Speculator Ghosts in the Oil Machine

Persistent strength in the price of oil has once again unleashed maximum nonsense about the influence of speculators. Yes, it’s painful that oil never returned to earth after its 2004 repricing. But, in the search for an explanation, substituting the arcane for the obvious will not help: speculators did not create 5-6 years of flat to falling global oil production. Furthermore, as oil made its way from below $25.00 to its new level at $100.00, more of the world’s cheap oil from old reservoirs was swapped out for the new. Given that this new oil is much harder to extract, the world economy is lucky that oil remains so cheap. $100 is a bargain.

In the United States where the economy has barely recovered (if at all) from the 2008 financial crisis, oil consumption remains weak. With punk demand at home, however, we are instead using our newly spare refining capacity to turn oil into oil products, which we then export. In just 2-3 years the US has doubled its export of gasoline, distillate, and diesel especially. Here is a chart through the latest reporting week in May, denoted in million barrels.

Global demand for diesel—the go-to oil product and the hands down favorite of the developing world—continues to pull the complex forward. To gauge this demand on a daily basis I have long suggested following the price of Gasoil. This distillate benchmark reveals the pulse of demand more accurately than West Texas Intermediate crude oil, as its a gateway to both industrial use of oil and also to diesel. When China experiences drought and reduced hydropower, and is already up against maximum coal capacity, it reaches for distillate. We have seen this as well in post-Sendai Japan: reduced power generation from their nuclear grid has sent Japan scrambling for coal, LNG, and more distillate. This is one of the reasons why oil inventories in Asia (and also Europe) are dropping hard this year.

In the two graphs to the right, we see Total Oil Inventories in OECD Europe and Asia have fallen below five year averages. It’s not a mistake that Gasoil has been trading in a band around $1000 a tonne, or that Brent crude oil remains stubborn at $110.00 per barrel. The loss of Libyan oil combined with the demand shocks out of Asia–Japan’s post earthquake and China’s drought and automobile adoption–are the obvious explanations for oil’s current price.

The effects of speculative price amplification only take place in timeframes that have little to no impact on consumers. Hardly anyone paid $148.00 for oil in the summer of 2008. Just as hardly anyone paid $34.00 for oil in early winter of 2009. Societal fears about the effects of speculators on price have been alive since the time of Cicero (see: A Famine at Rhodes). The average price of oil in 2008 was $99.67. The average last year was $79.48. And this year the average so far is $85.00. Those are the prices we pay. So, face up.

It is depressing that the US government, and the Obama Administration which has done nothing to downshift our dependency on the Auto-Highway complex, has also joined the speculation over speculation. Consumption growth rates among the 5 billion people in the developing world have been soaring for a decade. Global costs to extract new oil have doubled, and tripled. Watching the President serve up the tired narrative that speculators have driven the price of oil should dissuade optimists from thinking the US public is ready to face up to reality.

–Gregor

Graphics: IEA Paris Oil Market Report.

Further Reading:

CERA: Upstream Capital Costs Index.

James Saft: Oil Gets Evil Speculator Buy Signal.

  • http://twitter.com/eaanders Elwood A Anderson

    It can be shown rather easily that speculation CAN cause short term rises in oil prices, but over the long term the real trends prevail. Your chart clearly demonstrates this. But, even short term fluctuations can cause unnecessary inventory accumulation and panic consumers who don’t understand the process.

  • http://profiles.google.com/robert.kenneth.smart Robert Smart

    I’ve always argued that speculators are a stabilizing influence, and they bring forward price rises which means that production rises occur before they are needed, which is good. However I think the markets have a mot of momentum players who aren’t very good, and this means the good big players can do the following: slowly force the price of something up or down. They have a model of how this will bring in momentum players. Their model of the momentum players means that they know when the supply of suckers is running out and they can reverse course. I guess the momentum players will eventually be driven out by this, but in the mean time it is a case where speculation is destabilizing.

  • I Gimlet

    i dunno … ice july gasoil is trading at a very small premium to nymex july nyh heating oil and at a discount to nyh spot ulsd … extra distillates might just stay home in the coming months, leading the (us) complex lower.

    interesting argument, sort of a reprise of john kingston’s at platt’s back in 2008.

  • I Gimlet

    Also, Japan, IIUC, is expected to export distillate, especially diesel, given that their refineries are mostly up and running and produce more than is consumed domestically, the chinese in particular are expecting it.

  • Bryan Long

    And of course, there are all kinds of multiplier effects.  Higher oil prices drive up the costs of all industrial processes that rely on oil as a fuel or feedstock, such as mining and plastics production.  Many of the products from those processes are themselves required by the oil industry, driving up the price of oil, and so on.  Many commodity prices will go up, but due to cost rather than demand, so commodity company profits will likely be squeezed for a while, caught between long term supply contracts and rising production costs. 

  • Bryan Long

    And of course, there are all kinds of multiplier effects.  Higher oil prices drive up the costs of all industrial processes that rely on oil as a fuel or feedstock, such as mining and plastics production.  Many of the products from those processes are themselves required by the oil industry, driving up the price of oil, and so on.  Many commodity prices will go up, but due to cost rather than demand, so commodity company profits will likely be squeezed for a while, caught between long term supply contracts and rising production costs. 

  • gregor.us

    Yes. And that’s the point of the piece. Speculation amplifies price–in both directions–in the short term. Generally in timeframes up to 90 days. But absolutely, on a day to day basis.

    I just think it’s part of the universal human impairment, in perception, to think that small and novel influences are the influences that govern large systems. Show me someone who thinks speculators took oil prices from 25 to above 100 over 7 years, and I’ll show you someone who has no idea how much oil is used globally, how the US does not control the prices either by our demand or our futures market, or how the world is composed of myriad oil producers, acting in their self interest. And so on.

    G

  • gregor.us

    Yes, the global oil market is so vast (both geo-politically, and in terms of value traded) that it’s a huge benefit to have information specialists who can quickly digest newsflow, and try to set a better price for future delivery.

    And again, show me someone who thinks speculation over-controls markets and I’ll show you someone who has never studied the history of markets. The truth of price always emerges. Always.

    G

  • http://www.rossgreenspan.com rossgreenspan

    Do you think there is a case to be made that long-only physical commodity investment vehicles are influencing supply-demand dynamics and causing price distortion? Anecdotal evidence seems to indicate the violent boom/bust wave up-wave down pattern of price discovery is here to stay. I know that is a function of scarcity but is it being exacerbated by the “unnatural” participants in physical markets?

  • gregor.us

    Long only demand from investment vehicles only “distorts” price to the extent that this capital has correctly deduced the mega-trend: the decline of easily extractable natural resources. The influence of this capital pales to the 1. scarcity rent already being charged by owners of natural resources, 2. premiums that state and sovereign wealth funds are willing to pay for resources extractors to secure natural resources for their home countries, 3. the structural influence of rising extraction costs.

    When compared against these three trends, investment funds in the West are followers–not makers–of the price trend.

    G

  • Anonymous

    “Watching the President serve up the tired narrative that speculators have driven the price of oil should dissuade optimists from thinking the US public is ready to face up to reality.”

    I’d venture to say that it has less to do with the US public’s abiltiy to face reality than it does with politicians lacking the gumption to tell them the truth (about anything) and the complicity of the media.

  • gregor.us

    Yes, that too.