Early this year, the price of crude oil surpassedits previous inflation-adjusted peak of $103.76 a barrel (arecord established in 1980). Since then, the price of crudehas been making new record highs on a regular basis. Andthat’s not all. On June 6th, it surged by $10.58 a barrel – a recordone-day move. This was enough to bring the chattering classes outin full force. They produced a great deal of commentary – much ofit unfounded – about what was causing oil prices to go through theroof. They were also quick to condemn the traditional bogeyman– the speculators. Not surprisingly, the finance ministers from theGroup of Eight industrialized nations focused on oil prices duringtheir recent two-day meeting in Osaka, Japan.
Just what is pushing prices skyward? Surprisingly, the G-8 financeministers failed to mention the US dollar’s role. Every commoditytrader knows that all commodities trade off changes in the value ofthe greenback. When the value of the dollar falls, the nominal dollarprices of internationally traded commodities, like gold, rice, and oil,must increase because more dollars arerequired to purchase the same quantityof any commodity. Accordingly, a weakdollar should signal higher commodityprices. And it does.
For example, if the greenback hadheld its January 2001 value against theeuro, oil would have traded at about $76a barrel in May 2008. This is almost $50below the price that crude oil was tradingat in May 2008. Accordingly, thedecline of the dollar’s value accountedfor a whopping 51% of the $97 a barrelincrease in the price of oil from May2003-2008.
In addition, global economic activityand the demand for crude oil havebeen strong since 2003. This has beenaccompanied by weaker growth rateson the supply side of the oil market. Inconsequence, excess capacity has declined.These smaller margins of safetyand the fact that a large share of global oil production occurs in politicallyunstable regions result in larger risk premiums that contributeto higher oil prices.
To obtain a better grasp of the dynamics of the oil market, considerthe market for light sweet crude oil traded on the New YorkMercantile Exchange in New York. The accompanying chart showsthe prices for futures contracts. These are agreements between buyersand sellers to exchange oil at a later date (July 2008 – December2010) at a price fixed “today” (either June 5, 6 or 13, 2008). Amongother things, it is clear that market participants expect oil prices toremain elevated.
In addition, the chart shows the record jump in crude pricesfrom June 5 to June 6 and also the prices one week after the jump.These three curves contain information that can be used to calculatethe term structure of interest rates for oil. These commodity (or“own”) interest rates are presented in the accompanying table. Theyprovide important insights into the workings of oil markets.
Before interpreting the commodity interest rates, it is importantto realize that futures markets operate as loan markets for commodities.As such, they operate in a manner that is similar to money markets.When a handler of commodities purchases a commodity andsimultaneously sells a futures contract, he is temporarily borrowinga commodity. This procedure is much like borrowing money froma bank with the promise to repay the loan in the future. The salesof a futures contract, in conjunction with the purchase of a commodityin the spot market, allows a handler to borrow a commoditynow and repay it later. These simultaneous buy-sell transactions are,therefore, implicit commodity loans.
If the price of a commodity for future delivery exceeds the spot(or cash) price, the market is in contango, and the commodity interestrate is negative. A lender of a commodity has no incentive tolend to the spot market because he would be in effect selling low andbuying high. The reverse occurs when the spot price exceeds the futuresprice and the market is in backwardation. Commodity interestrates are positive. In this case, it pays those who hold commoditiesto loan them to the spot market.
When the price of oil made its record jump on June 6, manyconjectures were made about the causes. The one that turns out tobe the most plausible is the threat made by the Deputy Prime Ministerof Israel, Shaul Mofaz. After Mr. Mofaz stated that an Israeliattack against Iran was “unavoidable” if Tehran continued to pushforward with its nuclear program, the curve for futures contractsprices shifted up and its shape changed. With the change in shape,the commodity interest rate switched from negative to positive for 2008. In other words, it became profitable to lend oil to the spotmarket. This occurred because the precautionary demand for oilbecame elevated as oil users became concerned about a possible Israeliattack on Iran and the adequacy of their inventory levels. AfterIsraeli defense officials rebutted Mr. Mofaz, concerns were dispelledand the commodity interest rates became negative for 2008, indicatinga more relaxed precautionary demand and more adequateinventory levels.
Speaking of inventories, let’s examine the world’s largest– the US government’s Strategic Petroleum Reserve. The SPR is aresponse to the oil embargo imposed by the Organization of ArabPetroleum Exporting Countries after the 1973 Arab-Israeli War. Itcomprises five underground storage facilities, hollowed out fromsalt domes, located in Texas and Louisiana. By 2005, the SPR’s capacityreached its current level of 727 million barrels. At present,702.7 million barrels are stored in the SPR. That’s over twice the sizeof private crude oil inventories. To put SPR’s size into perspective, itscurrent storage would cover about 71 days of US crude oil importsor 47 days of total US crude oil consumption. The SPR’s drawdowncapacity is 4.3 million barrels per day. That rate is slightly greaterthan the combined daily crude oil exports from Iran and Kuwait. Inshort, the SPR is huge.
Not being faced with capital carrying charges and never wantingto be caught short, government officials, like proud pack rats,want to just sit on this mother of all commodity hoards. They arguethat the SPR represents an insurance policy for national emergencies.But without a specified release rule, just what is the insurancepolicy written for?
Instead of hoarding the SPR, the government should sell outof-the-money (at strike prices that exceed the current spot price)call options on the SPR. This would allow the purchasers to buyoil at the strike price until the option contracts expired. It wouldtransform what is in effect a dead resource into a live one. It wouldprovide the country with a huge inventory of oil, generate revenueto defray some of the government’s stockpiling costs, smooth outcrude oil price fluctuations, and push down spot prices relative toprices for the oil to be delivered in the future. In consequence, commodityinterest rates would become very negative as inventorieswould be abundant.
A stronger dollar and market-based release rules for SPR wouldprovide relief from sky-high crude oil prices.