More Speculation

Thomas Palley takes a contrary position on speculation and oil prices:

Beating the Oil Barons, by Thomas Palley: Over the past eighteen months, oil prices have more than doubled, inflicting huge costs on the global economy. Strong global demand, owing to emerging economies like China, has undoubtedly fueled some of the price increase. But the scale of the price spike exceeds normal demand and supply factors, pointing to the role of speculation – and underscoring the need for policy action to clean up the oil market.

Reflecting their faith in markets, most economists dismiss the idea that speculation is responsible for the price rise. If speculation were really the cause, they argue, there should be an increase in oil inventories... The fact that inventories have not risen supposedly exonerates oil speculators. ...

But, contrary to economists’ claims, oil inventories do reveal a footprint of speculation. Inventories are actually at historically normal levels and 10% higher than five years ago. Furthermore, with oil prices up so much, inventories should have fallen, owing to strong incentives to reduce holdings. Meanwhile, The Wall Street Journal has reported that financial firms are increasingly involved in leasing oil storage capacity. ...

Whereas oil speculators have gained, both the US and global economies have suffered and been pushed closer to recession. In the case of the US, heavy dependence on imported oil has worsened the trade deficit and further weakened the dollar.

This sobering picture calls for new licensing regulations limiting oil-market participation, limits on permissible trading positions, and high margin requirements where feasible. Sadly, given the conventional economic wisdom, implementing such measures will be an uphill struggle.

But some unilateral populist action is possible. A major form of gasoline storage is the tanks in cars. If people would stop filling up and instead make do with half a tank, they would immediately lower gasoline demand. Given lack of storage capacity, this could quickly lower prices and burn speculators. [uncut version]

Paul Krugman might respond with:

Iron Resolution, by Paul Krugman: Chinese steelmakers have agreed to a 96 percent increase in the price they pay for Australian iron ore.

One interesting point about this case is that, as I understand it, iron ore isn’t traded on an international exchange; trade takes place through bilateral deals between producers and consumers. In other words, there isn’t any easy way to speculate on future iron ore prices.

Yet ore prices are surging like oil prices. A bit more evidence against the speculative frenzy hypothesis.

Arnold Kling says:

Oil Speculation: Paul Krugman Mis-speaks, by Arnold Kling: Paul Krugman writes,

Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price.

He can't mean that. Think of the foreign currency market. If speculators bid up the future price of Japanese yen, then the spot price of Japanese yen will go up. And you won't see any particular pattern of inventories among currency dealers. The inventory issue is much closer to a red herring than to the decisive empirical data that Krugman maintains it to be. ...

My views on the oil market are almost the exact opposite of Krugman's. I believe that the futures price has to be the key determinant of the spot price. Because oil is a non-renewable resource, the oil market has to reflect expectations for demand and supply over the entire future time horizon, and those expectations ought to be embedded in futures prices. ...

I agree with Krugman that blaming oil speculators for the high price of oil is unhelpful. The politicians make it sound as though there has been a sudden outbreak of greed among oil speculators. Instead, there has been a change of expectations about future supply and demand. From what I can tell, there was no real news to cause this change in expectations. Either speculators were badly wrong six months ago or they are badly wrong today. It is more likely that they were wrong six months ago, but the probability that they were closer to correct then is far from zero. [Full Post]

Paul Krugman might follow this up with:

Various notes on speculation, by Paul Krugman: First, Friedrich von Schiller was right. ... Right now I see well-trained economists getting ... hung up on the financial relationships between spot and futures. Whatever you say about the futures market, it can only drive up the spot price by causing physical hoarding of physical goods.

Second, some ... have asked me why my inventory argument didn’t apply to the housing bubble. The answer is that a house is a durable good, which unlike oil, which you have to burn, isn’t used up by the consumer; what we consume are housing services — in effect, consumers rent houses, from themselves if they happen to be homeowners.

To see the equivalent in housing of what the oil bubble types think they’re seeing in oil, we’d have to have seen a sharp rise in rental rates. It didn’t happen. [graph]

Third, some people have asked what I said about the California energy crisis of 2000-2001, perhaps history’s greatest example of market manipulation. I first broached the manipulation issue in California screaming, written in December 2000. I didn’t really figure it out, however — I was still giving too much credence to the conventional wisdom about underinvestment — until The Price of Power, published in March 2001. The Real Wolf, published a month later, pulled it all together.

During that whole period, I was pretty much the only voice in a major news outlet even suggesting that market manipulation might be a central factor.

And here’s the thing: I applied pretty much the same reasoning to that crisis that I’m applying now. The only way market manipulators could have been driving up prices was by keeping physical supply off the market. And they were in fact doing just that: there was huge unused generating capacity, consistent with the idea of deliberate withholding. Some years later we would actually get hold of control room tapes in which Enron traders called plants and told them to shut down, and boasted about cutting off Grandma Millie’s power.

I’m still waiting for evidence that physical withholding is going on in the oil market.

Update: And Paul Krugman might also respond with:

Speculation and Signatures, by Paul Krugman: I’m trying to get my own thoughts on the oil stuff clear; so for the econowonks, a tiny theoretical paper for your enjoyment and/or detestation.

Comments

[save_the_rustbelt]

"But the scale of the price spike exceeds normal demand and supply factors, pointing to the role of speculation – and underscoring the need for policy action to clean up the oil market."

I am just a simple accountant and I figured this out. So why can't some of the economists "get it."

[Fred]

Paul sez: >I’m still waiting for evidence that physical withholding is going on in the oil market.

