The relentless rise of crude oil price has stirred panicky discussions in various circles. Not only many economists, market analysts and observers, but politicians and the general public alike are all searching the answer to the question, why such a powerful surge in the crude oil price. In this article we will put various ideas floating around to test by requesting that they are consistent with actual data. This kind of approach is essential if we want to treat economics as a rigorous science. Through this process we will be able to sort out facts from myths and to reach a comprehensive understanding about this powerful surge of crude oil price.
In the next section the claim from many market participants and their representatives on major financial media that the weak US Dollar against Euro is a major reason behind the surging crude oil price, is put to test against actual data. It is found that this claim is flatly false. Any correlation or no correlation between the crude oil price and Euro can rather be explained by an argument totally opposite to the above claim, that is, surging crude oil price has a tendency to lift the value of Euro, to a certain degree. With this understanding we can safely remove the gyrating exchange rate between Euro and Dollar from our consideration in searching the reason behind the surge of crude oil price, and will allow us to concentrate our attention toward the direction of the relation between the demand and the price of crude oil.
In Section 3 the US crude oil import, the crude oil price and the real consumption of gasoline are studied in detail. The rise of crude oil price up to the latter half of 2007 is attributable to the the problem that the expansion of crude oil supply is not catching up with the rapidly increasing demand. However, the powerful surge of the crude oil price since that time is due to several new factors.
In Section 4 the role of speculation in the crude oil future's market is studied. In Section 5 the question whether extra production of “sour” or “heavy” crude oil by Saudi Arabia can really calm down the crude oil market is analyzed. In the last section a comprehensive picture of the crude oil price surge is presented. The recent sudden plunge of the price is discussed and its future course considered.
There is a wide spread belief among analysts, commentators and market participants on the financial media that the main reason of the surging crude oil price is “weak” Dollar. When those people talk about “weak” Dollar, they do not mean weak Dollar vs. Japanese Yen nor weak Dollar vs. Chinese Yuan. They always mean weak Dollar vs. Euro. The reasoning behind this “weak Dollar vs. Euro” argument is that the crude oil price quoted by OPEC is in unit of US Dollar. When Euro rises against US Dollar, OPEC will raise the crude oil price to recoup their lost revenue if the crude oil price has been quoted in Euro and vice versa. This argument rejects the notion that crude oil prices are determined by the market condition of supply and demand, but claims that the crude oil price is completely manipulated by OPEC. In the mind of those believers OPEC fixes its eyes on the computer screen showing tick-by-tick the exchange rate of Euro vs. Dollar and adjust crude oil price accordingly. The believers then claim that if only FED (The Federal Reserve Board) raises interest rates to bolster Dollar, the crude oil price will fall, global inflation will calm down, robust economic growth of the US and the rest of the world will return, and the happy days will be here again. Many readers probably still remember that not long ago the same financial media were showing analysts, commentators and market participants cursing FED for not lowering interest rates fast enough in order to prevent the world to plunge into an abyss. Apparently we need to test this “weak” Dollar argument objectively to see if there is any merit in it.
In the strict form of the “weak Dollar vs. Euro” argument that the only reason of rising crude oil price is the weak Dollar vs. Euro, the crude oil price expressed in Euro/Barrel should be flat. This strict version can be dismissed easily since the crude oil price expressed in Euro/Barrel has risen rapidly, too. For example, at early February of 2008, the spot price of WTI (Western Texas Intermediate, the bench mark crude oil) was 60 Euro/Barrel, but has risen to 85 Euro/Barrel by the middle of June of 2008, a 40% rise in less than 5 months. How about we weaken the strict argument to a certain degree and claim that the weak Dollar vs. Euro is not the only reason but a major reason behind the surging crude oil price. In this case though we will not see a flat curve if the crude oil price is expressed in Euro/Barrel, we should expect to see a substantial difference between the price curve expressed in Euro/Barrel and the one expressed in Dollar/Barrel. We will be studying those two curves along this direction next.
In the graph at the right the daily spot price of WTI in unit of Dollar/Barrel is plotted as the black curve and the spot price in unit of Euro/Barrel is plotted as the blue curve respectively; the graph covers the period from January of 2008 to June of 2008. The red curve in the graph is the daily exchange rate between Dollar and Euro in unit of Dollar/Euro. The black and the blue curves are very similar down to the daily bumps and dips, whereas those bumps and dips are not correlated to the bumps and dips of the red Dollar-Euro exchange rate curve. This indicates clearly that the daily movement of crude oil is driven by something other than the exchange rate between Dollar and Euro. Furthermore, from the latter part of March of 2008 the rise of Euro has stalled but the crude oil price has staged an explosive rally. Those two observations should be enough to dismiss the argument of “weak Dollar vs. Euro” as a myth.
