Jan 23 Blog - High Oil prices caused by China's growth

[Higgenbotham]

I saw the 60 minutes piece, I think they did a decent (although incomplete) job as hardly anyone else in the media had been explaining the role of speculation in the commodities bubble and many (like you) were completely ignoring the role of the speculator on prices. No one said speculators were the ONLY cause of the run up in prices, but they certainly stretched things to new extremes.

Its ridiculous that you think 60 to 70% of the contracts on a given commodity can be purchased by speculators without impacting price the price at all.

I happen to agree with you, but you're just making claims such as "it's ridiculous". These are claims like your claims that "they can just print money" and then showing some money supply statistics which have nothing to do with your "new" definition of printing money.

To make a case, I believe you need to show how the futures and cash oil markets are linked. My opinion, although nobody seems to be able to answer it or even acknowledge it, is that they are not directly linked like some futures and cash markets are, but are indirectly linked through the cost of the carry and for that reason speculators in the futures markets can exert upward pressure on the cash market.

What is your exact reason for making this claim?

[freddyv]

As I've stated before, I'm a big picture guy and fail to see how arguing about minutia is helpful when we know what the real cause was.

--Fred

Minute details? Trying to better understand what drives supply/demand is hardly minute.

In itself, Supply/demand is often a load of garbage (at least at the macro level or may apply under extreme circumstances - and no, the recent oil price appreciation is not one of them).

Take your point quoted here for example "I am so often amused by those that wish to suggest that oil has some special quality that makes it immune from the basic rules of economics.".

Firstly, you are the one believing oil is the exception. I see you've still failed to address why wheat, corn, etc. have crashed in price as well. Why do you ignore that fact? Why are you treating oil differently? Is oil less important than food to the human race? Or you just don't want to address it because you can't?
...
Tobyguy

Settle down, now....you seem to be attributing a lot of things to me that I've never said.

I don't think food is any different than oil. When it becomes too expensive people eat less or shop more wisely or even kill each other over it. But yes, people can start eating less. Have you seen the typical American lately?

In good times people eat much more than they would in hard times and they use more energy than they would in hard times. Critical mass may send us into the "peak oil" or "peak food" range but every commodity I can think of will correct itself at some point and reset the cycle so that we produce more or find a cheaper substitute. With oil we have dragged our feet simply because oil has been so easy to pump out of the ground. We are surrounded by energy sources that will take over from oil when the time is right and as it makes economic sense.

What I notice often is that a lot of very smart people get hung up on the details of a situation and then end up missing the bigger picture and that is what I see here. I do it myself with certain subjects but I consider it a prime rule never to break when it comes to economics.

Regards,

--Fred

[Higgenbotham]

What I notice often is that a lot of very smart people get hung up on the details of a situation and then end up missing the bigger picture and that is what I see here. I do it myself with certain subjects but I consider it a prime rule never to break when it comes to economics.

Regards,

--Fred

Fred, I think it comes down to style of reasoning and strengths and weaknesses. I see people with an enormous capacity to absorb and recall detail and draw conclusions from it, the so called inductive reasoners. Others work better with the big picture. People who are drawn to this website would probably tend to be drawn to the big picture. You could call me paranoid. I like the big picture, but I have seen inattention to details really do a number on people in economics--Refco bankruptcy as a good example. Bobby Fischer used to say that winning a chess game was an accumulation of small advantages. I read that when I was 10 years old and never forgot it.

[Gordo]

To make a case, I believe you need to show how the futures and cash oil markets are linked.

Speculation is possible without hoarding. Speculators influence the spot price by running up futures prices as they pour in money (which is exactly what was happening) creating the perception that the spot price of oil will rise. A producer can say to a buyer in the spot market, “I’ll hold onto my oil and sell it to Mr. Speculator in the future unless you pay me more money now”. It boils down to the pure cost of storage - but in a tight market no storage has to even occur, the mere threat of storage is all that is required. When it comes to oil, commercial users have no choice - they must buy when they need it at almost any price. If demand is inelastic (and all indications are that it is), then the buyer must pay a higher spot price in order to get the oil. In many cases the buyer would even be willing to pay a higher spot price than futures are trading for because they need the oil now.

