Don't blame the speculators (There is no oil bubble)

The Economist ^ | Jul 3, 2008 | Economist

[curiosity]

ALTHOUGH the price of oil continues to hit new records, it has in one respect been a quiet week on the oil markets. America’s lawmakers are celebrating Independence Day by taking a few days off. That has led to a brief interruption in the torrent of proposals aimed at curbing speculation.

Ten different bills on the subject are in the works in Congress. Before the House of Representatives shut up shop, it approved one by a vote of 402-19. America’s politicians are not the only ones to have fingered speculators for the feverish rise in the price of oil and other raw materials. Italy’s finance minister believes that there is a “magnum of speculative champagne” included in the price of each barrel. Austria wants the European Union to impose a tax on speculation. Saudi Arabia and other big oil producers routinely blame the price on frothy markets, rather than idle wells.

The accusers point to the link between the volume of transactions on the futures markets and the price of oil. Since 2004 the near tripling of trading in oil on the New York Mercantile Exchange (NYMEX), the world’s biggest market for the stuff, has neatly coincided with a tripling in the price.

What is more, investing in oil has become something of a fad. Commodities traders and hedge funds with long experience have been joined by less expert sorts, including pension funds and individuals. All this, the theory runs, is contributing to a bubble in commodities. The rush of punters betting on higher prices is begetting a self-fulfilling prophecy: it is the tide of new investment, rather than inadequate supply or irrepressible demand, that is pushing the price of oil ever higher.

Follow the oil, not the futures

This reasoning holds obvious appeal for those looking for a scapegoat. But there is little evidence to support it. For one thing, the surge in investment in oil futures is not that large relative to the global trade in oil. Barclays Capital, an investment bank, calculates that “index funds”, which have especially exercised the politicians because they always bet on rising prices, account for only 12% of the outstanding contracts on NYMEX and have a value equivalent to just 2% of the world’s yearly oil consumption.

More importantly, neither index funds nor other speculators ever buy any physical oil. Instead, they buy futures and options which they settle with a cash payment when they fall due. In essence, these are bets on which way the oil price will move. Since the real currency of such contracts is cash, rather than barrels of crude, there is no limit to the number of bets that can be made. And since no oil is ever held back from the market, these bets do not affect the price of oil any more than bets on a football match affect the result.

The market for nickel provides a good illustration of this. Speculative investment in the metal has been growing steadily over the past year, yet its price has fallen by half. By the same token, the prices of several commodities that are not traded on any exchanges, such as iron ore and rice, have been rising almost as fast as that of oil.

Speculators do play an important role in setting the price of oil and other raw materials. But they do so based on their expectations of future trends in supply and demand, not on whims. If they had somehow managed to push prices to unjustified heights, then demand would contract, leaving unsold pools of oil.

The futures market does sometimes signal that prices are likely to rise, which might prompt speculators to hoard oil in anticipation. But it is not signalling that at the moment, and there is no sign of hoarding. In the absence of rising stocks, it is hard to argue that the oil markets have lost their grip on reality.

Some claim that oil producers are in effect hoarding oil below the ground. But there is also little sign of that, either among companies or countries: all big exporters bar Saudi Arabia are pumping as fast as they can.

It takes two to contango

Despite their dismal reputation, the oil speculators provide a vital service. They help airlines and other big oil consumers to hedge against rising prices, and so to reduce risk—a massive boon amid the economic turmoil. By the same token, they provide oil producers with more predictable future revenues, and so allow them to expand more confidently and borrow more cheaply. That, in turn, should help to lower the price of oil in the long run. Any attempt to curtail speculation, by contrast, is likely to make life harder for firms and oil more expensive.

[grey_whiskers]

If the runup is due to demand, why the increased volatility on a day-to-day basis?

It'd be a good double-check whichever way, to look at the average daily or weekly price changes (as a percentage of daily price) over the past 20 - 30 years, and to compare that to the average price itself.

If the *normalized* volatility remains in a constant range even while the price has gone up 48% in a year, that's well and good.

But if the (read the word again!) *normalized* volatility has increased just at the same time that the price has skyrocketed, that indicates something other than supply vs. end-user demand at work.

Cheers!

[meadsjn]

Just received this one today:

AN OPEN LETTER
TO ALL AIRLINE CUSTOMERS
From 12 Airline CEOs.

Hello {Mr. Airline Customer},
Our country is facing a possible sharp economic downturn because of skyrocketing oil and fuel prices, but by pulling together, we can all do something to help now.

For airlines, ultra-expensive fuel means thousands of lost jobs and severe reductions in air service to both large and small communities. To the broader economy, oil prices mean slower activity and widespread economic pain. This pain can be alleviated, and that is why we are taking the extraordinary step of writing this joint letter to our customers.

