riverpirate

Is Oil a Bubble? Part Two

Just think for a second about the actual dynamics faced by market participants:

1. 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.