- James Saft is a Reuters columnist. The views expressed are his own –

Even putting aside the spectacular but hard-to-measure risks of a financing crisis or the loss of its special status, the dollar faces really serious headwinds from boring old fundamentals.

The dollar has been weak for months and markets have been fretting over a host of big picture worries.

Perhaps the world’s oil exporters will stop using the dollar as the medium for petroleum trade. Or maybe the so-far patient and docile buyers of Treasuries will finally turn jittery. Either could be a disaster for the dollar, but you don’t need conspiracies or crises to be bearish on a currency from a country which on some measures has run the largest-ever deficit between what it imports and what it sells abroad.

One of the most interesting side effects of the first part of the financial crisis was that the dollar actually rose despite being the locus of the credit bubble and despite the U.S. consistently importing far more than it exports. That strength, which has now been reversed in part, was largely because the freezing up of markets set off a scramble for dollars.

The acute phase of the crisis is over and a return to something approaching normalcy is not treating the dollar kindly; from its peak this year the dollar has fallen more than 13 percent against a trade-weighted basket of currencies. The current account deficit — the balance of exports to imports — has also been reduced greatly, from a peak north of 6 percent of GDP to below 3 percent at the end of June, with further narrowing in the months since. That is because a weaker dollar makes U.S. products more competitive, but also because the price of oil, of which the U.S. is a net importer, has dropped, and consumption at home is flagging.

It is far too early, however, to say that the dollar adjustment has done its work and the deficit will now close.

“The U.S. current account shortfall was primarily driven by a consumption surge rather than an acceleration of investment on the back of productivity growth and high profitability,” Citigroup currency strategist Michael Hart wrote in a note to clients.
THINGS THAT CAN’T GO ON FOREVER DON’T

That is bad news for the dollar and bad news for the outlook for U.S. growth. A 2005 paper by Caroline Freund of the World Bank and Frank Warnock at the University of Virginia <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=875699> found worse outcomes for the countries that ran current account deficits to finance consumption as opposed to those which ran deficits in aid of investment.

Industrialized countries which, like the U.S., run current account deficits for consumption, find that the currency depreciation that follows tends to be deeper. What’s more, the adjustment in the deficit lasts longer and is often twinned with lower growth. It is not, I suppose, a big surprise that importing more than you export and then consuming it leads to depressed growth. The real wonder is the way in which the U.S.’s special status and the generous financing terms offered by its trade partners made this possible without more immediate damage to the dollar.

There is also the possibility that globalization has permanently raised the “natural” level of the U.S. current account deficit. Huge swaths of the U.S. manufacturing base and a growing wedge of the country’s service sector have been offshored or simply moved out of the U.S. Many of these goods and services are still consumed by the U.S., but now much of the money generated by those sales will be the result of dollars being sold to buy pesos, ringgits or yuan.

This may place more structural pressure on the dollar to fall over time.

Australia’s decision to raise interest rates last week hurt the dollar and for good reason. It demonstrated that as a recovery happens the action will not be in the U.S., but in resource-based economies and in places, mostly in Asia, where the best prospects for productive investment lie. The U.S., where the Federal Reserve will likely need to keep rates low for a very long time, will have a hard time capturing the imagination of investors.

For policymakers, and not just U.S. ones, the puzzle is how to allow the dollar to fall gently without precipitating trade friction or a disastrous loss of confidence. Because it’s more or less in everyone’s interest, it will probably more or less be avoided. A weaker dollar, though, is simply consistent with the outlook for the U.S.

A long shamble downwards rather than a fall off a cliff looks to be in the dollar’s future.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

– Neal Kimberley is an FX market analyst for Reuters. The opinions expressed are his own –

LONDON (Reuters) - An article in Britain’s Independent newspaper on Tuesday rightly attracted a lot of market attention with its provocative heading “The demise of the dollar.” While subsequent and almost co-ordinated denials from numerous capitals have taken the steam out of the story, the dollar’s role is again under scrutiny.

While the geopolitical realities of the Middle East would arguably rule out the re-pricing of oil in non-dollar currencies at this time, that may change in the future.

Alarmist conclusions that the dollar is on a swift road to ruin are wide of the mark. The road will be long and at its end the dollar will not be ruined, but it will be less important.

The dollar remains, however, on the back foot as the story resonated with a market that was already looking for an excuse to unload the greenback. Sovereign reserve managers, working for future generations, will have taken note. These stories add to the uncertainty of holding vast sums of dollars in trust.

