Oil Bubble: How Speculation May Contribute to Recent Moves in Oil Prices

by: James Hamilton posted on: May 19, 2008 | about stocks: OIL / USO    

An important recent trend in management of pension and hedge funds is the increasing allocation of investment dollars to commodity speculation. There are lots of ways you can do this. Perhaps the simplest is to purchase, say, the July NYMEX oil futures contract.

If you'd bought that contract Friday, it would enable you to take delivery of oil in Cushing, Oklahoma, some time in July for $126/barrel. As a pension fund, you don't actually want to receive that oil, so in early June you'd plan on selling that contract to someone else and using the proceeds to buy the August contract. If oil prices go up and you can sell the contract for more than $126/barrel next month, you will have made a profit. By rolling over near-term futures contracts in this way, your "investment" will earn a return that follows the path of oil prices.

The Goldman Sachs Commodity Index is essentially a mechanical calculation of how much money you'd have each day if you followed a strategy like this for each of the major commodity contracts, with energy prices comprising about 70% of that index. There are a number of firms that offer products that could implement such strategies on your behalf, such that the dollar value of your investment will essentially follow the GSCI (or similar index) less trading costs and management fees.

In April Bloomberg reported:

Investments in commodity indexes rose $40 billion in the first three months of the year to $185 billion, a larger gain than the whole of 2007, Citigroup analysts Alan Heap and Alex Tonks said today in a note to clients....

After investments in indexes, commodity trading advisers account for the biggest portion of the total amount invested, the Citigroup analysts said. At the end of the first quarter, advisers accounted for $94 billion, 18 percent more than at the end of last year, the analysts said.

Hedge funds ranked third, with $75 billion in commodity holdings, an increase of 25 percent over the end of 2007, Heap and Tonks said. In all, they estimate $70 billion in additional investment funds flowed into commodities markets in the first quarter.

What would be the effect of a big increase in the volume of purchases of near-term futures contracts? If investors were all equally informed and risk neutral, an increased volume of purchases would have no effect on the price. In such a world, there would be an unlimited potential volume of investors out there willing to take the other side of any bets if the purchases were to result in a price that was anything other than the market fundamentals value.

But with risk-averse investors or with differing information, the answer is a little different. For example, I might read your willingness to buy a large volume of these contracts as a possible signal that you know something I don't. For this reason, standard financial "market micro-structure" theory predicts that a large volume of purchases may well cause the price to increase, at least temporarily, until I have a chance to verify what the true fundamentals value would be.

But verifying that true fundamentals value in the case of current oil markets is not an easy thing to do. If you believe, as I do, that the Hotelling principle has now become a factor contributing to oil prices, the market fundamentals value depends on how much oil the world is going to be able to produce over the next half century and what alternatives we're going to develop. If you have a different answer to that than I do, it's a very difficult task for me to figure out which one of us is right.

Let us for the moment accept the possibility that a sufficiently large volume of speculative commodity investment could succeed in driving the price of those futures contracts above what they would have been in the absence of these purchases, at least for a while if the volume of such purchases continues to increase. That still leaves a key question: If speculation is driving the futures price up, what force is bringing the spot price up with it? Wouldn't the large volume of speculators selling the July contract next month drive the July price down at that time, so they make a loss, not a gain?

The enterprise at the end of the chain in July, the ultimate final buyer of the July contract, is someone who actually wants to take physical delivery of oil in Cushing, Oklahoma, some time in July. That would be a refiner who wants to turn it into gasoline. The demand for oil from a refiner in Cushing is responsive to the spot price through two mechanisms. The first is the demand elasticity that's ultimately inherited from the motorists who use the gasoline. If consumers face a higher price for gasoline, they will reduce their purchases, by which mechanism ultimately the refiner would want to buy less crude when the spot price goes up. But, particularly in recent years, that consumer demand response is very small.

A much more important way in which the spot price of crude would affect the refiner's demand for the product is through an intertemporal calculation. Given my customers' demand, I'm going to need to buy the product sooner or later. If you charge me a lower price today than you're going to charge me next month, I'd choose to buy more today to put it into inventory. If you charge me a higher price today, I'd rather run down my inventory and buy the oil next month, and of course the futures market allows me an opportunity to lock in a price for doing just that.

