One may recall the oil price increase between 2006 and 2008, its fall in the later half of 2008, and subsequent rise in 2008-09. Again this provides a fascinating study to estimate the power and reach of these speculators at the global level.

It may be noted that the US financial sector has begun to turn its attention from currency and stock markets to commodity markets. According to The Economist, an estimated US$ 260 billion was invested into the commodity market in 2008 - up nearly 20 times the volume in 2003. There was a global upsurge in the prices of commodities coinciding with a weak dollar and the new speculative interest of the US financial sector in the commodities market.

Most of these investments are bets placed by hedge and pension funds, always on the lookout for risky but high-yielding investments. It is interesting is that unlike margin requirements for stocks which are as high as 50 percent in several countries, the margin requirements for commodities is a mere 5-7 percent. This implies that with an outlay of a mere US$ 250 billion, these speculators would be able to take positions to the tune of US$ 5 trillion - yes, US$ 5 trillion in the futures markets! It was estimated that by mid 2008 half of these were bets placed on oil.

Readers may note that oil is internationally traded in New York and London and denominated in US Dollar only. Naturally, experts opine that since the advent of oil futures, oil prices are no longer controlled by OPEC (Organization of Petroleum Exporting Countries). It is now done by Wall Street. This tectonic shift in the determination of international oil prices from the hands of producers to the hands of speculators is crucial in understanding the spectacular rise in oil prices between 2006 and 2008.

Today, oil prices are believed to be determined by the four Anglo-American financial companies-turned-oil traders, viz., Goldman Sachs, Citigroup, JP Morgan Chase, and Morgan Stanley. It is only they who have any idea about who is entering into oil futures or derivative contracts. It is also they who are placing bets on oil prices, and in the process ensuring that the prices of oil futures go up (or come down) by the day. But how does the increase in the price of oil in the futures market determine the price of oil in the spot markets?

Answering these questions as to whether speculation has “supercharged” the demand for oil, The Economist in its issue in mid-2008 states: “But that is plain wrong. Such speculators do not own real oil. Every barrel they buy in the futures markets they sell back again before the contract ends. That may raise the price of “paper barrels,” but not of the black stuff refiners turn into petrol. It is true that high futures prices could lead someone to hoard oil today in the hope of a higher price tomorrow. But inventories are not especially full just now and there are few signs of hoarding.”

On both counts - that speculation in oil is not pushing up oil prices, as well as on the issue of the build-up of inventories - the venerable Economist could possibly be wrong. In June 2006, when the oil price in the futures markets was about US$ 60 a barrel, a Senate Committee in the US probed the role of market speculation in oil and gas prices. The report points out that large purchase of crude oil futures contracts by speculators have in effect, created additional demand for oil and in the process driven up the future prices of oil. The report stated that it was “difficult to quantify the effect of speculation on prices,” but concluded that “there is substantial evidence that the large amount of speculation in the current market has significantly increased prices.”

The report further estimated that speculative purchases of oil futures had added as much as US$ 20-25 per barrel to the then prevailing price of US$ 60 per barrel, indicating a cost of US$ 35 per barrel. When oil prices peaked to US$ 147 per barrel in mid-2008, approximately US$ 110 per barrel alone could be attributed to speculation! But the report found a serious loophole in US regulation of oil derivatives trading, which according to experts could allow even a “herd of elephants to walk through it.” The report pointed out that US energy futures were traded on regulated exchanges within the US and subjected to extensive oversight by the Commodities Future Trading Commission (CFTC) - the US regulator for commodity futures market.

The report also pointed out to the tremendous growth in the trading of contracts on unregulated OTC (over-the-counter) electronic markets. Interestingly, the report pointed out that the trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron into the Commodity Futures Modernization Act in 2000. The report concludes that consequential impact on account of lack of market oversight has been “substantial.”

NYMEX (New York Mercantile Exchange) traders are required to keep records of all trades and report large trades to the CFTC, enabling it to gauge the extent of speculation in the markets and to detect, prevent, and prosecute price manipulation. In contrast, however, traders on unregulated OTC electronic exchanges are not required to keep records or file any information with the CFTC as these trades are exempt from its oversight.