The dismiss of the “weak Dollar vs. Euro” argument as a myth does not mean that there is no relation between the Dollar-Euro exchange rate and the crude oil price at all. On the contrary the argument, that strong crude oil price tends to drag up Euro and vice versa but only to a certain degree, explains the curves in the graph well. Since Dollar is still the major trade settlement currency, oil producing countries will receive a lot of dollars as the payment for their crude oil exports. From various political reasons some countries do not want to hold a large amount of dollars in their foreign currency reserve. The natural choice of those countries is Euro since Japanese Yen yields near zero interest and Chinese Yuan is not openly convertible. Thus higher the crude oil price goes, larger the amount of dollars to be converted into Euro by those countries becomes, creating a broad upward trend for Euro as the crude oil price rises. However, the decisions of when and how much to convert their dollars into Euro in those countries are made by intelligent human beings, not by a preprogrammed computer. Those human decision makers will certainly not jump in and out of the foreign currency market in response to each tick of the crude oil price movement. Thus the uptrend of Euro induced by the higher crude oil price is broad based, and the daily bumps and dips of the crude oil price are preserved in both the black and the blue curves no matter their units are Dollar/Barrel or Euro/Barrel. As Euro advances to a very high level vs. Dollar as the case of March of 2008, just like ordinary currency market speculators, those decision makers will naturally start to question whether Euro has become overvalued, and thus rein in their conversion operations. With this kind of hesitation of the decision makers, Euro has lost the best friend and has started to stagnate against Dollar in spite of rapidly surging crude oil price that is induced by reasons other than the Dollar-Euro exchange rate. If the crude oil price drops sharply, there will be less petrodollars to be converted into Euro and Euro must struggle with its own weight to hold the rank with Dollar. Only after a prolonged consolidation period, the confidence in Euro will return and Euro will rise again if the crude oil price continues to surge.
It should be pointed out that by dismissing the “weak Dollar vs. Euro” argument as a myth and by gaining a proper understanding that it is the crude oil price driving Euro, we are no closer to find the true cause of the surging crude oil price but only know now that Dollar-Euro exchange rate is not relevant here.
In this section we will study the connection between the demand and the price of crude oil in the US. Twelve month moving average of crude oil import in unit of million barrels are plotted in the graph as the black curve; the curve is drawn in log-10 scale. Similarly 12 month moving average of imported crude oil price in unit of Dollar/Barrel, also in log-10 scale, is plotted as the red curve. The raw data for the black and the red curves are obtained from the website of The Census Bureau. Twelve month moving average of real gasoline and oil consumption in units of 2000 chained dollars is plotted as the green curve, again in log-10 scale. The data of the green curve is obtained from the website of The Bureau of Economic Analysis. The log-10 scales of the black and the green curves are the same so that by comparing the slopes of those two curves we can easily say which one is growing faster. In order to make the following discussions easy, alphabets A to P are inserted along three curves at critical turning points. The same alphabets in each of the three curves point to the same time period the scale of which is shown at the bottom of the graph.
The period from A to B is the early stage of economic recovery from the 1991-1992 recession. The crude oil price was steady in this period as the red curve indicates. The green curve shows that the gasoline consumption was rising modestly. However, the import of crude oil rose much faster than the gasoline consumption during the period as the steep upward slope of the black curve attests. This was due to the excessive inventory buildup by the crude oil consuming industries, anticipating that the crude oil price will rise soon.
Many non-OPEC oil fields had been developed following the energy crises of early 1980's. Those non-OPEC oil fields had started to produce crude oil around early 1990's. In spite of stepped up inventory building by US oil consuming industries, the sudden influx of non-OPEC crude oil pushed the price of crude oil lower starting from point B. Falling price is the enemy of the inventory buildup since the business with excessive inventory will sustain substantial losses when mark the inventories to the market value. Thus the tempo of inventory buildup had slowed in the period from B to C and the crude oil import also grew far slower in this period, that is, B to C than in the period A to B, though the gasoline consumption continued to grow steadily in the period BC as the green curve shows.
