Oil Prices & Speculators
James L. Smith
RFF First Wednesday Forum
May 2, 2012
What Do We Know?
1. Oil prices have done some weird things.
The Great Oil Price Spike, 2004-2008
Jan 2004:
$ 34
July 2008: $145
Jan 2009:
$ 34
What Do We Know?
1. Oil prices have done some weird things.
2. Financial traders have swarmed into the
market.
The Increasing Role of Financial Traders
What Do We Know?
1. Oil prices have done some weird things.
2. Financial traders have swarmed into the
market.
3. It appears that financial traders may have
caused oil prices to do some weird things.
The Debate -- on Wall Street and Main Street
Why Were Oil Prices So High?
Speculators
“the bubble will burst”
vs
Fundamentals
“the shortage will persist"
What are “Fundamentals” Anyway?
Global Oil Consumption, 1975-2010
Quantity Index (1975 = 100)
200
150
100
50
Consumption
Source: BP Statistical Review of World Energy, 2011
2010
2005
2000
1995
1990
1985
1980
1975
0
Quantifying a Shift in Demand
Price
If Supply is inelastic, the increase in
demand is not fully revealed.
S
P2
P1
D1
Q1
Q2
Q*
D2
Quantity
Global Oil Demand, 1975-2010
Quantity Index (1975 = 100)
200
150
100
50
Demand
Source: J. L. Smith, J. of Econ. Perspectives, 2009 (updated)
2010
2005
2000
1995
1990
1985
1980
1975
0
Non-OPEC Oil Supply, 1975-2010
Quantity Index (1975 = 100)
200
150
100
50
Demand
Supply (Non-OPEC)
Source: J. L. Smith, J. of Econ. Perspectives, 2009 (updated)
2010
2005
2000
1995
1990
1985
1980
1975
0
OPEC Production Did Not Fill the Gap
Quantity Index (1975 = 100)
200
150
100
50
Demand
Supply (Non-OPEC)
Source: J. L. Smith, J. of Econ. Perspectives, 2009 (updated)
OPEC Production
2010
2005
2000
1995
1990
1985
1980
1975
0
Oil Prices are High
Because OPEC Capacity is Low
Since 2000 …
• Demand increased by 53%
• Non-OPEC Supply decreased by 23%
• OPEC production capacity increased only
by 7%
The Quantity Theory of Futures
Financial traders brought new money to the futures
market that drove up the price of oil.
• Fixed supply of oil
• Greater demand
• Higher price (duh)
Like the “Quantity Theory of Money”
M × V = P × Q
The Quantity Theory of Wine
“Quantity Theory of Futures” Fails Because…
• Unlike 2009 Bordeaux, futures contracts are not in
fixed supply.
• Unlike 2009 Bordeaux, the purchaser of a futures
contract does not take delivery (cash settlement).
• Unlike 2009 Bordeaux, cash settlement requires
each trader to sell back what he initially bought, or
buy back what he initially sold.
• Unlike 2009 Bordeaux, buying pressure = selling
pressure = no pressure.
Small Gold Trader Makes Big Impact Splash
MARKETS: JANUARY 28, 2011
Small Gold Trader Makes Big Splash
Daniel Shak's Aggressive Bet Grabbed Sizable Chunk of Contracts, But
Prices Fell and Wager Went Bad
By CAROLYN CUI And GREGORY ZUCKERMAN
A huge trade by a tiny hedge fund has sent shudders through the gold market.
Thanks to the nature of futures trading, Daniel Shak's $10 million hedge fund held gold
contracts valued at more than $850 million, more than 10% of the main U.S. futures
market, and the equivalent of South Africa's annual gold production.
But as gold prices started falling this year, the trade, which was a combination of being
long and short gold contracts—bets that prices will both rise and fall—started going bad.
Monday, he liquidated his position, and is returning money to clients.
As a result, the number of gold contracts on CME Group Inc.'s Comex division plunged
more than 81,000, to about 500,000, the biggest single reduction ever. While his trade
didn't account for all of the contracts, an average daily move is about 3,000 to 5,000
contracts.
What Do We Do?
1. Think carefully.
2. Review all the evidence.
3. Learn from the past.
Where do the Speculators Fit In?
“It is still rather generally believed that futures
markets are primarily speculative markets. They
appear so on superficial observation, as the earth
appears, from such observation, to be flat.”
-- Holbrook Working, Stanford University,1960
Déjà Vu, All Over Again
“The popular fear of engrossing and forestalling may
be compared to the popular terrors and suspicions of
witchcraft. The unfortunate wretches accused of this latter
crime were not more innocent of the misfortunes imputed to
them, than those who have been accused of the former.
No trade deserves more the full protection of the law,
and no trade requires it so much, because no trade is so
much exposed to popular odium.”
-- Adam Smith, The Wealth of Nations, 1776
Thank You