How Big a Contribution Comes from Oil Speculation?

A key reason why oil prices have been going up is that Asia and the oil producing countries are consuming more while global oil production has stagnated. That means Europe and America had to consume less, and a very high price proved necessary to accomplish that.

I do believe that speculation has been another factor that contributed to recent high oil prices. However, a key element of the bubble story is that there needs to be a very limited response of quantity demanded to the price increases, which the most recent data persuade me is no longer the case. Some of the estimates I've been hearing of the size of the contribution speculation is currently making to the price are therefore difficult to defend. Here I explain why, essentially elaborating on Paul Krugman's theme.

Senator Barack Obama's (D-IL) recent proposal to "crack down on excessive energy speculation" collects some of the claims recently being made on this issue:

Akira Yanagisawa, Senior Economist at Japan's Energy Data and Modeling Center: "In the most recent terms (the third and fourth quarter in 2007), the fundamental prices [of oil] are estimated around 50 to 60 dollars. On the other hand, it is estimated the premium has risen up to around 40 dollars at maximum." [Institute of Energy Economics, 3/08, p. 13]...

Larry Chorn, Chief Economist of Platts: "says the actual costs incurred in producing the most expensive oil is only around $70 or $80 a barrel, meaning that about $50 of the current price represents 'the market's risk premium plus speculation.'" [BusinessWeek, 5/13/08]...

J. Stephen Simon, Executive Vice President, Exxon-Mobil: the price of oil should be $50 to $55 per barrel based on supply and demand fundamentals. [House Testimony, 4/1/08].

John Hofmeister, President, Shell Oil Co: The proper range of crude oil is "somewhere between $35 and $65 a barrel." [Financial Post, 5/22/08].

The average price of West Texas Intermediate during 2007 was $72/barrel. If you compare that with the numbers that these authorities are suggesting the price of oil should be, they appear to be claiming that, based on fundamentals, the price of oil should have fallen rather than risen in 2008.

If anyone claims that the price of oil today should be no higher than it was last year, then I think it's reasonable to ask them also to provide us with the following detail underlying their assertion-- If oil were selling today for the same price as last year, what would be the quantity demanded?

Here I offer some calculations to illustrate why I think it's necessary to ask this question. I'll use data for the first quarter of this year, because that's the most reliable currently available. U.S. real GDP was 2.5% higher in 2008:Q1 than in 2007:Q1. With an income elasticity of 0.5, I would therefore have anticipated something like a 1.25% increase in quantity demanded if the price had stayed where it was.

The U.S. consumed 20.8 million barrels/day of crude oil and petroleum products in 2007:Q1, so with constant prices I would have expected consumption in excess of 21 mb/d for 2008:Q1. In fact, we consumed not 21 mb/d in the first quarter of this year but instead 19.9 mb/d. That 1.1 mb/d net drop in quantity demanded relative to baseline growth is surely related to the fact that the price of oil did not remain at its value of the previous year, but instead averaged $98/barrel during the first quarter of this year, 36% above the average value during 2007, consistent with a short-run price elasticity of

(21 - 19.9)/21 x 72/(98 - 72) = 0.15

If the price had stayed the same, the quantity demanded would have been significantly higher than what we observed. That invites the follow-up question-- Where is the physical product to satisfy this extra demand supposed to have come from?

If oil producers had been selling us 21 mb/d but we were only consuming 19.9 mb/d, that would imply that in excess of 1 mb/d would have been added to inventory during the first quarter. An extra million barrels going into inventory each day would have increased inventories by 90 million barrels by the end of March 2008. But EIA estimates that U.S. stocks of crude oil and petroleum products in March were 1,653 million barrels at the end of March 2008, compared with 1,662 at the end of December 2007 or 1,677 at the end of March 2007. Inventories did not increase, they fell, over this period.

We were only able to buy 19.9 mb/d in the first quarter when we offered a price near $100. So why would it have been possible to secure the 21 mb/d that consumers would likely have wanted at a price of $72?

Given these data, I think it is impossible to argue that the volume of futures market purchases alone could be the reason why oil prices went up this year. A key and necessary element of any speculation-based interpretation must be some explanation for the factors governing the physical quantity of oil being supplied to the market.

