By Payam Sharifi, an economics Graduate Student at the University of Missouri-Kansas City
Here in the United States, discussions of our troubled times revolve around any of the following: the housing crisis, the federal debt, unemployment, the fiscal health of particular states, and sometimes even income inequality. Overseas, discussions can include these topics, as well as the plight of the Euro. One issue that I personally feel has gotten the short end of the stick is that of commodity prices, and in particular food and oil. There is a special significance to this issue: its ramifications affect nearly every human being in the world. As seen in prices on the NYMEX and other markets, oil and food prices are beginning to soar again, with the price of WTI futures hitting $90/barrel and Brent crude going over $100/barrel. This issue ought to be discussed again with a renewed interest – but the media and much of the populace at large have simply accepted high food and oil prices as an unavoidable fact of life, without any discussion of the causes of these price rises aside from platitudes. For example, a recent AP report quoted an opinion that gasoline was going to hit $4/$5 a gallon in 2011, but did not mention the possible relevance of speculation in the futures market. It seems that everyday observers (as well as even the financial media) find this issue so complex that they shrink from discussing it. I will now give my opinion on these issues, buttressed by what I have learned from a recent interview with commodities trader Daniel Dicker. His new book “Oil’s Endless Bid” is due out in April.
In 2007 and 2008 the world witnessed oil prices at heights never before seen, even on an inflated-adjusted basis. Soaring oil prices became the norm, with oil going above $100/barrel and eventually going higher than $140/barrel, with no respite until the effects of the housing crisis came home to roost. At the time I would hear debates over whether the price rise was ultimately driven by speculation or fundamentals and react with a bit of annoyance. Whether the spike was driven by fundamentals or speculation almost didn’t matter…our personal budgets had become a mess. I wondered, if speculation is the problem, why won’t somebody do something about it? I wasn’t the only one wondering: at the time it was an issue that even led to congressional hearings. Testimony from hedge fund manager Michael Masters and Professor Michael Greenberger, former Director of Trading and Markets at the Commodity Futures Trading Commission (CFTC), helped to give credence to the view that speculation in the over the counter (OTC) and futures markets by large commodity index funds and dealers was causing a bubble in the price for oil. Masters asserted that the emergence of these institutional investors into the futures market had had a deleterious effect on the price of commodities, and Greenberger agreed. Others, including prominent economist Paul Krugman, argued that this was a phenomenon driven primarily by fundamentals of supply and demand.
Krugman’s arguments against speculation in oil proceed along two basic lines. His first claim is that some oil must be hoarded in order for there to be a sustained speculative increase in the price of oil. In some sense, Krugman’s argument has a grain of truth in it as far as agricultural commodities are concerned: due to recent price increases, many developing countries are hoarding food, because they fear that its price will go even higher. This in turn causes a sustained increase in the price of said commodity. However, hoarding is not so neatly relevant in the case of oil, for reasons that Daniel Dicker explains:
Hoarding oil is not available to anyone except for those that already have capacity; those who have capacity have already leased it out well in advance and thus it isn’t capable of being taken advantage of. So the question is why is storage not being built? It is, but the costs of building it is a tricky business; they are unsure whether having that kind of storage is worth it long run, as they are not sure the price of oil will sustain this upward climb long term. Bottom line: storage is not flexible, period.
So if Krugman is right, speculation in the traditional sense of stockpiling can only occur in limited quantities. However, the one actor who is able to “hoard” oil is the producer. As naked capitalism poster Audrey recently wrote:
The only people with ability to really hoard oil are oil producers – by not producing as much as they could and leaving oil in the ground. So the speculation scenario would go like this – an oil producing company is producing and selling oil at $5/barrel. For whatever reason futures speculation drives prices up $10. Consumption shrinks, and the company cannot find buyers for all the oil it produces. At this point the company can either sell at $15/barrel, or reduce production. It reduces production, supply meets demand, price stays $10 higher.
So Krugman is right that speculative price rises should lead to a reduction in supply, but doesn’t realize that these reductions don’t have to involve hoarding in the traditional sense: most likely, the high prices reduce demand, and producers simply adjust. It is countries like Saudi Arabia that are doing the stockpiling. There are also other ways hoarding can happen: for instance, during the commodities spike, the Strategic Petroleum Reserve was increasing storage, but was not counted in total oil inventories.
Krugman also believes that the price of oil is necessarily determined by supply and demand forces (including possibly hoarding, although he doesn’t think that was the explanation for the commodities bubble). In particular, he doesn’t think that the futures market influences the price of oil. In order to understand what is going on here, a brief history of the futures market will be helpful.
Traditionally the futures market was dominated by those who wanted to hedge their exposure to oil. There were speculators in the market who made it more liquid for the person who wanted to hedge, and who provide what advocates of futures markets (a group that includes me) call “price discovery”. However, what we have today is quite different from this rather classical image of a futures market. Consider, for instance, a dealer in the OTC market, who flexibly creates financial instruments for clients. To allow an investor to “invest” in a commodity, the dealer may create a swap that delivers profits to the client when commodity prices rise. To hedge their exposure on this deal, the dealer will go long in the futures market.
What is new here is that the dealer does not care what the price of oil eventually reaches, because its goal is simply to hedge. The pension fund or other institutional investor that is getting exposure to commodities does not really care, either, because it believes that commodities is a new “asset class,” much like equities, and so it simply wants to go long (bet that commodities prices will rise). At this point we can ask the conventional question: “For every buyer in the futures markets there is a seller, so how can futures markets influence commodities prices?” With so many of these new institutional buyers in the futures market, why would anyone want to go short? As Dicker explains, it’s simple: if you raise the strike price of oil enough you generate a new demand, in the form of a trader willing to go short now that the strike price is another, say, $3 higher. Repeat this process a hundred times over and it’s not difficult to understand why we are in this situation today.
As long as these funds don’t pull their money from the OTC market then the game will continue.
Some academics may wonder: don’t the new entrants into the futures market have to take delivery of oil? Not so: in fact, according to Dicker, less than 2% of these contracts take delivery. The rest are rolled over into a new contract and cash settled. This process can occur with any commodity, but oil is particularly important in that a rise in the price of oil also drives up the prices of food (which requires fuel throughout the supply chain). The effects include disruptions in the developing world: the recent revolution in Tunisia and the ongoing events in Egypt are no doubt due in part to these types of price shocks. According to Dicker, the key thing to understand here is that these new institutional players in commodities markets have a different motivation in going long than did traditional speculators, and that matters a lot in how the price is determined.