US trade deficit had started to fall since the end of 1987 in response to the massive devaluation of Dollar vs. Japanese Yen started in 1985. As the US trade deficit fell, Dollar staged a modest rebound. US trade deficit fell to near zero in late 1991, bringing with it the economic recession. When the economy started to recover, the trade deficit had risen rapidly and Dollar weakened anew against Japanese Yen. This new wave of Dollar devaluation had started to restrain the expansion of US trade deficit around point C, and had ushered in an economic slow down as the stagnation of green gasoline consumption curve attests. This economic slow down continued until point D. On the crude oil front OPEC had started to cut back production in order to prevent further drop of the crude oil price. Thus the price had started to rebound from point C. The oil using industries had rushed to expand the oil inventory, totally disregarding the stagnating gasoline consumption. This rush to hoard crude oil resulted in the sharp rise of the black crude oil import curve from point C. The reason of such a rush to hoard crude oil was to take advantage of accounting rule of marking inventories to market so more crude oil inventory meant more (paper) profit when the crude oil price was rising. However, soon the reality of slow growth of gasoline consumption set in and the industries slowed down their inventory buildup, and the black curve braked to a more gentle rise until point D. With the slow down of the growth of the crude oil import, the price of crude oil also stagnated until point D.
Starting from the middle of 1995, Japan has adopted the never ending zero interest rate policy and unleashed the massive wave of yen-carry trades that boosted Dollar higher and higher against Yen. Pulled by the high flying Dollar, US trade deficit started to explode upward and thus created the Clinton economic bubble (for the detailed discussion of that period please see artile 1). The Clinton bubble boosted the consumption of gasoline until point G when the mad consumption race was finally curbed as oil price staged an impressive rally as will be discussed later. It is interesting to note that the Clinton bubble powered by the runaway trade deficit was so powerful that the Asian financial crisis caused no ripple to the rising green curve and the cave-in of Long Term Capital (a hedge fund) that almost brought down the whole global financial market only showed up as a tiny disturbance at F on the green curve. However, the situation at the red crude oil price curve and the black crude oil import curve were far from monotonic as the green gasoline consumption curve rose steadily from D to G as will be discussed in the next paragraph.
As US economy started to accelerate upward again from point D as discussed in the previous paragraph, the crude oil price also rose anew. With the modest rise of gasoline consumption but a sharp rise of crude oil price from D to E, industries returned to aggressive inventory built-up, thus the black crude oil import curve rose sharply from D to E. During the period of D to E, OPEC was still in the self-imposed production restraining mode, but non-OPEC producers were producing all they could and had benefited enormously. Eventually the flood of crude oil from non-OPEC producers caused the price of crude oil to peak at point E. As the price fell from point E, OPEC called non-OPEC producers to join them in the production control, but to no avail. Angered by the refusal from non-OPEC producers, OPEC started a price war by removing their self-imposed production curtailment, and the crude oil price fell sharply through point F toward the bottom at point G. From point E to point F crude oil using industries continued to expand the crude oil import in pace with the rapidly expanding gasoline consumption during the period. However, the relentless fall of the crude oil price changed the expectations of the oil using industries around point F and induced them to anticipate further continued drop of the crude oil price. The industries thus started to reduce crude oil inventory as fast as they could in order to avoid heavy financial losses when their inventories were marked to the market at a much lower price. Thus the crude oil import stagnated from point F to G in spite of continued strong growth of gasoline consumption pushed by the Clinton bubble running on the exploding US trade deficit.
From point G on to H and I the green gasoline consumption curve was already reflecting coming burst of the Clinton bubble. Its rise had slowed, and then the curve turned south from point H. The crude oil consuming industries had heeded to the falling trend of gasoline consumption from G to H and started to restrain the inventory buildup, even though the crude oil price had already risen strongly starting from point G. The reason of the rise of the price from G was due to the smooth absorption of the flood of oil from non-OPEC producers after three years of strong gasoline consumption growth as shown in the green curve. As the crude oil price continued to surge passing point H, crude oil consuming industries turned to inventory buildup again whereas the actual gasoline consumption was declining from point H to I as mentioned above. Thus the black crude oil import curve shot up smartly from point H to I.
