Thomas Palley: "Beating the Oil Barons" (And the Misunderstood Role of Inventories)

Although we don’t always agree with his views, we are fans of Thomas Palley posts because he is willing to question economic orthodoxy. We were particularly taken with his piece, “Demythologizing Central Bankers and the Great Moderation.”

In his latest offering, Palley disputes the idea that the recent runup in oil prices is entirely the result of fundamental forces. In taking, this position, he runs into plenty of high profile opposition, particularly Paul Krugman (“Speculative nonsense, once again” is one of many on this front) and Martin Wolf who in today’s comment declares,

No less important, however, is abandonment of the silly idea that price jumps in oil or food are the result of wicked “speculation” – a fantasy promoted by dangerous populists across the globe.

Well, it isn’t just populists who question that supply and demand gives a full explanation. Consider this paragraph from a report by Morgan Stanley:

Economists tend to be less well-versed in supply conditions in the energy sector. But the current oil price increases are curious. They are not quite supply driven, and the fact that global demand is decelerating appears to be inconsistent with accelerating oil prices. While the logic behind the increasing structural energy demand from EM makes a lot of sense, it is still difficult to justify how oil prices could more than double in 15 months, or rise by six-fold in seven years.

There have been other anomalies which indicate all is not well in Denmark. An oil-market participant. mxq, left this comment earlier this month:

Refiner crack spreads have suffered (and actually went negative a few weeks back) b/c there has not been a concomitant increase in distillate prices.

That is, the total refined products have been selling for less than the price of raw oil…that’s why refiners are at sub-90% capacity (and bottomed in the low 80%’s…aka Katrina/Rita levels).

Put another way, there is more demand for oil than there is for the actual distillates…or, one more way – the distillate paper market isnt responding like the crude paper market is (aka one of them might be broken).

In either case, this is the point where traders would short oil and buy distillates, arbing away the spread…but, as we saw last week, the shorts keep getting leveled, so that trade doesn’t work…

“The fact that refiners are willing to pay a higher price for physical supplies than the futures benchmark lends weight to the argument that speculators are not the cause of record oil prices.”

If anything, that makes me think speculation is even more of a problem given that the primary consumers in futures markets can’t rely on these markets to lock in the contracted future/spot prices.

Why can’t refineries lock in delivery at futures prices like they always have? That sounds dangerously similar to what is happening w/ grain markets where farmers are dropping out due to lack of reliability in spot/future convergence.

This is not definitive, but the fact that refiners are getting squeezed is not consistent with the notion that crude prices are driven by end market demand.

Similarly, Krugman has made much of the argument that if oil prices were too high in relationship to supply and demand, you’d see inventory buildup. But that is in a simple economic model with idealized supply and demand curves, not in an oil market with two places to store inventory, namely, above ground or below ground. As we have stressed, above ground storage is limited and costly. From Dan Dicker at$):

…in the world of energy trade, there is lack of fungibility that has always broken down thus: Electricity, non-storable — Natural gas, more storable — Crude oil, mostly storable

Although easiest of the three, oil storage has been historically inelastic, no matter the price… Over the last 4 years (and for most of my trading life) forward stocks have always hovered between 50 and 55 days — storage is expensive and limited, and just not efficacious.

This is why, at least in my view, that supply arguments are often overblown in oil pricing theory — supplies remain closely aligned to demand and rarely overrun — as OPEC members have time and again explained but are ignored. This is why President Bush can walk in to a meeting with Saudi ministers and be patted on the head like a silly schoolboy — “you don’t understand, Mr. President — we’ve got nowhere to SELL any more right now” and Bush will run home and talk about increasing domestic supply as if he hasn’t heard a thing

In Congressional testimony last fall, oil industry expert Phillip Verlegger explained that the role of inventories in the oil industry is misconstrued, particularly in a world with stores of value other than oil stocks:

Inventories are the most misunderstood economic phenomenon in the energy business.

Time and again, one reads statements by energy policy officials commenting on low stocks. Invariably, these officials call on OPEC to boost output so stocks will rise. The economic ignorance displayed in these appeals is appalling.

My favorite quote appeared in November. While attending the World Energy Congress, U.S. Energy Secretary Bodman called on OPEC to boost oil production. As the November 13 Financial Times reported, “Samuel Bodman, the U.S. energy secretary, urged
at such high levels in part because developed countries’ stocks were below their five-year averages.” The story then continued:

But Mr. Bodman told reporters at the World Energy Congress in Rome: “I have asked that that be reconsidered. I have asked them to increase production.” He said he was trying to draw OPEC’s attention to the factthat the inventory numbers were “troubling.”

Bodman’s statement makes it sound as if commercial inventories will increase if OPEC boosts production. But doesn’t something else have to happen for this to occur? Don’t companies have to agree to buy the oil? Suppose, given the current financial crisis, that companies choose not to buy the oil? What happens then?

The data demonstrate that companies accumulate incremental stocks oil only if it is profitable to do so. Since May, it has not been profitable. Since May, companies have been dumping stocks. This story is told with two charts.

