Veteran investor George Soros, in an interview with the Telegraph, describes speculation as a significant factor in the recent spike in oil prices. However, he doesn’t expect prices to break until there are signs of economic weakening. Later in the post, I’ll provide some information that suggests how traditional supply/demand forces could have been swamped by the volume of futures trading.
First, from the Telegraph:
Speculators are largely responsible for driving crude prices to their peaks in recent weeks and the record oil price now looks like a bubble, George Soros has warned….
In an interview with The Daily Telegraph, Mr Soros said that although the weak dollar, ebbing Middle Eastern supply and record Chinese demand could explain some of the increase in energy prices, the crude oil market had been significantly affected by speculation.
“Speculation… is increasingly affecting the price,” he said. “The price has this parabolic shape which is characteristic of bubbles,” he said.
The comments are significant, not only because Mr Soros is the world’s most prominent hedge fund investor but also because many experts have claimed speculation is only a minor factor affecting crude prices….
However, Mr Soros warned that the oil bubble would not burst until both the US and Britain were in recession, after which prices could fall dramatically.
“You can also anticipate that [the bubble] will eventually correct but that is unlikely to happen before the recession actually reduces the demand.
“The rise in the price of oil and food is going to weigh and aggravate the recession.”….
He said: “The dislocations will be greater [than in the 1970s] because you also have the implications of the house price decline, which you didn’t have in the 1970s.”
The warning undermines predictions that Britain will suffer only a brief and relatively painless recession, unlike the precipitous dives of previous years.
Mr Soros also warned that the Bank’s inflation report represents a “Faustian pact”, obliging it to keep interest rates high to control inflation, even as the economy is starting to slump.
“You had the nice decade,” he said. “Now that is over and you are in a straitjacket.”
Now let’s consider how Soros’ argument might be correct. In general, the notion that spot prices accurately reflect supply an demand is a bit overdone. As Matthew Simmons noted in 1998:
In our opinion…prices over the short-term tell us nothing about the supply and demand fundamentals for oil. Rather than being a perfect indicator for the fundamentals, price is a perfect indicator for the psychology of a small number of funds.
There are two arguments made against the speculation thesis. One is arbitrage: if oil was too high, someone would go short the future and buy oil in the cash market cheaper, and earn the arbitrage profit.
The problem with that logic is that price discovery happens in the futures markets; there isn’t another venue for setting the price and thus arbitraging it against futures. Worse, a substantial amount of that trading is either over the counter (hence not reported to US futures regulators) or on the ICE exchange in London (ditto).
The two most important visible markets are NYMEX and ICE, and far and away the two most important types of crude (in terms of price discovery and setting global prices) are West Texas Intermediate and North Sea Brent. A June 2006 US Senate Permanent Subcommittee on Investigations report on “The Role of Market Speculation in rising oil and gas prices,” found:
…there is substantial evidence supporting the conclusion that the large amount of speculation in the current market has significantly increased prices….
Until recently, US energy futures were traded exclusively on regulated exchanges within the United States, like the NYMEX, which are subject to extensive oversight by the CFTC, including ongoing monitoring to detect and prevent price manipulation or fraud. In recent years, however, there has been a tremendous growth in the trading of contracts that look and are structured just like futures contracts, but which are traded on unregulated OTC electronic markets. Because of their similarity to futures contracts they are often called “futures look-alikes.”
The only practical difference between futures look-alike contracts and futures contracts is that the look-alikes are traded in unregulated markets whereas futures are traded on regulated exchanges. The trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron ….
The impact on market oversight has been substantial. NYMEX traders, for example, are required to keep records of all trades and report large trades to the CFTC. These Large Trader Reports, together with daily trading data providing price and volume information, are the CFTC’s primary tools to gauge the extent of speculation….
In contrast to trades conducted on the NYMEX, traders on unregulated OTC electronic exchanges are not required to keep records or file Large Trader Reports with the CFTC, and these trades are exempt from routine CFTC oversight. In contrast to trades conducted on regulated futures exchanges, there is no limit on the number of contracts a speculator may hold on an unregulated OTC electronic exchange, no monitoring of trading by the exchange itself, and no reporting of the amount of outstanding contracts (“open interest”) at the end of each day.
ICE started trading WTI futures (and provided screen in the US) which meant that WTI trading was increasingly unsupervised by the CFTC. As the Senate report noted,
ICE’s filings with the Securities and Exchange Commission and other evidence indicate that its over-the-counter electronic exchange performs a price discovery function — and thereby affects US energy prices — in the cash market for the energy commodities traded on that exchange.
Moreover, the 2006 report found that $25 of the then $60 a barrel price was due to speculation, based oil inventory levels.
In recent testimony before Congress, Mike Masters discussed at some length how, via the so-called Swaps Loophole, futures transactions on exchanges by financial players, which ought to be listed as speculators (anyone other than a commercial buyer or seller is “non-commercial”) are instead classified as commercials. Thus even the trading under the CFTC’s surveillance is categorized incorrectly.
Now let’s look at the price discovery question. Derivatives markets can supersede cash markets because it’s more convenient to trade there. And we have examples in other markets of derivative prices distorting price formation in the cash markets.
