As we noted in part one of this article, much of the public commentary relative to the general increase in oil prices, particularly in the financial media, centers on oil price movements relative to traditional metrics related to supply and demand. Supply (both reserves and production) is seen by some to be on the verge of a plateau and soon a decline, while demand in developing nations like China, India and the Middle East is expected to ramp up dramatically. Policy decisions relative to the off shore drilling moratorium, or the utilization of the petroleum reserve or climate change policy are also seen to factor into current oil prices. Of course the recent Middle Eastern turmoil is triggering a traditional and fundamentally drive (to some extent) price spike. This second part of the article takes the counterpoint, that factors beyond the fundamentals might be adding an additional dollar or more per gallon of gasoline or heating oil.
Glass Half Empty or Half Full?
Many have foretold the doom of impending peak oil over the years and somehow technology, ingenuity and drive have kept expanding reserves. Conventional oil reserves can be extracted for a cost of between $6 and $40 according to the International Energy Agency. The reserves of easy and cheap conventional oil are under pressure and will run out some day, the question is when?
A range of conventional oil fields have been identified that have yet to be exploited and other conventional resources are under exploited. For example, Iraq has the third largest reserves in the world but currently has a production capacity of about 2.5 million bbl./day. Experts have estimated that it could be brought up to 12 million bbl./day which is higher production than Saudi Arabia.
The generally alternative energy friendly IEA (while downplaying the potential of Iraqi production) notes that these unexploited fields will generally replace the loss in production for other maturing fields of conventional oil but that will still provide a buffer for much of the current decade. So, should current futures prices be reflecting a potential transition period a number of years down the road?
There are also enormous reserves of somewhat harder and somewhat more expensive oil to be extracted once a higher base price of oil stabilizes. These reserves become profitable when the price of oil stabilizes in the $30 - $60 per bbl. range, though the initial start-up production costs in some cases are as high as $100 per bbl. These reserves include deep sea oil (as we all accept now after the BP spill with the appropriate oversight and monitoring); oil shale (oil trapped in rock and accessed through the maturing fracturing process), shale oil (the oil precursor kerogen trapped in rock requiring heat to process); tar sands; coal to liquids; gas to liquids; heavy oil; and arctic oil. Similarly, shale gas using the fracturing process has opened up tremendous reserves of that fuel source that could significantly offset oil consumption for transportation use, though with a range of potential environmental concerns that need to be researched.
In fact, it is telling that investment in many of these alternatives is stagnant today, when we have recently seen prices peak at $147 and often run above $30 per bbl. for extended periods. The reason is that the people looking to make investments understand that such high prices are not reliable today and that those investments are currently very risky.
Where the demand side of the equation is concerned, optimism about an uninterrupted and sustained growth in fuel use in China, India and other developing nations tend to overlook the enormous uncertainties behind those assumptions. The unrest in the Middle East, a projected growth region, highlights that in a very clear manner. The current unrest could break positively for economic growth, or have the exact opposite effect.
The economic/social disparity in China is enormous, creating a significant potential for future unrest.
According to a March 7, 2011 article in China Daily, 150 million people live below the United Nations' poverty line of one dollar a day. That represents about half the population of the United States. The article noted that the World's Children report by the United Nations Children's Fund placed China's national income per capita in 2008 at $2,770, which is the same as, if not lower than, the average for all developing countries worldwide. People living on $1 a day are exposed to the growing middle and upper classes that have extraordinary wealth by comparison. And at the same time, many of the protections and personal security the poorest Chinese enjoyed under the traditional Communist system – the Iron Rice Bowl – have disappeared. Will China be able to navigate what will invariably be a growing sense of class resentment?
Similarly, the Chinese economy while appearing to be an economic tiger by some economists and pundits is also seen as being shaky and uncertain by other economists.
Economically, the Chinese manufacturing-economy is currently beholden to western consumption which is uncertain. And, as wealth expands in China, the manufacturing economy with all of its fixed costs is vulnerable to competitors that can produce cheaper. There are real estate bubbles. There is the centralized government management which can at times be effective in handling crisis situations, but that breeds inefficiencies and corruption.
