"There Will be Blood" Part 2 - Futures speculation and the price of crude

"The commission said it is investigating potential abuses in the way crude oil is purchased, shipped, stored and traded nationwide, but did not reveal details. Also on Thursday the agency announced a handful of other initiatives designed to increase transparency of U.S. and international energy futures markets.

For example, the trading commission said it will immediately require monthly reports from institutional investors who manage funds designed to mimic the price of crude oil and other energy futures. The goal, the agency said, is to identify the amount of such index trading and to "ensure that this type of trading activity is not adversely impacting the price discovery process."

The agency also said it has reached an agreement with its British counterpart and with InterContinental Exchange Inc.'s Futures Europe to expand surveillance of energy futures contracts with U.S. delivery points, including the benchmark West Texas Intermediate crude, which trades on the Nymex."  SFGate

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I have thought for some time that the recent catastrophic rise in crude prices is not directly related to long term supply and demand issues, although those are certainly there in the background.

No, there is a short term supply problem caused by politically motivated regional suppliers who have found it easy to toy with the spot market enough to encourage traders of one kind or other to drive up prices of future deliveries in what can only be described as a "tulip" scenario.  The announcement of increased surveillance of these traders and their allies in the business intelligence world will stress the "skin" of the bubble and we will see something interesting.  It has already begun.  pl

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2008/05/29/BUMG11068I.DTL

http://www.mcclatchydc.com/251/story/38914.html

Comments

[Helena Cobban]

Pat, I think that for crude prices as for food prices, two things are going on. (1) There are underlying market realities-- soaring demand and (in the case of food, dwindling supply because of among other things the whole biofuels fiasco-- related, of course, to crude prices, too.) (2)There has been a massive flight of capital out of all those shady financial instruments, mainly related to the overheated US real estate market... so since the collapse of that bubble, the fund managers have been seeking a handy place to park their $$, and seeing the interesting (from their viewpoint) prospects in the commodities markets they have been massively injecting their capital into them.

So yes, undoubtedly in food and in crude there has been a LOT of speculative investment recently. I have big doubts whether the CFTC will find anything significant that they can take action on, however. After all, ain't capitalism the American way?

[Curious]

It's the entire vicious cycle, with oil price part of the chain.

1. Bush is printing money like crazy (budget deficit, stimulus, war cost, bank bail out) The amount is not trivial and all these money has to be absorb by global economy somehow. But it simply can't. Not even the european and chinese economy can absorb them all after 3-9% inflation respectively.

2. on top of that the fed is setting the interest rate at 2% trying to bail out bank after the imploding sub-prime. At 3-5% inflation, no fool is going to put his money in bank. It will vaporize quickly.

3. so investor are dumping dollar and putting their money in all sort of commodities. Oil, silver, gold, wheat, base metal..anything that doesn't lost value.

4. nobody want to put in housing, land deal or stock, since a) price is depressed. b) US economy is imploding, thus stock market is not growing fast enough against inflation.

It's stagflation. On top of global economic realignment against dollar.

here is one example to feel the quickening collapse of banking. (This is handing out money. They are taking the useless real estate backed paper and swapping it with tax payer backed treasury. last year the number was only a third or so. The Fed now only have $300B of reserve.)

http://biz.yahoo.com/ap/080529/fed_credit_crisis.html?.v=3

The Fed said it will conduct three auctions in June, with each one making $75 billion available in short-term cash loans. Banks can bid for a slice of the available funds. It would mark the latest round in a program that the Fed launched in December to help banks overcome credit problems so they will keep lending to customers.

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So under nightmare scenario:

1. The banking system finally collapse. (due to various reason.)

2. Congress need to step in and assume all the debt. This will increase the budget deficit from $400 to about $5-700B/year. (definitely not sustainable)

3. The global market start dumping dollar at alarming rate. (it doesn't take much, $100-200B out of the 4T are released, we are toast. Dollar devaluation by $10-20%)

suddenly the war in Iraq cost will double or triple. (paying fuel, equipments, transportation, increasing troop pays)

The entire thing is not sustainable. Watch the number. Somebody better find a solution pronto before gas hitting $6/gallon.

[Patrick Lang]

Helena

American preference for a capitalist economic system has little to do with the existence or non-existence of speculative bubbles.

Such phenomena collapse of their own weight because the level of price is eventually not supported by reality. pl

[b]

Hmm - not sure what the Colonel is alluding too.

Iran parking crude on rented tankers?
The Saudis holding back some production?

