Did Speculation Fuel Oil Price Swings?

[Hal]

You've got my vote Tao. My wife used to fly for one of the oil companies in Oklahoma and has a fair idea of how this works. (we are both commercial pilots) Her "ex" kept the books. Your thoughts are along the lines of her thinking on the subject. Interesting.

Hal

[bobsadler]

i would have thought the only way to determine if an oil company is somehow ripping off the market would be to look at their "return on capital".

my understanding is that "return on capital" for most - if not all - medium to large oil companies is roughly in line with, or somewhat below, that of companies in other industries

[Tourmaline]

Barry Rotholtz gets it right. 60 Minutes covers a very small fraction of the issues. The following quotation is from Barry's The Big Picture website:

"Last night’s 60 Minutes had a story on Oil Speculation. Its not that they said anything that was factually wrong per se, its more that they told 10% of the story of the rise and fall of energy prices. The entire report was surprisingly thin, and avoided discussing all of the many other factors that had been impacting energy prices during the 7 year rise and subsequent collapse (60 Minutes video here). Very often, major bull market moves begin on fundamentals, but shift towards the end of its life into a speculative frenzy. These always end in a price surge (i.e., a blowoff top), which is followed by a collapse. But note that it is in the end game where speculation dominates, not the first 7 or 8 innings. That was true as much for Housing in 2005-06 as it was for dot com stocks in 1999-2000.
Hot markets always attract hot money.
But merely claiming that the run up in Oil prices was due to unprecedented speculation misses the big picture of what actually occurred. And, it reflects a lack of understanding of how markets work, and the psychology of booms, bubbles and busts.
Here are a few factors that I believe the folks at 60 Minutes either misunderstood or overlooked completely during the run up from $20 to $100:

1. Oil is priced in US Dollars. Since 2001, the Dollar fell 40% (from 120 to 72); Oil rise nearly 5 fold over the same period. And Oil’s collapse occurred over a period when the dollar formed a short term bottom; it has certainly had its most significant rally in years (72 to 88).
2. Over the same period that Oil prices were rising, the US was fighting two major wars in the Middle East, Iraq and Afghanistan. These impact prices via psychology and risk of supply disruption — especially at a time when producers were running flat out.
3. Energy prices rose during a global economic expansion (fueled by low rates and cheap money); Oil fell during a period that marked the beginning of the US recession and the start of a global slowdown.
4. Since 2001, Commodities of all sorts rose significantly: Steel, aluminum, cement, cotton, soy, livestocks, foodstuffs, precious metals, etc. Were they all driven by speculation, or was something else going on?
5. Since the 1% Fed funds rate of 2002-03, inflation has had a dramatic impact on ALL prices — from medical costs to insurance to education to health care to transportation to housing to food and energy. That 60 Minutes failed to even mention inflation in a piece on Oil prices is a terrible oversight on their part.
6. Throughout the 1990s and 2000s, cars were increasingly replaced with SUVs and trucks in the United States. Not only did these get appreciably worse gas mileage, that fleet transition took place as the total US miles driven rose. Over the past 20 years, people have lived increasingly further away from their jobs. Hence, increased US demand for energy accompanied (and increased prices).
7. Since gas prices hit $4 a gallon and the recession began, total US miles driven fell significantly, by several billion miles. As expected,t he drop in driving was followed by a fall in prices.
8. 60 Minutes interviewed Mike Masters, a hedge fund manager who had testified before Congress that speculation was driving prices. They omitted to mention he was talking his book. His holdings in energy sensitive stocks — with large positions, the vast majority in call options, in AMR Corp (AMR), the parent of American Airlines, Delta Air Lines (DAL), General Motors (GM), UAL Corp (UAUA) and US Airways (LCC) — were responsible for his fund losing 35% of its value before the Fall 2008 market collapse..
9. China boomed~! More and more global manufacturing outsourcing saw factories being built throughout China. They also went through a wild process building out the nation in preparation for the 2008 Olympics held there. Oh, and China, like the US, also began filling its Strategic Petroleum Reserves. Another small country, India, was booming over this period also.
10. The rise of extremist terrorist groups like al-Quada, the hostility of Iran towards the West, supply and political disruptions in places like Nigeria, and overt hostility to the US by oil producers like Venezuela President Hugo Chavez also contributed to drive prices up. The political factors were also omitted.

There’s a lot more, but the bottom line is this: Higher energy prices were caused many many factors over the past 8 years. Certainly, speculation played a part at the end of the run — but it always does. Oil fell more precipitously than it rose, but don’t all markets do that? Didn’t the S&P just plummet nearly 50% in a year, after a 5 year run?
Speculation is merely one aspect of what happened. 60 Minutes missed the other 59 elements . . ."

[knottybuoyz]

Great responses guys. I now know a lot more about fuel prices than I did yesterday!

[Therapy]

Originally Posted by knottybuoyz

Great responses guys. I now know a lot more about fuel prices than I did yesterday!

Yea, me too but I want to know what it will cost in 3,6 and 9 months from now.

[Guzzi]

Isn't CBS (and other media outlets) the same outfit that was blaming the Bush Administration for high oil prices?
Now that their chosen one is taking office, they trot out a new reason for the "problem" so their guy won't get the blame, but they don't absolve Bush for the blame while doing it.

Also you must remember the price of oil isn't what oil companies charge for oil, it's what they must PAY for it.

Grocery stores try to work at a 33% profit margin. Why isn't the media hollering about "Big Grocery" and windfall profits?

