Kling’s question on oil speculation

Arnold Kling poses a question for Paul Krugman. Here’s how I would answer.

Kling writes:

Early in 2007, the price of oil was $60 a barrel. Recently, it has been above $130 a barrel. Which of the following does Paul Krugman believe:

(a) market fundamentals justified $60 a barrel then, and they justify $130 a barrel now; or

(b) market fundamentals justified a much higher price in 2007?

…We know that Krugman does not believe that today’s oil price is out of line with fundamentals. Krugman’s view, in effect, is that if speculators artificially boost the price of oil, then supply will exceed demand, and the excess has to go somewhere. Where are the inventories?

This view ought to hold in reverse. If speculators artificially kept the price of oil too low early in 2007, then demand should have exceeded supply and inventories should have vanished. Yet they did not. So is Krugman forced by his model to conclude that the price of oil of $60 also reflected fundamentals?

The “fundamentals” price of oil depends on a number of factors that cannot be perfectly foreseen. Among these are (1) will the world enter a deep and prolonged recession in 2007, and (2) will global oil production in 2007 be higher than it was in 2006? Today, we know that the answer to both questions is no, and conditional on knowing that answer, we can see that $60/barrel was too low a price. But a year ago, no one knew those answers.

Likewise, the price of oil today is very much dependent on the answer to questions such as (1) will the world enter a deep and prolonged recession in 2008, and (2) will global oil production in 2008 be higher than it was in 2007? Today, we do not know the answer to these questions. If the answer is yes, the price of oil today is much too high. If the answer is no, the price could still be too low.

As for the specific question of “where are the inventories”, let’s be a little more precise about the question being asked. The correct question is, Did the movement along the demand curve that resulted from the increased price show up as an increase in inventories? The correct answer is, no, it was offset by a shift in the demand curve for newly industrialized countries and the oil producing countries. For example, China may have consumed a half million more barrels of oil per day in 2007 compared with 2006.

Where are the inventories? China already burned them.

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58 thoughts on “Kling’s question on oil speculation

  1. Anarchus

    I’d want to ask Kling, “What exactly do you think is ‘wrong’ about the price of oil being $60 per barrel in early 2007 and over $130 today?”.
    We don’t live in a static world, and expectations were different in January 2007 from the reality of today — just consider the rosy historical projections of the CERA experts versus production gains actually realized, for one example.
    IF global demand for oil had weakened considerably over 2007 and 2008 and/or oil production had increased substantially AND the price of oil had risen from $60 to $130+, THEN I’d be willing to consider something strange being afoot . . . . . . . . but with demand strong and production gains very hard to come by, why should we be surprised that the price has gone up?
    I’d add that while good data has thus far escaped me, I believe that demand for low-sulfer crude has gone up dramatically while the supply has decreased (see Nigeria, for example), and that’s a larger part of the price rise in quoted futures prices than has been reported or widely understood to-date.

  2. dis

    steve waldman over at interfluidity makes the point that if to storage and interests costs you convenience yield, the market might indeed be in contango.
    he offers evidence that while convenience yield can be sizable. take a look at his post and charts
    in the comments the discussion about thinking of convenience yield not as a fudge factor, but as embedded optionality seemed interesting to me.
    would love to hear your thoughts on all this

  3. Jim Glass

    Anyone remember way, way back, all of nine years ago, to when US-produced oil was selling for for $8 a barrel??

    “OPEC met November 25-26, 1998 in an attempt to reverse the decline in oil prices. This meeting was a total failure…
    “To better understand the producers dilemma let’s look at a year end snapshot. … A crude oil producer on the low end is receiving $4.65 per barrel or 11 cents per U.S. gallon. On the high end they received $9.00 per barrel or 21.4 cents per gallon. Milk producers do much better than that and they don’t have to pump their product thousands of feet to get it out of the reservoir….

