Subcommittee on Oil and Gas and Other Energy Prices Committee on Aug. 27th, 2008

[The Chair, Conservative, James Rajotte]

Members, I am calling the afternoon meeting to order.

Pursuant to Standing Order 108(2), we are continuing this subcommittee's study on oil and gas and other energy prices. We had a very interesting morning session. We should have a very interesting afternoon session as well.

We have two guests appearing in person, and one witness is appearing by video conference and one by teleconference.

First of all, in person, from Carleton University, we have Ellen Russell, professor at the School of Public Policy and Administration. We also have Mr. Eric Sprott, the CEO and portfolio manager of Sprott Asset Management. Welcome to the committee.

Thirdly, by video conference, we have, from PFC Energy, Mr. Roger Diwan, partner and financial analyst.

Mr. Diwan, can you hear me?

[Roger Diwan, Partner and Financial Advisor, PFC Energy]

Yes, I can hear you very well. Thank you.

[The Chair, Conservative, James Rajotte]

Thank you.

And by teleconference, from Masters Capital Management, we have Mr. Michael Masters, the president.

Mr. Masters, can you hear me? This is the chair of the committee, James Rajotte.

[Michael Masters, President, Masters Capital Management]

Yes, I can hear you, James. Thank you.

[The Chair, Conservative, James Rajotte]

Thank you very much for that.

We have allocated about five minutes for each of you for an opening statement, and then we will have the rest of the two hours allocated to members for their questions and comments.

I think we will start with Ms. Russell, and then we'll continue with Mr. Sprott, Mr. Diwan, and then Mr. Masters.

Ms. Russell, you have five minutes for an opening statement.

[Dr. Ellen Russell, Professor, School of Public Policy and Administration, Carleton University]

Thanks very much. It's good to see you all.

I'm going to address the question of whether the price of oil is justified by underlying economic fundamentals. So do garden-variety demand and supply factors explain the high price of oil, or is something else going on that is distorting these fundamentals? Are there perhaps speculative pressures that are buffeting the price of oil away from fundamentals?

There are many angles one could take on this issue. I can't speak to all of them; my expertise doesn't extend to all of them. I am going to look at the role of financial deregulation in promoting speculation.

Recently there have been a lot of funds out there, including money that has fled other problems in the financial markets in the wake of the sub-prime meltdown. The money is coming from institutional investors, sovereign wealth funds, pension funds, and index funds. I sense that Michael Masters might address some of this. My angle on this is going to be the following question: if this money enters commodity markets, thanks in part to regulatory changes, do these institutional investors that enter commodity markets exacerbate speculative pressures?

Historically, speculation in commodity markets has been a big worry to regulators in commodity markets. In the United States, for example, in the wake of the Great Depression there was concern that price manipulation in commodity markets had run up the prices at one point and then contributed to this disastrous stagnation and downfall in commodity prices later. To prevent that kind of abuse from occurring in the future, laws were put in place in 1936, and subsequent regulations attempted to prohibit or at least deter speculation in commodity markets.

Typically, these kinds of regulations were intended to put speed bumps in place that basically limited the influence of speculation. Examples of these speed bumps included position limits--a limitation on the size of any one investor's holdings in an individual commodity, and limits on positions for market participants that were in the market for non-commercial purposes, entities that were not buying or selling commodities for underlying economic purposes. These sorts of regulations don't eliminate speculation. In fact, nobody thinks it's really possible to completely eliminate speculation, nor is it desirable. But speed bumps of this sort make it more difficult for speculators to overwhelm commodity markets.

Fast forward to the 1990s. As financial deregulation gathered momentum, many of those speed bumps were relaxed. One of the deregulatory milestones was the Commodity Futures Modernization Act of 2000 in the United States. It put oil in a so-called exempt category outside the regulatory regulations normally imposed by the Commodity Futures Trading Commission, the body set up to basically put these speed bumps in place in the first place. Thanks to this deregulation, two types of energy derivative markets were thereby exempt. One involved transactions between two counterparties that weren't executed within a trading facility, and the other involved trades done electronically.