As a result of these dynamics, the spot price of oil is determined by the futures price; thus Dicker says:
When I first started trading back in the early 80’s the spot market for oil influenced the futures market. In the past 10 years the situation changed, where the futures market was influencing the spot market. In the past 5 years or so the OTC market is influencing the futures market, which then influences the spot market.
And Yves gives additional information in ECONNED:
Most of oil sold is not sold in the cash market. It is pursuant to long-term supply contracts. And the bulk of those in turn are priced off the BWAVE, which is an average of futures prices. The BWAVE became the preferred means for pricing oil because spot oil had been so subject to price manipulation via “squeezes” or trading strategies to goose the price!
The point isn’t that supply or demand shocks can’t influence the price, but that the current structure that exists to determine the price of commodities has intensely exacerbated the relationship. According to Dicker, convincing evidence that speculation influences the price of oil comes in “crack spreads”. Oil by itself is a raw material, and so it shouldn’t be more expensive than the refined products made from it.
A good example of this is Valero Energy. They refine oil into gasoline, and despite the fact that oil is again going higher they have at times operated at a loss. Why is this? The price of oil has been more expensive than the price of gasoline. It’s crazy, but that’s the reality. In fact these crack spreads have become even more out of whack today than what they were even in 2008 when oil was hitting all-time highs.
In other words, the price for oil today is even more out of whack than it was in 2008!! How can supply and demand arguments explain these persistent spreads? Shouldn’t the prices of oil and gasoline go up and down by a similar percentage?
Another troubling point has been raised by Professor Randall Wray of UMKC. This is the issue of the self fulfilling prophecy. It works much like anticipated inflation: if the general investing public feels prices will go up, then they do (given adequate aggregate demand). What is worse is that these institutional investors do not care if prices rise. As Michael Masters points out:
One particularly troubling aspect of Index Speculator demand is that it actually increases the more prices increase. This explains the accelerating rate at which commodity futures prices (and actual commodity prices) are increasing. Rising prices attract more Index Speculators, whose tendency is to increase their allocation as prices rise. So their profit-motivated demand for futures is the inverse of what you would expect from price-sensitive consumer behavior.
So I’ll ask again: where’s the outrage? The media has been worthless on this issue, parading people who make predictions that gasoline will cost $4/$5 a gallon without explaining why this will happen (aside from bromides about growing demand and shrinking supply). It becomes easy to assume that this is just a fact of life that we need to come to grips with. Nothing could be further than the truth – there is no excuse for having these speculative forces control our daily lives.
So is anything being done about it? The CFTC has the mandate to control speculation, but due to disagreements among some of the members the issue has been put off until 2012…until they can ascertain whether there is “proof” of speculation. In other words, our political class still doesn’t have the cojones necessary to fight the good fight and put an end to this once and for all.
For now, the most important thing for us to remember is: let’s not fall for the “fundamentals” argument any more. The price of oil you see on the screen is a creation of modern finance.
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Doh, I wanted to write a post explaining how the non-producer/consumer demand drives up the futures but I see someone was faster!
I still might write one on how any sufficiently liquid derivative will in the end drive the physical market – unless the spot is not affectable (say inflation/weather futures)
In a nutshell, the best way to relate fundamentals to speculation is that under conditions of Peak Oil and food globalization, where the price is already extremely volatile and therefore vulnerable to the slightest influence, any effect of the crime of speculation is bound to be magnified far beyond what it could have been under normal conditions. What might have been petty theft becomes capital robbery.
(The natural, rational food market is overwhelmingly local and regional. The commodification and globalization of food was already a purely artificial crime against humanity. Speculation is a crime added on top of that.)
The author closes with:
“For now, the most important thing for us to remember is: let’s not fall for the “fundamentals” argument any more. The price of oil you see on the screen is a creation of modern finance.”
The whole article is about specs and the fact they control prices and push things around to everyone’s disadvantage. Rubbish.
This can not happen without the full cooperation of the Federal Reserve. ZIRP and QE are what you should be holding accountable for $100 oil. Aim a little higher next time and you might hit the target….
Bruce,
The same thing happened in 2008 with no QE or ZIRP.
You mis-characterize the article, it’s not about “specs” it’s about a special, recently created type of spec called an ‘index speculator’. Institutional funds “investing” in long-only commodity strategies, it should be banned.
Where to begin? The author makes a complaint about market manipulation.
All markets are manipulated. When the Fed buys Fan/Fred paper it manipulates the real estate market, when it buys Treasuries it manipulates the bond market: when China’s govt buys stocks on the Shanghai exchange it manipulates the China stock market along w/ other stock markets., when the ECB buys Greek bonds it manipulates the EU stock & bond markets, etc. Having an SEC or a central bank is a market manipulation. Life is manipulation, ya gotta get over it.
Likewise, the complaint about futures leading spot is to my mind incorrect. Chris Cook, who ran compliance dept for IPE before it was absorbed into the Intercontinental Exchange considers Index Specs as a foreign exchange hedge:
http://is.gd/C9gi9C
The physical market is where the price action takes place between shippers who hold all the world’s oil at one time or another (!!) and refiners who do the exact same thing. There is nothing to prevent these entities from buying/selling cargoes back and forth to each other multiple time from well- head to oil terminal which of course they do.
Here’s more: http://is.gd/jznKqy
Another exogenous input (use that word rather than manipulation) is capital accounts/foreign exchange which is driving China’s fuel purchase strategy. The subtext is China has a strategy and the ROW doesn’t. Waaah! It’s also a failing strategy which is ‘waaah’ for China.
The real prob w/ oil prices is the economic return on the use of the oil is becoming less than the cost of producing new oil. That is what peak oil is and the world is at or past that point.
Economic growth from this point forward requires the addition of four more Saudi Arabias to the supply.
Instead, the world gets four more Chinas worth of demand. This explains the current oil price, no?
Steve,
This is utter nonsense. First of all, comparing this sort of “manipulation” to the actions of the Federal Reserve misses everything entirely, from reasons for why its happening to how it can be stopped, to why it hasn’t been stopped. That you say nothing of even WHETHER it should stopped shows that you really don’t care about this subject matter.
