2011 Energy Prices and the Speculator’s Role in Oil Trade
As we wind down 2010 and look at the structure of the energy markets looming for 2011, this seems the perfect time to address several very pertinent questions from subscribers about what is coming.
Q: 1) Do you see the U.S. dollar eventually being replaced as the world’s reserve currency? What effect would that have on oil and gas prices?
2) In light of the current unemployment situation in the U.S. and the potential move to austerity by national and state governments in order to shore up the fiscal situation, do you see an economic downturn in the near or longer term reducing current levels of demand for oil and gas (both domestically and via contagion internationally)? If so, what effects would such a scenario have on prices? ~ Rocky H.
A: Rocky’s questions go to the center of a traditional oil market view – the price of crude ought to reflect exchange rates and demand.
Let’s tackle the first part of his question…
Given the structure of global oil trade, there is little likelihood that the dollar will be replaced any time soon. There are too many assets worldwide denominated in dollars to move from the dollar system easily. And the euro – the most likely replacement alternative – has problems of its own.
There are contracts emerging from places like the Dubai Exchange, Singapore, Iran, and Caracas that are denominated in euros, dinars, and even yuan. However, they continue to trade against dominant dollar contracts, not instead of them.
When it comes to denominating oil contracts – actually a result of a then-secret agreement between Secretary of State Henry Kissinger and SAMA (the Saudi Arabian Monetary Agency) in 1974 – the current position of euro-based European retail contracts actually offers advantages to European oil importers/refiners, who then provide a wide range of exports to the oil-producing countries at a premium.
Put simply, it would take a massive change in the global market to displace the dollar. And neither the Eurozone nor rapidly advancing economies (such as the Chinese or Indian) want the destabilizing pressures that would accompany moving the currency base away from the dollar.
Now, what will happen – and what has already been underway for several years – is the move toward a “basket” of currencies in several countries as a way to better reflect a more accurate valuation of domestic currencies. Here, a combination of foreign currencies determines the exchange rate for the local money.
In such an approach, the overall use of the dollar is offset by other trading currencies – the euro, yen, and others – or a new script is developed, such as the trading currency to be introduced by the (Persian) Gulf Cooperation Council members.
Even in this case, however, nothing is poisedto replace the dollar. Replacing the greenback would undermine the weight of assets worldwide held in dollars.
There is another move developing to emphasize the use of Special Drawing Rights (SDRs) as a reserve currency. In fact, the International Monetary Fund (IMF) established SDRs almost 40 years ago to do just that. The SDRs are based on a currency fund representing the IMF reserves (themselves contributed by the member nations).
China has been rapidly increasing its contributions to that fund as a way of increasing leverage over IMF policy. But even Beijing is not prepared for a move away from the dollar – it owns too much dollar-denominated debt, and SDRs would put too much weight on the Chinese currency.
As for Rocky’s second question – whether economic conditions will depress demand – the answer is much simpler: Already been there, already experienced that.
We are actually coming out of a lowered demand curve right now. That was the problem from the fourth quarter of 2008 through the first three quarters of 2009.
The recovery has already hit in other parts of the world and is slowly coming back in North America and western Europe. OPEC just increased its global demand forecast for the third time in less than nine months.
In addition, the International Energy Agency (IEA), the U.S. Energy Information Administration (EIA), and the U.S. and German military, along with every other forecast released in the last six months, points toward accelerating demand for both crude and oil products.
Remember, the primary demand projections are not coming from the U.S. and Europe. The rising demand levels are led by developing parts of the world. The U.S. recovery will play itself out in 2011, but the usage and pricing will already have increased due to events elsewhere.
Q: Thank you for your informative comments on the oil and gas industry and recommendations for investment. I have heard oil people say that there is ample oil to meet demand at the current time and that the high price is not a result of demand but is caused by speculators. Can speculation be stopped? ~ Ian M.
A: First, I need to explain why speculation is necessary for oil trading.
Oil is both a commodity and an asset in its own right. That means futures contracts – the agreement to buy consignments at a certain price and time – have a value in themselves, beyond the market value of the underlying oil for delivery.
For this futures market to work, we need investors who are prepared to take a financial risk on the other side of a trade. Put directly, if there is no counterparty prepared to take a financial risk, a trader cannot exercise a future contract.
The speculators provide necessary liquidity and usually (since they are in this for a profit) take the more extreme positions. That actually stabilizes the market for everybody else.
This is trade in paper barrels (the contracts), rather than wet barrels (the underlying crude). As such, it is normal to blame the speculators for the problem. But they are not the cause.
Speculators ply their approach by the thousands in locations all around the world. Without the profit motive that spurs their involvement, there would be no way to balance the market. Trade would be controlled by a few very large sources of money – sovereign wealth funds, hedge funds, and related clones.
Coming down heavily on speculation in the U.S. trading market would merely move those operations abroad, outside the ability of American regulators to control it at all. (Not a particularly good idea, when the American market is dependent on the rest of the world for upwards of 70% of daily crude oil needs.)
The problem is not the speculators, but the trading system itself – and the rising inability of that system to determine a correct range for the hedging of the contracts (the options). That produces volatility, and that uncertainty will be ushering in a major problem for the oil sector…
My next book, “The Vega Factor: Oil Instability and the Next Global Crisis,” will be out in a few months to explain in detail what is about to happen. It will discuss the issues raised by the questions we’ve just discussed, along with a range of other concerns.
Only one thing you need to know at this point: This crisis will provide the average investor with opportunities to make a great deal of money.
So stay tuned.