April 18, 2012
A ban on oil speculation?
Joseph P. Kennedy II, former Congressional Representative from Massachusetts, and founder, chairman, and president of Citizens Energy Corporation, has a proposal to make energy affordable for all. All we have to do, Kennedy claims, is "bar pure oil speculators entirely from commodity exchanges in the United States."
Writing in the New York Times last week, Joseph Kennedy (D-MA) explained why he believes that speculators are responsible for the high price that we currently have to pay for oil:
Today, speculators dominate the trading of oil futures. According to Congressional testimony by the commodities specialist Michael W. Masters in 2009, the oil futures markets routinely trade more than one billion barrels of oil per day. Given that the entire world produces only around 85 million actual “wet” barrels a day, this means that more than 90 percent of trading involves speculators' exchanging "paper" barrels with one another.
It's true that most buyers of futures contracts don't actually want to take physical delivery of oil. If I buy the contract at some date, I usually plan on selling the contract back to somebody else at a later date, so that I leave the market with a cash profit or loss but no physical oil. But remember that for every buyer of a futures contract, there is a seller. The person who sold the initial contract to me also likely wants to buy out of the contract at some later date. I buy and he sells at the initial contract date, he buys and I sell at a later date. One of us leaves the market with a cash profit, the other with a cash loss, and neither of us ever obtains any physical oil.
Let's take a look, for example, at NYMEX trading in the May crude oil futures contract. A single contract, if held to maturity, would require the seller to deliver 1,000 barrels of oil in Cushing, OK some time in the month of May. Last Friday, 227,000 contracts were traded corresponding to 227 million barrels of oil, which is indeed a large multiple of daily production. But it is worth noting that at the end of Friday, total open interest-- the number of contracts people actually held as of the end of the day-- was only 128,000 contracts, much smaller than the total number of trades during the day, and not much changed from the total open interest as of the end of Thursday. Many of the traders who bought a contract on Friday turned around and sold that same contract later in the day. If the purchase in the morning is argued to have driven the price up, one would think that the sale in the afternoon would bring the price back down. It is unclear by what mechanism Representative Kennedy maintains that the combined effect of a purchase and subsequent sale produces any net effect on the price. But the only way he gets big numbers like this is to count the purchase and subsequent sale of the same contract by the same person as two different trades.
It's also worth noting that on that same day, there were 146,000 May natural gas contracts traded, which if held to maturity would call for delivery of natural gas at Henry Hub in Louisiana. A single contract represents about 10 million cubic feet, so Kennedy's calculations would invite us to compare the 1,146 billion cubic feet of "paper" natural gas traded on Friday with the total of 78 billion cubic feet of natural gas that the U.S. physically produced on an average each day in 2011. Once again, the vast majority of Friday's natural gas futures trades were matched by an offsetting trade during the same day so as to have little effect on end-of-day open interest.
By what mysterious process can all this within-day buying and selling of "paper" energy be the factor that is responsible for both a price of oil in excess of $100/barrel and a price of natural gas at record lows below $2 per thousand cubic feet? I suspect the reason that Kennedy does not explain the details to us is because he does not have a clue himself.
Because of speculation, today’s oil prices of about $100 a barrel have become disconnected from the costs of extraction, which average $11 a barrel worldwide.
Here I have a modest suggestion. If Representative Kennedy knows a way to go out and produce another barrel of oil somewhere in the world for $11 a barrel, he would do a world of good if he would actually go out and do it himself, as opposed to simply asserting confidently in the pages of the New York Times that it can be done. People with far more modest fortunes than Kennedy inherited are out there using their resources to try to bring more of the physical product out of the ground.
And many, many more would be attempting the feat if it were remotely possible to produce a new barrel of oil for anywhere close to $11.
If you want to prove me wrong, Mr. Kennedy, then don't talk about how easy it is to produce more oil-- just go do it.
I have a final concern about Kennedy's policy proposal. How exactly do we define the "speculators" whose participation in the markets is to be banned? Suppose for example, we stipulate that the only people who are allowed to trade oil futures are those who are actually physically producing or consuming the product. If we do that, what happens if a particular producer wants to hedge his risk by selling a 5-year futures contract, and a particular refiner wants to hedge his risk by buying a 3-month futures contract? Who is supposed to take the other side of those contracts, if all "speculators" are banned?
Let me close by pointing those interested in this issue to a recent survey of academic studies of the role of speculation by Bassam Fattouh, Lutz Kilian, and Lavan Mahadeva. The authors conclude:
We identify six strands in the literature corresponding to different empirical methodologies and discuss to what extent each approach sheds light on the role of speculation. We find that the existing evidence is not supportive of an important role of speculation in driving the spot price of oil after 2003. Instead, there is strong evidence that the co-movement between spot and futures prices reflects common economic fundamentals rather than the financialization of oil futures markets.
Posted by James Hamilton at April 18, 2012 06:17 AMdigg this | reddit
On the surface, 'Obama's' plan, announced the other day, basically provides the CFTC with more funds to police the market and dictate higher margin requirements.
That doesn't sound too controversial. Of course, you have to pass the bill to find out what's in the bill.
It's all about political posturing.
The debate will pit Republicans who blame Obama for high gasoline prices against a White House that blames Republicans for coddling Wall Street.
The pattern is always the same regardless of the topic; main street/wall street, energy/CO2, healthcare, national debt, etc. The pattern is villify the target, marginalize the target, create a false narrative to sway public opinion, paint the right as protecting the villains, then use legislation and/or federal agencies to increase federal control.
Posted by: tj at April 18, 2012 07:12 AM
It seems to me, that without speculators "to take the other side of those contracts", that demand would diminish and that would bring down prices.
Where would housing prices be if not for investors? What happens when there is too much capital in an economy? These are of course simple questions but economists seem to avoid this line of questioning. But of course they don't claim to know what causes bubbles.
Posted by: rl love at April 18, 2012 07:12 AM
Agreed. The whole speculation thing is a bit bone-headed. I checeked oil inventories yesterday, and there's no clear indication that there's any sort of real build other than customary fluctuations.
A much more interesting story would have been a vigorous response to Argentina's expropriation of YPF. But no one took the bait, neither Obama nor Romney. By rights, Romney should have.
