The “real workings of the market” (for futures) are not governed by the physics of supply and demand.

They are goverened by money flows. When one accepts that truism, it becomes impossible for a rational person to not be skeptical about futures markets signals.

In other words, I think it is unwise to classify the spot/future correlation as spurious, as futures markets move because of money flows (aka human behavior). While not very dramatic and almost anti-climactic for peak oilers (no pun intended) — its that exact human behavior that has been responsible for turning many tried-and-true relationships into dubious ones.

So while there is no definitive way to prove causality, the variables used in the study are as close to the fundamental movers of prices as you can get (i.e. futures contracts for futures prices and supply/demand for spot prices). And when the most fundamental variable for supply and demand (spot price) has a stronger correlation with the most fundamental variable for future supply and demand (futures prices), when in fact they should theoretically have 0 correlation, if really has to make you say “hmmmmm.”

1) Proof of how speculation actually affected the sport price of ALL major crude types

This is a feature of the formula pricing structure put in place post-1987. This structure is one in which the prices of various grades of oil are set +/- in reference to a few (3) benchmark crude oils. From this it is not hard to understand that if, say, the price of Brent benchmark crude is pushed up, those referenced to it will also rise (even though rates of change within this can vary).

During the first years of the above, the direction of causation ran primarily from physical trade in benchmark oils to futures, i.e. prices were still dominated by actual sales/purchases of physicals even allowing for the Gulf War spike and slightly later (1993) Metallgesellschaft hedging debacle.

But production and shipments of benchmark oils were declining; the markets became increasingly thin, which facilitated manipulations. And it was just the latter which, in 2001, led dominant producers like Saudi Arabia to make an important shift away from pricing in relation to physical benchmarks to use of futures prices themselves as benchmarks. In this case, that meant shipments to Europe became priced relative to the Brent Weighted Average (BWAVE) as determined on the IPE (become ICE) while shipments to U.S. referenced NYMEX determined WTI lt swt.

The primacy of price determination moved from the physical to the financial where it became, at best, only real market related. The door had been opened.

OK, now think about what else was taking place at the same time:

-Returns from equities were collapsing.
-Very large IBs were recommending addition of uncorrelated investments, commodities, to portfolios, which I think also agreed with CAPM informed reallocation strategies.
-The 2000 Commodity Futures Modernization Act, along with its greater deregulation and exemptions for electronic trading and swaps dealers, had gone into effect.
-Reflationary policies, etc, were driving down cost of money.
-Leveraged speculation was facilitated.

Now, given all of the above + a credit forced expansion, it is hard to even imagine that a commodity price bubble would not arise.

So the head of one of Citi’s commodity desks could note with confidence that:

A flood of investment funds is driving…prices much higher than can be supported by fundamental analysis of supply and demand. It’s a bubble which could grow a lot bigger before bursting.

mentioning as well that

All commodities are involved. All classes of commodities – base and precious metals, energy and softs (agricultural goods), have enjoyed substantial price gains.

Long standing investors in commodity markets (hedge funds, CTAs, etc.) are being joined by long-only funds (mutual funds, pension funds, etc.) who are implementing an asset allocation shift away from more traditional sectors.
…
The growth in investment has been facilitated by new instruments, principally indices and others such as ETFs. Funds of funds are also an increasingly important means of siphoning money into a mix of investment instruments. However, direct investments on the commodity exchanges are also increasing.
Fund flows dwarf those of commodity markets.

The financialization of commodities, bubbling up of prices and some of the amazing rationales were more interesting than what they guaranteed, greater fragility and price drops.

[a theoretical base for the above may not be available within neoclassic econ but, with its concept of fictitious capital, is within at least one of the heterodox traditions]

Even the folks at The Oil Drum, etc., would say that there was a little speculation in all of this. Of course, then we have to get into the definition of speculation, etc., etc.

There are still questions about supply and demand either way…and energy is very cheap. Should we expect that energy will remain cheap?

My guess: it’s somewhere in the middle, just like it usually is. Look up the central limit theorem, right after you’re done with “inference, statistical” as prompted by the previous comment.

Many people, including self posted that speculation may be responsible for some price rise and that manipulation probably was responsible for nothing.

Several told speculation premium was in the range of max $30USD at the time of $147 oil.

Oil is now c. $34 down.

It remains to be seen if it’ll be down more on the short run.

On the long run? Who knows – recession is here. All bets on demand are off.

However, what is still missing is:

1) Proof of how speculation actually affected the sport price of ALL major crude types

2) Analysis how much of the recent fall had to do more with speculation unwinding and how much real demand dropping

It is easy to claim “I was right”, when one half of one’s assumptions appears to be wrong.

More than half of the price rise since fall 2007 is still unexplained by any claimed speculative premium.

If the floor settles at c. $110, then the price rise was more about fundamentals than anything else.

People should remember, that being write with one’s assumptions does not prove anything and that appearances can be deceiving.

We need facts. Let’s wait and see if any surface.

Anybody who is interested in the real workings of the market understands this.

Correlation chasers can go back to their Statistics 101 books and look in the index under “inference, statistical”.

This couldn’t be more right.

FT earlier this week, quoting Greenspan:

“The former Federal Reserve chairman said speculation was “importantly responsible” for the rapid move up in oil prices in late 2007 and early 2008…”It was classic stabilising speculation,” he said.”

(mxq: of course, whether or not this is acceptable, remains conentious, Gspan believes (obviously) that it IS acceptable)

G-span: “It brought forward the price increase that would have otherwise taken place over a much longer period of time, reducing demand sooner and ultimately cutting the top off the intermediate peak price.”

I guess he’s in the creative destruction camp…at least whenever its convenient.

You guys are fooling yourself if you think $200/barrel oil isn’t on the way, this minor correction is just correcting the over compensation the market acheived when fear mongering came into play.

You guys make me laugh, blame everyone but yourselves, good ol’ Americans, it’s never your fault, it’s got to be someone else…

There are other interesting asides, and granted, not all the above are exactly germaine here, but given the inter-connections of any fix upon other aspects of the “free market system”, I pointed them out as illustrations of what people who talk to Bernanke are telling him.

For my posts I received no end of negative comment on The Oil Drum, no doubt some of it from long oil posters and the remainder from cheerleaders for peak oil.

Although I do believe that oil is a finite commodity I do not believe that we are running out of the stuff yesterday. Above ground factors are, and will remain, as much a determinate of oil pricing as demand is for some time to come, imo.

Since I no longer post at TOD, I will use this opportunity to give my response to those who heaped scorn upon my humble opinions and remained long oil just a wee bit too long…and to all the cheerleaders for peak oil at TOD.

Nah, nah, na, nah, na!

River

http://www.econbrowser.com/archives/2008/04/commodity_arbit.html