Lynne Kiesling (Knowledge Problem),
(Environmental Economics) ,
(Disinterested Party), and whoever that is blogging over at Oil Wars were among those commenting on this article ($$ required) at the Wall Street Journal.
Bhushan Bahree and Ann Davis wrote in last Tuesday’s WSJ ($$):
Crude oil closed above $70 a barrel for the first time, highlighting a phenomenon reshaping the petroleum world: investment flows into oil futures are supplanting nitty-gritty supply-and-demand data as prime drivers of prices
In contrast to past bull markets in crude, this year’s run-up has occurred even though oil inventories in the U.S., the world’s largest market, have swelled to their highest levels in nearly eight years….
The answer to the puzzle posed by rising prices and inventories, industry analysts say, lies not only in supply constraints such as the war in Iraq and civil unrest in Nigeria and the broad upswing in demand caused by the industrialization of China and India. Increasingly, they say, prices also are being guided by a continuing rush of investor funds into oil markets. Institutional money managers are holding between $100 billion and $120 billion in commodities investments, at least double the amount three years ago and up from $6 billion in 1999, says Barclays Capital, the securities unit of Barclays PLC….
Since early 2005, the crude-oil market is in what traders call contango, meaning futures contracts for a given product are priced higher than that same good for near-term delivery. The price of oil to be delivered four months from now is about $3 more than oil to be delivered next month.
Flooded oil storage near Port Arthur, Texas
In short, it pays for refiners and other oil-market players to buy and hold oil now to sell it down the road. Making that trading opportunity possible, says Colorado-based oil analyst Philip K. Verleger, is the huge volume of new buyers on the other side: investors who he estimates have put more than $60 billion into U.S. crude-oil futures since 2004.
Indeed, San Antonio-based Valero has been operating with its crude tanks full since the start of the year. When the market is in contango, “you tend to operate at the top of your tanks,” says Bob Beadle, Valero’s senior vice president in charge of crude oil, supply and trading. Mr. Beadle estimates that in the U.S., the difference between the industry operating at full tanks and at minimum operating levels amounts to as much as 75 million barrels of oil, or about three days of supply.
I do not share the view that speculation should be thought of as a separate force from supply and demand contributing to the price of oil. An investment fund that today buys a September 2006 futures contract for $75 ($3 above the current spot price of $72) will only make a profit if the spot price of oil in September turns out to be above $75 a barrel. If such speculators prove to be correct and the spot price does rise from its current $72 to, say, $80 a barrel by September, that price hike would be a further factor depressing September demand and potentially increasing September supply. Why would the September spot price be even higher than the current spot price, if users of oil in September will be buying less oil than they are now? According to the speculation theory, we’d have to see even more investment dollars flowing into the market in September than we are currently, causing an even bigger addition to stockpiles (that is, the rate at which oil is added to storage must itself go up at an ever-increasing rate) in order to compensate for the lost demand that $80 oil would choke off as well as to justify an even higher price than at present. And that additional money, in turn, would supposedly be going into February 2007 contracts for $83 oil, in hopes that the February 2007 spot price would be even higher, say $85. All this only makes sense if one believes that investment funds will continue to pour ever-increasing sums into oil futures and an ever-increasing volume of oil gets added to inventory each month. Since the total investment funds and physical facilities for storage are inherently finite, someone in this chain is going to find that they have irrationally thrown their money away. I would argue that this someone is in fact the joker at square 1 who thought you could make money with a September 2006 futures contract betting against the fundamentals.
To me, a much more natural way to try to interpret this phenomenon is that the investment funds are betting not on a bigger fool to bail them out in September, but rather are trying to evaluate the September fundamentals for supply and demand. First, let’s look at the upside. There is currently very little spare capacity in global oil production, meaning that a supply disruption of just a few million barrels a day could easily result in a pretty impressive spike up in the spot price of oil in September. Where might such a supply disruption come from? Oh, maybe Nigeria, or Iran, or Iraq, or Saudi Arabia, or Venezuela, or Russia, to name a few. Even if the probability of such an event is low, the large payoff if it occurs could give an attractive expected rate of return– play such a gamble over a long enough time period, and you could make out quite well, even if everything remains calm over this particular coming six months.
And what about the downside? Certainly a global economic slowdown could bring oil demand and the September spot price down considerably. But my reading is that the economic news of the last two months has led investors to place a lower probability on a global downturn than they would have assessed at the start of this year. Another development that would lower oil prices is if we finally started to see big changes in how oil gets used (for example, a significant change in the fuel efficiency of the outstanding stock of vehicles). But again, the most recent evidence is that this doesn’t seem to be happening yet. And finally, big supply increases from new oil fields were expected by some to have been making a contribution by now, and again the news is that, so far at least, they haven’t.
So, it seems to me that speculators, weighing these ups against the downs, might quite rationally have decided that market supply-demand fundamentals justify a higher futures price than seemed appropriate a few months back.
I would further add that, if these speculators turn out to be right and earn themselves a tidy profit, they will have done us all a favor. By bidding up the price of oil today and filling the storage facilities to the brim, they will have caused consumers to conserve today in order to have more oil available in the event that we do run into a big shortfall in production before September. On the other hand, if the speculators turn out to be wrong, they bought high and sold low. That would be destabilizing, forcing us all through some current pain, which, if we somehow could predict the future with certainty, will turn out to have been unnecessary. Our only consolation would be that the speculators will undoubtedly feel our pain, and then some, as their multibillion dollar bets flew into the wastebasket.
So, the only reason I see to be concerned about the contribution of speculation is if you think that the speculators are in danger of making huge losses. But if that’s your concern, I have a simple cure– just put yourself on the selling side of some of those futures contracts– let their pain be your personal gain.
Not sure you want to take the other side of that bet? Then maybe you’re not so sure that the speculators are wrong in their assessment of the possibilities for September fundamentals.