I normally leave it to folks like Dean Baker to beat up on the press. But I can’t resist shining a bright light on today’s story about oil speculators in the Washington Post, which has also been discussed by Mark Thoma and Tyler Cowen.
David Cho opens his story in the Washington Post with this bombshell:
Regulators had long classified a private Swiss energy conglomerate called Vitol as a trader that primarily helped industrial firms that needed oil to run their businesses.
But when the Commodity Futures Trading Commission examined Vitol’s books last month, it found that the firm was in fact more of a speculator, holding oil contracts as a profit-making investment rather than a means of lining up the actual delivery of fuel.
Let’s start with some background. The CFTC issues a report each week that summarizes the number of open futures contracts in oil and a number of other commodity markets. The CFTC separates the holders of those contracts into three broad categories– commercial, noncommercial, and nonreportable. “Commercial” traders are those who
report to the CFTC that they are
engaged in business activities hedged by the use of the futures or option markets.
So, for example, if your company has significant fuel costs, you would quite reasonably satisfy that definition of a commercial trader, regardless of whether the particular futures contracts you buy or sell this month are intended to hedge those costs. The CFTC specifically says further that it would classify as a commercial trader
a swap dealer holding long futures positions to hedge a short commodity index exposure opposite institutional traders, such as pension funds.
To an economist, any conceptual distinction between “hedging” and “speculation” is inherently problematic. When an oil refiner takes a position with futures contracts, it is unlikely to be ignoring its own guess as to where prices are heading. But making a bet based on such guesses seems to be the definition many people have in mind when they speak of “speculation.” On the other hand, when a pension fund manager takes a modest long position in commodities, that can reduce the overall variance of the portfolio due to the negative correlations between commodity price changes and other asset returns, which would most naturally be described as hedging against inflation risk. The idea that the motives of a given trader can always be classified as either pure hedging or pure speculation, and that the positions of commercial versus noncommercial traders reported by the CFTC give us meaningful information about those motives, strikes me as a very dubious proposition. Discovering a potential “misclassification” could hardly be the basis for becoming legitimately alarmed.
What else does Cho dig up? The article continues:
Even more surprising to the commodities markets was the massive size of Vitol’s portfolio– at one point in July, the firm held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange.
That does sound like a lot, though enough details are left out to make me wonder what is actually being claimed here. Surely Cho doesn’t literally mean “all the oil contracts,” i.e., light sweet, Brent, heating oil, gasoline, and so on. If light sweet alone, are we talking about just futures, or futures plus options? Or is Cho possibly referring just to one very specific contract, such as the August CL futures contract? And were these positions held outright by Vitol or purchased on behalf of its clients?
Cho gets more quantitative a few paragraphs down:
By June 6, for instance, Vitol had acquired a huge holding in oil contracts, betting prices would rise. The contracts were equal to 57.7 million barrels of oil– about three times the amount the United States consumes daily.
Again I’d like to know if we’re including options somehow in this number. But more importantly, the claim that you can compare the number of notional barrels of oil implied by a futures contract if it were held to settlement with the number of physical barrels that the U.S. consumes repeats the egregious error committed by Michael Masters in his Senate testimony this May. You can’t compare the outstanding NYMEX open interest with U.S. daily petroleum consumption numbers directly because they are measured in different units. Open interest is a stock– it is measured in number of outstanding contracts at a particular point in time. Consumption is a flow– it is measured in barrels per unit of time. You can’t measure how many barrels of oil the U.S. consumes without specifying a time unit. We consume about 20 million barrels per day, or 14,000 barrels per minute, or 7.3 billion barrels per year. With which of these 3 numbers are we supposed to compare 57 million? Fifty-seven million sounds like a lot more than 14,000, and a lot less than 7.3 billion. You can make 57 million sound as big or as small compared with U.S. consumption as you want, because there’s an arbitrary time interval associated with consumption that is not associated with open interest. If you want the futures volume to sound big, you compare open interest with daily consumption, as Masters and Cho both do.