The idea that you could set up an electronic trading facility that could function without those speed bumps became known as the Enron loophole, so called because presumably Enron lobbied to have it put in place to facilitate its Enron online electronic energy market. The Enron loophole meant that limits on the size of positions that speculators could hold did not apply, so it in effect evaded the regulatory speed bumps that were supposed to deter speculation. In my opinion, the Enron loophole and other such manoeuvres to get around regulatory speed bumps have had an impact on oil markets. It's hard to quantify that impact. I can only rely at this moment on the IMF May 2008 regional economic outlook, which said it's hard to explain current oil prices in terms of fundamentals alone:

Producers and many analysts say it is speculative activity that is pushing up oil prices now. Producers in particular argue that fundamentals would give an oil price of about $80 per barrel, with the rest being the result of speculative activity .

So why should you care if speculative activity is at least in part elevating the price of oil? There are a number of reasons, and I'm sure you've discussed many, but consider this one. When the price of oil climbs, investment in oil-related sectors is stimulated. Investment projects that would not be viable if oil was at $80 a barrel become viable when oil is $100 or more per barrel.

Now, if the price of oil is determined by underlying economic fundamentals, then any free market economist would claim that additional investment in oil is justified. But if the price of oil is being pushed up by speculative pressures beyond what the underlying fundamentals would dictate, then investment in Canada in the oil sector may be distorted by speculation in oil.

This is one of the grave problems about speculative bubbles. In the dot-com bubble, for example, lots of investment in Internet-related projects went forward, and when that bubble burst it was subsequently revealed that investment was really wrong-headed. Ditto for the latest sub-prime bubble.

If speculation is playing as large a role in the price of oil as the IMF report I just quoted would indicate, it is possible that in Canada we are experiencing a grave misallocation of investment. It is possible that we're over-investing in oil and under-investing in other sectors. If we are experiencing that kind of unjustified distortion of investment because the price of oil is not a reliable price signal, then this could have a negative legacy far into the future. It would indeed be tragic if we let our manufacturing sector and others be hammered and our oil sector overblown, only to realize that we have been guided by price signals that have been distorted.

Thanks very much.

[The Chair, Conservative, James Rajotte]

Thank you, Ms. Russell.

We'll go to Mr. Sprott, please.

[Eric Sprott, Chief Executive Officer and Portfolio Manager, Sprott Asset Management]

Thank you very much. I look forward to the opportunity of presenting our views to the committee. We have a presentation that I think each of you has, and I will briefly go to that.

We have two views on this topic. One is that we think that fundamentally the price of oil is going up because of the Hubbert peak oil thesis, which I will discuss. Two, we certainly have a view about who is involved in the commodity markets, because my job every day is to be a student of those markets. We are involved to some extent in some of the markets, and I'd be happy to speak to that.

There is a reason I want to talk about Hubbert's theory. In 1956, M. King Hubbert predicted that in 1970 peak oil production would occur in the United States in the lower 48 states. In 1970, peak oil occurred in the United States and has gone down ever since. Those same theorists who I follow—I'm not a geologist or chemist or have any intimate knowledge with the oil and gas business other than being an investor in it—have predicted that we will hit peak oil in this decade. In fact, in the data points that we have, if you go to the third page, you can see that conventional crude oil production--not non-conventional such as tar sands, methanol, and biofuels, but conventional production--has peaked out in 2005.

On page 4, we've shown the level of discoveries by decade. It's very easy to see that we do not find much oil these days. In fact, I think the commonly accepted number is that for every six barrels we consume, we find one today. So anybody who has any level of math knows we're going to run out. There's absolutely no doubt about it.

