June 25, 2008
How big a contribution could oil speculation be making?
A key reason why oil prices have been going up is that Asia and the oil producing countries are consuming more while global oil production has stagnated. That means Europe and America had to consume less, and a very high price proved necessary to accomplish that.
I do believe that speculation has been another factor that contributed to recent high oil prices. However, a key element of the bubble story is that there needs to be a very limited response of quantity demanded to the price increases, which the most recent data persuade me is no longer the case. Some of the estimates I've been hearing of the size of the contribution speculation is currently making to the price are therefore difficult to defend. Here I explain why, essentially elaborating on Paul Krugman's theme.
Senator Barack Obama's (D-IL) recent proposal to "crack down on excessive energy speculation" collects some of the claims recently being made on this issue:
Akira Yanagisawa, Senior Economist at Japan's Energy Data and Modeling Center: "In the most recent terms (the third and fourth quarter in 2007), the fundamental prices [of oil] are estimated around 50 to 60 dollars. On the other hand, it is estimated the premium has risen up to around 40 dollars at maximum." [Institute of Energy Economics, 3/08, p. 13]...
Larry Chorn, Chief Economist of Platts: "says the actual costs incurred in producing the most expensive oil is only around $70 or $80 a barrel, meaning that about $50 of the current price represents 'the market's risk premium plus speculation.'" [ BusinessWeek, 5/13/08]...
J. Stephen Simon, Executive Vice President, Exxon-Mobil: the price of oil should be $50 to $55 per barrel based on supply and demand fundamentals. [House Testimony, 4/1/08].
John Hofmeister, President, Shell Oil Co: The proper range of crude oil is "somewhere between $35 and $65 a barrel." [Financial Post, 5/22/08].
The average price of West Texas Intermediate during 2007 was $72/barrel. If you compare that with the numbers that these authorities are suggesting the price of oil should be, they appear to be claiming that, based on fundamentals, the price of oil should have fallen rather than risen in 2008.
If anyone claims that the price of oil today should be no higher than it was last year, then I think it's reasonable to ask them also to provide us with the following detail underlying their assertion-- If oil were selling today for the same price as last year, what would be the quantity demanded?
Here I offer some calculations to illustrate why I think it's necessary to ask this question. I'll use data for the first quarter of this year, because that's the most reliable currently available. U.S. real GDP was 2.5% higher in 2008:Q1 than in 2007:Q1. With an income elasticity of 0.5, I would therefore have anticipated something like a 1.25% increase in quantity demanded if the price had stayed where it was. The U.S. consumed 20.8 million barrels/day of crude oil and petroleum products in 2007:Q1, so with constant prices I would have expected consumption in excess of 21 mb/d for 2008:Q1. In fact, we consumed not 21 mb/d in the first quarter of this year but instead 19.9 mb/d. That 1.1 mb/d net drop in quantity demanded relative to baseline growth is surely related to the fact that the price of oil did not remain at its value of the previous year, but instead averaged $98/barrel during the first quarter of this year, 36% above the average value during 2007, consistent with a short-run price elasticity of
If the price had stayed the same, the quantity demanded would have been significantly higher than what we observed. That invites the follow-up question-- Where is the physical product to satisfy this extra demand supposed to have come from?
If oil producers had been selling us 21 mb/d but we were only consuming 19.9 mb/d, that would imply that in excess of 1 mb/d would have been added to inventory during the first quarter. An extra million barrels going into inventory each day would have increased inventories by 90 million barrels by the end of March 2008. But EIA estimates that U.S. stocks of crude oil and petroleum products in March were 1,653 million barrels at the end of March 2008, compared with 1,662 at the end of December 2007 or 1,677 at the end of March 2007. Inventories did not increase, they fell, over this period.
We were only able to buy 19.9 mb/d in the first quarter when we offered a price near $100. So why would it have been possible to secure the 21 mb/d that consumers would likely have wanted at a price of $72?
Given these data, I think it is impossible to argue that the volume of futures market purchases alone could be the reason why oil prices went up this year. A key and necessary element of any speculation-based interpretation must be some explanation for the factors governing the physical quantity of oil being supplied to the market.
We're hearing from a number of experts asserting that there's no reason why the oil price should have gone up. I wish one of them would tell me where an extra million barrels per day in supply is supposed to come from.
Posted by James Hamilton at June 25, 2008 06:33 AMdigg this | reddit
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Tracked on June 26, 2008 03:11 PM
As it appears quite likely that some sort of governmental action will be forthcoming to "crack down on excessive energy speculation", would the proposals just be ineffective or actually make things worse?
Posted by: GWG at June 25, 2008 07:46 AM
Accepting the argument that speculation has a limited impact on prices over time, there are still things that speculation probably does that we'd rather not have. The notion is that speculation helps price adjustment take place, so that markets clear more quickly. However, that also seems likely to mean greater overshoot. That will contribute to price volatility. Even on the way to a market clearing price, speculation seems likely to cause short-term volatility. I don't claim to know whether oil prices have overshot their market clearing level, but we certainty do have short-term volatility right now.