Cho was trying the best he could to convince us that unregulated speculation was the cause of this summer’s spike in oil prices.
But instead he convinces me that he really couldn’t find much of a case.
Technorati Tags: oil,
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From FT:
“The former Federal Reserve chairman said speculation was “importantly responsible” for the rapid move up in oil prices in late 2007 and early 2008.”
If you believe that the market eventually finds the true value of a good or service, the recent settling of oil prices at about $115/bbl, down from its early July $145/bbl peak, suggests that speculation may have accounted for about 20% of the price rise. I have no allusions that Vitol or any other single or small group of players drove that speculation; they just made their bets in the marketplace.
In comparison with the ongoing housing deflation, the role of speculation in oil seems like a walk in the park.
Professor,
Great post!
I wonder where Masters and Cho are now that oil had dropped so much. Do they consider speculators as a problem only in up markets, but not in down markets? Do they believe that speculators are forcing prices down as they forced prices up? Maybe they see speculators actually preventing prices from falling as quickly as they might. If so couldn’t the same dynamic work in holding down price increases? Masters and Cho seem to be more about assigning blame by fiat rather than real analysis. Masters and Cho are just talk, but the problem comes when members of congress are so dull as to see such people as experts and then create regulations that actually harm markets.
I think Terry has it. The oil market has acted much like many markets do in a bubble. As typically happens markets overshoot significantly and whatever you want to call it it seems inherent to free markets. You see it in overvaluations and undervaluations in the stock market all the time.
Some like to claim that speculation, or whatever, dampens volatility but I would argue just the opposite. It causes markets to overshoot and go to illogical extremes.
If anyone took the trouble to read and understand the CFTC reports, the answers to many of these questions would be obvious.
In the competition between reporters and economists for display of ignorance, the outcome is too close to call without better measuring apparatus.
No reason to complain, though. That’s part of what allows traders to show a profit.
Spencer, consider the following formulation: in small numbers, speculators accelerate the adjustment of structural excesses. In large numbers, they become their own excess.
In other words, I am proposing that speculators in small numbers act as catalysts, while in large numbers, they drive out productive investment, which relies on long-term rises in value.
Let’s take up housing. Housing price affordability started to get out of whack in the 1980s as the ratio of median house price/income rose from 3.5 to above 4 (see fig. 6). Between the housing crash in the Bush I recession and rising incomes in the 1990s, the situation stabilized or even improved a bit. The deterioration of affordability under Bush II reflected a combination of stagnant incomes and very low interest rates, rather than speculation, at least until late in the bubble. Late in the bubble, speculation– or, more accurately, fraud driven by speculation– created unsustainable excesses. Rising interest rates and rising unemployment burst the bubble. Speculators contributed to the atmosphere of panic, and may drive prices to unsustainably low levels, but they neither created the unsustainability nor did speculation per se cause fraud.
I differ from James in the way I see the oil market, even if he may be right about Cho’s journalistic deficiencies. There is a very long history of manipulation of oil markets. It was always very difficult to prove the existence of manipulation in a court of law, yet it was pretty obviously so. There are many ways to manipulate the oil market. One is to simply not pump the oil. Another is to store/release it, as the US Strategic Oil Reserve has done for years. The list is very long.
James views this narrowly, as a question of what futures traders are doing. I think one has to look at the whole oil market. When oil company executives see the price of oil rising rapidly with no end in sight, are their incentives to rush more oil onto the market? Or are they to hold out, hoping for a higher price? When futures traders see oil executives slow production from its potential, are they likely to bid futures prices lower or higher? When nations like Russia see the importance of oil to western economies rise, are they more or less likely to threaten oil supplies to exert political leverage?
To see oil re-price down so quickly after Congress and the CFTC declared an interest in investigating speculation is pretty good evidence that futures trading is an element in oil prices. This is one of those situations where economists should go back to the profession’s historical roots in political economy.
James, you say that “Open interest is a stock– it is measured in number of outstanding contracts at a particular point in time. Consumption is a flow– it is measured in barrels per unit of time.”
