Tuesday, July 15, 2008

Oil and Speculators – Anecdotal Evidence

There has been a lot of debate going on about whether or not speculation is driving up oil prices. I haven’t taken a position one way or the other. I am not an expert in the commodity markets and I have been impressed with the evidence on both sides of the argument. Paul Krugman has done some interesting analysis (see this post and follow-up posts throughout the month of June) on this issue ultimately arguing that speculation is not driving oil prices. He points to the lack of inventory build that would be present in a traditional speculative driven market resulting from owners holding product off the spot market to sell at higher future prices. On the other hand, some very smart investors and former regulators have been arguing that speculation has caused somewhere in the neighborhood of $50/barrel of the price increase in crude. Finally, there is the common sense issue. Financial markets fall apart, stocks and bonds become less attractive investments, the housing bubble bursts, and suddenly there is a sharp increase in the price of a commodity that just happens to be in a market that was partially deregulated several years ago. This last part sounds too familiar to me to be ignored.

Today, I was watching the testimony of Ben Bernanke before Congress when the subject of speculation in the energy markets was raised. It was clear that Congress is serious about passing some regulations to address margin requirements and possibly other issues in this market. Suddenly oil dropped $9.00 a barrel from around $145 to $136. That’s a 6% decline within minutes. Now, whether this price drop was caused by the congressional testimony or not is something I cannot determine. The CNBC commentators are saying the cause of the price drop is banks liquidating their energy positions to meet capital requirements. Isn’t that speculation? And look at this coincidence: the investment banks decided it was a good time to unwind their energy position right at the moment it became clear Congress is going to act on the issue of speculation in the oil markets. Do you believe in coincidences like these?

Rational economic arguments aside, the anecdotal evidence suggests that “speculation” is having a meaningful impact on oil prices.

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4 comments:

Palermo's Blog said...

I am looking for input on this one. All educated input appreciated!

dd said...

I don't see how US regulations would dent the world market. The whole world is paying the same price and their are multiple exchanges - each with their own players.

Frankly, the perfect storm of factors have played a role in the oil price. Yes, financial institution activity has added value to the oil price through their no-physical delivery transactions. However, they provide necessary liquidity to the markets allowing them to fluidly function.

If your going to cut them out of the loop, providers will sell their oil in Europe where it will be readily bought and traded. Foreigners will also buy US Oil if its (temporarily) cheaper due to regulations. The end result - it will reach the same price equilibrium as it was before the "regulations" went into effect.

Most commodity exchanges operate with the notion that the buyer will accept physical delivery. Financial institutions function in between - they bet/involve themselves in futures pricing and involve themselves in elaborate hedging products. If they purchase any forward contracts - they play hot potato with it as they will have to sell before the delivery date arrives.

When prices rise, demand drops. When they in turn seek to liquidate their portfolio and their may not be any physical buyers as they buy based on projected demand - so they will be scrambling to get rid of it.

However, when factors which attract additional "speculators" continue to exist - such as turmoil in the middle east, saber rattling/Iran, etc. - more investors are attracted to the market and buy up futures contracts in the hopes of a price spike - but the bottom line is physical delivery has to eventually take place. Right now institutions are passing the hot potato back and forth in buying and selling, and thus far the demand for oil has not appreciably dropped where there's no one left to pass the potato to when the delivery date comes - thats why you may see days where it swings up and down - the days it goes down there may be a larger shipment.

If you look at it, the main reasons why we see such high Oil Prices is the value of the dollar, and the terrible US Foreign Policy which has destabilize markets and driven people to bet on supply disruptions. Supply disruptions cause the biggest price spikes since the people who actually take the physical delivery must at that point and their ain't a lot of supply to go around!

Dan said...

The problem with the issue is that everyone who has a differing view point as to what is causing the high crude prices are all in some way correct. Yes speculation is driving up the price, yes dwindling supply is driving up the price, yes global unrest is driving up the price, yes regulations are driving up the price. That’s why all sides have compelling arguments.

And until all of these things are addressed in a comprehensive way the problem is not going to be fixed.

Steve said...

I sold some shares a couple of weeks ago in a natural resources (Oil and such) mutual fund to skim off the profits I made. I moved the cash into another investment with less volatility. Am I an investor or an evil "speculator"?