Saturday, May 31, 2008


I have a simple rule of thumb for resolving economic questions: whatever the loud guy shouting on CNBC says is wrong. Ergo, there is oil speculation.

This argument has been thrown out before: because the spot price is based on real oil, "paper speculators" (index funds that buy and sell futures to avoid actually ever having the oil) then the real price of oil (the spot price) can't be influenced by speculators.

To paraphrase the Simpsons, Rick Santelli makes a very loud point.

His argument is essentially that if there's a lot more people speculating on oil going up then down, then when those speculators defer receiving the oil, they'll pay a premium since no one wants the oil (supply and demand).

Of course, that is exactly what's happening: the market is in contango - that is to say, there is a cost to paying someone else to hold your oil for you (so you can lock in the speculative gains). The index speculators are paying month to month. (Of course, they are rolling from 2 months to 1 months, at least in the case of Barclays oil ETF.)

So how can the spot price be affected? Simple: oil producers are in a perfect position to make a killing off of the contango.

Imagine I drill for oil in my back yard and can produce a barrel of oil a month. I enter a futures contract (locking in a higher price due to contango) to deliver in two months and put the oil in my garage. At the end of the month I look at the market and see that I can make a profit by selling another two-month contract while buying a one-month contract.

That one-month I bought perfectly balances the one I sold (two months ago, so now it's a one-month) and the barrel of oil in my garage backs the new two-month. I make (for free and risk free) the roll yield the commodity indexes are losing.

Of course, I've shut my well down. Is this a big problem? It depends on what I'd rather have: oil in the ground or dollars (which I'm making anyway).

Of course I don't even need an oil well to play this game - I could just buy one barrel of oil, sell it forward, and start rolling the contract. Essentially contango pays people to store oil.

So when you invest in rolling oil futures, you really are hoarding oil - contango is the "rent" you pay someone else to do the dirty work of stashing your barrels somewhere. (But you most certainly have a real claim on a real resource - that's what a futures contract is. No one is going to do anything else with "your" oil until the contract is settled.)

So what about the spot price? If this is all about contango and negative roll yield, why are we paying $4+ at the pump? What ties the spot price to the futures price? (Santelli's argument is that since the speculators only play with futures, they can only move futures prices.)

The answer is arbitrage. In a situation where the prices of futures contracts have gone much higher than spot prices, oil producers can make a ton of money with zero risk. They sell less oil on the spot market and more using futures contracts. As long as the price difference is larger than the storage cost, the producers make a profit, and the spot price goes up (due to a lack of supply).


alpilotx said...

I don't know if you have read the following blog post or not, but in the latter case I would highly recommend it to you:
Has Peak Oil--As a Meme--"Tipped"? (Out of Futures Backwardation and into Contango)

Andras / alpilotx

Benjamin Supnik said...

Hi Andras,

Interesting that you bring up Peak fear is that us humans tend to look for the general in the noise...and in this case we are attempting to see evidence of a very real, but slow and large trend (the exhaustion of accessible oil) in what is essentially a localized market fluctuation (e.g. demand is inelastic, production doesn't ramp up fast, thus we can get price spikes, then speculators jump in and amplify them).

My fear is that when oil crashes (as production belatedly ramps up while demand ramps down in response to both high prices and lower world GDP growth, the speculators will freak out and bail :-) people will say "see, Peak Oil is a myth", similar to how Global Warming gets attacked every time we have an unusually cold winter.

We're just not good at believing that noise in data really is noise in data. :-)

alpilotx said...

Hi Ben,

Yes the peak oil thing is a very complex beast as I learned over the years (and there are so many other "peak XYZ" just around the corner which we are less aware off). Because it is not a uni-/bi-/tri-variate equation, but one with so many variables that most people just can't understand (and this is always a good point where mainstream media can fill in the gap with manipulative propaganda - whatever their motivation might be). For example, I find it interesting, that a too high oil price can kill economies (or at least make them struggle big time), and when this happens, you see a big demand destruction. And such a demand destruction then would lead to lower prices ... from a pure mathematic point of view this would look nice, but as humans, who are more or less dependent on this system really don't want to live in the middle of the equation (where the demand destruction happens) ...

Other big factors are, that from a pure physical point of view, we are not short on energy. I mean, just look for example at the sun. The daily input from it far-far-far exceeds our need ... only problem, we are still struggling to harness it in large enough quantities ... not to mention the "tiny-little" problem of energy storage ...

So many factors, so many potential outcomes ... but the question is, which seemingly chaotic human/corporate decisions lead to which results ...

I could go on and on over this topic ... but I leave it as is for now :-)

Andras / alpilotx