It has long been the fate of reserve currencies to depreciate and be displaced. Global reserve currency status has always encouraged the beneficiary nation or empire to live beyond its means, safe in the knowledge that the rest of the world must hold its currency to pay for goods and commodities. The Roman dinar, the Spanish reale and most recently the British pound are all examples of currencies that have gradually lost their reserve status in this manner.

The key point is that the process is gradual. Displacement occurs in baby steps, small incremental developments which eventually create an unstoppable momentum. When the European Community first posited the idea of the single currency, the markets (particularly in London) sneered. Yet the euro was born and has prospered.

The dollar is entering a process of critical examination. This will take years, probably decades. Sterling retained significant world reserve status throughout the first half of the 20th century, despite clear signs economic primacy had shifted to the United States and despite the crushing financial weight of participation in two world wars.

One newspaper article is not a game-changer, but it is a reminder that the dollar’s position is under the microscope.

The market remembers only too well the suggestions of China’s Central Bank Governor Zhou Xiaochuan in March 2009. He said then that the world should consider adopting the Special Drawing Right, a basket of dollars, euros, sterling and yen, as a super-sovereign reserve currency.

The Chinese suggestion was a baby step toward change but the U.S. reaction was telling. Treasury Secretary Timothy Geithner said he had not read the proposal but added, “As I understand it, it’s a proposal designed to increase the use of the IMF’s Special Drawing Rights. I am actually quite open to that suggestion.” A masterful piece of political deflection but the market recognized the Chinese intent.

Even more recently, in September, the United Nations Conference on Trade and Development issued a report calling for a new global reserve currency.

It’s like the dripping of a tap. Across the world, institutions, governments and the media are wearing away at the dollar’s dominance. Central banks managing billions of dollars of reserves are not immune to these incremental developments.

In the past, Japanese officials characterized the best moment for intervention to be when they could “go with the wind.” In the current debate, reserve managers will consider that a light breeze is blowing against the dollar. They will make a measured and appropriate response. Marginal adjustments in reserves would increase the non-dollar component.

The Independent story may have been denied but it chimed with the market. It wasn’t the first such story and it won’t be the last. With the United States perceived to be living beyond its means and facing the challenges of rapidly rising economic and political rivals, the debate will continue. But it will be a long, long debate, and the effects on the value of the dollar will be incremental, not precipitate. To paraphrase Mark Twain, rumors of the dollar’s sudden death have been greatly exaggerated.

(Editing by Nigel Stephenson)

-- John Kemp is a Reuters columnist. The views expressed are his own --

Like Archbishop Thomas Cranmer before he was burned at the stake for heresy, the U.S. Commodity Futures Trading Commission (CFTC) seems about to make a dramatic recantation.

Later today, the Commission will hold the first of three public hearings to discuss whether to impose tougher position limits in energy markets and restrict the availability of hedging exemptions. But it is already preparing to release a report that will accuse speculators of playing a significant role in last year's oil price spike, according to a report in the Wall Street Journal.

While it might seem a minor shift in emphasis, it is a radical reversal of the Commission's previously stated view that there was "no evidence" that investment flows had a material impact on prices. Commission staff have doggedly maintained that physical supply and demand factors could explain all the observed volatility in oil and other commodity prices over the past two years.

The position was stated most forcefully by CFTC Chief Economist Jeffrey Harris in testimony to the House of Representatives' Agriculture Committee in May 2008 (http://www.cftc.gov/stellent/groups/public/@newsroom/documents/speechandtestimony/harris-fenton051508.pdf).

It was repeated in September 2008 in the CFTC's "Staff Report on Swap Dealers and Index Traders" and again this year in a joint report with the United Kingdom's Financial Services Authority (FSA) on commodity regulation for the International Organisation of Securities Organisations (IOSCO).

The Commission's view has come under pressure from sceptical legislators as the scale of speculative positions in commodity markets and the number of exemptions the Commission and exchanges have granted have been revealed. Congressional anger threatened to derail Gensler's confirmation. The price of allowing him to take office seems to have been a promise to take a tougher approach.

The CFTC's position had become politically unsustainable. The climbdown was foreshadowed earlier this year when incoming CFTC Chairman Gary Gensler admitted in a pre-confirmation letter that "rapid growth in commodity index funds was a contributing factor to a bubble in commodities prices that peaked in mid-2008" and "the expanding number of hedge funds and other investors who were increasing asset allocations to commodities ... also put upward pressure on prices".

But most observers expected it to announce a shift only after the three public hearings planned for July and August, giving the futures industry an opportunity to water-down the conclusions. The Commission's early move suggests it does not intend to be side-tracked from determined reform by vested interests.

