Last week, the U.S. Federal Trade Commission [FTC] issued new rules to prevent oil market manipulation, greatly boosting the agency's enforcement clout. The FTC will now coordinate its efforts with the Commodity Futures Trading Commission to police the physicals and futures markets.
Among other things, the FTC's new rules prohibit oil market participants from making misleading statements or intentionally omitting information that could affect prices.
In her advocacy for the tougher regulations, Sen. Maria Cantwell (D-Wash.), a member of the Senate's Energy and Natural Resources Committee, said this year's hike in oil prices raised questions about manipulation of the markets.
"Oil supplies are near 20-year highs," she said in a written statement, "and demand for oil is at a 10-year low -- so why have gasoline prices gone up a dollar a gallon since the beginning of the year?"
If we gauge the oil supply as the commercially available domestic stockpile outside the Strategic Petroleum Reserve, the senator's got a point. According to the U.S. Energy Information Administration, when Cantwell's statement was published, the U.S. oil supply stood at 349.5 million barrels. Twenty years before, 334.5 million barrels were available.
Gasoline prices, too, have risen this year, although when measured by unleaded gasoline futures, it's more like an 80-cent rise than a buck.
However, Cantwell has left behind a lot of context by pitting the crude oil supply against gasoline prices.
First, there's the trend in our domestic oil supply, represented by the dashed black line in the chart below. When you derive the trend line mathematically, smoothing out the choppiness, you see that our domestic supply is actually getting smaller.
The black solid line represents week-by-week oil inventories. The most recent peak was in May, when our domestic stocks topped 375.3 million barrels, the highest level since the summer of 1990, when we had 391.9 million on hand.
Spot crude averaged a price of just under $52/barrel in May. With oil supplies down some 26 million barrels by late July, though, the price of oil has risen nearly $20 a barrel.
Inventory Vs. Futures Spreads
Directly comparing today's oil price to supply over the longer term, however, ignores the effects of inflation. We've seen inflation's impact on oil prices in "A Picture's Worth A Thousand Word (Or Dollars)." When oil supplies peaked in summer 1990, crude was nearly $21 a barrel. Inflating the 1990 price by the Consumer Price Index makes the oil worth 34 simoleans in 2009 dollars. Inflation accounts for 42% of the apparent price rise since oil's last supply peak.
And the rest? Well, we can determine the legitimacy of oil prices by looking at the futures curve. When we're well-supplied with oil, contracts calling for later delivery are priced higher than the spot market; this price relationship is often called "contango." In May, for example, spot West Texas Intermediate [WTI] traded through NYMEX at $53.50 a barrel. A contract three months forward traded $3.58 higher at $56.78. The price differential mostly represents the expenses associated with carrying the oil cargo (storage, insurance and interest) until delivery.
Technically though, contango represents that part of the price premium in excess of carrying costs. On May 1, the per-barrel cost for financing, storing and insuring a WTI cargo was $1.68 a barrel. That means the excess carry or contango was $1.90 a barrel - incentive enough for savvy traders to buy, store and redeliver through futures. Contango balloons when the market's awash in oil, either because of overproduction or slack demand.
But the crude oil market isn't always flush with supply. At times, in fact, there's too little oil to meet demand. In such times, it's common to see the futures term structure invert. Nearby futures then trade above the price of distant deliveries; in other words, deferred delivery contracts sell at a discount to nearbys. This condition is known as "backwardation."
In June 2008, the WTI market slid into contango after spending nearly a year in backwardation. When the market's inverted, or backwards, the premium in the front months reflects bidders' desire for immediate, rather than later, deliveries. Everybody wants their oil now, so there's no carry in a backwardated market. The inversion is an indication of tight current supplies.
Think back now. Oil was being bought hand over fist in 2007 and early 2008, right?
Oil's flip to contango in June 2008 presaged the post-Independence Day plummet that took prices down $111 a barrel by year's end. Fully a month before crude tumbled from its nosebleed heights, the market was signaling a slackening in demand, and the prospect of a supply overhang.
If you look back over the past two decades, the crude oil market's vacillations between contango and backwardation line up pretty well with oil inventories. As inventories build (demand wanes), a carrying charge market develops. When the thirst for oil remains unslaked, the market tends to invert.
We're in a contango market now, meaning we have more oil than we need. But the contango's not huge by any means. Back in January, the carry trade could have earned you more than $14 a barrel; now, you'll clear just $2.
Yes, oil's higher than it was in the winter, but part of that move is seasonal. Oil and gasoline prices tend to decline in the winter as refinery and driving demands weaken. After winter maintenance is completed, refinery capacity increases. Input and product prices tend to rise, peaking with the summer driving season's finale around Labor Day. It's typical for gasoline prices to be higher at midyear. More importantly, today's gasoline prices have little connection to crude oil inventories two decades ago.
I'm not saying that there hasn't been manipulation, but I wonder just how well lawmakers like Sen. Cantwell understand the markets' seasonal and demand influences.
For now, while we're not awash with oil, our deck shoes are at least sticky with it.