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From The Socialist newspaper, 11 June 2008

Oil price shock - the chaos of capitalism

Years of frenzied speculation on commodity markets

We have been hit by a tsunami of energy price rises. A flood of speculative activity in oil markets has produced a huge bubble that will inevitably collapse in coming months. Record prices for fuel have given a vicious twist to inflation, pushing up the cost of living for workers everywhere. Higher fuel costs are propelling the US, Britain and other economies ever closer to a severe recession.
Why do soaring oil price rises have such a devastating effect? What lies behind the price surge? What effect will pricey oil and speculation have on the global economy?
Lynn Walsh investigates.

THE PRICE of crude oil recently surged to an all-time peak of $139.12 a barrel (42 US gallons/159 litres). At the end of 2006 oil was about $60/b, and about $90/b at the end of 2007. Since the beginning of this year, the prices leapt from around $100/b to the current level.

This has resulted in a surge in pump prices for petrol and especially diesel in Britain, Europe and the US. Dearer diesel fuel has provoked blockades by lorry-drivers, farmers and fishermen. Airlines are imposing surcharges and cutting back on their flights. In Britain, the US and elsewhere domestic gas, electricity and heating fuel bills have also soared.

Higher energy costs, moreover, are a major factor in the worldwide explosion of food prices. The increased cost of fertilisers, packaging and transport has worked through to the markets and shops. At the same time, the diversion of agricultural production to bio-fuels (mainly in response to the high cost of oil) has been a factor in reducing the supply of basic foods like cereals and cooking oil, pushing up their prices. Food riots in many countries are a symptom of increasing hardship, starvation and impoverishment.

Clearly, money spent on fuel and food cannot be spent on other goods and services. So living standards are being depressed, while falling (non-fuel and food) consumer spending is undermining economic growth. Coming together with the severe credit crunch brought on by the sub-prime mortgage crisis, the oil-price surge is likely to accelerate the slide of the world economy into a painful downturn.

Who is to blame?

What are the real reasons for the sudden surge in oil prices? Some, like Gordon Brown, blame the oil producing states of OPEC (12 states, including Saudi Arabia, Iran, Iraq, Nigeria and Venezuela), who in the past have restricted their output to keep up prices.

Australia's prime minister, Kevin Rudd, went further and called on the G8 nations last Sunday to "apply the blow-torch" to force OPEC to increase production.

Others blame Big Oil, the five colossal global corporations (Exxon/Mobile, ChevronTexaco, ConocoPhillips, BP and Shell) that dominate the refining and distribution of petroleum products.

Recently, however, accusing fingers have been pointed at the speculators, who have been feverishly gambling on commodity exchanges in New York, Chicago and London, seeking to profit from surging oil, mineral and food prices. What is the truth?

In 1973 (as a reaction to the Arab-Israel war) and 1979 (after the Iranian revolution) the OPEC producers imposed oil embargoes which quadrupled the price of oil in 1973 and doubled it in 1979. On both occasions, the oil price "shock" triggered a slump in the world economy.

In the recent period, as the price of crude has soared, the OPEC producers have certainly gained huge increases in oil revenue, as have non-OPEC producers like Russia. But it seems unlikely they have been restricting their output (in any case, OPEC now accounts for only 40% of world oil production). In fact, they have probably been pumping oil to something near their maximum capacity.

The oil regimes have welcomed price increases as compensation for the sharp fall in the value of the US dollar (in which oil is priced). In real, inflation-adjusted terms, the 1979 peak of $39.50 was only surpassed in May this year. But their strategists now fear that excessively high crude prices will provoke a world recession, leading to a fall in demand for oil and a disastrous slump in their oil revenues. They blame the speculators.

Big Oil also blames the speculators. These highly profitable corporations, however, are far from blameless. Just as the producers have always sought to maximise their revenue, these oligopolies have always manoeuvred to maximise their profits from pumping, refining and distributing petroleum products. For instance, as crude prices rose between 1999 and 2006, US oil refineries increased their profit margin per gallon of gasoline from 22.8% to 53.5%. Today, their profit margin is no doubt even higher.

Yet Big Oil has been very reluctant to invest in major exploration projects or additional refining capacity, fearing that prices will drop as the economy slows in the next few years. Since 2005, the big five have handed back $170 billion to their shareholders through share buy-backs rather than invest these profits in more capacity - or renewable energy sources.

