Saturday, May 30, 2009

Why Oil Prices Climb Steadily Though We Are Still In Recession?

At the moment of writing, oil prices have hit seven-months high thus breaking the barrier of $66 dollar per barrel. At one look, it seems to be very contradictive with the conventional economic wisdom. We often hear or read that during the period of global recession, people will become thrifty. They will cut their spending in almost everything. Firms in response, slash their production and rationalise the number of workers. The breakdown in entire economic activities should in theory hamper the demand for oil

But think again. Sometimes economic theories such as simple demand and supply may not be sufficient to explain such sort of phenomenon. It goes beyond the ordinary functioning of the market such as psychology factor


(1) Quantitative easing. In layman term it means easing the economy with quantity of money. The financial market in US is currently crippled with major financial institutions reporting historical loss. Common names like Bank of America, AIG, Citigroup, Wells Fargo and Goldman Sachs are popular headlines in recent times. In short, the whole financial system suffers from liquidity problem. Banks find it increasingly difficult to raise additional financing from money market since interbank lending rate increase. That left them with one most viable option that is attracting deposits. However, there is pressure from Fed to lower down the interest rates, which may shoo away savers

Therefore, Fed announced an alternative plan and that is pumping extra cash into the system by buying $300 billion worth of long term Treasury bonds and about $700 billion of mortgage backed securities from those troubled financial institutions. So investors and some countries are speculating that the end of dollar is near. They are afraid that US will inflate their way out of recession, thus imperilling the value of dollar. Another way to see this is increase in the quantity of dollar circulating around, so the greenback will fall in its value. Although this is yet to happen or will not happen actually, but unfortunately people “want” to believe that it will eventually come true. So this “self-fulfilling prophecy” could have gradually worked itself out. More people are dumping the dollar, causing it to really depreciate in value against other currencies. However, not to forget that black gold is quoted in dollar. So now it seems that buying oil is artificially cheap, pushing the demand upward

(2) OPEC’s optimism. Again this is another type of “self-fulfilling prophecy”. The OPEC members could have digested the report released in the recent saying that US economy will most likely recover by the end of 2009. Also it will be the catalyst in reviving global recession. In what capacity can an organisation or policymakers foresee a future? Is number crunching alone enough? I’m pretty doubtful of this

However, due to the “believe” that the OECD economies have seen the worst, OPEC is likely to stop increasing supply in order to help the gas-guzzling Western economies. They will want to hoard more oil inventories. Besides why increase the supply when these can be kept and sold at higher price in the future? Why make less when you can actually make more? In a nutshell, they wanted to “believe” that major economies will recover and thereby fuelling the demand once more. This is another point that explains the recent oil rally

(3) Investors’ sentiment. They too “feel” that the US economy will recover by the end of this year. As such by that time, revival of economic activities will once again fuel the demand for oil. In such anticipation, they immediately flock into oil futures betting that oil price will increase in near future. So the mentality of why-not-invest-now prevails and when oil price possibly hit beyond $70 dollar per barrel, they claim that their prophecy is truthful when they are the one who actually engineered it

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