According to Shell Oil president John Hofmeister, the “proper” range for oil should be somewhere between US$35 - US$90 a barrel. Based on that statement and assuming it’s more or less accurate, what do you think we should make of the current oil price of US$130 - US$140 per barrel? How much of the spectacular rise in oil is due to speculation? That is important to determine as excessive speculation could basically drive prices much higher than its real demand-supply equilibrium.
Open interest in WTI oil futures has been growing exponentially at 18% per annum since 2001, thanks to the entry of non-commercial players. The entry of more non-commercial players and speculators generally mean they would be on the long-side of the futures and options.
Many reasons are being cited for the oil price boom – speculation, fundamentals, dollar weakness, fuel subsidies, inflation, low interest rates. All factors are playing a part at some time or another, with different factors dominating at various times.
But one factor stands out as the biggest culprit – SPECULATION.
Spike in speculation
According to Michael Masters, index speculators are the primary cause of the recent price spikes in commodities. This is not selective information to back my view as he heads a highly respected fund management company – Masters Capital Management.
He recently (May 20, to be exact) delivered a testimony before the Permanent committee on “Investigations committee on homeland security and governmental affairs” to the US Senate. Hence his testimony carries a lot of weight.
Masters talked about the resurgence of several groups over the past five years who he deemed as newcomers to the “commodity speculation scene”. They are corporate and government pension funds, sovereign wealth funds, university endowment funds and other institutional investors. Collectively, they constitute the largest share of outstanding commodities futures contracts than any other group.
Masters refers to them as “index speculators” because they distribute their allocation of dollars across 25 key commodities futures according to popular indices, namely the S&P Goldman Sachs Commodity Index and Dow Jones AIG Commodity Index.
The rising interest in commodities was largely based on the assumption that historically, commodities have no correlation to fixed income and equities. It has to be noted however that while previously the futures market may have been relatively “not big enough” to provide this kind of diversification, this has not been the case over the last 10 years.
As at end 2003, assets allocated to commodity index trading stood at a whopping US$13bil. As of March 2008, that figure has ballooned to US$260bil! Obviously, something highly significant has happened here with equally significant consequences.
The culprits
Some political leaders have pointed their fingers at speculators as the primary culprits for driving oil price by more than 50% over the last 12 months alone. In my opinion, they are correct, partially.
The new index speculators are not your average in-and-out trading outfits. Collectively, these funds have stockpiled (long on inventory via the futures market) 1.1 billion barrels of petroleum. It’s not like they are actually going to take delivery of these oil barrels, but their stockpiling is tantamount to hoarding 1.1 billion barrels from the real market place. If real supply is constant, one can imagine what the 1.1 billion long positions will do to oil futures prices if they are rolled over.
Apart from index speculators, a huge number of long-only commodity funds and plethora of dedicated commodity ETFs have entered the scene in the past five years. A quick glance at Nasdaq will be able to give you an idea on the rising emergence of ETFs. Essentially, they are long players, trying to cash in on investors interest on a prolonged commodity bull run. But are they really interested to consume these commodities? NO.
Joining the bandwagon
Lending a great deal of support to index speculators are, unsurprisingly, investment banks. Swaps loophole exempts investment banks like Goldman Sachs and Merrill Lynch from reporting requirements and limits on trading positions.
The loophole allows pension funds (or any other aforementioned funds) to enter into a swap agreement with an investment bank, which can then trade unlimited numbers of the contracts in futures markets.
Even more interesting is that the WTI crude oil futures traded on ICE in Europe are exempt from regulatory action! ICE (Intercontinental Exchange) operates global commodity and financial products including the world’s leading electronic energy markets and soft commodity exchange.
Amidst all these hoopla, it would appear that Opec, which is traditionally everyone’s punching bag, is probably an innocent party to this catastrophe, this time around.
According to market estimates, the actual costs incurred in producing the most expensive oil is only around US$70-US$80 a barrel; the rest of the current oil price represents the market’s risk premium plus speculation. Note, that assumption is based on the high end of the cost spectrum and most are produced at a much lower cost.
Rising trend
You have heard this before: according to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels – an increase of 920 million barrels.
Over the same period, Index Speculators demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!
Bearing in mind that commodity futures markets are much smaller than capital markets, these substantive funds will have a far greater impact on commodity prices.
In 2004, the total value of futures contract outstanding for all 25 index commodities was US$180bil. In 2004, index speculators poured in US$25bil into these markets – a significant 14%. It would be safe to assume that the sums being ploughed into the commodity futures markets in the ensuing years to present is much higher.
