Sunday, June 8, 2008

There Isn't a Bubble in the Oil Markets?

Let’s look at oil prices for the last week. On Monday, June 2, 2008, the price of light sweet crude closed around $128 a barrel. On Tuesday, June 3, 2008, it closed around $124 a barrel, down about 3%. On Wednesday, June 4, 2008, it closed around $122 a barrel, down another 1.6%. On Thursday, June 5, 2008, it changed direction and closed at nearly $128 a barrel, up about 4.6%. Finally, on Friday, June 6, 2008, it closed at $138.54 a barrel, up about 8.4%. Oil price increases like these could slow the economy and aggravate inflation (i.e., produce stagflation). On Friday, the Dow Jones Industrial Average fell almost 400 points, into territory approaching its low point since the beginning of the mortgage crisis and the credit crunch.

If you were to believe the oil industry and government explanations for these price movements, what happened was: (a) on Tuesday, June 3, 2008, fundamental demand for oil, especially in China and India, dropped about 3%; (b) on Wednesday, June 4, 2008, fundamental demand for oil, especially in China and India, dropped another 1.6%; (c) on Thursday, June 5, 2008, fundamental demand for oil, especially in China and India, rose about 4.6%; and (d) on Friday, June 6, 2008, fundamental demand for oil, especially in China and India (where everyone was filling their tanks for weekend excursions), rose 8.4%.

That explanation seems absurd because it is absurd. Fundamental demand doesn’t explain current short term price movements in the oil markets, because it doesn’t change that fast.

News events may have influenced the direction of the price movements. Early last week, a gasoline inventory report indicated unexpectedly large inventories in the U.S. That, together with comments by Federal Reserve Chairman Ben Bernanke about supporting the dollar, pushed oil prices down. Then, counter-comments later in the week by the president of the European Central Bank to the effect that the European bank might raise interest rates (and thereby support the Euro and weaken the dollar), led to a price jump amidst a buying frenzy. It didn’t help that an Israeli newspaper reported the possibility of an Israeli attack on Iranian nuclear facilities some time soon.

Even though these news events may have affected the direction of prices, they don’t explain the frenzied trading and the large amount of the price changes. The possibility of interest rate increases by the European Central Bank has been mentioned in the financial news for months. The possibility of military action against Iran—by Israel or the United States—has been bandied about for years.

So what accounts for the pricing histrionics? Most likely, speculation and maybe a touch of manipulation. Let’s start with speculation. News reports indicate that hedge funds and other institutional investors are jumping into the oil market. That's not surprising. Professional money managers are measured against market averages. If you’re running a hedge fund and your performance only matches the S&P 500, your client base, and your continued employment, will have a very short half-life. In order to stay in business, you have to beat the market. So you look for whatever is hot. If it’s high tech stocks, you buy high tech stocks. If it’s mortgage-backed derivatives, you buy derivatives. If it’s oil, you buy oil futures. The hotter something gets, the more you want it. And since you can buy oil futures using a lot of leverage, you could boost your profits by borrowing aggressively. With the Fed generously cutting interest rates and taking all kinds of hinky assets as collateral, banks can obtain the funds to lend to commodities speculators.

It isn’t hard to discern a speculative bubble in the oil markets. Maybe some professional economists would assert that they can’t spot a bubble in the making. However, whether or not linear and/or nonlinear regression analyses would indicate a bubble in the oil markets, we shouldn’t let the professional orthodoxy of economists interfere with common sense. A bubble occurs when investors buy an asset because they believe they can sell it in the near future to someone else at a higher price. Their investment decisions are unburdened by any consideration of the fundamental value of the asset. They just hope to find a greater fool than they. We have a speculative bubble in the oil markets today.

Manipulation is darker possibility. Proof is harder to find, because much of the evidence may be overseas, in markets where regulation is even more diffident than the light touch of the U.S. Commodities Futures Trading Commission. But here’s how it could be done. OPEC is resolutely refusing to increase production. Other oil producers, who don’t belong to OPEC, appear to be producing pretty much at full capacity. Thus, there is a limited supply of oil that won’t be significantly increased in the next year or two. The inflexibility of supply allows for gamesmanship. The nasties could go to the less transparent markets overseas and, using leverage, buy up a shipload of near term futures contracts. A large part of the world’s oil production is delivered under long term contracts, so you don’t need to buy close to the entire world’s supply. You just need to buy enough contracts to influence the spot market. If you work in concert with a few of your like-minded money managers, you could put together a formidable consortium. Since your overseas buying might be rather opaque, other players wouldn’t easily pick up on what was going on and could unknowingly agree to deliver oil to you at prices they think are high. As your influence over the oil market increases, prices will rise unexpectedly higher. Your counterparties will rush to cover their exposure by buying contracts for delivery of oil themselves. That will only increase the buying pressure and push up the price further.

You wouldn’t need to corner the market in the classic sense. All you’d need to do is induce a little panic among the shorts. Because the near term supply of oil is static, if you create a bit of frenzy, your beloved counterparties will have to scramble.

Is there any way to get some control over the speculation and possible manipulation in the oil markets? Regulators of banks and broker-dealers could check up on how much credit is being extended to finance oil trading. Given the spike in oil prices, these loans are getting riskier and regulatory oversight would be appropriate. If commodities market regulators wish to investigate the possibility of manipulation, they could do so. However, commodities regulators aren’t renowned for being hard charging, and we shouldn’t get our hopes up that a whole lot of law enforcement will happen. The CFTC recently announced that it was investigating trading in the oil markets. But as we just noted, commodities regulators aren't renowned for being hard charging, and we shouldn't get our hopes up that a whole lot of law enforcement will happen. In the meantime, skip the meat and fish counters at the supermarket and start putting generic peanut butter on generic crackers in order to have enough money to cover your gas bills.

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