CFTC Belatedly Discovers the Speculative Oil Bubble 15 comments
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Peak Oil is not at hand but peak speculation in oil may well be. Given the weight of resource stocks in key global indices (and earnings), it will be interesting to see how markets react to a looming reversal in oil; some pretty brutal sector rotation would certainly result and the dollar would resume its stalled rally.
While a very tight supply cushion at the time of 1-1.5m b/d certainly supported prices in the $90-100 range, what amazed me was the overwhelming consensus among regulators including the CFTC and academics such as Paul Krugman that prices were being driven purely by fundamentals as they soared another $50 in a matter of weeks. That view has now changed radically, and both the CFTC and the FSA in the UK are investigating the oil market with a view to imposing position limits on traders, encouraged by the oil industry itself and key users like airlines who have been whipsawed by the extraordinary volatility of the past year. Let me emphasize one thing: it was not hedge funds or bank proprietary traders who drove this move, but pension funds, university endowments and other utterly respectable institutions whose mistaken analysis of asset risk correlations drove them to diversify their portfolios into commodity exposure. The relatively thin energy markets simply couldn't digest the tidal wave of new cash from buy and hold institutional investors.
Last month, an International Energy Agency (IEA) report said: "The cumulative amount invested by various funds in commodity indices quadrupled from about $75bn in January 2006 to almost $300bn last July, with crude futures taking a large portion of that amount." What kind of economist or regulator can't understand simple supply and demand? Whether prime real estate in the Hamptons or oil, any asset class in very finite short-term supply will see its price pushed higher by a surge of new cash seeking to gain exposure. Just this week we have seen oil slump 6% in a day on dreadful demand fundamentals (US distillate inventory at a 25 year high etc), only to soar 5% the next day on rising equities as investors bid oil higher as a reflation trade. In fact, the correlation of daily oil and equity movements in recent months has been at unprecedented highs, regardless of near-term fundamentals which are undeniably grim.
The argument of the believers in market fundamentals was that speculators invest in futures, rather than in physical supplies of oil so every month, they must trade contracts that are about to fall due for ones that will not mature for several months. That makes them big sellers of oil for prompt delivery and so they have no net impact on prices.
Nonsense. Buyers and sellers of futures which can be physically delivered, can buy or sell the spot / future (or a mix of the two) because they are exactly the same thing, just with a different delivery date. The actual position where futures players "invest" (front month or further along the curve) is immaterial. What matters is the "net exposure" of their investments, i.e. if a pension fund is now long $1bn of oil futures as a long-term investment, how they manage that exposure from futures expiry to expiry is less important than the fact that the demand curve for oil has shifted up by that $1bn on an ongoing basis. Rolling the position which consists of a buy and a sell order to keep the investment in the futures market, isn't the issue; it is only at initiation of the new position that the demand for the underlying commodity has increased. As more and more "investors" globally added commodities to their portfolios in 2007/8, from giant pension funds like Calpers to retail investors via energy ETFs, the "net exposure", net demand, and the equilibrium price for oil all soared.
I wouldn't hold my breath for radical action from the CFTC despite its belated recognition of the problem, as it is being heavily lobbied by Goldman Sachs and the other major commodity players (and the chairman is, of course, ex GS). At best, some restriction on open ended ETF positions in the energy markets and stricter reporting requirements are likely to result, rather than the position limits that apply in agricultural commodities, leaving us vulnerable to another surge in prices as economic recovery takes hold in 2010 and beyond and the current 4-5m b/d oil supply margin gets eroded. After all the US has long ceased to be a country where banks were subservient to the needs of the broader economy; indeed, quite the opposite.
Disclosure: None
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This article has 15 comments:
Funds are not, and it makes no difference what they are doing in month 2 or earlier month futures contracts, since they will be obliged by their clearing members (irrespective of what the exchanges provide) to get the hell out of contracts long before the expiry date.
On what basis do I say that? Well I oversaw the deliverable IPE (now ICE Europe) Gas Oil contract for six years and saw anything up to 400,000 tonnes delivered in the second half of a month. We (IPE and the clearing house) never considered for a minute that we needed position limits, although we kept a close eye approaching expiry.
The market that actually sets the benchmark crude oil price is the BFOE complex of contracts, and particularly the 21 day forward contract of 600,000 barrels. The global oil price is based on the price of spot (Dated) cargoes arising from this this contract either directly (60%) or indirectly through the ICE Europe WTI/BFOE arbitrage (most of the rest).
Since a month's production of not more than 70 cargoes is worth around $3bn at today's prices, it really is quite easy for the big boys to secure these cargoes with forward contracts and kick the price around like their own priivate football.
It's no wonder that the banks are happy to have position limits on exchange, because it makes not a blind bit of difference. In fact, it forces ETFs into the opaque world of OTC swaps if they still want to play.
