10 pounds in a 1 pound bag

I was in New York City for a few days on business and took the opportunity to talk to a friend who knows his way around the financial world.  Inevitably the talk turned to the current crude price crisis. 

This is a potentially catastrophic situation.  If the price of crude continues to drive upward, we are all looking at the prospect of a radically altered world in which our daily lives will be very different and much more limited and in which the international scene will shrink in importance as countries turn inward in the search for stability and resources.

My friend is going to assemble the opinions of his knowledgeable contacts for a post on this subject but for the moment I would offe the following opinion.

The oil spot and futures markets are limited in size, limited by the actual amount of crude available within the timescape of the contracts.  Investor money from institutions, pension funds, hedge and index funds , etc. is pouring into those markets as it flees from other investments that are not appealing at the moment.

An old army saying held that it is not possible to put 10 pounds of stuff in a 1 pound bag.  Nevertheless, that is what all that investor money is trying to fit into at present.  Is it really a surprise that prices are steadily rising?

A solution to this problem is not apparent.  Since this is a process detached from short term supply, it would seem that there is no upside limit to how high the price per barrel may go. 

Someone had better do something soon.  pl

Comments

[JohnH]

Quick! Bomb Iran! Grab their oil! Bush's energy strategy worked in Iraq, so it will work twice as well in Iran.

When history judges Bush, its harshest judgement will be about how he knew the oil crisis was coming and did absolutely nothing but try to grab Iraq's cheap, abundant oil. If he had put many pilot programs in place for conservation, high speed rail, higher CAFE standards, etc. we would now be facing a much more hopeful future.

Talk about a failure of imagination--or being totally beholden to a few cronies...

[John Howley]

One of the underlying factors is the shrinkage of the relative weight of the USA in the world economy.

In the old days, an oil price hike would provoke recession in the USA and global oil demand would slow because we were the dominant market economy.

Nowadays, an oil price hike may lead to recession and "demand destruction" in the USA, but the rest of the world carries merrily on its way, buying and driving cars.

Only five percent of the Chinese own cars and the rest want 'em. If only another five percent of the Chinese acquire cars in the next ten years, that's a lot of new demand for oil, even if the cars are fuel efficient.

Like the other nations of the world, we must learn to adjust our own behavior to conform to the economic realities. Or not.

Borrowing a trillion dollars to pursue policies that the rest of the world doesn't like while increasing one's dependence on them for oil hardly seems sensible.

Particularly as most of the remaining oil reserves are under Muslim-populated territory, a "demographic" that is especially unhappy with our policies.

But, heck, we can make our own realities, right?

[zanzibar]

In todays world of crony casino capitalism money always gravitates to the rising asset.

When it was Wall Street credit enabling billion dollar bonuses and a windfall ATM for an income starved consumer it was the magic of financial innovation. Now when it is light sweet crude crushing economies the pressure is rising to do something. Yes, the shoe is on the other foot.

I hope the role of public institutions working on behalf of private interests are also investigated and exposed as part of this disclosure of how our "free-trade" and "free-market" system is currently configured.

[Jonathan House]

There are two (groups of) questions related to role of speculation in the price of crude oil include:

1. As there is no direct effect of speculation (however defined) in future contracts on the price of crude oil on the spot market, what are the possible mechanisms of an indirect effect?

2. Ignoring the question of mechanism, what evidence is there that speculation is or isn’t having an effect on price how might that effect be quantified.

I am of the view that speculative activity in futures contracts has had little if any effect on the spot market. Useful articles include Krugman’s NYTimes column and his blog including today’s column and his post on his blog both yesterday and today which are well sourced. (Links below)

Also particularly useful and well documented is the latest in a series of articles/posts by an energy banker who writes under the name of Jerome a Paris – I recommend it and it can be found at: http://www.eurotrib.com/story/2008/6/26/175824/093

The Krugman pieces can be found at
http://www.nytimes.com/2008/06/27/opinion/27krugman.html?_r=1&hp&oref=slogin
http://krugman.blogs.nytimes.com/2008/06/26/speculate-speculate/
http://krugman.blogs.nytimes.com/2008/06/27/matters-of-convenience-very-wonkish/

Jonathan House

[Jonathan House]

PS

I do not think your assertion that "The oil futures market is limited in size, limited by the actual amount of crude available within the timescape of the contracts" is true. The volume of trading of future contracts is largely independent of the volume of crude available on the spot market in the "timescape" of the future contract. To a first approximation a future contract is a two sided bet on a future event - the spot price at a certain time and thus the $ volume of the future market ranges from 0 to infinite.

