Oil and the Futures Market

 

Please bear with me, I don't mean to be facetious here. Now that oil is over $140/barrel and everyone has a theory about why the price is so high, I thought I'd join the party and throw in my two cents as well.

First, there should be little contention that the commodity index funds raise futures prices, since buying, holding, and rolling over futures is what they are mandated to do. The table below shows crude contract prices out to December of 2016 (as of last Friday). The price increase appears uniform, i.e., the market is not expecting a decline anytime soon. Commodity index funds tend to buy only the near month contracts (An exception is United States 12 Month Oil Fund LP (USL), which buys one whole year into the future). Therefore, we are probably seeing the combined effects from the index funds and other speculators who either have a view of their own, or are riding on the coattails of the index funds.

For the sake of brevity I'll use the term "speculator" in the rest of this post to describe all those participating in the futures market (with no intention to take delivery) with no regard to their intended holding period or long/short bias.

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From the above starting point, a divergence of opinion quickly appears. Some argue that the total new futures demand is comparable to the actual new physical demand from emerging economies, while others argue that since speculators never take delivery, the spot price is solely a function of supply/demand. I'm not going to be a referee in this argument; instead, I'm here to explore a dynamic that I have seen mentioned elsewhere: the possibility of suppliers withholding production due to stable anticipated future prices.

First, let's recap the facts:

• Speculators bid up futures, including long dated futures.
• Speculators don't take delivery. There may indeed be hedge funds out there who think about doing this, just as there are rumors that hedge funds are looking into buying grain elevators. For now, I will take the inventory reports at face value. This is a crucial point as we know that the futures market in gold and silver do influence spot prices since a significant portion of physical demand is for investment which depends very much on investor psychology.

The common refrain is that producers have an incentive to produce as much as they can, given a flat futures curve in order to maximize the present value of total return. An example of this is a copper mine. While the spot price, production cost and cutoff grade of the mine might change, the actual copper in the ground is fixed in place. However, an oil field is a far more temperamental beast. If there's anything I learned from Matt Simmons' Twilight in the Desert, it's that the ultimate recoverable resource [URR] of any field is rate dependent, i.e., running too fast a flow rate decreases the URR.

A crude analogy, which is also the extent of my understanding of this issue, is imaging an oil well as a giant straw; the production rate can be increased by increasing the well pressure, commonly achieved by injecting water from underneath the oil layer. However, if the pressure is too high, oil can be driven above the opening of the "straw" and form pockets that are hard to get at, not to mention the water that also is pumped out. In an environment of stable future prices, it is entirely possible that the present value of a mature field is higher if current production is tapered in exchange for a greater URR. Thus, there is potential for a self-reinforcing, running-away train of oil prices. Once again, it's hard to lay the blame on either the speculators who bid up futures or the pre-existing tight supply/demand condition, since both are necessary for this vicious circle to occur.

 

What to do

We might be tempted to put a stop to "speculation" as several bills in the congress are promising to do. I doubt if any of them will have the intended consequences. For starters, speculative capital is mobile. If people can't speculate in Chicago or New York, they will do so in London or Dubai. The real losers will be pension funds who don't have the luxury of leaving this country. They will struggle to meet future obligations as the best asset class in an inflationary world becomes unavailable to them. They will have to be bailed out by taxpayers. Therefore, while the politicians are still at it, they might also want to read this timely article on the one commodity on which speculation has been banned.

Going back to the title of this post, conservation, voluntary or not, is still the best option. A 10% rise in average auto mileage saves as much oil as the production of giant oil field. Futures price will come down when there is clear demand destruction. I even believe it's prudent to raise gas taxes. Politically, it's definitely a non-starter. I might even have surprised some readers since my thinking have been consistently libertarian. However, I'll argue that in this case there's no escaping paying the government, be it the U.S. government now or the government of Iran, Saudi Arabia and Venezuela some time later. Who knows, it may even drive down gas prices.

Comments

[jtk]

interesting idea but i would think that oil prices this high are not in producer's interest as it is destroying some demand (e.g. SUVs out, Corollas in; Airlines will go bankrupt w/o government help, etc). I'd think it would be much better for the industry to keep oil high (i.e. $90) but not so high as to change people's dependent habits.

[bm1087]

Pension funds have no business influencing consumables. If they need to hedge against the dollar they can do so in several ways. Go long foreign currency, long metals, short the S&P and the list goes on. This has become a national security issue. They all need to be banned. Why should the tax payers foot the bill to bail out the airlines? Let the funds pay for it.

[User 221381]

It is commonly agreed that the low value of the Dollar is a major contributor to high oil prices in world market.

Here is a quick fix:

If the US Gov. will buy Dollars by selling large quantity of gold from its vault, the value of the dollar will rise, the price of oil and gold will go down. Is there any reason for the Gov. to store gold in a vault?

[Umm, yeah]

Everyone (especially Congress) seems to be so focused on the pension funds and the US oil companies...

What I'd like to know is what is there to prevent the following:

An oil producing country creates a Sovereign Wealth Fund with it's oil profits. It goes and buys oil futures, raising the price of oil. It then goes and buys more oil futures with those profits, etc., etc.