Figure 8 shows data on “returns to storage” for crude in 2006 and 2007. Returns to storage will be a new concept here because, to my knowledge, neither the Energy Information Administration nor any other organization follows the idea. However, the concept goes back to John Maynard Keynes, who, whatever his other vices, was one of the world’s great commodity traders. Returns to storage measure the financial return earned by purchasing a physical unit of a commodity, selling a future for delivery at a later date, and storing the commodity. If, for example, one buys crude for $50 per barrel and sells a future for delivery a year hence at $100 per barrel, one earns a return of 100 percent. The trade, referred to as cash and carry, can be very profitable. Rumor has it that Keynes once filled the basements of several colleges with wheat when the returns were really high.

Figure 8 shows that returns to storage for crude oil were positive through the second half of 2006 and the first half of 2007. Since the end of May 2007, though, returns have been negative. Logically, one would expect stocks to have accumulated during the second half of 2006 and the first half of 2007 and then be liquidated from June 2007 forward.

The data on inventory accumulation and liquidation confirm this hypothesis. Figure 9 shows that stocks tend to rise with positive returns and decline when returns are negative. Figure 9 shows the deviations of U.S. inventories from trend from 1990 to 2007. (Note: during this period, we have observed a steady decline in the “normal” level of inventories held by commercial firms. This decrease is explained by improved operating efficiencies in the sector.)

As can be seen from Figure 9, stocks decline when returns fall below zero while tending to rise when returns are positive. The explanation for this effect is quite simple. Financial officers of firms holding oil stocks have a wide number of options. They can invest their cash in commercial paper, Treasury bills, or inventories. They can even borrow to acquire additional stocks. Their decisions are driven by the returns offered by various instruments.

This finding, while intuitively obvious, seems to have escaped many who follow the oil market. Recently, though, the financial market’s effect on oil and the rest of the economy has become painfully apparent. In particular, the subprime crisis has caused many lenders to withdraw from the commercial paper market. In turn, the cost of borrowing has increased, raising the cost of holding oil stocks. At the same time, buyers who had lifted forward prices to a premium over cash prices have liquidated positions, in part to obtain cash. This has made it expensive to hold inventories and so stocks have dropped.

Thus oil inventories cannot be viewed as an indicator of whether market prices are too high or low; their level is a function of multiple factors.

Finally, to Palley:

Over the past eighteen months, oil prices have more than doubled, inflicting huge costs on the global economy. Strong global demand, owing to emerging economies like China, has undoubtedly fueled some of the price increase. But the scale of the price spike exceeds normal demand and supply factors, pointing to the role of speculation – and underscoring the need for policy action to clean up the oil market.

Reflecting their faith in markets, most economists dismiss the idea that speculation is responsible for the price rise. If speculation were really the cause, they argue, there should be an increase in oil inventories, because higher prices would reduce consumption, forcing speculators to accumulate oil. The fact that inventories have not risen supposedly exonerates oil speculators.

But the picture is far more complicated, because oil demand is extremely price insensitive. In the short run, it is technically difficult to adjust consumption. For instance, the fuel efficiency of every automobile and truck is fixed, and most travel is non-discretionary. Though higher airline ticket prices may reduce purchases, airlines reduce oil consumption only when they cancel flights.

This illustrates a fundamental point: in the short run, reduced economic activity is the principle way of lowering oil demand. Thus, absent a recession, demand has remained largely unchanged over the past year.

Moreover, it is relatively easy to postpone lowering oil consumption. Consumers can reduce spending on other discretionary items and use the savings to pay higher gasoline prices. Credit can also temporarily fill consumer budget gaps. Although the housing boom in the United States – which helped in this regard – ended in 2006, consumer debt continues to grow, and America’s Federal Reserve has been doing everything it can to encourage this. Consequently, for the time being the US economy has been able to pay the oil tax imposed by speculators.

Unfortunately, proving that speculation is responsible for rising prices is difficult, because speculation tends to occur during booms, so that price increases easily masquerade as a reflection of economic fundamentals. But, contrary to economists’ claims, oil inventories do reveal a footprint of speculation. Inventories are actually at historically normal levels and 10% higher than five years ago. Furthermore, with oil prices up so much, inventories should have fallen, owing to strong incentives to reduce holdings. Meanwhile, The Wall Street Journal has reported that financial firms are increasingly involved in leasing oil storage capacity.

The root problem is that financial markets can now mobilize tens of billions of dollars for speculative purposes. This has enabled traders collectively to hit upon a strategy of buying oil and quickly re-selling it when end users accommodate higher prices – a situation that has been aggravated by the Bush administration, which has persistently added oil supplies to the US strategic reserve, further inflating demand and providing additional storage capacity.

Absent a change in trader beliefs, the current oil price spike will be broken only by a recession that exhausts consumers’ capacity to buffer higher prices, or when the slow process of substitution away from oil kicks in. Thus, economic fundamentals will eventually trump speculation, but in the meantime society will have paid a high price.

