Dr. Susmit Kumar
It is a general misconception that the record oil price rise in the first half of 2008 was due to the increase in oil consumption by growing economies like China and India. But it was not true at all. According to the U.S. Department of Energy, the worldwide supply of oil actually went up from the last quarter of 2007 until the second quarter of 2008 whereas the worldwide demand went down and hence the price of oil should have gone down instead of going up, but instead the price of oil went to record levels. According to the November 2008 International Energy Agency forecast for global oil demand in 2009, the world will need an average of 86.5 million barrels of oil a day in 2009, compared with 86.2 million in 2008, a growth of just less than half a percent. This forecast was done before the onset of the 2008 global economic recession.
According to Michael Masters, a hedge fund manager, the investor demand for commodities, and oil futures in particular, was created on Wall Street by hedge funds and the big Wall Street investment banks like Morgan Stanley, Goldman Sachs, Barclays, and J.P. Morgan, who made billions investing hundreds of billions of dollars of their clients’ money. In his U.S. Senate testimony in May 2008, Michael Masters said, “Assets allocated to commodity index trading strategies have risen from $13 billion at the end of 2003 to $260 billion as of March 2008 and the prices of the 25 commodities that compose these indices have risen by an average of 183% in those five years. He also claimed that in the last five years, speculators demand for petroleum futures had increased by 848 million barrels that was nearly equal to the increase in demand of China (920 million barrels). These speculators have now stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum, effectively adding eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve over the last five years. These investors have purchased over 2 billion bushels of corn futures in the last five years. Right now, Index Speculators have stockpiled enough corn futures to potentially fuel the entire United States ethanol industry at full capacity for a year. That’s equivalent to producing 5.3 billion gallons of ethanol, which would make America the world’s largest ethanol producer. In 2007 Americans consumed 2.22 bushels of wheat per capita. At 1.3 billion bushels, the current wheat futures stockpile of Index Speculators is enough to supply every American citizen with all the bread, pasta and baked goods they can eat for the next two years. Commodities futures markets are much smaller than the capital markets, so multi-billion-dollar allocations to commodities markets will have a far greater impact on prices. In 2004, the total value of futures contracts outstanding for all 25 index commodities amounted to only about $180 billion. Compare that with worldwide equity markets which totaled $44 trillion, or over 240 times bigger. In 2008, Index Speculators poured $25 billion into these markets, an amount equivalent to 14% of the total market. These types of transactions are not between producers and consumers and have no real economic value.
It is worth noting that the margin required to pay for a commodity futures contract is only 10% and hence one can buy $1 billion worth of oil with only $100 million. If the price goes up by 10% in a week, the commodity speculator can make $100 million by selling the contract.
According to Dan Gilligan, "Approximately 60 to 70 percent of the oil contracts in the futures markets are now held by speculative entities. Not by companies that need oil, not by the airlines, not by the oil companies. But by investors that are looking to make money from their speculative positions," Dan Gilligan is the president of the Petroleum Marketers Association, representing more than 8,000 retail and wholesale suppliers. He says his members in the home heating oil business, like Sean Cota of Bellows Falls, Vt., were the first to notice the effects a few years ago when prices seemed to disconnect from the basic fundamentals of supply and demand. Cota says there was plenty of product at the supply terminals, but the prices kept going up and up. "We've had three price changes during the day where we pick up products, actually don't know what we paid for it and we'll go out and we'll sell that to the retail customer guessing at what the price was," Cota remembered. "The volatility is being driven by the huge amounts of money and the huge amounts of leverage that is going in to these markets." In a five year period, Michael Masters said the amount of money institutional investors, hedge funds, and the big Wall Street banks had placed in the commodities markets went from $13 billion to $300 billion. Last year, 27 barrels of crude were being traded every day on the New York Mercantile Exchange for every one barrel of oil that was actually being consumed in the United States.
In 2000, Congress effectively deregulated the futures market, granting exemptions for complicated derivative investments called oil swaps, as well as electronic trading on private exchanges. "This was when Enron was riding high. And what Enron wanted, Enron got." "When Enron failed, we learned that Enron, and its conspirators who used their trading engine, were able to drive the price of electricity up, some say, by as much as 300 percent on the West Coast," Greenberger added. The oil bubble began to deflate early last fall when Congress threatened new regulations and federal agencies announced they were beginning major investigations. It finally popped with the bankruptcy of Lehman Brothers and the near collapse of AIG, who were both heavily invested in the oil markets. With hedge funds and investment houses facing margin calls, the speculators headed for the exits. "From July 15th until the end of November, roughly $70 billion came out of commodities futures from these index funds," Masters explained. "In fact, gasoline demand went down by roughly five percent over that same period of time. Yet the price of crude oil dropped more than $100 a barrel. It dropped 75 percent." 
According to a June 2008 Massachusetts Institute of Technology study also, which analyzed the world oil production and consumption, concluded that the basic fundamentals of supply and demand could not have been responsible for 2008 run-up in oil prices. The study concluded, “The oil price is a speculative bubble.”
Petroleum exporting countries like Russia, Saudi Arabia, and Venezuela, several of them being anti-US, reaped the benefits of record oil price and made hundreds of billions of dollars. Russia has now the third largest FOREX (Foreign Exchange Reserve) in the world. But on the other hand, four dollar a gallon gas prices created havoc in the US economy. The best-selling gas-guzzling SUV market dropped drastically, causing auto manufacturers like GE, Ford and Chrysler to close down their manufacturing plants and showrooms and lay off tens of thousands of workers. This is one of the factors that caused them to be on the verge of bankruptcy. Although oil companies were raking in record tens of billions of dollars in profits each quarter, higher gas prices were causing a rise in transportation costs, raising the price of all food products in super markets. This increased inflation. It affected the sales of supermarkets like Wal-Mart and Kmart as higher food and gas prices left fewer dollars in the pockets of lower income people to spare. All over the world, hundreds of millions of people fell below the poverty line because of double digit inflation due to rising food costs. Oil-importing countries like India had to spend up to 2 to 3 percent of its GNP as subsidy on gasoline as a substantial rise in gasoline price would have destabilized the entire country. Several countries had double digit inflation for several months because of the rise in fuel costs. According to the World Bank, more than 100 million people have been pushed into poverty because of rising food prices due to oil price increases.
1 “Did Speculation Fuel Oil Price Swings?,” CBS 60 Minutes, January 11, 2009.
2 Schneider, Howard and Shin, Annys, “Gloom Goes Up Around Globe as Signs Point Down,” Washington Post, November 14, 2008.
3 “Did Speculation Fuel Oil Price Swings?,” CBS 60 Minutes, January 11, 2009.
4 Testimony of Michael W. Masters, Managing Member / Portfolio Manager, Masters Capital Management, LLC before the Committee on Homeland Security and Governmental Affairs, U.S. Senate, May 20, 2008.
5 “Did Speculation Fuel Oil Price Swings?,” CBS 60 Minutes, January 11, 2009.
7 Eckaus, R.S., “The Oil Price Really Is A Speculative Bubble,” Center for Energy and Environmental Policy Research, Massachusetts Institute of Technology, June 2008.