Futures prices always converge with spot prices, the arbitrage traders make sure of that.

This guy explains it like this:
"In a nutshell, participants (buyers and sellers) of futures which CAN be delivered, can buy / sell the spot / future (or a mix of the two) because they are THE SAME THING, just with a different delivery dates. Think of a spot sale as a future at Time = 0. With more buyers emerging to invest / speculate, demand has increased which equals higher prices.

Let me provide a very basic example. For simplicity assume no financing or storage costs associated with the futures, thus the futures prices should always be equal to the spot (or else there is an arbitrage opportunity) and that only two dates of which the futures are available; 1 and 2 years out...

1) With no speculators; spot price = futures price at Time 1 and 2
2) Speculators (or index investors) new to the market buy at Time 2, driving up prices
3) The difference between 1 and 2 year prices are arb'd out by futures participants (ignoring cash market for now)
4/5) The spot market converges as those who typically buy in the futures market have an incentive to buy in the spot (i.e. producers or even hedge funds), while sellers who typically sell in the spot market, have an incentive to sell in the futures market and keep storing the underlying (either in inventories or in the ground)."


Thus, the actual position where futures players "invest" (Time 1 or Time 2) does not matter. What matters is the "net exposure" of their investments. Thus, rolling the position (the trading of contracts quoted above) which consists of a buy and a sell order to keep the investment in the futures market, has little or no impact on the spot price, as the "net exposure" does not change!

It is only at initiation of the new position that the demand for the underlying commodity has increased. As each day passes, more and more "investors" globally are adding commodities to their portfolios (because commodities are exploding) which increases the "net exposure", the net demand, and the price even more! "

[Higgenbotham]

A producer can say to a buyer in the spot market, “I’ll hold onto my oil and sell it to Mr. Speculator in the future unless you pay me more money now”. It boils down to the pure cost of storage.

My opinion, although nobody seems to be able to answer it or even acknowledge it, is that they are not directly linked like some futures and cash markets are, but are indirectly linked through the cost of the carry and for that reason speculators in the futures markets can exert upward pressure on the cash market.

These 2 statements are approximately equivalent. Cost of carry is interest, storage, and insurance. Purely from this standpoint, I think it boils down to what extent the producer can make good on the threat in your statement above and to what extent the buyer believes he can. In some markets, storage is virtually unlimited, and there doesn't seem to be much deviation from the cost of carry. How true that is with regard to storage in the oil market is the question, and I would guess it is to a more limited extent. The volume of oil sold every day is enormous. The SPR only holds like 89 days of US oil usage or something like that (edit--that isn't right, it holds 90 days at maximum drawdown of 4.4 million barrels per day and after that the drawdown diminishes, the capacity is is 727 million barrels and more details are the DOE website).

Futures prices always converge with spot prices, the arbitrage traders make sure of that.

Well, OK, but March is the first futures contract listed for light sweet crude. As I stated earlier in the thread, silver and some other current month futures are traded on the futures market but oil is not. But as I said, if storage is available now, the arbitragers can lock in risk free profits today (or recently anyway) by buying spot and selling futures contracts and that is not speculation if the cost of carry is less than the differential between futures and spot.

[John]

Dear Higgie,

> Fred, I think it comes down to style of reasoning and strengths
> and weaknesses. I see people with an enormous capacity to absorb
> and recall detail and draw conclusions from it, the so called
> inductive reasoners. Others work better with the big picture.
> People who are drawn to this website would probably tend to be
> drawn to the big picture. You could call me paranoid. I like the
> big picture, but I have seen inattention to details really do a
> number on people in economics--Refco bankruptcy as a good example.
> Bobby Fischer used to say that winning a chess game was an
> accumulation of small advantages. I read that when I was 10 years
> old and never forgot it.

I actually met Bobby Fischer once. When we were both teenagers, and
he was US champion, I was in NYC and decided to visit the Manhattan
Chess Club. I met him and got his autograph although, alas, I've
lost it. I played in the club speed chess tournament while I was
there, but didn't get paired with him. Lucky for me.

But the concept you're describing, "accumulation of small
advantages," is actually a "big picture" concept.