We've also put in another chart, on page 5, that basically shows that if you take the known reserves of oil in the ground and their grades, most of them are heavier grades now. We've been producing light grades, which produce more transportation fuels. Now we have in the reserves a higher grade. To produce the same fuels as we have today, we have to go from 85 million barrels a day to 100.5 million barrels to get the same light fuels.

So the message I'm trying to deliver here is that the world is in a real state of declining production in conventional oil. Frankly, I'm not surprised for one second that the price of oil goes up constantly. I'll also talk about speculators in the market.

We've given some examples. The example of Canadian conventional oil is on page 6. Most people would be surprised to look at that number and see that it has been going down since 1971. That's conventional crude oil production. We've had a little blip up here recently, undoubtedly with Newfoundland coming into play.

If you look at the next few slides, we show North Sea oil production, Norwegian oil production, and the Cantarell field in Mexico, which is a famous example. In 2004 it produced 2.4 million barrels. As of the month of July, it was at 971,000 barrels. It has lost a million and a half barrels in four years. Perhaps you might have a sense of how difficult it is to create 1.4 million barrels when I put to you that to produce 100,000 barrels in the tar sands it takes 10 years and $10 billion. This field has gone down 1.4 million barrels in four years. We also show a few other fields there, and 60 of the 98 producing countries in the world have peaked.

So I am of the belief that we are going to have an oil shortage. That oil shortage causes all commodities in the energy area to rise, as we've seen uranium skyrocket, coal has recently skyrocketed, and natural gas has gone to 15%.

Is there speculation in the energy markets? Absolutely. We have our own “made in Canada” examples of it. Amaranth lost a large amount of money, being in long gas contracts, and essentially had to wind up their fund. We had an example of a major Canadian bank announcing that they had lost $680 million in natural gas derivatives. If you lose $680 million, how much did you have invested? You're a chartered bank. Are you speculating, or is this some logical thing?

I'm a student of the gold market. I see major banks get involved in the gold markets ad nauseam, negatively or positively affecting the price. I think the speculators are very much involved in the commodity markets. We have a nickname. We call it the New York Comedy Market—it's a bit of a joke sometimes to see the volatility in those markets.

That concludes my preliminary comments. Thank you.

[The Chair, Conservative, James Rajotte]

Thank you, Mr. Sprott.

Mr. Diwan.

[Roger Diwan]

Good afternoon. Thank you for giving me this opportunity.

What I want to talk about is price formation in the oil market and how we got from $20 to $140 and back down to $120.

What's important to know is that the oil market, between 1985 and 2003, had a very large “spare capacity”, unused capacity. We had over-invested in the seventies when oil prices went up and demand suddenly declined. During those 20 years, OPEC had to shut down a large amount of production. That spare capacity, between 1985 and 2003, shrunk a little bit every year but kept oil prices at a very low level, between $18 and $20. At these prices, we have under-invested in the industry for something like 20 years.

Think about it. It meant that for every new barrel of demand we had, we didn't need to go and find oil or produce oil. We just needed some of the producers to turn on the tap. If you look at how we met the rising demand during those 20 years, over 60% came from opening the tap. That didn't cost a lot of money.

In 2003, 2004, and 2005 there were two shocks, a supply shock and a demand shock, which basically wiped out the spare capacity. The supply shock happened in 2003 when there was the Venezuelan strike, the situation in Nigeria, and then the Iraq war. We removed a lot of barrels from the market at a time when the world was starting to witness a demand shock, not only from China but also from certain places in the Middle East and in the United States. In 2004 we had incredible demand in the United States. These two shocks at the same time have removed all the spare capacity, and without spare capacity, oil markets work in a very different way.

Think about it. Before that, if you were an investor or speculator, you weren't really willing to play on that market, because any decision by OPEC could increase or decrease production by a very large amount and completely change the price structure. So there was a political risk, an OPEC risk, which for a lot of financial players was unacceptable.

As spare capacity wilted, we saw the emergence of the supply narrative. According to this narrative, we don't have enough oil, peak oil is here, and demand is rising.