    Ah, the good old days. But here’s my point: Everyone’s talking about “speculation” & all moving price over the last one or two years.
    I’d like to see someone use their logic to explain the 10-year cycle of down to $8 then up to $140. I know everybody’s concerned just about today’s and future costs — but a real explanation of pricing has to explain this whole picture.
    A credible explanation of that whole swing instead of just the last bit of it would be a lot more impressive to me as an interested observer.

  4. Jim Glass

    “Where are the inventories? China already burned them.”
    China seems to be burning a lot of things.
    I can’t help but wonder how much money China can afford to keep burning by subsidizing oil, its exchange rate, losing money in US T-bonds as the dollar goes down, etc., etc.
    For all the talk of it being a “giant”, China after all is still a poor country per capita — and its GDP fell 40% last year.
    Isn’t it going to get a bill to pay for all this in the end?
    “[China's recent price increase] takes the pump rate to about 75 US cents a litre … Prices have doubled since 2003, but crude has more than quadrupled.” [Times.uk]

  5. rowen

    These are the things that we “know.”
    (1) Fundamentals should result in an upward trend, but not the parabolic growth that we’ve experienced.
    (2) Dollar depreciation does account for some of the parabolic gain.
    (3) Based on inventories, there is no indication of a speculative bubble.
    (4) Future prices tend to be less than spot, indicating that it’s spot moving futures, and not the reverse.
    The problem I have is that everyone is trying to explain this phenomenon using the standard Buyer/Sell model. However, aren’t integrated oil companies indirectly on both sides of the transaction? In other words, it seems that a company like Exxon or BP actually benefits from higher crude prices because all prices for refined products would be based on spot, not on production costs.
    Nah, market collusion doesn’t exist, does it?

  6. Anarchus

    rowen, I think a better explanation for the “parabolic” growth would be the very large but hard to quantify proportion of global oil demand that’s highly subsidized and price insensitive as a result.
    . . . . a problem made worse because many of the worst offending countries are oil exporters themselves — so high oil prices tend to spur domestic economic growth which is relatively oil intensive and subsidized to boot.

  7. tinbox

    ok, maybe it was $8 as a result of the Asian financial crisis. (I don’t recall the Economist focusing on that when they published their “Drowning in Oil” issue.) But arguments from inventory analysis, such as those employed now by Paul Krugman, did not explain the move down in 98-99 or the tripling of prices to over $30 over the next 18 months into 00-01. The fact that $10 was unsustainably low was not reflected in declining inventories.
    PK has many strengths as a writer and economist, but he pontificates about commodities first and looks for evidence to support his position later.

  8. JDH

    Rowen and Tinbox, the key feature of the oil market is that supply and demand are both highly inelastic. That is why huge deviations in price are necessary to restore equilibrium in response to modest changes in the quantity supplied. Here’s the relevant question– Did quantity demanded equal quantity supplied in 1998? Does quantity demanded equal quantity supplied in 2008? I believe it’s possible to cut through much of the fog here if you focus on those questions.

  9. Jim Glass

    “Jim, $8 oil was a direct result of the Asian financial crisis.”
    Of course I am aware of the then Asian crisis — but if that supply/demand factor was all there was to it then, why would there be more to it now?
    Then we just have a simple picture of oil being a commodity with a price that whipsaws because supply responds only after a long lag to large changes in demand. That could explain huge price swings readily enough, but there’s nothing particularly special or interesting about that explanation.
    Today though many people are saying there are other things at play — take “speculation”. Well, wth oil plunging to $8 after being as high as around $90, would there have been no “downside” speculation then? If so, what form did it take and what were it’s effects?
    I.e.,: if some factor drives the price of oil it should be accounted for through the entire price cycle, $90 –> $8 –> $140. That $8 was an extreme downside move. I’d expect any factor at play in extreme upside moves to be as visible in extreme downside moves one way or another.
    Explanations that cover only the last 15% of the price cycle risk being just-so stories good for filling op-ed columns on a hot topic of the moment for their authors.
    But if someone could show the influence on prices of a factor like “speculation” through the entire $90 –> $8 –> $140 cycle, or at least at the extreme ends of it, I’d find it much more interesting and persuasive.
    Same for the various other factors some proclaim to be in play today.

