Did Speculation Fuel Oil Price Swings?

[TaoJones]

Thank you for your well-reasoned post, Alan. I want to point out a couple of things before I respond to your analysis.

The thrust of my earlier posts was that:

1 - While supply and demand remained balanced pretty well in the physical oil market, in the futures markets there was an explosion of demand, not for oil or its by-products, but for futures contracts derived from those commodities.

This was caused not specifically by fundamentals or technical analysis, but by the actions of every oil-futures-trader who may or may not have educated him/herself on those fundamentals, may or may not have done any technical analysis and, frankly, may or may not have had a clue. It is this filtering through the minds and emotions of every trader who expresses him/herself by placing capital on one side or the other of a given trade that drives prices. Thus, my emphasis on trying to understand investor psychology.

2 - "Speculators" are an all-too-easy target when various stakeholders are upset by prices moving against their vested interest(s), and this is a label rather casually applied to an amorphous group of traders. Who among them is not speculating, from the biggest commercial to the kid sitting in front of his home computer?

3 - Mike Masters, the poster child of the politicians' (and 60 Minutes') attempt to place the blame on "speculators" for the rise in a commodity their constituents were dependent upon, is himself a speculator. As the founder of a hedge fund, based in the USVI to game the tax rules, and with a huge position in entities adversely affected by increased fuel costs, he was a dubious spokesman for the "blame the speculators" agenda. His firm had speculated that the price of oil and its by-products would not go up, and when it did, his firm stood to take enormous losses on its investments.

Now I'll try to cobble together a coherent response to your post.

You stated that ". . .I do believe he [TaoJones] has understated the significance of the impact that the speculative 'future traders/markets' had on the value of oil."

This may be true (though I would make that price of oil, not value), but then I have what some might consider a too-narrowly-defined understanding of what is meant by the word "speculator" as it applies to the futures markets. There are three generally-accepted groups of traders in commodities - commercials, funds and speculators - and the specs are, by far, the tiniest fraction.

Compared to the commercial interests (say, Exxon Mobile or BP in the oil pits) and the funds (hedge funds, mutual funds), the specs (everyone else) are but a fly on an elephant's butt. They're even further divided into small specs and large specs, yet we're to believe that specs can overwhelm the commercials and the funds and move the markets?

Impossible.

You mention the 15:1 correlation of an ounce of gold to a barrel of oil: While some hew to this ratio as a de facto gauge of relative worth, I never have. Over time, it may work out to an average in that range, but it can swing wildly around those numbers, and does - more often than not.

Have a look at this piece, particularly the chart:

Gold? Oil? Which Is Headed Higher? - Brad's Desktop - Hard Assets Investor

You will note that the ratio was around 6 or 7:1 in mid-July when the oil price spiked to $147/bbl. How do you trade this? Should you assume oil is priced "right" and therefore gold must rise to $2205/oz, or is gold priced "right" at ~$975/oz mid-July and therefore oil should fall to $65/bbl?

You get the point. Oil did indeed fall to $65/bbl, hitting that number on October 24, '08. Gold, though, had problems of its own and was far below its ~$975/oz of mid-July. In fact, gold touched $685/oz on October 24th, a number that proved to be its low for the entire year. But from that point, oil then fell another ~50% while gold has rallied, briefly touching $892/oz on December 29th before selling off to its present $809.70/oz.

Gold and oil are both dynamic, moving targets and there is no intrinsic "right" price for either commodity. And though I'm not a Keynesian, I do endorse the observation ascribed to him that "markets can remain irrational longer than you can remain solvent.

Since I don't place much validity in the 15:1 ratio, I can't accept your view that ". . .the price of oil should have peaked much lower (even when including consumer and investor psychology) probably around $90USD." Again, while your $90/bbl number may have been arrived at rationally, have another look at the bolded quote in the previous paragraph.

