In Part One of “The Oil Bubble,” we looked at the current price appreciation in crude prices and tried to determine if it whether or not it was sustainable. We compared the recent run-up to other various commodities, all of which have corrected sharply, and compared the multi-year advance to other bubbles like the tech bubble of the late 90s and the more recent housing bubble. Our conclusion is that oil is indeed a bubble, but that it is difficult to determine what inning of the game we are in, to use a mixed metaphor.
In this missive, we are going to look at the causes of the sharp ascent in oil prices. The media has run countless stories about who is to blame, and Congress has even hauled in big oil executives to point the finger and demand answers from them. However, as we will discuss in a bit, Congress should really take a more introspective look if they want concrete answers.
Economics 101 tells us that the rise in the price of a good is purely a function of supply and demand, and specifically the intersection where the two reach equilibrium. As such, if demand rises while supply is held constant, prices need to rise for the market to remain at equilibrium. So let’s look at both supply and demand, both of which have played a role in the oil bubble.
First, most observers consider it a foregone conclusion that demand has skyrocketed, due to the large number of new consumers that have emerged in countries like China and India. However, the recent run-up in oil prices has far outpaced anything seen on the demand side.
Global oil consumption grew +2% in the first quarter of this year, while production increased +2.5%. Therefore, there is not an outsized amount of demand, which is physically being consumed. That means that a large amount of demand is coming from speculators, who drive the futures prices of oil higher purely for investment reasons.
Institutional investors, battered by the bear market in 200-02, turned to a new so-called asset class in the form of commodities. Investment demand came from all sorts of institutions, from hedge funds, endowments, pension funds, Sovereign wealth funds, and exchange-traded funds. In the first quarter of 2008 alone, global investments in commodity indexes rose $40 billion (+28% yr/yr) to $185 billion, which, according to Citigroup, was a larger gain then all of 2007.
Hedge fund manager Michael Masters testified before Congress last week that while
Therefore, it is clear that demand is rising, but it’s not just from growth in emerging market economies. That part of the equation is relatively easy to quantify. The wildcard and the one which I believe has more to do with the recent parabolic spike we’ve seen in crude prices, is from the new “Index Speculators” as Mr. Masters has called them, or institutional investors.
In Part three, I will delve into the supply side of the equation, and investigate how Congress is really trying to deflect blame by casting the big oil companies as the enemy.
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This article has 43 comments:
- GORILLA800
- 37 Comments
May 30 10:37 AM- Roger H
- 1 Comment
May 30 11:23 AM"demand for petroleum index futures has increased by 848 million barrels."
One thing I am wondering is:
This oil that speculators are buying - it has to be stored somewhere - correct? After the futures contract closes, the oil that is produced has to go somewhere. Where is all this black goop? Who is hording this stuff? What do they do with it?
Thanks.
- Ernie Montague
- 173 Comments
May 30 11:33 AMAs far as the price, supply and demand theory in Econ 1 is just that, theory. It does not entertain the reality that water is a fairly renewable resource, and oil is not. So if you jigger supply and demand to include FUTURE supply, the sky is the limit. They ain't making oil anymore. Any sophmore in petroleum science knows that.
- paa
- 7 Comments
May 30 11:36 AM- ship shape and bristol fashion
- 59 Comments
May 30 11:49 AMEverything money can buy is a potential investment: Stocks, bonds, currencies, commodities, real estate, stamps, old handguns...
Every driver may feel free to hedge his risk by buying the USO or a similar product.
- Sophisse
- 52 Comments
May 30 11:50 AMI'm sure there are speculators around - when prices of anything shoot up, speculators will be there. Perhaps that means oil will drop some from current prices. But is anyone suggesting it will fall to $10?
- ChuckE
- 1 Comment
May 30 12:13 PM- Alex Filonov
- 282 Comments
My Website
May 30 12:20 PMSure. But we have mostly market of futures, not the market of oil. So in reality the price is defined by supply and demand of oil futures, not of the commodity itself.
- Paulo
- 63 Comments
May 30 01:12 PM- SweetHomeKilla
- 8 Comments
May 30 01:16 PMWhy are you Peak Oil/Chindia taking over the world/This Time it's Different fanboys so afraid of anyone calling the oil price a bubble? Just STFU and leverage up already! No one's going to talk the bubble down and you're not going to talk it up either.
- Ernie Montague
- 173 Comments
May 30 01:18 PMI am not suggesting anyone buy oil for investment. I am pointing out that the long term trend for oil is not likely to be an oversupply, given the increasing population and consumption. Any investment is risky. A recession for a year could drive oil down to $65 a barrel, and it could stay there for a decade. I am simply pointing out that supply and demand economic voodoo on a finite resource is simplistic.