Whereas oil speculators have gained, both the US and global economies have suffered and been pushed closer to recession. In the case of the US, heavy dependence on imported oil has worsened the trade deficit and further weakened the dollar.

This sobering picture calls for new licensing regulations limiting oil-market participation, limits on permissible trading positions, and high margin requirements where feasible. Sadly, given the conventional economic wisdom, implementing such measures will be an uphill struggle.

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  1. christofay

    Yves, blog moderator, I’m under the impression that you work on the east coast of the U. S. I also see that you post lots of material in the wee AM mornings. I hate to sound like the voice of your mom, but you’re not overdoing this blog thing are you? Perhaps you are preparing to make the jump to making the blog your full-time profession. I do appreciate what you are doing at N C. You’re providing the analysis, news filtering, and the voice and attitude that I’ve been looking for.

    Keep up the fabulous work

  2. Danny

    Why would people/countries/companies not be hoarding oil when an attack on Iran is becoming more and more certain every month? Is it speculation if you believe that oil will skyrocket if that happens and are hoarding now? And is that the result of people speculating or belligerent governments?

    Granted, there are numerous other factors, but between this, Nigeria, all of the financial uncertainty, the specter of a ‘profits tax’, a declining dollar, increasing demand in emerging markets, and declining oil production nearly everywhere outside of the Middle East, it is ridiculous to blame oil prices on speculators. Why are they speculating in oil and commodities? Because of lots of bad economic and foreign policy coming from most major governments worldwide creating lots of uncertainty about the near and middle term future.

  3. Ravi

    This was a great read. Thanks for putting it together.

    Question though, and apologies if it’s stupid. So there is an argument that oil inventories are a function of not just the difference between spot/future prices, but also storage costs.

    How does this discussion refute Krugman’s main point though — the only pathway / mechanism that future prices can effect spot prices is via inventories?

    If people are not accumulating inventories for a variety of reasons — great, I believe it. But then how does future prices, through which traders invest in, feed into spot prices?

  4. Chad @ Sentient Money

    @ Danny – An attack on Iran is actually becoming less certain every month. There are numerous reasons it won’t happen, but the biggest one is that the Iranian president is losing his backing, and the moderates are slowly gaining more power. Thus, with an Iranian election next year it’s better to wait and see the results than go to war.

  5. WRG

    The little dude who is the Iranian president has no power in terms of foreign/military policy. Most people do not know or understand this.
    It is what “Supreme Leader” Ayatollah Ali Khameini says and does which matters. Being an old, white-bearded cleric, he tends not to say much. He just sits there looking oracular, with everyone waiting with bated breath for his next oration.

  6. S

    The refutation to Krugman is that the OPEC countres are simply leaving oil in the ground, which is an effective inventory store…how do you calculate that impact…here again we come back to this little thing called interest rates…

  7. Richard Kline

    The summary in your commentary Yves, accumulated over the last several months of comments and media reports, is, to me, the real story. There is no independent spot price because inventories are too tight at all points of the delivery chain to resist higher futures prices: This is the point that Krugman and others don’t seem to get. This is why refiners are _lowering_ capacity, since that is the only way to lower their losses. End users are paying more, but consumption prices still haven’t caught up with the huge spike in raw prices.

    As you’ve also discussed before, Yves, again re: the informed comments of others here, the ‘witheld inventory’ is actually high sulfur sour crude left in the ground for now, which is less in demand and the price of which has come up much less than that of light sweet. This latter factor is, again, something that Krugman and other orthodox economists do not seem to get: all oil is NOT created equal. We can, and have, gotten a speculative price spike in only part of the oil market. Because that is the crucial part, though, because supplies of light sweet are running at full capacity, and because storage capacities for it in the chain are constrained, we still get a spike. There is no spot price for light sweet: refiners pay what the holders of futures options are willing to sell for until and unless end user demand eventually drops SIGNIFICANTLY from present levels. Which it hasn’t. And the amount of money speculative buyers can mobilize is _fully sufficient_ to lock up light sweet supply. What we have, Paul K., is a sweet squeeze.

    And what we need about that is a remedial bear hug on the squeezers. We are all paying for their hedges, which have a lot more to do with mortgages in the Hamptons than Bombs over Hormuz, a Bottom Drop Out on the $, or any such other factors.

  8. Anonymous

    I think the articles excerpted above miss a number of points. First, they only talk about the DOLLAR price of oil. Obviously, certain currencies float against the dollar. For instance, the EURO price of oil has not spiked nearly as much over the last twelve months. Second, I’m assuming we have no idea what refiner crack spreads are in China. Using the US number as a benchmark for the entire world is probably a little presumptuous at the point even though we still consume a large percentage of the world’s oil. Third, I think the use of the word ‘speculator’ in an attempt to conjure some pejorative connotation is not very helpful. If traders realized that a commodity was severely undervalued (and did in fact have a way to affect the spot price in a serious way, which I still mostly doubt with respect to this commodity), why shouldn’t they buy low and sell at true FMV? Isn’t that free market enterprise? Finally, I think the major fallacy of the points of view expressed above is that the proper price of oil was the relatively low prices we’ve experienced the last two decades. What if those prices were just a strange combination of circumstance (political pressure on all sides not to repeat the oil shocks of the 70s maybe?) and the prices should have been higher all along based on true worldwide supply and demand. We are talking about a commodity that is not inexhaustible. How much effect on worldwide demand has really occurred because of this price spike? Surely not enough to suggest that rock bottom prices of seven years ago were the proper clearing price for a barrel of oil.

