Myth and Meaning in the Great Oil Game: Speculation VS. FundamentalsProfessor Ferdinand E. Banks
June 6th, 2008
"Fools will be fooled"
A few weeks ago I published a preliminary version of this paper on the net, and as far as I could tell it was received with considerable scorn, which mostly took the form of some very negative evaluations of my competence. Frankly, I didn't mind this at all, since I have come to believe that scorn is what the highbrow portion of the "net" often specializes in. What I did mind however was the inability of some of my "detractors" to comprehend elementary economic and financial theory, or Econ and Finance 101, as they might say on CNN and Bloomberg. Given the opportunity I would have suggested that they examine Chapter 8 in my new energy economics textbook (2007), although admittedly it was unlikely that most of those persons would have been impressed by a user-friendly version of "Energy and Money", which was the title of that chapter.
What everyone absolutely and unconditionally needs to understand is that most of the speculation in oil goes through the futures (or paper) market, as illustrated in the story told in the sequel. There is some speculation in the physical market -- for instance, an oil producer might pump oil and then store instead of selling it immediately because he or she or management expects its price to rise. This is speculation (i.e. gambling) because the price might fall; but for the most part speculation involves buying or selling futures. Professor Paul Krugman of Princeton University says that trading futures is a "bet", and does not directly influence the spot price of physical oil, which is correct: indirectly there might be some influence because e.g. heavy speculation could influence the expectations of consumers and producers and bring about a change in behaviour, but this is a minor factor at the present time For example, oil price escalation has not resulted in large changes in physical inventories. The bottom line here is that fundamentals (in the form of demand outrunning supply) is the most important factor for explaining the worrisome oil price increases that buyers must try to endure.
If there is any meaning in the Jeddah Summit on Oil (June 22, 2008), it was injected by the U.S. Treasury secretary, Henry Paulson, who before deliberations began informed his audience that the run-up in oil prices did not have anything crucial to do with speculation. Exactly how that august assembly reacted or will react to this piece of news is unknown to this humble teacher of economics and finance, nor do I care, because as I have explained at both great and diminutive length, the realities of the oil price are strictly determined by supply and demand (or fundamentals). Of course, Mr Paulson did not elaborate on this theme, because if he had he might have inadvertently used the expression "demand destruction", in which case when he got back to Washington, he might have found the lock changed on his office door. I cannot imagine the rank and file of American voters possessing any pronounced sympathy for politicians or high ranking civil servants who express an intention to tamper with their demand for motor fuel.
But if he had used it, and was given the opportunity to back it with policies and laws, it probably wouldn't have any serious consequences. Just before the summit the Chinese announced that they were removing some subsidies on motor fuel. This is an example of demand destruction, however what happened was that after a slight fall, the oil price recoiled and finished on a higher level. The explanation of course is that the market -- though not perhaps the market's admirers -- knows that the countries of the Middle East are not going to let "demand destruction" interfere with their control of the oil price. I have been duly informed that those countries are sincere in their desire to see a lower oil price, which is not impossible, because never in their wildest dreams did they believe that the price could attain its present value this early in the 21st century. Just what a "lower price" means though is another matter.
The next section is about one-half of an introductory lecture on the oil futures market that that I have been giving for what seems like a few centuries. As I understand the situation, some observers do not like to receive important information in a non-formal setting, but these are usually the observers I referred to above, and who can't or won't understand it in any context. Although I believe in democracy (for the same reason that Clint Eastwood does), their preferences will be ignored for the time being.
INTRODUCING OIL FUTURES
In my recent lecture at the Ecole Normale Superieure (Paris), the "bottom line" reduced to the following: professionals mostly say fundamentals, while amateurs and conspiracy theorists mostly say speculation. The emphasis here should be on mostly, because amateurs sometimes get things right, while stars are completely wrong. Of course, in this matter, professionals will often say other than what they believe if they feel that their salaries and perks would be jeopardized if they arrived at the correct conclusions. I'm thinking here of the International Energy Agency (IEA).
