Saudi Soda, Persian Perrier

StinkRock asked about oil prices.  This is not an area in which I have spent any time in professional career, so I can't speak from experience.  Like many, I had assumed that the explosive growth in China and India had led to a demand spike that was outstripping supply.  It turns out, however, that global production has grown by about 9.87% from 77MM to 84.5MM barrels per day since 2002. In the same period, demand has only grown by about 9.38 from 78MM to 85.3MM.  In 2002, oil was about $20/barrel.  

Obviously, the picture is more complicated than that, especially because oil contracts settle in US dollars and the plummeting value of our currency is related to at least some of the rise in crude oil prices.

One interesting proposition is that oil prices have become disconnected with actual usage dynamics because of the explosion in oil trading by speculators who do not plan to take delivery.  This was the subject of Congressional testimony yesterday.

Commodities futures were created in the 19th century as a way of smoothing out the seasonal prices of goods so that producers and buyers could run their businesses more efficiently.  So, cattle producers could sell forward contracts to deliver beef and be assured that they had locked in the price.  The buyer of the contract would be a slaughterhouse or food company that would take delivery of the beef as settlement for the contract.

In oil, an example of end users hedging through commodities futures would be an airline, which would buy oil futures to lock in prices now for future delivery.  

What has happened since the turn of this century, however, has been a massive allocation of capital from institutions and hedge funds into commodities trading.  Their influence and exposure to the market has been amplified by the fact that margin requirements for oil contracts (i.e., how much of the value you have to put up versus how much you can borrow) is much lower than the 50% Reg T requirement for stocks.  This is, no doubt, one of the reasons why hedge funds have started to exploit the space.  If you can leverage every dollar into $10, you can make an enormous return on equity.  

This is not to say that the funds are evil or rapacious.  They are taking advantage of the way the system is set up because there is a strong incentive to do it.  And the commodities markets do require a certain amount speculation to provide liquidity so that end-users can effectively hedge.  But it doesn't strike me as unreasonable to have more stringent requirements on margin and trading in markets where the underlying asset has such a profound impact on the economy.  Simple, common sense regulations, like preferential treatment for end-users who are trying to hedge prices, don't strike me as a bad idea at all.  This is the kind of function that regulatory agencies are put in place to perform.  I'll be interested to see if there is any action on this in the months ahead.

UPDATE:  The contra case from the Wall Street Journal.  It goes out of its way to be defensive about oil traders, which is not unreasonable, but it is quiet on the effect of massive inflows of capital into a market.  Yes, the new commodity index funds are only applying stock index fund techniques, but they are still introducing a lot of new capital into the market.  Same with the amount of money brought in by hedgies.  In some respects, oil is not unlike other areas, like merger arb, where the massive inflows from hedge funds have created inflationary pressure.