Ridiculous Assertions About Energy Prices and Manipulation

There are so many silly assertions and so little time!

One of our missions is to identify strong sources of information and analysis. Even the most intelligent reader needs some expertise to make the key distinctions. Let us consider some examples.

Oil Demand and Price

The Statement: One of the CNBC talking heads repeatedly stated that oil prices fell by 80% but demand did not drop that much. To her, this was evidence of an inaccurate market. None of the many CNBC panelists contradicted her.

The Reality: Introductory Econ classes start with how markets clear, showing a supply function (a curve) and a demand function (also a curve). The markets clear at the intersection of the two curves. A lecture or two later there is a discussion of elasticity -- how much demand (or supply) changes with a unit change in price. There are examples of inelastic demand (insulin is a favorite) and more responsive demand.

The Conclusion: It is not proportional or linear. It is another case of pop economics intuition leading one astray. Let us suppose that the oil market is near a tipping point. A demand curve intersecting slightly above the production capacity leads to a price spike. At a slightly lower point, producers may still want to generate some revenue. It is all about the shape of the supply and demand curves.

Oil and Stock Correlation

The Statement: An expert says that stocks are trading based upon oil. There is a chart showing a correspondence between stock prices and energy prices.

The Reality: The relationship between energy prices and stock prices is situationally dependent. In general, high energy prices are a tax on the consumer. There is no reason for higher oil prices to cause higher stock prices.

The Conclusion: This is a classic case of a spurious relationship. This is a technical statistics term meaning that Factor A (in this case perceptions about the economy) is driving the behavior of both Factors B and C. The apparent relationship is not causal. In addition, this would make sense only if stock traders thought that energy prices were a more accurate read of the economic prospects.

Rogue Trading and Energy Manipulation

The Statement: There are some rogue energy traders who made drunken or mistaken trades. These needed to be unwound. This shows manipulation of the energy markets.

The Reality: Mistakes are discovered and corrected. It is not manipulation.

The Conclusion: It has no lasting impact on prices, despite the media hype.

Speculation drives Energy Prices

The Statement: Speculators have exacerbated price swings in energy. Some government officials in several countries want to hold hearings and consider legislation to curb speculation.

The Reality: Speculators are trying to make profits. They add liquidity to the market, acting based upon many sources of information about all conditions. Think "The Wisdom of Crowds."

The Conclusion: There is very good evidence on this point, from some excellent sources. Astute economist James Hamilton took a close look at this when energy prices spiked, and wrote as follows:

I personally do accept the view that the "paper oil" speculation has made a contribution in recent months to the increase in the price of physical oil. I believe that this speculation has resulted in a slight decrease in the quantity demanded that has required some modest supply reductions or accumulation of inventory by producers. But I expect that producers will find these changes not to be in their best interests as the demand adjustments become more prominent, at which point the price must return to that governed by the underlying physical fundamentals.

Ultimately, the price must be such that the quantity of physical oil demanded at that price is equal to the quantity of physical oil supplied. Any speculator who promises on paper to buy oil for more than the physical stuff is actually selling for will find themselves at that point with a big, fat paper loss.

Here is another take from noted investment advisor Dr. Stephen Leeb:

The real force at work behind last year’s run-up in prices, the subsequent decline and the rebound that has followed is the market’s invisible hand. In other words, good old fashioned supply and demand was the culprit. Unprecedented synchronized global growth between 2005 and early 2008 caused demand to soar, yet producers were unable to meet the call to increase production by anything more than a token amount.

Readers should check out his entire review of the history and his argument. Government intervention to distort markets is the last thing we need.

Our Overall Take

There is an active market in conspiracies and manipulation. It makes an ideal media story, whatever the reality. Commentators also seem to have a bias toward the legitimacy of equity markets and against futures markets, often citing off-hours trading. Perhaps those of us with more "Chicago" experience better appreciate the depth and liquidity of futures trading.

Those doing "pop economics" have a field day. It takes careful analysis to sort out the reality.

Comments

[conceptwizard:]

The ugliest example of illicit publicly noticed activity by Goldman Sachs in my opinion was the late summer 2006 change to the GS Commodity Index. They lowered the unleaded gasoline weight from 9% to 2%, forcing the sale of $7 billion in gasoline contracts. Nevermind motive, focus on execution. With $100 billion in indexed funds invested in the GSCI, Goldman knew what would happen. Gasoline fell sharply in price. GSax profited heavily, all legal, not even a prosecutable violation.

The Real reason that Goldman has gone bullish is that they expect that global supply growth over the next five years will dwindle to just 650,000 barrels a day—due to lagging investment and output in non-OPEC countries, especially. They expect s non-OPEC supply, about 60% of the world market, to fall by 400,000 barrels a day this year and by 910,000 barrels a day in 2010.Bloomberg News says that according to reports Goldman closed its trading recommendation to sell WTI July crude futures on Nymex, which was put in place on April 17 when the contract cost $54.66. The trade lost $11.56 a barrel. They are recommending buying crude options for the right to buy oil at $85 by June 2010, while selling a contract for the right to buy at $100 a barrel in the same period.

