Oil prices and markets a long way from ideal

Little cheer for oil traders as crude breaks psychological levels.

It is tempting to believe there is a magic price at which the world oil market is perfectly balanced: high enough to cover the spending needs of the major oil exporting countries and provide a fair return to investors, while being low enough for motorists to fill up without feeling a hole in their pocket. The trouble these days is that this ideal price is never quite where the market stands at the moment. Sometimes it feels a long way short of ideal.

When crude oil futures surged above US$100 a barrel for the first time at the beginning of this year, it seemed they couldn't get to $150 fast enough. Even before they reached their record of $147 in July, the chief executive of Gazprom, Russia's gas monopoly, predicted another vault to $250. Now the price has slid back below the $100 mark, there are already those who see no reason to buy crude oil at anything more than half that level. Merrill Lynch last week predicted prices could hit $50 a barrel next year if the world goes into recession.

At both ends of the spectrum, there are those who, driven by sentiment and scenario thinking, bet their reputations on extreme outcomes. Once the preserve of those who dealt directly in physical crude, the oil futures exchanges have evolved into highly liquid markets where hedge funds, private equity funds, pension funds and bankers now dominate the trade. With them have come the "algorithmic traders", black-box computers that assign a positive or negative value to every snippet of news on a given subject, and issue near-instantaneous "buy" and "sell" orders.

On the stock markets in the US and Britain, these machines already account for more than half of the total volume of trade, and their influence on oil markets is growing. They work on the assumption that they will get in at the ground floor of any move up, or at the top of any move down, thereby maximising profits. Economists say they improve the efficiency of markets by providing liquidity. But they also increase the "headless chicken" quality of the markets, exacerbating extreme market moves.

Just three months ago, it seemed nothing could bring oil prices down. The air waves were abuzz with "peak oil" theorists decrying an imminent collapse in global oil production. Countries known for promoting free international trade denounced the harmful effects of imported oil. Moralists emerged to castigate the wasteful use of the earth's resources and investors moved billions of dollars into costly alternative energy sources.

It was easy to get swept up with the emotion. Christophe de Margerie, the chief executive of Total, the French energy giant, proclaimed the end of the traditional cycle of boom and bust in the oil market. Some ministers in Opec even began to think the price would never again dip into double digits. These confident predictions were backed up by analyses of future consumption trends showing the next billion souls emerging into consumer status would demand mobility as well as mobile phones. They were prepared to pay a higher price for fuel than that to which the developed world had become accustomed, and they were not going away.

Much of this analysis was based on the assumption that the oil-reliant global economy would continue to grow rapidly. But, suddenly, the economic goal posts appear to be moving. Now, with fears of a global recession dominating sentiment across financial markets, it seems nothing can keep oil prices up. American motorists have disproved the theory that US fuel demand is price inelastic. Millions of women in Africa and Asia have discarded their kerosene stoves in favour of firewood. Even some Chinese and Indians are thinking twice about abandoning the bicycle for their first car.

Analysts, industry pundits and government officials are now desperately trying to pin down the new floor in oil prices. Is it $100 a barrel, the price at which the inflated budgets and massive subsidies of Iran and Venezuela break even? Or $80, the level at which some oil companies start to worry about their profits? Or will prices test the budgets of some of the world's largest producers, such as Saudi Arabia, which needs $50 to keep its infrastructure spending on track?

The truth for sentiment traders and black boxes is that, whatever the price today, the floor is simply lower than the current price. They are capable of driving prices way below their long-term sustainable level. Just as oil above $100 a barrel pushed President George W Bush onto an aeroplane to Saudi Arabia to call for more supply, so algorithmic traders could drive prices far below what Iran, Saudi Arabia and others would willingly bear.

Is there no better system for determining the price of this strategic commodity? Before the advent of futures markets, there was a system called the monthly posted prices, where the benchmark was set once a month by national oil companies such as Abu Dhabi National Oil Company, after private consultations with their customers. It moved in small degrees and was based on consensus. It depended on producers recognising their own vested interest in maintaining a healthy long-term demand for their products.

Of course it is impossible to say what level they would have agreed on now, but it is hard to believe it would have approached $150. Equally, it is hard to imagine they would have got close to $10 a barrel, where prices stood a decade ago. Oil markets have moved so far from their roots that it has become easy to forget there is a real world out there. Reality catches up in the end, but not before the black boxes and headless chickens have had their way.

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