And he'll wait forever if the withholding is taking place at the level of the oil exporters.

save_the_rustbelt sez: >price spike exceeds normal demand and supply factors

If supply is totally inelastic because we're dealing with a cartel, and demand is also quite inelastic, because it takes time to reorganize the economy to work around the factor of expensive oil, then all it takes a slight cut in supply (deliberate cutbacks by the cartel or cutbacks due to wars and similar factors) or a slight increase in demand (by the chinese) to cause prices to skyrocket.

[anne]

http://krugman.blogs.nytimes.com/2008/06/24/various-notes-on-speculation/

June 24, 2008

Various Notes on Speculation
By Paul Krugman

First, Friedrich von Schiller * was right.

* Against stupidity the gods themselves contend in vain.

[Mark Thoma is being diplomatic, very diplomatic.]

[anne]

Arnold Kling?

I prefer: ''He was thinking, but she could tell he wasn't good at it.''

[Fred]

Actually, there is one good policy that would fight the high prices. Whenever the government detects that oil prices are going up, raise taxes on oil. This will cause the demand to fall somewhat faster than it would have otherwise, thereby bursting the bubble somewhat faster and more strongly. Once the prices collapse, cut taxes, thereby giving back to the users what was taken from them previously. Oil exporting goverments are far less tolerant of severe boom/bust cycles than the United States end-users. The United States response is for disgruntled consumers with time on their hands to hyperventilate on blogs. Whereas the oil exporters might face revolutions if prices collapse and they can't afford high social spending. So if we can credibly threaten to accentuate the boom/bust cycle, the wiser or more frightened oil exporters (think Saudis) will probably do what they can to avoid p*ssing us off and triggering this taxation policy. In other words, they will produce more so as to push prices down lower than they would have otherwise. This assumes there is a cartel that is withholding production, naturally. Something the Peak Oil types deny.

Note that this policy I am recommending is is the exact opposite of the screams of tax cuts on oil whenever oil prices skyrocket.

[ndd]

The full text of the Barron's article calling an oil bubble and for prices to return to $100/barrel is now online in full:

http://online.barrons.com/article/SB121400286913193263.html?mod=b_hpp_9_0002_b_this_weeks_magazine_home_top

I encourage those who have not read it yet to do so. Again, I am struck by the difference in outlook between economists and traders.

[Ben P]

It strikes me that Krugman and Kling are both right.

Kling is right to say that it the expectation of traders that accounts for the price of oil, but so what? That has always been the case. And they are the basing their current case on the best available information we have. Kling makes it seem as though that speculators have somehow arbitrarily driven prices up - independent of any evidence. But this clearly hasn't happened. In 2007 and into this year, demand has continued to increase faster than supply. Until this situation is rectified, prices can - based on fundamentals - go higher exponentially, to infinity. And they would if traders believe there were no possibility of this happening.

It strikes me as hilarious that people who would not call for, say, price controls on any number of other items find it acceptable when it comes to oil.

To my mind, to argue that "speculators" are the problem is the same as arguing that capitalism is the problem. That should give people something to chew on - both free marketers and interventionists. A case could certainly be made for controlling the price of oil at a government level. I don't agree with this case because I don't think maintaining a fossil fuel economy at all costs is a goal worth having. But this is no different than, say, arguing any good - housing, medical care, whatever - is so important that its price shouldn't be determined in the market.

Something to think about.

[Oil In the Ground]

"The only way market manipulators could have been driving up prices was by keeping physical supply off the market."

The futures market is not keeping supply off the market, since futures are an insurance product. Countries that have a lot of oil in the ground are the ones keeping physical supply off the market. Figure out why they are doing so, and you will have your answer.

[Fred]

>to argue that "speculators" are the problem is the same as arguing that capitalism is the problem

economists have been in pretty much universal agreement for over a hundred years now that government intervention is a good thing with regards to natural monopolies, and the oil cartel is certainly that.

[hari]

Mark is trying to corner the *speculative bubble* without passing blame to anyone. And that I consider it not only *just* but also *correct* (as I explain below).

My own reading of Pauls work on trade policy always convinced me that he's still one of the best in his trade...and will be recognized (sooner than later) by my adopted country (if you understand what I mean).

The mystery of discovering exactly what's driving the crude futures price will surely be revealed by Paul himslef, and notwithstanding his remarks about Calif Energy Crisis (Enron loophole!), I suggest the issue of physical inventory is a non-issue for traditional commodity traders when they witness (simultaneously) what's going on in terms of *volume* on Futures Market - and (me thinks) latter is more likley a result of recent capitalist greed (yes!) gone wild
on hi fi sector. This is very much a non-traditional behaviour in a commodity market....

[SGC]

Cross posted from previous thread:

"Right now I see well-trained economists getting caught up in an equivalent fallacy — the doctrine of immaculate hoarding? — because they’re getting hung up on the financial relationships between spot and futures. Whatever you say about the futures market, it can only drive up the spot price by causing physical hoarding of physical goods."

I think the problem with his logic is that he thinks the spot price is simply set by physical demand and physical supply today. I by contrast think that there can be a different market-clearing spot price for every futures price (i.e. today's demand and supply are both dependent on futures prices). Anyone who thinks that future expectations are determinants of both demand and supply today will see no need for physical hoarding to explain how futures prices can affect spot prices (i.e. the relevant demand and supply diagram for the spot price is the one used to explain the Fisher equation).

Differences in underlying models undoubtedly explain ndd's comment: "I am struck by the difference in outlook between economists and traders".

[SGC]

I should have noted in my post above that this is pretty much what Kling is saying.

[hari]

It is interesting to note, in this regard, Barack and his economic staff seem to be following our commentary on speculation and crude prices. BO has gone on record that socalled Enron Loophole must be revoked to allow the regulatory regime to impact specualtion on commodity markets.

