

Wishful Thinking, Speculation and Oil (May 30, 2008)





Everyone and their sister seems to have jumped on the "oil prices are being driven by speculation" bandwagon, but perhaps that is nothing but wishful thinking. From the very beginning of futures trading--back in the 1600s when traders in Antwerp would buy and sell contracts on the cargo coming from the East Indies--the easiest game in town has been to blame speculators for price movements. If the price of a commodity is rising, then the villains are speculators. If the price is dropping, it's the short sellers' fault. Speculators are active wherever and whenever speculation is allowed. It's wishful thinking to expect oil will fall from $130/barrel back to $70/barrel if only those darned speculators would leave the market alone. Note to hand-wringing, finger-pointing pundits: those darned speculators are the market. As Harun points out in the chart below, Large Trader Open Interest (in futures contracts) is not out of line with the recent past. We also have to keep in mind that commercial traders play both long and short to hedge their gains. If you're long oil, then you also buy short positions to lock in your gains on the long side. That is, your short positions will gain in value if oil drops, offsetting your losses on the long side. That's the basic idea of hedging, and the major players have to hedge to protect themselves from huge losses on either side of the trade. Thus it is tricky to draw hard-and-fast conclusions from open interest. Yes, momentum traders will jump on a trend up or down; that's the nature of markets and trading. But the key metric is always supply and demand. The evidence is rather clear: demand is not being destroyed as oil climbs in price, and supplies are dwindling as major oil fields slip into the depletion phase of Hubbert's Peak. What many of the "it's all speculators' fault" commentators seem not to understand is that hundreds of millions of consumers are still paying low prices for gasoline. Many governments subsidize the cost of fuels, artificially suppressing prices to consumers, who then respond like all consumers do when a commodity is inexpensive: they use it profligately. Let's turn to frequent contributors Harun I. and U. Doran for more: Harun made these points: Shedding some perspective on the speculation debate. Is there speculation? Of course, that is how the futures markets are designed. Does this mean that speculators are driving price up or down. This argument has been around for centuries, it was inane then, it is just as inane today. Is there a bubble? The change in trajectory of price indicates a change in psychology. Trend-following funds are are going to increase positions as their models dictate. When we see the smartest guys in the room (commercials) become buyers (relatively) then we will probably see a shift in price activity. Spot market and futures as of today are equivalent and the market is no longer inverted, this also is a change. Technical indicators on the charts indicate subtle changes. Anything that goes straight up is unsustainable. The percent increases price are clearly unsustainable. People will change their behavior. High prices are the answer to high prices and low prices are the answer to low prices. The problem is that many nations are subsidizing their citizens' oil prices, so hundreds of millions of consumers are not paying higher prices. U. Doran submitted a telling article by "Sir Charts Alot" Gary Dorsch, who made these key points about supply and demand: (Is Crude Oil a "Bubble" Ready to Burst?) China, India, Russia and the Middle East combined are now consuming more crude oil than the US, burning 20.7 million barrels a day, up 4% from a year ago according to the IEA. The emerging economies are picking-up the slack in the oil market, more than offsetting a -1.3% contraction in US oil demand to 20.3 million barrels this year. Thus, a mild recession in the Western economies and Japan might not weaken global demand for oil. Economies of big oil-exporters in Russia, Mexico, and OPEC itself are growing so fast that their need for energy within their own borders will limit how much they can sell abroad. Internal oil demand in Saudi Arabia, Russia, Norway, Iran and the United Arab Emirates grew 6% last year, and their exports declined 3 percent. Mexicos oil output fell -9% in the first four months of 2008, from the same period a year earlier. If these trends continue, global crude exports could fall by 2.5 million barrels a day by the end of 2010, adding new strains to the global oil market. Oil production is shrinking in 54 of the worlds top-60 oil producing nations, including Britains North Sea, where output peaked in 1999 and has already plunged by half. The UK began importing liquid gas for the first time in history in July 2005, and its North Sea oil reserve is dwindling at an -8.5% annual rate. The curtain might fall on North Sea Brent by 2012 if enough isnt done to maintain development and exploration, according to the UK Offshore Oil Industry. The basic laws of supply-and-demand dont work in an economy where the government intervenes with price controls. In China, gasoline prices havent gone up since last November, even though crude oil prices have gone up 35% since then. Beijing controls gasoline prices to limit their effect on inflation and prevents refiners from passing on higher oil import costs to consumers. Without the price controls on energy distillates, Chinese inflation would already be in the double-digits. India is Asias third-biggest oil consumer, and imports 70% of its petroleum needs. Although crude oil has doubled from a year ago, and the Indian rupee has lost 5.5% against the dollar this year, New Delhi has only permitted just one increase in retail fuel prices in 20-months. The list of oil-producing nations with extremely cheap fuel (in some cases under $1/gallon) includes major exporters Iran, Venezuela, Indonesia and Nigeria. Toss in China and India, and you have hundreds of millions of consumers who are being protected from the true cost of fuels by their governments' massive subsidies. Traffic jams in Lagos are legendary, as fuel is cheap and the infrastructure hasn't kept pace with the population growth. The same is true in oil-producing nations' cities around the globe. Bottom line: fuel subsidies in oil-producing nations is driving demand up so rapidly that these nations will soon be unable to export any oil at all. Like all subsidies, the unintended consequence is tremendous inefficiency, economic distortion and waste. Efficiency and conservation don't pay when fuel is subsidized, just as nobody in the U.S. with gold-plated medical insurance thinks twice about going to the doctor--hey, it's "free," why not? What are the chances these governments will eliminate their fuel subsidies? Zero, zip, nada. Yes, they will inch them up, and suffer the riots and protests of their poorer citizenry; but to eliminate all price controls and expose their populace to market rate fuels would be political suicide for the oligarchs and elites holding power in these nations. So they will "suck it up" and keep prices low, regardless of how high oil climbs in price. If speculation is at such fever pitch, why is the volume of contract trading slowing down? As Harun notes on this chart, "The velocity at which contracts are trading hands has decelerated significantly during rapid price appreciation." It seems the trading was fast and furious as the price formed a bottom and began its steady rise from $55/barrel. Blaming the growing imbalance of oil supply and demand on speculation is a canard. My prediction for oil prices is a continuation of base trends, i.e. modest demand destruction and continuing declines in production/supply. As for the "solutions" to supply: 1. The Iranians have 20 supertankers filled with oil floating around somewhere.

