Economic Cycles, Price Movements And The Disconnect Between Demand And Supply: The Case Of Crude Petroleum

Economic Cycles, Price Movements and the Disconnect between Demand and Supply: The case of Crude Petroleum

Santhosh T Varghese 1 Introduction Economic cycles are characteristic features of capitalist economies. The advent of neo-liberal paradigm of economic development and the consequent hell-bent stampede for embracing globalisation in the economic plane rendered economies, even having substantial level of state presence in economic activity, vulnerable to the innate cyclical movements of market economies, within no time. The macro economic model of aggregate supply and aggregate demand considers exogenous changes in aggregate supply and aggregate demand are the forces that cause fluctuations in the economy as a whole (Mankiv, 2002). Exogenous changes in aggregate supply and aggregate demand curves are often called as supply/demand shocks and these shocks. The real business cycle models are also sometimes referred as models driven by aggregate “supply shocks”. But Plosser (1989) agues that such a description nevertheless seems approximately accurate for models driven by productivity shifts, it is potentially misleading, as there is nothing inherent in the real business model that limits it to the analysis of variations in technology or supply. Hence ‘supply shocks’ in the

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Lecturer, Post Graduate Dept. of Economics, PM Government College, Chalakudy, Affiliated to Calicut University, Kerala, India. Visit at: http://www.santhoshtv.in Blogs at: http://www.alwayseconomics.blogspot.com, and http://www.facts-unmasked.blogspot.com

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model of aggregate supply and aggregate demand alone are referred as ‘price shocks’. Price shocks alter the cost of producing goods and services and the prices that firms charge. The oft cited example of price shock/supply shock is the crude oil price shock which results in an upward revision of cost of production and prices across-the-board, especially in a developing economy. Such shocks disrupt economic well being by pushing output and employment away from their natural rates and causes fluctuations in the economy. In theory, the government can make use of the tools of stabilisation policy to dampen these fluctuations but the priorities and concerns of the government, especially in a neo-liberal environment, largely determines the nature and character of tools of the stabilisation policy and, by and large, it may end in protecting the interests of capital and market. As such, the interests of the general public and the unempowered need to be protected and for that, special efforts are to be taken to uncover the ‘obscure factors’ that largely propel the price movements of crude petroleum. This assumes significance as public offices sympathetic to market forces more often than not shirk in exposing these ‘obscure factors’ but religiously diligent in shielding them under the cover of ‘impact of economic/oil fundamentals’. Hence, it becomes imperative to examine; the role of ‘supply shocks termed as price shocks’ and the extent of influence of ‘economic/oil fundamentals’ upon the price movements of crude petroleum. If other factors, which are hypothesised as obscure factors, are found prominent in exerting undue influence they must be skinny dipped and their relationship with the neo-liberal economic environment is to be accentuated. To abridge, fortifying the general public and the poor from the capricious movements of crude oil prices needs a methodical and comprehensive appreciation of price movements especially in a neo-liberal regime.

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It is in context, the study attempts to dissect the price movements in crude oil to comprehend the reasons for the apparent disconnect between demand-supply balance and the factors behind price formation and its consequent impact upon the economic well being of the nation. The paper is divided into six sections. The first section delineates certain features of the present economic cycle, the second one highlights the role of crude oil prices in the overall make-up of wholesale price indices and its impact upon poverty, the third section analyses the behaviour of demand, supply and prices of crude oil, the fourth one sequesters the disconnect between oil ‘fundamentals’ and oil prices, the fifth section examines the role of futures trading and the elements of speculation and the last section furnishes the concluding remarks.

The Boom and Bust in the Sub-Prime Era Economists are yet to advance cogent theoretical explanations for the economic boom of 2001-2008 and the consequent continuing meltdown in economic activity. Nonetheless, it is well accepted that, the sub-prime lending, speculative movements of finance capital, low regulatory measures in financial sector and the heavily shrouded financial transactions and the latest argument regarding the role of US current account deficit, etc—all undoubtedly contributed to the present cycle in economic activity. Dissecting the economic cycle in the aggregate economy by considering the behaviour of all constituent time series, wide opens interesting and revealing scenes regarding the behaviour of conflicting movements among different time series. Bober (1971) clearly punctuated that an expansion or contraction phase does not mean that all time series in the economy are moving in tandem or in same direction, ie, upward in an expansion phase and downward in a contraction phase. He rightly pointed out that, for instance, “….once the peak is turned, the proportion of falling series edge clearly into majority and go on to become a greater and greater majority as contraction continues…” (Bober 1971, pp41).