  10. Jim Glass

    “In other words, it seems that a company like Exxon or BP actually benefits from higher crude prices because all prices for refined products would be based on spot, not on production costs.
    “Nah, market collusion doesn’t exist, does it?”
    What percentage of the world’s supply of crude do the major oil companies control? (Compared to the percentage controlled by OPEC and other government suppliers?) Is it enough to manipulate the price of crude?
    Were they equally colluding to manipulate the price of crude nine years ago when it was at $8?

  11. Expat

    Let’s use a lame analogy, shall we?
    You go to the store to buy an apple. There is a bin with ten thousand apples so you pay just ten cents for your apple.
    The following year you go to the store. There is still a huge bin but it has only one thousand apples in it. The apple delivery truck is out back unloading apples to refill the bin. But, dang, they just can’t fill it back up. People keep buying apples as fast as they fill it, sometimes faster.
    So, you pay twenty cents for your apple because you see all this demand. And you want to pick the nice one without bruises.
    That’s the oil market. We have the same amount of apples and the same orchards, but now the market is balanced, not long. Apples start trading at the marginal value.

  12. Michael McKinlay

    The elephant in the living room : Peak Oil
    The Oil Drum has an excellent piece on Peak Export Supply today : http://europe.theoildrum.com/node/4179#more
    Export oil supply is actually shrinking. Depletion in the non Opec countries is running rampant. Mexico, the North Sea and Russia have all peaked. Some are down double digits. Many Opec countries have also peaked including Kuwait, Dubai, Nigeria, Venezuela, Iran, Indonesia and the Emirates.
    The only countries increasing oil production to any great extent are Angola, Brazil, Iraq, and Kazakstan. Saudi Arabia is probably about to peak as their premier field Ghawar peaks.
    The latest Peak Oil Overview :http://www.theoildrum.com/node/4172

  13. Sandman

    The commodity bubble is a sad runoff of the Fed’s means to stop deflation. They are only partially succeeding. Having a stockselloff has surged oil again. 155 barrels is now reachable with the stock selloff.

  14. odograph

    I agree with this in general:

    As for the specific question of “where are the inventories”, let’s be a little more precise about the question being asked. The correct question is, Did the movement along the demand curve that resulted from the increased price show up as an increase in inventories? The correct answer is, no, it was offset by a shift in the demand curve for newly industrialized countries and the oil producing countries. For example, China may have consumed a half million more barrels of oil per day in 2007 compared with 2006.

    But I think looking for shifting demand curvs in newly industrialized nations might be a bit of a “just so story.” It makes the world match the theory.
    The fact is, every one of us on this blog paid those new prices, even those of us not in newly industrialized nations. We (or the market) discovered or price tolerance (at least for now).

  15. M1EK

    Yes, of course we all paid those new prices – which is where the fungibility comes in (at least until it inevitably breaks down at some point down the road).

  16. GNP

    Hilarious. Nicely put JDH.

    Beyond the real-economy inventory conundrum, it appears that the public would be surprised to learn that in the derivative markets frequented by oil ‘speculators’, for every long bet, somebody has made the opposite short bet.

    A naive observer could easily albeit mistakenly conclude that transactions are largely zero-sum in nature.

  17. Scott

    sometimes i catch myself attempting to fit data to hold theories…sometimes i don’t.
    a more valuable approach might be to attempt to disprove theory.
    i was dissappointed to read “If the answer is yes, the price of oil today is much too high.” come on…
    the Puplava posse spoke about rates of crude and oil product production along with inventories on the third hour at financialsense.com >> broadcast.
    one last thing, i am surprised at the lack of COT analysis in crude and oil products by the blogging community, especially given all the hub-bub revolving around the speculators etc. Don’t fret I posted some poorly constructed COT crude charts on my blog at http://trademore.blogspot.com/2008/05/speculators-driving-commodity-prices.html

  18. odograph

    “fungibility” breaks down?
    “Fungibility is the property of a good or a commodity whose individual units are capable of mutual substitution.”
    Why would oil barrels, or oil futures, cease being substitutable?

