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.

[curiosity]

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.

If it's going to shift the demand curve, then it's going to shift it out: anticipation of higher supplies in the future will discourage fuel-saving investments (i.e. higher mileage vehicles, housing closer to work, etc). That would put positive pressure on prices.

I think you are referring to the supply curve, rather than the demand curve. Anticipation that more supply is coming in the future might shift out the supply curve today, as producers holding oil in the ground would want to sell more now while prices are still high.

Speculative demand for futures would also shift in, as an announcement of more future supply would signal lower future prices. But that wouldn't have any direct effect on spot prices.

[econjack]

No, I was referring to a shift in speculator's demand for oil and it would be a backward shift because future expectations are now such that being in the market hold less profit potential than before. (You're on the right track in your last paragraph.)

Expectations don't have much of a supply effect. If they did react by supplying more now because they expect future prices to fall, they would just accelerate the price drop.

[curiosity]

No, I was referring to a shift in speculator's demand for oil and it would be a backward shift because future expectations are now such that being in the market hold less profit potential than before.

That's true, but I don't see how that's going to have much of an effect on spot prices.

Expectations don't have much of a supply effect.

If they did react by supplying more now because they expect future prices to fall, they would just accelerate the price drop.

Yes, that's true, but anyone who can readily increase short-run oil output would still benefit from doing so now if it were anticipated that oil prices were going down in the future. Most producers are too small to significantly impact prices with their own actions. Even if the producer is big enough to move prices, he'd still be able to get more now for his oil than if he waits for price drop when new supplies come online in the future. So any producers that can quickly increase production now would do so.

The problem is there aren't many such producers. It's hard to control output from a producing well. Unless a well is on the pump, and most wells aren't, the amount of oil coming out at any given time is determined by geological forces beyond the producer's control. Capping a productive well is also very expensive, so there aren't many capped wells that could be quickly uncapped. That makes it highly unlikely anything is going to happen to supply in the short run.

[ATOMIC_PUNK]

I read my children Animal Farm when they were preschoolers and then talked about it through out their lives. They learned about Freedom and politics that way.

Thats cool but i never read "Animal Farm" I grew up on a farm and experienced it in real life My parents never read to me but did teach me to read The first time i read the Constitution was the Week before i Joined the Navy I figured if i was going to fight for my country i should know just exactly what i was fighting for besides just Freedom and Independence

I talked to a 19 year old young man just 2 days ago who had no clue what the Constitution had to do with why we fight for Freedom ...That my friend Scares me ! Children are not being taught what it means to be an American or even why they should be proud to be one !.... Diversity is the Mantra of the new thinking Schools and almost a hatred of our own country ....

[bruinbirdman]

This is always a pet peeve with me. Different scales on comparative graphs. So, why does Oil Market Report by International Energy Agency use a scale of 2 mb/d increments for demand and 1 mb/d for supply?

In any event, it appears that supply tracks demand within a narrow price range. There seems to be no problem with supply.

Nigerian rebels shut down 200K bbl/day? Saudi Arabia tells GW it will do him a favor and increase output 200K/day.

India and China increase their demand/year? More Iran output comes on line.

Oil at $140/bbl? Congress refuses to amend Udall moratorium on oil shale production in Colorado and Utah.

yitbos

[Citizen Blade]

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!

Following this logic, then, the price of oil is potentially infinite.

[rurgan]

Just one example:

If you look at the last bars on the graph that represent the latest numbers for 2008 you will see that Demand is at 88 million barrels per day while Supply is at 87 million barrels per day. That means that Demand is greater than supply hence the rising oil prices.

Oil at $140/bbl? Congress refuses to amend Udall moratorium on oil shale production in Colorado and Utah.

On Democrats banning oil shale production ,the Udall moratorium on oil shale production, causing the $140 oil, you are absolutely correct on that.

[bruinbirdman]

"If you look at the last bars on the graph that represent the latest numbers for 2008 you will see that Demand is at 88 million barrels per day while Supply is at 87 million barrels per day"

Take another look at the graphs! Another trick.

Look at Supply 1Q2008 = 87. Demand actually shows 4Qs for 2008 (estimates?). But 1Q2008 Demand is less than 87.

yitbos

[rurgan]

No, the first Quater Demand for 2008 is 87 m b p/d while the first quater 2008 supply is about 86 and DOESN’T come close to reaching 87 m b p/d.

