Speculation About Oil

Last Spring, some Democrats and liberals (Ed Schultz and Bernie Sanders spring readily to mind) who have somehow resisted the enlightenment of unfettered free markets suggested that high oil prices are due to speculation.

Noah Smith took this subject on, asking the question: “Do speculators cause oil and/or gas prices to rise above their “natural” or fundamental level?” Noah’s take is that speculation is innocent, and he cites some corroborating experimental evidence. I’m a big fan, but this time I think Noah missed the point. First, I’ll state right up front that futures markets play a vital role in allowing the producers and first-line purchasers of various commodities to be able to stabilize their cash flows and construct realistic business plans. So – yes, futures markets are a good thing.

On the other hand, when quizzed by Senator Cantwell on why big, trans-national oil companies should continue to receive multiple billions of dollars in tax breaks, Exxon CEO Rex Tillerson admitted that a good estimate of a supply-demand determined price (considering the price of the next marginal barrel) for crude is in the range of $60 to $70 per barrel.

For reference, here is a chart and data table for Brent crude, going back to 1987.

At the depth of the global recession, on Boxing Day 2008, when the world was coming to an end, the price dipped below $34. Be that as it may, with recent prices back over $100, we’re looking at premiums over a rational value estimate of from 60 to 85%. Let’s just call it 75% for convenience.

Now, back to the point that Noah misses, and that Senator Cantwell suggested. What is the effect of unregulated speculation on the price of oil? The Senator estimates 30% activity by concerned stake-holders, and 70% by profit-seeking (in my view rent-seeking) speculators who are playing the market for a profit. The graph on Pg 5 of this study (18 Pg. pdf) suggests a ratio closer to 45% commercial and 55% non-commercial interest. Also it looks like open interest, which had been relatively flat for years, increased by a factor of 6 or 7. This financial tail chasing, aided and abetted by deregulation, is a direct manifestation of the asset misallocation that, in my view, is the real cause of The Great Stagnation.

A look at the oil price chart shows 10 to 15 years of more-or-less flat line in the range of $20, followed by a classic bubble and post-bubble bounce. As an aside, this is typical Elliott wave behavior. I can easily trace a five wave rise to the peak, and what looks like the recent end of a counter-current B-wave since the Dec. ’08 bottom. If this is anywhere near correct, the price of crude a decade from now will be eye-poppingly low, and fundamentals be damned.

As an example of a classic bubble peak, consider the Dow Jones Industrial Average during and after the 1929 crash.

But let’s look at fundamentals, anyway. Global GDP growth since 1980 has been in the range of 2 to 5%. Let’s generously call it 4%. The price of crude in 1990 varied from about $15 to $41. Let’s generously call it $30, on average.

If we compound $30 at 4% for 21 years we get (are you ready for this) $68.36. And this is based on generous numbers.

Not a rock-solid price algorithm, for sure, but it ought to be in the ball park. Maybe it’s just a coincidence that this number corroborates Rex Tillerson’s off-hand estimate.

Maybe it’s another coincidence that oil prices took off after Phil Graham pushed through legislation (signed by Billy-Bob Clinton at tail end of his battered second term) that exempted some speculative trading from certain regulations dating back to the Commodities Exchange Act of 1936. One of these exemptions was removing this requirement: “Either way, both the buyer and the seller of a futures contract are obligated to fulfill the contract requirements at the end of the contract term” from oil and other energy products. In case this is not crystal clear, it means that back in the bad old days of regulation, a contract had to be closed by executing the opposite transaction from the original prior to expiration, to avoid either supplying or receiving the physical amount of the contract. But after deregulation this requirement was not in force for oil.

Maybe it’s another coincidence that Morgan Stanley became the largest oil company in America. Plus, another point that Noah explicitly missed is that big, speculative finance entities did, in fact engage in physical hoarding. Here is a 20 month old news flash.

Oil traders are taking advantage of a market condition known as contango, in which the price for future delivery is greater than the price for spot (immediate) delivery. If the difference between the two prices is more than the cost of chartering an oil tanker, traders stand to profit. The difference between the price of crude oil for June delivery and the price of crude oil for July delivery is more than $2.00 a barrel; that’s enough to defray the cost of chartering a very large crude carrier (VLCC), which holds about 2 million barrels of oil and, as of April 23, cost $43,876 per day, according to the Baltic Exchange.

How much of an incentive to keep prices artificially high do you suppose is provided by a cost of $43,876 per day? That’s $1.31 million per month.

And that’s why I think Ed Schultz, Bernie Sanders, and Maria Cantwell might actually be on to something.
An earlier (and to be honest, inferior) version of article was posted on Retirement Blues back in May.