Randolph and Mortimer have moved on from FCOJ.

January 13, 2009 1:05 PM

Was market speculation behind this year's rise in crude oil prices? Earlier this year, prices topped $100/bbl, the highest seen since the oil crisis of the late 70s/early 80s. By July 2008, the price of crude oil reached a record high of $144/bbl, costing US consumers between $4-$5 per gallon at the pump.

Throughout 2008, economists were quick to name various possible causes: increased demand due to rapid development in China and India, mitigated by short supply and production shortfalls; unrest in various oil-producing nations; the ominous shadow of peak oil; and finally, crude oil speculation.

After months of rising nationwide consumer outrage, the Oil Speculation Reduction Act of 2008 was introduced in the House of Representatives in late June 2008. In response to the proposed bill, the Commodity Futures Trading Commission (CFTC) released a 48-page report stating their belief that "observed increases in the speculative activity and the number of traders in the crude oil futures market do not appear to have systematically affected prices"; the report was met with some skepticism.

Now that crude oil has dropped to a four-year low of $33/bbl, economists are faced with the task of finding someone to blame explaining the Great Oilpocalypse of 2008. A recent 60 Minutes report suggests that market speculation, and only market speculation - by hedge funds and big-name Wall Street investment banks - is responsible, going so far as to invoke the corporation we all love to hate, Enron.

Previously.

posted by elizardbits (29 comments total)

Well, a large economic contraction is going to change that market demand. Was it too high before? Probably. Is it too low now? Probably. Have the long term prospects for increasing prices changed? Not really.
posted by jaduncan at 1:14 PM on January 13, 2009 [2 favorites]

Paul Krugman isn't buying it, and points out:

You see, iron ore isn’t traded on a global exchange; its price is set in direct deals between producers and consumers. So there’s no easy way to speculate on ore prices. Yet the price of iron ore, like that of oil, has surged over the past year. In particular, the price Chinese steel makers pay to Australian mines has just jumped 96 percent. This suggests that growing demand from emerging economies, not speculation, is the real story behind rising prices of raw materials, oil included.

posted by Pants! at 1:15 PM on January 13, 2009

But what if the price of iron is tied to the price of oil in some way. Maybe in the form of the cost of energy to mine and refine iron? Not an economist, so I could be way off base here.
posted by reformedjerk at 1:20 PM on January 13, 2009 [3 favorites]

What's up with gas prices?
posted by burnmp3s at 1:20 PM on January 13, 2009 [2 favorites]

I'm certain that Ron Paul supporters are involved somehow.

Troublemakers, all of 'em.
posted by Joe Beese at 1:26 PM on January 13, 2009

How, then, does Krugman explain the price drop of oil?
posted by Chocolate Pickle at 1:29 PM on January 13, 2009

How, then, does Krugman explain the price drop of oil?

The shit hit the fan WRT the world economy? What looked liked unbridled growth in China and India for the next several years has vanished.

And it makes sense that iron ore prices would go up, these Australian companies aren't going to be able to expand and find new resources if they end up with a 10% margin.
posted by SirOmega at 1:34 PM on January 13, 2009 [1 favorite]

Barry Hitoltz gives his thoughts on the whole 60 Minutes story. He has some interesting points on possible greater causes than just unwarranted speculation.
posted by amuseDetachment at 1:42 PM on January 13, 2009

err Barry Ritholtz, rather.
posted by amuseDetachment at 1:42 PM on January 13, 2009

I know close to nothing about how the markets really work. I'm a reasonably intelligent person. That speculation was majorly fucking with commodities prices seemed obvious to me over a year ago. I don't get how anyone can doubt it at this point. Especially given the price collapse.

I understand there was mid-east turmoil, runaway demand fueled by insta-credit-for-all, and increasing fears about long-term supplies.. I think that just alternatively masked and fueled the rampant speculation.
posted by ninjew at 1:44 PM on January 13, 2009 [2 favorites]

You see, iron ore isn’t traded on a global exchange; its price is set in direct deals between producers and consumers. So there’s no easy way to speculate on ore prices. Yet the price of iron ore, like that of oil, has surged over the past year.

That seems like some pretty sloppy reasoning right there, coming from a Nobel prize winning economist. What's the basis for forming an analogy between iron ore and oil as commodities? They're two fundamentally different kinds of commodities used for fundamentally different purposes, so shouldn't the demand pressures that bear on their pricing have very little in common?