We're hearing from a number of experts asserting that there's no reason why the oil price should have gone up. I wish one of them would tell me where an extra million barrels per day in supply is supposed to come from.

Comments

[Paul S from Chicago]

"The average price of West Texas Intermediate during 2007 was $72/barrel. If you compare that with the numbers that these authorities are suggesting the price of oil should be, they appear to be claiming that, based on fundamentals, the price of oil should have fallen rather than risen in 2008."

You seem to be assuming that oil speculation didn't start until 2008...did any of these folks that you quoted also say that oil was correctly priced in 2007?

[Brian Pursley]

Speculation has less than zero to do with the price of oil.

www.bloomberg.com/apps...

"June 2 (Bloomberg) -- Hedge-fund managers and speculators reduced bets on higher oil prices by 80 percent since July as crude futures rose to records and U.S. regulators started investigating trading, government data show.

So-called speculative net long positions fell to 25,867 contracts on the New York Mercantile Exchange in the week ended May 27 from a record 127,491 on July 31, according to a U.S. Commodity Futures Trading Commission report on May 30."

[mangolfer]

Go to and read for yourselves:

hsgac.senate.gov/publi...

[mangolfer]

Must be gas lines in China and India. Have not seen any here....

[scfranklin94]

Mangolfer - Dennis Gartman reported yesterday that Michael Masters largest holdings in his hedge fund are American Airlines, Delta Airlines, and United Airlines, in shares and call options. Gee, is there a reason that he might want crude prices to fall by 50%?

[Paul S from Chicago]

scfranklin94 - It might also be the other way around...his hedge funds might have bought into the airline stocks because they believe that oil is going to fall.

[longoil]

Speculation has little or nothing to do with oil prices.
Politicians, during election season, are looking for scapegoats

It is simply Economics 101: World supply has plateaued at 85 mbl/day since 2003, demand is steadily increasing and oil is an inelastic commodity.

(Bloomberg, June 2008) Henry Paulson; US Treasury Secretary
"We have not seen production capacity for oil grow appreciably over the last ten years and demand has increased significantly, We need to really increase the investment in production capacity of oil and alternative fuel sources. I don't believe financial investors are responsible to any significant degree for this price movement.“

[Michael Levy]

10 Reasons Why Oil Price Speculation Requires a Change in the Rule of Law by Michael Levy

High oil prices that are governed by the commodity markets are in dire need of common sense law and order. When speculation and detrimental logic and reasoning take central command of human society, the results always turn out to be damaging to the majority, at the abundance of the few. The experts and speculators will argue we need free markets and any interference will take away free trade. Well, in many cases they are correct, however, when it comes to essential commodities of food and energy they are completely out of order. Here are a few reasons why essential commodity markets require new legislation.

1. There has been no shortage of gas at any filling station for the past 10 years yet prices are up 1200% because of futures trading going out more than eight years. Even the Saudi oil minister has recently stated the price of a barrel of oil should be no more than $70.00. Demand from China and India is still far less than that of the USA. The Chinese stock market is down 50% signifying a sharp slow down. This news still is not enough to stop the wild speculators hiking the oil prices.

2. When hurricanes hit Florida many gas stations are closed and there is a real shortage of gas for a few days. However, if a gas station increases its prices they will be prosecuted for price gauging. Therefore, if we take the experts argument that there is a shortage of oil then that still does not give anyone the right to profit from the shortage as this is deemed to be prices gauging. How can the USA governments have double standards and prosecute gas station owners who price gauge and not treat commodity markets in the same manner?

3. Oil is an essential commodity for every day living in the same way as water is an essential commodity. It makes no sense to trade water so why leave oil in the hands of anyone who wants to make a quick buck gambling on prices.

4. Pension and hedge fund managers have invested billions of dollars in oil futures. The futures markets are very volatile, thus, no place for pension funds to risk the money for people who trust them to build future wealth. The fiduciary duty of a pension fund manger is to find reasonable returns with low risk and the commodity markets is not that place.

5. If the price of oil was regulated between $40.00 - $80.00 a barrel, the price could go up and down on supply and demand. This would be fair to everyone, for even when supply was plentiful, the price would not drop below $40.00 which will still give a fair profit to most oil related industries. When oil is in short supply the price would be limited to a ceiling of $80.00 which is more acceptable to world economies.

