Rising Oil: how much of it is caused by actual demand versus speculation only?
June 13, 2009 by dragon
Perhaps 60% of oil prices are speculation
Goldman Sachs and Morgan Stanley today are the two leading energy trading firms in the United States. Citigroup and JP Morgan Chase are major players and numerous hedge funds speculate.
In June 2006, the senate investigation estimated that of oil traded in futures markets at some $60 a barrel, about $25 of that was due to pure financial speculation. One analyst estimated in August 2005 that US oil inventory levels suggested WTI crude prices should be around $25 a barrel, and not $60.
That would mean today that at least $50 to $60 or more of today’s $115 a barrel price is due to pure hedge fund and financial institution speculation. However, given the unchanged equilibrium in global oil supply and demand over recent months amid the explosive rise in oil futures prices traded on Nymex and ICE exchanges in New York and London, it is more likely that as much as 60% of the oil price today is pure speculation. No one knows officially except the tiny handful of energy trading banks in New York and London, and they certainly aren’t talking.
By purchasing large numbers of futures contracts, and thereby pushing up futures prices to even higher levels than current prices, speculators have provided a financial incentive for oil companies to buy even more oil and place it in storage. A refiner will purchase extra oil today, even if it costs $115 per barrel, if the futures price is even higher.
As a result, over the past two years crude oil inventories have been steadily growing, resulting in US crude oil inventories that are now higher than at any time in the previous eight years. The large influx of speculative investment into oil futures has led to a situation where we have both high supplies of crude oil and high crude oil prices.
Compelling evidence also suggests that the oft-cited geopolitical, economic and natural factors do not explain the recent rise in energy prices – this can be seen in the actual data on crude oil supply and demand. Although demand has significantly increased over the past few years, so have supplies.
Over the past couple of years, global crude oil production has increased along with increases in demand; in fact, during this period global supplies have exceeded demand, according to the US Department of Energy. The US Department of Energy’s Energy Information Administration (EIA) recently forecast that in the next few years, global surplus production capacity will continue to grow to between 3 and 5 million barrels per day by 2010, thereby “substantially thickening the surplus capacity cushion”.
Dollar and oil link
A common speculation strategy amid a declining US economy and a falling US dollar is for speculators and ordinary investment funds desperate for more profitable investments amid the US securitization disaster to take futures positions selling the dollar “short” and oil “long”.
For huge US or EU pension funds or banks desperate to get profits following the collapse in earnings since August 2007 and the US real estate crisis, oil is one of the best ways to get huge speculative gains.
The backdrop that supports the current oil price bubble is continued unrest in the Middle East, in Sudan, in Venezuela and Pakistan and firm oil demand in China and most of the world outside the US. Speculators trade on rumor, not fact. In turn, once major oil companies and refiners in North America and European Union countries begin to hoard oil, supplies appear even tighter lending background support to present prices.
In his blog, Jeff Matthews was talking to a congressman about the reasons for the rapid ascent of oil. “What about hedge funds, he wanted to know. What about all these traders carrying all these contracts?
I asked him how they had anything to do with it.
“Well there’s so much more oil traded than really exists,” he said. “Isn’t that driving up the price?”
I explained that’s pretty much the way it is with anything…stocks, bonds, oil, you name it.
He didn’t believe it. Then he said Congress is considering reducing the amount of oil contracts traders can buy and sell. “Won’t that reduce the price of oil?”
I explained that maybe if Congress had taxed gasoline and funded mass transit instead of giving tax breaks for SUVs and ethanol we wouldn’t be forced to go begging the Saudis for more oil.”
Opec blames paper trading of oil too
In their blog, accidentalhuntbrothers takes an article from a reuters report that say that If you were looking for a definition of excessive speculation this is it!
“OPEC’s Secretary General said on Tuesday more balance was needed between the amount of oil traded in the physical markets and the “paper” markets, which the group has often blamed for causing price swings.
“The paper market should be a reasonable percentage of the physical market, of the real barrels,” Abdullah al-Badri said at the Reuters Global Energy Summit.
Badri said in June 2007, there was the equivalent of 3 billion barrels of oil being traded in paper markets, when 67 million barrels a day were traded in the physical oil markets.
