http://www.slate.com/id/2195037/
The World Needs More Speculators by Tim Harford
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One of the key issues of our time right now is of course the price of oil. People have watched it with increasing concern over the last decade as it has broken the $10 barrier, $30, $50, $100 and within the next year, undoubtedly the $150 barrier. The Oil price affects every single business and practically every single consumer via various knock ons.
So it is not unsurprising at all that many of us, in various conversations across the world are discussing WHY this is happening. It does seem bizarre that the same commodity, utilised for the same purpose can increase in price so much, so naturally attention has turned to the undefinable 'speculator', some people state that speculators are the cause of all this trouble, some state the complete opposite, that more speculation serves to bring the price closer to 'market fundamentals'.
Both sides are logically incorrect, there is not enough evidence to prove the correctness of either side's argument, so instead without realising, people refer to their intrinsic gut feelings.
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So let's take a look at what is actually happening. The Oil market itself is characterised by inelastic supply in the short to medium term. In laymen's terms, this means that the supply of oil cannot be increased if the price of oil rises.
Lets take an example. Oil extraction costs in the Canadian (Albertan) Oilsands averages between $25-30 dollars per barrel. Ergo, it is profitable to extract oil at any price above say $35 to get a reasonable rate of return. Let us assume then, that this oil is being extracted at maximum speed possible based on their environment? Why? Because oil extraction has already achieved profitable rates of return and is hence being extracted at maximal capacity.. Now if the price for selling oil changes from $50 to $100, the rate of extraction will stay exactly the same, merely the profit for the entrepreneur will increase.
One can state that in the long term, that extraction of oil will increase, however we are dealing here in the short-to-medium term. It can take years to discover and begin exploiting new fields, even small ones. (vis-a-vis Peak oil theory, even the likelihood of long term increases of production seems to have been rendered unlikely with declining outputs from mature fields)
Regarding OPEC, the evidence suggests that OPEC is pumping at full volume, regardless of public announcements, because quite simply, the profits are there for the countries to grab. Especially since in a quota system, the higher the price, the more likely countries are to break the agreement to maximise gain for themselves, at the expense of their rivals. With game theory coming into place, this means that quotas are being broken wherever possible, with minimal outcry from other fellow quota breakers.
So to summarise, this means, that the hypothetical 100 units of production will occur regardless of the price increase.
Now lets look at demand.
In the short term, contrary to popular belief, demand is actually becoming inelastic. Oil is being used for key services which have no easy substitutes. Even a transfer of traffic from cars onto buses & trains does not change the underlying fundamental, that all rely, ultimately on oil.
(About electric trains running on energy generated via power stations, they may run on a mix of fuels ranging from nuclear to solar, but all are equally affected by rising energy prices which is directly correlated with rising oil prices)
In the medium to long term, one is likely to see fundamental shifts in oil habits and it is highly likely the oil efficiency per unit of GDP will increase, just as it experienced a major step change after the first oil shock in the 1970s.
However, as far as we are concerned, we are dealing with the short term, because going back to the original point, we are discussing 'speculation'. Oil is traded on the basis that X amount of barrels will be delivered to X location in 30 days.
So in this case, let us state that the hypothetical 101 units of demand will occur regardless of price.
Now this presents a major problem, if there is short term fixed demand, and short term fixed supply, how can price be determined? The diagram below presents the problem very well. Now the price will be determined by long term fundamentals such as how profitable it is to purchase 1 unit of oil, what it is used for etc. However, any change in demand, or indeed supply, will cause a massive price differential. This goes someway to explaining how OPEC in the 90's by contracting supply by as little as 2-3% was able to increase prices by an order of magnitude.
Now a similar situation may be occurring via demand. There are numerous risk factors that do affect the price of oil. The most famous (but not necessarily most important) of these included oil disruptions in Venezuela, Nigeria and Iran and long term increases in Oil production from countries such as Canada, Brazil, Russia etc. This is the key point, that as humans, we simply do not know what the future holds. The total sum of human knowledge when it comes to determining risk of oil supply as expressed via the market price will invariably be wrong. We simply do not know how the future holds, in effect, we can only make educated guesses.
The world is not an understandable machine with so many cogs in the wheel, it is only stated as such to help us construct (very useful) scientific models, to understand portions of the world, not as a fact itself.
An example of this is that in the Oil market, whilst it did factor in the Iraq war, in 2003, the market did not correctly predict that insurgents would specifically target oil installations and pipelines to cripple Iraqi oil supply, it was actually predicted by the balance of the market that oil supply would increase as oil firms flooded into Iraq in the 12 months following the invasion.
So this is a built-in factor in the price determining Oil price, the 'risk' that the market has factored in. This risk calculation may be as close as 0.001 percent into the reality of the situation. But when dealing with geopolitical situations, one simply cannot know for example if there is going to be an attack on Iranian oil installations and a counter attack on Bahraini installations.
So as the graph demonstrates, even an error of 2-3percent will result in massive price spikes (likewise so will an underestimate, let us not forget that the real price of oil may be undervalued based on what will happen in the next 12 months). The Blue represents demand, whilst the Red represents Supply, notice especially the sharp vertical nature of the two lines, if the lines move even marginally to the left, or the right, there will be considerably sharper price differentials.
This brings us finally, and neatly unto the speculators themselves. To me, a speculator is someone who does not deal in the commodity itself for their own personal use, but to gain a profit. The profit lies in being able to factor risk and the underlying value to a better degree than the market-at-large. Tim Harford, who is linked at the top of the article, suggests that inventory stocks would be rising if there was speculation, this is not occurring. Does that mean speculators are not operating in the market? No, unlike many other commodities, oil is primarily traded as a futures product, ie it is delivered 30 days in the future. It is perfectly possible for a trader to purchase oil and sell it 2 weeks down the line. This is especially likely as storing oil (inventorying) is a major expense as a percentage of the oil's original value. Due to the complexities of the trading markets, this may be very difficult to discern merely looking at the market and hence becomes an unknown.
Now as i stated earlier, oil demand is in the short term inelastic. Ergo there are only a certain number of purchasers. Ergo the following situation happens. Oil Producer A sells to Oil 'Speculator' C Sells to Oil Consumer B instead of; Oil Producer A sells to Oil Consumer B.
Now this introduction of the linkage may serve to bring the oil value closer to its true value. However, it is equally possible that the collective wisdom of the speculators is more erroneous than the collective wisdom of the consumers alone. In which case, as i stated earlier, with inelastic supply, this will merely serve to destabilise the price.
So after all that, what is happening........?
Well, what do you believe is happening....??
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