Oil and Commodities Pricing: Fundamentals, Bubble or Manipulation?

The Washington Post says the scale of speculative activity in commodities markets is larger than previous estimates indicated:

A Few Speculators Dominate Vast Market for Oil Trading, by David Cho, Washington Post: Regulators had long classified a private Swiss energy conglomerate called Vitol as a trader that primarily helped industrial firms that needed oil to run their businesses.

But when the Commodity Futures Trading Commission examined Vitol's books last month, it found that the firm was in fact more of a speculator... Even more surprising ... was the massive size of Vitol's portfolio -- at one point in July, the firm held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange.

The discovery revealed how an individual financial player had gained enormous sway over the oil market without the knowledge of regulators. ...

Some lawmakers have blamed these firms for the volatility of oil prices... "It is now evident that speculators in the energy futures markets play a much larger role than previously thought, and it is now even harder to accept the agency's laughable assertion that excessive speculation has not contributed to rising energy prices," said Rep. John D. Dingell (D-Mich.). ...

Using swap dealers as middlemen, investment funds have poured into the commodity markets, raising their holdings to $260 billion this year from $13 billion in 2003. During that same period, the price of crude oil rose unabated every year.

CFTC data show that at the end of July, just four swap dealers held one-third of all NYMEX oil contracts that bet prices would increase. Dealers make trades that forecast prices will either rise or fall. Energy analysts say these data are evidence of the concentration of power in the markets... 

Many people have said that recent price movements make it clear a speculative bubble in the commodity markets has popped. I can't add my voice to that exact wording.

The term "bubble" has become watered down with popular usage in the press and elsewhere, but technically a speculative bubble is the result of price movements that are divorced from the underlying fundamentals (as with housing). Yet the stories I hear for oil price and other commodity movements mostly involve fundamental factors.

Let me say this another way. I've also heard that it can't be supply and demand that's pushing prices around. But even if there's a speculative bubble or market manipulation, it's still movements in demand and supply that are pushing prices around. Demand skyrockets (or plunges in a crash), or perhaps supply is artificially constrained - it's just that the demand shifts are driven by non-fundamental factors. Supply and demand are still at work. It's simply a question of what is driving the shifts in the supply and demand curves - fundamentals or something else?

It's possible for the underlying fundamentals to shift quickly. The possibility of, say, a war can change very fast altering the outlook for future supplies and when it does  prices will change along with the change in the outlook, as they should. But that is not a bubble popping, that is a fundamental driving the price around. Big swings in fundamental factors that cause big swings in expected future supply or demand (and hence affect supply and demand today) can cause big swings in the price, and it can happen relatively fast.

I have yet to be convinced that the big swings in prices we have seen are due to prices departing from the underlying fundamental factors and then returning, i.e. that the price swing is from a speculative bubble in the technical sense (or maybe we are simply debating what we can count as a fundamental fundamental factor, but a technical bubble is still something different).

I don't deny, and never have, that speculation is at work in moving prices around, I've drawn diagrams in the past showing how a change in expected future conditions can change today's price. But I agree with the article, I just don't see the evidence of outright, intentional manipulation of the price. Holding large shares, or seeing large volumes alone are not enough to make that case, and it's hard for me to believe that manipulation alone can explain the size of the swings in price that have occurred in commodity markets. I also don't see the case for a more traditional speculative bubble (i.e. a price change driven by a departure from fundamentals rather than manipulation), but as I've said all along, this is hard to prove one way or the other and there could be some of this at work.

So maybe there was some manipulation attempts, I don't know, but if the evidence was strong we would have heard about it. And maybe there has been some departure from fundamentals. Again, it's hard to know with any certainty, but I still believe the majority of the price movements can, in fact, be explained by fundamentals as defined above.

I could be wrong, maybe there has been manipulation, or perhaps we've seen a more traditional speculative bubble, again in the technical sense, but so far I haven't seen enough evidence to be convinced that this is a better explanation for the preponderance of price movements than shifts in supply and demand driven by underlying fundamentals.

But that doesn't mean we shouldn't keep investigating to see if the claim of no manipulation holds up against additional scrutiny, or if there is evidence for a more traditional type of speculative bubble.

Comments

[Kenneth M:]

Our lawmakers should now act. The CFTC is allowing the destruction of our economy. The trading of US oil in overseas markets must end. Also the exemptions given to these investment banks need to be rescinded. There need to be limits on how much can be invested and you must actually have to buy the oil contract in order to reap the benefits.

2008 Aug 21 06:38 AM

[David White:]

At my first look at this situation, I was also suspecting a deliberate attempt at manipulation. Now I suspect that is not so much the case. Rather I think there were a lot of speculators who were buying commodity futures to hedge against the dollar going down. I think this likely worked for them for the most part. When the dollar bottomed and started upward, a lot of those speculators sold out of their futures positions. This created a spike downward in demand. That let to the big price falls we have seen. Some of the speculators may have even been shorting the futures (selling naked futures with the thought of covering them at a lower price). I am not sure I really consider this market manipulation. We might be better off if there were better restrictions on it though. Then we wouldn't have the wild swings that we are now experiencing. Dramatic movements are generally not good for the general public or the health of the markets. I have not thought of exactly what restrictions should be imposed though. In some ways it seems unfair not to let people hedge against the dollar with commodities. However, if one company is controlling 11% of a commodity market almost entirely for speculative purposes, it does seem that some regulation should be imposed. These specualtors could be accounting for 50% to 100% or more of the total demand for a commodity. They are likely doing this by just rotating from near term expiration futures to farther out expiration futures. You would have to think that this high level of speculation might account for a 25% to 50% (or even more) increase in the cost of the commodity. It doesn't seem right that the average consumer should be paying for the big, well organized, speculators to make money.