  9. Richard Kline

    So Anon of 11:06, no one can ‘buy low’ if there is no supply to buy low _at_. Your point re: the oil prices of c. 2000 as artifically low in relation to long-term trends is well taken; many, indeed, argued just this point at the time. Triple digit oil prices per barrel in $s are no surprise, and may very well be here to stay given global demant growth. A rapid price spike above $100 to ~$135-40 is . . . quite another matter.

    Regarding China’s refining capacity, if you’ve kept up with the news there refiners have been taking it on the chin _and_ in the groin because of hard low price caps on what they can sell distillates for: price is regulated. In brief, the situation with China’s refiners is fairly well reported. And that price spke in dollars for oil: wellll, oil is _priced_ in $s, so what else is the price going to spike in, pray? What the cost of Russian oil is in rubles is something that could be reasonably well figured should anyone want to, but if and when that oil is traded _outside_ of Russia, it will be quoted in $s for the forseeable future.

  10. Cool Guy

    Your reader’s crack spread comment is misleading. While the gasoline crack spread has been low, and sometimes negative, the heating oil (proxy for diesel) crack spread has been hitting historic highs. This is entirely consistent with the Asia (and particularly China) demand story, especially vis-a-vis the Olympics. While gasoline demand has declined – the US is one of the few major powers to use more gasoline than diesel – the demand for diesel has sky-rocketed. Just look at the prices at the pump and you’ll see.

  11. Anonymous

    Gee…as an oil producer I can either store (indefinitely) an appreciating commodity or trade it for a depreciating asset (any given currency, especially the dollar). What to do? Keep apprecaiting oil or trade it for devaluing dollars? Hmmm? They’re not idiots folks. Given the US’s national debt approaching $10 trillion, a projected FY2008 $500 billion budget deficit, an annual trade deficit exceeding $500 billion, accelerating inflation exceeding the Fed Funds Rate and LIBOR, a tanking US$, and impending recession who would wonder why the US$ is no longer the world’s reserve currency. Commodities, and oil in particular, have become the world’s reserve currency by default (for lack of anything else of real value).
    Speculation? Everyone is just trying to invest in something to save their assets against loss.

  12. Anonymous

    I’ve said this before, and it bears repeating. Inventories above ground are not loose at all, when viewed in terms of days’ worth of refinery runs, or days’s supply. Usually US inventories have been under 30 days’s worth — fine if all goes well, not so good if we have a 2005 style hurricane season. In most industries we discuss inventories in terms of days’ supply, not absolute levels. I assume the MSM discuss oil inventories in terms of the absolute number of barrels but that number in isolation is not helpful in my opinion.

    As to “speculation,” and holding “extra” inventories below ground: the prospect of peak oil may have changed the underlying dynamics of oil markets in a very important way. Before we got close to peak oil, if a producer held production back from the market, the prospect of increasing worldwide supply implied that there would always be another producer who would pump more oil and take market share, and this happened bigtime in the early 1980s.

    With peak oil either here or in the offing, suppliers who hold production down need no longer fear the loss of market share. Therefore, as Saudi Oil Minister Naimi recently said, the Saudis have every reason to hold onto at least some of their reserves for their grandchildren, rather than pump all the oil they can.

    If you want to know what a minipulated oil market really looks like: Back in the 1970s any observer could see that REALLY funny things were going on. Many people talked about oil “shortages” due to the so-called “embargo” in 1973 and the Iranian Revolution in 1979. However, the American Petroleum Institute’s own figures on oil imports into the US held steady or even ROSE during those “crises.” One can look that up in the back numbers of the Oil & Gas Journal if you don’t believe me. That’s what funny things actually look like, and that’s why I wrote about them as such in 1979 in The NYT and Baltimore Sun as a freelancer. I believe that the subsequent price collapses validated the reporting I did then. However, I just don’t see the same situation today.

    In my opinion, if speculation is really to blame, the price will break eventually and those speculators who were imprudent will lose badly, and things will work themselves out. And if oil is temporarily overbought within the context of longterm supply tightening (a more defensible position in my opinion) overleveraged traders could also get hurt as the market consolidates.

    Rather than worry about speculation it’s time to get serious about energy efficiency and renewable energy. Even if it turns out that there is lots of oil around (for now), we can only burn it once. The only sound policy is to work, and work hard, to implement sound, longterm solution to the energy supply problem.