[roger]

Actually, it would be very simple to burst the bubble. The bubble is being driven, in the short term - which is, after all, what we are talking about - by an insecurity premium. There is a lot of fear of a broader war breaking out in the Mideast as Israel and the U.S. have both made vague, menancing gestures towards Iran.

Iran has a lot of oil.
Iran also has a lot of sanctions. The flow of oil from Iran has to go through a lot of impediments.

Solution: peace with Iran! If the U.S. government recognized Iran's government and pledged not to support or foment regime change, and came out strongly against bombing Iran, the bubble would burst. I would expect to see oil drop immediately on the futures market.

This is so simple that it will never be done, due to the irrational commitment of a D.C. establishment to the impossible goal of re-colonizing the Middle East. It does have the advantage that it would be to the advantage of the vast majority of Americans, but American foreign policy has never been about anything but benefiting a small oligarchical circle of Americans.

Because it is rational, and because almost every instance of a quick price run up can be correlated with insecurity news from the Middle East, and because it goes against the hegemonic story the press wants to tell, the insecurity premium is almost never discussed in thumbsuckers about the price of oil. A nice instance was the announcement, recently, of the Chinese government's decision to selectively allow oil price raises, which was supposed to signal the blessed demand destruction we are all waiting for. The price of oil went up that day. Great puzzlement by the thumbsuckers, who seemingly didn't notice that, on the same day, Israel announced that it was conducting a big military game that just happened to mimic the bombing of Iran.

It is weird that, after five years of war, Americans seem to have forgotten we are at war. Of course, since it isn't across their landscape, they don't think it is really important. I think they think otherwise in the Middle East.

[Richard H. Serlin]

Arnold Kling writes,

"Because oil is a non-renewable resource, the oil market has to reflect expectations for demand and supply over the entire future time horizon."

This is not really true. Oil itself, specifically, is not renewable (in less than millions of years), but what really matters is the kind of energy oil provides. You can't create more oil anytime soon, but you can create more of the kind of energy it provides, like through nuclear and solar linked to plug-in hybrids and pure electrics or mass transit.

A great article on the realistic and cost-effective potential of solar in the not far future, by a noted scientist, is in the December 2007 issue of Scientific American, "A Solar Grand Plan", available at:

http://www.sciam.com/article.cfm?id=a-solar-grand-plan

[Richard H. Serlin]

I should add that the plan outlined in the Scientific American article is projected to cost $420 billion in government subsidies from 2011 to 2050, to achieve a solar network that would supply 69 percent of the U.S.’s electricity and 35 percent of its total energy by 2050.

$420 billion over 40 years may seem like a lot of money, but it's a fraction of the cost of the Bush/Republican tax cuts for the rich over that period, tax cuts that John McCain wants to make permanent – Yes, more and bigger yachts and mansions would be better for the economy and the globe than a vast solar network. Ignore what scientific economics says, turn off your brain, push out any thought longer than a slogan, and shout with fervent glee, pure free market, pure free market, pure free market!

[roger]

ps - oh, I guess I should say that the insecurity premium has been amplified by the Fed's policy of insuring the liquidity of the financial sector at the same time that the mortgage market that had provided the profit edge of financial institutions suddenly dried up. The great oil price spike is the result of a bet on future conflict radically squeezing supply, amplified by the actions of the Fed.

This isn't a matter of economics - but of detection. Looking at the period between January 2007-June 2007 and the period January 2008-June 2008, what is different? The intensity of the threat against Iran - the actions of the Fed.

[anne]

Mark Thoma has several times asked about the extent to which oil prices are being driven by war and the threat of war. I would even like to know what sort of insurance rates there are on specific Middle East oil exploitation projects and resulting shipments. What of the continual intimations of supply threats, and lack of field development, and transport risks? What of Nigeria, on another risk level?

[macburger]

Now, if Krugman can look at this chart and explain what happened in August 07 - change in demand/supply that caused prices to go up, I'll buy his argument.

Here is the 2 year price chart of Aug 08 crude

http://www.marketwatch.com/tools/quotes/intchart.asp?symb=CL08Q&sid=2228931
&dist=TQP_chart_date&freq=1&time=9

You can look at the chart of iPath S&P GSCI Crude Oil Total Return Index ETN (OIL) here http://www.marketwatch.com/tools/quotes/intchart.asp?symb=OIL&sid=2395435&dist=TQP_chart_date&freq=1&time=9

Again, the price shoots up after Aug 07

Look at June08 crude contracts - same story.

Can Krugman explain this? Otherwise, his models are junk in this real, messy world. The markets are not the perfect systems that he pretends it to be, on which he bases his "no speculation" thesis. Especially the crude oil market

So why does he vehemently carry on this argument, when his models and data could be all junk, when compared to reality?

Oh, the Fed started its cutting spree after Aug 07. China existed before Aug 07, so did India.

[anne]

"I guess I should say that the insecurity premium has been amplified by the Fed's policy of insuring the liquidity of the financial sector at the same time that the mortgage market that had provided the profit edge of financial institutions suddenly dried up."

Say what?

[anne]

Richard H. Serlin:

"Arnold Kling writes,

" 'Because oil is a non-renewable resource, the oil market has to reflect expectations for demand and supply over the entire future time horizon.'

"This is not really true."

[Oil company executives were using this argument in 2002; not really true, to be kind to the dears.]

[hari]

If Israeli/IDF attacks Iranian nuclear sites with 100 (US) jet fighters with a view to obliterate it - I suppose the Strait of Hormuz will be totally blocked by Iran - Gulf crude supply comes to an end.

That's one scenario of how geopolitics can affect speculation on hydrocarbons supply and futures market.