On the practical side of things, the current growth in Chinese automobile ownership, and its concentration in specific urbanized areas has already overwhelmed the transportation infrastructure. There have been recent traffic jams that are measured in days -- not hours. As much as the affluent Chinese would like to own an automobile and enjoy an American style open road, it simply might not be practical.
Similar challenges exist in India and the rest of the projected high growth regions. So, as with supply, long-term demand projections are not assured. And the glass on future oil supply and demand could very easily be half full as half empty.
Does Supply and Demand Reflect Traditional Metrics?
If the fundamentals are the divers of current prices, the prices should reflect traditional metrics. Is that the case? A number of traders and analysts say that is not the case, including Dan Dicker. Dicker has been a floor trader at the New York Mercantile Exchange with more than 20 years' experience. His recognized energy market expertise includes active trading in crude oil, natural gas, unleaded gasoline and heating oil futures contracts. He is currently finalizing a book on the issue of the markets driving oil prices titled: Oil’s Endless Bid: Taming the Unreliable Price of Oil to Secure our Economy.
“We’ve seen this movie before, it's not like we haven't, and that's why I wrote a book about it,” said Dicker. “We seen this volatility-based, trader-based roller coaster ride with prices based not upon the fundamentals because you can’t argue to me that oil is fundamentally worth $150 per barrel in July of 2008 and fundamentally at $33 per barrel in March of 2009. Supply and demand curves do not move that fast.”
Dicker noted that a fundamental thesis is needed in order to get the investors and traders to jump into the game. “You can look at something like natural gas which does not have any fundamental reason to be bought—the supplies are enormous, demand is down they are finding new technologies to drag more and more out of the ground every day – and it just doesn't get the excitement of traders out there right now. And it pretty much trades flatly on a fundamental basis. But if you look at anything else that offers even the smallest thesis for investing in it and the stuff doesn't go up 10 percent it goes up 80 percent or 100 percent and that includes oil and food commodities. Has there been a drought in Russia, yes. Has there been a slightly weaker cotton output from China and India in the last year, yes. Has there been a small problem with output in coffee supplies in South America, yes. But have they been equivalent to a 100 percent price rise in these things, I would argue no.”
Peter Beutel is the president and chief editor of Cameron Hanover, Energy Risk Management Services. He is the author of Surviving Energy Prices, A Comprehensive Guide To Navigating The Energy Markets In This Volatile Environment. Beutel noted in the December issue of Fuel Oil News: “We have more oil than we’ve had in probably three decades. And if it were not for our good friends – investors – I believe the price of heating oil should be somewhere between $0.50 and $1 on the wholesale level based upon the fundamentals we are seeing right now. The fundamentals are worse than in 1986 when we reached something like $0.30 cents per gallon. But in any event that is not our reality.” At the time, New York harbor heating oil futures were averaging about $2.50.
Speculation on Speculation
If supply and demand are not the primary drivers in price volatility and excessive pricing what is? As already touched on, to many oil analysts and traders, the answer is simple: Speculation. Or perhaps it would be best to use the term investor or invent a term like “investulator.”
Speculation has been a traditional and needed component of the markets back to their founding to provided needed liquidity. However, in recent years there has been an unprecedented move of major institutional investors into commodities to balance out portfolios or as a hedge against inflation. This is a relatively recent development that correlates well with the departure of oil prices from what have been traditional metrics relative to supply, demand and inventories. Huge amounts of money has moved into the markets at the same time there started a notable and steady increase in price. And the commodities markets are small enough that it doesn’t take much money to swing the price.
“Some 30 years ago there was a professor who told everybody that you needed to have 10 percent of your portfolio in commodities,” said Beutel. “Everybody heard it at the time and thought, ‘Gee wouldn't that be great.’ And a company, that I will not name, started pushing this idea in the 21st century and started getting a lot of traction with the big unions and sovereign debt and well-heeled investors. And to make a long story short you started to see a number of people with huge bank accounts starting to put 10 percent of the money into commodities.”
