Incorrect Media Speculation About Those Oil Speculators

by: James Hamilton August 22, 2008 | about stocks: DBO / OIL / USO    

James Hamilton

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I normally leave it to folks like Dean Baker to beat up on the press. But I can't resist shining a bright light on yesterday's story about oil speculators in the Washington Post, which has also been discussed by Mark Thoma and Tyler Cowen.

David Cho opens his story in the Washington Post with this bombshell:

Regulators had long classified a private Swiss energy conglomerate called Vitol as a trader that primarily helped industrial firms that needed oil to run their businesses.

But when the Commodity Futures Trading Commission examined Vitol's books last month, it found that the firm was in fact more of a speculator, holding oil contracts as a profit-making investment rather than a means of lining up the actual delivery of fuel.

Let's start with some background. The CFTC issues a report each week that summarizes the number of open futures contracts in oil and a number of other commodity markets. The CFTC separates the holders of those contracts into three broad categories-- commercial, noncommercial, and nonreportable. "Commercial" traders are those who report to the CFTC that they are

engaged in business activities hedged by the use of the futures or option markets.

So, for example, if your company has significant fuel costs, you would quite reasonably satisfy that definition of a commercial trader, regardless of whether the particular futures contracts you buy or sell this month are intended to hedge those costs. The CFTC specifically says further that it would classify as a commercial trader

a swap dealer holding long futures positions to hedge a short commodity index exposure opposite institutional traders, such as pension funds.

To an economist, any conceptual distinction between "hedging" and "speculation" is inherently problematic. When an oil refiner takes a position with futures contracts, it is unlikely to be ignoring its own guess as to where prices are heading. But making a bet based on such guesses seems to be the definition many people have in mind when they speak of "speculation."

On the other hand, when a pension fund manager takes a modest long position in commodities, that can reduce the overall variance of the portfolio due to the negative correlations between commodity price changes and other asset returns, which would most naturally be described as hedging against inflation risk.

The idea that the motives of a given trader can always be classified as either pure hedging or pure speculation, and that the positions of commercial versus noncommercial traders reported by the CFTC give us meaningful information about those motives, strikes me as a very dubious proposition. Discovering a potential "misclassification" could hardly be the basis for becoming legitimately alarmed.

What else does Cho dig up? The article continues:

Even more surprising to the commodities markets was the massive size of Vitol's portfolio-- at one point in July, the firm held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange.

That does sound like a lot, though enough details are left out to make me wonder what is actually being claimed here. Surely Cho doesn't literally mean "all the oil contracts," i.e., light sweet, Brent, heating oil, gasoline, and so on. If light sweet alone, are we talking about just futures, or futures plus options? Or is Cho possibly referring just to one very specific contract, such as the August CL futures contract? And were these positions held outright by Vitol or purchased on behalf of its clients?

Cho gets more quantitative a few paragraphs down:

By June 6, for instance, Vitol had acquired a huge holding in oil contracts, betting prices would rise. The contracts were equal to 57.7 million barrels of oil-- about three times the amount the United States consumes daily.

Again I'd like to know if we're including options somehow in this number. But more importantly, the claim that you can compare the number of notional barrels of oil implied by a futures contract if it were held to settlement with the number of physical barrels that the U.S. consumes repeats the egregious error committed by Michael Masters in his Senate testimony this May.

You can't compare the outstanding NYMEX open interest with U.S. daily petroleum consumption numbers directly because they are measured in different units. Open interest is a stock-- it is measured in number of outstanding contracts at a particular point in time. Consumption is a flow-- it is measured in barrels per unit of time. You can't measure how many barrels of oil the U.S. consumes without specifying a time unit. We consume about 20 million barrels per day, or 14,000 barrels per minute, or 7.3 billion barrels per year. With which of these 3 numbers are we supposed to compare 57 million?

Fifty-seven million sounds like a lot more than 14,000, and a lot less than 7.3 billion. You can make 57 million sound as big or as small compared with U.S. consumption as you want, because there's an arbitrary time interval associated with consumption that is not associated with open interest. If you want the futures volume to sound big, you compare open interest with daily consumption, as Masters and Cho both do.

Cho was trying the best he could to convince us that unregulated speculation was the cause of this summer's spike in oil prices.

But instead he convinces me that he really couldn't find much of a case.