  19. Joseph Somsel

    Economics is a social science, but as social sciences go, it’s one of the best.
    The concept of “equilibrium” is a foundational notion and has been very powerful in explaining the behavior of people and markets. However, it has its limitations as we see here. You’re trying to force human dynamism into equilibrium states when none exist.
    After all, most economic actors HATE equilibrium conditions and will do what they can to upset it. There’s money only for a few in equilibrium conditions! If you’re not the monopolist, your fortune is elsewhere, in some other state or in the process of changing state.
    Time for a paradigm shift!

  20. NJ Anon

    To me Expat’s lame analogy may not be so lame.
    Could it be that the price is being driven by there being little storage capacity – excluding strategic reserves which don’t make it to market easity – as compared with throughput. If this is true – and oil is in a bubble – then it would correct very fast once demand tanks enough since limited storage capacity could lead to clearance sales.

  21. M1EK

    odograph, what I meant was that there are easily foreseeable conditions under which the market for oil ceases being global (it wasn’t during WWII, for instance).

  22. M1EK

    The key difference to me remains this: people really burn oil; there’s a physical good which is difficult to store – and thus difficult to make speculative bets on which will pay off.
    Compare to tulips, or real estate, or internet stocks. Tulips are easy to store; so are shares in companies which are ten levels removed from anything productive; and neither one is actually needed by anybody – so even if nobody ever buys to use them, it doesn’t matter. Real estate – notice that the RENTAL market didn’t have a bubble like the ownership market did; because people who own properties that they don’t live in can’t afford to let them stay empty for too long, at least in aggregate.
    Oil is a lot more like the rental real estate market (that didn’t bubble) than it is like the ownership market. There’s little capacity to store the good once it’s extracted; and even less incentive to do so since it’s very expensive. There has to be a real buyer who was really willing to pay $140 for that barrel of oil – and not just because they’re going to turn around and try to sell that same barrel of oil for $150 to the next sucker (home ownership example), because they (typically) can’t afford to store the barrel of oil – they intend on refining it and burning it.

  23. odograph

    “There has to be a real buyer who was really willing to pay $140 for that barrel of oil” Yes, and there demonstrably are.
    That is the only thing that works with the obvious facts of: near-constant world production, near-constant world consumption, increased prices, and no observed expansion of storage.
    “they’re going to turn around and try to sell that same barrel of oil for $150 to the next sucker”
    Well, when my gas tank runs down, I’ll pay it.

  24. KevinM

    “These are the things that we “know.”
    (1) Fundamentals should result in an upward trend, but not the parabolic growth that we’ve experienced.”
    I don’t agree that “we” “know” fundamentals should not result in current pricing.
    The oil producers and refiners and gasoline sellers have realized that I can afford $2500 a year to drive my Silverado its 12,000 miles without forgoing my marginally satisfying Three Musketeers bar after lunch.
    I understand that the lot of them are in a collective price searching activity, trying to determine the optimal price and volume that maximizes profit.
    As comodity producers they should be price-takers not price-makers, but the Saudis and Venezulans are not subject to our US anti-trust laws. Nor should they be. Let them collude, and let us leave them holding the bag.
    If their governments adjust to budgets set by state-owned oil fields at this price point, and we get returns on our newly inspired alternative energy investmanents at the same time, oil will be priced like soft watermellons.
    Hollywood will be producing music videos to feed the starving United Arab Emiratese.

