Thursday, May 15, 2008

The Crude facts

In May 2008 the price of oil reached an unprecedented $125 a barrel, Oil has continued to hit record levels since January 2008 as the price of Oil passed the $100 mark when a single trader in search of market fame pushed through a small trade. It has risen by 25% in the last four months and by nearly 400% in the last seven years. The importance the black stuff plays in the modern economy is so crucial that slight changes in prices can affect economies.

Oil past and present

It was British naval power that brought Oil to the international scene. In 1882, Oil had little commercial interest. The development of the internal combustion engine had not yet revolutionised world industry. It was Britain's Admiral Lord Fisher, who argued that Britain must convert its naval fleet from bulky coal-fired propulsion to the new oil fuel. With Germany on the verge of shifting the global balance of power by developing its own oil propelled ship from that point, oil conversion of the British fleet dictated national security priority to secure large oil reserves outside Britain.

WW1 brought to the international scene the importance of oil; it came to be seen globally as the key to military success. In an age of air warfare, mobile tank warfare, and naval warfare bulky coal-fired propulsion gave way to oil. Oil required only 30 minutes for ships to reach top speed compared to 4-9 hours when coal was used, battleships powered by coal emitted smoke which could be visible 10 kilometres away whilst oil had no tell-tale signs. The strategic advantage it gave was insurmountable and the British empires control of oil supplies become became even more important given the fact that Great Britain had no oil supplies at the time. It was the capturing of the rich oil fields of Baku on the Caspian Sea denying vital supplies to Germany that resulted in the end of WW1 and German surrender. William Engdahl geopolitical expert outlined the importance of oil ‘rarely discussed, however is the fact that the strategic geopolitical objectives of Britain well before 1914 included not merely the crushing defeat of Germany, but, through the conquest of war, the securing of unchallenged British control over the precious resource which by 1919, had proved itself as a strategic raw material of future economic development – petroleum. This was part of the ‘great game’ – the creation of a new global empire, whose hegemony would be unchallenged for the rest of the century, a British – led new world order.’ Britain and France concluded a secret oil bargain agreeing in effect to monopolise the whole future output of Middle Eastern oil between them.

Today oil is used for numerous everyday products across the world, most commonly for powering combustion engines such as fuel oil, diesel oil and petrol. Oil is also used as fuel for heating and lighting (e.g. kerosene lamp). The petrochemicals industry produces many by-products such as plastics and lubricants. It also manufacturers solvents (alcohols) through oil, without which there would be no chemicals industry. The free flowing hydrocarbons allow many farming implements and fertilizers.

Oil Markets explained

Crude oil, also known as petroleum, is the world's most actively traded commodity. The largest markets are in London, New York and Singapore but crude oil and refined products - such as gasoline (petrol) and heating oil - are bought and sold all over the world. Crude oil comes in many varieties and qualities, depending on its specific gravity and sulphur content which depend on where it has been pumped from.

Because there are so many different varieties and grades of crude oil, buyers and sellers have found it easier to refer to a limited number of reference, or benchmark, crude oils. Other varieties are then priced around this, according to their quality. Brent is generally accepted to be the world benchmark, although sales volumes of Brent itself are far below those of Saudi Arabian crude oils. Brent is used to price 66% of the world's internationally traded crude oil supplies.
In the Gulf, Dubai crude is used as a benchmark to price sales of other regional crudes into Asia.

In the United States, the benchmark is West Texas Intermediate (WTI). This means that crude oil sales into the US are usually priced in relation to WTI. However, crude prices on the New York Mercantile Exchange generally refer to 'light, sweet crude'. This may be any of a number of US domestic or foreign crudes but all will have a specific gravity and sulphur content within a certain range.

Slightly confusingly, the Organisation of Petroleum Exporting Countries (OPEC) - a cartel of some of the world's leading producers - has its own reference. Known as the Opec basket price, this is an average of seven - always the same seven - crudes. Six of these are produced by Opec members while the seventh, Isthmus, is from Mexico. Opec aims to control the amount of oil it pumps into the marketplace to keep the basket price within a predetermined range. In practice, the price differences between Brent, WTI and the Opec basket are not large. Crude prices also correlate closely with each other.

Oil contracts are brought and sold on international exchanges with the largest being Nymex (New York Mercantile Exchange) in New York and the Intercontinental Exchange (ICE) Futures in London, who today control global benchmark oil prices which in turn set most of the freely traded oil cargo. They do so via oil futures contracts on two grades of crude oil - West Texas Intermediate and North Sea Brent. A third rather new oil exchange, the Dubai Mercantile Exchange (DME), trading Dubai crude, is more or less a daughter of Nymex, with Nymex president James Newsome sitting on the board of DME. All exchanges use the US dollar as the standard to price oil.

Due to the nature of oil requiring extracting and refining participants commonly use futures contracts for delivery in the following month. In this type of transaction, the buyer agrees to take delivery and the seller agrees to provide a fixed amount of oil at a pre-arranged price at a specified location. Futures contracts are traded on regulated exchanges and are settled (paid) daily, based on their current value in the marketplace. The minimum purchase is 1,000 barrels.

