May 17, 2008
How speculation may be contributing to the most recent moves in oil prices.
An important recent trend in management of pension and hedge funds is the increasing allocation of investment dollars to commodity speculation. There are lots of ways you can do this. Perhaps the simplest is to purchase, say, the July NYMEX oil futures contract. If you'd bought that contract Friday, it would enable you to take delivery of oil in Cushing, Oklahoma some time in July for $126/barrel. As a pension fund, you don't actually want to receive that oil, so in early June you'd plan on selling that contract to someone else and using the proceeds to buy the August contract. If oil prices go up and you can sell the contract for more than $126/barrel next month, you will have made a profit. By rolling over near-term futures contracts in this way, your "investment" will earn a return that follows the path of oil prices.
The Goldman Sachs Commodity Index is essentially a mechanical calculation of how much money you'd have each day if you followed a strategy like this for each of the major commodity contracts, with energy prices comprising about 70% of that index. There are a number of firms that offer products that could implement such strategies on your behalf, such that the dollar value of your investment will essentially follow the GSCI (or similar index) less trading costs and management fees.
In April Bloomberg reported:
Investments in commodity indexes rose $40 billion in the first three months of the year to $185 billion, a larger gain than the whole of 2007, Citigroup analysts Alan Heap and Alex Tonks said today in a note to clients....
After investments in indexes, commodity trading advisers account for the biggest portion of the total amount invested, the Citigroup analysts said. At the end of the first quarter, advisers accounted for $94 billion, 18 percent more than at the end of last year, the analysts said.
Hedge funds ranked third, with $75 billion in commodity holdings, an increase of 25 percent over the end of 2007, Heap and Tonks said. In all, they estimate $70 billion in additional investment funds flowed into commodities markets in the first quarter.
What would be the effect of a big increase in the volume of purchases of near-term futures contracts? If investors were all equally informed and risk neutral, an increased volume of purchases would have no effect on the price. In such a world, there would be an unlimited potential volume of investors out there willing to take the other side of any bets if the purchases were to result in a price that was anything other than the market fundamentals value. But with risk-averse investors or with differing information, the answer is a little different. For example, I might read your willingness to buy a large volume of these contracts as a possible signal that you know something I don't. For this reason, standard financial "market micro-structure" theory predicts that a large volume of purchases may well cause the price to increase, at least temporarily, until I have a chance to verify what the true fundamentals value would be.
But verifying that true fundamentals value in the case of current oil markets is not an easy thing to do. If you believe, as I do, that the Hotelling principle has now become a factor contributing to oil prices, the market fundamentals value depends on how much oil the world is going to be able to produce over the next half century and what alternatives we're going to develop. If you have a different answer to that than I do, it's a very difficult task for me to figure out which one of us is right.
Let us for the moment accept the possibility that a sufficiently large volume of speculative commodity investment could succeed in driving the price of those futures contracts above what they would have been in the absence of these purchases, at least for a while if the volume of such purchases continues to increase. That still leaves a key question: If speculation is driving the futures price up, what force is bringing the spot price up with it? Wouldn't the large volume of speculators selling the July contract next month drive the July price down at that time, so they make a loss, not a gain?
The enterprise at the end of the chain in July, the ultimate final buyer of the July contract, is someone who actually wants to take physical delivery of oil in Cushing, Oklahoma some time in July. That would be a refiner who wants to turn it into gasoline. The demand for oil from a refiner in Cushing is responsive to the spot price through two mechanisms. The first is the demand elasticity that's ultimately inherited from the motorists who use the gasoline. If consumers face a higher price for gasoline, they will reduce their purchases, by which mechanism ultimately the refiner would want to buy less crude when the spot price goes up. But, particularly in recent years, that consumer demand response is very small.
A much more important way in which the spot price of crude would affect the refiner's demand for the product is through an intertemporal calculation. Given my customers' demand, I'm going to need to buy the product sooner or later. If you charge me a lower price today than you're going to charge me next month, I'd choose to buy more today to put it into inventory. If you charge me a higher price today, I'd rather run down my inventory and buy the oil next month, and of course the futures market allows me an opportunity to lock in a price for doing just that. Thus by far the most important factor in refiner's demand for July oil will be the August futures price. If my production plans left me willing to buy July oil for $124.25/barrel when August oil was selling for $124/barrel, I'll probably want to buy July oil for $126.25/barrel now that I'm forced to pay $126/barrel for August oil. Thus to a first approximation, the spot price would move by exactly the same amount as the near-term futures price. A $1 increase in the August futures price would shift the demand curve for July spot oil up by $1. In this fashion, an ever-increasing volume of speculative purchases of the near-term futures contracts would drive the spot price up with them.
Now, the above argument abstracted from the effects of the price on final gasoline demand, and we know that the demand elasticity for the final product is not literally zero. Thus the bubble described here could not literally be self-fulfilling. Something else has to give-- this is the point emphasized by Paul Krugman. If it all transpired just as I said, with international producers all adjusting their price to move in step with the West Texas Intermediate delivered in Cushing, they would ultimately find they're selling less than they otherwise would have. And so you might expect to see stories like this one from Bloomberg:
Iran, OPEC's second-largest oil producer, more than doubled the amount stored in tankers idling in the Persian Gulf, sending ship prices higher as demand for some of its crude fell, people familiar with the situation said. The 10 tankers hold at least 20 million barrels of oil....
Iran has a glut of its sulfur-rich crude as refineries that can process the fuel shut down for maintenance. The discount on Iranian Heavy crude compared with Oman and Dubai petroleum has more than doubled since the start of the year, according to data compiled by Bloomberg.
"There's not much demand for heavier crudes such as those from Iran," said Anthony Nunan, assistant general manager for risk management at Mitsubishi Corp. in Tokyo.
And eventually the bubble could only be ratified if we saw decreased production from oil producers, or at least stagnating production in the face of growing demand. But of course it is a fact that global production has failed to increase the last two years.
The biggest single factor in the stagnating global production is the fact that Saudi Arabia in January and February produced 350,000 b/d less than its average level in 2005. The increase in production to 9,450,000 b/d announced yesterday in conjunction with President Bush's visit to the Kingdom would still leave Saudi production 100,000 b/d below the 2005 levels.
Arab News quoted Saudi Oil Minister Ali Al-Naimi as declaring on Thursday:
Financial markets have a logic and mechanism of their own. Such markets are influenced by ever-changing factors and parameters that transcend markets and boundaries and are often unregulated. Therefore, the short-term oil prices are more closely tied to the internal logic of the financial markets than to underlying supply and demand fundamentals.
Reuters reported this from a follow-up news conference the next day:
Saudi Oil Minister Ali al-Naimi said on Friday that the world's top oil exporter would meet any demand from its customers for oil. "Any demand for extra production capacity from consumers will be immediately met," Naimi told a news conference.
If we take these statements at face value, they seem to be declaring that Saudi policy is to allow their prices to follow the futures markets. If you offer to sell all that anybody wants to buy at that price, you'll discover that demand for your product has gradually slipped as a result. But of course, saying this is all caused by the futures speculation is quite inaccurate. If this is what has been going on, declining Saudi production played an absolutely critical role in the price bubble.
Let me repeat here that I do not believe that speculation is the reason oil went from $60 to $120 a barrel. The biggest part of that longer term trend is due to fundamentals, not speculation. Notwithstanding, it does appear that speculation has gotten ahead of those fundamentals in the most recent developments.
For the bubble to continue, we would need to see ever-increasing volumes of investment money pouring into the futures markets, and continuing stagnation in global production to ratify them. Even if the former occurs, my best guess is that the latter will not.
Posted by James Hamilton at May 17, 2008 12:00 PMdigg this | reddit
In the transition from glut to scarcity it seems only natural that investors would test the market to see how high they can push the price to maximise profit.
BTW, according to the latest EIA report, "This Week in Petroleum", crude oil stocks are exactly where they have been historically. I don't any evidence of a bubble there. This is very good data that is updated weekly and has been around for many years.
Frankly, all this talk of speculators seems more about deflecting blame to a nebulous group that can't be identified or held acccountable, more than trying to gain insight into what is happening in the market.
Posted by: vorpal at May 17, 2008 01:08 PM
Do you have any knowledge of or data about how storing oil in ships is impacting shipping rates?
the DryShips index plunged at the end of the year and generated hopes that oil prices were peaking. but since the start of the year this index has rebounded to new all time highs.