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This article has 13 comments:

  •  
    Aug 22 08:08 AM
    Clearly when numbers don't tell your story the way you want, you need to put more numbers to it or re-explain through semantics
    Reply | Link to Comment
  •  
    Aug 22 10:16 AM
    I have read 15-2 words of it,maybe you are right maybe not,call me a speculator too as I made money today trading CL and NG for a nice profit and now when you will decide with your followers,as you are guru,what to do about it,I will focus my attention on selling some additional shorts on this hell out of the Dow Jones,I like this dead cat baunces when Bernanke is buying index futures out of fear Fannie and Freddie are gone and no one is going to buy a debt from him before he will not raise rates till 10-12%.
    Reply | Link to Comment
  •  
    Aug 22 11:15 AM
    Here's one non-Republican who thinks that blaming speculators for increased commodity prices is like blaming old, warty women for the bubonic plague. U.S. oil prices are high for two reasons: (1) perceived world demand exceeds perceived supply and (2) the U.S. dollar is weak. Neither the Democrats nor the Republicans want to deal with those findamental facts. The speculation about speculation is a distraction, on a par with the chimerical price-reducing power of increased offshore drilling. Both ideas are voodoo. Check out some further thoughts in the August Edition of NG Market Notes at www.navigantconsulting.../ in the article Do Speculators Reflect in Mirrors?
    Reply | Link to Comment
  •  
    Aug 22 12:50 PM
    Great article, Mr. Hamilton. Always appreciate your dispassionate, data-based analysis of the issues.

    Frankly, since nobody has actually defined "speculation"... it's impossible to determine whether oil prices are largely due to it. Bu thye fact of the matter is that all stocks and commodities are driven by "specualtion"... in the braod sense of the world--when I buy a stock, aren't I doing it because I am speculating that it will go up in the future?

    How is that different than buying oil because I think it will be higher in the future?

    And if I buy an investment property, am I not doing it because I think I will be able to get more for it when I sell it?

    Jack
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  •  
    Aug 22 01:27 PM
    I like your number one reason Ray. Key word is "perceived". Who has been laying out the preception and scaring the heck out of people to invest in oil because they "perceived" it will go up. How does Goldman predict $125 and poof...the same day it shoots up $7 to get to exactly $125. Such bull crap. I agree with the weak dollar, but did you happen to notice that the dollar goes down when oil goes up and it is not that oil goes up when the dollar goes down so you can blow that thought from your head because oil moves before the dollar does...you can check that if you don't believe me. Off shore drilling maybe a vodoo trick but ya know it would have worked. I think that is the real reason for this whole thing. The white house wants it and had there bank pals that lost there butt try to get it done in return for them getting bailed out by the federal reserve and the money made off the stocks. Who went short you ask...well supprisingly the other sectors of the banks. They went long and short, because it had to be a ballence to keep eyes off of it. People are blind if they cannot see htat
    Reply | Link to Comment
  •  
    Aug 22 01:50 PM
    Can anyone say ENRON. No one believed that the U.S. energy market could be manipulated but Enron proved it could and no one closed the hole that allowed them to do it. I don't call it speculation I call it what it is...MANIPULATION
    Reply | Link to Comment
  •  
    Aug 22 04:58 PM
    I hear the frustration.

    Enron manipulated specific, physical markets--pipelines and electric transmission lines--not a big, general, financial market like oil futures. They physically induced the supply-demand imbalances on which the financial markets piggybacked. But without the underlying physical constraints--artificia... in Enron's case--speculation has nothing to leverage. Actually, Enron's far larger manipulation was in their accounting. They created sham companies to hide bad debt. They weren't speculating--they were breaking the law outright. No one yet has identified any lawbreaking activity under the oil markets. Not to say it's not there or couldn't happen--there's just no evidence.

    I take an Occam's razor approach. There's enought rationale for oil prices to go up and down dramatically without imputing conspiracies. On a common sense level, it seems very unlikely that the entire world is going to roll over and buy oil futures, in the absence of credible supply-demand data, just because Goldman Sachs says it's going up. What stopped that from happening before? What about the recent drop--is that speculative, too, led by big bank analysts who called the top? Is that also wrong? But there is physical supply-demand data, and plenty of it. Here's one link from the International Energy Agency (IEA) that projects year-end demand at 88 MM bbls but supply at 87. See the left-hand column.