  25. M1EK

    OK, another analogy. Consider the GM situation with SUVs – they were suddenly producing a lot more units than anybody wanted at the previous price. What happened? Price dropped dramatically. Was speculation necessarily to blame?
    Or when the Prius we both own originally came out and had long waiting lists due to contrained production capacity. When some dealers in South Florida started selling at a couple grand over MSRP, was speculation necessarily to blame?
    In both cases, people ended up buying what was produced (well, in the SUV case, GM will eventually drop production AND price to match the new demand curve). In both cases, prices rose or dropped even though production and units purchased stayed the same.
    I just think you’re going through a much more complicated set of gymastics in order to avoid the much simpler explanation about the geometry (elasticity) of the demand curve. Sure, speculation COULD be to blame – but Occam’s Razor suggests the demand curve.

  26. KevinM

    “Consider the GM situation with SUVs – they were suddenly producing a lot more units than anybody wanted at the previous price. What happened? Price dropped dramatically. Was speculation necessarily to blame?”
    Yes. GM speculated that oil (gas prices) would not get this high.
    A good way for a consumer to short oil right now is to low-ball SUV dealers. They are undervalued if crude prices are in a speculative bubble.
    A question I never considered: how long could a speculative bubble last? Historically, what are the longest and shortest notable bubbles?

  27. odograph

    ;-), I never said speculation was to blame for everything.
    I think there have been a few car situations that were similar. There were cases where a manufacturer took down payments for a limited production exotic, and prices increased before delivery. The deposits essentially became futures and were traded (BMW Z8? Ford GT?) To make it work you need limited production and a certain sort of deposit …
    As far as invoking demand curves, if they help you understand they are great, but they aren’t the actual market. Markets existed before demand curves, and they might even exist after … an interesting piece on the fall of models (with an overly grand title):
    The End of Theory: The Data Deluge Makes the Scientific Method Obsolete

  28. Hal

    As far as the Peak Oil claim that export reductions are the problem, we can’t untangle cause and effect here. It’s true that less oil is being sent from exporting to importing countries. Is it because exporters can’t supply enough? Or is it because demand in the importers is suppressed by high prices? The latter story explains it just as well.
    (And if you want to say that in that case, high prices would motivate exporters to export more, that neglects the Hotelling effect where oil producers who expect prices to rise even higher in the future will hold oil off the market so as to profit more later.)

  29. M1EK

    Hal, the Peak Oilers would come back with the fact that the Saudis, for instance, drastically increased the number of rigs they’re using just to apparently tread water.

  30. Charles

    Krugman’s latest dodge is to say (I paraphrase) “Look at iron ore prices. They are traded without futures, yet they recently rose 96%.” But this is specious. Even with that rise, iron ore is up far, far less than oil. Second, the contracts that rose were specifically Rio Tinto and Cleveland Cliffs contracts with China. The Chinese could be in a corner because of the earthquake or the previous contracts could have been below market (comparison of Cleveland Cliffs’ 8-K with the announced price would not suggest the latter).
    When Krugman is right, he’s very right, but when he’s wrong, he dodges.

  31. Anonymous

    Jim Glass says, “China after all is still a poor country per capita — and its GDP fell 40% last year.”
    Jim, you appear to be misreading the article you are citing. It states that the change in reported Chinese GDP is a statistical revision, not an actual decline. Nor is this discovery by the World Bank particularly unexpected.

  32. aaron

    Hamilton’s post is not worth the time it takes to read it.

    First of all, production of oil has been fairly consistent for several years. The fact that it didn’t rise doesn’t account for parabolic growth.
    Second, Hamilton confuses cause and effect. The recession was exacerbated by the high price of oil, and also wasn’t enough of a surprise to justify the jump in price.

    If I told you that the price of iron ore rose dramatically because production stayed constant and there was a recessionary environment, you’d laugh at me. Hamilton’s claims are equally off the mark.