Fischer's strength was that, better than anyone else in the world, he
could evaluate an entire position and judge its strengths and
weaknesses. Then he would imagine how he'd like to change the
position so that the strengths would increase and the weaknesses
would decrease. That's when he'd get to the details -- what move to
make to get to the position he'd envisioned. Of course those
"details" are super-important too.

You're right that Generational Dynamics deals with the big picture,
and lets the details fall into place. Whether it's the Sri Lanka
civil war headed for a climax, or the economy headed for a new Great
Depression, the end result may be known, but the details may be
unknown until they occur.

However, it's super-important to get the details right, but at least
I know that if I get a detail wrong then the Gordos of the world will
write to me and tell me how full of crap I am.

Sincerely,

John

[Higgenbotham]

But the concept you're describing, "accumulation of small
advantages," is actually a "big picture" concept.

Fischer's strength was that, better than anyone else in the world, he
could evaluate an entire position and judge its strengths and
weaknesses. Then he would imagine how he'd like to change the
position so that the strengths would increase and the weaknesses
would decrease. That's when he'd get to the details -- what move to
make to get to the position he'd envisioned. Of course those
"details" are super-important too.

That's an interesting comment because my thought was that a computer program can now beat any human through number crunching details without understanding the big picture, but it may instead be because the computer is able to evaluate the overall position better than a human can as it goes multiple levels deep.

You're right that Generational Dynamics deals with the big picture,
and lets the details fall into place. Whether it's the Sri Lanka
civil war headed for a climax, or the economy headed for a new Great
Depression, the end result may be known, but the details may be
unknown until they occur.

I've thought of it in comparison to thermodyamics problems, for example, where a gas can be expanded or compressed along different paths, but the end result is the same. While some of us will say this matters or that matters, we may think it does because of the path dependency given the way that some of the parameters are fixed versus past historical situations. So I can understand how some people here can be put off by that kind of minutia. Actually, I hang here because people who talk solely within narrow limits of specialization miss the large picture, whereas everyone here does have an understanding of what that entails. You've highlighted that many times in your blog. Last night I read an article by an "analyst" who said that the only possible monkey wrench in his forecast for a long term recessionary environment would be a breakdown in free trade. Say what? Strained trade relations are a characteristic of crisis periods. How could any person make a qualification like this entering a Fourth Turning environment? He just now thinks we will go into a Depression if Mr Obama or Mr Geithner slip up on their trade relations with China. So at least we don't have to read that kind of nonsense here except when someone highlights it.

[tobyguy]

Freddyv wrote: "In good times people eat much more than they would in hard times and they use more energy than they would in hard times"

Are you serious?

Are you trying to say that corn and wheat prices crashed because people started eating less? That the demand for the key components of many of our foods is being consumed less than before?

I'm not going to take that claim seriously, because of how rediculous that claim is (if that is what you are trying to infer).

What I will say on that topic is, that people would consume less of expensive food and beverage and consume more inexpensive food and beverage (which often contain more of the basic commodities than expensive food). I would bet that people would actually consume more of the basic commodities (eg. wheat and corn) which actually make up cheaper food.

In tough times, people will trade lobster for some other meat, yes. They will trade expensive wine for cheaper one, maybe.

But to infer the claim that commodities have crashed because people are eating less of them is outright rediculous period.

Back to oil for a second. Have you noticed that OPEC decreases in supply output has done nothing to restore the price of oil? Hmm... Interesting... I guess everyone's ignored that fact - that people don't really care about OPEC's threats.

Freddy also wrote: "What I notice often is that a lot of very smart people get hung up on the details of a situation and then end up missing the bigger picture and that is what I see here. I do it myself with certain subjects but I consider it a prime rule never to break when it comes to economics"

I still believe you are failing to understand my point. The "crowd" or "social mood" is the key factor that drives prices period. Whether it is the housing market, Nasdaq, S&P, DIJA, oil, gold, silver, and other commodities. Applying "peak theories", eg. oil or population growth/immigration theories to why housing prices would go up for ever, or that corn prices rose because of farmers using their farms for ethonal production, etc., in my opinion misses the whole point to what is really behind the unprecedented price increases in all markets at the same time (or what has been phrased "all the same markets").