Posted by: Steven Kopits at April 18, 2012 07:34 AM
A bit by me on Platt's this morning:
Posted by: Steven Kopits at April 18, 2012 07:35 AM
There has been minimal coverage of the Argentina story... mostly among investors.
MONDAY, APRIL 09, 2012
Argentina Wants To Be Like Venezuela
Posted by: Bruce Hall at April 18, 2012 07:52 AM
I think Congressman Kennedy could just be using this to frame rising oil prices in terms of "fancy wall street speculators" gambling with energy. That doesn't tell to entire story, but it's a better political strategy than giving a long policy talk about rising demand in foreign nations. Where's the bad guy in that? Especially when I see political ads everyday blasting Obama on his energy policy.
Posted by: Frank Muraca at April 18, 2012 08:07 AM
If there are a pool of investors buying and selling futures, each investor beginning with a certain supply of funds, and each contract resolves with one party making money and the other party losing money, what is the aggregate effect?
Does the total supply of funds in this market change?
As you explained, the oil futures market hardly ever involves oil. It is only the buying and selling of pieces of paper with some printed words on them (I imagine), or perhaps just some bytes. How does this buying and selling of pieces of paper effect the market price for actual oil, if it does so?
I can see that this market might effect the price of oil for a participant who might actually want to sell or buy oil in the future. But what is the mechanism by which the trading of pieces of paper effect the price that a person who actually wants to buy or sell oil itself, if it does.
Is it your assertion that the trading of certain pieces of paper does not effect the price of oil or natural gas? Or that it does not contribute along with other factors to the world prices of commodities? Your powerful example of the prices of oil and of natural gas shows that trading these pieces of paper may move prices up or down, if the trading can move the prices.
Posted by: Bernard Leikind at April 18, 2012 08:34 AM
Steven, that is an intersting post on the blog.
It sounds like a form of the prisoner's dilemma -
If neither of us approve a high threshold project then supply falls, prices rise and we both win.
If we both approve high threshold projects then supply rises, prices fall, and we both lose.
However, if you are the only one that approves a high threshold project, demand outpaces supply and you reap the incremental gains from producing high cost oil, while I do not.
Greed drives us both to accept high cost projects so we don't let the other reap all the added gains.
Posted by: tj at April 18, 2012 08:46 AM
The only ways speculators can affect the price of oil is if they store it or prevent it from being extracted from the ground (or, turn it into plastic products and chemicals, and store them).
Posted by: aaron at April 18, 2012 09:02 AM
rl love, only a person who buy physical product can affect the price.
If a speculator has contract for delivery of 1000 barrels of oil and nobody wants to buy at his price, he must take delivery of the oil. He has to pay trasportation, storage, watch it evaporate... If he can't or is unwilling to do this, he must sell at the spot price.
The market could be inflate like housing if the end product users buy at higher prices than their income can sustain. This would need to be done with debt or savings. That would push prices higher than they should be, and it's the (long)speculators who will take a HUGE loss when debt and savings run out.
Posted by: aaron at April 18, 2012 09:11 AM
I just wrote about this on my blog, as well:
Posted by: Frank Muraca at April 18, 2012 09:48 AM
It would seem that in order to prove your argument, you would have to do more than claim that the futures market is not governed by the price of oil. You would also have to show that oil market pricing is not futures-based, that the implicit values in the derivatives does not influence it. Oh, that's right! You can't actually show us how oil producer pricing decisions are made because there is no free market in crude oil production.
Thanks for playing!
Posted by: Paul Johnson at April 18, 2012 10:48 AM
Sorry for the missing S's and D's. Don't know what my problem is
I'd put them in, but I'll probably mess that up.
Posted by: aaron at April 18, 2012 11:07 AM
Futures and spot prices are both driven by the same fundamentals. One key is expectations. If the expectation is for the supply of oil to be tight in 6 months, then the spot price will rise today because producers will hold back some supply to take advantage of higher prices in the future. Large consumers will increase demand today today because they expect the spot price of oil to be higher in the future, so the spot price rises.
In the futures market, speculators open long positions today because they expect the price to be higher in the future.
Both the spot and futures price are reacting to the same fundamental information, so on average, the spot and future prices move in tandem because the 2 markets are reacting to the same fundamentals. If the difference between spot and futures price rises or falls relative to the average difference, all else equal, then speculators in one or both of the markets might be responsible.
However, if speculators observe a change in the expected difference between spot and futures prices, then the same speculators will 'arbitrage' the price difference back to the expected difference.
Therefore, speculators are not villains. They simply maintain the difference between spot and futures prices at the expected level.
Posted by: tj at April 18, 2012 11:34 AM
When he was in the House, Kennedy was known as the stupidest man in Congress. Quite a feat.
Posted by: Bob_in_MA at April 18, 2012 11:55 AM
PJ, you can't prove a negative. Let me re-phrase:
It would seem that in order to dis-prove your argument, you would need to do more than claim that the price of oil is governed by the futures price of oil. You would also need to show that futures price of oil is spot market based, that the implicit values in the derivatives does not influence it.
Posted by: aaron at April 18, 2012 12:11 PM
I am an engineer and think about things similar to some of the laws of physics, like conservation of mass or energy, where you draw a box around the item you are analyzing and everything inside that box is "conserved" or is constant. Just that is how I think about things, not that this applies to economic concerns. Why I bring this up is that there is something I can't get my mind wrapped around. If all of these speculators are all "betting" that the price of oil is going up, and then the price of oil does goes up, they make a profit on their 'investment.' Where does that profit come from? Is it magically created ala the immaculate conception of money?
Posted by: river at April 18, 2012 12:31 PM
James Hamilton wrote:
'Suppose for example, we stipulate that the only people who are allowed to trade oil futures are those who are actually physically producing or consuming the product. If we do that, what happens if a particular producer wants to hedge his risk by selling a 5-year futures contract, and a particular refiner wants to hedge his risk by buying a 3-month futures contract? Who is supposed to take the other side of those contracts, if all "speculators" are banned?'
James, do we know the minimum number of speculators, if any, that are required to create a liquid market? Are there any studies or simulations that attempt to answer this question?
