On the "Endless Bid" for Oil

Are we seeing a rerun of early 2008 in diminished form, as least as far as oil prices are concerned? Reader Michael sent along an article by Dan Dicker that contends that oil prices are well ahead of their fundamentals, and that, as before, the oil bulls are taking considerable cheer from Goldman’s boosterism. A key element that Dicker highlights that too often goes comparatively unnoticed is the small size of the oil market, Hence sudden influxes of funds can have a price impact.

Now some readers will pooh-pooh that notion, saying that prices that are “too high” should lead to hoarding. Well, unlike last time around, there are abundant signs of that, with oil in storage at virtually unprecedented levels, Moreover, regulators are increasingly accepting the view that prices in futures markets can and do drive the physical market. From Dow Jones Newswires:

Until recently, the U.S. Commodity Futures Trading Commission had more limited oversight authority over contracts traded electronically on exempt commercial markets such as IntercontinentalExchange Inc. (ICE). But when energy prices rose to record highs last year, lawmakers expressed fears that traders were affecting prices by using exempt commercial markets to bypass speculative position limits imposed on similar types of energy futures contracts traded on exchanges…’We were told to look at significant price discovery contracts and we have been doing that,’ acting CFTC Chairman Michael Dunn said Wednesday, noting that preliminary reports suggest ‘it was much larger than we originally thought’ and that staff was ‘surprised’ by the preliminary findings.

Notice the key expression, “significant price discovery.” Most economists believe that price discovery takes place in physical markets only. Yet as credit default swaps have shown, supposed derivative markets can not only be the preferred vehicle for price discovery, but actually drive prices of the supposed “underlying.”

Now to Dicker via The Street:

Oil has been rallying because of the weakness of the dollar and because of the specter of impending inflation…

Yet in the last several sessions, the dollar has found some amazing strength, and gold, the best proxy for inflation, has come down quite a bit. So what is going on with oil?…

It’s the endless bid.

Goldman Sachs recently revised its oil targets for 2009 and 2010, raising its $52 target price for the near three months to $75. It gets worse, according to Goldman. Year-end targets for the crude barrel in 2009 were revised up to $85 and a $95 target was set for 2010. How do they come up with these figures?

Goldman analysts cite increased demand. Yet there is absolutely no sign that demand is increasing, quite the contrary. Goldman argues that oil is rallying on expectations of increased demand along with similar expectations of recovering economies in the second half of ’09 and into 2010. Even if this gargantuan leap of faith were true, why isn’t natural gas, a perfectly wonderful and plentiful energy source, rallying as well? Why is it languishing at a mere $4s/mmBTU, while crude streaks ever higher?

And how do those Goldman oil analysts even create these mythical target prices?…

The endless bid is what I’ve begun to call the incessant, unrelenting and often unreasonable desire of investors to have exposure to oil…..there is a renewed interest in having oil as a part of every investor’s portfolio.

The oil market is a delicate market. Even more importantly, it is a relatively puny market….the entire notional value of crude oil traded on the Nymex is a little under $100 billion.

That sounds like a lot. But not if you consider that the notional value (market capitalization) of even one oil company like Chevron(CVX Quote) is 40% more. The market cap for Exxon Mobil(XOM Quote) is 3.5 times more. Intuitively, we can expect that even a relatively little amount of new investment interest in oil futures is going to have a huge impact on the price.

That’s the endless bid.

We saw the endless bid fuel the run-up in oil to $147 in July 2008.

We saw the endless bid withdraw just as quickly in late 2008 and through February of 2009 with a resultant low of $32 a barrel.

And now, it’s baaack .. and makes any estimate of a target price for oil a total shot in the dark, a complete guess, practically unrelated to any economic forecasts or supply/demand estimates.

Before you decide to run out and go short, bear in mind that some technicians think that black gold could run further. While I must note that technical analysis has about as good a reputation as astrology in respectable circles, I have also observed that a lot of investors use it as an input in decisions, and it allegedly works better for commodities than for stocks. That is a long-winded way of saying that if enough people utilize it, it can become a self-fulfilling prophecy.