Since high oil prices are partly a response to normal market forces, the nation needs to focus on increased energy supplies and conservation. However, there is another side to this story because normal market forces are being dangerously amplified by poorly regulated market speculation.

Twenty years ago, 21 percent of oil contracts were purchased by speculators who trade oil on paper with no intention of ever taking delivery. Today, oil speculators purchase 66 percent of all oil futures contracts, and that reflects just the transactions that are known. Speculators buy up large amounts of oil and then sell it to each other again and again. A barrel of oil may trade 20-plus times before it is delivered and used; the price goes up with each trade and consumers pick up the final tab. Some market experts estimate that current prices reflect as much as $30 to $60 per barrel in unnecessary speculative costs.

Over seventy years ago, Congress established regulations to control excessive, largely unchecked market speculation and manipulation. However, over the past two decades, these regulatory limits have been weakened or removed. We believe that restoring and enforcing these limits, along with several other modest measures, will provide more disclosure, transparency and sound market oversight. Together, these reforms will help cool the over-heated oil market and permit the economy to prosper.

The nation needs to pull together to reform the oil markets and solve this growing problem.

We need your help. Get more information and contact Congress by visiting www.StopOilSpeculationNow.com.

[Notary Sojac]

During the NASDAQ bubble of 1998-2000, new IPO's were being created daily to soak up the speculative demand.

During the housing bubble of 2002-2005, new spec homes were being thrown up by the millions.

Where's the new oil being pumped to meet the so-called bubble demand of 2008?. There isn't any. And you can't blame Harry Reid or Al Gore for the fact that there are no existing oilfields outside the US which show significant volume increases over the last couple of years.

[dirtboy]

Where's the new oil being pumped to meet the so-called bubble demand of 2008?. There isn't any

Oh, it's coming - every drilling rig in the world is running right now.

[econjack]

I agree. Still, since price expectations is one determinant of demand, I think that will shift the demand curve if an announcement of opening up ANWR, OCS, and federal lands to drilling is made. That could have a significant impact by itself without any supply shifts because of increased output. The impact will probably be most felt on the speculators, but also on large consumers (e.g., airlines) who have been hedging their bets in the futures market. Also, most people would be tickled pink to see a $.50 (12.5%) drop in price for a gallon of gasoline. It may be small, but it's still better than a poke in the eye with a sharp stick. For people who drive a lot (e.g., sales people, marketing reps, truck drivers, etc.) it could mean hundreds of dollars each month. Plus it also means that countries that support terrorism get less on each barrel, too.

In short, I really don't care if price only drops a half percent, that's better than nothing. Unfortunately, Congress could care less about us and they won't allow anything that makes us happy take place until after Nov. I say: Throw the bums out!

[george76]

bttt

Follow the oil, not the futures

[george76]

bttt

Despite their dismal reputation, the oil speculators provide a vital service

[econjack]

Man, I really hate articles like this. What they do is come up with some catchy phrase, like "bubble formation", and then go back in history and selectively pick out a number of examples that fit their "theory" to give it some credence. You can always spot such BS articles because they concentrate on the past and have very little on what the theory predicts. This relatively long article has one paragraph at the end that says anything about what will happen, and that doesn't fit what he said earlier all that well.

It makes for some fun "Golly, Gee!" reading, but Harper's magazine is probably not where you're going to find any hardcore economic thoughts.

[HamiltonJay]

Hhahahah.... I heard the same thing about housing prices and tech stocks.... oh and as a child I recall a similar thing too “Ignore the man behind the curtain”.

[econjack]

Oh, perfect! Let's have the gov't get more involved in the market and put regulations into effect that will become obsolete before they take effect. Even if they were effective, they would simply create a new market in some place where the US laws are not in effect. Like it or not, speculators do perform a function in the market.

If you really want to hurt speculators, Congress would be more effective if they would secretly set forces in motion that would dump about half of the Strategic Petroleum Reserves on the market overnight. Then, as the gov't is dumping the reserves on the market, have both parties hold a joint news conference and announce what they are doing as it is happening. The spot price of oil would go into the dumper. Speculators would take it in the shorts all the way down. When the new (lower) equilibrium spot price is sensed, the gov't jumps in and uses its ill-gotten profits to refill the SPR. While the spot price would go back up somewhat, it probably would increase due to the very real increase in demand from new markets like China and India rather than speculators who would likely be licking their wounds somewhere.

Obviously, our Congress doesn't have the stones to do such a thing, but I'd sure prefer that to more gov't intervention in the market place. I'd much rather see the gov't use the market than try to change the market through ill-conceived regulation.