For example in the old days of soft commodities (corn, wheat, etc.) what percentage of market participants where neither producer nor consumers? Can we learn anything from history on this topic?
Posted by: Pete at April 18, 2012 12:55 PM
River, as has been pointed out, someone is on the other side of each trade. That's where the money comes from.
Posted by: Kyle at April 18, 2012 01:00 PM
You nailed it on Argentina's expropriation of YPF. This is a very serious issue that has simply been under the radar. Nationalizing the central bank to use money for political campaigning and now nationalizing oil companies? Argentina seems to be on its way to perdition and doesn't even know it.
You also nailed it on Romney. Everyone pretends he is such a financial genius while most of the time he doesn't have a clue.
Posted by: Ricardo at April 18, 2012 01:13 PM
River, people who expect the price to go down.
Posted by: aaron at April 18, 2012 01:28 PM
Prices have been climbing for months now. Who really, really believes that it will go down, and they believe it so much that they are willing to lose money on the deal?
Posted by: river at April 18, 2012 02:12 PM
Class War For Idiots / April 15, 2011
Koch Industries Lackeys Admit To Manipulating Oil Prices…And Gloat About It, Too
By Yasha Levine
"Their methods weren’t that different from the ones used by Enron to boost the price of electricity: instead of shutting down power plants, Koch Industries siphons millions of gallons of oil into storage tanks."
ThinkProgress’ Lee Fang writes:
"In 2008, Koch called attention to itself for “contango” oil market manipulation. A commodity market is said to be in contango when future prices are expected to rise, that is, when demand is expected to outstrip supply. Big banks and companies like Koch employ a contango strategy by buying up oil and storing it in massive containers both on land and offshore to lock in the oil for sale later at a set price. In December of 2008, Koch leased “four supertankers to hold oil in the U.S. Gulf Coast to take advantage of rising prices in the months ahead.” Writing about Koch’s contango efforts to artificially drive down supply, Fortune magazine writer Jon Birger noted they could be raising “gasoline prices by anywhere from 20 to 40 cents a gallon” at the time"
"In recent weeks, gas prices around the country have surged to levels unseen since the 2008 oil spike. However, market fundamentals are not driving the nearly $4.00/gallon gas prices. In fact, under the Obama administration, oil production is at record highs and there is adequate global supply of crude. As Commodity Futures Trading Commission (CFTC) commissioner Bart Chilton has explained, rampant oil speculation, which is at its highest level on record right now, is to blame for current prices."
Posted by: rl love at April 18, 2012 02:29 PM
As I have opined before, there is no mystery as to why global annual crude oil prices doubled from 2005 to 2011, but politicians and most of the media would prefer not to address resource constraints.
We have seen two annual Brent crude oil price doublings since 2002, from $25 in 2002 to $55 in 2005, and then from $55 in 2005 to $111 in 2011.
In response to the first price doubling, we did of course see a substantial increase across the board in total liquids production (inclusive of biofuels), in total petroleum liquids, in crude + condensate (C+C), and in Global Net Exports (GNE) and in Available Net Exports (ANE). GNE and ANE numbers are calculated in terms of total petroleum liquids. ANE are defined as GNE less China and India’s combined net oil imports.
In response to the second Brent crude oil price doubling (2005 to 2011), we have so far seen a very slow rate of increase in total liquids production (up 0.5%/year from 2005 to 2010), virtually flat total petroleum liquids and virtually flat C+C production (through 2010), and a 1.3%/year and 2.8%/year respective decline rate in GNE & ANE (through 2010).
GNE fell from 46 mbpd (million barrels per day) in 2005 to 43 mbpd in 2010, while ANE fell from 40 mbpd in 2005 to 35 mbpd in 2010. (Top 33 net oil exporters in 2005, BP + Minor EIA data, Total Petroleum Liquids.)
Five annual "Gap" charts follow, showing the gaps between where we would have been at the 2002 to 2005 rates of increase, versus the actual data in 2010 (common vertical scale):
EIA Total Liquids (including biofuels):
BP Total Petroleum Liquids:
EIA Crude + Condensate:
Global Net Oil Exports (GNE, BP & Minor EIA data, Total Petroleum Liquids):
Available Net Exports (GNE less Chindia’s net imports):
I would particularly note the divergence between the first chart, Total Liquids, and the last chart, Available Net Exports (ANE).
I estimate that there are about 157 net oil importing countries in the world. If we extrapolate the Chindia region’s rate of increase in their combined net oil imports, as a percentage of GNE in 17 years from now, in 2029, just two of these oil importing countries--China & India--would consume 100% of GNE.
Posted by: Jeffrey J. Brown at April 18, 2012 02:43 PM
Obviously the issue of what is happening with oil and gasoline prices is currently highly politicized, with the discussion coming out of both sides of the political fence in the US seriously moronic as a result. Certainly, the issue is not speculation per se, or the role of speculators in the oil market. As Jim rightly argues, they usually perform a useful function, and indeed most of the time operate to stabilize markets.
The deeper issue has to do with the existence or identifiability of speculative bubbles. Jim has long argued that it is very difficult, if not impossible econometrically, to identify speculative bubbles, although by now pretty much everybody accepts that there was a big speculative bubble in US housing that led to very serious macro problems. Nevertheless, it seems to me that we rarely see speculative bubbles in oil markets, and that most of the time price changes, even when they are dramatic, as some past price spikes have been, have generally reflected expectations about fundamentals.
The one possible exception that I can think of is what went on during early 2008 in the runup to the last peak we saw of nominal oil prices in July of that year. While there was a lot of talk about supply limits and growing Chinese demand, the global economy was in fact decelerating (and officially in recession in US, even though that had not yet been declared by the NBER), even if the full extent of the coming crash was not fully perceived by most forecasters or the markets. So, while there is some basis for saying that even this boom was strictly fundamentals, quite a few observers have argued that there was a bubble at that time that certainly showed up in the behavior of speculators, but it was showing up in both the futures and the spot markets in any case.