Rising trend means index speculators are making a lot of money. The run attracts momentum players. Typically, rather than take their profits and run, index speculators tend to stay on because the allocation is a diversification bet not a straight out investing bet. They are more likely to reinvest their compounded gains and even more due to profit-motivated demand thinking.
Psyche of speculators
Index speculators are different from traditional speculators. The latter will trade, take their profits and run. The former prefers to keep the long position and generally, never sell. Instead of providing liquidity, index speculators are actually draining liquidity. Even if Opec promises to release more oil now, it would probably not dent the rally by much.
If index speculators weren’t a group but an individual, regulators would be on his back like a hawk and he’d be hauled up for attempting to corner a market. Masters highlighted to the US Senate that it is most important to close the loophole in the Commodity Exchange Act 1936 which exempt investment banks from speculative position limits when these banks hedge OTC swaps transactions.
According to Masters, almost 90% of index speculators effectively enter into commodity index swaps and face no limits on their positions. To puncture the oil price bubble, and yes, it is a bubble, Masters recommended that pension funds be forbidden from using commodity index replication strategies.
He added that the swaps loophole should be plugged immediately, thus causing all speculators to face position limits. In all likelihood, if the recommendations put forth by Masters or moves similar to that are put into action, the oil price bubble may be punctured.
Judging from market developments in recent weeks, it may be wrong to assume that “nothing will be done” by the US lawmakers soon.
We will find out – very soon.
p/s photo: Leah Dizon
11 comments:
Dali,
For the sake of the common people and equity traders and investors; let's hope some regulations will be introduced to curb the activities of these index speculators. It's a total mess the loophole. The people suffer. If it hits $150/barrel then lets hope that these restrictions on futures speculation will be forced to be introduced.
ps: There are many better pics of leah Dizon to use. Beautiful girl.
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Hi, Dali
No doubt there is speculative element pushing oil by oil producing country (try to make double profit) , private equity fund and pension fund. But what is more important is the likely impact on Malaysia economy if these bubble bust and eventually come back to normal level of US70 which purely driven by supply and demand force. Curently, Malaysia economy mainly support by two oil factor namely crude oil and CPO, If both undergo serious correction, i think stock market will first response negatively, probably falling back below 1000, and i don't think goverment will cut down petrol price but instead will just abolish subsidy on petrol, cooking oil altogether
If people get out of commodity complex, where do they put their money? Back to equities? Coincidently US election is coming. This is interesting... So we will find out fair value of oil after election?
If speculation is bad, then you have to ask why people behind the funds support their managers to enter into commodity futures? If speculation is bad, how about naked short selling? Is it because oil an easy/emotional target? So what is next? If a lot of people are poor, we have to 'get' some money from rich?
Is there going to be a bubble burst? How long and how high the oil prices will increase before the buble burst? How much oil will drop? Is it going to suffer the fate of tin in 1987?
Dear
Blogger Letting the time pass me by said...
Is there going to be a bubble burst? How long and how high the oil prices will increase before the buble burst? How much oil will drop? Is it going to suffer the fate of tin in 1987?
I can answer the first one, it will burst cause its a bubble. As for your other questions .... if I can answer them, you will have to light some joss sticks for me... cause I would have be God or Nostradamus.
"Collectively, these funds have stockpiled (long on inventory via the futures market) 1.1 billion barrels of petroleum. It’s not like they are actually going to take delivery of these oil barrels, but their stockpiling is tantamount to hoarding 1.1 billion barrels from the real market place. If real supply is constant, one can imagine what the 1.1 billion long positions will do to oil futures prices if they are rolled over."
For every buyer of a contract in the futures market there is a seller of that contract. So who are the sellers ?
Right now, the buyers are collectively 'stronger' than the sellers being reinforced by the entrants of new bulls attracted by the seemingly inexorable rise in price. The tipping point will come when price stops rising and the sellers become collectively 'stronger' and attract new recruits to their camp.
The futures market is just a tug-of-war between buyers and sellers.
There is no hoarding of 1.1 billion barrels from the real market place.
History has shown us that commodity prices tend to swing in boom/bust cycles. That is the natural outcome of imperfect (often poorly planned) adjustments in demand & supply, sometimes exacerbated by speculators (as may well be the case now).
However,the underlying cause is ALWAYS the imbalance between supply & demand.
The current boom in commodity prices (not just oil - look at other energy prices, base metals, soft commodities, food) is no different.
Today's high oil price follows decades of depressed energy prices which led to wasteful practices (gas-guzzling cars, excessive heating/cooling of homes & offices) and chronic under-investment in oil exploration & development.