6. There is a moral issue that greed cannot come before peoples basic needs ... No right-minded, ethical, principled government can allow starvation and financial ruin because of a system of trading that is completely out of control.

7. The price of a barrel of oil effects transport, food supply, industrial production and every part of modern day living. If terrorists wanted to devise a plan to destroy the world. economies what better way than finding a method to allow oil to trade at $140.00 a barrel. Why play a game that makes terrorists and anarchists happy.

8. Goodwill to all people is the credo every democratic country is built upon.$140.00 a barrel oil delivers no goodwill. It only brings hardship and political uneasiness.


9. Noble deeds and fair dealing is the hallmark of success for every truly prosperous person. Since the world is made-up from people, where are the noble deeds and fair dealing in the commodity pits.

10. We are all put on earth to help each other succeed in the pursuit of freedom, liberty and happiness. There is no freedom when people are slaves to greed. There are only liberty takers when oil trades over $80.00 a barrel. And finally financial hardship brings misery and discontent.

The time for change in essential commodity trading is now. To quote a few voices from the past...

“Experience demands that man is the only animal which devours his own kind, for I can apply no milder term to the general prey of the rich on the poor”_Thomas Jefferson

“For greed all nature is too little.”_Seneca

“It is greed to do all the talking but not to want to listen at all” _ Democritus

“He who is greedy is always in want.” _Horace

[Seriously]

To Brian Pursley - Just because they reduced their visible positions does not mean that they are not still in the oil market. In fact it points to the funds actually wanting to pour more and more money into oil and other commodities. Please do your homework.

[Global Warming is Junk Science]

No one that has blamed speculators for driving up the price of oil has ever been able to answer these basic questions: Why has it not happened in all commodities, since greedy speculators would have discovered a way to quick riches, and why did it not happen sooner?

[Brian Pursley]

Seriously: So when speculative net long positions fall you call that "speculation"... Please go purchase a dictionary.

[lucidone]

Excellent points, unfortunately commodity trading, and the financial industry in general is rarely governed by ethics. The contemporary free market is the most cutthroat and shrewd system every created by man.

[Donald E. L. Johnson]

I wish this was a message board so we could have a real debate. Briefly, anyone who believes the government should run the world should read Jonah Goldberg's Liberal Facism (liberal-facism.com). Anybody who has read the presentations to the April 22 CFTC roundtable on speculation understands how institutional speculators are inflating prices. They buy only. They set price floors. They distort the basis. They attract non-institutional speculators. They encourage producers to hoard, markup prices and talk up the market. See Iran war talk and Opec predictions of $170. They encourage consumers to hoard and over buy. In other words, institutional speculators generate inflationary momentum that influences not only the energy and ag markets, but also commodity markets where there is no futures trading. Institutional speculators' margins will be raised so they pay speculators' margins, not hedgers'. They will be subjected to much lower position limits, and the CFTC will collect and report much more info in the commitment of traders reports, perhaps daily. Institutional speculators say they're hedging against inflation for their beneficiaries. Instead, they're creating much more inflation than they're hedging against. Their managers are making big bucks, and that's what they are defending. Their jobs. Socialist politicians will deal with them, and they'll screw up the futures and world markets to the long-term detriment of consumers. Only power-hungry politicians stand to win in this game.

[mcadoo3312]

Everyone is spending so much time trying to place blame on one individual cause for the rise in oil, they are missing the big picture. Oil is a non-renewable resource that has been decreasing in supply and increasing in demand, as we all know, for the past several years. More so, this trend is expected to continue, and get worse, in the future. So, supply and demand fundamentals tell us that oil prices have to get higher at some point. But, something literally has to drive the prices higher which is where the "speculators"... come in. There are several different kinds of speculators, but the index speculators are the ones that have come in to focus recently because of their enormous cash inflows into the commodities markets as a form of asset allocation. This is why we are also seeing a negative correlation between oil prices and the value of the dollar. Now, to the person that said why haven't all commodities increased; most have, but most of those commodities are also renewable, oil is not. The price fluctuations of goods that will continuously be able to be reproduced are based on more short term fundamentals. Regarding oil, massive amounts of trades have been placed based on the expectation that the price of oil HAS to go up at some point. The market has gotten ahead of itself with the aid of the cash inflows from speculators. Take these cash flows out of ALL of the markets, not just the NYMEX, and we will see a short term reversion of its price. The price of oil will gradually go back up, but not at the outrageous pace we have seen in past years.