Anyway, I would agree with Jim that it would be hard to determine one way or the other definitively, and even if one decided that there was a bubble, it probably would have happened to some extent without the speculators. And as for the current (or recent, given that oil prices seem to have declined a bit) high prices, there certainly do seem to be fundamentals of various sorts that explain them, from supply shortfalls in various countries to the notorious effect of the sanctions against Iran policy, with the reports of the possibility of a deal with Iran possibly being the source of this recent decline. These recent high prices clearly have nothing whatsoever to do with speculators per se.
Posted by: Barkley Rosser at April 18, 2012 02:46 PM
Wow! Rarely has there been this much agreement here on any issue. Maybe someone needs to connect Wall St speculators with global warming.
Posted by: 2slugbaits at April 18, 2012 03:11 PM
As JR Crooks, Editor of Commodities Essential at Black Swan Capital, explained:
“As it pertains to domestic energy policy, investors and speculators certainly use U.S. policy as a foundation for crude oil price direction.”
“Speculation alone is not a guilty party but rather a scapegoat to explain away uncomfortably high prices. Speculation and rising prices are mere symptoms of excess liquidity (loose monetary policy).”
“Monetary policy has created a system of endless credit and artificially low interest rates that push investors further out the risk curve. In other words, excess liquidity incentivizes speculation in inherently risky assets like crude oil.”
Posted by: rl love at April 18, 2012 03:43 PM
So 100 traders buy a barrel, each selling for 1% more than he paid. The first trader paid $80. The 100th guy delivers the physical oil, at $216, to a refinery.
Every trader "added value", as proven by their 1% profit.
Will the economy gain even more value by adding another 100 traders?
Such a scheme relies on all traders being willing to pay. In a real market, some won't and somebody takes a loss. Say the 71st trader balks, so the 70th guy loses (say) 5%. Now only $72 of "value" have been added by the traders to the original $80 price.
In a culture of (impossible-to-prove) collusion or just general price optimism (encouraged by media fears), prices will tend to go up. Any professional trader (or trader's fraternity) should invest in encouraging more gamblers to participate (via, say tax advantages for players, and other marketing), and promoting fearful news. Buying some media influence is certain to be profitable, considering how cheaply it can be done.
Prices can, and probably are, driven up by adding naive money to the game, marketing and policy. Value is thus extracted from the economy. It is very hard to theoretically determine when a market is getting tulip crazy, but it is foolish to believe that it doesn't happen and that utterly free markets must always be optimal. Plainly, many professionals won't hesitate to sell 25 yr old Yugos as a new Mercedes if you don't regulate them.
Every system dealing with unpredictable inputs benefits from some damping, the question is: how much to put where? When does it hurt performance?
Have you ever seen a race car suspension designer argue that wheels should be completely free to react with no damping? That he has a innate belief that his suspension will always react perfectly if you just take the dampers off? Of course not. But such fanatics are common in finance. Markets react naturally! Overshoot takes care of itself! (at what cost?) Fraud is effectively policed by the market alone! etc
Some restriction on trading frequency, fraud, opacity and reserves reduces misallocated capital. ("loss")
Posted by: randy at April 18, 2012 03:43 PM
"A commodity market is said to be in contango when future prices are expected to rise, that is, WHEN DEMAND IS EXPECT TO OUTSTRIP SUPPLY."
This is patently false and shows that the author of the statement does not understand basic economics nor the basics of futures pricing.
Posted by: Jay at April 18, 2012 04:35 PM
President Obama would do well to digest the substance of Jim's post and the Fattouh, Kilian, and Mahadeva paper. For example, yesterday he declared, "We can't afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage, and driving prices higher -- only to flip the oil for a quick profit."
Posted by: Phil Rothman at April 18, 2012 07:03 PM
"Speculation" is the difference between the short run and long run price elasticity of demand. Thus, if the short run elasticity is around -0.3, and the long run elasticity is around -1.0, then we have to get from the short run to the long run somehow.
If the short run elasticity is low, then the demand response is insufficient, and prices will exceed the long-run equilibrium price by definition. You get an overshoot, because people aren't willing to yield their oil consumption in a timely fashion.
From an emotional perspective, the consumer will feel that prices above the long-run equilibrium price is price-gouging. And they're right! But it's the consumer, not the producer, who's doing the gouging! Consumers are clinging to prior consumption levels too long.
Thus, speculation, in this view, is the sound of consumers' expectations being broken. Or, to use Jim's framework, it is this overshoot which creates the innoculaton effect which resets expectations and sets the stage for subsequent elasticity below the maximum prior price level.
And that makes some sense empirically. US demand is quite elastic right now. So it's switched phase, we're just not sure quite why. But Jim's argument is certainly plausible.
So that's a view.
Posted by: Steven Kopits at April 18, 2012 07:45 PM
I'm skeptical of simplistic speculator stories. But the line that I've never quite been able to dismiss is the growth in net long "buy-and-hold" commodities positions, especially oil.
In other words, suppose that there are some investors who want to maintain a net long position, selling contracts before they come due and turning over the funds by buying longer-dated contracts. Now suppose that the number of such investors is increasing over time. People see that the price of oil is rising, they call up their broker and ask, "Am I long oil? Increase that!" Institutionally, commodities funds have blossomed for people to put $X per month of new money into net long positions. Are there equivalent funds for shorting the commodities markets? No. Doesn't that flow of new money into net long positions drive up the futures price? And doesn't the futures price drag up the spot price via storage arbitrage?
Against this I see people taking actual possession of actual oil at the spot price, and burning it for Joules, and surely that's the real measure of what a Joule of oil is worth, right?
Any help resolving this cognitive dissonance would be welcome.
Posted by: lilnev at April 18, 2012 07:54 PM
The market does not look like there is any speculation in it right now. It has traded in a very small range for a few months now, and it does not respond to news or moves in other markets. Further the continued existence of the Brent WTI anomaly has to be reckoned with. If speculators were important in the market, they would be attacking it.
Posted by: Walter Sobchak at April 18, 2012 08:40 PM
lilnev, the refiner sees the future price is high, so he buys more oil now pushing up the spot price. He ends up with a glut. He needs to clear his inventory, pushing the spot price back down (in the future).
I think the behavior you described could only produce a quasi cyclical variation. Which should be arb'd away.