Michael Masters, managing member/portfolio manager, Masters Capital Management, LLC, was one of the first voices to highlight the impact of speculation on commodity prices – particularly oil – and outlined the mechanism during his testimony before the Senate Committee on Homeland Security and Governmental Affairs on May 20, 2008. “I think speculators that are buying the index funds for instance are buying crude and other commodities for reasons that don't have anything to do with fundamentals at all,” he said. “There are 25 commodities in the Goldman Sachs Commodity Index and I would imagine if you asked the average portfolio manager holding that index to actually name those 25 commodities he or she could even name it. They are buying it because they think that commodities are diversification or an inflation hedge or whatever.”
Masters noted that the fundamentals argument is dominant in the media because the media has to have something to report, yet reporters and commentators are not privy to what is really going on in the markets relative to price swings. “If predator hedge fund goes out and (makes a major buy) and drives the price of crude up $3 they're not telling anyone. And in fact that is proprietary information. So the press is never going to know about that, although there can be rumors.”
The mid-2000s is generally seen as the point where the influence of the new class of investors/speculators began to have a level of influence that distorted traditional metrics. Exactly what had changed that could account for such a shift in market dynamics?
Professor Michael Greenberger, was another figure out in front on the issue of investor/speculative activity significantly impacting oil process. He testified several times on the issue in June of 2008 before Senate Committee on Commerce, Science, and Transportation. Greenberger is the founder and director of the Center for Health and Homeland Security at the University of Maryland and a professor at the School of Law. He has extensive experience with the energy markets and in 1997 became the director of the Division of Trading and Markets at the Commodity Futures Trading Commission. In that capacity, he was responsible for supervising exchange traded futures and derivatives.
Greenberger noted in his Senate testimony that the influx of these speculators came about because of changes to the Commodity Exchange Act by the passage of the Commodity Futures Modernization Act of 2000 developed during the final days of the Clinton administration. This created the “Enron Loophole,” so named because Enron pushed for it, which allowed the option of trading energy commodities on deregulated exchanges such as the Intercontinental Exchange (ICE) a “foreign” over-the-counter swaps market.
An additional result was that Wall Street banks were exempt from speculative position limits when those banks hedged over-the-counter swaps transactions as the CFTC’s classification scheme counts all speculators accessing the futures markets through the Enron Loophole as commercial rather than non commercial. This results in two notable impacts: it distorts the analysis of what is and is not a commercial participant when analyzing the impact of potential speculation on the market and it allows for highly leveraged trading that creates a casino atmosphere.
The first point is important because those arguing against speculation as having an impact can cite a balance between commercial and non commercial participants that does not exist in reality. Instead, Greenberger noted in his testimony that anywhere from 70 to 90 percent of the trading activity would be considered non-commercial.
The second point helps drive the action. “People like to play commodities because they like the leverage,” said industry fuels marketer Sean Cota, president of Bellows Falls, Vt.-based Cota & Cota and a leading figure in the industry’s role fighting for trading reform. “The standard leverage is 200 times. So if you get a 4-x account you can get 200 times leverage. And if you have a really good balance sheet it's not unheard of to get 400 times leverage. Try this at your local bank. Tell them you are pretty good gambler and you have $1000 in your pocket and asked them to front you $200,000 for Vegas. See what the response is. And in energy, if you are very sophisticated, you can have almost infinite leverage. You can lose your company in a matter of days or make huge amounts of money and that's where Wall Street has made all of its profits.”
The wariness of excessive speculation in key commodity areas like food and energy is hardly new. Greenberger noted that it was understood going all the way back to the Great Depression that futures markets would not function effectively and would not reflect supply and demand fundamentals if they were overwhelmed with speculative activity that is principally concerned about price direction rather than hedging for purposes of protecting price position. “What's happening is that essentially in the last 20 years the limits on speculation in the futures market have been eaten away in a fashion that really promotes investment products that are based principally on betting on the direction of prices – mostly on an upward price movement – and those people that are engaged in selling those investments need to lay off the risks and they are laying off their risks by buying long in commodities markets,” he said. “The pressure for buying long contracts is driving the price of futures contracts upward and in turn driving the spot price. When you get enough momentum going in an upward direction it's almost unstoppable and I think that is where we are right now.”