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The economic cycle of the sub-prime era also conforms to this conclusion and conflicting movements in time series are observed. The various time series related to crude petroleum exhibits conflicting movements compared to the aggregate behaviour. This needs to be explored further. Moreover, economic variables related to crude petroleum are crucial variables especially for a developing economy as the price of petroleum products have a cascading effect on prices across-the-board and adversely affect the budget line of vulnerable sections of the economy. Besides, adverse fluctuations in petroleum product prices fuel inflation and result in the northward movement of poverty ratios.

Crude Oil Prices, WPI and Poverty The wholesale price index (WPI) of India for the period 2002-03 to 2008-09 is analysed to understand the influence of fluctuations in crude petroleum prices. Even though, the fuel, power, light and lubricant commodity group have only a 14.23 weight in the wholesale price index (WPI) of India, during 2008-09, inflation rate of this commodity group (12.9%) is higher than that of the overall inflation rate (10.3%) and is also the highest among different commodity groups (See Table 1 given below).

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Table: 1

Wholesale Price Indices

All Commodities/ Major Groups

Weight 2002- 2003- 2004- 2005- 2006- 2007- 2008(%) 03 04 05 06 07 08 09*

All Commodities 100.00 166.8 175.9 187.3 (WPI) Inflation Rate (%) 3.4 5.5 6.5 Primary Articles (WPI) 22.02 174.0 181.5 188.1 Inflation Rate (%) 3.3 4.3 3.7 Fuel, Power, Light & Lubricants (WPI) 14.23 239.2 254.5 281.0 Inflation Rate (%) 5.5 6.4 10.0 Manufactured Products (WPI) 63.75 148.1 156.5 166.3 Inflation Rate (%) 2.7 5.6 6.2 N.B.:Yearly WPI is based on average of weekly indices * April-November 2008-09

195.6

206.2

215.8

236.6

4.4

5.4

4.7

10. 3

193.6 2.9

208.7 7.8

224.7 7.7

222.8 8.2

306.8 9.2

324.0 5.6

327.0 1.0

12. 9

171.4 3.1

179.0 4.4

187.9 5.0

204.6 9.9

364.4

(Provisional)

Source: GOI (2009b) A more detailed picture is displayed by the table given below which gives the time series of monthly WPI for selected groups and commodities for the period from January 2007 to February 2009.

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Table: 2 Time Series of Wholesale Price Indices of Selected groups

Feb09

Jan09

Dec08

Nov08

Oct-08

Sep-08

Aug08

Jul-08

Jun08

May08

Apr08

Mar08

Feb08

227.78

229.58

229.75

234.18

239.03

241.5

241.24

240

237.38

231.08

228.5

225.54

219.88

247.93

249.08

247.33

250.94

251.45

252.2

249.28

248.68

243.95

241.94

238.63

235.86

230.55

323.5

328.56

331

348

369.15

375.3

377.94

377.2

374.43

346.96

342.85

341.52

335.25

(II.B) Mineral Oils

378.35

388.44

393.65

427.6

470.65

483.23

488.56

487

481.4

425.58

417.08

414.58

405.15

(III) Manufactured Products

199.43

200.74

201.08

203

205.73

207.95

207.94

206.35

204.5

201.5

199.48

196.1

190.43

Jan08

Dec07

Nov07

Oct07

Sep07

Aug07

Jul-07

Jun07

May07

Apr07

Mar07

Feb07

Jan-07

218.15

216.42

215.88

215.18

215.06

213.78

213.63

212.28

212.28

211.5

209.76

208.88

208.83

224.58

222.5

223.88

223.85

225.98

223.75

224.5

220.6

220.93

219.18

214.64

214.95

214.23

334.5

331.7

327.1

323.7

321.86

322.35

321.85

321.98

322.05

320.35

319.84

319.8

322.05

(II.B) Mineral Oils

403.5

400.06

393.7

386.9

383.08

384.03

383

383.3

383.45

380.3

379.14

378.63

381.8

(III) Manufactured Products

189.95

188.58

188.28

187.98

187.46

186.08

185.73

184.88

184.83

184.55

183.52

182

181.7

All Commodities (I) Primary Articles (II) Fuel, Power, Light & Lubricants

All Commodities (I) Primary Articles (II) Fuel, Power, Light & Lubricants

Source: GOI (2009a)