Nice, but it's heavy crude, and the few refineries able to process it are already running flat out. Also, 20 supertankers is a drop in the bucket of global demand. 2. Deep abiotic oil is abundant. The Russian have the technology.

If the Russians have the technology, why is their production declining so rapidly? Where are the pipelines from their deep wells? 3. It's all the weak dollar. Once the dollar starts rising, the bubble in oil prices will pop.

Then how come oil is rising in all currencies and even when priced in gold? 4. Canada and the U.S. have nearly unlimited supplies of shale oil and tar sands.

Great, but real-world production will top out at 2.5 million barrels a day, about 10% of North America's consumption, and the process uses vast quantities of natural gas. 5. If only the tree-huggers would let us drill in the Alaska Wilderness.

The U.S. consumes 22 million barrels a day or 8 billion barrels a year. The Alaskan North Slope everyone talks about contains about a billion barrels--a whopping 45 days' supply for the U.S. Whoopie. In other words--it's all wishful thinking, folks: that it's all the speculators' fault, that new supplies will magically come on line and save us--there is simply no credible evidence for either supposition. It's supply and demand. Prices are set on the margin, and as a result a shortfall of a few percent has an amazing leverage on price. Go ahead and ban speculation, and see what happens then. Prices will not drop, they will simply become more disorderly/chaotic. As for demand destruction--let me know when China, India, Indonesia, Iran, Venezuela, Nigeria, Mexico et al. stop subsidizing the price of fossil fuels for their hundreds of millions of consumers. And as for supply, let me know when global production of oil from any source exceeds 90 million barrels and day and keeps climbing as producers take advantage of the high prices.

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