[retired 3 times]

You have got to be an active trader or represent a hedge fund or bank.Come on I traded that market before retiring. CFTC 's own numbers 13 m to 265m in 10 years only 29% of oil market controlled by oil industry.Over 70 % traded by big banks ,hedge funds and overseas with no regulation.Your greed is killing the average american.

[cjct]

I think that Mr. Hamilton's assumption that we should be building 1 million barrels per day in inventories ignores the fact that refiners are importing almost 500,000 less barrels per day and relying on existing crude supplies to tide them over until prices drop. If we had reliable data on global oil inventories I think we would see significant builds. Just look at the stories of Iranian tankers being loaded full of oil with nowhere to go (granted its sour crude but still).

[Donald E. L. Johnson]

In markets where there are no futures where consumers and producers can hedge, there is a lot of unreported speculative activities. I covered the metals markets during the early 1970s when Nixon's price controls distorted the markets. When the controls were lifted, I wrote 11 page one stories about consumers who were dumping their hoards on the gray and black markets. Because producers had stopped producing unprofitable lines because they were unprofitable, huge steel consumers had overbought and double ordered, increasing their inventories of steel to untenable levels. They had speculated that price controls and steel shortages would continue forever. They were wrong, and they paid the price of speculating, hoarding. As a result, when the selling started, prices plunged to levels that steel makers have only recovered from, thanks to increases in world wide demand. This frequently happens in other markets. Think about people who've hoarded new electronic gadgets that they thought would in short supply--iPhones, xboxes, Wii's, etc. They were speculators. They distorted markets short term. Some won. Many lost. Those markets worked themselves out. I'm thinking that the govt. will have to step in to fix regulations of the energy and ag futures markets, and I'm worrying that the politicians will over fix things.

[Donald E. L. Johnson]

In markets where there are no futures where consumers and producers can hedge, there is a lot of unreported speculative activities. I covered the metals markets during the early 1970s when Nixon's price controls distorted the markets. When the controls were lifted, I wrote 11 page one stories about consumers who were dumping their hoards on the gray and black markets. Because producers had stopped producing unprofitable lines because they were unprofitable, huge steel consumers had overbought and double ordered, increasing their inventories of steel to untenable levels. They had speculated that price controls and steel shortages would continue forever. They were wrong, and they paid the price of speculating, hoarding. As a result, when the selling started, prices plunged to levels that steel makers have only recovered from, thanks to increases in world wide demand. This frequently happens in other markets. Think about people who've hoarded new electronic gadgets that they thought would in short supply--iPhones, xboxes, Wii's, etc. They were speculators. They distorted markets short term. Some won. Many lost. Those markets worked themselves out. I'm thinking that the govt. will have to step in to fix regulations of the energy and ag futures markets, and I'm worrying that the politicians will over fix things.

[Donald E. L. Johnson]

Futures markets were created to reduce the impact of cash market speculating in the grains markets back in the mid 19th century. Futures make the speculative activities more visible and gave producers and commercials risk management tools that they have used ever since to hedge against speculation and unpredictable changes in the markets. With the arrival of index fund and other institutional speculators, the futures markets have been converted into casinos from risk management tools. That's the problem that politicians and the trade are trying to resolve.

[sickofthehype]

Under oath the Execs in the industry even state oil should be $50/barrel. And with so much of the price of oil determined by such honest and trustworthy 'investors', what do you expect..

[GH]

"So-called speculative net long positions fell to 25,867 contracts on the New York Mercantile Exchange in the week ended May 27 from a record 127,491 on July 31, according to a U.S. Commodity Futures Trading Commission report on May 30.""