I have my own slightly different opinion on that, but this narrative is very powerful among financial players, much less so among the industry players. Oil companies don't get that worked up about peak oil, but the narrative is important because it tells you that we're entering an era of scarcity, so this is the time to invest and put money into oil. That movement and that supply narrative, in a way, has created another phenomenon, which is the key to understanding oil prices. It's what I call the financialization of oil markets.

Before 2003 or 2004, oil markets were small commodity markets with few players, some of them very large, who were able to move a lot of barrels in arbitrage. In 2003 you had something like 50 financial institutions on the NYMEX. Today there are over 400 financial institutions trading on the NYMEX. So when you removed that spare capacity and added into the mix the supply narrative, that scarcity element, you brought into the market a lot of players. Many of them didn't know much about the commodity but saw one price trajectory, which seemed to them a good way to make money and to put money into play.

The financialization of the oil market is important because, between 2005 and 2008, the key oil price indicators became something other than supply and demand. I'm a fundamentalist. I've been doing this for 15 years. I know how to look at supply and demand and forecast oil prices. It worked very well until 2002. But between 2003 and 2005, the key indicator for forecasting the movement of oil prices became the amount of money coming into the exchange. It was purely the amount of money coming into the exchange, and later on, between 2006 and 2007, it was largely the position of the non-commercials, the net lengths of the non-commercials. So these specific speculators—and I have a lot of trouble with that term, for I would call them investors—were directing the magnitude and the shape and the trajectory of oil prices.

That's very important. Suddenly it's not the physical players but the financial players who are directing, just because of their weight and their size, the direction of oil prices.

As that market matured, in a way, and these players became a lot more savvy, suddenly we started to see other phenomena appearing, and what happened in the last 12 months is actually very intriguing. As all these financial players come into the market, suddenly they're making arbitrage: they're not only putting money in oil, but they're deciding, if they're putting money into oil, to take it from somewhere else. They're making portfolio arbitrage across all the asset classes. This is what I call it. Oil becomes an asset class per se. Suddenly they're deciding one day to invest in the dollar; the next day the dollar is going down, so they're investing in oil, or they're investing in the Canadian dollar, or whatever. They're making this arbitrage among their portfolio assets. That obviously has brought in more money, because new players have come in who are largely university endowments and pension funds—what are called more passive money, in general.

This arbitrage has somehow linked oil prices with other fundamentals, with what I call the “macro macro-fundamentals”. Suddenly oil prices in the last 12 months.... If you want really to understand what happened to oil prices, you need to correlate oil prices with the U.S. dollar and U.S. interest rates. The mortgage crisis in the United States, which has had an impact on loosening interest rates and weakening the dollar, had a tremendous impact on oil prices. You have a very good correlation there.

And actually we see it happening in the reverse now: as the dollar is strengthening, oil is weakening. In that sense, oil has become a financial asset, where the fundamentals matter. After all, we have under-invested for a long time. The physical supply and demand balances until now have been fairly tight. I think they're probably reversing a little bit in the next year and a half, because oil prices have started to destroy demand, but what you had in a way is macro-fundamentals and oil fundamentals having become, both together, the key driver of the oil prices.

I'll stop it here. I'll take questions later.

[The Chair, Conservative, James Rajotte]

Thank you very much, Mr. Diwan.

We'll now go to Mr. Masters.

[Michael Masters]

Thank you.

I appreciate the opportunity to speak with you today about a recent and never-before-seen phenomenon in the commodities futures markets. Historically, these markets have had two types of participants: one, physical hedgers, who are the actual producers and consumers of tangible, real-world commodities; and two, speculators, who trade commodities futures to try to make a profit.