From the discussion so far from point A to point I, we can see that the amount of imported crude oil is only from time to time synchronized with the actual gasoline consumption. In many occasions the crude oil import is rather synchronized with the crude oil price. As crude oil price rises, the greed of the oil consuming industries prompts them to expand inventory to profit from the rising price and thus push up the amount of crude oil import. When the crude oil price falls, those industries will be gripped by the fear of loss and reduce their oil inventory hastily. In the era up to point I, OPEC still had reasonable amount of spare production capacity so that they were able to control the vicious cycle of price rise, inventory built up, more price rise and so on. When the spare production capacity of OPEC diminishes, this vicious cycle will become a self fulfilling prophecy and create an explosive surge of the crude oil price. The powerful surge of the price from point H to point I seems to be foretelling this kind of catastrophic rise of crude oil price already.
Since the early part of the twenty first century, the global economic scene has changed substantially due to the emergence of China. The globalization scheme pushed by the US since the Reagan administration offers a quick rich short cut for developing countries. This road is to use very low labor cost and free to pollute environment to lure manufacturers in the developing countries to relocate factories to the devloping region, produce very low cost consumer goods, and export those goods to the US. For this model to work, the political regime in the developing country needs to be substantially authoritative so that dissent against labor exploitation and environmental pollution can be effectively suppressed. A successful participant of this scheme will see a large influx of US dollars due to run away trade surplus and the torrent of foreign investments that tends to push the local currency sharply higher against US Dollar. In order to keep its currency under valued vs. US Dollar so that it can continue to export to the US, the government buys up all those unwanted dollars to make its foreign currency reserve explode upwards. However, the government must sale local currency for those dollars, and thus flooding the local financial market with enormous amount of liquidity. Parties connected to the authoritative government will get hold of the lion's share of the liquidity and starts runaway infrastructure construction to get extremely rich, whereas the maddening pace of infrastructure construction trickles down to the general public and lifts their living standards. The infrastructure construction boom plus the rising living standard boost the crude oil consumption sharply in the country. On the other side of the ledger the US will experience runaway trade deficit under this scheme. The trade deficit serves as the seed money to the financial market in place of personal saving, and the runaway trade deficit has allowed US consumers to reduce personal saving to near zero and to spend all their disposable income. In essence the runaway trade deficit is equivalent to the scheme to borrow from foreigners and spend. With the borrow and spend boom US consumers have increased crude oil consumption through the heightened gasoline consumption sharply. The phenomenal increase of gasoline consumption from point D to point H under the push of the second phase of runaway trade deficit that created the Clinton bubble is a good example of this prosperity under the runaway trade deficit. In the dawn of the twenty first century, the thirst for crude oil in the developing China, and the failure of the US to curtail the gasoline consumption due to the third phase of the runaway trade deficit in spite of very high oil price, combined to pave the way for a perfect storm for the explosion of the crude oil price.
Now let us return to the point by point discussion. When the crude oil price rose to point I, OPEC increased production to bring the price down. As the price falls from I to J, industries quickly reduced oil inventory, causing the black import curve to decline in general from I to J. Ironically the gasoline consumption was increasing during the period from point I to point J. When the price fell to near point J, OPEC tightened the production again and stopped the price from declining further. As the crude oil price started to move up, oil using industries followed with a strong inventory accumulation from point J to K in contrast to the rather modest increase of the consumption of gasoline. This is another example that the crude oil import is synchronized with the price but not with the actual gasoline consumption.
When the crude price broke above the previous high set at point I, the industries started to fear of a crude oil price bubble and refrained from further inventory buildup; this change of attitude of the industries are showing up in the break from point K to L on the black curve. By that time China has become a significant factor in the global economy, and a potent force in the crude oil market in particular. The crude oil price from K to L was boosted by the increased demand from China in spite of the stagnating US crude oil import. The consumption of gasoline stagnated from L to M under the pressure of very high crude oil price. The industries became more pessimistic about the future crude oil price so reduced inventory aggressively in the stretch from L to M. Again the increased demand from the developing countries overwhelmed the declining US crude oil import and pushed the price stayed in the upward course until point M.
