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SPECULATION AND THE PRICE OF OIL

Professor Ferdinand E. Banks
ferdinand.banks@telia.com
August 26th, 2008

INTRODUCTION

Some observers think that speculation is the cause of the escalating oil price – an escalation that, as I have pointed out in many lectures and publications (e.g. 2007), is capable of cutting the ground out from under the international macroeconomy. Put another  way, these ‘pundits’ (= self-appointed experts) believe that we are dealing with a bubble, which is a price movement  unsupported by fundamentals

Among the gentlemen claiming that excessive speculation is responsible for the bad oil news being experienced by the buy side of that market, are the billionaire financier Mr George Soros (who admits that he is not an oil market expert, and that the oil price bubble has strong fundamental underpinnings), the influential television personality Mr Bill O’Reilly, and Lord Megnad Desai, who is a professor of economics at the London School of Economics. Many years ago Lord Desai and myself had a disagreement about the price of copper that  terminated in  the select learned journal Econometrica. I don’t recall  how the referees ruled on that dispute, although I do remember that with copper – as at present with oil – I took great care to avoid making embarrassing mistakes.

Nor do I intend to make one here. The steadily rising oil price that we have witnessed of late is basically explained by the relation between  ‘flow’ supply and ‘flow’ demand, where the term ‘flow’ will be explained in the next  section; with or without speculation the result would be almost the same.  What has happened – as you know as well as I – is that ‘normal’ demand is tending to  outrun ‘normal’ supply, causing a fundamental supply-demand imbalance that is independent of speculative activities.  This keeps inventories below the desired level, and leads to the earlier rather than later production of a certain quantity of oil, although later production could reduce the present value of  intertemporal  production costs by allowing a less intensive exploitation of high cost deposits. (Among other things, this might lower the rental rate for some production equipment, as well as reduce ‘overtime’ costs  for  employees.)

It should not be denied however that the financial market is now playing a more meaningful role than usual in the forming of  (oil price) expectations, which is largely due to the  price of this crucially important commodity rising higher and/or faster than the great majority of observers thought possible. The result is the oil price being observed and thought about much more intensely than before. This mention of  very close observation brings to mind Werner Heisenberg’s uncertainty theory which, employed in financial economics rather than physics, means that false signals are often generated.  For instance, when the influential oil investor T. Boone Pickens stated that oil could surge to $150/b, prices immediately moved higher. This display of respect for Mr Pickens’ acumen was impressive, although the term ‘over-reaction’ immediately flashed through my brain.

 I don’t know if Lord Desai is familiar with enough academic energy economics to understand what is going on in and around the oil market today, but I am sure that George Soros has a superior insight, and Mr O’Reilly is probably ready to claim that he deserves to be honoured  for merely taking an interest in the topic. For instance, in l992 Mr Soros was responsible for a magnificently correct bet that the British government would be forced to devalue sterling. Ostensibly, Soros’ Quantum Group of hedge funds had ten billion dollars on the table, and London wine-bar gossip then and later was prone to claim that  a billion of the resulting  windfall  ended up in Mr Soros’ pocket.

Mr O’Reilly, of course,  does not operate at those heights, but not too long ago he blamed “little guys in Las Vegas” for high oil (and motor fuel) prices. As Tina Turner might say, ‘what’s Las Vegas got to do with it’, in that he not only was completely wrong,  but expressing himself in that carefree manner would hardly endear him to more sophisticated members of his congregation.  Similarly, Senator Joseph Lieberman was considerably out of his depth when (in l990) he asserted that “It’s startling to think of oil prices being set by young guys on the floor of the exchange screaming at each other on the basis of rumours’. Actually, it is so non-startling that ten years later, when Lieberman was Senator Al Gore’s running mate in the U.S.  presidential  election, I forgot my allegiance to the Democratic Party and didn’t bother to exercise my franchise.

