Here’s how it was reported, for example, in the Wall Street Journal:
Reaction to the Wall Street bailout and frenzied last-minute trading in the oil market sent crude prices soaring by more than $16 a barrel, the biggest one-day jump ever.
The late-day spike, which shoved oil up 16% to $120.92 a barrel on the New York Mercantile Exchange, offered an illustration of Wall Street’s hard-to-predict moves amid broad market turmoil.
And here’s what really happened.
The most striking thing about yesterday’s oil prices was the disparity between different futures contracts. The October contract, which expired yesterday, did indeed settle at $120.92, up more than $16. But oil for delivery in November closed at $109.27, an increase of only $6.62, and longer-forward contracts saw an even more modest increase. Unquestionably what was going on was a short squeeze, in which traders who had sold the October contract short were scrambling to close out their positions before expiration, and having a hard time finding people willing to take the other side.
An $11 gap between October and November oil almost never happens, and with good reason– it represents an arbitrage opportunity that somebody missed. Anyone with uncommitted oil in storage in Cushing, Oklahoma where these contracts get settled could have profited handsomely by selling that oil to the panicked buyers and covering by buying November oil. So why didn’t they?
I’m guessing that part of the answer must be that some of these operators were following rules of thumb which usually work just fine in a properly functioning market, and weren’t alert to the profit opportunities at hand. I certainly would not expect a discrepancy of this magnitude to persist for as long as 24 hours.
But another possibility that suggests itself is some degree of local monopoly power in the Cushing market. If you’re selling that $121 October oil, you might not be anxious to cook the golden goose by bringing any extra oil to the temporarily thirsty market. This might be a reasonable case for the FTC and CFTC to investigate the mechanics of exactly what happened yesterday.
Although the spike for the expiring October contract was dramatic, the story of actual significance for the economy would be the $6/barrel increase in the price of most of the other contracts. What caused that? In terms of changes that affect the quantities demanded or supplied for the physical product, one could point to several developments. Foremost among these would be the 2% drop in the value of the dollar against currencies such as the euro. To a first approximation, that would mean that the demand curve for the rest of the world (plotted with the dollar price on the vertical axis and quantity demanded on the horizontal axis) shifted up by $2. Other news of potential relevance includes the cutbacks in oil exports from Saudi Arabia, Azerbaijan, and Iraq (hat tip: 321energy). But unquestionably the biggest factor in the 6% surge in oil prices yesterday was a resumption of flows of investment dollars into commodity futures contracts, reflecting fears about inflation and perceived risks associated with alternative investments. We may be entering a phase again in which those speculative flows are an important factor in short-run oil price movements, just as I argued they were last spring.
But to repeat that earlier analysis, ultimately an increase in the price of spot oil, whatever its cause, will have an effect on the physical quantity demanded. Demand is sufficiently price inelastic that the effects of a $6/barrel increase are very modest and would take some time to show up anywhere. But if we’d actually seen the price permanently move to the $130/barrel price that was the intraday high for October oil yesterday, the consequences for quantity demanded would become significant. If physical inventories of oil did not accumulate, if the quantity of oil brought to the market did not decrease, and if the feared inflation and further depreciation of the dollar did not materialize, the oil price would have to come back down, and speculators who bought at $130 would end up with a big loss.
But in the mean time, it could be a wild ride.