More important though is this business of what makes a professional. As I pointed out in the preface to my new energy economics textbook (2007), the best approach to the study of economics is to find out what you need, and if possible like, and then learn it perfectly. One of the things that committed students of energy economics need -- and should make it their business to not just like but love -- is a small amount of financial economics. Having written and taught from a book on financial economics (2001), I am under no illusion that this short contribution will supply more than a few intimations about futures, however even so I expect my beginning students to know the materials directly below perfectly, because becoming fluent with them might make it possible to avoid the enormous amount of foolishness in circulation about the decisive impact of derivatives (futures and options) and "hedge funds" on the price of physical oil.
I start with a modification of an elementary example that I always offered students of Economics 101, which I suggested that they should pay close attention to if they wanted a passing grade. I also informed them that they should give some extra attention to the terminology. Knowing this terminology is crucial for impressing colleagues, friends, future employers and, if you work in academia, enemies. It is much more important than being familiar with a few equations.
Millicent Koslowski is an undergraduate at the University of Pittsburgh, and a financial superstar in the making. She already has an innovative way of regarding the mechanics of her career: never buy when you should sell, and never sell when you should simply go home and take a shower! Most important, her radar is never turned off. She knows that what it takes to become a "rocket scientist" is more than a perfect knowledge of the fundamentals of derivative markets and a sincere belief that more money is better than less money. The most important things are an iron concentration and something they repeatedly told her brother during his basic training in the American army: stay alert stay alive.
While eating breakfast one day, her father mentioned that a friend's Uncle Charlie phoned him from Genoa (Italy) and told him that all the tanker crews in the Gulf were talking about going on strike. That was enough to cause Millie to immediately leave the table, and before ten minutes had passed she discovered that this information had not reached the media. In other words, if she was prepared to indulge in a little speculation, the means for financing her graduate studies at Harvard's School of Business had probably made an entrance into her young life. She picked up the phone and called a mentor and former teacher, Condi Montana, who is a commodities broker.
She informed the good Condi that the time had arrived to buy some futures contracts for crude oil. This is sometimes called "going long in paper barrels", as compared to the "wet (i.e. physical) barrels" aboard the oil tankers that might soon be lying idle: physical oil is the underlying. "How many?" inquired Condi, and so Millie told her of the developing situation in the Gulf as explained by somebody's Uncle Charlie, and told her to use her judgement.
Ms Montana immediately replied that she was going to buy 100,000 barrels for Millie, which meant 100 contracts, because each contract was for 1000 barrels, and since a maturity had to be specified, she was going to choose thirty days: after thirty days, if the (long) contract had not been offset with a sell contract (i.e. a short), and thus her position closed, Millicent would be the proud owner of 100,000 barrels of physical oil in the middle of Texas or somewhere, and will also have the pleasure of paying for it. In entering into this arrangement (i.e. opening a position), Millicent has the right to call herself a speculator, but she is NOT a speculator in physical oil. This is not what Millicent aspires to. The reader should be clear on this point, because unfortunately a lot of people aren't.
Moreover, like most speculators in paper oil (i.e. futures), Millicent has every intention of reversing her initial position before the expiry (or maturity) date of the contract, and she should be able to easily do this due to the adequate liquidity of the oil futures market -- at one time referred to as "the best game in town". Thus, the person who informed me (after reading an earlier version of this paper) that there is no difference between Millicent and a chemical manufacturer who needs physical oil for one reason or another is completely wrong -- unless of course Mr Manufacturer is hedging physical oil with futures (which I explain in full in my textbook).
Millie glanced at the latest edition of the Wall Street Chronicle, and noticed that the price of oil futures (with a maturity of 30 days) was $130/b, which meant that Ms Montana would be ordering about 130 million dollars worth of these assets for her friend (and client). That struck Millie as a nice round number for someone living in one of the less distinguished residential districts of Pittsburgh. The procedure usually is that she would have been asked for a (security) deposit -- from 5 to 10 percent of the transaction, which is called margin -- but today Condi Montana does not bother. The reason is that she is too busy buying a few barrels of paper oil for herself -- probably about a million. She knows that even a rumour of this strike could send the oil price off the Richter Scale, and knowing that she understands that this is the opportunity of a lifetime; the chance to change her name from Condi to Condo, in recognition of the kind of property she intends to purchase in quiet places like New Zealand and the south of Argentina -- localities that would be without interest to the new crews of hijacked planes.
