Wednesday, 9 July 2008

Oil Price Manipulation - One almost final time

Here is a final-interim look at Oil price speculation and manipulation. In due time, the reality will either prove this wrong or make life fairly miserable for all of us.

Speculation vs. Manipulation
There is a difference between speculation and manipulation. Most non-commercial actors in futures markets are speculators. They speculate in regards to where oil price might be headed by buying futures contracts and options on futures. This allows them to hedge against oil price risks in their operations. This is normal market activity; there is nothing shady about it. Further, futures market prices, however speculated, do not directly affect spot-prices. Spot price is what determines the price of oil in actual physical market or the premium over the long contract oil prices (effectively the same thing).

In theory markets can also have financial manipulation, which refers to the attempt at deceiving the market by artificially manipulating physical oil markets (i.e. physical availability or actual spot-price). This means that they would somehow control spot-prices of oil in way that does not reflect the fundamental supply & demand situation. However, this manipulation would only be possible, IF futures prices were able to dictate spot prices (we'll get to that later), or alternatively if the manipulators bought the physical oil off the market and hoarded it in oil inventories. Hoarding has not happened. This much is fact. It has been covered here and elsewhere many times. Discussion about that should be laid to rest, unless somebody has new factual data that actually differs from that already shown (ref: IEA/EIA stock/inventory data). We need data, not mere accusations.

Now, how about the manipulation of spot-prices through futures trading? Some have claimed it is possible, without really explaining how or without providing causal data that backs up this argument. The best that has been given is some correlating data that might or might not explain price manipulation, if there was an actual mechanism of causation. However, no mechanism has been proven and instead, many accusers have resorted to insinuations, factual errors and an argumentative fallacy of ‘guilty by association’.

Let us now assume that it was possible to affect spot-prices through futures prices. There’s no proof of this that I can find, in fact there is proof of otherwise. However, for the sake of the argument, let’s assume it was possible.

Unfortunately for this manipulation argument, the data does not support it.

Futures options are roughly balanced for long/short positions, thus they are not signaling the markets in any one direction:

NYMEX WTI Oil futures market has been evenly balanced for net long and short positions

Source: CTFC, Jeffrey Harris, 5/2008

Further, non-commercial actors (banks, funds, etc) have been halved their long positions in the past year, while oil price prices have doubled. Now, if non-commercial speculators - who have been accused of squeezing ICE futures markets (London), could actually control the price through long positions, then the oil price should have come down in the past year. But instead, it has gone up:

Non-Commercial speculators have bet less on price rise, when oil price has gone up

Source: CTFC/Reuters/Norges Bank, 6/2008

So, futures trades at ICEF cannot explain the rise in oil prices.

Theory of unregulated overseas markets

Additional accusations have been laid against ICE Futures (London). These are unfounded.

ICE Futures (London) has been accused of being a 'dark and regulated exchange". This is plain wrong. ICE Futures is independent party cleared market governed by Financial Services Authority (UK) and operates under a legal framework of Financial Services Act 2000 by UK law. So far, their regulatory track record is better than that of US counterparts of late (Enron, WorldCom, Arthur Andersen, Global Crossing) so that should put an end to all the silly 'dark and unregulated' accusations which are little more than fear-mongering.

Another argument has been that does not restrict the size of trader’s positions like NYMEX on oil futures. This lack of restriction appears to be correct. However, ICE Futures trade only 15-20% of WTI futures and options, rest flowing through NYMEX. There is no futures price differential between the two (ICE vs NYMEX). If there were - it would be a guaranteed arbitrage of silly proportions. Markets neutralize such imbalances rapidly.

Price manipulation & price speculation summary
There is no data that I can find that currently oil futures prices would be able dictate oil spot-prices, or that such effect – if it existed – is now raising the spot price of oil. In fact, data suggests that non-commercial futures speculative positions changes would lower the price.

Financial Fundamentals affecting price of oil
What is the effect of financial fundamentals other than speculation? Real economists have also weighed in on the matter:

Norge's Bank analysis of the situation and actual market data concludes (6/2008):
“To date, there is little empirical evidence that pure speculation has driven oil prices higher than the underlying fundamental and financial factors would suggest.” - Norge's Bank
What are these underlying financial factors? Well, Look at the correlation between crude oil prices and USD trade exchange value:

When USD value drops, oil producers raise the USD nominated prices

Source: Thomson/Norge’s Bank, 6/2008

Value of USD and price of oil almost perfectly inversely correlated for the past year

Source: TDE/IEC, 5/2008

In turn, Bank of England wrote in their analysis (6/2008):
“Speculation seems to have played a normal role along the futures curve. It remains quite difficult to explain the large rise in the oil price as due to the presence of speculators.” - Bank of England

Further, this is what several other economists had to say on the issue:
“The mismatch between unabated global desired savings and lower realized investment, between the amounts available for finance and the flow of hard assets to absorb it, has led to a liquidity glut which has pushed long term real interest rates the world over lower. This has spilled over into markets for existing real and financial assets - real estate, high-risk credit, private equity, art, commodities, etc - pushing prices higher.” - Raguram Rajan, 2006

Another noted economist Jeff Frankel has cited low interest rates as one of the most important factors for increase in commodity prices. The Central Banks have been blamed for the recent rise in commodity prices as they kept the monetary policy too loose for a long period of time. Guillermo Calvo, another renowned economist echoed similar thoughts.