Posted by: aaron at April 18, 2012 08:49 PM
If the price of oil were truly higher than that which would exist without speculators, where is all the excess oil being kept? Producers would simply extract oil at the marginal cost and sell forward their exposure. When the end user demand wasn't there, the oil would have to be stored or destroyed. Until I see massive stores of oil, I don't see how speculators have any meaningful impact on prices for any more than a few months.
Americans need get used to competing for oil against a rapidly growing number of foreign middle class consumers, in the context of rising costs of extraction. I guess it's easier to blame speculators than the Chinese.
Posted by: Steve mccourt at April 18, 2012 09:30 PM
Again great comments!! You blow away this whole idea of specualtion driving higher prices. Thanks.
Posted by: Ricardo at April 19, 2012 05:49 AM
It's being stored in the ground.
You want to go after speculators, go after Obama.
Posted by: aaron at April 19, 2012 05:58 AM
I suspect that this conversation lacks enough consideration of the influence of 'excess liquidity' on the cost of oil, or of commodities in general.
Here is a perspective worthy of consideration from by Prof. Ali Kadri:
"The price of oil is increasingly realised in futures markets. It rests on an assemblage of futures, spot, physical forward and derivative markets where, with expanding liquidity, the futures markets lead. Participants in these markets include major financial institutions such as Goldman Sachs, Morgan Stanley, Merrill Lynch, Société Générale, and J.P. Morgan. A large number of hedge funds and individual punters also take part in this market. Hedgers, one may add, are also speculators in view of their fear that the actual price is liable to be less favourable than the price that they are willing to ensure. In today’s oil market, therefore, the major players are speculators. The principal point to discern from this is that the price of oil also moves in response to differential rates of return from investment in other markets and not solely demand-supply concerns. Thus, in the presence of ample liquidity and low rates of return in other markets, concocted perceptions or expectations of what the supply-demand balance is likely to be in the months ahead including, fear of sudden future Gulf-war related shortage, draw the excess liquidity and become the most powerful driving forces of this market."
Odd that the term 'excess liquidity' has had so little use on this thread? But then, as I said earlier, economists don't claim to understand bubbles.
Posted by: rl love at April 19, 2012 06:45 AM
(For media access, contact Jan Mueller at jmueller AT aspousa.org)
I will be doing the following presentation on Thursday afternoon, 3:00 P.M. (Eastern Time):
Global Oil Exports: Smooth Sailing or Midnight on the Titanic?
This is the second in an continuing series of webinars presented as benefit to ASPO-USA members. For a minimum annual membership of $100 (and higher donations are always greatly appreciated), one will have access to all webinars during your annual membership period.
Following is a summary of our presentation.
Jeffrey J. Brown
Global Oil Exports: Smooth Sailing or Midnight on the Titanic?
Global annual (Brent) crude oil prices doubled from $55 in 2005 to $111 in 2011, an average rate of increase of one percent per month, although actual prices have of course been above and below this trend line. The available production data over this time frame, from the EIA and BP, show that global crude oil production and global total petroleum liquids production have been virtually flat, with a slight increase in total liquids production of about 0.5%/year (inclusive of low net energy biofuels).
A study of the top 33 net oil exporters in the world, which account for 99% plus of total global net exports, and which we define as Global Net Exports of oil (GNE), shows that GNE fell from 46 mbpd (million barrels per day) in 2005 to 43 mbpd in 2010 (BP & EIA data, total petroleum liquids).
Furthermore, China and India (“Chindia”) have been consuming an increasing share of this declining volume of GNE. At the 2005 to 2010 rate of increase in Chindia’s combined net oil imports as a percentage of GNE, the Chindia region alone would consume 100% of GNE by the year 2029, 17 years from now.
While the US has shown a small increase in crude oil production, up from the pre-hurricane rate of 5.4 mbpd in 2004 to 5.7 mbpd in 2011, a net increase of 0.3 mbpd, this is virtually a rounding error in the context of the multimillion barrel per day declines that we have seen in GNE, especially the ongoing decline in the volume of GNE available to importers other than China and India, which dropped from 40 mbpd in 2005 to 35 mbpd in 2010.
And while it is certainly true that US net oil imports have declined, a significant contributor to the decline in net imports was a large decline in US consumption, which was down by 1.5 mbpd from 2004 to 2010 (EIA).
So, while slowly increasing US crude oil production is very important, the dominant trend we are seeing is that developed oil importing countries like the US are being gradually priced out of the global market for exported oil, as global oil prices doubled from 2005 to 2011, and as developing countries like the Chindia region consumed an increasing share of a declining volume of global net exports of oil.
For more information, you can search for: Peak Oil Versus Peak Exports.
Posted by: Jeffrey J. Brown at April 19, 2012 06:48 AM
The following is from:
The Relationship of Unregulated Excessive Speculation to Oil Market Price Volatility
Professor Michael Greenberger
University of Maryland School of Law
Prepared for the
International Energy Forum
-The inflow of liquidity, the increasing role played by the futures market (paper barrels) over the spot (wet barrels), and the proliferation of derivatives which encourage betting on price changes rather than on the absolute level of prices all contribute to worsen the situation, amplifying price oscillations.‖9
Mr. Luciani concluded:
―One can find no justification in supply or demand disequilibrium for the increase of prices from about 50$/b at the beginning of 2007 to triple this level in July 2008, followed by a collapse to less than 40 in December of the same year . . . .‖10
Princeton Professors Tang and Xiong reached similar conclusions in a September 2009 working paper where they found that, inter alia, ―the financialization process of commodities precipitated by the rapid growth of index investment to the commodities markets,‖ had ―contributed significantly‖ to the volatility of commodity prices in oil and other non-energy commodities in 2008.11 Economists at Iowa State University in May 2009 offered similar results and concluded that noncommercial speculation in crude oil futures markets increases price volatility in a ―significant manner.‖12
Finally, an August 2009 study published by the James A. Baker Institute for Public Policy, corroborates these findings. Kenneth B. Medlock III and Amy Myers Jaffe note that noncommercial players now constitute about ―50 percent of those holding outstanding positions in the U.S. oil futures market‖ and state that the increase is ―highly correlated with the run-up in oil prices.‖
Away from this site, there does seem to be some differing opinion.
