Are We in a Speculative Bubble with Regard to Oil Prices?

TheDude

Totally rockin' article from last fall by our erstwhile moderator Khebab. Best explanation of how energy markets work I've come across and excellent commentary (on either side of the fundamentals/speculation equation) to boot.
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mefistofeles · Heavy Crude Joined: Mar 21, 2005 Posts: 225

I would argue that it doesn't matter if the oil price run up is caused by speculators.

Think of what markets a method for allocating goods. In a market the price is determined by discovery process between buyers and sellers where they "arrive" at what price each is willing to pay for something based on their current and future expectations.

As individuals they probably have a negligible effect, however as a group they can act as a collective intelligence. This though is more biology than economics the idea that once a certain activity level is reached you begin to see self regulating systems. For example ants in a nest. If there are very few ants the behaviour is very erratic but at some critical point the behaviour becomes much more steady.

The reason I think speculation is irrelevant is that if demand is speculator driven the price of oil will simply crash at some point in the future. Look at internet stocks or California real estate,in a speculative environment prices can't go on forever. In a sense the problem is really self correcting: too much oil will be produced and Americans can go back to driving their SUV's. The only people who really get hurt are speculators and oil producers, oil consumers would ultimately benefit from a massive speculative rush into oil because it would create too much new supply bringing down prices.

Of course I doubt this is true because we haven't seen a huge explosion in oil supply and the supply figures indicate that production growth is stagnant. Massive prices should result in massive investment, and even though we are seeing some very large investment the oil just isn't there. This really is very strong evidence for peak oil or inelastic supply. In other words no matter how much the world wants oil output is fixed, this is good but not perfect evidence for substantiating peak oil.

However the other alternative is much scarier: that the markets are working and telling us that we have a problem. Another way to look at markets is they tell us how scarce goods are relative to one another, i.e. oil versus real estate. If the price of oil is going up relative to other things, in this case it means we are running out of oil vis a vis other resources.

If this is true we have to act accordingly and realize that oil is become scarce and take appropriate steps,i.e. build alot more mass transit,require all new homes to have solar power.

Another problem with the current pricing paradigm is that its denominated in dollars. If an oil buyer and seller want to arrange for a delivery they have to arrive at a price by buying an oil future(denominated in dollars) and tack on a delivery fee. At least that's how I think it works. Of course there are various currency hedges the major players use so they don't get burned by a falling dollar.

The problem here is that if oil producers decide they have too many dollars and want something else the United States is in big trouble. Right now if the US wants to buy oil it just has to print more dollars, end of story.

However if the oil producers get tired of holding dollars we have serious problems because we are actually going to need ALOT of hard currency to pay for the US' basic energy needs. We are talking about 14 million barrels a day of energy that has to be paid for. That's just money the US doesn't have if oil isn't denominated in dollars.

Right now the dollar is inflation period. As various countries begin accumulating dollars they have to let one of two things happen.

1. Allow inflation to go crazy as they keep their currencies low against the dollar. I.e. China and Saudi Arabia.

2. Or let their currencies strengthen against the dollar.

Many the countries that have serious inflation problems also hold large dollar reserves,i.e. Saudi Arabia and China. Just allowing their respective currencies to adjust upward against the dollar can be quite helpful against inflation, since most raw materials are denominated in dollars.

Of course as the dollar continues to fall people will probably put more money into commodities as a hedge against inflation. In a sense its a vicious cycle: lower dollar equals higher inflation and more interest in commodities further pushing down the dollar.

The greatest problem concerning the US isn't the price of oil its making sure that everyone else is willing to take dollars so the US can get its oil for nothing. After all how much does it cost to print money?

The idiots that end up running the United States will probably destroy the country if they forget that its the US that depends upon the world and not the other way around, as the Washington elite so often forget. We depend upon the world to accept our dollars in exchange for crude oil.

Of course if you could buy something with those dollars that would be one thing. But look what happens when large foreign investors try to buy US assets:

Dubai Ports

CNOOC Unocal Bid

What this means is that all these people who hold dollars can't buy anything desirable with those dollars i.e. Microsoft or Intel. They are limited to Treasury Bills,Corporate Bonds and Mortgage Bonds(which I'm sure everyone knows are doing so well in this real estate market). This has got to make anyone holding large dollar reserves extremely angry.

