This is a guest post by Derik Andreoli, Senior Analyst at Mercator International LLC (firstname.lastname@example.org)
Never trust a politician to explain oil prices
I believe in markets. I believe that when supply falls short of demand, prices increase, and in doing so, send signals to consumers to conserve and producers to invest. I bet you agree.
Yet, when it comes to the price of oil and fuel, a significant portion of the population believes that Wall Street speculators are responsible for driving prices above the level supported by the fundamentals of supply and demand. While this explanation may be politically expedient, it reveals more about the politicians who have been promoting it than the oil market itself.
Shortly before penning this article, seventy members of Congress signed a letter addressed to the Commodity Futures Trading Commission (CFTC) urging the agency to lower position limits and increase margin requirements. Position limits cap the number of open trades that a single firm or individual can take, and margin requirements are the amount of collateral that must be posted to protect against credit risk.
Position limits can conceivably have some effect on the market-moving power of an individual institution, but to date nobody has demonstrated that this power currently exists. Lifting margin requirements, on the other hand, is like using a screwdriver to hammer in a nail. Margin requirements are tools for managing credit risk. They are not designed to dampen prices or minimize volatility. More importantly, increasing margin requirements will disproportionately impact traders with less capital, thus concentrating power in the hands of the larger players.
The letter further urged the CFTC to “utilize all authorities available to…make sure that the price of oil and gasoline reflects the fundamentals of supply and demand.” To borrow the language of the Dodd-Frank Act to which the letter refers, the CFTC is being pressed to curb ‘excessive speculation’. But precisely when does speculation become excessive?
If excessive speculation is defined as speculative activity which pushes the price above the level supported by the fundamentals, the letter will fall on deaf ears.
The CFTC’s own investigation of the impact of speculation on the oil market determined that there was no evidence that the 2008 price spike resulted from the actions of speculators. Rather, the report concluded that the price spike was the result of surging global demand and stagnant production – a viewpoint which happens to be supported by the data.
If the CFTC is guilty of having deaf ears, they are hardly alone. At the request of Congress, the Congressional Research Service (CRS) studied the effects of speculation on oil prices. The CRS concluded that although rising prices are correlated with an increase in speculative positions, the line of causality could just as easily run in the opposite direction than is commonly assumed. It is not unreasonable to suspect that tight markets and rising prices lured investors to purchase oil futures.
The CRS clearly states that, “The data do not support an argument that recent oil price spikes are the result of large, sudden inflows of speculative funds.” Regarding margin requirements, the CRS further concluded that there is “no empirical evidence that higher margins dampen price volatility.”
If the actions of the seventy signatories in Congress prove anything, it is that the CRS findings have fallen on deaf ears.
So, are the market fundamentals different this time around? Yes and No.
When demand grows faster than supply, surplus oil production capacity diminishes. During the prolonged price run which culminated in the 2008 price spike, surplus oil production capacity diminished from 9% of total liquid fuel consumption to just over 1%.
The global recession which ensued pulled down demand, and surplus capacity climbed over 5%. Since the first quarter of 2010, surplus capacity has been declining, and prices have been rising. This time around, however, tightening markets have been accompanied by rising geopolitical tensions which threaten to wreak further havoc on oil markets.
Geopolitical risks are to some extent priced into the futures market, and as high as prices are today, they would be much higher if Europe was not at risk of diving into a debt-induced recession.
Rising prices suppress demand and inspire upstream investment in exploration and production. As such they are precisely what the world needs given the trend in declining surplus capacity.
So, are speculators responsible for the rising price of crude? The short answer is a qualified, yes. Speculators and hedgers collectively set the price through the positions they take on futures markets, but they are only reacting to the fundamentals. Of course, these same energy traders are also responsible for the historically low natural gas prices that we currently enjoy, and in both the oil and natural gas futures markets, trades are based on a reasoned analysis of market fundamentals adjusted to a risk premium.
Given that this is an election year, it is easy to understand the temptation to scapegoat, and Wall Street speculators make an easy target. But speculators are not to blame. They simply translate the fundamentals into a price, and they do so collectively through their trades.
The position limits and margin requirements outlined in Dodd-Frank won’t solve the problem of high prices and high volatility, though they will likely transfer some trading from the more regulated NYMEX to the less regulated Intercontinental Exchange, which is where Brent oil futures are traded.
And this brings up another relevant point. If NYMEX speculators are driving the price up, why has the price for WTI fallen against Brent? The answer is simple. Speculators are reading the fundamentals, and the fundamentals of WTI are different than Brent.
Political grandstanding and ‘sloganizing populism’ is not only ineffective; it is counterproductive. Chasing scapegoats confuses the average Joe, which will only make intelligent energy policy that much more difficult to design and enact.
Can Speculators Profit from Declining Prices?
My motivation in writing this article is not to defend speculators or their actions. Surely there are rotten apples among the bunch, and their existence justifies regulatory vigilance. My goal is not to defend them. Rather my goal is to show that speculators can make money when prices fall just as easily as when they rise, thus the entire premise that speculators are to blame for high prices and volatility is called into question.