JH

[WP]

During the 1970s, I was in volved in litigating GNMA futures contracts sold to Credit Unions. Billions and Billions of dollars of contracts were traded in a totally unregulated market. On every trade, the broker took a cut. The trading was completely dissaciated from any real GNMA pools or anything else. There were essentially no deliveries. In the discovery process, I was able to depose the traders at the brokerage house as to how they did the business. It was an exteemely simple operation that generated tens of millions of dollars of profit. The broker kept a notebook on paper sheets with two colums, buys and sells. Using a telephone bank, the broker would never confirm a trade until a buy was matched with a sell. As a transaction approached delivery, a credit union would "close" their position with another "buy" or "sell" and the requirement of delivery by anyone would simply go away.
Essentially, there was no relationship between the trading and the real GNMA. The only thing that was really happening was a trading of air in that almost sumk most of the credit unions in the US when the NCUA woke up and started requiring the credit unions to mark to market. The size of the market was limited only by the amount of money in the system. That same brokerage remains active in the present oil bubble.

These investors just keep buying from each other in a great circle unlimited by any reality of supply and demand for oil. As long as enough matched trades can be cobbled together, the dreamworld will continue. Sooner or later, someone will ask the question as to what the "trades" really are? A perfect collapse is certain

[VietnamVet]

Colonel,

Thanks for your post. The Oil Shock will turn our world upside down.

There is an Oil Bubble. All the money generated by the Fed lowering interest rates last August is floating around the world looking for investments that are growing; after housing burst and Wall Street crashed, the only place left is commodities.

There is also an oil war premium; and even a peak oil premium; but it is all based on Fear. There are no shortages, no gas lines.

To end Fear and burst the Oil Bubble, three steps must be taken:

1) End the Middle East neo-colonial wars to wipe out the war risk premium

2) Balance the Federal Budget to stop the dollar decline

3) Enact a National Transportation Plan and 10 year Program for Energy Independence to lower oil demand

Three steps the Republicans are incapable of doing.

[WP]

Another thought.

I do not think that the price of oil can avoid the law of supply and demand. The reality is that the price of oil is ultimately restrained by the cost of production (which is much, much lower thant the current price), the available storage, and the need to sell oil. At the spot market, someone is buying real oil and someone who has oil wants to sell it. The time will come when the storage facilities are full, all of the tankers are at sea and full, and the sellers will do their job of being greedy notwithstanding the futures price. The spot price will bid down because the price of producing even very expensive oil is much less than the price. At the current price, many previously unproductive wells and prospects become very profitable and their owners will bid to sell. Whether or not we are at "peak oil" or not, the reality is that a huge amount of oil can be profitably produced at these current prices that otherwise would never appear on the market. Ultimately, the production incintives will produse a glut. The law of supply and demand never fails when the technical cost of putting product on the market is relatively low compared to the price. There may be a lag, but the production will come and the short-term glut will happen. This artificially high price resulting from the huge influx of speculative cash into the futures, not the spot market.

Do not be surprised if there is a political response as the oil glut grows. Iran already has at least 14 full tankers idling in the Gulf that they cannot sell.

War is a great tool of the monopolist to keep prices artificially high. One may even look at the Bush Administration as one of the most highly successful administrations ever because it has effectively kept the competively low priced Iraqi and Iranian oil mostly off of the market for years. To be able to sell high-cost-of-production oil like most US domestic oil, it is essential to keep the low-cost producers like Iran and Iraq out of the market.

For an amusing piece about one recent bubble, go to Youtube and search "Bird Fortune Subprime" Soon, the oil market will be much like the subprime market. There is simply too much money spinning around that must be invested.

[Curious]

As usual the DC insider is trying to come up with solution that should be implemented last cycle of problem now, while next bigger problem is growing.

It is not possible to pick a fight with Iran, rattling the cages while at the same time expecting oil price to climb down.

