Cezary Salad

This is the last of a three-part series of posts reflecting on what’s really driving the price of oil in today’s markets. Last Thursday’s post focused on the role of dollar depreciation. Then, on Saturday I reflected on the tightening outlook for global supply and demand. Today’s post will examine the impact of commodity price speculators.

The third - and definitely the most controversial - long-term trend that has put upward pressure on oil prices is increasing commodity price speculation.

Under most circumstances, financial theory would dictate that the inflow of speculative capital can’t have an outsize effect on a market as large, open and actively traded as oil futures. That’s because such a market is bound to have a large variety of participants - technical traders, physical hedgers, fundamental investors, passive investors, mean reversion traders - all following various objectives and trading strategies that can’t really have a measurable impact on it.

However, this fails to hold true if there’s so many participants all following the same strategy that they do in fact move the market by creating an imbalance between the number of buyers and sellers, resulting in either a spike (via excessive buying) or a crash (via excessive selling).

And, by the looks of it, that’s precisely what’s going on in the oil futures market right now. Over the past five years, an influx of new investors have flooded the commodity markets with speculative capital, much of it following the same strategy - go long and hold - which helped to create a spike in oil prices.

Big money, big market

Let’s start with the numbers. In May, Michael Masters, manager of hedge fund Masters Capital Management, estimated that assets allocated to commodity index trading have risen twenty-fold from $13 billion at the end of 2003 to $260 billion as of March 2008. Fair disclosure: his hedge fund stood to lose a lot of money with rising oil prices, so he had an interest in arguing for greater regulation of the commodity markets. Moral hazards aside, though, in early July, CNNMoney.com reported that the International Energy Agency had came up with nearly identical figures: $15 billion in 2003, growing to $260 billion by 2008.

Where did all this money come from? The inflow of speculative capital was enabled in large part by an innovation in the world of Exchange-Traded Funds (ETFs), which track indexes but can be traded like stocks. Since 2005, when Barclays Global Investors created the first broad-based commodity ETF, commodity ETFs dedicated to tracking the performance of futures commodity indexes like the Dow Jones AIG Commodity Index (DJAIG) or the Goldman Sachs Commodity Index (GSCI) have mushroomed. This empowered investors worldwide to participate in the commodities bull market like they never could before and naturally led to a huge influx of capital - and not just from hedge funds. In late 2006, for example, CalPERS - one of the largest U.S. public pension schemes - announced that it would earmark $500 million for a pilot commodities investment program. And CalPERS definitely wasn’t alone. By 2008, Masters estimated that investors bet nearly $1 billion per day on commodity indexes in the first 52 trading days of the year.

But it is important to view these numbers in context: there are trillions of dollars’ worth of commodities contracts traded every day (New York Times business columnist Joe Nocera puts the figure at $5 trillion). In this light, a couple hundred billion worth of speculators’ capital can only have a material impact if their positions are so concentrated on any one strategy that a large-scale retreat from or a run to that position reverberates through the market.

Crowded investment strategy

To see how this can happen, it’s important to first draw some distinctions. The Commodities Futures Trading Commission (CFTC), the regulatory body tasked with overseeing the commodity futures markets, distinguishes between two types of participants: commercial and non-commerical. Commercial participants are those who have a legitimate commercial reason to hedge their exposure to a given commodity - such as a grain farmer or an oil refinery - whereas non-commercial participants are those who participate in the market purely for financial gain (i.e. speculators). Both, however, act in the same global market and therefore answer to the same oil prices. Furthermore, there are two types of trading strategies of interest in examining non-commercial participants’ impact on the market: long and short. Long positions bet on rising prices and therefore their accumulation tends to put upward pressure on prices; short positions bet on falling prices (by borrowing shares, selling them high, repurchasing when low, returning them to the borrower and pocketing the difference) and therefore their accumulation tends to put downward pressure on rising prices.