He said it was not acceptable to have this imbalance. . . .
The Organization of the Petroleum Exporting Countries has previously said there was a need to control speculation and Badri reiterated there was a need for standards.”
John Heimlich, the Chief Economist of the Air Transport Association pointed out that in the month of June the combined volume of the NYMEX WTI, ICE WTI and ICE Brent futures contracts just by themselves is over 1 Billion barrels per day (this does not include the OTC markets which are larger). There are only 85 million barrels per day produced and consumed in the world. If every barrel produced was hedged (most are not) with a speculator on the other side and every barrel consumed was hedged (most are not) with a speculator on the other side then at least 830 million barrels per day are traded BETWEEN speculators. Oil futures trading is well above 83% PURELY speculative!!
Using OPEC’s numbers it’s over 95% speculative!!!
These are NOT side bets. Futures prices determine spot prices. Clearly speculators with 83%+ market share determine futures prices.
In conclusion, the dailyreview puts it best “Commodity trading is a legitimate enterprise. But Congress should require that oil be traded only within regulated exchanges, and that margins be at least comparable to those for other securities, which typically are limited to 50 percent.
Some speculation is inevitable in any capitalist system. But oil should have some relationship to actual supplies and demand.”
Personally, I would like to see paper oil trading at any exchange completely removed as this sets a vicious cycle that has grave effects on the economy. Feed, livestock, corn, labor, power, and most cost of goods rise like dominos. The devil must be smiling now.
——————-
Further reading on the history of oil. I had previously placed this sourced latter part at the beginning of my article, but after re-reading, realized it was too technical, so I decided to put the debate on actual supply and demand plus the conclusion first.
A brief history of traded oil and excerpts from atimes:
A June 2006 US Senate Permanent Subcommittee on Investigations report on “The Role of Market Speculation in rising oil and gas prices” noted, “… there is substantial evidence supporting the conclusion that the large amount of speculation in the current market has significantly increased prices”.
What the senate committee staff documented in the report was a gaping loophole in US government regulation of oil derivatives trading so huge a herd of elephants could walk through it. That seems precisely what they have been doing in ramping oil prices through the roof in recent months.
The senate report was ignored in the media and in the Congress. The report pointed out that the Commodity Futures Trading Trading Commission, a financial futures regulator, had been mandated by Congress to ensure that prices on the futures market reflect the laws of supply and demand rather than manipulative practices or excessive speculation. The US Commodity Exchange Act (CEA) states:
Excessive speculation in any commodity under contracts of sale of such commodity for future delivery … causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity.
Further, the CEA directs the CFTC to establish such trading limits “as the commission finds are necessary to diminish, eliminate, or prevent such burden”. Where is the CFTC now that we need such limits? It seems to have deliberately walked away from its mandated oversight responsibilities in the world’s most important traded commodity, oil. As that US Senate report noted:
Until recently, US energy futures were traded exclusively on regulated exchanges within the United States, like the NYMEX, which are subject to extensive oversight by the CFTC, including ongoing monitoring to detect and prevent price manipulation or fraud. In recent years, however, there has been a tremendous growth in the trading of contracts that look and are structured just like futures contracts, but which are traded on unregulated OTC [over the counter] electronic markets. Because of their similarity to futures contracts they are often called “futures look-alikes”.
The only practical difference between futures look-alike contracts and futures contracts is that the look-alikes are traded in unregulated markets whereas futures are traded on regulated exchanges. The trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron and other large energy traders into the Commodity Futures Modernization Act of 2000 in the waning hours of the 106th Congress.
The impact on market oversight has been substantial. NYMEX traders, for example, are required to keep records of all trades and report large trades to the CFTC. These Large Trader Reports, together with daily trading data providing price and volume information, are the CFTC’s primary tools to gauge the extent of speculation in the markets and to detect, prevent and prosecute price manipulation. CFTC chairman Reuben Jeffrey recently stated: “The commission’s Large Trader information system is one of the cornerstones of our surveillance program and enables detection of concentrated and coordinated positions that might be used by one or more traders to attempt manipulation.”