[ndd]

Some snippets from the Barron's article linked to above:

There is also speculation China has been hoarding diesel fuel ahead of the Olympics in August, in order to cut the use of coal for power generation around Beijing in the hope of cleaning up the city's notoriously polluted air. Once the games are over, China will go back to burning cheaper coal, the story goes.....

[snip]
[Note by me: If the hoarding is going on in China, or at sea in tankers (as has been speculated elsewhere), would Prof. Krugman know about it?]

The dollar's slide and the Federal Reserve's neglect of the greenback have supported commodity prices, oil in particular. But Fed Chairman Ben Bernanke and his colleagues finally seem to have realized that the Fed's aggressive easing actions since last summer, which dropped the key federal-funds rate to 2% from 5.25%, may be fueling global inflation. If the Fed moves to lift rates later this year, as financial markets anticipate, it could buttress the dollar and spur an exodus of speculators from the oil market.....

[snip]

inventory data may be misinterpreted as a sign of oil scarcity, though it is more a function of the recent state of the oil market, in which futures prices were below spot prices, giving refiners little incentive to maintain excess supply. If the Saudis sell enough oil to drive down spot prices relative to futures prices, refiners and others will be induced to buy and hold more oil in inventory....

[snip]

OIL-MARKET EXPERTS ACKNOWLEDGE THAT commodity-indexing strategies employed by endowments, pension funds and other institutional investors have helped push up prices in the past year. Such investments are thought to have totaled $260 billion as of March, up from $13 billion at the end of 2003.... Some $55 billion may have flowed into commodity investments during the first quarter alone....

Managers of leading university endowments, including those at Harvard, Yale and Princeton, in recent years have generated outsized returns from investments in hard assets, prompting other investors, such as the giant California Public Employees Retirement System, with over $200 billion in assets, to attempt the same. Calpers is upping its commodity exposure to $7 billion from under $500 million....

[snip]

Though little noticed, short-covering by independent oil and gas producers might have contributed to the recent strength in oil and gas prices. U.S. exploration and production companies ... have hedged an average of about 40% of their 2008 production by selling oil and gas futures, options or derivatives, according to Credit Suisse analyst Jonathan Wolff. As prices have surged, the hedges have slipped underwater, and some producers have sought to unwind their money-losing bets.

[Fred]

>Though little noticed, short-covering by independent oil and gas producers might have contributed to the recent strength in oil and gas prices.

Now if anyone should know what a "fair" price is for oil and gas, wouldn't it be these producers, as opposed to the manager of a university endowment fund, who gets paid a salary and who, to paraphrase Keynes, is always better off losing money by doing what everyone else is doing rather than making money by going against the herd?

Another thought: to have a futures market, someone has to sell future delivery. Speculators can sell what they don't possess, but wow is that ever risky when the ultimate producer is a cartel. But for the producers, selling is no risk, but rather a hedge. My gut feeling is that, far from unwinding short bets, what is happening now is that producers are making short bets. And who is taking the long side of these bets? All the dummies who've swallowed the peak oil theory. There is going to be a lot of blood on the ground if and when the price ever falls... Meanwhile, the producers are rolling in cash. It wouldn't be too hard to make soft-money bribes to a lot of columnists in order to stoke the peak oil theory. As in million dollar a year consulting contracts for journalists who've shown good behavior over the past few years, in order to encourage the others. And more money to pay off Republican politicos, to keep them from messing with the situation.

[muirgeo]

Why is the idea of an oil bubble so hard to believe? The financial wizardry of Wall Street and Enron style accounting seem to make bubbles from just about anything. It seems to be the a great factor in wealth inequality as far as I can tell.

From last weeks senate testimony some experts claimed as much as $50 dollars of the price of a barral of oil was related to speculation and loop holes created in 2001 by a bill snuck into law as a late night rider by Phil Graham.

I'm no expert but this is a huge issue and it's amazing no one seems to have the answers.

[muirgeo]

Michael Greenberger (Former director of the Commodities Futures Trading Commission) testimony on oil speculation.

http://www.youtube.com/watch?v=zbdtTGYQBMU&feature=related

[me]

"Why is the idea of an oil bubble so hard to believe? "

Help me understand how Saudi Arabia pumping 200,000 extra barrels of heavy crude that no one wants counteracts this,"June 22 (Reuters) - Oil companies and industry sources have detailed about 944,000 barrels per day of shut-in Nigerian production due to militant attacks and sabotage.

This represents more than 30 percent of the West African country's installed output capacity of around 3 million bpd."

Do you understand that refineries are paying a $5-6 premium for light crude? Is that a bubble or isn't there enough light sweet crude to go around.

Every producer in the world has been producing less, Russia, Norway. Mexico, Nigeria, Iraq, Venezuela. So where the hell is the 'bubble"?

Not to mention China and India and the Middle East using more.

[Ben P]

Here's a post from an informed source pouring some water on the "speculation" hype.

http://davidpascoeblog.com/2008/05/10/the-big-lie-about-oil-speculation/

"The truth is that speculation in oil futures adds almost nothing to the price of oil because futures trading is a zero sum game. It is like a poker game in which money is won only by others loosing. At the end of the game the same amount of money is on the table; it has merely changed hands.

Perhaps most importantly, the total amount of speculative trading (that is, hedge funds, etc) is only a tiny fraction of total contracts bought and sold by producers and refiners. Therefore, their impact could not possibly be large when you realize that annual world oil sales total about $3.4 trillion dollars.

The actual sale of oil takes place in a global auction in six major centers around the world, which are logically the major refining and distribution centers, in which thousands of trades take place simultaneously. These are completely free markets and are not “rigged” simply because it is not possible to rig them. The market is simply too large and diversified for that to happen. Keep in mind that in these auctions there are actual sellers who have oil to sell, mostly government-owned oil companies. Most of the buyers are independent oil companies, primarily refiners.

