Tuesday, June 24, 2008

Mischief in the Markets or World Oil Balance?

For the past three years, I have been looking into the excessive speculation occurring on the energy markets. I have done more than just scratch the surface; I’ve really delved deep into this issue to understand the extent to which market speculation is inflating the price of crude oil. I sat through the Enron hearings and saw how Enron manipulated the energy markets. Naturally, when I began to see wild swings in gasoline prices, I was suspicious of mischief in the markets.

And it’s not just me. While the Treasury Secretary and the Commodity Futures Trading Commission (CFTC) won’t acknowledge that excessive speculation is a big part of the problem, more and more people are reaching the conclusion that excessive speculation is a significant factor in the price Americans are paying for gasoline, diesel and all energy products.“

As the price of crude oil has doubled over the past year – up 40% so far in 2008 – more and more people, like the International Monetary Fund and even the Saudi Oil Minister, are coming to realize that speculation has played a significant role in the run-up of oil prices.

~U.S. Congressman Bart Stupak (D-Mich.), who introduced legislation aimed at "closing loopholes that are allowing speculators to manipulate energy markets and artificially inflate prices," Stupak’s Prevent Unfair Manipulation of Prices (PUMP) Act.

MP: The chart above (click to enlarge) shows the "World Oil Balance" from 2003-2007 using EIA data (thanks to SBVOR). Could high oil prices, especially during 2007, be related at all to the fact that since late 2006 (shaded area), world demand started consistently outstripping world oil supply according to the EIA?

Update: As Cato's Alan Reynolds reminds us, "There is no mystery behind the rise in oil prices. They rose too high too fast because of booming demand for oil for petrochemical products, electric power and shipping from many emerging economies (particularly China, India and the Middle East). Meanwhile, the supply of oil slipped in the US, Mexico, Venezuela, Nigeria and Russia."

Note: The EIA will provided updated world oil balance data next week.

16 Comments:

At 6/24/2008 8:59 AM, Blogger Sophist said...

MP, you ought to comprehend some basic commodity futures related facts:

When people purchase oil futures long, this essentially adds to the demand for oil because there is potential for delivery of that oil. When producers see excessive purchases of futures contracts they raise prices to ease future demand otherwise they may fail to deliver.

If the speculation is continuous like it has been going on for the least year or so, prices keep going up.

It is very easy to manipulate the price of a commodity that has a certain level of supply by continuously purchasing futures contracts long. This is what has been going on, it is simple, straight forward, I am surprised you and others do not see it and wonder why, it is plain failure to comprehend that facts, inability to understand basic stuff, or something else?

 
At 6/24/2008 9:03 AM, Anonymous diz said...

I'm not sure those graphs represent "supply" and "demand" so much as "quantity consumed" and "qauntity produced".

In any given time period the only difference between consumption and priduction is changes in (above ground) inventory. Above ground inventories tend to be operational in nature -- that is, the amounts needed for refineries to ensure smooth operations. As price rise, I would expect refineries to react by carrying less inventory whenever possible. Of course, inventory in the crude oil world can be kept underground by simply not producing.

"Supply" and "Demand", are of course functions of price. We should expect price to rise or fall to equilibrate supply and demand. (I would call inventory draws part of supply, and inventory builds part of demand.)

So, the question for those peddling the "speculators are responsible for artificially raising prices" storyline is "If prices are artificially high, how come supply is not significantly exceeding demand at the current price?" In other words, "artificially high" prices imply that crude should be piling up in inventory somewhere...

Which is simply not happening.

Current prices are clearing the market of all the crude that is being offered.

 
At 6/24/2008 9:08 AM, Anonymous diz said...

When people purchase oil futures long, this essentially adds to the demand for oil because there is potential for delivery of that oil.

It's not clear you understand the basic functioning of the futures market.

When someone "goes long" in the paper market, it is necessary for someone else to "go short" the exact same position. There is never any net length in the futures market.

 
At 6/24/2008 9:11 AM, Blogger Sophist said...

