Speculation About Oil
Last Spring, some Democrats and liberals (Ed Schultz and Bernie Sanders spring readily to mind) who have somehow resisted the enlightenment of unfettered free markets suggested that high oil prices are due to speculation.
Noah Smith took this subject on, asking the question: “Do speculators cause oil and/or gas prices to rise above their “natural” or fundamental level?” Noah’s take is that speculation is innocent, and he cites some corroborating experimental evidence. I’m a big fan, but this time I think Noah missed the point. First, I’ll state right up front that futures markets play a vital role in allowing the producers and first-line purchasers of various commodities to be able to stabilize their cash flows and construct realistic business plans. So – yes, futures markets are a good thing.
On the other hand, when quizzed by Senator Cantwell on why big, trans-national oil companies should continue to receive multiple billions of dollars in tax breaks, Exxon CEO Rex Tillerson admitted that a good estimate of a supply-demand determined price (considering the price of the next marginal barrel) for crude is in the range of $60 to $70 per barrel.
For reference, here is a chart and data table for Brent crude, going back to 1987.
At the depth of the global recession, on Boxing Day 2008, when the world was coming to an end, the price dipped below $34. Be that as it may, with recent prices back over $100, we’re looking at premiums over a rational value estimate of from 60 to 85%. Let’s just call it 75% for convenience.
Now, back to the point that Noah misses, and that Senator Cantwell suggested. What is the effect of unregulated speculation on the price of oil? The Senator estimates 30% activity by concerned stake-holders, and 70% by profit-seeking (in my view rent-seeking) speculators who are playing the market for a profit. The graph on Pg 5 of this study (18 Pg. pdf) suggests a ratio closer to 45% commercial and 55% non-commercial interest. Also it looks like open interest, which had been relatively flat for years, increased by a factor of 6 or 7. This financial tail chasing, aided and abetted by deregulation, is a direct manifestation of the asset misallocation that, in my view, is the real cause of The Great Stagnation.
A look at the oil price chart shows 10 to 15 years of more-or-less flat line in the range of $20, followed by a classic bubble and post-bubble bounce. As an aside, this is typical Elliott wave behavior. I can easily trace a five wave rise to the peak, and what looks like the recent end of a counter-current B-wave since the Dec. ’08 bottom. If this is anywhere near correct, the price of crude a decade from now will be eye-poppingly low, and fundamentals be damned.
As an example of a classic bubble peak, consider the Dow Jones Industrial Average during and after the 1929 crash.
But let’s look at fundamentals, anyway. Global GDP growth since 1980 has been in the range of 2 to 5%. Let’s generously call it 4%. The price of crude in 1990 varied from about $15 to $41. Let’s generously call it $30, on average.
If we compound $30 at 4% for 21 years we get (are you ready for this) $68.36. And this is based on generous numbers.
Not a rock-solid price algorithm, for sure, but it ought to be in the ball park. Maybe it’s just a coincidence that this number corroborates Rex Tillerson’s off-hand estimate.
Maybe it’s another coincidence that Morgan Stanley became the largest oil company in America. Plus, another point that Noah explicitly missed is that big, speculative finance entities did, in fact engage in physical hoarding. Here is a 20 month old news flash.
Oil traders are taking advantage of a market condition known as contango, in which the price for future delivery is greater than the price for spot (immediate) delivery. If the difference between the two prices is more than the cost of chartering an oil tanker, traders stand to profit. The difference between the price of crude oil for June delivery and the price of crude oil for July delivery is more than $2.00 a barrel; that’s enough to defray the cost of chartering a very large crude carrier (VLCC), which holds about 2 million barrels of oil and, as of April 23, cost $43,876 per day, according to the Baltic Exchange.
How much of an incentive to keep prices artificially high do you suppose is provided by a cost of $43,876 per day? That’s $1.31 million per month.
And that’s why I think Ed Schultz, Bernie Sanders, and Maria Cantwell might actually be on to something.
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An earlier (and to be honest, inferior) version of article was posted on Retirement Blues back in May.
