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Generational Dynamics Web Log for 23-Jan-2009
Speculators around the world are storing oil in supertankers

Web Log - January, 2009

Speculators around the world are storing oil in supertankers

This refutes the nonsense about oil speculators last summer.

A great drama is playing out around the world. While transportation of most commodities and finished goods has come practically to a standstill, the business of transporting oil is suddenly booming. Oil is being transported from one place to another ... and back again ... and round and round it goes.

With oil prices falling from $147 per barrel last summer to below $35 recently, speculators are storing about 80 million gallons of oil in supertankers around the world. They purchased the oil at the current low prices, in the hope of being able to store it long enough to make a lot of money when the price of oil goes back up.

For several weeks, Morgan Stanley has been negotiating to secure an oil supertanker, in order to store millions of barrels of oil in the Gulf of Mexico. (The deal may have collapsed on Monday.)

Six months ago, when oil was above $140, oil companies were struggling to rush oil to market to keep up with increasing demand and soaring prices. But that's all changed now, and the same companies are acting in ways that would have been unimaginable until recently.

What caused the oil price bubble?

There was a lot of nonsense last summer, as analysts and pundits were proclaiming that the high price of oil was the fault of "speculators," artificially driving the price up to make money.

That never made any sense anyway, because the spike in oil prices coincided with similar spikes in copper, iron ore, wheat, and other commodities. But no one was claiming speculators were driving up the price of copper -- just oil -- so the whole claim was silly.

What was the cause of all the price spikes? It was pretty clear that they were all caused by the demands of China's exponentially growing bubble economy. And it's no surprise that all of these bubbles burst, all at once, along with the recent collapse of China's economy, following the Beijing Olympics.

I'd still like to know exactly what happened. In June, I made an interesting speculation: "I can't prove this, but my intuition tells me that some sort of tipping point has been reached -- perhaps a structural limit in the markets that can't be cured in the short run. It might be that all easily available land is used up, or perhaps the worldwide transportation and shipping infrastructure is so overloaded that it's locked up in some way, and can no longer expand in the short run. I think that we're seeing the Law of Diminishing Returns in action. In "normal" times, these situations would be self-correcting in a few months, but some long-term structural limitation is keeping the supply/demand mismatch from clearing up."

I still think something like that happened, and it would be very interesting to understand it better.

I also wrote that bubble would burst soon because of a war, or because "a financial crisis that will bring the increasing demands for oil and food in China and India to a screeching halt."

That's exactly what appears to have happened.

Could speculators have caused the oil spike?

The way a speculator works is by buying up almost all of some commodity in order to drive prices up, and then selling it off in small quantities to take advantage of the high prices. In order to be successful, the speculator has to have time on his side. He has to be able to store the commodity for a while, to allow prices to rise. If he's forced to sell what he has, then he'll be flooding the market with produce, driving prices down, and he'll lose a lot of money.

You might be able to do that with gold or silver or maybe even wheat, if you can find a huge stadium or something where you can store the commodity until you're ready to sell.

But with oil, you can't do that. The only reasonable place to store it is in tankers -- that's what's happening now, but it wasn't happening then.

What confuses pundits and analysts who insist that speculators were at work last summer is that they don't understand the difference between oil and oil futures contracts.

You could try to corner the market by buying up all of next month's futures contracts, which means that you're buying up the oil that will be delivered next month. The problem is that you don't have time on your side. There's a "drop-dead date" on these futures contract -- when the contract date arrives, then you must take delivery of the oil. You have to get rid of the oil, or else store it in tankers, so we're back to where we were.

On the day that someone takes delivery of 10 million barrels of oil and wants to sell it, the price he gets will depend on the market for oil on that day, and only that day. The prices of past or future oil contracts is irrelevant.

The fact that the oil bubble coincided with other commodity bubbles, and also coincided with the China's construction bubble, makes it almost doubtless that it was demand from China that caused the oil bubble. And the fact that the bubble collapsed when China's economy collapse makes it absolutely certain.

Nonsense at '60 Minutes'

It's interesting to take a look at the reasoning used to claim that speculators were at work last summer.

The CBS show '60 Minutes" had a segment last week called, Did Speculation Fuel Oil Price Swings? The '60 Minutes' story reeks of the confusion between oil and oil futures contracts. It quotes an oil industry executive as saying,

"Approximately 60 to 70 percent of the oil contracts in the futures markets are now held by speculative entities. Not by companies that need oil, not by the airlines, not by the oil companies. But by investors that are looking to make money from their speculative positions. [They don't actually take delivery of the oil.] All they do is buy the paper, and hope that they can sell it for more than they paid for it. Before they have to take delivery."

That's exactly right -- speculation among futures contracts -- and the speculators have to get rid of them before they have to take delivery of the oil.

Another executive says, "We've had three price changes during the day where we pick up products, actually don't know what we paid for it and we'll go out and we'll sell that to the retail customer guessing at what the price was. The volatility is being driven by the huge amounts of money and the huge amounts of leverage that is going in to these markets."

But those weren't three prices changes in the price of oil; those were three price changes on the price of oil futures contracts.

Another quote: "Did China and India suddenly have gigantic needs for new oil products in a single day? No. Everybody agrees supply-demand could not drive the price up $25, which was a record increase in the price of oil."

No, that's not true. That was a record increase in the price of oil futures contracts. And the gigantic needs of China and India didn't occur in a single day -- they grew for years.

