Friday, 27 June 2008

Oil at $142

Can oil prices possibly go higher? Everyday, we get the same answer, as one shocking number replaces another. However, here is a more interesting question - how high do oil prices have to rise before central banks act?

Central banks may not have any oil rigs in their backyard, but they are responsible for the price of oil. Since last August, the large central banks have either cut rates (the Fed, the Bank of England) or maintained very low rates (the ECB) at a time when inflation has picked up. As central banks have delayed responding to the growing inflationary threat, price expectations have picked up. Nowhere is this more true than in the oil market.

Lower rates reduced storage costs for oil. It was already a tight market before the monetary easing. With little prospect that demand will slide in the short run, it pays to be holding onto oil right now.

Lower rates has also prompted a speculative frenzy. The rate of return on riskless short term treasury bills are negative. Rather than lose purchasing power, many investors have turned to the one market making serious money - commodities, and in particular oil.

Today's commodity markets are deeply mired in a speculative bubble. Like all bubbles, prices rise because they rise. This may have a circular logic, but over short time horizons, it has sufficient plausibility to push the oil price up to $142 or higher. In the absence of a better reason, oil keeps going up, and as it does, it encourages investors to take a punt on an even higher future price. Anyone looking for a high risk, high return investment today buys an oil futures contract.

However, it is hard not to be struck by the irony behind today's oil price rise. Back in 2001, central banks tricked their way out of a modest slowdown by cutting rates. That spurned the housing bubble. For a while, central banks seemed to get it right; rapid growth, low inflation, and appreciating asset values.

Then housing went bad and threatened to take down the banking system. The Fed and the Bank of England tried the same old trick - lower rates. Only this time, it generated a nightmare - a commodity price bubble. Now central banks are trapped; the banks are still in trouble, inflation is rising out of control, and economic growth is slowing rapidly.

So what is the way out of this mess? The first step to recovery is to recognition - central banks must understand the magnitude of the problem and the dangers of inaction. The second step is prioritize; the key problem is inflation. If prices are stable, economies will recover quickly. Bank failures are nasty, but if they are cleaned up quickly, financial systems can recover. Inflation, on the other hand, can take decades to control. Sort out the inflation problem first, then move onto the banking problem with a slash and burn strategy. The economy will take care of itself.

Only central bankers can stop this frenzy in the oil market. If the Fed raised rates today by 100bps, the price of oil would be $80 by Monday morning. It is that simple.

21 comments:

ztop said...

$142? It will be $200 by xmas.

huntse said...

I'm sorry but I don't buy this analysis at all. Crude oil stocks are currently at 0.306m. The average over the last 10 years is 0.309m. If speculators holding physical oil is such a big factor in the price, how come inventories now are lower than they were in November 1999 when the price was a fraction of what it is now?

The fact is that the cost of storage and carry is not what's driving the market right now, it is the expansion of demand in the BRICS, uncertainty in the Middle East, and political instability in practically all oil-producing nations. Secondly, years and years of underinvestment means processing capacity is nowhere near where it should be so the market can't respond that fast to increased demand even if the supply is there.

aSteve said...

I completely agree.

The thing that is most curious is that, if the value of commodity oil is rising rapidly, wouldn't you expect the value of companies owing oil fields to rise rapidly? Well, BP and Shell, for example, haven't perceptively risen this year. Some smaller players have risen and some have fallen. This is not consistent with a shortage of crude - or a demand shock.

I think that the price of oil is high because speculators are driving it higher. I heard on BBC parliament (Energy Select Committee) that gas is traded 14:1 in London - i.e. that for every 1 unit of gas futures contract there are 13 financial long and 13 financial short contracts. I suspect something similar is true of oil. If this is the case, we have to ask the question: who are taking the short contracts? What is their motivation? With such a ratio, it suggests to me that the commodity itself is all but irrelevant... as key speculators can afford to deprive the world of energy for three months... which puts them in a strong position to demand "protection money" - in the form of higher (or lower) prices depending upon what OTC contracts they've signed.

The whole debacle reeks of Enron and Californian electricity.

With oil principally traded in US$, the 2% fed rate, I think, is crucial to facilitating these time-limited monopoly plays. Given that oil companies hold great influence over US Congress, I doubt that anyone will really be motivated to resolve this until it looks set to cripple the entire world economy.

I expect it to rise a little from here, and have a mental note to engage in a fantasy-short position when it reaches $160 - with an assumed contingency to accept losses should the price rise to $200 - before collapsing catastrophically.

What is relevant is not the availability of oil, but the solvency of companies taking long/short oil OTC contracts.