Moreover, it hardly would have made any difference if Millie and Condi and some others had bought ten times that much. Even in a highly liquid market like the oil futures market, the price of futures (i.e. paper) contracts might have increased somewhat in order for a much larger order to be absorbed, but this does not mean that a drastic interpretation of this phenomenon would have been made by actors in the physical market. Where the price of physical oil is concerned, purchasing ten or twenty million more barrels of paper oil would hardly have the impact of a decline or perhaps suspected decline in the availability of e.g. 2 million "wet" barrels (i.e. physical oil).
Something that needs to be emphasized at this point is that Millie is buying futures and not forward contracts. True, a futures contract can be regarded as a forward when e delivery of the physical commodity (e.g. oil) is specified on the contract, but as compared to a forward, delivery does not have to take place, and indeed scarcely takes place. Instead, in a highly liquid futures market, a contract can be offset (or reversed) by just picking up the telephone and selling (or going short), if the opening transaction was buying (or going long). As a rough example the reader can think of the share (stock) market, where e.g. a position can be opened in the firm Standard Oil by calling your broker and buying, and an hour later your position in Standard Oil can be closed by calling your broker and selling the same amount. Transactions in the futures markets for oil and oil products are easy to carry out because futures contracts are standard contracts, for a specific amount of a commodity, and should delivery take place because the holder of a long contract keeps the contract until the maturity (or expiry) date, which is 30 days in this example, then delivery takes place to only a few specific locations. (In the U.S. the stipulated delivery locations are New York Harbour or West Texas.) However as explained in my new textbook (2008), it has become increasingly popular to settle contracts that are open at the expiry date with money instead of taking (or making) delivery. This is called "cash settlement".
That afternoon, when Millie returned from the university, she switched on the television, and heard that tanker crews in the Gulf were indeed going on strike. Already the spot price (i.e. the price for immediate delivery) of physical oil on both the New York Mercantile Exchange (NYMEX), and (Brent oil) on the International Petroleum Exchange in London had jumped up several dollars. It was being quoted in both places as $134/b, but spokespersons for the oil companies are claiming that everything humanly possible was being done to reach an agreement with the tanker crews. This isn't easy because floating objects had been observed in Gulf waters, and when they questioned their employers they were told by one of these gentlemen that "every ship is capable of serving as a mine sweeperĄonce". That good person was only joking, but this was not the kind of humour that their employees appreciated.
Millie called Condi again. The price of physical oil has gone up, she told her, and once she read a brilliant energy economics textbook by a great teacher who claimed that when the price of physical oil rises, it was very likely that the price of oil on futures contracts -- i.e. paper oil -- would also increase.
Yes, Condi Montana told her. I know the book, and as usual that gentleman was correct. The price of paper barrels is now 133 dollars, but there is an ugly rumour going around that the strike may be settled very soon, perhaps in a few hours. In addition, although this is not always the case, the fact that the futures price is below the price of physical oil is not a good sign at the present time.
"Sell my contracts now," Millie said. "Dump them all". Everything considered it had been a nice ride, and although it had ended in 6 hours, she increased her "wealth" (before taxes) by about $300,000 [ = 100,000 (133 ţu 130)] . Who said that there was no justice in this world, she found herself thinking. Something that should be noted here is that the price of futures and physicals do not have to be equal when the transaction was initiated, and the same was true when the position was closed, assuming that it was not closed on the expiry (i.e. maturity) date of the futures. (Once again I refer to my textbook for an explanation of the last statement!)
Now let's turn this delightful exercise around. An acquaintance calls Condi Montana from Rome and tells her that a large oilfield has just been discovered in Western Egypt next to existing oilfields in Libya. In other words, in order to get the oil to market hardly any new pipelines will have to be constructed. Supply up, price down, as Condi (and Millie) learned in Economics 101. Condi immediately went short (sold) a very large number of contracts for herself, and then called her former student Millicent Koslowski, and gave her the news. She suggested that Millie should also make a substantial investment -- for instance, sell 100,000 barrels, or 100 contracts with maturities of e.g. 30 days.