Consequently, as there is no monitoring of such trading by any oversight body, the Committee believes that it allows speculators to indulge in price manipulation. Finally, the report concludes that whether or not any level of speculation is “excessive” lies entirely in the eye of the beholder. In the absence of data, however, it is impossible to begin the analysis or engage in an informed debate over whether our energy markets are functional or are constantly in the midst of a speculative bubble.

That was a few years ago; much water has flown down the Mississippi since then. Now to answer the second part of the question: how speculators are able to translate the future prices into spot prices. The answer is fairly simple. After all, oil price is highly inelastic - i.e. even a substantial increase in price does not alter the consumption pattern. No wonder, a mere 3-4 percent annual global growth has translated into more than a compounded 40 percent annual increase in prices for the three or four years between 2004 and 2008. 

But there is more to it. One may note that the world supply and demand is evenly matched at about 85-97 million barrels every day. Only if supplies exceed demand by a substantial margin can any downward pressure on oil prices be created. In contrast, if someone with deep pockets picks up even a small quantity of oil, it dramatically alters the delicate global demand-supply gap, creating enormous upward pressure on prices. The obvious question is who is this someone with deep pockets? 

It is interesting to note that the US strategic oil reserves were at approximately 350 million barrels for a decade till 2006. However, by mid 2008 these reserves had doubled to more than 700 million barrels. Naturally, this build-up of strategic oil reserves by the US (of 350 million barrels between 2007 and 2008 i.e. close to one million barrel a day) was adding enormous pressure on the oil demand and consequently its prices.

Did the oil speculators know of this reserves build-up by the US and were they indulging in rampant speculation? Were they acting in tandem with the US Government? But who foots the bill at such high prices? At an average price of even US$ 100 per barrel, the entire cost for the purchase of this additional 350 million barrels by the US worked out to a mere US$ 35 billion. Needless to emphasise, this can be funded by the US Government. After all, it has a currency that is acceptable globally and people worldwide are willing to exchange it for precious oil.

Possibly the US Government and the US speculators were targetting the Chinese in the run up to the Beijing Olympics. Or was it an innovative methodology adopted by some companies within the US financial system? Whatever, the world was made to bleed to ensure that it funded the US war on terror.

No wonder Goldman Sachs predicted in early 2008 that oil will touch US$ 200 to a barrel shortly, perhaps anticipating that the US Government will fully back its prediction (as it eventually did in 2008 and 2009 through the Troubled Assets Relief Programme whose sole beneficiary was the US Financial sector). And, in the past three years alone the world has paid an estimated additional US$ 3 trillion (the premium due to this manoeuvring and resultant speculation on conservative basis) for its oil purchases. Oil speculators (and not oil producers) are the biggest beneficiaries of this price increase. That would explain why OPEC countries, notably Saudi Arabia, were crying hoarse over the rise of the crude prices when in fact they should have celebrated.

The global crude oil price rise is complex, sinister and beyond naive, simplistic and timeworn theories of demand and supply. It is speculation, geopolitics and much more. Obviously, there is a symbiotic link between the US, the US Dollar and oil prices. And unless this truth is understood and the link somehow broken, oil prices cannot be controlled. Similarly, those who fashion oil prices have a deep nexus with governments, control policies of the governments and have the ability to punish those who sound voices of protest and resistance. Worse, suggestions for alternate currencies for trade in oil have invited swift retribution.

Oil economics beyond comprehension of analysts

It is thus obvious that this spectacular gyration in the oil prices since 2004 has flummoxed the world. Nothing, it would seem, explains the phenomenal rise in crude oil prices - from a mere US$ 30 per barrel just a few years ago to well above US$ 147 per barrel in July 2008 - a rise in excess of 350 percent. Some economists rationalised this consistent and spectacular rise in the price of oil for the past few years as being caused by gross mismatch between steep demand and supply.

