Wednesday, June 11, 2008

Do Speculators Cause Oil Price Inflation?

Previously, the esoteric notion of speculators as a predatory investor class was discussed. Many of these institutional investors and pension funds are acting as agents of retirees, public servants, and individual investors in their quest for greater diversification and higher returns. The media has demonized this anonymous notion of speculators while presidential candidates have proffered images of exploitive hedge fund managers that earn billions in fees while Americans suffer at the pumps. Somewhere amongst all this noise lies the truth.

There are two markets for oil that differ in function, but are intrinsically related. The spot market is a delivery market with the spot price representing the current value of oil flowing from the giant oil tankers offloading their black gold in Texas, New Orleans, or other major refining centers. The futures market represents contracts for future delivery of oil consistent with a certain quality level. Futures prices and spot prices often differ, but due to arbitrage relationships are related based on the factors of storage costs, interest rates, and the convenience yield (the current value of holding physical oil vs. oil for future delivery). As the expiration of futures contracts nears, all of these factors become less relevant and the futures price and spot price must converge.

Speculators’ influence on spot oil prices is dubious at best. Ultimately, on any given day, the supply and demand for oil determine the market price. The large sunk costs incurred by previous capital investment in vehicles, power plants, machines, and equipment that require petroleum for fuel results in highly inelastic demand for oil (i.e. a relatively low impact on demand with changes in price). While oil prices have risen well over 100% in the past year, recent reports suggest that fuel consumption in California has only dropped 4% year over year.

With the inelasticity of demand established, consumers plead for additional supply. The large capital investments required to locate oil reserves, build oil wells, and construct pipelines for delivery necessitates long lead times before new production can be brought online. A strong opposition to domestic drilling has further exacerbated this growing problem over the past 5 to 10 years. Currently, supply and demand are in such fragile balance that small shocks can send oil prices soaring (or plummeting).

Speculators, characterized as investors with no intent on taking delivery, have little impact on the market price of oil. If the futures contract expiration date nears and futures are trading rich to the spot price, a speculator could buy oil in the spot market and sell oil futures. When the contract comes due, the speculator would deliver oil to the counterparty of the futures contract, which would be an actual oil consumer. This arbitrage will occur until spot prices and futures prices converge, effectively clearing the market based on supply and demand. Conversely, if spot prices are rich to futures, oil producers would want to sell oil in the spot market at higher prices. That increase in supply will drive spot oil prices down forcing convergence with futures prices.

Ultimately, spot market supply and demand will determine prices in commoditized markets such as oil. The only means of reducing oil prices is to enact structural changes that reduce the demand for oil while concurrently investing in additional supply. While alternative energy sources may possess long term promise, the degree of research and development as well as infrastructure required to support these new technologies ensures that widespread integration is decades away. It would be much more prudent for Congress to avoid meaningless witch hunts and hearings about “excess profits” and instead learn from their prior mistakes by crafting a meaningful energy policy for America.



Courtney Anne Walker said...

Cant oil suppliers block the fut from converging to the spot? By pledging all oil reserves to future markets, essentially making supply for spot bleak and driving price of spot up. And since they hold the power, and the demand is inelastic, you dont want to get in front of it and short the future with the assumption that the suppliers will control the supply available in the near future.

JB said...

In order for the arbitrage relationship to hold, it must be possible to short physicals in the spot market. Assuming sufficient access to capital, there would be no limitation on buying oil spot and selling futures to capture arbitrage profits if futures are rich versus spot. Selling oil spot, however, could be complicated. If slack production capacity exists, an oil producer could increase production, sell oil spot, and buy futures to capture arbitrage profits when futures trade cheap to spot. While in theory this could reduce discrepancies in the future-spot relationship, there may be insufficient slack capacity or delivery constraints (oil in the Persian Gulf takes 60 days to reach Texas) that prohibit the execution of this trade.

Alternatively, a trader could borrow oil reserves to sell in the spot market to capture the arbitrage profits. If all market participants are rational, however, the financing rate for borrowing oil reserves should be virtually equal to the arbitrage profits that could be captured. The owner of the reserves could easily capture the arbitrage profits for themselves absent structural constraints such as access to markets, legal prohibition, or trading expertise. If the owner of reserves is a rational and informed market participant, it should be able to extract virtually all of the arbitrage profits if it chooses to lend the oil.

Ultimately, the ability to force short term convergence to intrinsic value is dependent on the ability short in the spot market with no supply limitations. Given the likely limited supply of reserve oil or slack production, the ability of the arbitrage trader to capture risk free profits may be limited. Therefore, spot oil could trade rich to futures persistently prior to futures contract expiration, but this is not consistent with an argument that speculators drive up gas prices as they would transact in the futures market.

FourOhh said...

Drill here. Drill now. Pay less.

According to RAND, the US oil shale contains resources three times larger than the reserves in Saudi Arabia.

Supply and demand say "hello."

Despite efforts to open the oil shale for production (and overwhelming support in states like Utah), Congress fails to act.

FourOhh said...

Cuba and China are pumping oil 60 miles off the coast of Florida, but democrats won't allow us to do the same. Florida is a moratorium state.

Excellent policy.

57% of Americans want us to drill oil here, and do it now. 42% are opposed. Congress! Wake up!

RBOB Gasoline futures were 147.80 in Feb 2006. Jun 2008 contracts are selling for 339.40.

Thanks Pelosi.