May 22, 2008
Several readers call our attention to testimony by Michael Masters, of Masters Capital Management, before the Senate Committee on Homeland Security and Governmental Affairs, on the role that speculation has played in recent commodity price movements. Here is what I think Masters is missing.
What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant....
In the popular press the explanation given most often for rising oil prices is the increased demand for oil from China. According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels.8 Over the same five-year period, Index Speculators demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!
One notices right away that one problem with trying to compare demand from index speculators with the demand from China is that the two concepts are measured in different units-- the Chinese demand is measured in barrels per year, whereas Masters' speculation-based number is measured in barrels, with no clear time interval associated with them. But a more fundamental reason you can't add the two numbers together to get total demand is that there is an underlying physical commodity to whose spot price instruments such as the NYMEX oil contract are ultimately tied. There are individuals who use this physical commodity-- namely, consumers who use the gasoline to drive their cars-- and separate entities that produce it-- most importantly today, the national oil companies of the oil-producing countries. The key question is, How would the behavior of these two parties change as a result of a new higher price for the basic commodity they are consuming or producing?
If your answer is, neither consumers nor producers change anything they do at all in response to the price increase, then I agree you could make a case that speculators by themselves could make that price any old number. But I don't believe it is accurate to assume that both consumers and producers would do exactly the same thing, no matter how high the price goes. At a higher price of gasoline, consumers will use less of the physical commodity. Not much less, I grant you, and that's why I agree that speculators are able to have more of an influence than I might have expected. But I would insist that if you drive the price of gasoline sufficiently high, consumers will respond.
And that's a problem for any "paper oil" theory-- if consumers are buying less of the physical commodity, what's happening on the production side? If production doesn't change, then oil must be piling up somewhere in inventory, possibly some just idling in tankers in the Persian Gulf. But no one has an incentive to keep adding more and more oil to inventory forever. So ultimately, the "paper oil" theory is going to require a reduction in the production of actual physical oil.
And that leads you to the question, Why would producers want to cut production? If the answer is, they make more profits with lower production and higher prices, then they would want to make those same production cutbacks with or without the speculation, and you'd have to blame the whole phenomenon on the operation of those profit calculations themselves, with the speculators just a device that got us to equilibrium between supply and demand more quickly.
Now, I personally do accept the view that the "paper oil" speculation has made a contribution in recent months to the increase in the price of physical oil. I believe that this speculation has resulted in a slight decrease in the quantity demanded that has required some modest supply reductions or accumulation of inventory by producers. But I expect that producers will find these changes not to be in their best interests as the demand adjustments become more prominent, at which point the price must return to that governed by the underlying physical fundamentals.
Ultimately, the price must be such that the quantity of physical oil demanded at that price is equal to the quantity of physical oil supplied. Any speculator who promises on paper to buy oil for more than the physical stuff is actually selling for will find themselves at that point with a big, fat paper loss.
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» BizLinks and Open Comments | 5.23.08 from Loren Steffy
Halliburton makes $3.4 billion bid for Expro Spending On Iraq Poorly Tracked Bad Oil Bets Haunt Speculators ($) -- James Hamilton offers his own perspective on Oil speculation Airlines ponder how far they can push customers as 9 Airlines... [Read More]
Tracked on May 23, 2008 06:26 AM
» Global Energy Forecast from At These Levels
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Tracked on May 23, 2008 09:51 AM
» If you think it's the "index speculators"... from Interfluidity
Michael Masters' testimony regarding the role of speculation in commodity prices has drawn a lot of comment since last week. [See, for example,[Read More]
Tracked on May 28, 2008 05:02 PM
But speculators do not buy on the spot market; they buy the futures contracts, which go out for years.
So, as Jeff Frankel suggests, an oil producer has the choice of "selling now" and pocketing the dollars, or "selling later" at the futures price. If that futures price is very high, and the interest rate on dollars is very low, then it might be rational to delay production until the future.
And thus, speculation on futures could push down current production. I admit I am not entirely clear how long such a mechanism might operate, and what exactly would happen when/if it unwound. But it does seem a possible answer to your question, "Why would producers want to cut production?"
Posted by: Nemo at May 22, 2008 08:32 PM
Posted by: MikeQ at May 22, 2008 09:25 PM
What about price caps/subsidies in emerging mkts? That does not allow for demand destruction to occur. If the underlying mkt isn't functioning properly, how could the derivative mkt possibly provide accurate information.
In addition, OPEC is a cartel, and therefore could care less about the basic laws of supply and demand.
Posted by: Anon at May 22, 2008 09:31 PM
People want to invest in something other than dollars, preferrably something with intrinsic value, possibly one of the two types of gold: gold or black gold.
The gold market is too small to absorb massive new investment. The black gold market is large and liquid (no pun intended.)
Make the dollar stronger and this problem goes away. Fat chance of that happening.
Posted by: Max at May 23, 2008 03:43 AM
Higher gasoline/oil prices reduce the flow quantity demanded of gasoline/oil. An increased expectation that gasoline/oil prices will continue to rise will lead to increased demand, a shift in the demand curve for gasoline/oil. Consumers of gasoline/oil will add to their stock inventories of gasoline/oil. Low interest rates and financial market returns make an investment in gasoline/oil inventories even more inviting. The demand curve for oil will shift again, a decrease in demand, with the expectation that gasoline/oil prices have stopped rising. Consumers of gasoline/oil will cash out their inventory investments, reducing their inventory stocks of gasoline/oil.