In contrast to trades conducted on the NYMEX, traders on unregulated OTC electronic exchanges are not required to keep records or file Large Trader Reports with the CFTC, and these trades are exempt from routine CFTC oversight. In contrast to trades conducted on regulated futures exchanges, there is no limit on the number of contracts a speculator may hold on an unregulated OTC electronic exchange, no monitoring of trading by the exchange itself, and no reporting of the amount of outstanding contracts (“open interest”) at the end of each day.
Then, apparently to make sure the way was opened really wide to potential market oil price manipulation, in January 2006, the George W Bush administration’s CFTC permitted the ICE, the leading operator of electronic energy exchanges, to use its trading terminals in the United States for the trading of US crude oil futures on the ICE futures exchange in London – called “ICE Futures”.
Previously, the ICE Futures exchange in London had traded only in European energy commodities – Brent crude oil and United Kingdom natural gas. As a United Kingdom futures market, the ICE Futures exchange is regulated solely by the UK Financial Services Authority. In 1999, the London exchange obtained the CFTC’s permission to install computer terminals in the United States to permit traders in New York and other US cities to trade European energy commodities through the ICE exchange.
The CFTC opens the door
Then, in January 2006, ICE Futures in London began trading a futures contract for WTI crude oil, a type of crude oil that is produced and delivered in the United States. ICE Futures also notified the CFTC that it would be permitting traders in the United States to use ICE terminals in the United States to trade its new WTI contract on the ICE Futures London exchange. ICE Futures as well allowed traders in the United States to trade US gasoline and heating oil futures on the ICE Futures exchange in London.
Despite the use by US traders of trading terminals within the United States to trade US oil, gasoline and heating oil futures contracts, the CFTC has until today refused to assert any jurisdiction over the trading of these contracts.
Persons within the United States seeking to trade key US energy commodities – US crude oil, gasoline and heating oil futures – are able to avoid all US market oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the NYMEX in New York.
Is that not elegant? The US government energy futures regulator, CFTC, opened the way to the present unregulated and highly opaque oil futures speculation. The present chief executive officer of NYMEX, James Newsome, who also sits on the Dubai Exchange, is a former chairman of the US CFTC. In Washington doors revolve quite smoothly between private and public posts.
A glance at the price for Brent and WTI futures prices since January 2006 indicates the remarkable correlation between skyrocketing oil prices and the unregulated trade in ICE oil futures in US markets. Keep in mind that ICE Futures in London is owned
Because the OTC and London ICE Futures energy markets are unregulated, there are no precise or reliable figures as to the total dollar value of recent spending on investments in energy commodities, but the estimates are consistently in the range of tens of billions of dollars.
and controlled by a US company based in Atlanta, Georgia.
In January 2006, when the CFTC allowed the ICE Futures the gaping exception, oil prices were trading in the range of US$59-60 a barrel. Today, some two years later, we see prices tapping $120 and trending upwards. This is not an OPEC problem. It is a US government regulatory problem of malign neglect.
By not requiring the ICE to file daily reports of large trades of energy commodities, it is not able to detect and deter price manipulation. As the senate report noted:
The CFTC’s ability to detect and deter energy price manipulation is suffering from critical information gaps, because traders on OTC electronic exchanges and the London ICE Futures are currently exempt from CFTC reporting requirements. Large trader reporting is also essential to analyze the effect of speculation on energy prices.
The report added:
ICE’s filings with the Securities and Exchange Commission and other evidence indicate that its over-the-counter electronic exchange performs a price discovery function – and thereby affects US energy prices – in the cash market for the energy commodities traded on that exchange.
In the most recent sustained run-up in energy prices, large financial institutions, hedge funds, pension funds and other investors have been pouring billions of dollars into the energy commodities markets to try to take advantage of price changes or hedge against them. Most of this additional investment has not come from producers or consumers of these commodities, but from speculators seeking to take advantage of these price changes. The CFTC defines a speculator as a person who “does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes”.
The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil for future delivery in the same manner that additional demand for contracts for the delivery of a physical barrel today drives up the price for oil on the spot market. As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum.
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