If you would prefer to stay ignorant on the fundamentals of the OTC and futures market shows that you really aren’t serious. There is nothing substantive in what you’re saying.
Well said and cogent to the issue.
Payam,
You are treating “speculation” as if it is a dirty word, a sin, an evil to be excised from the financial markets.
Speculation is related to price discovery. In a pro-cyclical environment (goosed by the manipulative-evil-money-printing fed)all the markets care about is “how high is high.”
In a countercyclical environment, all the markets care about is how-low is low.”
Crude oil is simply one of the better products out there that investors/traders purchase as a hedge in a pro-cyclical environment, or a hedge against policymakers inducing asset-inflation with zero or negative interest rates and quantitative easing.
Will there be collateral damage to the economy and the lower and middle classes when gas prices climb to $4-$5? Absolutely. But you can’t hang traders and investors for buying products that provide hedges against bad policies that produce hyper-inflationary outcomes.
You have to recognize that it is the money-printing policies of the Fed and US gov’t that are amplifying price distortions in the various commodity markets.
If you excise the Fed’s easy money policies, you tone down the inflation burden of higher prices on the rest of society diminishes.
John,
I know you’re trying to be nice but it’s quite apparent you didn’t comprehend my article, at all. Read it again and you will see that I’m a supporter of futures markets as they were originally constructed. Just read it again anyway, because you’re still treating speculation like it isn’t a problem. If you want a good rebuttal to your comments you will see that my post actually answers them.
I think the author’s point in this piece is that the modern financial sector is completely divorced from fundamentals. You’ve got the emergence of a new “bubble economy,” one in which the traditional parabolic speculative cycle is not bound by the cold hard facts of the underlying economy. For instance, if you look at stock market capitalization as proportion of nominal GDP you’ll see that this figure is too high relative to the underlying fundamentals of the economy.
Of course, all bubbles burst but in the new bubble economy the effects are not limited to the speculators themselves, but bring down entire sectors of the economy.
I see this speculation in a somewhat different light. I see it more as a ‘carry-trade’ or just excess money trying to find a better return. I see the QE printing presses as forcing money into equities, commodities and emerging markets thus exporting inflation into these markets. This is why many emerging markets are trying to control capital inflows so they don’t have to deal with the eventual very damaging huge capital outflows. When QE is turned off I see this carry trade ending with equity and commodity prices coming down. I don’t fully understand OTC swaps but they sound opaque and setups for fraud and manipulation similar to Goldman Sacs exchange rate swaps with Greece which made its debt look better to the EU than it really was…
Thanks for posting, and you bring up an important matter but one that is besides the point.
While it is true that the case of institutional investors coming into the derivatives market is a case of investors seeking yield, it says absolutely nothing about the LIMITS government can put in place to prevent this kind of speculation. So again, while it is true that the Federal Reserve’s policies are contributing to this it says nothing about whether we can stop it and, if so, why we haven’t.
Prosecuting fraud would help. Also pension funds, insurance companies etc probably shouldn’t be investing in these sort of vehicles…
http://seekingalpha.com/article/79277-index-speculators-responsible-for-commodity-prices
“””Markets will always seek an equillibrium. In a capitalist economy though you also tend to get exaggerations on both sides of an equation. If the market for crude demand is X at $75 and supply is willing to supply X then we have a balance. What Masters is arguing is that the legitimate purchasers of this commodity are having to pay more because speculators are bidding up the price. Instead of the bid being for X at $75 they are adding volume to the bid os it may be X+1 and the supplier says that they are not willing to provide the +1 at $75 and so the bubble begins to form.
The bottom line is that this is not going to end well. As we have seen numerous times in the last 10 years or so speculative bubbles eventually run out of steam. The problem is that they have a tendency to expand further than we originally anticipate. The price will move forward until the speculators begin trying to cash out and they all move for the cash register at once.”””
fm; How the heck are you going to prosecute fraud when the governments of nearly every country are actively involved in the markets. I know traders who have abandonded the currency markets because government involvements are making it too risky to trade. The same appears to be true in the oil and financial markets. Many of the frauds carried out are just an extension of policy, so unless one has some inside track to what the next gambit is, trading is a certain path to bankrupcy.
Yes great points, very hard to find good corporate governance and why should they when there is so little oversight ie in the UK http://www.ianfraser.org/the-accountancy-profession-is-in-urgent-need-of-an-overhaul/
The FSA/PwC investigation into RBS ‘bad decisions’ is a joke, right?
December 3rd, 2010
=====
When things are going well and everyone is making money people tend to cast a blind eye and say whatever as long as my stocks are going up. The questions start coming when stocks go down. Many people are skittish of the stock market because of all the shenanigins but others just seem to blindly invest. Ie I think I’ll buy apple because ipads are selling well. They often don’t even know the P/E ratio let alone how management is making off with post dated stock options etc.. People should understand what they are investing in but surprisingly few people seem to give it the care they should.
You are complaining that gas prices at the pump are less than they should be? And that crude prices are too high? If true, that would mean that the high oil prices you blame on speculation were miraculously not being passed on to ordinary people–so tell me why we should care! If Valero wants to pay a huge premium for its crude, why should it bother me?
But I am very skeptical about the speculation argument, because: (a) Krugman is rarely wrong; (b) global oil production has clearly plateaued over the past 5 years, despite significant increases in demand from China. Oil is peaking and we are in trouble. See Professor Hamilton’s work–he blogs at Econbrowser.
No, the argument is that at there have been consistent spreads at times between the price of gasoline and the price of oil, which suggests the financial component that ultimately determines price. It is not to suggest that gasoline isn’t also going up, because it surely has. The Valero argument was made to illustrate a point, not so that we should feel sorry for them.
Question: should the “oil is peaking” argument be used to justify further price increases when there is little evidence to suggest we are at that point? Even if the data does suggest we are ever so slightly reaching a peak, that should necessarily correlate into ever so slight price increases, would it not? The volatility in oil prices does not help your argument, and especially not with the rapid rise and fall of oil in 2008 and 9.
I do respect the supply arguments though, because I understand the power of those price signals.
You’ve hit the nail on the head.
Speculator LOVE the talk of peak oil.