  13. macndub

    Figure 8 shows data on “returns to storage” for crude in 2006 and 2007. Returns to storage will be a new concept here because, to my knowledge, neither the Energy Information Administration nor any other organization follows the idea.

    He must mean government organizations, because I assure you that traders pay a great deal of attention to returns on storage. And they do funny things in short periods of time. You can have negative returns to storage, yet have massive storage increases because of seasonal factors, for example. Even if the market is in backwardation in March (futures lower than spot), refiners will build storage in order to process crude into final product.

    Cracks also go negative for a variety of reasons. Heavy-light differentials are all over the map, and a function of refinery capacity, Chavez, oil sands shutdowns, nat gas prices… This is a very complicated business, and short run prices do all sorts of really insane things that will blow your head off (as well as bugger up analyses). Trying to say anything about the oil market by looking at storage spreads is a good way to look very, very stupid.

    Rather than worry about speculation it’s time to get serious about energy efficiency and renewable energy. Even if it turns out that there is lots of oil around (for now), we can only burn it once.


    In my opinion, if speculation is really to blame, the price will break eventually and those speculators who were imprudent will lose badly, and things will work themselves out.

    Agreed, but this may take a while since the shorts are hurting so badly right now.

  14. Lord

    Refining is local rather than global so one would not expect these to run in tandem. More likely hedging than speculation, but some consider hedging just another form of speculation.

  15. Anonymous

    With all due respect, most if the discussion about speculation in oil is indeed hogwash. Two point I agree with: First, as S said “…OPEC countries are simply leaving oil in the ground, which is an effective inventory store…” while blowing smoke complaining about speculators. Well, maybe not leaving it in the ground but not being terribly motivated to extract it in a big hurry. Second, as Anonymous said, “…as an oil producer I can either store (indefinitely) an appreciating commodity or trade it for a depreciating asset (any given currency, especially the dollar).” Bingo!

    Face it, folks, the only effective speculators in the oil market can be the producers but, then, this is not speculation but running one’s own business. When production capacity increases sufficiently above consumption, game theory predicts that prices will drop as some will take advantage of high prices to sell and then every producer and his uncle will be selling the depreciating asset (oil). This is bound to happen by 2011 or whenever Ben decides to strengthen the dollar.

  16. mxq

    I think economists, like PK, often approach these problems as if they are binary in nature – supply/demand – cause/effect. Richard Kline has had some enlightening posts re: this phenomenon. Specifically, as it applies to this discussion:

    “Terms like ’cause’ and ‘effect’ simply do not mean the same thing in self-organizing systems; often, those terms are functionally meaningless. That is hard to get one’s head around, I know. I’ll say it again: Systemic interactions are seldom cause and effect because different portions of a common system are not discrete from each other. Keynes and the Austrians are informed 20th century perspectives on 19th century capital flows, neither of which even in their day well-described mutual modulation in systemic processes. It is time, time and past really, to junk the economics we have learned and to make an economics that uses definitions and relationships consonant with the processes represented.”

    Maybe this is just how unregulated markets work?

    Unfortunately, when the long-run finally rolls around and time has allowed the market to equilibriate, we’ll probably all have been dead and gone.

    Of course, the obvious conclusion is…if we’re all dead, who want’s/needs an unregulated market?

  17. Juan


    If Krugman’s main point is: “the only pathway / mechanism that future prices can effect spot prices is via inventories”, it only indicates that he has not kept up with changes in the price regime.
    In general, ‘spot’ indexes to the prompt month (or a weighted avg.) futures price; futures prices became the benchmark(s).

    The process of financializing crude oils prices began with the breakdown of netback pricing in, if I recall, 1986-87; OPEC’s loss of ability to administer prices and the near simultaneous development of crude oil futures transformed the whole process of price formation into one which, by this decade, became only “market related”.

    ‘Related’ in this case means portfolio allocation and reallocation strategies/decisions, expectations, etc, so is not perfectly divorced from reality but sufficiently so to permit price to deviate from real economy fundamentals, especially as trend following becomes trend-driving and as all types of rationales are found to justify an ‘onwards and upwards’ mania — just as higher prices can be used to help justify tech advances which might not otherwise be viable but hold socially beneficial promise (if not themselves transformed into another bubble).

    Now the above may sound quite extreme and perhaps it is but can be found in various publications from the IEA to Matt Simmons, or within the understanding of a close friend who operated as an independent oil producer for over fourty years.

    Richard Kline;

    Frank Veneroso included a comment on long term trend in his World Bank presentation last year:

    “[O]ne may ask, is it a bubble? Two years ago the noted money manager Jeremy Grantham posed this question in an interesting way. He presented a chart of the real inflation adjusted oil price going back to 1875.

    He then noted: “Over the years we have asked over 2000 professionals for an exception to our claim that every asset class move of 2 sigmas away from trend had broken, and not one of the 2000 has ever offered an exception! This should be scarier than the fact that GMO has tried so hard to find one and failed. But we always have said that intellectually you can imagine a paradigm shift in an asset class price, even if we have been unable to document one yet in history. …”

    Price moved upwards by more than two sigmas in the late 1970s, again in 1990, and had again in 2005 (the year of Grantham’s comment). Per his (GMO’s) chart, the late 1990s saw a one sigma decline.

