Why Oil Speculation Is Actually Necessary

| About: iPath S&P (OIL)

The downswing in oil prices over the past two weeks has once again introduced supply/demand questions while, at the same time, renewing suspicions that speculation is the cause of oil pricing instability.

Discussion of the supply/demand question usually gravitates to the "peak oil" debate: How much oil is left, and when will the markets conclude that over 50% of the total supply has been exhausted? This latter consideration has become a mainstay of the debate. That's because it cuts to the core of how traders view the relationship between available supply and price.

In a normal market, pricing – whether for paper barrels (futures contracts) or wet barrels (actual consignments of oil) – is primarily based on the price of the next available barrel. It is, therefore, a forward-looking process, based less on where the price has been than on where traders conclude the price is going. (These are forward contracts and deliveries, after all.)

In a supply-constricted market, however, the focus changes to the price of the most expensive next available barrel. Why? Because the normal process of pricing being determined by the interchange between supply and demand only works if there is reserve supply and an ultimate cap on demand expansion.

Price usually serves as the barometer of both – higher prices enticing both increasing production and declining use; lower prices discouraging marginal increases in extraction, but prompting additional use. (Declining energy prices always result in rising consumption.)

But when a concern emerges over how much supply can be brought onto the market in a given time frame, the dynamic changes. Now the uncertainty of satisfying market demand will gravitate the price to higher levels, reflecting competition for the available supply. In this situation, a trader needs to peg the trade to the highest price; otherwise, he or she cannot guarantee access to volume. We are not (yet) in a supply-constricted situation.

Additionally, I want to emphasize – again – that we are not in, nor are we approaching, a peak oil environment, either. (See "Why This Is Not A Peak Oil Crisis," March 4.) There is plenty of oil left. The problem surrounds the end of cheap oil.

The new oil coming online is more expensive to extract, process, transport, and refine. As we move into an accelerated tapping of unconventional sources (such as oil sands, shale, heavy oil, and bitumen), the cost factor increases even more.

Okay, so that provides us with one indication of why prices (until recently) have been increasing. But if the essential culprit is not availability, then is it speculation?

Why Speculation Is Actually Necessary

In a normally balanced market, speculators tend to offset. Even when the presumption is that the price will be moving up or down, there is still an offsetting factor in the trading process.

Speculators are necessary to allow trade. (I have discussed this before as well. See "2011 Energy Prices and the Speculator's Role in Trade," December 28, 2010.) If I want to make a transaction, I need somebody on the other side prepared to take a financial risk. I need, in short, somebody interested in making money off of the transaction – not a party needing to buy or sell the actual oil (more on that in a moment).

Speculators add liquidity. And they tend to take the more extreme positions in trade – both to increase the return potential to them and to provide adequate leverage for exercising a series of options to manage their own risk, thereby narrowing the range of risk for others.

Occasionally, a market can heat up or cool down to the extent that the positions taken by speculators may have an impact greater than usual. However, even in such situations, the existence of the speculative element more reflects – rather than produces – the market effect.

This is important, because current political rhetoric from inside the Beltway finds it very convenient to blame the speculator for the run-up in prices.

One proposed solution is to restrict the speculation in New York. Changes in margins, contract volume, and the like may well be in order. But attempting to restrict futures contracts only to those who have an interest in the underlying wet barrels – i.e., actual buyers or sellers of the crude – will simply move the speculation to markets beyond U.S. control.

Not a good idea for a market already dependent on other countries for upwards to two-thirds of daily oil needs. It also merely accentuates what I do regard as the primary cause: Hedging.

Why Hedging Is A Valid Exercise, Too

It allows providers and recipients of both crude oil and oil products to protect their bottom lines from undesirable changes in prices. They will do so by either counter-positioning consignments or taking options (which essentially do the same thing).

However, the parties are not the same in each case. With crude oil, the provider is a production company while the recipient is a refinery. In the case of oil products, the provider is a refinery, with the recipient a wholesaler (or "jobber").

Leaving hedging as the only, or primary, arbiter of price will bring us back to the situation that prompted creation of futures contracts in the early 1980s. They were designed to open up markets to more participants and effectively wrestle the determination of price from the hands of a few very large international oil companies (the famous "Seven Sisters").

These days, returning to hedging as the way to set pricing once again allows a few players to dictate prices. Today, however, the main participants are not international majors, but national oil companies, other OPEC members, or Russian Rosneft (OTC:RNFTF).

The market price would not be determined by thousands of smaller end users, but by huge producers bent on maintaining higher prices. Nonetheless, the larger vertically integrated oil companies (VIOCs) – those who control the process from wellhead to refinery to retail outlet – would still benefit if hedging were the only solution.

The refinery remains the lynchpin in the entire process. Those who control refinery capacity control the pricing in the regional and local markets they serve.

Anecdotal evidence is already emerging that VIOCs were unusually active in trading in near-month futures contracts in their own product – both when crude oil and gasoline prices were rising through close on April 29 and thereafter, as crude plummeted almost 15% through close on May 6.

Does this improve either the pricing picture or the demand-side concern hitting the average consumer at the pump? I think not.

Disclosure: None

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