While there may be some degree of overlap between the factors driving demand for oil and iron ore (both are used, in the broadest sense, in manufacturing, I guess), but it doesn't seem like there'd isn't a whole lot of overlap between their uses. Iron's uses are primarily in the manufacture of durable goods and construction materials, while oil's uses are primarily in agriculture, the manufacture of consumer goods, and transportation, aren't they? Maybe they seem to track together, but surely that's just a coincidence, not any proof of the correctness of either of the pricing tracks.
posted by saulgoodman at 1:47 PM on January 13, 2009 [1 favorite]

saulgoodman: it's not too hard to reason that iron ore and steel would be heavily correlated, and we can see on the markets that steel is heavily correlated to oil (actually it looks like it's a slightly leading indicator for oil prices in a long timeframe).

The problem, IMO, is that most people don't have any familiarity with commodity prices. They see 8% returns on their mutual fund in one year and think that's insane returns (let alone checking accounts), the fact that prices in real, hard good can swing wildly scares people. (Actually, I wonder if there's a business reselling gas futures contracts for retail customers as insurance policies, sounds awfully lucrative right now with insanely low gasoline prices...)
posted by amuseDetachment at 2:03 PM on January 13, 2009

Enron: Here's California, with plenty of electricity supply and transmission capacity, suffering rolling blackouts and crazy prices. Turns out, it was Enron dicking with the market, because they basically were the market, and they could.

Oil prices: Here we are, with all oil producing nations cranked up and claiming there is no shortage of any kind, and stockpiles are higher than they've ever been, and oil goes to $140 a barrel. How on earth can it not be completely obvious that the market for oil was being manipulated by someone powerful enough to do it? Someone made big bets that the price would go up, and then used their own leverage to drive the price up (we'll find out how eventually) and made a shit ton of money.
posted by rusty at 2:19 PM on January 13, 2009

It comes back to the Giant Pool of Money. It's smart and it's hungry. It seeks out bubbles and makes them grow. It's your pension. It's my savings. It's out of control.
posted by grahamwell at 2:29 PM on January 13, 2009

Wow, that law must have really worked to lower the price of oil! After all, nothing else happened since June that would have lowered oil demand!
posted by delmoi at 2:43 PM on January 13, 2009

That seems like some pretty sloppy reasoning right there, coming from a Nobel prize winning economist. What's the basis for forming an analogy between iron ore and oil as commodities? They're two fundamentally different kinds of commodities used for fundamentally different purposes, so shouldn't the demand pressures that bear on their pricing have very little in common?

the use of Oil is a proxy for "economic activity". You need to burn oil to do lots of stuff. Steel is the same way. You need to use things made out of steel to do all that stuff (mostly) which means someone had to buy that raw Iron, turn it into steel, and build that stuff out of it.
posted by delmoi at 2:50 PM on January 13, 2009

The issue of speculation in oil markets is an interesting one. The Wall Street Journal has been reporting on the role played by Dutch-Swiss energy trading giant Vitol Group.

A single trader in Vitol's six-person hedge fund in Houston accounted for more than 11 percent of all outstanding crude-oil bets in July. The trader, 38-year-old Andrew Serotta, has been asked to leave Vitol. Serotta's trades earned Vitol well over $100 million.

The Sunday Times published this account of how Serotta's trades worked.

“We just watched, thinking they were going to get run over,” said one rival Houston-based trader of Serotta’s purchase. “To a bystander it looked crazy.”

In July last year, the price of a barrel of oil was hovering at about $70. Almost everyone expected the price to fall during 2008 to around $60 a barrel, but Serotta bought 40,000 futures contracts linked to a price of $80 a barrel.

The Commodities Futures Trading Commission, which regulates the oil futures market, distinguishes between two different kinds of oil trades. There is speculative trading, involving derivatives like oil futures, and there is physical oil trading, involving actual oil that's often stored on tankers. Vitol is the world's largest physical oil trader, and denies that it is involved in speculation.

Serotta worked at a six-person hedge fund that Vitol established in Houston to profit on speculative oil trading. These weren't one-way trades, but rather a mix of long and short trades. Vitol's hedge fund makes pennies millions of times over on small price anomalies on oil contracts.

Serotta told Bloomberg that Vitol decided to "shrink" its derivative oil trading after U.S. regulators classified his trades as speculative.