The commodities futures markets were started by physical hedgers and exist to serve them, and traditional speculators are allowed to participate because they provide liquidity by actively buying and selling. However, in the last five years, large institutional investors have adopted the misguided belief that commodity futures are an asset class in which they can make a passive, broadly diversified, long-term investment in the form of commodity indices. I call this new and more damaging breed of speculator “index speculators”. They have been encouraged by Wall Street to think of an allocation to the S&P Goldman Sachs Commodity Index or the Dow Jones-AIG Commodity Index, which are the two leading indexes of commodity futures, in the same way as they think about the S&P 500 stock index. The problem is that commodity futures markets are not capital markets, and when deep-pocketed investors try to make passive, long-term investment in commodity indices, it causes great damage to the commodities futures markets and to the economy as a whole.

Institutional investors have poured hundreds of billions of dollars into the commodity futures markets, and assets tied to the commodity index investments have ballooned from $13 billion in 2003 to approximately $317 billion as of July 1, 2008.

As chart one in my written testimony shows, this has driven up prices for essential food and energy commodities by an average of more than 200% in the last five and a half years. In fact, the total open interest of the 25 largest and most important commodities upon which the indices are based was $183 billion in 2004. From the beginning of 2004 to today, index speculators have poured $173 billion into these 25 commodities. This is a very significant amount of money flowing into what amounts to a very small market.

As chart two in my written submitted testimony shows, this has caused futures prices to rise dramatically as the commodities futures markets were forced to expand in order to absorb this enormous new influx of capital. Index speculators have bought more commodity futures contracts in the last five years than both physical hedgers and traditional speculators combined. They are now the single most dominant force in the commodities futures markets today.

In 1998, physical hedgers on average outnumbered speculators by a greater than 3:1 ratio, according to the CFTC. Today speculators in general outnumber physical hedgers by more than a 2:1 ratio. This is a colossal shift in the balance of power. Physical hedgers' positions have grown more than 90% in the last 10 years, while speculators' positions have grown more than 1,300% in the same timeframe.

The worst thing about index speculator buying is that it has really nothing to do with true supply and demand fundamentals. As an example, when a $10 billion pension fund investment committee decides to put $500 million, or 5% of its portfolio, into the S&P GSCI commodity futures index, then the $200 million that consequently flows into WTI crude oil futures has absolutely nothing to do with the supply and demand for crude oil in the marketplace. More damaging still, because index speculators enter the commodity futures markets with a fixed amount of dollars to invest, they care little what price they pay per barrel as long as they can put all their money to work. They buy as many barrels as they can, at whatever price they have to pay, until all their money is fully invested.

As a result, the prices for commodities are pushed much higher and are amplified more than supply and demand dictate. This means that the price discovery function of the commodity futures markets is greatly damaged. In fact, because futures prices are the benchmark by which commodity prices are set in the real world, this raises the real-world prices for food and energy. So not only are the misguided actions of index speculators distorting the commodity futures markets, but they're hurting the worldwide economy because every participant in the spot market is forced to pay more for food and energy.

The U.S. government must take action to re-establish reasonable and rigid limits on speculation and to prohibit the damaging practice of index speculation. The world's economies cannot be held hostage by the investment whims of Wall Street.

This concludes my testimony.

[The Chair, Conservative, James Rajotte]

Thank you very much, Mr. Masters. We appreciate that.

Now we'll go into questions from members.

Mr. Masters, there are 12 members of the committee, so we'll ask each member of the committee to identify themselves as they ask questions, especially for you and Mr. Diwan on video conference.

For the first round, we have six minutes for each member; for the second and third rounds, we have five minutes for each member. It's a very limited time for questions and answers, so we ask that you be as brief as possible in your responses. If a question is asked of one witness and someone else would like to answer, please indicate that to me.

We'll start the six minutes with Mr. Dan McTeague, the vice-chair.

[Dan McTeague, Liberal, Pickering—Scarborough East, ON]

Thank you, Mr. Chair.

Mr. Diwan, Mr. Masters, Ms. Russell, and Mr. Sprott, thank you for being here today.