That behavior has also translated to the commercial side. Greenberger noted that commercial players are now trying to hedge their position by abandoning traditional futures markets. They are turning to swaps or over-the-counter market because they expect better performance. In his opinion and they think that is the answer – they think that they’re going to do better in a swaps market than the futures market and they are just jumping from the frying pan into the fire.
Is It Even a Good Investment Strategy?
Does the current interest in commodities represent a sound investing strategy? That depends upon the player and likely the commodity. For the investment banks it’s a winner. For the investors caught short at the end of the party without the proper risk management it is a loser.
And, even when things are rolling along it is likely not much of a winner. “It's a horrible investment for these guys because it is a direct transfer of wealth from pension funds to Wall Street,” said Masters. “Anybody who's doing cash and carry with these markets in contango ( when the futures price is above the expected future spot price) you pay a huge amount of storage every month so it's a silly investment, but people are still doing it. With all of the talk about how great they are last year I think they were up about 2 percent of 3 percent on a total return rate. Commodities broke 20 percent or 30 percent but it was eaten away by the contango in these markets.”
But the ultimate loser is the consumer. “The banks very rarely take positions in securitization and the mortgage crisis was one of the few times they actually had a lot on their books,” said Dicker. “The banks trade and hedge themselves and in the end the ones that take the brunt of the cost of all of these hedging operations are the consumers. They are the ones that ultimately pay for the costs and risks inherent in all of the stuff.”
Arguments Against Speculation
During that 2007 – 2008 timeframe the EIA, and the Bush administration, downplayed the idea that speculation was playing a role. EIA is currently less sure about that however it still generally sees traditional market factors as the primary driver in oil prices. However, the EIA Senior Economist Tancred Lidderdale did note that the run up of prices in 2008 and the following collapse are difficult to explain relative to traditional factors.
There are a range of studies out on the issue (and more currently being conducted) that could be used to support either side of the argument. The Commodity Markets Oversight Coalition issued a recent press release noting that over 50 recent studies, many conducted in regard to the commodity price bubble of 2007-2008, supported the notion that, “Unprecedented volatility and price bubbles in commodity trading markets are most likely due to financialization and excessive speculation, and not necessarily economic fundamentals of supply and demand….”
A variety of investment banks, including Goldman Sachs and Morgan Stanley and the Securities Industry and Financial Markets Association, were unsuccessfully attempted to be contacted for specific comments contradicting these claims. This was not unexpected as other writers have commented on having a similar experience when covering the issue when trying to get a counterpoint for articles covering speculation concerns.
Despite the current lack of feedback, a variety of arguments were made particularly during the run-up in prices in 2008 that cited speculation played a minor, if any role in prices. Unfortunately, or perhaps tellingly, since the price collapse that occurred after those peak prices were reached there has been very little published countering the speculation as a significant factor.
Using the older material, notable counter points to the speculation argument were presented by New York Times columnist Paul Krugman, The Economist, Forbes and numerous bloggers (typically building upon the major published rebuttals). The anti-speculative arguments were basically that the futures markets, by their nature, should not influence the spot markets directly; that with speculation you would have seen an increase in inventories as product was taken off the market and stored and there was no evidence of that (in the 2008 run up timeframe); and that the futures market is a zero sum game: “for every buyer there is a seller” and that there is a downward push on spot prices every time that future is sold.
Oil analysts and traders respond that these highly academic observations do not reflect the reality of the markets, particularly where petroleum is concerned.
For starters, the direct linkage of the spot price to the futures market was decided several decades ago as the futures market was specifically chosen as the price discovery mechanism for major end-user contracts. “The long-term crude contracts between refiners and oil-producing entities tend to be based upon a plus or minus one of the major contracts like Brent or WTI that is where you get the most direct linkage between the futures market and the day-to-day spot price,” said Beutel.
