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Friday, July 04, 2008


oil market dynamics: futures set spot prices

i recently referenced the quality analysis of peak oil debunked in assessing the speculative component of the oil price bubble, but -- via yves smith again -- jd outdies himself in explaining exactly why efficient market theoreticians such as paul krugman are wrong on the pragmatic material aspects of this particular issue.

Most crude oil is traded based on long-term contracts, and the prices in those contracts are set by a system known as "formula pricing". In this system, the price of delivered crude is set by adding a premium to, or subtracting a discount from, certain benchmark or marker crudes, namely: West Texas Intermediate (WTI), Brent and Dubai-Oman. ...

Originally, the benchmark prices were spot prices, but over time problems began to arise due to the depletion of the benchmark crudes ...

To deal with this problem, many key oil exporters shifted away from the spot market, and began to use futures prices as the benchmark in formula pricing ...

As you can see, Krugman and Birger are profoundly confused about the way the international oil markets actually function. Futures aren't a paper bet on the direction of prices determined by some independent process. Futures themselves *determine* the price of most physical oil traded today. The futures price (+ or - the differential) literally *is* the price of oil.

this information definitively ends the debate. futures prices are not derivative of the physical market; indeed exactly the opposite is true for oil. the price of oil in fact has little to do with supply and demand of the spot market. no one doubts that the speculative contract volume in the futures market is several times greater than that of either producers or end users. so it becomes absolutely crystalline that speculators essentially set the price of oil, and have since the early 2000s. moreover, the fact that speculative contract volume has skyrocketed in recent years confirms the fact that oil prices are in a manic bubble.

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Hmmm... Ends the debate? My understanding was that this fact invalidates just part of Krugman's argument -- that speculation in the futures market can't affect the price of oil -- but that Krugman's core point remains that if price actually paid for oil remains above that warranted by true supply and demand fundamentals, then inventory must be building SOMEWHERE. (e.g., in the ground, throughout the consumption chain, with secondary or tertiary stocks, in hidden hordes in China or with hedge funds, etc). I know Yves has covered some of this aspect also...

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lol -- maybe that's a bit optimistic on my part, hbl... :)

fwiw, i think there's a lot of places oil storage may be building that aren't widely reported -- but the most important thing to know about storage from my perspective is that it is irrelevant as to whether i can find it or not. no bubble could exist if the storage were easy to see -- everyone is looking for it, and if it were found conclusively by the time i knew it the bubble would have already been broken.

in other words -- not seeing it is isn't proof that no bubble exists. if it is a bubble, where the oil was stored will only become obvious in the aftermath.

but i am fairly sure oil is being stored -- as the nymex futures curve has been in contango for much of the last few years. as the wsj said in 2006:

In short, [contango] pays for refiners and other oil-market players to buy and hold oil now to sell it down the road. Making that trading opportunity possible, says Colorado-based oil analyst Philip K. Verleger, is the huge volume of new buyers on the other side: investors who he estimates have put more than $60 billion into U.S. crude-oil futures since 2004.

as long as that's true, you can wager that oil is being stored.

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more recently john hussman discussed oil market contango.

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Thanks for the followup (and there seems to be some disagreement about how much oil has been in contango versus backwardization but it doesn't seem to matter given recent acknowledgement of the convenience yield). I do agree that oil is very likely in a speculative bubble and that people put way too much faith in the inventory data. As you say, all will likely become clear (with respect to inventory) in hindsight. It's actually amazing to me that someone as smart as Krugman isn't more skeptical of the data, especially after the recent widespread misperception of agency ratings' quality!

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