A more important person on the oil price scene is Abdullah el-Badri, secretary-general of the Organization of Petroleum Exporting Countries (OPEC), who last month summarized his thinking on the oil price by saying “The market is really crazy”. In a broad sense this is absolutely correct, because much of the craziness originates with politicians and civil servants in the oil importing countries, who until recently believed that OPEC would never get its act together, and as a result the oil price was destined to go south rather than north. If anything this incoherent behaviour has intensified, since as will argued below, there is a bizarre craving to believe that the OPEC countries would really and truly like to see lower oil prices. What they should believe is that very high oil prices provide these countries with the wherewithal to continue the diversification of  their economies ‘out’ of the export of crude oil (and possibly gas),.

The chairman of BP (British Petroleum) offered some quaint remarks on this state of affairs recently in Stockholm, saying that “the (present) oil price has an influence on the world economy that is not positive. To deny this is silly.”  As Dave Cohen, who writes the weekly column for ASPO-USA (http.//www.aspo-usa.com) has pointed out though, the denial club still has many members.

WHAT THEY SHOULD AND COULD HAVE TAUGHT YOU IN ECON 101 ABOUT THE PRICING OF OIL

 

What I want to do now is to  systematize, on a very elementary technical level, the most important aspect of short-run pricing in the oil market, even if it has been claimed that oil traders are altering their views and focus on the oil markets, shifting from short-term to long-term. This is not entirely false. You already know something about this topic if you are a careful reader of the financial press, or have watched BLOOMBERG and perhaps Fox News instead of the daytime soap operas.  In elaborating on this matter the present  section also contains an original diagram that I forced on  first year economics and finance students in Sweden. It  taught them something  about short-term commodity pricing, which in some cases enabled them to feel a cut above their colleagues.

A few years ago, in the Financial Times (November 4, 2004), the commodities page contained the following information. “Crude oil futures moved lower in volatile trade, following a large increase in U.S. commercial crude inventories, signalling that the oil market is well supplied.” Let’s put this statement in equation form: the change in price (Δp) of physical oil is a function of the difference between desired inventories (DI), and actual  inventories (AI). If that equation is linear, then we could write Δp = λ(DI – AI), where  λ (or ‘lambda’) is a constant, and Δp (‘delta’ p) is the change in price.  I wouldn’t be surprised if I could explain this simple relationship to the students at the secondary school I attended in Chicago – which, at that time, was one of the worst in the U.S.  

Both CNN and Bloomberg – especially the latter –  constantly  mention inventories, but without explicitly referring to a relationship of the type presented above. That expression is also completely absent from mainstream microeconomics textbooks,  and the same is true of  most books on energy economics. This is one of the reasons why many academic discussions of the oil and gas markets are without any scientific value.

We are now going to work our way up to the above equation again, and in the course of doing so look at my diagram.  This diagram, which at first glance may appear difficult, is actually extremely simple. It is so simple that it should be  examined by all readers, but if they judge it  too abstract they can go to the next section in this paper! I can mention that graduate students in my course in oil and gas economics in Bangkok who could not reproduce and thoroughly discuss this diagram in the final examination were assured of a failing grade, and a similar promise was made to my first term, first year (i.e. Econ 101)  students at the universities of Stockholm and Uppsala.

To begin however, I  slightly extend the above discussion. Oil inventories (i.e. oil stocks) are a stock concept : they are defined in e.g. barrels, and measured at a certain point in time, but they lack a time dimension. They have been designated  AI and DI. On the other hand, current production (s) and demand (h) are flow concepts: they are defined and measured in terms of a certain unit of time (e.g. million barrels of oil per day (= mb/d).  Microconomics 101 deals almost exclusively with flow variables.

Stocks and flows are closely related, since the change in stocks is determine by the net investment (or disinvestment) in stocks during a given period, or s – h:  i.e. flow supply (s)  minus flow demand (h).  Moreover, in this model we define that famous concept equilibrium  as the situation where desired stocks (DI) are equal to actual stocks (DI = AI), and the resulting ‘state of rest’ (i.e. equilibrium)  is characterized by Δp = 0.