This index has a good record as a leading-concurrent indicator of oil and other commodity prices.
The fundamental rule of intelligence analysis is to seek independent sources of information.
What is your source on Iran storing oil and do you have a second source of info that confirms the first source?
Vorpal, US demand for oil imports has been flat over the last few years so US oil inventories would have little or no impact on world supply-demand balance. I would look for info on what is happening to inventories in the rest of the world.
Posted by: spencer at May 17, 2008 02:31 PM
Ok, I just read the Bloomburg article.
So there may be 10 ships storing oil off of Iran.
Out of a total fleet of over 5,000 oil tankers this does not seem to be a large enough impact on demand to explain the big increase in shipping rates since early this year.
Posted by: spencer at May 17, 2008 02:49 PM
I agree with Professor Hamilton on this one. I concede that if speculators could tie up ships by storing oil, this could raise the price at delivery points. But I haven’t seen sufficient evidence of this.
What we’re seeing is rising demand in emerging markets and a plateauing of oil production. One vast untapped resource here in the US is carpooling. Our leaders should be promoting this.
Posted by: touche at May 17, 2008 03:54 PM
Re: Dryships -The dry ship carriers, with charge rates measured by the Baltic freight index, are different beasts from oil tankers and other vessels designed to carry fluids. Dry ships carry steel, ore, grains, etc. It's expensive to convert one type of ship to the other so the rates don't correlate well at all. This site seems to list recent historical data for tanker rates.
Posted by: Josh Stern at May 17, 2008 11:48 PM
"Perhaps the simplest is to purchase, say, the June NYMEX oil futures contract. [...] so in early June you'd plan on selling that contract to someone else and using the proceeds to buy the July contract."
just a technical detail: the expiry for the June contract is May, 20th.
I am very happy to read blogs like yours
Posted by: technical detail at May 18, 2008 01:51 AM
"If you charge me a lower price today than you're going to charge me next month, I'd choose to buy more today to put it into inventory."
Okay, so if speculation is to blame for the price rise, it should show up as an increase in inventory with the refiners even if they're not the ones driving the speculative buying. EIA reports that total US crude oil stocks are well below last year's level, and are about normal for this time of year. The amount in storage at Cushing has been rising more rapidly, although it is even further below its level of a year ago.
OECD crude oil stocks from the IEA were also not showing any sign of a big build-up as of February, the most recent month showing up on their public website data. That's the month the latest big price rise started, so perhaps more recent data is required there. But last fall during the previous big run-up in oil prices, OECD stocks were falling according to IEA.
"hoping to find confirmation or refutation of that theory on the basis of the quantity data may be asking too much."
Quite. So where *is* the evidence that "speculation has gotten ahead of those fundamentals"? Slower world economic growth does not necessarily do it I think, after all it is still growth. The demand curve for oil is not going to be a straight line. If oil production growth really is failing to keep up with demand growth, an increase in the rate of increase of oil prices would be expected as it takes a higher price to get the more wealthy and/or less discretionary users of oil products to cut back on consumption. Much like the increase in production begins to depend on rapidly increasing expenses as they begin to drill extreme deep water, etc.
Of course it is entirely possible that speculation has temporarily gone too far once again, but so far I don't see any easy way to decide just how likely that is.
Posted by: shan at May 18, 2008 04:54 AM
The increase in the price of oil from $20 to $100 is better explained by looking at the declining value of the dollar rather than looking at supply/demand for oil or speculation. In terms of Euros, the price of oil increased only half as much. Priced in gold, oil didn’t increase at all. The move from $100 to $126 may be due to speculation however as the dollar has held steady and gold has fallen during the time of this move.
Posted by: Jeffrey Knoll at May 18, 2008 06:09 AM
Shan and Vorpal, I realize that many people have claimed that speculation must show up in inventories, but please focus on the specific details of what I'm describing here rather than general things you have heard from others. There is no incentive at all in the process I described for refiners to increase inventories. You want the same inventories when July is $124.25 and August is $124 as you'd want when July is $126.25 and August is $126. My claim is that this process would result not in an increase in refiners' inventories but instead as a decline in the demand facing producers. To the extent that some producers behave in the manner that the Saudis tell us they have been, it would show up in the data in the graph I provided, not in inventories.
Posted by: JDH at May 18, 2008 06:51 AM
Ttechnical detail, thanks much for noting that. I've fixed it now, I think.
Posted by: JDH at May 18, 2008 07:00 AM
Josh -- thanks for the link.
It led here
Better info of weekly rates since 2002
Posted by: spencer at May 18, 2008 07:21 AM
I think that the speculation if fundamentally rational, but not for peak oil reasons. I have $10,000 to invest long term, where should I put it?
- Stocks? P/E ratios are at 23, way above the historical norm. The dividend yield is also below 2%, also a historically low.
- Housing? The average home price is still more than 3X median income, very high by historical standards.
- Bonds? The ten year t-bill has an interest rate of around 3.5% Nominal GDP growth ( ie money supply growth) is usually around 5%. If I hold on to an asset with a fixed supply, and the money supply increases by 5%, that asset will become worth 5% more. Thus an interest this low is actually negative.
So I don't want to invest in bonds, because the growth rates are negative relative to the ROI on a fixed asset. Housing and stocks were good investments for a while, but have now been overproduced, and their prices will be held down because there is too much supply.
That leaves commodities. Since there is largely a fixed supply of commodities, we don't have to worry about high prices inducing a supply glut. We should thus expect people to invest more and more into commodities. The only solution is that interest rates must be higher than money supply growth. That's the only thing that will get people to invest in dollars rather than commodities. That's what Volcker had to do in the 1980's to curtail inflation, and that's what Ben will have to do today.
Posted by: Patrick Fitzsimmons at May 18, 2008 08:38 AM
Commodity price increases (after a century of flat prices) suggest that the Hotelling model is working. That means that prices will continue to increase. That means that producers will hold back production, waiting for higher prices. That will cause supply shortages which justify and support the seemingly speculation driven price increases. The whole thing holds together, and there is no reason to assume that a price collapse is in the works.
Note though that despite the superficial similarities to Peak Oil predictions (higher prices and lower production) the real reasons are economic, profit maximization on the part of producers. It's also worth noting that Hotelling's model happens to maximize the net value of the scarce commodity to the world. It is wasteful to pump all the oil and consume it today. We need to husband it, to spread it out so it will be available in the future as well. Hotelling's production schedule does this in an optimal way, in terms of the total value it adds to the world economy. So our high prices, to the extent they can be blamed on this kind of effect, should actually be welcomed. Painful as they are today, they insulate us from even greater pain down the road.
Posted by: Hal at May 18, 2008 10:21 AM
If you'd bought that contract Friday, it would enable you to take delivery of oil in Cushing, Oklahoma some time in July for $126/barrel...If oil prices go up and you can sell the contract for more than $126/barrel next month, you will have made a profit.
I'm an economist, not a trader, so you might want to get a second opinion, but I think this is a little off. What you've described above is how a forward contract works. E.g. you agree to buy 1000 barrels of oil from me at $125 / bl in August, and then by August if the spot price is actually $135, then that forward contract is worth (at the time of exercise) $10,000.
But with a futures contract, the embedded futures price is constantly marked to market, with the accounts of the people who are long and short being constantly credited or debited. At any given time, the market value of a futures contract is zero, because it merely entitles the holder to the current futures price.
Of course if you buy when the futures price is $126 and then it goes up to $130, you have made money, but my quibble is just that you already made your money while holding the contract. When you unload it (because you don't want to actually take delivery of physical oil), you don't make any money; you sell it for a price of $0.
Again, I am not an actual trader so you might want to run this by someone, but I'm pretty sure the above is basically correct.
Posted by: Bob Murphy at May 18, 2008 12:04 PM
Shan and Vorpal, I realize that many people have claimed that speculation must show up in inventories, but please focus on the specific details of what I'm describing here rather than general things you have heard from others. There is no incentive at all in the process I described for refiners to increase inventories. You want the same inventories when July is $124.25 and August is $124 as you'd want when July is $126.25 and August is $126.
This is intriguing; can you elaborate? Because I thought the same thing those other guys did.
