15 June 2008

Oil: Bubbleheads vs. Fundamentalists

The diagram above portrays the basic fundamentals of the oil market. It resembles an engineering flow diagram, for those with an engineering or computer science background. The diagram comes from an essay by economist Ferdinand E. Banks. In the essay, Banks explains to the rest of us why oil prices cannot possibly be caught up in a speculative bubble. Banks claims that recent price trends in oil are fully explained by the fundamentals of supply and demand--of flow. His argument is reasonably straight forward and comprehensible. If Banks is right, oil prices should continue to climb in a zigzag manner.

In opposition, Bill Jamieson claims that oil prices have been caught up in (and are feeding into) a generalised commodity price boom over the past 18 months. Jamieson claims that the fundamentals do not support oil prices well over $130. He points out several reasons for speculative over-reaction in oil prices, and suggests that a large downward correction is in order. If Jamieson is right, a lot of speculators will soon be thinking about jumping off high buildings.

Shell Oil president John Hofmeister thinks the fundamentals point to oil under $90 a barrel. The US Congress is looking at ways to close speculative loopholes for investment bankers in the commodities markets.

The economics of any important global commodity is quite complex. It is often difficult to determine how closely prices are tracking fundamentals. The larger and more complex the market, the greater the difficulty.

The instant giveaway for speculative influence in a market is volatility. When a commodity jumps significantly up and down on the basis of newsreleases and rumours, it is not fundamentals that are driving the price. It is fear. Fear drives speculation, and speculation drives prices.

Investment banks such as Morgan Stanley, Goldman Sachs, etc. have stockpiled at least 8 times the amount of oil that is contained in the US strategic reserve. Iran and other Gulf states have stockpiled at least as much. Saudi Arabia promises to increase its output by 500,000 barrels a day, starting in July 2008. China's stockpiling of oil for the Olympics should be curtailed after August. India is slowly phasing out its fuel subsidies, which should reduce demand in the subcontinent.

The threat of global price inflation from a "cascade-down" effect of high oil prices further confuses the economic picture. Hints at future interest rate hikes from Brussels and Washington have had a slight subduing effect on an irrationally exuberant commodities market.

Current popular expectation is that prices will continue to go up-up-up. But there is no economic model that supports such an indefinite upward trend in prices. Except the bubble. And bubbles eventually pop.

PS: Inflation in the context of a fiat currency constitutes one type of bubble.

Update: Here are two interesting blog posts trying to tease out some of the more relevant aspects of the problem:
Brian Westenhaus looks at the refinery bottleneck and who is responsible
JD looks at the surplus of heavy crude on the market


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Blogger CarlBrannen said...

I guess I don't see why prices should go up and up, unless we're in a general inlationary period. A clue would be oil not coming back down. But having oil go up $15 in two days is definitely not something that is determined by market forces. But it's also not really much of a move, percentage wise, relative to the secular trend. Oil has gone up slowly a lot more than it has gone up quickly.

One of my friends back in college got caught in the commodity bubble of the late 1970s. It was fairly amusing. We suggested that he take delivery of his 3 contracts of coal, but he would also have had to pay for shipping.

The problem with blaming long term commodity price trends on speculators is that speculators don't have enough storage to keep coal off the market. Or oil.

Sunday, 15 June, 2008  
Blogger al fin said...

Speculators and various actors (investment banks, middle eastern sovereign funds, governments etc.) have been buying and storing oil, although whether the amount being sequestered is enough to impact the market price by more than 5 or 10 % is unknown.

I am looking at speculation as affecting the price in a psychological manner, which does not require large amounts of storage. Not being an expert on commodities pricing, until I force myself to learn more of the details I will rely upon my rather greater expertise in human psychology. ;-)

Monday, 16 June, 2008  
Blogger CarlBrannen said...

The general idea is that high prices cause an increase in production and a decrease in consumption. Commodities like corn are produced once per year and so there is infrastructure to store a full year of production. Speculators can run corn prices up for most of a year, but then the new crop will arrive and if there is massive amounts of unused corn there will be no place to put it and the price will collapse.

Oil is produced all year around so the infrastructure to store a year's worth does not exist. There is no place to store oil. Here's the data for US oil storage back to 1990. A typical figure is 1.6 billion barrels. This includes the "strategic petroleum reserve" which is something like 0.7 billion barrels. Our consumption is between 5 and 6 billion barrels per year.

So petroleum is not being stored up. In fact, there is no place to put it. The oil market is just very still, small changes in production or consumption make for wild changes in price.

What I'm trying to say is that it is easy for speculators to move the price of a commodity for a short time. The definition of "short time" depends on the commodity, specifically how long it is possible to store enough commodity. For stuff like gold, "short time" is a very very long time because gold is nice and small. Things like oil and corn depend on the infrastructure available for storing it.

I think the oil bubble has been going on too long to be blamed entirely on speculators. Our petroleum reserves are not increasing, the oil is getting consumed.

I guess you could say that maybe the oil is being left in the ground, but the speculators don't control oil that is in the ground, they buy futures for oil that is above ground. The people who own the oil below the ground have every incentive to pump it. But I don't see a trend in that data either, other than the steady decrease in production as we run out of the stuff:

Monday, 16 June, 2008  
Blogger al fin said...

The Iranians are storing oil. So are sovereign funds in the middle east. The investment banks like G-Sachs and M-Stanley are storing a variety of petroleum products including crude and fuel oil. Enough to affect prices? Probably not more than a few per cent of spot price.

But spot price is generally given for light sweet crude. There is a glut of heavy crude because of a refinery bottleneck.

You don't have to believe that speculation is responsible for more than 20% or so of the price to see that long-only index funds can be enough of a problem to push many industries over the edge.

Monday, 16 June, 2008  
Blogger The Irrefutable Fool said...

I'm almost for them putting a tax on oil to maintain the current prices. Otherwise the push to diversification will stall when oil comes down again, and these crises will repeat.

Maintain the minimum price at $70 bby I think would be good. It also measures in some externalities ( defense of oil spending for example).

Tuesday, 17 June, 2008  
Blogger al fin said...

The next drop in price will probably only go down to $100 a barrel.

To go down much more, refinery capacity has to go up and technology needs to find cheaper ways of dealing with heavy crude and tar sands.

Eventually, biofuels (BTL, cellulosic, 2nd and 3rd gen fuels) and coal to liquids will drop the bottom out of oil prices, and your oil tax to maintain $70 a barrel may come into play.

To clarify my view on speculators, they are only one cause among a constellation of causes. When I highlight a particular cause out of many, it is not to claim that it is the most important cause, but only to examine that particular cause more carefully.

Wednesday, 18 June, 2008  

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