    Personally, I’m inclined to take the view that these so-called “market fundamentals” explain but don’t “justify” prices. I would answer Kling that demand is inelastic in the short term, so “market fundamentals” would have justified >$100 oil last year. If the price of oil had suddenly risen to $130, people would still have bought it, and maybe it would have gotten even higher given the better economic environment at the time. However, the inelasticity of oil’s prices is only in the short term, so look for demand to drop as people cut down on usage and develop alternative energy sources.

    Again, Hamilton misses the mark. Oil prices are largely a reflection of current demand (I’ll get to speculation in a second). Think about it this way: would the price of oil go down if we knew the economy was going to improve or crash next year? Of course not.

    What we are seeing is a structural change driven by speculation. Speculators have tested for an upper bound to demand for commodities, and have not yet found it. Speculators in just about every commodity market are pushing up prices and realizing that people will still buy oil, corn, iron, etc at those prices. The lesson to learn from the past few years is that, in the short term, demand for commodities is inelastic up to a certain point. Until recently, prices were held in check by the presence of substitute goods, but speculation has caused all prices to rise at once…

  33. Anonymous

    I think you’re on to something. Just as banks test the consumer with how much fees you will accept without losing you as a customer. The speculators are doing the same here.

  34. Mr. K

    I am new to this blog, so please forgive the absurdity of this question. Everyone assumes speculation is having little impact on prices because there does not appear to be any known build up of inventory. But stocks may not be tracked or documented carefully all over the world, and at the current prices and rapid increases in price, storage is an alternative. What if speculators are now buying in the spot market, and just paying for tankers to sit in port or in storage somewhere in the world?

  35. Randy Miller

    Help me on this, please. Let us assume there will be 100 million barrels of oil pumped out of the ground in August 2008 (I know that is not the right number, this is just an illustration) So there are X refiners who offer to enter into a futures contract for 100 million barrels( 100 million being total industry capacity). Then there are X producers who offer to enter into a future contract to sell 100 million barrels total. Refiners and producers are in balance. However at the same time, buyers Y and Z offer to enter into a futures contract for another 50 million barrels, and they have no intention of taking delivery. At the same time, A and B are willing to go short on 25 million barrels, here again no intention of touching the oil.
    The market is out of balance. I have buyers trying to purchase 150 million barrels for August delivery (remember, Y and Z plan to clear their positions before the August close date) and I only have 125 million for sale (remembering that A and B are planning to clear their positions by August close date. If the market price is say $130 for august, that price has to float up until, for instance, short sellers C and D will bet that they can enter into a contract today for perhaps $140, and clear the contract for 130.
    I am not aware of any mechanism to limit futures contracts to the amount of oil that can be produced for a given month. Am I correct?
    The refiners are trying to buy oil at a price where they can make money REFINING the oil. The speculators are just betting that the price will go up, and they can cover their position at a profit. One could say the refiners will cut back on their purchases if they think they are going to lose money, but then you get into fixed costs, etc. So demand staying where it is will somewhat support the higher price, but that is not the whole story. Refiners want to make sure they have adequate stock to keep the refinery producing and satisfy their consumers. But if the speculators go into a feeding frenzy, they drive up the price, even though there is no real imbalance between refiners and producers. However, they have driven up the price.
    How much of this is paper chasing paper? And don’t you think it odd that the prices of corn and soybeans have doubled at the same time? Seriously, if this is all supply and demand, do all three of those markets have exactly the same fundamentals? The one common factor is that there is a lot of money out there looking for a home, and it does not feel safe in the stock market or banks.