In fact, if anything, today the swaps market is now in the driver’s seat where setting prices are concerned. “There are a number of things that have changed in the way the futures market operates in 25 years that I've been engaged with in it,” said Dicker. “The first thing that has changed is that when I started in the 1980s the cash market was the prime mover of how futures traded. In other words, if demand came into the cash market it would drive futures higher and demand sapped its way out of the cash market it would drive futures lower. That has entirely reversed itself. At this point, the futures market drives the price that people are forced to pay on the spot market and that is been seen most clearly, not in oil, though it's definitely there, but with the grains. That's gone a third level. The swaps market has gotten so large that in fact what is happening in OTC derivatives is now moving the futures market, which then controls the cash market. So if you think about the tail wagging the dog, this is like the hair on the tail wagging the dog. The growth in over the counter derivatives in oil has just been jaw-dropping with little to no governors, or price controls or anything. Nobody really knows, but the last estimate was about $4 trillion worth of nominal value on oil alone out there.”
Inventories were not seen to build due to demand destruction and the physical stockpiling of product among speculators during the price run up in 2008 as would be expected academically with excessive speculation. In the first case, demand is fairly inflexible with petroleum as transportation use is fairly inflexible. Demand destruction does (and did) occur, but in relatively delayed and gradual way. As for the stockpiling of inventories, that’s pretty inflexible as well.
“The storage argument is based on true and fundamental economic laws but what economists fail to understand is what people in the oil markets know—storage is an inflexible commodity,” said Dicker. “There is a certain amount of storage that is basically being used almost all of the time. The differential between how much storage is available and how much is being built at any one time is very tiny compared to what is being used. And building additional storage and storing oil is something you cannot do in 3 seconds flat. And from an investment standpoint, the fact that it's a very good business right now does not mean it’s going to be a good business three years from now or five years from now.”
Further, outside of the Western world it is difficult to track what has been happening with storage. Anecdotally there are indications that physical product has been put in storage, in some cases floating in tankers. And storage does not have to take place above ground. “You can leave inventories in the ground,” said Masters. “And one of the things you have gotten because of that is the state of almost permanent contango in many of these markets. And in my mind that's indicative of the large pools of money that have used crude oil as an asset class. They're never going to take delivery. You can do a swap with somebody with inventory in the ground and you would never see those inventories because the pension funds never take delivery. They are prohibited by contract from taking delivery and in cash and carry that's exactly what people do.”
Another argument is that “for every buyer there is a seller” and that the process is a zero-sum game. That, too, tends to be more academic than reality.
“They're right, for every buyer there is a seller, but you have to find them,” said Dicker. “Because, overwhelmingly, the people who are entering the market want to buy. So how do you scare up sellers, how do you find them? There is only one way to get a seller to sell something that they don't want to sell and that is higher prices. They have to bid it up. The banks do a tremendous job of this they trade off of this stuff and they hedge against all sorts of things—the stock market, bonds, other commodities, other grades, physical outlets—but the bottom line to all of this is that what's coming into the market is an inflow of buyers. And in essence the pool of sellers is something you have to create on the backs of people who want to play. It doesn't go one way, it goes in fits and starts, but those are the influences that are impacting the market over time. They want to argue that in the end the market takes care of itself. You can argue that but I disagree. What you cannot argue in any way shape or form is that it creates an enormous amount of volatility unnecessarily.”
While it is difficult to find an argument today that disclaims speculation playing a significant role in oil prices, you can readily find arguments that speculation is merely a helpful tool and that prices might be out in front of reality, but that they are preparing and easing society into the rapidly approaching time where these prices will be a reality. As noted previously that itself is debatable. Another argument, and one with considerable merit, is that you should not blame speculators as much as you should blame monetary policy. With the looming debt crisis there is a realistic concern that the Federal Reserve solution will be to devalue the dollar and generate inflation. This takes the investment beyond mere portfolio diversification and into an active and preferred investment strategy.
