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Inventories, Speculation, and Hedging
After the End of Cheap Oil

by | published May 20th, 2011

The downswing in oil prices over the past two weeks has once again introduced supply/demand questions… while, at the same time, renewing suspicions that speculation is the cause of oil pricing instability.

Discussion of the supply/demand question usually gravitates to the “peak oil” debate: how much oil is left, and when the markets will conclude that over 50% of the total supply has been exhausted.

This latter consideration has become a mainstay of the debate. That’s because it cuts to the core of how traders view the relationship between available supply… and price.

In a normal market, pricing – whether for paper barrels (futures contracts) or wet barrels (actual consignments of oil) – is primarily based on the price of the next available barrel. It is, therefore, a forward-looking process, based less on where the price has been than on where traders conclude the price is going. (These are forward contracts and deliveries, after all.)

In a supply-constricted market, however, the focus changes to the price of the most expensive next available barrel.

Why? Because the normal process of pricing being determined by the interchange between supply and demand only works if there is reserve supply and an ultimate cap on demand expansion.

Price usually serves as the barometer of both – higher prices enticing both increasing production and declining use; lower prices discouraging marginal increases in extraction, but prompting additional use. (Declining energy prices always result in rising consumption.)

But when a concern emerges over how much supply can be brought onto the market in a given time frame, the dynamic changes…

Now the uncertainty of satisfying market demand will gravitate the price to higher levels, reflecting competition for the available supply. In this situation, a trader needs to peg the trade to the highest price; otherwise, he or she cannot guarantee access to volume.

We are not (yet) in a supply-constricted situation.

Additionally, I want to emphasize – again – that we are not in, nor are we approaching, a peak oil environment, either. (See “Why This Is Not A Peak Oil Crisis,” March 4, 2011.)

There is plenty of oil left. The problem surrounds the end of cheap oil.

The new oil coming online is more expensive to extract, process, transport, and refine. As we move into an accelerated tapping of unconventional sources (such as oil sands, shale, heavy oil, and bitumen), the cost factor increases even more.

OK, so that provides us with one indication of why prices (until recently) have been increasing.

But if the essential culprit is not availability, then is it speculation?

Why Speculation Is Actually Necessary

In a normally balanced market, speculators tend to offset. Even when the presumption is that the price will be moving up or down, there is still an offsetting factor in the trading process.

Speculators are necessary to allow trade. (I have discussed this before, as well. See “2011 Energy Prices and the Speculator’s Role in Trade,” December 28, 2010.)

If I want to make a transaction, I need somebody on the other side prepared to take a financial risk. I need, in short, somebody interested in making money off of the transaction – not a party needing to buy or sell the actual oil (more on that in a moment).

Speculators add liquidity.

And they tend to take the more extreme positions in trade – both to increase the return potential to them and to provide adequate leverage for exercising a series of options to manage their own risk, thereby narrowing the range of risk for others.

Occasionally, a market can heat up or cool down to the extent that the positions taken by speculators may have an impact greater than usual. However, even in such situations, the existence of the speculative element more reflects – rather than produces – the market effect.

This is important, because current political rhetoric from inside the Beltway finds it very convenient to blame the speculator for the run-up in prices.

One proposed solution is to restrict the speculation in New York.

Changes in margins, contract volume, and the like may well be in order. But attempting to restrict futures contracts only to those who have an interest in the underlying wet barrels – i.e., actual buyers or sellers of the crude – will simply move the speculation to markets beyond U.S. control.

Not a good idea for a market already dependent on other countries for upwards to two-thirds of daily oil needs…

It also merely accentuates what I do regard as the primary cause: hedging.

Why Hedging Is A Valid Exercise, Too

It allows providers and recipients of both crude oil and oil products to protect their bottom lines from undesirable changes in prices.

They will do so by either counter-positioning consignments or taking options (which essentially do the same thing).

However, the parties are not the same in each case. With crude oil, the provider is a production company, while the recipient is a refinery. In the case of oil products, the provider is a refinery, with the recipient a wholesaler (or “jobber”).

Leaving hedging as the only, or primary, arbiter of price, will bring us back to the situation that prompted creation of futures contracts in the early 1980s. They were designed to open up markets to more participants and effectively wrestle the determination of price from the hands of a few very large international oil companies (the famous “Seven Sisters“).

These days, returning to hedging as the way to set pricing once again allows a few players to dictate prices.

Today, however, the main participants are not international majors, but national oil companies – Saudi Aramco, Petróleos de Venezuela (PDVSA), other OPEC members, or Russian Rosneft.

The market price would not be determined by thousands of smaller end users, but by huge producers bent on maintaining higher prices.

Nonetheless, the larger vertically integrated oil companies (VIOCs) – those who control the process from wellhead to refinery to retail outlet – would still benefit if hedging were the only solution.