The only producer who probably hates it is the Saudis. They want pricing control back over the speculators.
Bingo!
Anybody who thinks the Saudis were happy with $140 oil in the summer of 2008, or $30 oil in the first few months of 2009, has their hat on backwards. As I recall, their target price during this entire period was something like $70 or $75 per barrel.
As the world’s swing producer the Saudis can only control the most basic of fundamentals: supply.
It’s clear, however, that they have lost control of the market. There’s clearly something going on in the markets, unrelated to fundamentals, that the Saudis can no longer control.
I’ll have to leave it up to smarter people than myself to figure out what this “something” might be. But for those who argue that there is not “something” besides fundamentals going on, they are either in denial or just ignorant of the facts.
Charlie-an interesting side note about Saudis-apparently they have informed Obamaland that IF protests of any magnitude occur in “The Kingdom” (look it up-the book), Saudi military WILL open fire…
First, you are correct that peak oil does not itself explain the fluctuations in price. Also you are coorect that the fluctuations in price in 2008 were not QE/ZIRP related. Thus, your argument holds that speculation has impacted negatively on prices.
However, in my opinion (it is just that) the impacts of peak oil and QE outweigh speculation. Peak oil is real. It should be blatantly obvious to anyone that understands a lick about finance. Quite simply, why would oil companies choose to look for oil in 10,000 plus feet of water, tar sands or shale; if there were plenty of easy sources of oil under 200 feet of ground? That simple question should make it painfully clear that peak oil is real. From peak oil, we should expect consistently rising oil prices.
QE has a direct effect on prices: the greater the money supply, the more things will cost. If we did not have QE, we could reasonably expect much lower oil prices.
Finally, speculation has more of a temporal effect. Ultimately supply and demand will rule.
QE would have little to no impact if we had some sort of controls on who can buy these contracts on these derivatives exchanges(or other measures). This is why I have absolutely 0 respect for the QE argument, because really it is just a mask that covers ones contempt for the federal reserve(which is fine, but ignores the real issue at hand, which is putting something like speculation limits in place)
Payam, how on earth could QE not have an effect on prices? If you can explain to me how it should not, I will kneel before you.
As it is, I would suggest you find a different line of work if you think the QE argument is just a mask to cover ones contempt for the federal reserve.
And someone could explain why the difference between Brent and WTi is higher than $15/barrel?
That’s simple; Canadian Oil sands and Egypt.
Thought the post was a bit weak. But good point that producers are hoarding. Saudi Arabia needs oil in the $80 range or it can’t support itself.
The oil-food price ratio is far less important when you don’t use machines or agri-business to grow your food. Or transport it by truck 2000 miles. Or use fertilizer.
I’d agree that oil prices are one of the few things that the average American sees which are the result of global inflation. Painful, yes. But it is still cheap relative to the rest of the world because of taxation.
I’m not too familiar with it myself, but here are some noteworthy things:
1)WTI and Brent cannot converge(in the traditional sense)because it is illegal for WTI to be shipped overseas.
2)WTI is being affected by canadian oil sands raising supply
3)Brent can be shipped anywhere in europe and asia(I believe..)
That essentially explains the divergence as INVESTORS see it(for they are the ones that determine the price, remember!)
This point “storage is not flexible, period” is not really true. During the last few years, many empty oil tankers were used as cheap floating storage in the Straits of Malacca especially.
Here’s one article on this trend:
http://www.dailymail.co.uk/home/moslive/article-1212013/Revealed-The-ghost-fleet-recession-anchored-just-east-Singapore.html
This has declined somewhat now, as trade has picked up.
Isolated examples do not disprove the norm. It’s not as if there are empty tankers everywhere waiting to be filled.
Look at the entire commodities complex. Most every commodity is up by an alarming percentage. Speculation clearly influences short term pricing and is one factor. The author may want to consider the other factors and the interrelationships. One is left to guess how much of these price ramps are due to the funny money (e.g. QE, etc.), supply, demand, and speculation.
Gretchen Morgenson, Sunday NY TIMES, Sept. 2004 documented Goldman-Sachs held 13.8% of TOTAL world energy=oil futures,
while Lehman, JP Morgan, Bear-Stearns, etc, owned circa 7%
each. What they had been doing to blow $OIL$$ price up from
$1.00 per gallon Clinton era, was SELL these “futures” back and forth to one another=SPECULATION. At each sale the price rose..DRIVEN by speculators. They are not end users, as most here understand-they aren’t airlines, who buy to solidify seat prices.
Gretchen documented that in Sept. 2004, Goldman sold off 1/3
of their energy futures-the others blinked. Goldman attempted to set them at ease promising to buy back in, in blended fuels-biodiesel. BUT next month Goldman sold off another 1/3, and everyone sold, bringing prices for oil down
just in time for November Bushit re-election..
THAT’s how speculators manipulate oil markets..
Yep. Exactly. $4 gasoline in 2004 would have elected John Kerry.
You can thank excess liquidity for that.
Thank Greenspan, the Fed, Bush, and Congress for going to war, cutting taxes for the rich, and keeping interest rates too low for too long.
Same thing happened to houses, which I couldn’t afford then and still can’t afford now.
ummmnn…actually folks, John Kerry was elected in 2004, but for THIS from Ohio, including “vote shunting” by Ohio
vote counters-Cheney I.T. man deposed day prior to Obama election, dead weeks later-of course everyone knows what “vote shunting” (to a Republi$$K$$an controlled basement in Tennessee-tabulated-back to Ohio) is..?
This is a great video about Ohio-vote shunting-Cheney’s i.t man is named-scam documented-defined:
http://www.freeforall.tv/
By the way, TRUTH is how liberals must “fight back”, and this is a LOT of truth..
I agree for the most part with the author. The other evidence is the historically high rate of correlation across all commodities.
QE has nothing to do with it. After the 2000 crash the mantra in the pension fund world became diversification which ultimately led to large scale commodities “investment” flows. Nothing else can counter this and so oil and all commodity prices must rise.
Storage facilities and even barges are incredibly expensive to build. These things are designed to be safe and last for decades. No speculator is going to risk being stuck with a giant, un-sellable barge in the event the shell game collapses before they are able to get in on it.
Change the rules to forbid pension funds from commodity investment and most of this goes away quickly.