  But if the stock market is out of equilibrium, e.g. DI > AI (because of expectations about present or future demand), then in the flow market we must have s > h in order to close the  (DI – AI)  gap. To obtain s > h,  price must increase: the increased price raises flow supply (s) while decreasing flow demand (h). The  size of  (s – h)  says something about how rapidly inventory holders want additional inventories. Hopefully, in the analysis,  DI will eventually equal AI, and Δp = 0.  Please note that the equation,  Δp = λ(DI – AI), or  p_t+1 – p_t =  λ(DI – AI),  is a simple linear relationship between excess stock demand and the price change, assuming λ is a constant. Now let us look at the diagram.

 The current (or flow) supply (s) goes into stocks (i.e. inventories) and current (i.e. flow) demand (h). Price is formed by the relation of  actual stocks (AI) to desired stocks (DI), with the flows playing a secondary (but important) role.  The equilibrium expression is AI = DI, and when this situation prevails, s = h, and price is constant (i.e. Δp = 0)! Put another way, a stock equilibrium implies a flow equilibrium, while a flow equilibrium does not imply a stock equilibrium. In this type of model expectations are very important because of their influence on desired stocks, and futures (i.e. paper) prices have some influence in forming price expectations in the physical market. Expected prices are undoubtedly more difficult to describe than via the simple implicit expression shown in the figure – i.e.  p^e = f(p) –  but the main thing to recognize is the non-trivial role of  expectations  in determining the oil price, even if it was only when the oil price moved past $100/b that they received their true weight in the scheme of things.

Students of electrical  engineering should immediately note that the diagram (with its feed-back ‘circuit’ p↔DI)  takes on the appearance of a servomechanism, in which case very high volatility is perfectly natural. This volatility is one of the reasons why futures and options markets for oil are so important, because they have permitted buyers and many sellers  to hedge price uncertainty. For example, even though price spikes might be narrow, there are times when they can ruin  unhedged buyers or sellers.

That immediately insinuates that a few comments about oil futures markets are justified.  In l980 the volatility of physical oil prices became so large that a futures market became attractive to speculators as well as dealers in physical oil.  For instance, , there was a decreased propensity by some categories of  the latter  to hold inventories as a precaution against having to buy in a rising market. Instead, individuals and firms requiring oil in the future bought a number of futures contracts, which (as explained in my textbooks)  enabled them to lock in the existing oil price. Later they went into the spot market to buy their oil, while at the same time making an offsetting sale of futures contracts. The markets for oil options and oil futures-options also functioned well. Without going into detail, the presence of these  derivative markets contributed to restraining rather than increasing the price of oil, since they  reduced the risks faced by buyer and sellers. They upgrade market efficiency by providing an increase in the quality and quantity of information and, as noted once by Professor Lester Telser, “they facilitate trade among strangers”. Well, so do some of the bars near the university where he teaches, but perhaps that subject belongs in another scientific discussion.

Then why has the oil price been  lingering around $130/b for the last few weeks?  To begin, it is not “little guys” in Las Vegas or big guys at the New York Mercantile Exchange (Nymex) or the International Petroleum Exchange (in London) who are responsible,  but changes that have taken place in the actual  movement over time of  (FLOW) supply and demand, as well as the expected movement (which is influenced to some extent by the price of futures – i.e. paper oil).. As we all are aware,  expectations about the long run price are greatly influenced by the rapidly increasing demand of China and a few other countries,  as well as the steadily increasing demand of many other countries (to include countries that are large producers and exporters of oil), and movements in short run prices.  The latter now helps to emphasize the slow growth of readily accessible conventional and non-conventional oil supplies – the simple fact that the supply response is no longer as flexible/spontaneous as it once was.