Thus by far the most important factor in refiner's demand for July oil will be the August futures price. If my production plans left me willing to buy July oil for $124.25/barrel when August oil was selling for $124/barrel, I'll probably want to buy July oil for $126.25/barrel now that I'm forced to pay $126/barrel for August oil. Thus to a first approximation, the spot price would move by exactly the same amount as the near-term futures price. A $1 increase in the August futures price would shift the demand curve for July spot oil up by $1. In this fashion, an ever-increasing volume of speculative purchases of the near-term futures contracts would drive the spot price up with them.

Now, the above argument abstracted from the effects of the price on final gasoline demand, and we know that the demand elasticity for the final product is not literally zero. Thus the bubble described here could not literally be self-fulfilling. Something else has to give-- this is the point emphasized by Paul Krugman. If it all transpired just as I said, with international producers all adjusting their price to move in step with the West Texas Intermediate delivered in Cushing, they would ultimately find they're selling less than they otherwise would have. And so you might expect to see stories like this one from Bloomberg:

Iran, OPEC's second-largest oil producer, more than doubled the amount stored in tankers idling in the Persian Gulf, sending ship prices higher as demand for some of its crude fell, people familiar with the situation said. The 10 tankers hold at least 20 million barrels of oil....

Iran has a glut of its sulfur-rich crude as refineries that can process the fuel shut down for maintenance. The discount on Iranian Heavy crude compared with Oman and Dubai petroleum has more than doubled since the start of the year, according to data compiled by Bloomberg.

"There's not much demand for heavier crudes such as those from Iran," said Anthony Nunan, assistant general manager for risk management at Mitsubishi Corp. in Tokyo.

And eventually the bubble could only be ratified if we saw decreased production from oil producers, or at least stagnating production in the face of growing demand. But of course it is a fact that global production has failed to increase the last two years.

World Production of Crude Oil, NGPL, and Other Liquids, and Refinery Processing Gain, in million barrels per day, from EIA.

The biggest single factor in the stagnating global production is the fact that Saudi Arabia in January and February produced 350,000 b/d less than its average level in 2005. The increase in production to 9,450,000 b/d announced Friday in conjunction with President Bush's visit to the Kingdom would still leave Saudi production 100,000 b/d below the 2005 levels.

Arab News quoted Saudi Oil Minister Ali Al-Naimi as declaring on Thursday:

Financial markets have a logic and mechanism of their own. Such markets are influenced by ever-changing factors and parameters that transcend markets and boundaries and are often unregulated. Therefore, the short-term oil prices are more closely tied to the internal logic of the financial markets than to underlying supply and demand fundamentals.

Reuters reported this from a follow-up news conference the next day:

Saudi Oil Minister Ali al-Naimi said on Friday that the world's top oil exporter would meet any demand from its customers for oil. "Any demand for extra production capacity from consumers will be immediately met," Naimi told a news conference.

If we take these statements at face value, they seem to be declaring that Saudi policy is to allow their prices to follow the futures markets. If you offer to sell all that anybody wants to buy at that price, you'll discover that demand for your product has gradually slipped as a result. But of course, saying this is all caused by the futures speculation is quite inaccurate. If this is what has been going on, declining Saudi production played an absolutely critical role in the price bubble.

Let me repeat here that I do not believe that speculation is the reason oil went from $60 to $120 a barrel. The biggest part of that longer term trend is due to fundamentals, not speculation. Notwithstanding, it does appear that speculation has gotten ahead of those fundamentals in the most recent developments.

For the bubble to continue, we would need to see ever-increasing volumes of investment money pouring into the futures markets, and continuing stagnation in global production to ratify them. Even if the former occurs, my best guess is that the latter will not.

This article has 24 comments! Add yours below...

James Hamilton

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This article has 24 comments:

  •  
    CrossProfit
    May 19 05:11 AM
    My Website
    Excellent article.

    The last link (Econobrowser) is one of our sources of information when compiling evaluation lines for the energy sector.

    Note that future projects fall sharply as most companies and governments work on three and five year plans. Towards the end of 2008 this will be updated. Also note that the pie chart does NOT give the breakdown between heavy/sour and sweet crude. This is very important as the U.S. has limited capacity to refine sour.

    Saudi Arabia is building a 'sour' refinery (Yanbu) with the capacity to supply 2% of U.S. consumption but it is still several years off from completion. Read more about this in this old article from March 2007: www.crossprofit.com/ar...

    The main reason for this comment is to alert readers that the trade deficit is likely to INCREASE based on new supplies coming on line even if the price of oil reverts to $60 per barrel over the next several years. The reason is that currently most of our (U.S.) consumption is in the form of crude oil. In the near future this is about to change as oil exporting countries build refineries and export refined product.

