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Countdown to $200 oil: $140 oil and speculation
Posted by Jerome a Paris on June 30, 2008 - 9:55am in The Oil Drum: Europe
Topic: Economics/Finance
Tags: $100 oil, $200 oil, original, speculation [list all tags]
| As you may have heard, oil prices have reached a new high above $140. I can already hear the outcry against speculators and their out-of-control games to enrich themselves at our expense. |
Never mind that speculators have been caught shortselling oil (ie betting on a fall in prices) more than a few times in recent months. Never mind that spot oil prices, which require actual physical deliveries of oil at the end of each month, have behaved the same way as paper futures. Never mind that oil storage seems to not be increasing.
Nope, it is just too convenient, too irresistible and, let's say it, too comfortable an excuse that speculators are to blame. It's not our fault, we have our scapegoat. Our price increases are temporary, we'll soon be back to "normal" lower prices, as soon as (take your pick) speculators have been punished/oil companies are taxed for their profiteering/"fundamentals" are left to set prices.
This is just denial.
There are A LOT of good reasons why oil prices are going up. Let me show you just a few.
A Countdown to $200 oil diary
One you've probably heard by now is the "risk premium", linked to the prospect of a war with Iran. Let me explain how that works.
Say that the market price for oil, if there were no prospect of war with Iran whatsoever, were $100 per barrel.
Say that the market price for oil, should there be an attack on Iran, is estimated at $400/bl (because of production disruption in Iran itself, possibly a blockade of the Straits of Hormuz, etc...)
Say that the probability of such an attack is estimated, by markets, at 10% this year.
In that case, the price for oil will be 90%x100+10%x400 = 130$
A 10% probability of war with Iran which would tentatively quadruple oil prices increases the market price by 30%. Now you may quibble with the estimates I've provided here - but the point is, the market will sum up all the various hypotheses made by all players in that game into a single price, which will reflect the combination of war premium, and war probability that the market, as a whole, includes in the price.
So it is very much possible that 20-40$ in the current price are linked to worries about war. But speculators, here, are actually providing a valuable service: by betting on oil prices (in both directions), they allow all players to hedge that risk of war. Those that think war is more likely will be happy to buy oil futures at prices they think are very low; those that think that war is unlikely and that there is too much of a premium will be happy to sell futures into that market.
While this may create an increase in prices, it would only reflect the reality that a war with Iran would have consequences, and that it's not completely unlikely yet. However, I'd note that futures do not seem to change much in 2009 compared to 2008: so either the markets don't actually think that Obama will be elected, or they don't seem to think that it will have a material impact on the probability for war. Or there is no war premium now, and we're back to square one.
2) Chinese growth
This one has also been widely discussed, so I presume most of you are familiar with it. Still, a few graphs are worth showing here:
As discussed on Casey Research, China is enjoying staggering growth rates for car ownership.
Assuming that the 7.3 million new car owners in 2008 each drive 5,000 miles a year, and they achieve 40 miles per gallon, the result would be an additional 45.6 million barrels of crude demand, equivalent to 125,000 bbl/day. In other words, new Chinese drivers will devour 25-30% of the recently promised Saudi production increase in a single year.
Looking at this over a few years (from the International Energy Agency (pdf):
The lighter blue bit is mostly diesel. Note that 2007 consumption was 347 million tons, ie 7mb/d.
To put this in another perspective again (from Net Oil Exports):
Chinese growth in consumption dwarfs by far the declines noted in rich world countries like Japan, Germany and, yes, the USA (note that the decline in the US is still a lot smaller in absolute terms than those in much smaller economies in Europe or Japan).
So: Chinese demand growth is very real, it's very large, it's highly likely to continue for a number of years (when people finally reach the car affordability stage, they're not going to be stopped by the cost of fuel - not for a while anyway. The difference between no car and a car is so massive that the price of gas is a minor consideration - especially when gas prices are still subsidized...). and it certainly has an impact on oil prices by its sheer size, given the current stagnation of oil production.
3) Saudi numbers
The previous two graphs, and this one above (from the IEA again (pdf), provide interesting information regarding oil producers: not only is their production stagnant, but their consumption is going up massively. And it's no wonder: they're flush with money, gas is heavily subsidized at home, so people drive more and more. Thus, the biggest increases in oil demand, beyond the "usual suspects" of China and India are almost all big oil producers: Saudi Arabia, Brazil, Russia, UAE. If you look over a slightly longer period, you'll also find Iran and Canada in there.
Which means that volumes available for export, and thus volumes available on the global oil market, are shrinking (from Net Oil Exports again):
The numbers don't lie (from westexas [ed: the table was actually provided by datamunger]):
The only major producers which have increased exports lately are Angola and Russia, and Russian production is now declining (while consumption is booming). The conclusion is simple: there is less and less oil on the market for us.
4) Production declines
Beyond Russia, it is striking to note how many regions we have been relying on are experiencing absolute production declines. All mature fields have a natural decline rate, and whole provinces are seeing absolute declines in their production.
