Over a barrel
The world has become accustomed to increased crude oil prices in recent years. But while most oil analysts ascribe the major price upsets to factors inherent to the crude oil market, the Organisation of Petroleum Exporting Countries (OPEC) has put part of the blame on the speculative role of pension and hedge funds.
Saudi Arabia’s oil minister, Ali Naimi, has said that the kingdom would lift its oil exports to meet near-term demand to curb the current price hikes. However, he has made clear that the flood of investment in oil futures from pension funds, hedge funds and banks had sharply curbed OPEC’s ability to cool prices. In a speech to the international oil summit in Paris last April, Naimi reiterated that Saudi Arabia’s current production was 9.5m barrels a day (bpd), though he didn’t say how much more crude it would ship. And in a direct attack on so-called speculative factors, Naimi stated that “despite our best efforts, Saudi Arabia and OPEC have had little ability to curb the rapid rise in prices”.
Prices are more than 65% higher than at the start of 2004 and there are growing concerns that they are now a drag on economies worldwide. In his speech, Naimi said that the burgeoning influence on world oil prices from a new breed of investors had weakened OPEC ability to influence the market.
“Pension funds buy and hold a position, which creates a long market,” he said, citing some $12bn (€9.5bn) that tracked oil within the Goldman Sachs Commodity Index (GSCI) last year. He noted that international banks should also share the blame. “Even banks are jumping on the bandwagon,” he said, adding: “Some analysts expect that oil could soon be traded as an exchange-traded fund, meaning that it could be offered almost like a stock.” This would attract even more investors, he said. In short: “There is a widespread feeling in the industry that this activity will continue to push the market higher despite OPEC’s and Saudi Arabia’s strong efforts to stabilise prices.”
Although most oil analysts have identified a $5-8 per barrel war/fear premium, the rest of the increase needs to be ascribed by other external and internal factors. Production constraints have never been as influential as at present, and this effect has combined with increased demand by Asian consumers. Nevertheless, there could be a substantial element of truth in OPEC’s accusation. No rational explanation other than speculation can account for the current unexpectedly high crude oil prices.
However, the financial markets do not agree with OPEC’s fundamental accusations. Stefan Weiser, commodity sales executive at Goldman Sachs in Singapore, says that there is no real foundation for the statement that the current oil price levels are due to overall investments by pension funds. In a Goldman Sachs Commodity Research report of 1 April 2005, Weiser states that in the recent period, near-dated WTI crude oil time spreads have deteriorated despite a sharp rise in WTI spot prices. This, he notes, is an anomalous situation because sharp rises in spot prices have historically been accompanied by strengthening time spreads.
It has been suggested that this abnormality is the result of investor activity concentrated in near-dated contracts and, in particular, of a substantial increase in passive commodity index investments. However, GS research indicates that the rise in spot prices has been driven primarily by a substantial upward shift in long-dated oil prices as the depletion of excess capacity across the oil supply chain has led to rising marginal costs in the industry, rather than the more typical tightening in near-term fundamentals that is normally associated with rising oil prices and strengthening time spreads.
The claim has been supported by the fact that improved inventory management and industry consolidation over the past decade have allowed the market to operate at lower inventory levels than in the past, reducing the inventory level at which the near-dated time spread shifts from backwardation into contango, the breaking point at which the oil market is constrained by either demand or supply factors. The GS Commodity Research report says that, taking both of these factors into account, the recent spread weakness can be completely explained by weaker fundamentals and does not suggest that the increase in commodity investments has affected either the shape of the oil forward curve or likely returns from commodity investments.
Overall, according to Weiser, around $50bn has been benchmarked against commodity indices worldwide, out of which approximately $35bn was invested in the GSCI. This means that, with a total crude accounting for 43% of the GSCI (28.8% crude oil, 14.27% Brent) in recent days, there has been some $15bn benchmarked in oil from GSCI investments. Weiser indicates that these are rather conservative estimates, noting that hedge funds normally do not invest much in indexes. In addition, available data do not indicate that current net speculative long positions in futures in the US are at very high levels, which shows that no excessive speculation is going on.
This supports Weiser’s claim that most of current oil price levels is due to the continuing market fundamentals, not to market speculation. With spare capacity still on the low side, oil prices will keep within the current price range. The increased levels of tax imposed by producing countries have also been pushing overall prices upwards. As Weiser states, the market at present is trading normally and the only real changes in the current market are found in long-term prices.
These claims are supported by Dirk Hoozemans, portfolio manager equities at Robeco Asset Management in Rotterdam. He told IPE that there are no real indications of the overall impact of pension funds and hedge funds worldwide on the crude oil market. However, Hoozemans notes that US-based Commodity Futures Trading Commission (CFTC) non-commercial net positions (ie hedge funds and speculators) have grown over the past decade. He indicates that the main reason for increased interest in commodities by pension funds is that as an asset class commodities are significantly negatively correlated with both bonds and equities and perform better when inflation is rising. Also, returns in commodities have been very high over the past three decades.