It's also worth noting that Vitol's Swiss arm, Vitol SA, pleaded guilty in New York state court to a criminal charge for supplying kickbacks to the Iraqi regime of Saddam Hussein in return for oil contracts.
posted by up in the old hotel at 3:12 PM on January 13, 2009

It makes sense to me that if the price of oil was speculative bubble or not would be an open question while it was acutually happening, but I'm not sure I understand why, after the fact, it's still such a topic for debate. If it was due to speculation, won't those speculators have lost huge sums of money now that the price has dropped so dramatically?
The 60 minutes article does mention money being made on price volatility, up or down, but it also suggests most bests were based on it going up. Would we (the world at large) be aware of these loses or would they known only to the company themselves?
posted by adamt at 3:50 PM on January 13, 2009

As opined last June, yes. Mostly gut feel at the time, but lots of disparate data sources all pointed to the same conclusion: speculative bubble. Speculators moved into the Futures market in a big way, and once CFTC started poking about many of the dicier participants lost interest in the game.

Now there's lots of hot money in fixed income, almost all govvies, but lately the action seems to be moving into high yield. TIPS are undervalued as well, and supply is sharply constrained; that sector will be interesting to watch as well in Q2.

Keep an eye on 3M Dollar LIBOR.
posted by Mutant at 3:52 PM on January 13, 2009 [1 favorite]

Paul Krugman isn't buying it

This is where Krugman does himself a great disservice. Very smart guy, but because he's forced to write two columns a week, he's bound to come up with some shitty logic and bad examples.

There was an oil bubble, but more generally, there was a commodities bubble, in which people assumed continued global growth outside the US (leading to higher demand) PLUS dollar devaluation because of inflation and a consumer-led recession (that would only affect the US), which raises the price of dollar-denominated commodities (like oil). Keep in mind that little over a year ago the Euro, Canadian dollar, and British Pound hit record highs against the US dollar. This was because people thought that the BRIC nations, along with other countries, would get past the imminent downturn in the US (the decoupling theory) and continue to grow on their own. Not many people expected both a recession AND a financial crisis, both of which sent shockwaves across the globe, and not simply contained in the US.
posted by SeizeTheDay at 4:29 PM on January 13, 2009 [1 favorite]

there is no bubble. when this wierdass deflation ends
and the dollar starts to drop we will see prices that
make 140 look cheap.
posted by mano at 5:18 PM on January 13, 2009 [1 favorite]

But what if the price of iron is tied to the price of oil in some way. Maybe in the form of the cost of energy to mine and refine iron?

Yeah, duh. It takes a lot of diesel fuel to get ore out of the ground and onto ships.
posted by ssg at 5:30 PM on January 13, 2009 [1 favorite]

Low prices now are due to lower worldwide demand.

Speculation ISN'T the answer. Oil contracts might have traded at a premium earlier in 2008, but they still need to clear upon maturity. That is, companies still have to purchase the oil at these prices. The fact that companies cleared these contracts at the exorbitant prices means speculation wasn't a culprit.
posted by achompas at 5:51 PM on January 13, 2009

Speculation makes perfect sense if you know it wasn't just the hedge funds and energy traders making the deals but pension funds like CalPERS.

Another thing to keep in mind -- the spike in oil (and other commodities) coincided with the first big market shock in late 2007 and continued upwards from there. If you know that mortgages and CDOs are toast and securities and equities are going to tank, you're going to look for your earnings somewhere, and with "emerging market demand" and "peak oil" combined with a plummeting dollar it was pretty clear that oil would get you a return, and lookie there we're through $90 time to load up on March delivery we can flip for $120!

And see, if you knew the US economy was in trouble, and you knew it was because of the mortgage market, and you knew everyone had their finger in the MBS/CDO market, you'd also know that there's no way in hell that emerging markets alone could push prices up, because they are still net exporters to Europe and the US.

In June of last year one of my far crunchier and more liberal co-workers and I got into a heated argument about the price of oil. She insisted that $4/gallon was here to stay, and I told her no, this was a bubble and prices would eventually crash and I grew up in oil country and these runups are unsustainable. I bet her that you'd be able to buy a gallon of gas in Seattle for $2.99 within three years.

I collected in October.
posted by dw at 6:29 PM on January 13, 2009

There's been a little research on whether futures markets increase or decrease price volatility. There aren't many products which have a history of trading both in, and out of, futures markets, but one such product is raw onions. Onions once traded on the commodities markets, but were delisted by government fiat because onion growers claimed that the commodity markets caused increased price swings.

Thus, it's possible to compare price volatility in commercial, wholesale lots of onions both during the time there were onion futures, and during a later period in which only physical onions could be traded.

Results: there was less price volatility during the time there were futures on onions. Conclusion: 'speculators' do not cause volatility. They decrease it. They smooth the bumps. They help 'price discovery'. They provide a larger market whether you're buying or selling, and that's always a good thing.