    One scenario is that crack spreads increase drastically and being this is a comment and not an article, we'll leave it at that.

    CrossProfit
  •  
    ArtfulDodger
    May 19 08:00 AM
    Mr. Hamilton:

    I appreciate your article very much; it's very informative, particularly for those who're not familiar with futures trading.

    I think I am in agreement with you. At least I agree with your title, although your conclusion is somewhat vague.

    Here is my view of the world's energy situation.

    In 1970, proven world oil reserves were 560 billion barrels.

    By 2000, they had almost doubled to over 1 trillion barrels, and output was at 79 million barrels a day, more than 50 percent higher than in the early 1970s.

    Today, you can add at least another 600 billion barrels to those reserves due to the very recent report from the US Geological Survey regarding the oil reserves in the Bakken area of North Dakota.

    Moreover, both Brazil and China have had large recent discoveries.

    Thus, there is no reason that oil prices should stay as high as they currently are. The fact that they are as high as they are is due to the "momentum investing" crowd and their piling on technique of "investing."

    These momentum players and their cronies in the media can keep markets irrational much longer than anytime in the past—much longer than most of us could imagine twenty years ago—and that's what we have today.

    But when this group and their many followers pull out of a sector, prices crash much, much faster than they rise. And this is especially true with commodities.

    Indeed, when they finally move to other sectors, all of a sudden the world will be flush with oil and all hard commodities. It's happened before and it's going to happen again.

    Rebeldog

    See here for the latest US Geological Survey on the huge oil reserves in the Bakken: energyandcapital.com/s...?...

    See US coal reserves here: xist.org/charts/en_coa... (The best estimates I can find about coal is that the US alone has enough in-ground to last at least three-hundred years burning at the rate we’re burning it today.

    Lasting even longer should be no problem because we’re inventing more efficient ways to use coal every year.

    Once a very dirty source of energy, we’re now burning it cleaner than ever. With technological discoveries taking place nearly every day, the trend for carrying us into more efficient and even cleaner coal usage will continue—barring government intervention.

    But that’s the problem. Natural gas and nuclear power concerns have the money and the lobbying power at this point. On top of that, leftist “environmentalists” have blackened coal as an energy source in the world’s eyes.

    So instead of turning toward our greatest natural energy resource, we’re moving away from it.

    Could nation-building also add to the reason we’re not using our coal and buying energy from other countries?

    Jimmy Carterites certainly love buying from poor nations to build them up and that in turn sneakily transfers America's wealth abroad.

    The American people hate foreign aid, and high oil prices are a perfect way for the nation-building politicians to covertly send money to the Third World. That's the most obvious reason why there is no real outcry in Congress over the current high prices at the pump. Rebeldog)

    Another work that everyone interested in energy should read is Dr. Thomas Gold's writing regarding where oil and coal actually come from: "The Deep Hot Biosphere: The Myth of Fossil Fuels."
  •  
    John
    Angstrom
    May 19 08:28 AM
    I don't buy your argument at all. Most of the surge from $60 to $125 occured after the Fed started slashing rates. There is a high probability therefore that this is a speculative bubble, unless you believe in the uncanny coincidence that demand/supply deteriorated at precisely the same time as the Fed cuts.

    The price of oil is highly manipulated. Not a week goes by without news of production problems in Saudi and Russia. And guess who is giving us this news: the Saudis and the Russians.

    Speculators should be banned from the commodities market. It is really a disgrace that people would jump ahead of buyers who really need a product, just to make a buck. Think of food commodities, now out of reach for many families in other countries, while the fat cats at hedge funds get fatter. Shameful.
  •  
    paultaut
    May 19 08:31 AM
    What type of crude is every one talking about? If it is light or WTI, name one just one large recent discovery.

    I agree wholeheartedly that there are vast amounts of the other varieties which would drop crude prices like a big, big rock. Lets compare apples to apples. Crude is priced as WTI or Brent each are of the Light grade...where are the large discoveries of this grade.

    Remember Jed in the Beverly Hillbillies, Light crude is generally found at the surface, good luck finding more in large quantities.

    Meanwhile, Oil Sands used to be called TAR sands, Shale oil...no difference...If you can not refine it, don't bother increasing your capacity. Its like that sludge sitting off the coast of Iran...20 million brls worth of unrefinables.