Both happening now.

Still the big top is pure speculation. Future contracts have increased 40% over the last months.

The most serious offender here is the Fed.

After the dot.com bubble blew, it lowered interest rates and created a housing bubble.

After the housing bubble blew it again lowered interest rates and created a commodity bubble.

Every hedge fond and investment bank is having fun in the commodity pit.

The Fed literally kills people who can't afford food that goes up with oil prices.

It was obvious happen. I wrote about last Decenber and again in February.

http://www.moonofalabama.org/2008/02/deadly-reckless.html

[b]

The first time the Colonel posted "there will be blood" it was about Shia politics in Iraq. So what is trying to tell us now. That the gangs in Basra stopped exporting?

Hmmm ...

[Clifford Kiracofe]

Per tulipmania,

As I mentioned on a different thread, a senior official of a foreign multinational oil company told me several years ago that his company calculated speculators/hedge funds accounted for about $15 of the then $60 per barrel price.

I do not know the statistic offhand, but aren't a considerable number of hedge funds located in the Cayman Islands? And other 'offshore' areas?
http://en.wikipedia.org/wiki/Cayman_Islands

Are any of these funds cover operations for governmental (pick one) economic warfare operations?

"Free" enterprise? "Capitalism?"....or cloaked economic warfare waged by governments via supposedly "private" machinery ("proprietaries"), perhaps?

The "sanctions" against Iran at present are a form of economic warfare being waged by the US government.

So what are other governments up to?

Congress -- as usual -- has failed in its oversight role and its regulatory role...imparing our economic and financial security.

"Gentlemen don't open others mail" or engage in economic warfare? Come now...

[zanzibar]

Pat,

IMO, the crude market is not a classic bubble in that the average person is not speculating in it nor have commodity funds become a popular vehicle for the public to invest in. However, your point that there is a large speculative content to the recent price rise is an observation I agree with. If you notice crude futures recently were in contango usually a sign of an impending correction. Spot prices are already moving down relative to distant futures contracts. You will notice this relationship through the 90s and even as recently as late 2006-early 2007 as contango developed crude collapsed from $80/barrel to $50/barrel.

Part of the speculation it seems is about momentum investing - money flows to the rising asset. In addition there apparently is some real buying as China stockpiles prior to the summer Olympics while crude output has declined a few points.

But taken as a whole the global economic environment is certainly facing some stiff headwinds and our financial system is still in a precarious state. Unfortunately, our policy and practice of privatization of profits and socialization of losses does not allow the business cycle to work itself out. And the regulators recently seem to ignore enforcement of existing rules when it comes to large political contributors.

[jonst]

Helen,

I see govts running the gaunlet from Mercantilism, to Monachary, with professed socialists (Venezuela, and, to a lessor extent, Nigeria)and Fascists (Russia) in between,more than happy to participate, with the Capitalists, in the conspiracy that is the gray market in oil futures. In the end I just call them thieves.

[jonst]

By the way...for those interested in the alleged speculation going on:

http://www.mcclatchydc.com/251/story/38914.html

[J]

Colonel,

living in 'oil patch' one learns a few things that so many are not aware of, for example the barrel of that $135 per barrel oil, the poor saudis are only getting $3 or so per barrel, and it costs them roughly $.40 to bring that barrel to the surface.

it is also interesting and sad how the international petrol exchange in london and their speculators are turning everything upside down and ripping so many off in the process.

also did you know that our very own alaska crude that the congress 'prevents' from being allowed on our 'domestic market' even though the original intent of the alaska pipeline in the 70s was to send the alaska crude to our domestic market so we wouldn't be manipulated by foreign nation/london exchange's decisions to play the troll. instead congress makes sure that our alaska is prevented from entering our domestic market. and a real kicker, we (spelled u.s. via congress) are selling our alaska crude to canada who in turn is putting a markup on it and then re-selling our own alaska crude to u.s.. real irony don't you think?

if it were to come to the point where the only alternative transportation was to go back to buckboard and buggy, all i'd have to is saddle up and go.

just so you know, the mennonite and amish communities make some really nice buggies, and buckboards.

we the u.s. are sitting on so much oil and natural gas that is makes your eyes water. and that's not even getting into all the oil and natural gas that's sitting in the domestic shale deposits, and that really makes your eyes water.

there are a number of people whom in my opinion need to go to federal jail cells for their extortion/ripoff/speculations regarding oil and food.

maybe rep. maxine waters is right, it's time to 'nationalize' our nation's oil industry.