[Christian Van H]

Guzzi, this thread was entirely non-political until you entered it. This forum is non-political, and I dont want or need your political opinions. As for the thread up until now, I really learned alot.Thanks guys for sharing your knowledge and understanding!

[READY2GO]

I agree Christian, we don't need politics here. I too have learned alot. Thanks guys.

[bastonjock]

At its worst,diesel hit $13.00 a gallon over here in the UK,i believe that these prices were a strong contributing factor in undermining confidence.

I am not an economist,but for the last 18months i have been warning people that we were heading for a recession,a friend who is a London broker told me that i was wrong 18 months ago

i am of the conviction that the oil price was artificailly inflated by the city sharks to cover their losses in the real estate markets

[TaoJones]

Originally Posted by bastonjock

At its worst,diesel hit $13.00 a gallon over here in the UK,i believe that these prices were a strong contributing factor in undermining confidence.

I am not an economist,but for the last 18months i have been warning people that we were heading for a recession,a friend who is a London broker told me that i was wrong 18 months ago

i am of the conviction that the oil price was artificailly inflated by the city sharks to cover their losses in the real estate markets

It's possible that your friend, the broker, was saying more than you realized if he told you 18 months ago that you were wrong about the UK economy heading into a recession - he may have had an inkling that the economy was already in recession and that the Exchequer was massaging the numbers to disguise that fact.

That's the way it's done here (US), and we learned our wicked ways from our colonial masters.

For those confused by your term "city sharks," The City is the City of London, a small area forming the center of the UK financial and legal world. It's like referring to The Street here in the US - most people are now aware that this is shorthand for Wall Street.

TaoJones

[GordMay]

Originally Posted by bastonjock

... i am of the conviction that the oil price was artificailly inflated by the city sharks to cover their losses in the real estate markets

If the City Sharks could occasionally inflate prices to recoup losses, why wouldn't they always inflate them to increase profits?

Originally Posted by Guzzi

... Grocery stores try to work at a 33% profit margin. Why isn't the media hollering about "Big Grocery" and windfall profits?

Actually, grocery stores operate on about 25% GROSS Margin, resulting in NET Margins of about 5 - 7%; rightly less than the "riskier" oil business.

Some interesting reading on the subject:
Google Answers: published supermarket profit margins

I cannot vouch for the accuracy of the chart below:

[David M]

Gord,
I am so glad you brought up that chart. I said earlier in this thread that oil companies make about an 8% to 10% profit margin and this chart reflects exactly that.

If the media did its job people would know this. As it stand now, peoples perceptions of what the oil companies make is really inaccurate.

[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.

[David_Old_Jersey]

Originally Posted by TaoJones

the economy was already in recession and that the Exchequer was massaging the numbers to disguise that fact

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

........"the definition - two consecutive quarters of negative growth - had no basis in economic theory and was created by the US Government in 1967 to aid the re-election prospects of President Lyndon Johnson............had the neat idea that if we had a definition of recession which meant that people could say we are not actually in a recession, not technically, that would get the president out of a difficulty....So on the back of an envelope he invented the idea that in order to call it a recession you had to have had two consecutive quarters of negative growth"

Definition of a recession 'drawn up on back of an envelope' - Telegraph

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

[anglooff]

I am always interested in reading any of Tao Jones’ writings regarding the present economical situation and his erudite examples. However in this occasion I do believe he has understated the significance of the impact that the speculative “future traders/markets” had on the value of oil.

Every reason/example given in his posts for the “demand increases” are all valid, and would increase its value, however, I do not believe constituted sufficient reason for oil to reach nearly $150USD per barrel.

It used to be that the price of one barrel of oil, related to 1/15th of the price of one oz. of Gold. The many mentioned reasons listed in TaoJones’ second post are in part why these ratios (between oil and gold) dislocated. Notwithstanding these valid reasons, the price of oil should have peaked much lower (even when including consumer and investor psychology) probably around $90USD.

As you are well aware from your dealing with precious metals (futures) the New York Mercantile Exchange is the pre-eminent energy futures market in the world. It has become the de facto price-setting mechanism for oil. Even OPEC refers to NYMEX when it sets its price targets ( Even you do in your second post, so its now written in stone). For approximately 4-6% “good faith” margin deposit an individual investor can control 100% of the contract IE $4-6k controls $100K of product.
Early 2008 OPECwas producing at levels not seen since the early 1970s — and that didn’t even include Iraq, which was struggling to achieve pre-Gulf War production levels. Global production still outpaced consumption and even including the dramatic fall in the strength of the USD the $147USD per barrel was obscene. Many times last year we saw that future contract months were selling for bigger premiums over spot or nearby contracts. As you will be fully aware this is almost unprecedented in times of tight supply ( No matter the commodity).
The difference, I would, with respect suggest, was made up by speculation and although its extremely difficult to accurately assess what level of increase was impacted I would suggest circa 50% minimum. OPEC is not foolish… If someone was willing to pay $147USD, to reject it. Notwithstanding that, most OPEC members in their more serious moments understood that every time oil had previously reached an unprecedented level that an inevitable backlash would occur, which was why most thought $80-90USD was the optimum level and conservatively budgeted their national expenditures much lower.
Finally speculation needs liquidity, Airlines, cities etc. do too of course, but they also need the product subsequently their “Hedge programmes” is to take delivery; most trades were bought to sell on. I would further suggest that a large part of oil’s decline, was that the easy/cheap availability of liquidity in global markets dried up. Even in a recession people need oil and I wouldn’t be surprise to see it around $65-70USD before the end of the year.

Best Regards
Alan