2009:H2: [We have] a cyclical bull market as the economy stabilizes and OPEC maintains cuts to draw inventories to 10-year average levels. We are raising our end of 2009 WTI [West Texas Intermediate crude oil] price forecast to $85/bbl from $65/bbl.
—Goldman Sachs, June 3, 2009
I admit the human element seems to have failed us here.
—General “Buck” Turgidson, from Dr. Strangelove
Layer upon layer of confusion pervades the discussion of why oil prices have been so volatile over the last 3 years. People often yearn for simple explanations. Some want somebody to blame, while others hold on to cherished theories. In these cases observers demand a Black Or White view of events which caricatures more complex realities.
I was reminded of these tendencies when a friend told me about Matt Taibbi’s Rolling Stone article The Great American Bubble Machine. Taibbi trashes Goldman Sachs, accusing them of blowing or taking advantage of one bubble after another—the run-up to the the Crash of 1929, the Tech Stocks (dogfood.com) fiasco, and the Housing Craze. It’s a great read and chock full of damning information, at least for those of us who can still concentrate long enough to get through something longer than a 140-character Tweet.
In the interest of full disclosure, I must admit to a tinge of jealousy here because Taibbi despises Goldman Sachs even more than I do and expresses his contempt so well see note 1. And of course he writes for Rolling Stone and I don’t! But seriously…
My problem with Taibbi’s account is his Bubble #4, called $4 A Gallon. I need to quote this at some length.
With the public reluctant to put money in anything that felt like a paper investment, the Street quietly moved the casino to the physical-commodities market—stuff you could touch: corn, coffee, cocoa, wheat and, above all, energy commodities, especially oil. In conjunction with a decline in the dollar. the credit crunch and the housing crash caused a “flight to commodities.” Oil futures in particular skyrocketed, as the price of a single barrel went from around $60 in the middle of 2007 to a high of $147 in the summer of 2008…
That summer. as the presidential campaign heated up, the accepted explanation for why gasoline had hit $4.11 a gallon was that there was a problem with the world oil supply…. But it was all a lie. While the global supply of oil will eventually dry up. the short-term flow has actually been increasing. In the six months before prices spiked, according to the U.S. Energy Information Administration [EIA], the world oil supply rose from 85.24 million barrels a day to 85.72 million. Over the same period, world oil demand dropped from 86.82 million barrels a day to 86.07 million. Not only was the short-term supply of oil rising, the demand for it was falling – which, in classic economic terms, should have brought prices at the pump down.
So what caused the huge spike in oil prices? Take a wild guess. Obviously Goldman had help – there were other players in the physical-commodities market – but the root cause had almost everything to do with the behavior of a few powerful actors determined to turn the once-solid market into a speculative casino. Goldman did it by persuading pension funds and other large institutional investors to invest in oil futures – agreeing to buy oil at a certain price on a fixed date. The push transformed oil from a physical commodity, rigidly subject to supply and demand, into something to bet on, like a stock. Between 2003 and 2008, the amount of speculative money in commodities grew from $13 billion to $317 billion, an increase of 2,300 percent. By 2008, a barrel of oil was traded 27 times, on average, before it was actually delivered and consumed.
Hold your horses, Matt! Did you happen to notice that the demand number you cite (86.07 million barrels-per-day) is higher than your supply number (85.72)? I give you Figure 1.
Demand easily outstripped supply as 2007 wore on, and as oil prices rose, demand started easing as supply strained mightily to rise enough to bring the market into equilibrium in the summer of 2008. There is no reason to think, as Taibbi claims, that oil prices should have been falling while demand still exceeded supply, even if the former was falling and the latter was rising—July, 2008 was the historical peak supply month at 86.653 million barrels-per-day. Finally, after 6 straight quarters in which supply fell short of demand, the market achieved a very temporary balance in 2008:Q3.
Figure 1 illustrates the early stages of the peak oil problem. Production was unable to rise in a timely fashion to meet burgeoning new consumption in the emerging economies (China, India, etc.). July, 2008 was the only time that all-liquids supply ever surpassed 86 million barrels-per-day, and there is a good chance that it will never exceed that level ever again (or 87, or 88, or something in the 86-88 range).