This is nowhere as spectacular - and worrisome - as in Mexico, where the supergiant Cantarell field has lost close to half its production capacity in the very recent past, thus threatening exports to the US from a (relatively) friendly neighbor: (from here)
Just like the decline of the North Sea seems to have caught the UK government unaware, and is leading to quasi-panicky behavior by the UK government (which one day blames the Russians, one day wants to go all nuclear, one day wants to go all-wind, and generally blames "uncompetitive" continental Europe for its plight rather than its own policies, or lack thereof), the brutal decline of the Cantarell field, and of overall Mexian production is likely to have brutal consequences, as the country loses its main source of exports and the Mexican government its main source of tax income. Social unrest, and massive migration toward the North could be one outcome...
5) Lack of spare capacity
But let's come back to the oil market for a second: you have a combination of still strong demand growth (in particular in oil producing countries) and stagnant production combining into shrinking export capacity and, more importantly, into a quasi-permanent lack of spare capacity (from this comment by SamuM in a recent thread):
The significance of such tightness of supply cannot be overstated. In normal times, when demand varies, market equilibrium is reached by adjusting production to such demand, which is a relatively easy and cheap process. But when supply is constrained, as it is now, any brutal change in the market (whether on the demand side, for instance through a cold spell in winter requiring more heating, or a hot spell in summer requiring more AC, or on the supply side, for instance guerilla attacks in Nigeria, a refinery strike in Scotland, or a pipeline accident anywhere) will require market equilibrium to be reached by demand destruction, which is a lot harder and triggers much more substantial price movements: prices need to move high enough for some users of oil to renounce such use and "take their demand out of the market", whether by not doing what they wanted to, or by finding a substitute. In the US, people travelling less for vacations, or carpooling, have barely managed a couple percent demand destruction. Imagine that the Saudis and Venezualeans, with their subsidized prices, are immune fro msuch pressure, and that several percent need to be cut off demand abruptly: it will require much higher price hikes than have been experimented yet.
It's simple really: price will go high enough for the pain to translate into lower oil use in price-sensitive countries, the list of which is topped by the US, where consumption is high, oil price variations are not dampened by massive taxes (prices going from $3.50 to $4 is more painful than prices going from $8.50 to $9).
The lack of spare capacity certainly explains why very small variations in output or demand can have disproportionate impacts on prices: when you are right on the edge of the knife, any movement can make you fall off.
6) Refining issues
I thought I'd add just a few words on refining capacity in the US, as it is often blamed for gas prices as well.
Energy information Agency data shows that refining capacity has gone up in recent years even though no refineries were built, with refinery capacity use very stable at high levels. This has not changed much in the past 2 years, even as Katrina took its toll for a while.
And as the tables that are provided on a monthly basis by Californian authorities show (see 2008 numbers and 2007 numbers), refining margins are actually a lot lower this year than last (roughly down from a dollar per gallon to half a dollar per gallon) and have helped lower the impact of oil price increases in the past few months. So you certainly can't blame refiners this year, even though global capacity is tightening:
Altogether, it appears that they are a number of factors explain oil price increases perfectly well, with no need to go into conspiracy theories or market manipulations.
I'd like to see some probabilities and values in a chart--instead of what appears to be an arbitrary number of 200. For example, if production is declining by 5% a year, then we can expect to pay an extra 25 cents (or what?) over what we are paying now per gallon. Same for the attack on Iran (which may range from zero to 300 percent?).
As for Chinese consumption, you need to maybe lower your estimate a bit. For those who are making enough money to be able to afford a car, they may buy one (but keep the old foot-powered bicycle or electric bicycle), but not necessarily use it that much. When I was living and working in China a couple years ago, the "managers" and higher-ups bought cars (Chinese are very status conscious), but kept them parked most of the time, using the bus for work and the bicycles for errands. The car was a "show off" instrument, rarely used, and when used used to show off, like taking friends to dinner around the corner (but making a big fuss about the car and finding a place to park it, usually right on the sidewalk next to the restaurant). So maybe the Chinese buy cars but not that much gasoline. The same goes for other developing countries where it's far more convenient to walk than drive.
As far as chinese transportation using more oil, a lot of the increase in consumption is for diesel fuel. This is used by the trucking industry (many independant truckers there just like US), along with growth in railroad haulage of containers, coal and minerals. Many routes used for dense RR passenger traffic are electrified, but many heavy RR freight lines are diesel powered. This is based on the opinion of a friend of mine that has been to China several times in recent years.
I have heard that traffic problems are severe in Shanghai and I suppose other large cities. I know that where I live in Thailand there is no recent easing of traffic. To me this implies that even if some do keep their car parked there are still a great many out there driving. While it's hard to say whether Jerome has over or under estimated this I'd say with certainty that 40mpg is an over estimate on typically congestion bound car usage.
The single human being who comes up with a formula to accurately predict price response to each percentage shortfall in petroleum will be a multi-billionaire in short order. Your request is rather odd as no one has yet demonstrated any methodology capable of accurately making such a prediction. The only thing we do know is that there have been price responses to shortfalls in production and that the price responses appear to have varied greatly. In other words, the price response to the first percent of shortfall has not been consistent with the second percent or the third percent.