Oil prices

So what is it that moves oil prices up and down? Most analysts and experts continue to interpret the price of oil price movements due to fundamentals – in the oil industry the fundamentals are factors that influence the supply of, and demand for, oil. Things such as the increasing demand from China and India, as well as fears that a stand-off between the US and Iran could interrupt supplies; have a bearing on oil prices. Alternatively, financial factors may be at work, such as a hedge fund having to sell a particular oil contract so it does not end up receiving a tanker-load of oil - or a trader deciding it would be fun to be the first to trade oil above $100 a barrel. However most fundamental information is not freely available. Mark Lewis from Energy Market Consultants explained in a BBC interview “We really don't know what the fundamentals are doing at any point in time, the markets are looking for signals from the fundamentals. Some of them are irrelevant, some of them are wrong, some of them are meaningless, but they affect prices nevertheless.” Sean Cronin, editor of Argus Global Markets explained “When the New York oil price broke through $100 a barrel for the first time at the start of 2008, one of the factors cited as being behind it was the assassination of Benazir Bhutto in Pakistan on 27 December 2007, that didn't strike us as making any sense at the time.”

Hence there needs to be a distinction between the factors that raise the oil price because they affect sentiment and the ones that genuinely affect supply and demand for oil. The dotcom boom in the 1990s was over inflated, but as long as everyone believed in it, the price of internet companies continued to rise. Once speculators stopped believing in internet stocks rising, the price went down. Thus Speculators trade on rumour, not fact.

Speculation driving oil price hike

A variety of reasons have been presented for why the price of a barrel of Oil continues to rise. For the study of Oil prices many consultants are paid elaborate rates to predict trend in oil. Many politicians continue to cite China and India as the chief reasons for the current price of oil. Many analysts have cited geopolitics as the chief reason such as conflict in Nigeria, oil peak and the rise of bio fuel. Although these factors have had some bearing on Oil prices they are not the actual causes for the price of oil to reach the current historical level. Speculation by traders is at the heart of the current hike.

Today's oil prices are really determined by a process so opaque only a handful of major oil trading banks, such as Goldman Sachs or Morgan Stanley, have any idea who is buying and who is selling oil futures or derivative contracts that set physical oil prices in this strange new world of ‘paper oil.’ Today 60% of crude oil price is pure speculation driven by large trader banks and hedge funds and with the development of unregulated international derivatives trading in oil futures over the past decade, the way has opened for the present speculative bubble in oil prices.

A June 2006 US Senate Permanent Subcommittee on Investigations report on "The Role of Market Speculation in rising oil and gas prices" noted, "... there is substantial evidence supporting the conclusion that the large amount of speculation in the current market has significantly increased prices".

A common speculation strategy amid a declining US economy and a falling US dollar is for speculators and ordinary investment funds desperate for more profitable investments amid the US sub-prime disaster to take futures positions selling the dollar "short" and oil "long." This is where one borrows dollars and sells them for a short period, betting the price of the dollar will fall. Then such a trader would purchase the same dollars at the new fallen price and return the borrowed money taking the profit from the new fallen price to the original higher price. Lehman Brothers, the investment bank, has estimated that fuel is 30% overpriced because of an influx of money into the oil market from investment funds. It believes that hot money accounts for between $20 to $30 of the recent increase in oil prices and that about $40 billion has been invested in the sector so far this year — equal to all the money pumped into oil last year.

Energy Geopolitics

Although the current crisis has in large part been due to speculators moving out of the sub-prime crisis and into commodities there are however a number of Geopolitical factors and trends and we should be aware of that will shape the global situation. The age of oil, produced its own technology, its balance of power, its own economy and its pattern of society. The future of energy security will play a key role on the global balance of power.

These factors are four:

1. The Eastern threat - The Middle East is gradually shifting from being a unipolar region in which the US enjoys uncontested hegemony to a multipolar region. The US will face more competition from China and India over access to Middle East oil. Soaring global demand for oil is being led by China's continuing economic boom and, to a lesser extent, by India's rapid economic expansion. Both are now increasingly competing with the US, the European Union and Japan for the lion's share of global oil production.

This additional demand comes at a time of continuing production problems in a number of oil-producing nations. Production is down in Nigeria after continues attacks on pipelines by anti-government militants, while Iraqi exports through the north of the country have been hit by renewed cross-border raids by Turkish forces against Kurdish insurgents.

Economists warn that continuing high oil prices will impact on the global economy, hitting growth and fuelling inflation. More importantly it will impact America's ability to fuel its own economic growth and in turn become more reliant on China for cheap goods. The American economy used to be the world's powerhouse, but today it is being left behind by emerging economies. To compound its problems, The demand for greater oil is affecting America's ability to pull itself out of its downturn and is creating inflation across the Western world. If China at any time in the future should develop its political will and ambition, it is in a relatively strong economic position to substantially weaken America.