  36. JDH

    Randy, let’s follow this through, (as I did by the way here, for example). There are two separate markets. One is the market for spot oil, and the second is the market for an August futures contract. Both markets will be in equilibrium at all times, in the sense that the number of barrels sold through August contracts equals the number of barrels purchased through August contracts, and the number of barrels sold spot equals the number of barrels purchased spot. Arbitrage will always cause these two prices (August futures and current spot) to move together instantantaneously. But at the end of the day, the number of barrels physically sold at the spot price will equal the number of barrels physically demanded. That is the one loose end that none of the casual theorists pontificating on this issue have ever come to grips with. You can ignore this loose end only if you hypothesize that we’re talking about a sufficiently small spot price increase over a sufficiently short period of time that demand is perfectly price inelastic. As soon as you have a response (fewer physical spot barrels that people want to purchase at the higher price), you need to finish your story by explaining what adjusted in terms of physical barrels being produced to accomodate that movement along the spot demand curve. The many discussions you’ve seen in posts at Econbrowser are all about dealing with that particular issue.

  37. halbhh

    Most appear to still accept the presumption unquestioned that speculation would lead to an inventory buildup.
    I think that is very unlikely.
    Simply put, in order for gasoline inventories to build up significantly (enough to force price reductions), refiners would have to make *mistakes* in estimating end demand for their anticipated price levels (seen in the futures markets, which they use as a partial guide).
    In other words, the inventory issue isn’t widely understood in a realistic way in the discussion with Krugman, et al.
    Several key parties price using the futures market as a partial guide.
    Yet many contracts in the futures market do *not* take actual delivery.
    This is a typical instance of how a model fails to be as complex as reality.

  38. josh_stern

    The direction of cause and effect between price rises in oil and other commodities is far from clear. I’ve read that 1/6 of U.S. energy consumption is used directly in farming; other commodities are also energy intensive to produce. It’s quite possible that energy prices are going up just because each year a hundred million or so additional consumers can buy adequate food and other basics compared to the year before.

  39. Jim Glass

    Jim Glass says, “China after all is still a poor country per capita — and its GDP fell 40% last year.”
    Jim, you appear to be misreading the article you are citing. It states that the change in reported Chinese GDP is a statistical revision, not an actual decline.
    It was an ironic comment. Such things don’t seem to convey better in blog comments than e-mail.
    Yet it is true that after the revision Chinese GDP was seen to be 40% smaller than was believed by the likes of us before it.
    And that is entirely relevant to the question of “how much money can the Chinese gov’t keep burning?” … through fuel subsidies, exchange rate support, massive investments in T-bonds as the dollar drops, etc.

  40. M1EK

    “Yet many contracts in the futures market do *not* take actual delivery.”
    Yes, but the only way this would happen is if the speculators lost a bunch of money betting too high, right? Which would tend to be self-limiting?

  41. halbhh

    Re not taking delivery, for instance if an oil producer brought a contract for one month, sold a contract for a further out month, the 2 trades roughly cash neutral (or close), but they don’t have to take delivery of their own oil, etc., etc.

  42. halbhh

    For instance Exxon or any state oil company could buy and sell contracts on the futures market, “clearing” the market, etc., removing the inventory build up effect (price spiral up, but oil producers “clear” the market, etc)

  43. odograph

    Compare (really quick sketch) the situation to an egg framer who supplies two towns. Quantities produced and consumed are stable, prices are drifting up. Speculators start buying future contracts from the farmer, and then go to the supermarket in the first town “Hey, prices are heading up. if you don’t pay that other town will. So buy my contract.”
    If it takes a long time to add chickens … if the consumers are stubborn about eating eggs … it works.
    It becomes “price discovery” … a phrase that I really thinks describes this cycle. All that remains is for us to discover if this is a short-term crunch price or a long term one.

  44. Mr. K

    A key argument against speculation as a cause for the price spiral is the lack of evidence of growing inventory. But we really only have reliable records of inventory in the west. Who is to say that some oil producing countries or oil companies are not helping by bidding for their own product? Plus the, money that has left stocks and real estate is now making a market in oil. It now makes sense to buy oil and pay to store it, like gold, to sell later…it costs about $1/mo/barrel to store…especially if there is a self filling bubble. The higher prices for fuel distress economies, causing more cash flight to – oil.