Your observation about Chinese behavior is identical to US behavior early in the adoption of the automobile. But as time wore on, people used their automobiles for more and more activities. That is already beginning to occur in China and how much higher prices moderate that changeover does not seem to be something we can easily predict. In other words, your anecdote is just an anecdote and is used by you to extrapolate to a guess. Jerome, on the other hand, is observing a statistical trend across a wide body of participants in China.
Buying gas in China is a 3 hour long venture as you go to a gas station and wait in an incredibly long line. I suspect they'll have a short term cure for that during the Olympics, but then return to status quo
It was mentioned a bit ago that China cut some of it's subsidies to gasoline. This was seen as a way to cut demand, but may in fact increase it because they'll have more fuel available to sell.
Although you explain a few reasons why other factors account for the price increase, I do not see an explanation why speculation can't be a reason for the price increase. I got flamed last month for suggesting that speculation could very well be behind the high prices.
Those that suggest that speculation is the cause state a very sobering fact- "Assets allocated to commodity index trading strategies have risen from $13 billion at the end of 2003 to $260 billion as of March 2008". I've not seen anyone dispute this figure. I can understand that statement, and I can see that MUST have an effect.
Those that refute the speculation theory state their case in terms that I can't understand, which translates to obfuscation, for me anyway. I readily admit that I don't understand how the futures market works. And neither do many others, so it is easy to go with an explanation people do understand.
I do understand this though - if speculators can bid up the price of houses, and people do buy those houses though overpriced, and if speculators can bid up the prices of stocks (a-la dotcom, et al) and people buy those stocks even though overpriced, why can't speculators bid up the price of oil and refineries buy that oil even though overpriced?
As for the spot market, doesn't it just follow the futures market? Irrelevant of the (over) price?
I cannot discount the speculator theory as long as I don't understand why it can't be so.
I'd like to see numbers comparing how much of that index trading is simple derivatives that have no influence on physicals and how much actually affects the physical market. I can understand that when people are piling funds into side markets and not buying physical then they are not creating false demand for a commodity but actually more like bets on a race horse. The analysis I've seen doesn't really delve into this in any meaningful way. I think that money looking for a place to find returns doesn't automatically mean pressure upwards on the market but it's unclear. I think more and more these flows of money are more and more like gambling - people are so desperate for some place to put their funds since the dollar is so very unattractive. If you are a fund manager holding cash of declining value then your clients have no need for you - they can hold cash without your help.
"I think more and more these flows of money are more and more like gambling -" If this gambling is a bet on the price of oil will be going up, I think that's a very good bet. To bet the other side you have to believe the official line about peak oil.
http://news.xinhuanet.com/english/2008-06/29/content_8456576.htm
A report the U.S. Congress released Monday showed that, in January 2000, 37 percent of the NYMEX crude futures contracts were held by speculative traders; but in April 2008, the number has soared to 71 percent. Meanwhile, the proportion of contracts held by commercial traders greatly declined.
The U.S. Commodity Futures Trading Committee (CFTC) revealed in May that it began investigating potential price manipulations in the oil trading market in December 2007. The early findings show that since the sub-prime mortgage crisis large amount of speculation fund has turned to buy commodities like crude as a hedge against inflation.
Why not? More money piling into the same amount of product means higher prices. You said it yourself, if money is not bidding then why not just put it under the mattress.
What I meant by this is it's unclear how much of the money ends up buying product and how much ends up in derivatives of product. For example, when you buy stock options you don't actually buy or sell stocks and hence have no effect on the stock price. I'm not clear on whether options trading on commodities (or other fancy ass derivatives that seem to be the rage with wall street nowadays) are where the big numbers are or whether all this money is in the physical market. Even when looking at the physical market whether future or spot one has to look at the difference between long and short rather than just the number of contracts held by specs. If a heavy short position is squeezed by underlying commercials needing more product, then specs will losing money from a push upwards.
I know if I were a spec (and I'm not in the market in any way) then I'd be long but still one looks around the media and guesses that many people think we're at unfathomable heights ready to crash - one can't help but wonder if the media is playing a part for wall street in making sure that some specs are willing to take the losing bet.
Along the same lines, hedge funds and institutional investors tend to move as a herd because when something goes wrong they can all claim solace together that they did the right thing but lost out. ie. when all funds lose money, they blame the market but when a unique single fund opposing conventional wisdom goes wrong, well everyone knows who to blame.
"I'm not clear on whether options trading on commodities ... are where the big numbers are or whether all this money is in the physical market."
Not in the physical according to most TOD posters but I would maintain there is still a linkage with the physical via information.
The report says that 71% of future contracts was held by speculators. But does the report specify a date when this percentage was held? If I'm correct, at the end of each month (actually 3 bus. days prior to the 25th) the number of contracts held by speculators should approach 0%. If they where to hold on to these contracts they would need to take delivery, which I'm sure no speculator wants.
So you can't simply say that in April 2008 speculators held 71% of the contracts. Because on the 22th of April the number of contracts held by speculators would surely have been close to 0%.
Shit, I don't know.
I was just quoting the news article I linked to. That's my point exactly, I don't understand it, but I'm trying to.
I believe that there are clearly more investment dollars in the oil futures market (thank you, in part, Ben Bernanke).