At the very least, wouldn't inventories go up permanently by a month's worth in the process you describe? I.e. in the very beginning of the speculative bubble, conditions are such that refiners buy oil on the spot market instead of the one-month-ahead futures market. So they clearly should have their inventories go up right there.
Until the bubble pops, there is no reason for that extra month's worth of inventory to go away. And in fact, if you want to use your mechanism to explain a continued pumping up of the bubble, I would think you would have to expand the story. E.g. now the refiners start buying spot crude for their production needs two months out (since it's cheaper), etc.
I realize I am probably misunderstanding the mechanism you are describing, but I just wanted to add that I too thought it should lead to accumulating inventories by the refiners.
Posted by: Bob Murphy at May 18, 2008 12:14 PM
Sorry for so many posts, but one last thought: I don't think anyone has brought up the fact that crude was in backwardation during much of the time when everyone was really claiming "speculators!", and now it apparently is back to contango. I think that might be an important part of any test about whether it is speculation or fundamentals driving prices.
Posted by: Bob Murphy at May 18, 2008 12:19 PM
One point: It is generally true for all tradeable assets in an economy that the futures price for delivery at time T must be equal to the spot price divided by the price of a $1 risk free bond that matures at time T. This is true for stocks, bonds, commodities, options, as long as inventory costs are negligable.
The argument is as follows:
consider the following trading strategy:
@ time t
1) short 1 unit of asset
2) buy (asset price)/(bond price) units of 1$ bond maturing at T with money obtained from short sale
3) enter into futures contract to buy 1 unit of asset at time T for price K
@ time T
1) Sell bonds and get (asset price)/(bond price) dollars
2) Buy 1 unit of asset at price K to satisfy futures contract
3) close short sale
You start with zero dollars and at time T you will have P&L = (asset price)/(bond price) - K
If (asset price)/(bond price) > K you will make risk free profit by following this strategy. If (asset price)/(bond price)
(asset price)/(T maturity bond price) = futures price
in order to avoid arbitrage.
Posted by: assman at May 18, 2008 12:48 PM
Posted by: JDH at May 18, 2008 01:12 PM
Bob Murphy, inventories do not go up-- not temporarily, not permanently, not at all. I am describing the equilibrium, not a "process." There is no reason for any trades ever to take place at anything other than the equilibrium values-- if they did, somebody's throwing money away for no good reason. The old equilibrium had July at $24.25, August at $24.00, and inventories at K. The new equilibrium has July at $26.25, August at $26.00, and inventories at K. Nobody is adding to inventories and nobody is drawing inventories down.
Yes, these are futures not forward contracts, but the differences between the two are completely irrelvant for any of the points I'm making, and the exposition I chose was quite deliberate in order to convey the core issues as clearly and simply as possible.
Posted by: JDH at May 18, 2008 01:26 PM
I agree with the article. A rise from $100 to $128 in just 4 months is absurd and dot-com like. Demand did not rise by 28% in just 4 months (assuming 1:1 elasticity). In the US, demand actually dropped.
I think that if oil crashes back down to $100 (which itself was a scary record high just months ago), then the economy immediately rebounds.
Posted by: GK at May 18, 2008 02:27 PM
As financial investors (ETF, asset managers,...) do not want to be delivered with the underlying, they probably have no other choice then rolling their position periodicaly. Assume many of them do it around the expiry of the front month contract then maybe the degree of financial speculation that brought CL contract from 100 to 127 will be revealed as the June contract is about to expire and investors rush for the exit with not so many refiners or other structural buyers willing to be on the other side of the deal.
Posted by: technical detail at May 18, 2008 04:06 PM
read "from USD100 to USD127" instead of "from 100 to 120"
Posted by: technical detail at May 18, 2008 04:09 PM
Ha, me thinks the jokes on us.
Posted by: touche at May 18, 2008 05:14 PM
The gas price is not the cause of one country. There are 1.2 trillion barrels of oil reserves. The world uses 84 million barrels a day. If consumption stays the same (not possible) there is 40 years of oil left. This is why the price is going up.
Posted by: Teltech54 at May 18, 2008 07:25 PM
I am sure someone will correct me if I am wrong, (my knowledge of the oil industry is limited to drilling for the stuff), but it seems to me that the buying of futures contracts does not occur in a vacuum- there has to be a seller: these futures contracts do not appear ex nihilo. This implies that for every buyer speculating that he can sell that contract in the future for a profit, there is a seller speculating that the price of the contract will go down, and that the seller is avoiding a loss.
This has long puzzled me, especially when the business media use the phrase "there were more buyers than sellers on Wall St. today, so stocks went up." It seems to me the number of stocks (or bonds or futures contracts) bought is necessarily equal to the number sold.
The number of people betting correctly is always 50% of the people betting.
Posted by: Imethisguy at May 18, 2008 09:36 PM
There are not 5000 vlcc's in the market. Between TNT and Iran, about 18 were taken off the market. This has been a major factor in higher (>200 WS) spot rates for V's.
Reserves are tricky things. Are you talking about proven, recoverable, or total reserves? What is the marginal cost of extracting all those barrels? For example, if you can extract ten barrels a day from a field at peak production for ten years, you might then spend thirty years extracting two barrels a day.
The point about the rise in oil is not the total amount of reserves but that we are using more than we can cheaply extract on a daily basis. Think about it. If reserves were 1.5 trillion barrels and we could extract and consume 400 million barrels a day, then what do you think the forward price of oil on the fourth day would be? Higher or lower? Similarly, if we can cheaply extract 85 million barrels a day (say at 125 $/bbl) but demand rises to 86 million barrels, where will the price go?
The price of tankers and barrels of oil, like most economic goods, are priced at the margin. If the only VLCC left is asking WS 250 for a voyage, then that is the market rate. If the cost of extracting a marginal barrel of oil is 125$/bbl (Brazil?), the the market will be there.
Posted by: Expat at May 19, 2008 12:08 AM
production and consumption figure in paragraph three should be 400 billion barrels (not million)
Posted by: Expat at May 19, 2008 12:10 AM
This bit of wisdom from the guy who pronounced gold a terrible investment (at around $500),
and 6 mos ago that oil had peaked (at 90ish).
Posted by: RN at May 19, 2008 05:37 AM
If you look at oil consumption in the US (the largest user) you can see that our consumption has returned to the 1978 (pre CAFE standard) peak only in the last couple of years. When demand approaches production, it is possible for speculators and Cartels to drive up the price of oil. It took years after dropping oil consumption to see much breakup in OPEC pricing. Only a drop in oil consumption back to 1983 levels will put enough pressure on the cartels and speculators that oil prices will truly drop. Lack of coherent conservation and efficiency programs have put the US 'over a barrel'.
Posted by: bakho at May 19, 2008 06:17 AM
RN, as always you make up words I did not say in order to find something to criticize. I never used the word "terrible" in describing gold as an investment. Instead, the actual words I used were "it's not for me." And it's not. But I guess it doesn't sound so bad if you accuse me of saying gold was not for me, so instead you accuse me of advising people that gold is a "terrible investment."
The peak I mistakenly called in oil prices occurred Nov. 20 at $99.16 for WTI. This you tell readers was "oil in the 90s".
I have told you that you were inventing this accusation "terrible investment" out of thin air before. I don't have the patience to tell you again.
Posted by: JDH at May 19, 2008 06:26 AM
Imethisguy, the number of buyers of July futures at a price of $124/barrel outnumbered the number of sellers. That is why the price rose to $126, which is the point at which the number of buyers was equal to the number of sellers. It is in this sense that an increase in the number of people who wanted to buy the contract led to an increase in the price of the contract, even though it is exactly true as you observe that in equilibrium, the number of buyers equals the number of sellers.
Posted by: JDH at May 19, 2008 06:33 AM
The impact of this new investment capital in commodities goes beyond price, and includes structural strains. This has been more apparent in the ag markets, and may ultimately be unsustainable. For some thoughts:
With regard to energy, because of the heavy weight in the GCSI index, it seems likely to have an impact (even with the deep energy markets, it seems hard imagine that $100BLN+ wouldn't matter). The last time the crude futures were in a contango, cash/futures arbitrage resulted in large storage of oil. Economically, this is ridiculous -- demand for oil to fulfill an arbitrade situation caused by investment dollars flowing into commodities because prices went up because of demand for oil -- anyone else see a problem with that?