The period from point L to point M is very interesting. The consumption of gasoline had flattened out in the period due to the high crude oil price as the green curve showed, though the US economy was still expanding. The consensus of the market was that the crude oil price was already too high and might plunge soon so that oil using industries were aggressively reducing their oil inventory, causing the black crude oil import curve to decline quite sharply from L to M. That consensus were not only for the US market but had to be shared by other major economic regions like Europe and Japan, so we expect that their oil using industries were also reducing inventories just as their US counter parts. There were no major oil production interruptions during the period. Nevertheless the red crude oil price curve continued its sharp rise from point L to M. This indicates the wane of the influence of US consumption in the global crude oil market and the rise of the influence of the thirst for crude oil of fast growing new entrants like China and India. Only after the demand from China and India took a breath, probably induced by the rapidly rising price, the crude oil price stagnated from point M to N. Around point M the US housing bubble has started to unravel. In couple with substantially higher gasoline price US consumers has started to curtail gasoline consumption and the green curve has started to fall literary, through point N and continued to the last point P in the graph. During the period M to N the black crude oil import curve did not move very much in average. The anticipation of crude oil consuming industries that the price would crack was apparently wrong as the price just stagnated from M to N. The industries tried to rebuild the inventories, causing the black curve to go up from point M, but the reality of falling gasoline consumption set in quickly and the black curve fell toward point N.
Another surge of the crude oil price from point N is the result of many factors. Chinese Yuan has been forced to give up its peg with US Dollar, and has been revalued upward slowly since the middle of 2005. This revaluation effect has caused China's trade surplus against the US to grow slower starting from the middle of 2007, the usual two year delay for currency movements to be translated into trade status. However, China is capable to compensate its slowing down trade surplus with the US by its rapidly expanding trade surplus with EU since Euro has moved up even faster than Yuan against US Dollar. As the consequence China's economic growth has only slowed down slightly, from 11 plus percent a year to 10 plus percent a year, so China's thirst for the crude oil is growing continuously. The Summer Olympic of 2008 at Beijing does not help either. In order to satisfy its promise to the International Olympic Committee that the notorious dirty air around Beijing will be cleaned up by the Olympic in August, Chinese Government induces industries around Beijing to switch to clean burning diesel from dirty coal. It has been reported that China's import of diesel is surging as the Olympic approaches. Then there is an ironic factor resulting from the rising crude oil price itself. Flush with cash from selling high priced crude oil, oil producing countries have started massive infrastructure construction projects. Citizens of those countries also benefit from the oil bonanza and increased gasoline consumption rapidly. As domestic consumption of crude oil increases in oil producing countries, the amount of crude oil available for export has started to decline. It is said that the increase of crude oil consumption in the oil producing countries rivals that of China and India combined. At the tail end of the surge from N to P, the factor of crude oil futures weighs in as will be discussed in the next section. Facing the rapid surge of the crude oil price during the period of N to P, crude oil using industries first tried to hoard by increasing inventory again so the black curve rose from point N, but than sank under the weight of continuously falling gasoline consumption. Actually ordinary drivers are not immune to such instinct of spontaneous hoarding. If we examine the green gasoline consumption curve closely, we will find that the downward slope of the section NP is gentler than the slope of the section MN. This means that the rate of decline of gasoline consumption has slowed on the face of the price surge of the period from N to P. The spontaneous hoarding by an average driver is the result of carrying a few more gallons of gasoline in the gas tank by going to gas stations to fill up more frequently. When 300 million cars in the US are doing similar things, it amounts to the increased consumption of about 20 million barrels of crude oil. The spontaneous hoarding by the industries using crude oil and by ordinary consumers naturally slowed down the reduction of crude oil consumption in spite of the surge of the crude oil price and thus is like pouring oil on the fire of the price surge.
When the crude oil price surges, naturally everyone points his finger to someone to blame, without realizing that himself probably is also contributing to the price surge by doing some degree of spontaneous hoarding. The most favorite whipping boy is the crude oil futures market. In the next section we will analyze the claim that speculators in the futures market is to blame for this gigantic crude oil price surge, by studying the actual data, not just from hypothesis and conjectures.