    Yes, I understand this is not exactly what you are speaking to but thought it might be of interest.

    Anon 2:10 PM,

    Counterintuitive but worth considering that, from a revenue perspective, high price can also work against greater production.

  18. Anonymous

    To Richard Kline:

    This is Anon of 11:06. I think you may have misread my post. I did not mean to state that oil was “priced” in something other than dollars. I meant to say that the real price of oil for consumers using the Euro did not spike as much as for consumers using dollars. Dollar deflation (at least versus the Euro or the RMB, the currency of the two most obvious consumers of oil other than the US) is probably going to lead to a price increase in a dollar-denominated commodity. Obviously, none of my points explain all the runup in the price of oil; I merely intended to show that much of the spike resulted from factors other than “speculators.” To the extent that a small portion of the runup is attributable to “speculators,” then fine. I find it difficult to imagine that eliminating the “speculators” is going to make a substantial difference in our lives going forward.

  19. Yves Smith

    This is a great comment stream, thanks everyone.

    One thing I need to clarify in future posts (I always think this is obvious, but with long posts one can’t assume what people will take away) is that I am not disputing the peak oil hypothesis. What I am questioning is whether a 50% increase in oil prices in five months is due entirely to fundamentals. Everyone seems to be looking for binary (thanks Richard Kline) answers: either it is, or it isn’t, meaning the result must be due to “speculators’. There isn’t sufficient attention to notion that a lot of messy factors could be at work.

    And the word “speculator” is maddeningly imprecise. The ways Eskimos allegedly have lots of words for “snow”, we need more words for speculative phenomena. In the oil context, anyone who is not a commercial buyer or seller is a speculator, but the terms “speculator” includes those whose activities help markets function in an orderly fashion, and those who don’t, the extreme is parties who engage in manipulative behavior, who might be called “profiteers”. One can also have specualtors whose intent is benign but in aggregate can, and I underscore can, cause short-term distortions, like momentum traders.

  20. mxq

    RE: Cool Guy

    I agree that diesel is in huge demand.

    But its not misleading to say that the aggregate barrel has clearly been blown apart (see page 10…yellow bars, and then scroll to page 8 from this link). And by blown apart, i mean like a $5 discount on $60 oil turning into a $55 discount on $130oil.

    Also, keep in mind: gas and asphalt are in peak season, yet they are trading at record low (to negative) cracks.

    Arbs and traditional speculators can’t sell wti (or diesel) and buy up the rest of the barrel. Their margin calls blow them out of that trade. The assumption being that there is unrelenting buying pressure.

  21. DownSouth


    As always, thanks for your comments.

    Of all those who talk about how speculation might affect the oil price, yours is the only one that, upon close scrutiny, makes any sense. That is because you are the only person who attempts to explain the specific mechanism by which spot prices could be set and/or stongly influenced by futures prices. Other adherents to the speculation-plays
    -a-significant-role-in-setting-oil-price hypothesis seem to expect us to take it on blind faith, received knowledge or just plain magic that this mechanism exists.

    I must admit that I am still a little foggy on how the mechanism might work. But I did find this the other day that might offer a parrallel situation:

    “Japan seems recently to increasingly profit from the run up in oil prices as LNG purchased on long term contracts becomes relatively cheaper as a source of energy based on heat content. Developers of LNG facilities generally preferred long term contracts due to the capital intensive nature of the LNG business as this also increases the predictability for return on the investment and a steady profit flow. This is also one of the reasons why it has been challenging to establish a well functioning spot market for LNG.

    So, please correct me if I have it wrong, but what you are saying is that much of the oil that actually changes hands sells at what is effectively a contract price, that the price was agreed upon some time prior to the actual date of sale, and that it is agreed upon that the sales price will reflect whatever the futures price was on such and such a date? And if the amount of oil that sells with such an arrangement dwarfs the amount of oil that sales on the spot market, then the spot market does not function properly?

  22. Cool Guy


    Clearly the typical seasonal trades have been blown apart this year. The misleading claim though, is to say that this couldn’t be because of demand fundamentals.

    Refiners in the US are set up to produce more gasoline than diesel. We are an anomaly in this way because we, unlike most of the world’s major players, use more gasoline than diesel.

    So, because:
    a) The US is experiencing declining gasoline demand (about 1% yoy), and
    b) The rest of the world, particularly China leading up to the olympics, is seeing very strong diesel demand (Chinese imports of diesel are up ~10X yoy),

    the plight of refiners in the US could be explained by fundamental demand factors. If US refiners have to produce more diesel to meet global demand, then they necessarily have to produce more gasoline (since they have a relatively fixed fuel mix). This oversupplies the gasoline market, and so we would expect it to push down the gas crack.

