Friday, June 27, 2008

Don't Blame the Speculators; Without Futures Markets, Oil Might Be At $200 Instead of $135

Excerpts below from the Fortune Magazine article "Don't Blame the Oil Speculators: A Campaign in Congress to Punish Traders for Record Oil Prices Reveals a Fundamental Misunderstanding of How Futures Markets Work":

Here's a suggestion: The next time a Congressional committee wants to hold a hearing on how "speculators" are driving up oil prices, each committee member should first be required to demonstrate - preferably in their opening remarks - a basic understanding of the mechanics of futures trading.

Even better, they should be required to explain in detail how it is that investors who never take delivery of a single barrel of crude - and thus never remove a drop of oil from the open market - are causing record high oil prices.

"Do I think politicans understand the role of futures markets - how they facilitate price discovery and the transference of risk?" asks former U.S. Commodities Futures Trade Commission chief economist Gerald Gay. "No, they're clueless - at least most of them."


If our representatives did understand the oil markets, they'd know that the true telltale sign of a speculative bubble is not rising trading volumes but rising oil inventories. Speculators would be hoarding oil - building up inventories either in anticipation of higher prices or as part of a scheme to drive prices there. Yet according to the Department of Energy, U.S. oil inventories are now at below-average levels. U.S. oil stocks stand at 309 million barrels, versus 330 million in June 2005.

A more basic misconception in Washington involves what these so-called speculators are really buying. They're not buying oil, they're buying futures, and this is a crucial distinction. A futures contract is an agreement between a buyer and a seller to deliver a set amount of oil at a specific price on a specific date. The value of that contract rises and falls, depending upon market conditions, right up until the date of delivery.

"For speculators to be propping up the price of oil, they somehow have to be taking physical oil off the market," says energy markets expert Craig Pirrong, a finance professor at the University of Houston's Bauer College of Business.

There's something else politicians conveniently overlook: futures trading requires two to tango. For every investor who is betting oil prices will go up, there also needs to be an investor willing to take the opposite side of that bet.

Today's speculators are evenly split between shorts and longs. Moreover, the percentage of futures contracts held by speculators (as opposed to commercial traders) actually decreased over the last year even at the same time that oil prices were increasing.

Without a futures market, I believe we'd be decrying oil at $200 a barrel oil instead of oil at $135.

12 Comments:

At 6/27/2008 10:51 PM, Anonymous Anonymous said...

The Fortune article says: "If our representatives did understand the oil markets, they'd know that the true telltale sign of a speculative bubble is not rising trading volumes but rising oil inventories. Speculators would be hoarding oil - building up inventories either in anticipation of higher prices or as part of a scheme to drive prices there."

So this at least settles the issue that speculators do have the ability to cause a speculative bubble. The theoretical arguments that such is impossible are not entirely correct. Just ask my neighbor, an administrative assistant, who got into day trading and investing in ipo's after work from her home computer just before the dot com crash.

 
At 6/27/2008 11:37 PM, Blogger Gregory said...

I agree that the sign of speculation is rising oil inventories. However, as you say, oil inventories are low. As such, it appears there is no shifting of volume from the past to the future, as there is no hoarding. As such, while speculation in futures markets is having a marginal effect of letting consumers know prices will be high in the future, it is not shifting much supply into that future (which I guess would be the present?), as such it sounds silly to suggest without speculators oil prices might be $200 instead of $135.

Speculators did not call it early and they are they are not substantially shifting supply, so the price should be close to what it would be otherwise.

 
At 6/28/2008 12:21 AM, Anonymous Anonymous said...

Typically, every fall my local co-op offers its members the opportunity to enter into a pre-paid contract for delivery of a certain amount of LP gas at a certain price for a year.

I'm sure they (or the coop association of which they are a member) aggregate these contracts and use some futures market plays to enable delivery of the LP gas at that price.

So I guess I'm indirectly a member of an organization that "speculates" in the futures market.

I should be so evil... hahaha.

 
At 6/28/2008 12:32 AM, Anonymous sam said...

professor,the article suggests our congress may not understand futures,but prof micheal greenberger of univ of maryland former board member of cftc and micheal masters a hedge fund manager with extensive futures contract knowledge are just 2 of the people who testifed before congress and claim excessive speculation on the unregulated london intercontinental exchange[ICE]not the nymex as stated in the article. everyone with[current cftc bias] always talks about how futures are handled on nymex,but never address what's going on the ICE-because its outside cftc oversight.this is the exchange that allowed enron to push up natural gas prices in california claiming it was decreased supply.i still think we need to know what's going on there before we are so sure it's not an imbalance with index speculators-long only. oil is sitting in tankers off the coast of iran,there is oil supply out there but price keeps climbing.for tally of supply see http://www.businessweek.com/lifestyle/content/jun2008/bw20080626_022098_page_2.htm

 
At 6/28/2008 12:38 AM, Anonymous Anonymous said...