The standard explanation for the increase in oil prices between 2006 and 2008 was that either oil supply was falling or that global demand was rising. Better still, it was predicted to be a combination of both. The most prominent factor for the oil price rise according to these economists, which fuelled global demand at that time, was the rapid growth of major economies, notably, the booming economies of China and India. Beyond China and India, it was also pointed out that emerging economies across the globe were also recording robust growth, and along with it, creating their own pressure on global oil demand.

Simultaneously, economists have been just as fair to the supply side of the debate with equally smooth arguments. The fundamental assumption was that oil supplies could never match the burgeoning growth of global economy as the planet had run out of oil. Brighter ones came with up with theories of “peak oil” being behind us, implying that we had used more oil than was available with Mother Nature.

Often supply disruptions, as happened in Nigeria for instance, or potential supply disruptions perhaps in Iran, were cited as examples to buttress these arguments. In this connection one notes, for instance, that the supply disruption caused by terrorism in Nigeria of 200,000 barrels a day (the global supply is approximately 85-87 million barrels) – which was less than a mere 0.2 percent of the daily global supply - was sufficient to cause a significant spike in global oil prices. If oil prices were so sensitive to such minor supply disruptions, terrorism backed by oil speculation (or is it the other way around) must indeed be a profitable business.

With the benefit of hindsight we can conclude that this seems to be profitable business with a purpose.

It would seem that the dividing line between terrorists and oil speculators is indeed getting increasingly blurred. Did the economists who handed down facile arguments and those that remained silent, play a vital role in blurring those lines? This is one question which seems to have escaped the attention of most in the rise and fall of oil prices.

This requires some reference to certain geo-political developments in those heady times of 2008. In mid-2008 the entire world feared a serious conflagration in the Gulf. Analysts, geo-strategists and political analysts (surprisingly all simultaneously and in an orchestrated manner) believed that Israel would launch a pre-emptive strike on an Iranian nuclear facility. This war psychosis was calibrated measure by measure till it reached a crescendo in June-July of 2008.

Analysts joined oil speculators and began playing (should I say leveraged?) on the fears of the entire world to this possible scenario. As a possible retaliation to an Israeli attack, some analysts gave Iran totally bizarre advice - that Iran should not retaliate by carpet bombing Israel, but by drowning its own ships in Hormuz Strait! Why Hormuz Strait? The reason is not far to seek.

Hormuz Strait is a very narrow sea passage, yet it facilitates significant movement of oil. Forty percent of global oil, as per some estimates, passes through Hormuz Strait in huge oil tankers. Obviously, if this narrow passage were blocked by Iran by sinking its own ships, there would be a huge supply constraint. It was argued that such a strategic strike on its own ships by Iran would block oil to the rest of the world. Given this possible paradigm, these economists predicted, oil prices would shoot up well over US$ 200 per barrel. Talk about diabolical!

Further, at that price, it was implicitly held by these analysts that Iran, more than anyone else, could profit - implying that even a war was good for Iran!

It is in this connection that every thing the Iranians did was analysed ruthlessly by the same analysts. Every rise of the Israeli eyebrow was clinically dissected by these economists. And virtually everyone across the globe came to the near unanimous conclusion - Israel would (and should) attack Iran shortly. Crucially, it would lead to significant rise in the prices of oil.

It may be recalled that in the first half of 2008 when oil prices were rising substantially, a report from Goldman Sachs stunned the world with a prediction of oil at US$ 200 per barrel. Naturally such predictions from eminent financial houses were carried “faithfully” by the mainstream media in every country. That would explain how all data - or seemingly unconnected information - was interpreted to mean global supply constraints or exaggerated global demand with a sole intention of psychologically tutoring the minds of people across the world. Given the prevalent mood in those weeks, it was sacrilege for anyone to voice any contrary thoughts. Even independent media houses of repute became victims of such consistent tutoring on oil prices.