I just want to say that your testimony here is absolutely important. Several months ago when we were looking at the issue of why prices were instantaneously rising without real explanation, certainly not from the industry, it was refreshing to hear your comments to the U.S. subcommittee. It's too bad we weren't able to do this earlier, but this is a committee that works by consensus. I'm glad that the amendment I made to get this on the record is indeed bearing fruit today.

We've just heard from representatives of the downstream of the oil industry who suggested that in fact supply and demand are very much in order as it relates to pricing. Of course I don't believe that, and I'm refreshed by the comments you have just made.

I'm wondering if, Mr. Diwan or Mr. Master, and perhaps you, Ms. Russell, you can explain to us the dimension to which Canadian pension funds, sovereign funds, index investors, and institutional investors, as you've called them, may be involved in taking advantage of the loopholes created by the commission on futures trading in the United States.

[Michael Masters]

I believe the Ontario teachers' fund is one of the participants in commodity futures indexation replication strategies. Beyond that, I am not aware of any others. It is a reasonably popular asset class now for many pension funds across the United States. And I imagine there are other participants in Canada other than the Ontario teachers' pension fund.

[Dan McTeague, Liberal, Pickering—Scarborough East, ON]

Mr. Diwan.

[Roger Diwan]

I'm not particularly well aware of the Canadian market; I work mostly here in the United States. But I imagine that hedge funds and pension funds have replicated what American, European, Asian, and Middle Eastern pension funds have done. Unless there is a legal reason in Canada not to be able to do that, I imagine they have done what their counterparts have done.

[Dan McTeague, Liberal, Pickering—Scarborough East, ON]

Yes. I just noticed the IntercontinentalExchange has one of its offices here in Winnipeg, Manitoba.

Ms. Russell.

[Dr. Ellen Russell]

Well, I think that when one group of institutional investors, say in the United States, is able to do something, it creates pressure for everyone to do likewise. So even where there might be some regulatory restrictions in place, they will scramble to try to find their way to do what the other folks that are in the same ball club do. There's a lot of pressure there for them to do likewise.

[Dan McTeague, Liberal, Pickering—Scarborough East, ON]

Let me ask all of you if this is correct.

I'm noticing that the Department of Energy has just released its figures, saying that demand in the United States, which represents half of the world's transportation demand on fuels, has now dropped to levels we haven't seen since 1998 in terms of crude, gasoline, and jet fuel.

I find it rather interesting--I'm looking at Bloomberg as we speak--that gasoline prices are heading up 7.7¢ to 8¢ a gallon tonight; crude is up $2 a barrel. Is this an example of the sickness and the dysfunctionality of this market, which has eluded Canadian officials up until now, Mr. Diwan?

[Roger Diwan]

Well, yes and no. I mean, there are short-term events. There is a very big storm in the Caribbean coming toward Louisiana, and you have a long holiday here--Monday is closed--so the market is preparing for a potential big disruption. You have to be careful about these small movements.

I want to comment a little on the gasoline, because that's important. If you look at supply and demand in gasoline in the United States, it has really loosened, and the suspicion is that gasoline is fairly oversold now. You are producing more gasoline than you need or you're importing a lot less, and you've seen it in the gasoline prices. The gasoline prices are low in the United States. What's high is the crude portion of the price, not the gasoline portion. Refiners are not doing well. They're not losing money, but they're not really making money. They have very low margins, so we have to be careful when talking about gasoline prices. Yes, the price that consumers are paying is high because the crude portion of it is high, not because the gasoline portion of it is high.

[Dan McTeague, Liberal, Pickering—Scarborough East, ON]

Mr. Diwan, if I were to tell you that Canadian refiners are charging 30¢ a gallon more than NYMEX RBOB unleaded gas, would you say that's a fairly profitable proposition for Canadian refiners?

[Roger Diwan]

Yes, it's certainly profitable.

[Dan McTeague, Liberal, Pickering—Scarborough East, ON]

Thank you.

Mr. Chair, how much time do I have?

[The Chair, Conservative, James Rajotte]

Mr. Sprott, did you want to comment?