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The data in the table is plotted in the adjoined graph to better understand the behaviour of the time series. A clear cyclical movement in the WPI of mineral oils is quite evident from May 2008 onwards where it peaked in August 2008. Figure: 1 Series of Wholesale Price Indices All Commodities

Primary

Fuel group

Mineral Oils

Manufactured Products

500

450

400

350

300

250

200

It is worth noting the fact that, mineral oil sub-group alone manifested a pronounced cyclical movement. It is in this context, the study took the time series related to crude petroleum for a detailed study and analysis, to comprehend the behaviour of various crude petroleum time series and to unearth what determines the formation of crude petroleum prices and how it would impact the economic well being.

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Ja n -0 9

D e c -0 8

N o v -0 8

O c t-0 8

S e p -0 8

A u g -0 8

Ju l-0 8

Ju n -0 8

M a y -0 8

A p r-0 8

M a r-0 8

F e b -0 8

Ja n -0 8

D e c -0 7

N o v -0 7

O c t-0 7

S e p -0 7

A u g -0 7

Ju l-0 7

Ju n -0 7

M a y -0 7

A p r-0 7

M a r-0 7

F e b -0 7

Ja n -0 7

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Global Demand, Supply and Prices of Crude Petroleum The appropriate indicator of Oil Prices

According to the International Energy Outlook, (Energy Information Administration 2008, pp26) in every year since 2003, WTI (West Texas Intermediate) is often considered as the indicator of world crude oil 2 prices as a whole. But the Oil Market Report (International Energy Agency 2009, pp39) points out that the unprecedented collapse in the WTI pricing structure over the past six weeks, posited question marks regarding the relevance of WTI as a global price benchmark. Another view is that, the Brent crude produced in Northern Europe, which is used as a benchmark for 60% of crude streams around the world, would better serve as a measure of world crude prices (Wit and Smith 2008). At the very same time, the OPEC basket average price cannot be sidelined altogether and is also an important indicator of world oil prices, even though OPEC controls only around 35% of global oil supply. In this backdrop, Brent spot price and OPEC basket average price are taken as indicators of price of crude oil at global level.

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Crude oil: surface separating facilities. Depending upon the characteristics of the crude stream, it may also include: (1) Small amounts of hydrocarbons that exist in gaseous phase in natural underground reservoirs but are liquid at atmospheric pressure after being recovered from oil well (casing-head) gas in lease separators and are subsequently commingled with the crude stream without being separately measured. Lease condensate recovered as a liquid from natural gas wells in lease or field separation facilities and later mixed into the crude stream is also included; (2) Small amounts of non-hydrocarbons produced with the oil, such as sulphur and various metals; (3)Drip gases, and liquid hydrocarbons produced from tar sands, oil sands, gilsonite, and oil shale. Liquids produced at natural gas processing plants are excluded. Crude oil is refined to produce a wide array of petroleum products, including heating oils; gasoline, diesel and jet fuels; lubricants; asphalt; ethane, propane, and butane; and many other products used for their energy or chemical content.

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Demand, Supply and Prices of Crude Oil The behaviour of the time series with respect to demand and supply of crude oil is so patent that it treads through a plain terrain where there are no noticeable humps or troughs. This behaviour needs to be discussed in conjunction with the behaviour in crude oil prices that exhibits a cyclical movement. The time series given below in the table and plotted in the figure are quite instructive to ponder upon. The OPEC and Brent prices exhibit almost same behaviour. Brent price is slightly above the OPEC price and is understandable given its high quality compared to the low quality high sulphur rich OPEC oil.