This debacle has been inevitable since 1999 saw Clinton signed the Gramm Leach Bliley Act - stating that investment banks are now sufficiently sophisticated as not to pose the risks they did in 1930s when separation of Investment and Commercial banking interests was demanded by the Glass-Steagall Act - in an attempt to avoid repeat of the Great Depression. Too clever now? Yeah, right! Pull the other one, or let Monica Lewinsky do that for you!

http://en.wikipedia.org/wiki/Glass-Steagall_Act

http://en.wikipedia.org/wiki/Gramm-Leach-Bliley_Act

aSteve said...

Clarification... I completely agree with Alice, not huntse.

The physical stockpiles are all but irrelevant. The revolution to supply chains has been to minimise inventory. The oil that has been stockpiled is not physical sticky black oil... No, that's too cumbersome to transport and store. The oil that has been stockpiled is future oil.

Because the rate of interest in the USA has fallen from 5.25% to 2% speculators have been able to plough over twice as much money into buying oil futures as they previously could. This can double the price of oil for future delivery - which is how much oil is bought... because buyers need to establish where to send it. The stockpiled oil is still underground.

The snag with this otherwise "brilliant" (aherm) plan is that, with higher oil prices, demand will fall and supply will rise... and when it comes time, there's be more oil than consumers can afford... and there will be speculative losers. Providing the losers aren't already insolvent, this will be OK... but, being a cynic, I suspect they are... and this is why they're trying such a reckless last throw of the dice.

huntse said...

Why does everyone hear "short" and think "speculator"? When you are a producer and you want to hedge the price vol of your future inventory, being short futures is what you do. You are selling the oil you will have in the future.

This is nothing to do with Enron and it's not a conspiracy. You can't short oil futures and deprive the world of oil and demand money later. This would be market abuse and if you look back to attempts to corner the metals markets, what the futures exchanges do in these cases is to change the delivery terms to prevent the squeeze.

huntse said...

Oh, and as far as funding is concerned, if you think that there are a lot of market participants around who are able to borrow close to fed funds with capital and tons of leverage to buy oil futures right now you haven't been paying attention to the credit crunch.

This "speculation" line denies the obvious, that if speculation was driving the price you would see lots of inventory (ie a clear disconnect between spot and futures). The fact that you don't says that is all media nonsense. There is a perfectly cogent rationale for high oil prices because both supply and demand of physical oil are extremely inflexible so small changes in either are able to shift the price a lot. And we have seen an explosion in demand from the BRICS and elsewhere and no real increase in supply at all.

All these people who are so sure prices have peaked should put their money where their mouth is and short oil.

aSteve said...

Huntse, I think you give Alice/myself too little credit.

First, there is nothing "wrong" with speculation, per-se - as long as you can afford the maximum potential loss. It is criminal to speculate otherwise.

Both short and long plays (in the sense of derivative trading) are by their very nature speculative. No asset is transferred - hence only speculation as opposed to investment is a logical explanation for the transaction.

I am well aware that futures can be used to hedge business risk. It is not however credible that business risk (from the real economy as opposed from speculators divorced from the "real" economy) make supply risks a credible explanation for the futures price? I do not.

While there are clearly differences with Enron, if you can't see any similarities, maybe you're the one who's looking surface deep? It is a grand claim to suggest that there is "no conspiracy" - because by saying that you're asserting that no two individuals have done anything illegal anywhere in the world that has caused the price of oil to rise. I certainly don't have evidence to support that - and neither, I think, do you. What is amusing, however, is that I do not claim a conspiracy - merely a crisis in commodities facilitated by a short-sighted response to a crisis in credit.

With respect to commodities exchanges blocking moves to corner markets, while I commend the textbook answer, I think you overlook an elephant in the room. Speculators in oil do not need to buy oil futures themselves... all they need to do is to facilitate OTC contracts to hedge the risk... then leave it to individual speculators to buy the futures contracts - hedging any potential risk in over-paying for a futures contract with a corresponding short OTC. The commodity exchanges would have no idea if a market was cornered - or by whom.

As far as funding is concerned, there don't need to be a lot of participants who can borrow cheaply - it is sufficient that the investment banks can do this.

The argument that "if speculation was driving the price you would see lots of inventory" is flawed. Since the speculation is in future price, and because there is a lag between changing prices and changing demand, I would not expect to see any physical surplus. I would expect to see oil producers deciding not to operate at full capacity though - which we do. There's no point in pumping if it then costs to store the damned stuff!