“In 2007 Ben Bernake started to give us an introduction to himself just as oil prices were starting to selloff from the previous summers high of $78 and change,” said Beutel. “At that point he let everyone know that he was going to let interest rates stay at a particularly low level and from there oil prices broke above the $78 dollar level and kept going up to $147. Since that time, he has been extraordinarily thoughtful and considerate of the people on Wall Street and made sure that they don't ever have to guess what he is thinking or planning on doing. So we now have things like quantitative easing and if you look back in September when he started to float the idea oil prices began moving up rather substantially from that point.”
Is Regulation the Answer?
If excessive investment and speculation are the problem, then what is the answer? While the industry typically is not a fan of regulation, a compelling argument can be made to return the markets to where they were at more than a decade ago with a greater focus on the true commercial players with a return to with position limits, greater transparency and oversight. The Food Conservation and Energy Act of 2008 made some inroads in this effort, but failed to substantially address the Enron Loophole.
The next, and most serious step, was undertaken with the signing of the Dodd-Frank Wall Street Reform and Consumer Protection Act on July 21, 2010. The energy portions of the act were spearheaded, in large part, by the New England Fuel Institute and the Petroleum marketers Association of America and the Act passed in the face of tremendous lobbying from the financial industry. Some energy-related specifics of the new law include aggregate position limits on speculative oil traders; mandated clearing of OTC commodity derivatives; exemption of end-users (petroleum marketers for example) from clearing and margin requirements if they are doing so for commercial purposes; and Commodity Futures Trading Commission authority to regulate swaps, OTC, energy-related, and electronically-traded transactions by closing the so-called “Enron,” “Swaps,” and “London” or “Foreign Exchange” loopholes.
Financial institutions would also have to separate their commodity derivatives trades into a separately capitalized entity walled off from federally insured deposits. This will essentially reduce the amount of leverage speculators take in trading West Texas Intermediate crude oil, RBOB, and heating oil contracts.
If the intent of the act is fully realized in the rulemaking processes, it has the potential to greatly curb some of the speculatory excesses of the past decade. The analysts and traders contacted for this article cited they became involved with the issue on their end when they realized the impact it would heave on the American economy and the true commercial market participants. Those that were asked for the article, and most were, had unanimous support for the energy provisions of the Dodd-Frank Act.
“The people who are involved in this are doing really good work,” said Beutel. “They are trying desperately to try and prevent these huge investors and investment funds from swamping the commodity and destroying a number of end-user businesses. How do you afford margins in a market that's moving so much faster and so much quicker and make so much less sense? How do you lock in your supplies or hedge your demand when you have people that are looking at the euro or equities or the latest piece of economic data and couldn't care less whether you got 30 million barrels more than you had a year ago. It becomes very difficult. This is absolutely very necessary and needed work and I support them wholeheartedly. I have never in my life before, probably never will since, been a supporter of regulation, but in this case it is vital.”
However, the Act continues to facing tremendous headwinds from the financial lobby as it enters the rulemaking process. Dicker is less than assured of the outcome. “I don't think it can happen, “he said. “I've seen the process start in July and I've seen proposals that look very tough but I just saw on Reuters the other day they are not even going to look at position limits until 2012. They're not even going to look because they've just gotten buried and they can't get anything approved. They know it. They say they're going to wait for swaps reportage in the third quarter of 2011 and that's really kicking the can down the road because the legislation basically said you had to have the rules in place by the end of this month for energy. It's disheartening.”
Michael Greenberger is a bit more positive, though we may have to face another price crisis (perhaps the current one) to push it over the edge. “I fully expect that if gasoline goes over $4 you're going to see a repeat of what happened in the summer of 2008 where the American public is going to demand results, and I think the there is a strong likelihood that there will be a push in Congress and possibly from the Obama administration to impose position limits,” he said. “In the summer of 2008 it was the threat of speculative limits that drove prices down. I don't think the threats are going to be enough this time, and I think that if gasoline is over $4, and maybe even approaching $5, as the next election season comes up that incumbents will be in danger, and at that point, they will know that the only thing they can do is drive the speculation down. At that point, it will not just be increasing the price people have to pay for gas, but it may break the back of the recovery and all incumbents will be in problem situations whether they are Republicans or Democrats.”