The Spector of Speculators

When it comes to oil we are in a parabolic run up not dissimilar to the Nasdaq bubble of 1999/2000. The thing about bubbles is that they can inflate for a lot longer than you’d ever imagine. There are a lot of companies who have significant energy costs or are otherwise impacted by the price of oil that are rushing in to lock in prices for the future. It is a lot like a short squeeze. Everyone is panicking that if they don’t lock in now they are going to get hurt even more.

Joe Lieberman says he is going to introduce a bill that will prohibit anyone from trading in oil futures that are not able to take physical delivery. So I guess this means that for companies where managing their energy exposure, like airlines, but do not take physical delivery, will be barred from the future exchanges?

Other bills are being introduced by the Democrats to prohibit index funds from trading commodity futures. Are we really going to say Party A can invest in only these types of investments and Party B can invest in others? Is this the Soviet Union?

It is doubtful that speculators are materially affecting oil prices. There are many traders taking short position in oil right now, expecting the bubble to pop. It is not a long only market when it comes to traders. If fact, speculators, let's call them commodity traders (investing in futures without intending to take delivery of the physical commodity), create liquidity that is highly beneficial to the price discovery and companies being able to efficiently move in and out of positions.

If traders that do not take physical delivery are the cause of rising prices, then consider this. Eventually, these traders have to sell their futures contracts before the commitment date to take delivery. If speculators were such a powerful force, then this selling should cause the price to fall dramatically at the point when the contracts have to be "rolled forward". Last week was futures expiration for the quarter and options expiration for the month. No drop in price was experienced.

The global daily production of oil peaked in 2005 at 85 million barrels. The current demand is about 85 to 87 million barrels. Since 2005 emerging economies such as China and India are consuming ever greater amounts of energy and commodities. Without more supply, and growing demand, the price goes up. Certainly there will be some downward pressure in short term prices as the high costs cause demand destruction and substitution behavior. We have already seen some of this in the U.S. over the last several months.

A clue to determining if speculation is a factor is to look at other commodity prices that are not traded on futures markets. Iron ore and coal are good examples. Both of these commodities are traded through contracts between private parties. Neither of these are traded on a futures exchange. But the cost of both of these commodities have skyrocketed more than the price of oil due to global demand.

In fact, all the commodities that are needed to build out the surge in global infrastructure and racing up due to skyrocketing demand in the face of a long lead time to increase supplies. Why do steel companies have sustainable pricing power for the first time in generations? It is because China and Russia used to be able to flood the market with cheap steel. Now China is making as much steel as they can and importing much more. Why has the price of coal more than doubled recently. China used to be a net exporter of coal. Now they are a net importer. Not only are they now a net consumer of coal but all the other countries in Asia that used to buy coal from China are now scrambling to obtain substitute supplies from Australia and the United States.

Congress, having created the lack of supply, and frantically looking for political cover, will undoubtedly make the situation worse. If Congress wants to close the "Enron loophole" then I'm fine with that. And it might have some short term effect. But it will not change the fundamental supply and demand dynamics of the market.

The U.S. Congress always feels compelled to "do something". But that something rarely solves the problem, makes it worse, and has severe unintended consequences. Take Enron for example. Congress' solution was to pass Sarbanes-Oxley. "Sarbox" has solved nothing and has had the unintended consequence of driving new companies to IPO in London and Hong Kong instead of New York. Sarbox has had a chilling affect on attracting capital to the U.S. and has been financially untenable for smaller U.S. companies.

If Congress has its way with making the U.S. commodities exchanges non-competitive in the world market then oil futures trading will simply move to the Dubai exchange. Nothing will have been solved. But the Nymex will be damaged irreparably. Like with Sarbox, Congress is always fighting the last war.