[john s.gordon]

oil price is already well past the point where synthetic fuels from coal are economically attractive, based on domestic u.s feedstocks, & will provide employment for domestic workers. where is the venture capital to get this industry started?
> jack

[cqadvisor]

Speculators, especially Wall Street, set the price of crude (& Nat gas for that matter). NYMEX rules favor speculators via greatly discounted margin requirements for spread trades, (i.e. a buy of a nearby contract and a sell of a distant forward contract) over producers who typically only sell futures to guarantee stable "future" price of their oi. If spread trading rules were changed to make them even to hedging rules, the price of oil would drop $25/bbl. Why won't we do this? CFTC (NYMEX watchdog) is not an elected body; appointees are there thanks to our oil-man president. Don't look for this to change under either of our candidates for next term--both will owe too much to big oil to impose new rules. Another rule that needs changing: natural gas pipelines should be required to disclose line pack inventories to keep spikes from occuring during summer ac and winter heating seasons. Will this happen? Not unless we change out FERC appointees.
This is not a message in support of any candidate, but a request that we look a bit deeper into what we do to cause our own financial mess.

[au trader]

some of the most naive statements I've ever read.

sell gold for dollars? do you even know how much gold the us has in reserve? hint - its a lot less than what the fed gave to banks to recapitalize the so far in '08 (and a fraction of what china holds in $$). that might move the dollar by a penny - maybe 2!

cq - you understand that producers are net long now, right? check the crude COT.

[dafay]

There may be some truth in the idea of a Sovereign Wealth Fund that is fueling the price of oil - has anyone thought about that oil producing country (ies) as the UAE which includes Dubai?

[Al Fin]

There are trillions of barrels of oil equivalent in North America. It would cost $40 a barrel to produce this oil. Nancy Pelosi and Barbara Boxer will not allow you to have this oil. Why not? What is the US Congress problem with energy--including oil, coal, gas, and nuclear? Does America need a whole new set of legislators?

[Sophisse]

Well I liked your article anyway! And thanks for the onion link, an interesting counter.

[iThinkBig]

Yes Alfin, the U.S. needs to be educated about how we are made as a species and then understand that government policies that attempt to greatly distort the Survival of the Fittest theory should be thrown out of office. So much for the 90% of the Democratic party and 50% of the Republican party. By the time the full crisis has revealed itself, it will be too late to prevent U.S. economic COLLAPSE. Idjits, but it will change back to the better, just such a shame such selfishness could emerge so quickly in our leadership. There's going to be a lot of heavy lifting to do... Meanwhile, I am adding some special names to my Hall of Shame database to make sure after We the People fix the problem that these idjits never get to run even a hamburger joint again. Responsibility is too complex a concept for them and they would simply decide to not sell beef...

[BrucePile]

The reservoir flow rate argument mentioned above is probably a mute point for post peak production. Throttling production to maximize URR is what you do in the primary recovery and, unfortunately, in the world's two biggest producing areas, Saudi Arabia and Russia, that was not done very responsibly.

Saudi Arabia cranked up production in the 70s to try to keep up with the demand surge of that era (yes, it was demand, not an embargo that lasted a whole 10 years) to the point of field damage and a set of Congressional hearings into the American oil companys' production of the Saudi fields before they were taken over by the Saudis. Matt Simmons details these hearings in his book Twilight in the Desert. Russia in the 70s and 80s was busy taking over the world and making it a Marxist Empire. They produced little of interest to global trade other than oil and lots of it. So their prolific fields were produced at gunpoint by the dictates of the generals more than by geology 101.

If you look at a production profile of these two giants (together they pump nearly a quarter of the world's oil) you see a collapse of production in the 80s and 90s followed by a relatively weak recovery that has now fizzled. This was due to having to rest the fields in Saudi Arabia and by the collapse of the Soviet Union in the late 80s. Just when we really need all that bypassed oil that was left behind in the ground of the damaged fields as we approach global peak production, the poor past management of these fields is now denying this crude to the world market.

Russia, which had been producing 9.9 mbpd (as compared to the Saudis' 9.5) was really the swing producer in control of world oil prices the last few years just barely able to keep up with the demand growth from India and China barrel for barrel. But last October, their production stopped climbing, in accordance with Hubbert analysis done at the Oildrum about 2 years ago on Russia. Raw production has dropped 2.3% since October, but more significantly, their exported oil has dropped by about 5% since then. It is net exported oil that is bid on and sets the oil price. Last October is when the present price climb began to gather steam, and that may be more than just a coincidence.

[San_Fran_Sam]

you tell 'em ThinkBig. After the revolution, let's first kill all of the lawyers.

[bds231]

"Umm, yeah": Very intersting thought about oil-producing entities keeping the price up by buying futures. But as "jtk" mentions, it certainly appears as though $140 is causing demand destruction, some of which might be permanent (e.g. major r&d/investment in alternative fuel vehicles).