    Sure refining capacity overseas for this sludge is increasing and that would alleviate the shortage of refined product but our ports are already clogged. How do we double their capacity to offload same.

    Cry all you want, ain't nothin happenin any time soon.
  •  
    paultaut
    May 19 08:38 AM
    Idiots abound, margin requirements for crude contracts have increased 140% over the last year...crude prices have increased by about the same.

    Why don't we stop all commodity trading in the US altogether? Gee not only will we not be able blame the speculators who help keep our markets fairly stable, but we also put crude oil pricing overseas...lose jobs here and send more money abroad! Go Liberals!
  •  
    John
    Angstrom
    May 19 08:42 AM
    Paultaut, "speculators help keep our markets fairly stable?" Please don't make me laugh. All of Wall Street would be insolvent and taking the whole economy down the drain, were it not for Bernanke's emergency cuts, which may not work in the end.
  •  
    Jack Yetiv
    May 19 09:26 AM
    Who here believes that OPEC or Russia (who collectively account for nearly 50% of world production) would let oil drop below $100?

    OPEC (even our "friend" Saudi Arabia) has made it pretty clear they like $120 oil (and I don't blame them--like everyone, they are out to maximize their profit). Otherwise, Saudi Arabia would have raised more than 300K barrells and done it when oil crossed $100, or $110--not $127.

    And although many doubt if OPEC can INCREASE production, nobody doubts that OPEC can DECREASE production.

    And who thinks OPEC will not DECREASE production if by some fluke, world supply outstrips world demand?

    Jack Yetiv
  •  
    zenalgorithm
    May 19 10:01 AM
    Rebeldog,

    "These momentum players and their cronies in the media can keep markets irrational much longer than anytime in the past—much longer than most of us could imagine twenty years ago—and that's what we have today."

    I completely agree with your statement. Many analysts on CNBC last week saying that the earthquake in China was bullish for oil since the Chinese would need to use more gasoline power generators with electricity out...were simply sham analysis. Those poor chinese don't have expensive gas generators - most Americans don't even have them. Most of the streets in those destroyed cities have vast amounts of rubble in them, thus cars and buses won't be moving or consuming much gas for the next few months until those streets are cleared. I live in Seattle, some streets in Seattle were closed off for years following the big 2001 earthquake that hit here, because of unstable buildings - I'm sure those Chinese buildings are built much worse than those in Seattle. I highly doubt closed roads are bullish for oil.
  •  
    Ops did it
    again
    May 19 10:09 AM
    The fact that so many people think this is a bubble makes me think that is not. Also my guess on the Iranian tankers out there with oil is that it is their "insurance" against US attacks. Also I don't think OPEC can increase supply in any sustainable way. Also I think oils has not really gone up that much in real terms. It has gone up on fake terms due to the worthless US $$. The fact that Arab countries refuse to increase production tells me: 1) They can't. 2) They want more of those green pieces of paper we send them in exchange because they are (and will) be worth less to them. In other words that are protecting themselves from future US $$ debasement which is todays' US policy. Things will change when we change governments
  •  
    blah-blah
    May 19 12:26 PM
    Great article!

    There's plenty of moronic funds that haven't jumped on the bandwagon yet although as the article mentions, there's announcements all the time(recent JPM announcement comes to mind).

    The good news for you oil bulls who believe the supply BS, the bubble looks like it's got 30%-40% to go so party like it's 1999 - till it all blows up of course.
  •  
    weak dollar
    May 19 12:46 PM
    Currently oil is about 70+ Euro and 120+ dollars. If the dollar were at the same level vis-a-vis the Euro as it was 6/7 years ago the price of oil would be somewhere near $60.
  •  
    Skjellifetti
    May 19 12:52 PM
    I've been waiting to see someone bring all of the important bits and pieces (Hotelling's rent, Krugman's excess supply graph, Iran's ship tieups, stagnating production, etc.) together into a coherent holistic argument.

    Now we just need to add monopolistic/oligopoli... supply theory to the mix since the Saudis and other large suppliers can affect prices and, IIRC, have an incentive to prevent the price from rising too rapidly in order to reduce incentives for technology changes that would ultimately reduce demand. I wonder if the Saudis are worried that demands to stop global warming will finally provide the incentives for alternative technologies and have decided that keeping the price low is no longer in their long term interest.
  •  
    iThinkBig
    May 19 12:56 PM
    My Website
    You nailed it Free Market. Debasing the currency by a government's choice has always created inflation which is a way to tax the non-suspecting population. Too much money has been skimmed from the top through ponzi schemes like subprime or wasted on wars.