Barbara Lewis, in the International Herald Tribune (May 23, 2008), says that the change has been indicated by “record-high oil prices for (futures) contracts stretching out to 2016”. This statement is incorrect, because anybody who possesses a practical knowledge of the futures market would make a point of avoiding contracts of that maturity (8 years), for which there is hardly any liquidity, and therefore the price of the contract might be very unfavourable when the position is closed.  This matter of liquidity and maturities should never be overlooked by serious students.

SPECULATION OR FUNDAMENTALS?

Speculation means that there are some aspects of a bubble present. By way of  broaching this subject it might be useful to consider three famous bubbles, of which two were all bubble, or ‘extreme’ phenomena,  and the third largely but not entirely bubble. I am thinking of the South Sea Bubble (‘An unnamed venture that will bring great riches’), and the Tulip Bubble (‘Buying and selling simple tulips for fantastic prices’) for the first two, and the 1929 stock-market crash for the third. My international finance book (2001), and GOOGLE can tell you about these. The bottom line in all three was mass irrationality and excess  greed that the market eventually  identified and punished. This suggests that in the long run, on average, markets are more intelligent than individuals, and because of technological  progress the long run is now much shorter.

What is going on in the oil market just now is no bubble, because if it was the market would have found out, and the bubble component of the oil price would have been liquidated. Instead, oil should be judged scarce on the basis of scientific predictions of the amount that will be demanded at both now and in the future,  as well as the  optimal behaviour of the major oil producers – by which I mean ‘Big Oil’ as well as  big producers in e.g. the Middle East. It is easy to give the illusion of an unstoppable ‘bull’ market if there is a deluge of speculative  buying at the right time, as Edward Morse (of Lehman Bros.) said took place recently, but  if  oil  prices did not feature an extensive fundamental component (or ‘base’), then if this buying weakens, as occasionally takes place, the price should  rapidly  decline. This hasn’t happened, because in considering fundamentals,  if  buying slackens, the producers of oil in the Middle East have the means and probably the intention to keep the price up by ‘adjusting’ supply.

They definitely have the means, but suppose that in reality they do not have this intention. Speaking as a teacher of economics and finance, I would advise my political masters to always assume that they do have this intention until they obtain irrefutable proof that such is not the case, because the kind of economics that I study and teach leads me to insist that, theoretically, adjusting supply in such a manner as to keep the dollars rolling in makes all the sense in the world. For instance, at the Jeddah Summit that just ended, the oil minister of Saudi Arabia said that his country would not just raise output by several hundred thousand barrels per day, but achieve a total production of  12.5 mb/d by the end of next year. This may indeed be so, but it will not be sustainable production: instead, if it happens, 2 million (or more) of this will be due to surge capacity (that can only be maintained a short period of time).

In claiming that there is no  predominant bubble or scam in the oil market, I am also claiming that there is no irregular amount of speculation in this market.  There is instead an evolving supply crunch, that features a disappointing non-OPEC supply.  But if this is so, why would people like George Soros and (Professor) Lord Desai come to another conclusion?

George Soros already has many billions of dollars, and if he makes the right bets on oil, he can easily  pick up some extra lunch money. The right bet that I am thinking of is the one made after convincing  other players that insightful speculation by high achievers (like themselves) could result in  amassing more ‘green’ then, for example, the  confused amateurs who rushed into Nymex a few weeks ago to buy long-term contracts for reasons that even a veteran psychologist would find it hard to comprehend. As most of those punters will soon discover, their net  worth might never  measure up to that of Mr Soros and his colleagues who, despite appearances, bet fundamentals rather than rumours or headlines.

