Posts Tagged ‘crude oil’

Another Reason Oil Prices Are Falling?

July 10, 2009

Last August, economist Robert McCullough examined the volatility in the crude oil market surrounding the price spike on July 3, 2008 and the subsequent fall in energy prices.  In his final report McCullough examined the many events and announcements that had the potential to impact oil prices over this period.  He found that fundamental factors of supply and demand were not statistically significant, but found (on page 13 of the pdf):

The proxy for the short-lived Commodity Markets Transparency and Accountability Act of 2008 was highly significant. Interestingly, this was the only variable that would have affected excess speculation as opposed to supply and demand fundamentals…. One conclusion to be drawn from these statistics is that the news stories cited by pundits to explain the dramatic spike in oil prices have little or no explanatory power.

In other words, the prospect of regulation of the futures markets had a statistically significant impact on prices.   Let’s fast forward to the steep drop in crude this month.  While there’s certainly been negative news on the economy, we had some negative news at various points while oil doubled from February.  It is at least worth noting that the recent drop in oil coincided with a period in which Washington is seriously considering constraints on excess speculation in the energy markets. 

To the degree that excess speculation is a factor in artificially inflating oil prices, it needs a constant inflow of new money to sustain those prices, just like a Ponzi scheme needs new funds to keep the game going.  It’s hard to imagine money managers continuing to commit capital to commodities at the risk that they might be forced to liquidate if position limits are imposed.

More on the Wheat/Crude Oil Connection

July 6, 2009

Apparently the Senate report of excessive speculation in the wheat market has moved (discussed in this post last week).   All 247 pages of it can now be found here.

Going through the report, one of the footnotes briefly references an op-ed of mine that appeared in the Boston Globe last August and can be found here.

It’s interesting to see the Senate report touch upon the crude oil/wheat connection — the authors are absolutely right to see linkage.  That connection is the fact that we are treating contract markets (whether exchange trades futures or OTC swaps) as if they were capital markets.  These markets were designed with different ends in mind (contract markets are designed for risk transference, while capital markets are designed for investment), and require different rules of governance.  

Whenever I write about the need for regulatory reform in these markets, I get some responses accusing me of everything from gross ignorance of the commodity markets to Marxism.  The need for reform is consistent with broad free-market beliefs, but recognizes that those markets need governance (not necessarily governmental) to protect their integrity.  In the capital markets, everyone accepts the need for prohibitions against front-running customer orders or trading on inside information.  Contract markets need rules, too, (e.g., speculative position limits) and while these rules differ from those that govern investment markets, we should accept that they are no less critical.

Why Crude Oil Traders Should Care About Wheat

June 30, 2009

Last week the Senate released a report that concluded that non-commercial participants, particularly index speculators have been disrupting the wheat futures market (for those not inclined to read the 247-page report, there’s a good summary in this BusinessWeek article).   The term, “index speculators,” refers to that new breed of market participant that treats commdodities as buy-and-hold investments rather than as short-term trading vehicles.   Index speculators are often people and institutions one would not associate with speculation — endowments and pensions, for example.  They generally have bought into the notion that a basket of commodities (or commodity futures) is a legitimate investment asset class; this is a view I dispute — I know of no other “investments” where the inherent value can only be realized in the consumption and destruction of the asset.

The wheat report highlights one of the dangers of “overspeculated” futures markets, a condition where non-commercial interests so outnumber commercial participants that the relationship between cash and futures prices (the “basis”) breaks down.  An erratic basis in a commodity futures contract is more than a mere curiosity: it can mean that the futures markets no longer offer reliable risk mangement tools for producers and users.  It’s worth remembering that these markets were never intended to serve investors, but were chartered from the begining to serve the commercial commodity industry.   Dramatic shifts in the basis can also cause severe financial problems for commercial hedgers who must meet margin calls. 

A spike in the cotton basis in March of last year was devastating for that industry.  I’ve often thought that the cotton problem was the “canary in the coal mine,” warning us of dangers ahead.  Wheat going down the same path is troubling indeed.  From the standpoint of greatest economic risk, one must wonder whether crude oil is also heading in this direction.  If crude oil is “overspeculated,” there’s a particular vulnerability given the geopolitical risks that can crop up with oil.  My sense is that much of the oil in storage is part of a cash/futures arbitrage play which means, as I believe happened with cotton, a sudden influx of futures buying would have no natural constraints, sending futures prices soaring.  With the central role energy prices play in the economy and the heavy participation in the crude oil markets by our wounded financial companies, a price disruption of this nature could have far reaching consequences.