But it is also true that futures contracts specify a date of delivery. So, while it’s true that the contracts are not explicitly temporally unitized, I think you are overstating the case.
To the peanut gallery: as for relying on the CFTC to make the determination… well, this is the agency that said that Enron wasn’t manipulating the California electricity market… at least until Enron e-mails made it very clear that they were. The CFTC is a weak reed to lean on.
Professor,
Unfortunately what you have pointed out is all too common. Fundamental errors of analysis and statistics – misrepresentation of data to achieve an agenda.
Global Warming is another example of the misuse of science/data/analysis to draw confident conclusions where none exist (on a global scale and on a long term basis).
For example, in Al Gore’s presentation of historical temperature and CO2 a clear correlation is observed. The conclusion that there is a cause and effect is scientifically wrong. It is quite easily possible that a third (yet unknown) variable is influencing or causing both responses. Furthermore, AL Gore neglects to mention that this data shows that CO2 increases follow changes in temperature by about 800 years. Generally, for the “cause and effect” supposition to have any chance of being real, you need the cause to happen prior to the effect! That this inconsistency is not even mentioned in Al Gore’s presentation is illustrative of how science, data and media reporting is often manipulated in order to realize an agenda.
There is nothing new about this. For thousands of years “priests” have come up with plausible causes for why crops have failed and plagues have hit – the standard explanation is that “God(s) is angry – we have sinned or offended” and the solution, surprisingly enough, often involves something that benefits the priest or consolidates his/her power (tithes, sacrifices, tributes). In the modern world, the concept that we are being punished by a God(s) seems ludicrous to most people (it doesn’t wash anymore)- so instead “modern priests” use technical mumbo jumbo couched as “real scientific truth” (something most lay people easily and blindly accept – after all modern science is seen as a “miracle” and technology is clearly the modern equivalent of “magic”) to explain how we have “sinned” in a new modern sense: our crimes are now against nature – the mother planet – no less. This works well and people feel guilty and that the “preachers” gain power and notoriety is hardly surprising. Furthermore, the scientists who are prepared to subscribe to this new form of “church”, and become proletizers are rewarded with kudos and funding, as they travel the world, preaching at conferences and advancing the cause of their religion. Meanwhile, non-believers are treated with absolute scorn and derision, and although the non-believers aren’t told they will burn in hell – the implication is that they and their children will burn on Earth in climate catestrophe of their own “sinful” making…
Ok, so what does this have to do with Economics – after all this is an economic blog?
Well consider how each economics camp, Keynes on one side and Friedman on the other, manipulates economic data in their papers in order to proletize their particular view of the best way to run an economy.
Charles, you’re quite right that we could measure delivered contracts as a flow, namely, so many barrels were delivered on such-and-such day or over the course of such-and-such week. But that would be a vastly tinier number than this 57 million barrels figure.
http://www.time.com/time/business/article/0,8599,1834888,00.html
Charles says that choosing to “simply not pump the oil” constitutes “manipulation” of oil markets. What if you choose to pump more rather than less oil, is that manipulation too? By these standards, perhaps everything that happens in any market counts as “manipulation.”
If you decide not to sell your house because you think it will be worth more next year, are you “manipulating” the housing market? Isn’t that how markets are supposed to work?
Ed…there’s little action in the housing futures market.
JDH says, “Charles, you’re quite right that we could measure delivered contracts as a flow, namely, so many barrels were delivered on such-and-such day or over the course of such-and-such week. But that would be a vastly tinier number than this 57 million barrels figure.”
Then, to be fair, you’d compare that to the number of barrels consumed on that day, James, which would also be a smaller number than the annual consumption figures. Furthermore, as we have discussed on these boards, only a few percent shift in demand is needed to drastically affect price.
I’m open to argument. My suggestion is to present the figures on a normalized (by units of time) basis or compare trends.
ed argues, “What if you choose to pump more rather than less oil, is that manipulation too?”
It’s a reasonable question, ed, but you should have at least considered my point that the Strategic Petroleum Reserve exists to manipulate price.