The problem with people in finance is that they think all the problems are caused by people in finance.
Go to the theoildrum.com:
1) Westexas’s (Jeffrey Brown) ELM (Export Land Model) – the price is made by importers bidding for exports. When there are less net exports – the price rises dramatically.
2) Obvious loss in production (Mexico – Cantarell, UK – the North Sea, …) – note that when this happens the exporter’s (or former exporter’s) consumption doesn’t drop as quickly as production – if at all.
3) Producers hoarding – bullshit. If Saudi Arabia is hoarding and can produce so much more than they are then why are they looking to drill under the Red Sea – miles under if I’m not mistaken – if they have all this cheap oil that they are leaving in the reservoirs. The only reason we have this mystique is that OPEC hasn’t had any transparency in 30 years. The majors in OPEC have more-or-less ignored quotas (producing above quota) for what 25 years? Your whole argument relies on held back production – you better be right, because this affects major long term planning.
4) Emerging economies demand for oil has climbed dramatically – read China (while OECD consumption has actually gone down).
I don’t see the world Enron-style conspiracy of driving up prices. If it’s all just finance then to hell with the Prius, I’ll drive a T-34 to work.
Duffolonious said: “Your whole argument relies on held back production…”
And your whole argument relies on the assumption that the Saudis are as we speak producing at their maximum producing capability.
When you said that “OPEC hasn’t had any transparency in 30 years” you hit the nail squarely on the head. But then you turn right around and presume to know things that you cannot possibly know.
I think you’ve been spending too much time on theoildrum.com. There are some smart people there, but overall the site gets bogged down with a bunch of doomsayers and their fatalistic ideologies. Also, of the three propositions—-peak oil doesn’t matter, peak oil matters, and peak oil is the only thing that matters—-entirely too many of theoildrum.com crowd fall into the latter camp.
Inevitably Saudi oil production will peak, but when that will be no one knows.
Heck, if the GFC experiences a second leg down, which could be far more severe than the first leg down, it could destroy enough world oil demand to delay peak oil for many years.
DownSouth,
>> Heck, if the GFC experiences a second leg down, which
>> could be far more severe than the first leg down, it
>> could destroy enough world oil demand to delay peak oil
>> for many years.
“Delay” it? Or will this demand destruction of which you speak represent one blip down on oil production? (I don’t know.)
Peak oil has a silver lining, BTW. Cheap fossil fuel has been creating all sorts of problems (global warming, floating plastic patches) that aren’t nearly as obvious to people as rising gas prices. Peak oil might spur people to seek more sustainable living.
Re: Saudi production:
http://www.theoildrum.com/node/7465
Also, as I pointed out, a lot of other countries have individually hit “Peak Oil” (non-OPEC has peaked) – and of the countries that _haven’t_, their are many these countries that keep their production clouded in mystery. I don’t see how that gives any sort of warm fuzzy feeling (oh, it must be the futures market!).
Btw, as far as hoarding – that’s good for us in the long run (Norway is doing it). Why should we stop them? It’s their oil. Is Goldman Sachs telling Norway to lower production? I doubt it – Norway just doesn’t want to be as stupid as the UK squandering the North Sea (stripping the reserves as fast as technically/economically possible). Maybe Norway, Opec wouldn’t have such a great bargaining position.
And the USA is in the worst position to deal with this from multiple angles: corrupt govt.; lack of trust (Tea Partiers, or everybody that assumes Big Oil controls the world); and being the largest importer with the worst maintenance costs (suburbs, exo-burbs).
Yeah, the theoildrum commentator are often on the pessimistic side, but the actual articles are pretty good. And other outside sources are constantly changing their tune to be more in line with theoildrum (e.g. EIA and their constantly revised down projections – peak 2050, no 2030, no 2020, 2015? 2012? now?).
I don’t love Goldman Sachs or JP Morgan, but sometimes the problem isn’t those schmucks. And I find claims that it is highly dubious. What should the price be?
Apologies in advance for a relatively stream-of-consciousness defense of the “speculation” that outrages some…
The money I’m willing to pay to buy long-term futures will stimulate some farmer/miner to produce supply to meet my demand. If I and other speculators pay more, more will be supplied. If we push the price — and production — too far, then the follow-on demand will not be there, we’ll lose money, and the rest of the world will eat cheap food.
You want to participate and take the risks of losing money, too? Open a futures account. Nothing’s stopping you.
I’m not going to sit here and watch Bernanke, Wall Street, RINO’s, DINO’s, bloated military contractors, and generally overpaid government workers (except the apparently underpaid ones in Wisconsin whom I support) continue debasing my savings without trying to protect myself. This time next year, all the politically-connected fuqs in and around federal and state capitols will have another $1.5+ trillion in cash created out of thin air. Who knows how much extra credit will be created by that time. That devalues the money in my pocket. How am I supposed to protect myself from being robbed?
The markets have become a rigged game. Buying something “real” is the only thing I’m comfortable with.
If you want something to criticize about, go criticize how “everything is f’d up and no one goes to jail”. We wouldn’t be in this position if that weren’t the case.
ummmnn..there’s a BIG difference between “owning some” oil futures and owning 49% of total world futures, as Gretchen Morgenson defined the major U.S. investment banks did circa
2004, WHEN they were simply selling them back and forth to one another to DRIVE prices up.
I’m sure most people here have read their “Wall $treet-A History” by Geisst, or someone else-this scam has gone on since 1800’s in un-regulated markets of all sorts-it’s going on today in commodities-rice quadrupled in price over the last 2 years.
Foreign markets are beginning to demand “speculators” who land buying billions of something local keep their “investment” in country for 2-3 years, in an attempt to defeat speculators flying in, monopolizing, driving price
up locally, profiteering, leaving markets destroyed…
I’m sure people are aware of this…
“So I’ll ask again: where’s the outrage?”
That is an interesting question considering that the U.S. is the worlds largest consumer of oil, one would think the media,WH and both political parties would be running over themselves with outrage but they are concerned with social security payments and teachers salaries!
Part of the answer is found in natural gas touted as the next energy wave, cheap,abundant and right below our feet, so there is probably a fair amount of political dollars pushing this energy source with higher oil prices speeding up the alternative. The other is Green Technology which the government has heavily backed and is the new hope for energy independence, a fundamental belief that sun /battery/wind power financed by government research/money and new equity IPO’s will solve peak oil.