That trading moved from the NYMEX to the ICE to dodge regulation. Bush's head of the CFTC is in on this con, which was originally set up as Enron's loophole by Phil Gramm (McCain's chief economic advisor) and his wife. I believe Senate Commerce Committee testimony before I believe anything on SeekingAlpha (although Mr. Hamilton seems to have an excellent understanding in my humble opinion).

[Hank P]

"Oil soon to $150"; "Libya cuts demand due to existing supply"... Duh! Why should companies produce more when the price is being driven up for them? These are sad days when greed is even more supply than oil.

[User 190596]

Hamilton is correct. If OIL price isn't 30% to 60% speculation, then why does oil jump $10 every time a gun is fired in Nigeria or Israel fires up a jet engine. This has very little to do with fundamentals. There are no gas lines and there is ample supply for the foreseeable future.

[User 1]

Since oil prices are at an all time high, why are oil producers not increasing production to take advantage?

[King of Sanity]

User 190596:

Take speculators out of the oil pricing loop; then we have $50.00-$65.00 per barrel prices that remain stable of the long course. Prior to the advent of the internet, speculators did not have a tool that could effect oil prices overnight. Something must be done very soon to bring speculators under control or we will be paying $8.00 or more per gallon and our entire economy will fall into ruins that may never recover for the long term. We are in a much more dangerous situation than most people realize. Once they realize what is going on, it will be too late to fix the problem. This is why it is so important that swift action take place, and ASAP.


On Jun 26 11:57 AM User 190596 wrote:

> Hamilton is correct. If OIL price isn't 30% to 60% speculation, then
> why does oil jump $10 every time a gun is fired in Nigeria or Israel
> fires up a jet engine. This has very little to do with fundamentals.
> There are no gas lines and there is ample supply for the foreseeable
> future.

[User 1]

"we will be paying $8.00 or more per gallon and our entire economy will fall into ruins"

They already pay $8 to $10 per gallon in Europe and have been doing so for many years. Their economies are still doing quite well.

[nakedjaybird]

Want to determine how much speculation exists?

Stop the LEVERAGE. Everything buck for buck. Make delivery mandatory. And set Margins @ 100%.

[Irony]

User 1 - the price recently jumped to these levels and sparked protests in UK, Spain etc. And if you think Europe is OK, go to live in Italy. A Brithish electronic retailer announced 11% sales drop in the country. It urgently needs new consumers!

[redbaron]

Why investigate speculation in the oil markets, and leave all the other commodities that are also setting new highs, alone? Wheat, Corn, Beans, Rice, Iron, Copper, Nickel, Zinc, Srap Metals of all varieties, gold, silver, etc., are all setting or have recently set, new highs. Why just investigate high oil prices speculation, when speculation is happening in all these other markets as well? There has always been speculation, is my point, and there always will be. And while we are at it, why not investigate the high prices of real estate, that recent low interest rates have generated. Why are high oil prices a problem, when high prices for real estate are considered to be not a problem?

[sml_tx]

To Brian Pursley,
You do know that when "speculative positions" are referred to in those reports that they are referring to the CFTC's classifications. The big banks are classified as commercial and not as speculators and are the main drivers with 'swaps' and the ETF's Look through that data and you will find that most of it is long. The big problem with it all is that the classifications are misguiding since the "Enron Loophole". Physical traders and true commodity hedge funds should be the commerical users and all other Wall Street investors should be classified as specualtors and I think you see a very different picture. Just look at the amzoing increase in actual futures contracts over this period.

[sml_tx]

Pardon some spelling errors. I was typinig to quickly!

[Karl F.]

James Hamilton: I doubt that your income elasticity considerations are helpful. Too many other variables are interfering.

Recent news from credit card companies suggests that US gasoline demand, on a comparable level, is down by about 5%. I guess that is twice as much as the IEA, which seems always behind the curve in its demand projections, is taking into account – price elasticity wise. European consumption has apparently fallen by a similar percentage. That dwarfs the projected demand increase from the Chinese for this year.

So we can assume that oil consumption growth in 2008 is probably below the IEA’s current forecasts.
On the other side, global oil production is inching upwards, even with the much publicised Nigerian problems. Spare capacity today is double that of 2005 and, following the IEA, will further increase towards year end, probably reaching 3.4 Mb/day. The IEA doesn’t distinguish between real demand (consumption) and speculative demand. For the IEA, the latter doesn’t seem to exist. It simply says that all demand is satisfied. Some independent experts believe that average consumption is currently more than 1 Mb/day below production.