But what about the oil price? Taibbi believes speculators drove prices in 2008:H1 far beyond where they should have been. And he’s right! But multiple factors were pushing up the price. What caused gasoline prices to shoot up over $4/galllon is not a Black Or White issue. It was not exclusively EITHER bloodsucking speculation OR supply & demand fundamentals (OR hedging against a constantly falling dollar since 2003). All these problems combined to create a record high of $147 for a barrel of oil on July 12, 2008, and there is a subtle relationship among these factors.
The mature, calm observer see shades of gray and multiple causation. Black Or White thinking is called “primitive” by psychologists. Adults under stress can easily backslide (regress) into mutually exclusive dualities typical of childhood.
When small children are learning to use words and organize their thoughts, it is normal and expected for them to see and express their world in very black and white terms. When a young child feels they are not loved, they feel they must be hated. When a child feels his or her parents don’t pay enough attention to them, that child will say, “You never pay attention to me.” Developmental psychologists call this primitive thinking.
Unfortunately, under duress, adults often regress to primitive thinking. Adults are most prone to regressing to primitive thinking when they are having a hard time and feel overwhelmed by their own emotions. A regression, in psychoanalytic parlance, is a backsliding from mature functioning and thinking to immature ways of functioning and thinking. For that one moment, when the adult starts relying on the words “always” or “never,” and seeing the world in black and white terms, they are slipping back to the way they saw the world as a child.
It is perfectly understandable why we might feel freaked out in 21st century America. Everything is really screwed up—our cliff-diving economy, our unrepentant, bailed-out financial oligarchy, our overwhelming debt, our paralyzed political system, our impoverished state governments, you name it. Writing a diatribe blaming all the world’s ills on Goldman Sachs is better than a headlong flight from reality, which is the preferred solution of most Americans. I largely agree with Taibbi: if America is now circling the drain, Goldman Sachs has found a way to be that drain. But Goldman Sachs is not our only problem, not by a long shot.
If we are to have any chancenote 2 of working our way out of this mess, we must avoid regressive thinking, stay calm, appreciate complexity, and think clearly about the right course of action. I’m going to take a proper look at speculation in the oil market to see what the problems are and what we might actually do about them. It’s one big problem among many, I know, but you’ve got to start somewhere.
Not Everything That Can Be Traded Should Be Traded
Let’s start with a mature approach to price distortions in the oil markets. The quote and Figure 2 are from Jeffrey Korzenik’s Crude Oil Trading Regulation: A Terrible Idea Whose Time Has Come. He’s talking about index speculation made possible by the swaps loophole.note 3
If we’re going to trade crude oil like a currency, we should regulate it like a currency, too.
I hold an apparently quaint and obsolete belief: Not everything that can be traded should be traded. Specifically, there’s great danger in using long-term, long-only commodity futures positions as an investment asset class. The same is true of the derivative baskets of commodities that replicate such futures positions. Please note that I’m not talking about futures funds (which trade both sides of the market and are generally in positions only for the short term), but rather the way that commodities are increasingly being used by pensions, endowments and hedge funds as investments rather than short term speculations; this has sometimes been called index speculation, to distinguish it from the traditional variety.
Investment flows into the futures market can distort the pricing that should instead be determined by producers and users of commodities. Price distortions of this type cause enormous economic inefficiencies, are deeply injurious to the world’s poorest, and create significant structural risk in the markets. The chart below is a good illustration of just how “financialized” energy prices have become… [Figure 2].[My note: Long traders are betting on a longer term price rise, whereas those “going short” are betting the price will fall. The price has risen steadily since February, 2009 despite weak fundamentals (follow the pricing link above.]
Figure 2 — The trade-weighted U.S. Dollar index (the dashed line) versus the DJ-UBSCI Energy Spot indexnote 4 (the solid line) since the beginning of the year. Korzenik says “as emphasized by the arbitrarily drawn horizontal line, these plots are virtually mirror images of each other (running a regression results in a correlation of -0.88). This corresponds to the type of linked price action we saw during the buildup to the commodity frenzy last year. It’s interesting to note that commodities like gold show nowhere near the correlation (-0.177) with the dollar over this same period. Clearly, the pricing of crude oil and energy products have become dominated by financial, not commercial interests.”
