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What really makes oil move

Today's Financial News - Posted December 3, 2008

No matter how the spot and future prices change (both up, both down, one up, one down), when the futures contract expires, the price gap closes and they make money. All this activity thus will close the abnormal gap between futures and spot prices to normal contango levels. Conclusion: making money is hard work—there is no free lunch—even for speculators!

by J. Christoph Amberger

Baltimore — (TFN):

“Why do you assume that a fall of 70% in price should map to a 70% fall in demand,” asks TFNeNews reader J. F. in an email to me this morning. “Haven’t you heard of the concept of inelasticity?”

I found his remaining comments so interesting that I have drafted him to write today’s message for me:

You may find the following interesting.

“I would ask all the fundamental guys why oil was $147 a month ago and $114 today,” says Tony Kolton, the founder and president of Logical Information Machines, a provider of research to most of the world’s major energy-trading companies for two decades. “Their opinion that crude moves purely on real demand is BS. When the fast money comes out, there’s a giant sucking sound.”

OK, thanks for asking!

To say that speculators moved up the price of oil is like saying political futures really elect the president. If all it takes is speculation, then everyone could make money for ever and no one would have to work. This perpetual money machine would be equivalent to a perpetual motion machine— which violates the second law of thermodynamics.

Speculators in oil trade in the futures market. There is no buying or selling pressure on physical oil.

Speculators do not take delivery of oil nor supply oil. Speculators play a zero sum paper game. For every long contract, there is a short contract. Each such pair constitutes one open interest. The buyer of the long speculates that oil will go up. But there must be someone on the other side – the seller of the short contract bets that the price of oil will go DOWN.

Before the contract expires, the holder of the long position will sell back his position to the exchange—hopefully at a higher price than he bought it; while the holder of the short position will buy back his position from the exchange hopefully at a lower price. As time progresses, the price of any given contract moves in the direction to equilibrate the number of bids and asks for that contract. This auction action evinces the price discovery mechanism of the totality of speculators in the oil market.

The number of speculators playing the oil market is never static. If speculators see an upward secular trend in oil, some of those not in the oil market will of course abandon out of favor segments and jump into the game. But this does not change the rules of the game (“manipulate” oil prices) just as more players jumping into a poker game do not change the rules of poker or the odds of poker hands.

Speculator have recently seen that there is an abundance of demand destruction: Europe and Japan have recently recorded negative GDP and China and the USA are consuming less. Therefore open interest in oil futures has fallen. To say that this fall in open interest is causing the price of oil to drop is like saying that the flying of a bullet out of the barrel of a gun causes the gunpowder to explode —it’s backward reasoning. The majority of the hundreds of thousands of eyes of the speculators saw and their brains deduced that oil was going down and some got out of oil to play a different game. Moreover, there is no sucking sound, nor are there any speedometers on the money.

Nickel also trades on the futures market, but prices have plummeted! Gee, where were the speculators?

Iron does not trade in the futures and hence no speculators. But iron prices have surged! Hmm.

One ant is not very smart. But a hoard of ants is – they become a neural network by communicating with scent trails like the axons and dendrites of the brain. So the speculator crowd forms a giant neural network and is far more intelligent than you or I. This is called swarm intelligence. It is a valuable price discovery mechanism that enables commercials (buyers and suppliers of physical oil) to hedge their commercial activities.

In the rare case that the futures price exceeds the spot price by advantageously more than the cost of carry, then refiners will buy the spot oil and buying pressure on the futures will lessen and the buying pressure on spot oil will increase. Also, oil producers will store oil or keep it in the ground so that they can sell it at the future price. But more importantly, the arbitrageurs that control large amounts of money will execute program trading – they will go long spot and short futures.

So no matter how the spot and future prices change (both up, both down, one up, one down), when the futures contract expires, the price gap closes and they make money. All this activity thus will close the abnormal gap between futures and spot prices to normal contango levels. Conclusion: making money is hard work—there is no free lunch—even for speculators!

The only way that speculation can move the price of oil is that speculators must actually buy real oil and store it. This is called hoarding and is what the Hunt brothers did when they CORNERED 50% of the silver market. But there is no evidence of increased storage of oil – storing oil is expensive, so the potential profit must exceed the cost of carry.

Several times in the past few years, oil futures have gone to backwardization (spot prices exceeded the futures prices). This shows that demand was exceeding supply (Oooh, fundamentals!)

It amazes me how so many people don’t really understand the law of supply and demand. This alone explains the run-up of oil and its volatility. Both the demand and supply curves are extremely inelastic. It takes a large increase in price to shut off a little bit of demand. And it takes a large increase in price to produce a little bit more oil. This double whammy constitutes and amplifier – much like the amplifier in your stereo. So a small swing in demand or supply produces a large swing in price.

See? Was that so hard?


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Posted by J. Christoph Amberger · Filed Under Oil and Energy, Options, Politics 

One Response to “What really makes oil move”

  • RDD Says:
    December 3rd, 2008 at 7:05 pm

    From an oil trader and speculator, cogently and succinctly put. Now, could you somehow get thiese concepts thru O'Reilly's head? I have sent several e-mails trying to just get a little of this thru his head to- no avail.

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