[Fred]

Pat,

I think that we would do well to remember the California electricity 'crisis' in 2000-2001 and the collapse of Enron. There strategic decisions to avoid power plant development and reliance on outside power generation (hydro-power from the pacific northwest), coupled with the lack of transparency in creating the trading rules during de-regulation as well as the outright manipulation of the market by constraining supply led to extreme rates, rolling blackouts and political upheaval, including the re-call of then Governor Grey Davis. (http://en.wikipedia.org/wiki/California_electricity_crisis ) I believe similar factors are causing a repeat of this experience in the oil markets, to the detriment of people around the planet and the enrichment of the few. (Only a small portion of this is caused by the strategic decisions such as refinery building and oil field development. ) Combined with this market manipulation are larger economic forces that are de-valuing the dollar and driving inflationary pressures in the US. One has to wonder just who was in attendance at the energy policy meetings hosted by Dick Cheney and just what was said. Why are those meetings so secret that the American people are forbidden to know the facts?
Fred

[meletius]

The Fed bailed out the commercial banks by allowing them to pledge their worthless mortgage backed securities to the Fed for more loans and by opening up the Fed's borrowing windows to unregulated investment banks (also accepting their worthless mortgage paper as collateral).

By obtaining funds from the Fed for these worthless bonds, and not having to eat their losses by being forced to sell them to raise reserves, the Fed has allowed these "banking" institutions to take positions in the commodities markets and create this disastrous bubble.

The goal, I think, appears to be to allow these institutions to make huge profits and regain their solvency on the backs of the world's citizens and poor.

And the Congress approves as far as I can tell, and doesn't raise a peep.

[Cloned Poster]

meletius, you took my post out of my thoughts, bubble upon bubble upon bubble, perfect storm for an Iran/Tonkin, incident..... the West's economy is burning alive.

[Mongoose]

"Puts" and "calls" and derivatives and derivatives of derivatives in securities and commodities have become so complex and arcane that I doubt that those who exercise these options truly understand them. I'm like Socrates (not my favorite philosopher) in the sense that at least I know that I don't know how all this stuff works.

I'd be shocked if these investigations and perhaps others (by Congress?) discover any nefarious activities--at least the issue will be so obfuscated by reference to "markets," and "supply and demand" that nefarious behaviors will be explained or, more likely, explained away to the "satisfaction" of the public (the word "public" itself seems to me to be on the verge of becoming an archaism.)

Primping and posturing are Congress' raison d'etre, especially given how secure most, but not all, congressional seats have become. The lack of sound and the absence of fury (save the blogopunditry) except for the occasional faux outrage of Senators and Representatives, regardless of which crisis is under discussion, is indicative of this sad state of affairs.

[rst]

I found the following articles helpful in tracking these issues over the past few weeks. From newest to oldest, and easiest to densest (densest?):

1. from an IMF economist and a Georgetown prof:

http://www.atimes.com/atimes/Global_Economy/JE29Dj02.html

2. two from F. William Engdahl:

http://www.atimes.com/atimes/Global_Economy/JE24Dj02.html

http://www.atimes.com/atimes/Global_Economy/JE06Dj07.html

[Steve]

I agree that the price of oil nowadays to some extent is primarily a result of speculation, and not underlying supply and demand.

IMHO, though, it's still the price everyone pays, regardless of whether the price is "real" or "speculated". And the economic effects are the same. Money is money.

What the speculated price means though is that in the short term is that oil supplies may not be as dire as is thought.

That's fine.

But I think it bodes ill to think that there is no long/medium term downside to what is an inevitable decrease in world oil supply.

Petroleum dependent economies should begin now to wean themselves off the oil teat. It can be done, and should be done. We have the capital and the intellectual capital to do it.

[JohnH]

Current market conditions certainly seem to lend themselves to speculation. Some reports allege that demand is exceeding supply by 2 MM barrels per day.

But the current price also discourages investment in new production by the national oil companies who control most of the world's energy reserves: their budgets are overflowing with manna from heaven without even having to part with part of the bonanza to invest in new production. And every barrel left in the ground today will be worth more tomorrow. So what's the urgency to produce more, particulary when they keep assuring us that there is plenty of supply on the market already. But it can only get worse unless they start investing heavily in new production.

So what are you going to do, invade and force them to produce more? Hmmm, we tried that once already. Unless, of course, Iraq is really producing a lot more than we know, which could be the case, since their wells are conveniently not metered.