In the long run, supply/demand fundamentals win out, but because the flow of investment capital has been increasing, this impact is masked.
However, like some of the previous posters, I think investment dollars is probably a tertiary factor in energy (after 1.developing economy demand and 2. weakness in the dollar). But still important.
Posted by: jdk at May 19, 2008 08:16 AM
Comment on back and forth between RN & JDH (I've jumped into this before):
1. I've made some snarky comments in the past, in particular regarding the futures market and the predictive powers of economics.
2. Running in the San Diego afternoon heat yesterday (wondering why I was killing myself), I pondered this issue of explanation versus prediction. It's a major question and issue with respect to science (and history), particularly when faced with complexity and/or chaos.
3. I don't necessarily intuitively agree with JDH's assessment on some matters, but I have no solid analytical evidence to counter him.
4. The value of JDH's analysis--and I value it highly--is that he looks at the facts and data--and how they relate. There are those in the economic community who argue for a more qualitative approach--moving away from rigorous analytical econometric approaches--a return to what might be called rhetorical, logical, and even moral argumentation. That position has merit as well. But looking at what the data tells us is also valuable. It's one view--a fairly consistent one, even if not necessarily or accurately predictive--that has much value.
Use the data JDH provides as one view into the phenomena we are discussing. Try to integrate it with other views.
Posted by: General Specific at May 19, 2008 09:23 AM
A 1:1 elasticity? HAHAHA.
The price of oil tracks very strongly the producer price index for capital and labor inputs. The marginal cost of new oil is strongly dependent on finding and lifting costs, which are tied to the PPI.
Fundamentally, oil is just about where it should be, and it wuill stay in this environment until the PPI comes down. If more steel and copper and cement capacity come on the market, and more labor flows into the energy sector, then prices will relax. But not until then.
All this talk of speculators is for simple-minded conspiratorialists.
Posted by: bartman at May 19, 2008 10:32 AM
bakho, in the 1970s/1980s, substantial additional capacity existed which wasn't being used. That is not the case today - the only producer who even alleges such is Saudi Arabia, and their trustworthiness is less apparent each day.
Posted by: M1EK at May 19, 2008 12:06 PM
Correct me if I am wrong please. It seems like what you posit is that the prices of oil we see today reflect actual clearing (equilibrium) prices that end users transact at because there needs to be an ultimate physical delivery. And the components of market participants that are non-end users, ie. the indexers, hedge funds, etc., merely play the role of accelerating the discovery of what that true market clearing price is.
Yet it won't be a contradiction of the above to also adopt the view that speculators did play a meaningful role in raising the price of oil recently if oil had been arguably mispriced (underpriced) for a long time in the absence of a catalyst. It just happens that speculators are now contributing to pushing/accelerating the discovery of the true equilibrium price.
Posted by: Francis at May 19, 2008 02:37 PM
When you're in Cushing picking up that oil you've purchased, you really should run over to Perkins and eat at Dimarios pizza. It's pretty good.
Posted by: rmark at May 19, 2008 02:43 PM
Crude has hit another record high to trade above the USD 127/bbl mark, Saudi Arabia planing to increase output by 300,000 barrels a day, thats really huge crude can touch 100 USD in near future.
Posted by: Sandy at May 20, 2008 12:17 AM
So how much of the commodity price rise is 'real' and how much is speculative. Here are some rumblings across the globe that I came across by :-
- As per Commodity Futures Trading Commission, which regulates commodity futures in US speculators account for around 37 percent of outstanding contracts in U.S. crude oil.
- There is a research carried out by a researcher in Korea very recently where the researcher has tried to approximate the % contribution of key factors (speculation, demand-supply, dollar weakness and geopolitical reasons) in the commodity price rise. It seems for oil and wheat more than 40% of the price rice has been contributed by speculative interests and another approx 40% by demand-supply reasons
- Oil ministers from nearly all the OPEC countries from Saudi (the biggest) to Qatar (smallest producer) are vociferous in their statements that there is no shortage of oil, that the inventories are piling up and the price rise has been driven by speculative interests. Is anybody listening to them ?
Posted by: Amar Harolikar at May 20, 2008 01:09 PM
even if the critics of the speculators are right it seems the price of oil is here to stay barring demand drop like a chinese recession ect...
if the pension funds are barred by erisa law from owning (discussed today by lieberman) everyone knows that the market will bear today's $120+ prices. why would they sell cheaper?
Posted by: oops at May 20, 2008 04:08 PM
I find this all very interesting. I work in a refinery for one of the majors What is fascinating to me is the mentality that describes who sets the prices. For integrated oil companies high oil prices are good. But consider Valaro who is refining and retail. Think about the power they have if they don't buy the contracts. Now you have a bunch of speculators with paper contracts and no mechanism to take delivery. If they would exercise their power in the food chain as a member of the limited group who can take the oil, they could drive the price of oil down almost single handily until the economics said don't drill or pump the oil. Its the problem with big business, people are told how to do their jobs and they are no longer hungry and aggressive.
Posted by: CEO_My_Life at May 20, 2008 08:27 PM
CEO My Life...
Where the refiners sit is intriuging. Looks like crack spreads have been squeezed since oil traded around $80/bbl. But the dynamics of the industry is such that as long as there's a margin to be made (even if smaller by the day), then conceivably refiners will continue paying up for oil.
I guess at some point the spread/margin becomes so razor thin or negative that you will not buy oil. But since oil is an international commodity and with countries outside the US eager to make purchases for strategic reasons (or where retail gasoline/distillates are subsidized thus distorting the demand element), could we conceivably see refiners in the US get pressured to loss making levels?
Posted by: Francis at May 21, 2008 09:11 AM
A technical point on the example of Iran's storage of its heavy sour grades. This is not a story of speculative hoarding, i.e. storing and waiting for the price to go up. As another Bloomberg article on this topic quoted a trader, (as exactly as I can remember the quotation) "If this was Nigerian Bonny Light, it would have no trouble finding a refiner."
This oil is being stored because there is not enough global refining capacity to process more of such heavy crude. Most refineries would be hard pressed to make marketable fuel oil of it, much less gasoline. In other words, its being stored because there is a bottleneck that prevents it from moving down the supply chain. I suspect that this may be among the first crudes sold to Reliance's sophisticated new Indian refinery scheduled to open this summer. If someone wants to make a point about speculative hoarding, show me evidence that better grades of crude are being treated in the same manner.
Posted by: kevin at May 22, 2008 04:20 AM
Kevin, I did not bring up Iran as an example of speculative hoarding. Exactly the opposite. My interpretation is that futures brings up the spot with the result that producers find reduced demand for their product. I am interpreting the Iranian tankers exactly as you describe, which I'm claiming is exactly the kind of thing you'd expect to see from the speculation-drives-spot-prices story.
Posted by: JDH at May 22, 2008 06:09 AM
The Reagan economists are correct about supply and demand; what we call Reaganomics.We always fail to mention that when we have Texas oil men [or boys]in charge they tilt toward protecting their own interests which just happens to benefit Middle Eastern oil ministers as well.Then the weapons dealers can easily sell them more sophisticated weapons through another investment corporation which just happens to be owned by the same good ol boys.Enron smelling crap all over again.These guys smell like Houston, which smells like sulfur,which is worse than sewage.
Posted by: dcmeyer at May 23, 2008 01:37 PM
Speculation is an important topic. I believe that ï¿½shanï¿½ is right and the concern about speculators driving up prices is essentially a witch-hunt: a search for scapegoats; much like the bubonic plague was blamed, on cats, witches, and Jews.
Iï¿½d like to take this opportunity (if Iï¿½m not too late on this board) to challenge you to explain how the current round of price increases could have been caused by speculation in the futures market. Iï¿½m NOT saying that you are wrong. But I am saying that your assertions that you have explained it are not convincing. If you are correct, then you have certainly not yet explained it clearly and THAT is important.
I have yet to hear a plausible explanation of how futures market speculation could raise SPOT prices except by a contango causing an inventory build.
I challenge you and the other posters to explain the mechanics of the price increase. I am most comfortable with explanations of how futures market speculation causes excess demand in the petroleum spot market. You can convince me by writing down the appropriate and plausible excess demand function.