Armed with this knowledge, let’s look at the trends. Last year, the same Congressional committee that Masters testified in front of tasked Edward Krapels, manager of the gas and power practice at consultancy Energy Security Analysis, Inc., to answer essentially the same question: what is the effect of index speculators on oil prices? To answer the question, Krapels examined the difference between non-commercial speculators’ long and short positions on West Texas Intermediate (WTI) crude oil from 1986-2007. What he found was that, with some exception, between 1986 and 2002 non-commercial investors were net short on oil. Between 1992 and 2001, they oscillated between net long and net short interest. But between 2002 and 2007 - a period which saw WTI rise from $20 to $100 - the non-commercial investors were usually net long. For the sake of convenience, below I’ve reproduced the charts that Krapels uses to illustrate these trends (sorry for the bad resolution):

If anything, after Krapels’s testimony in December 2007 we can only guess that this trend continued to snowball. The public spotlight on the tight global supply and demand conditions as well as the plunging dollar gave non-commercial commodity investors few reasons to go short - an indication of how inter-connected these three trends really are. And again, the credit crunch stands out as the common element because in its wake, with the debt markets frozen and the equity markets in disarray, commodities indexes stood out as the only relatively safe place for skittish investors to park their vacant capital. The result? More capital chasing futures contracts using predominantly the same strategy: go long and hold.

Material impact on price

Now, keep in mind that futures prices are driven by expectations. As I argued in my last post, worries about fundamental supply and demand are already putting upward pressure on futures. But this effect is exacerbated by specualtors’ increasing net long interest in oil futures contracts because as more index speculators wishing to go long and hold crowd the market, the marginal futures contract becomes more expensive to purchase, which bids their prices even higher.

Here it is crucial to point out that commodity futures contracts expire every month, which forces their holders to either take the physical delivery of the commodity or to sell the contract. In practice, only about 5% of futures contracts ever result in physical delivery, and this figure isn’t any different in today’s market than in years past. So critics argue that non-commercial commodity investors cannot possibly be bidding up the price of oil since they are not removing a single drop of oil from the market (this is a point espoused by New York Times columnist Paul Krugman); they simply use calendar swaps to sell the contract to someone else before it expires and physical delivery is ultimately accepted by a commercial market participant. Thus, were non-commercial interests bidding up the price of oil, we would see huge pile-ups in oil inventories thanks to the likes of Goldman Sachs and JPMorgan, which is not the case.

But this line of reasoning misses the point. It is not the physical delivery of oil today that determines its price. Instead, it is the futures markets that are at the very front and center of how oil is priced since - as I explained in my last post - oil is priced over a futures benchmark.

Mixing water with oil

This distinction helps explain why comparisons to other commodities markets which are not as heavily traded as oil but are nonetheless surging in price - such as the global market for iron ore - are off the mark.

Yes - by all measures, prices for iron ore globally are booming thanks to growing demand from China. And because this is a market in which the only market-making activities are individual contracts between buyers and sellers, there is no room for speculative influences. Ergo: fundamental demand must be driving iron ore prices, not fundamentals.

Fair enough. But to point to this and to say it this is evidence that oil must also therefore be booming purely because of fundamental demand brushes over several crucial differences that don’t make this an apples-to-apples comparison:

• Oil pricing is benchmarked off of futures contracts. Iron ore pricing is based on spot contracts between individual market makers
• Oil has far more sophisticated market mechanisms that allow for greater price discovery (exchange-based trading, swaps, futures). Iron ore doesn’t
• No one market participant is large enough to significantly impact the price of oil. Conversely, the market for iron ore is dominated by big players who have significant control over price; when Brazilian miner Vale announced in February that it would sell iron ore to South Korean and Japanese steelmakers for 65% more than its 2007 prices, that deal effectively set the price benchmark for the whole industry
• The price of oil is growing by leaps and bounds. Iron ore is experiencing a more modest price escalation. Even a 65% year-over-year increase isn’t bad compared with the more-than-doubling of oil over the last year

Clearly, this well-intended comparison mixes water with oil.