Jazz,
To add to you data – From Kevin Drum’s site – chart from Goldman_Sachs. This is the supply/demand curve for oil recently.
BTW, Physcal hoarding is the correct solution to the supply/demand problem especially when you beleive price will go up or there will be a shortage. Doesn’t matter if its oil or any other commodity. I saw it during my tour in Europe over disposable diapers (of all things). The disposables were very expensive on the local markets (almost 5 times vs cost at the military exchanges). They were also hard to come by and my wife would make a practice of showing at the closets BX during the day the trucks arrived. Then you would ‘buy and horde’ since you weren’t sure when the next supply would arrive….but we didn’t have a resale option either…
Islam will change
Buff,
No resale option? I’m sure you could have found a willing buyer in the local market. Against policy sure, but I’d bet there was some of that black market trading ocurring. Just like when we sold our gas allocations in the Italian economy when stationed there in the 70’s. I think the larger point here, is that there is no requirement to fulfill the contract in the futures market. I could be wrong, though.
nanute,
Resaleing (and getting caught) was a quick way to end a career (I was their in the 90s). I watched the service dis-charge two majors becuase there wives were caught resaling gas coupons. The people they sold them too folded when questioned by the police. Another big issue was meat. You basically couldn’t get the quality of meat available at the BXs on the local economy. It just wasn’t there. We gave NY Strip steaks for Birthday and Christmas presents to all our German & Dutch freinds – they loved it. (Then they fried it on the stove (!!!!) – a capital offense in Texas)
If you don’t have to fullfill the contract what is the recourse for the party who expected to recieve the oil??? Is there a penalty or does it go to court – which I would think would hurt the profit motive…
Islam will change
Are you talking about speculators who take delivery or those who only trade futures contracts? You appear to be talking about pure speculation, without touching the physical product.
If they take delivery, they can affect supply and demand and therefore price. If they’re engaged in pure speculation, what is the mechanism by which they affect price?
Ths physical hoarding was by those with no commercial interest, like Morgan Stanley. And I don’t see this as a solution, even with diapers, except for a very narrow interest. Good for you, perhaps, but bad for your neighbor. And how could it be good for you to have more than you need, especially if unloading the excess carries a big penalty?
However, with contago, there is no penalty. The only downside is market risk, which you prop up by bying more long contracts that never have to be covered or fulfilled. This causes Upside pressure with no corresponding downside pressure. That seems pretty fundamental.
Remember Morgan Stanly had no ise for the oil. They were using hoarding purely as a rent-seeking activity.
I’m tied up the rest of the day. Will respond to other comments when I can, but that might not be until tomorrow.
Cheers!
JzB
Of course produces can horde crude without the expense of chartering an oil tanker via the simple expedient of pumping less. THAT’S why I’m not a big fan of opening up ANWAR for oil leases. I believe that we’ll get more money for that oil 50 years from now.
Of course produces can horde crude without the expense of chartering an oil tanker via the simple expedient of pumping less. THAT’S why I’m not a big fan of opening up ANWAR for oil leases. I believe that we’ll get more money for that oil 50 years from now.
Of course produces can horde crude without the expense of chartering an oil tanker via the simple expedient of pumping less. THAT’S why I’m not a big fan of opening up ANWAR for oil leases. I believe that we’ll get more money for that oil 50 years from now.
Successful speculation is good because it raises prices before a shortage. Everything speculators buy, they eventually sell, so they don’t affect total supply. Instead they discourage consumption today and make more available for tomorrow when it is more needed. Higher prices send a signal that you should consider buying a Prius instead of a Hummer, and this mitigates the potential for a shortage in the future.
The main reason why they affect the price is by scale. The more speculators in the pool, tieing up more and more oil deeper into the future, makes the future oil more expensive. The working theory in the late 2000’s being that demand is going to steadily increase over time deep into the future, and oil futures were a safe and profitable place to store “value.” In reality….the speculators “created” their own demand bubble, because with the change in the law with CFMA in 2000, foreign players and “Over The Counter” financial instruments were allowed to trade outside the jurisdiction, and allowed to trade at volumes greater than the regulatory setup under the Commidity Futures Trading Commission.