I learned this about a decade ago, but googling now, it looks like onions are still up to their old tricks.

And yet even with no traders to blame, the volatility in onion prices makes the swings in oil and corn look tame, reinforcing academics' belief that futures trading diminishes extreme price swings. Since 2006, oil prices have risen 100%, and corn is up 300%. But onion prices soared 400% between October 2006 and April 2007, when weather reduced crops, according to the U.S. Department of Agriculture, only to crash 96% by March 2008 on overproduction and then rebound 300% by this past April.

posted by Slithy_Tove at 9:55 PM on January 13, 2009 [3 favorites]

That seems like some pretty sloppy reasoning right there, coming from a Nobel prize winning economist. What's the basis for forming an analogy between iron ore and oil as commodities? They're two fundamentally different kinds of commodities used for fundamentally different purposes, so shouldn't the demand pressures that bear on their pricing have very little in common?

Indeed, they have vastly different uses, but if you wanted to predict the demand for either commodity, the very first input you'd put in your model for either one would be global GDP growth.
posted by Kwantsar at 4:48 AM on January 14, 2009

I think ssg's point makes for an even better refutation of Krugman's argument here: Since the price of oil directly informs the costs of iron ore mining, any price swings caused by oil speculation would necessarily be reflected in corresponding swings in iron ore prices.

So, all other factors being the same, any change in oil price should and apparently does trigger a corresponding and roughly proportional change in iron ore prices. But that still says nothing about whether or not speculative interest influenced oil prices.

My original criticism should be qualified: there is a relationship between oil and iron ore prices, but it's not one of parallel correlation, rather it's a dependent relationship.

the use of Oil is a proxy for "economic activity". You need to burn oil to do lots of stuff.

Sure, but the original question Krugman's analogy was meant to address was the question of whether or not speculative interest (rather than normal economic activity) influenced oil prices. Krugman offered up an observed correlation between oil and iron ore prices as evidence that only normal market pressures were at play, but if the price of iron ore is dependent on the price of oil, the evidence of a correlation only shows that speculative interest directly influenced the price of oil, which indirectly influenced the price of iron ore in turn. It doesn't offer any basis for conclusions beyond that.

Either there's got to be a better rationale for Krugman's argument than your suggesting delmoi, or he was just phoning it in that day.
posted by saulgoodman at 7:43 AM on January 14, 2009

the very first input you'd put in your model for either one would be global GDP growth.

But wasn't there a global GDP decline during the same time frame that Oil prices were skyrocketing (as I understand it, the latest information is we've actually been in or heading toward recession for longer than anyone would admit at first)? So wouldn't that put downward pressure on oil prices in anticipation of declining demand, as it reportedly is now?
posted by saulgoodman at 7:47 AM on January 14, 2009

The money line fro 60 Minutes: Both [Goldman Sachs and Morgan Stanley] declined 60 Minutes' requests for an interview, but maintain that their oil businesses are completely separate from their trading activities, and that neither influence the independent opinions of their analysts.

So, it doesn't even take much cleverness to figure out how they did it. GS and MS both had both a stake in the futures market and a large presence in the physical market. So they started buying futures at high prices, and driving large pools of client money into the same market with their analysts recommendations. Driving up the futures market automatically made their huge storage tanks full of oil more valuable, since they had filled them up at pre-bubble prices. Sell off that cheap oil at the new high price and buy some more at the now partly inflated spot market price, thus both confirming the "reality" of the new price (because hey, the futures are not disconnected from the spot market!) and reinforcing the futures inflation loop. Lather, rinse, repeat until global economic meltdown and serious threat of government intervention.

No doubt the $200/bbl "prediction" was the next price target, and it would have got there if it weren't for those pesky kids bank failures. Anyone with a hand on the steering wheel of the vast pool of invisible cash can inflate any market they choose to, with full knowledge and control of how big the bubble gets and when it is allowed to pop. It's market manipulation 101, and we made it completely legal.

It's sort of amazing that even now, nine years on from 2000, we're still living with and suffering the effects of the disastrous market deregulations that we already know, and have known for nearly a decade, have this kind of bubble not as an unfortunate side-effect, but as the primary and intentional result.

It's also worth recalling that Enron collapsed because of a lot of really bad expansions and investments, and fraudulent bookkeeping. The CA electricity fraud was the only thing actually making them money at the end. If it weren't for the rest of the mess there, it would never have come out so quickly and completely. The oil bubble can be viewed as an iteration of the exact same scam run by much more competent companies, who took their profits and walked away scot-free.
posted by rusty at 9:30 AM on January 14, 2009