The problem with futures speculators is that they have no interest in anything other than buying and selling paper. How they do this is often a matter of whether they have enough money and influence to control market activity.
Thomas E. Brewton’s recent commentary on oil prices addresses everything except one extremely important item; the role of speculators in the marketplace. While there are many economically based reasons why prices can rise in a competitive market, none of them satisfactorily explain why oil and gasoline prices have risen at the rate they have. The amount of increasing demand might cause the price to rise gradually over time, or at an increased rate over what might otherwise occur, but not as fast as we are seeing. Chinese and Indian demand may cause upward pressure on prices, but not sufficient pressure to cause the increases we have seen.
Analysts have pointed to increasing tensions over terrorism, and the Iranian situation as reasons for price increases. This in turn points us to the cause of the problem. The market for oil is being driven by expectations, by manipulation, and by people who are anticipating the possibility that at some future date there will be a shortage. In a real shortage prices will rise due to the supply and demand relationship. What we see now is not a shortage. Oil is still being supplied to the international market in amounts as great as ever. It is not the market, but what people think about the market that is making the difference.
A similar phenomenon occurred in California’s real estate markets during the last several years. It began when speculators began to enter the market buying land and houses for cash, at above market prices. This simple fact created two distinct effects. First, it created comparable properties used in appraisals that were above what would otherwise be the normal market price. Second, because the buyers were paying cash, rather than borrowing, their purchases were not subject to bank underwriting or appraisals. They were able to pay above market prices because they had bypassed bank underwriters who would have declined to lend because the property was being overvalued.
With cash sales providing the basis, appraisers began increasing their valuations of properties. This, in turn, allowed banks to lend larger amounts, and realtors began soliciting people to buy and get in on the real estate boom. Speculators continued to participate, making money on the artificially inflated prices, feeding and feeding on the expectations that the market would continue its phenomenal rise. The situation was similar to what occurred in the stock market during the Roaring Twenties, just before the Crash of ’29. Of course, the real estate boom didn’t last forever, and prices in California, and other places that experienced similar price runs, have cooled off. There hasn’t been a crash, thank God, but you can expect that the speculators have gotten out of the market before one could occur, and this has helped to bring things back closer to reality.
Now, what does this all have to do with the price of oil? What many people aren’t aware of is that oil is subject to intense trading in commodity futures markets, and while some of us may recall the commodity brokers who were advertising heating oil and gasoline futures on the radio a few years back we don’t always realize the effects that these financial contracts have on what we end up paying.
Commodities contracts are not new. There is evidence that they existed as far back as ancient Rome when the people who speculated on the price of wheat imported from Egypt tried to prevent the Emperor Claudius from building a sheltered port at Ostia so that Rome could have regular shipments during the winter storm season. In more modern times they have served farmers by providing them with a guaranteed price on their produce. However, as with stock option markets, many people buy and sell these contracts without ever having any interest in buying or selling the underlying commodity. They settle everything in cash, and are banking on market expectations natural disasters, or other phenomena to move the price in the direction, which will give them a profit on the paper. This is true of pork bellies, coffee, gold, soybeans, international currencies, cotton, orange juice, sugar, wheat, crude oil, heating oil and gasoline.
The problem with futures speculators is that they have no interest in anything other than buying and selling paper. It is in their interest to buy at a low price today and sell tomorrow at a higher price. How they do this is often ignored, and while many people believe that it is a matter of luck or ability to predict market forces, when you are dealing with people who have enough money and influence, their ability to control market activity and pricing may be the most important factor. George Soros has been linked to questionable international currency deals where he manipulated the market through the volume of money traded so that he could make a profit. On occasion it has also been suggested that highly placed people in oil exporting nations have started rumors in order to personally benefit from changes in oil prices. In some respects futures contracts can dictate to the market what prices will be paid for a given item. When futures traders are betting that the price of oil will be $100 per barrel next week, oil dealers will try to get the highest price possible will move their asking price to follow. Buyers, such as oil refining companies that make gasoline have little choice but to buy at their price, unless they are holding options or futures contracts allowing them to buy at a lower price. For this reason many oil companies have whole departments devoted to commodity futures trading in an effort to protect themselves. It doesn’t always work. On April 24 Neil Cavuto and Gene Henssler appeared on Sean Hannity’s radio program where they explained that gasoline sales generally average between eight and nine cents per gallon markup at the pump. Compare this to the fifty or sixty cents in gasoline taxes collected by the government, and it is easy to see that markup is not a major factor in the price increases. Backing off taxes would help, but so would suspending futures trading, or barring trades settled in cash, rather than actual oil or gasoline. Regardless, at bottom line we must also address our own failure to continue producing oil at home, our counterproductive attempts at using corn ethanol, and our failure to find alternatives. In Texas an independent candidate for governor, Kinky Friedman is promoting “biodiesel” which may be an offshoot of the notorious “Anything Into Oil ” article in Discover magazine a few years back. Chemist Paul Palmer doesn’t seem to think it is practical.