The shift is significant because it changes the question from "whether" to limit the impact of investment money on commodity markets to one of "how". The Commission has issued a set of questions for the hearings that include a strong presumption the outcome will be some form of tougher and more comprehensive position limits (http://www.cftc.gov/newsroom/generalpressreleases/2009/pr5681-09.html).

The move leaves the FSA increasingly exposed. It has not accepted there is a problem in the commodity markets it regulates, let alone agreed that the solution is tougher limits and more stringent regulation. The FSA's line is still that there is "no evidence" speculation has influenced prices. If the CFTC abandons that position, however, the FSA's could become intellectually indefensible, and London's sleepy regulator may come under strong pressure to fall into line.

-Arvind Ganesan is the Director of the Business and Human Rights Program at Human Rights Watch. The opinions expressed are his own.-

Equatorial Guinea is a tiny country of about half a million people on the west coast of Africa, but is the fourth-largest oil producer in sub-Saharan Africa.

Most of the investment in the country’s multi-billion dollar oil industry comes from the United States. ExxonMobil, Hess and Marathon are all there. Right now, the U.S. imports up to 100,000 barrels of oil a day from Equatorial Guinea, or about a quarter of the country’s oil production.

Oil money gives the country the means to be a model for development and human rights. The economy is nearly 130 times as big as it was when oil was discovered in 1995. But as a report released by Human Rights Watch today details, the government has squandered or stolen much of the money at the expense of its people.

It is a sad contrast, since the country has a per capita income comparable to Spain’s or Italy’s and development indicators more like Afghanistan’s. For just one sad example, infant and child mortality actually has increased -- from an already-dismal 103 deaths per thousand in 1990 to 124 per thousand in 2007. Similarly, under-5 mortality rates increased from 170 per thousand in 1990 to 206 per thousand in 2007.

The president and his family are doing just fine, though. They lead lavish lifestyles while most people live in crushing poverty.

A series of corruption scandals involving government officials and their families will give you some idea of how bad it is.

In 2004, a U.S. Senate investigation into the country’s dealings with the now-defunct Riggs Bank detailed how President Teodoro Obiang Nguema Mbasogo used the country’s oil wealth to finance numerous personal transactions, including spending $3.8 million to buy two mansions in a suburb of Washington, D.C. That investigation led to one of the largest fines against a bank in U.S. history, and ultimately the bank’s takeover.

Obiang’s eldest son, Teodorin, bought a $35 million property in California in 2006. In 2004, he spent about $8.45 million for mansions and luxury cars in South Africa. His only known income was a $4,000 monthly salary as a government minister. His $43.45 million in spending on his lavish lifestyle from 2004 to 2006 was more than the $43 million the government spent on education in 2005.

The people of Equatorial Guinea have no way to hold their government accountable. Obiang has been in power since 1979, when he deposed his uncle in a coup. The government severely curtails press freedom and independent civil society, and the political opposition is weak and faces constant government harassment, intimidation, and arrests. In the most recent parliamentary elections in May 2008, Obiang and his allies won 99 out of 100 seats.

The government has joined the Extractive Industries Transparency Initiative (EITI), an effort to make natural resources benefit everyone by setting a global standard for openness in oil, gas, and mining. However, the government has been very slow to implement the initiative’s standards. The danger is that EITI may give the government a veneer of legitimacy even while it stifles its critics and opposes real scrutiny.

Perhaps the best prospect for reform lies with the Obama administration since most of the investment in Equatorial Guinea’s oil comes the US. There are in fact things the administration can do now to break the cycle of corruption in a place like Equatorial Guinea. It should hold the government accountable for human rights and insist that it rigorously enforce anti-corruption laws. Under the Bush administration, that did not happen.

The same month in 2006 that Obiang’s son bought a $35 million Malibu mansion, Secretary of State Condoleezza Rice met with Obiang in Washington and called him “a good friend” at a news conference.

Unless the Obama administration makes it clear to Equatorial Guinea’s leaders that they must share the oil wealth with the country’s people , the human cost of the oil that the US imports from that country will continue to be staggering.

-Ben Amunwa is a campaigner with oil industry watchdog Platform, where he runs Remember Saro-Wiwa, a project that uses art and activism to raise awareness about the impact of the oil in the Niger Delta. The opinions expressed are his own.-

When the news broke of a settlement in the Wiwa v Shell case, a cacophony of responses soon flooded my inbox. Hailed as a victory for human rights by some, others felt disappointed that Shell could throw money in the face of justice. In such a high profile and emotive legal battle, holding oil giant Shell responsible for human rights abuses in Nigeria, including the execution of charismatic activist Ken Saro-Wiwa, hopes were inevitably high.