As to the CFTC, I'd like to know where they get the legal authority to do what they propose to do, since Bill Clinton exempted them for federal oversight by signing the "Enron loophole" into law as his last gift to America in 2000. As a result, there is no legal way to know just what energy traders are doing. Zilch. They manufactured the California electricity crisis in 2001, so why wouldn't they repeat it on a bigger scale with oil?

Meanwhile, Hillary has called for closing the loophole, now that it's politically expedient. But whre was she when Bill signed it into law in the first place? Is the "Enron loophole" part of the legacy of "experience" she claims? If so, we can definitely do without that kind of pandering to oil speculators.

The real solution is transparency, so we have the information needed to identify the acutal problem(s). Unfortunately, none of the players seem the least interested in providing providing useable data, the Bush administration being as bad as the Saudis in that regard.

[whynot]

The price of oil isn't going up because the Fed has printing press running full steam and turned the dollar into a piece of trash. Or because demand is growing but supply simply can't keep it up. Or because we've turned the ME into a cauldron of death and chaos.

No, clearly the speculators are driving the price up to get us. Hey let's investigate them. Better yet, let's sue OPEC. Bailout nation, can't change the facts so they turn into crybaby nation.

It's all quite comical and sad.

[Patrick Lang]

whynot

Rubbish. People are speculating in oil to make money, the same reason people do anything in business. Are the Saudis willing to screw us a little to enable that speculation? You bet. Why wouldn't they?

Investigate the speculators? Sue OPEC? How old are you?

The oil bubble will collapse when the last speculator loses confidence in his ability to pass the risk on to a greater fool. pl

[Twit]

"The oil bubble will collapse when the last speculator loses confidence in his ability to pass the risk on to a greater fool."

I think this (i.e. a pyramid scheme) is an apt description of our country's collective mentality over the last few years. While not many are participating directly in the oil bubble, lots have gotten caught up in the IT bubble, the Kool-Aid fear bubble, the housing bubble, the Obama bubble, etc.

What are we, Albanians? (although at least they took to the streets...)

[Bobo]

What goes up must come down & Tulipmania are old adages when things get out of whack. For all I know it will go down to $10 or up to $250 a barrel, a year from now.

Some comments, from individuals who I think know what they are talking about this past week.

1. We could be looking at $7.00 a gallon for heating oil this winter.

2. The cost of Transportation will be changing Globalization at these prices. Goods from Asia will not be as competitive as in the recent past. Trading patterns will be radically changing in the near future.

3. Gasoline & Diesel consumption is down 5-7% in the USA but our excess products are being exported to Asia and South America in volumes never seen before.

Whatever these comments mean, it bodes ill will for you and I should these prices remain the same for an extended time.

[Curious]

Oil is at $125 today. So the price went up $10 then going down $10 within a week. That's 8%. I seriously doubt world energy demand fluctuate that wildly. Global economic growth is only at 3-4% annually, not 8% within a week.

It's hot money going in and out of commodities market. (The question: how come there are so much hot money sloshing around like never before? So much that it can affect global oil price to fluctuate 8% up and down within a week?)

[Old Bogus]

I agree with curious. Tracking the actual M3 money supply against commodity prices reveals an almost 1:1 correlation. The price of oil is not going up; the value of the dollar is going down.

It isn't speculation; it's insurance. Holding dollars is a losing proposition; buy SOMETHING!

[zanzibar]

Old Bogus

Dollar depreciation is only part of the answer. Crude has risen even in Euro, Yen and Swiss Franc terms although relatively less compared to the dollar price. So the underlying commodity has got more expensive. Part is due to tight supplies and strong short term demand - although refined product consumption is beginning to weaken in the US. The other part is clearly speculation. All speculation is not bad - speculators do provide market liquidity. However, since they are not interested in delivery of physical product and since humans tend to act in herds the markets also tend to wax and wane. Mean reversion is a good maxim - but forecasting the extent of the pendulum swing on either side of the mean is really unknowable.

[Cieran]

Fred:

One has to wonder just who was in attendance at the energy policy meetings hosted by Dick Cheney and just what was said.

One doesn't have to wonder. The folks at Judicial Watch FOIA'ed the government and got notes from those meetings that Cheney held many months before 9/11.

And what were these discussions about? Iraqi oil reserves!

http://www.judicialwatch.org/iraqi-oilfield-pr.shtml

Go figure...