    (Incidently, that's what I meant by "perceived"-... not that it's made up or not real, but that it's in the future, and futures markets are by definition about, well, the future. Markets are anticipatory mechanisms. They're not about whether there's enough oil in storage tanks today, any more than Google at $500 a share is about Google making $100 billion this year.)

    No one is entitled to low priced oil. It is finite, and goes to the highest bidder. (Maybe capitalism is a bad thing, but that's another discussion entirely.) As China, India, and Russia all demand more oil to expand industrialization, price pressures will persist. That's why we need to ramp up programs to move away from it as a fuel. It would be nice if we could just find and punish a scapegoat and set the world to rights. But is that the expectation of a mature, intelligent person in a growing, industrializing, and complex world full of competing interests? The reality of demand outstripping supply is, to me, far more disturbing. But it is something we can actually address, if we collectively decide to.

    Read the article on the link in my previous post.
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  •  
    Aug 22 05:00 PM
    The IEA link: omrpublic.iea.org/inde...
    Reply | Link to Comment
  •  
    Aug 22 05:08 PM
    The last comment is one that all who ardently defend the markets should keep in mind to ensure there is some humility to their hardened positions. Enron was a market manipulator, and could be so because they controlled the trades of energy. I also think that small traders can drive up price. Though it may be heresy as a capitalist like me to say so, I believe that part of the ".bomb" bubble was driven by numerous people working on the margins of the market answering every increase in stock prices of certain darings that were otherwise unsubstantiated by buying long. Potentially, somewhere in the of Enron and little old men day traders lies Vitol making it worth a look.

    I am tired of hearing oil mouth pieces working so diligently to convince everyone that its all about supply and demand, and that the oil companies are only earning reasonable margins. While both may be true, neither explains more than doubling the price in a year on top of prices that were already wratched up. demand has not increased in that kind of proportion, and oil companies are less worried about margin than they are return which are up 2x or 3x each quarter of the last 6. Hopefully, the gig is finally up with the attempts to shed some light in the dark places.

    After all, even econ 101 teaches markets are most efficient where there is the greatest transparency. Commodities in general and oil in particular are certainly not as transparent as they need to be.
    Reply | Link to Comment
  •  
    Aug 22 06:07 PM
    Vitol is a partner in the Dubai Mercantile Exchange so they have massive market manipulation power. combine that with their partner Goldman Sach and like another post states Goldman says $125 and poof oil is at $125. No one can control a massive market like oil Bull Shit!


    DME enlists Goldman, Vitol, Shell to boost trade
    Reported 08/11/2008 by Trade Arabia

    Royal Dutch Shell PlcThe Dubai Mercantile Exchange (DME) has enlisted six international energy traders and investment banks as new co-owners to help it attract liquidity, selling them up to 20 per cent in the exchange, it said on Monday.The DME, a joint venture between Oman
    Reply | Link to Comment
  •  
    Aug 22 06:53 PM
    As usual Jack Y is right on the money.
    I listen to him very carefully. I have some Canroys for dividends (and trading)
    and I have made some money on DUG options - both directions and haven't lost yet.
    I hope I wasn't responsible for oil prices because I "speculated" . Silly me - I thought that is what I do when I buy/sell options ?
    I even sell "naked" put options when I want to own the stock anyway so I spose the SEC will be coming after me now ???
    Reply | Link to Comment
  •  
    Sep 01 08:07 PM
    Require all energy trading to be cash settled at the end of the trading day. No margin trading, if you buy 100 contracts you pay the price of them at that time. If you can not take physical delivery you can not buy the contracts or the products. This should apply to all derivatives trading! If you want to gamble go to Vegas or Jersey, I think the consumer has had enough of the parasitic drain of speculators taking a cut of all the money spent on energy! I believe another solution would be to allow oil consumers to purchase speculator futures, I myself would bet that the amount of speculators would decrease especially if hunting permits to thin the herd out would be available. I would be willing to pay a significant sum for permits such as these!
    Reply | Link to Comment
  •  
    Sep 10 07:51 PM
    OK . Now that we know who is to blame then how come no one is talking about compensation for the public. That’s right. We all got ripped off at the pumps and we want our money back. Vitol, Goldman Sachs, Morgan Stanley and the rest of the scoundrals have an obligation to make it right again and the CFTC should be disbanded and punishment administered to the ones that covered up this massive mistake. As usual, I agree with Mangolfer
    Reply | Link to Comment
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