Cross currents on speculation

So, I was never completely convinced by the argument many propose as a way to justify the fundamental nature of $140 per barrel oil -- namely, the purely financial nature of the futures market and the lack of inventories. Lots of people have made this argument, which does make sense, and is essential to consider. I do think that a lot of people don't follow up very thoroughly on the argument however. It's one thing to observe that the index funds are buying futures and not storing physical oil, and it's another to jump to the conclusion that the futures market has no impact on the spot market and hence there can be no speculation. The link between the two markets is indirect, but real, and can come from hidden inventories (kept in the ground), or from intertemporal calculations by refiners, or from fuel subsidies and very inelastic demand curves, or, as this post suggests, from the mechanics of the way contracts are priced.

Most crude oil is traded based on long-term contracts, and the prices in those contracts are set by a system known as "formula pricing". In this system, the price of delivered crude is set by adding a premium to, or subtracting a discount from, certain benchmark or marker crudes, namely: West Texas Intermediate (WTI), Brent and Dubai-Oman. Generally, WTI is used as the benchmark for oil sold to North America, Brent for oil sold to Europe and Africa, and Dubai-Oman for Gulf crude sold in the Asia-Pacific market (Source1, Source2).

"JD then provides a description of how the spot market became increasingly subject to manipulation, which led oil exporters to turn to the futures market, which was more liquid and hence less subject to games-playing, as the basis for contract pricing. JD cites a paper by Bassam Fattouh of the Oxford Institute for Energy Studies:"

[T]he futures market has grown to become not only a market that allows producers and refiners to hedge their risks and speculators to take positions, but is also at the heart of the current oil-pricing regime. Thus, instead of using dated Brent as the basis of pricing crude exports to Europe, several major oil-producing countries such as Saudi Arabia, Kuwait and Iran rely on the IPE Brent Weighted Average (BWAVE).11...

[11] The BWAVE is the weighted average of all futures price quotations that arise for a given contract of the futures exchange (IPE) during a trading day. The weights are the shares of the relevant volume of transactions on that day. Specifically, this change places the futures market, which is a market for financial contracts, at the heart of the current pricing system.

This is not to argue along with so many politicians that "it's all speculation". At this point I've formulated what I think is a reasonable view on this stuff -- the price increases from 2001-mid 2007 were by and large fundamentally based, despite the gradual shifting of money into futures indexes. When the credit crisis started and real interest rates went negative, speculation started to become an important factor, and occurred through a variety of channels, not all of which would actually fit the definition of speculation most people have (it's actually a damned slippery term when you try to apply it to a cyclical market like commodities). So oil and other commodities are in a bubble, if by this you mean that they may suffer sharp declines -- but they are not going to mean revert to their 2001 price, and there really is a fundamental supply and demand problem that needs to get solved one way or another (historically its been solved by a combination of recession/depression and supply growth/conservation). Right now things are just overshooting, and the greatest danger is in taking the easy road out by scapegoating the evil speculators and ignoring why the speculation got started in the first place.