In the current situation, however, the main responsibility for soaring oil prices appears to lie primarily with the big financial speculators who are playing the volatile commodity markets. The price of petroleum, a product absolutely essential to the functioning of society, is being set in the casinos of finance capitalism.

Oil as a financial asset

With the fall in interest rates (as central banks struggle to counteract the effects of the credit crunch), big investors like hedge funds, investment banks and pension funds have turned to the commodity markets in search of higher returns. While low interest rates have reduced the return from some other financial assets, the rise in crude oil and other commodity prices offer the prospect of big gains from commodity futures.

A 'future' is a contract to buy a consignment of oil or another commodity at a certain price on a certain date. Normally, they are used by those trading the physical commodity - producers, merchants and distributors - to smooth price fluctuations and control their cash-flows.

Speculators, on the other hand, treat commodities as a financial asset. They buy futures on the expectation that, on the due date, the consignment will be worth more than they actually paid for it under the future contract, so they can sell it at a profit. Even if the price difference is relatively small, speculators can make big profits if they trade on a large scale.

The capital flowing into major commodity funds shot up from $13 billion in 2003 to $260 billion today. Not surprisingly, hedge funds (unregulated, private clubs of hyper-rich speculators) and investment banks are involved, using huge sums of borrowed cash to speculate in futures and other complex financial instruments, such as options and swaps.

Moreover, they can acquire a future by advancing a 'margin' of only 7% of the value of the contract. But the biggest speculators in commodities recently have been the big pension funds. They have been investing in so-called 'index funds', groups of big investors which automatically buy futures when their projected yield exceeds the average of a broad index of shares or bonds.

Working hand in hand with big investment banks (which rake in a fortune in fees), the pension funds have found loopholes that enable them to avoid regulations restricting speculative trading on commodity markets.

In 2000, the US government, in response to lobbying by energy traders like Enron, relaxed the regulations on trading in commodity markets. Since then, there has been a six-fold surge in trading volume. "Over the last five years, investors have become such a force on commodity markets that their appetite for oil contracts has been equal to China's increase in demand over the same period, said a hedge fund manager who testified before Congress ... last month..." (Washington Post, 6 June 2008)

Pension funds gamble

George Soros, who made his own fortune from gambling on world currency markets, warns that the pension funds' index trading is exaggerating price rises and creating a dangerous bubble in oil and other commodity markets. Pension fund managers, of course, strenuously deny this.

A spokesperson for the California Public Employees' Retirement Plan denied that their futures investments were having any significant effect on the market. "The price spikes stem from fundamental supply and demand dynamics." (Financial Times, 4 June 2008) Their line is that their investments simply follow rises in oil prices that arise from increased demand and short supply.

The speculators' story is being backed up by political leaders. Both Gordon Brown and US Treasury secretary Paulson blame "lack of balance between supply and demand". The US Commodity Futures Trading Commission - a sleeping watchdog - says that "broad-based manipulative forces" are "not driving the recent higher futures prices in commodities across-the-board." (Financial Times, 29 May 2008)

What is the truth? There is no doubt that, as a broad trend over recent years, oil prices have been pushed up by supply and demand factors. Strong growth of the world economy after 2003 (averaging 5% a year) and even higher growth in China and India (over 10% a year) undoubtedly created exceptional demand for oil.

At the same time, supply has been restrained by a series of problems. Globally, the production of crude oil is rising faster than the discovery and development of new reserves. Some experts argue that 'peak oil' has already been reached and from now on reserves will inevitably decline.

In any case, recently discovered reserves are mostly more costly to exploit and transport because of their location (arctic regions, deep sea, etc) or poor quality (for example, high sulphur content, requiring more costly refining).

Geo-political factors have also pushed up prices and provoked volatility in oil markets. The turmoil in the Middle East provoked by the invasion of Iraq by US and British imperialism - aimed at controlling the region's oil fields and securing cheap oil - has undoubtedly pushed up oil prices.

The disruption of supplies, for instance, from Iraq and Nigeria, the impact of hurricanes in the Gulf of Mexico, and scares of disruptions (fears, for instance, of a US attack on Iran) have all added to the volatility.

In addition, the fall of the US dollar, the currency in which oil is priced, has led producers to increase the dollar price in order to maintain their oil income in terms of stronger currencies like the euro.

