High Oil Price Bubble -- Driven by Speculation?

Between February and May of this year the oil price went from below USD 90 to USD 128 a barrel, a monthly growth of 9 per cent. If the rise continued at this rate, it would mean an unprecedented doubling in price every eight months. In recent days, after the price briefly touched a high of USD 135, there has been a bout of profit-taking. Although the price fell it did not drop much below USD 125 and it has rocketed again to USD 135.

The latest price rise has baffled many. What has happened to supply and demand to cause such a steep and sudden price rise? Gordon Brown, the British prime minister, said last week that "the cause is clear: growing demand and too little supply". China and India are buying more oil. Costs of exploration and extraction are going up. Nigeria and Venezuela are causing anxieties about supply. But these factors are not new. Nothing has happened in the real oil economy to justify such a sharp and steep rise in its price.

There is a growing feeling that the latest sharp upsurge in the price of oil may be a speculative bubble rather than an outcome of market fundamentals. The US Commodity Futures Trading Commission indicated last week that there may be "system risk" and George Soros, the veteran investor, in testimony on Capitol Hill on Tuesday, warned that commodity index funds, which treat oil as an asset rather than a commodity to be bought and sold for use, are creating a bubble.

Bubbles come to an end eventually but there is no guarantee that this will happen soon. The global economy is likely to be forced into a serious crisis if we do not explore the possibility that this is a bubble that needs to be burst quickly. The market can then resume its trend, depending on whatever the fundamentals dictate.

Much of the rise in oil price is the result of activity on the New York Mercantile Exchange, the energy exchange. This is activity by index funds and pension funds that are investing in oil futures, not for direct use but as financial assets for profit. That contrasts with activity by oil producers and consumers who buy and sell to smooth out fluctuations in price and delivery.

These financial institutions -- index funds and pension funds -- are neither buying oil nor selling it. They are passive investors in commodities. They have invested USD 260bn (EUR 169bn, GBP 133bn) in commodity markets, compared with USD 13bn just five years ago. Much of this money is in oil. The Goldman Sachs Commodity Index is heavily weighted by oil -- 78 per cent compared with less than 2 per cent for precious metals.

The point is that this paper market is not driven by the pressures on demand and supply but entirely by price expectations. An underlying situation -- which may well indicate a medium-run rise in oil price -- is being exacerbated by the bolstering of expectations that prices will rise even faster. It is this extra layer of price rise that is driving money into even the farther future contracts. There are futures contracts being bought and sold for 2016 at USD 138 -- only astrologers pretend that they can forecast that far ahead.

How large is the speculator activity? The total open interest -- the number of open or outstanding contracts for which an individual is obliged to the exchange because that individual has not yet made an actual contract delivery -- in the 2008 contracts on May 21 was 849.472 contracts, which equals 849m barrels, or nearly 10 times the daily crude oil production. The daily volume in the 2008 contracts on May 21 was 657.391 contracts, equivalent to 657m barrels or nearly 8 times the daily crude oil production.

This is a problem that requires immediate action. The best way to counter speculation is to make it less profitable. Step one is to protect the regular traders in the real oil economy (those who intend to close their positions by making or taking delivery of oil) and charge them a lower margin than those who have no intention of plying the oil trade. The purely financial traders must be made to pay a proper price for their speculation. This can be done simply by increasing the margin that they have to put down to trade as open interest, from the current 7 per cent to about 50 per cent.

It is up to the Group of Eight leading industrialised nations leaders to urge Nymex to implement this policy. It is in tune with free market logic and at the same time it makes oil speculation less profitable. There is no need for western governments to go down on their knees to Arab oil sheikhs, or to ration oil to the increasingly cash-strapped and angry consumers.