Nevertheless, consider this chart from Bespoke Investment (hat tip FT Alphaville):

Bespoke’s comment:

The current rally in oil is nearly twice the average bull market gain in nearly half of the average duration.

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  1. Richard Kline

    A lot of investors use _astrology_ as an input to their decisions. And if enough to, than this influences outcomes. Call it epsilon stability, where a noise factor, if large enough, dominates the system in which it is active, even if extraneous to anything in that system. Turn up the music; no effect on the walls of Jericho. Get The Big Guy to turn up the volume, and yes, noise can drive the system.

    If GS and its ilk want the price of oil to be $95, they can, b'God, get it there, even if all they have for substantive reason are noisemakers.

  2. Bsjo

    I've never understood why oil independents and oil integrated don't take advantage of these market conditions in larger volumes.

    These companies had the chance to lock-in at prices well above $125 Q1 2008. This opportunity is replaying itself now. I cannot imagine how they can miss it twice.

  3. Purple

    The rise in oil is speculative, just as the blow-up last year was. The 'real economy' does not offer enough profitable investment right now, so speculation is where capital wants to flow.

  4. Thomas

    I still fail to understand how "speculation" can move the spot price through any other mechanism apart from build-up of storage (i.e. hoarding):

    The oil offered by the producers needs to be physically sold to somebody. So if end-demand is not enough, there can only be a market clearance if enough people buy the oil to store it somewhere. If they don't do that, the producers can't sell the oil, so the price either plumemts, or the producers refrain from selling (which would mean lower supply).

    How else can "speculation" work for a spot-delivery price?

  5. Brick

    I have just had a perusal through the latest EIA data for crude storage and gas supplies and it becomes quite clear that consumption is generally down with one notable exception. Apparently the supply of gas to the east coast of the US has gone up.


    Before we all start cheering the green shoots it may be worth noting that ftalphaville had a little article about how JPMorgan was using tankers to store gasoline.
    To which I would draw your eyes towards an article by seeking apha on oil swaps.


  6. mxq

    Bsjo: "I've never understood why oil independents and oil integrated don't take advantage of these market conditions in larger volumes."

    Good question that a lot of people wonder about. My guess is that working capital for producers is finite. Last Q conf. calls were full of CFO's talking about tying up working capital to rent storage/and or hedge. Given the volatility of markets, depending on which way a trade goes, companies have to post more/less collateral — sometimes in the form of more bbls of oil. So there is a finite amount of working capital working against the "endless bid" of the literally hundreds of billions of dollars in investment funds.

    Brick: "How else can "speculation" work for a spot-delivery price?"

    I struggle to understand this too…to the best of my knowledge, the whole point of speculation is to bridge the gap between buyers and sellers, helping facilitate a more orderly market. As yves pointed out, though, markets are getting halved and/or are doubling every 6-9 months…that is not an orderly market. In other words, market clearing prices aren't necessarily healthy — housing is the most obvious example. Houses cleared the market for years and at levels much higher than what normal markets would have been willing to clear for. So speculation can distort markets more than people think. What's even worse is when policy and/or LT investments are made based upon these faulty market clearly prices. That's why insights from traders like dicker are more important than any wonks' proof. Everything looks good on paper and sounds good in theory, but like everything, there are lots of destructive unintended consequences.

    Just to further dickers stats about the size of paper demand vs. bona fide producers, via John Heimlich, the Chief Economist of the Air Transport Association:

    "in the month of June the combined volume of the NYMEX WTI, ICE WTI and ICE Brent futures contracts just by themselves is over 1 Billion barrels per day (this does not include the OTC markets which are larger). There are only 85 million barrels per day produced and consumed in the world. If every barrel produced was hedged (most are not) with a speculator on the other side and every barrel consumed was hedged (most are not) with a speculator on the other side then at least 830 million barrels per day are traded between speculators.”

  7. billmo

    Trading technicals works well because patterns represent the emotions of market participants. Most technical traders fail because they think they are smarter than the market or can't control their emotions or don't trust the patterns or have no risk management.

  8. onetimepadlock

    I don't know why nat gas isn't following oil around, or whether it should follow oil at all, but there are reasons for why natural gas is where it is, independent of oil demand.