The problem here is that the speculators are absolutely necessary, if commercial traders are to achieve the stability of long term oil prices, which is the entire point of a “futures” market. They absorb the majority of the risk involved as prices fluculate, and as world events effect supply.
“A high oil price can be contributed to a weakening of the dollar, through mounting trade deficits and U.S. debt.
In 2007 and 2008, dramatically rising oil prices fed the U.S. trade deficit leading to increased U.S. indebtedness. This, in turn, contributed to an even weaker dollar, which further drove oil prices higher in a self-perpetuating pattern. Oil-linked index funds became an asset class for investors wanting to escape the falling dollar and weakening stock market, adding to the speculative fervor in oil. According to the International Energy Agency, as of July 2008 financial investors had about $300 billion invested in such indexes, which track the value of futures contracts. The IEA contends that this 2008 level of investment represented a fourfold increase from index-related investment in January 2006.”
http://bakerinstitute.org/publications/EF-pub-MedlockJaffeOilFuturesMarket-082609.pdf
“Remember Morgan Stanley had no ise for the oil. They were using hoarding purely as a rent-seeking activity.”
There is no problem with this! It is necessary for outside non-commercial players to gamble on price flucculations. They absorb all the risk, allowing commercial players to achieve long term price stability, and long term commitments.
Those who were deep into oil futures as the economy tanked, demand collapsed, and the price decreased in 2007-2008 lost their ass……your comment should have read…..”they attempted to participate in rent seeking activity,” but lost big time exposing their over exposure, and exposing why the limits under the CFTC regulatory umbrella are necessary for long term stability.
Look at that graph above. Does that look like long-term price stability to you? Your theory is nice and cool, but doesn’t appear to match reality. Hmm….
The sort of people who can afford either a Prius *or* a Hummer (well, there’s no such thing as Hummer anymore, but you get the gist — a large inefficient luxury vehicle) aren’t affected by speculative surges in oil prices because they’re already likely in the top 20% of taxpayers. I know that I wasn’t affected at all by the price of gas on the recent 4,000 mile road trip I took in a vehicle that gets 17mpg on a good day, sure, I spent $1K on gas, but for a once-per-year vacation thing for a guy with a six-figure salary that’s less than 1% of my annual income. Trivial.
The bottom 50%, those who *are* affected by speculative surges, can’t afford either a Prius *or* a Hummer — they’re likely already driving a second-or-third-hand used Toyota Corolla or Mazda 3. What I hear you say is, “let them eat cake.” Which might be a successful economic policy in a theoretical world, but in the real world tends to lead to abnormally altered necks. Just sayin’.
– Badtux the Reality-based Penguin
I am saying that speculative buying only works when something is more valuable in the future than it is now. If you want everyone to have affordable gasoline in the future, there needs to be more of it available. Higher prices now encourage oil companies to expand production.
Also, the Prius and Hummer were just meant as a stark examples. Many people do respond to prices, because in the end there is only so much stuff available. I am not sure why you think it would be so terrrible if some Americans have to reduce their oil consumption. Maybe they will get more fuel efficient cars, drive less, or eat less meat. If that happens it will be because there is not enought oil handy for 2+ billion people to use all the oil they want.
The problem is that for 50% of Americans, they can’t afford a new more-efficient car, they can’t reduce their use of the automobile any more than current because they have to get to work and that’s the only way for the bottom 50% to get to work (remember, there are only actual working functional mass transit systems allowing existence without the automobile in only two American cities — New York City and San Francisco — accounting for maybe 2% of the U.S. population) and if they don’t get to work they don’t eat. In that respect fuel is the same thing as food, there is biological necessity there and below a certain point you just can’t reduce your consumption because then you starve and the result is food riots, social disorder, revolution, and lots of altered necks. And BTW, the statistics over the past four years of the Great Recession show that people in the bottom 50% have already reduced their driving to basically the minimum needed for subsistence, so the low-hanging fruit is *gone* there. Any additional reduction in fuel use by Americans responsive to prices would require government intervention to subsidize effective alternatives (since it’s clear the market has no intention of doing so, because it’s more cost-effective for them to simply extract more rents in exchange for allowing that population the “privilige” of continuing to exist).