Of course, there are also companies who buy a lot of futures to guarantee their cost of goods to some extent. Some of these companies also speculate beyond their needs. I am not sure how exactly you regulate all of this. Did you have some particular suggestions?

2008 Aug 21 07:56 AM

[David White:]

Has anyone checked to see if the OPEC oil barons are at all behind the speculation on commodity futures (especially oil futures)? If they are a substantial force in this area, this could be a sneaky way for them to drive up oil prices, while seemingly providing the amount of oil needed to meet current demand. Is there a way of checking on this?

2008 Aug 21 08:11 AM

[Vox Rationalis:]

David White - I can't answer your question, but I'll pose another: where's the incentive for the Saudis et al to push prices so high that alternative energy development not only becomes more interesting, but actually becomes economically viable?

2008 Aug 21 08:23 AM

[Bruce Allen:]

As a former broker, the vernacular term for this practice is "pump and dump." Speculators use it to speculate. There are plenty of guys in very expensive suits walking around New York, London and Milan who made large money when oil was in the $140s and have left the building. They'll be back. Meanwhile, countries with carbon-based economies, namely every one worth noticing, will continue to suffer as secular growth in global demand works on markets and prices.

2008 Aug 21 08:28 AM

[David White:]

BS Detector: Your argument is logical to an extent, but it is unconvincing. Greed is often a short term thing. Some people want to get as rich as they can as fast as they can. Further I am sure it would appeal to some Arabs to really stick it to the large oil consuming nations of the west, especially the "Great Satan". Also the alternative energy revolution was coming even at lower prices. Some oil barons might view this as another reason to make as much money as possible before oil begins to decline again.

I am by no means saying that I necessarily believe this is going on. I don't disbelieve it either. I just thought it would be an interesting thing to check into. It does seem like a very possible (or even probable) scenario.

2008 Aug 21 09:29 AM

[Chris B:]

Another reason I've been double-short oil since 7/18 (DTO). Supply and demand is exactly what it was when oil was $100 a few short months ago, maybe less on the demand side due to the recessions around the world.

I blame "momentum" investors more so than mafia-esque figures. If enough money bets on what is going up, it will go up, until the bubble bursts (much like when a ponzi scheme ends). This happened with tech stocks, housing, and natural resources - all in the last dozen years. The smartest of these momentum traders took profits off the table regularly and thus still came out OK when the bust came and wiped out their most recent investments. They lived to play the game another day, unfortunately.

The trick is to figure out what's the next bubble they will inflate. In all cases, an expectation develops that upward momentum is inevitable due to some reason. For tech, it was rapid advances and earnings growth. For housing, it was low interest rates and perceived shortages. For resources, it was inevitable inflation, peak oil, Chindia, etc. What's next?

Asian stocks (again)?
Renewable energy?
Infrastructure?
Latin America?
Forex (again)?
Defense?
Bonds?

2008 Aug 21 09:50 AM

[gabe borens...:]

There is no doubt that the price of crude and other commodities have been distorted by the unprecedented leveraged speculation(hedge fuinds?).There is absolutely no way to justify the prices of crude at four times the average of the past 10 years(about 28-30 dollar) based on the final deman.In fact the economic deceleration in the U.S ,in Europe and emerging market economies will implode the demand for crude.In fact the new justification for the high prices is the inability of most refineries to "crack" heavy crude which is abundantly available .On the other hand the technology available from certain companies(at least one of them Canadian) are being ignored.Surely ,the final demand is not what is driving the crude prices.In fact updated info ,did negate the CFTC's original conclusion.
The precious metals are as well the bastion of the speculative activity which contributes to buy commodities psychology driven by the high inflation perception.
Europe is only months away from recession and the Emerging Market Economies will follow .The commodity prices will implode to the long term average prices.In fact Detroit's auto issue should have a negative impact on the industrial metals.
One thing for sure ,cyclically the home prices have kept up with the rate of inflation. The home prices have been declining ....so much for inflation .I would be concerned if there was an evidence of the final demand driving the prices up.

2008 Aug 21 10:10 AM

[TheRealBull:]

Sure we are in bubble territory with commodities.

That is why the US oil supply inventory is in decline, the dollar has lost 1/3 of its value in the past 8 years, food prices are going parabolic, and the economy is robust and expanding. In addition, there is no price pressures coming from China and India, their use of oil is contracting, their demand for food and the Western lifestyle is contracting.

We just don't get it. We long ago threw out any real fundamental knowledge of the markets. No wonder our financial system is collapsing. There is a true lack of vision and this is quite apparent with many of the arguments posted. Bottom line, America is so full of themselves that they don't even see the rug being pulled out beneath them.

2008 Aug 21 04:10 PM

[User 248652:]

Vitol's web site is interesting there is no information on the management, investors, clients or any typical information you would expect to see on such a company.

what can be found is a Oil For Food violation in 2007 and archive.gulfnews.com/a...
majority share of a refinery in UAE

who are they?

2008 Aug 22 05:40 PM

[TinyTim:]

Let's differentiate between speculation and manipulation. Speculation is essential to the market. Speculators try to anticpate changes in fundamentals. They can also be party to and even drive bubbles. Manipulation is exerting non-fundamental influence on prices by affecting or controlling a significant amount of supply or demand. This influence can be accomplished directly in the markets (eg squeezing or cornering) or by affecting other participants (pump & dump or initiating a bubble or peak oil).
Just because a firm like Vitol has a huge position is not de facto evidence of manipulation. "Concentration of power in the markets" isn't either. It's just difficult to believe that players can end up in this position and not take advantage of it. When the media spotlight hits them, as it just did, I don't think the drop in oil prices is a coincidence.

2008 Aug 23 04:05 PM