In plain English: when the reserve currency of the world (USD) goes down in value, oil goes up (not necessarily in that order). Of course, we all knew that already. More importantly, correlation is of course not causation. Regardless, if somebody wants to look for guilty parties for the rise in the price of oil (in nominal USD) based on correlation alone, then they should be looking at the Bush Jr government and particularly the Federal Reserve plus some of the other loose-money-policy central banks. If there has been financial reason for the price of oil in the past year, then it's coming from these sources.

An astute observer might add that the very reason US congress is holding hearings about oil price manipulation is for the very reason that they want to divert attention away from themselves. However, I think Hanlon’s razor applies here as well: “never attribute to malice that which can be adequately explained by stupidity.” Regardless of the reason, this is - as Euan has stated - a failure of leadership by G8 politicians and to some extent financial institutions.

Unsolved issues and accusations
Perhaps there are still some issues left unwrapped which I’m sure will continue to be debated:
  • Several oil industry seniors claim the fundamentals in oil industry have not changed since oil was $65/barrel. In their opinion, the price rise is either due to financial fundamentals (USD value) or to financial manipulation.

  • CTFC is undertaking a detailed study on the issue of market manipulation. If they find manipulation, then the levers that allow for this will likely be removed swiftly. So far, they’ve found none.

  • Bank of England has, imho, correctly pointed out that in a hypothetical situation of a manipulative bubble, OPEC has very little incentive to keep growing their own inventories due to increasing inventory costs in the face of bubble bursting. When the bubble finally bursts, the producer inventories can be so low that that the increase in demand hits another supply wall, rapidly bouncing up the price of oil again.

  • Further BoE suggests that the old oil market fundamentals may not hold true anymore. We may have moved beyond the earlier assumed OPEC price band and that new fundamentals may be setting in.

  • Now that both oil price demand elasticity and oil price income elasticity have gone down in the world according to economists, it is likely that the rise in prices will affect spending habits much slower than assumed earlier. Sure, demand response and even destruction will happen, but will it magically save us by quickly cutting demand so much that the prices crash? Nobody can know for sure, but the data on this does not offer immediate cause for relief.
Please note that these completely acknowledge the fact that futures prices normally alone can do very little to affect spot prices of physical delivery. Further, they do not explain, how futures prices could currently affect spot-prices. Even more, their arguments are contradicted by data given above.

In the end, all parties seem to agree that the supply-demand situation has tightened considerably in the past 10 years and that it continues to be tight in the near-term. This includes almost all the so-called cornucopian optimists.

So, even if speculation was effecting the physical oil market, the majority of price rise is more likely to stem from the fundamental supply/demand issues.

And again, just like pointed out in various TOD analyses, this does not exclude the likelihood of a significant price drop in crude oil prices in some future time. In fact, this type of see-saw price curve is exactly what some Peak oil analysts have predicted already years ago. If the see-saw manifests itself, prepare for more of it in the future.

A way to put an end to the discussion?
Is there any way we could finally resolve this question of manipulation/speculation?

The data we all would like to see and which would go a along way in either proving or disproving various price theories:
  • Future flow rate of each crude variety (API/sulphur) offered to the market
  • Future flow rate of each crude variety demanded by the market
  • Better understanding of oil price demand elasticities and their effects on various regions
  • Existing refinery capacity + capacity under construction as time series into the future broken down by input crude variety and distillate output capacities
  • Forecast for flow rates of each crude variety, based on known megaprojects and the little spare capacity we have left currently (this we know roughly vias aggregates of light/heavy/unconventional, but data is not publicly available broken down into smaller API/sulphur categories)
  • Transparent transaction data in all physical and financial oil markets
This data would show how the mismatch between supply and demand in various crude oils has developed and is likely to develop. It would also lay bare all speculative and manipulative levers in the market, if they existed. Further, through elasticity data, we could at least better guess what would likely happen to various economies due to oil price rises.

The supply data we can estimate, which is in fact what the good people at ASPO have been doing these many years. And the results are not encouraging, if one looks at the possibility of where the oil price and supply security is heading in the future.

However, as it remains likely that before we get any more accurate numbers even resembling those listed above, 2010 or even 2015 will have come and gone. We all know what that likely means:
“By 2010, the production of the fuel that has driven the world’s economy will start to rapidly decline. This will conflict with the steadily increasing demand for oil. The collision of these two trends will lead to shortages and increased prices, providing a strong incentive to shift to alternative fuel resources…Due to unequal distribution through the world of oil and gas supply and consumption, [the upcoming] transition will result in significant shifts in global power and wealth.” – Ray Leonard, VP of Kuwait Energy in a private meeting in June 2008, as reported by ASPO-USA
So, brace yourself. This could be a only the beginning of a big ride.