Monday, October 16, 2006

Thinking About Oil Prices

A piece in this week's Fortune magazine by Nelson Schwartz has made me think a little about oil prices. The article addresses the question of "Why gas prices dropped". Here's the answer given by Schwartz:
According to Joel Fingerman of Chicago-based, between the peak of $77 a barrel in August and the October low of just under $58, traders dumped nearly 40 million barrels (a 20 percent drop) from their long positions. The volatile gasoline market showed an even sharper decline - with traders cutting long positions from 32 million barrels in midsummer to just 1.7 million in October.

"Whatever you want to call it - speculators, fast money, hot money - a big part of the drop in crude that we've seen this year is because of selling by hedge funds," says Merrill Lynch technical analyst Mary Ann Bartels.
But there are a couple of loose ends that this explanation doesn't tie up. First of all, as I've written about before, it is unclear to me exactly how speculators (as a group) could maintain a long position in a commodity such as oil for an extended period of time (say, for several months or even years) without actually having the physical oil stored somewhere. Doesn't the physical oil actually have to be removed from the spot markets in order for the spot price of oil to be driven up by speculation? Put another way, it's hard for me to see how futures prices can affect spot prices without some physical storage of oil to move the physical oil from today to the future. Given that, and given the fact that government statistics show that the amount of oil being stockpiled around the world has not increased dramatically over the past two years, I'm skeptical about the speculator story.

But here's a second point: suppose that you do believe "speculation" has driven the price of oil up above where it would otherwise be (as Schwartz seems to). For example, the article cites an estimate by prominent energy consultant Joe Stanislaw that the price of oil would be around $50 per barrel if it weren't for speculative activities (in part related to geopolitical instability). Well, then take a look at the picture below.

The picture shows the spot price of oil compared to Stanislaw's $50/bbl guess. The area between $50 and the actual spot price of oil is some sort of "speculation transfer" that oil consumers have paid to oil producers as a result of speculative activity. For the US alone (which consumes about 20 million barrels of oil per day), that "speculation transfer" adds up to over $90 billion in wealth transferred from consumers to oil companies in the past 15 months.

Even to an economist, $90 billion is a lot of money, especially when that figure describes a transfer in wealth from US consumers to oil companies that resulted from simple speculation in the futures markets (again, assuming you believe in the speculation story in the first place). This seems to be something worth a little more thought and attention than simply concluding that speculation happened, and now it's ending, and that's the end of the story.

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