Last year there was a great debate about the role of index and other speculators in disrupting commodity prices.  Unfortunately, too much of this debate centered on the oil industry, not only one of the deepest markets, but also one of the most opaque.   It’s simply hard to get the data needed to see the risks in crude.  Looking at smaller markets like cotton, it is easier to grasp that treating commodity futures as investment assets can cause grave problems.  Although the debate is still tainted by politics, it’s good to see that these dangers are getting the recognition they deserve.

A Terrible Idea Whose Time Has Come

June 23, 2009

If we’re going to trade crude oil like a currency, we should regulate it like a currency, too.

I hold an apparently quaint and obsolete belief: “Not everything that can be traded should be traded. ”  Specifically, there’s great danger in using long-term, long-only commodity futures positions as an investment asset class.  The same is true of the derivative baskets of commodities that replicate such futures position.  Please note that I’m not talking about futures funds (which trade both sides of the market and are generally in positions only for the short term), but rather the way that commodities are increasingly being used by pensions, endowments and hedge funds as investments rather than short term speculations; this has sometimes been called “index speculation,” to distinguish it from the traditional variety.

Investment flows into the futures market can distort the pricing that should instead be determined by producers and users of commodities.    Price distortions of this type cause enormous economic inefficiencies, are deeply injurious to the world’s poorest, and create significant structural risk in the markets.  The chart below is a good illustration of just how “financialized” energy prices have become, charting the trade-weight U.S. Dollar index (the dashed line) versus the DJ-UBSCI Energy Spot index (the solid line) since the beginning of the year:

Dollar vs Energy Prices

Dollar vs Energy Prices

As emphasized by the arbitrarily drawn horizontal line, these plots are virtually mirror images of each other (running a regression results in a correlation of -0.88).   This corresponds to the type of linked price action we saw during the buildup to the commodity frenzy last year.  It’s interesting to note that commodities like gold show nowhere near the correlation (-0.177) with the dollar over this same period.  Clearly, the pricing of crude oil and energy products have become dominated by financial, not commercial interests.  Specifically, oil is being treated as a currency and not as a commodity.  This is a terrible idea, but apparently a terrible idea whose time has come.

While using crude oil as a currency/asset class is a bad idea, there are some good (or at least interesting) ideas on how to address the associated risks.  I have been a fan of applying speculative position limits to energy contracts, importantly including the OTC swaps market.  This approach has some downsides: a) it may be ineffective since the problem is really that all the positions in aggregate are dangerously large, but perhaps not on the individual basis constrained by position limits, and 2) it may simply migrate investment interest away from futures and into hoarding physical oil.  In some ways this has already happened, as the speculative interest in crude oil (“virtual hoarding”) has created a cotango market that has resulted in a massive, arbitrage-induced inventory buildup (physical hoarding). 

Last July as crude was peaking, my friend, Tom Rooke, submitted an alternative idea to the House Committee on Agriculture, the Congressional committee which oversees the Commodity Futures Trading Commission.  With the bust in crude prices in the latter half of 2008, this whole issue was put on the back-burner.  With energy prices once again being pushed up by speculative forces, it’s worth reexamining Tom’s idea.  By way of credentials, Rooke has extensive experience in the world of commodities, having served as the head of UBS PaineWebber’s futures division for many years.  He is an expert in the term structure of futures contracts and in cash/futures arbitrage. 

Rooke’s proposal, in essence, regulates crude oil much like some of the ways that money supply is regulated.  In his creative structure, the U.S. would require that holders of crude be required to maintain a reserve requirement which would be controlled by a central governmental authority, much like the Federal Reserve can change reserve requirements for banks.  This would raise the costs of hoarding crude (probably not a bad thing), represent a second, private strategic petroleum reserve in event of national emergency (definitely a good thing), and provide a stabilizing buffer in crude oil pricing (much like what OPEC used to do when it had more market power).  In the proposal, the initial transition period and reserve buildup would be eased through using depository receipts issued by the Strategic Petroleum Reserve.  Tom’s submission can be read here: TWR Letter.  The specific proposal starts on page 10, although the earlier pages include a discussion of index speculation and the evidence that it was impacting crude oil prices.  It’s worth noting, that at the time the crude oil futures were in clear backwardation and the impact of speculation was more muted (Tom estimated 10% of price increases, I guessed around 20%); with the cotango markets we’ve seen more recently, speculation plays a more direct and potentially greater role.