- tuj
- 82 Comments
May 30 01:20 PMIf there is truth that the supply-demand is tight, then the speculators are doing everyone a favor by moving prices higher now, which should accelerate changes in demand.
I'm baffled why so many free-market advocates want to tinker with the oil market. If you believe in the market, then it should correct itself, right?
- riverpirate
- 5 Comments
May 30 01:58 PM1. Refiner. He needs to buy oil in the cash market and/or futures market. He knows that the crude costs $45 on average to pump. Why would he be willing to pay $135 for that barrel? Because he has to. Refining margins are pathetic right now due to this, but refiners have a lot of leeway to pass on their costs due to the public's general accetance of volitile gas prices. In short, the refiner does not care about the price he pays unless it will cause him to operate at a loss -- which will only happen if somehow demand for gasoline fails to slacken AND his ability to pass on costs is constrained. Barring an act of congress this will not happen.
2. Index Speculators. They bet that oil will be scarce and are willing to pay a premium -- any price really -- to have a piece of the action. They are willing to pay any price because no matter what that price is, they belive it will be higher due to 'supply and demand' dynamics in the future.
2. The producers. The producers SELL their crude to refiners in both the cash and futures markets. Many people dismiss the oil runup as a bubble because "cash and futures markets' operate independently and there is no delivery of paper barrels. I belive this is a TRAGICALLY flawed argument. Why? If I'm a producer who's average cost to deliver a barrell is $45, I would be willing to sell my oil for $50 any day, right? Easy money. However, why would I sell my oil on the cash market (which is detached from the futures market) for $50 when I could wait 1 month and get the future's price, which will make me literally 17X more profit!
The truth is while many people say that CASH and FUTUTES markets operate independently, they hold each other hostage because there would be an arbitrage opportunity if the prices diverged too much. What would that arbitrage opportunity be? Hoarding oil! This isn't rocket science really. Until refiners operate at a loss or are no longer able to pass on the cost of their oil inputs, they have no real incentive to challenge the price they are paying in the cash market. Additionally, the cash market participants must charge a similar price to the futures price, because if it were wildly different they could make good money by simply holding on to it for a later date. Since refiners need oil to keep doing business, they pay the cash price, which is tied to the futures price by an arbitrage mechanism.
Guess what, the futures price is set by a steady deluge of "hot money" from every corner of the market right now. From hedge funds, to index funds, to armchair specs, they all want a piece of the action. In order to get sellers for their INSATIABLE demand for contracts they are running up the bids: it is the only way they can attract parties to the other sides of the contracts.
What makes matters worse, all the other world grades are held hostage to the WTI price. Why? Because if the WTI price is $135 the other grades could be arbitraged if their price did not rise to a level that reflected $135 minus deminished refining potential. The whole of the world's oil is indeed being priced by a deluge of demand for futures contracts by non-commercial players, and I've yet to hear a compelling reason why these dynamics are not what is exactly what is taking place.
- E. Gjertsen II
- 1 Comment
May 30 04:02 PM- hsbgill
- 1 Comment
May 30 04:28 PM- anaconda
- 36 Comments
May 30 05:26 PMTo Ernie Montague: The supply of petroleum is not constrained from a physical aspect. There is lots of oil to discover and produce, expensive, yes, but will be produced at the right price.
Most of this oil is offshore, as to your comment, "They ain't making oil anymore. Any sophmore in petroleum science knows that."
That may be true. But there is a lot more oil than is currently generally believed. And, sorry, but sophmores in petroleum science don't know squat, because, oil geologists wrap themselves in dogma.
There is hard science, lots of it, that says oil is not due to algae, but you wouldn't learn that in petroleum science class.
Check out today's Oil Is Mastery blog post and subsequent comment on George F. Becker. Interesting science that contradicts "fossil" theory, which has never been rebutted by "fossil" theorists.
- yuman
- 26 Comments
May 30 07:15 PMSince they buy/sell contracts and most of those have a life of a month, the effect of speculators must be limited to this lifespan. At the end of the contract's life, the buyer must sell and the seller buy, canceling out their effect. Therefore, the speculators only serve to facilitate the market during that lifespan.
The continued rise in oil price beyond a month due to speculation can only be explained with continued inflow of speculative funds that support the uptrend.
Then, the question is why is there so much net inflow that bet on the rising oil? Why don't the speculators bet on dropping oil?
At $130, there are still plenty of buyers of oil, who obviously accept the price as reasonable. If price does not destroy demand, why is this a bubble? Or, is this a demand bubble, rather than a price one?