Mirroring mainstream opinion, BBC in a report dated June 23, 2008, stated: “Despite an emerging global consensus that oil prices are dangerously high, there seems little chance of the cost of oil falling significantly in the near future.” Coming from BBC, the opinion had an aura of invincibility about it. Let us not miss the woods for the trees here. It is well known that many of these financial institutions (surely the honourable BBC would be an exception?) had taken huge positions in the futures markets in oil in the first place. Naturally, it was in their interest to see the rise of oil prices. In the course of these events, there was no declaration by any of these institutions, analysts or economists, providing details of their interests or exposure to oil before providing such forecasts! Obviously, this is an ethical issue that needs to be tackled by the world sooner than later.

The interests of these financial houses in first speculating on oil prices, secondly how they could continue to finance their operations through their relationship with the US Federal Reserve and the continued build-up of the strategic reserve stock by the United States Government has been briefly explained above. It is a remarkable coincidence that this build-up of Reserves, increased allocation by the financial sector to the oil futures market, and oil price hike in the spot markets, happened simultaneously.

But what made oil prices come down in the later half of 2008? It is quite possible that the US had run out of storage capacity by then. This would have eased demand pressures leading to the easing of oil prices. In the absence of verifiable data pertaining to the unfilled reserve oil storage capacities in the US, at best our analysis of the rise and fall of oil prices is only an inspired guess. Yet this possibility cannot be ruled out. Whatever the case may be, slowly but steadily, analysts began their exercise of analysing oil prices without batting an eye-lid and without one convincing counter argument for the unwinding of oil prices in the second half of 2008!

Nevertheless, it may be noted that some countries, by then ostensibly under enormous pressure created by these predictions, had also turned oil speculators and taken positions in the futures market at high prices. In the process, it does seem that some of these oil speculators exited the markets at very high prices, thus pocketing huge profits. No wonder, as oil prices unwound, the entire reasoning of some economists built assiduously over the past few years was turned on its head. Suddenly, demand-supply mismatch was no longer offered as the plausible explanation. Similarly, the fears about Israel-Iran conflict have miraculously receded. In the spring of 2010, the world seems to have forgotten about oil.

As pointed out, oil fell by 75 percent since July 2008 and has risen once again since then. Global demand by any stretch of imagination has not recorded a concomitant fall or rise. Obviously, if it was speculation all the way up, it is speculation all the way down and speculation once again. Yet most economists continue to offer standard theoretical explanations, little realising that whatever the reason for the rise and fall of oil and commodity prices, their own credibility has registered a huge fall.

Let us examine the impact of all this on national economies. In his column in The Times of India on June 22, 2008, titled “Oil will fall below US$ 100 per barrel,” India’s foremost economist Swaminathan S. Anklesaria Aiyar noted with authority that prices would definitely take a downward spiral: “For these reasons, I predict a modest rise in the production of and modest cooling of the demand for oil in the second half of 2008. That should suffice to bring the price down to US$ 100/barrel. That is not exactly low. And it may go up again if the world economy grows strongly in 2009. But let us be thankful for any decline, even a temporary one.”

Aiyar added, “My prediction could be wrong for several reasons - a US/Israeli attack on Iran, terrorist attacks on US oil installations, hurricanes in the Gulf of Mexico that destroy oil platforms. But let me not take refuge in ifs and buts. Let me stick my neck out and shout, Oil at US$ 100/barrel.”

That was in June 2008. Barely a fortnight later in the first week of July 2008, Aiyar was, given the rapid rise in the prices of crude, compelled to revisit the subject. In an article titled “India should turn oil speculator,” he suggested “Politicians in India and abroad have lambasted traders who buy oil contracts for future delivery as speculators that have driven oil to US$ 145/barrel. In fact, India itself should start buying oil futures and options. This will be a sensible risk management, not villainous speculation.” 