Your observation that the fundamentals did not support a price of $147/bbl, and therefore that price was "obscene" is, in my view, an emotional reaction to something your logical mind tells you is illogical. But I do not concur with your notion that higher prices in future delivery months than spot or nearby months ". . .is almost unprecedented in times of tight supply ( No matter the commodity)."

Rather, in normally functioning futures markets, the further out in time one goes to contract for delivery, the higher the price of the contract, even in times of restricted supply. This is known as "contango," and is a reflection of the carrying costs going forward and the risk attendant with the uncertainty that accompanies these increased spans of time.

The opposite of contango is backwardation, when futures prices are lower than spot. Backwardation has a definition, of course, but trust me, it is the market's way of saying that there is no physical available for delivery at any price. This is a condition that the gold market entered in December. The outcome is still up in the air.

Your statement that "Finally speculation needs liquidity . . ." is correct, of course, but to me it's a bit like saying "If you want to buy something, you have to pay for it." I do agree with your observation that the freezing-up of the credit markets had a profound effect on all other markets, including the oil market.

As to your observation that oil might reach $65-70/bbl before the end of the year, I don't disagree that it's possible. But I also am of the opinion that it could go much higher than that - even higher than the $147/bbl of last summer - or it could go back down to $10/bbl.

The point is that there is no way of knowing what's going to happen. There is no "correct price" for oil or anything else, and the price of any commodity at any particular moment in time is merely a reflection of all of the opinions of all of the interested (and invested) traders at that moment.

But will the price change? Count on it! Up? Down? Yes!

TaoJones

[bobsadler]

presumably the speculators that drove the price to near $150/bbl were the same ones who drove it down to around $35/bb - oil traders operate in both directions but only get complained about when the price is rising

it's a bit like the old saying that everyone's a capitalist when the stock markets going up and a socialist when it's going down

[bastonjock]

Tao

i have enjoyed your input very much,thankyou for breathing some fresh air into a subject matter that is so full of Poo artists

I have worked on the trading floors of several large financial institutions in the "City of London" the most amusing was EBRD,all the stories were true about its French boss

These days i run my own small retail business,the current climate is the worst that ive known,so i guess ill be heading back up London soon :-( i am one of those engineers that do the technical stuff

[anglooff]

This subject is extremely complicated and impossible to cover to any adequate degree within the understandable constraints of this format; I hope one day we can engineer the opportunity to discuss this and associated topics over a meal and a nice bottle/s of wine.

Winston Churchill once stated that “We were a common race only divided by a common language” It’s my Scottish education but “value” and “speculation” was intended to indicate price and any entity including hedge/mutual fund or individual, who had no intention of taking delivery, but hoped that their investment would return a profit.

Nothing wrong with that; I am a disciple of Adam Smith and although he is considered the father of “Supply and demand” reasoning and a believer in free markets. I would suggest that he should be better remembered for his words on “the unintended consequences of actions” which although he believed, even if the actions were driven by greed and avarice, never the less, generally would have an overall positive effect/contribution going forward… However he was also aware and warned about what abuses could occur.

Knottybuoys original thread was “Did Speculation Fuel Oil Price swings“ Allowing me my terminology as stated above I believe those “Speculators” did. Using your more “ Narrower” terminology I would concur that they were relatively insignificant.

As to Mike Masters and Hedge Funds in general…The former is unknown to me and I didn’t have the time to access the link, so I have no comment… However, Hedge Funds ( the ones that are not Ponsy schemes).. I do. It was always assumed that the Hedge Funds large annual fees charged to their clients plus the often 20% bonus returns for performances above projected returns, was because their supposed superior Beta expertise ( Simply put; the ability to better understand and therefore more successful in obtaining gains in the more volatile/ riskier investments) combined with their algorithmic investments programmes, made them unique.

We now know that they were very Alpha normal and the only real skill difference was that the leverage ratios they were able to arrange with banks and investment houses. They were able to do that only because Banks and IH’s, already beginning to experience the downside of the tightening of liquidity in 2007 were looking to continue the high ROI ratios they had then been recently experiencing.