Without a futures market, I believe we'd be decrying oil at $200 a barrel oil instead of oil at $135.

Sorry - how can this be? How can a futures market keep the price down ($135) and not up ($200)?

If this is true, wouldn't the opposite also hold true?

Just trying to get a better understanding.

 
At 6/28/2008 1:47 AM, Anonymous rg said...

sam,

Thanks for the interesting article in businessweek.com. It of course immediately brings up the question; now that this info is public knowledge, why is the price of oil staying up high? And how many more super tankers do the Iranians have which they can fill up.

I have some problems believing in a conspiracy theory that oil traders conspire to keep the price up. There are too many of them. And of course if all this is true, then the oil price should come crashing down at some point.

But, looking at this chart

http://upload.wikimedia.org/wikipedia/en/f/f5/EIA_IEO2006.jpg

suggests world demand has not increased enough to justify increasing the price by as much.

Any GOOD explanations out there?

rg

 
At 6/28/2008 1:55 AM, Anonymous rg said...

My link above is too long. here it is in clickable form

Energy use by EIA

rg

 
At 6/28/2008 7:11 AM, Blogger juandos said...

"The next time a Congressional committee wants to hold a hearing on how "speculators" are driving up oil prices, each committee member should first be required to demonstrate - preferably in their opening remarks - a basic understanding of the mechanics of futures trading"...

Heck! I'd like to these Congress critters actually show us they understand something as simple as the law of supply and demand...

 
At 6/28/2008 9:49 AM, Blogger Sophist said...

The answer to Fortune's naive question is simple:

As prices climb, foreign countries store more oil and this causes inventory to remain at about the same levels.

This is a feedback mechanism with positive error correction, which is an unstable dynamic system.

Fortune's question is another in a series of straw man arguments probably financed by wealthy NYMEX oil trading houses.

Speculative premium at this point should be around $60. This is what OPEC and many experts believe.

 
At 6/28/2008 11:16 AM, Anonymous Odofakyodo said...

As prices climb, foreign countries store more oil and this causes inventory to remain at about the same levels.

I'm not an expert in futures markets, but this statement doesn't make sense to me. If price goes up then supply goes up because suppliers are willing to sell more at higher prices. The only way storing more oil when prices are high will benefit foreign countries is if prices get higher in the future. So countries that store more oil would have be betting that prices are going to get higher, in which case they have turned into speculators. I find it difficult to believe that most suppliers would take such risks, and never sell the inventory they have.

 
At 6/28/2008 7:22 PM, Blogger OBloodyHell said...

> I'm not an expert in futures markets, but this statement doesn't make sense to me.

That's ok, it doesn't make any sense to anyone but sophist, who works real hard to remind us all how little effort he's placed into studying economics.

As wiki says, the reason for the US's SPR is "The United States started the petroleum reserve in 1975 after oil supplies were cut off during the 1973-74 oil embargo, to mitigate future temporary supply disruptions.". Since this jibes with what I've encountered elsewhere, I'm assuming the Wiki is correct.

In other words, you don't hoard it because prices go up, like sophist claims so brilliantly, you store some to deal with disruptions. Congress and the Admin have also taken steps to stop adding to the reserve (again, exactly the opposite of what sophist makes up out of thin air) so as to lessen the pressure on the supply and help lower prices (which effectiveness can be debated, but is, as I just noted, exactly the opposite of what behavior sophist claims).

Geenyus. Sheer, Comic Geenyus. How does he keep coming up with these utterly entertaining absurdities?

 
At 7/03/2008 7:55 PM, Blogger JD said...

Even better, they should be required to explain in detail how it is that investors who never take delivery of a single barrel of crude - and thus never remove a drop of oil from the open market - are causing record high oil prices.

Here is that explanation: Most crude oil is traded based on long-term contracts. The prices in those contracts are determined by a system called "formula pricing", where the price is set by adding a premium to, or subtracting a discount from, the prices of certain benchmark crudes, namely: WTI (NYMEX), Brent (ICE) and Dubai-Oman. Originally, the benchmark prices were derived from spot prices (spot WTI, dated Brent etc.), but in the early 2000s, depletion of the underlying crudes led to very thin trading, and numerous "squeezes" and other distortions of the spot markets. To solve this problem, large exporters such as Saudi Arabia, Kuwait and Iran adopted a system where the futures price (specifically BWAVE) is used as the benchmark in formula pricing.

Futures aren't a paper bet on the direction of prices determined by some independent process. Futures themselves *determine* the price of most physical oil traded today. The futures price (+ or - the differential) literally *is* the price of oil.

These facts are all supported by detailed references here

Jon Birger, the author of the Fortune article, is grossly misinformed about the current state of the international oil pricing system. Is it asking too much for reporters to do a modicum of research on the actual market structure before they shoot their mouths off?

 

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