictable
governments in Tehran and Washington, plus supply uncertainties in
Nigeria. But the role of booming commodity funds takes the speculation
game further than that.

Basically, speculative investment in commodities on top of the
fundamental increase in demand from solid US growth and the “Chindia”
story has set off a classic bubble whereby prices go up because punters
keep betting on prices going up. That
story is neatly told by last night’s Wall Street Journal:

The answer to the puzzle posed by rising prices and
inventories, industry analysts say, lies not only in supply constraints
such as the war in Iraq and civil unrest in Nigeria and the broad
upswing in demand caused by the industrialisation of China and India.
Increasingly, they say, prices also are being guided by a continuing
rush of investor funds into oil markets.

Institutional money managers are holding between $100 billion and $120
billion in commodities investments, at least double the amount three
years ago and up from $6 billion in 1999, says Barclays Capital, the
securities unit of Barclays PLC.

The initial commodities investment surge was based on fundamentals, but now animal spirits are at play.

“What’s been happening since 2004 is very high prices
without record-low stocks,” says Jan Stuart, global oil economist at
UBS Securities. “The relationship between US inventory levels and
prices has been shredded, has become irrelevant.”

It remains to be seen whether this belief in a paradigm shift that
permanently buoys oil prices will stand the test of time…

…Analysts say that behind the flush US inventories lies a new trend
born of the extended run-up in oil prices. Refiners of crude, who once
sought to hold lean inventories, and traders, many of whom prefer to
flip paper rather than buy and hold actual oil, are now grabbing more
than they used to.

Since early 2005, the crude-oil market is in what traders call
“contango,” meaning futures contracts for a given product are priced
higher than that same good for near-term delivery. The price of oil to
be delivered four months from now is about $3 more than oil to be
delivered next month.

In short, it pays for refiners and other oil-market players to buy and
hold oil now to sell it down the road. Making that trading opportunity
possible, says Colorado-based oil analyst Philip K Verleger, is the
huge volume of new buyers on the other side: investors who he estimates
have put more than $60 billion into US crude-oil futures since 2004.

…The last time US inventories were at today’s levels, in 1998, the
market was about to crash. By the end of 1998, prices fell below $11 a
barrel from an average $18.32 in December 1997.

The strong and growing demand in Asia underwrites oil prices to a large
extent – petrol isn’t going to be cheap again – but the speculative
froth of the last US$20 on a barrel of crude can disappear very
quickly. An outbreak of rationality about and in Iran could do that,
sending the commodities funds all heading for the door at the same time.

That’s what worries OPEC. If the punters suddenly start thinking
OPEC is right in saying supply and demand are actually nicely balanced,
the contango forward premium could turn into a backwardation – and the
game would be expensively over.

Peter Fray

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