The impact of Speculation on Oil Prices

abarrelfullabarrelfull wrote on 11 Feb 2011 10:14

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I tend to see the "speculators are driving up the price of oil" crowd, as a bunch of ignoramouses fighting against that which they don't understand. They are generally anti market, and they criticise in terms that would have Trotsky nodding in approval.

The problem is that I have never been able to really argue my corner, being that I am not an Economist of great international repute. So when I found such a person, pontificating on speculation, I was most happy indeed.

Many people on the “speculators did it” side like to point to financial data, especially large purchases of futures by various players. But food is a physical commodity, and plays in the financial markets can only move the price to the extent that they affect physical flows and stocks.

The futures market simply creates a price for the future, which may lead physical traders to increase or decrease stocks now, based on those expectations. The key is that should the expectations prove to be wrong, the market will self correct over time. To bet constantly against the fundamentals of market is the most stupid investment strategy since Bernie Maddoff. You will lose your shirt.

A good example of when speculation did increase prices can be found here

This type of oil investing was quite popular in 2005 and 2006 when, like today, the price of oil one year out was much higher than the spot price. Back then, contango trades were so popular that one of Morgan Stanley's top energy traders, Olav Refvik, leased so much oil storage that he earned the nickname "the King of New York Harbor."

There's no question the investing strategies pursued by Refvik and others were pushing up oil prices. By putting large sums of oil into storage, they reduced the supply available to consumers.

Note that it was the existence of a Contango that enabled traders to make these bets. Note also that this contango disappeared before the prices peaked in mid 2008.

What happened that year was a mix of fear and greed. Oil companies increased inventories, either to make stock gains, or to save themselves from having to buy more expensive later on. For the most part, not being hedged, they exposed the owners to the full risk of oil prices. When prices started to go south, there was panic as everyone sold inventory. Thus the flow of products into and out of storage, accelerated both the upward trend and the crash.

The reason that so much was blamed on the hedge funds, was basically nothing more than a good scapegoat. The oil companies descovered that there was actually one group of people less popular than themselves, and they took every opportunity to pass the buck.

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