Posted by: rl love at April 19, 2012 08:34 AM
Arguments claiming that futures markets drive oil prices tend to be stated in dense, turgid prose. Arguments taking the opposite position seem to be more straightforward and lucid.
Occam's razor would seem to apply.
Posted by: r eng at April 19, 2012 09:36 AM
Re: ASPO-USA Webinar.
Note that it is next Thursday, 4/26/12.
Re: rl love .
Our data table shows that the global supply of net exported oil dropped by about three mbpd (million barrels per day) from 2005 to 2010 (last year for which BP has annual data), and our data show that the global supply of net exported oil available to importers other than China & India (what I call Available Net Exports, or ANE) fell by about five mbpd from 2005 to 2010.
While we have seen a slight increase in global total liquids production, global crude oil production (which comprises 98% of the input into US refineries) has been flat since 2005. The following chart shows where we would have been at the 2002 to 2005 rate of increase in global crude oil production, versus actual data:
EIA Crude + Condensate:
Given flat global crude oil production, and given a measurable decline in global net oil exports, could someone explain to me why oil prices should not have gone up?
I can only attribute the absolute refusal to acknowledge the obvious supply limits to cognitive dissonance on a global scale.
People want to believe in infinite energy, so they have to explain away the doubling in global crude oil prices since 2005. Since they don't want to address resource constraints, they have to blame rising oil prices on some other factor.
When I cite the production and net export numbers, I might as well be communicating in a foreign language.
Regarding US oil production do the rescue, I think that increasing oil production in the US is to the decline in Available Net Exports of oil (Global Net Exports less Chindia's net imports) as the pumps on the Titanic were to the incoming flood of seawater. The pumps helped, but the fate of the Titanic was sealed when the ship hit the iceberg at about 11:40 P.M.
At around midnight, only a handful of people on the ship knew that the ship would sink, but that did not mean that the ship was not sinking.
I've called it the Best of Times for US oil producers, but the Worst of Times for US consumers, as global annual crude oil prices doubled in six years.
Posted by: Jeffrey J. Brown at April 19, 2012 12:30 PM
I provided a link to a paper that disputes your contentions. That paper quotes a long list of experts and esteemed professors from some very respectable schools and etc. You, on the other hand, seem to be someone trying to hustle some interest in some webinar. Yet you don't hesitate to insult people with some half-baked equations that ignore an historical demand disruption that is impossible to measure. You also seem oblivious to the fact that oil producers and traders alike have been making record profits while the global economy teeters at edge of a full-blown failure. So, I hope that you can understand why I find your comments to be smug.
Posted by: rl love at April 19, 2012 01:19 PM
Re: rl love
To repeat my question:
Given flat global crude oil production, and given a measurable decline in global net oil exports, could someone explain to me why oil prices should not have gone up?
Posted by: Jeffrey J. Brown at April 19, 2012 02:53 PM
Too much money chasing too few investments that can be considered "safe". Oil futures seem to be where the big money is so the investors go haring off. Yes, the result can easily be higher prices that can't really be explained by anything related to supply and demand on actual barrels of oil. Apparently many here don't remember how easily these markets can be rigged and have been rigged in recent history. Enron and Southern California electricity, anyone?
Posted by: Jim S at April 19, 2012 07:13 PM
Actually, the Titanic's fate was sealed when the captain reacted. If he just hit it, the ship would have survived.
Posted by: aaron at April 19, 2012 07:51 PM
Aha! So the speculators are simply doing it for fun? As a break from other commodity trading where they don't make money either....
Posted by: john problem at April 20, 2012 02:40 AM
I think to a certain extent the hype regarding energy speculation hinges on that with the Iranian situation, speculators jump in going long on Brent, exacerbating the price rises from the trade hedging etc. Essentially, general S&D issues which could be mitigated with a lot less commotion by commercial entities, are driven more so by those with no interest of taking delivery. I'm not advocating this view, merely relaying what seems to be the consensus anti-spec view.
Posted by: Tony Yeboah at April 20, 2012 03:52 AM
john problem at April 20, 2012 02:40 AM, randy at April 18, 2012 03:43 PM, river at April 18, 2012 12:31 PM, and others: I think you are still not digesting the fact that futures contracts are simply an agreement between two parties. For every buyer, there is a seller. If one defines a "speculator" as someone who does not seek actual physical delivery, then usually both the buyer and the seller are speculators. If the price of oil goes up, Speculator 1 (the buyer) makes a profit and Speculator 2 (the seller) makes a loss.
Bernard Leikind at April 18, 2012 08:34 AM: What matters is the price at which futures trades take place, not the volume. A bigger volume of trades, by itself, does not make the price go up or down. This is because for every buyer, there is a seller. You could equally well say, speculators bought 227 million barrels of oil on Friday, so the price should go up, as you could say, speculators sold 227 million barrels of oil on Friday, so the price should go down. The mere fact of a futures trade does not cause the price to move one way or another.
lilnev at April 18, 2012 07:54 PM: I explore this issue in detail in Section IIIC of my recent Brookings paper.
rl love at April 19, 2012 08:34 AM: Perhaps I will have time to respond to your itemized points in detail in another post. For now, let me just suggest that you will find most of these addressed in the Fattouh, Kilian, and Mahadeva study that I mentioned.
Posted by: JDH at April 20, 2012 04:27 AM
If you will send me "$100(and higher donations are always greatly appreciated)", I will take the time to do the work that will answer your question.
Posted by: rl love at April 20, 2012 04:53 AM
Ray, "These developments . . . have given rise to new investment assets that get their reward from price performance of oil futures and derivatives rather than the old-fashioned form of market reward through capital investment into oil exploration and extraction, and the resulting higher production.
This is not financial speculation, it's inadequate capital investment. This is storing oil in the ground to drive the price up.
Posted by: aaron at April 20, 2012 05:37 AM
Excuse me. This is storing oil in the ground, which drives prices up (motive is not necessarily there, it may be due to laws and politics).
Posted by: aaron at April 20, 2012 05:39 AM
Doesn't the devaluation of the dollar have a greater impact on the price of oil? Maybe if Washington would QUIT PRINTING MONEY and allow the dollar to rise, the price would come down.