Assuming these points are correct (anybody?), the next question is whether the cost is worth the benefit of booster-assisted price adjustment. We should also ask ourselves about market structure. Does the current state of regulation, transparency, concentration and the like seem optimal? Do things as they now stand foster overshoot and volatility, and could we arrange things so that the market clearing benefits of speculation are still there, but with less volatility and overshoot>
Posted by: kharris at June 25, 2008 08:02 AM
You analysis is, no doubt, correct. But blaming speculators is so much more fun for politicians and oil sheiks than blaming the law of supply and demand.
To me the key question is whether the Sauds can pump more oil or not? If they can't, then any growth in production will be slow and prices will stay high.
Posted by: Fat Man at June 25, 2008 08:36 AM
Thank you Jim Hamilton.
There is a lot of crazy talk out there about speculation. Unfortunately that crazy talk might have teeth. We need more experts like yourself and PK explaining to the masses (and to certain senators and presidential candidates) what is really going on.
I think economists call it scarcity.
Posted by: Michael Roberts at June 25, 2008 08:40 AM
As I read the quotes from other sources you highlight, they all appear to be talking about 'fundamentals' supporting $50ish to 70ish dollars per. One even explicitly says that estimate is pre-speculation and risk premia. Your analysis begins from actual observed prices- i.e. those not decomposed into 'fundamentals' , 'risk' and 'speculation.' So in some sense, is your analysis consistent with theirs? I guess I'm failing to see the direct refutation of the 'there's a speculation problem here which we might want to deal with' line of thought?
You well make the point that there is an important role for higher prices to rebalance the distribution of supplies/ consumption globally. But isn't their question whether the entirety of this price driven rebalancing is based on the so-called 'fundamentals' of supply capacity as opposed to there being 'something else' going on as well?
Posted by: tegwar at June 25, 2008 09:17 AM
I am amazed that I agree with Paul Krugman and even more amazed that he disagrees with the Democrat presidential candidate. I think his political bias is slipping.
There was an interesting discussion on the Lehrer News Hour where both participants accurately placed current oil prices squarely at the feet of the FED. They did say that there was some slight foolish specualtion that was pushing up the price but it was not being done professional investors but by Union funds and other funds making foolish investments. One of them made the point that the investors would be surprised if they knew they were actually speculator taking a great risk in their investment.
Here is an excerpt from a paper by Robert Murphy from the Institute for Energy Research that gives a good analysis of why specualtion is not a problem. http://www.instituteforenergyresearch.org/wp-content/uploads/2008/06/oil_speculators.pdf
Record-high oil prices demand a target, and some politicians are increasingly pointing the
finger at speculators in the commodities futures markets. But high oil prices are due to
restricted supply, booming demand, and a weakening dollar.
There is no hard evidence that speculators are responsible for high oil prices. If the price
of oil truly were above the level that the fundamentals could support, we would see
growing inventories of crude. But inventory levels show no such pattern.
Speculators provide a vital function. By buying when prices are low and selling when
prices are high, they actually make oil prices less volatile. [My emphasis. Many miss this totally] Large investment funds
provide liquidity to the commodities futures markets, and allow producers and consumers
to concentrate on their core businesses.
Government restrictions on investment in the oil futures market will only hurt consumers
by making the oil market less efficient. New regulations will do nothing to ease oil prices
in the long term.
Posted by: DickF at June 25, 2008 09:20 AM
I find the latest phantom menace, the oil speculators, as another diversionary political tactic to avoid facing the reality of supply (much controlled) and demand (uncontrolled) and once called an oil addiction.
Cost to get the oil varies widely from US hard to get-high tech production to some easy to collect foreign production. Cost, you say is $70/bbl. Cost has no role in the setting of price. The term risk premium applied to the profit margin, market price less cost, does not fit.
If I control vast oil resources and collaborate on keeping the supply level favorable for a high profit margin, say market $140/bbl less cost $40/bbl, I will charge whatever the market will bear.
The market in the long term has nothing to do with the short term swings and moods of speculators. It has everything to do with the fundamentals which include too little response to price and little control on the consumer demand side. On the other hand, if I, a corporate producer, acquired oil production in the Gulf in 2005 based on the economics at $40/bbl, I would have the good fortune to make the huge margins that the foreign suppliers are controlling. Buy oil stocks!
I will next look for the story in the news which reported significant reductions in miles driven by US drivers. That is our only escape from spending off our future by filling foreign treasuries with oil dollars.
A real factor is that the US spending on oil continues to drive down the value of the dollar. Oil prices in euros are not rising nearly as much. On the other hand, gasoline prices in Europe, in euros or dollars, continue to much higher than in the US. Could they be on to something?
I am still for the $1/gallon plus tax as a way to take control of our addiction. Possible a liberal government could spend some of the revenue on therapy for recovering oil addicts with most revenue going to reduce income tax and strengthen the economy with more "real dollars" than the Bush giveaway dollars.
In conclusion, I cannot help but feel that continued misinformation on policy issues that is fed to the media is current US domestic policy.
Ben of NOLA
Posted by: ben claassen at June 25, 2008 10:08 AM
The speculation issue extends beyond oil to the grain markets. Your (and Krugman's) argument make sense. But something has gone wrong in the grain markets. Cash and futures are not converging at expiration of the future, contrary to experience over a hundred years on the Chicago exchanges. Those in the grain business, as represented by the National Grain and Feed Association, maintain a lage part of the probelem is the massive influx of hedge funds, etc., in the futures market -- exclusively on the long side.
If its not speculation, what is causing this serious problem of non-convergence??
Posted by: wogie at June 25, 2008 10:26 AM
Wogie, Scott Irwin offered some thoughts on your question here.
Posted by: JDH at June 25, 2008 10:39 AM
If speculation is not raising the current price of crude oil, it is not doing its job. What do people mean when they talk about 'fundamentals' of oil prices in the spot market? If demand is set to outstrip supply at current prices in the not-too-distant future, then we are probably set to see a big increase in the price of oil. Speculation should move part of that price increase into the present, ameliorating the future increase. It can accomplish this by causing producers to hoard more oil (e.g., keep it in the ground) and by causing consumers to start economizing now, rather than wait until the wall is hit in future. Imagine how much better off we could be today if speculators had moved some of the current price spike back to a smoother, slower increase starting in 2002. Maybe we wouldn't be stuck with so many SUV's.
Posted by: don at June 25, 2008 10:40 AM
This -- "Speculators provide a vital function. By buying when prices are low and selling when
prices are high, they actually make oil prices less volatile." -- is lovely in theory, but saying (or even highlighting it) it doesn't make it so. It assumes that speculators are smarter than the rest of the world, that they recognize when price are low and high, relative to equilibrium. Why would that be so? They increase the volume of trade in financial instruments, which should help markets clear, but that is not the same as limiting volatility. US of leverge allows speculators to trade larger positions, which means their trades can be large relative to trades by other entities. Large trades are likely to induce volatility.
You express your surprise at agreeing with Krugman. Read his work on currency overshoot. There is no reason I can think of that the same factors could not lead to overshoot in other markets.
Posted by: kharris at June 25, 2008 10:43 AM
It's good to try to set the politicians straight, but I think that wogie is right. There's a much more interesting issue that economists should be trying to explain. Defining the difference between speculation and legitimate, price-shifting investment/betting would be a great advance in itself -- and it might even help the politicians understand what's going on.
Posted by: SGC at June 25, 2008 10:49 AM
"legitimate" should probably be replaced with "unobjectionable" in the post above.
Posted by: SGC at June 25, 2008 10:51 AM
I was finally convinced that "speculation" was a bogus hobgoblin by this argument: Refiners are willing to pay $135 for a barrel of oil. They do this because they believe that they will be able to sell the refined products for a profit. If they were wrong, the gasoline market would be glutted, and gas prices would have to fall until the market cleared. Refiners (or someone downstream, gas wholesaler/retailer) would be taking huge losses on every barrel. They aren't."
(It's true that gas prices haven't risen quite as steeply as crude, and refining margins are currently squeezed, but certainly no one is taking $50/barrel losses, or whatever amount of speculative bubble is claimed.)
What may be happening is that the market is in overshoot because of the time delays to bring long-term elasticities to bear. Oil producers say their marginal costs are $70/barrel, but production can't be scaled up instantaneously. If they believe prices will stay at this level, they'll be investing in expanded production to come online in a few years. But demand elasticity is slow too. Perhaps with a few more years of declining SUV sales and other such adjustments, demand will come down enough that $70/barrel becomes the new equilibrium price.
Posted by: lilnev at June 25, 2008 10:57 AM
lilnev, well expressed, except for the inherent assumption that daily production can be raised. There are a lot of folks who say it can't.
Posted by: M1EK at June 25, 2008 11:33 AM
Is it possible that the oil producers have already sold all of their oil for the next few months based on prior future contracts, and so cannot bring the price down by locking in these prices now?
This seems doubtful, since the planet burns over $10 billion of oil every day, so it would take a HUGE amount of money to lock them up. But I don't know the numbers so I can't be positive. (Even at $70 a barrel, that would've been nearly $6 billion a day needed.)
Posted by: Dan Weber at June 25, 2008 12:15 PM
Thanks, James for the analysis. It really does seem that supply and demand is the simple explanation, after you factor out the dollar depreciation.
Kharris suggests that speculation, while serving a useful purpose in price adjustment, may be subject to overshoot. In control theory, to prevent overshoot you add a damping factor. Dean Baker suggests a small tax on futures trading.
Posted by: Joseph at June 25, 2008 12:29 PM
Commodity specualtors are a special breed who follow commodity prices more closely than most people. For this reason they are "smarter" than most people when it comes to price variations in commodities. Like all investors they win and lose but their object is to win more than they lose. They do this by watching trends. When the price of a commodity seems unusually high they will sell putting downward pressure on the price. When the price is relatively low they will buy putting upward pressure on the price. So the specualtor actually slows the upward or downward pressure as prices move. This is a stabilizing force in markets. You will have to demonstrate your overshoot theory.
Joseph, Specualtors are the controlling factors that prevent overshoot. You discourage specualtors and you discourage the traders on the margin who hold down price variations. kharris asked what makes speculators smarter than we are but the real question he has to answer is what makes them dumber than we are. I doubt there is anyone here who would run out and buy high to sell low.
You have to draw a distinction between specualtors and fools. Fools buy when the price is high and lose, lose, lose. But they do not have a significant impact because they don't last very long as traders - unless they are in government using our resources rather than their own.
Posted by: DickF at June 25, 2008 12:59 PM
The solution of the equation in my opinion is that with FED policy we have more us currency than last year: more currency circulating higher prices the result.
Posted by: Willy at June 25, 2008 01:38 PM
All this poppycock about developing nations putting a strain on supplies is just that. If that were so then there would be true shortages of which there are none. A blind man and an absolute imbecile can see that speculation is driving the vehicle upwards. On a twist of Roosevelt we can only say "All we have to fear is the fears of the speculators." And if you are looking for an excuse then any excuse will do. If this thing is not soon put to rest I fear that we will see pitchfork laden mobs beating down the doors of the comodities markets-worldwide.
Posted by: Mike Gasaway at June 25, 2008 02:32 PM
Speculation, by definition, cannot last for years and years.
However, it is quite possible that Oil will rapidly crash back down to $100, which was a record high just 4 months ago, but will now appear to be a 'relief' price to those who have now seen $139.
Remember when you were irritated by gasoline being $3/gallon? What if it went back to that today? $3 would actually be welcomed.
Posted by: GK at June 25, 2008 03:06 PM
I am not an economist, but here is the logic I worked out for myself: supply and demand have been finely balanced, and near-constant, for the last three years. Into that environment came tremendous cash inflows to commodity funds. Where could that money go? With constant production and consumption, it could only bid for (and bid up) forward delivery contracts. The market might have crashed soon after, but given short term elasticity, the thirst for oil, end-users suffered the higher prices. Speculation became price discovery ... in the short term.
It strikes me that this could unwind, even with continuing, constant, production and consumption. All that's needed is a plateau in price, and the start of a run from commodity funds. They must then unwind their positions, dumping futures on the market.
That could be triggered by longer term reactions (and tipping points) among oil consumers.
... but I see that it could go either way. It all hinges on the end user, and if they choose to abide these (or higher!) prices.
Posted by: odograph at June 25, 2008 03:33 PM
Question to the "where's the inventory" crowd: If there isn't "inventory" where did the money go? We see oil funds, oil ETFs, etc. ... if they don't own oil what do they own?
Posted by: odograph at June 25, 2008 03:36 PM
Higher tax takes, resource nationalism, environmental NIMBY attitudes to drilling, high cost inflation, geopolitical factors, and lack of industry resources (old work force & old aging equipment/rig fleet) are the real contributors to the high prices.
Sadly, over the last ten years, world leaders and energy policy makers have globally & universally restricted private capital from access to new sources of hydrocarbon production - just at a time when it was sorely needed.
Of course, these same ministers and policy makers are going to blame speculators, demand growth from China or any number of fictitious causes.
The reality is, as the famous saying goes;
"Once upon a time, there were four people:
Their names were Everybody, Somebody, Nobody and Anybody.
Whenever there was an important job to be done, Everybody was sure that Somebody would do it.
Anybody could have done it, but Nobody did it.
When Nobody did it, Everybody got angry because it was Everybody's job.
Everybody thought that Somebody would do it, but Nobody realized that Nobody would do it.
So consequently Everybody blamed Somebody when Nobody did what Anybody could have done in the first place."
The simple fact is that policy makers everywhere thought it was Somebody's job to take care of global oil supply.
Ten years ago, Everybody thought Russia, deepwater and a move to natural gas would be the supply solution and Nobody ever thought that fighting simultaneous production declines in many mature basins (North Sea, Mexico etc.) would add so heavily to the burden. So Everybody went on merrily taxing/nationalizing/restricting the oil industry with the conviction that Somebody would take care of supply.
Politicians and energy policy makers have Nobody to blame but themselves...but that is the last thing they will ever admit to their citizens...especially now that many will suffer and the poor will even go hungry!
Posted by: Anon at June 25, 2008 03:38 PM
odograph, supply and demand are always balanced if price floats. That doesn't tell you much, and is the first clue that the Saudis are pandering to economic illiterates when they talk about how the price is unjustified since all demand is being satisfied.
"demand" is meaningless. What matters is quantity demanded at a given price. And at a constant price, demand clearly went up over the last few years; with supply at that price having trouble keeping up, hence the higher price.
Posted by: M1EK at June 25, 2008 03:39 PM
Regarding speculators as a stabilizing force...
I have always understood speculators to be technical traders. As such, they will increase volatility some of the time and decrase volatility at at other times, depending on the situation.
If price rises through a ceiling then they pile in and cause the price to overshoot to the upside. If price falls through a floor then they pile in and cause the price to overshoot to the downside. In these cases they are clearly increasing volatilility.
Otherwise, speculators trade the range between the floor and ceiling in which case they act as stabilizers. They buy as the price approaches the floor from above and sell as the price approaches the ceiling from below. If they bet that the resistance will hold and they are wrong, (50% of the time in an efficent market), then they have to reverse their trade to avoid loss. In this case they also increase volatility by selling when the floor is unexpectedly broken on teh way down and buying when the celing is unexpectedly broken on the way up.
I attribute much of the recent volatility to herd behavior of technical traders following the same technical trading rules.
As to the proportion of price that can be attributed to speculators, I have no idea. However, CNBC and others have noted that the increase in commodity prices are associated with a significant increase in open interest. Perhaps the committment of traders report can shed some light on the subject? I used to follow it, but haven't looked at it lately.
Posted by: tj at June 25, 2008 03:41 PM
I appreciate very much your careful and thorough review of developments in the oil market, and your analysis of speculation. I've written about some of your pieces at my blog, Streetwiseprofessor.
I am not convinced of your conjecture that speculation is partially to blame for the post-January oil price increases, and the example that you use to counter the objection that speculative distortions should be accompanied by a rise in stocks. I have an extended post at SWP that lays out the theoretical and empirical basis for my objection.
In general, in my view a rise in stocks accompanying a rise in prices is likely a necessary, but not a sufficient condition for speculative distortion. I've laid out the reasons why its not sufficient in several posts dating back to August, 2006. In a nutshell, when the volatility of fundamental shocks (e.g., net demand shocks) is itself stochastic, a shock to fundamental volatility tends to induce an increase in stocks and prices. I think this stochastic fundamental volatility is plausible, and hence we need to be careful about concluding that speculators are distorting the market when stocks and prices rise together; we need to be especially skeptical when prices are rising but stocks are not.
I look forward to reading your future musings on the oil market.
Posted by: Craig Pirrong at June 25, 2008 04:23 PM
M1EK, I think you reiterated what I said about new cash driving price discovery. But for some reason you make the argument that these prices will stick by beating "economic illiterates" rather than making the case directly.
Is $130+/bbl sustainable?
Posted by: odograph at June 25, 2008 04:30 PM
In a market as oligopolistic and as historically famous for price manipulation as the oil market, I think it's naive to ask where the 2 million barrels per day are being stored. It's entirely possible that they're by design simply not being pumped. We saw an example of that in the recent Saudi statement that they will expand production. If they had been rational economic actors in a genuinely free market, they would have expanded production about $60/barrel ago.
Posted by: Charles at June 25, 2008 05:54 PM
A couple of datapoints worth pondering: In 2007, the US planted 93.6 million acres of corn, and in 2008 the USDA estimates that only 86 million acres of corn were planted (pre-flooding). Now, ethanol-fueled demand for corn this year is up 28% versus last year, and about 31% of the US corn crop is going to be converted into ethanol. Against that backdrop, is it surprising that corn prices are up this year?
One major buyer of corn this week noted that the prices they were paying for physical corn were consistently about $0.50 per bushel BELOW the quoted futures price on the CBOT -- which they thought was a decent estimate of the "speculative" impact of commodity index fund buying on the price of corn.
A couple of odd details have helped obscure the gradually developing short-supply situation in oil and grain. With oil, OPEC countries historically in aggregate had substantial excess capacity. In the late 1980s and throughout the 1990s, the OPEC excess capacity was gradually used up by steadily growing global demand, until sometime around 2003 the superfluous excess capacity was pretty much used up. And a heckuva lot of complacency got built up over those two decades of superfluous surplus.
In ag, for much of the 20th Century the problem was keeping American farmers from producing too much product, and there were all sorts of odd government set-asides and quotas devoted to depressing farm output. Over the past 20-40 years, however, economic growth and real estate development steadily reduced the US' plantable acreage, so today the country is running around 330 million acres down from some 400 million acres in mid-century past. AND WE'RE PLANTING FENCEPOST-TO-FENCEPOST the last couple of years and prices are still going up. Brazil and Argentina have excess land that can be prepped and tilled and farmed, and that's a good thing, and certainly Europe and China and a few other luddite countries need to open their minds and start using genetically-modified seeds and get their yields up . . . . . . but at the end of the day, you can't just flip a switch and get more ag production in the US or anywhere else the way you could in the good old days of yore.
Posted by: Anarchus at June 25, 2008 07:56 PM
Dear Prof Hamilton,
If oil producers had been selling us 21 mb/d but we were only consuming 19.9 mb/d, that would imply that in excess of 1 mb/d would have been added to inventory during the first quarter. An extra million barrels going into inventory each day would have increased inventories by 90 million barrels by the end of March 2008.
Are we assuming that any excess supply available would be purchased and put into inventory?
How does this assumption come about?
Posted by: savahn at June 26, 2008 04:02 AM
Savahn, I am making the point that there was no excess supply going into observed inventories. Inventory data thus support the conclusion that we consumed (at 19.9 mb/d) all the oil that was being supplied to the market. The question I raise in this post is therefore, If demand had been instead 21 mb/d (as it perhaps would have been if the price had stayed at $72), where would that extra 1 mb/d in production come from?
Posted by: JDH at June 26, 2008 06:15 AM
Re: Where is the physical product to satisfy this extra demand supposed to have come from?
The supply-side is treated as a "Black Box" that automatically responds to demand, whatever it is, in all these scenarios that pin the steep price rise on speculation or the declining dollar.
But as I know very well, there is hardly any spare capacity in this market.
Also, the 2007 average price is misleading. The year started out at about $54 barrel after an anomalous, unwarranted price slide that started in August, 2006. About a year later, oil prices got back on the longer term price trend that had started in 2003. See my ANWR Is Not the Answer for a discussion.
Posted by: Dave Cohen at June 26, 2008 06:44 AM
odograph, no, I reject the idea that prices rose because of "new cash", if the implication is that it was simply investors looking for a place to park some money.
They rose because the demand curve shifted. And when the Saudis talk about how the price shouldn't be high because everybody who wanted a barrel of oil got one, they're presenting demand as a static number rather than a curve.
Posted by: M1EK at June 26, 2008 06:48 AM
Depending on when you count, 36 millions acres of the decline in total cropland from 400 to 330 million acres is accounted for by the Conservation Reserve. The name is a misnomer, as the program was started in the 1980s to reduce crop surpluses. The decision not to allow crop planting on a significant chunk of these acres in 2008 was one of the most foolish agricultural policy decisions of the last 50 years. We may get lucky with growing season weather the rest of the season, but regardless, prices would have been much, much lower if this decision had been made. Look for the USDA to open the CRP for 2009. A day late and a dollar short!
Posted by: Scott Irwin at June 26, 2008 07:29 AM
M1EK, I looked for that famous graph of oil prices superimposed with new commodity fund investment but couldn't find a link (anybody?). I hope you aren't disputing that big money flowed in.
Given that fact, how on earth could the new money "fit" without an increase in prices?
I see it as a simple case of more buyers for future deliver contracts (from producers) bidding up prices.
Do you live in a world where more bidders for a fixed quantity produce a same-priced result?
Posted by: odograph at June 26, 2008 08:18 AM
Odograph, the graph can be found here.
Posted by: JDH at June 26, 2008 08:22 AM
Posted by: odograph at June 26, 2008 08:31 AM
As you're aware, there's a debate going ongoing over how productive the 36 million acres of land in the CRP actually is -- clearly, the yields would have to be below the average yield (since only crazy farmers would put their more productive land in the CRP), but the difference of opinion among people I talk with is pretty large. You probably also saw that Ag Secretary Schafer is close to making a final decision on the CRP release in the next couple of weeks . . . .
btw, one of the larger ethanol producers came through recently observing that the price they were paying for physical corn was consistently $0.50 per bushel below the CBOT - the difference they thought was caused by index fund holdings of futures contracts.
Posted by: Anarchus at June 26, 2008 09:14 AM
Not very up on commodity trading, but I took a look at the June 17 Commitments of Traders Report -- futures and options combined. By far, commercial interests account for most of the positions. Speculative large traders (presumbaly those of interest on the speculation issue) accounted for just 28.4% of total positions. And intersting, spread positions accounted for 69% of total large trader speculative positions, i.e., their long trading offset by short contracts. These traders presumably seek profit from the narrowing or expansion of the spread betwen selsected futures contracts (it would be interesting to see which contracts they are trading -- and what has happened to the spread).
Since the long and short contracts offset each other in spreading, its not clear to me how the trading drives the large increase in futures and spot prices
Posted by: wogie at June 26, 2008 09:44 AM
I don't think I have seen any discussion of a backward-sloping supply curve; if this is happening, the higher the price, the lower the output (the income effect of higher prices on suppliers swamps the propensity to pump more). With world demand relatively income elastic and price inelastic, this is probably enough to account for the increases with minimal speculation.
I believe this effect was postulated during the last great oil crisis c. 1973.
Posted by: SteveB at June 26, 2008 09:52 AM
Should have noted the commitments of traders I addressed was for crude oil on the NYmex
Posted by: wogie at June 26, 2008 09:59 AM
odograph, because other people will have gotten 'out' of that market (profit-taking; demand-destruction). In other words, I fall in line with the commentary in that post with the graph you liked so much - this isn't like an internet stock where there's ten degrees of indirection before any actual good or service of value materializes (if that); there's a real physical good which has to be used or stored.
Posted by: M1EK at June 26, 2008 12:32 PM
My argument does not require that oil be like internet stocks, nor that any oil disappear into storage. It only requires (a) that new buying pressure from investors have its natural effect, and (b) that end-users accept those now-higher prices.
Perhaps you can explain how you sneak $250,000,000,000 in as new holdings without a price rise?
I have my explanation of how it worked with a price rise but without new inventory.
In that other article the Prof asks: "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?"
My answer is that consumers do not buy less. They grunt and pay up. They buy futures contracts from third parties as they mature, and the investors roll their money forward in expectation of future increases.
The Prof says: "So ultimately, the 'paper oil' theory is going to require a reduction in the production of actual physical oil."
If I've got a "paper oil" theory, I disagree. This is instead a game that can continue until investors discover how high end-users are willing to go.