That might have led you to this broader consideration: certain economic behavior makes sense from the standpoint of a single small producer. When the price of wheat goes up, farmers plant more, for example. When economic behavior does not make sense from the standpoint of a single small producer, one has to suspect oligopolistic pricing. There is, as I point out, a history.
In the case of oil, there’s no question that (relatively inelastic) demand has been rising faster than supply, so we expect price to rise. But in such situations, there’s a lot of money to be made by having the price rise a bit more than economically rational behavior would suggest. My point is that one would have to be a fool to imagine that some people wouldn’t try to make it so.
And that is market manipulation.
Anonymous@2:14PM is, in fact, Charles.
Spencer wrote:
Some like to claim that speculation, or whatever, dampens volatility but I would argue just the opposite. It causes markets to overshoot and go to illogical extremes.
There are speculators and there are speculators. Those who enter the market following to make a killing from a trend may in fact be a force to increase prices or increase prices to an extreme, but there is the countervailing force of the serious speculator who plays the odds and who sees a market being over heated and so he invests in the down side. The dynamic of these two create the marginal price changes that we see in all economic sectors as they operate at the margin. But what too many fail to realize is that this speculation works on the down side as well as the up side. Spencer takes the position that the irrational speculator rules the market and so markets overshoot tops and bottoms. Others of us take the position that the rational speculator rules the market and they are a rational break on increases and decreases. It becomes a matter of opinion, but what I see on Spencer’s side is that the irrational speculator’s day are numbered while the rational speculator lives to make his living another day.
But additionally to hold Spencer’s view you must assume that there is a “real” price. My question is how is it determined if we do not have speculators working at the margin. The problem Spencer has is knowing the “real” price, but that is the job of the speculator. Remove him from the economy and you have no market or you have Fascist (not perjorative) economic price setting at an imaginary “real” price.
The action in oil this year is a result of the decreasing presence of pure speculators in the market. Not their presence, in any over-influential way.
Data clearly shows that Open Interest at the NYMEX has been on an eye-opening downward path, for over one year. When chatter about congressional action rose this Spring, Open Interest declines accelerated. All the action from 100-147 and back down again to 111 has the classic signature of a market bereft of information specialists, who provide the smoothing function. We are witnessing what happens when a market, with little to no spare capacity, is hit repeatedly by commercial users (buyers) and commercial producers (sellers) at random times, in a pattern than resembles car traffic jams. Neither of these specialize in information. One uses oil, the other produces oil. Their timing is neither good, nor the top consideration.
The re-classification of Vitol from commercial to speculator, in addition, is dumb. Groups like Vitol and others for years have come into the market, to try and help commercials (who as I said above are not traders) do their hedging (either buying or selling).
Show me a journalist writing about oil speculation and a faithful reader lapping it all up, and I’ll show you two people who only started watching, thinking, and analyzing the oil market sometime in the last 90 days.
Sheesh.
As usual, Hamilton is spot on.
Gregor
This link
says that total open interest in Nymex crude oil, futures plus options, is on the order of 3mm contracts. Cho claims that Vitol had positions totalling 59mm barrels of oil – that is 59,000 contracts at 1000 bbl/contract. A little less than 2% of open interest.
Of course we still need more information for a meaningful discussion. 59mm barrels may be a net number, or may only reflect futures and not options or vice versa, or may only refer to one contract, in which cases the true fraction is higher than 2%. On the other hand, some or all of those contracts are likely to be client business and/or hedged with other positions, OTC and ICE trades, etc – in which case the true size of Vitol’s speculative position is lower than 2%.
From the tenor of the article, I suspect the true fraction is lower than 2%, perhaps substantially.
DickF asked: Maybe they see speculators actually preventing prices from falling as quickly as they might. If so couldn’t the same dynamic work in holding down price increases?
In a January 1998 report, Matt Simmons made the argument that were it not for a small number of traders on NYMEX, price of WTI Lt Swt would have, during the mid-later 1990s, been higher.
