Tuesday, August 12, 2008

The CTFC's Interim Report on the Crude Oil Market

In July, the CFTC's Interagency Task Force released a report on the crude oil market, in response to high prices and at the request of Congress. This report is filled with easily understood graphs, that deliver power points about the fundamentals of the crude oil market.

This report was heavily criticized by folks who deemed it to be politically motivated, and because they didn't like the conclusion of the report, (that the market price rally of the last 4 years has been fundamentally driven). More on the dissension regarding the conclusion in upcoming blog posts. The report is approximately 30 pages in length, and a hyperlink to the report is included below this posting, but I thought I would take an opportunity to draw out some points that I gleaned from it.

First....the conclusion:
[T]o this point of the examination, the evidence supports the position that changes in fundamental factors provide the best explanation for the recent crude oil price increases. Observed increases in the speculative activity and the number of traders in the crude oil futures market do not appear to have systematically affected prices."
So what are the fundamentals that the CFTC say is driving the market price rally? Take a look at the three charts below. (By clicking on the charts you can make them larger and easier to read.)

The first chart here is the annual growth rate in oil demand. It is broken out into three parts, US, China, and Other. What is interesting to me is that since 2003, the US has had a negligible growth rate in crude oil consumption, while the world's consumption is up over 6.0 million barrels per day. Total global demand is a number that is hard to estimate, but I have seen it pegged at around 83 million barrels a day. That means that non-US demand has risen more than 8% over the time frame we are discussing. If the US were to conserve (stop driving/turn up thermostats) to balance out this worldwide growth, we would all need to cut our consumption by approximately 30%. 

It is important to note that the US does more with more - in other words, our GDP output per barrel of oil is much higher than that of any other major world economy. However, per capita, we use about 25 barrels of oil, and the Chinese use about 2. As the Chinese economy continues to mature, the consumption habits of the Chinese worker will increase as well. The graph on the right above illustrates this huge difference. 

Finally, let's talk about the biggest picture. The world in 2008 is hydrocarbon based. Let me illustrate. Currently, I am eating some wheat chex. The wheat that it was made with was fertilized by a hydrocarbon molecule. In the process of the wheat becoming cereal and the cereal arriving at Wal-Mart, it was shipped several times. The packing material was shipped, too. These shipments used deisel fuel, another hydrocarbon. Likewise, I am eating the cereal out of a plastic bowl. (You see the pattern....plastic is a hydrocarbon-based product). This last chart (above) attempts to illustrate that world GDP is linked to the availability of crude oil. If this is true, then if crude oil production stays flat or decreases, then crude's price must rise, as world economies fuel their growth.

Is crude oil at a fair value at $150 or at $50? No one knows for sure, although lots of analysts will try to tell you they do. The only certainties are that there have been several compelling shifts to the fundamentals that underpin our markets and that volatility is here to stay.

Complete CFTC Report Weblink: