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.
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Jim-
I find it hard to believe that an arbitrage opportunity would last for 24 seconds, let alone 24 hours.
Hurricane Ike shut down both producers and refiners, but not consumers. Gas prices went up.
However crude oil prices dropped and gas never reached a shortage condition. There are only a few scattered anecdotes about stations without gas.
Sort of implied that crude prices dropped because more refining was hit by the storm than production, causing a temporary oversupply of crude. Since consumption was roughly flat, refined inventory must have picked up the slack.
So now we have refineries conditioned to refill inventories and restock customers, while supplies are still coming back up. Crude price bounces back, but gas prices went back down.
Duh.
Rich, this required physical arbitrage– actually selling oil out of inventory in a particular location– and not just anybody can do it.
“more refining was hit by the storm than production, causing a temporary oversupply of crude.”
That was my theory too, and I’m sticking to it. Maybe there wasn’t a whole lot of uncommitted oil in storage at Cushing left; the amount in storage there declined sharply the week before, and possibly last week again.
You might’ve noticed that oil had a big move up on Friday as well – when gold was down. Gulf of Mexico oil production being down by 90% for so many weeks was bound to push the price up a bit eventually. Whether concerns about inflation and market risk were the single-largest factor strikes me as entirely questionable, though no doubt that’s important too.
However crude oil prices dropped and gas never reached a shortage condition. There are only a few scattered anecdotes about stations without gas.
The Charlotte area, for one, is still short on gas. I looked yesterday and about half the stations have no gas at all. I have seen no stations with midgrade or premium for at least two weeks, so I’m essentially running on fumes.
Maybe it’s Soviet-style hoarding, but it’s odd that premium would be hoarded and not regular.
Dan,
I’m 2 hours away in Raleigh, and the Kangaroo stations have gas of al types.
The Nov. Price rise was indicative of the several financial/dollar factors and some S/D issues…
BUT, the October Contract? Hmmm….
Wonder if the few contracts that were traded in such desparation had something to do with those 6 mos. contracts struck in April, or the 90 day ones struck in July at $147 when our two most enlightened WS Firms who created the “passive long investor” concept and commodity index funds had a bunch of ‘swaps’ that were in fact previous ‘longs’ at $130 or so.
Wonder what they will due on Nov.’s close date’s trades?
Hmmm….
What happened to oil markets on Monday?
Panic flight from the dollar into a hard asset in anticipation of another inflation binge.
JDH:
It is instructive to look at what happened in the crude cash markets over the past couple of days.
The following is the cash spread between October and November deliveries. This represents prices for actual physical deliveries.
9/18: + $0.34
9/19: + $1.80
9/22: + $5.00
9/23: + $1.30
So there was an effect in the cash markets, but not as big as in the futures market. There appears to have been an arbitrage opportunity, but it was not exploited away. Why not? Mostly because it isn’t that simple to physically trade crude. There isn’t really a spot market for trades, because all ownership trades have to be co-ordinated with deliveries, and large delivery mechanisms like barges, tankers and pipelines all have to be booked at least a couple of weeks in advance. The only readily available transportation mechanism for crude trades is the tanker truck, which carries a miniscule amount. So that $5 spread probably applied to a very small amount of crude.
So the answer is, there is too much friction in the physical markets for quick arbitrage profits to be realized.
I’m looking forward to talking to you in Cambridge in November.
you mean prior to expiration those oil speculators caused the price to go down to an undeliveralbe price? those rats!
they probably thought they were shorting morgan stanley and said oops!
Hurricane effects and short-covering are popular explanations for the recently observed sharp volatility in the oil prices.
Street pundits are talking about “emotional trading” in the equity markets or what we might refer to as increased uncertainty about the direction of future financial and real markets.
Some have predicted that these massive injections of liquidity will help prop up oil prices. That could work as a short-term trade but I would expect oil prices measured in nominal US dollars to decline much lower than previously anticipated prior to recent financial events. Gross fixed capital formation (Investment)–the most volatile part of expenditure flows–is about to take a significant hit, and demand growth for oil should follow.
Confusion and uncertainty reign.