We have been talking about the wrong type of oil inventory

By Sendy Filemon, 25 October 2008

When one think about speculating on commodities, products with physical form, one thinks about hoarding.
Popular example in an Asian country would be, rice hoarding, speculators buys rice, hoard it in some warehouse, create supply gap in the market, prices starts increasing, consumer start to perceive the increase in price, consumers join hoarding rice, price gets even higher, then the original speculator release his stock. (For readers who don’t live on such country, please exchange “rice” with any other staple food in your country).

This is how the speculator makes his killing, creating false supply and demand gap, leveraging market sentiment to create a snowball effect, and reap the profit when the snowball gets big enough.
To execute this type of speculation effectively, the speculator would need large amount of capital and physical space.

We understand that both food and oil are important for people’s daily lives, that’s why speculating on them is possible. Since these items have a direct effect on people’s lives, there are emotions attached to it. Hunger, cold, darkness, all these elicit human emotions, emotions that can be leveraged to create the snowball effect. And since so many people are directly affected by food and oil, there are more hearts to play with, compared with say, speculating on molybdenum, perhaps an important material, but are directly comprehend by relatively few people.

Now, what’s the difference between rice and oil? This is important, this is the first factor that makes speculating on rice has a different nature than speculating on oil. Rice is renewable, oil is not.

Rice and oil affects daily life. Rice and oil can only be produced by a limited amount each year. Yet, the total stock of rice recovers each year, while the total stock of oil keeps diminishing.

Since oil cannot regrow by next year, the psychological effect is even more pronounced. This is what the oil futures market is all about. It’s about hedging your future oil needs, because everybody knows that oil is not renewable. You know you will use it, you know that the amount being extracted each year is limited, and you know that the absolute stock of oil keeps diminishing, well, then might as well secure the price now.

To respond to this need, the oil futures market thus provides a tool that removes one important hindrance in speculating oil, physical space. That tool is the futures contract itself.
Now technically, oil is being stored in a physical space, it’s called underground.

With rice, if you want to keep an amount of rice for the next six month, you have to have a warehouse to keep the rice that was harvested just now.
But with oil, if you want to keep an amount of oil for the next six month, you just buy the futures contract. Where is the oil being stored? Underground. How do you know that the oil will be available for use by six month? Because at that time, the oil producer would have extracted the oil from underground, and deliver the oil to you, at the agreed futures price off course.

This is the second factor that makes oil speculating possible, a fallacy that economic experts often ask “if there’s speculation, how come inventory level stays the same?” The fallacy is that they are looking at oil inventory above the ground, on the man made tanks. While there’s another inventory of oil, a much bigger one, the one underground. This is what people buy when the buy futures contract.

I will try to summarize this, when traders buy oil futures contract, they are buying oil that are underground. The man-made market system waves its magic wand, when there’s no future contract, the oil is underground, yet nobody says “this amount of oil underground, I don’t care who extract it, is mine”. But when there’s future contracts, an amount of oil under ground is being claimed, as more oil is being bought through futures contracts, more oil under the ground is claimed.

“But wait, isn’t the total amount of oil under the ground is being reduced each year? Doesn’t the inventory-level-not-increasing argument still hold?”
Now, nobody knows the total amount of oil in the ground, this is the big question mark.

To talk about inventory of oil, we need to understand that the futures contract brings an interesting twist to the concept of inventory. With or without futures contract, the entire stock of oil underground is there, underground. But when one buys future contract, the amount of oil being claimed, the inventory, increases. This is the concept of inventory of oil that futures contract make possible, inventory not as in oil extracted and stored in tanks, but inventory as in oil under the ground whose ownership has been claimed.

Let me help you with a diagram –

Now, let’s look at another diagram that will help in navigating the last paragraphs of this article

Source: Energy Information Administration, Press search

What increase in global demand?

Do you notice that although the US, the biggest oil consumer in the world, has been in financial problem since early 2007, the price of oil keep increasing. Funny isn’t it? One would expect that financial problems in the US will impact US economy and US demand of energy. Surely there are many smart heads in the US that could recognize, since early 2007, what the financial crisis will become, bubbles always bursts. Yet besides the obvious signs, the market doesn’t anticipate a reduction in US oil demand, as represented by oil price data from January 2007 to June 2008.

The main argument of “supply and demand drive prices” is that oil production capacity will be strained by the demand growth from China and India. For China’s and India’s growth to have such impact, two important premises must accompany it, one, demand reduction from developing countries does not nullify the demand growth from China and India, two, China’s and India’s demand will continue to grow at the same booming pace for at least the next decade.

Let’s explore these premises. For the 9 year period between 1998 to 2007, both China’s and India’s daily consumption grows by approximately 4.4 million barrel/day. Yet this entire result of 9 years of booming growth is equal to only 15% of oil demand by 4 developed nations (US, Japan, Russia, Germany) in 2007. Bear in mind that even before the financial crisis, Japan’s and Germany’s oil demand has experience negative growth during this 9 year period. Second, the 4.4 million barrel increase is made possible by the huge growth momentum that China and India enjoyed during the last 10 years. Many of the advantages that allow this momentum (cheap labor, sourcing trend) are slowing or disappearing altogether. China’s and India’s growth has been fueled by external factor, the shifting of production from developed countries. The shift has been so large that there’s not much that can be shifted to China without significant investment in technology. Now China and India must rely on the demand increase from its domestic market and its neighbors. Though this market is large, their purchasing power is small compared to citizens of developed nations. China and India will experience growth, but will they be able to repeat their booming performance if fueled mostly by its domestic and neighboring markets?