It is critical that this issue be addressed.   Rooke’s proposal may not be the right way to go, but it deserves serious consideration.  On the third page of his letter, Rooke outlines just one type of structural risks we could face.  We’re flirting unnecessarily with danger.  What’s truly amazing is that without greater regulation of the commodity swap market, we won’t even know how close to the precipice we are or how far the fall might be.

The Oil – Dollar Relationship is a Self-Fulfilling Prophecy

June 12, 2009

Last year, in preparation for my July Capitol Hill testimony on the role of pension and index investing in the commodities market, I examined the much discussed relationship between the dollar and commodity inflation.   I never published the work although I shared it privately with a few people involved in the policy debate.  Frankly, I thought the bursting of the commodity bubble and the reversion to costly (from the standpoint of long indexers) contango markets would demonstrate the ultimate problems with viewing commodity futures as an asset class, but apparently here we go again…

With the short dollar/long oil trade  once again rearing its ugly head, I thought it would be worthwhile to put the work out there with the write-up I did at the time.  I concluded that the correlation was due to the financial trade rather than fundamentals.  I was tentative in my assessment then, but feel more strongly about now with the benefit of hindsight. 

I do believe that over the long term we are in for a good run of fundamentally justified hard asset inflation.  However, some (not all) of the current runup in oil reflects the influence of financial players in the market place — once again, this market is becoming overspeculated with the “tail wagging the dog,” as financial flows overwhelm fundamental concerns.   A renewed tight inverse relationship between the dollar and oil is evidence of this problem, not a rationale for the continued distortion of our commodity markets.  Here’s what I wrote up then:

The Dollar and Commodities

June 20, 2008

Observers of commodity inflation often point to dollar weakness as a critical component of the price increases.  While currency movements are an important factor in commodity pricing, it is only one of many influences.  We use the $/Swiss Franc as a proxy for broad currency moves, since actual trading data for this preexists the Euro.  We compare the Dollar/Franc series to the Goldman Sachs Spot Commodity Index both in aggregate since 1987, and broken into discreet 2-year increments.  This produces some surprising results.  For one, the correlation between commodities and currencies has not only been weak historically, it has also changed direction at times.  This suggests that commodity pricing is generally dependent on a multiplicity of factors.  More puzzling is the very strong correlation which has developed over the last 18 months.  One possible explanation is that, given that this period coincides with an explosion of investment (index speculation) capital in the futures markets, commodity pricing is being driven by factors divorced from traditional physical supply and demand considerations.

Dollar Commodity relationship

Dollar commodity correlation matrix

“60 Minutes” Gets It Right

January 12, 2009

You can find the “60 Minutes” clip on oil speculation here on the Accidental Hunt Brothers website.  Given the constraints of a 13 minute television piece, I thought the show did a good job outlining the issue.

For me, the most telling point was when Mike Masters reviewed the EIA (“Energy Information Administration,” part of the U.S. Department of Energy) statistics which showed that during the period of the rapid rise in crude prices, the first 2 quarters of 2008, world petroleum supply was actually increasing and demand was decreasing.   The supply/demand environment is wholly inconsistent with the move in the price of oil — the increase in investor speculation during the period is the best explanation for this anomaly.   The EIA stats can be found here (Excel spreadsheet).

The Oil Stimulus

January 8, 2009

Economist James Hamilton(UC-San Diego) blogs at Econobrowser.   He has provided some very thoughtful insight on the oil markets, and is one of the minority of economists who understood that speculators played some role in last year’s oil bubble. 

Hamilton has posted recently on the impact that the oil bubble had in worsening the recession (part 1 and part 2).  Hamilton regards the oil price rise to be the key factor in turning a slowdown into a recession and elucidates the way oil impacted key segments of the economy like autos and housing.

There are two implications of this analysis.  The first, given the importance of oil prices moves to the economy, it is all the more critical that we understand the role of speculators in spiking oil prices (this relates closely to my topic yesterday).  The second implication concerns the necessity of the large proposed stimulus plan.   Assuming symmetry (i.e., declining oil prices help as much as they hurt when rising), the sharp decline in crude should be extremely helpful to the economy.  As Hamilton’s discussion shows, there is a substantial lag factor, so the positive impact of lower energy costs will only just start to have an impact in the next several months.