A settlement was always going to stir some controversy. Activists wanted to see Shell on trial for aiding and abetting the Nigerian military in crackdowns on the Ogoni people in the 1990s. Myself and many others travelled to New York expecting a trial, but came home empty-handed. Yet none of us had spent hours locked in settlement negotiations, nor lived with the burden of a 12-year litigation, not to mention the personal trauma of losing our loved ones to brutal violence. There is a growing consensus that the settlement is a victory in favor of the plaintiffs, and a step forward on the long road to corporate accountability.

Eager to flex its public-relations muscles, Shell claimed they agreed to a settlement for "compassionate" reasons. A statement on Tuesday said:

“Shell today agreed to settle a court case in New York related to allegations in connection with the Nigerian military government's execution of Ken Saro-Wiwa and others in 1995, making a humanitarian gesture to set up a trust fund to benefit the Ogoni people…Shell has always maintained the allegations were false… we were prepared to go to court to clear our name.”

In spite of Shell’s official denials, all the signs point towards complicity. No multinational company settles out of court for $15.5 million due to "humanitarian" or "compassionate" impulses. According to attorneys, this payout is far higher than similar cases.

The real reason why Shell settled is because the evidence compiled by the plaintiffs, was damning enough to force an out of court settlement. Far from being willing to defend itself before a jury, Shell has spent the last 12 years fighting to stay out of the courtroom, and to keep the evidence out of the public eye. If Shell was innocent of any wrongdoing, why didn’t they tough it out in court?

For the plaintiffs, the prospect of an appeals process adding another 4 years to the litigation, and the fact that they could only expect monetary damages anyway made a settlement worthwhile.

The grievances of local people in the Niger Delta, and the injustices that Ken Saro-Wiwa fought against are far from settled with this case. Campaigners will now be publicising the evidence gathered by lawyers about Shell’s partnership with Nigerian military, until the company comes clean about its role in the violence.

If Shell has any genuine concern for the dignity of the Ogoni people, or other communities in the Niger Delta, it would put an end to the daily environmental devastation caused by gas flares and oil spills. These practices have poisoned communities and choked livelihoods for as long as Shell has been producing oil. This daily abuse of human dignity and rights shows just how much more needs to be done before justice is served in the Niger Delta.

The Wiwa case was always about the claims of 10 individuals, and it is the first victory in what we hope will be a long line of cases that hold corporations to account for violations of international law.

— Neil Collins is a Reuters columnist. The views expressed are his own –

So you’d like to work for BP? A fine company, recognisably the same business as half a century ago, and likely to be around in half a century’s time — yup, it’s a fine choice for a career.

It’s going to be an even better one for the ambitious twenty-something, because no-one joining after next March will be able to join its final salary scheme.

These schemes are comfort blankets for pen-pushing civil servants (and, of course, snouts-in-trough British MPs) so if getting into one is the height of your ambition, then perhaps BP can manage better without you.

Schemes where the employer undertakes to pay a pension linked to your salary when you retire, whatever that is, are dying, and quite right too.

Imagine you had joined BP at 25, and at 45, stuck in a cul-de-sac inside this vast company, you got an attractive offer from a small competitor.

You’d love to do it, but matching the current value of your accrued pension rights would ruin the prospective employer. You must either walk away from your biggest asset outside your house, or resign yourself to 20 more years buried inside The Organisation.

These schemes damage the employer too. The cost of shedding our 45-year-old against his will is high, because he remains a deferred member of the scheme.

From next year, BP’s recruits will be invited into a defined contribution scheme, where employer’s and employee’s contributions are used to buy a growing pool of assets which belong to the employee. The employer has no future liability to fund, and the employee can consider a mid-life career change without penalty.

Of course, ensuring a comfortable old age is expensive, which is why BP expects to contribute 15 percent of salary into the scheme for new employees. Even that might not be enough, but it will put the individual, rather than the employer, in charge of his own financial future, and nobody ever claimed that freedom was cheap.

– Diana Furchtgott-Roth, former chief economist at the U.S. Department of Labor, is a senior fellow at the Hudson Institute. The views expressed are her own. —

President Obama is in favor of moving towards “energy independence,” but his new 2010 Budget specifically seeks to raise taxes on domestic oil exploration by $31 billion over 10 years, a larger tax increase than on any other industry. In addition, oil and gas producers would bear a disproportionately heavy share of other tax increases on business, more than $320 billion.

Surely a president who desires energy independence would leave oil companies alone so that America could develop greater domestic reserves.  But this is not the case.