At the time of the powerful surge of the crude oil price, people naturally try to point fingers at some villain responsible for the problem. The most often mentioned culprits are speculators and crude oil futures market where speculators buy future contracts to boost crude oil price. Let us first consider who are the speculators. Instead of playing with the words to define “speculators”, we simply consider some explicit examples. Let A be a party not related to the business of processing crude oil nor using a large amount of final products derived from the crude oil. A can be a hedge fund, a pension fund, a university endowment, a trust for super riches, or just a very rich individual playing in the commodity markets. Suppose A believes that the crude oil price will continue to rise so it buys one million barrels of crude oil, hoping to sale and profit handsomely 3 to 6 months later. Without any doubt we will call A a speculator and what A is doing is to hoard crude oil. Let B be a crude oil refinery. B usually buys one million barrels of crude oil every 3 months. Suppose B also thinks that the price of crude oil will continue to rise so this time B buys two million barrels of crude oil, hoping to derive profits by using the extra one million barrels in the period of 3 to 6 months later. The effect of B's action on the crude oil market is exactly the same as the action of A. We will call B also a speculator, though B will claim that it is only doing hedging; in this case “hedging” is simply a sugar coated word for “hoarding”. How about an airliner that buy future contracts of crude oil for hedging future price increase of jet fuel? The effect of the action of this airliner on the crude oil market is not so different from the actions of A and B, and we will say that this airliner is also acting as a speculator; actually A may claim that it is also just hedging because it holds stocks that will plunge as the crude oil price rises. Then there are average drivers. If an average driver believes that gasoline price will continue to rise along side with the crude oil price, and keeps one extra gallon of gasoline in his gas tank, is the average driver a speculator? The answer is affirmative. Some may say that the amount of hoarding in this case, one gallon of gasoline, is irrelevant, but with 300 million cars in the US, it amounts to the hoarding of 300 million gallons of gasoline, or about 8 million barrels of crude oil. Thus we can see that a large fraction of the society as a whole acts like speculators if they believe that the crude oil price will continue to rise at the time when they are accusing others as speculators. It is clear that if anyone is causing the hoarding of the actual crude oil, then he is a speculator and his hoarding action will contribute to the surging crude oil price. Can we stop such hoarding by defining who is allowed to hoard and who is not? The answer is that it is almost impossible. Fortunately crude oil is not easy to hoard. The storage tanks will not appear from the vacuum. The hoarding by storing oil in tankers that do not sail to anywhere, and increasing the amount of gasoline in the gas tanks will all hit a limit. This means that the explicit hoarding of crude oil and its final products like gasoline will soon run its course as the storage capacity is exhausted.
There are two kinds of crude oil markets, the spot market and the future's market. The spot market is the one where physical crude oil is actually traded, and the price in the spot market is called the spot price. Most part of the hoarding and the inventory buildup talked about in the previous section and the previous paragraph are phenomena of the spot market. Thus the spot price is actually the crude oil price directly influence the whole economy. The futures market is a derivative market to the spot market. The bench mark crude oil futures are the futures based on WTI (Western Texas Intermediate) brand of crude oil. WTI based crude oil futures call NYMEX (New York Mercantile Exchange) as its home, though in recent years WTI based crude oil futures are also traded in several oversea futures markets. Many think naively that massive buying in the future's market by speculators is behind the meteoric rise of the crude oil price. In order to see how the price in futures market is connected to the spot price of the crude oil, we need first to understand some characteristics of crude oil futures.
Futures are zero-sum games. When someone wants to buy (called “long”) a future, there must be someone willing to sell (called “short”) the future to the buyer. At any time the long positions and the short positions on any future contract must be equal by definition. It is a misunderstanding to say that the future price has gone up because there are massive long positions since there will be equally massive short positions to cancel out all the long positions; from the massiveness of outstanding long and short positions we cannot say whether the future price will go up or down. Future's price is determined by the attitudes of those longs and shorts. If the longs are more aggressive than the shorts, price will go up and vice versa. Let us consider an example to illustrate this point. Suppose the current future's price is in line with the spot price. Someone thinks the spot price will go up 10 dollars so he wants to long, or buy 1000 future contracts. If there is no one willing to sell those futures to him at the current price, the buyer needs to raise his bid price, say to 8 dollars higher than the current price to lure enough sellers. The shorts must be thinking that the spot price will only go up by 6 dollars from the current price so by selling at 8 dollars higher than the current price, they will gain 2 dollars, whereas the buyer thinks that he can make 2 dollar profit if the spot price go up by 10 dollars as he expects. Thus the aggressive buyer has pushed up the futures price by 8 dollars in this example. In average the chance for the longs to win is 50 – 50 even the spot price moves up, and the chance for the shorts to win is also 50 – 50. If the longs gain x dollars, then the shorts must lose x dollars and vice versa. There are people claiming that only if we forbid the aggressive speculative longs, like the above quoted example, to come into the market, but only allow hedgers to long futures, then the problem of the surging crude oil price will be solved. Unfortunately, those people are wrong. Even if there is no aggressive pure speculators to buy 1000 future contracts as in the previous example, hedgers still need to pay exactly 8 dollars higher than the current future price to get their long positions for hedge, as long as the shorts are still expecting the spot price to go up by 6 dollars, since the shorts will not be foolish enough to throw away their money by selling future contracts below the level of 8 dollars higher than the current crude oil price.
