Editore"s Note
Tilting at Windmills

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August 20, 2008
By: Kevin Drum

OIL SPECULATION....Was the recent spectacular rise, and subsequent fall, in oil prices driven by speculation? In June I admitted that "the huge increase over the past five months has had a bit of a bubbly feel to it," but I didn't really have any evidence to back that up. In July I linked to a report from the CFTC, the body that regulates oil futures trading, which said that prices were up because of supply constraints, not speculation. In August, a "quiet data revision" suggested that maybe the CFTC ought to change its mind about that. And finally, today, thanks to David Cho of the Washington Post, the other shoe dropped:

Regulators had long classified a private Swiss energy conglomerate called Vitol as a trader that primarily helped industrial firms that needed oil to run their businesses.

But when the Commodity Futures Trading Commission examined Vitol's books last month, it found that the firm was in fact more of a speculator, holding oil contracts as a profit-making investment rather than a means of lining up the actual delivery of fuel. Even more surprising to the commodities markets was the massive size of Vitol's portfolio — at one point in July, the firm held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange.

....The CFTC, which learned about the nature of Vitol's activities only after making an unusual request for data from the firm, now reports that financial firms speculating for their clients or for themselves account for about 81 percent of the oil contracts on NYMEX, a far bigger share than had previously been stated by the agency.

Read the whole thing for more. This still isn't conclusive evidence one way or the other, but it's certainly suggestive that there have been a few big financial players helping to drive prices up in the past few months. Supply constraints are still the main culprit for long-term price increases, but all the same it's beginning to look like it wouldn't hurt to tighten up the oversight of the oil futures market a wee bit.

Kevin Drum 11:46 PM Permalink | Trackbacks | Comments (36)

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Comments

The reason the price of oil is dropping is because there is an election coming.

Posted by: tom on August 21, 2008 at 12:29 AM | PERMALINK

Phil Gramm thinks you need to quit blogging, get out of the wagon, and help push...him all the way to the bank.

Posted by: jimbo on August 21, 2008 at 12:32 AM | PERMALINK

I'm sorry did the world use 20% more oil 8 weeks ago than it does now? Anybody who didn't think speculation was driving up prices this spring either wasn't paying attention or was trying to protect their own bets.

Posted by: markg8 on August 21, 2008 at 12:51 AM | PERMALINK

And still PK says that oil speculation is not like tulip or housing speculation and that you can't speculate on oil unless you can actually take the oil off the market and store it.

PK or KD. KD or PK.

Tough decision.

Posted by: jerry on August 21, 2008 at 12:55 AM | PERMALINK

So let`s wait & see what the spot price is in the January March time frame.

It sure won`t be anywhere near $40/b like a lot of folks dream/hope/wish.

Speculators my a**.

"During times of universal deceit, telling the truth becomes a revolutionary act." - George Orwell

Posted by: daCascadian on August 21, 2008 at 1:03 AM | PERMALINK

Why do people like markg, continue to think that price should change in proportion to supply/demand. Oil is famously inelastic, which means that a small change in supply or demand can change the price a lot. The only way a price equilibrium is established is when oil consumers respond to price by either buying (increasing consumption), or not buying (decreasing consumption). The market is essentially an auction. If there are 2% more buyers than product, and no one is of a mood to go without, the price has to go very high until 2% of the buyers do drop out.

Well, enough for talking about elasticity. We are seeing changes in demand, most notably US consumption is lower, and Chinese closing of factories, and cutting back on on driving for the Olympics, has clearly temporarily depressed demand there. Speculators will only bid the price of something up, is they think they can get an even higher price later. Speculation is fueled by the expectation of finding the greater fool to unload the stuff onto.

Posted by: bigTom on August 21, 2008 at 1:12 AM | PERMALINK

HOW IS IT POSSIBLE TO TRADE 13 TIMES THE AMOUNT OF OIL PHYSICALLY AVAILABLE?? THERE IS ONLY ONE ANSWER TO THAT, AND ITS CALLED SPECULATION.


[Richard, would you turn your caps lock off please? Thank you, --Mod]

Posted by: RICHARD on August 21, 2008 at 2:06 AM | PERMALINK

Oy vey. All this means is that there are speculators in the market. It says nothing about speculators driving prices higher.