It is not possible to fight inflation while handing out cheap money.

It is not possible to rebuild consumer confidence, specially in housing, while at the same time screwing average consumer wallet. (bankruptcy law, energy costs, tax regulation, credit card law, bickering about spending)

By september we will reach critical point. (third quarterly report is in)

It will be worst than current quarterly report.

All negative fundamentals that create current situation are still at work. Why would anybody expect things will get better?

[FB Ali]

No, the hike in the price of oil is not in itself a "potentially catastrophic situation" which would lead to "a radically altered world".

If you want to visualize a real catastrophe and a radically altered world, read :

http://www.tomdispatch.com/post/174949/mike_davis_welcome_to_the_next
_epoch.

It outlines "the chaos that could soon grow exponentially from the convergence of resource depletion, intractable inequality, and climate change".

And, it seems to be coming much sooner than most of us realize.

[Nicholas Weaver]

The other thing is the "this isn't speculation" camp actually has a potentially better model:

In the short run, demand is very inelastic.

In the short run, supply is very elastic, up until you start reaching global production limits, and then becomes very inelastic.

Thus rather than a classic line or curve, the supply line in the supply v demand curve is very vertical and then has a sharp point where it shifts to very horizontal.

Thus we could POSSIBLY be looking at supply and demand curves like this:

http://www.icsi.berkeley.edu/~nweaver/sdcartoon.gif

Where going from D to D' on demand has little effect on prices (how much more oil did we consume between 1985 and 2000 without a significant effect on prices), but going from D' to D'' can see prices shoot up stratospherically, with just a very small increase in demand.

[otiwa ogede]

I find it hard to understand how any initiative can effectively stem the rising cost of crude in the face of the Bush administrations belligerent policies in the key crude producing regions of the world. Coupled with the need to deflate the value of the dollar in order to wage overseas wars, and have an expansionist foreign policy it's clear that the price of oil is headed in a direction that nothing short of a broad strategic undertaking can prevent.

In other words withdraw from Iraq, and full spectrum diplomacy with Iran.

[Cujo359]

I hadn't thought about this before, but it makes sense. Much of the economy is in the tank right now for various reasons. Oil is one of the few growth industries right now, except maybe for bankruptcy law.

And yes, I sure don't see a way out of it, either. It's beyond the ability of any one government to control, and the UN sure isn't going to fix this.

[nathan kirk]

In any discussion of oil prices, the author should state his beliefs about human causality in global warming. If the belief is that humans are causing it, then high oil prices are a god-send. And given that a significant portion of the electorate has that belief, then high oil prices are seen as a mixed blessing, not unmitigated danger.

[Paul]

Pundits like to say that the great American public has collective wisdom. Poppycock!

The American public is a herd of cats. They cannot agree on the time of day, and they barely react to major catastrophy. Katrina held their attention for a couple of days but they soon returned to their ball games and beer drinking.

If (and it is perhaps too much to hope for)the public collectively decided to stop using petroleum products for a week or two, the price would fall significantly and quickly.

The speculator/traders (those within the same circle) understand the stupidity and laziness of the American public and they are making their bets on the "business as usual" basis as do most Ponzi schemes. Boycotts work.

[Mark Logan]

There was 6 hours of testimony to the House sub-committee on Energy and Commerce on Monday. It's available on C-Spans site.

Parts 1 & 4 outline that "oh, so clever game" the Col. previously mentioned. Clever indeed.

It seemed highly probable there will be bipartisan support for the closing of a few loopholes currently being exploited in regulations intended to limit volatility in the energy market. I could not get any indication on how long the revision process might take, but several of the experts did predict that once in place, quite rapid and significant effects.

Anybody wishing to skim through this might wish to
view part 4 as a general recap. About an hour.

[Cieran]

Re: Nathan Kirk's excellent comment:

In any discussion of oil prices, the author should state his beliefs about human causality in global warming.

I'll heartily second that notion, and add a couple polemical thoughts to the mix...

First, it's not a question of "beliefs" as to whether global warming is being caused by human activities. We either subscribe to the fruits of science or we don't, and all the best science says that human activities are indeed a contributing factor. We don't yet know all the details of that contribution (the predictive results are notoriously ill-conditioned), but the general outline is clear, and the science is sound, regardless of what certain corporate shills may assert to the contrary.