Hoozemans says that he expects hedge funds and pension funds will bring increased volatility to commodity markets but does not agree with OPEC’s overall views on the price
position of funds. Most of the price moves in the crude oil market are still driven by physical trade/arbitrage, he states. Robeco thinks that hedge funds/pension funds have just added extra volatility.
But independent analysts are in dispute over this analysis. According to information published by international oil tracking consultancy Petrologistics, OPEC production in April was 30.4m bpd, up from 29.7m bpd in March. At the same time, a $1bn GSCI deal sent the Commodity Research Bureau (CRB) Index up seven points and crude up $2. Analysts say that Saudi Arabia is pumping to capacity, the pension funds buy the output and that physical oil fills the world’s inventories. Every $1bn going into the GSCI adds 13,000 energy contracts to open interest. Financial magazine Barron’s quoted Goldman as saying in a report that indexed commodity money has risen to $50bn from $15bn at the end of 2003. And several websites claim that the total could exceed $80bn now, up from $50bn last year. Warren Mosler, principal at US broker-dealer AVM, claims that so far this year the GSCI rollers (the cost of storage of one barrel of oil) have given away about $3 this, or about 75¢ per barrel per month. Last month, it was about $1.50. If the cost of holding the oil averages 75¢ a month, crude needs to go up $9 on the year for the GSCI roller to give the funds a profit.
Paul Muoio, an analyst at Citigroup Global Markets and Catherine Sitts, founder of Solari Inc, have gone on record as saying that while this cost may not get pension funds to exit the field, it will certainly make them think twice about increasing investment in commodities market. However, the reality until now has been the opposite, with pension funds increasing investments.
Jim Rogers, founder of Quantum Fund, told an ABNAmro meeting in March that commodities such as wood, oil, iron and coffee are the investments of the future. Forecasts of demand from China support such claims and indicate increased potential for high investment yields.
Commodities will become more expensive across the board, according to Pim Lausberg, an analyst at Dutch bank Stroeve. He says that pension funds have become attracted to commodities as hey represent a more stable form of risk taking. Stroeve in-house research has found that “Dutch pension funds have played a leading role in this”. While large institutional investors such as Dutch pension funds PGGM and ABP were not at all active in commodities five years ago, ABP has since invested around 3% of its total investment portfolio in commodities, while PGGM has even reached 4-5%. This means that the two largest Dutch pension funds have already invested around €5bn between them. Metalektro, another Dutch fund, has an investment of €800m in commodities, of which 73%, or almost €600m, is in energy via the GSCI. Funds like Metalektro say that given the current climate they expect their investments in the GSCI will increase from a current 5% of their portfolio (some $800m), to around 6-7% in future. Metalworking and mechanical engineering sector pension fund PMT is investing around 3% of its portfolio in commodities, of which around half, or e300m, in crude oil, according to fund spokeswoman Paula Legen.
First indicators show that it definitely can be stated that crude oil prices would fall if pension funds stopped buying. But whether it would be by enough to bring crude oil prices down to the levels of before 2002 cannot be ascertained. The effect of speculation was surpassed over the last year by growing demand-supply constraints, which have put a new bottom under prices in general.
When trying to asses the so-called ‘leading role of Dutch pension funds’, the funds’ financial position within the total market should be taken into account. With a volume of around $50bn already invested in the GSCI, the main commodities index, the overall portion of Dutch pension fund investments in the oil sub-sector is significant but is definitely not leading the pack. Despite several major Dutch funds being willing to enter the commodities market, the large majority are staying away. Only some five or six of the
80-plus industry-wide pension funds have tapped the commodities market. This is due to the sector’s traditionally conservative investment policies.
However, most financial analysts expect that over the coming years larger funds will enter the commodity markets, especially to sustain their own financial requirements as set out by the Dutch Central Bank (DNB). The regulator demands that pension funds’ liabilities be at market value and given that commodities have been delivering a higher yield that equities such an investment would make it easier for funds to achieve their self-targeted yield while still complying with the DNB’s rules.
Institutional investors reject accusations that they have a role in moving crude oil prices. Most pension funds do not feel that they have an unfavourable impact on the crude oil market, as most investments have been passive. “We do not accept that pension fund investments have been behind the oil price increases,” says Ten Brinke. He supports the thesis that oil market fundamentals should be blamed as there has been no real active participation in the physical oil market at present.
However, this cannot be said of hedge funds, which participate directly and actively in markets, sometimes with detrimental effect. These positions are still under scrutiny, but hedge fund players refuse to discuss the issue. Even given that overall oil contracts have not increased substantially, there is still room for possible speculation.