Taibbi fixated on price speculation in the run-up to $147/barrel in 2007-2008. Better he should have focused his attention on—he does mention it—the recent rise from an average monthly price of $39.16 for crude oil in February to about $68.00 now during the worst economic downturn since the Great Depression. While some of the price rise might be due to OPEC cuts and stockpiling in China, no data I’m aware of show an increase in demand, or even a definite stabilization of the recent downward trajectory in global oil consumption.
Therefore we must conclude, and it’s no secret, that the recent price rise has been due to long-term, long-only community futures positions taken by index traders (e.g. pensions, endowments, hedge funds) using the avenues available to them. Conveniently, the means are furnished by Goldman Sachs, among others. Here is economist James Hamilton writing about how the speculation works on May 17, 2008.
An important recent trend in management of pension and hedge funds is the increasing allocation of investment dollars to commodity speculation. There are lots of ways you can do this. Perhaps the simplest is to purchase, say, the July NYMEX oil futures contract. If you’d bought that contract Friday, it would enable you to take delivery of oil in Cushing, Oklahoma some time in July for $126/barrel. As a pension fund, you don’t actually want to receive that oil, so in early June you’d plan on selling that contract to someone else and using the proceeds to buy the August contract. If oil prices go up and you can sell the contract for more than $126/barrel next month, you will have made a profit. By rolling over near-term futures contracts in this way, your “investment” will earn a return that follows the path of oil prices.
The Goldman Sachs Commodity Index is essentially a mechanical calculation of how much money you’d have each day if you followed a strategy like this for each of the major commodity contracts, with energy prices comprising about 70% of that index. There are a number of firms [like Goldman Sachs] that offer products that could implement such strategies on your behalf, such that the dollar value of your investment will essentially follow the GSCI (or similar index) less trading costs and management fees.
Long-only index traders are now said to be hedging against expectations of future inflation, which manifests as a hedge against a falling dollar as shown in Figure 2. Wall Street bankers, who know that short-term inflation expectations are nonsense, are no doubt driving & riding the long wave, as I described in Mr. Market Gets It Wrong Again. Thus Goldman Sachs issues bogus oil price forecasts to keep the ball rolling (like the one in our opening quote at the top).
Taibbi approvingly quotes hedge-fund operator Michael Masters, who believes the influx of index speculators into the oil market has been the sole factor driving up prices since 2003, and was the biggest factor in the price rise from end-2007 until July, 2008 (Figure 3).
Figure 3 — The open-interest (contracts) in oil rose steadily until the end of 2008. The rise was largely due to the influx of index (pensions, endowments, hedge fund) traders. This graph is taken from the Air Transport Association’s Energy Matters presentation dated June, 2009. The airline industry is understandably upset about index speculators. Some airlines took a bath when they tried to hedge their risk by locking in forward (6-month) prices at $120/barrel or more. At the time, few foresaw the crash in September. Some airlines were thus stuck with exorbitant oil prices long after the price had fallen below $50.
Masters’ position is a caricature of reality. If it’s Black Or White, let’s call his view the “Black” alternative. He can explain Figure 2 (recent speculation) but he can not explain Figure 1 (the supply & demand imbalance). Nevertheless, the recent price rise strongly suggests that there was speculative froth over and above what the “fundamentals” price should have been in 2008:H1. This premium might have been somewhere in the $25-35 range, as it is today. That would suggest that the “real” price at the top should have been somewhere between $100 and $110/barrel, as I argued in Mr. Market.
The “White” position ascribes the entire upward price movement in 2007-2008 to supply & demand fundamentals. From the June 17, 2009 CNN Money story Obama vs. the Oil Bubble—
Scott Irwin, an agricultural economist at the University of Illinois, says there is little evidence to support the notion that index fund buying is playing a substantial role in the level of commodity prices. “The academic work to date finds no evidence that the massive run-up of commodity prices can be traced to the index funds,” he said.