Where's the oil? How can you sell something that you don't have, which is what my students asked me the first time that I lectured on futures markets. The answer is that if you open a futures position by selling oil (i.e. going short), you can close it at any time before the expiry date by buying the same amount (i.e. going long).. In this situation the ownership or location of physical oil is irrelevant. If, however, the contract is kept open until the closing of the exchange on the expiry date, then conventionally 100,000 barrels would have to be purchased from some source and delivered to a designated delivery point. Of course, it might be so that the contract could be cash settled, in which case if Millie held the contracts until the expiry date, she would have to pay the difference between the opening and closing prices if she lost on the transaction, or receive the difference if she gained.
All this is fairly easy to understand, I hope. Condi Montana works now as a broker because she wants to avoid stress, but earlier she did proprietary trading in a financial institution, which means that she traded for them, and in return received a salary and -- if things went well -- a nice bonus. And things usually did go well, because as Gordon Gekko explained to Bud Fox in the film Wall Street, the key thing in that business was information, and the trading departments in the major investment banks had access to a very large amount. At the same time they employed people who knew how to interpret it. Mistakes and bad outcomes occasionally surface, but usually this requires a great deal of carelessness on the part of traders and analysts, and in addition laziness on the part of executives. Something else: at the bank at which Ms Montana worked, at no time did anyone talk about stocking or destocking physical oil.
So much for "speculation", but what about hedging -- i.e. some kind of insurance against unpleasant price movements up or down. (And observe: hedge funds are really speculative funds, and on average about one-tenth of these go out of business every year. I once sat through an inane lecture by a director of one of these, and I have no doubt at all that that gentlemen and his colleagues eventually had to find another line of work, although of course they may be back in business under another name somewhere else. After all, it didn't take the directors of Long Term Capital Management many months after a 3.5 billion dollar bailout before they were merrily practicing their trade in new offices.)
In any event, suppose that two weeks ago you concluded that the oil price was going to rise to $130/b or above, and so you went down to the local 7-11 and bought two thousand barrels of physical oil for $99/b, which was the price for oil at that time. But now you are not so sure as you were then that the oil price is going to rise, and so you find yourself with an overwhelming urge to hedge your investment. How would you initiate this particular risk management exercise?
One way is to call Condi Montana and tell her that you wanted to sell /i.e. go short) two futures contracts (= 2000 barrels). Then, if the price falls, what you lose on physical oil you gain on futures, because later you can close your futures position with a "buy" at a lower price than the price at which you went short. Moreover, if it appears that certain so-called experts were right and the bottom is going to fall out of the oil market, you should find it easy to sell the small amount of physical oil that you are storing in every square meter of your home, while perhaps keeping your futures contracts, which -- since you opened your position by going short -- become more valuable with every decrease in their price. Or, if things went the other way, reverse (i.e. offset) your short futures position by going long two contracts, and retain your physical oil. Maybe the price will break the $100/b barrier, and in the ensuing buying spree, you can make some serious money. Of course, if you can't make up your mind, you can always call Millie, who will soon be in the fast lane on Wall Street.
One more observation. You should never forget that Metallgesellschaft (MG) -- the 14th largest industrial firm in Germany -- lost 1.5 billion dollars in the futures and swaps markets in a few months. In addition, when a clean-up crew was brought in to put things right, they apparently made as many mistakes as the people who got MG into deep trouble. On occasions such as these it pays to remember a very important Russian adage: The wise man learns from the mistakes of others; the fool must find out for himself!
Is there anything special that readers should notice here. One thing is that the futures market lives a life of its own. The people dealing in physical oil -- and particularly the very large sellers -- would hardly have more than a modicum of interest in the comings and goings of Millicent, Condi, somebody's uncle Charlie, and a million more like them unless there was a heavy departure from orthodoxy. I won't go into this at the present time, but the bottom line if I did would be that somebody is very wrong in trying to pin the escalating oil price on speculators..