Posted by: TexFinEcon at May 23, 2008 04:16 AM
I am always amazed at how often normally intelligent people do not understand Henry Hazlitt's Economics in One Lesson. A futures contract is not on-sided; it has two sides, a buyer and a seller. If Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors are making stupid speculative investments they shoud be losing tons of money and those selling them the contracts must be rolling it in. Now I do recognize that this has happened especially with government investments, JDH has given us some good examples there in San Diego, but even at that the tranactions do not drive the market. They only make government tax us more to pay for their mistakes.
I challenge anyone to enter the futures market - just get into the stock options market - and try doing what is suggested. Oh, I do recommend you do not use any money you can't afford to lose.
Posted by: DickF at May 23, 2008 04:51 AM
"But I expect that producers will find these changes not to be in their best interests as the demand adjustments become more prominent, at which point the price must return to that governed by the underlying physical fundamentals."
The question of how, and especially when, this will occur is crucial in this context though; what worries me is that the speculation-induced "misalignment" could be long lasting.
Posted by: EuropeanEconomist at May 23, 2008 05:05 AM
Your analysis neglects the loophole that Masters makes in his presentation: that namely, the normal position limits imposed by the CTFC DO NOT APPLY to investment banks.
"The CFTC has granted Wall Street banks an exemption from speculative position limits when these banks hedge over-the-counter swaps transactions. This has effectively opened a loophole for unlimited speculation. When Index Speculators enter into commodity index swaps, which 85-90% of them do, they face no speculative position limits."
Combine this with the inherent leveraged nature of futures positions, and you're looking at serious inflows of speculative capital. We are talking about a situation where it is possible for large hedge funds to take multi-billion dollar positions and effectively corner the market.
Given the relatively poor performance of traditional equity markets, and the extremely short term performance mindset of hedge funds and the typical investor, I'm more than willing to say that speculation is driving oil prices higher than can be explained by a supply demand mismatch.
Posted by: dyson at May 23, 2008 05:18 AM
"Your analysis neglects the loophole that Masters makes in his presentation"
His analysis neglects it because it is irrelevant. Paper positions, no matter how large, need to be closed out or rolled forward each month. Large paper positions in deferred contracts could lift spot prices if producers were induced to hold supply off the market or if inventory was accumulated to deliver aginst them. In that case the forward price curve would be in contango. It is, in fact, in backwardation and has been through most of the price move. This indicates that physical supplies (particularly for mid-distillates) are tight.
Posted by: MG at May 23, 2008 05:56 AM
Anytime a businessman appears before congress pleading that "Government MUST BAN" something, I see a guy engaged in rent-seeking.
I doubt Masters is dumb enough to actually believe what he was saying to the committee.
As an aside, there is an often overlooked factor in the futures numbers. The contracts all expire on one day in a certain month, but in reality, oil is consumwed every day. So if you want to compare the scale of the futuires market to the physical market, you have to take the amount of open interest for every month and divide this by 30 to get an equivalent daily flow. It is common for analysts (especially the CFTC Position data) to lump together all tenors of open interest into one big number, so you could have 60 months (or more) of volume that often gets compared to a daily physical flow. This is why people are often wrong when they say the paper market is X times bigger than the physical.
Also, the amount of speculation money in commodity markets tends to affect the front end of the curve, the back end is always basically fundamentally driven.
Posted by: bartman at May 23, 2008 06:29 AM
MG, just read your post. Parts of the crude curve moved into contango in the last couple of days, but it's all over the place, and moving pretty fast.
And yes, the distillate market is super tight. European diesel and jet fuel prices are going crazy, and physically affecting prices on this side of the pond.
Posted by: bartman at May 23, 2008 06:36 AM
Masters gets one major factual issue wrong. He claims there are no gas lines, whihc is true for the US, but the rest of the world is having major shortages - see energyshortage.org
He also claims that putting a "buy and hold" in the futures market is a form of hoarding, but that is silly. For speculators, buying and holding still means selling the front month contracts in time for settlement and buying contracts further out, which provides more credit and liquidity to producers. Calling this "hoarding" is dishonest.
Posted by: Omri at May 23, 2008 06:59 AM
Omri...but those shortages are the effect of the subsidizing that occurs by governments...they regulate where the oil goes, it isn't distributed evenly. That is more the effect of logistics than lack of supply.
Posted by: MikeQ at May 23, 2008 07:08 AM
A U.S. Senate panel listened to testimony on May 20 that said financial speculation by institutional investors and hedge funds in the commodity markets are contributing to energy and food inflation.
"The regulatory environment is becoming so undesirable to foreign and domestic funds that they have no choice but to go offshore," said Kevin Kerr, president of Kerr Trading International and editor of MarketWatch's Global Resources Trader.
