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Some controversy remains as to whether speculation or fundamentals were behind the spectacular rise in the oil price in 2008, or for that matter the rise in the oil price during the last 6 months. The dissention can partially be traced to academics like myself, who have been careless in our explanations of this issue. For instance, even in my textbooks (2000,2007) I failed to note that the speculators in question are not like the ladies and gentlemen in the neighbourhood betting shops in Sydney (Australia), nor the young lads who used the alley behind my home in Chicago as the site for an occasional game of dice.
Instead, a majority of the professionals speculating on oil resemble those in front of the screens in the film Wall Street, and they have comparable educations. Most of them really and truly understand the dynamics of oil markets, and if they don't they are encouraged by their superiors -- at e.g. investment banks and other financial institutions -- to find another line of work. They also do not call themselves speculators! The few whom I encountered in Singapore and Sydney called themselves traders. In my textbooks I referred to their activities as proprietary trading.
In my course on oil and gas economics at the Asian Institute of Technology (Bangkok), I discussed two oil price escalations. One 'about' 1981, when the Shah said goodbye to Iran; while the next was in l990-91, during the run-up to the Gulf War. Last year I concentrated my attention on the approach of the oil price to $147/b. This breathtaking escalation began in 2008, somewhat earlier than when I gave a long lecture on the oil price at the Ecole Normale Superieure (Paris), just prior to which I read several articles by a journalist in Le Monde, Jean-Michel Bezat, who had some very bad news to present his readers about the intentions of King Abdullah where the supply of oil was concerned. Among other things, His Majesty said that when there were new discoveries, they should be left in the ground for the children (les enfants) of the Kingdom.
Let's look at these upward oil price movements. The first mentioned above raised the price several hundred percent before it swung back, and if you examine a plot of oil prices it is quite obvious that it was a 'spike': it jumped up and fell back in a very short time. The second was also a spike of about one-hundred percent.
The third price rise was not a spike. It was a sustained price rise that continued for several months. What about the behaviour of speculators on these occasions? In the two spikes some of them made a lot of money, but the smart ones did not try to prolong their windfalls. This is because they knew that there was a great deal of easily obtainable oil in the crust of the earth, and in addition oil producers possessed considerable spare capacity. It has also been claimed -- though not by reliable sources -- that there was considerable 'cheating' by OPEC producers. The price had to fall.
Things were different in 2008. There was still a large amount of oil in easily exploitable deposits, but its owners had no intention of producing it given prices and price expectations -- nor would you if you had been in their place. In fact, as I argued in my Bangkok lectures, they might not have increased their output at any price. On that occasion there about two million barrels per day (= 2mb/d) of spare capacity, with most of this in Saudi Arabia. In these circumstances speculators, anti-speculators, neighbourhood betting syndicates, moonwalkers, day-trippers or anybody with an urge to make some quick cash went long in oil (by which I meant that they tended to purchase oil futures, which are also important for pricing physical oil). This was the period when the billionaire investor T. Boone Pickens predicted that oil was on its way to $200/b, and he might have been correct if the macroeconomic-financial market meltdown had not commenced. It was also clear at a fairly early stage that this (outrageously) high oil price could bring about a macroeconomic disaster.
Here we have the reason why President Bush visited Saudi Arabia in May (2008), and requested some assistance from King Abdullah. The well known outcome of that episode was that his host graciously thanked him for his concern and wished him a safe flight back to Washington.
That brings us to the bottom line in the fundamentals versus speculation dispute: logically, if X depends on Y, and Y depends on Z, then X also depends on Z. To the extent that the oil price is influenced by speculators, and speculators obtain their clues from fundamentals (e.g. demand, reserves, OPEC policies), then what weight speculators exert on the price is mostly due to fundamentals. Mostly? Well, that is a figure of speech, since there are undoubtedly a few speculators who play 'hunches' instead of fundamentals, but they tend to have a minimum of 'juice' in this very complicated market, even if occasionally a few of them are lucky.
In his testimony before a congressional committee, Michael Masters took what was virtually a sacred oath that speculators were responsible for the big oil price upswing in 2008. He was probably right, though his logic was very different from that in the above discussion, where the point is that the price rise originated with fundamentals in which demand threatened to outrun supply, and to which speculators reacted. Mr. Masters seemed to be in favor of banning or limiting speculation, which would be something like banning the musical background in a Fred Astaire or Gene Kelly film.
