372. SPECULATION FIGHT: JUST WARMING UP

Recently, the CFTC released an Interim Report arguing that speculation has not systematically driven the rise in crude oil prices. In the Oil Drum camp, this was greeted with a wave of high-fives and honking of party horns, as if it marked the end of the speculation debate. The debate has not ended, however. In fact, it has hardly begun, and will continue and intensify for a number of powerful, common-sense reasons:

1) The speculation issue is not limited to crude oil. It involves agricultural futures markets as well. Farmers and grain elevators are facing punishing margin calls, inability to market their crops, inability to capture futures prices, and failure of futures to converge with cash prices Source1, Source2, Source3, Source4.

Here's Tom Buis, president of the National Farmers Union: "There's something wrong. I have doubts whether the CFTC is the place to rectify the problem - it may warrant congressional intervention. When regulators say a problem doesn't exist, despite the fact farmers cannot market their commodities that sounds an alarm." Source

These problems in agricultural markets have become so bad that the CFTC has been forced to call hearings in April and July to deal with irate farmers, grain dealers etc. And the people complaining are not denialist newbies grasping at the straw of "speculation" to avoid facing peak oil. They are long-time futures market insiders -- people who've been in the market for decades. They say the problem is a massive influx of speculators from Wall Street. Should we tell the farmers to shut up because the speculation debate is over? Tell them they're in denial? That it's all in their heads? Obviously not. Rampant commodity speculation is causing severe problems in a broad range of markets, and common sense says we should dig down and get to the bottom of it. There is no reason whatsoever for allowing Wall Street to turn critical markets for food and energy into casinos for rich people.

2) The issue isn't: did speculation singlehandedly cause the run up in oil from $10 in 1998 to $145 in 2008? Clearly, supply and demand are the foundation of the trend. Everyone agrees with that. The issue is: how much cheaper can oil (and other commodities) be if index speculators are forced to liquidate their rolling long positions? Even a $10 or $20 benefit could be worthwhile.

3) Here's the Interim Report on the topic of index investors:

Commodity index funds have grown significantly during the past few years, bringing significant long positions to commodity markets. In the futures markets, these funds have typically been long-only funds, buying near-term futures contracts and rolling their positions into more distant months as the delivery month approaches. Commodity index funds are often utilized by pension funds and other large institutions that seek commodity exposure to diversify existing portfolios of stocks and bonds and this exposure is provided by swap dealers. Although commodity swap dealers' gross positions have grown significantly, swap dealers' net positions decreased substantially between 2006 and June 2008. (Figure 12) This suggests that flows from commodity index funds have been offset by other swap dealer activity and thus have not necessarily contributed to the recent price increases in crude oil.

Across all maturities, the aggregate position of swap dealers in WTI crude oil futures contracts was only marginally net long as of the end of June 2008 and was net short on average during the first five months of 2008. This means that swap dealers' futures positions, on balance, were poised to benefit more from a fall in crude oil prices than from a rise in crude oil prices.
(P. 23-24)

So the argument is this: The long positions held by index investors are being offset by the short positions of someone else in the market and thus have "not necessarily" contributed to rising prices.

But if you look at it that way, every participant in the futures market is being offset by his or her counterparty, so no one does/can contribute to a price rise or fall. It's very much like saying that a bubble can't form in the stock market because for every buyer of a stock, there must be a seller, and thus the downward pressure of each seller cancels out the upward pressure of each buyer. In short, it's a piece of sophistry.

As I said above, the important question is: how much cheaper will oil be if index speculators are forced to liquidate their rolling long positions? As I showed in 360. WHEN INDEX SPECULATORS SELL, the experiment has already been done once, and the results were very interesting. In 2006, index speculators were forced to sell $6 billion worth of rolling long positions in gasoline due to a rejuggling of the composition of the GSCI, and gasoline prices fell $0.82 in four weeks.