  •  
    special1pers
    on
    May 19 01:12 PM
    My Website
    Oil speculators are geniuses!

    Just ask Steve Forbes, -R:

    "October 20, 2005 Steve Forbes has predicted oil may well plummet to $35 a barrel in 2006"
  •  
    ArtfulDodger
    May 19 02:00 PM
    Folks, here are two articles everyone interested in energy should read:

    Refilling Oil Wells
    www.rense.com/general6...

    Sustainable Oil
    www.wnd.com/news/artic...

    The above two articles tie in well with Gold's "The Deep Hot Biosphere: The Myth of Fossil Fuels."

    Rebeldog
  •  
    Brian
    Pursley
    May 19 04:43 PM
    My Website
    Commodity price primarily due to weak dollar: seekingalpha.com/artic...

    However here is the case that speculators set oil prices: peakoildebunked.blogsp...
  •  
    STOP THE
    BOYCOTTS
    May 19 04:50 PM
    this could also happen if,"powers that be" ""allow"... the price higher,creating a pricing bubble, to sap currency from China and INdia , who subsidize large portion of cost, artifically creating currency imbalances and thus affecting those economies.

    the price movement then attracts speculators, who have been chasing commodities, one to another, all year...witness the sell off in wheat corresponding to move up in Oil.

    the excess liquidity the fed has created must go somewhere...Goldmans' CDS and MBS/CRE biz is gone forever...and those profit revenues need to come from somewhere, so go long, pump up the price to 140/200...and then allow your traders huge profits once they sell into the ensuing retail buyers...

    what a game...
  •  
    investor 911
    May 20 12:03 AM
    Bubble? Wake up guys..it's only the beginning.
  •  
    Jackafuss
    May 20 06:34 AM
    Professor Hamilton,

    For financial futures to seriously impact the price, there has to be storage involved. I understand the short term "push" you mention and I understand the 20 (now said to be 30) million barrels in ships off the coast of Iran but where is there evidence of additional storage or "hoarding" if you will?
  •  
    Jimmy from
    da Bronx
    May 20 12:25 PM
    free markets said "The fact that so many people think this is a bubble makes me think that is not."

    Good point, free markets! Like when Lucent was $80 a share! Better buy some Lucent before it gets more expensive! Or Cisco! Cisco will be $150 a share! Buy now or be priced out forever! I also hear I can make a killing in California real estate! I've heard "they're not making any more land", you know. Land is a finite resource! Better buy now or be priced out forever!

    Just checked NYMEX crude! almost $129 a barrel! Cashing out my 401(k) right now to get my position before the rest of you suckers! I'm rich! They're not making any more oil!
  •  
    Kunst
    May 22 09:18 PM
    The only thing Steve Forbes ever had going for him was rich parents.
  •  
    OIlBear
    May 23 01:49 AM
    My Website
    I don't know what I'm missing, but it seems simple to me to remove much of the speculation from the market. Why not increase margins to 100%? They did it when the Hunts drove up the price of silver. We could do it now, and it would bring prices down quickly. There could also be limits on opening long positions imposed by the CFTC.
  •  
    Commodity
    Bubble
    proponent
    May 23 07:38 PM
    Two quick points:

    1. Speculation is clearly involved in this market. As of right now, there is no oil shortage anywhere globally. The guys that predictably tell us there is a shortage are the same ones that are profiting from the same thing.

    2. Investment banks now own massive oil storage facilities globally. Morgan Stanley and Goldman Sachs have actually been taking delivery of oil products to sell at a later date. Precisely the definition of "hoarding". This is just a few articles that demonstrate how this activity has taken place since 2004. I'll let you all draw your own conclusions.

    business.timesonline.c...
    online.wsj.com/public/...
    online.wsj.com/article...
    www.commoditytrader.co...

    Conveniently as the latest Oil Movements report shows, most supply stock building as occured offshore and out of sight (translation: it doesn't show up in EIA reports). I personally think the investment banks learned from what happened the last time oil correct 30% (when they filled up Cushing in 2006) and figured that the best way to deal with it is to store the oil where the EIA can't calculate it.
  •  
    gatornose
    May 26 11:48 AM
    Reading your comment on hoarding makes me ashamed to be
    in the human race. I hope they loose their shirts.
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