Posted by: Jay at April 20, 2012 08:35 AM
Re: rl love
Sure. Tell me where to send the $100 bucks. I'm always interested in explanations as to why fundamental supply & demand factors don't work in the global oil markets.
But here is what I don't understand. Let's assume that the doubling in global (Brent) crude oil prices from $55 in 2005 to $111 in 2011, was 100% due to "speculation."
We saw a huge across the board increase in production & net exports from 2002 to 2005, as global annual crude oil prices doubled from 2002 to 2005.
Why have we seen no material increase in global crude oil production since 2005, in response to a doubling in annual global crude oil prices since 2005?
Why have we seen measurable declines in Global Net Exports of oil (GNE) since 2005, in response to a doubling in annual global crude oil prices since 2005?
We did see a slight (0.5%/year) rate of increase in total liquids production after 2005 (inclusive of low net energy biofuels), but this was in marked contrast to the 3%/year rate of increase that we saw from 2002 to 2005.
Since we have seen measurable declines in GNE since 2005, with the Chindia region consuming an increasing share of a declining volume of GNE, why is this not prima facie evidence that high oil prices were necessary to balance demand against a declining supply of GNE?
Globally, based on extrapolating 2005 to 2010 rates of change in consumption to production ratios, I estimate that post-2005 Global CNE (Cumulative Net Exports) were already about 22% depleted, through 2010, and I estimate that post-2005 Global CNE that are available to importers other than China & India (Chindia) were about 40% depleted, through 2010.
Rising US oil production is critically important, but the dominant trend we are seeing is that developed oil importing countries like the US are gradually being shut out of the global market for exported oil as the developing countries, like the Chindia region, consume an increasing share of a declining volume of Global Net Exports of oil (GNE).
Posted by: Jeffrey J. Brown at April 20, 2012 09:49 AM
This should not be an impossible question to answer. The specualtors are trying to make money. I would think that the total speculative premium would be the difference between the total dollars that the end users pay and the total dollars that the proucers recieve. If this data exisits, it should be possible to track it over time. Obsiously this measure is going to be extreemly variable on the short term, and it has to be for the market to be able to effectivly smooth out the prices to the end users and producers.
That being said we should expect some amount of speculative profit to compensate for taking on the risk of price volitility. I would expect that the end result would be that producers would sell for a bit lower, but more stable price and end users would buy for a bit higher but more stable price than the actual spot market.
If this gap has changed significantly over time there might be an issue. If not, then the prices would be strictly fundamentals shifted.
Posted by: Jesse at April 20, 2012 09:55 AM
Jesse: Here is a link to a recent paper I wrote that tries to do exactly what you describe. I am currently working on an extension of these ideas.
Posted by: JDH at April 20, 2012 11:19 AM
JDH, That is very interesting.
Am I reading this correctly to say that prior to 2005 producers have paid the risk premium to specualtors, and that after 2005 index funds (the naive speculators) have paid the risk premium.
What would be really interesting is for each contract to take the originating price (the price traded at as early as possible for any given contract) and the price paid just before it closed. I would assume the earliest price for any given contract would correspond to the producres price, and the very last one to the final users price, and to plot what that gap has done over the last 30 years.
If I'm understanding your conculsions correctly, then this gap shoudl have narrowed after 2005, as it is now external money (index funds) that are funding the speculators, not the producers, and that the increased use of index investments is actually lowering the specualtion preimum in the price of oil?
Posted by: Jesse at April 20, 2012 12:09 PM
Re: $100 (minimum) membership fee in ASPO-USA
Note that ASPO-USA is a non-profit organization that focuses on providing accurate and timely information on our energy situation, and we also host an annual conference.
As a service to members, ASPO-USA is hosting a series of webinars.
I am doing the next one, while Art Berman did the first one and he will be doing the one after me. Art and I, and other speakers, are donating our time.
For more info: www.aspousa.org
Posted by: Jeffrey J. Brown at April 20, 2012 12:30 PM
Jesse at April 20, 2012 12:09 PM: That's essentially it. On average, the risk premium before 2005 could be interpreted as a payment made by producers for the privilege of being able to hedge price risk. Since 2005, the risk premium is on average zero, which could be interpreted as on average, producers no longer need to pay for insurance when they sell short because there's a ready demand from index-fund type investors who want to buy long. However, the risk premium since 2005 appears to be much more volatile than before, with index fund buying at times the ones who pay a significant premium.
Posted by: JDH at April 21, 2012 07:50 AM
I am just a lowly driver who works in the oilfields(currently in MT/ND); but, there are things that even those of us at the bottom of the pecking order are able to understand. For example, if those of us whose employment depends on oil/gas production,(I have also worked on the Barnett), want some time off, we know not to ask when the prices are high. Conversely, if prices are low, we are encouraged to take holidays and etc.
I in fact lived in Cleburne, Texas for several years and could acurately estimate the price of nat. gas by the amount of truck traffic on the local roads. In other words, it is all manipulated.
Then too, I remember (2009?) a WSJ article that claimed that if all of the oil-tankers being used for storage were put end to end... those tankers would be 27 miles long. And this was during the period when you would have us believe that demand was out-pacing supply. There was also a phase about then that tankers were in short supply because so many of them were being used for storage.
And I know that the amount of oil being withheld was not all that substantial in relation to global usage but I also know, because my livleyhood also depended on the availability of fuel back in the 1970s, what happens when demand gets ahead of supply, and there was no evidence of any such shortage this time, yet prices doubled. (during a period that clearly had far more 'speculation').
In your arguement, I can find no mention of the demand side of the equation, and of course it matters not how much was produced, or what net exports might have been, without knowing how much was needed. Simple stuff I suppose for an economist, but this information would be very difficult for me to find. But if you send me the $100, I suspect that even an old truckdriver can 'google' his way to an answer.
Miles City, Montana
Posted by: rl love at April 21, 2012 08:40 AM
Does the increased volatility also translate to volatility in the short sale price? In other words, are the producers no longer able to effectively hedge, or are the index funds giving them a freebie? If that is the case then restricting speculation wouldn't merely be bad policy, but actively hurt consumer prices...