The simplest way of settling this issue is to take a pass on the spin and Wall Street smoke screens, and do the test empirically. Force the index longs to sell without rolling, and see what happens. The CFTC says index longs aren't affecting prices at all, so nothing will happen. What have we got to lose?

4) It's interesting how a generally leftish website like The Oil Drum immediately pimps for banks, hedgefunds, speculators and other Wall Street interests on the speculation issue. In a way, I think they see speculation as a sort of stealth carbon tax... "What's wrong with index funds and other long-only investors keeping oil prices at an elevated level? That's exactly what we wanted to do anyway! It's like a carbon tax, only better, because the NASCAR stooges can't object to it."

Another way to look at it, I suppose, is that commodity speculation is the last hurrah for the banks. You know the swap dealers we keep hearing about? It turns out that these are the same large banks who brought you the mortgage crisis. They're like vampires that have to suck the blood of some financial bubble, and at this point, their commodities businesses are the only profit center left standing. This is likely a major reason why the Bush administration is so keen to paper over the issue, and let the commodity speculation fest continue.

5) Many defenders of speculation say something like this: "The people who are investing long in oil and other commodities are only trying to preserve the value of their money against inflation. You can't blame them." And that's all true. However, if it's okay for one person to change their money into commodities to protect it against inflation, then surely it's okay for everybody to simultaneously change all of their money into commodities. We can't blame them right?

Unfortunately, that scenario isn't an investment strategy anymore; it's a full-scale loss of confidence in paper currency, which would be an unmitigated disaster for everyone. We simply can't have everyone changing their money into wheat or petroleum products and holding it as a money surrogate.

If it's not okay for everybody, then it shouldn't be okay for a privileged elite.

6) Eliminating index speculators from commodity markets is not an "anti-market" move. It's simply a restoration of futures markets to the smoothly functioning Ronald-Reagan-approved free-market state they existed in for decades before the index fund pig wallow of the 2000s.

7) Some people claim that futures markets are just a form of gambling that doesn't actually affect real world prices -- rather like people betting on a basketball game who don't affect the outcome. If that's the case, there's really no good grounds for not regulating speculation. Governments routinely regulate gambling.

Further reading:

Commodity Speculation Fight Only Just Beginning
The industrialised world, which has the power to substantially reduce commodity speculation if it chooses to use it, is ultimately disadvantaged by high commodity prices. If the blow represented by rising demand and severely constrained supply can be softened then it is not hard to argue that it should be. Free market diehards may disagree, but sometimes free market principles have to be sacrificed for the sake of realpolitik, or maybe just commonsense.

CFTC Official Seeks Independent Study On Speculators In Markets
A Commodity Futures Trading Commission official said Tuesday that billions of dollars in speculative investment are having an impact on futures markets, but Commissioner Bart Chilton is calling for an independent study to determine just how much.

Chilton said Bush administration officials have continuously downplayed the role of speculators on oil and agricultural futures but that an independent evaluation is needed to take political spin out of the assessment.

"I've got to believe that $250 billion (in new speculative investment over recent years) is having some ... impact" on futures, Chilton said in a written statement.

by JD

371. SURGE IN US GASOLINE AND DIESEL EXPORTS

This is an interesting phenomenon:

A record 1.6 million barrels a day in American refined petroleum products were exported during the first four months of this year, up 33 per cent from 1.2 million barrels a day over the same period in 2007. Shipments this February topped 1.8 million barrels a day for the first time during any month, according to final numbers from the Energy Department.Source

One contributor to the recent drop in crude prices has been the rise in US gasoline and diesel stocks due to falling demand:

These rises in stocks are even more impressive when you consider that, so far in 2008, US product exports are running at 1.6 million bpd -- up by 312,000bpd over 2007 (Source: EIA). Stocks continue to build even though large volumes of gasoline and diesel are being exported.

by JD

370. MORE SLACK IN DEMAND

The latest Weekly Petroleum Products Supplied stats from the EIA show another massive drop in U.S. oil consumption. Here's the figures:

July 20, 2007: 21,006kbd
July 18, 2008: 19,903kbd

That's a year-on-year drop in U.S demand of 1,103,000 barrels/day. Huge. Roughly equal to the production of a super-giant oil field, or a small producing country like Qatar, Indonesia or Azerbaijan.

