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Oil prices: Economists get it wrong again!

Last updated on: August 18, 2008 13:36 IST

The spectacular rise 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 $30 per barrel in few years back to well above $145 per barrel in July 2008 -- a rise in excess of 350 per cent.

However, most economists had rationalised this consistent and spectacular rise in the price of oil for the past few years, as one being caused by a steep demand and supply mismatch.

The standard explanation was that oil prices must be rising either because 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 that fuelled global demand 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 also been fair to the supply side 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.

But all these in hindsight seem to be with a purpose.

Often supply disruptions (Nigeria, for instance) or potential ones (like in Iran) were repeatedly pointed out to buttress these arguments.

It is in this connection that one notes that, for instance, a supply disruption caused by terrorism in Nigeria of 200,000 barrels a day (the global supply is approximately 85 million barrels) -- less than a mere 0.2 per cent of the daily global supply -- was sufficient to cause a significant spike in the 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.

In fact, it would seem that the lines differentiating terrorists and oil speculators are indeed getting blurred.

And did the economists play a vital role in blurring those lines -- a question that seemed to have escaped most of us in the rise and fall in oil prices.  

Oil at $200 per barrel

Readers may recall that it was only a few weeks back that the entire world feared a serious conflagration in the Gulf. Analysts believed that Israel would launch a presumptive strike on Iranian nuclear facility. This war psychosis was built-up step by step till it reached a crescendo in June-July of this year.

Economists naturally began playing (should I say leveraged) on the fears of the entire world to this possible scenario. And as a possible retaliation to the Israeli attack, it was even openly advised by many that Iran should not possibly retaliate by bombing Israel, but by drowning its own ships in Hormuz Strait.

Why? The reason for the same is not far to seek. Hormuz Strait is a very narrow sea passage, yet it facilitates significant movement of oil -- 40 per cent of global oil, as per some estimates passes, through Hormuz Strait in huge oil tankers.

Obviously, when this narrow passage would be blocked by Iran by sinking its own ships, the assumption was that there would be a huge supply constraint. Logically, it was explained that such a strategic strike by Iran would block oil to the rest of the world. Given this possible paradigm, economists predicted, oil prices would shoot up well over $200 per barrel.

Further, at that price, it was held by economists 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 Iranian was analysed ruthlessly by analysts. Every rise of the Israeli eyebrow was clinically dissected by economists. And virtually everyone across the globe came to the near unanimous conclusion -- Israel would attack Iran shortly. Crucially, it would lead to the significant rise in the prices of oil.

It may be recalled that in the first half of this year when the oil prices were rising substantially, a report from Goldman Sachs stunned the world with a prediction of oil at $200 per barrel. And naturally coming from such financial houses, such predictions were carried 'faithfully' by the mainstream media in every country.

And that would explain as to 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 the people across the world.

Given the prevalent mood in those weeks it was sacrilege for anyone to voice any contrary thoughts. And even independent and media houses of repute became victims of such constituent tutoring on oil prices.

For instance, mirroring the mainstream opinion of the economists on June 23, BBC in a report 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." It was an opinion, no doubt, but coming from BBC it 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 had taken huge exposures 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 process nowhere did I ever come across any declaration by any of these institutions, analysts or economists providing details of their interests or exposure to oil before providing such forecasts! Obviously, it is an ethical issue that needs to be tackled by the world sooner than later.

As oil unwinds, economists stand exposed

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 was brought out in one of my previous columns: The real reason why oil prices are rising.

One of the suggestions put forth there was that the US had virtually doubled its strategic stock of petroleum reserves from 350 million barrels to 700 million barrels within the last two years.

It is this build up of reserves, I had argued, that was leveraged by the US financial sector successfully to make huge profits by raising the prices of oil.

Perhaps the US has run out of storage capacity. In the process that could be easing demand pressures leading to the easing of the oil prices. In the absence of authentic data pertaining to the unfilled storage capacities one is not sure. Yet this is one possibility that one cannot rule out.

Similarly, with the Olympics almost behind us, one feels that China could possibly dilute its huge stocks as it may no longer want to hold such huge quantity which it could have built up in its run up to the Olympic Games. Whatever the case may be, slowly but steadily, economists are building up an argument for the unwinding of oil prices!

Nevertheless, it may be noted that some countries, by then ostensibly under enormous pressure created by these economists had already turned into oil speculators and taken positions in the futures market at high prices. In the process it does seem that some of these oil speculators have exited at such high prices pocketing huge profits.

No wonder, as oil unwinds, the entire reasoning of economists built assiduously over the past few years seems to turn on its head. Suddenly demand-supply mismatch is no longer offered as the plausible explanation.

Similarly, the fears about Israel-Iran conflict have miraculously receded in the past few weeks.

In fact, the meltdown in oil is no longer an exception. Recent weeks have been witness to a general meltdown in all commodities including oil, gold and silver. The ostensible reason for all this has been suddenly laid at the slowdown in global economy, notably the US economy.

The theory of burgeoning global demand that was supposed to be the chief driver for the rise in the prices of these commodities for the past few years has been turned on its head. Falling commodities prices are strangely attributed by economists to slackening global demand. Isn't it a bit strange considering that till the other day economists argued that it was global demand that fuelled the rise in the prices of these commodities?

As already pointed out, oil has fallen 25 per cent in the past five weeks, that is, in effect 5 per cent every week. Surely, global demand by any stretch of imagination has not recorded a concomitant fall. Nor has supply built up that significantly over the past few weeks. Obviously, if it was speculation all the way up, it is speculation all the way down.

Yet economists continue to offer standard theoretical explanations, little realising whatever be the reason for the rise and fall of oil and commodity prices, their credibility has registered a huge fall.

PS: If US economy is witnessing a slowdown, would economists explain as to why the US dollar is strengthening in the past few weeks?

Other articles by the author:

The author is a Chennai-based chartered accountant. He can be contacted at

M R Venkatesh