[Notary Sojac]

We are not at "Peak Oil" but we are definitely at "Peak Cheap Oil".

We'll never see the good side of $80/bbl again.

[SAJ]

When open interest is rising, as here, and the market is moving sharply lower, as it has for much of this week, the only logical conclusion is that new capital is entering the mkts on the sell side.

Actually, crude OI is rising just a little bit over the past week. Natgas OI, though, is off 30K contracts in a week's time, and the mkt is down some 6-7% during that period, This is clearly the liquidation of long positions.

[Democrat_media]

You say that someone is manipulating the oil market. Can you name names or have evidence of who specifically is doing it?

I haven’t seen any evidence. And I don’t think speculators are Causing the high oil prices. It is Democrats who have caused the high oil prices. Democrats have said no to more oil drilling, no to more nuclear power plants, no to more refineries, no to drilling in ANWR, no to drilling in the OCS, no to oil shale, no to coal to oil liquefaction, no to coal mining, no to coal power plants, etc. etc. and so on ad infinitum.

Congress Has Made It Illegal to Develop Oil Shale!, Do you believe this???...
http://forums.4aynrandfans.com/index.php?showtopic=8625

[McGruff]

I'm an economist who specializes in the financial markets.

How much have you made off speculating so far?

[USFRIENDINVICTORIA]

As I said, I think it was worth reposting — no apologies necessary.

The search function does seem to be hit-or-miss sometimes — this could happen to anyone.

[USFRIENDINVICTORIA]

This appears to be a CYA letter, written by airline CEOs, who all deserve to be fired by their respective Boards of Directors for their failure to properly hedge against oil price increases. Southwest hedged & now they're eating these losers' lunches.

When a large consumer (such as airlines) doesn't hedge oil — that consumer is speculating. It's speculating that the oil price won't rise.

The futures market exists to provide insurance against wild price swings — for both consumers and producers. Hedging is like buying any other kind of insurance — a prudent business practice.

These CEOs don't believe a word of what they're saying (if their CFOs told them this crap — they should be firing their CFOs). They're just desperate to deflect blame. Shareholders should be in revolt & demanding some accountability from the respective Boards of Directors.

[curiosity]

How much have you made off speculating so far?

I don't speculate. I put about 5% of my savings in a commodities index fund as a hedge against inflation, just like the university endowments and pension funds are doing.

[rurgan]

Demand is higher than supply and has been for several years. Have you HamiltonJay or jveritas looked at the graphs below?

The following graphs of world oil supply and demand clearly show that world oil supply has not met world oil demand for several years. Demand has been greater than supply.This , the most basic law of economics, the law of supply and demand should put an end to all this scapegoating of the speculators (the free market), hopefully.

Proof that demand has not met supply for several years

We have enough oil in the ground , in oil shale , in coal to oil, etc. But democrats have not let us get to that oil and they won't unless the American people make them. How can we have enough oil production/supply when for decades Democrats have said no to more oil drilling, no to more nuclear power plants, no to more refineries, no to drilling in ANWR, no to drilling in the OCS, no to oil shale, no to coal to oil liquefaction, no to coal mining, no to coal power plants, etc. etc. and so on ad infinitum?

[Toddsterpatriot]

A barrel of oil may trade 20-plus times before it is delivered and used; the price goes up with each trade

LOL! That's funny! Get your guaranteed profits now. Buy oil, the price goes up every time it trades. LOL!

[RightWhale]

-——You and others like you who are pushing peak oil theory-——
Not a problem. Nobody is woried about Peak Oil.

---

http://money.cnn.com/2008/07/10/news/international/opec_report.ap/index.htm

VIENNA (AP) — World energy needs will spike by more than 50% by 2030 but adequate oil reserves, conservation and new methods of recovery mean supply will keep pace with demand, the Organization of Petroleum Exporting Countries said Thursday.
. . .

The report projected oil demand to rise by 29 million barrels a day from 2006 through 2030 to reach a daily 113 million barrels a day - a drop of 4 million barrels a day over its predictions last year, “due in part to the higher oil price assumption” - expectations that pricey petroleum is here to stay.

New recovery methods to boost supply

A large part of that projected demand will be met by new recovery and production procedures, meaning total demand for “conventional crude” - oil pumped from wells and other methods using present day technology - will not exceed 82 million barrels a day by 2030, said OPEC.
. . .

---

It’s Peak Oil, but not a problem. Prices will remain high, maybe not above $100 forever, but that’s high enough. OPEC would not be pushing Peak Oil anyway, not politically in their interests even if it is so.