Irwin said a recent study of dynamics in the corn market, where prices spiked
last year as well, shows that the rise in futures buying by index funds and other long hedgers was met with increased selling by large commercial interests—the entities that these markets were created to serve.
Back on September, 2008, Hamilton published Scott Irwin takes down Michael Masters at Econbrowser.
My purpose in writing this post is to show that Mr. Masters’ bubble argument
does not withstand close scrutiny. He first makes the non-controversial observation that a very large pool of speculative money [Figure 3] has been invested in different types of commodity derivatives over the last several years. The controversial part is that Mr. Masters concludes that money flows of this size must have resulted in significant upward pressure on commodity prices, which in turn drove up energy and food prices to consumers throughout the world. This argument is conceptually flawed and reflects a fundamental and basic misunderstanding of how commodity futures and related derivatives markets actually work. It is important to refute Mr. Masters’ argument since a number of bills have been introduced in the U.S. Congress with the purpose of prohibiting or limiting index fund speculation in commodity futures and OTC [over the counter] derivative markets.
The first and most fundamental error Mr. Masters makes is to equate money inflows into futures and derivatives markets with demand, at least as economists define the term. Investment dollars flowing into either the long or short side of futures or derivative markets is not the same thing as demand for physical commodities. My esteemed predecessor at the University of Illinois, Tom Hieronymus , put it this way, “for every long there is a short, for everyone who thinks the price is going up there is someone who thinks it is going down, and for everyone who trades with the flow of the market, there is someone trading against it.” These are zero-sum markets where all money flows must by definition net to zero. It makes as much logical sense to call the long positions of index funds new “demand” as it does to call the positions of the short side of the same contracts new “supply.”
[My note: Irwin presents other economic fundamentalist arguments in this vein.]
I wonder how Irwin explains away the recent rise in oil prices, an increase which apparently reflects a “financialized” market that does not serve the interests of oil end-users and is almost entirely divorced from supply & demand fundamentals. Given his recent remarks to CNN Money quoted above, I guess he thinks everything is OK and there is nothing to explain. Worse still, his argument that the commodities markets are always in (or only temporarily out of) equilibrium—this is his “zero sum” game—seems to imply that bubbles are impossible in principle!
The key word here is “temporarily.” In the longer run, the tail (speculation) does not wag the dog (fundamentals). Bubbles are temporary by definition—they must all collapse sooner or later. But while they are going on—they can go on for months at a time—a lot of damage is done to the commercial interests the market is supposed to serve. Why should buyers & sellers of commodities be put at such risk? If you doubt this, just ask Delta Airlines.
The upshot of Irwin’s argument is that the skyrocketing price in 2008:H1, the precipitous fall in 2008:H2, and the recent rise in 2009:H1 were all due entirely to supply & demand fundamentals. Like Masters’ view, Irwin’s position is a caricature which ignores the human—you know, crazy—element in economics, now properly modified to be behavioral economics. See Scientific American’s recent article The Science of Bubbles and Busts (July 9, 2009).
It’s not Black Or White. But let’s go to the heart of the matter. Why speculate in energy (oil)? Why is oil being treated like a currency?
If you’ve been paying any attention to events in the oil markets over the last 5 or 6 years, you probably “know” four things: 1) economic growth always seems to be accompanied by growing oil consumption; 2) thus, growing economies like China and India are using more and more of the stuff; 3) the price got really high in 2008 and rose for 5 years before that; and 4) there’s a persistent rumor about something called “peak oil”—even if you’re not quite sure what that actually means. (Does it mean oil production starts declining when half the reserves are gone? or are we Running Out Of Oil?, or some other nonsense?)
If you are a pension fund or an endowment armed with this “knowledge” that oil is really precious stuff, betting that oil prices will rise in the future looks like a sure thing. So we see that Figure 1 and Figure 2 really do fit together, despite what Taibbi, Masters and Irwin say, and despite the mistake index traders are making by going long on oil far too early.