Stormy outlook

Considering all of this, it is difficult to argue that speculators aren’t having any impact on the skyrocketing price of oil. Rather, the appropriate questions are: how much of an impact and how big relative to the other two trends. This is difficult to quantify, but estimates such as 50% of today’s oil price being caused by speculation - as offered by Masters during his testimony - don’t pass the smell test and only galvanize those who wish to keep speculators’ hands clean (in which case, rather than focusing their efforts on rebutting Masters’s testimony point-by-point, critics should try to deconstruct the much more balanced analysis offered by Krapels).

At the same time, though, it is important to remember that any price tag that we apply to speculation’s share of a barrel of oil would not be as high as it is without dollar depreciation and concerns about tight supply and demand since the three are very closely interconnected. As Krapels put it, “it would be naïve to expect any sustained causation between trading strategies and prices,” but “there are, nevertheless, several areas where causation should not be dismissed, all of them consistent with normal economic analysis,” among which he names:

1. Perfect storm episodes: there are likely to be periods of time when the condition of the physical energy market and trading strategies of financial market participants are in such good alignment as to produce “herding” and “bubbles” or their opposite, crashes
2. Variations on the market power syndrome: It is possible that the positions of some market participants - index funds as one example - are so large as to constitute witting or unwitting market power. A large-scale infusion or retreat from any of the various positions very large index funds might have price effects

By the looks of it, we are currently experiencing both situations: the mixing of these three trends has indeed created the perfect storm, and the resulting influx of long-and-hold speculators helped to grow it into the hurricane that it is today.

This is part two of a three-part series of posts reflecting on what’s really driving the price of oil in today’s markets. Thursday’s post focused on the role of dollar depreciation. Today’s post will focus on the tightening outlook for global supply and demand.

The outlook for diminishing supply combined with surging global demand for oil is probably the best-documented of the three long-term trends that are driving up oil prices - the other two being the depreciating dollar, which I wrote about on Thursday, and speculation, which I will write about in a future post. It is also the explanation most favored by everyone from the business press to regulators and talking heads on CNBC.

However, there is reason to believe that its impact on current oil prices is not as powerful as everyone believes. True, expectations of higher demand and lower supply do add upward pressure on futures prices and, in turn, spot prices today. But since longer-term supply and demand expectations regarding China and India are “old news,” they are to a great extent already priced into the market and thus cannot by themselves trigger an oil shock of the magnitude we are seeing now.

Hard truths

Let’s start with the facts. As the Energy Information Administration (EIA) detailed in its latest short-term energy outlook, world consumption of oil is continuing to grow despite 7 years of conscutive increases in oil prices, with decreases in demand from the U.S. being more-than offset by increases from places like China and the Middle East. Meanwhile, the pace of supply growth in non-OPEC countries is expected to continue to fall short of expectations and consumption growth - as it has in years past - thanks to faster declines in older oil fields and delays in expansion projects.

[For more information on these fundamental trends, check out the EIA's slideshow, "Next Stop for Oil Prices: $100 or $150," available here. Hint: it was written by economists, so the answer, of course, is "it depends."]

No one denies that these are the cold, hard facts on the ground (or rather, underneath). But what is of interest is how these longer-term realities impact prices today and where the rational limits of that impact lie. It is here that the plot thickens.

