By Payam Sharifi, an economics Graduate Student at the University of Missouri-Kansas City
Here in the United States, discussions of our troubled times revolve around any of the following: the housing crisis, the federal debt, unemployment, the fiscal health of particular states, and sometimes even income inequality. Overseas, discussions can include these topics, as well as the plight of the Euro. One issue that I personally feel has gotten the short end of the stick is that of commodity prices, and in particular food and oil. There is a special significance to this issue: its ramifications affect nearly every human being in the world. As seen in prices on the NYMEX and other markets, oil and food prices are beginning to soar again, with the price of WTI futures hitting $90/barrel and Brent crude going over $100/barrel. This issue ought to be discussed again with a renewed interest – but the media and much of the populace at large have simply accepted high food and oil prices as an unavoidable fact of life, without any discussion of the causes of these price rises aside from platitudes. For example, a recent AP report quoted an opinion that gasoline was going to hit $4/$5 a gallon in 2011, but did not mention the possible relevance of speculation in the futures market. It seems that everyday observers (as well as even the financial media) find this issue so complex that they shrink from discussing it. I will now give my opinion on these issues, buttressed by what I have learned from a recent interview with commodities trader Daniel Dicker. His new book “Oil’s Endless Bid” is due out in April.
In 2007 and 2008 the world witnessed oil prices at heights never before seen, even on an inflated-adjusted basis. Soaring oil prices became the norm, with oil going above $100/barrel and eventually going higher than $140/barrel, with no respite until the effects of the housing crisis came home to roost. At the time I would hear debates over whether the price rise was ultimately driven by speculation or fundamentals and react with a bit of annoyance. Whether the spike was driven by fundamentals or speculation almost didn’t matter…our personal budgets had become a mess. I wondered, if speculation is the problem, why won’t somebody do something about it? I wasn’t the only one wondering: at the time it was an issue that even led to congressional hearings. Testimony from hedge fund manager Michael Masters and Professor Michael Greenberger, former Director of Trading and Markets at the Commodity Futures Trading Commission (CFTC), helped to give credence to the view that speculation in the over the counter (OTC) and futures markets by large commodity index funds and dealers was causing a bubble in the price for oil. Masters asserted that the emergence of these institutional investors into the futures market had had a deleterious effect on the price of commodities, and Greenberger agreed. Others, including prominent economist Paul Krugman, argued that this was a phenomenon driven primarily by fundamentals of supply and demand.
Krugman’s arguments against speculation in oil proceed along two basic lines. His first claim is that some oil must be hoarded in order for there to be a sustained speculative increase in the price of oil. In some sense, Krugman’s argument has a grain of truth in it as far as agricultural commodities are concerned: due to recent price increases, many developing countries are hoarding food, because they fear that its price will go even higher. This in turn causes a sustained increase in the price of said commodity. However, hoarding is not so neatly relevant in the case of oil, for reasons that Daniel Dicker explains:
Hoarding oil is not available to anyone except for those that already have capacity; those who have capacity have already leased it out well in advance and thus it isn’t capable of being taken advantage of. So the question is why is storage not being built? It is, but the costs of building it is a tricky business; they are unsure whether having that kind of storage is worth it long run, as they are not sure the price of oil will sustain this upward climb long term. Bottom line: storage is not flexible, period.
So if Krugman is right, speculation in the traditional sense of stockpiling can only occur in limited quantities. However, the one actor who is able to “hoard” oil is the producer. As naked capitalism poster Audrey recently wrote:
The only people with ability to really hoard oil are oil producers – by not producing as much as they could and leaving oil in the ground. So the speculation scenario would go like this – an oil producing company is producing and selling oil at $5/barrel. For whatever reason futures speculation drives prices up $10. Consumption shrinks, and the company cannot find buyers for all the oil it produces. At this point the company can either sell at $15/barrel, or reduce production. It reduces production, supply meets demand, price stays $10 higher.
So Krugman is right that speculative price rises should lead to a reduction in supply, but doesn’t realize that these reductions don’t have to involve hoarding in the traditional sense: most likely, the high prices reduce demand, and producers simply adjust. It is countries like Saudi Arabia that are doing the stockpiling. There are also other ways hoarding can happen: for instance, during the commodities spike, the Strategic Petroleum Reserve was increasing storage, but was not counted in total oil inventories.
Krugman also believes that the price of oil is necessarily determined by supply and demand forces (including possibly hoarding, although he doesn’t think that was the explanation for the commodities bubble). In particular, he doesn’t think that the futures market influences the price of oil. In order to understand what is going on here, a brief history of the futures market will be helpful.