And for those who don't believe in the associated science, they should simply and honestly demonstrate their disbelief by never checking the weather forecast or getting on an airplane (or for that matter, by driving a car, because the science of fluid mechanics that governs engine combustion is a close sibling to that which predicts the near- and long-term reactive behaviors of the atmosphere) .

Only when this class of Luddites fully disassociate themselves from the fruits of said science do they get to voice their "beliefs" to the contrary without attendant hypocrisy. Like those who supposedly believe in creationism but who would prefer to utilize the latest developments in antibiotic technology, these folk demonstrate that their stated beliefs reside only from their lips forward.

Second, sound risk management principles require us to pay much more attention to the environmental damage that the wanton burning of fossil fuels produces. Given that the downside risk of climate change includes "seriously damaging the world we leave to our children", even the slightest chance of said risk would require us to act with infinitely more prudence than humanity has so far exhibited.

In other words, the oil under the Middle East doesn't belong to the U.S., and it doesn't belong to Iraq or Iran, either. It took tens of millions of years to create, and since the human race has been around for only a tiny fraction of that, the notion that it belongs to a few generations of our kind is both laughable and hopelessly solipsistic.

[Jose]

The current crisis could have been prevented if we had planned for it, look at these two articles from Wikipedia:

http://en.wikipedia.org/wiki/Alternative_fuel#Other_fossil_fuels_and_the_Fischer-Tropsch_process

http://en.wikipedia.org/wiki/Oil_shale#Reserves

Starting alternative fuels programs combined with reduction in demand will help correct the problem in the long-term basis but there is no immediate relief in our futures.

Just imagine what a strike by Israel and/or the United States on Iran will do to the price of oil and the World Economy.

This article shows the changes already taking place, really interesting:

http://www.washingtonpost.com/wp-dyn/content/article/2007/11/09/AR2007110902573.html

[William R. Cumming]

And of course this is facetious! Offer statehood to the Provinces of Canada (except for Quebec which will be set free so that we may continue to party and eat well a la francoise in N.America). And if they decline well you know the answer? The states of Mexico with oil also of course! And if they decline well you know the answer! And if you don't know the answer just read a neo-cons conversion in Robert Kagan's "Dangerous Nation." His slim new volume called something like "End of Dreams" might also be of interest.

[David W.]

This is the what deregulation and swallowing wishful thinking about markets has wrought, and it carries with it ramifications about other crucial resources as well--what if such corporate control and speculation turned to, say, fresh water supplies?

[Buffalo]

Oil shale is not oil. It is a sedimentary rock which can be made to yield a substance from which synthetic fuels can be produced. Little enough was known about it in the 1970's that it was a plausible strategic weapon, and proponents often speak of the immense area and difficult terrain under which it is located as if that were some kind of advantage. A better name for it would be Barnumium.

[Cieran]

David W:

what if such corporate control and speculation turned to, say, fresh water supplies?

Already going on here in the U.S., courtesy of oil interests such as T. Boone Pickens and the Bass family. Pickens is trying to speculate in water transfers from the TX panhandle (no great source of sustainable water supplies) to cities to the south. The Bass brothers are notorious for their attempts to corner key California water supply markets.

If anybody thinks gas lines are bad, just wait until you can't get potable fresh water.

And this whole mess is created courtesy of legal shenanighans where federal and state water laws are written without due regard for the much less forgiving laws of nature.

[Cold War Zoomie]

An old army saying held that it is not possible to put 10 pounds of stuff...

Stuff?

I remember a different word.

[William R. Cumming]

Post-script for David W! European companies are heavyily investing in buying up US water supplies.

[jonst]

PL,

The only thing I found even remotely hopeful in your post (don't get me wrong, I agree with all or most of it)is you acknowledge the possibility that the nation will concern itself less with "the international scene [which] will shrink in importance as countries turn inward in the search for stability and resources". I hope you are correct. It is the only answer, in the long run.

William, and David W,

The water war is heating up here in Maine. It is not getting the publicty it deserves, but people are starting to wake up now.
http://www.commondreams.org/archive/2008/06/26/9901/