The key to comprehending what is taking place in the world oil market today is understanding the behaviour of the large oil exporters, particularly those in the Middle East. They hold the balance of power in the world oil market, and they know it and they are no longer prepared to accept bargain basement prices for this invaluable commodity. Needless to say, miracles featuring dramatic increases in output still play a role in the daydreams of many so-called oil optimists in academia and influential research establishments, but thinking tends to be otherwise in the executive suites of Big Oil and Gas, regardless of what its directors say to the television audience about the oil that is going to be found in Northern Canada or the Caspian (See e.g. Maureen Crandall on the latter (2005).) A number of petroleum magnates like to claim that there is still an enormous amount of oil that new technology will find, which is very likely correct, however my knowledge of oil discovery rates, consumer demand and the likely behaviour of the oil majors leads me -- and almost certainly those persons frequenting the corridors and restaurants of oil power -- to believe that even an "enormous amount" will be insufficient.
People who think otherwise -- who can't talk about oil without going off the deep end about speculation -- tend to forget that the behaviour of suppliers is the pivotal item in any scientific discussion of "fundamentals", and what has happened is that a "loose" producers association called OPEC has now become a strong producers association -- strong enough in fact to attain quasi-cartel status, and assume a decisive position on the global oil supply curve.
Few people know more about oil prices than Edward Morse, the chief energy economist at Lehman Brothers, and unlike most observers he expects that (perhaps sooner rather than later) the bubble component will be squeezed out of the oil price, and it will decline to around $80/b. I wouldn't bet on it: the Middle Eastern OPEC countries have the discipline, knowledge and intention to defend an oil price of or close to the present price, regardless of anything they may say or do. The enormous export income they are now realizing suits them fine. They definitely prefer this to the dreary alternative, which was going to the large importers with their hats in their hand and trying to explain to them that the price of oil should exceed the price of coca cola.
Wouldn't you feel the same way if you were in their place? Wouldn't you continue doing the simple things that are necessary to prolong the present oil price arrangement, regardless of what speculators do? It case you have some problem with the expression "simple things", it means the same kind of things that were done by wholesalers (i.e. generators) in California and/or states close to California when electricity was "deregulated": although in theory the availability of electricity was supposed to increase, unforeseen "glitches" caused it to decrease. Similarly, the promised increase in output by Saudia Arabia of almost 3 mb/d by the end of 2009 will not take place -- at least if that increase is supposed to be sustainable output. As I told a gentleman recently, my position on this forecast is strictly non-discussable.
Another so-called oil insider returned from the latest Montreux energy conference with a belief that the price will not only fall, but fall to $60/b. Like many of the self-anointed he is only partially acquainted with oil economics and history. For instance, on the basis of his latest newsletter he reveals that he does not know that China has an unbridgeable oil deficit, as has the United States, and what he calls the inter-temporal oil cycle is a very special kind of cycle, due to the exhaustibility of the commodity on which it is based, as well as the location of that commodity and the not-very-special philosophy of its owners. A philosophy that, when I lived in the United States, was summed up by the quaint expression "Look out for number one!".
Banks, Ferdinand E. (2008). "Speculation and the price of Oil". Stencil.
________. The Political Economy of World Energy:An Introductory
Textbook (2007). Singapore, London and New York: World Scientific.
________ "The sum of many hopes and fears about the energy resources of
the Middle East". Lecture given at the Ecole Normale Superieure
(Paris), May 20, 2008..
________ (2001). Global Finance and Financial Markets: A Modern
Introduction. Singapore, London and New York: World Scientific.
Crandall, Maureen (2005). "Realism on Caspian energy: over-hyped and
Under-risked". IAEE Newsletter (Second Quarter).
Holmes, Bob and Nicola Jones (2004). "Brace yourself for the end of cheap
Oil". New Scientist, 2 August.
Professor Ferdinand E. Banks
June 6th, 2008
The University of Uppsala, Uppsala Sweden
The School of Engineering, Asian Institute of Technology, Bangkok Thailand
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