You said in your post, that you were referring to the ï¿½most recent moves in oil prices.ï¿½ and ï¿½..Notwithstanding, it does appear that speculation has gotten ahead of those fundamentals in the most recent developments.ï¿½
I specifically want to address the question:
∑ Can futures markets drive up spot prices except by providing an incentive to physical inventory building (hoarding)?
The ï¿½most recent periodï¿½ has been characterized by backwardation and no increase in observed (i.e. OECD) physical commercial inventories of crude oil and products.
I do agree that there is lots of speculation in the futures market, but that is a separate market from the physical market for crude oil. Futures are paper and can be recycled into next monthï¿½s NY Post, but cannot be made into gasoline. So we must askï¿½ ï¿½What is the linkage between the two markets?ï¿½
I understand the case that you described as ï¿½intertemporal calculationï¿½, a steep contango that finances storage. But that is an inventory (hoarding story). And it wonï¿½t happen and drive up spot prices when the market is in backwardation as it is right now.
But otherwise, I believe that futures market speculation is simply a ï¿½side betï¿½ that does not affect the physical market. Betting on ï¿½Annieï¿½s Dreamï¿½ in the third race at Belmont doesnï¿½t make ï¿½Annieï¿½s Dreamï¿½ run any faster. Nor will heavy speculation on weather futures cause global warming.
You said that you had a second story about how futures prices affect spot prices without directly driving inventories. Then you cited the example of Iranï¿½s floating storage (which was actually the result of a bottleneck in deep conversion capacity). Iï¿½m confused. Please explain. Walk me through it -- Commodities Speculation for Dummies: Part Deux.
Posted by: kevin at May 24, 2008 07:47 PM
Kevin, price changes do not require excess demand. If the demand curve shifts, the price should go up without any trades ever needing to occur out of equilibrium. I explained, I thought, exactly how the demand curve for spot oil would indeed shift as a result of a change in the futures price even with backwardation. I do not know what you disagree with or did not understand since you comment very little on what I actually said. Please let me know which specific statements in the paragraph beginning "A much more important way" you disagree with or do not understand, because this is where I explain exactly why the futures price is an argument of the spot demand curve. Note that the numerical example there specifically allows backwardation throughout the process, and note further that there is no change in inventories between the initial equilibrium and the new equilibrium. What happens is purely that an increase in the futures price results in an increase in the spot price.
Posted by: JDH at May 24, 2008 08:08 PM
Please let me repost--I obviously had some problems with characters not being properly displayed.
Speculation is an important topic. I believe that "shan" is right and the concern about speculators driving up prices is essentially a witch-hunt: a search for scapegoats; much like the bubonic plague was blamed, on cats, witches, and Jews.
I'd like to take this opportunity (if I'm not too late on this board) to challenge you to explain how the current round of price increases could have been caused by speculation in the futures market. I'm NOT saying that you are wrong. But I am saying that your assertions that you have explained it are not convincing. If you are correct, then you have certainly not yet explained it clearly and THAT is important.
I have yet to hear a plausible explanation of how futures market speculation could raise SPOT prices except by a contango causing an inventory build.
I challenge you and the other posters to explain the mechanics of the price increase. I am most comfortable with explanations in the form of how futures market speculation causes excess demand in the petroleum spot market. You can convince me by writing down the appropriate and plausible excess demand function.
You said in your post, that you were referring to the "most recent moves in oil prices." and "..Notwithstanding, it does appear that speculation has gotten ahead of those fundamentals in the most recent developments."
I specifically want to address the question:
Can futures markets drive up spot prices except by providing an incentive to physical inventory building (hoarding)?
The "most recent period" has been characterized by backwardation and no increase in observed (i.e. OECD) physical commercial inventories of crude oil and products.
I do agree that there is lots of speculation in the futures market, but that is a separate market from the physical market for crude oil. Futures are paper and can be recycled into next month's NY Post, but cannot be made into gasoline. So we must ask -- "What is the linkage between the two markets?"
I understand the case that you described as "intertemporal calculation", a steep contango that finances storage. But that is an inventory (hoarding story). And it won't happen and drive up spot prices when the market is in backwardation as it is right now.
But otherwise, I believe that futures market speculation is simply a "side bet" that does not affect the physical market. Betting on Annie's Dream in the third race at Belmont doesn't make Annie's Dream run any faster. Nor will heavy speculation on weather futures cause global warming.
You said that you had a second story about how futures prices affect spot prices without directly driving inventories. Then you cited the example of Iran's floating storage (which was actually the result of a bottleneck in deep conversion capacity). I'm confused. Please explain. Walk me through it -- Commodities Speculation for Dummies: Part Deux.
Posted by: kevin at May 24, 2008 08:18 PM
Kevin, Suppose that before the futures price increase, the August futures price was $124.00 and the spot price for July delivery was $124.25. I'll take the backwardation (preference for oil now) as given. Suppose that you as a refiner were at those prices planning to buy 1.5 million barrels in July and 1.5 million barrels in August. That means that one point on your July spot demand curve, which is a relation between the July spot price and the July quantity demanded, is Q = 1.5 and P = 124.25.
Now let's say you are exactly the same refiner in exactly the same position as before, except that this afternoon speculators bid the August futures price up to $126.00. Here is the question for you-- if August were at $126.00 and July still at $124.25, would you still plan on buying 1.5 in July and another 1.5 in August? I am suggesting you would not, that instead you would plan on buying, if the July price were $124.25, more than 1.5 for July and less than 1.5 for August. In other words, Q = 1.5, P = $124.25 is no longer a point on the demand curve for July spot. Instead, the July spot demand curve has shifted up relative to where it used to be, and the variable that shifted it up is the change in the August futures price. If you think your customers will still be needing the 1.5 million barrels each month, you'd probably be willing to buy 1.5 million barrels for July at a July price of $126.25. In other words, the July spot demand curve has to a first approximation shifted up by exactly the same dollar amount that the August futures price went up.
Posted by: JDH at May 24, 2008 09:03 PM
You just wrote: "price changes do not require excess demand. If the demand curve shifts, the price should go up without any trades ever needing to occur out of equilibrium."
I think that this explanation does not recognize that inventory changes will occur under the circumstances you are describing.
The total change in inventories is the difference between total well-head production (or the alternative fuels' equivalent) and final consumption (sales to final consumers: input into auto gas tanks).
If the refiners' July demand curve shift out in response to the August futures price and final consumption does not -- inventory builds. It may build in the form of products, but it builds. It makes no difference where in the supply chain it builds: it builds. However, as oil prices went into a vertical climb the last few weeks, U.S inventories, at least, were declining relative to seasonal norms.
Now if final consumers also increased their consumption in response to futures prices, the story might be different. But the idea that drivers decide to take vacations in July because of the August futures price published in the WSJ has no appeal.
So we do disagree. I think that your story is plausible as a mechanism for increasing spot prices. We agree on that. But I also think that your hypothesis implies building inventories. That is where we disagree. And observable (OECD) inventories have not built in the relevant time period.
So I agree that your story could occur, but I just do not think that it explains the events of the last few weeks. Now it is certainly possible that inventories have built where we have not observed them. They could be building in unmeasured secondary and tertiary storage. That is possible, but I'm not willing to think that these inventories are suddenly behaving in a new manner without some reason.
In fact, inventories could be building anywhere outside the OECD. The IEA's May Monthly Report hinted at the possibility that inventories were being rebuilt in Asia. China could be stockpiling ahead of the Olympics. That is a speculation story, but has nothing to do with the third month price on the NYMEX.
On the other hand, analysts may not be able to precisely measure trend growth in wellhead production and final consumption with sufficient precision. In that case, we might not have previously understood what price would be necessary to balance the market. In other words, analysts simply lack the data and insight to do as well as they would hope.
The hypothesis "Analysts don't understand as much as they wish" certainly survives Occam's Razor.
Posted by: kevin at May 24, 2008 09:42 PM
No Kevin, you're still not understanding. The demand curve for crude petroleum shifts out. It initially passes through the point Q = 1.5, P = 24.25. The new curve passes through the point Q = 1.5, P = 26.25. In equilibrium, the new Q is 1.5, exactly the same as before, but the new P is 26.25. There is no inventory build necessitated by the fact that the demand for spot crude has shifted right. The quantity of crude purchased before the curve shifted was Q = 1.5, and the quantity of crude purchased after the curve shifts is still Q = 1.5.