The financial and economic crisis so evident since late 2007 breaks the first and second premise. There is a real potential that demand reduction from developed countries will nullify the growth effect of China and India, and the same crisis will also put a dent on China’s and India’s ability to repeat the impressive economic growth they have posted since 1998.

Can we still convincingly say, looking at the abundance of signs of financial and economic crisis, that demand in 2009 onwards will increase so significant as to warrant oil price as of June 2008?

I argue that if one took careful look at US financial crisis since early 2007, one would not anticipate a significant increase in global oil demand within the next 5 years.

But for some unknown reason (I suspect it’s the deliberate playing with the oil market to hedge losses from the mortgage bust), so many people fail to link the financial crisis, to the US economy, then to the US oil demand, and global oil demand. So oil price keeps soaring, until July 2007.

Supply and demand assumptions at June and August 2008 are the same, yet prices fall on July, why?

Ok, let’s ignore the ignorance of the market, let’s assume that the market assumption, that global oil demand will grow is valid. The no-speculation wisdom says, price increase because of increasing demand and difficult supply situation. In June 2008, the market believes this is true, in August 2008, the market still believes this is true, yet price falls in July 2008. What happens in July 2008?

Shares of Freddie Mac and Fannie Mae falls, Barclays seek US$ 8.9 Bn to bolster capital, IndyMac fails, and US Congress announced that they plan to curb oil speculation. Which of these of four events is significant enough to have triggered a reverse on oil price? Have similar events in the near past triggered such reverse?

The falling share of financial companies? That had happened since Sept 2007. A bank looking for capital? Citibank did the same in Nov 2007. A bank failing? Well, several other financial institutions had also failed. All the financial woes that had happened since early 2007 didn’t reverse the oil price. That leaves us with the US Congress announcing plan to curb oil speculation.

In July 2008, even though the demand and supply estimate remains the same, after US congress express intention to curb speculation, eliminating value from speculating, oil price falls. (Do remember that the full fury of the financial crisis and the gloom it cast on world economy has not been unleashed until September 2008).

The full meltdown from the financial crisis happens afterwards, casting recession on US economy and US oil demand, this send oil price further down the drain. The aforementioned refusal to recognize the impact of financial crisis on economy and oil price has finally caught the market on September 2008.

This is a strong indication of oil speculation, that even though current and future supply and demand condition was perceived to stay the same, yet when the US Congress announcing to curb speculation, just this one factor that has changed and not had happened in the near past, oil price drops. So much for the “it’s driven entirely by supply and demand”

Oil was hoarded and price was mostly driven by speculation

Now, some economist has been saying that speculation doesn’t happen because they don’t see the precursor of speculation, hoarding. That is, hoarding as in its traditional sense of accumulating extracted commodities above the ground.

But this is like saying that a woman doesn’t get pregnant because she hasn’t had a relationship. While another possible explanation would be that she had had an in virto fertilization. (Then when the baby comes out, maintains “nah, she didn’t get pregnant, the baby appears out of nowhere”)

Rather than exploring the possibility that hoarding, in another form, had indeed occurred, some economist choose to maintain an argument (“it’s all about supply and demand”) when the evidence took another turn (supply and demand assumption stays the same yet price falls).

Petroleum supply might be strained in the next decades; even this prediction has plenty of qualification in it. But if one look carefully at the bubble brewing in the United States, one would also expect to see the effect of such bubble bursting to global oil consumption.

So, I argue that the price increase of oil and gas in 2008, especially the second quarter, had been led mostly by acts of speculation. That the precursor, hoarding, had indeed occurred, inventory had increased. Not in the traditional sense of hoarding, accumulation of extracted source, but hoarding as in increasing ownership claim of unextracted resource, made possible by futures contracts.

_____________________________________________________________________________________
Author’s note:
This disconnect between price and real supply and demand condition is echoed in an article by Roger Lowenstein in the New York Times discussing how price is driven in the New York Mercantile Exchange “Though in theory the price on the Merc reflects the underlying supply-and-demand trends, on any given day the futures market often wags the physical market, not the other way around. Last June 5, for example, when the decrease in Americans’ gasoline consumption was already apparent, crude oil inexplicably shot up $5.49 a barrel — a record move. As analysts searched for an explanation, the following day oil soared like one of those fabled East Texas gushers — up $10.75. According to Raymond Carbone, a floor trader on the Merc, two news items — neither having anything to do with supply and demand — were behind it.”

(Lowenstein, Roger. ” What’s Really Wrong With the Price of Oil.” New York Times. 17 Oct. 2008. 26 Oct. 2008 .)

2 Responses

  1. […] their oil supply, and Speculators of oil also use demand projection to further pony up the price. I argue on a previous post that the price increase in mid 2008 has been driven mostly by speculators. Who justify their price by waving the demand projection for 2020 and beyond. If we want to keep […]

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