The ostensible rationale for the tax increases is that the current tax system “distorts markets by encouraging more investment in the oil and gas industry than would occur under a neutral system. To the extent expensing encourages overproduction of oil and gas, it is detrimental to long-term energy security…” This wording, with reference to credits, lower tax rates, special treatment, and accelerated depreciation, is repeated eight times in the Treasury Department’s Green Book, a description of proposed spending and revenue changes in the budget.

President Obama believes that subsidies for renewable energy are acceptable, even though renewable energy is only responsible for 4 percent of America’s supply.  He does not consider expenditures of $60 billion on “clean energy investments” to be distortions.  But oil, which accounts for almost 40 percent of America’s energy usage, is a different matter, apparently deserving of higher taxes to limit overproduction. With fuel prices close to $5 a gallon last summer, we could have used a little overproduction.

If America is to reduce use of imported fuels, it needs to raise domestic production to increase long-term energy security. Every additional barrel of oil produced in America is one barrel fewer that needs to be imported.  The oil and gas industry already employs more than 1.5 million workers, and has the potential to employ many more.

Estimates of American oil and natural gas reserves keep growing, potentially generating more job opportunities.  In 2007, 200 trillion cubic feet of natural gas, equivalent to 33 billion barrels of oil, or about 18 years of U.S. oil production, were found in the Haynesville Shale, a rock formation in northern Louisiana. Discoveries have also been made in Texas, Arkansas, and Pennsylvania. New optimism about U.S. gas reserves and production capacity has been pushing natural gas prices down.  Since the fuel is there, why propose new taxes to discourage production?

President Obama’s new tax proposals, rather than leading towards energy independence, would drive oil and gas production abroad.  New taxes would place American producers at a disadvantage in the global market, punishing domestic American oil and gas companies and benefiting countries with large reserves such as Venezuela, Saudi Arabia, Iran and Russia.  Does President Obama really want these countries, all under fire for their neglect of basic human rights, to get richer at our expense?

Moving towards energy independence is under attack from another quarter—extreme environmentalists. After Tuesday’s failure of California ballot initiatives to cut spending, Californians might take seriously Governor Arnold Schwarzenegger proposal to allow additional offshore drilling from Platform Irene, off the coast of Santa Barbara, which would raise $1.8 billion. But drilling on the Outer Continental Shelf remains unpopular. It’s telling that residents find it preferable to release 40,000 prisoners from jail or fire thousands of teachers—rather than drill offshore, which could bring in a steady stream of revenue to the state capital of Sacramento.

Until the United States has the technology to operate its 250 million motor vehicles without gasoline and natural gas, we need more domestic exploration, not less.  At some point, maybe later this year, maybe in 2010, our economy is going to shift to post-recession recovery, and oil and gas consumption are going to rise.  We don’t want a repeat of $5 gasoline and sky-high home heating bills.

– John Kemp is a Reuters columnist.  The views expressed are his own –

The record differential between the front-month and more liquid second-month contracts at expiry last week once again raised pointed questions about whether the NYMEX light sweet contract is serving as a good benchmark for the global oil market, or sending misleading signals about the state of supply and demand.

The expiring January 2009 contract ended down $2.35 on Friday at $33.87, while the more liquid February contract actually rose 69 cents to settle at $42.36 - an unprecedented contango from one month to the next of $8.49.

Criticism of the contract is not new, and past calls for reform have been successfully sidelined. But with policymakers taking a keener interest as a result of wild gyrations in oil prices this year, and a continued focus on regulatory changes to improve market functioning in future, there is at least a chance changes will be adopted as part of a wider package of futures market adjustments.

AN UNREPRESENTATIVE PRICE

During the surge to $147 per barrel earlier this year, OPEC repeatedly criticized the NYMEX reference price for overstating the real degree of tightness in the physical market and causing prices to overshoot on the upside.

While rallying NYMEX prices seemed to point to an acute physical shortage and need for more oil, Saudi Arabia could not find buyers for the 200,000 barrels per day (bpd) of extra oil promised to U.N. Secretary-General Ban Ki-moon or the 300,000 bpd promised to U.S. President George Bush in June.

Bizarrely, rather than acknowledge there was something wrong with the reference price, some market participants suggested Saudi Arabia should increase the already large discounts for its physical crude to achieve sales in a market that clearly did not need the oil, and was not paying enough contango to make storing it economic (contango is where the futures price is above the spot market).

The NYMEX WTI price may have achieved unprecedented media fame as a result of the “super-spike”, but a futures price to which producers and consumers were paying ever larger discounts for actual barrels was clearly not a good indication of where the market as a whole was trading.