- pachanguero
- 104 Comments
May 31 08:05 AM- mpkirby
- 11 Comments
May 31 08:34 AMWhile the "future" price of oil might be high due to speculation, ultimately when the speculators roll the contracts forward, they sell their soon to expire contracts to someone that actually wants to get the oil.
If it is a speculative bubble, that oil ends up being purchased at a loss to the speculator. Or a speculator actually takes delivery of the oil and stores it, pushing up oil inventories.
Inventories are not up, and there isn't a significant loss being taken by speculators.
Therefore, we can assume the demand is real at this price.
Mike
- john s. gordon
- 544 Comments
May 31 08:58 AM> jack
- Jack Yetiv
- 442 Comments
May 31 09:20 AMIn other words, who think that if oil corrects "too much" OPEC will NOT cut production by a million barrells or more to push oil back up to at least $110 or $120?
Remember, in inflation-adjusted dollars, $100 oil is no more expensive that oil at its peak 30 years ago. Plus take into account the falling dollar, and OPEC can legitimately argue it's not really getting much more goods and services in exchange for for its oil (priced in dollars) than it was 30 years ago.
Jack
- paulk8756
- 885 Comments
May 31 10:27 AMThink that $4 drop in oil prices was a coincidence? Or are the traders on Wall Street simply watching the "know nothings" in Congress and taking their cues from Capitol Hill? We'll find out this coming week... Cap and trade (Warner-Lieberman) comes up in the Senate, and the Market will react accordingly.
This will once again confirm that the market is trading on the supply and demand for oil, not speculation. Congress has mandated 85% of our offshore oil and gas resources out of bounds to oil and gas exploration (...except to Cuba and China, believe it our not, who are drilling there as we speak).
So watch the debate, and watch energy prices. The two will continue to correlate exactly. Proof again that our energy crisis has been manufactured by our politicians. It will be interesting (...and enjoyable!) to see what happens, now that the Senate is aware the public has caught on to them.
- Xenon
- 4 Comments
May 31 10:35 AM- CLH
- 607 Comments
May 31 10:35 AM- oil baron
- 20 Comments
May 31 11:57 AMWorldwide production capacity stands at just under 89mmbopd.
The most optimistic capacity predictions rise to 93mmbopd by 2015.
Several professional oil analysts already predict Saudia Arabian production is maxxed out and in decline. Indonesia recently dropped out of OPEC due to the drop of production under 1mmbopd.
85% of the known world oil reserves are in countries not friendly to the United States.
I don't know how much affect speculators in the futures markets have on oil prices but I do know that as time passes oil prices will continue to rise and ultimately to well over $200 a barrel.
It all comes down to supply and demand and to try to analyze oil prices on a micro rather than a macro basis is an exercise in futility.
We have no energy policy in this country but we do have an anti-energy policy. I blame Congress for not have the balls to stand up to the likes of the Sierra Club and the treehuggers.
Our only salvation is to get over the "Three Mile Island" syndrome and start the approval process to begin building at least 20 nuclear plants.
- Dr. No
- 27 Comments
May 31 12:19 PMTo that end a myopic oil view isn't helpful. The latest commodity bubble being cotton contracts should make people wonder where all of the sudden the cotton demand is coming from. Why are farmers in the South not able to get contracts? Did all of a sudden a new fashion trend explode in going cotton pumping demand? Let me just make up a couple of urban legends:
* Cotton is in higher demand as more countries move out of poperty and desire higher value clothing with cotton.
* China and India has increased the average wardrobe size and now they need to fill it.
* The prolongation of the Iraq war has increased the demand for white tees by our forces.
* China is planning to build the largest Cotton shield for the olympics and that has dramatically added to cotton demand.
* As the polar caps melt, the increase in population in those regions will not wear fur but cotton to deal with the summer heat.
Anybody else wanna have a go ?
- Jack Yetiv
- 442 Comments
May 31 01:12 PMJack
- User 202964
- 1 Comment
May 31 01:33 PMThe 2 markets do have independence. The cash market is the only one where real oil is traded and it reflects immediate demand and supply. The futures market attempts to anticipate where the cash market is going to be. A flow of money into the futures market favouring higher prices would create losses to the speculator if they bet wrong when settlement date approached.
But does bidding up the futures price influence the cash/spot market? Will producers hoard oil to achieve a higher price later in the year as the futures price suggests?
Probably not. Every market has sellers who need cash now so there will always be sellers to match buyers. At the same time, hoarding creates inventory that must later be sold and is negative for futures pricing. So hoarding can have no long term effect on pricing. The idea that inventories or ability to supply is increasing will destroy the higher futures pricing. The incentive to hoard will end. If there is a link between the futures and the cash market, it is not lead by money flow into the market, but by very real considerations of supply and demand.
