Traditional economics lead us to believe that the soaring oil prices can be explained away by the law of demand and supply. The increasing demand is attributed to the growing consumption in the emerging economies like China and India.

While the militant attacks on the production units in Nigeria and strike calls mainly account for the disruptions in the supply side. There is so much talk on increasing oil output and cutting off subsidies. China has cut subsidies to restrict its growing demand. And the Opec is being held responsible for not increasing the production and for cartelization.

So, it just seems to be a simple issue of supply and demand as made out by the US government.

But there is another side of the story. Each stakeholder has its own version of the present oil crisis. US is the largest consumer of oil, accounting for more than the combined consumption of China, India, Japan and Russia. The present trend of recession in US has cut its growth in demand for oil significantly. So even if the demand is growing, it is not outdoing the supply to an extent depicted by the prices.

Events like these did not trigger such crises in the past when supplies were disrupted for 19 months due to American invasion of Iraq, let alone the Gulf war. And Opec members seem to be rightly blaming the weak dollar and speculation for such abnormal price hike. US economic slowdown, poor economic data and the prevailing credit crunch have weakened the dollar significantly.

Weak dollar: A weak dollar has three fold effects on the oil prices. As the oil is widely sold in dollar with the future contracts also denominated in US currency, a weak dollar makes the oil cheaper for countries in euro-zone, China and India, resulting in greater demand which pushes the prices up.

Second, as many oil companies are big multinationals, their retail receipts are denominated in dollars while the cost of production is in currencies other than the greenback, depending on the individual oil producing countries. So with dollar weakening, the receipts tend to get lower as compared to the costs and this also discourages more investment.

Third, with dollar on the slide, the multinationals have started hedging their foreign exchange risks through the oil futures and a rush in futures has resulted in a speculation fever which has distorted the basic demand-supply theorem of determining the prices.

Speculative games: Oil futures are the contract to buy 1000 barrels of oil at a specific price at a specified date and are regulated by the Commodities Futures Trading Commission (CTFC). To hedge the uncertainty of higher prices in near future, companies enter into the future contracts at a fixed price. So when the contract matures (after the specified time), they get the oil on the specified prices, ideally (although there are risks involved).

The trading was limited by CTFC to only oil and energy companies so that the stakes did not get high, without the intention of actually buying the commodity. But after the stock crashes in the early 2000’s, outside investors stepped in and to avoid the CTFC regulations, set up International Commodities Exchange (ICE) in London where they could invest in futures freely. Instead of using commodity futures as an effective hedge, most outside investors used these as an investment and created speculative hedges against weak dollar (since when dollar goes down, oil prices go up, so losses and gains are offset).

Many of the institutional investors have put heavy investments in commodities market as the Federal Bank has slashed the interest rates in a move to save the US economy from going into recession; so it makes commodity futures even a more lucrative investment. Surprising is the five per cent margin requirement in the futures market (the initial sum which is deposited as a guarantee and maintained at day’s end to cover the losses) as compared to the 50 per cent margin in stock market equity investments.

As the closing date of the futures draws nearer, the margin increases so instead of buying the oil at the specified date, investors sell their futures and roll over their investments. This low margin has resulted in cheap entry in a highly volatile futures market. So many multinationals over hedge their foreign exchange and oil prices exposure.

Since, there are a large number of investors who are willing to pay prices that high in hope of future gains, this increases the demand of future contracts and pushes the prices even higher defying the traditional actual oil demand supply hypothesis. And, as we all know that the prices of tomorrow affect the prices of today as well so high speculation has pumped a big oil bubble. Like George Soros, the billionaire investor commented “The price has this parabolic shape which is characteristic of bubbles.”

Strong dollar: Weak dollar is the essential element for the successful expansion of big US multinationals. Auto manufacturers, tourism industry and big multinationals have blossomed in the past due to weak dollar. As dollar gets weaker, the exports get cheaper for foreign buyers, increasing the sales and this contributes to the competitive edge over the European producers. This also results in huge revenues through tax collections.

But the policy of weak dollar is hurting the US economy the most as US is the largest importer of oil and prices have reached to such an extent that it is contributing to huge deficits. This is time that the US think tanks revisit their economic policies as we know that when giants collapse, the waves affect all the economies of the world.

Currency basket: To counter the range of crises caused by a weak dollar, Iran and Venezuela have proposed a basket of currencies in which oil should be traded. The move may not only slow down speculation but may help simple demand and supply determine the prices. But it is more of a political than an economic issue and it is pretty hard to overcome the influence of US policies.

Futures trading: Regulations should be imposed on ICE on the same lines as in CTFC and to cap the investments that can be held. For starters, the margin requirement should be increased even if temporarily, to slow down the market.

CTFC has already entered into an agreement with ICE to share the trading data on daily basis so as to monitor the speculative positions of investors. But, unregulated over the counter agreements will also need to be monitored as these form a huge part of total trading.

Jeddah Summit: Under foreign pressure, Saudi Arabia has agreed to increase its daily production by 200,000 barrels per day. This will not help bring down prices as output is too little to influence the market, especially when the same amount of low cost refined Nigerian oil is being lost daily due to political unrest. And it also a signal that market is not reacting to supplies to a big extent but to other factors.

US reserves: Another solution could be to release some oil from the State Petroleum Reserves of US which has storage of more than 700 million barrels of oil. The Energy Policy and Conservation Act authorises the use of reserves if the president finds that (a) there is an emergency situation due to lack of supplies (b) prices have shot up considerably due to such circumstances (c) prices are adversely affecting the national economy. All the three conditions apply in the present scenario.