    So basically, the divergence of the diesel crack and the gas crack is an indication to me that the rise in oil is due to a fundamental demand shift – and, at the very least, that the low gas crack does not reflect the role of speculators. In my view, traditional arbs/speculators have been getting blown out of the water because they a) underappreciate China/the Olympics, and b) overemphasize the historical role played by the US in these markets.

  23. mxq

    (fyi…the “comment deleted” was me…accidentally hit post instead of preview before i could finish my thoughts)

    Cool guy…i don’t disagree. You provide some great analysis.

    And I’ll second that notion that diesel production takes a back seat to gasoline. In fact, according to the doe(production by product…at the bottom) diesel looks to be about 25% of the barrel.

    But my problem (which could be flawed logic, as you assert), is that 25% of the barrel is driving 100% (maybe more?) of the wti price. If demand is falling in the rest of the barrel, the aggregate price of the other 75% of the barrel should be providing downward pressure on wti prices (as cracks suggest).

    In other words, i think that the wti elephant is being propped up by the diesel stick, and index buying pressure is trying to convince us that diesel is really that valuable to trump the rest of the barrel.

  24. Juan


    I’m trying to say that the modern oil price regime is one of formula pricing in which the prices of particular crude oils (there is a wide variety) are set as differentials to a few benchmark crudes (brent, wti, dubai/oman).

    Spot trade in the physical benchmarks determined prices during the early portion of the present regime but, over roughly the last decade, this has largely ceased to be the case. The futures markets became, in effect, the spot — the direction of causality shifted.

    Saudi Aramco, for instance, prices its exports to Europe relative to the Brent Weighted Average (BWAVE) which is made on what used to be the (London) Intl. Petroleum Exchange but now the Intercontinental Exchange while those to the U.S. price as differential to the Nymex contract.

    Financial markets became the heart of the pricing system. Prices became real market related rather than determined, which is also to say that price formation was opened to other than specifically economic pressures but also a multitude of beliefs, expectations, desires, allowing for and, imo, becoming a self-fulfilling financial mania rather than the efficiency that mainstream economists love to argue.

    Something Robert Mabro wrote in 2005 might be the proverbial nutshell:

    “A tidy mind will find it odd that the reference price for a physical commodity should be borrowed from a market where people buy or sell a contract that carries its name but which is only partly related to it.”

    A few years ago, an offer to sell Saudi Light Crude Oil noted among other things that “SLCO can be sold either on spot deals or long term contract basis. SLCO also can be sold at moving average or at an agreed fixed price…”, or, as you can see, a variety of contract possibilities but I would expect all to be related to futures determined benchmark prices.

    In an offering last year the U.S. Mineral Management Service outlined a pricing mechanisms as:
    “an increment or decrement from either or all of the below pricing formulas. If you would like to submit…based on an alternative pricing formula, please caveat the offer with the alternative pricing formula used.
    1. (Calendar NYMEX + Daily Roll) – (Platts WTI – Platts Crude Type)
    2. (Calendar NYMEX + Daily Roll) + (Argus Weighted Average Crude Type Differential)”

    Platts and (Petroleum) Argus are private assessments that I’d prefer not to comment on other than note that one has been shown open to possible manipulation.

    Perhaps closer to what you mentioned:

    “China…plans to increase crude oil imports through long-term contracts and cut spot purchases to cushion against price and supply fluctuations.
    “We need to gradually change the status of an over- weighted proportion of spot trading in crude oil imports”…”
    (China Trade Information, March, 2008)

    This last has a ‘back to the future’ ring to it since decades ago the trade was centered in long-term contracts.

  25. Cool Guy

    mxq, thanks for the response, I definitely see where you’re coming from.

    The problem with the link to the DOE site is that those figures only represent the fuel mix of US refiners. Our refineries are geared to produce much more gasoline than diesel, but worldwide it is the other way around. A cursory search turned up this figure (

    “The world consumed 30.2 million barrels of diesel and related distillate fuels, 16 percent more than the 26.1 million barrels of gasoline in 2006, according to statistics compiled by BP Plc.”

    Not sure what the demand distribution is at now, but I would bet that the disparity has widened.

    Look at page 24 in this report on European refining: . It shows the product yields for refineries in Europe. For most European countries, diesel and gasoil yields dwarf yields of motor gasoline.

    So, I would argue that distillates are more important than gasoline when the rest of the world is considered. Which (btw) is why I think US commentators are so quick to buy the speculators argument – since, again, there is a home bias in our analysis.

  26. Richard Kline

    So Juan, sorry for my late reply: I’m on vacation, and only intermittantly near a keyboard. : ) (—And the market blows up!) The point you raise that two sigma deviations have invariably broken back is very interesting; thanks for the mention. This, btw, is _real_ data, the statement of what is not what might be. Now, there is one problem in that trends do modify over time, so that backward comparisons will inherently under-describe cumulative shifts. This is why so-called paradigm shifts ‘seem’ so sudden, backward comparisons maintained a family resemblance until someone births a mutant (so to speak). Still, if all the evidence says that wide trend divergences for asset classes are ‘unfundamental,’ that’s something I want to know, and wish that policy makers had on a single sheet of paper, double space, on their desks tomorrow.