Speculative activity in commodity markets has grown "enormously" over the past several years, the Homeland Security and Governmental Affairs Committee said in a news release. It pointed out that in five years, from 2003 to 2008, investment in the index funds tied to commodities has grown by 20-fold -- to $260 billion from $13 billion.
The growth offers "justifiable concerns that speculative demand, divorced from the market realities, is driving food and energy price inflation and causing human suffering," HSGAC said.
"If Congress makes some laws that reign in speculation, it's possible that speculators will move out of the U.S. markets and into Dubai," said Phil Flynn, a vice president at Alaron Trading.
Posted by: Joe at May 23, 2008 07:09 AM
Uh, no. Those shortages are the result of utilities building oil-based generators that burn bunker fuel in the era of $20 oil, and who now can't afford to run those generators on $120 oil.
That's why you're seeing more blackouts than gas lines.
Posted by: Omri at May 23, 2008 07:10 AM
I have to agree with Bartman that Masters is engaging in rent-seeking. Could it be that the entry of index funds is adding too much inertia into the markets and that this is what is putting the bee in his bonnet?
Posted by: Omri at May 23, 2008 07:23 AM
What do you think of Yves Smith's idea of where some of the 'missing inventory' might be going?
"Thus if I were an OPEC member, I'd have every reason to foster the Peak Oil story, which undoubtedly is generally accurate, the question is how immediate. Second, I would not pump more if I could, or would make only token supply increases, Indeed, I'd be trying to restrict supply without looking like I was doing so, which makes the Iraq war and supply disruptions godsends."
Full link: http://www.nakedcapitalism.com/2008/05/international-energy-agency-to-try-to.html
Posted by: psummers at May 23, 2008 09:21 AM
Anon says, "OPEC is a cartel, and therefore could care less about the basic laws of supply and demand." Even if I agreed that OPEC is effectively functioning as a cartel (and I don't), I would still say you have this exactly wrong. If OPEC is a cartel, then it is the law of supply and cares most intimately about the character of demand. The supply decisions that OPEC deems to be in its own best interests are exactly and precisely what I am referring to when I talk about what is in the interests of producers. Either you can believe that the price is the one at which OPEC makes the most profits, or you can believe that the price is controlled by speculators. But if those are claimed to be two different numbers, you have to choose between your two stories.
Posted by: JDH at May 23, 2008 10:05 AM
PS: OPEC's pricing strategy has always revolved around one goal: maximizing the current price while disincentivizing future alternatives. If OPEC sells the (idiotic) Peak Oil story too strongly, then they induce too many alternatives and kill the future markets for their only product.
For example, if the US fleet MPG average increased to 35 MPG from 23, we'd reduce our daily consumption by about 5-8 million barrels/day, and a drop of that magnitude would knock at least $50 off the price of oil in a heartbeat.
The current pricing regime has been about OPEC learning to become comfortable with high prices, but that comfort might come back to bite them.
Posted by: bartman at May 23, 2008 10:10 AM
Nemo - One problem with your theory, if you look at oil futures out to 2012, they are about the same as the price today. Not a very high yielding investment.
Posted by: don at May 23, 2008 10:29 AM
Your characterization of OPEC's pricing policy may be accurate, but that wasn't really my point.
The big argument against speculative influences on the oil price is that if it's true, we should be seeing inventories accumulating somewhere, and we're not. Yves Smith's piece that I quoted from contains what I think is an intriguing way to explain this -- the Saudis are leaving more in the ground than they otherwise would.
I'm not saying I subscribe to that view. I know far less about the plausibility of that argument than many on this blog, not least our host! I brought it up because I hadn't heard that argument being made before.
Re your example about increasing mpg standards, fair enough. But surely it's not unreasonable to "speculate" that one could profit from high oil prices long before such a change in standards became expected??
Posted by: psummers at May 23, 2008 10:55 AM
OPEC's policy has always been a very precarious balancing act, horribly complicated by the fact that the future is uncertain :-)
There is another factor, rarely talked about, why certain Gulf states (but perhaps not Saudi) have no incentive to produce more: they have too much revenue per capita, and no place to invest it. Leaving it in the ground may be the best investment. The ability of the Gulf states to absorb more domestic investment is about nil - they're simply building as fast as they can as it is; and given that most global investment vehicles are either off limits (Dubai Ports World fiasco, etc.), too expensive (in weak US$) or yielding nearly nothing (US T-Bills), what are they to do with their revenues?
Posted by: bartman at May 23, 2008 11:35 AM
I've said this before, to seemingly deaf ears:
In a world very close to a capacity constraint in production, the marginal barrel of oil is priced at the cost of finding, developing and lifting new oil.
The producer price index of capital inputs for oil exploration, development and production companies has accelerated at basically the same rate as oil. (Actually, it ran ahead of oil for most of 06-07: the oil price ramp since Sept 07 has been due to oil catching back up to this index.) So, currently, the marginal barrel is basically priced on fundamentals. The producer price indices are jumping up in great leaps and bounds every month.
It is my belief that in the next couple of years we will see a reserve margin build up in industries like steel and copper and cement. This will be followed by a softening of the PPI's for capital inputs, and we'll probably then see a softening of oil prices as the marginal new barrel gets a bit cheaper to produce. Also, the engineering firms are all operating at capacity, but are furiously training up new staff, so we might see a bit of a skilled labor glut in a year or two, which will also help oil prices moderate.