What about Lord Desai?  In a column written for the Financial Times, he informs his admirers that the oil market bubble must be “pricked” before it results in some ugly macroeconomic damage. His recipe for dealing with this issue is for the (futures) market’s clearing house to increase  margin – or ‘security deposits’ –  for all transactions in order to squeeze open interest, which he sees as a measure of speculation,

Normally I would hesitate before commenting on this suggestion, but not on the present occasion. It is theoretically possible – though unlikely – to  have a very high open interest in a market without any speculation at all! Furthermore, ceteris paribus,  squeezing open interest would reduce liquidity, and thus could make it more difficult for traders in physical commodities (i.e. non-speculators) to hedge price risk. Desai is also upset by the growing tendency to deal in contracts with a maturity of e.g. 8 years. I can’t understand why, because on the basis of the open interest statistics now available, a market with an 8 year maturity is almost totally illiquid, and therefore is strictly for chumps. The oil futures market was and is a short term hedging and speculation tool.

In a Business Week article (January 21, 2008), it was stated that six Gulf States control sovereign wealth fund assets of about $1.7 trillion – or as much as all the hedge funds in the world.  I consider the importance of hedge funds largely a dramatic myth where influencing the global macroeconomy is concerned, however I am prepared to admit that something that cannot be disregarded is the ability of money generated in that part of the world to influence the price of oil.  This is not the place to provide a comprehensive resumé of that issue,  although I will say again that  (ceteris paribus) the higher the oil price, the greater will be the pace of diversification (into e.g. refining, petrochemicals and tourism) by the major oil and gas producers of the Gulf (and Russia); and the more rapid this diversification, the more modest will be the intentions and effort  to produce and export larger amounts of oil and gas.  For readers who intend to make a thorough study of oil market fundamentals, this  should never be forgotten.

FINAL STATEMENTS

“I don’t think this is about financial investors,” the U.S. Treasury secretary said a few weeks ago. “It’s about long-term supply and demand.” Analysts at Barclays Capital and the Commodity Futures Trading Commission think likewise. And, as quoted by Barbara Lewis, Olivier Jacob of Petromax said that “The fundamentals rule, but the question is whether the futures market should reflect the fundamentals of the next few months or the next few years.”  It may be a question to him but not to me: after six months, and often less, the decline in liquidity in a futures market is precipitous, and longer maturities should be avoided. But recklessness and ignorance aside,  the fundamentals have always ruled in paper (i.e. futures) as well as physical markets. Let’s put it this way: the professionals – unless they have ulterior motives – say fundamentals, while the amateurs and conspiracy theorists  say speculation.

Finally, in  light of  the above, I would like to  get the peak oil issue off the table (again) by repeating something I once wrote, and replay in all my lectures on oil, to include this one, as well as any and every conversation touching on that subject, regardless of how inappropriate the occasion.  Peak oil is not about the future – it’s about the past!. It’s about a (generally unspoken)  strategy   formulated many years ago  by  the most  important countries  in OPEC,  which features a stagnation or decrease in the output of their invaluable oil (and probably also gas) when they get the opportunity. The present high oil price has given them the opportunity!. It’s not only  about more money rather than less, but using that money to obtain  the kind of future that the oil importers thought that they had an exclusive right to. Readers can take it from there.

REFERENCES

Banks, Ferdinand E. (2007). The Political Economy of World Energy: An Introductory Textbook. World Scientific: Singapore, London and New York.

______ (2001). Global Finance and Financial Markets. World Scientific: Singapore, London, and New York.

______ (2000). Energy Economics: A Modern Introduction. Kluwer Academic Publishing: Boston, Dordrecht, and New York.

______ (1980). The Political Economy of Oil. Lexington Books: Lexington Massachusetts.

Hicks, John R. (1939). Value and Capital. Clarendon Press: Oxford.

Lindahl, Björn (2008). ‘Rekordpris trots fyllda oljelager’. Svenska Dagbladet (Feb. 21).

Sarkis, N. (2003). ’Les prévisions et les fictions’. Medenergie, No.5.

Professor Ferdinand E. Banks
ferdinand.banks@telia.com
August 26th, 2008
The University of Uppsala, Uppsala Sweden
The School of Engineering, Asian Institute of Technology, Bangkok Thailand