OPEC weighed in on the discussion by claiming that speculation was behind the price rises, although to my way of thinking OPEC's supply policy is perhaps the cornerstone of today's oil market fundamentals. Even if Mr. Masters and his distinguished interrogators did not understand this rather unique situation, intelligent speculators did.
It also needs to be stressed that the decision makers at OPEC know -- as I also know -- that without speculation market liquidity could plummet, which in turn could -- could, not would -- lead to a situation of the kind shown in a French TV film last year, in which mules (or horses) were seen pulling luxury automobiles. I am not suggesting that OPEC movers and shakers are thrilled at this prospect, but if the oil price exceeded $300/b -- i.e. the price that oil reached in that French film -- those gentlemen would probably find the change in Paris street scenes more than tolerable during the lovely vacations that they might be inclined to take in that magnificent city. And finally, it should be noted that a partial or full reduction in speculation would have drastic consequences for the hedging of (oil) price risk -- a hedging by consumers and producers of physical oil. If Mr. Masters had been aware of this, and what it would mean for future investment and production in the oil sector, he might have tried to be less dramatic in his condemnation of speculation.
Banks, Ferdinand E. (2009). 'Economic theory and some aspects of the new world oil market. Geopolitics of Energy (March).
______. (2007) The Political Economy of World Energy: An Introductory Textbook. London, and New York and Singapore: World Scientific.
______. (2001). Global Finance and Financial Markets. Singapore: World Scientific.
______. (2000). Energy Economics: A Modern Introduction. Dordrecht And Boston: Kluwer Academic.
Bezat, Jean-Michel (2008). Petrole: le pouvoir a changé de camp. Le Monde (20, Mai).
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I don’t see anything wrong with oil future speculation. You can speculate price going down as easily as going up. The speculators can’t walk away from the losing bets, thus have symmetrical risk of wining and losing. And loser doesn’t require taxpayer bailout.
The wrong kind of speculation is the housing speculation, in form of 0% down loan. You can’t speculate as easily that housing price would go down. The speculators can walk away from losing bets by defaulting on the loan, thus have asymmetrical risk of winning and losing. And loser DOES require taxpayer bailout.
Jim Beyer 8.17.09
I hesitate to make too much of a comment on this issue, as any viewpoint is likely to be controversial. However, in this rare instance, I have the ability to verify or test my position.
I think the role of speculators with respect to oil prices has been played up to mute the panic of peak oil. I think world oil production peaked in July, 2008. (Obviously, time will tell on this point. That's the test I mentioned earlier.) Now, the world economy has cooled so demand for oil is lower. The dawning reality of peak oil is thus being spread out over 3-5 years, instead of being a point event. As a result, we (the world) can react to it in a less panicked manner. So blaming the speculators, if erroneous, may have been a good thing to do.
Harry Valentine 8.18.09
During the oil price boom that endied in late 2008, demand in the United States heavily influenced oil prices. Hurricane Katrina magnified the problem by taking refinery capacity off-line. The USA has a shortage of refinery capacity and expanded refinery capacity would greatly moderate oil prices . . . and moderate the magnitude of the speculation.
There is untapped oil in the Bakken oil fields of North Dakota in the Northern USA and Saskatechewan, Canada. Additional oil resources may become available in the Arctic as well as at numerous offshore locations around the USA.
Tom Matthews 8.18.09
Nobel Laureate Milton Friedman famously argued the case for market speculation in a 1960 article titled, In Defense of Destabilizing Speculation. Friedman argued that the goal of speculators is to buy low and sell high. Markets become volatile only when participants are willing to pay too much for a commodity or sell below prevailing market prices. If speculators are increasing volatility, then they are destined to go out of business. Hence, successful speculation must reduce market volatility.
Len Gould 8.26.09
Tom: Friedman may be a god to some, but he was wrong there. Those claiming "speculators stabilize prices" need to read the history of the Tulip Bulb bubble, the South Seas bubble, any of the land booms in wetern N America in the 19th century, etc. etc. etc.
Bottom line is, speculators take a specific percentage of every $ spent on petroleum products, sometimes higher, sometimes lower. Fred believes that percentage is worth the price, I remain unconvinced.
