Weekend reading: The investors' role in the oil price spike

If there's one issue in the commodities markets that can start a bar brawl, it's the question of whether investors and speculators are partly, mostly or not at all responsible for the run-up in raw materials prices -- particularly oil -- the last few years.

My weekend column in The Times jumps into the fray. You can read it here.

Based on how commodity-futures investment by pension funds etc. has mushroomed, and the strategy of many of these investors to be exclusively long, I don't see how anyone can argue that they've had no effect on prices.

No question that basic demand from actual commodity users, and tight supplies, lit the fire under prices. And yes, Peak Oil Theory is gaining more believers by the day. But does anyone really believe that the pile-on effect from investors and speculators isn't a meaningful factor in driving prices now -- as opposed to, say, 10 years ago, before the institutional-investor crowd caught the hard-asset bug?

All of the testimony from the Senate hearing I reference in the column can be viewed here. If the issue interests you, I think you'll find it all to be worthwhile reading.

Comments

[Simontay78]

Do google this "PEAK OIL"

And bite the bullet, it's not about a bubble due to investors but a believe that the oil production of the world is in decline and the demand had outstrip supply. Welcome to the real world.

[Bob]

The Economist has a different take -
http://www.economist.com/finance/displaystory.cfm?story_id=11413334

[Michael Snyder]

O.K. people, let's get real here. Things are a little tense at the nineteenth hole at Boca Dunes this year as the realities surrounding "subprime" bubble to the surface. Kinda reminds me of a septic tank.
For the past decade Wall St. traders have been happily leveraging themselves into orbit. As the idiotic underwriting standards of the past few years have come home to roost, "investors" have found a new venue for their no-load gambles.
Although the "fundamentals" do not support the price of many commodities, the ability of highly leveraged investors to manipulate demand and pricing has brought the world economy to its' knees. I know the Government says inflation is under control.... And we're winning in Iraq... And shares in the Golden Gate Toll Co. can be purchased here for a small consideration...
Meanwhile banks are tightening lending standards beyond historical norms the Fed is laundering almost $400 billion in their subprime paper and the commodities markets are being driven by people with little or no skin in the game. As long as the prices keep climbing the profits will come in. But just like in So. Cal. real estate, the only constant is change. When these prices dip, and they will, "investors" are going to discover how little cash there is in the system. When this over-leveraged house of cards comes tumbling down there won't be a government on earth that can print enough money to hide the mess. Meantime I'm converting my vehicles to hydrogen hybrids & installing Solar power.

[rgb]

From wikipedia.org:
"An investor is any party that makes an investment.

The term implies that a party purchases and holds assets in hopes of achieving capital gain, not as a profession or for short-term income."

With this definition the "investors" this writer refers to (long term investors) will probably not affect the price of oil significantly. But the scum who are only in it for the money on a daily basis certainly will. Unfortunately that is who most the commodities traders are. These profiteering SCUM are jsut as bad as the oil company execs trying to justify $43B profit because these people drive the raw material price too high!

[Mark]

I like the Economists view: "If the indexed funds were indeed pushing the price of oil beyond the level justified by supply and demand, then they would be having trouble selling their futures contracts at such high prices before they matured. But there is no sign of that."

Exactly. Demand is as strong as ever while supply seems to be struggling to keep up. I think investors have seen this and are getting into the market not necessarily for instant big gains but for solid long-term results. Prices may yet come down some, which would be wonderful, but I think long-term we're looking at steady price increases as demand bumps up against supply constraints.

[will]

Hopefully investors will see the long term value of renewable energy and make the fundamental shift before it's too late.

[Michael Snyder]

rgb,
The pond scum would easily be removed from the pool by sensible capitol reserve requirements for everything from commodities investments (say 25%) to CDSs (say the same percentage of insured assets allowed to the primary insurer.). Both allowances would permit capitalized / responsible investors reasonable leverage and weed out the no-load scum fouling the waters.
Now, do I expect such a return to sanity?

[Tom Petruno]

Re the Economist piece: This reader, commenting on the magazine's story on the Economist's website, rebuts some of the assertions made about speculation's effect or lack thereof:

From reader Amusis to the Economist:

Where will it stop? It will stop where all bubbles stop- in misery.

This article displays appallingly poor Economic reasoning by The Economist. First:

"The price of oil may soon hit $200 a barrel.... A few years ago such a prediction would have seemed absurd. But the price has doubled in the past year and has risen by 40% this year alone.....So more spectacular increases seem all too plausible."

This is precisely the kind of linear, illogical, obtuse reasoning that has fuelled every bubble since time began: "The price (of tulips, dotcom stocks, property) doubled yesterday, so it is plausible that it will double tomorrow." Or, to phrase it in more familiar terms, "the price can only go up."

We are now in the hype stage of this bubble. The hype stage is when the bubble asset grabs the business headlines (as we can see is happening). Shortly after the hype stage comes the mania stage. This is when everybody and their sister wants to get in on the action, and shoeshine boys (and hedge fund salesmen) start giving tips on how to buy crude oil futures.

After the mania stage comes the blood in the streets, the jumping from tall buildings, the profusion of suicide notes, calls for more regulation- and the search for the next bubble.

And while this patently obvious bubble is building, the Economist spouts ridiculous theory:

"Economic theory suggests that the future price is simply traders’ best guess of the shape of things to come."

Yes. That doesn't mean it isn't speculative. It means the traders believe that 'the price will always go up', so they will be able to sell the underlying crude for a profit in future. These are the same idiots who just lost billions in a real estate bubble.

"That is important because it means that there is no hoarding, typically a prerequisite for a speculative bubble."

I'm sorry, I must have missed the hoarding of stocks during the dotcom boom, and the hoarding of houses during the property bubble. The fact that there is no hoarding of physical crude does not mean the price rise is not speculative.

As any Eco 101 textbook will tell you, it simply means the speculative demand for futures exceeds the supply of physical crude, which bids up the price of the futures. When every hedge fund and his dog is bidding for a clutch of futures, the price of each cargo goes up precisely because supply is limited. And the bubble will burst (as they all do) when these speculators try to sell in future and discover that there are no takers at $130. That's when the fun will begin.

A bubble is when the price of the asset influences market behaviour rather than vice-versa. We are there. Mark my words well.

[Harley]

Here's a thought: the big boys know that new technology is suddenly going to eliminate oil as an important fuel! So they are trying to cash as much as they can right now. And maybe they will try to own the new fuel sources too, so they can charge us even if it's free!

[Ron Ek]

But -- bubbles based on high tech or dot.com didn't hurt Joe Small (at least not very much and not directly). But these speculative investments on crude and wheat etc are hurting Joe Small. He has to eat and he has to drive to work. "..just working to buy gas..." is the new mantra out there. I don't think that pension funds should be in the speculation business -- maybe a few need to go belly up. Or maybe more towns in California need to declare bankruptcy. Financially, virtually every city, state, school district, what ever, is on the verge of failure. And we have pension funds betting on big profits at the expense of Joe Small. Seems like we've become too smart for our own good!