Oil Bubble: How Speculation May Contribute to Recent Moves in Oil Prices

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Includes: OIL, USO
by: James Hamilton

An important recent trend in management of pension and hedge funds is the increasing allocation of investment dollars to commodity speculation. There are lots of ways you can do this. Perhaps the simplest is to purchase, say, the July NYMEX oil futures contract.

If you'd bought that contract Friday, it would enable you to take delivery of oil in Cushing, Oklahoma, some time in July for $126/barrel. As a pension fund, you don't actually want to receive that oil, so in early June you'd plan on selling that contract to someone else and using the proceeds to buy the August contract. If oil prices go up and you can sell the contract for more than $126/barrel next month, you will have made a profit. By rolling over near-term futures contracts in this way, your "investment" will earn a return that follows the path of oil prices.

The Goldman Sachs Commodity Index is essentially a mechanical calculation of how much money you'd have each day if you followed a strategy like this for each of the major commodity contracts, with energy prices comprising about 70% of that index. There are a number of firms that offer products that could implement such strategies on your behalf, such that the dollar value of your investment will essentially follow the GSCI (or similar index) less trading costs and management fees.

In April Bloomberg reported:

Investments in commodity indexes rose $40 billion in the first three months of the year to $185 billion, a larger gain than the whole of 2007, Citigroup analysts Alan Heap and Alex Tonks said today in a note to clients....

After investments in indexes, commodity trading advisers account for the biggest portion of the total amount invested, the Citigroup analysts said. At the end of the first quarter, advisers accounted for $94 billion, 18 percent more than at the end of last year, the analysts said.

Hedge funds ranked third, with $75 billion in commodity holdings, an increase of 25 percent over the end of 2007, Heap and Tonks said. In all, they estimate $70 billion in additional investment funds flowed into commodities markets in the first quarter.

What would be the effect of a big increase in the volume of purchases of near-term futures contracts? If investors were all equally informed and risk neutral, an increased volume of purchases would have no effect on the price. In such a world, there would be an unlimited potential volume of investors out there willing to take the other side of any bets if the purchases were to result in a price that was anything other than the market fundamentals value.

But with risk-averse investors or with differing information, the answer is a little different. For example, I might read your willingness to buy a large volume of these contracts as a possible signal that you know something I don't. For this reason, standard financial "market micro-structure" theory predicts that a large volume of purchases may well cause the price to increase, at least temporarily, until I have a chance to verify what the true fundamentals value would be.

But verifying that true fundamentals value in the case of current oil markets is not an easy thing to do. If you believe, as I do, that the Hotelling principle has now become a factor contributing to oil prices, the market fundamentals value depends on how much oil the world is going to be able to produce over the next half century and what alternatives we're going to develop. If you have a different answer to that than I do, it's a very difficult task for me to figure out which one of us is right.

Let us for the moment accept the possibility that a sufficiently large volume of speculative commodity investment could succeed in driving the price of those futures contracts above what they would have been in the absence of these purchases, at least for a while if the volume of such purchases continues to increase. That still leaves a key question: If speculation is driving the futures price up, what force is bringing the spot price up with it? Wouldn't the large volume of speculators selling the July contract next month drive the July price down at that time, so they make a loss, not a gain?

The enterprise at the end of the chain in July, the ultimate final buyer of the July contract, is someone who actually wants to take physical delivery of oil in Cushing, Oklahoma, some time in July. That would be a refiner who wants to turn it into gasoline. The demand for oil from a refiner in Cushing is responsive to the spot price through two mechanisms. The first is the demand elasticity that's ultimately inherited from the motorists who use the gasoline. If consumers face a higher price for gasoline, they will reduce their purchases, by which mechanism ultimately the refiner would want to buy less crude when the spot price goes up. But, particularly in recent years, that consumer demand response is very small.