During the period last quarter 07 and first quarter 08 I would assert that commodities (all) had a paradigm change, insofar as they became for the first time in modern history an investment sector, similar to tech, industrials etc., rather than either a specialist sector or a 10-15% diversification tool for portfolios. Institutional buyers, Funds and individual investors “invested” (as of course they had every right to do) and this created a bubble…. The only point of debate would be its size.

To return to my famous countryman Adam Smith who was the Professor of Moral Philosophy at Glasgow University, when he began laying the foundations of his ideas regarding what would eventually become the “enquiry ……wealth of nations” he always had an eye to protect the individual. Whether oil and food should somehow in the future be protected against speculation ( my description) is probably a debate waiting to happen, but we saw food riots last year in developing countries, rolling back decades of fragile, yet continual economical, social and political improvement. The Hunt brothers in the late eighties tried to corner the market in Silver and a simple change regarding “leverage” ratios finally foiled the scheme.

I do not and did not seek to cast aspersions on “future” trading in general…it requires consider skill, experience and research to achieve success over a long period and from your previous post on this and other threads I happily place you within that group. Nor do I believe groups sought to “corner” oil and other commodities, but by having the opportunity to "greatly leverage" their positions, whatever matrix one uses the investment into oil, and indeed other commodities distorted their fundamental “ supply and demand” …. In my view much lower Price.

Best regards


Alan

[bastonjock]

Alan,did you know that Adam Smith and Gordon brown both come from Kirkaldy?

[Nauticatarcher]

Did Speculation Fuel Oil Price Swings?
does Rose Kennedy have a black dress? is the Pope a Catholic? and maybe we should use all the Hot air in this forum to generate electricity?

[DeepFrz]

OK Tao, was that a yes or no?

[Robertcateran]

Thank you al for an interesting discussion.
I feel the increase was due to the knowledge that the way the world economy was going, the supply would not keep up with demand, so that the price would increase to what the market will bear. The difference in supply and demand only has to be very slight to boost the price of such a valuable product. Liquid petroleum is an amazingly compact source of easily transported and stored energy and the price is so much less than its value. If the economy had kept on going the way it was, then the prices would have been realistic. The economy fell over, demand dropped to below supply and the price dropped to what can generate a small profit on production.
The supply side will eventually get below the demand again, and I can see another price rise, triggering another economic slowdown. I feel the price will oscillate between these prices- what the market will bear, ie the value of the product and the cost of production. Eventually the bottom price will have to rise as the cheaper sources are used up.

[TaoJones]

Originally Posted by anglooff

This subject is extremely complicated and impossible to cover to any adequate degree within the understandable constraints of this format; I hope one day we can engineer the opportunity to discuss this and associated topics over a meal and a nice bottle/s of wine.

I would look forward to such a meeting with pleasure, Alan. Perhaps by the time of such a meeting, Brad (Southern Star) would also be living in Venezuela - I can imagine that the three of us could get together at his place (Playa Zaragoza, Isla de Margarita) and have a wonderful time conjuring solutions to all of the world's many problems.

During the period last quarter 07 and first quarter 08 I would assert that commodities (all) had a paradigm change, insofar as they became for the first time in modern history an investment sector, similar to tech, industrials etc., rather than either a specialist sector or a 10-15% diversification tool for portfolios. Institutional buyers, Funds and individual investors “invested” (as of course they had every right to do) and this created a bubble…. The only point of debate would be its size.

In my view, commodities have always been "an investment sector," but one little understood by the great majority of the investing public - even professional investors. Commodities are the very basic ingredients of everything that is produced, and ultimately, consumed.

What scares people away from commodities is, I think, the very method of investing that you mentioned elsewhere. That is, the rather trifling amount of capital that one can use to control vast quantities of a given commodity. Small moves in commodity prices can then quickly create either huge gains or huge losses, doubling your invested funds or totally wiping them out in a short span of time if things are volatile.