At some point even the Arabs and Russians will understand that this is an idiotic business proposition:selling valuable oil for US dollars that don't buy anything.

Since the dollar really can't buy anything its inevitable that crude will be priced in something that can buy something or may even become the benchmark of a new global currency.

For the oil producers at least pricing oil in dollars is something that can't continue. At some point when oil pricing changes the US is going to have serious problems getting the energy that it needs.

essex

excellent post

kokoda · Heavy Crude Joined: Aug 24, 2006 Posts: 441

Economists know sweet FA about the causes the current surge in prices ... or if they do they don't want to admit it.

I love this video in which Robert Hirsch really puts Joanne Lipman, the Editor of portfolio magazine, in her place. She is talking about surveying economic "experts". The mere fact that these people are so bad at predicting oil prices casts doubt on any claim they have of being "expert" in my opinion.

He has a great quote ... Economist don't understand that we are limited by geology.

http://www.youtube.com/watch?v=bGHpWOSsDZk

mefistofeles · Heavy Crude Joined: Mar 21, 2005 Posts: 225

mrobert

There are 3 things (sorted in the order of their importance, most important first), that contribute to higher prices:

1. Market conditions (high demand, not enough offer)
2. The decline of the US dollar
3. Market speculation (using commodities as a hedge against the falling US dollar).

Now, if you fix number 2, and prop up the dollar by a decent 20%, this would also fix number 3, which would cause the price of crude to be at around $100, and a gallon of gas at a around $3. We could get along with this just fine.
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mefistofeles · Heavy Crude Joined: Mar 21, 2005 Posts: 225

mrobert

@mefistofeles: I know that proping up the dollar is not an easy task.

The US makes a lot of nice things. Too bad they killed the economy for a short lived gain of cheap chinese crap.

Take my Zippo lighter for example. Manufactured in the US.
I paid about $40 for it. Expensive for a lighter, but it's durable. I know it will last me a few good years. I can always start buying chinese plastic lighters for $1 a piece. I would pay the price of the Zippo in about 2 years.

What do I have left after 2 years?
A) A good piece of american lighter that still works and will continue to work. It can be recycled if needed. It's made out of metal and cotton (I assume is used) for the wick. Did it's manufacture involve chemical processes that damage the environment? Not that much really.

B) About 40 pieces of useless plastic chinese lighters. Can they be recycled? Not really. Did the manufacture process involve chemical processes that damage the environment? Yes.

These are the things US should focus on, and start doing again.
Quality and durable things.
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DantesPeak

kokoda · Heavy Crude Joined: Aug 24, 2006 Posts: 441

smallpoxgirl · Moderator Joined: Nov 08, 2004 Posts: 6278

I'm pretty strongly of the belief that speculators are not driving the price of oil up. The simple reason is this. When people want to speculate in oil, they do it in the futures markets. The way futures work is that, producers sell contracts for future delivery. People bid them up and down, and then eventually the contract expires. When the contract expires, the person holding the contract is entitled to delivery of 1,000 barrels of crude oil. Speculators buy the contracts and hold them, but they sell out before delivery. As all those contracts expire, someone has to be willing to buy them and take delivery. If the people interested in actually buying physical oil had enough, the contracts would drop precipitously at expiration. They're not doing that, so that's pretty clear evidence that there is not a surplus of physical oil and that the price is a fair price. Speculators can easily drive up the price of stocks or precious metals because speculators take physical possession of those things and horde them. The only real hoarding of oil that going on is the SPR. Now maybe you want to say that Dubya is the evil speculator driving up oil prices by filling the SPR. That argument, I think, could be made. The point of the SPR though is that things are only going to get worse from here, so a little hording today is worth it to offset even worse shortages in the future.
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mrobert

/sarcasm on

@smallpoxgirl: You are wrong! Gas is expensive because of the speculators. Haven't you seen it on TV?

/sarcasm off

Now ... I wonder when all stupid reasons for high oil price expire ... will they just admit the truth?
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TheDude

I simply borrowed the title of the TOD article for this thread, should've known it would have taken wing on its own. No harm though!