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Table: 3

Year & Month

Demand, Supply and Prices of Crude Oil

World Supply mb/day

OPEC Supply m b/day

Non-OPEC Supply mb/day

World Demand 3

OPEC %

OPEC Basket av. price US $ /b

Europe Brent Spot Price FOB 4 US $ /b

Jan-05

83.60

28.80

54.80

84.80

33.96

40.24

44.51

Feb-05

84.30

29.00

55.30

84.80

34.20

41.68

45.48

Mar-05

84.20

29.10

55.10

84.80

34.32

49.07

53.10

Apr-05

84.50

29.40

55.10

82.60

35.59

49.63

51.88

May-05

84.60

29.30

55.30

82.60

35.47

46.96

48.65

Jun-05

84.60

29.30

55.30

82.60

35.47

52.04

54.35

Jul-05

84.70

29.32

55.38

83.20

35.24

53.13

57.52

Aug-05

84.90

29.70

55.20

83.20

35.70

57.82

63.98

Sep-05

83.80

29.80

54.00

83.20

35.82

57.88

62.91

Oct-05

84.40

29.60

54.80

84.20

35.15

54.63

58.54

Nov-05

85.00

29.60

55.40

84.20

35.15

51.29

55.24

Dec-05

85.00

29.30

55.70

84.20

34.80

52.65

56.86

Jan-06

84.60

29.20

55.40

85.60

34.11

58.29

62.99

Feb-06

84.60

29.60

55.00

85.60

34.58

56.62

60.21

Mar-06

84.50

29.70

54.80

85.60

34.70

57.86

62.06

Apr-06

85.10

30.00

55.10

83.60

35.89

64.44

70.26

May-06

85.00

29.80

55.20

83.60

35.65

65.11

69.78

Jun-06

85.20

29.80

55.40

83.60

35.65

64.60

68.56

Jul-06

85.50

29.80

55.70

84.60

35.22

68.89

73.67

Aug-06

85.80

30.00

55.80

84.60

35.46

68.81

73.23

Sep-06

85.40

29.80

55.60

84.60

35.22

59.34

61.96

Oct-06

85.30

29.40

55.90

85.70

34.31

54.97

57.81

Nov-06

85.40

28.90

56.50

85.70

33.72

55.42

58.76

Dec-06

85.40

28.80

56.60

85.70

33.61

57.95

62.47

Jan-07

85.50

30.20

55.30

86.20

35.03

50.73

53.68

Feb-07

85.50

30.20

55.30

86.20

35.03

54.45

57.56

Mar-07

85.30

30.10

55.20

86.20

34.92

58.47

62.05

Apr-07

85.50

30.30

55.20

85.10

35.61

63.39

67.49

May-07

84.90

30.10

54.80

85.10

35.37

64.36

67.21

Jun-07

84.30

30.17

54.13

85.10

35.45

66.77

71.05

Jul-07

85.30

30.50

54.80

85.70

35.59

71.75

76.93

Aug-07

84.60

30.40

54.20

85.70

35.47

68.71

70.76

Sep-07

85.10

30.70

54.40

85.70

35.82

74.18

77.17

Oct-07

86.50

31.20

55.30

87.20

35.78

79.36

82.34

Nov-07

86.50

31.10

55.40

87.20

35.67

88.99

92.41

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Global demand for crude oil is quarterly averages given by Oil Market Report, International Energy Agency, (various issues) for each calendar year.

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Pertains to a transaction whereby the seller makes the product available within an agreed on period at a given port at a given price; it is the responsibility of the buyer to arrange for the transportation and insurance.