  45. Bernard Guerrero

    That is why huge deviations in price are necessary to restore equilibrium in response to modest changes in the quantity supplied.
    Tinbox has it. And that’s why you can expect a pretty sharp drop in crude based on a relatively small bit of demand destruction in the near future.

  46. Josh Stern

    JDH wrote, “Rowen and Tinbox, the key feature of the oil market is that supply and demand are both highly inelastic. That is why huge deviations in price are necessary to restore equilibrium in response to modest changes in the quantity supplied”.

    Another funny feature of the oil market is that the production plants with the lowest marginal cost are often controlled by the least capitalistic entities (e.g. governments) – they control the fields that are easiest to extract oil from. So the exploration companies with higher marginal cost have a particularly tough job in estimating future supply/demand balance and how they can profit from it.

  47. odograph

    That’s true Josh, and at the other end you’ve got large state consumers (and subsidizers) who are slow to respond to price. The US DOD will keep buying, and China has so far kept buying.
    I see lots of actors who don’t perform as perfect economic demons in anyone’s model.

  48. odograph

    As far as I’m concerned those studies have “guilt” and “blame” fascination. I can be right that investment was only an accelerator to price discovery, and they could choose the same facts and speculation is not to “blame.”
    Of course prices hinged on demand, but the pace …

  49. Anonymous

    “Where are the inventories? China already burned them.”
    By how much did China (and India, and other developing countries) increase their demand for oil over the past year? Is this increase in demand enough to justify the price increase over the past year?

  50. JDH

    Anonymous, the link above suggests that the increase from China alone could be 1/2 million barrels per day during 2007– we’ll have to wait for more authoritative numbers. As for whether this is big enough to justify the price increase, the question is, How much of a price increase did it require to bring demand from the rest of the world down by 1/2 mb/d? If the realized price increase was more than enough to accomplish this, then we would see inventories accumulating. That is why all of us are talking about inventories.

  51. odograph

    The interesting thing about China, as we model oil price changes (formally or casually) is that they are a bureaucratic purchaser. It may take them some time (far more than month-to-month) to decide what their new strategy should be, at $130+ oil.
    Well, that’s assuming they pay that, and that their earlier long-term purchases are not still in the pipeline.
    A combination of factors got us here (including I believe a world-wide rush to commodity investment) and certainly a combination of responses will shape the next year in energy.

  52. Randy Miller

    If EIA projects worldwide oil production for October to be 2.6 billion barrels, there is no way I know of to prevent the total contracts for that month to exceed that number. If the total barrels contracted is, for instance, 3.6 billion, we have 1 billion barrels worth of contracts that are blue sky.
    I don’t think anyone believes there is hoarding going on. Speculation does not have to involve hoarding.
    And isn’t the term commodity investment an oxymoron. Investments create wealth. Building a new factory is an investment, developing a new piece of software is an investment. If these hundreds of billions of dollars in hedge funds were in venture capital for new energy systems, such as nuclear, that would create wealth, and serve the country better.
    Getting transparency on the OTC market and foreign markets would give all commodity brokers better information on just how much of a given commodity is contracted for a given month. How could you shine a light on these so-called “dark markets?”
    IF you believe this runup in oil prices is genuinely based only on supply and demand, and you could invest in a surefire product to produce oil for $100 per barrel, would you do it?

  53. SteveB

    BP does a nice annual energy statistical review at http://www.bp.com/productlanding.do?categoryId=6929&contentId=7044622
    Their comments on crude are (essentially, and from a C-Span presentation of results):
    Over last 2 or so years, production is down to support prices and due to mature field declines, demand is price inelastic in fastest growing markets due to price subsidies, and surprisingly to me, reserves are up.
    So production remains in the ground (reverse supply curve effects??), and demand is inelastic where it counts.
    So, the price runup is largely fundamental; recent removal of price subsidies may be the best hope for enough demand destruction to moderate prices; if supply is backward sloping, there will not be significant supply increases in spite of increased reserves.

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