Who's responsible for the oil price decline?

The price of oil has been going down of late and it got me thinking - who's responsible for this?  Then I remembered that according to the media, it is the Wall Street Speculators who set oil prices.  So I just wanted to say a big thank you to them.  Thanks for getting the oil price lower just in time for summer road trips.

Turns out that the Grumpy Economist also had the same feelings of gratitude.


For a more complete discussion of the role of speculators, see here.

Speculation and Oil Prices (again).

The Grumpy Economist has an excellent piece on how speculation is unlikely to be causing oil price increases.   Read it because the author, John Cochrane, rarely pulls punches.  He's great (and also very smart).

Great quote:

It's also worth noting that on that same day, there were 146,000 May natural gas contracts traded... By what mysterious process can all this within-day buying and selling of "paper" energy be the factor that is responsible for both a price of oil in excess of $100/barrel and a price of natural gas at record lows below $2 per thousand cubic feet?  

As my regular reader will note, I've blogged on this quite a bit before, but I am sure I will blog on it again.  My guess is next in the next election cycle.

What's driving gas prices?

I've said it before, it is not speculators and drilling won't help much.

Oil arbitrage

Brent crude (priced in Europe) and West Texas Intermediate (WTI) (priced in OK) have deviated in price quite a bit recently - raising the question - Are higher oil prices a result of a lack of pipelines between OK and the East Coast?

It's an interesting question.  Certainly more pipelines would allow oil to flow more rapidly to wherever markets need it.

In the case cited above, the higher prices are in Europe and presumably would be lower if we could export more WTI to that market to substitute for Brent crude.  But this isn't likely to impact domestic prices, as domestic prices are driven by the price of WTI.

I'd have thought that a pipeline would result in WTI prices rising and Brent prices falling as the mispricing declines.

It's also worth remembering that the keystone pipeline proposal runs north-south and not east-west.

High oil prices are not caused by Obama or speculators

Spring is in the air, and as usual at this time of year, the talk turns to oil prices, and specifically why they are high. While the various GOP Presidential candidates are furiously blaming the President for the level of oil prices (and in doing so demonstrating their complete lack of understanding of how oil markets work), the media is blaming nasty speculators.  Today's Mcclatchy piece in my local paper has the bold headline "Markets to blame for oil prices".  Well duuhh, of course markets are to blame - they are to blame when prices are high and when prices are low, because markets set prices.  It's like saying the weather is to blame for the rain.   But dig into the article a bit further and we find that apparently it is actually evil speculators that are to blame - something that I seriously doubt.

But I won't go into the arguments as to why it is unlikely that speculators are to blame, because about a year ago, Srini Krishnamurthy (my colleague) and I wrote an op-ed piece explaining just that.  I discuss this piece in more detail in a blog posting back then.

In the meantime, I suggest blaming supply and demand.

Supply and Demand for Corn

And then there is corn.   The Government subsidizes corn production, mandates its use in ethanol and imposes import restrictions.   The amount of corn being used for ethanol now exceeds that being used for food.  At the same time, ethanol production is doing nothing for the environment or oil prices.  Brilliant.

Reposted from Felix

Are speculators causing higher oil prices?

My colleague, Srini Krishnamurthy and I have an op-ed piece in today's News and Observer that answers this question.  The bottom line is that global supply and demand is a more likely explanation for the price you pay at the pump than speculation in the futures markets.  Furthermore, manipulating oil prices by trading futures contracts is very difficult because for every buyer of a contract there has to be a seller.  In effect, the futures market is just a bet on the level future oil prices.

The N&O also published an excellent editorial from the LA Times next to our Op-Ed piece.  The gist of the editorial was that increasing oil production in the US is unlikely to have any effect on short term oil prices - despite the claims of numerous politicians.  This is due to two reasons.  First, bringing new oil production online takes years - so any new drilling is only going to impact future oil prices at best.  Second, and I think this is the point often not well understood, the US buys oil in a global market.  It doesn't really matter if we increase domestic production 10% because that increase will be a drop in the proverbial global bucket.  We could only hope to lower oil prices by increasing supply to such an extent that it impacts the global supply of oil.   Even then, OPEC could just as easily cut production to offset the new supply increase.
The best way to deal with higher oil prices would seem to be to focus on the demand side and use less oil.

This all ties back to basic finance.  When should an oil company drill for oil?   The answer is when doing so is a positive NPV project after taking account of all the real options involved.  MBA students will study real options in MBA 521 - Advanced Corporate Finance.

Speculators and oil prices

In my local Sunday paper today, there was a pretty poor article about the effect of speculators on oil prices.  The article was a McClatchey piece and so probably appeared in numerous other papers.  The article's basic premise was that oil prices are high because the proportion of speculative traders relative to commercial traders is high.  Therefore speculators are causing high oil prices.

I've blogged on this before.   The argument is flawed for several reasons.

1. The assumption that the relationship runs from speculators to oil prices is a classic case of confusing correlation with causality.  
2. It makes little sense that highly informed traders would bid the price of oil up way beyond its fundamental value.  If they did, they would expose themselves to monumental risk of the price collapsing.
3. Most oil speculators are trading futures contracts.  As a result they never actually take delivery of the oil.  It is hard to manipulate a market if you don't actually take possession of the commodity.
4. The presence of more speculative traders makes it far more likely that a bubble in oil prices would burst sooner rather than later for the simple reason that bursting the bubble would make a lot of traders who bet against high oil prices very rich.
5. The argument that shows that US refineries are not running at peak output and that US demand is down completely ignores the global demand for oil which is increasing steadily.
6. The biggest "speculators" are the oil companies themselves who choose not to refine more oil and instead keep it in their reserves.  They just understand that real options have value.