You’ve got it wrong if you believe that only speculation pushed oil prices up from 2003 to 2008 or only fundamentals drove all the price increase—an ongoing market disequilibrium between available supply & potential demand gave and still gives legs to speculation in oil. Both factors played a role in inflated oil prices, with supply & demand being the underlying cause—that’s what the word “fundamentals” means. It’s Black And White. Goldman Sachs is merely a morally-challenged facilitator of short-term price bubbles, i.e. they are the drain we’re going down.
There’s No School Like the Old School
Speculation causing temporary bubbles in the commodity markets is a bad thing. Unwarranted price distortions & volatility cause needless pain for producers and consumers. I don’t know enough about the gory details of how the NYMEX currently works to recommend specific solutions, but I do know this: the “swaps loophole” must closed and “bona fide hedging” exemptions should be repealed. The market should probably work as it was set up in 1936. I agree in principle with Taibbi when he writes—
In 1936, however, Congress recognized that there should never be more speculators in the market than real producers and consumers. If that happened, prices would be affected by something other than supply and demand, and price manipulations would ensue. A new law empowered the Commodity Futures Trading Commission – the very same body that would later try and fail to regulate credit swaps – to place limits on speculative trades in commodities. As a result of the CFTC’s oversight, peace and harmony reigned in the commodities markets for more than 50 years.
Depression-era regulation has been repealed over and over again in the last 20 years. You can clearly see where that got us. There’s no school like the old school. The derivatives industry is against proposed CFTC changes. That’s bona facie evidence that something good might be in the works.
Taibbi describes how Goldman Sachs is preparing to blow or take advantage of a new bubble in the Cap & Trade carbon trading market (Bubble #6, Global Warming). Inflated “asset” values (carbon?) are a likely outcome if the legislation passes. A society that can not define and police its markets properly has no chance of fixing the longer term problems (the oil supply, the climate) that underlie them.
Contact the author at [email protected]
1 This is a slide from the American Transport Association (see Figure 3).
Investment banks must issue bullish reports to drive the index investor herd (the Goldman Sachs theme song…)
Rollin’, Rollin’, Rollin’…
Keep Movin’, Movin’ Movin’
Though they’re disaprovin’
Keep them doggies moving,
Don’t try to understand ‘em,
Just rope and throw and brand ‘em,
Soon we’ll be living high and wide.
My heart’s calculatin’
My true love will be waitin’,
be waiting at the end of my ride…
2 A few protests in the streets à la Iran might be helpful too. Americans can’t afford to hit the snooze button on the alarm clock anymore. Even if the protests wouldn’t accomplish anything, they could still demonstrate that we’re awake and watching something other than TV.
3 From the Senate testimony of Michael Masters last summer:
When Congress passed the Commodity Exchange Act in 1936, they did so with the understanding that speculators should not be allowed to dominate the commodities futures markets. Unfortunately, the CFTC has taken deliberate steps to allow certain speculators virtually unlimited access to the commodities futures markets. The CFTC has granted Wall Street banks [like Goldman Sachs] an exemption from speculative position limits when these banks hedge over-the-counter swaps transactions. This has effectively opened a loophole for unlimited speculation. When Index Speculators enter into commodity index swaps, which 85-90% of them do, they face no speculative position limits.
The really shocking thing about the Swaps Loophole is that Speculators of all stripes can use it to access the futures markets. So if a hedge fund wants a $500 million position in Wheat, which is way beyond position limits, they can enter into swap with a Wall Street bank and then the bank buys $500 million worth of Wheat futures.
In the CFTC’s classification scheme all Speculators accessing the futures markets through the Swaps Loophole are categorized as “Commercial” rather than “Non-Commercial.” The result is a gross distortion in data that effectively hides the full impact of Index Speculation.
4 About the Dow Jones-UBS Commodity Index: “UBS Securities LLC has acquired AIG Financial Product Corp’s commodity business has of May 6, 2009. As such, the Dow Jones-AIG Commodities Indexes have been rebranded as the DJ-UBSCI effective May 7, 2009.” I’m not going to make a big deal out of this; I just thought you ought to know.