"Which is simply not happening."

How do you know?

China, Japan and other countries are piling up crude in old, single hull, tankers that are out of commission now.

You raised an important question and there are several important answers that basically resolve the issue.

 
At 6/24/2008 9:16 AM, Blogger Sophist said...

diz, please do not waste bandwidth here... I trade commodities for over 20 years. The conterparty (short_) must deliver the good, if requested.

You do not understand anything it seems.

There is no such term as "net length". If you are an engineer please stay away form ean economics forum. Please..

 
At 6/24/2008 9:41 AM, Blogger Mark J. Perry said...

See update on post:

"There is no mystery behind the rise in oil prices. They rose too high too fast because of booming demand for oil for petrochemical products, electric power and shipping from many emerging economies (particularly China, India and the Middle East). Meanwhile, the supply of oil slipped in the US, Mexico, Venezuela, Nigeria and Russia."

 
At 6/24/2008 11:10 AM, Anonymous diz said...

diz, please do not waste bandwidth here... I trade commodities for over 20 years. The conterparty (short_) must deliver the good, if requested.

You do not understand anything it seems.


Heh.

Well, since you are a self proclaimed commodity market expert, why don't you explain to exactly us what a commodity trader does to make prices "artificially"
go up, and how he profits from doing it. And what we should expcet to see going on in the physical market for the commodity while he's doing it.

 
At 6/24/2008 12:14 PM, Blogger Sophist said...

Nobody can help you diz, if you cannot help yourself. You have a bad attitude and that has costed you a lot during your lifetime.

 
At 6/24/2008 1:08 PM, Blogger SBVOR said...

Dr. Perry,

Thanks for the plug!

Keep up the excellent work.

You have some new and enthusiastic readers among my closest friends and relatives.

 
At 6/24/2008 1:15 PM, Anonymous diz said...

Nobody can help you diz, if you cannot help yourself. You have a bad attitude and that has costed you a lot during your lifetime.

Let's just drop the personal comments and have a serious discussion.

Let's start with a market in equilibrium at $50 per barrel.

Meaning, there are just as many buyers as sellers at $50 for physical oil.

Now, you are going to profit wildly by "speculating" in a fashion that drives the price up. What exactly do you do?

 
At 6/24/2008 1:19 PM, Blogger matt said...

sophist, I disagree with you but I'd like you to help me see it your way. Please help me understand.

You said producers react to increased 'paper' demand by raising the price out of fears to not be able to meet demand. I thought producers only sell futures for quantities they can deliver, but that doesn't matter right now.

Anyway, since the price for oil has skyrocketed, I can assume 'paper' demand has only continued to increase. You also said that supply is constant. I agree. So, increasing demand and constant supply makes prices increase.

So, my question. What is the mechanism that traders use to fake demand? Is there fake 'paper' demand, then that doesn't correlate into real demand? Are traders taking delivery of oil and storing it somewhere?

 
At 6/24/2008 2:13 PM, Anonymous rvturnage said...

"China, Japan and other countries are piling up crude in old, single hull, tankers that are out of commission now."

That's heavy crude, not the light, sweet crude usually used for gas/diesel, which is what most of our refineries are set up to refine.

http://www.economist.com/displaystory.cfm?story_id=11453090

"The problem is exacerbated by a growing mismatch between the type of oil being produced and the refineries that must process it. The most common benchmark prices, including the one used in this article, refer to “light” crude, the least viscous sort, which produces the most petrol and diesel when refined. “Heavy” oil, by contrast, yields more fuel oil, which is used mainly for heating.

At the moment, diesel is in short supply and there is a glut of fuel oil. That makes processing heavy oil unprofitable for some refineries, since the gains from diesel are outweighed by losses on fuel oil. As refineries turn instead to lighter grades, it pushes their prices yet higher. The discount on heavier crudes has risen to record levels. But even then, points out Ed Morse, of Lehman Brothers, another investment bank, Iran is having trouble selling the stuff. It is storing huge quantities of unsold oil on tankers moored off its coast.

