Robert Bryce on Oil Speculation
By Robert Murphy -- January 6, 2009Robert Bryce is one of the leading journalists on energy issues. He is Managing Editor of Energy Tribune, and in a recent article gave a mea culpa on oil speculators:
Back in June, I wrote a piece for The American in which I argued that oil prices were being driven higher by the immutable law of supply and demand. Today, with prices plunging to near $40 instead of the $145 level seen in mid-July, it’s abundantly obvious that speculators were a key driver, probably the main driver, of the surge in oil prices that occurred between late 2007 and July.
So, to be clear, I was wrong. The leaders of OPEC were right. So, too, was my pal, Ed Wallace. In May, Wallace, a savvy journalist from Fort Worth who writes for the Fort Worth Star-Telegram and Business Week, published several articles [in] which he showed how the unregulated futures market was being used by speculators to push prices upward.
Of course, it’s not politically correct to give OPEC credit for anything. But last summer, the leaders of OPEC were united in their pronouncements that there was no reason for oil prices to be as high as they were. Their claims were met with widespread scoffing. The response from the International Energy Agency, as well as some of the biggest oil companies in the world…was that the high prices were being caused by supply and demand. On June 30, during the World Petroleum Congress in Madrid, BP chief Tony Hayward, when asked why oil prices were shooting upward, replied, “It’s about fundamentals. Demand is outstripping new supply.” …
Oil prices have fallen to less than one-third the levels seen in July and the world has shifted away from worries about peak oil and shortages to concerns about oil surpluses that could last for years. That makes what I wrote back in June — “the easiest explanation for higher prices may be as simple as this: there are too many buyers in a market that has insufficient spare production capacity” – look, rather, well, dumb.
Now, as refreshing as it is to see a prominent commentator on politically charged matters admit to being wrong, I think Bryce has jumped the gun here. The mere fact that oil prices have collapsed in just a few months doesn’t prove that speculators were responsible for driving up the price. But before we proceed, we need to define our terms.
In the broadest sense, any price is caused by “supply and demand.” The prices for Las Vegas real estate in 2006, as well as for Dutch tulip bulbs in 1637, balanced the quantity demanded with the quantity supplied. Even at the height of a speculative bubble, sellers can only receive what buyers are willing to pay.
In the present context, however, it is common for people to contrast “the fundamentals” from mere “speculative demand.” In the case of oil, if demand has increased because factories need to run their machines harder or because refiners expect motorists to buy more gasoline, then that is deemed a legitimate, fundamental driver of higher oil prices. On the other hand, if hedge fund managers invest in oil futures contracts not because they forecast higher fundamental demand, but rather because they are simply betting that the market value of the contracts will appreciate, allowing the hedge fund to unload the contract before physical delivery, then that is considered pure speculation.
Market bubbles—in which speculators drive up the price in a self-fulfilling prophecy—are theoretically possible. Indeed, many analysts think that is (at least partially) what happened with dot-com stocks in the late 1990s and real estate during the mid-2000s. Of course, once the bubble pops, it quickly deflates, since it was only fueled by everyone’s belief in its continued growth. This is why Robert Bryce thinks the oil market was clearly in a bubble up until July 2008.
But there’s more to the story. Even though bubbles are certainly possible, they exhibit tell-tale signs. For one thing, if speculative activity in futures markets really were holding the spot price of oil $50 or more higher than the “true” market price, then there should have been a glut on the physical spot market. In other words, if the market price now equals the “correct” price of $40, whereas for much of 2008 it was above $100, then producers should have been delivering more barrels of oil to market, than ultimate end users wanted to purchase at such a steep price. Oil inventories should have been accumulating somewhere because of this (alleged) discrepancy that lasted for years.
Yet there is no evidence of growing inventories, at least in the official numbers tabulated by the EIA, as the chart below shows. Other theories, such as the claim that oil producers “stockpiled” barrels in the ground, don’t work either, since oil production increased precisely during the period when prices rose the fastest.
Those who claimed during the oil price run-up that speculation wasn’t responsible were relying on arguments such as the ones I sketched above; they weren’t merely saying “supply and demand” to excuse big profits for Big Oil.