IMHO ETFs attempting to hedge inflation provide much needed liquidity for producers trying to hedge. The villains of the piece are the true speculators - ie the trading and financial intermediaries currently laughing up their sleeves.
There is no "London Loophole" , but there IS a global "Physical Loophole".
Why do you think the canny GLG hedge fund is getting into the physical oil trade? Because that's where the money is.
I believe that a joint Transatlantic Commission - maybe made up of Senator Levin's sub-Committee on Investigations and a sub-committee of the UK parliament's Treasury Select Commitee (to whom I gave evidence this time last year) - should investigate the dysfunctional Brent Complex and make recommendations for an alternative market architecture which actually acts in the interests of consumers and producers, and is served by intermediaries, not owned, controlled and exploited by them for huge profit.
> jack
I'm sorry but a 2% margin in oil supply is a shortage as any number of problems could have wiped that out and did for short times.
You will find we did hit peak oil and will never produce the amount we did in early 2008 again. We are finding only 1bbl for every 4bbls we use in the world and many fields are dying fast. Soon the North Sea, Mexico and others will dry up in a few yrs. Alaska use to produce 2mbbls/day now down to 800kbbls/day and dropping.
Now add 3 billion people coming from 3rd world to first world economy and oil is going up with a bullet until we replace it which at $4-6/gal won't be hard, just take 10 yrs. .
But it was speculators as even pension funds, etc are too.
Personally I think futures should only be sold to those needing to hedge oil, corn, etc needs. A .0025 tax on all trades from futures to stocks and all other investments would do wonders cutting this short term trading that is killing our economies, producing bubble after bubble.
Your comments about long-term pension fund participation in commodity markets are a step in the right direction.
We suggest more attention should be directed to the fundamental role of commodity markets, since they are not long-term capital markets, they are price discovery markets intended for a completely different function.
Large long-term capital participation of pension funds and trusts raises the price level of commodities beyond what could be expected by intersection of supply and demand by produces and users. The new higher indicated market-clearing price then sends unreliable signals to both produces and consumers alike further distorting long-term capital allocation decisions.
The result is higher commodity costs for society as a whole benefitting the brokers, dealers and Commodity Trading Advisers who convinced pension fund trustees that commodities should be considered another long-term portfolio asset class suitable for portfolio diversification and risk reduction.
Suitability is the operative word. From a fundamental perspective, commodity futures are not suitable for long-term portfolio investment.
Jack
That is perhaps the funniest post I've ever read on this site. "The Saidi minister said so: ... LOL , If you believe that you are a complete moron.
"Personally I think futures should only be sold to those needing to
hedge oil, corn, etc"
And the buyers would be who exactly? If you bar the speculators you'll have an issue here. You can't match end-users and producers without timing & volume issues
This is all about bubbles, herd mentality, and who has better information. Everyone perceived that GS and Morgan Stanley had better information, so when they came out with price projections showing oil going higher and higher, the herd believed them, and stampeded to long contracts, creating the bubble.
So.... are the Nigerian rebels blowing up any pipelines this year? Are the Israelis planning any air strikes into Iran?
One of the factors driving up prices was the fear that the Israelis would strike Iran, Iran would close the straits of Hormuz, and we would lose 20 percent of the world's oil supply. A GS spokesman could obliquely refer to that to drive up the price, and one of Goldmans US government insiders would already know that the Bush administration had put the kibosh on any Israeli overflights over Iraq to Iran. Is GS really any smarter, or do they just have better contracts?
A free market only works correctly if all participants have access to the same information. The winners will do a better job of analyzing that information and make money. But, there is no free market without transparency in all markets, so why isn't Larry Summers effectively pushing transparency?
"... they are not long-term capital markets, they are price discovery markets" - why can't they be long-term price discovery markets? Doesn't long-term price discovery imply long-term capital participation? Is there any problem with long-term investments in commodities? I think they can basically lead to one of two things, inventory buildups or increased production. What is the problem with either of those?
"Large long-term capital participation of pension funds and trusts
raises the price level of commodities beyond what could be expected by intersection of supply and demand by produces and users." - Realy, how? Please be very specific as to the mechanism. "long-term capital participation" does not directly affect supply and demand, as these participants never take delivery. How exactly do they raise price levels?
On Aug 02 06:11 PM Jack Walker wrote:
> We suggest more attention should be directed to the fundamental role
> of commodity markets, since they are not long-term capital markets,
> they are price discovery markets intended for a completely different
> function.
>
> Large long-term capital participation of pension funds and trusts
> raises the price level of commodities beyond what could be expected
> by intersection of supply and demand by produces and users. The
> new higher indicated market-clearing price then sends unreliable
> signals to both produces and consumers alike further distorting long-term
> capital allocation decisions.
> Somebody show me a valid price elasticity of demand calculation that
> would show me how a very small percentage reduction in crude demand
> could produce an 80 percent price drop, from $147 bbl to $32 per
> bbl.
