Captives of the free market

Economics is governed by the law of supply and demand. Our collective mind-set has been conditioned not to question the superiority of market forces, the "invisible hand" which renders everyone happy. Governments do best if they do less. The price of crude oil (and its derivative products including aviation fuel, petrol, diesel and fuel oil) impinge on each one of us. Are we getting a fair deal?

Crude oils are not all alike. Physical properties including viscosity and sulphur content differ considerably and so does their yield (end products derived through refining). "Light oils" that yield more top-end products, such as petrol, command higher prices. There are about 161 types of traded oil, each graded by its density or specific gravity. From 1973 to about 2000, the price of oil was generally fixed by the Opec countries. Today, Opec accounts for less than 40 per cent of global oil production and is in no position to control prices.

For pricing purposes, Brent oil (North Sea) is used as a marker for the European market and West Texas Intermediate for the American one. Platt's, a private European publication, indicates the daily prices for various types of crudes and oil derivatives. Each of the oil derivative products has its own market, which has its own dynamics. Recently, for the first time ever, the price of diesel was higher than that of petrol, even though the latter is a "lighter" product. The international price of oil is denominated in the US dollar, so its "real" price depends also on the currency market.

The price of oil reported in the media refers to the price of "futures" (a contractual obligation to exchange an amount of oil at an agreed price on a specific date). Unlike with "spot" prices, no immediate delivery of the physical product is required. Futures can be traded freely until the date of maturity. Their market is determining oil prices, even though only a fraction of the 80 million barrels that the world consumes daily is actually sourced through this channel.

Since 2000, US legislation has exempted trading via electronic exchanges from supervision by the Commodity Futures Trading Commission (CFTC). This led to an explosion in "paper oil", that is future contracts traded through unregulated electronic markets. Subsequently, the situation was further complicated by the CFTC itself authorising ICE Futures (London) to trade US oil futures without imposing any reporting requirements. This when the other leading oil exchange, the New York Mercantile Exchange (NYMEX), was obliged to report all transactions on a daily basis. As a result, the CFTC was no longer in a position to monitor the market for speculation and price manipulation. Now nobody knows exactly who is selling oil to who.

Neither does the industry agree as to what is determining the price of oil. Some analysts say it is supply and demand. They mention the insatiable demand of China, India and other developing economies, the supply limitations due to the lack of investment in refineries, that producing countries have reached the peak of their output capacity, and the market uncertainties that arise from political instability and natural disasters. These are all undeniable factors.

Other experts blame "structured" speculation for higher prices. They point to the rise in prices from $100 to $147 in just the first six months of 2008, to all the talk about prices reaching $100 and then $200, and to the billions invested by giant trader banks and pension funds as they deemed the oil market a good way to recuperate some of their real estate losses.

For sure, while consumers are paying record prices for their energy and fuel requirements, the other stakeholders of the oil industry are making mega-profits. It is estimated that oil producing countries have earned an extra $3 trillion over the last four years. Exxon Mobil, one of the "Seven Sisters" that dominate the industry, posted $40.6 billion profits in 2007, the biggest ever by an American company. There are huge vested interests benefiting from such high prices. Could these interests be using the anonymity of the futures market to rig prices? (Time magazine, August 22, 2008).

Over these last months, consumption of oil in Europe and the US has been falling. Their economies are slowing down, while inflation is on the rise. The oil industry knows that a global recession will lead to plummeting oil prices. Prices have already fallen by some $30 in the last two months. Have consumers and investors been taken for a ride? Only time will tell.

In the meantime, governments need to be more proactive in the energy sector. The mess we are all in is partly due to their laissez faire attitude. For them to continue collecting higher revenues from taxation on petroleum products is adding insult to injury. Too much time has already been wasted. Governments should now push and incentivise the development of alternative energy and educate consumers on how to use energy and fuels efficiently. The invisible hand, at best, will only work in the long term. And by then we will all be dead.