Whatever happens, one should hope that if the price of oil stays high enough long enough, someone will find a substitute. High prices are often the mother of invention, or what makes an invention economically useful to the benefit of everyone concerned.
slaib@intellectualconservative.com
http://intellectualconservative.com
Read more articles by Steven D. Laib
[…] The cost of crude oil is also affected by conflict in oil-exporting countries, such as the Arab oil embargo of 1973. This most recent spike is caused by supply disruptions in the Gulf of Mexico and Nigeria. A correlating effect is caused by oil futures speculators who bid up the price of a barrel of oil whenever relations with oil-exporting countries sour, such as the current dispute with Iran over uranium enrichment and our increasingly poor relationship with Venezuela. […]
Pingback by The Loft » Blog Archive » The Real Reason Why Gas Prices are Increasing | May 1, 2006
Steven,
You are right that speculation (as in: those who manipulate the market to make a quick profit) plays a part in driving up the cost of oil, but not as much as you'd think. All my researches into this indicate speculation plays a minor part, at best. What appears to drive it far more is uncertainty.
Last year several things sent the price of oil spiraling upward: lost production from Kuwaiti oil wells, hurricane damage, political uncertainty, and Asian economic expansion. Of these, the last has had the most effect and is anything but uncertain. Asia is growing fast and gobbling up all the reserves. Asian growth has been squeezing the market for many months. Then, early last year, we began getting reports the Kuwaitis were having problems meeting their quota. Because the Kuwaiti wells are near sea level, they've been getting salt water seepage contaminating some wells and shutting them down. This is a situation that was anticipated but not corrected for by developing new wells or exploring for new sources. Later the same year, we had two hurricanes damage our own production, forcing greater reliance on foreign oil. Concurrently, Venezuela’s strong-man decided to take advantage of our dependence to hurt us. What advantage he thinks he’s deriving from this is unclear other than thinking he will turn a greater profit than did OPEC when they tried the same thing back in the 1970’s. This will net him a short-term gain, but long-term loss.
As always, two things drive the real price of any commodity: supply and demand. Speculation may cause some minor ripples (hugely profitable to speculators operating on small margins on high volume, but not really very big). Both supply and demand are going through a major adjustment just now, and that’s why we’re getting this huge spike.
On the supply side, we are getting a lot of panic and claims that we’re seeing the end of cheap oil. That may be true or it may be false. We’ve seen this kind of alarmist speculation before. The Kuwaiti development seems to tell us some of our key sources may be all but exhausted. But are they? And, if they are, are there no other sources that will serve to keep things going. Oil companies tend to explore for new sources only when driven to. Exploration is costly and risky, and is too often undertaken only when a supply crisis hits us. Twice in the past, we heard the well was dry only to find there was more oil no one had bothered to find. We’re at another of those crossroads now, and oil men and investors are deciding if now’s the time to explore yet again. I expect we’ll see the price climb until a couple of new sources are located and developed that will keep production meeting demand. Likewise, new refining capacity will be developed to meet the needs of Asia.
Barring new sources, we still are a long way from bottom. Oil-shale and tar-sand (sour) oil have lain largely undeveloped because they’re uneconomic relative to sweet oil. With rising prices, we can expect someone will take an interest in finally developing those assets to keep up with demand. Sour oil is harder (more expensive) to get out of the ground, crack, and refine to get the same mix of products; which is why it has remained relatively undeveloped. After the known sources, there is oil in the ground that is deeper, more compact, and under hard rock that we will surely extract before we truly reach bottom.
Until these other assets are developed, supply will remain tight and prices high. As they come on-line, prices will fall to something more in line with past pricing.
Comment by Bob Stapler | May 27, 2006