Oil Bubble: How Speculation May Contribute to Recent Moves in Oil Prices 24 comments
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An important recent trend in management of pension and hedge funds is the increasing allocation of investment dollars to commodity speculation. There are lots of ways you can do this. Perhaps the simplest is to purchase, say, the July NYMEX oil futures contract.
If you'd bought that contract Friday, it would enable you to take delivery of oil in Cushing, Oklahoma, some time in July for $126/barrel. As a pension fund, you don't actually want to receive that oil, so in early June you'd plan on selling that contract to someone else and using the proceeds to buy the August contract. If oil prices go up and you can sell the contract for more than $126/barrel next month, you will have made a profit. By rolling over near-term futures contracts in this way, your "investment" will earn a return that follows the path of oil prices.
The Goldman Sachs Commodity Index is essentially a mechanical calculation of how much money you'd have each day if you followed a strategy like this for each of the major commodity contracts, with energy prices comprising about 70% of that index. There are a number of firms that offer products that could implement such strategies on your behalf, such that the dollar value of your investment will essentially follow the GSCI (or similar index) less trading costs and management fees.
In April Bloomberg reported:
Investments in commodity indexes rose $40 billion in the first three months of the year to $185 billion, a larger gain than the whole of 2007, Citigroup analysts Alan Heap and Alex Tonks said today in a note to clients....
After investments in indexes, commodity trading advisers account for the biggest portion of the total amount invested, the Citigroup analysts said. At the end of the first quarter, advisers accounted for $94 billion, 18 percent more than at the end of last year, the analysts said.
Hedge funds ranked third, with $75 billion in commodity holdings, an increase of 25 percent over the end of 2007, Heap and Tonks said. In all, they estimate $70 billion in additional investment funds flowed into commodities markets in the first quarter.
What would be the effect of a big increase in the volume of purchases of near-term futures contracts? If investors were all equally informed and risk neutral, an increased volume of purchases would have no effect on the price. In such a world, there would be an unlimited potential volume of investors out there willing to take the other side of any bets if the purchases were to result in a price that was anything other than the market fundamentals value.
But with risk-averse investors or with differing information, the answer is a little different. For example, I might read your willingness to buy a large volume of these contracts as a possible signal that you know something I don't. For this reason, standard financial "market micro-structure" theory predicts that a large volume of purchases may well cause the price to increase, at least temporarily, until I have a chance to verify what the true fundamentals value would be.
But verifying that true fundamentals value in the case of current oil markets is not an easy thing to do. If you believe, as I do, that the Hotelling principle has now become a factor contributing to oil prices, the market fundamentals value depends on how much oil the world is going to be able to produce over the next half century and what alternatives we're going to develop. If you have a different answer to that than I do, it's a very difficult task for me to figure out which one of us is right.
Let us for the moment accept the possibility that a sufficiently large volume of speculative commodity investment could succeed in driving the price of those futures contracts above what they would have been in the absence of these purchases, at least for a while if the volume of such purchases continues to increase. That still leaves a key question: If speculation is driving the futures price up, what force is bringing the spot price up with it? Wouldn't the large volume of speculators selling the July contract next month drive the July price down at that time, so they make a loss, not a gain?
The enterprise at the end of the chain in July, the ultimate final buyer of the July contract, is someone who actually wants to take physical delivery of oil in Cushing, Oklahoma, some time in July. That would be a refiner who wants to turn it into gasoline. The demand for oil from a refiner in Cushing is responsive to the spot price through two mechanisms. The first is the demand elasticity that's ultimately inherited from the motorists who use the gasoline. If consumers face a higher price for gasoline, they will reduce their purchases, by which mechanism ultimately the refiner would want to buy less crude when the spot price goes up. But, particularly in recent years, that consumer demand response is very small.
A much more important way in which the spot price of crude would affect the refiner's demand for the product is through an intertemporal calculation. Given my customers' demand, I'm going to need to buy the product sooner or later. If you charge me a lower price today than you're going to charge me next month, I'd choose to buy more today to put it into inventory. If you charge me a higher price today, I'd rather run down my inventory and buy the oil next month, and of course the futures market allows me an opportunity to lock in a price for doing just that.