- Forgot
- 1 Comment
May 31 04:18 PM- rainman
- 48 Comments
May 31 05:55 PMOil is the only hard currency!
- Reinko
- 329 Comments
May 31 05:56 PMAnd when you realize oil production is not elastic because it is running at almost maximum capacity, barrel prices could be 37.2% lower compared to what we have now.
Dr No from above says it all: There is still much to much money into the system because every dollar of profit on the oil markets generate many dollars of damage on a global scale.
- MNSL
- 31 Comments
May 31 06:04 PMDefinitely we see speculation in the oil market in addition to demand factor. Everybody into commodity now. We know what happened to all types of bubbles in the history. Very soon oil bubble will burst.
- AverageJoe
- 1 Comment
May 31 10:41 PMAs far as supply goes. If oil wasn't over $100, the oil companies would nit have made these large new discoveries, drilling 10 miles underwater is soemwaht costly.
And finally we still many shall I say not to friendly people trying to blow up pipelines and tankers.
Oil will not ever go under 80 again until we find a replacment for the combustible engine.
I am now seeing peopel adjust to higher oil prices. What did they do they stopped spending like glutonous spoiled consumers that they are.
They walk, they take public transportaiton and finally the soccer moms have stopped tooling around in theire big A$$ SUV's talking on the phone all day.
Just my thoughts form Boston MA
- farhad
- 10 Comments
Jun 01 05:30 AM- ship shape and bristol fashion
- 59 Comments
Jun 01 10:23 AM1. It makes new reserves recoverable.
2. It forces economies around the world to be more efficient in their
use of energy.
3. Oil north of a hundred bucks a barrel is a great opportunity particularly
for the United States. US oil service and offshore drilling companies are
the undisputed leader in the world market.
4. For Ford, GM and Chrysler it means: You either make a technological
leap forward or you go bankrupt.
Wouldn't it be nice if US car makers were leaders in technology for a change?
- ship shape and bristol fashion
- 59 Comments
Jun 01 10:24 AMwhere did you get that nonsense, that demand and price have a linear relation?
- green_cheeks
- 45 Comments
Jun 01 12:07 PM- green_cheeks
- 45 Comments
Jun 01 12:58 PMThe price of oil will continue to ascend it's price at a steady acceleration due to the lack of alternatives for current users/addicts.
Due to the high price of oil and it's direct influence on our economic reality, our spending will shift from wants to needs in a progressively gradual manner(needs being food and shelter (rent, mortgage, and/or comfort).... most of us have no need for new clothes). It will be more important to feel somewhat warm and cozy in the winter and somewhat cool in the summer, at least more important than the pleasure we derive from our eyes and hears and all industries that revolve around them. We will still have the American appetite. I know few people that will sacrifice their favorite carbon input loaded diet for much else, me included with my avocados, California salad greens, coconuts and other tropical fruits. We will no longer be able to have our cake and eat it too, in a sense. There will always be the super rich with the ability to buy whatever they please, but the other 95% of us will be choosing to heat or cool our homes moderately, eat our same or similar diet without a lot of changes. Nothing is as close to a person's heart both literally and figuratively as their stomach. We have had a economy that has serving our neurosis and our needs. Well, when push comes to shove, our neurotic selves give way to the needs of the body.
It thus my belief that our economy could focus on consumer needs for a while and that the next bubble will include all of the industries that are required for the production, supply, and distribution of these items, thus oil, ag, natural gas, nuclear, wind, solar, rail delivery as opposed to truck, etc. Some could argue that we have seen a bubble already forming in these industries but then again, it is not like people are pulling ALL of their money out of Apple at this point to invest in our more immediate and basic industries. The market seems to be fairly diversified still, a diversification that resembles the idea that cheap oil will perpetuate into the unknown future.
So I guess my little ramble is this, we have had an economy predicated on cheap oil for a long time and it will correct itself. It is as we have been taking out a loan that is now due. The way it will be paid off is through a more subsistence like lifestyle. It is also my belief that commodities will be the most stable currency. The people that get in early are going to see those investments grow exponentially, even if one starts today.
This is the way Warren Buffet thinks. Ken Heebner, the other, virtually unknown Wall Street maverick (currently on the cover of Fortunre) also is on this track. Both these investors are basic needs investors and virtually no tech to boot.
One other thing I would like to address is the "it is different this time" theme that sometime props up. Well, it actually could be different this time. We now have 6 billion people fighting for dwindling resources.