I concurr with the speculative trading opinion. Goldman dictates the Oil prices.

Jul 10 07:49 AM

[Old Trader:]

Its unfortunate too many people find it too taxing to do a bit of thinking, combined with some reading/study. Its so much easier to buy into the soundbites thrown out by various talking heads. Matters aren't helped by politicians taking advantage of the country's "populist" streak, and calling for investigations, censure and castigation of various groups of "they", whether "they" are "oil speculators", "big oil", etc.....done in the hope of currying favor with the electorate.

Jul 10 08:38 AM

[John Galt:]

THE COURT: So whether he’s detained or not doesn’t him from communicating that information to you or anyone else. And therefore the server could be accessed and the financial institutions and the markets compromised as you have described.

MR. FACCIPONTE: It would certainly be more difficult, Your Honor. And I don’t believe the public ought to bear the burden or the risk of that coming to past. In addition --

seekingalpha.com/artic...

This was piece was taken from Tyler Durden's blog, concerning a Russian IT genius stealing the code to Goldman Sach's program trading comupter.

Basically when GS is trying to build the case for how important the stolen information is, they argue that it gives the user the ability to "compermise"... some would say manipulate... the market.

Then they have the nerve to argue that the poor old public shouldn't have to bear the burden of a manipulated market.... ( If this gets in the wrong hands LOL). Those good old guys at GS are always trying to look out for us. That evil Russian IT guy shouldn't have the keys to the car that can drive over the market... Goldman Sachs should. Pathetic.

Jul 10 08:53 AM

[sieraromero:]

Why would anyone believe or give any credibility at all to what the talking heads on CNBC are touting. They have given up any respectability in the ability to actually do any respectable reporting, and instead have become commentators and talking points for whoever and whatever is paying them for their services at the moment. At what time they were very good and respectable, now they are just charletans and snake oil salesman!

Jul 10 09:47 AM

[Tom Armistead:]

Jeff, most of what you say makes sense to me but not this article about speculation and oil futures.

Perhaps a nice graph with an actual supply and demand curve, supported by data sources to explain how the supply and demand were developed. It would be a start.

My observation on these cases where futures or derivatives are traded far in excess of the underlying is that what George Soros calls "reflexivity" cuts in and the fantasy world begins to affect reality in very destructive ways. In point of fact it was this type of thing that trashed the economy and financial system.

Maybe economists need to do studies to determine if any such phenomenon as reflexivity exists.

Jul 10 12:35 PM

[John Lounsbury:]

Jeff - - -

Good article, but I would add some thoughts.

1. The price of oil may not drive stock prices (I agree), but, stock prices may, at times, effect oil prices. To the extent that movement in stock prices indicates economic expectations, rising stock prices imply an expectation for rising demand for oil. Conversely, if falling stock prices indicate an expectation for lessened economic activity, then falling demand for oil is indicated.

2. Speculative driven price changes in commoditiies have always led to corrections, sometimes spectacular. You wrote about the process of price discovery. I would just add that price discovery does not have fixed timelines. Sometimes bubbles have extended lifetimes, and then the collapses are dramatic. Collapses are followed by new price discovery moves, sometimes overshooting again to the upside.

Price discovery can happen quickly or suffer long delays. To quote somebody I should remember, but don't at the moment: "Markets can remain irrational longer than the rational can remain solvent."

All that being said, I agree with what I detect as an unwritten undercurrent to your article: Futures markets work and any changes that would reduce liquidity would be counterproductive to price discovery. If I am inferring the wrong intent, Jeff, please correct me.

Jul 10 02:55 PM

[jambo:]

All very adeptly explained market force information. But the case for no manipulation in $149 barrel oil is pitifully thin and in my opinion B.S.
We'll find the "true market value" of oil the same day we find the clean end of the turd, UNLESS accountability is added to the trading and the number dollars backing puts is raised.
Whats wrong with trades using real money? Hell, I sell an etf and dont get the cash til it all "clears". But if I'm speculating I can do it all with a tiny amount of actual cash, of course the commissions are higher, oh wait, I get it...!

Jul 10 09:12 PM

[tjhorton:]

The author misses an extremely significant factor. Goldman Sachs is under investigation regarding the price of oil, and with good cause.
www.forbes.com/forbes/...
Semgroup was short 20% of the oil market. Goldman Sachs knew about this, from client relations. There is an investigation underway that Goldman used this knowledge to profit by putting Semgroup in a short squeeze, and drove the large spike in the price of gold.

Wild conspiracy theory or simple greed? My impression is that Godlman may be the dirtiest bankers of all time, and I'm not alone.
www.goldmansachs666.com/

Jul 11 10:33 PM

[bartpr:]

with the dwindling of reserves in the world oil supply, coupled with the cutbacks in exploration and production it is easy to see how a little drop in supply has a price reaction, even with demand in a downward trend. how much excess production is there. maybe 5mbpd. look out when the world economy turns up. oil will be at 150 plus. watch the politicians howl. it will be a while yet before alternative energy makes a dent in supply.

Jul 12 05:26 PM

[factandveritas:]

There are so many interventionists, crooks and cheaters and so little time......

Jul 12 08:08 PM