They all peaked at the same time (all within 1-2 years of each other, with most months of each other) because the same phenomenon was driving them all (credit flowing into all markets and people believing price increases would go on forever/positive social mood). They also all started crashing around the same time as each other, again because of the same culprits (except this time, credit contraction and fear/negative social mood). This is unprecendented in all of our lifetimes (except in deflationary times).

To your point, the only counter arguments anyone in this thread has put forward is the kind of technical minute detail that itself misses the point (margin buying, etc.)

Tobyguy

[mannfm11]

Figures lie and liars figure. If there was any long term influence by speculators in oil, they had to be taking delivery. The oil companies know where the oil on the market is and so does most of the other entities that buy it. Oil isn't like corn in that crops dont fail and it pumps generally rain or shine, save the hurricanes in the gulf and a few other temporary interruptions. My points are these. One, if there is shortage, the short isn't going to let the long out of the contract. If there isn't one, the short is going to force the long to buy the product. On the other side, the long that knows his tank is empty is going to keep pressure on the market. A spec would have an advantage if he knew the commercial longs were going to delivery and the shorts couldn't deliver. But, to say that specs won that war almost single handedly over and above the guys in the business is a reach. I don't give a damn what kind of anti-speculator, communist organization you can pull out of the closet. This is not to say that if there was a true shortage that the longs didn't get some extra money out of the game, but the point is they didn't cause this mess. Remember they are just as liable if the price goes down as they are gaining if it goes up and they have control of neither.

Remember, it only takes an awareness there is one contract worth of oil out there for the entire group of shorts to step back let the longs have the oil. Truth is that long specs were beating up short specs because they weren't beating the counter parties that had oil for sale. Those traders already had their price locked in. Maybe they wished they could have sold higher, but in general, that wasn't their goal, as locking a price was. I believe the last $30 to $50 on the run up had to do with that company that was trying to hedge its forward sales and oversubscribed its position. They had to buy themselves out once they had to mark to market. That was several billion dollars from what I recall, which can wreck havoc in a tight market. I believe the actions of the Federal Reserve and the trade deficit created the top on the oil market and that China bought oil instead of bonds.

Speculators don't always get rich. Look at the speculating going on in the gold markets right now. There is also speculation in the oil markets because there are people that believe the inflation gig. You might go to [url http://www.eia.doe.gov/oil_gas/petroleu ... /wpsr.html[/url] and examine the Excel sheet called data 2. It has petroleum storage figures since 1920. It reveals a huge storage going into the depression that just collapses as everyone is liquidated. I have followed oil prices and commodity prices for a long time. You might recall the collapse in oil prices in the late 1990's, when gasoline fell into the 90 cent or lower range in a lot of areas. A lot of people saw the price of oil because they buy gasoline, but not many saw the price of coffee, cotton and cocoa. I venture that all of these were owned as investments and stored in Indonesia, which had a literal depression in 1998 and 1999. Indonesia was and probably still is the largest consumer of cotton in the world, probably due to textile manufacturing and the late 1990's and early 2000's didn't exactly produce great cotton weather. Yet cotton fell to 29 cents a pound on the exchange. 5 cents was the all time low, set in 1905, but CPI comparison, the 2002 price was about 1.25 cents a pound, some 25% of the all time low.

It is hard to defy market forces. Corners have never worked, whether they be run by a cartel or an individual. Neither will the fake bailouts that are being done now and those betting on higher oil will find themselves helpless against such forces. There is probably 100 million barrels of oil that could be had on various markets at current prices right now, especially if the 80 million barrel tanker hoard is correct.

[Higgenbotham]

To your point, the only counter arguments anyone in this thread has put forward is the kind of technical minute detail that itself misses the point (margin buying, etc.)

Tobyguy

That could even be negated with your thesis. Reason being, let's just say that margin buying did drive the price of oil up. Your counter to that would be that the only reason that happened was because positive social mood allowed people to speculate on all kinds of things they had no business speculating on anyway, and that it was positive social mood that motivated them to get involved with it. I've read At the Crest of the Tidal Wave and, from what I remember, it would not be at all surprising if one of his predictions is that sometime during this bear market speculative futures trading will be banned. I believe it will be and no longer trade futures.