Friday, May 30, 2008

Oil speculation

The Economist leader this week is about oil. Clearly, at $135 a barrel the world is suffering a serious oil shock. Equally clearly, everyone is looking around for someone to blame. One of the favorites is those-evil-speculators. The Economist puts it thusly:
Stuck for answers, politicians have been looking for scapegoats. Top of the list are the speculators profiting from other people's hardship. Some $260 billion is invested in commodity funds, 20 times the level of 2003. Surely all that hot money has supercharged the demand for oil? But that is plain wrong. Such speculators do not own real oil. Every barrel they buy in the futures markets they sell back again before the contract ends. That may raise the price of “paper barrels”, but not of the black stuff refiners turn into petrol. It is true that high futures prices could lead someone to hoard oil today in the hope of a higher price tomorrow. But inventories are not especially full just now and there are few signs of hoarding.
Of course, as useful and intelligent as The Economist is, it sometimes suffers from over-compression an idea in order to fit it into their bite-size chunk type of format. If you actually look at it the facts, there is every reasons to believe that speculation is in fact contributing substantially to the run up in oil prices. This is not to say that the entire move over the last four years from $35 to $135 has been caused by speculation. There is certainly a broader supply and demand trend. But to ignore the contribution of changes in the financial markets is foolish, no matter how well it sits with your market fundamentalism faith. On top of that, The Economist, while mumbling a bit about inflation, does nothing to explore the role that negative real interest rates have in all this.

In reading over this question, I often feel it can be reduced to a case of the all-powerful force and the unmovable object. On the one hand, The Economist and a lot of other people claim that there is no possible way that the money coming through index funds into futures can effect the spot market. They claim that this is just "paper oil" we'd see a huge rise in inventories, which we don't. This is impeccable logic. On the other hand, when the fund inflows into commodities are as large as they are and you can see long-time industry participants complaining about the distortions that are happening in the markets, you have to assume that this amount of new money is going to have some effect on the price.

So, in sum, there absolutely must be commodity speculation, and there can't possibly be.

Of course, as happens with most speculative manias, both are partly correct. There is always a long-term story, and it always gets over-hyped. In this case, the conclusion is that the days of $35 a barrel oil (the marginal production cost) are over, but that neither is there any reason to believe that the price will stay above $100 for very long. Half of the story is the growing demand and long lag time on new supply of an ultimately finite resource, and half is a financial bubble -- "peak oil" meets peak oil frenzy. So let's not beat around the bush. The price of oil will stabilize around $75. That's my story, and I'm sticking to it.

No comments: