THE FINAL PROBLEM: SPECULATION AND THE PRICE OF OIL AGAINProfessor Ferdinand E. Banks
September 30th, 2008
ABSTRACT: The speculation versus fundamentals controversy is in some respect what Sherlock Holmes might have called ‘The Final Problem’. It is final because the peak-oil quandary has, to a considerable extent, been settled: a majority of observers now accept that a global peaking of the oil output is quite conceivable, and could – not will – happen in the near as opposed to the distant future. What we should be considering though is the geopolitical rather than the geological peak, as implied in a brilliant article in 321 Energy (2008). This is because the bottom line where conventional oil is concerned is its price, rather than the peaking of output. Should a new price escalation commence after the international macro-economy has been put in order, then a physical peak (or ‘plateau’) becomes a secondary issue. The background to this update of a previous article with almost the same name is a short piece in the New York Review by George Soros, based on his testimony before the US Senate Commerce Committee Oversight Hearing on June 3, 2008, at which time he stated that “there is a bubble superimposed on an upward trend in oil prices”, where this trend is caused by “demand growing faster than the supply of available reserves”. Readers should focus on this remark, and especially the word ‘available’, because as emphasized in my new energy economics textbook (2007), it tells almost the entire story of the latest oil price increase.
KEY WORDS: futures (i.e. paper) markets, trend, bubble, physical market
If Mr Soros is correct, an important issue is the size of the bubble (where a bubble is usually defined as a price movement unsupported by fundamentals), or more elegant, the size of the ‘speculative premium’. My answer to this question is ‘not very large’, because most of this speculation is taking place in the ‘paper’ as opposed to the ‘physical’ market. Unfortunately, many observers refuse to understand this, although last year the students in my course on oil and gas economics at the Asian Institute of Technology (Bangkok) understood it perfectly, because I made it clear that if they experienced a crisis of comprehension, they would be rewarded with a failing grade.
Something else brought to the attention of those ladies and gentlemen is that the preposterous ideas about speculation largely originated with persons in or near the OPEC directorate, who claimed that it was speculation and not the inability or unwillingness of OPEC exporters to deliver the goods that was the main cause of the unexpected and drastic rise in the oil price. Our political masters and their experts did not believe this explanation, but for various reasons it could not turned into an object of contention, even though the sudden increase in the oil price was recognized as a major factor behind the present deterioration of the international macro-economy.
Before continuing, let me make it clear that this paper is NOT the kind of anti-OPEC rant that is going around the blogosphere these days, because for several years OPEC repeatedly proposed cooperation between the major oil exporting and importing countries, arguing that oil was an exhaustible resource, and to some extent – formally or informally – its extraction and/or price should be programmed so as to provide all market actors with an optimal level of satisfaction. This proposition was rejected by the governments of the importing countries, because they were convinced by people like the late Milton Friedman that the price system would always ensure the adequate discovery and production of oil, regardless of the amount of reserves that were actually present in the crust of the earth.
In any event, there is an articulate and very wise and/or well placed group of advisors, consultants and students of the oil market who are fully aware that the cause of the oil price escalation can be traced to fundamentals, however they say ‘speculation’ because it is in their personal (financial and/or social) interest to promote this absurd allegation. Senator Hillary Clinton might have been one of these people in order to inject a populist note into her bid for the Democratic presidential nomination, and a similar innovation has been hatched in the executive suites of some of the largest oil firms, in a bizarre attempt to quash the ongoing criticism of the super-profits being realized by these enterprises. Then of course there is a very much larger group of half-baked academic economists and casual onlookers, who say ‘speculation’ because no thinking is required. Accepting and/or supporting another claim might require a laborious effort to obtain at least a fragment of specialized knowledge about this very complex market.
The steadily rising oil price that we have witnessed of late is basically explained by the relation between ‘flow’ supply and ‘flow’ demand, as distinguished from the demand for stocks (i.e. inventories). As discussed in my textbook, the latter mostly influences the short term movement (or variability) in price. As a result, with or without speculation, the trend result would be almost the same, as I have pointed out for years, and George Soros now affirms. What has happened – as you know as well as I – is that ‘normal’ demand is tending to exceed ‘normal’ supply, causing a fundamental supply-demand imbalance that is independent of speculative activities. Where details are concerned, this imbalance leads to the premature production of a certain quantity of oil, although later production of the same amount might reduce the present value of intertemporal production costs by allowing a less intensive exploitation of high cost deposits. This is the main explanatory factor for recent price dynamics that featured an oil price increase from about $60/b at the beginning of 2007 to a peak of $147/b in July, 2008, before declining in the wake of the international macroeconomic and financial market deterioration for which the rising oil price rise was at least partially responsible.
It cannot be denied though that the financial market occasionally plays a non-trivial role in the forming of (oil price) expectations, and this may be especially true at the present time due to the oil price rising higher and/or faster than the great majority of observers thought possible. One result of this state of affairs is that the oil price is being observed and thought about much more intensely than before. The allusion to very close observation brings to mind the ‘uncertainty theory’ of the Nobel laureate Werner Heisenberg which, transmuted from physics to financial economics, suggests that misleading 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.
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. Some of the persons who were employed by Mr Soros on that glorious occasion may still work for him, but if not similar associates have probably played a key role in helping that gentlemen to reach the correct conclusions about oil.
Readers who want to learn more about this topic should focus on the word “expectations“. For the most part the financial market impinges on the physical market via expectations, which means that e.g. the price of paper assets (such as futures) has a certain amount of influence where consumption, production and inventory decisions are concerned. What does “certain amount” imply in this context? It implies some but not nearly enough to convince a serious student of financial economics that it makes sense to claim that an upward trend in the price of physical oil that has lasted almost 18 months should be attributed to speculation in the paper market. There are also no movements in (physical) inventories of oil which suggest that extraordinary speculation is taking place, as people like Paul Krugman and James Hamilton (2008) point out. Or, as Charles A. Hall has noted, speculators react to market conditions, they do not create them, which tells me and should tell you that regardless of the actions of speculators, it is the enormous demand for oil in coming decades that will establish the tone of the oil market.
An important person who has insisted that traders are responsible for driving the oil price up is Abdullah el-Badri, secretary-general of the Organization of Petroleum Exporting Countries (OPEC), who recently 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 can be attributed to politicians and civil servants in the oil importing countries, who liked to postulate that OPEC would never get its act together, and as a result the oil price would ‘tank’ rather than move north. The delusions of some of these persons have intensified, since many of them still entertain an irrational conviction that the OPEC countries would genuinely like to see lower oil prices, and are willing to help to bring this about. What should be believed instead is that very high oil prices have provided some of these countries with the wherewithal to continue the diversification of their economies ‘out’ of the export of crude oil (and possibly gas).
SOME ASPECTS OF ‘PAPER’ AND PHYSICAL MARKETS
Recently I received a mail from the director of the International Energy Agency (IEA), saying that it was a “pity” that Professor Banks keeps insisting that IEA oil experts were responsible for an absurd forecast of the 2030 global output of oil, when in reality – he said – his organization only forecasts consumption. This assertion by Mr Mandil is remarkable, because a consumption forecast for so distant a year in the future that does not take into consideration the constraint imposed by production hardly attains the status of nonsense. More confusing, the Wall Street Journal (May 22, 2008) noted that the IEA was reducing its “oil-supply” forecast for 2030, which I remember constantly describing to my students in Bangkok as ‘nutty’ or ‘looney-tune’, while on the same occasions emphasizing that a director of the oil ‘major’ Total (in the same city as the IEA) once said that the output of oil would never exceed 100 mb/d, which is 21 million barrels per day less than the IEA prediction.
Now you perhaps understand why articles like this have to be written! Mr Mandil and I share the same belief about nuclear energy, but like many street-corner and wine-bar economists he possesses only the faintest clues as to the interior logic of the global oil market, and apparently he has made no efforts to correct this lamentable shortcoming. Similarly, my new energy economics textbook (2007) devotes a chapter to energy derivatives (i.e. futures, options and swaps), but I have yet to see any indication that students and teachers of energy economics have gone beyond the useless Hotelling model of resource depletion in their efforts to understand what the oil future will bring.
When asked about how the present topic should be approached, I tell my students that the place to begin is NOT in my textbooks or lectures, but with GOOGLE. There are at least three prices (or sets of prices) that should be recognized and understood before the interaction of speculation and fundamentals can be systematically examined. These three sets of prices are spot and forward prices for physical oil, as well as a range of futures prices that apply to ‘paper’ oil, and take into consideration the maturity – or ‘running time’ – of these contracts. Spot prices usually involve comparatively small amounts of a commodity that moves from seller to buyer almost immediately; while forward prices generally refer to larger transactions that are arranged privately between buyers and sellers, and which could be delivered periodically over a fairly long time horizon, at prices that generally are NOT quoted publicly. Futures prices and spot prices are for the most part highly visible, and a good example of the latter are spot prices for West Texas Intermediate (WTI) oil or North Sea (Brent) oil.
The beauty of paper oil is that it is bought and sold on exchanges that are analogous to a stock exchange, and with highly transparent prices that can occasionally serve as a proxy for the price of physical oil. In my textbook a gentleman is walking down a street on the South Side of Chicago when he suddenly gets the urge to buy a million barrels of paper oil with a maturity (= expiry period) of one month. Thanks to his cell phone, this purchase is completed before he reaches the next corner. At the same time a number of what Mr Bill O’Reilly would call “little guys in Las Vegas” might also decide to ‘go long in’ (i.e. buy) a few million barrels of paper oil, with the same maturity. Regardless of whether these little guys are actually in Las Vegas, or enjoying the café and disco life in Guadacanal or Pago-Pago, the transaction might be concluded in the New York Mercantile Exchange (NYMEX) in New York, or the International Petroleum Exchange in London. Given the high level of liquidity in these markets, it should not be a problem to immediately find sellers of this paper oil – that is to say market actors who are willing to sell ( or ‘go short’) without a large (upward) movement in the price of this paper oil.
Professor Paul Krugman of Princeton University has taken part in the speculation-fundamentals discussion (2008), and he classifies the actions of e.g. the South Side of Chicago person and the Las Vegas ‘guys’ as gambling, which has no influence – “nada” he says – on the price of physical oil. This is almost but not quite true, because the price of paper oil is a component – strong or weak – in the forming of expectations.
By way of rounding out this discussion, it might be useful to present an example of how speculation would work if it were provided an unlimited range of options. The example concerns the actions of Nelson Bunker Hunt and his brother almost thirty years ago, when these two very rich men from Texas decided that it was a good idea to purchase a great deal of silver. Had they merely treated this as a superior investment opportunity, very little might have been said, but somehow the authorities came to the conclusion that they were intent on establishing a corner in that market. They not only purchased the actual bullion, but also ‘paper’ silver (in the form of futures contracts), and eventually the price of silver increased from 6 dollars an ounce to 50 dollars an ounce. At that point regulators and officials from the futures exchanges got into the act, and before the smoke cleared the price of silver declined to under 10 dollars an ounce, and the Hunt brothers found themselves in personal bankruptcy – an embarrassment which led Bunker Hunt to remark that “A billion dollars isn’t what it used to be”.