If commodities investors were wiser about their money management and used margins of at least 50%, they would be in exactly the same position as those in equities who invest on margin. They would also quickly learn that commodities are, generally, less volatile than stocks. And for those who operate on no margin at all (as I recommend), commodities are positively tame compared to equities. Employing options on futures (the second derivative) is another way to control risk in futures trading.

Commodities bulls typically last about 17 years, and the current bull materialized around 2000-2001. If you consult a chart, you will see that even the so-called bubble you cite of early 2008, and the ensuing "bursting" of same that occurred 3Q08, have not altered the fact that commodities remain in their secular bull.

The Hunt brothers in the late eighties tried to corner the market in Silver and a simple change regarding “leverage” ratios finally foiled the scheme.

Actually, the various tinkering that the individual commodities markets employed to derail the Hunts' attempted silver corner had little effect. Even when margins were raised to 50% and limits were placed on position size (number of contracts), the Hunts kept buying silver and silver futures (they had assembled a silver-buying group with a couple of Saudi sheiks who were allegedly fronting for the Saudi royal family). It was when COMEX officials (who were later proven to have had large short positions in silver futures themselves) instituted a closure of the silver market except to liquidate contracts that the price collapsed.

Obviously, when an investor cannot buy, and can only sell, the price must decline.

I personally couldn't care less about the Hunt brothers, and their attempted silver corner may, in fact, have been illegal. But the undeniable lesson I take from the incident is that if the market establishment (vested interests with significant positions that are moving against them) will do whatever it takes to preserve their financial health, then the much-ballyhooed concept of a "free market" is of little consequence to them and will be quickly jettisoned if their financial ruin will result from maintaining it. That the CFTC would sign off on such a blatant example of self-dealing should give every investor pause.

I do not and did not seek to cast aspersions on “future” trading in general…it requires consider skill, experience and research to achieve success over a long period and from your previous post on this and other threads I happily place you within that group. Nor do I believe groups sought to “corner” oil and other commodities, but by having the opportunity to "greatly leverage" their positions, whatever matrix one uses the investment into oil, and indeed other commodities distorted their fundamental “ supply and demand” …

Again, I have to respectfully disagree. The totality of all investors in the oil markets (commercials, funds and specs) is, generally, split 50/50. That is, half are bullish and half are bearish. As the percentage shifts, prices move. If the movement is in a bullish direction, prices rise. Or, if in a bearish direction, they fall. The percentages rarely move far from 50/50 for very long.

Why not? Because when one side of the market is overloaded, it creates an opportunity on the other side, and experienced traders know this. As they begin moving capital to take contrarian positions, generally by taking profits and abandoning their positions on the side of the market that is getting "heavy," it re-balances the markets.

The amount of collusion that would be required to corner any market, especially one as gigantic as the world oil market, is, in my view, impossible to achieve. Everyone in the game is only interested in the well-being of one client - him or herself. But since there are only two possible positions - long or short - sometimes a confluence of unforeseeable reactions to events will create a seeming conspiracy to move the market(s) in one particular direction. That, I would assert, is what occurred in the oil market in 1H08.

I steadfastly maintain that the occasion of a heavy preponderance of capital flooding one side or the other of any market is merely a coincidence, and a self-correcting one at that. Most are probably aware of the adage that "The cure for high prices is high prices." It's an opinion that I heartily endorse.

* * *

Shall I clear my schedule and alert Brad so that we can get together in Venezuela in future, Alan?

TaoJones

[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.”

[Sahara]

I own an oil and gas exploration and production company in Texas. A small one. Insofar as crude oil is concerned:

1.) Oil companies do not set the price. If they did, we would not have had $8.00/bbl oil in the late 90's. I have virtually no control over the price I receive for oil and gas. When prices are high, I make a good profit. When they are low, I am lucky to stay in business.

