High Oil Prices: The Truth About A Misguided Witch Hunt

by Keith Fitz-Gerald | May 14, 2012 10:30 am

It has been less than a month since President Obama declared war on those evil oil speculators.

Standing in the Rose Garden on April 17th, the president laid out a $52 billion initiative to increase federal supervision of oil markets in an effort to crack down on oil price spikes.

At the time, oil was trading at $117.41 a barrel and $5 a gallon gas seemed all but inevitable.

According to the president, evil speculators had been working behind the scenes to screw the rest of us while engorging themselves on riches beyond our wildest dreams.

I said it then and I’ll say it again — the president is chasing a ghost he’ll never catch. Spending $52 billion on additional oversight is a complete waste of money and a misguided witch hunt.

I mean, think about it. If speculators are the same ones responsible for high oil prices, ask yourself why they’re the ones getting raked over the coals these days as oil prices fall.

The short version: It’s because speculators don’t control oil prices and never have.

The Real Culprits Behind High Oil Prices

Pricing inputs¬† — for better or worse — are driven by geopolitics, supply constrictions, war, tyrants with spigots and buyers who will only purchase as long as the prices are low enough.

This is not complicated. Any time there are more buyers than sellers, prices go up. When there are more sellers than buyers, prices go down. Whether or not what’s happening now turns out to be short- term noise or a long- term trend remains to be seen.

As I noted before, legitimate speculation has a valuable and essential role in the markets. It’s very different from the already illegal manipulation that the president seems to confuse with speculation.

Oil prices are driven by two groups of participants¬† — hedgers and speculators.

The former are typically producers or suppliers with a vested interest in securing as high a price as possible for their output. They can also be manufacturers who depend on procuring as low a price as possible for their raw materials. Both parties are interested in delivery as a function of pricing.

Speculators don’t care about delivery and, in fact, go to great lengths to avoid it.

They profit from price changes that would otherwise hold hedgers apart while also providing liquidity to other market participants.

Here’s an example that may help bring this to life.

Both McDonald’s (NYSE:MCD[1]) and the farmers growing potatoes for the restaurant’s world famous French fries are hedgers. McDonald’s wants to ensure the smoothest, lowest price it can for the millions of pounds of potatoes it needs. The potato farmers want to obtain as high and stable a price as possible for their spuds.

Speculators, on the other hand, profit from changes in prices that the hedgers are trying to avoid. They also make a market when the two – buyers and sellers – can’t agree on appropriate prices.

In this case, they may jump in, for example, if McDonald’s seems to be buying more potatoes than usual or if crop conditions suggest a lower harvest.

Their willingness to take on these risks helps ensure smoother prices that move up and down depending on what the market will bear.

Now here’s the thing…speculators don’t get it right any more than hedgers despite the fact that the Ministry of Whitewash seems to think they’re in control.

What Really Controls Oil Prices

It doesn’t matter whether it’s French fries, hog bellies, wheat, or oil…sometimes there’s simply too much supply and prices fall no matter who’s “long” or expecting prices to rise.

At other times demand plummets and those who want to sell simply have to lower their prices to the point where buyers step in. That’s what is happening now.

Why really doesn’t matter. But if you must attribute a reason for the move lower, try this on for size. The threat of a eurozone blowup has got traders pouring into U.S. dollars in a classic flight to safety.

Oil is priced in dollars. So as the dollar rises, oil prices generally fall.

No doubt there are others, too[2]. For instance, the threat of open warfare in Iran seems to be diminishing as is the risk of supply disruptions in Russian and South American fields. That’s helping deflate the so-called risk premium.

But have no fear, higher prices will return. It’s only a matter of time.

Given the way our world works, there are bound to be more buyers than sellers as global demand rises over time. Don’t let anybody tell you otherwise.

To that point, global demand is forecast to increase wildly in the next decade. One study projects a 25% increase in demand to 105 million barrels a day by 2015.

That’s up from roughly 89 million barrels a day now as noted in Oil and Gas: A Global Outlook by Global Industry Analysts, Inc. and up from the 84 million barrels used as a basis for the projection.

Other estimates vary but every serious study I’ve seen suggests an increase in demand. It’s only logical that prices will follow.

In the meantime, it’s better not to buy the dips. Sell the rips instead.

Endnotes:
  1. MCD: http://studio-5.financialcontent.com/investplace/quote?Symbol=MCD
  2. there are others, too: http://investorplace.com/2012/04/why-100-oil-is-the-new-80/

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