Thursday, June 12, 2008

Pure Speculation

It is a long standing belief of mine--founded on nothing but mere observation--that the economic comprehension of Americans begins and ends with gas prices. A loose association to be sure, but it goes a long way toward paving the road for hours of discussion per day on the subject without ever addressing the core issues. Sure, cable news is rife with self-evident tips to save money on fuel--'drive less;' who knew?--and coinage of meaningless phrases like 'staycation,' but absolutely no examination of the root cause of the prices.

It is this environment which allows the fallacy that the prices are purely a reflection of supply and demand to be perpetuated by people like the Fed Chairman and oil executives. At this point, it is beyond all doubt that a healthy percentage of the price of a barrel of oil is based on speculation alone, based on artificial shortages created on paper in the futures market rather than physical shortages, and yet feeding the public a line that pretends gas prices are held to the same laws as widgets in a elementary economics textbook is enough to throw them off the scent. And given the current pathetic state of American media, they're not enthused about putting in any more effort than simply reporting the statements without qualifiers of any kind.

In order to establish any such simple relationship, however, it seems that one would need to be able to point to either a decrease in supply or an increase in demand that outpaces production capacity. Neither apply.

A quick toggle through the OPEC production levels over the past decade show that quarter 1 production in 2008 has been on pace, if not beyond that of the previous years. That leaves out any significant foreign production capacity issues, so we turn to home. Domestic production has been down slightly, true, but the Republican mantra of making more land available for drilling is simply well off the mark.

The cause celebre is ANWR, which is presented by the talking heads and on the Senate floor as the only available piece of land for new drilling. Even assuming that was the case, the EIA analysis of the likely production capabilities of the area doesn't point to a significant boost to domestic production or affect gas prices in any meaningful way.

With respect to the world oil price impact, projected ANWR oil production constitutes between 0.4 and 1.2 percent of total world oil consumption in 2030 [assuming leasing had gone forward in the 90s], based on the low and high resource cases, respectively. Consequently, ANWR oil production is not projected to have a large impact on world oil prices. Relative to the AEO2008 reference case, ANWR oil production is projected to have its largest oil price reduction impacts as follows: a reduction in low-sulfur, light (LSL) crude oil prices of $0.41 per barrel (2006 dollars) in 2026 in the low oil resource case, $0.75 per barrel in 2025 in the mean oil resource case, and $1.44 per barrel in 2027 in the high oil resource case. Assuming that world oil markets continue to work as they do today, the Organization of Petroleum Exporting Countries (OPEC) could neutralize any potential price impact of ANWR oil production by reducing its oil exports by an equal amount.

But, of course, ANWR isn't the only land in the US available for drilling, as this Committee on Natural Resources report illustrates quite clearly.

Between 1999 and 2007, the number of drilling permits issued for development of public lands increased by more than 361%, yet gasoline prices have also risen dramatically contradicting the argument that more drilling means lower gasoline prices. There is simply no correlation between the two.

Even if increased domestic drilling activity could affect the price of gasoline, there is yet no justification to open additional federal lands because oil and gas companies have shown that they cannot keep pace with the rate of drilling permits that the federal government is handing out.

In the last four years, the Bureau of Land Management has issued 28,776 permits to drill on public land; yet, in that same time, 18,954 wells were actually drilled. That means that companies have stockpiled nearly 10,000 extra permits to drill that they are not using to increase domestic production.

Hence, ANWR has been held up, not as the last great hope for domestic drilling, but as a 'want-what-I-can't-have' prospect that ignores the availability of immense amounts of other land on which to drill. Oil companies are only drilling on 27% of the federal lands leased to them and 24% of the offshore acres, leaving the companies with 68 million acres of leased acreage on which they are not producing oil or gas. From this it becomes clear that the problem is not the availability of land on which to drill, but the ability of the oil companies to produce on the land that they've already leased.

As it stands, there's even plenty more land for lease to oil companies in Alaska's Arctic region, 91 million acres to be precise, of which only 11.8 have been leased. The National Petroleum Reserve-Alaska also presents 22 million available acres, of which 3 million have been leased. Seemingly, focus on a small area of less than 20 acres has prevented the usage of several times that many in the same region. To hold up ANWR as the last possibility in domestic production is fallacious and disingenuous.

As for demand in the US, the first quarter saw lower demand from the same period a year ago.

All this leads to speculation as the root cause of the steep increase in oil prices, not some simplistic supply-and-demand relationship which doesn't fit reality. A 2006 Senate report indicated that as much as 60% of the price of a barrel of crude was pure speculation, due to unregulated commodities trading made possible by the Enron Loophole slipped onto the end of an 11,000-page appropriations bill by Phil Gramm, among others.

Commodities trading, now free of the watchful eye of the CFTC, can lead to unfettered market manipulation and the creation of paper shortages. In other words, opaque trading practices make it appear as if there is a supply issue when in fact there is none.

The 2000 deregulation is more than a simple poor policy choice, it led directly and quickly to market manipulation, yet has not been altered.

In 2001, [sic] certain Wall Street executives [used] the media to sell the public on stocks in order to bid up the price – so their firm could divest of its shares without taking a beating. Meanwhile, other trusted advisers pushed stocks that were fundamentally worthless, because their affiliated banks had large loan agreements with those companies.

The year before Enron had been caught manipulating the California energy market, even forcing rolling blackouts across the northern part of their state apparently just for effect – to support their claim that there just wasn’t enough electricity to go around. Again, we now know that claim was untrue. It was Enron shutting down certain power generation plants, while placing bets on their unregulated energy futures market. The net cost to California consumers was almost $8 billion.

It didn’t end there. Amaranth Advisors, a hedge fund, literally was cornering the market on natural gas futures, to make it appear that there was a shortage of natural gas, when the Commodities Futures Trading Commission told Amaranth to liquidate its position on the NYMEX because its bidding had already moved natural gas prices far beyond the reasonable limits of supply and demand. Now, remember this name: ICE, short for Intercontinental Exchange – the "dark futures lookalike market."

Once the CFTC told it to back off its natural gas futures contracts, Amaranth simply shifted gears, got out of the NYMEX, placed its massive bets outside of government regulation in ICE and managed to drive natural gas futures to $8.50 per MBtu.

As the Senate investigation into the manipulation of the energy markets showed, "Amaranth – the day before they failed, natural gas was about $8.50; the day after it failed, it went to $4.46 MBtu." That’s right, one major hedge fund managed to double the price of natural gas simply by loading up on futures contracts; when the government told them their bets were unwarranted, they simply moved their monies to a futures exchange that was unregulated. Only when Amaranth failed did natural gas prices fall back to what was considered normal for supply and demand.

Sadly, like oil today, when this was happening we were being told that natural gas supplies were tight worldwide. That statement simply wasn’t true.

Yet, for the mountain of evidence available just since the deregulation of the markets, the same false premise of a supply/demand market price is allowed to be perpetuated without question. Nothing could be more evident based on every available metric and on recent history of energy commodities, be it electricity, natural gas, or oil.

There is no shortage of oil. The only thing lacking is honesty.

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