The refinery remains the lynchpin in the entire process. Those who control refinery capacity control the pricing in the regional and local markets they serve.

Anecdotal evidence is already emerging that VIOCs were unusually active in trading in near-month futures contracts in their own product – both when crude oil and gasoline prices were rising through close on April 29 and thereafter, as crude plummeted almost 15% through close on May 6.

Does this improve either the pricing picture or the demand-side concern hitting the average consumer at the pump?

I think not.

Sincerely,

Kent

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  1. James O. Bleidner
    May 20th, 2011 at 13:39 | #1

    The definition of a “speculator” is a person that believes that the price of a “good” is not correct and who procedes to invset his money on that belief. A “speculator” is not a “demon,” as some would suggest. James O. Bleidner

  2. David Krasowski
    May 20th, 2011 at 13:57 | #2

    Hello Sir, I am not where I thought I would be financially this late in my life. I have joined many different services always looking for an edge, something that could boost me in to having a nice retirement fund. With no retirement benefits and lessthan $60,000.00 in my RRSP
    my question to you is; where should I be investing to get the biggest bang for my buck, or the lack there of?

    Thank you,
    Dave

  3. Glen
    May 20th, 2011 at 14:22 | #3

    This article was very informative but ended rather abruptly and left me wanting more. What did the VOICs accomplish by their hedging in the latter months? What was their motivation?

  4. Bob
    May 20th, 2011 at 15:04 | #4

    Hi Dav;
    Me niether but misery helps neither you nor I. My schawb guy tells me there are new CDs that are tied to different commodities. That sounds the safest to me. I’m what use to be called an adviser on money matters and investments counseling. All I can really tell you is that all the rules have changed and I have not the slightest idea how to measure security anymore. As per the 1929 crash annuities use to be the most secure but the yields suck too much now. If 60 k is it then those CDs are my opinion.
    I have not been with Kent Moors for long so I can’t help you here. As far as investments go i (like you) am looking for a posse to ride the market with. Right now I count myself in Kent Moors Posse. Good luck.

  5. Bob
    May 20th, 2011 at 15:35 | #5

    Hi Dave;
    Dave says,”I am not where I thought I would be financially this late in my life.”.
    Me neither but misery helps neither you nor I. My schawb guy tells me there are new CDs that are tied to different commodities. That sounds the safest to me. I’m what use to be called an adviser on money matters and investments counseling. All I can really tell you is that all the rules have changed and I have not the slightest idea how to measure security anymore. As per the 1929 crash annuities use to be the most secure but the yields suck too much now. If 60 k is it then those CDs are my opinion.
    I have not been with Kent Moors for long so I can’t help you here. As far as investments go i (like you) am looking for a posse to ride with in this wild west market. Right now I count myself in Kent Moors Posse. Good luck.

    PS Kent sets the record straight today contrary to media hype, speculators are mandatory to deal with supply on demand flux. It is hilarious to watch supposed experts in the media trying to push on strings to make their points.

  6. H.ALDOUS
    May 20th, 2011 at 17:13 | #6

    I follow, and invest in, both the free , Advantage, and subscription , Circle, services but find that it is unclear to me the differences between the two. Are the reason for selection different? Are the goals different? Why is one free and the other by subscription and does the fact that one is charged for imply that it is better?

  7. Ben Greyling
    May 20th, 2011 at 17:41 | #7

    @James O. Bleidner The problem is speculators are not always as smart as you think and do sometimes turn into lemmings.

  8. Leslie Schroeder
    May 20th, 2011 at 19:35 | #8

    The symbols provided earlier this week for options trade were inaccurate and reported to you as such. No response! Hey, are you for real?

  9. Marky
    May 21st, 2011 at 14:24 | #9

    The fact that the Oil prices are always rising faster is the possibility that Oil Refineries are being manipulated by the their leader….

  10. Aristo Kiziroglou
    May 22nd, 2011 at 15:58 | #10

    Dr. Moors, I have been receiving many e-mails during the last month or so referring to the following :
    “New Chinese “Oil Colony” Discovered — Chinese workers are rushing to complete work on this $12 trillion source of emergency oil. The location of this oil could be worth a fortune to investors… But you must ACT NOW. Right now, the Chinese are frantically rushing to put the finishing touches on a massive new source of oil… Workers have been coming and going around the clock. They work long shifts, taking as few breaks as possible. Their goal is to finish by summer. Experts say there could be as much as 100 billion barrels of untapped oil involved — roughly $12 trillion worth at today’s prices. When they’re done, China will immediately pump this oil into its economy.”

    If there is any truth to this whatsoever, you must certainly be aware of it. Would you kindly clarify what this is all about; is there any truth to it and if so, how would this affect the whole oil industry, your portfolio and our individual investments in the short and long run. Many thanks.

  11. August 6th, 2013 at 12:36 | #11

    Precisely what several really good poems blogging or possibly website pages to share journal posts?

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