In short, you are correct that *IN A THEORETICAL WORLD* a rise in prices would result in a decreased consumption of fuel. But we live in the *real* world, where fuel = food, and people have this bad habit of needing to eat in order to perpetuate their biological existence. So all that happens is that you end up reducing consumption in *other* areas of the economy — which reduces consumption of fuel, sure, but only because now-unemployed people have no need to drive to work every day. Which I suppose attains your goal of reduced fuel consumption, but hardly in the ridiculous ways you hypothesized would happen in your theoretical world of magic unicorns and cotton candy trees, and hardly in a way we should be wishing for (unless you *like* food riots, revolutions, and lots of dead people, the inevitable end game of basically permanently removing people’s ability to earn food for their table).
– Badtux the Reality-based Penguin
Bad Tux
I think I am going to agree with Heart of Flint here..
high prices for oil have never been so high that people can’t get to work. just the sight of high prices will tend to motivate them to find less fuel intensive solutions to their various problems… over time.
i don’t like “speculators” or “speculator driven price rises” any more than you do.. but i think the danger is more in the direction of manipulated markets and “unearned” wealth.
finally, I think Jim A was on the right track: if “best science” suggests that oil is going to get more expensive in the future, it would make sense for the government to keep as much of it as it can in the ground. a time may come when we have better uses for it than commuting 20 miles to work at even 20 miles per gallon, much less the use of a car as a status symbol.
perhaps the housing bubble would better illustrate your point about speculation leading to lost jobs. as for the altered necks… this is a democracy so we have only ourselves to blame.
Coberly, the problem is that your assertion is contradicted by, well, actual statistics. Until the 2007 recession per-capita usage of gasoline over the past thirty years was pretty much constant at around 2.56 gallons per day, *regardless of the price of oil*. So your speculation is interesting, but speculation that disagrees with actual observed reality is pretty much just idle speculation of no use in the real world. (See http://politicalcalculations.blogspot.com/2010/06/us-per-capita-oil-consumption-plummets.html for nice pretty chart of per-capita gasoline usage over the time period 1982-2010).
That said, I do agree that *LONG TERM* sustained high gas prices would, OVER THE LONG TERM, result in a re-making of American society from one that is car-centric to one that is more sustainable. The problem is that speculation is not creating such sustained high gas prices, instead it’s making the price of gas fluctuate all over the place — hardly the sort of thing that provides proper signals to the economy regarding long-term oil usage.
Regarding the current decline in per-capita gasoline consumption, that appears to be a case of people who are unemployed not needing to drive to work. Or pretty much as would be predicted (see my prior messages about why so).
The price instability in the charts were not caused by speculation under the CFTC regulation, they were caused by speculation not under the CFTC regulation. This fake demand affected the value of the dollar, which then drove the price higher.
There needs to be innovation in regulation, all OTC and foreign players need to be enveloped under CFTC regulations, but speculation must be part of the market place.
There is a big difference between what you are hinting……which is the end of speculation….that would spell disaster!
Bad Tux,
The best I can tell….you want to end all speculation and set up price controls. You may rethink that. that has been tried before….only to end in disaster.
I think you’re reading something into what I said that is not what I said at all. Speculation *as such* is useful for smoothing out price fluctations. What I am against is speculation *as currently implemented*, which is clearly not performing that task.
– BT
“hardly the sort of thing that provides proper signals to the economy regarding long-term oil usage.”
Jeeez….Now your suggesting that the point of price stabillity over the long term is to social engineer the culture away from oil? You seem to be forgetting that well before and recently the overwhelmiing majority of speculators are commercial-delivered. Only in the period between 2001 and 2008 was speculation a controversy after the Law change of 2000. This period saw a senerio where 50% of the speculation was Non-Commercial/undelievered.