You are correct that there should be a small change from final consumers of gasoline, who presumably now want slightly less than Q = 1.5. This arises from the fact that the short-run demand for gasoline curve is less than perfectly inelastic. But this curve is nonetheless quite inelastic, so this is a much smaller number than the kinds of effects you are thinking about. It is correct that this slight drop in final consumer demand must show up somewhere as a gain in inventories or a decrease of production by the crude oil producers, and this small adjustment is what I am discussing in the post in terms of declining production and Iranian oil tankers.
I still believe that the answers to all the objections you have raised were given in the original post, and encourage you to try to find in the details of what I have said the specific points with which you think you disagree.
Posted by: JDH at May 25, 2008 07:59 AM
I apologize that these postings are in such a confusing order. I reposted one message and others crossed in a confusing manner. My May 24, 7:47 posting printed poorly and should be ignored.
For those coming in late -- The others should be read in the order, all on May 24: Kevin 8:18 PM, JDH 8:08PM, Kevin 9:42PM, and JDH 9:03PM.
I'm now getting a clearer picture. On the basis of your 9:03 PM posting, I believe that you are confused.
Your second sentence of the second paragraph states: "Here is the question for you-- if August were at $126.00 and July still at $124.25, would you still plan on buying 1.5 in July and another 1.5 in August?"
That situation is a contango. And you are assuming (and I agree) that in that situation, the refiner will try to procure some of his August barrels at the July price. If he does that, he will try to store part of his purchases for sale during the next month: He will build inventory. And don't forget, in your example of August at $126 and July at $124, anyone with access to storage at Cushing can earn $1.75/bbl minus storage and interest (I don't have a current quote, but I believe that storage was $0.40/bbl/month a couple of years ago.) So inventory will build at Cushing as well as at the refinery.
Posted by: kevin at May 25, 2008 10:02 AM
(continuation of my previous post)
Let's also check on this from a couple other perspectives.
Refiner's purchase and sales: The refiner will still buy the exact same amount in July Q= 1.5 at $126 as he bought at $124.25 in your example. But now he intends to save some of that for August, so he will have to sell his customers less than 1.5. Let's assume that the final retail price is the crude spot price plus a $7 refiner's margin. Originally, final demand (FD) was 1.5 at $124.25 + $7 or FD($131.25) = 1.5. And passing through the new July price: FD($133) is less than 1.5. The refiner buys 1.5, sells less than 1.5 and, by identity, inventory builds.
Global perspective. Define supply as wellhead supply WS, which is a function of spot price WS(P). Assume that initially, the July spot market was in equilibrium at $124.25 without any inventory accumulation, i.e.:
FD($124.25 + $7) = WS($124.25).
Then at a higher July price, of $126:
FD($126 + $7) is less than WS($126).
The difference, WS($126) - FD($126 + $7), is the global accumulation of inventories.
So I believe that my challenge stands.
JDH, your story is one of contango and inventory accumulation. It makes eminent sense and is internally consistent, but it is not the story of the increase of WTI prices from $100 to $130. The spot price during this period was never higher than the forward price. Nor does the inventory story match.
If speculation in the financial futures markets has caused the price of spot WTI to climb from $100 to $130 over the last few months, I wait for an explanation of the mechanics of that process.
Posted by: kevin at May 25, 2008 10:08 AM
No, Kevin. Please focus first on this question: What is the position of the demand curve? Once you're very clear about the answer to that question, then you're ready to think about the second one: What would the quantities and equilibrium be that are associated with a demand curve in that location?
So please with me think solely for the moment about the first question: What is the position of the demand curve? This is the answer to a "what if" question-- if the price were P, what quantity Q would the refiner want to buy? We have for the initial conditions (futures price is $24.00) one point on the initial demand curve, one answer to the "what if" question-- for those initial conditions, if the spot price were P = 24.25, then Q desired would be 1.5. So P = 24.25, Q = 1.5 is one point on the initial demand curve, and happens to be the point of initial equilibrium as well.
Next we change the initial conditions, and try to see what the new position of the demand curve might be. To do this, I again ask a "what if" question-- What if the price remained at P = 24.25, now that the futures price is 26? And I see very clearly, and tell me please whether this is somehow the point that is not clear to you, that the answer to the "what if the price remained at P = 24.25", the answer can no longer be, "then quantity demanded would still be 1.5".
Where you are apparently led astray is telling me all sorts of other implications of what would happen if we actually had transactions occur at P = 24.25. But these implications are all irrelevant, because all we were doing with the numbers P = 24.25 and Q = 1.5 was reasoning with them to see that the point P = 24.25, Q = 1.5 was not a point on the new demand curve. Instead, the new demand curve (in the case of perfectly inelastic gasoline demand) would go through the point P = 26.25, Q = 1.5.
Only when we are sure of the position of the new demand curve should we then turn our attention to the second question: What is the new equilibrium? The outcome of the new equilibrium is in fact the point on the demand curve that we just found-- P = 26.25, Q = 1.5.
Now that we've found the new equilibrium, let's compare it with the initial equilibrium. The value of Q turns out to be exactly the same as it was initially. The refinery has accumulated zero inventory relative to before. All that has happened is the spot price has gone up.
This is the way in which an increase in the futures price results in an increase in the spot price. We would jump to the new equilibrium instantly-- in an efficient market, the spot price will jump up by $2 at the very instant that the futures price jumps up by $2.
Posted by: JDH at May 25, 2008 11:18 AM
Now that I have focused on your refiner's demand function, I believe I see the root of your error.
In the example that you give, the refiner's demand is a function of current price and forward price. In the example you give:
RD(Spot, Futures Price) = RD($24.25, $24.00) = RD($26.25, $26.00) = 1.5.
One could even simplify this formulation and state that the refiner's demand is a function of a single variable, the spot-future spread. In your example, the spread is $0.25. So that drawing this out:
RD($0.25) = RD ($95.25 - $95.00) = RD (115.25 - 115.00) = RD ($150.25 - $150.00) = 1.5.
So in your formulation, the magnitude of the price of oil drops out of the demand function. There are obvious problems with that. Obviously
RD($0.25, 124.25) is greater than RD($0.25, 126.25).
Why? Let's take the two extreme cases (ruling out inventory accumulation which we have already stipulated shouldn't happen).
If the price of crude goes up $2 and the refiner fully absorbs the cost to keep the retail prices constant, his profit margins go down. Under those conditions, the refiner's demand for crude will decline (even under Chinese price controls).
If the price of crude goes up $2 and the refiner fully passes though his costs to retail prices in order to maintain his margins, then his sales volume declines. If the refiner does not wish to accumulate inventories then obviously he must reduce his crude purchases.
So I believe that this description of demand is erroneous. In less extreme formulations it has useful features and could certainly help explain how futures markets could influence spot markets, but in the end those explanations would involve inventory accumulation.
Posted by: kevin at May 25, 2008 07:47 PM
Kevin, I have already answered this question again and again and again. The refiner passes the costs to the buyer of the gasoline, and the magnitude of any decline in sales volume that would result from that depends on the price elasticity of gasoline demand, which all the evidence suggests has been extremely small in recent data. In the special case that gasoline demand is perfectly inelastic, then the equilibrium is exactly that the refiner continues to buy 1.5. I have referred explicitly to this special case at least a half dozen times above. Did every mention of "perfectly inelastic gasoline demand" above just slip past you unnoticed? I have further described many times that in the case that gasoline demand is not perfectly inelastic, there must be either some decline in the quantity of crude produced or some increase in inventories held by someone in the system (not particularly by the refiner), which of course is the consequence of the decline in sales volume that you think you have just discovered as the "error" in my analysis.
Please read the original post. Every objection you have come up with in your now long string of remarks was already addressed in detail there.
Posted by: JDH at May 25, 2008 09:38 PM
In some ways, we are very close in our analysis. My objection to your post is this sentence from the next-to-last paragraph in your original post.
"Notwithstanding, it does appear that speculation has gotten ahead of those fundamentals in the most recent developments."
Now I will confess my age and tell a beatnik joke. A pedestrian is hit by a car and crawls to the curb where he sees a beatnik. He gasps, "Please, call me an ambulance." The beatnik replies, "OK Man, you're an ambulance!"