I am aware of the "perfectly cogent rationale for high oil prices" arising from BRICS demand. I do not think this justifies the recent price trends - and, hence, I am convinced that oil is in a bubble. That is entirely different to believing that it has peaked. I just believe that if people buy and hold at today's prices for - say - 6 months to a year, they are likely to loose. That doesn't mean I don't think sufficient idiots/fraudsters exist to drive the price of oil higher than it is today. Such an outcome seems likely, in fact... but that doesn't refute that oil is over-priced.

powerman said...

I think Oil has reached the price it has simply because of what people don't want to invest in.

They don't want to hold dollars. They don't want stocks and they don't want bonds. Oil does have supply and demand fundamentals suggesting an upward trend in price, it's widely accepted as something people will need for the forseeable future, so that's where a lot of the money which has fled other things has found shelter.

aSteve said...

Powerman, I agree.

The questions that remain are these:

1. How flexible is demand?
2. How flexible is supply?

What I'd love to see is for OPEC countries to pony-up a huge number of oil futures reaching years ahead... then, after a few months... double production... thus allowing them to sell oil at a premium to futures speculators... and at a regular price on the spot market. Timing, of course, is everything. ;)

alice cook said...

Huntse,

Thank you for your comments. I enjoyed reading it.

I understand and your position. However, the problem I have with the "fundamentals" story is why has oil surged in the last 6 months, just as there are signs of a worldwide slowdown. It is a hard story to reconcile with the data.

I don't blame anyone for speculating on oil right now. It looks a little dangerous, given that there is a modest probability that central banks will wake up and do something.

The speculative explanation has lots going for it in terms of evidence.

Again, thanks for your comment.

Alice

alice cook said...

powerman, totally agree. Alice

huntse said...

OTC contracts are far from being the "elephant" in the room. What happens when you book an OTC contract? The dealer that sold you that contract goes and hedges their delta and gamma so you see the effect in the underlying market. Unless you think that all of the dealers have just decided to give up on hedging their book, which they have not. Secondly OTC dealers still have to report any sort of trades that amount to an abusive corner or would result in price positioning in the physical or options markets and a bunch of other stuff. So OTC doesn't give you the chance to rig the market either I'm afraid.

Long and short derivatives plays are not necessarily speculative. Arbitrage is of course not. Neither is hedging physical production, to pick two obvious examples.

Secondly, the stupid decision to give cheap funding to investment banks at the moment doesn't mean they are passing that funding on to counterparties. If you try to put on an OTC oil trade right now you will pay points upfront and have to post a bunch of collateral.

aSteve said...

The other possibility with OTC trades is that the broker can pair long and short trades. We know from the structure of commodities index trackers that there is a ready market for long positions... what we want to see now is whom might hold the short positions. It is worth noting that with cheaper interest rates to investment banks, it is cheaper to hedge against underlying markets too. OTC contracts definitely do provide a facility to influence the market... as to whether the market can be "rigged" rather depends upon what you believe to be "right". Without clearly defining terms such arguments are futile.

We differ in our interpretation of the word "speculative" - since, while arbitrage (assuming no counter party risk) need not (in principle) be speculative, hedging as well as uncovered long and short positions are speculation according to my dictionary.

I also think that it is relevant to ask if market makers (investment banks) are manipulating price by demanding asymmetric margins to go short/long.

Even if the investment banks pocket the difference between the Fed rate and the market rate when lending to hedge-funds, say, it is difficult to argue that they are not being encouraged to make more loans rather than less... and that this encourages them to turn a blind eye to risk. If they're lending to an insolvent party, it won't bother them what interest rate they're charged.

Alice Cook said...

Huntse,

Could you point me in the direction of oil supply data?

I found what you wrote very thought provoking.

Alice

huntse said...

The oil supply data I was using was from bloomberg, so its not publicly available I'm afraid. There is a lot of detail about production, supply, inventories, the derivs market etc there though and a lot of it is published separately (outside of bberg) as well. I've left my login key at work so I can't log in till Monday but if I remember I'll try to track down the public data then.

There's a lot of housing data there also :-)

Anonymous said...

Alice,

Have a look at this post on The Oil Drum looking at the volume of oil exports.

It suggests that the total oil available for export peaked in 2005 and has started to decline (and the rate of decline will get much worse in only a few years time). Price elasticity of oil is very low (from memory 100% increase in price has reduced gasoline consumption by 1.5% in the US), so you need a very large price rise to reduce demand to compensate for the small reduction in supply. We are now 1-1.5m bbl/day off the peak so a 100%+ increase in crude oil is not unexpected. You don't need to invoke speculation to explain the price increase.