[clip]:
Four years ago, crude oil prices plunged over a period of six months. Simmons & Company was among the first to identify the unwinding of the German company, Metallgesellschafts (MG) extensive oil contracts as the likely reason. We also suggested at the time that oil might surprise all the bears, who were predicting prices would either stay in a $12 to $14/bbl band forever or perhaps even fall to lower levels. We felt that, if we were right about the MG situation, it was a short-term phenomenon and oil prices would recover because the underlying fundamentals for oil were still strong as horse radish. (See Is MG the Culprit?, February 1994).
…
As we have pondered this, we were struck by the abnormally high short positions held by the large, non-commercial holders of oil contracts on the NYMEX. Non-commercial holders are classified as fund buyers and sellers and other large holders.
Their large short positions prompted us to review the past several years of data on the noncommercial holders of crude contracts to see if any meaningful patterns would arise. To our surprise, this exercise revealed that these owners appear to have an extraordinary influence on the price of crude oil. (emphasis in original)
(Matthew R. Simmons, Is Another MG At Work? (Or, What is Driving Down the Price of Oil?), January 27, 1998)
Charles considered that: in small numbers, speculators accelerate the adjustment of structural excesses. In large numbers, they become their own excess.
Which I agree with but might rephrase to say that speculators following a particular trend-following strategy can induce herding behavior among arbs ‘who may decide to ride the wave’ so amplify and prolong rather mitigate a price bubble.
To which I’ll add that since price formation takes place in the futures markets, there is no question that the trade is a (or the) ‘major element in oil prices.’ Nor is this a matter of speculation but (generally ignored) recent history.
JH, swaps dealers are not commercials and should never have been placed in that category, if only because it provided a false COT picture of position size and bias, something that became evident when the CFTC began breaking out Index Traders in a weekly supplemental for most of the ags (but not energy and metals).
Juan, the report you cite from Simmons&Co is unconvincing to say the least.
To paraphrase, S&Co find that over several years, in months when the crude price went up, noncommercials, that is hedge funds and self-described ‘speculators’, tended to switch from short to long, and vice versa in down months. The report admits that this does not prove causality, but says their conclusion that a small number of small players are determining the price of nymex crude – and making money at it, which presumably is the diagnostic for market manipulation – is intuitively obvious. The conclusion is not only not obvious, but utterly backwards. Indeed it’s the old commentator’s fallback: “The market closed higher today because there were more buyers than sellers.”
If we got ahold of Etrade account data for the last several years, I am certain that the same pattern would hold for day traders versus retirement accounts: over periods where GOOG went up, day traders tended to switch from short to long and vice versa, while big banks and funds would show a much weaker correlation. Does this mean that all those day traders in their basements determine the price of Google stock – or, for that matter, that day trading Google stock is easy money?
Of course every price move is not based on rock-solid news about fundamentals. The market incorporates facts, expectations, and order flow, as well as sunspots and Elliot waves on some days.
In contrast, the question of whether there can be too many noise traders distorting prices with herd behaviour is a valid one. My (semi-informed) opinion: not in the vast, vast, vast majority of cases, and certainly not in Nymex crude.
Wikipedia says it well: In fact, a market without noise traders will tend to break down, because prices in such a market will become fully revealing. Informed traders will not enter a market without noises, because it is impossible to profit from trading in a completely efficient market. Informed traders need the existence of noise traders to “hide” their trades and by trading on their private information, informed traders make profits. Through trading, informed traders gradually release relevant information to the market prices and together with the noise traders, they help bring the market back to equilibrium.
Some Behavioral Finance articles point out that the risk generated by noise traders can lead to limited arbitrage: thus, the presence of noise traders undermines the classical no-arbitrage reasoning. However, whether noise traders can survive in the long run, and if they can, how much of a pricing distortion they create, are still open questions.
A couple questions for thought –
Do you need market power to manipulate? How is marlet power defined? These answers would seem core to any manipulation discussion.
Further, it seems that a positive aspect of futures trading is “moving the price signal forward”. This would seem to prevent the eventual bubble peak/valley by incenting behavoir today – for example we see today’s gas prices reducing demand which lenghtens the time the commodity will be available in the future – based on future expectations.