Crude oil futures, just like other kinds of futures, have many series each one of which expires at a fixed date of different months. At the time of expiration short positions still open must deliver 1000 barrels of WTI crude oil per contract to the long positions still open at the time of expiration. Let us ignore all the costs of transport and storage for this delivery for simplicity of the discussion. At the expiration time the price of the expiring future will converge to the spot price. If those two prices do not converge at the time of expiration, arbitragers will move in to buy the lower priced one and sell the higher priced one to make profit and at the same time to make two prices to converge. This character of futures means that long side speculators that do not have the capacity to actually hold and store crude oil will avoid the future series that is expiring but will buy futures expiring at later months. When the future contracts held by speculators approach their expiration, speculators must sell those contracts and buy new ones with a later date of expiration. Suppose long side speculators and hedgers like airliners that do not use crude oil directly buy further-out-month contracts aggressively, and as the result push up the price of such futures compared to the price of expiring future. Can arbitragers come in by selling further-out-month contracts at the same time of buying expiring contracts to boost the spot price? Such arbitragers must be prepared to take the delivery of the actual crude oil when the contracts expire, so they are limited to the parties that have the facility to store the hoarded crude oil. This means that the aggressive speculative buying of further-out-month crude oil futures can only boost the spot crude oil price until the idle storage capacities are all used up.
The ability of aggressive buying of further-out-month crude oil futures to boost the spot price to certain degree as discussed in the previous paragraph does not mean that such practice is necessarily happening. In order to see what the futures market is doing we look at the price disparity between the expiring month and the further-out-month explicitly in the next graph. Data is taken from the website of Energy Information Agency. In the category of NYMEX WTI crude oil contracts, daily closing prices for 4 types of contracts are listed in the website. Contract 1 is the future's contract that will expire at the earliest date, Contract 2 is the one that will expire next to Contract 1, and so on. We take the price of Contract 2 and subtract the price of Contract 1 from it. The result is plotted in the graph at the right as the red curve. The spot price of WTI is plotted as the black curve.
From the beginning of 2008 to the middle of March, the red curve is close to a mirror image of the black curve, that is, when the black curve rises, the red curve falls and vice versa. This means that the speculators in the crude oil futures market not only has nothing to do with the surge of the spot crude oil price but the aggressive short side players had kept the surging crude oil price in check. Without them the surge of the spot price in that period would have been more intense. Only after the week of April 21, the red curve has risen along with the black curve. This means that after the relentless rise of the spot crude oil price, in the late April the speculators in the futures market finally throw in the towel and have jumped on the band wagon of the surging crude oil price. This change of consensus among futures market players to outright bullish since the middle of April probably has fueled the rise of the spot crude oil price, but it is false to claim that futures market speculators was the instigator of the most recent powerful surge of the crude oil price that has lasted near a year since the latter half of 2007, that is the surge from point N to P in the graph of Section 3.
In the process of searching for scape goats for this relentless surge of the crude oil price, some point their fingers at OPEC, especially at Saudi Arabia. They claim that Saudi Arabia is refusing to pump more crude oil and thus is deliberately manipulating the crude oil price higher. Another group then claim that because crude oil price has risen to such a high level, Saudi Arabia can get all the money they can spend even with reduced output of crude oil, and thus is manipulating the crude oil price higher. However, there are many experts pointing out that the idle capacity of Saudi Arabia is for the production of sour, or heavy crude oils. They say that currently sour crude oil is already plentiful in the market and even if Saudi Arabia pumps more sour crude oil the surging spot price of sweet crude oil like WTI will not be curbed. In this section we try to entangle those opposite claims by looking into actual data.