Now, there's a lot of confusion on what this means for oil prices due to the classic doomer/oil-bull soundbite:

If we burn less, India and China will burn it up, no problem.

OR

The less we use the more China will use. China and the other emerging economies set the price of oil now, not the US.

Let's look at the figures, and see if that theory holds up. I've compiled the following Table from the BP Statistical Review 2008. For the most important regions and countries, the Table gives the average annual increase in oil consumption (in 1000s of barrels per day) for the periods 2003-2007 and 2005-2007, as well as the increase in 2007 over 2006. This Table should give you a better feel for the size of demand growth under business-as-usual conditions. (Click the table to enlarge)

As you can see from the Table, US consumption has been approximately flat over the past few years, so the steep recent drop in US consumption is a net negative for world demand growth.

A 1.1 million barrel/day drop in US demand is gigantic -- literally enough to wipe out all growth in oil consumption for the entire world, which at the moment is running at about 0.9mbd. (The current IEA forecast for 2008 demand growth is 0.89mbd. Source: July 10 OMR)

There is simply no way for China and India (who combined have average annual growth of around 0.5mbd) to overcome a 1.1mbd drop in US consumption. They simply can't grow that fast.

To conclude this post, here are some links with interesting detail on the current oil situation in China:

BEIJING, July 22 (Reuters) - China's crude oil imports from Iran in June halved from a year ago to its lowest monthly level in 18 months, contributing to the overhang of crude stored offshore in Iran, official customs data showed on Tuesday.
Iran shipped 1.176 million tonnes, or 286,000 barrels per day (bpd), of crude to China last month, 50 percent less than in June 2007, data from the General Administration of Customs showed.
This is also well below the 400,000 bpd of term volumes officially contracted for this year, and the even higher 465,000 bpd average imports of Iranian crude for the first quarter.Source

*****

BEIJING (Reuters) - China's worsening power woes are all but guaranteed to trigger a surge in imported oil, just as they did in 2004 during the worst crisis in decades, right?

Wrong, say experts and industry sources. While the theme is familiar, the circumstances couldn't be more different, suggesting that oil bulls looking for a reason to push crude beyond $150 a barrel will need to look elsewhere.

[...]

China appears to be well-stocked with foreign fuel after 8 months of steady inventory builds that caused diesel imports to surge 9-fold in the first five months this year.Source: Unlike 2004, China oil demand unmoved by power woes

by JD

369. OIL FLAT, GROWTH CONTINUES

Great graphic over at the Oil Drum today:

It comes from the new CFTC report which finally and conclusively proves that futures market participants have no effect whatsoever on prices in the futures market.

The folks at TOD had their own nefarious reasons for posting this, but what caught my eye is how global growth just keeps on trucking, even without growth in oil. Which is a little odd considering that no less a figure than Colin Campbell, the Pope of Peak Oil, has called oil "the principal driver of economic growth"Source.

by JD

368. OPEN THREAD

To everyone: I've deleted this post because my reasoning was shoddy, and it didn't hold up to scrutiny. Please accept my apologies. I will do my best to ensure that Peak Oil Debunked keeps a higher standard in the future.

There were some good links in the comments which I will post here:

Juan: WITH ALL THE TALK ABOUT PEAK GLOBAL OIL SUPPLY, WHAT ABOUT PEAK OIL DEMAND?