Posted by: bartman at May 23, 2008 11:45 AM
You guys are still thinking "EQUILIBRIUM."
No one makes real money under equilibrium conditions - except the lowest cost producers.
What this looks like (and I'm not an oil trader) is an underdampened control input.
Consider the case of your steering wheel. Your front wheels normally have "toe-in" - a bit of pigeon-toedness to keep the car going straight ahead without the driver working too hard.
Imagine your car's front end is out of alignment and the front wheels are dead ahead and parallel. You make a little cut to on side or one wheel hits a bump and the car swerves in an oversteer condition and you have to cut back to keep on track.
For the oil markets, a small shift in supply/demand, regulatory requirements, or need for security holdings of oil attracts "mad money" that overshoots the equilibrium.
I think there is a lot to peak oil and suspect that every producer is pumping near flat-out while demand continues to grow. OPEC is not in control. Prices will rise to produce demand destruction SOMETIME in the FUTURE. But we're in a disequilibrium state at the moment and underdampened.
Posted by: Joseph Somsel at May 23, 2008 11:54 AM
What number are people looking at and saying that it indicates speculation? If the price is $130 and people are paying it, then the price is right. If you call that price "high," then you are simply unnecessarily characterizing it. The price is the price.
Since when has OPEC kept prices "high?" Through the 90's the price was going down down down.
JDH omits the political view of the situation. People are very sensitive about the price of oil right now. What producer would risk the political fallout of squeezing consumers by deliberately lowering production? Not many, I suspect. Perhaps they will do this when people have adjusted to the seller's market a few years from now, but they would be crazy to risk the censure, or invasion! by holding back production.
Posted by: vorpal at May 23, 2008 12:12 PM
Vorpal, in the 90s OPEC had a target range of $22-$28, but it had a hard time getting price there because a lot of extra capacity came onstream in the 80s after the second oil shock, and you had recessions in the West in the first half of the decade, and in the East in the second half.
In the brief period between these recessions, OPEC was able to manage the price on the upside to stay in their target.
Posted by: bartman at May 23, 2008 01:17 PM
Take my options challenge. You will have just as much luck controlling the price of stock options as OPEC has controlling world oil prices.
Vorpal is exactly right. The price is the price. If you don't like it don't pay it. That is how you lower the price. As long as people are buying oil at $130/bbl oil will sell for $130.
Posted by: DickF at May 23, 2008 01:55 PM
Maybe my writing is not clear, but I never disputed that "the price is the price". I am arguing against the "speculator" hypothesis. I am a market fundamentalist who is always annoying the traders and managers where I work by scratching out a supply and demand diagram and talking about marginal utility of consumption and marginal cost of production whenever they ask me about oil prices.
However, under standard oligopoly theory, it is clear that at certain sets of conditions, OPEC can manipulate or massage or nudge (as opposed to "control") the market price. The same is true of any industry with a single large player and a fringe. I'm pretty sure that OPEC is choosing to not try and manage prices right now. They trying to discover the shape of the demand curve.
Posted by: bartman at May 23, 2008 02:31 PM
Do you guys think that there is excess supply left in the supply curve? (At least short term?) OPEC can only "manage prices" when all the producers are flat out by further cuts in production.
Other than Venezula's loger term self-inflicted reductions (not short term reversible), who has extra to sell?
Posted by: Joseph Somsel at May 23, 2008 03:10 PM
Will oil prices and energy stocks continue to go up? Steve Peasley talks about this in his podcast noting that although oil prices are going up, energy stocks aren't. http://investtalk.hitfastforward.com/?p=59
Posted by: Ruth at May 23, 2008 03:43 PM
After reviewing some of the comments, especially those of Bartman on costs, I need to amend what I wrote yesterday.
I had said that a long paper position would not affect the spot price unless the forward curve shifted into contango encouraging suppliers to defer output and/or accumulate inventories. This was incorrect.
If extraction costs are expected to decline (Bartman) it is possible for deferral of output to increase net cash flows even if the forward curve is in backwardation. Speculative longs encourage this by causing the curve to be flatter (less backwardated) than it otherwise would be. Low or negative real interest rates also encourage this behavior. This raises the spot price.
Of course, by shifting the price curve up, speculative longs also improve cash flows of supplier/hedgers resulting in more production eventually. They sow the seeds of their own eventual losses.
Thank you all for enlightening me.
Posted by: MG at May 24, 2008 06:17 AM
Nemo - One problem with your theory, if you look at oil futures out to 2012, they are about the same as the price today. Not a very high yielding investment.
How much will dollars yield between now and 2012? See also Bartman/MG on production costs.
If you call that price "high," then you are simply unnecessarily characterizing it. The price is the price.
Let me guess: You bought a house in the summer of 2005?
Of course speculation can drive prices away from intrinsic value for a very long time, at least in some markets. The questions are (a) whether oil is such a market, and (b) whether speculation is in fact responsible for the current runaway prices. Or: (a) Is it possible? And (b) Is it happening?