Only a fortnight ago Aiyar had “stuck his neck out” on the fall in the prices of crude to less than US$ 100 per barrel. But as the prices rose to 145, perhaps he was unnerved. Concluding in his inimitable style Aiyer noted, “all speculation may not be insurance. But all insurance is a speculative bet on possible disasters.” But the crux of Aiyer’s argument was that India should purchase oil at that high price in the futures market to partially offset the uncontrolled price hike in crude oil prices in mid 2008. Aiyar, the economist, was in effect prescribing the speculative route as an antidote to cure the unprecedented price rise of crude oil (145 dollars to a barrel) when only a fortnight ago he pointed out that the prices (100 dollars to a barrel) would not hold out.

One is not clear whether speculation causes price rise or whether speculation can cure price rise! Crucially, speculation is linked to sentiments. It would seem by manipulating sentiments one can exaggerate boom and exacerbate gloom. And that is what makes the global financial cabal with its ability to manipulate sentiments through the media, absolutely sinister.  

Speculation and its links to sentiments

Interestingly the users of oil lost out even when oil fell below the US$ 100 mark in the second half of 2008. Air Mauritius is often quoted as a classical case of how a company was trapped into a false sense of panic in the oil markets as oil prices shot up. Fearing further escalation in prices, companies such as Air Mauritius purchased oil in the futures markets at elevated prices, confident that prices would not fall below US$100 per barrel. But when prices of oil fell to even US$ 33 per barrel, these companies faced huge losses. It does not take a seer to predict who were the beneficiaries of the fall in oil prices. 

The Annual report of Air Mauritius of 2009 captures the entire paradigm rather succinctly: “Faced with the extreme volatility of fuel prices and as most airlines did, we took the decision to hedge our fuel consumption. We gradually increased our hedging activities to cover 80 percent of our expected fuel consumption at an average price of USD 104 a barrel over a period of 2 years. At that time, market forecasts indicated that fuel prices would have gone well above the USD 150 a barrel. Subsequent events defied all predictions and fuel prices fell from USD 147 a barrel in July 2008 to USD 33 a barrel in December 2008. Consistent with most airlines that followed a fuel hedging strategy, we suffered substantial fuel hedging losses as a result of the overall drop in prices. These losses amounting to 100.5 million Euros for the year turned our hard earned Operating Profit to a loss.”

Several airline companies in India and in other parts of the world declared crippling losses in this period. Conveniently, analysts blamed it on the global economic meltdown. But how many airlines suffered losses on account of such volatility of oil is anybody’s guess. It is certain Air Mauritius would not be an exception.

The rise, fall and rise of the crude-oil prices had nothing to do with demand and supply of crude oil. It is often seen that markets not linked by economic fundamentals are invariably under the disruptive influence of strong speculative forces. This is modern economics at work, where the fundamental laws of economics are suspended. In this kind of economics, it is the confluence of greed, speculation and deceit, all played in the full glare of Regulators with little or no relation to fundamentals, which calls the shots. 

In the process little do we realise that the grammar of speculators is significantly different from the grammar of investors, producers or consumers. Speculators aim for short term (sometime on an hourly basis) gains only through the first mover advantage. For them news is important, interpreting it instantly becomes crucial. Every bit of news has to be “discounted” even before others assimilate it. Fascinatingly, it is often noticed that a vast majority of speculators react uniformly to “news.” This is simply because when one of the players, especially a large and influential player, exits a particular market, others necessarily have to follow even if it were to create a stampede at the exit. Similarly, when large players enter a market, others necessarily have to follow suit.

In the Indian context, the ultimate beneficiaries of all these policies to play up (and play down) market sentiments are those who manipulate markets. At the risk of repetition it is once again stated - manage sentiments and manipulate Sensex – or for that matter any economic index.

In such a situation where prices are strongly influenced by speculative flows, little do Governments and Regulators realise that markets function inefficiently. The disproportionate influence of large players can been seen when they determine the “favourable conditions” for their entry or exit from a market. Smaller players with contrarian views do not matter as they cannot make or mar the markets. But what adds fuel to the fire is when the media acts in tandem with such large players.

Recall what we just discussed – hyping every bit of news of importance and interpreting them is crucial to playing a winning game at the markets. That makes it a heady concoction with little or no antidote to the Government or Regulators. Once the media takes up a story, competition within the media ensures a momentum of its own; especially as sections of the media are also active market participants. That in turn makes or mars the markets, making it extremely volatile.