Now it’s true, we still have to reckon with the collapse in prices. Bryce is ready to throw in the towel and admit it must have been speculators all along. But the fundamentals have changed sharply since July 2008. On the demand side, the world has entered a severe recession, which has curtailed physical demand for oil, especially in powerhouses like China. On the supply side, the U.S. moratorium on offshore drilling expired—and note that the two major events corresponded neatly with falls in crude prices. On top of it all, investors have rushed to the U.S. dollar as a safe haven, which has also contributed to a sharp fall in the quoted price of oil.
It is an empirical question whether speculative trading, versus changes in “fundamentals,” was responsible for the rise and collapse of oil prices. The collapse per se is not a smoking gun.
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Quite right. It was definitely not western speculators. However, it is very likely that at least some government producers (such as PDVSA) lacked sufficient incentives and organizational ability to boost production as much as a private firm would have managed.
“In other words, if the market price now equals the “correct” price of $40, whereas for much of 2008 it was above $100, then producers should have been delivering more barrels of oil to market, than ultimate end users wanted to purchase at such a steep price.”
I’m not sure I understand that point. The end users use what they need…whether $40 or $100 per barrel. So why would producers deliver “more” oil than was needed at any particular price?
I’m not trying to imply that you’re wrong…only that I don’t understand the point [probably b/c I have no formal economics training].
Let me be clear: I have never professed to be an oil price analyst.
To my mind, predicting prices in a market as complex as the oil business is a fool’s game.
That said, I appreciate Robert Murphy’s critique. I take no offense. But I will stick to my original claim, that excessive speculation was a key factor, probably the key factor, in driving prices to their July peak. As the EIA’s data shows, world oil demand peaked in 4Q07 at almost 87 MMbbl/d. See: http://www.eia.doe.gov/emeu/ipsr/t21.xls
And by summer of 2008, there was no shortage of crude. None. In fact, producers had so much crude available for sale that some Persian Gulf producers were stockpiling crude on tankers. So why the price run up in the futures market? As I stated in my piece in Energy Tribune, companies like the now-bankrupt SemGroup were taking huge positions in the futures market. I do not believe it coincidental that oil futures prices peaked on July 14 and that SemGroup got caught in a margin squeeze and was forced to unwind its positions on July 15. (SemGroup declared bankruptcy a week later.)
Yes, supply and demand is the major factor driving oil prices. And yes, worries about global supply helped drive prices up. And yes, today, the global recession is killing demand and creating excess capacity. But those are not the only factors that have been affecting prices in recent months. Looking back at what happened last summer, it’s obvious that hot money was driving the market. And now that much of the hot money has moved to the sidelines, the oil market has cooled.
I’m an oil analyst who still believes that the oil price was cause mostly by fundamentals, for a couple of reasons.
Firstly, if the future price was artificially inflated by excess speculative demand, we would see extreme volatility in price around the contract closing date every month. We didn’t see that, except for the expiration of the October contract on September 22, in which case the price spiked up because there were too many sorts trying to settle out.
Secondly, most laypersons (and a surprising number of economists) don’t understand that prices are formed by expectations. Clearly, expectations of demand have changed drastically between July and now, and that explains most of the price decline.
When you get near a capacity constraint, supply curves become almost vertical, and huge price swings can occur on small changes in quantity consumed. That is what we have seen over the past year. It really is textbook stuff, and is a good teaching moment for those in the classroom, yet so many people remain flummoxed for reasons I can’t comprehend.
Russell,
Even though people’s purchases of gasoline etc. are less responsive to price than for some other products, it’s still the case that when the price of oil goes up, producers sell more and consumers buy less. So if $40 per barrel is the “true” price that balances the fundamentals of supply and demand, then a price of $110 per barrel should lead producers to bring more barrels to market than end-users want to purchase.
Even if you think that the # of barrels purchases isn’t related much to the price asked, consider the supply side. Surely the owners of oil fields boost output when they get $110 per barrel rather than $40 per barrel. And indeed, world oil output rose as prices were skyrocketing, and now OPEC is cutting back to deal with the drop in price.