A secondary goal is to shed light on the so-called evidence upon which the market-manipulating speculator theory is built. National statistics regarding oil inventories, oil production, and the balance between imports and exports do not reflect the global conditions which drive prices.
Sen. Bernie Sanders’ recent statements reflect a common misunderstanding regarding how oil traders turn a profit. Sen. Sanders mistakenly believes that, “The function of these speculators is not to use oil but to make profits from speculation, drive prices up and sell.”
In the context of the interview from which this quote was pulled, it is clear that by ‘up’, Sen. Sanders means a price above that which would be justified by the fundamentals of supply and demand. Clearly Sen. Sanders believes current prices are not supported by the fundamentals. The fact that global demand continues to grow despite rising prices proves that he is wrong. Prices are, in fact, well-supported by the fundamentals. If they were not, we would see demand destruction.
Regarding demand destruction, while gasoline consumption may be on a downward trend in the U.S. and Europe, demand destruction in advanced economies is more than made up for by rising consumption in emerging markets. And this is precisely why the U.S. has become a net exporter of diesel and gasoline.
The U.S. achieving net exporter status has been interpreted by some as evidence that the world is awash in oil, and therefore the high prices must be part of a big conspiracy orchestrated by Wall Street. The truth is less fantastic. Foreign consumers are simply willing and able to outbid U.S. consumers.
While U.S. crude oil and product inventories are high, the U.S. surplus is driven by two factors which are not widely comprehended, and European inventories have been hovering near decadal lows. Those in possession of the physical commodity have every incentive to store it when prices are expected to rise (i.e. when the market is in contango). Why sell today when the price will most likely be higher tomorrow?
In addition to being impacted by the expectation that prices will increase, U.S. inventories have been impacted by the recent boom in production of Canadian Syncrude and Bakken shale oil production that has overwhelmed the oil transportation infrastructure and the capacity of local refineries to process the crude.
No conspiracy theory is required to explain the inventory rise.
More importantly, while it is true that speculators are driven by the profit motive, speculators do not need prices to rise in order to make a profit. They just need prices to change – to move up and down – preferably while following an identifiable trend.
To be clear, a futures contract is an agreement to purchase a defined quantity of a commodity to be delivered on a predetermined date for a specified price. ‘Going long’ or taking a ‘long position’ describes the act of buying a futures contract. Traders can of course earn a tidy profit by purchasing a futures contract, but only if the price rises above the level specified in the contract. If the market price falls below that level when the contract reaches expiry, the trader will lose money.
What seems to be lost on Sen. Sanders and others is that traders can also profit from taking a ‘short position’ – by betting that prices will decline. If a trader believes the price is going to fall, they will sell a futures contract, and if the price does indeed fall, the trader can then re-purchase an equivalent quantity of oil for less money, pocket the difference, and play another round.
In addition to going long and going short, oil traders have another option. They can also take a spread position in which they simultaneously buy and sell futures contracts. There are a number of common spreads, including crack spreads, arbitrage spreads, relative value spreads, and time spreads. The vast majority of the increase in futures trading over the last decade has been concentrated in spread positions.
To understand how a spread works, imagine that you are a trader and you believe the price of heating oil is going to rise relative to West Texas Intermediate crude. In this case you would play the crack spread by shorting WTI and going long heating oil. If the spread increases, you can then sell heating oil then re-purchase an equivalent amount of WTI for less than you sold it, pocket the difference, and play another round.
It is important to understand that this isn’t really a bet that heating oil is going to rise in absolute terms. Rather, a profit will be made so long as the price difference between heating oil and WTI increases, which can happen even if the absolute price of heating oil falls.
As you can see, traders can profit when prices decrease just as easily as when they increase.
Furthermore, pointing the finger at speculators ignores the fact that there is a trader on both sides of every transaction, and as a consequence, whatever one trader gains, the other loses. Only the trader that correctly forecasts the direction that the market is going earns a profit.
We can pull two important conclusions from this. First, Sen. Sanders insinuated that speculators are motivated to manipulate the market, drive the price up, and sell. Of course by the same logic, other speculators (i.e. those with short positions and many of those playing the spread) would be motivated to drive the prices down.
Think about it, if speculators could control the market, they could make just as much money by driving the price below the level supported by fundamentals, then selling when the price bounces back up.
This brings us to the second point. Prices are not random. Market fundamentals exert a strong pressure on every commodity. This is true even in uncompetitive markets. Consequently, every trader has the incentive to gather, analyze, and interpret as much information about the market fundamentals as can be garnered.
The real problem with the oil futures market is that the information available to oil traders (hedgers and speculators alike) is often poor or incomplete, and sometimes the most important factors are unknowable (consider production forecasts for Libya, Iraq, Sudan, or any number of other unstable countries).
In short, every trader evaluates the information at hand to determine whether markets are set to tighten or loosen. Because every transaction requires a buyer and a seller, every transaction reflects the fact that the buyer and seller have opposite opinions regarding where the price is likely to go. This may sound crazy or chaotic, but this process ensures that the market price reflects the collective wisdom of the group. In a way, each purchase/sale represents a vote, and the price is set democratically. There is no better, more reliable, or more robust way to determine the value of oil to be produced and consumed at some point in the future.
– Derik Andreoli