The actual sale of oil does not take place by means of futures contracts, but rather spot market contract sales. These contract sales can be for immediate delivery, or delivery at a future time, in which case they are called forward contracts. What distinguishes forward from futures is that forward are binding commitments to make and take delivery. With futures actual delivery almost never takes place. Contract sales are for “cargoes,” that is ship or barge loads of oil or in some cases amounts delivered via pipeline.

So, what is the futures market all about? Its about hedging one’s bets on future price. Futures serve as a price signal about where the price is likely headed, and most importantly for actual oil traders, futures trading serves the function of leveling out both gains and losses; in other words futures trading actually stabilizes prices for traders. To blame those who speculate with futures is plain wrong."

[me]

You need to understand that globalization means there is more to the world than the US. Tune out Fox Noize. For example check out this slide.

http://paul.kedrosky.com/WindowsLiveWriter/TheAgeofScarcity_BB23/slide2_2.png

[Ben P]

I should also add, again for emphasis: the data for 2007 indicated that demand was higher than supply, and represented a continuation of a trend in that direction.

However, 2007 was the first year (at least since the 1970s) when demand outstripped supply, although the trend was in place for several years.

This also is related to the recent IEA (major global energy forecasters) suddenly turning much more pessimistic on at least the medium term for this supply/demand equation.

Further, it also comes on the back of what looks like the terminal decline of Mexican and North Sea oil (not insignificant sources of oil supply). Britain has just become a net importer of oil for the first time in 30 years, Mexico likely will within a decade. It is also possible that Russia has reached its peak productivity, as too with Venezuela (at least in terms of conventional oil).

Further, a number of projects expected to offer salvation in the early part of this decade have been delayed and the ultimate expectation of what they will produce has been significantly downgraded - this is particularly true for the Caspian Sea/Central Asian region.

In general, major discoveries are becoming very rare.

Add in things like geopolitical tension - not just in Iran, but also regarding Nigeria, a significant producer. Iraq is also underproducing and remains very unstable for a variety of reasons.

And of course, sky rocketing third world demand - which is in many cases heavily subsidized.

In sum, you have something of a perfect storm. I think it is possible that the price contains a bit of speculative froth, but nowhere near what the likes of Masters is suggesting (who , BTW, knows nothing about the oil industry).

So in sum, you have:
1) skyrocketing third world demand, from overheated economies with fuel subsidies (50% of all petroleum consumption in the world is government subsidized)
2) declining production from a number of important fields, with some previously important suppliers now becoming net importers
3) disappointing returns, both in terms of new fields discovered and the ability to pump from what has been discovered
4) geopolitical problems, particularly with regards to Nigeria, Iraq, as well as the Iran situation

Together, these factors have contributed to the last 6 year run up. Remember, the current spike must be viewed with relationship to the broader bull market trend.

[ken melvin]

Given the decline of the dollar, if I were a producer, I'd want a least 50% more for my oil.

[MG]

Lots of interesting points raised here.

Roger's "insecurity premium" is always a factor in oil markets especially when there is little excess capacity. But this doesn't rely on participation by speculators. If commercial players expected supplies to be cut off they would attempt to build inventories which would send prices upward. Presumably, stocks would eventually increase, unless a series of supply (Nigeria) and demand (China coal shortages) shocks interfered.

Increases in the demand for inventory is also consistent with SCG's point about spot prices not being set exclusively by physical (flow) supply and demand.

Finally, Macburger's Fed-related timing argument is hard to refute. Lower interest rates do appear to have played a role.

[Fred]

>I think it is possible that the price contains a bit of speculative froth, but nowhere near what the likes of Masters is suggesting (who , BTW, knows nothing about the oil industry).

You don't need to know anything about the oil industry to understand there is something awry. If the fundamentals call for $130/barrel, then why would anyone sell for $30/barrel, which is what the price was back in early 2002, which is AFTER the 9/11 attack? The only reasonable answer is that none of the producers was smart enough to have foreseen the growth in Chinese and other emerging market demand back in 2002. That might be partly true, but it seems pretty obvious to me that this demand is especially vulnerable to high prices. Given that the supply and demand curves for oil are so inelastic, once that Chinese demand abates, due to high prices, we'll see a collapse in oil prices. The correct term for this situation is commodities boom rather than speculative bubble, though bubbles and booms look the same. Also, both speculative bubbles and commodities booms are always followed by busts. This oil boom will be no exception.

[Bill Jefferys]

"Fred says...

"Actually, there is one good policy that would fight the high prices. Whenever the government detects that oil prices are going up, raise taxes on oil. This will cause the demand to fall somewhat faster than it would have otherwise, thereby bursting the bubble somewhat faster and more strongly. Once the prices collapse, cut taxes, thereby giving back to the users what was taken from them previously. "

I agree with this, and it would not be hard to implement. Right now, federal fuel taxes are excise taxes, paid by the supplier. McCain (and Clinton) proposed eliminating this excise tax temporarily, but the problem is that it's likely the suppliers would have pocketed most of it.

The better approach would be to eliminate the excise tax and replace it with a sales tax at some percentage, to be collected directly on each gallon of fuel sold. Almost every pump is computerized, and this would be easy to implement (consider: every gas station already sells stuff, subject to sales tax, in every state except ones like the benighted New Hampshire; it cannot be difficult to add to the software to collect a federal sales tax as well. If this is too difficult, let the states collect it and rebate it to the feds.)

With a sales tax, when the price of the fuel goes up, the tax goes up, and when one goes down, the other goes down, all automatically.