The answer to (a) appears to be "yes", for reasons described on this thread. Although lots of reasonably smart people are arguing "no" because "the price is the price", speculators cannot affect the spot price for very long, etc. I think the "yes" side has a better case.
The answer to (b) is, in my view, very hard to say... Because the evidence, as I understand it, is insufficient. That said, nothing naturally doubles in price in one year, with no major supply or demand shocks, unless the supply or demand (or both) are extremely inelastic. If "Peak Oil" is here, then the supply is truly inelastic, since everybody is already producing as much as they can.
But the parabolic price rise over the past year sure has the shape of every other speculative bubble in history. Add in Masters's testimony, and this becomes my best guess for what is happening now.
To DickF -- I am not planning to trade based on any of this, partly because I am not sure, but mostly because "the market can remain irrational longer than you can remain solvent". I am not sure what mechanism will ultimately force it to unwind, but in general, speculative bubbles can last longer and go higher than anybody expects. I would rather be kicked in the groin than touch oil futures right now, whether long or short.
Posted by: Nemo at May 24, 2008 07:11 AM
masters just ignores the fact that there are those speculating in a price decline as well. for every long there is a short. unless people can show a dramatic drop in the short positions of the speculators then they need to lay off of the speculator blame game.
Posted by: oops at May 24, 2008 09:05 AM
Did you read the testimony? Masters's entire point is that the institutional money is long-only.
Posted by: Nemo at May 24, 2008 11:18 AM
im not an economist but have u considered that china and india dont buy most of their oil from the market rather they secure supplies through contracts with countries like sudan,burma,angola. so basically alot of the oil that china is buying is not available to the market and hence cheaper than whats on the market. i dont know the relationship but it makes sense why china is looking for oil in the most obscure african countries.
Posted by: Louis at May 25, 2008 12:48 AM
Care to fill us in on how institutional buyers are long-only? As you saying there are enough stupid individuals who will go short to support the institutions? Are you one of those?
Posted by: DickF at May 27, 2008 04:51 AM
im not an economist but have u considered that china and india dont buy most of their oil from the market rather they secure supplies through contracts with countries like sudan,burma,angola.
You are right, you are not an economist but you can learn. The market for any good or service is not what is sold openly it also includes private sales. To help you see this consider that you buy half of the apples at a local farmer's market each weekend. Another supplier approaches you are agrees to sell you half of your need at a fixed price lower than the farmer's market price. The next weekend you only buy 25% from the farmer's market. What economic effect do you expect? Hopefully from this you can see that even private sales effect the market.
Posted by: DickF at May 27, 2008 05:03 AM
Care to fill us in on how institutional buyers are long-only?
As I said, read Masters's testimony. This is pretty much his entire point. If you missed it, try reading it again.
As you saying there are enough stupid individuals who will go short to support the institutions?
Of course there is never a buyer without a seller. But this is true for any market; for example, every house bought in the past few years was being sold by somebody. But this trivial observation is irrelevant to the question of whether a "bubble" exists.
Are you one of those?
As I said, no.
Do you ever read anything, or is the Internet a write-only medium for you?
Posted by: Nemo at May 27, 2008 08:02 PM
Okay Nemo, I went back and read it again. Never does Master's address who it is selling the contracts to the institutions. If the institutions are making profits someone must be facing losses. He comes close when he equates futures buying with hoarding, but this is a ridiculous comparison. Hoarding takes a commodity away from the market. Futures contracts expire and no futures contract removes the commodity from the marketplace.
I have said it before bad assumptions make bad analysis. Masters seems to be totally ignorant of monetary policy. Commodities are in a "bubble" because our monetary authorities have been generating inflation. Many miss the impact of inflation because they do not realize that it is something that changes over a long time frame. We have been inflating now for almost 10 years.
We are going to face growing inflation for years to come until we have a very severe recession, but such a recession is totally unnecessary. If the monetary authorities would simply hold the value of the currency stable and allow the market to work the inflation would slowly work out of the system, but with a fiat currency there is no incentive. It is almost impossible for politicians like the FED governors to make the hard decisions of dealing with inflation, not to mention their lack of understanding.
Many institutional investors are successful because they do understand monetary policy and markets. They understand that commodity prices do react to inflation and they are investing in commodities because they know that is where inflation will be manifest.
Finally, rather than suggesting we curb inflation and open markets Masters suggests Fascist central planning. It is the typical recommendation of one whose economics is only central planning. He simply does not understand that central planning brought the failure known as the Great Depression. One serious concern is that the next Great Depression may not have any economists who understand market economics and as things get worse all power will be given to the great central planner to make the "trains run on time."
Posted by: DickF at May 28, 2008 02:38 PM
First, thank you for your civil response to my hostile post. I really need to learn never to write anything before my morning coffee.
Futures contracts expire and no futures contract removes the commodity from the marketplace.
If the futures price is high enough, a rational producer will curtail production today. In this way, I believe an "unnaturally high" futures price can become a self-fulfilling prophecy, at least for a while.
I am trying to imagine what would happen, exactly, if the "institutional money" were always long the distant futures contract, rolling as they reach expiration. (Imagine so much money deployed in this fashion that the counter-balancing short sellers are simply overwhelmed.) It seems to me that this could keep spot prices elevated for an extended period of time, and the cost to the long-only funds would be merely the prevailing rate of interest in the steady state.
