Did Speculation Fuel Oil Price Swings?

[knottybuoyz]

It was about this time last year we were faced with rapidly rising costs for fuel. It was one of a number of indicators that something was truly amiss with the economy and was quickly followed by announcement of boat mfgr closings & bankruptcies. I knew we all blamed the big bad oil companies for greed but what follows is a great article from CBS News 60 Minutes on how/who fueled the greed and low and behold it wasn't the big oil companies. It's a good read, I highly recommend it.

Did Speculation Fuel Oil Price Swings?, 60 Minutes: Speculation Affected Oil Price Swings More Than Supply And Demand - CBS News

[TaoJones]

Originally Posted by knottybuoyz

It was about this time last year we were faced with rapidly rising costs for fuel. It was one of a number of indicators that something was truly amiss with the economy and was quickly followed by announcement of boat mfgr closings & bankruptcies. I knew we all blamed the big bad oil companies for greed but what follows is a great article from CBS News 60 Minutes on how/who fueled the greed and low and behold it wasn't the big oil companies. It's a good read, I highly recommend it.

Did Speculation Fuel Oil Price Swings?, 60 Minutes: Speculation Affected Oil Price Swings More Than Supply And Demand - CBS News

Don't believe everything you see on TV, knottybuoyz.

If you take the time to do a little research on Michael Masters, the "star" of the report you cite, you will discover that:

- Michael Masters is founder of Masters Capital Management, a hedge fund.

- Masters is not the concerned private citizen he pretended to be when testifying to Congress last May, just trying to help the economically-ignorant Congresspersons understand the futures markets.

- Masters is the strategist of his fund's decision to invest heavily in entities that were extremely energy-sensitive (especially General Motors and the airline sector).

- Masters firm was based in the USVI for tax reasons, and like other hedge funds, they were under extreme pressure by the Feds for skirting the tax rules.

Along with the other hedge fund operators in the USVI, Masters felt persecuted by the Feds two years ago. Many fled the USVI. See:

Bloomberg.com: Germany

From the Bloomberg article:

"Michael Masters, principal at and founder of hedge fund firm Masters Capital Management LLC, says the 2004 law and the IRS clampdown have had a chilling effect. 'Witch hunts aren't good for anybody, including the government,' he says. 'It's a waste of resources.' ''

In other words, Masters ringing the alarm bell on "speculators" is a textbook example of the pot calling the kettle black. It's a bit like Ernesto Berterelli and Alinghi pointing the finger at Larry Ellison and BMW Oracle for manipulating the America's Cup Deed of Gift and using his vast resources to secure an advantage.

Masters, like Berterelli, is utterly lacking in credibility and without clean hands.

As always, those evil-doers - the speculators - are the easiest target when things are going south. The truth, however, is that the American economy, wildly mismanaged by the hacks in Washington, is the source of the dollar's problems, and the anemic dollar is the cause of the extreme volatility in oil and its by-products. With volatility comes large price movements, both up and down.

Until the endemic corruption at the heart of the American system of finance is brought under control, volatility will continue to perk along at very high levels. Until volatility calms, big price swings will be the rule, not the exception.

As Margo Channing (Bette Davis) says in All About Eve, "Fasten your seatbelts, it's going to be a bumpy night!" Sadly, this is going to be the longest night of all our lives.

TaoJones

[Maren]

Originally Posted by knottybuoyz

It was about this time last year we were faced with rapidly rising costs for fuel.

It basically comes down to whether you think the prices were driven by fundamentals, speculation or a hybrid. I have my opinions but let's look at this from a ration observer perspective for a minute.

Do you think:

1) The demand for fossil fuels approximately doubled in a year and then reversed itself due to the economic collapse?

2) The acceleration of the energy demands and plastics for both emerging and developed markets is small compared the group think that prices were on their way up and it was-get-on-or-miss-the-boat?

3) Something else? (I can't let you off that easy... What and why?)

[TaoJones]

Originally Posted by Maren

It basically comes down to whether you think the prices were driven by fundamentals, speculation or a hybrid. I have my opinions but let's look at this from a ration observer perspective for a minute.

Do you think:

1) The demand for fossil fuels approximately doubled in a year and then reversed itself due to the economic collapse?

2) The acceleration of the energy demands and plastics for both emerging and developed markets is small compared the group think that prices were on their way up and it was-get-on-or-miss-the-boat?

3) Something else? (I can't let you off that easy... What and why?)

I'd like to think that I'm a rational observer, my friend Maren, so I'll take a swing at your questions.

1, 2 & 3) It depends upon where you measure the demand. If it's measured at the wellhead, then it probably moved up only slightly, just as it had been doing for the past several quarters as the developing world needed more energy to keep its factories operating. If it's measured at the terminal in Oklahoma, then the increase in demand was similarly only slightly elevated. But if it's measured in the futures trading pits where the "wily, cutthroat speculators" are doing their buying and selling, then yes, demand did indeed double in less than a year. And, ultimately, fell just as quickly.

