rationalist

Watch for Yourself: 60 Minutes Oil Story Was Spot On

Can anyone explain me how these markets really work? I was doing some quick research on the internet but I couldnt find any confirmation of what I've heard:

1. roughly 10% of all global oil trade (i mean the physical stuff) is conducted on commodity markets; the remaining 90% is traded in the form of long-term oil contracts... however - most of these contracts do not have a fixed price, but a price that is indexed to the commodity market price. This is certainly true for example with Gazprom natural gas contracts with its european customers. Is it true with Oil???

2. As I understand the no-delivery futures contracts - these are pure bets, gambling. For example - I can buy oil, while I don't receive any physical stuff. I can also sell oil, while i don't need to actually send the physical stuff to anyone. What happens is a cash settlement at the end of the contract (unless I sell it sooner, which in fact is also a cash settlement). Of course this is obvious that this can be useful for those really holding oil and oil related contractual obligations. However - this also opens wide the gates to speculation - i.e. to gambling on the price. It is amazing to me that a substantial part of today's financial system became one large casino. All those quants in hedge funds and investment banks are equivalent to crazy math students, who go to Casion to "trick the system".

3. take point 1 and 2 together, add easy money and no credit standrads (i.e. huge leverage) and you get a bubble-ready environment. A small market (10% or x% of phisical deliveries), with cash-settlement tools (no need to actually bother with the real stuff) and easy money. The guys that have easy money go and start gambling. Some say - oil will go down, other that it will go up - and they place bets on their predictions. If it went up, the losers pay the winners in cash. Now - since there is more that say it will go up, it really goes up. The greater the difference between those that buy (say "go up") and sell (say "go down") the faster it actually goes up... Why demend and suyppy cannot correct it? Why oil doesn;t flood the market? Because the supply needs years of development (research, drilling, etc), because existing oil fields are being depleted, and finally - because the producers are benefiting from the high price. If there was no OPEC and the oil production was a highly fragmanted industry, there would be a relatively fast increase in production in response to higher price. This would be like sliver. But it is not - OPEC does not care that much about keeping price down - on the contrary - it was set up precisely to keep the price at a high level. That's for supply. What about demand? Well - demand is very inelastic in this case. The whole world is addicted to oil and there is no serious alternative to it now. People cannot say - i will not drive to work today, because oil is high. Of course - some adjustments are taking place, but very slowly.

What about the remaining 90% of deliveries that take place off-market? Well - as long as the prices are fixed or at least semi-fixed, they will be lowering the price at the pump. However, since (as I suspect) many of them have an indexed price to the price on the exchange, they berly passively follow the market. If there was a true bidding market for all physical oil (and no funny cash-settled instruments), we would then be able to discover the real price. Of course the way in wich those long-term contracts are structured is in some way informative about buyers' and sellers' preferences. I am sure that for those contracts that were signed 15 years ago, some negotiation has been taking place (Especially if the price was fixed then). However - the most important that it tells is that people are ready to accept a wide range of prices (as set by our gambling boys) because the supply and demand are both so inelastic.


Now - the bubble may form or may not. All depends on psychology and easy money. Once it starts it will grow to some extent. Nobody can say how much and how long. Tulips in Holland were the same as oil now. Back then there was a genuine demend for tulips and people were ready to pay quite a high price for them. This was however a basis for the bubble. From psychological perspective bubbles form because people have a tendency to ascribe value to assets, while the real value is only with utility that the end user perceives. From financial perspective bubbles form, because there is easy money (thank you, Mr Greenspan).