Wednesday, June 11, 2008

Oil Price Speculation? So What?

These days its very fashionable to scream "foul play" whenever the price of crude oil (or other commodities) comes up in conversation. The Commodities Futures Trading Commission last week announced that it is probing possible manipulation of energy commodity prices. Does this mean that the dramatic run up in oil prices is simply the result of evil speculators holding us all to ransom?

Don't you believe it for a second. Here is reality. For sure, folks are trying to protect their portfolios against run away commodity price increases by investing in commodities, including oil. I have, in fact, contemplated doing the same myself in past (and even wrote a couple of pieces on the subject). However, such moves by investors cannot be causing the price increases we have been seeing. Why? The answer is very simple. Nobody is actually taking any oil off the market.

Investors like myself have absolutely no intention of taking possession of actual barrels of crude. For one thing, I know that my wife would take a dim view of my trying to store the filthy stuff in our closets, and our storage space by the car port is filled with all manner of other junk. When simpletons like me invest in commodities, we do so through taking a position in the futures market. However, we better sell the stuff before it's time to take delivery of the actual commodity or else that whole spouse thing comes into play. So what do we do? We sell, and by selling we return the commodity back into the market. If you (reasonably) claim that purchases of crude futures make the price go up, you must accept that selling those same positions makes the price go back down. So, how exactly are speculators causing the commodity price inflation?

Another take on the subject from a "slightly" more reliable source than your humble blogger, comes from a story titled "Recoil" published by The Economist on May 31 (BTW, I highly recommend that magazine to anyone interested in economics, business or world affairs):

"Stuck for answers, politicians have been looking for scapegoats. Top of the list are the speculators profiting from other people's hardship. Some $260 billion is invested in commodity funds, 20 times the level of 2003. Surely all that hot money has supercharged the demand for oil? But that is plain wrong. Such speculators do not own real oil. Every barrel they buy in the futures markets they sell back again before the contract ends. That may raise the price of “paper barrels”, but not of the black stuff refiners turn into petrol. It is true that high futures prices could lead someone to hoard oil today in the hope of a higher price tomorrow. But inventories are not especially full just now and there are few signs of hoarding.

If the speculators are not to blame, what about the oil companies, which have failed to increase output in spite of record profits? Profiteering, say some. However, that accusation doesn't stand up to much scrutiny either. The oil price is set in a market. For Shell, Exxon et al to hoard oil underground would be to leave billions of dollars of investment languishing unused."

Where does all this leave us? With no simple answers. It appears that we need to either get used to the high price of oil or - gasp - learn to do without or with less... rejoice! Economics may save our planet from CO2 poisoning yet!

By the way, the argument presented above is probably not as valid for speculation in some other commodities, specifically precious metals. The reason for this is that there are mutual funds that actually take such precious metals permanently off the market by storing them for safe keeping as actual gold and silver bars on behalf of their customers. The difference? I suspect it has something to do with the volume required for storage and the ease of maintenance.

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