    Today's energy report indicated an increase of 106 bcf. There's plenty of natural gas available domestically. There's also new unconventional means of nat gas production (shale, coal-bed methane).

    When natural gas fell below $5, many believed that it would only be a matter of time before producers shut-in production because it was unprofitable. Now it seems that $4 natural gas is still quite profitable for somebody, probably coal-bed methane producers. They may even have been quite comfortable at $3.

  9. juan

    Thomas said: I still fail to understand how "speculation" can move the spot price through any other mechanism apart from build-up of storage (i.e. hoarding)

    Spot prices are related to futures prices which do not directly and automatically capture real economy fundamentals. Prices for the physical crudes are at very best only real market related — trying to understand this on the basis of neoclassic efficient market theories rather than the actual history of and change within oil price regimes is exactly why most mainstream economists failed to grasp the speculative nature of the price run up, krach, and the current rise. IOW, they refuse to think beyond an ingrained theoretic box and in so doing helped provide additional justification for commodities bubble-in-general and oil in particular.

    The attached [and incorporated links], while far from perfect, might help with perspective:

    Futures Prices Determine Physical Oil Prices

  10. matt h2o

    Couple of comments.

    For one, it's not that hard to roll an exchange-based contract from one month to the next so long as the market is in contango – you take a transaction cost but so long as you can sell the same oil for a higher price the next month, you never have to deliver. As a consequence of that practice, though, if the market backwardates you could see a big shift in the speculative positions, which would exacerbate the likely downturn in prices, at least short-term. Add to that the fact that all the oil and products currently in floating storage will be brought back to market as soon as the contango flattens – and you have major downside potential.

    Secondly. Different producers have different costs of production, and all the players in the market have hedged forward at particular prices. That is the reason instrumentals work in the commodities markets – major players will defend prices because they are marking against a set price, not because it's cheaper or dearer on the day. If the market likes a particular price, it's often because it's a comfortable compromise between the spot/prompt market and longer-term liabilities.

    Now I've got some of the market basics out of the way, I'll get to the major complicating factor. A large part of the rally in oil prices is that the dollar is depreciating, and oil is benchmarked in dollars. I've rebased European oil and gas prices (lots of gas contracts are linked to oil) and the recent decline in oil prices has been lagged by the European gas market becuase of the currency effect. So basically your dollar-denominated moves may not look as scary in other countries, which means demand may be more resilient (both to rise and fall) than the dollar changes would suggest.

  11. matt h2o

    Corollaries to my first point. Exchange-traded contracts tend to be futures, not spot – so while speculators are rolling the futures, the spot can stay low because the physical demand isn't there. That exacerbates the contango. Also, while there is a contango and a lot of floating storage, speculators are gambling that they can cover by buying spot and holding to deliver when their contracts are due – so you have to look to the cost of hiring the ships against the cargoes they carry to work out when the contango is too flat and the speculators will cash out in physical.

    Of course, all that physical coming to market will push prices down – but by then the market will probably be in a bearish mood, so the contango won't resurrect.

    Anyway, enough of the market commentary.

  12. John

    Something i've noticed for awhile now is the markets seem to be working counter-intuitively,as if there is a purposefull agenda to destabalize ones ability to invest properly.Hence many people are LOSING their money..and that money ends up in whose pockets?Beware of what you think is a good bet in anything.In my opinion the game is completely rigged now.Savings don't beat inflation,markets have shrunk up and many businesses have gone away,why save money if the dollar is due to collapse?what can one buy to resell if the depression deepens?what could support a recovery?There are no good answers here and that smacks of thorough manipulation and control.

  13. Anonymous

    OPEC states on their website that oil prices are set by the futures markets. See: http://www.opec.org/library/FAQs/aboutOPEC/q20.htm which says, "In today's complex global markets, the price of crude oil is set by movements on the three major international petroleum exchanges, all of which have their own Web sites featuring information about oil prices. They are the New York Mercantile Exchange (NYMEX), the International Petroleum Exchange in London (IPE) and the Singapore International Monetary Exchange (SIMEX)."

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