The fact is that for speculators to drive prices higher, futures prices need to be at least equal to spot prices, plus foregone interest that would have accrued over the fperiod up to the future delivery date, plus the cost of storage of oil from current to delivery date. If futures prices are less than that then speculation can't be driving up prices because the speculators are betting that it's not worth it to bid up prices in order to horde for future sales. And throughout the run-up in prices, futures prices have generally been below spot prices, and occasionally marginally above spot prices but not nearly sufficiently above to cover the cost of oil storage plus the opportunity cost of foregone interest.

There also hasn't been any increase in hording of oil; on the contrary, reserves have been going down. During the recent run up, people simply never were bidding up oil prices on a bet that they'd be able to sell for more in the future by hording in the present.

The economic facts are pretty straight forward, and it's an economic impossibility that speculation drove the recent price increases. The belief that increases were driven by speculation is every bit as irrational as the worst supply-side gobbledygook about balancing budgets by slashing taxes while spending like a drunken sailor.

Posted by: R Johnston on August 21, 2008 at 2:31 AM | PERMALINK

I'd like to point out that Iraqi oil production has been increasing dramatically, and US demand has been falling in response to higher prices. Thus, lower prices! It's magic! If the price stays low, we'll see what US behavior does next? I suspect it will modestly increase consumption in an attempt to find equilibrium. Ah, econ 101.

Posted by: Rashad on August 21, 2008 at 3:23 AM | PERMALINK

The price of oil has moved inversely to the rise and fall of the dollar against other currencies for the past several years: big dip in the dollar, big jump in oil prices. The recent drop in oil is no exception and mirrors the strengthening of the dollar (the past two days, the dollar fell again and look what's happened to oil prices).

I'm sure there is some speculation and some supply shortfall at play as well. But, it's hard to look at a chart that graphs the price of oil and the value of the dollar and not conclude that the administration's (and the Fed's) weak dollar policy is the primary reason for expensive oil (and other commodities, like corn, wheat, precious metals, etc.).

Posted by: DevilDog on August 21, 2008 at 3:28 AM | PERMALINK

As I said in your previous post in which you said something to the effect of "so oil speculation wasn't nearly as big a part of it as some thought."

I simply laughed at you.

I now simply laugh again. Stop bungling around in the minutia and poke your head up and take a look around. That you still can't see it, boggles me to no end.

Posted by: simp on August 21, 2008 at 4:12 AM | PERMALINK

Capitalism eats itself. Send the Vitol pirates to prison for at least 20 years.

Posted by: The Conservative Deflator on August 21, 2008 at 6:46 AM | PERMALINK

Yes, people were speculating that prices were going to go up. It's called the market. In principle it doesn't matter whether it's George Soros or a thousand blog commenters from the Oil Drum.

Of course Vitol may have been trying to manipulate the market (haven't seen the evidence yet). They at least have a lot more information than the average investor. Come to think of it, isn't it weird that the world waits to hear what oil and gasoline stocks are from the EIA before trading. 1) I don't understand how the information is so hard to come by, 2) which Bush lackey is in charge of the department, and 3) shouldn't we tap his phone.

Posted by: B on August 21, 2008 at 7:21 AM | PERMALINK
Yes, people were speculating that prices were going to go up.

Uh, no. That's the whole point. People were pretty consistently speculating that prices would drop or not keep pace with alternative investments throughout the recent run up in oil prices. Futures prices were well below spot prices plus a modest return on investment the entire time, most of the time even at or below spot prices themselves. Throughout the run up in prices, speculators were, if anything, putting a break on price increases. That's why oil reserves dwindled, eventually halting the more recent skid in prices once it was noticed exactly how low they had gotten--investors were betting that it would be cheaper to eat into reserves and replenish them later than to hold on to reserves.

Posted by: R Johnston on August 21, 2008 at 7:46 AM | PERMALINK

Hi,

I design futures contracts for a living.

For every futures market buyer, there must be a seller. The supply of futures contracts is theoretically infinite, as it is not an asset, but a derivatives contract.

