Speculation: Stocks vs. Commodities

Oil surged above $126 today. Speculators are buying options on oil reaching even $150 in the next two weeks. The speculative fervor was fanned by a Goldman Sachs report that oil might spike to $150 or even $200 in the next six to 24 months. Oil had reached the $120 level and then fallen back to close to $110 as the Fed signaled the end of the rate cuts cycle and the Dollar rallied against the Euro. The report came in just in time to revive the Oil bulls as the short dollar-long commodity play was being unwound.

The surge comes at a time when OPEC said that the oil markets are well supplied and unlike what is reported by many observers, there is at least three million barrels per day of spare capacity available. OPEC chief went on to say:

"Crude oil movements indicate that some member-countries are unable to find buyers for their additional supply," he said.

Commodities as an Asset Class

Over the past few years a number of new financial instruments have come out which allow the average investor to add commodities to their portfolio. Investments in funds which track commodities have increased to $250B, up $71B from the start of the year. The ETF USO which buys US oil futures contracts has about $620M in assets and currently holds 5016 oil futures contracts corresponding to more than five million barrels of crude oil. These investments are all speculative; the holders of USO never intend to take possession of the crude oil.

This divergence shows up in the commitment of traders report. Commercial hedgers are net short; speculators are net long crude oil. Oil producing nations are commenting upon this phenomenon too.

Oil's gain to almost $120 a barrel is caused by speculation by investors, OPEC members Kuwait, Libya and Qatar said yesterday. ``The fundamentals aren't controlling the price,'' Kuwait's acting oil minister Mohammed al-Aleem said in an interview.

Stocks versus Commodities

Bubbles in equity markets are common. By their very nature equity markets are speculative and tend to overshoot in both directions. With access to commodity market with stock like instruments, the commodity markets are also showing similar speculative behavior. However unlike stocks commodities have different market dynamics. Further unlike spikes in equity prices, the price of commodities has far reaching implications.

Little Short Term Elasticity in Oil

Stocks have elasticity on both the supply and demand side. Companies can do stock buy back when they feel their shared are undervalue. They can also issue more stock if they believe that they can have a better return on equity on the newly raised capital. Investors in stock sell when they believe the price is high reducing demand; they can buy if they believe the supply is more.

On the other hand, both the supply and demand elasticity of oil is limited in the short term. It is hard for users to change their energy usage patterns in the short term; the situation is further exacerbated with subsidies for oil in the emerging economies. Similarly it takes years to bring new oil supplies online.

Economic and Geo-Political Impact of High Oil Prices

Speculative bubbles in commodities have a serious, direct impact on the life of the common man on Main Street. Bubbles in stocks do not have the similar, negative effect.

1. Commodities are not paper assets; they can lead to drastic change in the life of people, especially in emerging economies. People cannot do without commodities; most people in the world do not care about the stock market.

2. Commodity prices are resulting in a net transfer of wealth between nations. Right now, many of the oil exporting nations are not amicable to US interests. High oil prices translate to the US funding its foes.

3. Energy prices are a tax and they will have a damaging effect on economic growth all over the world.

Futures Market: Marginal Barrel and Speculation

The price in any market is determined by the marginal trade. Due to the lack of elasticity in the supply and demand of oil, there can be extreme volatility in the price of the marginal barrel of oil. It is the price of the marginal barrel traded on futures exchanges which determines where oil gets priced at.

When there is a lot of speculative money in the futures market, the marginal barrel can be priced higher and higher, with little consideration to underlying fundamentals. There are some reports that commercial hedgers are watching from the sidelines since they believe that the current oil market is strongly disconnected from fundamentals.

Speculative money also gives oil producers the chance to artificially inflate the price of oil by intervention in the futures market.

Futures Market: Leveraged Effect of Intervention

The price in the futures market of commodities has a leveraged effect. For example the total open interest in the NYMEX June futures around 300K contracts. This corresponds to delivery of 10K contracts per day (10K contracts/day ~ 10 million barrels/day). The total consumption of oil in the US is 20.687M barrels/day. New York market not only serves the US but is used as a trading venue by a lot of international players too; so the total open interest on the NYMEX does not correspond to just US market only. The total consumption of crude oil is at least 83M barrels/day with at least 40% of that corresponding to international trade.

So an oil producing entity can intervene in the futures market to support pricing since they know that it will have a leveraged effect on their profitability. For example, if an entity needs to sell 10,000 barrels a day, you would expect it to sell 10 futures contracts every day. However, instead of selling they can also start buying future contracts at critical technical points. Since oil has a lot of speculative interest, buying at key technical trading levels can ensure that the speculative bubble can continue (see this article on how technical levels affect trading). Speculators by nature are looking at trends and momentum, and the producers of oil can help support the momentum.