The claim that financial markets can be stable was debunked by George Soros himself in a testimony before the Banking Committee of the US House of Representatives. Soros told the committee that when a speculator places a bet that the price of a commodity will rise, and it falls instead, the speculator will be forced into selling; this accelerates the downward spiral and thereby increases market volatility.

Soros’ testimony also revealed the perspective of the financial speculator, for whom volatility is a source of profits. He also spoke about his experience of how speculators could shape the directions of market price and create instability. George Soros is a legendary name because he has made and unmade many markets – commodities, currencies, stock, interest and others. A New York Times article titled, “When Soros speaks, World Markets listen” credited him with being able to increase the price of his investments. After taking a position against the German Mark, he was quoted as saying that he expected the Mark to fall against all major world currencies. The Mark did indeed fall as world over traders agreed that this was a Soros market. Similarly, on November 5, 1993, the New York Times Business pages carried a story titled “Rumours of buying by Soros send gold prices surging.” Remember, that was nearly two decades ago. Things have definitely not improved since then.

The reach of these “financial players” is not restricted to any specific commodity, currency or stock markets. In September 1992, Soros sold 10 billion Dollars worth British Pounds (referred to at the outset). In doing so he was credited with forcing a devaluation of the Pound that contributed to breaking the system of fixed exchange rates in the UK. The resulting gyrations in the markets left the British Pound to fall forty-one percent against the Japanese Yen over the next year or so. In the words of Felix Rahatyn, a senior partner with Lazard Feres & Co “In many cases the hedge funds and speculative activity in general, may now be more responsible for foreign exchange and interest rate movements than intervention by Central Banks.”

Obviously, speculators thrive on volatility and abhor stability.

In contrast, when there is stability in any market, it is in their interest to dynamite it and usher in volatility at the earliest. This leads to price movement not justified by fundamentals, thus causing significant damage to the real economy. Some economists continue to argue naively that a bit of speculation is good for the markets as it would provide liquidity. This argument would be acceptable if markets were perfect. But when have markets been perfect? Economists more often than not do not realise the innate power of these speculators in preparing the minds – read sentiments - of market players. It is these sentiments which determine the demand and supply of the markets and therefore the prices. With a pliable media playing ball, speculators and market manipulators never had it so easy, especially in the Indian context.

As the financial sector invests into the commodities futures market, the fundamental law of economics - the price of a commodity and its relationship to supply and demand seems to have been suspended. What is worrying analysts is the growing influence of these players, “who tend to take only long positions that exert upward pressure on prices.” Consequently, it is observed that the size of their positions has become so large that they can significantly influence prices and create speculative bubbles. Moreover, their activities are obviously coordinated across currency, stock and commodity markets. In this connection, the UNCTAD Trade And Development Report 2009 observed “Commodity prices, stock prices and the exchange rates of currencies affected by carry trade speculation moved in parallel during much of the period of the commodity price hike in 2005–2008, during the subsequent sharp correction in the second half of 2008 and again during the rebound phase in the second quarter of 2009.”

To conclude:

The purchase of a four percent stake by George Soros is not an issue in itself. Within the BSE, one does not know how many understand the power of financial speculators and their ability to manipulate markets. And even if there were some who understand the nature of this power, how many within these markets have the financial ability to counter vastly powerful individual and government speculators? How many within the media have the capacity to appreciate these facts and the required honesty to deal with the situation? How many within the polity – the bureaucracy and ministers – are on the direct pay roll of this cabal and are therefore fashioning our economic policies to suit these interests?

Why are the Opposition and other political parties that are supposedly ideologically opposed to the entry of these firms, silent on this explosive issue? The answer to all these questions is that we have lost our ability to even understand what constitutes national self-interest. And that for a free nation spells its death-knell.

M R Venkatesh is a Chennai-based chartered accountant; his email is mrv@mrv.net.in