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Year & Month

World Supply mb/day

OPEC Supply m b/day

Non-OPEC Supply mb/day

World Demand 5

OPEC %

OPEC Basket av. price US $ /b

Europe Brent Spot Price FOB 6 US $ /b

36.70

87.19

90.93

Dec-07

87.00

32.00

55.00

87.20

Jan-08

87.20

32.00

55.20

86.80

36.87

88.50

92.18

Feb-08

87.50

32.10

55.40

86.80

36.98

90.64

94.99

Mar-08

87.30

32.10

55.20

86.80

36.98

99.03

103.64

Apr-08

86.80

31.90

54.90

85.70

37.22

105.16

109.07

May-08

86.60

32.30

54.30

85.70

37.69

119.39

122.80

Jun-08

86.50

32.40

54.10

85.70

37.81

128.33

132.32

Jul-08

87.80

32.80

55.00

85.20

38.50

131.22

132.72

Aug-08

86.80

32.50

54.30

85.20

38.15

112.41

113.24

Sep-08

85.60

32.30

53.30

85.20

37.91

96.85

97.23

Oct-08

86.90

32.10

54.80

85.00

37.76

69.16

71.58

Nov-08

86.50

31.30

55.20

85.00

36.82

49.76

52.45

Dec-08

86.20

30.90

55.30

85.00

36.35

38.60

39.95

Sources 7 : 1. Oil Market Report, International Energy Agency, (various issues) for demand and supply figures. 2. Monthly Oil Market Reports, OPEC, (various issues) for OPEC Basket average prices and supply. 3. "Energy Information Administration", Official Energy Statistics from the US Government, http://tonto.eia.doe.gov/dnav/pet/pet_pri_spt_s1_m.htm for Europe Brent Spot Price FOB US $ /b What is so palpable is the obvious disconnect between demand-supply balance and the prices of crude oil which follows a cyclical path. This is the conflicting movement, mentioned earlier, among the time series related to crude oil in a phase of an economic cycle. The aggregate economy of the world as whole is treading along a cyclical path and even the crude oil prices follow suit, 5

Global demand for crude oil is quarterly averages given by Oil Market Report, International Energy Agency, (various issues) for each calendar year.

6

Pertains to a transaction whereby the seller makes the product available within an agreed on period at a given port at a given price; it is the responsibility of the buyer to arrange for the transportation and insurance. 7

For all the figures, the most latest reports are relied upon.

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the demand and supply of oil refuses to follow and shows a conflicting behaviour. Apart from that, throughout 2008, world demand is lower than the supply 8 , but prices displayed a lucid cyclical path peaking at July 2008. What do they mean?

See Note: 2 (Global demand for crude oil is quarterly averages given by Oil Market Report, International Energy Agency, (various issues) for each calendar year.) 8

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Figure: 2 World crude Oil Demand, Supply and Prices

World Crude Oil Supply

World Crude Oil Demand

OPEC Bechmark Price

Brent Spot Price

140.00

120.00

100.00

80.00

60.00

40.00

20.00

Jan-09

Nov-08

Sep-08

Jul-08

May-08

Mar-08

Jan-08

Nov-07

Sep-07

Jul-07

May-07

Mar-07

Jan-07

Nov-06

Sep-06

Jul-06

May-06

Mar-06

Jan-06

Nov-05

Sep-05

Jul-05

May-05

Mar-05

Jan-05

0.00

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It only illuminates the stark yet familiar fact in a market economy that prices often do not lay at the intersection point of actual supply and actual demand but at the intersection point of perceived supply and perceived demand. Wherefore, it becomes imperative to explore what influences the perceived supply and perceived demand.

Crude Oil Prices and the Influence of ‘Fundamentals’ Often, when crude oil prices takes northward direction, it is often declared from the roof-tops of market-friendly public offices, that this time, the price rise is due to ‘fundamentals’ and there is no major speculative element beneath. The main fundamentals that determine the oil prices are demand, supply and the growth rate of the world economy. The first two are analysed and now the importance of growth rate of the world economy in the price formation need to studied. The table given below gives the relevant data. Table: 5 Year & Month Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05 Jul-05 Aug-05 Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06

Crude Oil Prices and Forecasted World Growth Rates OPEC Basket av. price US $ /b 40.24 41.68 49.07 49.63 46.96 52.04 53.13 57.82 57.88 54.63 51.29 52.65 58.29 56.62 57.86 64.44

Europe Brent Spot Price FOB US $ /b 44.51 45.48 53.10 51.88 48.65 54.35 57.52 63.98 62.91 58.54 55.24 56.86 62.99 60.21 62.06 70.26

Growth rates forecasted for the current year but revised in each current month 4.10 4.20 4.10 4.10 4.10 4.10 4.10 4.10 4.10 4.20 4.30 4.40 4.30 4.30 4.40 4.50