High expectations

The answer to the first question can be found in the role that expectations play in the oil market. As supply and demand conditions get more and more attention in the business press, sellers of oil have more reason to expect that they can capture a better price tomorrow than today and are therefore more likely to hold on to the marginal barrel of oil for sale at a future date. As a result, we’ve seen a steady upward revision in sellers’ future price expectations. For example, the price of crude oil for delivery in 2011 has more than doubled since January 2007, rising to $120 in May 2008, as economist Stephen P.A. Brown of the Federal Reserve Bank of Dallas illustrates in this chart from his article, “Crude Awakening:”

But how does a rise in futures prices impact spot prices today? As with many financial instruments, oil is priced over a benchmark - similar to a loan being quoted as LIBOR plus a credit spread. In the past, this benchmark used to be based on spot prices for certain crudes, such as West Texas Intermediate (WTI) or dated Brent. However, as this somewhat technical, but clearly-written and well-sourced post from the blog “Peak Oil Debunked” explains, since the mid-1980s, the oil industry has gradually shifted away from spot benchmarks to benchmarks based on futures prices because the former are easier to manipulate and corner than the latter. So when you see oil prices surging higher, what you’re seeing is a price formula that reflects changes in a weighted average of futures contracts for certain “benchmark” crudes (the WTI benchmark for U.S. oil, the Brent benchmark for oil sold by the Middle East to Europe, the Dubai-Oman benchmark for Middle East oil) plus a premium or minus a discount. Thus, higher futures prices lead to higher spot prices today.

This is why the venerable Economist was wrong when it argued in its July 3rd edition that futures contracts are simply “bets on which way the oil price will move” that “do not affect the price of oil any more than bets on a football match affect the result.” If football games were won by taking a weighted average of expectations over which team will win and then adding or subtracting some points for actual team performance, then the analogy would be apt. But since oil futures act as the benchmark for spot prices and therefore directly impact their levels, it is not.

So it’s clear that the bleak global supply and demand outlook is helping drive oil prices higher; here there is no bone to pick with analysts, the business press and talking heads. Instead, there is only the caveat that this is happening because of the way oil is priced over futures benchmarks - not spot prices.

Old news

Still, there is a hard limit as to how big the impact of this upward pricing pressure can be. That’s because none of the bleak macro supply and demand projections are news to investors. That is, it’s not as if late last year the world all of a sudden realized that India and China have very large and rising energy needs. We’ve known about this for years and it’s been priced into the markets for years. And at the end of the day, markets react to new information, not old news. Thus, unexpected announcements of buildups in oil inventories will move the needle one way or the other, but having a talking head on TV say that demand from China and India is growing doesn’t add any new information that hasn’t already been priced into the market.

Hence, the same old story of rising demand from India and China couldn’t by itself trigger such a precipitous rise in prices: it needed a spark. And that spark - as with the depreciating dollar and (as I will argue in a future post) speculation - came from the onset of the credit crunch. After the debt markets shut down last summer, billions of dollars that couldn’t be invested in debt securities went looking for a safe haven, which they found in the commodities markets. As I will explain in a future post on the role of speculators, this had an upward impact on the price of futures contracts and - via the same pricing formula desribed above - on spot prices. And once this happened, everyone from the business press to Treasury Secretary Hank Paulson and the EIA reiterated the tight supply and demand picture, which only exacerbated the panic and reinforced expectations of higher oil prices in the future.

This suggests that supply and demand forces aren’t as powerful here as one might think. This becomes even more evident when we consider the fact that the bleak global supply and demand outlook is a longer-term macro trend which stays pretty constant over time. That is, we know that China and India are probably going to be consuming more oil over the next few years and that supplies in non-OPEC countries will likely not keep pace with demand. But consider the fact that between the beginning of March and the middle of June nothing much changed in this fundamental supply and demand picture while the price of oil nevertheless jumped nearly $40/barrel over the same period. To say that this jump was all due to fundamental demand from India and China and tight supply in non-OPEC countries would be like explaining a particularly hot summer day by referencing global warming. Point being: it’s a long-term trend whose explanatory power diminishes as we focus on short-term oil shocks rather than gradual price increases over longer periods of time.

So yes - tight oil supply and real growing demand are powerful forces and serious problems that need to be dealt with. But their impact on the price of oil likely takes a passenger seat to the depreciating dollar and - as I will argue in my next post - the impact of speculators.