2. The Russian threat - Russia, the leading producer of natural gas and one of the leading oil producers, is the global winner. The relationship between the European Union and Russia is now dominated by Russia and will in the future make Europe dependent on Russian oil and gas. The oil shocks of the 1970s had different effects on different European countries. Britain had some North Sea oil and the prospect of more, as did Norway. Germany and France had little or no oil of their own. Differential shocks in the coming period of oil shortage will make it harder to maintain the Euro-zone.

Vladimir Putin has already used oil and gas as a diplomatic weapon against the European states, which have had to fall into line in June 2007 after making grandiose demands against Russia. Russia even made veiled threats against Britain during the famous spy poisoning case. Russia has also in the last year stopped supplying energy to its neighbours to quell dissent and ensure political allegiances.

Unlike China and India, Russia has a history of political strength and maturity, and the evidence over the last two years is that Russia has begun re-inventing itself as a regional power, after winning back Kazakhstan and Uzbekistan from the American grip and managing the stop the influence of the three revolutions in that region. America is becoming increasingly worried about the growing economic and political influence of Russia.

3. Oil and Petrodollars. One of the achievements of the US in the 1970's was to peg the price of oil to dollars. This meant that oil transactions are carried out in dollars only. This has allowed the US to maintain the dollar as the world premier currency and the currency of choice for foreign reserves.

However one of the key factors behind the rise in the price of oil is the devaluing of the dollar. Now trading countries want more dollars for oil simply because the dollar is worth less - this would have increased the price of oil regardless of the increasing demand for it.

Today the European Union led by Britain and Germany are increasingly calling for pegging oil to the Euro; thereby stabilising the price of oil, and giving a stable revenue to oil producing countries. However, this severely impacts the dollar as a currency and if this was to happen would perpetuate America's economic crisis as the dollar would devalue even more.

Although this is not yet an impending threat, if America cannot bring itself out of its severe downturn, this threat may become more real - particularly if China was to add to this growing call.

4. The importance of the Middle East. Despite current supply shortages of oil around the world and the future restrictions, the importance of the Middle East, will not lessen. In fact it will become the most crucial area in the world.

This is because 66% of the world’s oil reserves are in the Middle East. “Proved" oil reserves are those quantities of oil that geological information indicates can be with reasonable certainty recovered in the future from known reservoirs. Of the trillion barrels currently estimated, 6% are in North America, 9% in Central and Latin America, 2% in Europe, 4% in Asia Pacific, 7% in Africa, 6% in the Former Soviet Union. Today, 66% of global oil reserves are in the hands of Middle Eastern regimes: Saudi Arabia (25%), Iraq (11%), Iran (8%), UAE (9%), Kuwait (9%), and Libya (2%).

Currently of the 11 million barrels per day (mbd) the US imports 3 million barrels per day from the Middle East. But in the years to come dependence on the Middle East is projected to increase by leaps and bounds. The reason is that reserves outside of the Middle East are being depleted at a much faster rate than those in the region. The overall reserves-to-production ratio -- an indicator of how long proven reserves would last at current production rates – outside of the Middle East is about 15 years comparing to roughly 80 years in the Middle East. It is for this reason that George Bush said last April, U.S. dependence on overseas oil is a "foreign tax on the American people."

This is on of the most volatile region in the world; and its importance will only grow stronger. The US is currently very worried about political developments in this region. A return of the Khilafah as predicted by several think tanks can potentially cripple America's economy, at a time where its political leverage is at its weakest since the end of the cold war.

Conclusions

The Oil price crisis once again highlights that the greed of speculators knows no bounds. It was greed that drove many banks to lend sub prime loans to individuals with no ability to repay the loans. It is again greed that is driving speculators to bet on Oil prices with no intention of actually purchasing the oil in order to make profits on the price differences – whatever the affect on the world. Such speculators drove the dot.com bubble, and then moved to the sub prime bubble once it burst and now they are pouring into the last remaining sector commodities – it is for this reason food and oil prices have reached astronomical levels, well beyond the reach of those who need it most. The Western world consumes 50% of the 21st century’s most important resource; oil, it produced less then a quarter of it. It is over consumption rather then China and India that are causing the crisis. The US specifically produced only 8% of the world’s oil but consumes 25% of it.

The Oil crisis also reveals the treachery of the Muslim rulers, whilst China and Russia are manoeuvring to weaken the US Saudi Arabia increases production of oil to ease US oil prices. Without the help of the Muslim rulers the US may not even be a super power, the Muslim lands hold what’s is considered the resource of the 20th century and most likely the resource for the 21st century, they should be the worlds superpower dictating global politics and actually doing what they continuously say they do – carrying dawah to the rest of the world.

As US consumption continues to rise the competition for dwindling energy sources will intensify, this will make the Muslim lands even more important and as with Iraq occupation may well be justified for stable supplies of the black stuff.

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