The price of oil is soaring because of speculation, and due for a fall once the CFTC steps in say Eugen Weinberg, Barbara Lambrecht and Carsten Fritsch, commodity analysts at Dresdner/Commerzbank in report published yesterday, which the FT’s Alphaville picked up.
In the report, Dresdner/Commerzbank (D/C) reminds us that at the start of the year they predicted the price of oil would trade in the $70-$75 range–where it is now–by year end. They’re revising the estimate to $50 by year end because of the CFTC.
As the world’s governments get more and more concerned about the rising price of oil, they will clampdown on the oil market. This will shake out financial investors. Once those people are gone, the price will drop since there’s no demand driven reason for oil prices to rise, says D/C. “The fundamental data also indicate a slower increase in the oil price due to enormous inventories worldwide and plenty of production capacity.”
The only thing that could change all of this is “geopolitical tensions.” Short of that, “there is little danger of an oil shortage in the foreseeable future,” so there’s no logical reason for prices to rise in the short term.
They’ve long banged the drum on speculators. In the note they thump their chests, saying they called out speculators last year. When oil crashed from $150 to $30, D/C felt vindicated. “We interpreted this as an exaggerated reaction, after many investors simply fled the oil market.”
They say they have no idea how much speculation is going on because of the lack of transparency in reporting about who is buying oil. It’s hard to know who’s a commercial player, and who isn’t.
Here’s what D/C does know: Our markets weren’t built to support what’s going on.
Another method of determining the proportion of speculators in the market, based on comparisons according to the principle of “where would the price be if there were no financial investors in the market?”, is also somewhat wide of the mark. Admittedly the comparison is a legitimate one, and relatively easy to determine if, for example, one compares historic changes in the reach of the world crude inventory in days over time or the free production capacity of OPEC with the corresponding oil price. It is clear that one could explain many past price changes on the basis of these factors. However, the price of a commodity does not always necessarily correspond to the current supply and demand situation. The greatest advantage of exposure of financial players and speculators to the commodity markets that we can see, apart from representative and liquid pricing, is their ability to process and act on available information quickly and efficiently. So ideally, speculators should iron out the hugely exaggerated upward or downward price movements. They should buy when physical demand is very low but about to recover, and sell in the opposite situation. However, the financial markets and financial market players have utterly failed in this role.
Instead, it is our opinion that in recent years, because they drew the wrong conclusions and over-invested, they caused a speculative bubble in commodities, particularly in the oil market. Rather than profiting from existing trends, investors greatly accelerated and to some extent caused those trends. It was precisely their clumsy dealing that, in our view, made the exaggerated upward and downward price swings possible in the first place. The problem is that commodity investors exert far more influence on the market than physical traders. On the one hand, investors exert their influence through regular rolling of commodity futures. On the other hand, one needs to consider the leverage made possible by futures market trading. To purchase a WTI contract on the NYMEX usually requires less than 8% of the value of 1000 barrels of the crude oil which it represents.
But the key thing to understand is that the commodity futures exchanges were not really in a position to absorb investments of billions of dollars. In our opinion these investments damaged the existing pricing system, upset “normal” trading and allowed it to run out of control. The relationship between the physical market and “virtual” stock market trading has gone off the rails. Between the years 2003 and 2008 both WTI oil price and the number of outstanding WTI contracts (futures and options) on the NYMEX have gone up six-fold. This was at least partially responsible for the massive price increase in the last years (chart 6).
When WTI futures were introduced on the NYMEX in the mid-1980s, production of the US domestic crudes which were chosen as a “good delivery” for the benchmark and were available for delivery in Cushing, Oklahoma stood at around 1.5m barrels of crude oil per day. The total trading volume of WTI on the NYMEX averaged the equivalent of about 10m barrels. The relationship was therefore largely satisfactory because WTI was also accepted as the benchmark for all trading both inside and outside the USA, as it still is today. In the 1980s demand for oil in the USA alone stood at 16-17m barrels per day. However, as investors increased their exposure, the relationship changed utterly. Today, on the NYMEX alone, WTI futures worth the equivalent of 600m barrels of crude oil are traded daily, while US production is less than 5m barrels per day. Even compared with global demand for oil, which currently stands at around 83m barrels per day, there is a huge discrepancy. This becomes clearest when we compare the volume of WTI actually produced with market trading volume: WTI oil production has now fallen to just 300,000 barrels per day. So now, each barrel of WTI crude is traded on the futures market nearly 2000 times over (Chart 7). It is no wonder that calls are increasingly heard, especially in political circles, for an end to the current “madness”, “casino system” and “oil bubble”. The US regulatory authority for commodity futures trading, the CFTC, now intends to do something about this.
NOW WATCH: Briefing videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.