Please note the following. Had the Hunts confined their activities to the futures market, they would indisputably have been within their ‘rights’ to buy as much (paper) silver as they desired, and to make (or lose) all the money that they and other ‘longs’ were capable of making or losing, but as David L. Crawford pointed out (2008), “bets on the future do not determine the future”. More pertinent, as with oil, they would have been taking a very large risk if it had not been possible to manipulate the price of silver bullion by acquiring and storing the real thing. When the government moved against the Hunts, the principal object of their concern was the impressive inventory of silver bullion in the possession of the Hunts, because had those two gentlemen or other speculators – who included, it was said, members of the Saudi Royal family – decided to augment their fortunes simply by betting on the price of paper silver, they might have eventually found themselves with even more billions, or cashing welfare checks.
FINAL COMMENTS: DRILL BABY DRILL!
At pep meetings and rallies of the Republican Party in the US, the cry “Drill Baby Drill” often goes up when the subject turns to oil. It has been said that the persons joining in this chorus believe that America’s energy future can be solved if the offshore regions of the US are more thoroughly probed. This belief is probably a flight of fancy.
Arnold Kling has concluded that Paul Krugman is wrong when he thinks that the buying or selling of futures by speculators is merely a wager (or ‘bet’). Dr Kling unambiguously says that futures markets determine oil prices, because they substitute for a “planning bureau”. If this were fact rather than fantasy, the cry should be Buy Baby Buy, because futures market participants might have enough muscle to get the drills humming at a record pace, and thus bring cheap motor fuel back to the Republic. I have also been told that two econometricians at Hofstra University have “proved” that the oil price escalation can be attributed to speculation rather than fundamentals.
Having taught econometrics at two universities, and having been visiting professor of econometrics in Sydney Australia, my position is that econometrics is mostly a pompous con, and over the past two or three decades has revealed hardly anything about the oil market that is interesting or useful. As for Dr Kling, his reference to a “planning bureau” is something that I have not heard since the Berlin Wall came tumbling down, which was just about that point in human history when reckless and pretentious adventurers in cyberspace declared war on mainstream economic science. Fortunately though, since I have gradually come to disbelieve most of the moonshine raining down on the earth from the Blogosphere, neither hearing that Gordon Gekko clones function as a planning bureau that can move the price of oil, or that drilling in the middle of the Atlantic and Pacific oceans are worthwhile projects, brought a wrinkle to my brow. I will admit though that on the basis of his CV, Dr Kling – like my good self – is very likely a dedicated teacher and student of economics, even if the structure and purpose of futures markets appear to be beyond his compass.
Confronted with these confusions it pleases me to note that the billionaire George Soros has not fallen victim to the Drill Baby Drill syndrome, even if his short essay is depreciated somewhat by remarks which identify global warming as a “fundamental” problem. Politically it may turn out to be the most fundamental of all, and I can remember being willing to occupy one of the cheaper seats on the global warming gravy train if given the opportunity, but since I now fail to see a great deal of merit in any of the proposed remedies for dealing with this matter, especially emissions trading, and I have little or no faith in the other passengers, I have decided that the less I hear about climate dilemmas the better. This is not to deny however that Mr Soros may be correct when he pictures the optimal solution to the “perilous” oil issue – or better, the perilous ENERGY ISSUE – as a crucial prerequisite for optimally addressing climate warming.
Banks, Ferdinand E. (2008). ‘Economic theory and the price of oil’. Forthcoming.
______. (2007) The Political Economy of World Energy: An Introductory Textbook.
London, and New York and Singapore: World Scientific.
______. (2001). Global Finance and Financial Markets. London, New York,
and Singapore: World Scientific.
Crawford, David L. (2008). ‘Oil futures are a phony target’. Philadelphia Daily
News (August 4).
Donnernv (2008). ‘Peak oil and nuclear power’. 321 Energy (September 18).
Hamilton, James (2008). ‘Kling’s oil speculation question’. Seeking Alpha (June 27).
Krugman, Paul (2008). ‘Speculative nonsense once again’. New York Times (June 23).
Soros, George (2008). ‘The perilous price of oil’. The New York Review (September).
Professor Ferdinand E. Banks
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