Presumably, Iran and other heavy-oil producers will eventually be obliged to drop prices far enough to make processing the stuff worth refiners' while. In the longer run, more refineries will invest in the equipment needed to crack more diesel out of heavy oil. Both steps will, in effect, increase the world's oil supply, and so help to ease prices."

 
At 6/24/2008 2:19 PM, Blogger Sophist said...

Tree intelligent question in one shot. Thanks you Matt for asking:

" What is the mechanism that traders use to fake demand? Is there fake 'paper' demand, then that doesn't correlate into real demand? Are traders taking delivery of oil and storing it somewhere?"

(1) Mechanism: fear of the producer and the consumer. The producer does not know whether people who are long futures contracts will take delivery or not. Lack of that knowledge translates into potential demand. Consumers panic and that does it.

(2) Fake versus real demand. Where and when do you draw the line. It's too philosophical. What is real after all? Are you an Idealist or a Materialist.

(3) Delivery: Countries like China and Japan whose economies depend on manufacturing goods have been storing oil like crazy. So the excess supply goes fast.

But I also believe, and this is only a belief not justifiable by any means at this point, that the specific speculators that drive up prices find ways to disrupt. For example, look at the frequent attacks in Nigeria and other places whenever price of oil turns south.

Destabilization of West and its economic system may be the ultimate objective of this kind of manipulation that has not been stopped yet because some people appear friendly to speculators.

Remember that high inflation is like a bifurcation. It takes years to repair the damage and the victims are countless.

It's ready to ignite unless something is done. Major US companies are announcing price increases. Losing game to protect the "speculator".

 
At 6/24/2008 3:02 PM, Anonymous Anonymous said...

"destabilizing the west"

Do you honestly think that a nation with one of the highest per capita incomes is more vulnerable to rising fuel prices than the rest of the world including developing nations?

There are a great many countries that are far less able to withstand rising prices than the U.S. China, for example, has been subsidizing oil prices to the tune of billions of dollars and only recently allowed an 18% rise in the price of gasoline. World food prices have also risen dramatically with the rise in the cost of transportation.

You were doing better with futures and speculators.

 
At 6/24/2008 8:01 PM, Anonymous Anonymous said...

Forgive me if I'm wrong, but aren't futures market like any other market? If one set of speculators were selling contracts at an artificially high price, wouldn't there be others who would sell it at a lower price in order to beat out the competition?

 
At 6/25/2008 8:54 AM, Anonymous diz said...

Forgive me if I'm wrong, but aren't futures market like any other market? If one set of speculators were selling contracts at an artificially high price, wouldn't there be others who would sell it at a lower price in order to beat out the competition?

That's a little but what I was trying to get at with sophist.

If you start with a market in equilibrium at $50/bbl, by definition there are an equal numnber of buyers and sellers at $50/bbl.

Now, if you come in and start buying up futures, you change the equilibrium. More buyers than sellers at $50 means the price goes up until you draw in enough sellers to balance the market.

Let's say you are responsible for a binge of buying that drives the price up to $100 per barrel. This is a fairly deep and liquid market, so this is would likely require an enormous amount of speculatinve buying on your part.

Now, what has this gotten you?

You have driven the market from $50 to $100 solely by your demand unbalancing the equilibrium that existed at $50.

Now you stop buying. Or perhaps even start trying to liquidate your position.

Where is the new equilibrium going to be?

By definition, your binge of buying has driven the market to the point where there are an equal number of buyers and sellers at $100. Now, you are not a buyer so there must be more sellers than buyers at $100.

We know the equilibrium was $50 (equal number of buyers and sellers) before you entered the market. If you come out as a as a massive seller, the equilibrium ought to be even lower than $50.

This is why people generally don't expect to profit by having their own demand drive a price increase. To do so essentially requires a "greater fool" to come along and sustain the artificial bubble as he exits his position.

 

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