Please use the word "speculation" much more carefully. t is just better not to call something "speculation" without solid data and theory to justify that exact term.
We both concur that price increases are being driven by fundamentals, especially the disappointing growth of oil supply. You are then trying to connect futures markets investment, casually labeled "speculation", via tenuous linkages to by producers' decisions not to expand output. You need extreme assumptions (extremely inelastic price elasticity demand and supply) to make your "speculation" story work. But those same assumptions justify the label "fundamentals" for extreme upward price movements when rapid economic growth collides with two years of zero supply growth. With those elasticity assumptions, prices will skyrocket every time the inaptly named MEND breaks something new in Nigeria or Mexico's Cantarell field disappoints (oday's uplifting news).
The "speculation" story is just analytically unnecessary and should be cut by Occam's Razor. At 10:30 Wednesday morning the market watches EIA U.S. inventory data and if those disappoint -- prices go higher. That drives inventory and production targets, spot prices, and the futures market.
Dermot Gately has already made the point forcefully that it is not in OPEC interest to keep prices low if the rest of the world cannot demonstrate some combination of non-OPEC supply elasticity and/or demand elasticity. You do have a useful story tied into the Hotelling Principle that producers are watching price movements and deciding that it is not in their interests to increase production. That story is worth fleshing out.
But is OPEC watching futures and not spot or the price of OPEC's composite barrel? They certainly don't need futures for the purpose of price discovery. I see no reason to suppose that if the futures markets were dissolved tomorrow that OPEC would behave differently. Throwing in the word "speculation" is distracting and confusing.
Let's get to the immediate question, your statement: "Notwithstanding, it does appear that speculation has gotten ahead of those fundamentals in the most recent developments." Why did price increase by 50% in less than six months?
I will give you a speculation story to explain it. But it is a much more traditional speculation story dealing with hoarding (actually dishoarding) of physical inventory. According to EIA, global inventories declined last year at a rate of 800k barrel per day: the equivalent of Qatari production. Now if that suddenly has to stop because we come too close to minimum operating inventories or even a stock out, the sudden loss of this flow to market will require a very large price adjustment given the extreme price inelasticities that we have observed. My guess is that the recent price spike coincided with the end of this destocking process. It may take a long-time before this phenomenon is observed (if it is recognized at all). However, the important conclusion is that: "Prices shot up not because speculators were buying, but because they stopped selling." But until they lost the means, speculators (inventory managers) were doing their job of consumption and price smoothing.
Am I arguing over semantics? No! When an economist of your stature blames speculation, there is an implicit policy prescription.
The same story is playing out in agricultural markets and people are blaming speculators as inventories hit all-time or multi-decade lows. India, after several years of belated economic progress, has now banned trading in agricultural futures in order to control food prices. Will that do any harm? I do not know. I cannot see how it will do any good. U.S. farmers rely on futures as an important hedging instrument (and ironically complain about the margin requirements when they lock in higher prices).
Would it do any harm to ban the commodities roll? I do not know. I cannot see what the value-added is in this activity. It was invented by the same geniuses that invented subprime mortgage-backed bonds and CDOs. But if we did try to ban speculation and hoarding in physical markets and screwed up inventory management, we would do great harm.
Why start a witch-hunt? Why help OPEC use the term "speculation" as a form of magician's misdirection to obscure the fact that they are unwilling or unable to balance the market at lower prices?
Posted by: kevin at May 26, 2008 12:41 PM
I appreciate this explanation of how the spot and futures markets might be linked. However, there is one aspect of this linkage that I'd welcome a more explicit explanation of.
Let's start off with the initial conditions - July oil (spot) for $124.25/barrel and August oil for $124/barrel. Then, August oil suddenly jumps to $126/barrel.
The argument that's been made, if I understand it correctly, is that since the July price is momentarily more attractive relative to the August price, demand for July oil (spot) will rise (virtually instantaneously) until the price July price reaches $126.25/barrel.
However, the part here about the July price being momentarily "more attractive relative to the August price" seems to be based on the implicit presumption that the refiner believes that the current August futures price reflects what the August spot price will ultimately be. If refiners believe there is little to no linkage between the current August futures price and the ultimate August spot price, the incentive for the refiners to bid the July spot price up to $126.25/barrel goes away (if they are prepared to wait and buy their August needs on the spot market). Conceivably, the July spot price could remain at $124.25.
Posted by: TJ at June 1, 2008 09:38 PM
TJ, you're basically asking why don't refiners assume that the speculators will be proven wrong and bet against them with their own inventory drawdowns. I'm guessing that in a world where the fundamentals are sufficiently hard to discern, they're not willing to take that risk. Certainly if they're just following rules of thumb in managing inventory to meet customer demand, they'll behave as I postulate. And if they behave as I postulate, the expectations I've assumed them to have would be rational to hold in the equilibrium I describe.
Posted by: JDH at June 2, 2008 06:15 AM
People forget to consider the fact that the increase in volume on futures (which is the price discovery mechanism) has exploded and there are unknown trillions involved with the unregulated paper being exchanged through internationally financial institutions.
This "EXTRA" volume is by definition Speculation to the Long side as it always has been through countless bubbles in history and in the present.
The normal requirements of liquidity in the futures market now turns into a disrupting higher OBV, On Balance (more extreme) Volume. The impact on price discovery leads to a breakdown of the normal operations in the physical commodity business. If you are in the physicals business, it is extremely hard to operate in the distribution/crack/spread pipeline due to price uncertainty within short time periods.
There is no rhyme nor reason at this point other than letting the psychology of fast money play to the end. How do you explain this to an economist that wants his equation to work like a Swiss clock but instead works like Swiss cheese.
Linear economic thinking with cute "this causes that and then this will happen" will not help your understanding of in the real world of price discovery.
A denial of speculative influences will not prepare you for the fall out when these Long positions unwind in the not too distant future. That is when you will discover the dumb money causing more trouble than they were worth. They should have been heavily regulated unless you believe disaster capitalism and 1929 are proper goals to balance greed and fear.
Posted by: Arnold Thompson at June 9, 2008 04:07 PM
Thank you, JDH.
Based on the discussions here, the "economists" in the group seem to believe that the market always achieves equilibrium. Possibly -- in the long run (when we're all dead). But that doesn't mean that speculation isn't driving up current futures prices for oil. NYMEX might be regulated, but there is no regulation going on in the OTC commodities futures market. The trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron and other large energy traders into the Commodity Futures Modernization Act of 2000 in the waning hours of the 106th Congress. (Thanks you, Phil Graham, John McCain's economic advisor.) And, yes, this is the same legislation controlling (or not controlling) instruments like mortgage-back derivatives. Is anyone suggesting that there wasn't speculation going on in mortgage-backed securities? But there is no speculation going on in the oil market? Please, that's so naive. Oil is where money is being made these days. In and of itself, this means there is speculation going on.
Posted by: PMH at June 10, 2008 08:56 AM
10 Reasons Why Oil Price Speculation Requires a Change in the Rule of Law by Michael Levy
High oil prices that are governed by the commodity markets are in dire need of common sense law and order. When speculation and detrimental logic and reasoning take central command of human society, the results always turn out to be damaging to the majority, at the abundance of the few. The experts and speculators will argue we need free markets and any interference will take away free trade. Well, in many cases they are correct, however, when it comes to essential commodities of food and energy they are completely out of order. Here are a few reasons why essential commodity markets require new legislation.
1. There has been no shortage of gas at any filling station for the past 10 years yet prices are up 1200% because of futures trading going out more than eight years. Even the Saudi oil minister has recently stated the price of a barrel of oil should be no more than $70.00. Demand from China and India is still far less than that of the USA. The Chinese stock market is down 50% signifying a sharp slow down. This news still is not enough to stop the wild speculators hiking the oil prices.
2. When hurricanes hit Florida many gas stations are closed and there is a real shortage of gas for a few days. However, if a gas station increases its prices they will be prosecuted for price gauging. Therefore, if we take the experts argument that there is a shortage of oil then that still does not give anyone the right to profit from the shortage as this is deemed to be prices gauging. How can the USA governments have double standards and prosecute gas station owners who price gauge and not treat commodity markets in the same manner?
3. Oil is an essential commodity for every day living in the same way as water is an essential commodity. It makes no sense to trade water so why leave oil in the hands of anyone who wants to make a quick buck gambling on prices.
