Oil prices were already known to contain a risk premium. Now they seem to carry a big speculative premium too. Dr Muhammad-Ali Zainy tells Financial Review that the US's review will probably find some sort of legislative compromise.

There has been a fair amount of talk about the speculative froth in oil prices, and the extent to which this mainstream cost for the importing, substantially OECD or Western, countries has been driven by financial traders. What is your view of that debate? Who are the players in such trading? And does it surprise you that the reaction has not become more political, general and vocal?
There has been a positive correlation between the volume of trading on the oil futures markets and the price of oil. Tens of billions of dollars have moved to the oil futures markets trading in 'paper' barrels. This phenomenon has given rise to speculative pressures pushing the oil price upwards. One should remember, however, that these investor-speculators are not haphazard gamblers basing their decisions on mere luck; they study the market carefully and make their decisions. Such decisions, therefore, incorporate, in addition to speculation, elements of potential impacts of geopolitics as well as fundamentals.

The New York Mercantile Exchange (Nymex) is regulated by the Commodity Futures Trading Commission (CFTC), so traders on this exchange cannot follow manipulative practices or excessive speculation since such practices are prohibited by law and regulated by the CFTC. The billions of dollars of the so-called speculators are playing the over-the-counter (OTC) exchanges and the US trading terminals of the London-based Intercontinental Exchange (ICE) trading in West Texas Intermediate (WTI). The OTC and ICE US terminals are unregulated and their dealings are opaque. The players are, therefore, not exactly known to the public, but they include corporate and government pension funds, sovereign wealth funds, large trader banks, hedge funds and other institutional investors.

I believe the reaction to such practices is gathering pace. As the oil price soared, the US airlines, truckers and other shipping companies are calling for a crackdown on financial speculators. It is also becoming more political as the Democrats in the US Congress have proposed legislation to curb speculation in energy trading. The Republicans, however, want to introduce several amendments, including removing the congressional ban on drilling in the US Outer Continental Shelf (OTC); President Bush has already removed the presidential ban on drilling in the OTC. There may also be pressure groups (such as the US pension funds) impeding such legislation. 

Before the speculative premium it used to be the risk premium that received most mention, sometimes cited as representing perhaps $20-$30 of the price, even at $100 (Dh 367.3) per barrel. How would you relate that element to the fundamentals of oil pricing currently?
A risk premium is always there, given the chronic instability in the Middle East, terrorism, military conflict, infrastructure sabotage (as in Nigeria) and resource nationalism (as in Russia, Venezuela and some other countries). The risk premium was quite pronounced in 1973-74 in the aftermath of the Arab-Israeli war, in 1979 with the impact of the Islamic revolution in Iran, and a brief premium (price spike) in 1991 Gulf War, which premium was then suppressed by a prompt production increase from Saudi Arabia and good management of the US Strategic Petroleum Reserve (SPR).

The risk premium would be very little when Opec, the world's swing producer, had ample spare production capacity that would cover any perceived supply disruption. That was the case with the Gulf War in 1991 when Saudi Arabia, more than any other Opec member, had a considerable spare capacity and was able to replace Iraq's exports plus Kuwait's exports when the latter disappeared from the market for a brief period. Tight spare capacity, on the other hand, gives rise to large premiums, which characterises the situation nowadays.

Opec's current spare capacity is barely 2.5 million barrels per day (bpd); about 75 per cent of it rests in one country, that is Saudi Arabia. Given Iran's nuclear issue and the possibility that it might be attacked, Opec's spare capacity cannot replace Iran's present production of over 3.9 million bpd, let alone deal with the potentially disastrous event of closing the Strait of Hormuz through which around 40 per cent of the world's oil trade passes. There is definitely a pronounced risk premium now, which itself partially fuels speculation.