The amount of buying necessary to push futures markets to new speculative highs independent of a wide spread panic is gigantic, beyond the capacity of any one entity of smaller size than governments.

That said, entire groups of traders can move markets. It is possible that a huge, huge group of speculators not acting together moved the markets. Think of all the groups that had to act in concert to create the housing bubble and you have started down the road to understanding. It wasn't Vitol acting alone. It was Vitol acting with another 70% of the market that drove prices higher.

Something else to know is that a very small percentage of contracts are held to delivery in ANY futures market.

Did speculation drive the prices higher? Probably. But the question is: If we do something about it, do we destroy the futures markets?

This is a fundamental question. It should be clear to anyone who has studied the "panics" of the late 1800's that deregulated capitalism is a highly unstable system prone to excesses. The futures markets are some of the best markets on the planet simply because they have an appropriate level of regulation to allow for fair participation during normal times. However, given that we've deregulated (or left unregulated - like hedge funds and trading shops) so much of the supporting areas of the economy, the futures markets might not work properly at all times.

The solution should not be to alter the futures markets as it should be intelligently regulate the funds themselves.

Posted by: mickslam on August 21, 2008 at 8:15 AM | PERMALINK

In the seventies, there were position limits, i.e., maximum amounts of any commodity, that futures speculators could hold. Did the Republican creeps get rid of them? Anyway, posing as a hedger when you are really a speculator is fraud. You are undermining the system on purpose.

Posted by: Bob M on August 21, 2008 at 8:17 AM | PERMALINK

Just for example, I've recently been offered (by my fuel oil supplier) an option to buy 800 gallons of oil next winter, at some price TBD but close to the current price of fuel oil (which was recently $4.30/gallon). It looks like the options cost $.50/gallon. So, shortly I'll be speculating, if I take this deal. (And the letter is much more carefully worded than years past, as far as amounts of money that I'll need to pay by whenever, etc.)

If lots of people take this deal, and supplies are short, then prices (for the remaining oil, not locked in to options contracts) could zoom.

Posted by: dr2chase on August 21, 2008 at 8:39 AM | PERMALINK

Since the peak, Europe and Japan have gone into recession. Growth forecasts for the second half in the U.S. are for a sharp deceleration after the Q2 blip. Growth forecasts for Emerging Asia have also seen a sizeable recent markdown. The dimming global growth outlook is all the explanation one needs.

Read Paul Krugman again. And James Hamilton. No one can prove a negative: Speculation might have been responsible for the last $10/bl. rise in oil prices; it might not. But the fact that one or a handful of companies was engaging in "speculative" activity (in a market that turns over $300 billion a month) isn't evidence in either direction.

Posted by: Matt on August 21, 2008 at 9:05 AM | PERMALINK

The next Obama commercial just wrote itself:

"John McCain calls former Senator Phil Gramm his top economic advisor. (Put in a hugging shot of the two here--or maybe one of them looking conspiratorial together, maybe an ear-whisper). The same Phil Gramm who led the fight to deregulate the oil markets, sending prices skyrocketing from [FILL IN PRICE ON DAY DEREGULATION PASSED] to over $100 a barrel.

So the oil companies and their cronies --some of McCain's biggest campaign contributors--pocket billions of dollars in record profits while Americans at home struggle to pay their gas and fuel bills. (Show headlines about ExxonMobil's record profits, sky-high gas prices, inflation, etc.)"

"The oil companies can trust John McCain to do what's best for them. But can you?"

I'll bet Jackson Browne would let them use "Runnin' On Empty" for that ad.

Posted by: sullijan on August 21, 2008 at 10:21 AM | PERMALINK

The reason that people don't know how much speculation was involved is that oil supply information is treated as a state secret by very nasty regimes. Nobody knows how much oil is out there. As a result, nobody knows what a rational price for oil might be. So, 5% of the world's economy is based on guesswork. The price goes up. The price goes down. It's all whim and shenanigans.

And people believe in Capitalism through thick and thin despite their lack of knowledge.