Murray Duffin 8.26.09
Quote from Business Week 10 Aug '09 "The forthcoming review of spiking oil prices will suggest that speculators play a big role in wild swings" The referenced report is expected from the CFTC in August, and completely reverses their original views on the 2008 price run-up. Fred's contention that all speculators in oil are well versed in oil fundamentals probably wiuldn't stand scrutiny. In Q2 2008 investment money was already moving to the sidelines, and big investors, like pension fund managers were looking for some place to make money. When oil started up, as Fred says, for sound fundamental reasons, a lot of "new" money dived in. Money in oil fitures was north of 10x the value of oil actually being bought and sold. Trend riders piled in in a big way. For sure, prices above about $110./b were speculation. Murray
Jim Beyer 8.28.09
Speculators add liquidity. That's their main value to a market. But at some point, sufficient liquidity is achieved such that additional speculation has no further market value. This could be translated into how many contracts outstanding vs. how many contracts are actually delivered. And not writing uncovered shorts.
I think recent and not so recent history has shown that speculators can exhibit highly volatile behavior. This could be limited by increasing margin requirements. Nothing that Friedman said indicates speculators have a right to 90-95% leverage. Let the dumb speculators fail. Just don't let them crater the rest of the financial system as well.
Don Hirschberg 8.28.09
Len wrote: "Bottom line is, speculators take a specific percentage of every $ spent on petroleum products, sometimes higher, sometimes lower."
I guess I don't understand. When oil falls from > $ 140 to < $ 40 what do you call the people who take a bath (beside losers)?
Ferdinand E. Banks 8.29.09
Murray, when it comes to energy matters the people contributing to this forum know more, on the average, than the people writing in the best business magazines, and if I am not sure of anything else, I am sure of that. So, I do not need to read the Business Week summary of this thing. What I need is to meet their writers in a seminar room. Then you would see some blood flow, and it wouldn't be mine
Furthermore, the oil speculators in the big financial institutes know more about this subject than anybody else, ON THE AVERAGE. That's why they take home a couple of hundred thousand every year - plus bonuses. They have the highest IQs, they work harder, they love money more, they have been to the right schools which gives them certain social and other advantages, etc.
Now lets see what I said in this note. I mentioned two spikes when the oil price jumpted up, but these were spikes and not sustained escalations. Why? Because the speculators, on the average, were smart enough to know that there was plenty of oil, and OPEC did NOT have its act together. Those speculator/traders who stayed in took a bath, but so what. .
This time it was different. OPEC HAS ITS ACT TOGETHER, and moreover, what they SAY they are going to do where things like investment and production are concerned, and what they ACTUALLY DO are two different things. When the oil price started up in 2008 and people like Matthew Simmons and T. Boone Picens started talking about it going to $200/b, and demand from China and India were high, and there was no reserve capacity anywhere in the world except Saudi Arabia - and regardless of what they said they did not have much - then it was time to start buying and to keep buying even when the oil price hit the magic number $100/b.
And when the price reached 100, OPEC simply asked: WHAT'S WRONG WITH MORE? We like money too.
Then who is selling if these Wall Street people are doing a lot of buying? Answer:. Other traders/speculators who think differently, and later - in that highly liquid market - some of those sellers closed their positions and became buyers, and some of the buyers changed their minds and etc, etc. There were also plenty of chumps in this market are there are in all markets: they are called noise traders, and some of the older ones remember Milton Friedman saying that the oil price was going to fall to 5 dollars. BUT THE KEY THINGS WERE THAT PHYSICAL DEMAND WAS OUTRUNNING PHYSICAL SUPPLY, AND THE OPEC PEOPLE HAD READ A FEW PARAGRAPHS IN A GAME THEORY BOOK, AND KNEW HOW TO PLAY THIS THING.
Say that you are going to invest and produce, but don't!
And by the way, without the macro melt down the oil price would be much higher today, although it was the steady rise in the oil price that undoubtedly contributed to a lot of the macro and financial market trouble. And ladies and gentlemen, I' afraid that there might be some bad news ahead, because today's oil price is too high.