2.) Of course there was speculation, and oil was overbought at the top. At the same time, there was a very narrow supply/demand situation, because of the (then) booming Chinese/Asian economies. That said, one person's speculation is another's risk management. Both people who are naturally long and those who are naturally short in a commodity will use futures markets to reduce risk and uncertainty. Producers, like me, are naturally long. If I want to make an expensive capital investment that requires a certain oil price to be profitable, it only makes sense for me to try and lock in prices in the futures markets. Many times, bankers will require this as a condition for making a loan.

Oil users, such as trucking companies and airlines, are naturally short the commodity. They know for a fact that they will need a certain amount of fuel over the next number of years. Buying hedges against a rise in prices can be a useful strategy to reduce risk.

While some speculators did very well, those who bought at the top, or sold floors to producers, have taken a huge hit in the price collapse. That is the nature of risk.

3.) The price is largely determined by a very small margin of surplus or shortage. If there is a 1% shortage in supply, users will bid up the price of that oil in order to get it. That will raise the price of all of the crude in the marketplace. If there is a 1% surplus, the price of those barrels will fall until they find a buyer, thereby lowering the price of all of the barrels in the marketplace.

[LtBrett]

Oh, by the way, if you are doing basic supply/demand analysis, you can't forget elasticity. Elasticity describes the slope of both the supply and demand curves. It answers the question for a $1 increase in the price, how many fewer barrels are demanded. In the short run, oil supply and demand are quite inelastic. Oil can shoot up $50, but usage will take some time to drop off. In fact, that amount of time between spot (current) price and when the cost is fully impounded into the economy has been estimated at between 12 and 18 months. Our economy today is feeling the effects of last January's oil price. So speculators play their role at the margin, creating volatility but also liquidity. The economy reacts slowly, producers try to change their supply but are also slow to react, and we are left with the question of whether we are looking at a simple decrease of demand (movement along the demand curve) or a shift of demand, reflecting factory closures and an overall re-definition of our world's need for oil. So yes, speculators played a role. So do end users. And when the supply siders started talking about "entering a whole new world" where half the world's oil had been used up, you knew a bubble was about to form. Anytime you see lots of people buying into the "whole new world", expect a bubble. Or in our current economic climate, the complete capitulation that will mark the bottom.

Brett

[TaoJones]

Originally Posted by David_Old_Jersey

Recession? only a word..........

<snip>

I also had taken the definition as being based on something slightly more substantial than political spin. But......??

Well, it may just be a word, but a rose by any other name . . .

http://www.nytimes.com/2009/01/24/bu...n.html?_r=1&hp

Recession Britain: It's official | Business | guardian.co.uk

BBC NEWS | Business | UK in recession as economy slides

The point is, of course, that whatever one wishes to call the current economic climate, a lot of people are finding it decidedly uncomfortable. There is talk now that the pound may very well fall to parity with the $US. And we all know how "healthy" the $US is.

We are much closer to the beginning of these economic difficulties than the end, I fear. Heaven help us all when the really bad times arrive.

TaoJones

[twisty]

I didn't read all of everything posted here but I wanted to relay to you a story I was told by a Wachovia Securities administrator back when gas and diesel were at their highest.

Speculators were buying oil 3 and 4 weeks out but never taking delivery until the price reached the point here they could make a profit. With all that oil sold on paper it was creating a shortage inturn driving the price up. That's obviously the extremely abridged version.

What I am concerned about now is all this bailout money the banks got. Several banks have already bought all the oil they possibly could and have it sitting in tankers offshore waiting for the price to come up. Basically doing the same thing the speculators did, except they are taking delivery. The kick in the pants is many of the big banks are also involved in the bulk/tanker shipping industry which means the cost of keeping it on a tanker offshore is a lot less and they can keep it there indefinitely. Wells Fargo is one of the banks playing this game.