Posted by: Jesse at April 21, 2012 08:41 AM
rl love: You say your personal experience is that when the price is high, they want you to work overtime. That means when the price is high, they're trying to bring more to market. Bringing more to the market makes the price go down, not up. When you work less when the price is low, that's the market's way of responding to periods of low demand. That's not manipulation, it's market forces responding the way they should.
Here's a link to one of the stories about storing oil in tankers that you may remember. Notice the date: November 21, 2008. At that point oil was selling for $49 a barrel. Again, at that point somebody who was trying to do the best thing for the country (and the best thing for themselves financially) would want to save the oil to sell it later when it would be needed more.
And as for your research on whether fundamentals might have anything to do with the price of oil, let me encourage you to begin with this earlier piece from Econbrowser.
Posted by: JDH at April 21, 2012 09:34 AM
Jesse at April 21, 2012 08:41 AM: Yes, the volatility means that at times you can make money on the short side, and at other times you can make money on the long side.
Posted by: JDH at April 21, 2012 09:35 AM
JDH This might be slightly off the topic of speculation, but being off topic has never stopped me before. I'm not an economist, but my understanding is that economic theory predicts exhaustible resources like oil should conform to a Hotelling model as supplies traverse to zero. But I don't think the empirical evidence bears this out. The market does not price oil that way. To me it's very hard to reconcile economic theory's prediction of a Hotelling market price path and the random walks (perhaps with drift) that we actually observe. So how are economists justified in claiming that oil markets both price oil efficiently and extract oil from the ground at the socially optimal rate? And if price and extraction rates cannot be justified via the market, then isn't this an argument for imposing either a tax (if oil is underpriced) or a subsidy (if oil is overpriced)?
Posted by: 2slugbaits at April 21, 2012 11:01 AM
2slugbaits: That's an excellent point, and one that's extremely relevant for the discussion here. My view is expressed here, and is that, although historically oil was priced essentially without a scarcity rent, we would soon transition, if we have not already, to a situation such as Hotelling described. I further maintain that the transition will not be easy or smooth, but will involve some highly disruptive lurching around as the market tries to figure out how to price this correctly. Political factors (such as the controversies being discussed here) will also greatly complicate this.
Posted by: JDH at April 21, 2012 02:51 PM
Is this article for real? Leverage/credit means more buyers than sellers and price moves up hence lower interest rates and QE push paper asset prices higher. This is very basic and is not even controversial so while there are sellers there are more buyers.
This destroys purchasing power of millions, pushes food and other living costs through the roof all so the players in commods markets can make a bundle. More wealth transfer which is what easy money always ends us being.
*Disgraceful* blog post. Embarrassing really.
Posted by: Mike C. at April 22, 2012 05:46 AM
Mike C.: A futures contract represents an agreement between two parties. One party promises to deliver the oil, if held to maturity, while the other party agrees to receive it, at a price to which the two parties agree today.
You suggest that leverage means there are more buyers than sellers. Who, then, are you imagining it is that has agreed to deliver oil to the buyers?
Posted by: JDH at April 22, 2012 06:05 AM
Perhaps my saying that:"it is all manipulated" would be better put thusly:"it is all 'controlled' by the info provided by the market, (or something along those lines). But it is far more accurate to say that the price of oil is 'manipulated'... than to say that the market is 'free', (especially when tanker ships are being used for storage[and how could such a lengthy conversation on this subject not include the 'accident waiting to happen' factor?. [Should 'effecient markets' put the planet at risk?])
And this thread also provides other indications of what is wrong with 'peak-oil' theories when those are used to defend the magical process of price discovery, to begin with, it was beyond obvious that the spike in 2008 came as a result of monies being removed from other investment areas to commodities, especially into oil futures. And yet the excess liquidity issue was mostly ignored here on this thread (you did of course recommend a paper but it struck me as a long and stiff assortment of unsupported claims).
But perhaps the most telling flaw here in regards to what is missing, is any mention of margin requirements for oil futures.
Or maybe it is even more telling that the 'Triffin Dilemma'and the need to recycle dollars make it necessary for the USA to import oil, and so, oil is being left in ground for safe keeping as perhaps the mother of all 'manipulations'(globalization). But of course these other controversial factors weaken the peak-oil theories and so we are expected to believe that the oil market is effecient, as if vast fortunes are not being made by putting the planet and mankind at risk for the benefit of the few.
C'mon, professor, mankind needs people like you to fight against the bad guys, not to help them. And it is obvious that too much liquidity causes bubbles, and the margin requirements for oil futures are far too low even without ZIRP and QE.
Posted by: rl love at April 22, 2012 09:55 AM
I wonder if when he claims that the "cost of extraction" is $11 per barrel, he's only considering the costs to get oil out of the ground in an already discovered well, and not counting costs of exploration. Or perhaps he's counting the average costs of exploration and extraction from only successful wells, and ignoring the failures.
Apparently, to lower oil costs, what we should do is simply stop looking in all the places that turn out to be wrong.
Such logic wouldn't surprise me, since it's what pharmaceutical critics do all the time.
Posted by: John Thacker at April 22, 2012 03:33 PM
They are trying to destroy speculation, so the market won't be as forward looking. This would allow them to then use very short term strategies to affect the price (like opening up the strategic reserve), for political gain.
Posted by: Doc Merlin at April 23, 2012 06:29 PM
It is conceivable that natural gas speculators are betting on lower prices. If that is the case, the author's argument fails.
Posted by: JRW at April 25, 2012 06:30 PM
The article above says in the last actual paragraph:
"If we do that, what happens if a particular producer wants to hedge his risk by selling a 5-year futures contract, and a particular refiner wants to hedge his risk by buying a 3-month futures contract? Who is supposed to take the other side of those contracts, if all "speculators" are banned?"
If those speculators are gone and no longer are able to buy the contracts specified above, then the prices will drop until there is a buyer. That is why oil speculation causes prices to go up. The demand for "paper" oil is much greater than the actual demand for physical oil, thus it makes sense that speculation would drive up prices.
Posted by: Eric Bauer at April 28, 2012 02:10 PM
Here is a 2006 column I wrote on this topic:
Posted by: Hal Varian at May 9, 2012 03:19 PM