Murray Duffin 8.31.09
Actually, in Q2 '08 there was no supply shortfall. The combination of supply/demand balance and dollar weakness might have supported a price as high as $110./b. Anything over that was speculation, and was mainly driven by hot money and trend followers, but by well informed investors. Maybe what you call "chumps" in the market place. Those chumps are spculators, and they had enough clout to drive the markey. For those who doubt that speculation drives commodity price peaks, see the following on natural gas. I hope to soon find a similar report on oil 2008. Murray
From EnergyBizInsider 8/31/09 I believe that the size of the markets and the effects that they have on the day-to-day lives of the American public make it that much more important that we aggressively fulfill our mandate," says Gary Gensler, head of the commission, at a Congressional hearing. "Position limits should enhance liquidity by promoting more market participants rather than having one party that has so much concentration so as to decrease liquidity." Created in 2000, the Enron loophole had exempted from government regulations most over-the-counter energy trades and trading on electronic commodity indices. The thinking was that all commodities could be packaged and sold over online trading forums. Unfettered markets would then bring down prices for everyone. But such free market finesse has been blamed for not just excessive price volatility but also fraud and manipulation. In the intervening years, Congress introduced legislation that went nowhere. However, last year one such bill passed both chambers and was sent to President Bush for his signature. And while he vetoed it, Congress was able to override that rejection in June 2008. One of those accused of price manipulation was hedge fund Amaranth that managed $9 billion in assets. On a practical matter, the feds are still dealing with the fallout resulting from its failure in 2006. The Federal Energy Regulatory Commission recently approved an agreement that settles the case against the fund -- one that concluded its large natural positions created unstable markets and forced average people to pay much higher prices. The settlement requires the Amaranth parties to pay $7.5 million to the U.S. Treasury. Task Ahead Amaranth had dominated trading in U.S. natural gas markets just before its collapse, holding about 40 percent of all outstanding natural gas contracts on the New York Mercantile Exchange. At times, it held 100,000 natural gas contracts in a month. Critics maintain that such large positions have been the driving force behind higher natural gas prices. They add that speculators generally have become the dominant force in the futures markets, distorting the basic economic laws of supply and demand. In testimony before Congress this month, the Industrial Energy Consumers of America said that from January 2008 to August 2008, the price of natural gas more than doubled because of too much speculation. During the same time period, U.S. production of natural gas actually rose about 8 percent while national inventories were well within the five-year average and demand was essentially unchanged from the same period of the previous year. As a result of that excessive risk taking, consumers paid more than $40 billion in higher natural gas costs, it concludes. A report by the Government Accountability Office in 2007 tends to agree with that overall assertion. It said that speculation among futures traders could cause prices to escalate.
Xuguang Leng 8.31.09
"Market can stay irrational longer than you can stay solvent."
Functioning market doesn’t yield rational price all the times. $147/b oil doesn’t necessarily mean dysfunctional market.
Murray Duffin 8.31.09
That should say "not by well informed investors"
Len Gould 8.31.09
With whom does one choose to agree among original signors of the Declaration of Independence? 1) Those who agree that "faction" is the problem of a republic, or 2) those who believe that avarice and greed among the elites is the problem? 3) got short shrift in historical documentation, but in fact has turned out to be THE weakness.
Len Gould 8.31.09
SB 2) got short shrift
Ferdinand E. Banks 9.1.09
Murray, I dont think that we need to argue on this one. If you are saying that fundamentals supported a price of $110 and speculation took it the rest of the way, that's almost good enough for me. I think that fundamentals took it higher, but certainly there were some 'noise traders' (speculators) in the picture. I also heard from some of the experts in New York about this thing, and everything considered we are all in the same ball park where fundamentals are concerned - they account for the oil price going over the 100 dollar level where OPEC never, in their fondest dreams, expected to be for a long long time.
But you see, what OPEC started doing after that was trying to figure out what the oil demand curve looked like. I mean, they jumped for joy when the price of oil went above 28 dollars a barrel - which was the top of their desired range - and now suddenly it was above 100, and the international economy was cruising along without a (visible) bump. That's when the lies and dreams started about raising production and investing in new deposits, and when George W. flew to Saudi Arabia to request some assistance, he was politely told to get lost.
Think about it. According to the USEIA, Opec raked in more than 900 billion in 2008. You don't get that kind of money by making plenty of oil available. Now they know that, it's part of the latrine gossip in that building in Vienna, and because they know it the price of oil is around 70 dollars a barrel instead of.....
As for the natural gas, I'll have to read your comment again later in the day
Ferdinand E. Banks 9.3.09
By the way, when the oil price was on its way to $147/b, President Bush didn't go to Wall Street and threaten the 'speculators' with long jail sentences if they couldn't control themselves when they were sitting in front of their computers. Instead he went to Saudi Arabia with his hat in his hand and asked for more production of oil and investment in new capacity..
According to the EIA, the OPEC countries raken in more than 900 billion dollars in 2008. They could never have gotten that much money without restraining their production of oil.