As a former oil industry worker, I witnessed the massive scaling down of investments & departure of skilled colleagues into non-productive industries (finance, sales, etc).
I worked in oil producing countries which were almost bankrupted by the 20 $/bbl prices of the 80's. These same countries are now being maligned for not producing oil fast enough to satisfy increased demand from developing countries.
Many analysts argue that we are running out of oil, ignoring the simple fact that higher oil prices inevitably lead to more investments in exploration & production, especially from the more difficult sources such as the massive tar sands of Canada & the unstable nations of Africa. However, these new investments take years to produce effective results, so high prices are here to stay for some time.
Yes, speculators are exploiting the current tumultous oil markets but they are just an easy punch-bag in lieu of the underlying supply-demand imbalance.
Bush behind Oil Bubble?
Main Traders:Goldman Sachs, Morgan Stanley, JP Morgan Chase, Citigroup, Deutsche Bank or UBS.
Main Exchange Facilitators:London ICE Futures Exchange (formerly the International Petroleum Exchange). ICE Futures is a wholly owned subsidiary of the Atlanta Georgia International Commodities Exchange. ICE in Atlanta was founded in part by Goldman Sachs, which also happens to run the world's most widely used commodity price index, the GSCI, which is over-weighted to oil prices.
The Regulatory Facilitator:Bush.A convenient regulation exception granted by the George W Bush administration in January 2006, the ICE Futures trading of US energy futures is not regulated by the Commodities Futures Trading Commission (CFTC), even though the ICE Futures US oil contracts are traded in ICE affiliates in the US. And at Enron's request, the CFTC exempted the over-the-counter oil futures trades in 2000.
Bush in Oil Bubble?
-After Enron Case,why regulation is still so lax on energy futures?
-On the contrary, Bush Admin has added more fuel to the fire. In collaboration with Wall Street Bankers(The Jewish Club TJC), the world financial mechanism is under their whims & fancies.
-Why would Fed Reserve be willing to bailout the main street bankers and swap for such inferior asset class in lieu. Fed must have known what TCJ is up to in the Commodities Bubble(CB). CB would strengthen USD. CB Profit by TJC would pay back Fed for their temporay asset swap.
-Fed's injection into TJC banks has greatly added tp CB by upping their gigantic leverage. This explains why the trmendous rally in crude futures since TJC bailout.
-Paulson/Bush has been exceptionally sensitive to any threat to abolishment of USD for energy futures trading.Sadam Hussain?
Yes public outrage will be growing. Bush is going anywhere. Whoever is taking over will face a stagflation economy. It has been a month since the Master's testimony, Congressional hearing ? They did that in 06 and 07 and twice in 08 so far. They did nothing. These Congressman are multi millionares , bet they invested their money with Goldman Sach oil hedge.
Veritas,
Yes, there can be hoarding because your argument that for every buyer there is a seller of the futures contract does not hold water. If your argument holds water, then there will be no px movement as buyers always equate corresponding seller side?!!
I give you a simple example, lets say there were 20 contract players to start and 10 on buy and 10 on sell, willing buyer willing seller a price of $50.00 was achieved. Next month there were another 20 players, same sized, but 15 were buyers and only 5 sellers... the px would have to adjust to that demand supply. Now there are 10 +15 buyers = 25 buyers. Sellers 10+5 = 15. To match, there has to be an additional 10 sellers, which will come from the buyers taking profit at higher levels. Thus all equal.
But no, the 10 long players who took profit returned in the next month as long players as well. The 25 buyers from previous month stayed long. Then another 20 new contract players come in and 15 were buyers only 5 sellers.
You can do the math. The ones keep going long are basically hoarding... if not how to corner the gold, silver, tin mkt in the past... They never sell. Why they never sell, well if u r diversifying a US$10bn portfolio... u want maybe 15% in commodities, hence no need to sell, and u should not sell a diversification move, its not a trade.
The many ETFs and long only commodity funds launched are are not end consumers. None of those who go long are. The sellers in this equation: oil producers, they sell n they regret the next month, could have sold higher. How can u say there can be no hoarding.
Hoarding means increasingly stockpiling WITH no intention to consume the commodity.
Your most potent point is that financial speculation amount to hoarding. Its only hoarding if the demand does not arise. Given that China demand in the past is equal to the contracts, how can it be untrue especially given other country rising demand also?
So you are wrong. The issue really is will supply meet and exceed future demand? The speculators are saying no and soundly so at least at the moment. The only thing that will prick that bubble is technology or several huge deep sea oil finds.
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