Tuesday, June 24, 2008

Low Supply of Oil: The Effect (not Cause) of Futures Speculation?


Paul Krugman continues his "speculation on speculation":

Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price. And that’s true no matter how many Joe Shmoes there are, that is, no matter how big the positions are.

As I've already detailed, this would make sense EXCEPT that actual oil is delivered to the owner of the futures contract, so there is in fact a DIRECT effect.

Now to his most recent "speculation on speculation"; in summary Paul does not believe futures have impacted oil prices specifically because there has been no coinciding increase in oil inventories. His charts are clear and I do agree with them, BUT they ignore one key component that his readers keep posting to his site. Since he may not be reading his readers comments, I'd like to summarize them by attempting to answer his parting question:
Maybe I’m misinterpreting what the advocates of a speculative story are thinking. But in that case, what are they thinking? I’m curious.
Paul likes basic examples, so here we go with a little story about Country A....

Background:

  • Country A owns one oil well.
  • This oil well contains 1000 barrels of oil.
  • They planned to sell 100 barrels of oil this year (1/10th of their total inventory) at a forecast of $70 / barrel.
  • They can pump out more oil, but they are worried about their future when they run out (currently projected at 10 years)
  • They do however, need at least $7000 / year to manage their country

So what happens when speculation drives up the futures price to $140 / barrel? Country A is faced with two options (keeping it simple):

  • Option 1: increase production and lock in this profit
  • Option 2: meet the current budget by selling half of the amount planned (50 barrels); sell a portion of the remaining inventory in the futures market
So what are the pros/cons of each? Lets take a look...

Option 1:

  • Pro: can lock in this high profit and get cash to meet future budget needs
  • Con: what do they do with this money (in reality they may already have too much cash to put to use)? The best investment opportunity for global investors these days is where else? Energy companies and commodities! Why take the best investment option for many and swap it for U.S. dollar based Treasuries which barely have a positive real yield?!?!?!

Option 2:

  • Pro: along with the possibility of even higher prices in the future (global demand, geopolitics, peak oil), Country A can maintain its relevancy as an oil producer in world politics for more than the previously thought 10 years.
  • Con: uncertainty of the future price of oil, but Country A can sell to Joe Shmoe, who is now an investor in the futures market or more simply, just keep it in the ground!

So what is happening to the world supply of oil? Production by the Organisation of the Petroleum Exporting Countries fell by 350,000 barrels of oil a day last year, coinciding with a decline in net imports of crude into the U.S.



In summary, oil producers have a significant value in keeping oil in the ground. In fact, I believe the important question to ask is whether this value is causing the price of oil to spike OR whether speculation in oil (i.e. massive amounts of new commodity investments) is in fact creating much of the value in keeping it in the ground?