Posted by: Jeffrey Davis on August 21, 2008 at 10:50 AM | PERMALINK

The rise in price of a barrel of oil from $40 to $80 reflected the decline in the value of the dollar. The Fed doesn't want to admit this because its actions addressing the credit crunch are what is causing the decline. The remainder of the increase is speculation.

Posted by: steve on August 21, 2008 at 10:53 AM | PERMALINK

Matt: . But the fact that one or a handful of companies was engaging in "speculative" activity (in a market that turns over $300 billion a month) isn't evidence in either direction.

Matt, you miss the point of commodity futures. Speculators put up only 5% margin; they don't trade at the full amount. If hedge funds speculate in the billions, they can swamp the other side, at least temporarily, and then (hopefully, of course) get out with a profit. And if they conspire together to attack one side of the market, watch out.

That, I assume, is why they had position limits on traders in the past.

Posted by: Bob M on August 21, 2008 at 10:56 AM | PERMALINK

It is simple math! I moved from Rochester, NY to Atlanta in May of 2005. Gas was 1.10 a gallon. Today it is 3.75. Did demand TRIPLE in three years?

Posted by: P.C.Chapman on August 21, 2008 at 11:10 AM | PERMALINK

PC,

The "official" answer to your excellent question can be found in comments above.

Oil consumption is very inelastic, so in today's supply strapped conditions, large, non-linear, increases in price are to be expected.

There is always an answer that doesn't involve them rigging the market, which is the whole purpose of cartels. Remember them?

Posted by: says you on August 21, 2008 at 11:30 AM | PERMALINK

Tom nailed it on the first post! (It's the upcoming election and the need of Republicans to be reelected that's lowering the price of gasoline.)
Look for the price to drop to perhaps lower than $3 / gallon until December when it will zoom right back up to $4 because 'the needed shift to production of heating fuel'. Hasn't everyone older than 20 years already figured this out.

Posted by: slanted tom on August 21, 2008 at 12:56 PM | PERMALINK

From today's The Mogambo Guru at Asia Times Online:

""Our markets are affected by paper silver futures contracts, and very few people ever attempt to take delivery of that silver; they buy it on leverage, for the investment returns, not for real silver. So, some people can sell 'silver promises' to excess, and never deliver, and if they sell more 'paper silver' than exists, that can manipulate the price.""

This is entirely congruent with SeekingAlpha.com blaring the headline "The Disconnect Between Supply and Demand in Gold & Silver Markets". They explain that "western markets are, with the exception of some fabrication and industrial demand, almost 90% paper based", which is making it very easy for the world's bullion banks to affect the price of silver by "managing deliveries of physical gold and silver to artificially reduce the quantities delivered", which they do by restricting credit to buy gold."

And the ugly lesson is; you thought that the fraud of naked short selling was only for stocks? Hahaha! Wrong! It's every-freaking-where! Hahaha!"

And when you have that kind of pandemic, systemic corruption, created by greedy people exploiting inattentive regulators and complicit government, and financed by the damnable Federal Reserve creating all the money and credit to pay for it all, then you are 100% right to be buying silver and gold to protect yourself against the inflation in prices and economic calamity that are sure to follow."

Your only mistake was to not take delivery of the actual silver, but instead taking a flimsy piece of paper."

Posted by: Mrojo on August 21, 2008 at 1:26 PM | PERMALINK

Is Vitol connected to UBS?

Do the Swiss suddenly hate us or just find us weak and ripe for the pickin'?

Posted by: MarkH on August 21, 2008 at 6:03 PM | PERMALINK

"The solution should not be to alter the futures markets as it should be intelligently regulate the funds themselves."

Posted by: mickslam on August 21, 2008
--------------

As I understand it the Democratic energy bill proposes only to limit positions in the market.

Isn't that the sort of light touch regulation we should cheer?

Posted by: MarkH on August 21, 2008 at 6:08 PM | PERMALINK

"The rise in price of a barrel of oil from $40 to $80 reflected the decline in the value of the dollar. The Fed doesn't want to admit this because its actions addressing the credit crunch are what is causing the decline. The remainder of the increase is speculation."

Posted by: steve on August 21, 2008
-----------------

How about the rise from $25 to $37. Oil didn't even hit $30 until the Bush years -- and we know how oily that period has been.