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Year & Month

OPEC Basket av. price US $ /b

May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08

65.11 64.60 68.89 68.81 59.34 54.97 55.42 57.95 50.73 54.45 58.47 63.39 64.36 66.77 71.75 68.71 74.18 79.36 88.99 87.19 88.50 90.64 99.03 105.16 119.39 128.33 131.22 112.41 96.85 69.16 49.76 38.60

Europe Brent Spot Price FOB US $ /b

Growth rates forecasted for the current year but revised in each current month

69.78 68.56 73.67 73.23 61.96 57.81 58.76 62.47 53.68 57.56 62.05 67.49 67.21 71.05 76.93 70.76 77.17 82.34 92.41 90.93 92.18 94.99 103.64 109.07 122.80 132.32 132.72 113.24 97.23 71.58 52.45 39.95

4.70 4.70 4.70 4.80 5.00 5.00 5.10 5.10 4.50 4.60 4.60 4.70 4.80 4.90 5.00 5.00 5.00 5.10 5.20 5.20 4.70 4.60 4.60 3.90 3.90 3.90 4.00 3.90 3.90 3.80 3.70 3.60

Sources: 1. Monthly Oil Market Reports, OPEC, (various issues) for OPEC Basket average prices and Global forecasted growth rates 2. "Energy Information Administration", Official Energy Statistics from the US Government, http://tonto.eia.doe.gov/dnav/pet/pet_pri_spt_s1_m.htm for Europe Brent Spot Price FOB US $ /b

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Nov-08

Sep-08

Jul-08

May-08

Brent Price US$/0.1b

Mar-08

Jan-08

Nov-07

Sep-07

Jul-07

May-07

Mar-07

Jan-07

OPEC Price US$/0.1b

Nov-06

Sep-06

Jul-06

May-06

Mar-06

Jan-06

Nov-05

Sep-05

Jul-05

May-05

Mar-05

Jan-05

Figure: 3 Crude Oil Prices and Forecasted World Growth Rates Ex. Growth Rate

13.25

11.25

9.25

7.25

5.25

3.25

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The forecasted growth rates for the world economy during April 2008 to June 2008 virtually stagnated at 3.9%. But even during that period, the oil prices 9 did not show any connection with the ‘fundamentals’ that should determine the prices. Despite the stagnation in the forecasted growth rates for the world economy, oil prices continued its climb which started from January 2007. The plotted series unambiguously manifest disconnect between ‘fundamentals’ and oil prices where the two series started to diverge as early as December 2007 and the midriff widened till July 2008. Moreover, from November 2007, the forecasted growth rates started to show what really lies underneath and it became more pronounced from January 2008. By virtually defying all these obvious indications or latent panic signals, oil prices skyrocketed to stratosphere only to dovetail from August 2008. To sum up, the analysis shows that global oil prices are not much influenced by ‘fundamentals’. It is to be explored further to unearth the real factors that decisively influence the global crude oil prices.

The Role of Futures Trading and the Elements of Speculation Futures trading in crude oil are largely dominated by the New York Mercantile Exchange (NYMEX) and Tokyo Commodity Exchange (TOCOM). NYMEX 10 is more popular and deals with the high quality light sweet crude oil with low sulphur content. NYMEX selected the landlocked city of Cushing, Oklahoma in United States, as the physical delivery point for the futures contracts because of its massive pipeline network and distribution infrastructure.

The oil prices are transformed to make it easy to present and visible in comparison with the forecasted world growth rates. Normally crude oil prices are quoted for one barrel in US dollars. For plotting the graph given above, these prices are transformed to represent price of crude oil per 0.1 barrel (instead of one barrel) by dividing the per barrel price with 10.

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At NYMEX, futures prices are quoted in dollars and cents per barrel and are traded in lot sizes of 1000 barrels (42000 gallons). Contracts at NYMEX constitute the promise to buy or sell crude oil in the city of Cushing, Oklahoma at a fixed price in a particular month in the future. 10

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Moreover, Oklahoma has close historical ties with the oil industry as it were earlier an area of oil production. Later when oil supplies dried up there, NYMEX identified it as an appropriate location point for the delivery of its futures with its massive storage facilities of a staggering 45 million barrels of oil. The area’s proximity to major oil producing and trading centres like Texas and the Gulf Coast became the added attraction for its selection. Besides, it is sometimes argued that NYMEX futures price is almost equal to the spot prices at Cushing, Oklahoma. Anyway, all this gives—the NYMEX Cushing, Oklahoma crude oil futures prices— a sort of universal acceptance for NYMEX futures. The table given below shows the data of OPEC basket average and Brent prices and the NYMEX futures prices.