How can I be so sure? Because the prima facie evidence of doubled prices indicates that there was an increase in demand for future delivery set against a limited supply of product available to meet that increased demand in the futures market. Why were futures buyers willing to bid up the prices if the physical supply remained fairly steady? Because they expected the demand to rise at a greater rate than the production of physical product.

Who were some of these "greedy speculators?" Well, among others, airlines, over-the-road truckers, railroad companies, towns and cities trying to anticipate their winter-heating needs many months before the fact - there are any number of entities who might wish to lock in a future price in the present if they anticipate the price will only be higher if they wait until they actually need the commodity.

The just-in-time model of acquiring product at the last possible second might have worked splendidly for Dell Computer and others, but it was too risky and unreliable for those entities mentioned above. They had to budget for the acquisition of an essential commodity - their very life-blood. Without fuel/energy, they were out of business.

So what happened? In September, Lehman Brothers was allowed to fail, resulting in a 180 degree turn in market sentiment. Once the market began to bleed out, margin calls led to increased pressure to get liquid. This, in turn, led to forced selling of everything, and a vicious circle of margin calls/forced selling brought the markets spiraling downward, ultimately driving the entire economy to its knees.

Once a deflationary mindset had been established, demand for virtually everything withered. With the destruction of demand, factories around the world first slowed production, then halted it temporarily, then permanently stopped production by laying off their workforces and shuttering factories.

Closed factories have very low energy demands. Suddenly, a still-steady supply met a greatly-diminished demand. At the same time, frightened capital rushed headlong into the US dollar, driving its value up in a so-called "flight to safety." This "dollar appreciation" put further pressure on commodities priced in US dollars (oil, precious metals, grains - virtually everything).

Falling demand for a commodity priced in an appreciating currency can only compound, resulting in lower prices.

When the demand for crude at the wellhead and at the Oklahoma terminal dropped, demand in the futures pits no longer had any support either. As demand fell, and everyone tried to get through the exit at the same time, the bottom fell out of the prices of commodities in the futures markets.

The deflationary mindset had come to the commodities markets.

The wildly-inflationary expectations of early spring through mid-summer had driven futures prices precipitously higher, and the wildly-deflationary expectations of the fall had driven them precipitously lower. All within a span of less than a year.

This, though, is a picture of supply and demand for a derivative of the physical commodity, not the physical commodity itself. In the actual marketplace, the price is a reflection of what happens in the futures markets and typically follows what happens there. If you want to know what the price of gasoline will be in the short term, follow the action in the futures markets.

As many investors, and probably all governments, know: If you want to move prices in an attempt to control something, you do it in the futures markets.

TaoJones

[Maren]

Originally Posted by TaoJones

I'd like to think that I'm a rational observer, my friend Maren, so I'll take a swing at your questions.

I would say you are too, but you might be cheating, have a good deal more immersion in the field than most.

1, 2 & 3) It depends upon where you measure the demand. If it's measured at the wellhead, then it probably moved up only slightly, just as it had been doing for the past several quarters as the developing world needed more energy to keep its factories operating. If it's measured at the terminal in Oklahoma, then the increase in demand was similarly only slightly elevated. But if it's measured in the futures trading pits where the "wily, cutthroat speculators" are doing their buying and selling, then yes, demand did indeed double in less than a year. And, ultimately, fell just as quickly.

I think you and I have the same view: a combination of factors with investor psychology being a large one.

But, if there is any difference in our views, it's the relative weight. I think the growth in oil demands is substantial but has been partially offset by increases in production. But the larger factors were, I think, the fall in the dollar (which had been falling since about '02) and a much larger base of investors looking either for speculative gains, position hedging (both of which you noted) and portfolio diversification (substantially in the CTA/mechanical trading arena).

The fall of the dollar point I don't really think is contradictory to your analysis, and is the (in my opinion) other side of the coin of what you wrote:

Falling demand for a commodity priced in an appreciating currency can only compound, resulting in lower prices.

As for the mechanics of the breakdown, the Economist couldn't have said it more succinctly. The last quote was so good, I had to use if for the title.

[Christian Van H]

Without starting an all out war...oh, wait, we've already done that too... Here's my gut feeling on gas prices. You guys seem really well read. I've listened to some of the best and brightest on these gas prices, and so far, they've been dead wrong. You can blame anyone you want, but here's a simple observation; Big Oil made giant, off the charts profits for the last several years. America is sick to death of the prices they paid, and our incoming administration is listening and maneuvering toward a new fuel for our everyday rides. Miraculously, gas prices have PLUMMETED! Funny though, home heating oil and diesel are still holding higher prices for a lesser refined product. Huh? Why? We're not talkin' about replacements yet for trucking and heating...Go figure! Just a coincidence, I'm sure.

[George Raffa]

Very simple answer. $70-$147-$34. This type of swing in prices did not happen based on a increase or decrease is usage from the consumers. The amount of money going into energy funds, ETF and others has controlled the price. Hedge funds are currently out of the market, funds are in negative flows,etc. This will change.