Both Forbes and The Economist have excellent articles on this topic.  Notably these articles were written last time Congress went looking for a scape goat to explain supply and demand.

The end of asset allocation?

Felix Salmon blogs that asset allocation is dead. He argues that the basic idea of spreading your risks across asset classes with low correlations isn't working anymore, in part due to commodity ETFs being bought up by investors in the name of diversification. Apparently, this action brought the correlation between equities and commodities closer to 1.

I don't really buy this whole, "the correlations have gone to 1" argument. First of all Felix states that correlation is impossible to measure and cites a wired article about the Gaussian Copula. This is a bit of a straw man. Correlation isn't hard to estimate at all. Felix's second point is that correlation is backward looking and therefore no good. I agree that it is a backward looking measure, but I wouldn't through the baby out with the bath water quite yet.

You have to consider what are the alternatives there are to asset allocation. Felix states:

In investing, nothing lasts forever. And the era of asset allocation is in its waning years. The problem, of course, is that no one has a clue what might replace it.

Asset allocation is not a trading or market timing strategy which might loose its ability to generate returns over time. Asset allocation is a method of managing risk. It will reduce portfolio risk overall, but as we have seen, in severe events, correlations do not necessarily go to 1, instead the impact of the market component on diverse assets becomes far more important. Nothing except being in cash would have saved you in the recent market drop, but for most time periods, asset allocation has and will continue to reduce portfolio risk. Put another way, if you are driving a car a seat belt (asset allocation) will help a lot, most of the time. But there are times when it won't (i.e. you drive off a cliff). That still doesn't mean that you shouldn't wear a seat belt.

Contango in the oil market

Bloomberg reports that Investment Banks (I thought that they were extinct) are looking to rent super tankers to store oil for future delivery. They want to take advantage of the contango in the futures market for oil. Contango is the amount a futures price exceeds the spot price.

Ordinarily, you shouldn't be able to buy the oil today and sell a futures contract for future delivery and then make money by storing the oil. But apparently, because traders are worried about a severe cut in OPEC supply in the future, the futures price is much higher.

An interesting data point from the article reveals that it costs about 80-90 cents per month to store a barrel of oil on a super tanker. So, given that:

West Texas Intermediate crude oil futures for March delivery are trading at $45.98 a barrel, about $4.78 more than the February contract.

This means that you could make well over $4 a barrel just storing Oil in March. An example of a supertanker mentioned in the article holds a million barrels. Of course there is also the cost of borrowing to pay for the oil up front, but with interest rates as low as they are, this shouldn't be too significant.

Pigovian Taxes

Greg Mankiw has an excellent article on why gas taxes should be higher. I'm inclined to agree with him. In fact the majority of economists support the notion of Pigovian taxes on gasoline. These are taxes that are used to correct some externality generated by consumption. In the case of gasoline, the externalities are pollution, congestion, climate change etc.

Mankiw also explains why cap and trade policies are inferior to a simple carbon tax. The primary reason being that the revenue from the carbon tax can be used to offset the tax burden - for example - it can be used to reduce payroll taxes.

Primary opposition for carbon taxes come from politicians - but as Mankiw points out; just because they oppose a carbon tax - doesn't mean that carbon taxes are a bad idea.

Anyhow, it is an excellent read for both economists and non-economists alike.

Hat tip goes to the Freakonomics blog where I saw this posted.

Why have gas prices fallen?

Gas prices have fallen and oil prices are well below their recent peek - which raises the question: Why? Some might say it was supply and demand with the higher price reducing demand, thus resulting in a lower equilibrium price. Others offer a different explanation...prayer.

Perhaps this will lead to a new area of theological economics.

Some thoughts about oil prices

An article in Fortune says that it is unlikely that higher oil prices are due to futures trading. There are two basic reasons for this. First, these futures traders are not building inventories of oil, in fact oil inventories are down. Second, for every futures contract, there has to be a long and a short. If the longs are paying too much - the shorts should stand to make a killing. As usual, congress is blaming speculators for high oil prices and proposing legislation to reign in these "speculators". A similar article is in the Economist




On a related note, Newmark's door has an article about how the onion market is more volatile than the oil market, perhaps because there is not a futures market for onions. This finding is supported by my own work that shows that Single Stock Futures reduce volatility in the spot market for stocks. In fact most evidence shows that futures markets have a stabilizing effect on the underlying spot asset.

Finally, on NPR this weekend I heard a story about people trying to trade in their SUVs for more fuel efficient vehicles. In the story, one person brought a 2007 Escalade to a CarMax dealership. The truck was a year old, and cost over $70K. The owner was making $1400 a month payments on it. The CarMax buyer offered him about $30K for it. Here's what I don't get. You buy a 70 grand SUV a year ago when gas prices are $3 a gallon, but when gas prices hit $4 a gallon, you can't afford to run it? What's more, the owner said he would have sold it for $40,000 to the dealer - basically taking a $30,000 loss to save the pain of an extra $1 per gallon of gas. In behavioral finance this is called "mental accounting".