The reality is that there is big money in higher oil costs as alternative solutions seek various levels of funding both private and through government loans and grants. The media loves these story lines so consumers buy various energy efficient auto/trucks,install energy saving appliances and upgrade various parts of the home to SAVE energy costs. My own view about all these energy saving or alternative technologies to oil is that they are a waste of money and time which is why most folks and the media love them so much. The simple fact is that American consumers will have to reduce there energy footprint which will include giving up the suburban house for apartment style living, giving up auto’s for mass transit along with international business relocating close to employment centers and AG becoming mostly local produced. Not a storyline that anyone wants to dwell upon nor as sexy as speculation or new technology but probably what the only viable longterm direction.
Pardon me, is this a typo?
“At this point the company can either sell at $15/barrel, or reduce production.”
I don’t understand why its $15/barrel, if someone could fill me in, I’d appreciate it.
> So the speculation scenario would go like this – an oil
> producing company is producing and selling oil at
> $5/barrel. For whatever reason futures speculation drives > prices up $10.
to $15.
simple. we have a democrat in. there can be no bad news. remember bp. get a silly repub in and hear all the complaining…hell tv will run it 24 hours a day. remember our furher said about unemployment…not his job.
lock and load is all that is left.
This kind of speculation has been going on since 2004. You can go to the EIA site or another and look at daily futures prices and compare them year over year or however you want to look at them. What you will see is that, while there is fluctuation due to supply/demand issues or external factors like hurricanes or threats of war, the baseline for prices goes up over time and stays up. The only time it didn’t was when the $140 price spike collapsed.
The days when the Saudis could control price by “hoarding at the wellhead” are long gone. Some countries, like Iran, have always been quota breakers. The difference is that with oil prices so high due to excess speculation, the effects of quota breaking are reduced. It’s important to note that many oil producing countries can’t hoard. They have expanding young populations and fairly ineffective and corrupt administrations. These governments need to pump flat out no matter what the price just to keep up.
As for the relative weights of the spot market vs. the futures market. The futures market is much larger. On top of that, you only need to deposit margins of 5%-7% (last I heard) so you have leverage of 16-20 whereas in the spot market it’s cash on the barrel so to speak.
Other observations: If Obama had wanted to do something about, speculation in commodities, he would have appointed Greenberger to head the CFTC. As for the oildrum, I haven’t been there since the BP disaster, but in general they are excellent on the physical side of the oil industry and poor on the financialized side of it.
The party line is that we’re supposed to be in a ‘Japan lost decade’ situation — persistent low growth and low inflation as companies pay down debt. This is politically handy situation if your constituency benefits from government fiscal stimulus. We just need more stimulus, and that all turns into more political favors to hand out.
We’re not supposed to be having inflation. We’re supposed to be happily QE-ing away, and muddling along. The problem with the rise in commodity prices, is that it’s not according to script, so the leaders and media tune it out, however they can. They’ll say it’s temporary, or that the market will equalize, or whatever. I expect we’ll see more complex mental gyrations by economists as they attempt to defend conventional wisdom against contrary evidence.
I don’t know, maybe the smart move is to get on board, and try to hop off before this thing hits the cliff? Is that what people are thinking? We all know, this can’t end well, right? At some point commodities hit a price where no company can afford to make anything, then what happens? A financial bubble in commodities has the potential to shut down all manufacturing. The planet becomes a wasteland of uneaten stored food and oil, idle factories and starving homeless people.
Cathryn. Two things here:
There is a huge belief in many people’s minds, that inflation is the only way that the US can escape the debt to those ‘perfidious Chinese’, and also the only way for ordinary Americans to escape their personal debt. There is little understanding of the true effects of hyperinflation and the consequent inability to earn enough money to pay even day to day expenses.
And as I mention in the following post, guilt has been installed in our minds that we deserve to suffer scarcities due to our previous excesses. Those who have manufactured this guilt will happily consume what we cannot.
At least with hyperinflation the wages and prices both rise. I don’t see how we get hyperinflation without wage increases to match, and the forces are all still pushing wages down. I think maybe it’ll be slightly worse — where goods are produced to be speculated on rather than be consumed, and the normal people are out of the game. High prices without corresponding wage increases as the financial system uses its ability to summon infinite money to compete with consumers and manufacturers for goods.
As far as paying back the Chinese, you know, whatever. We just have Fed summons up dollars out of thin air to buy US bonds and then the USG passes the dollars over to China. No problem. It’s not the inflation that pays back the Chinese it’s the Fed buying bonds that does it. Will this cause inflation? This is a matter for debate I suppose. Conventional wisdom is that QE will not lead to inflation, and everyone has been around and around on this argument. You know, we’ll see.
wages down, prices up=DEPRESSION..if we check our Gore Vidal, he stated over a year ago we are in 2 “lost decades”-
at least 20 years, then U.S. will never be as it was..
commodities prices are rising..we’re all being told so. The REAL unemployment # is closer to 20% than 10%..
Reagan changed the “way” we view it; if anyone has EVER taken out unemployment, you are NOT a “NEW” claim..those who have fallen off aren’t counted, and 1/3 of those who apply are rejected. There’s a new scam also, having to do with “offering” people “contracted worker status”..and THEN,
“contract workers” don’t get to apply, when their “contract”
ends…
Cathryn; wage inflation is a figment of conservative imaginations. Prices rise in response to a variety of different stimuli, mostly production problems and regulations. Wages are only a secondary aspect which rise as workers try to keep food on the table. Therefore, the gap between wages and costs increases rapidly. This process only ends when people can nolonger sustain life on what they earn. At which point the economy collapses totally.
btw. China already has many more dollars than they want, they won’t accept any more. If your government tries to print it’s way out of the problem (welches on their debt), nobody else will accept those dollars either??
“Where is the outrage?”
It is being subverted by propaganda and bullshit! People who consume oil and all it’s many derivatives are so frightened and confused that they cannot achieve a basis for reality. More than half of the population of the developed world fully believes that peak oil more than justifies the oil prices we see. Many think we are actually getting a good deal considering, “the scarcity of oil”??