[Christian Van H]

Tao, please explain the giant price differences between gasoline, home heating oil, and diesel? I don't see how it fits into your equation...

[TaoJones]

Originally Posted by Christian Van H

Tao, please explain the giant price differences between gasoline, home heating oil, and diesel? I don't see how it fits into your equation...

If I understand your question correctly, Christian, you're puzzled about the differences in the prices of the three petroleum products at the retail level (the price the consumer pays). I should probably state that I am about as far from being a chemical engineer as it's possible to be, so I won't pretend to know about the complexities of refining crude oil into the various finished products.

My emphasis and understanding derive from the movement of prices in the trading markets, and even there I do not pay close attention to the energy complex. My preferred markets are precious metals and currencies.

I did find a couple of webpages through Google that seem to address what you're asking about. Have a look at:

This Week In Petroleum {Gasoline vs Diesel Pricing}

for a closer look at the disparities in gasoline and diesel pricing.

And here's a page that has an up-to-date set of price charts on crude, gasoline, diesel, heating oil and propane:

This Week In Petroleum

A cursory scan of the spot price charts of the various products indicates that they do indeed track closely with the movement of crude, as one might expect. Diesel and heating oil, both of which derive from diesel distillate, seem to move almost tick-for-tick, while gasoline shows the same trend, but with more variation.

In one of those sites, above, I read that there are more state and federal taxes added to diesel. The thinking seems to be that it's far easier to pile taxes on a smaller group of mostly commercial interests, who can probably pass the costs along, than loading them on the backs of the far more numerous general public. Consumers are highly sensitive to gasoline costs and have the potential to retaliate at the voting booth.

As far as prices of various commodities in the futures markets, some have high correlations with their base commodity, and/or with one another - some occasionally seem to have no correlation to reality or common sense at all. It's one reason why I give greater weight to the study of investor psychology than to logic.

TaoJones

[Christian Van H]

Originally Posted by TaoJones

It's one reason why I give greater weight to the study of investor psychology than to logic.TaoJones

Amen, Brother!

[pjbsailing]

Put two oil men in office, and blow up part of the middle east, and you get high oil prices. Kind of simple really. They made their money, stole the second largest reserve, now they're gone, and oil comes down in price. We're left with the pieces, that get put patched up with our increased taxes.
Ever since Iraq nationalized their oil, and kicked out the oil companies, the oilys have been trying to get it back. They got it for measly price of 1 million civilian lives, and 4,228 US troops and counting.

[Tourmaline]

Speculators have a function in the crude oil futures market: they provide much needed liquidity, particularily in times of uncertainty. Here's an excerpt from today's Bloomberg article .....

Crude Oil Market Needs More Speculators, Deutsche Bank Says

By Margot Habiby
Jan. 20 (Bloomberg) -- The crude-oil market needs more speculators to help stabilize prices six months after the traders were blamed for pushing the commodity up to a record $147.27 a barrel, Deutsche Bank said in a report.
A lack of liquidity is distorting prices, particularly for near-term delivery, amid an oversupply of oil at Cushing, Oklahoma, said analysts led by Paul Sankey in New York in the Deutsche Bank report dated yesterday. This is sending the “wrong” price signals to refiners and producers.
“We clearly have a fundamentally imbalanced market, with far too much crude, that needs to be resolved,” the analysts said. “We need more market activity to correct these issues, but for technical, political and financial reasons, the liquidity of the market has dried up and the long-term price of oil is partly distorted.”

[David M]

Christian, there are different costs to producing the various fuels as well as different demands for the various fuels, therefore they cannot all be priced at the same price per gallon or thermal unit.

If you look at the oil companies profit margins, percentage wise they did not make greater profits than companies in other sectors.

Exxon's profit margin is around 10%. Chevron has a 8% to 10% profit margin. BP 7% and Dutch Shell 6% to 8%...depending on the quarter.

Since when is a 8% to 10% profit margin outrageous? Apple (AAPL) at almost 15% has a much higher profit margin than any of the oil companies.

Source:
http://finance.google.com/finance?q=NYSE%3AXOM

http://finance.google.com/finance?q=NYSE:CVX

http://finance.google.com/finance?q=NYSE:BP

http://finance.google.com/finance?q=AAPL

Sometimes all one needs to do is look up the facts to discover the reality.

[Christian Van H]

David, Thank you for the links. I will research as time allows. As far as prices go... Diesel should cost more to manufacture, and there should be less or more demand, in order to account for the difference in price?

[David M]

I never said anything about the reason for the price swings. I only mentioned the largest of the oil companies profit margins....which are not outrageous for your typical large cap corporation.

From what I have read from other sources, it was primarily speculation which caused oil to peak at 147 per barrel. Today oil closed at 37.70 per barrel which I think reflects the reality of oil countries cranking out what they can to try to make up for less revenue, the lower demand for oil caused by a world wide recession plus a concerted effort world wide to use less fossil fuel.

Its quite a combination of reasons. Pointing ones finger at the oil companies really does not describe the reasons.