I would propose a sales tax of 100%, which would probably allow the government to counteract externalities like global warming by wise investment in alternatives, and infrastructure support like bridges and highways (which still need support since that is what the current federal excise tax is supposed to fund). Alternatively, much of it could be rebated to taxpayers through income tax/social security tax/direct rebates or other means. Or, the tax could be introduced on a schedule over a number of years.

[don]

I think speculation may have caused oil prices to rise, but if so, I don't think this was a bad thing. Consider the following. No one knew what the price of oil would be in the future, so producers were happy to settle for the market price. Along came 'speculators' who could see that the future price was set to jump to a much higher level than the spot price. They thus bid up the price of future deliveries in their 'side bets.' Suppliers were informed by this and adjusted by keeping some of their oil in the ground, so the spot price went up more than it otherwise would have. Instead of the sudden price increase set for the future, some of the price increase was transferred to the present. Thus, 'speculators' may have caused the present price to rise, but they did this by ameliorating the sudden price increase that was set for the future. They didn't store oil after it came from the ground, but they caused the oil producers to cut back on production.
It would seem hard to prove or disprove this story, as we can never observe the counterfactual. That is, we can't see the oil production that would have occurred now and in future without the speculation. Also, it relies on speculators informing the oil producers, but that may not be such a stretch. As Fred noted, unless current prices are completely whacko, the oil producers were pretty stupid about the value of their product in 2002.

[reason]

Kling is not noting the difference between a stock and a flow. Krugman has noted the difference.

I don't understand this from Palley:
Furthermore, with oil prices up so much, inventories should have fallen, owing to strong incentives to reduce holdings.

He should be more specific. If refiners think that crude prices will rise further they should surely maximise their inventories?

Nowhere do I see the logic of asset management by suppliers invoked. If suppliers think prices are now to high (i.e. they will fall in the future), then they should increase output now. Conversely, if they think prices will rise further in the future then they should withhold production (all this is logical behaviour without collusion). What we have seen is price discovery by suppliers. There were incentives in OPEC to exaggerate reserves and production capacity (game theory within OPEC). As it starts to become clear that supply is limited, rational behaviour within OPEC goes from cheating (producing more) to supply constraint.

[hari]

ndd - ref to Barrons article is a takeoff on Reuters study in May which more or less listed almost all non-traditional speculators leveraging their bets on futures crude market.

With a pseudo-name like *reason* there is very little or no reason(able) logic in your arguments since yesterday. There is no supply constraint either with Opec cartel or non-Opec suppliers (eg. Norway, Russia).

The real constraint on supply is (anticipated) political reaction to this speculative bubble...sooner or later the bubble will lead to a path to fundamentals, as Mark rightly indicated above.

[hari]

From a geopolitical perspective, I sort of like *roger's* intervention (above) to sue for peace with Iran! It's not a fools-paradise, but the idea is worth exploring (after GWB exits).

Recall Iran is today a net importer of gasoline products - with hardly little developed refining capacity on the ground because US oil companies were forced out of the country after the fall of Shah. Gasoline rationing is a serious political problem for the current leadership in Theran.

So, if one can facilitate some radical shifts in the geo-political environment and bring Iran out from the *cold* into current globalized world market, there is no hard or fast rule to believe that it won't be a win-win policy.

A country with +3000yrs of cultural heritage cannot be isolated by the (stupid/racist) whims of a *diktat* from GWB and his cohorts, me thinks.

[ndd]

This is Yves Smith of Naked Capitalism in support of Palley and contra Krugman:

This is not definitive, but the fact that refiners are getting squeezed is not consistent with the notion that crude prices are driven by end market demand.

Similarly, Krugman has made much of the argument that if oil prices were too high in relationship to supply and demand, you'd see inventory buildup. But that is in a simple economic model with idealized supply and demand curves, not in an oil market with two places to store inventory, namely, above ground or below ground.

Smith is a trader, not an economist. Once again....

[reason]

ndd..
But only the suppliers can

Hari...
I don't understand your post, and I don't like your ad homonim attack. You haven't addressed my arguments. Why do you think there is no supply constraint (and particularly with regard to Norway - Russia and Saudi Arabia are arguable but NORWAY)? Why all of a sudden are OPEC driving prices higher when they didn't do it before (since the 1970s)? Your own posts make no sense to me.

[reason]

ndd.
To complete my half completed sentence - only the suppliers can choose to keep the oil in the ground. And in that case it is not speculation it is asset management assuming they think the price will continue to rise (and only they can know what the supply situation really is.)

Hari...
you should stop calling people names and start to argue on the basis of factual information. If you don't like my argument about the incentives facing suppliers then please show me where it is wrong.

[ndd]

reason:
Understood, here is a little more fleshing out of Yves Smith's argument:
Although easiest of the three, oil storage has been historically inelastic, no matter the price... Over the last 4 years (and for most of my trading life) forward stocks have always hovered between 50 and 55 days -- storage is expensive and limited, and just not efficacious.

This is why, at least in my view, that supply arguments are often overblown in oil pricing theory -- supplies remain closely aligned to demand and rarely overrun -- as OPEC members have time and again explained but are ignored....

[snip]

The data demonstrate that companies accumulate incremental stocks oil only if it is profitable to do so. Since May, it has not been profitable....

[snip]

returns to storage for crude oil were positive through the second half of 2006 and the first half of 2007. Since the end of May 2007, though, returns have been negative. Logically, one would expect stocks to have accumulated during the second half of 2006 and the first half of 2007 and then be liquidated from June 2007 forward.

The data on inventory accumulation and liquidation confirm this hypothesis.

