What Greece has to do with oil prices

We’re all enthralled by the Greek drama that is slowly unfolding before our eyes, fervently hoping that tragedy will be averted. Oddly, electoral politics in the German state of North-Rhine Westphalia is affecting Greece, providing evidence of our increasingly interconnected world. But there’s another big issue that is not getting as much media coverage at the moment, despite the possibility that it could prove to be just as important. The oil price is beginning to creep up again: data from the Energy Information Administration (EIA) shows that just in the past month, world crude prices have risen by around 6%, to $82. This is well off the zenith of $137 in July 2008, but still significantly higher than the nadir of $35 in January 2009. Is this trend in oil prices likely to continue? Are we likely to see significant increases in oil prices accompanying significant reductions in global output? Is there a chance of that worst of scenarios, namely, high unemployment accompanied by high inflation?

Around the time of the zenith in oil prices, there were significant concerns about the role of speculators in the rise of oil prices. The rise and rise of oil prices in the preceding five-year period was attributed by several commentators, including George Soros, to the fact that there were large increases in the amount of capital allocated by speculators to commodity futures. Others argued that this increase in speculative activity in the futures market had no direct bearing on the rise in spot prices. Rather, increases in the demand for oil from India and China (and other energy-hungry emerging markets) were responsible for the rise in commodity prices. Which view is correct? This is important if we are to predict the future direction of oil prices. Holding the demand for oil constant, if speculators’ desire for oil futures drives prices, then we should think hard about the magnitude of speculative capital that will be committed to oil futures. If not, we should probably just look at global ‘real’ demand for oil.

So which view is correct? Recent academic work suggests that Soros’s view might be right. When the amount of speculative capital committed to commodity futures increases, there are subsequent increases in futures and spot prices. This continues to be true even after controlling for other sources of information (such as increases in real economic activity) that should affect these prices. For example, research done at the New York Fed shows that when financial institutions have a greater appetite for risk, commodity futures and spot prices increase. Researchers at Princeton and Wharton have shown that when open interest in futures markets grows, future commodity returns are high. Concurrently, together with researchers at Columbia and NYU, I have discovered evidence that measures of commodity producers’ hedging demands predict commodity futures and spot prices. We believe this is because increased speculative activity creates the space for hedgers’ demands to be satisfied at a lower cost.

The reference to Greece at the beginning of this article was not accidental. Consider what would happen if Greece defaults. Financial institutions’ appetite for risk will inevitably fall, leading to reductions in the capital they invest in all risky assets, including commodities. Using the logic above, this means there will be decline in commodity prices. Of course, the reduction in growth would directly affect commodity prices; the point here is that the speculative channel reinforces and amplifies the impacts on these prices over and above any information about global growth. On the other hand, if Greece manages to stave off default, commodity prices will likely face less downward pressure. This is like a natural hedge, and is reassuring—the nightmarish scenario of low growth and high commodity prices (and hence inflation) seems unlikely by this logic. In order to get that nasty scenario, the risk appetites of global investment managers and hedge funds would have to move in the opposite direction to global economic growth rates. That is a hard story to tell.

There are, of course, other factors at work that could raise oil prices even if Greece defaults. Ominously, a damaged British Petroleum oil well in the Gulf of Mexico is currently leaking around 5,000 barrels of crude a day, according to the US Coast Guard’s most recent estimates. While this is a tiny reduction in the supply of crude oil (estimated world production is 80 million barrels a day), it presages the need for more stringent safety and environmental safeguards on oil production, especially deep-sea drilling of the sort envisioned in Brazil and the Bay of Bengal. These safeguards, if implemented (as they should be), will raise oil production costs. But as far as the speculative channel is concerned, there’s more than one reason to watch Greece.

Source: Financial Express

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