But are these forces of supply and demand sufficient to explain the recent surge in crude oil prices? Supply and demand have fluctuated only slightly since oil was $60 a barrel at the end of 2006. There have been no big supply shocks recently. Demand, moreover, has declined slightly as a result of a slowdown in the US and some European economies. "Consumption has been falling for the past two and a half years." (The Economist, 29 May 2008) Normally, oil prices would be easing downwards under these conditions. Yet they have exploded - and the obvious cause is speculation.

The real reason for the oil price explosion was recently spelt out by a veteran Wall Street oil analyst in testimony to a US Congressional committee that is investigating the oil market. Fadel Gheit of Oppenheimer & Co told the committee: "I believe the current high oil prices are inflated by as much as 100%. I don't think industry fundamentals of supply and demand justify the current high prices, which I believe, are driven by excessive speculation." (Wall Street Journal, 20 February 2008)

"There is a total disconnect between supply and demand" and the price of oil, Gheit testified. Oil companies can profitably obtain crude oil for $15 to $20 per barrel. Historically, the price of crude has been about three times the extraction price. So oil should be selling at $45/b. "Anything over $45 a barrel is all fat."

Interviewed by Foreign Policy magazine (www.foreignpolicy.com, November 2007), Gheit said: "I truly believe that major investment banks and a large number of high-risk-taking financial players have seized control of the oil markets, especially in the last six months... Financial institutions, while making billions of dollars in profits, are wrecking global economic growth. The same bubble that happened in housing and tech stocks will come back and haunt us."

When the bubble bursts

Soros has warned that the oil bubble will inevitably burst. Today's speculative frenzy, he says, is similar to the situation before the 1987 stock exchange crash. "If the trend were reversed and the [pension funds and other] institutions as a group head for the exit as they did in 1987, there would be a crash." In fact, the flow of speculative capital into energy companies has artificially propped up share prices on major stock exchanges. A flight from these companies would undoubtedly trigger a major crash.

The 2006 collapse of the hedge fund Amaranth Advisors, with $6 billion losses from trading oil and gas futures, is a warning of things to come. If there are major drops in energy futures, warns a financial analyst, they will all want to get out and it will be "like entering a revolving door at the wrong time in the wrong direction." (Peter Beutel, MarketWatch, 30 May)

The soaring prices of petrol and diesel are already aggravating the downturn in the US economy provoked by the credit crunch. The effect of tax rebates just sent out under the US government's 150 billion stimulus package will be cancelled out by increased fuel prices. The US slowdown, moreover, is already acting as a drag on Europe, Japan and elsewhere.

The 1973 and 1979 OPEC price rises hit the world economy as sudden shocks. Over the last couple of years there has been a slow-motion shock - about to climax in a self-inflicted knock-out blow for the advanced capitalist economies.

The signs are that oil is rapidly approaching its 'breaking point' or 'demand destruction point', where it becomes so expensive that demand for oil falls away. This is already happening in the US. As a result, oil prices will inevitably decline, probably quite rapidly at a certain point.

Chaos or planning?

"Because the price has been driven up by speculative money... the fall will be dramatic," says a Commerzebank economist. (Financial Times, 28 May 2008) But the return to lower price levels will come too late to prevent an economic downturn. Moreover, lower prices - and therefore reduced oil revenue - will spell economic and political crisis for many of the oil-producing regimes.

Now, after eight years of unrestrained speculative activity on commodity markets, the US Commodity Futures Trading Commission, under int-ense pressure from Congress, has announced that they are carrying out an investigation in conjunction with the British Financial Services Authority.

Calls for more transparency and stricter regulation are mounting. Political leaders have been shaken by fuel protests, while manufacturing firms are screaming that their profits are being squeezed by higher commodity prices.

There may well be moves to curb some of the most predatory activity of the speculators. Under capitalism, however, regulation never has much effect.

Speculators always find a way to evade new regulations, especially in globalised financial markets. In any case, new regulations will be too late. The commodity bubble is near bursting point and the damage will be done before new controls could be implemented.

The frenzied speculation in commodity markets - like the sub-prime crisis - arises from the chaos of capitalism, where big oil corporations and ultra-rich financiers compete for the biggest share of the profits.

Capitalism is incapable of securing and supplying vital energy, food and raw materials in a balanced way that would meet the needs of society as a whole. They will never take adequate measures to conserve natural resources, protect the environment and combat global warming. Capitalist governments and giant corporations are taking only token measures to develop alternative sources of safe, renewable energy.


Take over Big Oil

Sky high energy prices are a disaster for working people everywhere. The chaos in commodity markets calls out for system change. We need a socialist approach, based on:

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