Consider ordinary inflation, dollar devaluation and you end up where the analysts said (to Congress) it should be $50-$60/barrel.

Can anyone really justify more than that?

Posted by: MarkH on August 21, 2008 at 6:13 PM | PERMALINK

MarkH,

Yes, I can justify more than $50-60.

Basically, the price drop in the 80s was caused by a bunch of new big fields coming on all at once - Cantarell, the North Sea, North Slope and Samotlor. These fields or regions all provided several million barrels a day each.

In the 2000s, they all declined rapidly, at around the time when Indonesia, India, China and a bunch of other countries started putting a lot more cars on the road - and if you have just spent 3 months salary on a car, you *will* drive that car.

The production to replace these is a lot tougher - I'll use the Bakken Shale as an example.

To bring in a Bakken Shale well, you need to drill about 10 000 feet straight down, and then go sideways for another 10 000 feet or so (you'll probably want three of these laterals). The rock you will be drilling through is about 10 feet thick and the consistency of reasonably dense concrete. Note this is the rock you want - the rocks you dont want are worse.

Clearly, if you are doing this, you are in a world of hurt with $50 oil.

I can tell similar stories for deepwater subsalt plays like Jack, Tupi and so on.

Posted by: Ian Whitchurch on August 21, 2008 at 7:06 PM | PERMALINK

I don't get it. How do speculators drive up the price of oil? Please point out the flaw in my understanding as communicated below.

Ultimately there are Oil Producers, Oil Refiners, Oil Retailers, and Oil Consumers. For this discussion, the Oil producers take crude oil out of the ground and distribute it to the Oil Refiners. The Oil Refiners then refine the crude oil into a variety of products and sell these products to Oil Retailers who then sell to Oil Consumers.

Since the cost of producing oil is not affected by artificially high prices, Oil Producers should greatly benefit from artificially high crude oil prices. In our world, prices are driven artificially high through monopolies or, in the case of Oil Producers, through formation of cartels. In theory, the Oil Producers manage crude oil price fluctuation risks through hedging in the futures market.

It is hard for me to see a way that the Oil Refiners benefit from high crude oil prices. Oil Refiners also manage crude oil price fluctuation risks through hedging in the futures market.

Speculators play in the futures market to make money off of the fluctuations in the expected (future) spot price of crude oil. A futures contract is a metaphorical piece of paper representing an obligation to buy (or sell) a commodity (in this case crude oil) at an agreed upon price and time (in the future). This agreed upon price is known as the contract’s strike price. This strike price is theoretically the spot price of the crude oil that is expected at the time the futures contract expires. The speculator buys futures contracts if they believe the expected spot price of crude is going up. They sell futures contracts if they believe the expected spot price is going down.

Even though the futures contract strike price is theoretically the expected spot price, speculators can, drive this strike price up (or down) depending upon the supply (willingness to sell a piece of paper) and the demand (willingness to buy the piece of paper). There is considerable risk in this speculation. Ultimately, someone has to actually buy (and sell) the crude. The only legitimate buyers are the Oil Refiners. The only sellers are the Oil Producers. The speculators playing only the paper game with no intention of actually buying (or selling) crude oil must close out their positions in their futures contract holdings prior to contract expiration. As they close out their positions there are about as many winners as there are losers.

Presumably speculators with a lot of resources can manipulate the price of futures contracts (but not the underlying commodity) and guarantee a profit. This is a high risk game that, in the end, should not affect the spot price of the crude oil underlying the contracts.

Oil Producers could be playing this speculation game. In this case they would be using the futures market to create the illusion of scarcity and they would be raising their (spot) prices for crude oil in tandem with the futures market. I suppose Oil Producers could also just be riding the speculation bubble. Some collusion would be necessary for this to work. If this is the kind of speculation we are talking about, this should be pointed out. This is not a “generic” speculation problem.

So that is my understanding. I believe I made a case that, without Oil Producer collusion, speculation cannot drive the spot price of crude oil. Please tell me what I am missing. Thank you.

Posted by: ChrisL on August 21, 2008 at 11:36 PM | PERMALINK

http://www.time.com/time/business/article/0,8599,1834888,00.html

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