Posted by: odograph at June 26, 2008 01:31 PM
Note: I suppose "efficient market" types might wonder why oil producers did not play this aggressive game of price discovery themselves. They might have done, but it's contrary to the stated OPEC (and esp. Saudi) goals. They say they are about creating a stable target price that maximizes their return and but does not produce large efficiency or alternative energy drives in client nations.
Posted by: odograph at June 26, 2008 01:35 PM
wogie,in the official COT data, the CFTC categorizes the now infamous swaps dealers as commercial entities . . . . . . if you recategorize the swaps dealers as non-commercial entities (where they belong), the speculative non-commercial percentage of open interest is 69.7% in April 2007, up from 58.4% in April 2008. Over the past 12 months, the swaps dealers share of open interest rose from 21.0% in April 2007 to 31.8% in April 2008.
I would like to know what proportion of the swaps dealer OI is "net long" . . . . . if the overwhelming proportion of the swaps dealer OI is net long, then wouldn't you think the market share can't rise above 50%, ever? Just wondering.
Posted by: Anarchus at June 26, 2008 01:44 PM
odograph, the fact is that IF end-users accept the new price, then to me it's simply evidence that the elasticity of demand is lower than you thought it would be. (It's clearly not completely inelastic). That's a long ways from presuming that it must be evidence that the earlier price was too low or that the later price was too high.
"Perhaps you can explain how you sneak $250,000,000,000 in as new holdings without a price rise?"
Chicken and the egg. If the demand was actually very elastic, then the 'new holdings' would have purely displaced old holdings. Since it didn't, again, this is just evidence of the inelastic demand most people assumed was there all along.
Posted by: M1EK at June 26, 2008 02:00 PM
I did not presume, in fact I said:
"... but I see that it could go either way. It all hinges on the end user, and if they choose to abide these (or higher!) prices."
I don't get your "chicken and egg" thing at all. I am asking for a nuts-and-bolts explanation of what those funds buy for $250,000,000,000 and how that affects the markets. A sudden invocation of "very elastic demand" is not very satisfying.
Posted by: odograph at June 26, 2008 02:54 PM
Odograph, have you read this?
Posted by: JDH at June 26, 2008 03:02 PM
Yes I think I did, though it is filtered through all the all the other pixels spilled on this since.
Q: What if oil producers were stubborn and used their engineering schedule as the source for all of their deliver contracts ("selling" a barrel a little early or a lot early, but "pumping" it on schedule)?
How would that change the idea that bidders for futures contracts must force a change in production?
In other words, would stubborn production itself force fiercer bidding for a fixed set of available contracts?
Posted by: odograph at June 26, 2008 03:12 PM
Thanks for the insight odograph. If you will, please advise where I find the breakout of swaps dealers from commercials' positions
Posted by: wogie at June 26, 2008 08:52 PM
wogie, I don't know what that means ... but I think most agree that we are looking at a large influx of "long only" funds. The mechanisms may be less important?
Posted by: odograph at June 27, 2008 04:58 AM
odograph, it's the same thing that would happen if a 250B fund decided all of the sudden to go buy some other commodity - a bunch of people would sell their positions; prices might go up very briefly; and would eventually settle back to the market-clearing position without much long-term impact.
Again, this is unlike the other cases of speculation people talk about. Oil is expensive to store. The market is fungible. People burn what they buy, except for the US government, and that's a small fraction of demand.
Posted by: M1EK at June 27, 2008 06:22 AM
You are invoking magic, M1EK.
A bunch of people suddenly sell, because prices of their holdings are going up?
... and you still don't get it if you talk about storage. See the Prof's old post. That's pretty much what I'm talkin' about.
Tyler Cowen is on the same page as well, today:
The bottom line is that when it comes to the key substantive questions about the oil market - why are prices so high -- the correct answer is the Lachmannian one: "expectations." If you push one step further on that, and try to evaluate or "source" those expectations, the correct answer is "we don't know."
Jim Hamilton hints at some of this -- and the imprecision of the "inventories" term -- in this insightful post.
Posted by: odograph at June 27, 2008 07:18 AM
I like this section for Cowen as well:
Arnold Kling wonders why so many commodity prices have risen at the same time. I'll repeat that fundamental value -- and thus the concepts of speculation and bubble -- are trickier and vaguer with commodities than in stock markets. I'll say that "expectations" have driven the general rise in commodity prices. If those expectations turn out to be wrong, we can call it all a bubble; if they turn out to be right, then it hasn't been a bubble. What should we call it in the meantime? We're not going to solve that problem in any factual way. Make your bets, as they say.
It's similar to my own first post above.
Posted by: odograph at June 27, 2008 07:21 AM
"A bunch of people suddenly sell, because prices of their holdings are going up?"
Yes, because every transaction has to have a buyer and a seller. By definition, if a bunch of new buyers show up and actually get to buy some widgets, and if there's really no more widgets than there were before, somebody else had to sell widgets they previously were carrying.
The true 'magic' here is people asserting speculation having most of the price impact on a fungible commodity that's expensive to store (except for not extracting it at all). While it's theoretically possible, it's much less likely than simple moves along the demand curve.
Posted by: M1EK at June 27, 2008 09:08 AM
I am only suggesting the natural and obvious result of "more buyers" -> "higher prices"
I don't have to jump through hoops, and and rely on otherworldly economic effects.