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Table:6

OPEC and Brent Prices and NYMEX Futures Prices

Year & Month

OPEC Basket average Price (US $/b)

Europe Brent Spot Price FOB (US $/b)

Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05 Jul-05 Aug-05 Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07

40.24 41.68 49.07 49.63 46.96 52.04 53.13 57.82 57.88 54.63 51.29 52.65 58.29 56.62 57.86 64.44 65.11 64.60 68.89 68.81 59.34 54.97 55.42 57.95 50.73 54.45 58.47 63.39 64.36 66.77 71.75 68.71 74.18 79.36 88.99 87.19

44.51 45.48 53.10 51.88 48.65 54.35 57.52 63.98 62.91 58.54 55.24 56.86 62.99 60.21 62.06 70.26 69.78 68.56 73.67 73.23 61.96 57.81 58.76 62.47 53.68 57.56 62.05 67.49 67.21 71.05 76.93 70.76 77.17 82.34 92.41 90.93

Cushing, Oklahoma Crude Oil Future Contract 1 (US $/b) 46.85 48.05 54.63 53.22 49.87 56.42 59.03 64.99 65.55 62.27 58.34 59.45 65.54 61.93 62.97 70.16 70.96 70.97 74.46 73.08 63.9 59.14 59.4 62.09 54.35 59.39 60.74 64.04 63.53 67.53 74.15 72.36 79.63 85.66 94.63 91.74

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Year & Month Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09

OPEC Basket average Price (US $/b) 88.50 90.64 99.03 105.16 119.39 128.33 131.22 112.41 96.85 69.16 49.76 38.60 41.52

Europe Brent Spot Price FOB (US $/b) 92.18 94.99 103.64 109.07 122.80 132.32 132.72 113.24 97.23 71.58 52.45 39.95 43.44 43.32

Cushing, Oklahoma Crude Oil Future Contract 1 (US $/b) 92.93 95.35 105.42 112.46 125.46 134.02 133.48 116.69 103.76 76.72 57.44 42.04 41.92 39.26

Sources: 1. Monthly Oil Market Reports, OPEC, (various issues) for OPEC Basket average prices and Global expected growth rates. 2. "Energy Information Administration", Official Energy Statistics from the US Government, http://tonto.eia.doe.gov/dnav/pet/pet_pri_spt_s1_m.htm for Europe Brent Spot Price FOB US $ /b and http://tonto.eia.doe.gov/dnav/pet/pet_pri_fut_s1_m.htm for NYMEX futures prices. The data sketches a close relation both in terms of behaviour and value between all the three price series. The NYMEX futures price acts as the upper bound for price movements. The only exception is for a small period from March 2007 to July 2007 where the Brent prices slightly overtook the NYMEX futures prices because of temporary storage limitations faced at Cushing, Oklahoma. The figure given below presents the simplified picture. The figure delineates that in July 2008, the NYMEX futures prices took the downward movement well before the OPEC and Brent series reached their 20

respective peaks. In July 2008, both the spot prices registered an upward movement but the NYMEX futures price took a downward movement despite the fact that the forecasted world growth rate for July 2008 is 4%, up from the June rate of 3.9%. It is clear evidence that NYMEX futures know things better. But one cannot take solace in the oft-repeated market slogan that market knows things better and faster for this behaviour of NYMEX futures. We have seen the eyesight of market and its so-called efficiency during the era of sub-prime crisis. So it is prudent to zero in the attention else where and obviously upon the speculative forces so active in the futures markets. The OPEC prices through out lie at the lower level and the Brent prices lie just above it. Two interpretations are possible. First, NYMEX futures prices are not much different from the Brent and OPEC spot prices. One implication is that speculative elements in futures trading are not rouge. Second, NYMEX futures prices acts as the benchmark for spot price fixation. Spot prices are always looking upon the futures prices rather than the strength or weakness of ‘fundamentals’. Furthermore, it is already found that OPEC and Brent prices are not at all influenced by demand, supply or forecasted growth rate of the world economy. Hence, the close affinity of OPEC and Brent spot prices with NYMEX futures prices only highlights the fact that these spot prices are gravitated by the futures prices. As such, the implication is that speculative elements in futures trading are exerting undue influence upon the spot crude oil prices. The analysis so far accentuates that disconnect between demand-supply balance and oil prices are so patent and suggesting. It is only in such a situation, futures prices could exert influence upon spot prices of commodities, though exceptions are possible. But they are exceptions only.