Many people have a feeling of guilt for past “overconsumption”, and whatever we have to pay in the future is only just retribution. Most have no concept of the necessary economic linkage between the price of a barrel of oil and people’s willingness and ability to buy gasoline. Propaganda and fearmongering have impaired the rational processes. This is little different than being unable to understand that houses cannot be worth more than the buyers can earn to pay for them.
As others have alluded here, the ‘storage’ is virtual. When one looks at the distant future profile in the commodity exchanges (out 20+ years), you see contracts written and options granted by funds who will never produce or consume a teaspoon of oil. These are merely positive and negative particles which, when they collide, make a little pop like a soap bubble. The only result is the release of a small amount of energy (money).
Those who rule our lives are very pleased with these confusions. When the sheep (I’m talking about we who try to understand and moderate the world), are confused and milling in circles, there is no possibility of any revolt. As I demonstated with the Israeli lies yesterday http://www.nakedcapitalism.com/2011/02/links-21711.html#comment-328247
There is nothing they will not do to mislead the public. The middle east uprisings are directly linked to what is being discussed here, not through the price of oil, but through the control mechanisms running this planet. I fear the new democracy movement is doomed because it has been linked in people’s minds to a threat to our standard of living and as such will only get limited external support. It is hard for people to empathise with those we have been told will cause a disruption in oil supplies.
Here’s my go, at the economics on a high-level of abstraction:
Money, including its extended forms as financial securities, has three, distinct functions:
1.) means of exchange
2.) store of value (aka insurance)
3.) unit of account
The distinction is a purely abstract one: in all cases, money has all three properties, and all three properties are in play. Economists, though, can play an intellectual shell game, by emphasizing one or two, and hiding the remaining properties, in a simple model.
The argument in the post about the “role of speculation” in elevating the price (distorting the unit of account) is an argument about the role of insurance in casino capitalism.
There’s nothing, but untrustworthy central banks, regulating what used to be called “the money supply”. There was a time, when economists got away with a very simple analysis linking unit of account to means of exchange to “the money supply”, hiding insurance (precautionary balances) behind a lot of flimflam about velocity.
The money supply (aka money creation) has been pretty unrestrained for a long time, as all readers here know well, and that money creation has flowed into the insurance demand for money in all its extended forms, as financial securities. The sheer quantity of money in the form financial securities — debt — is huge. There’s really only one function for pure financial wealth — I’m distinguishing financial paper from equity ownership of actual productive capital — and that is insurance.
Krugman wants to apply a classic Samuelson analysis of speculation in commodities to the problem of whether speculation can create an elevated price. MISSES THE POINT ENTIRELY!
There’s an enormous quantity of financial paper sloshing around seeking returns on insurance. They way to create such demand is to create volatility, not permanently elevated prices.
What we are witnessing is the creation of volatility, for the purpose of generating returns on financial wealth, aka insurance. It is is Casino Capitalism at its now well-developed “best”. As in an actual casino, the only sure winners will be the House and its dealers.
Conventional, well-functioning futures markets should tend to dampen volatility. What we’ve got will, certainly, increase volatility.
This increased volatility will serve to increase income inequality as more of global income flows to the holders of financial wealth and to the banksters, who run the casino.
A Note on the Real Economy implications:
Oil flows through lengthy processing and distribution chains. Standard Oil, it will be recalled, was founded on a scheme to dampen the volatility of oil prices, which, in turn, permitted the company to build out, very profitably, that huge, long chain of transport, refining, marketing and distribution. As long as the volume of oil demand drove throughput in the chain up, there were reliable rents and quasi-rents to be had in the management of the chain.
Peak oil! There’s no longer an expectation of increasing throughput. The huge sunk costs represented in that chain are vulnerable to hard bargaining from the well-head.
The point in the post about the lack of storage capacity for hoarding ought to be related to the phenomenon of peak oil. Formerly, with an expectation of growth, any node in the chain might have been induced to add to storage in response to volatility in the price, dampening that volatility. Now, not so much. No one in the chain wants to add capacity.
The vulnerability of the refining and distribution chain to disinvestment attacks on its quasi-rents ought to worry us.
Nice post. Also do not forget the other choke points. Unrefined oil is worthless?? And governments everywhere are errecting ever higher barriers through “environmental regulation”. Who controls the government?
agree-nice post-paul’s post was well taken also..
This is a complex subject IMHO. Imagine for just a moment that you had the great good fortune to be born into the House of Saud. You are bright and have been charged with managing the family’s primary resource, oil. You have a very good estimate of existing reserves, current production capacity, potential production capacity, historical prices, the costs of production, etc. You discover that given the rate of global depletion and recent price increases, the best way to increase the PNV of your resource is to stop all production, thereby creating a shortage, and to not resume production until the price exceeds $200/bbl. You check with the Royal Treasurer (your brother) and discover that there is enough in the treasury to discontinue production for a decade and still meet the family’s income need. The only rub is that if you discontinue production, prices would soar and the projected rate of consumption would go way down as the search for substitutes (e.g. electric cars) would accelerate. Also, the nations with highest demand for oil have military muscle you could not resist. My point is this – of course there is speculative froth in the price of oil, but there are likely a bunch of other considerations – including my view that maximizing value might require minimizing production – that likely play a part in the current rate of production. BTW – I know about as much about economics as I do astrophysics, but I figure thought games are of equal value of mathematical proofs.
“…the best way to increase the PNV of your resource is to stop all production, thereby creating a shortage, and to not resume production until the price exceeds $200/bbl.”
In my opinion, the most powerful revelation to come out of the WikiLeaks releases so far is the fact that the Saudi’s desperately want to attack Iran. I knew the House of Saud was OK Israeli flyovers, and targeted US mini-strikes, but I didn’t realize the Kingdom actually desires all out war with Iran — and the sooner the better.
Why? Well, it could be the old Sunni/Shia thing, or the old Arab/Persian thing, or it could be just for basic Middle-East dominance, etc., but; the Saudi’s have to know that Iran will attack them in kind. Why would they want this?
If attacked, Iran will launch hundreds of missiles of all different varieties and they will severely damage or destroy the Saudi’s only two Gulf side offshore transfer facilities, the export terminals at Ras Tanura and Al Juaymah, through which 95% of the Kingdom’s petroleum exports pass, and they will also severely damage or destroy the crude oil processing plant at Abqaiq, which handles 70% of the Saudi Arabia’s oil production.