Perhaps it is the case that there could be (insert your own percent)% speculators in the market at any given time, but based on whether they are long and/or short they may not have a corresponding effect on price - one way or the other.
On Friday Karl Denninger said this in his Frightful Friday commentary:
Moe Gamble said this on Friday's DB:
So, it seesm that if you know where to look and how to interpret that it is realtively "easy" to determinthe level and effect on specualtion in the market.
Perhaps the what, where , and how of oil futures speculation effect could be the suject of a guest post by someone who can walk (many of) us through this?
Of course this seems to be happening downthread ;-)
Pete
That may be 71% across all contract months - as speculators are closing out all their delivery day contracts, most they tend to be 'rolling over' into the next month (ie: taking out a new contract for the next delivery month)
So the OVERALL ratio of speculative contracts, across the board, is probably reasonably constant. Generally though, lots goes on on the last couple of days, and I wouldn't be surprised if these are routinely excluded from 'averaged' stats.
1) the SPECULATORS are not really who are being blamed. Actually, the speculators, like Michael Masters who recently testified before Congress, are net short oil, and net long equities, so they want oil to go down. Its the index funds that are net long commodities. ETFs and funds linked to the GSCI or other commodity indexes.
2) Index funds are also very long wheat and gold and other commodities. Yet some of these markets have crashed from where they were a year ago - wheat dropped 50% from its highs of last year. Reason? The actual producers came in because there was plenty of wheat to supply at those high prices and for every index fund/speculator who wanted to buy wheat above $12 per bushel, an actual producer said 'here you go - I am very happy to sell you my wheat at $12". In this case reality caught up with a frothy market... If a large portion (or even a moderate portion) of oils rise is due to speculation (and index funds), the same will happen. Actual oil producers will sell the 'freely available oil' at what are 'too high of prices' and oil will do what wheat did. Hasn't happened yet.
3)By the same logic, those corporations (e.g. airlines) that are buying long term contracts to lock in prices could be swamped by actual oil companies selling them contracts if future oil availability seems adequate (based on their own internal reserve and production estimates. Thus producers will sell forward more contracts than hedgers will in the long dated months and prices will drop into backwardation. We have seen just the opposite.
4)Part of the reason we are this high is that speculators are SHORT the market, e.g each time we rally 10% there is a positive feedback loop where they have to cover their shorts and the market spurts higher again, which then encourages other deep pocketed hedge funds, who don't buy into the general peak oil concept of limited flow rates, to go short. After all, there will be plenty of ethanol and tar sands to make up for the 'possible' decline in crude. This is all changing as firms like Wood Gundy, Goldman, Barclays, etc. have started to publish very realistic research on how dire our oil situation is (though they are writing from a profit/investment perspective as opposed to a social/policy one). So once everyone has gotten oil religion and the large funds stop 'shorting' the market (e.g. no shorts left), then we will be free to drop in price. In this sense speculators ARE influencing the market, but in a very sneaky, self interested way not being discussed 'before Congress'.
5) Finally, oil margins have recently been raised to $8,500 per contract:
Consider we are at midway point of URR and there are 1 trillion barrels left, this is 150 barrels per person living on the planet (and none for any of their children or grandchildren). For $8,500 one can control 1,000 barrels of oil, 8 times ones all time allotment for posterity (assuming that each human had equal rights to oil, which clearly isn't the case). Imagine what $85,000 or $850,000 or $8.5 billion could do. As I've written about often here, there is a paradigm shift coming between abstract wealth (paper currency) and real wealth (commodities, real goods, social, natural capital, etc.) Left to their own devices the deep pocketed institutions could run oil closer to its true value, in the thousands per barrel, but OECD trade and the economic system as we know it grinds to a halt before that time.
Interesting and important times. I agree with Jerome. Lets hope our leaders are mature enough to look beyond the easy scapegoats and make some uncomfortable but necessary planning choices. Its always difficult to admit that its our own fault...
That's enough for everyone currently in the world to drive a car 500 miles (or 800km)*
Write that on your bumper sticker.
That really puts the scale into something people can start to comprehend - and start to realize just how little oil left in the world...
Say what ? 150 barrels lets you drive only 500 miles ?
ok, typing on calculators is dangerous (typed 19.5x25 when I've should've typed 19.5x150)
150 barrels at 19.5 gallons per barrel and 25gpm is
3000 miles per person in the world (or 4700km)
and the common rebuttals to this type of statistic is:
1)but there are so many people in the world that don't use ANY oil that your numbers are meaningless
or
2) ya but your forgot about ethanol and oil shale
(n=5 from personal experience)
To (1), "Virtually nobody uses no oil, it's just that a few people use a lot. For example, Ghanans use about a barrel of oil each a year, and Americans use 25. So those 150 barrels each could keep Ghanans going for 150 years, but Americans only for 6 years. Anyway, put together Europe, Japan, the US - and that's about a billion people using 15 barrels each. Ten years if nobody else gets any."
At this point they go silent and look surly and obviously hate me already, so I add, "Maybe you should take the bus."
Since when does 15 barrels per person times 1 billion people times ten years = 1 trillion barrels?
I make 15 x 10 x 1,000,000,000 = 150 billion. Out by an order of magnitude.