The only place where the report even mentions oil is to say, "Morgan Stanley has the capacity to store and hold 20 million barrels." Well, that's less than 25% of a single day's supply, hardly enough to make a dent in world supply for more than a brief period.

And what ended the oil bubble, according to 60 Minutes?

"The oil bubble began to deflate early last fall when Congress threatened new regulations and federal agencies announced they were beginning major investigations. It finally popped with the bankruptcy of Lehman Brothers and the near collapse of AIG, who were both heavily invested in the oil markets. With hedge funds and investment houses facing margin calls, the speculators headed for the exits."

So the report concludes that these high-powered speculators, driving prices up in order to make many millions of dollars, were driven off by the mere threat of an investigation? I don't think so.

This 60 Minutes report made no sense whatsoever. It never explained why speculating in oil futures causes oil prices to rise, it never explained why price rises in oil were different from price rises in other commodities, and it ignored the collapse of China's economy. All in all, it was an extremely shoddy piece of journalism.

There's something about oil that drives ideologues (on the left and right) crazy. Oil is part of every conspiracy theory. People are ideologically obsessed with oil. There was one guy I worked with a while back who could take any international news story and turn it into a story about oil, usually involving President Bush, as if nothing else mattered besides oil. I used to joke with him that he probably thinks that Hannibal attacked Rome around 200 BC just to get the oil.

If you look at the things today that are likely to cause a world war, oil just isn't near the top. The Jews and Palestinians have lots of issues, but none is about oil. And Taiwan is a big issue for the Chinese, and I don't believe that there's any oil on Taiwan. The really big issues today are land, food and water, with oil farther down the list.

Blogger Jeff Madrick

I came across this article by Jeff Madrick on Huffington Post when I was doing research for my recent article, "Blog Watch: Naked Capitalism's Yves Smith blames economists for being wrong."

Madrick's article was written in August, at the height of the election. This article is absolutely fascinating because it makes no sense whatsoever, and is pure ideology:

"With crude oil prices now twenty percent below their levels of just a month ago, and other commodities down as much or more, it's time for the countless economists who told us the rapid prices increases had little to do with speculation to stand up and explain themselves."

Madrick does have the sense to refer to other commodities, but what is his reason for believing that speculators were to blame?

"Now, anyone writing about or discussing economics is going to make mistakes. But this claim was a whopper. More to the point, and the reason it brings out this writer's passionate anger, is that the rapid rise in prices has caused so much pain for the world's poor."

This shows the danger of expressing an opinion on economics while under the influence of an ideology. Most people are concerned about pain for the world's poor, but ideologues are only concerned about such pain when they can make a political point. Phony outrage about the world's poor has nothing to do with speculators.

"The simple fact is that prices for any commodity can be moved by speculation about the future. When they are financialized, as is crude oil, it means non-users can make easy bets on future prices that require only a small down payment.

It's just like the stock market. Do stock prices reflect only rational projections of corporate earnings and dividends? We've had enough of irrational exuberance and its opposite to know better now. Then why should oil futures prices reflect only genuine shifts in supply and demand?"

Here's where he goes off the rails. Like the 60 Minutes report, he makes no attempt to explain why speculating on oil futures is the same as speculating on oil.

When you take delivery of 10 million barrels of oil, and you have to sell it, the price you get will depend on the oil market on THAT DAY, not on how much oil futures contracts are selling for two months later. The two prices are completely unrelated.

Why is it so hard to understand that buying 10 million barrels of oil is very different from buying securities?

"What is really galling is when economists make such claims implying that anyone who disagrees is simply ignorant of the basic laws of economics or just not bright enough to understand all the nuances."

This is your brain on ideology
This is your brain on ideology

I'm not saying that Madrick is ignorant of all the basic laws of economics, or that he's not bright, though those are possibilities.

I'm saying that Madrick's brain has been completely fried by his ideology.

And that's always the problem. All you have to do is listen to ideologues like CNBC's Larry Kudlow on the right or Congressman Barney Frank on the left. They say such incredible things that they make your head spin.

And that brings us to the big economics issues of the day: The causes of and cures for the current financial crisis. I wrote about this in my article "The outlook for 2009."

You have people on the right saying that we should follow the lead of Ronald Reagan: just cut taxes and let the economy take care of itself.

You have people on the left saying that we should follow the lead of Franklin Roosevelt: just spend money, and that will cure the economy.

Both of these ideological positions are wrong. Reagan was President during a generational Unraveling era, so anything he did is irrelevant to today's crisis era.

Roosevelt was President during the last generational Crisis era, so his example is a better choice. But as I explained in "The outlook for 2009" and in "As his Great Historic Experiment collapses, Ben Bernanke scrambles to save his reputation," the timing is wrong, since it's too early in the deflationary spiral. Even worse, the plans to spend are growing chaotically into the trillions of dollars, with politicians acting like kindergarten children in a candy store, fighting over the best pieces of candy.

We're lucky that we have oil tankers treading water these days, put there by speculators storing oil, hoping to drive the price up, but failing miserably. It gives us a chance to see how punditry about the oil price spike last summer was purely ideological.

But we're unlucky because there's a far worse financial problem on the horizon, and the ideologues running things in Washington have no more idea what's going on than do the 60 Minutes producers or Jeff Madrick, and it looks like they're going to only make things worse.

(23-Jan-2009) Permanent Link
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