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.

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.

OJ at an all time high

From my friend Ron (of InvestorCookbooks):

OJ futures are at their highest since 1977, as Ron said to me

"I'll bet you that Eddie Murphy and Dan Akroyd are making a killing!"

http://www.marketwatch.com/story/oj-futures-surge-as-fda-tests-for-fungicide-2012-01-10

Note that Video contains some bad words.

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.

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.