Ending Speculation

There is no doubt that the speculation is having a big impact on the rate of growth of oil; speculators are net long; commercial hedgers are net short. Since both the supply and demand elasticity of oil is limited in the short term, speculators can continue to push up the price with little risk of downside. The only way to break the trend is to reduce the attractiveness of the oil market to speculators; i.e. to replace greed with fear.

· Increase Margin Requirements: The easiest way to reduce the impact of speculators is to increase the margin requirements for trading in oil futures for non-commercial traders. This needs to be a coordinated effort with all the major oil exchanges in the world.

· Use SPR as a Price Management Tool: The US has 700 million barrels of crude oil in SPR. The Department of Energy continues to fill the SPR even though it is almost full. The DOE can start using the SPR as a price management tool. They can sell futures contracts against the SPR. Well times futures sales can change the sentiment away from greed towards fear and drive speculators away.

Strategic Compulsion for a Short Term Fix

As I had written in the earlier article, many of the oil exporting countries are not friendly to the United States and our interest. At a time when the US economy and the banking system are fragile, the high price of energy can have severe negative impact on the US. High oil prices also contribute to the increased trade imbalance, putting a downward pressure on the US Dollar. Interests not amicable to the United States can undermine the US without firing a single shot, by keeping oil prices high.

The current market system allows oil producers to not only control supply but also intervene in the futures market at critical points to provide support. We need a counter-weight to this which puts some fear in the mind of speculators. In the stock market, there is a saying 'Don't fight the Fed'; speculators in the oil markets also need a similar mantra of fear 'Don't fight the US'.

There have been some arguments that lower oil prices will encourage use of more oil. Even at $100/barrel oil prices are high enough for oil companies to invest in developing new oil fields. Further there is almost near unanimity in both the political and the investment community that investments in alternative energy is not only essential but will also be profitable. We have reached that critical point, and do not need oil at $125/barrel to drive home the message.

Disclosure: Vikram holds both long and short equity, options and futures positions in crude oil and oil related industries.

Comments

[dougnhi]

While I agree that there is a need for fear to chase away speculators, I think the problem is actually more related to the Fed's trashing of the dollar. This game of devaluing the currency over and over through constant market intervention and interest rate cuts has only emboldened speculators to make bigger bets on inflation. They have a valid point to make (just as bond vigilantees did during the Clinton era). The Fed can't continue to trash the dollar and not expect all commodities to hyperinflate. Paulson and Bernanke have played a very dangerous game and it appears that they're losing. The sad part of what they're doing is that real people are being hurt by the false priorities of saving bankers and the market. Well, that's not the way the commodities folks see it. By monetizing all bad debts, backstopping the entire financial system, and feeding huge sums of dollars overseas to foreign governments, it's our government (Fed+treasury) that have caused the core problem. Personally, I think speculators are only the symptom. Introducing an element of fear is good, but much more important is a change of course and leadership in the Fed and treasury. We need more responsible leaders in these institutions. Bernanke and Paulson (and for that matter, all the Goldman Sacks expats who enhabit the central banking system around the world) must be flushed out and replaced by Volker types...if not, they'll just inflate till they die (or we have a monster depression).

[BrucePile]

Over at theoildrum.com, there is a study where they charted the climb in oil the last few years pricing it in various major currencies other than the USD. The huge climb happens in the other money, too.

As for those darn speculators, Haven't we been told it's all their fault eversince $45/bbl? How many of these hot shots are of the buy-and-hold for 4 years type anyway? If they would all leave, would oil really go back to $30?

[itsonlymoney]

Thank you for this informative article. I am wondering, do I cheer when Ford or any automobile company reports that their car sales are up by 40% in China?

[Vikram]

Here is an interesting piece on how the investments in commodity indices are allowing speculators to bypass position limits created by CFTC.

www.bloomberg.com/apps...

"Asset Diversification'

With the popularity of long-only commodity index funds and the prevalence of total-return index swaps, the definition and quantification of speculation has changed, according to Jim Bianco, president of Bianco Research in Chicago.

Let's say a pension fund, like the California Public Employees Retirement System, wants to increase its exposure to commodities. Calpers, a speculator according to the CFTC, does a total-return swap with Goldman Sachs Group Inc., a hedger. Goldman promises to pay Calpers the total return on the Goldman Sachs Commodity Index and hedges the swap by buying futures contracts. Calpers's speculative bet on commodities gets recorded as Goldman's hedging in the COT report. In so doing, investors circumvent the position limits on non-commercials, says Aronstein, who estimates that passive commodity index exposure in commodities amounts to some $250 billion.

With everyone on board the express train, pension funds can market these bets as ``asset diversification.'' And who will argue otherwise in the middle of a boom? "