To the extent that it has become part of the political arena, for instance in Congressional hearings in the US and parliamentary scrutiny in the UK. How do you interpret that attention and reaction and where it might lead?
There is much more political fuss in the US Congress than in the UK parliament and, perhaps, that is due to the fact that oil is cheaper to the euro and sterling areas by virtue of the US dollar decline against these two currencies. The Americans are not used to very high gasoline prices which, for some time, exceeded $4 (about Dh14.71) per gallon at the pump. Price inflation of gasoline and diesel hurt the constituencies of Senators and Congressmen, and they have to respond to the outcry of their people if they want to be re-elected, especially as this year happens to be an election year. The Democrats are moving ahead with legislation to curb speculation and the Republicans introduced amendments to open the US Atlantic and Pacific Outer Continental Shelves for oil and gas drilling. The outcome will ultimately result in some legislative compromise to accommodate both. Speculation will have to be reined in and, after all, if the US needs to increase its domestic oil and gas production and reduce its reliance on the Middle East, it will have to lift the 1981 congressional moratorium on drilling the OCS and, maybe, even the Alaska National Wildlife Refuge (ANWR).
Climate change, energy conservation and alternative fuels have become mantras globally.  What is your view of these general efforts in the face of the world's historic dependence on fossil fuels, and especially oil. Is it well-informed? Is it too little, too late?
According to the BP Statistical Review of World Energy 2008, during the four decades spanning the period 1967-2007, world oil consumption increased from 36,072 million bpd to 85,220 million bpd, world natural gas consumption increased from 765.4 billion cubic metres to 2,921.9 billion cubic metres and world coal consumption increased from 1,442.5 million tonnes oil equivalent to 3,177.5 million tonnes oil equivalent, each growing at an average rate of 2.1 per cent, 3.3 per cent and 2 per cent per annum respectively. This is, of course, a clear growing dependency on fossil fuels, especially oil since it is almost the only energy source, so far, to fuel the transportation sector.

Burning fossil fuels emit carbon dioxide (CO2), which is a greenhouse gas (GHG) that contributes to global warming, although the world is not absolutely clear whether the global warming phenomenon is entirely due to the emission of GHGs or a recurring one in the earth's past history. CO2 emission, however, has to be curbed, whether through the Kyoto Protocol, emissions trading or some other system. To curb the world's dependence on fossil fuel in general, energy conservation should always be pursued and improved, and research has to continue in earnest for the development of economically viable alternative sources of energy. The ongoing efforts in this direction are not too little and it is never too late.

If strong global demand trends for hydrocarbon-based energy is presumed, what trends do you foresee on the supply side, particularly from the Middle East? What price expectations and perception of the strategic dimension do you have in this respect for the medium term?
By hydrocarbon-based energy I assume oil is meant, to the exception of natural gas and coal, since the question's focus is on Opec and Arabian Gulf states. Non-Opec supply is faltering and many of the major oil provinces are now in decline. The recent announcement by the US Geological Survey that the area north of the Arctic Circle holds around 90 billion barrels of oil and 1,670 trillion cubic feet of natural gas is good news, but supplies from there will not be forthcoming in the medium term. Oil supply from Alberta's oil sands is slowly rising and may reach 3-4 million bpd in the medium term, but the cost per barrel (capital and operating) is about $70 (about Dh257.1), which will put a floor to the oil price as long as oil from oil sands remains the market's marginal supplier.

The onus will fall on Opec supply in case of a strong global oil demand trend. And out of the 12 members of Opec, only Saudi Arabia, Iran and Iraq promise oil supplies that would meet any expected strong demand, given their present proven reserves of 264, 138 and 115 billion barrels respectively. Strategically speaking, there could be a scramble for oil supply security between the rising Asian economic giants: China and India on the one hand and the United States and Europe (to a lesser degree) on the other hand.

Do you agree with the pundits who say that oil prices will now remain high indefinitely? It is not so many years that they dropped into single digits, and for many years they stayed comparatively low, without any expectation of a climb, let alone rocketing ascent. What other themes or factors do you think should be borne in mind about the current situation, and future?
The price explosions of the 1970s were in the lesser part justified by the economics of the oil market at the time, especially when the price was raised in 1973. On the major part, however, the price exploded either in response to geopolitical events (the Islamic revolution) or raised mechanically by Opec without justifiable market forces. To such unwarranted high prices the market responded by opening the new oil provinces of the North Sea and Alaska and also new additional supplies from many other parts of the world. Additionally, conservation drives and improved efficiency of oil use played a significant role in reining in demand.

The situation now is different, as there has been a major structural change in the market. The price increases from 2002 and afterwards were, essentially, demand-led. Demand increments, caused by emerging markets (led by China) are still on, albeit with lower volumes. Non-Opec supplies are practically stagnant, and will increase only slowly and modestly as there aren't North Seas or Alaskas anymore. The Arctic potential supplies will need a long time to materialise, and by then world oil demand will have increased too.

Opec will remain with a relatively small spare production capacity, and world refining conversion capacity is currently very tight and may remain comparatively tight even with the addition of new capacity in Asia and the Middle East, given that the marginal Opec supplies are mostly heavy crudes. I have already mentioned above that oil sands, being a marginal supplier, are putting a price floor of $70 per barrel (about Dh257.1). Even if additional non-Opec supplies start pressuring the price downwards, I do not think that Opec will accept a price below the range of $70-$80 per barrel. Opec will move to cut production.

- Interview by Andrew Shouler, Editor, Financial Review.