[snip]

Recently ... the financial market’s effect on oil and the rest of the economy has become painfully apparent. In particular, the subprime crisis has caused many lenders to withdraw from the commercial paper market. In turn, the cost of borrowing has increased, raising the cost of holding oil stocks. At the same time, buyers who had lifted forward prices to a premium over cash prices have liquidated positions, in part to obtain cash. This has made it expensive to hold inventories and so stocks have dropped.

Thus oil inventories cannot be viewed as an indicator of whether market prices are too high or low; their level is a function of multiple factors.

I don't want to mislead in my references and quotations to pieces contra Krugman. I think his point about hoarding is excellent. At the same time, it does seem that hoarding can be hidden out of view, and we would not know about it now.
Also, Krugman's theoretical point ought to be borne out procedurally in the markets. When you have a guy in a three piece suit giving an expensive powerpoint presentation with lots of graphs in the home office, and the guys and gals in the trenches out in the field tell you that's not what they are seeing day-to-day, I sense a problem. And I suspect its the guys and gals in the trenches who are probably on to something.
That's why I keep harping on how traders seem to see the situation very differently from economists.

[reason]

ndd...
So what you are saying (or rather Yves Smith is saying) is that unlike say grain where the decision to produce is made many months before sale, oil is only pumped when there is a definite buyer there for it. I understand that. But while OPEC is a swing producer, it is still only one producer among many. Given that the price is so high why are suppliers grabbing the opportunity to get a greater slice of the market by offering more supply? A lower price would surely mean more demand. And if demand is so weak that no more needs to be produced, why is the price so high? You still haven't explained the dynamics in the forward/spot market.

[ndd]

reason:
if demand is so weak that no more needs to be produced, why is the price so high? You still haven't explained the dynamics in the forward/spot market.

I won't pretend to have anything even remotely close to expertise in this. But isn't "the dynamics in the forward/spot market" exactly what the Jesse's Cafe Americain post was explaining?

[reason]

Well no - they were talking about metals which are easy and cheap to store. Different kettle of fish.

[ndd]

Reason, the Jesse's post submitted that the futures market in energy should operate the same way as the futures market in metals (with which that author had more familiarity). Can you provide a link or an explanation as to how the two futures markets operate differently?

[reason]

ndd...
I reread that article and really there is no conflict with what Krugman is saying, I think they are misunderstanding him because he is an academic and sees practical circumstances and logical consequences as two different things. A futures contract (as against a forward sale) IS a bet. He did not say in a well functioning market that forward prices don't influence opening spot prices, (or that in turn spot prices don't influence short term futures). He just said that the two markets are not DIRECTLY connected. So speculations on futures exchanges don't DRIVE spot markets independently from supply and demand on the spot exchange. Naturally buyers and sellers expectations drive both. If a speculator wanted to drive up prices on the spot market then they would have to influence either supply or demand. Supply normally will be increased by and increase in price and demand reduced, so speculators wanting to increase the price will have to reduce supply and increase demand by buying and holding.

It is true that in the short term expectations of accelerating price inflation (rather than merely higher price) could have perverse effects (by encouraging suppliers to wait for a higher price and buyers to buy now rather than later) but this cannot go on indefinitely. It may be that this is what is happening, but such a process cannot explain the whole of the last 5 years.

[anne]

http://krugman.blogs.nytimes.com/2008/06/25/dangerous-populists/

June 25, 2008

Dangerous Populists?
By Paul Krugman

Martin Wolf calls for *

"abandonment of the silly idea that price jumps in oil or food are the result of wicked 'speculation' – a fantasy promoted by dangerous populists across the globe."

Hmm. Who are these “dangerous populists”?

Well, elsewhere in the FT there’s an article titled “U.S. senator seeks clampdown on speculation in oil markets”, which quotes Joe Lieberman saying that speculators are a

"significant contributing factor to the economic distress now being felt by American consumers every time they stand in the grocery store checkout line or pay for a fill-up at the gas pump"

Joe Lieberman, the Huey Long of Greenwich!

And let’s not forget those wild-eyed, shaggy-haired leftists at National Review, who have been telling us that high oil prices are a bubble that’s about to burst for more than 5 years. **

By the way, the FT article on Lieberman mentions that

"Some observers say lawmakers have not explained how speculators or pension funds are boosting prices or why the prices of raw materials such as iron ore, rice or coal - in which speculators have limited access - are also booming."

I’m delighted at the promotion. I used to be one of Those Who; now I’m Some Observer.

* http://www.ft.com/cms/s/0/6459fb74-420b-11dd-a5e8-0000779fd2ac.html

** http://www.nationalreview.com/nrof_leuffer/nrof_leuffer-archive.asp

[anne]

Against stupidity the gods themselves contend in vain.

http://www.earthpolicy.org/Updates/2008/Update72_data.htm#table14

January 23, 2008

U.S. Fuel Ethanol Use, Grain Production, 1980-2007

(Million Tons)

1980 1 of 268
1985 7 of 345

1990 9 of 310
1991 10 of 278
1992 11 of 350
1993 12 of 257
1994 14 of 353

1995 10 of 275
1996 11 of 333
1997 12 0f 334
1998 13 of 347
1999 14 of 332

2000 16 of 340
2001 18 of 321
2002 25 of 294
2003 30 of 345

2004 34 of 386
2005 41 of 363
2006 54 of 336
2007 81 of 414

2008 114 of 400 (Projection)

[anne]

Against stupidity the gods themselves contend in vain.

http://www.earthpolicy.org/Updates/2008/Update72_data.htm#table4

January 11, 2008

World Grain Production, Consumption, and Balance, 1960-2007

(Million Metric Tons)

1960 824 815 8

2000 1,843 1,857 -15
2001 1,875 1,902 -28
2002 1,822 1,909 -88
2003 1,862 1,934 -72
2004 2,043 1,990 53

2005 2,017 2,019 -2
2006 1,992 2,043 -51
2007 2,075 2,098 -22

[anne]

http://www.earthpolicy.org/Updates/2008/Update72_data.htm#table13

April 9, 2008

World Grain Yield Annual Increase by Decade, 1950-2007

1950-1960 2.0%
1960-1970 2.5
1970-1980 1.9
1980-1990 2.1
1990-2000 1.2
2000-2007 1.2

[ndd]

Anne, I'm not exactly sure what you are driving at here, but are you suggesting that the oil market and the grain markets are reflecting the same fundamentals? Because the overarching story of why the oil market is behaving the way it is, usually boils down to two words: "Peak OIl!"