Thus by far the most important factor in refiner's demand for July oil will be the August futures price. If my production plans left me willing to buy July oil for $124.25/barrel when August oil was selling for $124/barrel, I'll probably want to buy July oil for $126.25/barrel now that I'm forced to pay $126/barrel for August oil. Thus to a first approximation, the spot price would move by exactly the same amount as the near-term futures price. A $1 increase in the August futures price would shift the demand curve for July spot oil up by $1. In this fashion, an ever-increasing volume of speculative purchases of the near-term futures contracts would drive the spot price up with them.
Now, the above argument abstracted from the effects of the price on final gasoline demand, and we know that the demand elasticity for the final product is not literally zero. Thus the bubble described here could not literally be self-fulfilling. Something else has to give-- this is the point emphasized by Paul Krugman. If it all transpired just as I said, with international producers all adjusting their price to move in step with the West Texas Intermediate delivered in Cushing, they would ultimately find they're selling less than they otherwise would have. And so you might expect to see stories like this one from Bloomberg:
Iran, OPEC's second-largest oil producer, more than doubled the amount stored in tankers idling in the Persian Gulf, sending ship prices higher as demand for some of its crude fell, people familiar with the situation said. The 10 tankers hold at least 20 million barrels of oil....
Iran has a glut of its sulfur-rich crude as refineries that can process the fuel shut down for maintenance. The discount on Iranian Heavy crude compared with Oman and Dubai petroleum has more than doubled since the start of the year, according to data compiled by Bloomberg.
"There's not much demand for heavier crudes such as those from Iran," said Anthony Nunan, assistant general manager for risk management at Mitsubishi Corp. in Tokyo.
And eventually the bubble could only be ratified if we saw decreased production from oil producers, or at least stagnating production in the face of growing demand. But of course it is a fact that global production has failed to increase the last two years.
World Production of Crude Oil, NGPL, and Other Liquids, and Refinery Processing Gain, in million barrels per day, from EIA.
The biggest single factor in the stagnating global production is the fact that Saudi Arabia in January and February produced 350,000 b/d less than its average level in 2005. The increase in production to 9,450,000 b/d announced Friday in conjunction with President Bush's visit to the Kingdom would still leave Saudi production 100,000 b/d below the 2005 levels.
Arab News quoted Saudi Oil Minister Ali Al-Naimi as declaring on Thursday:
Financial markets have a logic and mechanism of their own. Such markets are influenced by ever-changing factors and parameters that transcend markets and boundaries and are often unregulated. Therefore, the short-term oil prices are more closely tied to the internal logic of the financial markets than to underlying supply and demand fundamentals.
Reuters reported this from a follow-up news conference the next day:
Saudi Oil Minister Ali al-Naimi said on Friday that the world's top oil exporter would meet any demand from its customers for oil. "Any demand for extra production capacity from consumers will be immediately met," Naimi told a news conference.
If we take these statements at face value, they seem to be declaring that Saudi policy is to allow their prices to follow the futures markets. If you offer to sell all that anybody wants to buy at that price, you'll discover that demand for your product has gradually slipped as a result. But of course, saying this is all caused by the futures speculation is quite inaccurate. If this is what has been going on, declining Saudi production played an absolutely critical role in the price bubble.
Let me repeat here that I do not believe that speculation is the reason oil went from $60 to $120 a barrel. The biggest part of that longer term trend is due to fundamentals, not speculation. Notwithstanding, it does appear that speculation has gotten ahead of those fundamentals in the most recent developments.
For the bubble to continue, we would need to see ever-increasing volumes of investment money pouring into the futures markets, and continuing stagnation in global production to ratify them. Even if the former occurs, my best guess is that the latter will not.
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Why don't we stop all commodity trading in the US altogether? Gee not only will we not be able blame the speculators who help keep our markets fairly stable, but we also put crude oil pricing overseas...lose jobs here and send more money abroad! Go Liberals!
OPEC (even our "friend" Saudi Arabia) has made it pretty clear they like $120 oil (and I don't blame them--like everyone, they are out to maximize their profit). Otherwise, Saudi Arabia would have raised more than 300K barrells and done it when oil crossed $100, or $110--not $127.