    So Anon of 11:06, I did read and grasp your point, but my response was tangential to it. In consequence, I expect that I misrepresented your point to a degree; my apologies. Now, I don’t think that we can look at raw oil unit costs in relation to the dollar or the euro alone because the issues all interlock. For instance, the euro didn’t stay stable, which I’m sure that you know, so that a dollar decline in part is represented in a euro rise so the euro buys more of a set unit of oil (which is itself a moving target). We have a Three Body Problem, here, and no overall picture can be properly assembled from the perspective of any one component alone, dollar, euro, or oil.

    Oil costs more relative to other units of value; on that, I think we can all agree. The key issue is whether the speculative component is ‘small,’ as you imply. How small is ‘small’ to you? 5% of the quote? 15% of the quote?? 25% of the quote?? To my untrained but splenetic I (a mixed metaphor but I like it), I view the speculative component at least at 25%. That is not ‘small.’ That is large enough to wipe out the shorts on NYMEX, and terribly distort pricing overall. Specialists who are quoting and eventual ‘price fall back’ to, say, $70, a number which has been quoted, in effect define the speculative component as the large part or entirety of 50% of the quote as of 28 June 08. That just isn’t ‘small”: That’s gross.

    I’ll add that I don’t see all ‘speculators’ as profiteers. Airlines, pension funds, and hedge funds legitimately trying to hedge inflation risks in long positions are speculating by any technical use of the term but as necessary parts of their fiduciary reponsibilities. Fat, hot, dark, money out of London via Bermuda bidding up select oil futures are profiteers who neee to be restrained. I’m tempted to say “Up against the wall,” but those who so pronounce tend to end there thermselves, so I’ll be more circumspect for now.

  27. DownSouth

    Cool Guy,

    Thanks for your comments. Very enlightening.

    As an expat, one of the things that always strikes me about the United States is just how insular it is. A majority of Americans have no ability to think beyond the borders of the U.S.

    I don’t know what it is. Arrogance? An almost religious adherence to American exceptionalism? Ignorance?

    But the parochial mindset transcends mere market mechanics. Beyond this, other countries have different economic philosophies–different ideas about how best to run an economy. And I think it is pretty safe to say that, at the current moment, the American way is in descendency and other ways are in ascendency.

    Here’s a recent NYT’s article that gives a lot of insight as to the philosophical sparring that is currently going on:

    As the article states: “Some officials are promoting a Chinese style of economic management that they suggest serves developing countries better than the American model…”

  28. mxq

    “American way is in descendency and other ways are in ascendency.”

    So -55% since october is ascendency?

  29. Richard Kline

    So DownSouth, American exceptionalism is sustained in the cultural gestalt at the level of a religious believe because it in fact derives from a religious concept embedded in the culture, that the original evangelical colonists had an actual pact with the divine mediated at the level of individual profession in a community of believers. The sociocultural aspects of this concept, the seed which shapes the tree of social concept even for now convincedly secular Americans by the million, many of whom _do not_ descend directly from Anglo evangelicals, is a fascinating historical structure. I won’t write on it extensively myself, but the intellectual history behind that observation is something to which I gave a deal of background reading in pursuing other historical trajectories. I hope that someone else does the real historical monograph on this in time to come.

  30. DownSouth

    Richard Kline,

    What makes a nation exceptional?

    That the United States is exceptional goes without saying. As Richard Bernstein noted: “The plain and inescapable fact is that the derived Western European culture of American life produced the highest degree of prosperity in the conditions of the greatest freedom ever known on planet Earth.”

    And of course there are many, like those who assert that the United States is a “Christian” nation, who believe America’s exceptionalism was based on religion.

    J.H. Elliott, in “Imperial Spain: 1469-1716,” also posits the question. Regarding Spain’s rapid rise to being the world’s number one military, economic and cultural power, and its equally rapid fall, he asks:

    “How all this can have happened, and in so short a space of time, has been a problem that has excercised generations of historians, for it poses in a vivid form one of the most complex and difficult of all historical questions: what makes a society suddently dynamic, releases its energies, and galvanizes it into life? This in turn suggests a corollary, no less relevant to Spain: how does this same society lose its impetus and its creative dynamism, perhaps in a short a period of time as it took to acquire them? Has something vital really been lost, or was the original achievement itself no more than an engaño–an illusion–as seventeenth-century Spaniards began to believe?”

    I of course have my own theories about how the U.S. became exceptional and why it is now in decline (Is it really? Again this is an expression of my opinion.). And while American exceptionalism may indeed have its historical roots in Puritanism, I for one believe that religion had little to do with it.

    And I would also argue that no nation with an ethos of parochialism has ever become, or remained, exceptional. This is one of the reasons I believe the United States is in decline. There is no sense of intellectual excitement in the country, no thirst for cultural contacts with the outside world.

    The United States is beginning to remind me of the man who was once rich but has since lost his money. The pride remains, but nothing else.

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