You'd be more convincing if you could add up.
Why not just skip the maths and go back to:
We use 30 billion barrels per year.
We have about a trillion left.
That's 30 years supply.
...oh wait that wasn't the answer you wanted. Not dramatic enough. Now you'll have to explain flow rates. Damn.
.
Flow rates are derivative of available supply and demand. The bell curve is simply the normal derivative. So we don't have 30 years of oil left in the ground because supply and demand are not constant.
Actually, we probably have 100 years of oil left in the ground. It's just that 1/3 of it will be used up in the next 15 years or so.
That is the point where the bell curve (assuming we are already past peak) will go into negative curvature, and drop gradually over decades to a point where a tiny number of users can afford the remaining resource. After that point is reached, it will become a niche market commodity.
Prices may begin to fluctuate normally, but only because it will no longer be in mass demand as a consumer application. It would no longer be a question of marginal demand-killing, the price would be high enough that the utilization would drop off as the vast majority of users switched to alternatives and we'd have excess capacity again. As the utilization dropped off, so would demand for unconventional oil.
Unconventional oil will increase total reserves, resulting in a second supply peak or echo peak, further extending the time frame for remaining oil in the ground, possibly indefinitely. But this secondary bell curve for new, higher-price oil will be much lower (in annual output) and wider than the current peak.
So we would never get back to today's flow rates because of the expense (relative to energy and work) needed to replace conventional sources of oil barrel for barrel, so oil would remain available even as the cost of using it goes up and the number of users goes down.
that makes 73000 miles?
The people who actually buy oil, primarily refiners, hedge their purchases on the futures market. They are experts with inside info betting against amateurs with incomplete info. Guess who wins? According to an IMF study in 2005, real oil traders win their bets 75% of the time. If they didn't, futures couldn't be a hedge. Its the hedge funds and index funds that are the net loosers and their money actually helps keep the price down, not up. Keep in mind that there is a winner and looser for every contract, so it's a zero sum game.
And despite your observation you fail to mention how those funds are being invested. For instance, the AMEX president stated that for May that the large speculators (amongst whom are US banks) were short over $50 billion on oil and had to scramble to cover their missed shorts, which in turn drove prices higher. In other words, many of the big speculative players were shorting oil (betting on price declines!!) not going long. And they lost. And they appear to have lost again this last week.
To state again, the big speculative players bet against the fundamentals. And the fundamentals are roughly flat production over 4+ years (maybe 1.5 mbpd max more in certain quarters) now versus a near 8 mbpd increase in consumption by China and India. If we subtract out that 1.5 mbpd occasional bump up in production, that means China and India combined are taking 6.5 mbpd away from someone else who was consuming that oil in 2004. And that doesn't account for increases in consumption elsewhere in the world, which have been documented.
There is no doubt that some small part of the price increase is due to the falling dollar. But measured in other currencies oil is at record highs also. So a larger part is due to something else. You appear to be asserting that this is entirely speculatively driven. I will grant that some portion of the price increase may be speculatively driven but that fundamentals were going to lead to higher prices over time regardless. In other words, without speculation maybe we'd be at $120 or $110 or even $100 per barrel. But it would not have stayed at $80 or gone back to $60 per barrel. The fundamentals, the lack of production increases coupled with the changes in consumption (mostly who is consuming), argue against lower prices and for higher prices.
What no one has yet demonstrated is what proportion of today's price is due to speculation. I don't think you can accurately show that as a specific number, and since a large part of the speculation is in shorts I do not think you can even argue clearly what effect speculation is even having in this market.
Speculation is adding about a 6 dollar premium to the price of oil pretty much independent of the price flucations.
And no I won't tell you how I figured this out. Given that you know its six you can read it off the market charts.
Speculation is only an issue because supply is tight enough to make speculation worthwhile.
When supply was plentiful, it was only a dull futures day-in-day-out-grind.
It's the shortage, stupid!
cfm in Gray, ME
One of the functions of speculation is "price discovery". You can't say something is over-priced until you discover that people are not willing to buy it any more. When you go to a market and haggle over price both sides have an interest and when you decide not to buy the seller also loses a sale and is stuck with the product. For decades I've listened to Americans on high horses about self-interest is good, greed is good. This is the way they designed their markets and it's absurd that when it comes back to bight them they all cry foul. It ought to fall on deaf ears as cries from around the globe have for decades on American ears. Speculation may play a part in this market - but it's the role it was always intended to play, liquidity and discovery. I think people are just shocked to "discover" how much they really want, need oil, must have oil. When the public stops buying, the refineries will be ready to stop buying and the sellers will accept a lower price. That is barely starting to happen now but still most people believe by throwing a tantrum they can get their way.
Indeed, the market 'works'. People who blame 'speculators' for the high oil prices are fooling themselves in two ways: it gives them an excuse to ignore the fundamentals, the peak oil that is happening, and the ELM that goes with it. And secondly it is a play of huge hypocrisy...
Why should I not be able to put my money on the market, risk loosing it on my belief that the price will go up in the future? Isn't that the whole idea of capitalism? What about the airline companies? Aren't they allowed to hedge their fuel costs?