The only way to get price back down is to destroy demand faster than export supplies decrease, i.e. massive conservation and energy efficiency efforts. Blaming speculators will do nothing to destroy demand so will not stop the prices increasing.

This appeared to be the unwritten text that came out from the meeting in Saudi Arabia on Sunday. The Saudis said that there was no extra oil and the politicians started to talk about nuclear power and renewables a little more forcibly.

The decline in oil exports and the consequent massive increase in the price of energy make the bursting of the housing bubble different this time. Food and energy costs will increase significantly, reducing disposable income and making it increasingly hard for people to pay for housing. Food and energy prices are set by factors outside the UK (and can't be inflated away without huge interest rates to prevent sterling falling), so housing costs will have to give.

Jeremy

Barry said...

Folks, how much is the steadfast refusal of the US to exploit is own oil resources a factor in the rising prices? Would be useful to have some clues.

Nick Drew said...

I am with Huntse on this.

The puzzle that's confounding asteve and others is - "why $ 140 ?": there doesn't seem to be a reason why this particular price clears today's oil market, and it seems too high.

The answer is that when the S/D balance in any commodity becomes really tight, even when the market is working 'perfectly' (i.e. driven by fundamentals) prices will spike higher than those who aren't familiar with markets expect, or see as 'reasonable'. It's not a neat, linear function of inventory, or reserve ratios, just as pain isn't on a linear scale with ordinary sense of feeling. It's the market sending a very loud, clear signal.

I can show you very clear examples from close to home in (e.g.) the UK gas market, where very identifiable physical events (say, an explosion at a big storage facility) cause a huge (short-lived) spike, to levels several times the average spot price. Why 'several times' ? Well, it just turns out that these are the price-levels that re-balance the gas market in acute circumstances. Spectators gasp, but market participants just get on with it.

If they can't stand the hit, they should have been hedged. (BTW, does anyone suggest that hedges against today's oil prices taken out, say, 2 years ago, are not being 'honoured' ?)

But although spectators get very agitated, actual market participants will tell you that trading is continuous throughout, and that the prices are 'real', i.e. if you are willing to pay them, you can get the commodity.

aSteve said...

My problem with your answer, Nick D, is not that I assume that I assume linearity of price with demand... but because I see demand destruction...

We haven't seen considerable supply shocks - and, more relevantly, we haven't seen prolonged supply shocks that would correspond to a steady, if steep, incline in oil prices. The data simply doesn't support the premise that this is a supply/demand issue for oil. The evidence does support the idea that speculators (acting as if they were a monopoly) have driven up the price in an effort to capitalise by dominating the futures market.

I see the price of oil to be a great analogy for the price of houses - all be it one that has grown more quickly in the context of a more liquid market.

Nick Drew said...

"have driven up the price"

the price of what ? Putting aside some of the technical complexities of the Brent market (because the WTI market behaves broadly the same way, and it doesn't have the same complexities) speculators only deal in futures / forwards, with no capability to handle the physicals - very few players have this. There is no reason to believe forward prices alone can 'drag' physical / spot prices: indeed, there is often a systematic disconnect except at the very prompt end (where genuine arb is possible via storage), hence the expressions 'contango' (when forwards are higher than spot) and 'backwardation' (when they are lower). But of course the whole spot/forward complex can - and does, e.g. recently - move up and down together.

There is such a thing in commodity markets as a ramp in the forwards. In such cases, players with natural short positions (i.e. consumers) who see what's going on, stay short until the prompt period instead of hedging.

I assure you that no natural energy short is successfully running a 'stay short' position in this particular oil / gas / electricity market. (I could name a few who have been trying - and who have been getting caned.)

So - I am convinced the present oil price is driven by (current) fundamentals. None of this is to say that prices couldn't collapse. As Alice says, they could, and I have long predicted they will - when the fundamentals change. She offers one potential trigger. My guess (along with many others) is that it will be whenever China takes its first major hiccup in its Long March - which could be later this year, "after the Olympics" as they say.

[BTW, oil (as you surmise above) trades at a multiple of way more than 14 - an order of magnitude more]

aSteve said...

Nick Drew, I guess one can always say that a market is driven by the fundamentals - it's a tautology, of sorts. The question, however, is this: Are the fundamentals of the oil market, at present, significantly influenced by a sudden rise in long-speculation by non-consumers of oil? I'd say they are.

P.S. I'd love a reference that suggests that the volume of trading in oil is ~140X the volume of physical oil. That seems remarkable in itself.