These same tactics used in the Oil Futures, are the exact same happending in the other commodities. Are you suggesting that speculation in those markets be ended as well? What happends when large oil producers, big manufacturing, and big transportation lose the ability to secure energy well into the future?
There is an answer to that last question, and the answer is, that there will be periods of massive supply or massive demand and the price will still fluctuate at every level of the economy…..but probably even more severe.
Uhm, no. What I’m suggesting is that the purpose of markets of this nature is to provide long-term price signals to the economy so that the economy can adjust how it uses resources to what the pricing will be in the future. And as you point out (but apparently did not yourself recognize), pretty much *all* futures markets currently are not functioning in a way conducive to providing proper price signals to the economy so that consumers (whether commercial, industrial, or individual) can make proper decisions about how to allocate resources in the economy. Please note that I did *not* propose a solution to the problem of broken commodities markets… I simply pointed out that they *are* broken, because they are failing to provide one of the most important things needed from the viewpoint of an economy attempting to make most productive use of resources, i.e., coherent price signalling.
What is the solution? I did not — and do not — propose one because I do not fully understand the reasons why the markets are currently broken, just that they *are* broken. Proposing solutions when I do not fully understand the causes would be foolhardy and make me no different from a typical Washington politician, and I strive for a bit more than that.
I made it clear in the post that futures markets are good and necessary.
I did not make it clear the speculators are necessary to provide liquidity to a futures market, but I’m doing so now.
It’s a matter of degree. Beyond some ill defined point, speculation can become the market driver, rather than a market enabler. This is one difference between a regulated and unregulated market, and part of why the regulation is necessary.
By analogy, the finanace sector has captured a much larger percentage of total corporate profits over time. The finance sector is necessary. However, a finance sector beyond the size needed to grease the economy diverts money from productive activity to financial tail chasing, and oil speculation is just one example. I’ll have more to say about this in the future.
I also have a follow up post where I try to get a more secure handle on the problem I believe unregulated speculation has caused with oil pricing.
Meanwhile, if you think I’m wrong, then please construct a alternate narrative that explains the bubble, crash, and post-bubble bounce.
Cheers!
JzB
Jazz:
Read here about the Enron Loophole for oil speculation. Championed by Phil Gramm for Wendy Gramm. http://www.nytimes.com/2008/11/17/business/17grammside.html?pagewanted=all
Jazz:
I had a much better post going; but, it kept getting deleted.
Oil speculation has been a topic at AB before. There was a commentor by the name of Jaun who explained very clearly how the spec market was setting the retail price. Even Yves Smith commented in her book or at her blog that there were many who did not get this change of the futures market. She mention Krugman in particular as one.
At the same time, the entire approach to risk management that is now the norm in finance has made it’s way down to the average citizen: insurance. It is now common for the consumer to have to decide if they will “gamble” and purchase insurance via their oil man and a contract to protect them against the price going to high and the oil man not selling enough or, buy it based on the daily price.
What has happened with the process of purchasing heating oil is not a development that has made peoples lives less risky. Though it has allowed those who make money from money the ability to capture more the middle class’s money.
run –
Send it to me in email. jazzbumpa@gmail.com.
Cheers!
JzB
Bad Tux
well, “actual statistics” can be slippery things, especially in a complex environment. far as i can see high oil prices have led to some people using less gas. if other people pick up the slack, it’s hard to tell what they would have done with low prices.
if you don’t think that higher prices are likely over the LONG TERM you have different expectations than i have. moreover I think that the more we can do to reduce gas consumption the better off we will be LONG TERM. naturally i would rather see the government get the money than the speculators.
btw
i looked back to see what “assertion” i had made. couldn’t find one.
It appears to me that your source for global GDP growth is in real terms (based upon constant year 2000 U.S. dollars) and that your figures for the price of oil are in nominal U.S. dollars.
http://www.stanford.edu/~kenneths/OilPub.pdf