4. Pension and hedge fund managers have invested billions of dollars in oil futures. The futures markets are very volatile, thus, no place for pension funds to risk the money for people who trust them to build future wealth. The fiduciary duty of a pension fund manger is to find reasonable returns with low risk and the commodity markets is not that place.
5. If the price of oil was regulated between $40.00 - $80.00 a barrel, the price could go up and down on supply and demand. This would be fair to everyone, for even when supply was plentiful, the price would not drop below $40.00 which will still give a fair profit to most oil related industries. When oil is in short supply the price would be limited to a ceiling of $80.00 which is more acceptable to world economies.
6. There is a moral issue that greed cannot come before peoples basic needs ... No right-minded, ethical, principled government can allow starvation and financial ruin because of a system of trading that is completely out of control.
7. The price of a barrel of oil effects transport, food supply, industrial production and every part of modern day living. If terrorists wanted to devise a plan to destroy the world. economies what better way than finding a method to allow oil to trade at $140.00 a barrel. Why play a game that makes terrorists and anarchists happy.
8. Goodwill to all people is the credo every democratic country is built upon.$140.00 a barrel oil delivers no goodwill. It only brings hardship and political uneasiness.
9. Noble deeds and fair dealing is the hallmark of success for every truly prosperous person. Since the world is made-up from people, where are the noble deeds and fair dealing in the commodity pits.
10. We are all put on earth to help each other succeed in the pursuit of freedom, liberty and happiness. There is no freedom when people are slaves to greed. There are only liberty takers when oil trades over $80.00 a barrel. And finally financial hardship brings misery and discontent.
The time for change in essential commodity trading is now. To quote a few voices from the past...
“Experience demands that man is the only animal which devours his own kind, for I can apply no milder term to the general prey of the rich on the poor”_Thomas Jefferson
“For greed all nature is too little.”_Seneca
“It is greed to do all the talking but not to want to listen at all” _ Democritus )
“He who is greedy is always in want.” _Horace
Author, Poet, Philosopher.
Posted by: Michael Levy at June 15, 2008 12:05 PM
The only people that are talking fundamentals on oil are the speculators themselves. Trying anything to prop up the supply and demand theory. Oils demand is whatever people driving there cars makes it and the road to work looks eerily quiet. There is no more traffic its like people arent even going to work industry is down demand on gas is down. Production of goods down distribution down. Talk fundamentals all you want. This is a bubble created by hedge fund investors chinas demand on oil is fake created by subsidizing. Hope you got insurance for the next futures contract that blows up. I have been spending more on gas by the gallon but less on gas in general. And so is everyone else id rather watch tv than go anywhere. The bubble will pop before summer of 08 is up. Companies are just making as much profit as they can to make up for recent losses in the financials and housing. Youd like it to go up forever but there just is no demand just like you the bull investors. Thought housing would go up forever and it couldnt sustain it. Neither will the price of oil because the consumer just doesnt have the money it doesnt matter how much oil is left. If we cant afford to buy. Start thinking realistic. And stop trying to blind us with big words and math problems. Simple facts of supply and demand is that eventually someone wont pay 200 dollars a barrel for oil. Ill go back to a horse and wagon and grow my own food instead of working to pay to go to work and so will the rest of the world. I dont caviar or escargo or any other nonesense that i cant afford. Once oil is unaffordable people wont buy it to think that oil will go up as a precious resource is ridiculous. The people that own the oil will keep it for themselves and the rest of the world will move on to another form of energy. If mccdonalds tells me that the double cheeseburger is going to cost me 3 bucks because of supply and demand i might still buy it but if they tell me its goint to be 10 dollars im gonna pass and so is everyone else. The only people that will pay for 200 dollar a b oil is rich people in your own little micro economy. The larger economy 98% of the world will not pay for gas at the price. And you will lose production in china russia wherever. Supply and demand only works if someone wants to pay for it and the world is alredy crying uncle. Notcie the economy this is an oil recession not a housing. Its been oil. Since hurricane emily. 176 before 275 after and growing and ever excuse to make it go higher. As the middle class gets squeezed all over the world including china, russia, and brazil is non entity in oil folks they us ethanol at 40cents a gallon so you can stop using them as a reason oil goes there economy functions with out it. Careful folks getting caught up in the hype of oil. As prices go up here it goes up everywhere putting stress on the other countries too the only thing to help drive the real cost of oil in the us is the value of the dollar. But most of it is speculative. This dam is about to break soon and the bulls are going to go running like the dickens. Keep buying into those futures though more of you that get slammed now less of you to pump it back up later. GREED
Posted by: Anonymous at June 19, 2008 11:54 AM
This particular commodity trading has moved from transparency to the shadows of unregulated, unbridled capitalism.
We simply have NO DATA on WHO is trading, in what volumes, and to what end.
That is not the "free market". It is fear based, greed driven specualtion be parties that create NO VALUE. Have NO USE for the commodity. Are UNINVOLVED in it's product. The system will naturally collapse as inappropriate, as it aims at economic gain, not human happiness. Perhaps within your life time.
Posted by: David Joy at June 27, 2008 08:12 AM
This is just a bubble in Oil trade when oil goes to $142 high. Its a cartel that is trying to get the money from peoples pocket, and then bring it back to $110 - $120 a barrel.
We forsee that Oil would be back to $120 within 2 weeks time.
Posted by: Sanjay Gadhesariya at June 28, 2008 05:58 AM
If the immediate problem is too much liquidity flowing into long positions, then isn't the ultimate problem too much liquidity period?
The speculators are doing their jobs, reacting to the differential between the asset and the cost of funds - - the latter's downward movement is the only new element in this equation.
Posted by: Pat T at June 30, 2008 12:28 PM
July 2, 2008
My only question is, what strategy can be established now to counter act the unnecessary spiraling cost of kWh electricity when it is discovered by unscrupulous business managers of today?s complex world?? See if we learned anything from the way gasoline prices spiraled out of control for no concise tangable excuse the last year?? There are plenty of unacceptable reasons and excuses for the predicament we suffer from today.
What is ?ethics?? Merriam-Webster Dictionary defines ethics as: ?the discipline dealing with what is good and bad and with moral duty and obligation?a set of moral principles or values?the principles of conduct governing an individual or a group?a guiding philosophy.? Ethics is the art of what should be done, as opposed to what can be done. The debate about the ethical practices of some business men deserves serious attention.
Ethics is doing the right thing for the right reasons every time.
Ethics violations will destroy both friend and foe.
Think about it.
Posted by: David High at July 2, 2008 07:24 PM
For people who want to see a good explanation of the basic economics of speculation, there is an excellent slide presentation by the International Energy Agency. It is sad that they had to begin by reminding even sophisticated audiences about elementary economics. However, the first few slide do it very well.
Posted by: Kevin at July 4, 2008 10:11 AM
The bottom line here with oil is pure greed!! Wall street is screwing us to death and our goverment is to dumb to even notice. The speculators and wall street screwed up housing and then screwed up the teck industry and believe me the speculators and wall street will screw millions of people out of their money like never before over this oil bullshit!! trust me when the smoke clears their will be lots of speculators and hedge fund companys and the Goldman Sacks of the world paying a huge price for what they have done to the american people and a few will probley do jail time. Bottom line their is no oil shortage its just a bunch of greedy Wall Street speculators making up every bullshit story in the world to drive prices up!!
Posted by: cory at July 13, 2008 09:59 AM
Dec. 28, 2008 . WTI $37.00 per barrel. The other shoe has fallen. The bubble has burst. It was pretty obvious when you lookesd at a chart of price vs. time, wasn't it?
Posted by: flippant at December 28, 2008 02:18 PM
Spot on flippant.
To quote from the Saudi Oil Minister in this article, " Financial markets have a logic and mechanism of their own. Such markets are influenced by ever-changing factors and parameters that transcend markets and boundaries and are often unregulated".
We now have the TARP bailout due to this very situation allowed to exist in our present financial markets, speculate, speculate, speculate! So what if we defy gravity in our financial dealings as long as we are making money, right! No one is watching us to tell us we can't! And the party jet isn't grounded! It is now fueled by the Federal Government thanks to the taxpayers of the United States! My Rebel blood is boiling!
Posted by: Stuart at January 1, 2009 03:02 PM