A much more important way in which the spot price of crude would affect the refiner's demand for the product is through an intertemporal calculation. Given my customers' demand, I'm going to need to buy the product sooner or later. If you charge me a lower price today than you're going to charge me next month, I'd choose to buy more today to put it into inventory. If you charge me a higher price today, I'd rather run down my inventory and buy the oil next month, and of course the futures market allows me an opportunity to lock in a price for doing just that.

Thus by far the most important factor in refiner's demand for July oil will be the August futures price. If my production plans left me willing to buy July oil for $124.25/barrel when August oil was selling for $124/barrel, I'll probably want to buy July oil for $126.25/barrel now that I'm forced to pay $126/barrel for August oil. Thus to a first approximation, the spot price would move by exactly the same amount as the near-term futures price. A $1 increase in the August futures price would shift the demand curve for July spot oil up by $1. In this fashion, an ever-increasing volume of speculative purchases of the near-term futures contracts would drive the spot price up with them.

Now, the above argument abstracted from the effects of the price on final gasoline demand, and we know that the demand elasticity for the final product is not literally zero. Thus the bubble described here could not literally be self-fulfilling. Something else has to give-- this is the point emphasized by Paul Krugman. If it all transpired just as I said, with international producers all adjusting their price to move in step with the West Texas Intermediate delivered in Cushing, they would ultimately find they're selling less than they otherwise would have. And so you might expect to see stories like this one from Bloomberg:

Iran, OPEC's second-largest oil producer, more than doubled the amount stored in tankers idling in the Persian Gulf, sending ship prices higher as demand for some of its crude fell, people familiar with the situation said. The 10 tankers hold at least 20 million barrels of oil....

Iran has a glut of its sulfur-rich crude as refineries that can process the fuel shut down for maintenance. The discount on Iranian Heavy crude compared with Oman and Dubai petroleum has more than doubled since the start of the year, according to data compiled by Bloomberg.

"There's not much demand for heavier crudes such as those from Iran," said Anthony Nunan, assistant general manager for risk management at Mitsubishi Corp. in Tokyo.

And eventually the bubble could only be ratified if we saw decreased production from oil producers, or at least stagnating production in the face of growing demand. But of course it is a fact that global production has failed to increase the last two years.

World Production of Crude Oil, NGPL, and Other Liquids, and Refinery Processing Gain, in million barrels per day, from EIA.

The biggest single factor in the stagnating global production is the fact that Saudi Arabia in January and February produced 350,000 b/d less than its average level in 2005. The increase in production to 9,450,000 b/d announced Friday in conjunction with President Bush's visit to the Kingdom would still leave Saudi production 100,000 b/d below the 2005 levels.

Arab News quoted Saudi Oil Minister Ali Al-Naimi as declaring on Thursday:

Financial markets have a logic and mechanism of their own. Such markets are influenced by ever-changing factors and parameters that transcend markets and boundaries and are often unregulated. Therefore, the short-term oil prices are more closely tied to the internal logic of the financial markets than to underlying supply and demand fundamentals.

Reuters reported this from a follow-up news conference the next day:

Saudi Oil Minister Ali al-Naimi said on Friday that the world's top oil exporter would meet any demand from its customers for oil. "Any demand for extra production capacity from consumers will be immediately met," Naimi told a news conference.

If we take these statements at face value, they seem to be declaring that Saudi policy is to allow their prices to follow the futures markets. If you offer to sell all that anybody wants to buy at that price, you'll discover that demand for your product has gradually slipped as a result. But of course, saying this is all caused by the futures speculation is quite inaccurate. If this is what has been going on, declining Saudi production played an absolutely critical role in the price bubble.

Let me repeat here that I do not believe that speculation is the reason oil went from $60 to $120 a barrel. The biggest part of that longer term trend is due to fundamentals, not speculation. Notwithstanding, it does appear that speculation has gotten ahead of those fundamentals in the most recent developments.

For the bubble to continue, we would need to see ever-increasing volumes of investment money pouring into the futures markets, and continuing stagnation in global production to ratify them. Even if the former occurs, my best guess is that the latter will not.