Now the market risks overshooting in the other direction. Intense pressure on the front month in recent weeks has more to do with the contract’s peculiarities (in particular storage restrictions at the delivery point) than a further deterioration in oil demand or a market vote of no-confidence in the 2.2 million barrels per day further cut in oil production announced by OPEC at the end of last week.

The collapse in NYMEX prices nearby risks exaggerating the real degree of oversupply  and demand destruction, sending the wrong signal to producers and consumers about the wider availability of crude in the petroleum economy.

DOMESTIC PRICE, GLOBAL BENCHMARK

The NYMEX contract is for a very special type of crude oil (light sweet) delivered at a very special location (Cushing, Oklahoma) in the interior of the United States. It is not representative of the majority of crude oil traded internationally (most of which is heavier and sourer) and delivered by ocean-going tankers.

These specifications made sense when the contract was introduced as a benchmark for the U.S. domestic market.

U.S. refiners have a strong preference for light oils, for which they were prepared to pay a premium, because of their much higher yield to gasoline. The inland delivery location, centrally located and near the main Texas oilfields, rather than one on the coast, made sense for a contract that tried to capture the “typical” base price for crude oil paid by refiners across the continental United States.

But these specifications make much less sense now the NYMEX price is increasingly used a benchmark for the global petroleum economy, in which light sweet crudes are only a small fraction of total output. Just as NYMEX prices sent the wrong signals about physical oil availability on the way up, distorting the market and triggering more demand destruction than was really necessary, they now risk sending the wrong ones on the way down.

Earlier this year, the problem was a relative shortage of light sweet crude oils at Cushing, while all the extra barrels being offered to the market by Saudi Arabia were heavier, sourer crudes that could not be delivered against the contract. Moreover, extra Saudi crudes would have arrived by ship, and the pipeline and storage configurations around Cushing would have made it difficult to deliver them quickly against the contract.

Financial speculators were able to push NYMEX higher safe in the knowledge Saudi Arabia could not take the other side and overwhelm them by delivering physical barrels to bring prices down. The resulting spike exhibited all the characteristics of a technical squeeze:  tight contract specifications ensured there could be shortage of NYMEX light sweet inland oils even while the global market was oversupplied by heavier, sourer seaborne ones.

Now the opposite problem is occurring. Crude stocks at Cushing have doubled from 14.3 million barrels to 27.5 million since mid-October. Stocks around the delivery point are at a near-record levels and approaching the maximum capacity of local tank and pipeline facilities (https://customers.reuters.com/d/graphics/CUSHING.pdf).

As a result, the market has been forced into a huge contango as storage becomes increasingly expensive and difficult to obtain, ensuring the expiring futures trade at a substantial discount.

But Cushing inventories are not typical of the rest of the U.S. Midwest (https://customers.reuters.com/d/graphics/PADD2_EX_CUSHING.pdf) or along the U.S. Gulf Coast (https://customers.reuters.com/d/graphics/PADD3.pdf), where stock levels are high relative to demand but nowhere near as overfull as in Oklahoma.

Once again the problem is geography. Coastal refiners have responded to the downturn by cutting imports of seaborne crude, limiting the stock build. But the inland market is the destination for some Canadian crudes that have nowhere else to go, and the pipeline configuration means they cannot be trans-shipped to other locations readily.

Light sweet crude has been piling up in the region, with refiners choosing to deliver the unwanted excess to the market by delivering it into Cushing.

NEW GRADES, NEW DELIVERY POINTS

The easiest way to make NYMEX more representative would be to widen the number of crude grades that can be delivered, and open a new delivery point along the U.S. Gulf Coast. Both reforms would link the contract more tightly into the global petroleum economy.

NYMEX already permits some flexibility in delivery grades. Sellers can deliver UK Brent and Norwegian Oseberg at small fixed discounts to the settlement price, and Nigerian Bonny Light and Qua Iboe, as well as Colombia’s Cusiana at small premiums.

In principle, there is no reason the contract cannot be modified further to allow a wider range of foreign oils to be delivered at larger discounts to the settlement price.

More importantly, NYMEX could open a second delivery location along the Gulf Coast, increasing the amount of storage capacity available, and linking it more closely into the tanker market.

If prices spiked again, a coastal delivery location would make it much easier for Saudi Arabia to short the market and deliver its own barrels into the rally. By widening the physical basis, it would also make it easier to support the market by cutting international production and avert a glut trapped around the delivery location.

So far, the market has continued to resist change. But there are signs policymakers might enforce one.

Earlier in the year, Saudi Arabia strongly hinted western governments should look at reforming their own futures markets rather than call for production of even more barrels of oil that could not be sold at the prevailing (unrealistic) price.

