Crude oil prices have slipped more than 20 per cent in just about a month. Have the market fundamentals changed dramatically and will lower prices sustain? And, don't speculators deserve some credit for this correction? By Vivek Sharma

The Russian offensive against Georgia was the litmus test, not for NATO's resolve against its Cold War enemy but for international crude oil price trends. The test was whether the recent decline was only a short-term correction after the eye-popping surge earlier this year or the start of an intermediate downtrend. Until mid-July, it didn't take events as significant as the Russia-Georgia conflict to ignite oil prices. Even minor developments used to push up prices by $5 or $10 per barrel, in a day.

When news of the Russian incursion first broke, crude oil prices broke the downward spiral and made a feeble attempt at recovery. After rising slightly over $1 per barrel in opening trades that day, prices slipped again and ended lower.

It seemed as if not even a war could push up crude oil prices. When the threat of a storm on the US east coast a few days later also did not move oil prices higher, the verdict from oil analysts and commentators were near unanimous. Crude oil prices have peaked for the intermediate term and will remain subdued for a while.

Barely a month after oil prices set a high near $150 per barrel, is it too early to make that call even if prices have slipped more than 20 per cent from the peak? Or, have market fundamentals changed substantially enough? Have all the oil speculators who were pushing up oil prices been browbeaten by the veiled threats and rhetoric of politicians?

Why not credit the speculators now?
When crude oil prices were on the way up until mid-July, politicians of all ideological hues the world over blamed just one group of market participants - devious speculators. We were told that trade excessively in commodity markets, push up prices and make billions of dollars in profits for themselves. Their billions in profits were looted out of ordinary tax-paying consumers, who saw the prices of everything go up and their lives turn even more miserable. The speculators must be reined in and the world will be fine again.

To establish the evil nature of speculation, regulators were unleashed. In the US, the Commodity Futures Trading Commission was asked to do a detailed study. Its early finding was that only about 38 per cent of all trades in crude oil on the NYMEX were by non-commercial traders, or the so called speculators.

You cannot blame speculators when the majority of trading is by the 'real' players. So the CFTC decided to reclassify some of the real traders as speculators and the share of non-commercial trades crossed the 50 per cent. It is another matter that the group newly classified as speculators is in fact commercial brokers in the energy market who act as intermediaries in 'real transactions'.

Even if majority of trades are speculative in nature, how can such traders be kept out of the market? That would be like saying there should not be any non-delivery or intra-day transactions in the stock market. It is not even feasible to limit speculative traders. Can the authorities say trading will be halted when non-delivery transactions exceed a certain threshold, say, 20 per cent or 30 per cent? If so, what is the ideal threshold and who will fix it?

It is nobody's argument that speculation did not contribute to the rise in oil prices and commodity prices in general. It is just that such speculators were acting on the basis of a real shift in long-term market fundamentals. That the increase in demand for hydrocarbons was at a faster pace than earlier thought and would outstrip supplies sooner than forecast, unless the world decided to become more energy efficient and develop alternate fuels. As former US Fed chairman Alan Greenspan said last week, it was 'good speculation' or 'classic stabilising speculation'.

By pushing up prices to such an extent, the speculation actually helped focus the world's attention on the significance of the problem.

In any case, even in the absence of speculation, it was likely that prices would have responded to a fundamental shift in demand-supply balance in a market like that for crude oil where suppliers are limited in number and wield inordinate pricing power. It is also more likely that, in such a scenario where a limited number of suppliers control the market, higher prices would have prevailed much longer.

But, why are the speculators not getting any credit for the decline in oil prices? If excessive trading was responsible for the sharp rise in prices, the same must have had a hand in the even sharper correction as well. Many traders who profited in the oil price surge have lost in the decline. Some astute traders would definitely have made money from the decline, but a few hedge funds are believed to have been caught by surprise in the swift decline and were nearly wiped out.

Nobody is thanking speculators now because it is politically inconvenient to accept that they react to weakening market fundamentals by pushing down prices, the same way they pushed up prices when market fundamentals were tightening. It is for politicians and regulators to read the price signals from the market and formulate policies accordingly.

Nothing cures high prices like high prices
That is an old saying which has been proven time and again. It is no different this time too, in the case of crude oil prices. Yes, the two most significant reasons for the oil price correction are the weakening global growth outlook and the dollar recovery. Lower global growth will obviously affect oil demand and forecasts have been cut for next year and beyond. The dollar strength reverses the earlier trend of the weak greenback contributing to higher oil prices.

But, evidence of natural demand destruction because of higher energy prices abound. Sales of heavy cars and SUV's are down in most markets while every car manufacturer is scrambling to bring smaller cars to the market.

This week there was a report that Hyundai is planning to introduce the smallest car in its portfolio, the i10, in the US market. Until very recently, no manufacturer would have thought of bringing a car as small as the i10 to the US.

But times have changed and Americans no longer laugh at the tiny cars the Europeans and the Japanese drive. The 'best buy' lists in American auto magazines usually dominated by large sedans and SUV's now have small cars like the Smart and the Mini, besides the hybrid Toyota Prius which has become something like a legend.

Not surprisingly, Americans drove less for the eighth consecutive month in June. And surprisingly for many, traffic jams are easing in California. The decline in average monthly miles driven by all Americans has been close to 4 per cent in recent months and fuel consumption have slipped nearly 3 per cent from a year ago. Demand for products which consume less energy remains firm, even as overall consumer demand is weakening in the US. Even in the midst of one of the worst housing decline in the US, prices of homes close to city centres have declined less than suburban homes as people chose to travel less to reduce fuel bills.

Higher energy prices are even affecting globalisation. As imports become costlier because of higher shipping costs, local manufacturers in most economies are seeing increased demand. Again, this is most evident in the US where manufacturing has performed surprisingly well - though also because of increased exports supported by the weaker dollar.

Are lower prices here to stay?
Given the decline in global growth outlook and falling oil consumption in major markets like the US, it is likely that oil prices will not scale back the recent peak in a hurry and may remain subdued for a while. More than US demand trends, changes in oil consumption in emerging markets like India and China will be crucial to future price trends. But, in both countries, fuel prices continue to be subsidised and hence may not see the kind of demand destruction seen in other markets. Again growth outlook for both China and India remain strong, when compared to other economies which are teetering on the brink of recession, and should support energy demand. Also, the dollar may not sustain the recovery for long and that will remove one of the reasons for the oil price decline. So it is also unlikely that oil prices will fall substantially from the current levels.

The current oil prices should also be seen in the right perspective. Yes, prices have dropped more than $30 per barrel to $115 now. But, that is still well above the price levels that prevailed last year. Even earlier this year, oil at $115 per barrel would have scared most policy makers. So the correction has only been relative and appears significant only when seen from the peak of $147 per barrel. For the real economy, oil prices are still high.