Interesting video showing how supply and demand curves interact in peak oil:


Brother Cadfan:
Goldman Sachs obviously aren't liking the decrease in oil price over the last few days!
Link

Otherwise, feel free to use this as an open thread.
JD

367. TELEPRESENCE

My model of peak oil is the biological process of succession. As Joel E. Cohen writes in his classic "How Many People Can the Earth Support?":

Different species have different requirements for a given element, as Liebig knew. Consequently, when one element is limited in a community of species, population growth typically does not grind to a halt; rather, a species that is less constrained by that limiting element replaces another that is more constrained in a process called succession.(P. 242)

The technological/industrial analog of this process is becoming increasingly obvious in many areas. As oil prices rise, truckers are getting hit hard, but rail and barges are booming. SUV sales are plummeting, but electric and gas scooters are on the rise. Fishermen are suffering, but aquaculture is thriving. It seems that for every "species" (i.e. industry) that is withering under high oil prices, there is always a less dependent corresponding industry that is surging to fill the vacuum. The dinosaurs are dying, but scurrying little rodents are rapidly breeding in their vacated niche.

Another good example is the rise of telepresence as an adaptation to the decline in airlines and business travel. Cisco has developed a new system called "TelePresence" described in this video (and many others on youtube):



This product is growing at a phenomenal rate, and saving Cisco very large sums of money:

Charles Stucki, vice president and general manager of Cisco Telepresence Systems, said the teleconferencing technology is their fastest-growing new product in the company's history.

Of the companies that have implemented use of this new technology, Hsieh said it has likely paid for itself multiple times over just in travel cost reduction.

Cisco CEO John Chambers, said Cisco has cut its own global travel budget by $180,000,000 over the past year using the aforementioned technology.Source

And that is just one company and one application. A similar technique is being developed for use in medicine:

Clearly this technology has a bright future, and is only going to get better. It's also going to save massive volumes of wasted transport fuel. It inspires the imagination -- a futuristic world where people are even more mobile than they are now, even though no one is actually moving.

by JD

366. FUTURES PRICES DETERMINE PHYSICAL OIL PRICES

A number of high-profile economists, like Paul Krugman, have recently been making the argument that trading in oil futures can't really influence the price of physical oil because it doesn't remove any oil from the market. Here's a classic statement of this argument by Jon Birger, a staff writer from Fortune:

Here's a suggestion: The next time a Congressional committee wants to hold a hearing on how "speculators" are driving up oil prices, each committee member should first be required to demonstrate - preferably in their opening remarks - a basic understanding of the mechanics of futures trading.

Even better, they should be required to explain in detail how it is that investors who never take delivery of a single barrel of crude - and thus never remove a drop of oil from the open market - are causing record high oil prices.Source

I will now provide that explanation, and in the process show that both Krugman and Birger are grossly misinformed about the way physical crude is actually priced in the global oil market.

Most crude oil is traded based on long-term contracts, and the prices in those contracts are set by a system known as "formula pricing". In this system, the price of delivered crude is set by adding a premium to, or subtracting a discount from, certain benchmark or marker crudes, namely: West Texas Intermediate (WTI), Brent and Dubai-Oman. Generally, WTI is used as the benchmark for oil sold to North America, Brent for oil sold to Europe and Africa, and Dubai-Oman for Gulf crude sold in the Asia-Pacific market (Source1, Source2).

Originally, the benchmark prices were spot prices, but over time problems began to arise due to the depletion of the benchmark crudes:

In the early stages of the current oil pricing system which emerged in the period 1986-88, crude oil was priced off the spot market quotations of these benchmarks (namely dated Brent, spot WTI and Dubai) as assessed by oil reporting agencies such as Platts and Petroleum Argus. In the last few years [i.e. since the early 2000s] however, there have been some serious doubts about the ability of the spot physical market to generate a price that reflects accurately the margin of the physical barrel of oil. One of the main problems is that very little actual trading occurs in these crudes which makes the process of price discovery very difficult.Source

The rapidly declining size of spot markets for the benchmark crudes led to chronic problems with speculators cornering those markets with a technique called the "squeeze":