Thanks… For some reason I was stuck on somewhat inelastic demand and wasn’t really considering the supply side.
The elasticity of demand for oil and other energy products is subject to sticky elasticity of demand, analogous to ketchup. Tap a ketchup bottle ten times and nothing happens, yet give it a whack equivalent to 5 or so taps and out the ketchup comes. Same with energy. I still remember an executive at NNG in the seventies saying that natural gas had no elasticity of demand. That November in Omaha, people’s gas bills skyrocketed (price and temperature reasons). My bill went from $80 the prior November to $330. You have never seen a thermostat go down so fast – from 72 to 62 and out came the sweaters. Tougher to respond with gasoline, but if the price goes high enuf, fast enuf – and people think it will stick, because of the idiots in the media telling them so, they will modify their habits. Thus looks like a prime example of catastrophe theory in action in both directions.
Ah, the dreaded “speculator,” the perennial whipping boy of anti-capitalists. What is so evil about the speculator? Just like the entrepreneur, he makes judgments about the future, risks his own capital, and is the bearer of uncertainty. If his crystal ball is clear he profits and expands; cracked and he incurs losses and eventually works for someone with better vision. He allows the farmer, oil company, and refiner to offload uncertainty and risk. He is a hero, not a villain.
Co-managing a hedge fund makes me a speculator I guess, and as a short seller, one of the most dreaded kind. Last spring we began shorting crude oil around $100/bbl and backed up the track at $145/bbl. I remember friends complaining at the time that speculators were driving up gas prices and that they would continue higher. It was a conspiracy of Big Oil, OPEC, and those “greedy” speculators. I simply replied, “if you’re so concerned, put your money where your mouth is – buy a futures contract.” And I reminded them I was doing the same, taking the other side of the trade.
What caused the bubble in oil prices? A variety of economic actors – consumers, producers, and yes, speculators – bet wrong. Some bought into Peak Oil theories, others believed in the “decoupling” theory which extrapolated growing demand in the BRIC countries despite a retrenching U.S. consumer. Many underestimated the severity of global recession and ignored conservation measures crimping demand. Also forgotten is the role of Fed policy which was aggressively easing in order arrest the bursting of a massive credit bubble. Investors and speculators feared inflation and bid up inflation hedges – not just crude oil, but grains, precious metals, and other commodities. Platinum, for example, jumped 77% in just 6 1/2 months after the Fed began cutting interest rates in August, 2007.
That the future is uncertain and human beings are prone to error is a given. The question is, who is better at this endeavor, the entrepreneur/investor/speculator risking his own capital or the politician/bureaucrat/regulator influenced by special interests and risking taxpayer money? The free market – as the oil spike and collapse shows – has a feedback mechanism for correcting error. The political system has a way of ensuring the worst come out on top, as the recent presidential primaries make clear.
Blaming speculators is a lazy man’s way to deal with markets. It is what we would expect from Sixty Minutes but bad economics. Speculators simply make their best guesses about where the market is heading. If the fundamentals are not there, others will enter and correct the price. This is particularly true of the oil makers where many of the participants are major participants in the physical market.
Any discussion about oil demand/prices over the next decade must include an attempt to quantify emerging economy demand as an important driver at the margin. Here is a simple thought experiment using Chinese demand to generate some rough “back of the envelope” forecasts:
– China moves from 3 bbls/person/year to the South Korean per capita consumption level of 17 bbls/person/year over the next 30 years
– No peak in global production
Result: In next 10 years we must find 44 million BOPD – 26 million BOPD to maintain supply and 18 million BOPD to keep up with demand increases.
If you superimpose peak production on top of this demand profile using the following parameters oil prices would increase approximately 250% in real terms over next 10 years – something would have to give far before that price level:
– Oil demand elasticity of -0.3
– Current production 84 million BOPD, current price US$ 80
– Peak production 100 million BOPD
– Post peak decline rate of 3-4%
If you want to try the model for yourself using your own assumptions it can be found at Petrocapita in the “Research” section: http://www.petrocapita.com/index.php?option=com_content&view=article&id=128&Itemid=86