And although many doubt if OPEC can INCREASE production, nobody doubts that OPEC can DECREASE production.
And who thinks OPEC will not DECREASE production if by some fluke, world supply outstrips world demand?
Jack Yetiv
"These momentum players and their cronies in the media can keep markets irrational much longer than anytime in the past—much longer than most of us could imagine twenty years ago—and that's what we have today."
I completely agree with your statement. Many analysts on CNBC last week saying that the earthquake in China was bullish for oil since the Chinese would need to use more gasoline power generators with electricity out...were simply sham analysis. Those poor chinese don't have expensive gas generators - most Americans don't even have them. Most of the streets in those destroyed cities have vast amounts of rubble in them, thus cars and buses won't be moving or consuming much gas for the next few months until those streets are cleared. I live in Seattle, some streets in Seattle were closed off for years following the big 2001 earthquake that hit here, because of unstable buildings - I'm sure those Chinese buildings are built much worse than those in Seattle. I highly doubt closed roads are bullish for oil.
There's plenty of moronic funds that haven't jumped on the bandwagon yet although as the article mentions, there's announcements all the time(recent JPM announcement comes to mind).
The good news for you oil bulls who believe the supply BS, the bubble looks like it's got 30%-40% to go so party like it's 1999 - till it all blows up of course.
Now we just need to add monopolistic/oligopoli... supply theory to the mix since the Saudis and other large suppliers can affect prices and, IIRC, have an incentive to prevent the price from rising too rapidly in order to reduce incentives for technology changes that would ultimately reduce demand. I wonder if the Saudis are worried that demands to stop global warming will finally provide the incentives for alternative technologies and have decided that keeping the price low is no longer in their long term interest.
Just ask Steve Forbes, -R:
"October 20, 2005 Steve Forbes has predicted oil may well plummet to $35 a barrel in 2006"
Refilling Oil Wells
www.rense.com/general6...
Sustainable Oil
www.wnd.com/news/artic...
The above two articles tie in well with Gold's "The Deep Hot Biosphere: The Myth of Fossil Fuels."
Rebeldog
However here is the case that speculators set oil prices: peakoildebunked.blogsp...
the price movement then attracts speculators, who have been chasing commodities, one to another, all year...witness the sell off in wheat corresponding to move up in Oil.
the excess liquidity the fed has created must go somewhere...Goldmans' CDS and MBS/CRE biz is gone forever...and those profit revenues need to come from somewhere, so go long, pump up the price to 140/200...and then allow your traders huge profits once they sell into the ensuing retail buyers...
what a game...
For financial futures to seriously impact the price, there has to be storage involved. I understand the short term "push" you mention and I understand the 20 (now said to be 30) million barrels in ships off the coast of Iran but where is there evidence of additional storage or "hoarding" if you will?
Good point, free markets! Like when Lucent was $80 a share! Better buy some Lucent before it gets more expensive! Or Cisco! Cisco will be $150 a share! Buy now or be priced out forever! I also hear I can make a killing in California real estate! I've heard "they're not making any more land", you know. Land is a finite resource! Better buy now or be priced out forever!
Just checked NYMEX crude! almost $129 a barrel! Cashing out my 401(k) right now to get my position before the rest of you suckers! I'm rich! They're not making any more oil!
1. Speculation is clearly involved in this market. As of right now, there is no oil shortage anywhere globally. The guys that predictably tell us there is a shortage are the same ones that are profiting from the same thing.
2. Investment banks now own massive oil storage facilities globally. Morgan Stanley and Goldman Sachs have actually been taking delivery of oil products to sell at a later date. Precisely the definition of "hoarding". This is just a few articles that demonstrate how this activity has taken place since 2004. I'll let you all draw your own conclusions.
business.timesonline.c...
online.wsj.com/public/...
online.wsj.com/article...
www.commoditytrader.co...
Conveniently as the latest Oil Movements report shows, most supply stock building as occured offshore and out of sight (translation: it doesn't show up in EIA reports). I personally think the investment banks learned from what happened the last time oil correct 30% (when they filled up Cushing in 2006) and figured that the best way to deal with it is to store the oil where the EIA can't calculate it.
in the human race. I hope they loose their shirts.