There is enough refinery capacity in the world able to handle the sour crude of the Saudis and the Iranians. Nevertheless, the Iranians have apparently problems finding buyers for their oil. (Reliance, btw, is in the process of opening Jamnagar 2, a 500000 b/day refinery specially targeting all those difficult oils)

Global political risks and oil supply risks today are not higher than they have been in the last 3 years.

In light of all those facts, we have to ask: why is the price of oil still rising? The answer is simple: it’s a speculative bubble.

Masters presented a chart (from Goldman Sachs) showing that, by March 2008,
“Commodity Index Investment” had risen to 260 Billion $ (from 13 B, 4 years before). A major part of that seems to be in oil. And that is only part of the total speculation in commodities and in oil.

The energy agencies admit that they don’t have reliable data regarding global oil inventories. Even the numbers for the US rely on voluntary reports not covering the whole sector and having never been verified. Finance investors could in fact control more than 1.5 Billions barrels of oil currently – without much knowledge about that in those agencies.

Someone who believes that the additional demand from finance investors/speculators hasn’t contributed significantly to the oil price increases in recent years should see a brain doctor.

[Alan von Altendorf]

"We are all put on earth to help each other"

How does a starving, crippled child in Zimbabwe or Somalia help a scientist, engineer, investment banker, butcher, baker, candlestick maker? What we are seeing in the commodity markets across the board is hoarding, a Persian Gulf war hedge. Makes sense.

[mangolfer]

I just cut and paste this stuff:

Independent experts agree that excessive speculation is elevating oil prices:

Akira Yanagisawa, Senior Economist at Japan's Energy Data and Modeling Center: "In the most recent terms (the third and fourth quarter in 2007), the fundamental prices [of oil] are estimated around 50 to 60 dollars. On the other hand, it is estimated the premium has risen up to around 40 dollars at maximum." [Institute of Energy Economics, 3/08, eneken.ieej.or.jp/en/d..., p. 13]

Michelle Foss, Center of Energy Economics at University of Texas: "[G]iven that inventories of crude and products are healthy in many locations and that the very real risk of supply disruptions has so far been avoided, the remaining factor left to balance the price per barrel is speculation. The role of speculation in oil markets has been widely debated but could add upwards of $20 to the price per barrel." [Oxford Institute for Energy Studies Working Paper, 2/07, www.oxfordenergy.org/p..., p. 34].

Larry Chorn, Chief Economist of Platts: "says the actual costs incurred in producing the most expensive oil is only around $70 or $80 a barrel, meaning that about $50 of the current price represents 'the market's risk premium plus speculation.'" [BusinessWeek, 5/13/08, www.businessweek.com/b.../ db20080513_734146_page...

Senate Permanent Subcommittee on Investigations: "Several analysts have estimated that speculative purchases of oil futures have added as much as $20-$25 per barrel to the current price of crude oil, thereby pushing up the price of oil from $50 to approximately $70 per barrel." [Staff Report, 6/06, levin.senate.gov/newsr.../ 2006/ PSI.gasandoilspec.0626...

Clarence Cazalot Jr., CEO, Marathon Oil: "$100 oil isn't justified by the physical demand in the market - it has to be speculation on the futures market that is fueling this." [CNNMoney, 11/12/07, money.cnn.com/2007/11/...? postversion=2007111216...

J. Stephen Simon, Executive Vice President, Exxon-Mobil: the price of oil should be $50 to $55 per barrel based on supply and demand fundamentals. [House Testimony, 4/1/08, globalwarming.house.go...].

John Hofmeister, President, Shell Oil Co: The proper range of crude oil is "somewhere between $35 and $65 a barrel." [Financial Post, 5/22/08, www.financialpost.com/...].

Gerry Ramm, Senior Executive, Inland Oil Company: "Excessive speculation on energy trading facilities is the fuel that is driving this runaway train in crude oil prices." [Senate Testimony, commerce.senate.gov/ public/_files/RammSena...