Low volumes of crude oil available for spot trading make price discovery problematic and increase the vulnerability of markets to squeezes, distorting prices and undermining market confidence. A squeeze refers to a situation in which a trader goes long in a forward market by an amount that exceeds the actual physical cargoes that can be loaded during that month. If successful, the squeezer will claim delivery from sellers who are short and will obtain cash settlement involving a premium. It is true that all markets are prone to squeezes and in the last few years there have been occasions on which the Brent market was subject to successful squeezes. But it is also true that it is easier to squeeze thinner markets.Source

The Brent spot market in particular was plagued by frequent squeezes in the early 2000s, and this is well attested to by numerous sources here, here(pdf), here, here, and here etc.

Here's an interesting tidbit on the subject:

Dated Brent, which acts as a price marker for many international grades, is physical crude traded on an informal market, rather than a regulated futures exchange. This lack of regulation poses problems for oil producers and consumers seeking a fair price, said Robert Mabro, director of the Oxford Institute for Energy Studies and a leading Brent expert.

"There are regular squeezes in the Brent market," Mabro said. "In the trading community, people are fed up. This general view that you can do whatever you like in an informal market is okay, as long as you regulate the market a bit. But if it's a free-for-all, you're back to the cowboy age."

A typical Brent squeeze involves a company quietly building a strong position in short-term swaps called contracts for difference, or CFD's, for a differential not reflected in current prices. The company then buys enough cargoes in the dated Brent market to drive the physical crude price higher, which boosts the CFD differential, Mabro said.

The company may lose money on the physical side, but it's more than compensated from profits on its offsetting paper position in the short-term swaps market, Mabro said.

"The whole trick is to collect more money in CFDs than you lose on the physical squeeze," Mabro said. "People seem to do it in turn. It depends on who's smart enough to move in a way that nobody notices until it happens."Source

To deal with this problem, many key oil exporters shifted away from the spot market, and began to use futures prices as the benchmark in formula pricing:

The declining liquidity of the physical base of the reference crude oil and the narrowness of the spot market have caused many oil-exporting and oil-consuming countries to look for an alternative market to derive the price of the reference crude. The alternative was found in the futures market. When formula pricing was first used in the mid-1980s, the WTI and Brent futures contracts were in their infancy. Since then, the futures market has grown to become not only a market that allows producers and refiners to hedge their risks and speculators to take positions, but is also at the heart of the current oil-pricing regime. Thus, instead of using dated Brent as the basis of pricing crude exports to Europe, several major oil-producing countries such as Saudi Arabia, Kuwait and Iran rely on the IPE Brent Weighted Average (BWAVE).¹¹ The shift to the futures market has been justified by a number of factors. Unlike the spot market, the futures market is highly liquid which makes it less vulnerable to distortions. Another reason is that a futures price is determined by actual transactions in the futures exchange and not on the basis of assessed prices by oil reporting agencies. Furthermore, the timely availability of futures prices, which are continuously updated and disseminated to the public, enhances price transparency.

[11] The BWAVE is the weighted average of all futures price quotations that arise for a given contract of the futures exchange (IPE) during a trading day. The weights are the shares of the relevant volume of transactions on that day. Specifically, this change places the futures market, which is a market for financial contracts, at the heart of the current pricing system.Source(pdf)

As you can see, Krugman and Birger are profoundly confused about the way the international oil markets actually function. Futures aren't a paper bet on the direction of prices determined by some independent process. Futures themselves *determine* the price of most physical oil traded today. The futures price (+ or - the differential) literally *is* the price of oil.

-----

Further information on this topic is available in The Oil in the 21st Century: Issues, Challenges and Opportunities, Ch. 3 "Origins and Evolution of the Current International Oil Pricing System" (P. 41-100) and in Petroleum Refining: Separation Processes, Ch. 3 "International Oil Markets" (P. 77-114)

by JD