Demand for oil is very inelastic. We can arrive at that conclusion by micro observation (driving habits, asking people at what gas price they would cut back, etc), or just from the macro view which shows that as oil went UP from $50 to $147, demand was not significantly reduced. Going down that far in response to a slight oversupply is the exact reverse of it going up that far in response to a slight shortage.
> Somebody show me a valid price elasticity of demand calculation that
> would show me how a very small percentage reduction in crude demand
> could produce an 80 percent price drop, from $147 bbl to $32 per
> bbl.
Actual data:
Jan 2004, oil at $32-$36, US consumption 20.479 mbpd (source: EIA)
Jan 2007, oil at $50-$60, US consumption 20.567 mbpd
Jan 2008, oil at $86-$100, US consumption 20.247 mbpd
Conclusion: over this price range, US oil demand is (was?) comlpetely inelastic: price tripled in four years without any significant effect on demand. Works both ways of course.
In a purely commercial market only oil producers could ever sell future delivery contracts and only consumers could ever buy them and take delivery. If there is no buyer at price $X for a particular delivery date then there is no "demand" for oil at that price or time. Or if there is no producer willing to sell at that price or able to deliver on that date then there is no "supply" at that price on that date. To induce a buyer the producer will lower the asking price, or to induce a supplier the consumer will increase the offered price. This continues until a deal is made and ultimately the oil is delivered on that date at a price agreeable to both buyer and seller.
Wow! "Price discovery", operating in a free market where supply and demand sets prices. Can anybody explain to me how allowing speculators into this equation can produce any beneficial effect at all, other than simply distorting the price discovery mechanism of legitimate buyers and sellers of this commodity?
> Wow! "Price discovery", operating in a free market where supply
> and demand sets prices. Can anybody explain to me how allowing speculators
> into this equation can produce any beneficial effect at all, other
> than simply distorting the price discovery mechanism of legitimate
> buyers and sellers of this commodity?
derryl - I thought that most seekingalpha readers, being speculators, would already know the answer. apparently not, as a lot of people keep asking that exact question. maybe i'll write an article about it ;)
the job of a speculator is to help balance supply/demand over a certain time span. if they do their job right, they prevent shortages and gluts. to do that, they have to buy during gluts and sell during shortages. that's the service in exchange for which speculators make money. if they do their job wrong, ie buy during shortages and sell during gluts, thus making both worse: then they lose money, and other market participants make money off of them.
i think that about covers the speculation 101 lecture.
the popular picture of a speculator who moves prices to extremes detached from fundamentals (usually it's "drives prices up") is the picture of a speculator who isn't doing their job right it's basically a speculator who is trying to make money off of other speculators (another description is trend follower, "buy high sell higher"). that may work for some players some of the time, but if that is how speculators as a group behave they would very consistently as a group lose money: ie, they would give away money to the hedgers in the market.
if i'm an oil producer, and i believe the fundamentals of oil imply a price of $60, i would be *ecstatic* about there being a fool who would buy my oil at $150, and i would endeavor to sell them as much as i possibly can at that price. the guy who drives the price up in this case is not an *evil* market manipulator, he's a *stupid* market manipulator who is just handing his money over to me. why would i ever complain about that?
Despite huge increases in exploration and drilling programs between 2000 and 2008 OPEC is unable to increase production capacity.
Moreover, offshore dayrates for jackup drilling rigs has soared from around $30K per day to $150K, in large part to the rapidly increasing demand from Saudi Arabia.
As I'm sure readers know, the only time crude oil producers go offshore is when onshore production has been maximized due to the increased cost and risk. In fact, offshore costs tend to run about 5 times greater for offshore production.
Now consider what is actually being produced. Saudi Arabia has been producing increasingly heavier crude. Why would the Saudis switch production to heavier crude if there was ample supply of the more valuable stores?
I don't think Saudi Arabia or OPEC for that matter, have demonstrated themselves to be a reliable source on production capacity or reserves. Here's an example: Between 1982 and 1988, six OPEC members added 322 BILLION BARRELS to reserve estimates, almost DOUBLING OPEC reserves, although no major oil field had been discovered during this time.
Curiouser and Curiouser but when one considers that the dramatic increase in "proven reserves" was a result of OPEC quota shares being linked to reserve estimates.....well the motivation for playing funny with reserve estimates becomes more clear.
It is also worth noting that if one buys into OPEC reserve claims, it would appear that OPEC alone is able to defy reality by drinking from a bottomless cup. Since 1988 six OPEC members (including SA) have produced around 250 billion barrels of crude, without ANY major new discoveries, but their stated reserves have hardly changed. To the observer, it would appear as though OPEC has simply stopped estimating reserves.
Quickly switching from the supply side of the ledger to the demand side and we can see that growing demand, notably from developing markets like China, will continue to pull the demand curve.
The real question is what is the slope of the supply curve going forward and the simple answer is we don't know beyond the fact that it is down.