Then again, oil futures have been traded for about 25 years, so if oil-producing entities are indeed keeping the price up, you have to wonder why they let the price get so low in the late-90s...

Very interesting to think about, although I don't have the expertise to know if this is actually feasible -- has anyone done the analysis to see if this pecils out?

[BrianPursley]

Everything you know about oil is wrong: oilismastery.blogspot....

[jjason]

On onions...I am self sufficient in green onions for the 8 month growing season...but I can't drive the car without gas.

The hedge funds, pensions funds and others that are speculating in the futures markets are going to ruin the US economy for everyone else.

This needs to be fixed now. If the huge prices caused by whatever you think is causing the huge prices continues there will be higher inflation and lower growth...and higher unemployment.

So, increase margin requirements on all commodity trading and mandate that commodity traders take delivery. It will help get rid of "paper oil" and the hording of commodities.

Finally, conservation is staying home this 4th of July weekend and taking the time to write your Congressman and Senators to tell them that the Commodity Futures Trading Commission has not done their job properly.

The writer of this article probably knows what I am talking about.

If you don't know what the CFTC has been doing then inform yourself. One hint...called the Intercontinental Exchange ( ICE ) and The Dubai Exchange.

OPEC has figured out another way to screw us. And the CFTC has helped them.

[Kashyap_Swamy]

I don't think Sovereign Wealth Funds (SWF) of Oil producing nations would buy oil futures. Remember, buying a future contract also means that you need to take physical delivery! Why would a producer want to buy more oil? If they are just "rolling it" then there would be a HUGE contango in the front months (not just $1-$2).

Don't forget that NYMEX WTI is sweet, light crude. Arab heavy crude (which does not have a futures contract) is trading at $132/ bl. (a $10 discount but not a lot different). I don't think its all speculation...

[KevinB]

User221381's suggestion to sell all the gold in Fort Knox is remarkably stupid and uninformed. The 147 million (approx.) ounces at Ft. Knox is worth about $139 billion (approx.) today. If the US attempted to liquidate that amount of gold, a number of things would happen:

1 - The price of gold would plunge, making the total proceeds to the US government far less than the $139 billion noted above.

2 - Even if, by some miracle, the US managed to realize that $139 billion, that amount is about 4 months' worth of the current account deficit. Any support it would provide to the US dollar would be momentary at best before the dollar again began its downward slide.

3 - The sight of the US government selling - you should excuse the phrase - the family silver would remove any last vestige of confidence in the dollar and would result in an even faster and deeper decline than today's environment of jawbones and crossed fingers.

Nice try, though. We welcome more of your enlightened thinking for our alternate edification and amusement.

[alpha24seven]

I think you are missing the point. The speculators (whoever, whatever) only show up to participate in a market because they believe they can make money.

Why are they showing up? The real answer is that somebody is distorting the supply and demand paradigm to cause panic buying.

Fact 1. We have WAY more oil than they are letting on.

Fact 2. Global demand isn't as strong as they are letting on.

Fact 3. Less than five people on the entire planet move the oil market on their commentary.

The people screaming "fire in the theater" need to be really looked at as to why they are doing so. I think a big clue is a prop commodities desk... Think about it. The speculators are only showing up because somebody keeps telling them "we are running out" which is a complete fallacy.

Look and ye shall find...

[surgcare]

The problem ,alpha24seven , is that too many people think like you do(fantasy land ) and thats why we have high oil prices going higher .I am sure speculators are rushing to by oil because of rumors that we're running out of oil . BRILLIANT Just BRILLIANT

[magnumaudio]

You dont think that if the NY and CHI markets closed to oil speculators London wouldn't follow suit? Europe is hurting even more than the US on oil prices.

[Aalan]

Maybe I'm slow, but I'm still on the actual issues in the article, and not trying to save the world. I don't get this:
"since speculators never take delivery, the spot price is solely a function of supply/demand."
If the market price is unaffected by all the speculators buying contracts, how do the speculators profit? Do we really think we can buy into a market en masse and have no effect on the price? I don't know of any other market that works that way.

But don't blame the pension funds--they have a fiduciary duty to stay solvent, and when every other market is disintegrating, there's no choice but to go where there's profit to be made.

Strongly agree with the conclusion: the only solution for oil importing countries is to reduce consumption. That is easy to do: we had plenty of warning, and we could all have cars getting 35 mpg by now instead of the US average of 22 or so. The US has been slow and stupid on this issue, and we'll be paying for it a long time.

[backroads367]

My question to the Politicians, which I have'nt seen asked by anybody as of yet is Why can't we say to the oil companies that we are going ahead with producing the engines that get 200 and 300 miles to a gallon of gas? These promo vehicles have been around for the past 20 years. The oil companies have been buying out these patents for millions, so they don't ever make it to the production line. If this isn't a cornering Monopoly than I don't know what is. the 35 mpg cars are a joke. The Government seems like they can do what ever they want, except what is good for the People that put them in office. If they were serious about this problem, then they would deny any patents for this technology of having them mass produced. This alone would bring this economy out of a recession, which is headed for a major Depression.