So, in addition to "Peak Oil!" did we simulatneously also manage to hit "Peak Corn!" Peak Wheat!" "Peak Gold!" "Peak Copper!" "Peak Everything?!?"

Against the arrogance of those who label people with opposing positions as "stupid" the gods need cot contend, because the vice is open and obvious.

[anne]

http://www.earthpolicy.org/Updates/2008/Update72_data.htm#table11

January 19, 2006

World Irrigated Area, Total and Per Person, 1960-2003

(Million Hectares - Square Meters Per Person)

1960 134.7 444

1990 245.2 463
1991 248.6 462
1992 254.9 466
1993 258.1 465
1994 260.1 462

1995 263.7 461
1996 266.0 458
1997 269.8 459
1998 271.4 455
1999 274.1 453

2000 276.3 451
2001 274.9 443
2002 277.2 441
2003 277.1 436

http://www.earth-policy.org/Books/Seg/PB3ch04_ss2.htm

June 4, 2008

Falling Water Tables, Falling Harvests
By Lester R. Brown

Scores of countries are overpumping aquifers as they struggle to satisfy their growing water needs. The drilling of millions of irrigation wells has pushed water withdrawals beyond recharge rates, in effect leading to groundwater mining. The failure of governments to limit pumping to the sustainable yield of aquifers means that water tables are now falling in countries that contain more than half the world's people, including the big three grain producers—China, India, and the United States.

Most of the world's aquifers are replenishable, so that when they are depleted, the maximum rate of pumping will be automatically reduced to the rate of recharge. Fossil aquifers, however, are not replenishable. For these—including the vast U.S. Ogallala aquifer, the deep aquifer under the North China Plain, or the Saudi aquifer, for example—depletion brings pumping to an end. Farmers who lose their irrigation water have the option of returning to lower-yield dryland farming if rainfall permits. But in more arid regions, such as in the southwestern United States or the Middle East, the loss of irrigation water means the end of agriculture....

[anne]

Ndd:

"Against the arrogance of those who label people with opposing positions as 'stupid' the gods need not contend, because the vice is open and obvious."

I know, I know, but where is the speculation?

[reason]

Rapid growth in the consumption of real resources by China in particular (growth in the developing world is relatively resource hungry) is meeting supply constraints. To some (varying) extent resources are substitutes for one another. And oil in particular is used in many production processes. What we have observed is in this respect is hardly surprising. Yes people are speculating, but this is surely a chicken and egg story - do the resource shortages come first, or the speculation about (on) them?

[Cynthia]

The fact is that we can do something about oil speculators, but there's not a damn thing we can do about the fundumentals of oil. While we can put a stranglehold on oil speculators, the fundamentals of oil are out of our hands.

So it's nothing more than wishful thinking to believe that flighty speculators (not well-grounded fundamentals) are driving up the price of oil. After all, it's much easier to live in a fantasy where there's no end in sight for oil than face the grim reality that oil is nearing its end!

[anne]

Cynthia:

"So it's nothing more than wishful thinking to believe that flighty speculators (not well-grounded fundamentals) are driving up the price of oil. After all, it's much easier to live in a fantasy where there's no end in sight for oil than face the grim reality that [inexpensive] oil is nearing its end!"

I would only add a provisional word.

[anne]

There is a peculiar arrogance about us, that failing to think of or act in case of possibly expensive oil for decades, what is essential now is to deny that there just might be fundamental reasons for the fuel price increases we are experiencing. This is especially interesting in light of the determined selling of the idea by warriors that war in the Middle East was not just right but useful in assuring us cheap fuel forever. So, the warrior class after the invasion of Iraq was immediate and continual in denying that fuel price increases could be meaningful. So too, oil company executives for years denied the possibility that price increases could be lasting (not to mention denying the contribution of fuel burning to global warming).

[anne]

So that we understand how much conditions have been changed, as fuel prices have climbed and food as well. Not only is ethanol production gobbling up as much as 1/4 of our corn crop, raising prices on the way, and we are the dominant world producer and exporter of corn, but corn which is even subsidized for ethanol use is so wildly profitable that there is no reason to invest in alternatives to corn ethanol such as to the often discussed to no avail switch-grass.

The corn-ethanol lobby has immense influence in both political parties, but was especially important in influencing Democratic primaries and will retain the influence if there is a Democratic Administration as well as if there is a Republican Administration. What then if ethanol production has been both contributing to increasing food prices and is suspect in environmental terms?

[reason]

Let me clarify my position here. It is not true that we have peak everything. There is no doubt in my mind that some commodity production can be increased substantially (especially grain production). I walk past fields every day which have started producing grain only in the last 12 months (they were effectively unused before that). But I also have no doubt that it is unlikely that crude oil flows will increase much from current levels, especially the light sweet crude that refiners like and whose price is what we see quoted. So I don't think all commodities will move in tandem intermediate term. That said, demand for commodities is growing faster at present than supply is, so we can expect an uneven picture of price rises (naturally ESPECIALLY in the in trouble USD).