New to the Blog so be nice…
Thanks
The cure for high prices is high prices.
All bubbles, once having burst, seem to follow the same trajectory, irrespective of the nature of the commodity or asset. We will see $75/barrel before we see $150.
Decoupling my arse.
If the market was only responding to consumption numbers, production numbers, and inventory numbers, would it have been as volatile as it has been for the last year. What has driven most of that volatility is SPECULATION about the effect of political and environmental events on the supply side.
An Israeli cabinet minister talks about attacking Iran, somebody at Goldman Sachs guesses what the effect would be, and oil goes up $10 in one day.
More recently, concerns about Russian-American tensions, coupled with some technical buying factors, drive up the market $6 in one day, and when reality sets in, it goes back down $6 two days later.
During the month of July, when the price was varying from $122 to $145 on the spot market, what percentage of total barrels delivered cost the buyer more than $122 and less than $145? And how many buyers paid much less because they had forward contracted at much lower prices?
So, for all you guys that said that $145 oil was based on supply and demand, were you recommending investment on projects that had a break even of say, $130 or better?
Those of us in business have to make decisions based on what we think our costs will be for energy for the coming years. Do we pay a premium price to replace our 12 mpg pickups with 20 mpg pickups, calculating that gas will be over $3.50 for the next five years, and therefore we can show a payback? Some of us in the real world have to make real decisions that have financial consequences and we would like to rely on the economists to give us some forecasting ability. Even Samuelson said in Newsweek several weeks ago that maybe the economists really do not understand what is going on in this “new economy”. It has often been said that when forecasting whether or not it will rain ten days from now, you can predict just as accurately as a weather man by just flipping a coin. I am getting concerned that so many economists are so wrapped up in defending their paradigms, that they cannot see the world for what it is.
Randy, I think the key uncertainty this year was how high prices had to rise before there was a significant response in the quantity demanded.
I’ve written a paper called Understanding Crude Oil Prices that might be of interest to you, though maybe it will just make you even madder. Among the claims I make there is that no one is very good at predicting the price of oil, and nobody should be.
JDH please understand that I am not mad, not at all. This is a great website. And I will read your paper.
I am just respectfully challenging the thinking of people like Krugman and Samuelson that the runup in oil prices is purely about supply and demand. I was enrolling one of my daughters in college yesterday, and I pulled out her econ textbook to refresh myself on the calculation for price elasticity of supply and demand. The problem I have been struggling with is that in oil I see a very small percentage change in supply projections, and the price of oil doubles. So if 1 million barrels a day is taken off the market because of some geopolilitical reason, the market has to ration the remaining supply, and price is the best way to do that. However, the guys at GS and MS predicting that oil will hit $150 or $175 per barrel seems to be pure speculation on their part. And yet the market moves after they make their prediction. I think there has become a herd mentality in the commodities markets and these guys can spook the herd. So if I am a hedge fund manager who sold short for October delivery, and these guys convince me there is a good chance that oil will move to $175, and I can lock in a purchase to cover my position at say $135, I might do that. My thinking would be that I have to answer to somebody if I do not lock in, it does go to say $160, and the somebody I answer to jumps on me and says “Miller, did you really think you were smarter than the guys at Goldman Sachs and Morgan Stanley??”
Gettting away from the markets to the real world, I work for a company that is one of the largest comsumers of plastic laminates in the world, and oil is a major feedstock for plastic laminate. We bid some jobs as far as a year in advance. If we had bid a job in summer of 2007 when oil was around $60, and the job was for delivery this summer, AND the price of laminate went up 50 percent, we are going to lose a lot of money on the job. But if we had factored in a price increase of that magnitude, we would not have gotten the job.
Your website, and other like it, are different than a lot of websites that might for instance discuss what is going to happen in pro football this year. I am trying to get a handle on market volatility in the commodities markets, because it is so disruptive to real world decisions. For instance, the volatility in the corn and soybeans market has driven a lot of producers out of the market, witness the fact that our nation wide cow herd is the smallest it has been since 1950, and sow managers are aborting pigs because there is no profit in feeding them. When corn prices go down, it will take quite a few years to get the cow herd back up to 2007 levels, and that will have an impact on beef prices for the next ten years.