I am not saying this is happening -- although the behavior of oil prices over the past year, never mind the past four months, sure looks crazy. So I am just starting to believe it is possible.
For what it is worth, I share your skepticism about central planning and central banks. I have always been a libertarian (small "l") at heart. But I am also starting to wonder if the severe disparities in global wealth are not morphing into a "hoarding" of necessities from the poor by the wealthy, though the machinery of hedge funds and commodity futures...
Posted by: Nemo at May 28, 2008 08:23 PM
I did not at all feel your post was hostile. I am often strong in my posts because I feel I am doing battle against a very numerous foe in the central planners and they hold the power in government and academia.
I am not sure why a rational producer would curtail production if the futures price is high. It would be just the opposite. Higher futures prices would shift producers into producing the product. Just notice the shift in corn production for example.
If instutional investors continue to roll their contracts forward they would actually lose based on commission and the differential between the price and the futures premium. Work with stock options for a while and you can understand. You simply cannot over-price a product unless you have a buyer willing to take a huge loss and when you are talking the big bucks of institutions you are talking guys who have been around.
The institutional investors do not expect to lose any money on their investments. They expect inflation to push commodities higher and higher. The loser in this situation is actually the little guy who is mostly in dollars. The owners of hard assets like commodities gains what inflation eats away from those who hole US$.
Once again we should not be attacking the institutional investors who are doing their jobs. We should be insisting the government central planners both in our monetary institutions and fiscal institutions stop tinkering with the markets. We need a turn the policy wonks toward sanity. Bad central planning policy is at the heart of the problem.
Posted by: DickF at May 29, 2008 06:08 AM
The price also won't lesson, as we try to find new sources for digging oil, the price those processes need to gain profit need the high oil prices or they are operating in the hole. The process to get the oil out of the ground is also becoming more expensive as nearly all the oil fields are depleted of natural pressure.
Posted by: joe at May 29, 2008 12:35 PM
So the CFTC probe is going to be pretty much useless ?
Posted by: Anonymous at May 29, 2008 06:57 PM
- OPEC's ability to manage price ended more than two decades ago. Please read the history, quite a bit of which can be had at the Oxford Institute for Energy Studies.
- A formula structure of benchmarks and references came into being as did exchange based futures contracts, Nymex in '83 and the IPE in either '86 or '87 (this latter acquired by global electronic trading platform, ICE, in 2001).
- Declining production of benchmark crudes, and associated narrowing of their physical trade, pushed price formation more and more into the strictly financial, both exchange traded and OTC. It is an error to persist in beliefs that price is a beacon for physical supply/storage/demand when it has been progressively financialized and more dependent on asymmetries within/between representations of the physical of which, in '05, only 5% made delivery.
- Per Alan Heap, who likely knows a bit more about commodities trade that this board, long only funds had become noticeable no later than early 2004. These funds are able to circumvent normal position limits as they operate through the mediation of swaps dealers. This has been covered in some detail elsewhere. What has been lacking is much grasp of hedge fund and fund of funds commodity derivative positions, more than a notional $8 trillion in 2006. (Veneroso to World Bank)
- It strikes me as patently absurd to imagine the price moves we've seen as representative of world real economy conditions. Well, perhaps not absurd but favoring become-commonplace rather than actual research.
Posted by: juan at May 29, 2008 10:25 PM
Juan says, "It strikes me as patently absurd to imagine the price moves we've seen as representative of world real economy conditions." What supply and demand elasticities are you assuming describe world real economy conditions, and how low a value do you regard as "patently absurd?" If the price is currently such that the physical quantity supplied is greater than the physical quantity demanded, by how much is it greater, and where is the surplus going?
Posted by: JDH at May 30, 2008 06:26 AM
I would like to take the moment to say my use of 'patently absurd' was, first, very impolite and secondly, an implication that I know exactly what price curves the various physical oils would have followed within a price regime that does not exist but can only be assumed.
As I believe you touch upon in your recent paper, production management decisions may well have resulted in greater-than-otherwise supply (in)elasticities. Simultaneously, products demand side inelasticities have, I believe, been greater due to both direct and indirect subsidies, which are coming under pressure.
Perhaps it is correct to think of house-as-asset price inflation and the ability to monetize this as having provided a multi-year indirect subsidy to many within the largest consuming nation? (Related; relatively inefficient car fleet may provoke greater behavioral changes than expected).
If the above paragraph is correct, some portion of the 2002-08 rise in prices has no doubt been rational. I would be interested in the terms of government to government contracts; private sector long-term contracts, and transfer pricing. Not that these are perfectly divorced from the present "market-related" price regime but degrees of contradiction.
Posted by: Juan at June 2, 2008 05:20 PM
I appreciated reading the article and comments. I am concerned about ALL of this. We are looking for legistlation to correct what is common sense and right. We are just now settling the "housing crisis" which by all factors was a form of speculation by all parties. We are just now finding out the details of the extent. We cannot allow this sort of speculation to continue. The cost to the world is too high. I am generally not for additional government but one way to solve this is to make the speculators pay up front. Buy the TOTAL cost of the gas now and they can hope for the best. I liked the analogy of pharmaceuticals. Buy an entire supply of a good needed drug and see what happens. Need I say more.