The sad irony is that the liberal free market advocates are crawling out of their caves of unreality to demand market controls and government intervention because this time the market isn't going their way...
People seem to equate 'oil speculators' to war profiteers who deny food and shelter from the hungry and homeless in order to extort all that they own from them. But if oil is indeed like food and water to us - then many would argue that trading it is like trading human lives - except that we already trade food and water in many countries...?
Peak oil brings us to an unprecedented situation, a world of paradoxes, where all the old ideologies become obsolete - both left or right - and people sticking with them are going to get ever more confused, paranoid, insane...
Now that the world of reality has come to put an end to all our ideologies we treat them like like the straw dogs they are, void of utility we discard them into the fire...
Hans,
This is a true statement
This is a false statement.
It is necessary for you to have some understanding of the futures market to understand why the first statement does not lead to the second. It is not reasonable to say that, since you don't understand, others are obfuscating.
You have three choices really:
1) either accept the expertise of those who you acknowledge understand something important to the hypothesis that you dont understand.
2) educate yourself so that you do understand [the oil drum is not the right site for this, but there are many trading sites with excellent tutorials - be aware that watching the market for a few months is probably required for this]
3) stay stuck where you are, and be perceived as someone who chooses beliefs based on an acknowledged lack of understanding.
Please understand I'm honestly not having a go here!
Even when they are known to be less informed - that way lies blind faith, counter-science, and foolishness.
And here is the one, critical tidbit, that might explain, or might leave you going 'I don't understand' - but I will try:
With houses, or dot-com stocks, there is a restriction on supply. This means that people can profit by hoarding (collecting/acquiring) the resource. While new dot-com companies came along, it was still possible to bid-up their individual share values.
With futures, there is an infinite supply of contracts that can be written - there is no way in which a contract can be taken 'off the market' in the way a share, or a house can be. For every new contract there are two sides, one party betting that the price will go down, the other betting that it will go up - the same is not true for houses or shares, where parties sell their holdings not because they are betting on a price drop, but because they want to realise their profits (perhaps to build a new house, or invest in different dot-com stocks). There is simply no real comparison between the futures market, and the stock market or the housing market, because one trades in a finite supply of something, the other in an infinite supply (CONTRACTS for supply/purchase of oil, NOT oil).
The reverse is more true, the futures market CAN lead the spot market to a degree, but much more the futures market FOLLOWS the spot market, and then adjusts for the average of what the market thinks is 'likely' or 'could happen' in the next 30, 60 days, five years, or whatever for the specific contract. The starting point though is TODAY's price, as per the spot market.
Neither should you give it any credence though. You either place trust in those who you acknowledge know better, or you learn for yourself (your responsibility to put the leg-work in - asking for help here is a cop-out), or you look gullible. I strenuously recommend the middle option, as you're obviously curious about this.
By way of analogy, I'm sure there is something than you are quite capable, perhaps expert in - I'm sure other people must respect your skill, or knowledge in this area. How annoying would it be if people told you that they didn't believe what you told them about something in this area, because they were not experts, and you being an expert meant they didn't understand what you were saying, and so they thought the absolute opposite made more sense. It's frustrating - especially from someone who seems genuinely curious.
Apologies for and rant-like bits - I HOPE this has been helpful - if not, all I can say is, if you want to understand more, you need to learn more - as with everything else in life
"The reverse is more true, the futures market CAN lead the spot market to a degree, but much more the futures market FOLLOWS the spot market..." Are you saying this "much more" is the general case or is true in the particular case of the current oil market. And if the latter do you see the possibility of continual official denial of the realities of oil can interfere with the speculative function of price discovery? The speculation sends a signal. But denial continues.
Hi again...
The general case.
The Oil futures market is the only one I feel qualified to talk about really. Having said that, it seems reasonable that the same mechanism would apply in all futures markets (for physical goods at the very least).
I do think the official denials are interfering with the speculative price-discovery function, particularly for long-dated contracts, mostly by damping it. Without the official denials, 2016 futures would I expect have found prices at least double 2008 prices.
[disclosure: I stand to profit when, if, and as, that interference starts to fail, and speculative price-discovery for long-dated contracts becomes unhindered by official denial (whether deliberate or ignorant)]
Thanks Jaymax. The problem I have with making such a post is that I will seem like I'm asking people to explain things to me for no other reason than to save me from the trouble of finding out myself. I am not, and tried to word it such that I would not come across this way. But the problem is, I have done many hours of research and I can't find any explanation of how the futures system works that I can understand.
And I'm not a dummy, either. I am an electronic engineer, and as you speculate, yes I am well respected in my particular area of electronics. I can grasp most concepts, physics being my outstanding subject.
But it's not justme, and that's what I wanted to point out. The MSM and others are going along with the speculator theaory because 'why it could be' IS easier to understand than 'why it couldn't be'.
You said that 'must have an effect on price' is a false statement. I don't understand why it is false, but I will not ask you to explain. I will find it out in time.
Another thing here, too. I must state that I am NOT asserting that the speculators are to blame, I was hoping that my wording made that clear. I am only stating that I am open to the belief that It could be. The simplistic arguments I have heard that 'it could be' have so far outwieghed the complex arguments that I have heard so far that 'it couldn't be'.