Naturally, some of the reform impetus has ebbed along with prices and demand. But policymakers continue to show interest in structural reforms, as was evident at last week’s London Energy Meeting, and there is an increased willingness to challenge unfettered market dynamics.

It is still possible the incoming Obama administration might force contract changes as part of a wider package of reforms designed to improve the functioning of commodity markets, reduce volatility and send clearer, more consistent price signals to the industry and consumers.

For previous columns by John Kemp, click here.

John Kemp is a Reuters columnist. The views expressed are his own.

LONDON, Dec 8 (Reuters) - China’s decision on Friday to link domestic fuel prices to the international price of crude oil, but increase consumption taxes on gasoline and diesel sharply to spur more efficient use of energy in the medium term, raises the question whether the incoming Obama administration might be tempted to do the same.

China is taking advantage of a cyclical pull back in energy to push through a permanent structural increase in taxes and prices. The aim is to combine a short-term boost to the economy with longer-term and more consistent incentives for improving energy efficiency.

By consolidating a series of tolls and administrative charges into a single, easy to collect consumption tax, the government is simplifying the tax system, creating a new source of revenue, and ensuring the change will have no impact on the politically sensitive inflation rate.

More importantly, it creates a fairly simple mechanism for raising energy costs further in future to spur additional efficiency gains, irrespective of cyclical changes in the crude oil price.

Once short-term economic weakness is past, the government can easily raise the consumption tax progressively over the next few years.

In effect, the tax breaks the link between the government’s energy efficiency programme and short-term oil-market movements.

NEW ADMINISTRATION PRIORITIES

Across the Pacific, the incoming Obama administration has made clear improving energy efficiency is also one of its highest priorities.

The president-elect’s future national security adviser, General James L. Jones, has been working on energy issues for an affiliate of the U.S. Chamber of Commerce since retiring as NATO’s supreme allied commander in Europe. He made clear in a recent interview improving energy security would be one of his central objectives, marking an unusual extension of the adviser’s traditional role.

The incoming administration faces several related challenges, however:

• It needs to maintain the recent trend towards smaller and more fuel efficient motor vehicles, even though retail gasoline prices have halved in less than six months.
• It needs to find a way to increase the volume of ethanol blended in the gasoline supply, even though ethanol is now more expensive than fossil-fuel gasoline, and mandated volumes are running up against the technical limits of the U.S. car fleet (the “blending wall”).
• And it needs to find a way to continue providing incentives for developing alternative energies (such as advanced biofuels and oilsands) as well as alternative power sources (fuel cells, electric vehicles).

VOLATILITY DEGRADES PRICE SIGNAL

The common problem is that short-term price volatility threatens long-term strategic planning by both energy producers and consumers.

Adam Smith’s theory of the “invisible hand” has price changes acting as a signal to ration demand and encourage supply.

Policymakers have long accepted that inflation can interfere with these signals by making it hard for consumers and producers to distinguish between a relative change in prices and incomes (to which they should respond) and a general rise in the price and income level (to which they should not).
Inflation introduces “noise” into the price mechanism, making it hard to extract signals correctly.

Extreme price volatility can have the same impact. Large price movements and repeated price reversals leave producers and consumers uncertain about the correct response.

The problem is worse in sectors such as energy where changes in consumption and production involve long-time lags and costly investment.

The oil price surge in 2006-2008 was widely interpreted as a response to the threat of a long-term shortfall in supply (since there was no actual shortage of physical crude oil in the near term). It appeared to send a strong signal about the need to develop substantial new oil reserves, invest heavily in alternative fuels, and achieve massive increases in energy efficiency.

The subsequent collapse, including long-dated prices, seems to be signalling that these long-term high-cost investments will not be needed.

Producers and consumers are struggling to work out whether the market was right in JulY 2008; whether it is right now; or whether the world really has changed that much in less than six months.

A HELPING HAND FOR ADAM SMITH?

The incoming administration’s public announcements indicate senior policymakers believe all these new and alternative fuel supplies will be needed. The question is how to maintain the efficiency drive and incentives for long-term investment during a period of price weakness.

Following China’s example and raising fuel taxes is probably the most attractive mechanism.

By raising the long-term floor for domestic gasoline and diesel for any given level of international crude prices, it sharpens efficiency incentives and would maintain the pressure towards smaller and more fuel efficient vehicles.

Crucially, it could solve the problem of the blending wall. Most U.S. vehicles are able to run on a maximum 90-10 gasoline-ethanol blend (E10) that will limit the overall amount of ethanol blended into the fuel supply to around 12-13 billion gallons per year, and is likely to become binding in the next 18 months.