And there certainly have been more buyers, as investors arrive with long-only positions.
Posted by: odograph at June 27, 2008 09:13 AM
(By magic I guess I am saying that you are inventing sellers out of whole cloth to make your argument work. There are no new sellers. There are only producers with fixed quantities.)
Posted by: odograph at June 27, 2008 09:14 AM
Well, if we're using THAT model, then there are no 'more' buyers either - if production didn't increase. Some old buyers got replaced, but there's certainly not 'more'.
Posted by: M1EK at June 27, 2008 12:39 PM
Be sure to distinguish between end users and interim holders of financial instruments. Investors did not add to end users, no.
Posted by: odograph at June 27, 2008 01:25 PM
Your post stated: "if you recategorize the swaps dealers as non-commercial entities (where they belong), the speculative non-commercial percentage of open interest is 69.7% in April 2007, up from 58.4% in April 2008."
My question was how were the swaps dealers identified. And if they are, to what extent are they spreading rather than overwhelmingly Long?
Posted by: wogie at June 27, 2008 06:31 PM
Wogie, it was actually my post that passed along the April 2007 and April 2008 swaps dealer data.
As you're probably aware, the CFTC (under political pressure) has been holding hearings on the failure of physicals and futures contracts to converge at delivery and on the energy markets separately. Past Commitment of Traders (COT) reports have not separated out swaps dealers from regular commercial traders - it's all been lumped together. One of my research contacts got the April '07 and '08 data from somewhere -- data which the CFTC has committed to making regularly available in the interests of transparency but hasn't had time to follow through (yet).
The swaps dealers themselves are easily identified by the CFTC -- it's a fairly concentrated market where 3 or 4 dealers like Goldman Sachs have the bulk of the volume -- but the summarizing and tabulating of reams of data presumably takes some time. As I understand it, the primary function of swaps dealers in these futures markets is to enable large scale NON-COMMERCIAL traders (such as passive commodity index funds) to utilize the special exemption created on behalf of Enron back in the late 1990s to avoid the position limits that preclude "speculators" from taking oversize positions in contracts and possibly distorting the markets.
I'd guess when all the data becomes available and widely distributed, it's possible or maybe even likely that the regulators will experience some non-trivial amount of embarrassment. Time will tell, I suppose.
If the data I have is accurate and in crude oil the market share of swaps dealers has risen from 58.4% of the OI in April '07 to 69.7% in April '08, I'd expect the regulators will have some explaining to do.
Posted by: Anarchus at June 27, 2008 08:55 PM
If it hasn't already been pointed out, we can't make these reasonable presumptions about inventory as in the post.
For instance, it isn't in the Saudis interest to tell us exactly how much oil they could supply nor to supply more than they expect demand to ask for at prices they might guess at themselves.
Also it isn't in refiners' interest to buy more inventory than they guess actual real use might be at some price point...
In other words, the inventory situation outlined in the post isn't realistic.
Posted by: halbhh at June 28, 2008 11:04 PM
A lot of people seem to be saying that spculators could not be affecting the price of oil because no one can store enough of it to force the price up. However Enron had no trouble doing this with electricity, and that cannot be stored either.
They seemed to do it by picking the times to make large buys when the market was more volatile or nervous. Speculators might be buying futures in large quantities and trying to appear like they represent countries that will need much more oil than the market can supply. If they then act confidentally enough in buying at higher prices the market would assume these countries will pay these higher prices.
They could also buy oil futures whenever there was a minor disruption in the market making it appear they needed the oil at any price.
Posted by: RCH at July 1, 2008 11:26 PM
Oil is priced in dollars. Fix the Dollar and you will fix oil.
Posted by: raymond at July 2, 2008 05:31 AM
YES., We can say, it SPECULATIVE INVESTMENT as main Culprit behind the rise of OIL Pricing and Food Pricing.
When there is Growth around the globe, everyone knows that DEMAND is rising, and there is lesser chance of DROP in price and hence NO BIG LOSSES if they make investment.
Becuase of this theory, actual RISE in PRICE is Higher.,normaly it should rise by 10-20% or 30% ..........but this SPECULATIVE INVESTMENT
had increased the PRICE RISE to much Higher by 100-200 or 300%.
Further, The commodity Exchange around the world keeps MARGIN MONEY to 5-10% this has accelarted the Investment Value further higher.
The can Invest just 5-10% money and get there PURCHASE LONG POSITION created.
Increasing the MARGIN MONEY requirement to 100% of value of LONG POSITION and NO ROLLOVER of position for Future contract over 3month., will Bring down the OIL and FOOD price to there REAL VALUE.
Posted by: Mukesh Chandan at July 7, 2008 07:28 AM
m1EK: "odograph, supply and demand are always balanced if price floats. That doesn't tell you much, and is the first clue that the Saudis are pandering to economic illiterates when they talk about how the price is unjustified since all demand is being satisfied."
Yep, this is right next to: "high oil prices can't be due to supply and demand because there are no lineups". I am shocked at how often I hear this.
Posted by: Darren at July 15, 2008 10:32 PM