As for putting my faith in those who do know. I don't who they are. Everyone seems to be an expert.
Once more for the record, I am not asking anyone to explain to me that which I should be finding out for myself. I am just pointing out that if there was an easy way of explaining why the speculators are not the cause, the MSM and others might have their doubts put to rest. Even congress openly admits that the derivatives market is 'convoluted and unaccountable'.
Another thing you just added to my confusion. How can there be an infinite number of contracts? Surely you can only write a contract for something you actually intend to supply? I just don't understand this stuff.
Apologies if I sounded like I was lecturing!
Understanding this is the crux of the matter. Once you get this, you will see how speculation in futures cannot drive prices to any significant amount/duration.
Anyone can write a futures contract - there is absolutely no need to have any intent to supply whatsoever. And indeed, many speculators are doing EXACTLY this all the time. It is wrong to think that all that speculative money is going into the BUY side of futures contracts.
How is that possible? What happens when the contract is coming due and there are a hundred times more barrels of oil contracted for delivery than available? The answers are actually quite simple - once you get your head around them. But that is exactly the situation - it is EXACTLY the same as someone (like myself) who contracts to buy oil, but has no intent to receive thousands of barrels of oil in 2012.
So I could write a contract to sell a million barrels of oil, sell it on the futures market, and say 'so long, suckers'?
Remember that $260 billion?
Those million barrels require 1000 NYMEX oil futures contracts.
Exchange rules require your broker to have on deposit from you about $12,000 per contract in order to place your sell order. So yes you can, but you need to deposit $12 million up front! - Incidentaly, the figure (the margin requirement) is exactly the same for the buyers.
Furthermore, lets say the price of oil goes down $2 per barrel overnight relative to the price you contracted for. Your broker now requires you to cover that margin (ie: maintain that $12,000 per contract), so now you must pay your broker a further $2,000,000 by the end of the business day.
If you fail to do that, and lets say the market drops another $3 per barrel during the day, your broker will close off your position (by finding other 'sellers' to take it on at the market price). It's okay though, because your broker will still have $7 million of your $12 million margin deposit, and you can have that back no problem, you just lost $5 million in two days is all ... :-)
[nb: this is a little bit simplified, but pretty close to reality - there can be different margin requirements for day traders etc]
So, if I understand this 'infinite contracts' thing correctly -
I could create a contract, out of thin air, to sell a million barrels of oil, then sell it on the futures market.
I watch the price go up and down, and then before it expires and I would have to supply the oil, buy it back, screw it up and throw in the bin, and take the profit or loss.
What a scam! No wonder congress wants to put a stop to it.
On the other hand, if I bought a contract on the futures market that someone created out of thin air, and held onto that contract until it expired, the person who created that contract would have to quickly find some oil to supply to me. But if I sold it before it expired, he would be off the hook and would take the profit or loss.
Is that close enough? (I hope so, because I understand how that would not affect the 'real' price)
See, this is why you shouldn't look here for an explanation - when there are much better writers, because obviously I'm not being clear.
You cannot screw it up and throw it in the bin - your broker will transfer your obligation to someone capable of fulfilling it, and it will cost you dearly.
There is no scam!
If EITHER buyer or seller holds on to their end of a contract until it matures, and realises all their margin calls, they then become legally liable (it's a contract after all) for the supply of, or the paying for and receiving of 1000 barrels of oil at the contracted price. Failure to deliver your end of the contract will end up with you in court I imagine - certainly you will lose your entire margin deposit and any profits.
This is what separates speculators from commercials, speculators never hold on to contracts until delivery dates, commercials do (more so). A speculator who is long sells to a speculator who is short (or vice versa) and effectively, the two contracts become one. (I owe you $10, you owe X $10, what say I just owe X $10)
Also, whether you hold on to your end of a contract, has no bearing on whether the person on the other side holds onto their end - they may, and probably have, long sold it - this is the basis for any contract market. The two sides can be independently traded - this is how the market discovers fair value.
Incidentally, futures contract DON'T expire, they fall due. Options expire - but that's a whole 'nother story (and one that no-one AFAICT is accusing of manipulating prices)
In that case, I back to where I don't understand how there can be infinite contracts if there is not infinite oil.
But it's not me you have to educate, it's the MSM and elected officials.
its a chain of obligation
It's easier to look at things more simply, in my view, rather than worrying about the technicalities.
You can place a bet on oil, that it goes up or down.
If you are wrong, you loose, plus the transaction costs.
If you are right, you win, minus transaction costs.
So you are effectively betting against the house, and it really only make sense if you are buying for an airline, say, so if you are wrong you have just suffered some losses, but if you are right you may have saved your company from bankruptcy.
This is a very different thing from speculation in property, where rental income covers part of the cost and so can more properly be counted as investment, and it is only to the extent that the real reason for the investment is in the hope of profit from rising property prices that it is speculation.
Fundamentally those who are saying that it is a speculative premium causing high oil prices are arguing that the bet that oil prices will continue to rise is wrong.
Any investment is a speculation, as profit is dependent on certain conditions coming true.