So, you guys can really help us by increasing our understanding of market volatility, and getting to the root causes of that volatility.
Thanks for this website.
Charles,
Your analysis of housing leaves out several of the most important variables: new favorable tax laws, interest rates dropping from 18% to 6%, and household size decreasing while population increased.
If nobody pays cash for a house, then the sales price of the house relative to income is nearly irrelevant. Its ownership cost relative to income that matters.
If you scale the Schiller index by 30-year fixed rate mortgage payment at average rate by calendar year it is much less pronounced. Was the error on the part of RE speculators, or was it a failure of RE lenders to calculate risk premium on new lending standards?
I am not an economist but isn’t the price of oil is something that is agreed by the market participants based on their understanding or guesses of the supply and demand situation. Sufficient supply of oil does not necessarily mean lower price if buyers are anxious enough about not getting enough supply, they will be willing to lock in the supply at the high prevailing price which otherwise should be lower had the supply and demand situations been transparent.
Kevin, where on this chart–for the period of the 1990s to present, which is the subject of my post–do you see interest rates at 18%?
It’s fine to suggest that other factors are involved in the evolution of economic variables. One should, however, start the analysis from some point within the known universe.
Randy, in theory, the oil futures market exists precisely to help out with problems like yours. You could have bid on that job assuming $60 oil, bought oil futures at $60, and assuming laminate moves sufficiently similarly to crude, you would have little risk.
Or, to take the example of replacing your fleet of pickups, you can replace them, sell heating oil futures, and be guaranteed a cost savings.
The sellside research energy bulls have lost a lot of credibility. Some made the right calls on the direction of oil prices last year but many have now revealed themselves to be no more than mere trend chasers. It’s constantly the same mantra… supply is tight, EM is growing, etc.
One shop in particular had harped on $100 oil last year (when oil was well in 2 digits) based on their longer-term macro view. Yet now their updated call less than a year later is for oil to be at $150/bbl. What in the world changed so dramatically in the last few quarters for their oil target price to shift so dramatically by 50%?
Being on the buyside, you can almost see the sellside research folks trip over themselves trumpeting ever more outlandish estimates without any new substance. And they will be very right until they are very wrong, but the prominence they and their shops get in the news is what matters for trading and their businesses.
Unfortunately many non-commercial users of oil also move the curve which ultimately influences the cash price. I used to be firmly in the camp of fundamental supply-demand driving oil prices, but now am not so sure any more.
Going back to an earlier question, what is the best guess for how much oil in a given month sells at the current spot price, how much sells at the highest price for August delivery in the futures market, and how much sells for a price locked in last summer?
May be Mark McGrew sheds some lights here:
“….85% of the wells drilled in America are drilled by the little guys. 62% of the oil produced is from the little guys. Oil prices go high to encourage the little guys to drill. When there is enough oil in inventory, the price bottoms out, the majors move in and buy that oil for pennies on the dollar.
Pure unbridled greed is what determines the price of oil. And war or no war, it will go higher….”
http://english.pravda.ru/business/finance/106070-1/
It must not be forgotten that the market for oil is not a free market, the supply side is controlled by a cartel – OPEC. The degree of control that OPEC exerts over supply is greater when prices are high as the cartel’s pricing discipline tends to erode in periods where supply outstrips demand.
In a free market, higher prices result in higher production and lower consumption and prices tend to moderate. Such is not now the case as demand is at least static now and future demand will continue to grow. Supply on the other hand is controlled through OPEC, who have no interest in increasing supply, the cartel was in fact formed to regulate supply to support higher prices.
In such an environment any speculation has to be on the long side… the chance of supply responding to higher prices is low.
Member states of OPEC are more interested in diversifing their economies from oil supply dependence and cashing in their rapidly devaluing petrodollars for harder assets.
If it smells like a rat, it probably is a rat