What’s driving the price of oil?

Not only has the price of crude oil jumped to unforeseen levels, but its rate of increase has also been unprecedented. This affects everyone, but particularly those of modest means and those who have a business reliant on the consumption of oil.

So what is accounting for this dramatic rise in price of something that has been so central to our economy and our lives?

It is true that demand for oil is increasing particularly in the supercharged economies of India and China. It is true that the production of biofuel is also ironically increasing demand because it is used in the production of fertilizer. It is also true that there are uncertainties in various oil producing regions of the world, especially the Middle East. However, the biggest driver of the recent massive escalation in the price of oil is pure speculation. Greed.

It is shocking to note that today’s crude oil prices have little to do with any traditional relationship between supply and demand. Today’s oil price is largely controlled by an elaborate and opaque market system and by four major oil companies. It is estimated that as much as 60% of today’s crude oil price is pure speculation driven by large trader banks, pension and hedge funds. So how does this happen?

First, international oil exchanges in London, New York, and to a lesser extent Dubai, control the global benchmark on the price of oil. What is happening is large financial institutions, hedge funds, and pension funds have been pouring billions of dollars into the energy commodity markets to try to take advantage of price changes or hedge against them. This investment does not come from producers or consumers of these commodities but from speculators seeking to take advantage of rapid price changes. These speculators do not produce or use the commodity but are simply trying to turn a quick profit. Thus, large purchases of crude oil futures by speculators have created a false demand for oil driving up the price dramatically. As far as the market is concerned demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel of oil that results from the purchase of a futures contract by a refiner or other user of petroleum.

This behaviour is pure speculation and has nothing to do with the true value of the oil as defined by its supply and demand. One of the reasons why this is occurring is that the electronic purchase of energy commodities is unregulated and exempted from any security oversight, unlike futures that are traded exclusively on regulated exchanges.

This is a very complicated area understood by very few, however, the US Senate warned that this excessive speculation is a major cause of sudden and unreasonable fluctuations in the price of a commodity such as oil. (The same can be said for foodstuffs to a degree)

To fix this problem, it will require in part, better oversight and transparency in the trading mechanism, a single Canadian Securities Exchange to prevent large institutional speculators from moving billions of dollars suddenly into a commodity and thus unreasonable driving its price skyward. One is loath to interfere in the market but what is occurring now is that the price mechanism, the relationship between supply and demand is effectively broken. We will also need to work with Great Britain and the United States to modernize the mechanism for commodities futures trading to ensure that we will have a fair trading system while excluding the predatory speculators in the commodities market that affects not only oil, but also food and other essentials.