At the peak of a speculative bubble stocks such as high tech in the last bubble trade at silly premiums to any forecastable earnings.
If you want to know whether the present price of oil, which as I have tried to indicate when you hold it is not generating any income at all, is speculative or soundly based you only really need to look at what you consider is the likely supply and what is the likely demand.
So the people who are arguing that there is a lot of speculation in the price are saying either that there is plenty more oil out there which will come on stream or that conservation or recession will drastically reduce demand.
I know the MSM troll TOD a bit, but still...
on one hand, this is a convenient break from study, on the other, it's a useful exercise in working out what works explanation wise and what doesn't.
Also, I've given up on the MSM and authority - they have a responsibility to educate themselves - if they fail, I feel sorry, but not responsible, for all the people they hurt in the process.
Last try (probably) :-)
See if this makes sense
P is producer
C is consumer
U, V, W, X, Y and Z are speculators
V and W take out a contract between themselves (V is long)
X and Y take out a contract (X is long)
U and P take out a contract (U is long)
C and Z take out a contract (C is long)
So
V<-W ; X<-Y ; U<-P ; C<-Z (where <- is one contract)
The day before the last trading day of the month W and X take out a contract. Then Y and U take out a contract.
V<-W<-X<-Y<-U<-P ; C<-Z
Now, W's contracts with X and V may be for different prices, but any loss will have been covered by W's margin calls; same goes for X, Y, U.
W, X, Y, U all take their profits (or loss) and thier contract positions are 'closed' by the market, as they hold offsetting short and long contracts (like the I owe you; you owe X)
V<-P ; C<-Z
The last day of trading, V closes off position too (in reality of course, the market matches buyers and sellers, rather than any of the traders having to identify the trader on the other side of the contract
C<-Z<-P ; as before, Vs positions is cancelled by the market, V take their winnings or remainder of margin deposit.
So, Z is left with two contracts, at different values, Z neither want to take delivery nor supply any oil, Z must exit the market, again, in reality the market mechanisms handle this automatically, and by showing a single chain rather than a morass of trading. If you imagine Z being the net speculative position at this point, Z is either net short, or net long; Z must find either real-world buyers, or real-world sellers depending on Z's net position; this forces the price Z ultimately gets to what the physical market will pay for his surplus contracts.
C<-P
Contracts fall due ; from many contracts at the start of the month, very few remain, and all of those are held by traders who actually want to trade gloopy stuff.
Infinite contracts available at the start, and remain so in the market as a whole, but NOT at the closing date for the front-month contract. As the number of contracts nominally available moves from infinite to finite, so the speculators are pushed out of the market, and the price moves to that determined by physical traders.
[Now, if you have physical oil speculators - you can keep the game going - BUT those speculators have to take delivery and store the oil - the moment they sell it, it pushes down the physical market - this is the basis for the no inventory build, no speculative driver argument]
Post exams and holiday in the UK, I'm going to think about an animated diagram, with running account totals, or something.
OK. I understand that. The speculators are only making - or losing - money off each other. Thanks for your patience with me, Jaymax.
I wasn't aware of the 'infinite contracts' before, so I assumed that speculators were bidding for contracts from producers, and then accepting bids on those contracts from consumers. I imagine that is what the MSM and EO believe. They will need to be corrected, too.
It seems to me that it would be far better to only allow producers and consumers to trade, but I have read that speculators bring stability to the market. I don't know how, but if that is the way it is, then very well.
Thanks for bearing with me to an extent as well.
It's not so much stability that speculators bring, as fluidity and honesty - by having lots of people interested in what a commodity is worth, theorising and betting on the price, we all get the net benefit of the net of all that knowledge.
By having many fewer parties trading, especially big parties (like OPEC, or refining operations) and trades much less often, there is hugely more scope for market manipulation (think of the commodity markets where manipulation has occurred) and also much more scope for information to be hidden if it's not in a particular players interests.
Speculators are like lubricant, sometimes a cog can be spun too fast, but it corrects easily, vs everything locked in place, inefficient to operate, and you need to hammer it until it suddenly gives way, or breaks down completely.
This may seem a dumb question, but what happens if an oilsheikh or a sovereign wealth fund used a lot of dummy buyers to buy secretly a heap (say a few hundred million barrels) of contracts a few years out.
When the month of delivery comes around then instead of closing out for a prorit/loss they insist on delivery.
Sure millions of barrels will be delivered but IIRK the contract even specifies the specific type of oil ( Cushing?). So what happens then when there isn't the possibility of supplying the specified oil?
BTW I'm assuming the buyer has booked a heap of tankers to store any delivery.
I'm not sure what you mean by "secret" but I guess you mean the buyer isn't identified, since the trade certainly isn't secret if it's executed on the commodity exchange floor.
What your'e saying is that someone wants to buy that quantity of oil - real oil, that's called "demand" and the price goes up according to how available it is. It doesn't matter who the buyer is, if they are going to take delivery then they are buying oil and then they have to store it or use it. But what's the point? If some sheik is buying oil for a higher price then he's going to pay for it. He's going to sell or use it? Your'e back to the argument that a speculator can drive the price only if they are going to store the oil. This secret sheik of yours is going to store the oil, right?