Posted by: Dan at June 4, 2008 08:40 AM
If there is speculation going on, the solution is simple enough to me. End investor to investor transactions. At least one side of every transaction needs to be either a producer or a consumer.
This should provide enough liquidity for the market to be efficient so companies don't need to horde crude and also put a pin to the bubble. And no I don't give a damn if somoeone loses money in their investment portfolio.
Posted by: DaveNate at June 17, 2008 12:48 PM
The more GREED we see in this country, the more government regulation we end up needing. Just look at the bank scandle under Reagan and Sr Bush. The speculation of oil and the mortgage fiasco now is a perfect example of the problems caused by this crazy dream of "easy money" in the so-called "free market" of commodity trading. So many "investors" and get-rich-schemes and not enough hard-working Americans making money the old-fashioned way (ie hard work), if you ask me. Why dont these "organizations" that invest in mortgage backed securities and now commodities, as well as all the banks, Enrons execs and other yo-yo's go back to school and get real jobs that require real work and build something that adds value, rather than moving money around on a computer screen.
If you ask me the problem is that all the people that had over-invested in realestate began to shift their dollars into commodities, in a panic for returns on investment.
The relationship of the current price of gas and oil is this: Everyone in the food chain, except the consumer, makes a profit when oil goes up....OPEC, producers, refiners, sellers, etc. Period. The wild card is demand. That isnt going away and increasing, but can slow, and will as oil increases in price. As soon as that levels off (as its seems to have), there is no place for investors to run to for returns, so they will sell to make their money. As they do, refiners will ease back buying oil again, and supply increases, and prices go down and consumers return. But guess what....because investors "have" in contrcats, 70% of the world's oil on paper, they now control the price folks. Refiners may be in control of how oil is supplied, and producers how much is pumped out of teh ground and delivered, as long as people HAVE to buy oil to survive in this world, the price will be high from here on.....UNTIL, some regulation steps in and shuts off the speculation valve, and move the buy/sell back to the refiners and oil companies. Thats what the Saudi's are trying to tell Bush's cronies, but his Energy Sect cant seem to figure that out.
Posted by: Stormy at June 21, 2008 10:22 PM
June 26, 2008
I fear untill we change the laws of disclosure for all polictians with their investments in stock trades and commodity positions we will never expierence what is good for the people ever take presencance over their profitable interest with the Oil Speculation.
They may appear with sessions such as the sub committee on Oil Speculation by the House with what government be done to break the bubble and allow the costs of gasoline to come down, where in truth due to their silent involvement in the Oil Speculations their voting will reflect the greed.
Coruption is braking the back of the American and our entrusted elected offical do not care.
How much are they making? What is Bush making on the Oil Speculation with Commodities?
Both parties are criminal and our law allows them the to hide their crimes upon the people.
Posted by: Time Factor at June 26, 2008 01:45 PM
You guys have your heads so deep in the finacial woods that you cannot see the big picture.
1. Big Investment funds and pensions get worked by real estate/mortgage meltdown.
2. Big Investment funds and pensions go to futures.
3. Guy coughs in Libya and oil the price jumps.
4. Middle class get F'd
Posted by: LastPostEver at June 27, 2008 07:57 PM
This was a great series of posts. I learned alot and it answered many of my questions about what is happening. I'm not a trader but I have brain and I am paying $4 for gas would like to know why.
After reading all this, from a completely "middle class" non-financial logic point of view, it looks like this:
1. There seems to be no fundamental reason for oil spiking in price: i.e. Israel hasn't nuked Iran, etc. Saudi oil fields aren't burning; China doesn't need to double production to cover for the Olympics, etc. The spike has to be due to non-fundamental sources.
2. If I had a bunch of oil in the ground and was used to selling it at a nicely increasing (inflationary rate) price, but suddenly the price increased 40%, I would be producing whatever I could and selling it during this high point! I wouldn't be waiting for it to go even higher. Surely the oil-producing countries have been at this awhile and they know how the game works. They can smell a bubble when they see it.
3. You would think large funds, after getting their butts kicked in the real estate market, would be more cautious about jumping into something else that could bust also but, there are major underlying differences in the real estate bubble that don't exist in the oil market. I HAVE to drive my car, I don't HAVE to sell my house or buy a new one. Only a very small percentage of the real estate market is in the "have-to" situation. This is the major difference. There really is nothing other than Armageddon that will limit the current levels of oil consumption. If I stop driving to the park on the weekends, that's just not going to have a significant enough percentage impact in the market.
4. If an oil company or an airline needs to lock in pricing for oil or fuel for the next year, they go to the Futures market and buy their contracts. But what happens if they think we are in a bubble? They hedge it also to limit the impact in case the bubble bursts before they take delivery. Could this could also explain why the amount of trades are up? The real traders who actually take delivery have hedged themselves?
I like the idea of having a limit to how many players can be in the market that do not produce or consume oil. But there is also a need for some liquidity which speculative investors bring to the table. What is the magic formula? I don't think it's 75%. If only 5% of contracts actually made delivery in '05, then this issue has been going on quite awhile.
