Here’s the first installment of our summary of Mr. Verleger’s important testimony to the CFTC Wednesday. The testimony is really a small and invaluable pamphlet of 41 pages of detailed, sharp and factual analysis and review of the run-up, run-down and re-run-up [if I can use this term] of energy prices and the underlying fundamentals of those markets and is very much in line with my past posts on the matter – although in much more detail and much better articulated.
Mr. Verleger concludes that the increase in crude prices last year was caused by
the incompatibility of environmental regulations with the then-current global crude supply.
…and not by speculation. He also points to a recent report (June 2009) by the International Energy Agency that reaches the same conclusion.
On the flip side, the collapse in oil prices in the 2nd half of 2008 can be tied to 5 underlying reasons:
(a) the decline in demand that accompanied the spreading recession, (b) the increased availability of ultra-low-sulfur diesel fuel, the proximate cause of the price increase, (c) the decision by Congress to stop the Bush administration from filling the Strategic Petroleum Reserve (SPR), (d) the strengthening of the dollar, and (e) the possible liquidation of futures positions.
This years price increase (Jan.-Jul. ‘09) has occurred because firms in
the energy business—including oil companies, trading firms, and banks have earned risk-free returns by acquiring inventories, selling futures, and storing the oil. This near-record accumulation of stocks should have been welcomed by anyone who cares about energy security and decreasing volatility.
Another major point touches on the global nature of the energy market:
We will see several large price increases in the coming months and years absent changes in environmental regulations and/or settlement of the low-grade civil war in Nigeria regardless of the steps the Commission takes. […] speculation has had little to do with the price increase and changes in regulations will not eliminate price volatility.
Also, as we have also mentioned in this blog, OPEC plays a role that cannot be ignored. While it cannot affect prices of light sweet crude it does control sour crude prices. OPEC’s actions can and do discourage investment in refinery upgrades and perpetuate price swings.
But here’s a key point:
Changes in crude prices are uncorrelated with flows of money into the two key WTI oil futures contracts offered by the InterContinental Exchange and the New York Mercantile Exchange. In other words, money flows into oil contracts have not affected oil prices.
Changes in crude prices are also uncorrelated with flows of money into or out of commodity funds. Again, the correlation is zero.
Commodity index funds act to stabilize oil price movements. Rebalancing due to changes in oil prices relative to other prices could cause these firms to add or subtract oil futures in a manner that tends to steady prices.
Imposing position limits on passive investors—or even banning passive
investment in oil futures—would not affect the spot price of oil but would alter the incentive to hold inventories. If stocks decline, as history suggests they would, the market will become more volatile.The use of futures markets by banks that do not take physical delivery but rather write financial options to firms producing or consuming oil and natural gas is vital. Any measure that limits the access of financial firms to these markets would have serious adverse impacts on investment in oil and gas, ultimately causing dependence on imports to rise. Such regulatory proposals should be labeled for what they are, “energy capitulation.”
Very well put. The full document is a must read for anyone interested in the energy markets and we’ll offer more insight from it and other testimonies on this vital issue in the coming week.
Gad Barnea – CEO – FlyMiwok, Inc.
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