And that’s just for starters. Iranian missiles and whole array of other weapons systems — including sabotage teams — will wreak havoc on the rest of the Kingdom’s petroleum infrastructure, including the defenseless latticework of oil pipelines that lines the Gulf itself .
And we shouldn’t forget that Iranian surface to surface missiles, many outfitted with 2,000 pound warheads, might well sink every supertanker uploading, offloading or just plain sailing in Persian Gulf. Talk about an oil spill.
At that point, Saudi Arabia would no longer be an oil exporting nation. For how long? Quite possibly for many, many years.
Interesting.
”
Royal Treasurer (your brother) and discover that there is enough in the treasury to discontinue production for a decade
”
Would you guess that the RT, Royal Treasurer now has more diversification than the average Bear Stern? Hell! He worries more about oil shortage than you do. Worries that all his many companies will not have moderately priced oil to grease up their wheels of production. The oiler’s true problem is the lag-time of many years from further up the pipe to retail sales. What the oilers seek is a steady market for all of their integrated activities. They don’t relish the dismantling of a refinery or a pipe-line during years of lean, years of lean brought on by conservation brought on by exorbitant price/barrel. The Texas Railway Commission has attempted to moderate the price for years on end. Did the Bush Dynasty send Texas Rangers to Persian Gulf twice over the past 20 years? Who knows. One thing for sure, “USA Peak Oil is now history with GPO, Global Peak Oil now knocking on our door.” We need to stop screaming, “There was a flag on the play”, but start developing conservation and alternative military and civilian tactics applicable to a DHW, Dry Hole World.
Show me your ball-bearings that roll without grease! Show me your ovens that bake your Boston Beans by mirror that concentrates the sun’s heat! Show me your executives that teleconference without jet-fuel! Show me your fly-fisher who rows his own boat without outboard. Show me your innovators. Show me your American Ingenuity!
Grazia
!
What’s with the fighting over the cause of high oil prices in the comments? It’s all three:
1. Peak Oil hitting now-ish
2. Fed money printing driving investment capital into commodities of which oil is pretty much the biggest market
3. Pure speculation on the first two causes rapidly increasing prices
The auther is just highlighting the third last mile component that the CFTC could and should regulate to some degree greater than they already should.
I applaud those who want to tackle #2 as it is directly related to the Fed’s decision to finance the zombie banks instead of letting them goin under.
Finally, to further point out the ignorance of the general public, my community newspaper interviewed random people who all expect the price of gas to keep going up because of the trouble in the middle east. I must be the only one that realizes the price of oil has dropped 10% since the peak of Egypt’s revolution yet gas prices have continued rising since that event. The sheeple do indeed believe every soundbite their local newscaster gives them. I shouldn’t complain. These same people are probably all on the other side of my winning stock trades.
Valero is a poor refiner choice for comparing gasoline prices to Brent or WTI oil. Valero processes a large amount of the high sulfer crude from Mexico and Venezuela. Heavy,sour crude sells at about a 25% discount to WTI.
Interesting, thanks for the info. Perhaps Dicker was referring to an earlier period in the run-up in prices?
Peak oil is true to the extent that the big pools of easy to pump sweet crude have been found and declining (so what the price will be is the determining factor – $150 a barrel oil did seem to trigger the inevitable housing collapse). But as Sheik Yamani said back when OPEC was at its head and he was in charge of Saudi production, “The stone age age didn’t end because of a shortage of stones and the oil age won’t end because of a shortage of oil. Or as Yergin put it, the oil supply is finite but at any given time there is a glut of oil. This is what Leon Hess, someone who knew a little about both the supply and finance of oil stated to a Senate committte,”I’m an old man, but I’d bet my life that if the Merc [New York Mercantile Exchange] was not in operation there would be ample oil and reasonable prices all over the world, without this volatility.”
So even without ‘Peak oil’ or China demand their was ample volatility in oil prices that had nothing to do with supply and demand. This was the result of financial manipulation. Prices are rising now as they did in 2008 without any rising demand or bottleneck in supply. Oil Companies once again are posting absurd profits. Back in the 70s we still had viable unions so there was a classic wage price spiral feedback loop happening leading to the stagflation. Since Reagan US workers have been beaten back with globalization and outsourcing so wages are stagnant or declining. The powers that be are now working on crushing the last remaining source of organized strength of working people – the public employee unions.
The reason there is no outpouring of outrage is the same reason that TARP happened and the FED and the Treasury were able to (other than NC readers and a few others) give trillions to finance and nothing happens – reading about economics is a good alternative for sleep medications. Since the Chinese became capitalists and the Soviet Union disintegrated, the gloves are off. There is no need not to take back the door prizes given to the American middle class in the last depression.
To those of you that responded and provided input: I offer my thanks.
here is my parting note for those that want to know more about WTI and Brent spread:
http://www.cnbc.com/id/15840232/?video=3000006380&play=1
..people need an education..to learn HOW to think…it’s called “liberal arts”..prior to discerning “outrage”…
I’m perfectly willing to make this statement, knowing I’m setting myself up for retaliation-but people who attempt to retaliate first must comprehend what disciplines are involved..
I think we are vastly over-complicating this discussion.
First, with respect to Speculation & Oil prices, people speculate in commodities to make a profit. That profit becomes an added cost to the consumer.
Who are the speculators? “nonclassical” points out the role of the big Wall St Banks, holding more than 40% of oil futures.
Can speculation interfere with the classical supply-demand-price relationships fundamental to a sound economy? With a group holding ~ 40% of futures, sure sounds to me like they can.
And, as far as the argument “you can’t speculate if you can’t hoard” is concerned, are we forgetting the dozens of supertankers sitting off our coasts in 2008-2009, loaded with oil, waiting for the price to go up?.
Then, before crying “Peak Oil”, lets look at the Industry view, “Statistical Review of World Energy 2010”, @ http://www.bp.com/productlanding.do?categoryId=6929&contentId=7044622. In particular, check out “Energy Outlook 2030”. That shows pretty clearly that we don’t have a problem, provided we manage it sensibly – which is not helped by speculation.
the saudis are the only ones with spare capacity, so they are the ‘swing producer’ and necessarily set price and let quantity adjust.
it’s necessarily a simple case of monopoly pricing, however disguised.