Let us spend some time here to explain some characteristics of crude oil for the sake of readers not familiar with this issue. Crude oil pumped out of underground always contain certain amount of sulfa. The crude oil that contains relatively lower sulfa concentration is called “sweet” or "light" crude and the ones with high sulfa concentration is called “sour” or "heavy" crude oil. Sweet crude oil is easier and less costly to refine into gasoline, heating oil and other final products of crude oil. Thus the price of sweet crude is naturally always higher than the price of sour crude oil. WTI brand of crude oil that has been widely used as bench mark and discussed exclusively up to this point in this article is a very sweet, or light crude oil. Next to WTI comes the crude oil of UK Brent that are produced in the North Sea. Saudi Arabia produces crude oil ranging from light to heavy, but the Saudi Light is still sourer than UK Brent. In order to measure the appetite of the market for the Saudi Heavy crude, we look at the price difference between a sweet crude and the Saudi heavy crude oil. We use UK Brent as the sweet crude for this purpose. Monthly data of UK Brent and Saudi Heavy are again obtained from the website of Energy Information Agency. In the graph at the right the monthly prices of UK Brent and Saudi Heavy are plotted in blue and black curves respectively, both in log-10 scale. The price difference between UK Brent and Saudi Heavy is plotted as the red curve, but in linear scale. When the red curve rose sharply, it indicates that the market already has enough heavy oil. Further production of heavy oil will only drive down the price of heavy oil and widening the gap between the light and the heavy oil, but will not reduce the price of light crude anymore. The red curve rose sharply during 2004, hitting a peak of about 13 dollars. We may take this $13 price as a guiding level above which the appetite for Saudi Heavy wanes and further production of Saudi Heavy will not help to calm down the price rise of WTI. Considering the inflation since 2004 that has pushed up the extra cost to refine Saudi Heavy, we guess that the added production of Saudi Heavy will be able to contain the price surge of WTI until the red curve rise above somewhere like $15. After the sharp rise of the red curve to $13 in early 2005, it fell to $5.5 by October of 2007. However, the red curve has risen recently to $11 already. We expect that the ability of more Saudi Heavy to cool down the market will not last very long.
Through the analyses of previous sections we can summarize the situation as follows: The surging demand from the developing worlds and the reluctance of the consumption of gasoline to go down quickly in the US in spite of higher prices, both the outcome of the globalization scheme as discussed before, form the basic tenor of steadily rising crude oil price. Spontaneous human reaction to hoard crude oil when the price is rising whereas to dump the inventory as the price falls, and the ironic factor that the consumption of crude oil in oil producing countries will increase rapidly with the price surge and vice versa add volatility to the basic rising trend of the price. Special fctors like the Summer Olympic will just make the situation worse.
Since we closed out data compilation for this article that extends to the middle of July, the crude oil price has suddenly dropped by about $20 a barrel. This drop is timed exactly with the extra production of Saudi Heavy. As discussed in Section 5 there is some room for the extra production of Saudi Heavy to calm down the crude oil price rise, so this Saudi effect probably forms the background of this sudden drop of the crude oil price. The second factor that may contribute to the drop is the wane of China's appetite for the diesel to improve the air quality of Beijing for the Summer Olympic as the opening date of the Olympic, 8-th of August, approaches. The third factor is the imposition of the limit of holding near-month crude oil future contracts by one party. This last factor probably needs some explanation. In the modern financial system there is a huge (like $75 trillion) private derivative market. Crude oil swap is one of the instrument within this monstrous private derivative market. A party willing to bet on the surging crude oil price enters a crude oil swap with a large bank with the understanding that if crude oil price surges, the party gains but the bank loses, and vice versa. The bank holding such a potentially dangerous position if the crude oil price continues to rise, will hedge its position by purchasing a matching amount of crude oil future contracts. Since the bank will enter such crude oil swaps with many of its clients, the bank will buy a monstrous number of crude oil future contracts, and thus the economy of size enables the bank to offer a lower fee for clients in the swap deal than the case if each client enters the future's market by himself. When the limit of holding future contracts is suddenly imposed, the large banks are forced to liquidate a large number of long positions in a hurry so they become the aggressive sellers to drive down the crude oil prices both in the futures market and in the spot market alike sharply.
Everyone is probably interested to know how far will the crude oil price fall. In Section 4 we have pointed out that from the latter half of April, the players in the futures market joined the trend of anticipating surging crude oil price. If the recent plunge of the price is mainly due to the imposition of the limit on holding futures contracts by one party, the prevailing price of late April, that is $120 per barrel, will be the first place that the plunging price will encounter a resistance. In order for the price to plunge deeply, say to $55 to $60 level of the period M to N as indicated in the graph of Section 3, the US economy needs to enter into a real recession and the economic growth of China needs to be pulled down to like 5% a year. If the current lukewarm condition persists, the price of crude oil will bounce back soon. As the rising price persists for a while, the spontaneous hoarding and the sudden increase of oil consumption in oil producing countries will all come back to create another rapid surge of the price.