[rurgan]

No, the first Quater Demand for 2008 is 87 m b p/d while the first quater 2008 supply is about 86 and DOESN’T come close to reaching 87 m b p/d.

So Demand(87) is higher than supply (86).

[bruinbirdman]

"first quater 2008 supply is about 86 and DOESN’T come close to reaching 87 m b p/d.

Just to be sure we are looking at the same chart: What is 1Q2008 supply on this chart?

yitbos

[Freedom_Is_Not_Free]

Good article. I want to say I’d already read it a couple of months back, but maybe I am just experiencing Deja Vu?

[Freedom_Is_Not_Free]

I don’t mind eating crow when I’m wrong. I state my beliefs and I try to state my reasoning as well. When I am wrong, I’m wrong, and I admit it.

The core for me is, why has the price of oil risen so far so fast? My problem is, the sudden meteoric rise in prices, up 46% year to date, as it relates to your belief that the fundamentals of increased demand and reduced supply and expected supply are the basis for today’s oil prices.

No doubt a good chunk of that increased cost is due to the dollar’s tumble. And if the dollar strengthened to par with the Euro, we would see a direct proportionate decrease in oil prices.

That leave the balance of that 46% year to date increase, attributable either to fundamentals of supply and demand, or speculation, or both.

Here is the source of my doubts that supply and demand is responsible: the price of oil has been soaring since 2003. I can’t find a reasonable, logical explanation for the sudden shift in oil prices, straight up. Everyone has been aware of the stellar growth in developing nations. This is not something that just appeared beginning in 2003 and caught everyone off guard. Everyone has been aware of the possible plateau in world oil supply for quite a long time.

I simply can’t reconcile why oil was selling for $30 a barrel all through 2002, and suddenly spiked. I can’t accept that investors and retailers and supplies just woke up one morning in January 2003 and smacked their heads in shock with the sudden realization that oil demand was steadily increasing while oil supply was not.

What was this not priced into oil price in 2002? And in 2001? And in 2000, etc?

Now you know why I am having such incredible difficulty believing that market fundamentals alone account for $140/Bbl oil (in conjunction with a weakening dollar).

So, how is it that the market so suddenly and so rapidly discovered the looming supply/demand problem in 2003 and beyond, when they seemed to be completely asleep at the wheel prior to that time?

If you have a logical answer to that question — why the world market completely discounted the obvious and looming problem with future oil supply and demand prior to 2003, and just suddenly and forcefully discovered it — then I can start to open my mind to the possible idea that there is not a bubble in oil prices and that $140/Bbl oil is here to stay.

Any help you can give me in that regard is appreciated. Without a logical answer to that enigma, I just can’t accept the fact that prices went from $30 in 2003 to $140 in 2008 on the sudden revelation that world demand was increasing faster than world supply.

FWIW, I am assuming that if the dollar were to strengthen to par with the Euro, a Bbl of oil would cost $80 US today. So the rise in oil prices not considering currency is an increase of 170% in 5 years. I am finding it very difficult to believe that a 35% annual increase in the cost of oil since 2003 is due to market fundamentals of supply and demand alone, discounting the weakening dollar. Hopefully, you can explain to me why how this could be, because I really can’t see it.

[gogeo]

http://jewishworldreview.com/cols/sowell051308.php3

[curiosity]

So, how is it that the market so suddenly and so rapidly discovered the looming supply/demand problem in 2003 and beyond, when they seemed to be completely asleep at the wheel prior to that time?

Demand for oil in China, India, and other Asian countries grew a lot more than exected. For example, no one realized how huge the expansion in low-tech manufacturing in China was going to be. That boom enabled millions who previously could not own cars to now own them. Car ownership in developing countries has been growing far faster than anyone expected. And that, of course, has caused the demand curve for oil to shift out. Elasticity of supply is low, so small shifts in the demand curve mean large changes in prices.

In addition to that, the rate at which new oil fields were discovered declined, and some of the biggest oil fields in the world are starting to decline faster than expected. There were also some major disruptions in oil supply from places like Nigeria. The long-run elasticity of oil demand is quite low (~0.4). That means small changes in supply have a large impact on the price.

The bottom line is that the oil market is clearing: the price is such that demand ~= supply. If oil were overpriced there would be an oversupply of oil, and hence an inventory buildup. But that's not happening. Inventories are declining, which if anything, means the price is too low and demand is slightly above supply.

[grey_whiskers]

Sorry to yank your chain, but I came across this whilst looking for something else.

What was the price per barrel over the last week again?

Cheers!