Tuesday, June 24, 2008

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.


Tony Alva said...

I'll be the first to admit that I get about 70% of what you've written here on this topic, but that's better than the generous score of 50% I'd give myself on the micro level of understanding before I read it. So, thanks for dumbing it down for guys like me.

Overall (and largely due to my lack of knowledge), I'm cautious about doing anything too drastic before allowing enough time for you big brains to figure out how to keep the market from taking unfair advantage/profits at the expense of our economy. I'm philosophically opposed to intervention as a rule, but shit gas prices are killing me too.

Dave Cavalier said...

I certainly believe that free markets are the most efficient at things like price discovery, but free markets do not necessarily mean totally unregulated markets. For example, imagine a market where "naked" shorting (i.e., selling short shares that your broker didn't have in inventory for settlement to loan you) was totally acceptable and legal. The opportunity for price manipulation would be substantial and would undermine confidence in the price discovery role of the market.

The mistake I think both Obama and McCain are making is to go at this issue by vilifying the traders. These guys aren't doing anything illegal or irrational. They are playing the market as it currently stands. Attacking them allows responses like the WSJ's, in which they can rail against the unfair treatment of traders.

This is not to say that I know that this theory of oil inflation is totally correct, but there is an intuitive attractiveness to pointing out that prices will tend to rise in an asset when a large amount of new capital flows towards it.