Thanks for the education...
Posted by: Uursamajor at July 1, 2008 07:49 AM
USE LEGISLATION TO PREVENT OIL COMPANIES AND PRODUCERS AND YOUR AVERAGE PUNTER SPECULATING
To prevent the continued speculation on oil prices leading to a world wide recession legislation be put in place to make speculating on increasing oil prices decidedly unpalatable. This legislation need not be permanent but could stay in place until we have alternatives to oil and reductions in our use of oil fully sorted. It would not only need to be put in place in The US but in as many countries as the US can convince to join them in doing so. Given every ones concern over the matter this sounds easy. The problem is that the oil companies and their subsidaries all contribute to so many political parties campaign funds. So in order for it to work, it will need to be acknowledged that this is the case and legislation needs to be put in place concurrently stating that the public purse will make up for any differences in funds received from the oil companies and their subsidiaries in the next election compared to those received in the last. This would prevent politicians putting their natural concern for the financial welfare of their party above that of the need to stop this speculation as soon as they can.
1. That only hedging with an underlying position in mind would be allowed by law. That any other use of the futures market for pure speculation be temporarily forbidden with both financial penalities and criminal penalities attached to it.
2. That directors of any financial institution involved in speculation be held accountable by way of receiving a $100,000 fine and one year of week end community service.
3. That any trader involved in the same be afforded the same fines and penalities.
4. That any gains made by any citizen or company through speculation on the price of oil be subject to a 100% tax on the gain plus a 300% penalty fee on the gain.
5. That each citizen or company be made liable for not only direct speculation made by them but for any gains made on their behalf as share holder or unit truster holder in a mutual trust, hedge or superannuation fund.
6. That the names of those caught speculating in oil be published in the various newspapers in large print for all to see for a period of seven days after they are determined to have done so.
7. Claiming that one's gain was inadvertent will not be a defense unless it can be shown that a citizen undertook to determine that they were not gaining from speculation and had duplicitous representations made to them that they relied upon. The duplicitous representations need to be in writing and from an officer of the financial institution involved - not just a receptionist who works there for example.
8.That they be put on notice that the deals on the market will be audited and as much as is practicable will be traced back to their beneficial owners. They need not think that it is unlikely that their gains from any ongoing speculation will go unnoticed.
The announcement of these measures as forthcoming would have an immediate, desired effect on the market in oil futures. Unlike the "Tech" bubble which had a lot of perhaps foolish, misguided or greedy people losing money this bubble is now starting to effect all of us and before any serious damage is done it needs to stop.
The main speculators are of course the owners of the oil and the oil companies. They are speculating through off shore vehicles through money held in Monaco and other tax havens. The money there is then put into mutual funds and hedge funds which in turn invest it in further mutual and hedge funds. This can make a large money trail but following the money trail of only a few trades meticulously back to off shore funds that we have no control of will still help. Legislation can be put in place to say that these funds are to be black listed if they refuse to say who they have invested on behalf. Any citizen or company investing with these funds will then have to pay a considerable fine if they do so. Any bank dealing with the funds will also have to pay huge fines if they continue to do so after the cut off date for co-operation ends.
To stop speculation by the oil owners and oil companies legislation would need to be introduced to make it the responsibility of the futures market to have the paperwork for the underlying in any trade in oil within 72 hours of that trade taking place. If it is not received then the broker who has handled the trade will become responsible for any cost in closing out the trade if it is in the negative and the broker will pay a tax of 100% on any gain on the trade plus a penalty of 200% for having dealt without having the appropriate paperwork to hand.
Keep in mind that if you fail in this, there will be a huge world recession and these same gentlemen who are behind this speculation, albeit helped by some members of the general public, will then be able to scoop up assets around the world at bargain basement prices with their ill gotten gains.
Posted by: kate stuart at July 2, 2008 03:49 AM
Let's get down to the basics that even I can understand. If the price of oil is due to the middle east countries, let's trade them a bushel of wheat for a barrel of oil. If it is due to speculation, let's enact a law the you cannot buy oil or its futures unless you are an oil company. If the price of gasoline is due to our own companies, the consumer will take care of them thru boycotting one or more producers.
Posted by: Larry Littlejohn at July 11, 2008 08:08 AM
So an overly inflated commodity has been created by speculation. Investors buy long term contracts and sell them in the short term for gains. This market falsely inflates prices due to implied demand that the investors create themselves in an under managed market.
Then the same investors buy the same commodity back on another long term contract and sell it short. More profits.
Now, the rest of the economy still consumes this commodity, a somewhat inelastic one, and suffers the pains of these falsely inflated prices.
Then one day the bottom drops out and the real supply and the real demand must be used to price the market.
Now am I talking about housing and the mortgage crisis or about energy and the oil crisis?
The big investors are flipping commodities at the expense of those who reside on the true demand curve. Maybe they learned a trick since the mortgage collapse, but do they care? No, the government will step in and fix it on the back end with a "subsidy" to bale out those holding the bag while all the profiteers move on to the next market to plunder.
Posted by: RichardM at August 4, 2008 10:58 AM