Exhibit A is the credit default swaps markets. Estimates vary, but at $62 trillion, the amount of CDS is believed to be roughly ten times in aggregate the amount of cash bonds (some names have much bigger multiples of CDS written on them than others). This year, corporate bond issuers, even AAA rated ones like General Electric and Berkshire Hathaway, have raised fund at costs over the risk free rate that seem wildly high. Why? Disruption in the credit default swaps markets due to a shortage of protection writers and blow-ups in correlation models. It’s generally agreed that the resulting price in the cash markets are “wrong” but guess what? Via arbitrage, the CDS price drives the cash market price.
Now remember, the CDS is ten times as big as the cash bond market. The Nattering Naybob was so kind as to do the math on the size of a futures contract relative to the underlying physical trading. Remember, you can arbitrage futures to physical only if you are permitted to do so (only certain traders, known to have access to the storage and transport, are allowed to take or make physical delivery) and can actually obtain the relevant commodity:
Global Oil Production 2007 is 85.6 million barrels PER DAY.. times 365 = 31.244 Billion per year…The amount of Brent on ICE is only a small portion of the whole.
Now divide 57 billion ICE Brent contracts by 1.980 billion barrels and the price leverage is 28.78 to 1.
NOTE: The price of Brent as traded on the International Commodities Exchange is predicated on barrels of Brent for delivery at Sullom Voe.
Brent crude is a blend of oil from several fields in the northern part of the North Sea, including Ninian and the Brent field itself.
Sullom Voe is an inlet between North Mainland and Northmavine on Shetland in Scotland. It is a location of the Sullom Voe oil terminal.
Oil is pumped to Sullom Voe via the Brent and Ninian pipelines. Crude from the Schiehallion and Clair fields are also exported from Sullom Voe.
According to a Bloomberg article,
“Brent exports from Sullom Voe peaked in 1985 at about 1.2 million barrels a day.”
2007, estimated total oil exports from the UK, which includes Sullom Voe:
616 million barrels divided into 57 billion virtual barrels = 92.4 to 1 pricing leverage.
Consider: this is only the volume trading on exchanges. It does not include the amount traded OTC, which is considered to be significant.
The argument against the notion that oil prices are distorted (which clearly is possible given the weight of money in the futures market versus the actual value of the physical commodity traded) is that if prices were too high, you’d see physical hoarding of the commodity.
Consider where the mystery inventory might be:
1. Given the speed of the run-up, there may be a delay in hoarding taking place (real world buyers and sellers may have thought prices would fall back, as they did for a bit earlier this year).
2. Tankers full of Iranian crude are floating around the Gulf. Admittedly, this is nasty, less preferred crude, but it is still in surplus
3. The Chinese are very secretive, and known to be stockpiling diesel, and possibly crude as well to prevent any embarrassing outages before and during the Olympics. According to Xinhua, China’s oil and oil derivative products growth 1Q 2008 versus 2007 is well ahead of GDP growth of 10.6%.:
China’s net imports of crude oil was 44.95 million tonnes in the first quarter, up 14.9 percent, and net imports of oil products rose by 31.8 percent from a year ago to 5.47 million tonnes, according to General Administration of Customs. China’s imports of diesel in the first quarter surged over 600 percent to 1.66 million tonnes and the imports of gasoline, rose by nearly twice to 76,654 tonnes.
The article also noted:
Deng Yusong, a researcher with the Development Research Center of the State Council, said that abnormal needs boosted by below-cost prices of refined oil products controlled by the central government over concerns of the country’s rising CPI is another major reason contributing to the country’s surging oil consumption.
In other words, domestic players suspect that the government will have to raise oil prices and are moving their purchases forward.
4. The IEA only counts primary inventory as inventory. Anything else is demand:
Demand is total inland deliveries plus refinery fuels and bunkers minus backflows from the petro-chemicals sector. It is thus equivalent to oil consumption plus any secondary and tertiary stock increases.
Further note how narrow the definition of primary stock is:
Unless stated otherwise, all stocks included in the report are primary. They include stocks held in refineries, natural gas processing plants, oil terminals and entrepôts (where these are known), pipelines and stocks held on board incoming ocean vessels in port or at mooring.
Thus any end user inventory, which is one place you might see hoarding, would not be included as inventories.
5. Finally, some suppliers may simply be choosing not to pump. Some readers and commentors have provided anecdotal evidence, and James Hamilton in his new paper also provided some quotes from the Saudis and Kuwatis along those lines. A reader gave the logic:
It is being left in the ground.
For over a hundred years the oil industry has been building out a huge infrastructure for mining, transporting, refining and distributing oil and its associated products.
It doesn’t make much sense to add to this infrastructure, if we’ve reached the peak of physical throughput. Going forward, refining capacity will probably move closer to the source of crude, and more of the transport will be devoted to moving of product. But, that prospective shift is a detail.
There’s no accumulation of speculative inventories in the refining and distribution chain, because there’s no slack in that chain, and won’t be any, because, looking forward, creating such slack makes no sense.
The only way to “hoard” oil effectively in these circumstances, is to delay oil production from fields with low marginal unit cost, while shifting production to fields or sources with high marginal unit costs. This conserves the expected rents, in a balanced way. That is, those with low marginal cost oil to produce see their wealth rising, while those with quasi-rents on infrastructure are protected.