Oil Speculation part 1

"Deep speculation. The oil speculator's dream." Harper's Weekly, February 11, 1865

They just won't stop talking about oil. The most recent run up in the price of oil has people flummoxed and alarmed. Not a few people have suggested that the market is being manipulated--indeed, Frum implied as much in my previous post by suggesting that investors were hoarding oil in order to sell it at a more propitious moment. I pooh-poohed this notion, but did suggest that oil producers might be holding production off the market by slow-stepping production. This seems to have gotten some traction, at least amongst refiners!

"Let's say I'm an oil producer and a refiner comes to me and says, 'Last week I paid $110 a barrel for crude, I'll pay you $110 a barrel today,'" WTRG's Williams said. "I tell the refiner, 'I'll get $130 a barrel if I just sit on the crude for a month.' What's the refiner going to do? He has to pay."

And the risk here is that if demand decreases (due to belt-tightening and recession) at the same time as producers ramp up production, the price of oil will fall dramatically--as dramatically as it has run up in the past few months.

However, John Dizard of the Financial Times agrees with Frum.

This is not to say, in my view, and of others, that today's oil prices reflect the economics of marginal supply and demand. There are people out there who have bought physical oil and stored it so as to sell it in the future. But the real commodities buying frenzy has been defensive buying by consumers, government stockpilers, and processors trying to protect themselves from the adverse effects of future price increases.

Eugen Weinberg, a commodities specialist with Commerzbank, who thinks we are in the late stages of a bubble, says: "At the moment we have big inventories worldwide, about 3.5bn barrels in the OECD countries, which does not include China. That is enough so that if Saudi Arabia stopped exporting, the world could run at its present level of demand for a year and a half with no increases in production from other countries." [Emphasis added.]

I wonder if that includes such stockpiles as the strategic petroleum reserve. Nonetheless, it is striking that he mentions people who are hoarding for purely speculative reasons. But where could these supplies of oil be held? Naked Capitalism offers some possibilities:

1. Given the speed of the run-up, there may be a delay in hoarding taking place (real world buyers and sellers may have thought prices would fall back, as they did for a bit earlier this year).

2. Tankers full of Iranian crude are floating around the Gulf. Admittedly, this is nasty, less preferred crude, but it is still in surplus

3. The Chinese are very secretive, and known to be stockpiling diesel, and possibly crude as well to prevent any embarrassing outages before and during the Olympics. According to Xinhua, China's oil and oil derivative products growth 1Q 2008 versus 2007 is well ahead of GDP growth of 10.6%.:

China's net imports of crude oil was 44.95 million tonnes in the first quarter, up 14.9 percent, and net imports of oil products rose by 31.8 percent from a year ago to 5.47 million tonnes, according to General Administration of Customs. China's imports of diesel in the first quarter surged over 600 percent to 1.66 million tonnes and the imports of gasoline, rose by nearly twice to 76,654 tonnes.

The article also noted:

Deng Yusong, a researcher with the Development Research Center of the State Council, said that abnormal needs boosted by below-cost prices of refined oil products controlled by the central government over concerns of the country's rising CPI is another major reason contributing to the country's surging oil consumption.

In other words, domestic players suspect that the government will have to raise oil prices and are moving their purchases forward.

4. The IEA only counts primary inventory as inventory. Anything else is demand:

Demand is total inland deliveries plus refinery fuels and bunkers minus backflows from the petro-chemicals sector. It is thus equivalent to oil consumption plus any secondary and tertiary stock increases.

Further note how narrow the definition of primary stock is:

Unless stated otherwise, all stocks included in the report are primary. They include stocks held in refineries, natural gas processing plants, oil terminals and entrepôts (where these are known), pipelines and stocks held on board incoming ocean vessels in port or at mooring.

Thus any end user inventory, which is one place you might see hoarding, would not be included as inventories.

5. Finally, some suppliers may simply be choosing not to pump. Some readers and commentors have provided anecdotal evidence, and James Hamilton in his new paper also provided some quotes from the Saudis and Kuwatis along those lines. A reader gave the logic:
It is being left in the ground.

For over a hundred years the oil industry has been building out a huge infrastructure for mining, transporting, refining and distributing oil and its associated products.

It doesn’t make much sense to add to this infrastructure, if we’ve reached the peak of physical throughput. Going forward, refining capacity will probably move closer to the source of crude, and more of the transport will be devoted to moving of product. But, that prospective shift is a detail.

There’s no accumulation of speculative inventories in the refining and distribution chain, because there’s no slack in that chain, and won’t be any, because, looking forward, creating such slack makes no sense.

The only way to “hoard” oil effectively in these circumstances, is to delay oil production from fields with low marginal unit cost, while shifting production to fields or sources with high marginal unit costs. This conserves the expected rents, in a balanced way. That is, those with low marginal cost oil to produce see their wealth rising, while those with quasi-rents on infrastructure are protected.

Of all of these, choice 5 seems the most reasonable (Calculated Risk seems to agree as well). But they all could be true to an extent, and they could be pushing the price of oil up. But what many people are claiming is that the price of oil is being pushed up by futures speculation. To me, this doesn't make sense unless you assume that the speculators themselves are hoarding the oil--which seems only possible with options 2 and 4 (and possibly 3, if we assume the Chinese are secretly playing the oil futures market with a mind to manipulation--a secret attack on the decadent West!).

But a lot of what has been said about speculators running up the price of oil is that futures trading is responsible. I don't totally understand this--which is not to say it's wrong. The kingdom of financial things I don't understand is vast, after all. Mary Novak, a consultant with Global Insight, explained how futures speculation would work.

Each day about 88.5 million barrels of crude trade on the Nymex, Novak said. Because of speculators, the total trading volume can be three times the physical amount of crude available. Most are paper trades, with speculators betting the real crude will be available when contracts are settled.

"The 20th (of each month) is when parties contract to take delivery," Novak said. "If the amount of crude available is short of what's needed, the crude price rises. You as a refiner have to have the crude, and it has to be delivered." So the going price is paid.

But this implies that investors are holding the contracts to expiration, and that they actually expect receive oil. This can't be true. Indeed, the Pittsburgh Tribune article quoted above goes on to say:

"A large number of contracts bought and sold are paper contracts, and so when it's time to match up contracts to physical product, many contracts are liquidated because speculators want nothing to do with product," said Tom Skarada, vice president-refining at Warren, Warren County-based United Refining Co., a privately held, small refiner (70,000 gallons of crude oil per day), who also is a wholesale and retail gasoline supplier.

So at the end of the day, how is the demand for delivered oil mismatched with supply? Excluding hoarders (including the Strategic Petroleum Reserve), the only people who want oil delivered are refiners. So I still don't understand how futures speculation adds to the price of oil. Again I appeal to my 13 dedicated readers to explain it to me in the comments. I'm serious. I really want to understand how futures speculation is pushing the price of oil higher than it would be is the price were being set purely by supply and demand fundamentals.