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Figure:4

Relation between OPEC and Brent Prices and NYMEX Futures Prices OPEC Price

Brent Crude Oil Price

Cushing, OK Futures Price

135.00

125.00

115.00

105.00

95.00

85.00

75.00

65.00

55.00

Jan-09

Nov-08

Sep-08

Jul-08

May-08

Mar-08

Jan-08

Nov-07

Sep-07

Jul-07

May-07

Mar-07

Jan-07

Nov-06

Sep-06

Jul-06

May-06

Mar-06

Jan-06

Nov-05

Sep-05

Jul-05

May-05

Mar-05

35.00

Jan-05

45.00

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Hence, the first interpretation is difficult to accept and the connection between, both in behaviour and value, OPEC/Brent prices and futures prices prompts to accept the second interpretation which punctuates the influence of speculative elements in the futures trading of crude oil prices upon OPEC an Brent prices. However, the magnitude of influence of speculative trading in the futures market upon world oil prices could be cemented only by considering and analysing the net of long and short positions in the futures market along with this.

Recapitulation

Prices of crude oil are a hot topic in the discussions of inflation in a developing economy like ours. Market friendly public offices often try to mask the real factors that influence the formation of prices of crude oil. Many a times, they attempt to play down the reasons beneath the skyrocketing of oil prices by suggesting that price rise is due to the influence of economic fundamentals like soaring growth rate of the world economy, demand pressures, supply limitations etc. They seldom mention about the role of speculative elements vigorously engaging in the futures markets across the globe. In this backdrop, the study attempted to dissect the reasons behind the cyclical movement of oil prices. It found that there exist a glaring disconnect between demand-supply balance and oil prices. Moreover, oil price movements often and crucially defy forecasts of world growth rates and thereby strewn its own path led by factors better known themselves. However, there is close connection between the NYMEX futures prices of oil and the benchmark oil prices of Brent and OPEC oils, where in it came to the inference that the OPEC and Brent spot prices are highly influenced by the NYMEX futures prices. Last but not the least, the ‘oil price shock’ of 2008 is not a ‘supply shock’ as pointed out by the macroeconomic model of aggregate demand and supply where ‘supply shocks’ are often referred as ‘price shocks’ and

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hence needs to be understood as some thing under the guidance of the nether side of market economy.

References

1. Bober, Stanley (1971): The Economics of Cycles and Growth, Wiley Eastern Private Limited, First Wiley Eastern Reprint, New Delhi. 2. Energy Information Administration (2008): International Energy Outlook, September, Washington DC 3. GOI (2009a): Index Numbers of Wholesale Prices in India—by Groups and Sub-Groups (Monthly Averages), http://dbie.rbi.org.in/ 4. GOI (2009b): ‘Inflation Rate, Wholesale Price Index and Consumer Price Index’, Monthly Economic Scenario, February, http://eaindustry.nic.in/mes/Crude_oil.pdf 5. International Energy Agency (various years): Oil Market Report, Paris, France 6. Mankiw, N. Gregory (2002): Macro Economics, Fifth Edition, Worth Publishers. 7. OPEC (various years): Monthly Oil Market Report, Vienna, Austria 8. Plosser, Charles L (1989): ‘Understanding Real Business Cycles’, The Journal of Economic Perspectives, Vol. 3, No. 3, 51-78. 9. Wit, Joeri de and Smith, Aaron (2008): ‘What is the Price of Oil?’, Agricultural and Resource Economics Update, Giannini Foundation of Agricultural Economics, University of California, Vol. 11, No.5.

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