Traditionally the futures market was dominated by those who wanted to hedge their exposure to oil. There were speculators in the market who made it more liquid for the person who wanted to hedge, and who provide what advocates of futures markets (a group that includes me) call “price discovery”. However, what we have today is quite different from this rather classical image of a futures market. Consider, for instance, a dealer in the OTC market, who flexibly creates financial instruments for clients. To allow an investor to “invest” in a commodity, the dealer may create a swap that delivers profits to the client when commodity prices rise. To hedge their exposure on this deal, the dealer will go long in the futures market.
What is new here is that the dealer does not care what the price of oil eventually reaches, because its goal is simply to hedge. The pension fund or other institutional investor that is getting exposure to commodities does not really care, either, because it believes that commodities is a new “asset class,” much like equities, and so it simply wants to go long (bet that commodities prices will rise). At this point we can ask the conventional question: “For every buyer in the futures markets there is a seller, so how can futures markets influence commodities prices?” With so many of these new institutional buyers in the futures market, why would anyone want to go short? As Dicker explains, it’s simple: if you raise the strike price of oil enough you generate a new demand, in the form of a trader willing to go short now that the strike price is another, say, $3 higher. Repeat this process a hundred times over and it’s not difficult to understand why we are in this situation today.
As long as these funds don’t pull their money from the OTC market then the game will continue.
Some academics may wonder: don’t the new entrants into the futures market have to take delivery of oil? Not so: in fact, according to Dicker, less than 2% of these contracts take delivery. The rest are rolled over into a new contract and cash settled. This process can occur with any commodity, but oil is particularly important in that a rise in the price of oil also drives up the prices of food (which requires fuel throughout the supply chain). The effects include disruptions in the developing world: the recent revolution in Tunisia and the ongoing events in Egypt are no doubt due in part to these types of price shocks. According to Dicker, the key thing to understand here is that these new institutional players in commodities markets have a different motivation in going long than did traditional speculators, and that matters a lot in how the price is determined.
As a result of these dynamics, the spot price of oil is determined by the futures price; thus Dicker says:
When I first started trading back in the early 80’s the spot market for oil influenced the futures market. In the past 10 years the situation changed, where the futures market was influencing the spot market. In the past 5 years or so the OTC market is influencing the futures market, which then influences the spot market.
And Yves gives additional information in ECONNED:
Most of oil sold is not sold in the cash market. It is pursuant to long-term supply contracts. And the bulk of those in turn are priced off the BWAVE, which is an average of futures prices. The BWAVE became the preferred means for pricing oil because spot oil had been so subject to price manipulation via “squeezes” or trading strategies to goose the price!
The point isn’t that supply or demand shocks can’t influence the price, but that the current structure that exists to determine the price of commodities has intensely exacerbated the relationship. According to Dicker, convincing evidence that speculation influences the price of oil comes in “crack spreads”. Oil by itself is a raw material, and so it shouldn’t be more expensive than the refined products made from it.
A good example of this is Valero Energy. They refine oil into gasoline, and despite the fact that oil is again going higher they have at times operated at a loss. Why is this? The price of oil has been more expensive than the price of gasoline. It’s crazy, but that’s the reality. In fact these crack spreads have become even more out of whack today than what they were even in 2008 when oil was hitting all-time highs.
In other words, the price for oil today is even more out of whack than it was in 2008!! How can supply and demand arguments explain these persistent spreads? Shouldn’t the prices of oil and gasoline go up and down by a similar percentage?
Another troubling point has been raised by Professor Randall Wray of UMKC. This is the issue of the self fulfilling prophecy. It works much like anticipated inflation: if the general investing public feels prices will go up, then they do (given adequate aggregate demand). What is worse is that these institutional investors do not care if prices rise. As Michael Masters points out:
One particularly troubling aspect of Index Speculator demand is that it actually increases the more prices increase. This explains the accelerating rate at which commodity futures prices (and actual commodity prices) are increasing. Rising prices attract more Index Speculators, whose tendency is to increase their allocation as prices rise. So their profit-motivated demand for futures is the inverse of what you would expect from price-sensitive consumer behavior.
So I’ll ask again: where’s the outrage? The media has been worthless on this issue, parading people who make predictions that gasoline will cost $4/$5 a gallon without explaining why this will happen (aside from bromides about growing demand and shrinking supply). It becomes easy to assume that this is just a fact of life that we need to come to grips with. Nothing could be further than the truth – there is no excuse for having these speculative forces control our daily lives.
So is anything being done about it? The CFTC has the mandate to control speculation, but due to disagreements among some of the members the issue has been put off until 2012…until they can ascertain whether there is “proof” of speculation. In other words, our political class still doesn’t have the cojones necessary to fight the good fight and put an end to this once and for all.
For now, the most important thing for us to remember is: let’s not fall for the “fundamentals” argument any more. The price of oil you see on the screen is a creation of modern finance.