To meet the longer-term objective of blending as much as 36 billion gallons into the fuel supply by 2022, the administration will need to increase the number of vehicles taking higher 15-25 percent blends, or shift an increasing proportion of the car fleet to flexible-fuel vehicles running on a 15-85 gasoline-ethanol blend (E85).

The problem for policymakers is whether to go for a big-bang approach (pushing for widespread adoption of E85-adapted vehicles) or a gradualist one (increasing the standard blend to 15 percent, then 20 percent, etc).
Widespread adoption of E85 requires investments in an expensive pipeline infrastructure and new cars.

Neither is likely unless distributors, pipeline companies and motor manufacturers can be guaranteed sufficient minimum demand for the fuel and associated cars.

The question is how to promote widespread adoption of higher 15-20 percent fuel blends and E85. One possibility is to make production of E85 vehicles a condition of any government rescue package for the major auto makers.

But rolling out E85 vehicles does not guarantee they will actually be filled up using E85 fuel. Federal agencies have been obliged to buy E85-capable vehicles since the early 1990s. Most are filled up with regular gasoline, owing to the lack of filling stations carrying E85 in most areas outside the Midwest. And at low gasoline prices, there is no guarantee ethanol will be competitive.

There must be a temptation to impose a sharply differential tax rate on the fossil fuel and ethanol components of gasoline to encourage higher blend rates or E85 vehicles, creating clear long-term incentives for switching to more ethanol use.

The main factor restraining policymakers is fear of advocating any tax increases at a time when households are struggling with mortgage payments and falling employment.

But the big pull back has created some headroom to raise tax rates and long-term energy costs while still allowing pump prices to fall in the short term.

Raising fuel taxes will therefore be a very tempting option for the new administration. It could be presented as part of an integrated energy efficiency, climate change and national security strategy, raising useful revenues to pay for some of the massive stimulus and speed the return to fiscal discipline in the medium term.

The question is less whether fuel taxes will rise substantially, but when.

– John Kemp is a Reuters columnist. The opinions expressed are his own –

U.S. oil refiners have relied heavily on exporting surplus gasoline and especially distillates to help offset plunging domestic demand over the last eighteen months.

Record product exports have averted a much deeper crisis within the industry, an even bigger collapse in gross margins and a huge inventory build.

But as the spreading slowdown cuts demand in key export markets across Europe, Asia and Latin America, the export window is set to close. Refiners look set to respond with unseasonal run cuts over the next two months to prevent a massive stock build before spring.

The total volume of gasoline supplied to the U.S. domestic market has fallen 80 million barrels (3.1 percent) from 2.539 billion barrels in January-September 2007 to 2.459 billion barrels in January-September 2008.

Distillate supplied has fallen 70 million barrels (6.1 percent) from 1.148 billion barrels in 2007 to 1.079 billion in 2008.

Refiners have responded with deep run cuts, supplemented with process adjustments to increase the yield to distillates, and heavy exporting to try to limit the build up of unwanted stocks and provide support for pressured margins.

Distillate exports have risen by 94 million barrels in the first nine months of the year to a record 146 million barrels (+181 percent). Gasoline exports are up by a more modest 12 million barrels to 50 million barrels (+32 percent) (see https://customers.reuters.com/d/graphics/US_GSDSEX1208.gif).

Strong overseas demand for motor diesel as well as heating oils for on-grid generation and back-up power generators during H1 2008 provided a useful and generally profitable way of disposing of excess diesel production. Diesel exports have offset all the decline in domestic demand and even provided a useful fillip to total marketable output.

Overseas demand for gasoline has been weaker, limiting product placement.

Contrasting international demand explains why U.S. gasoline margins have collapsed this year while diesel margins, though under pressure, have stayed positive.

Without profitable diesel exports, U.S. refiners would have had to cut throughput much more severely during the summer months.

Overseas diesel markets have provided a crucial source of support for the U.S. refining industry this year. Diesel sales (including record exports) have cross-subsidized loss-making gasoline production.
But as overseas diesel demand falls, that prop is being taken away.

Gasoline inventories have already begun their normal year-end build (refiners produce excess gasoline as a by-product of winter heating-oil runs). Gasoline stocks normally draw down during the February-April maintenance season. But this year the gasoline build has started earlier and is occurring more aggressively than normal.

Refiners are under pressure to react with early run cuts, or start the maintenance season earlier and take more capacity offline for longer after the turn of the year.

In either event, refinery demand for crude oil looks to soften even more than usual as the northern heating season ends. Prospective run cuts heighten the risk of a very large build up in crude oil inventories in Q2 2009, adding to the downside price risks in the near term.