In reply to BusinessWeek Economics Editor Peter Coy, Ed Wallace clarifies why the oil futures market is not working properly
"When money has nowhere to go, it is parked in commodities, as this is one of the few investment instruments that actually rises the more money you pour into it." —Oliver Jakob, an analyst at Petromatrix in Switzerland.
"Oil Near $143 on View Dollar Will Keep Falling," —John Wilen, Associated Press, June 27, 2008
First of all, I would like to thank you for your response (BusinessWeek.com, 7/8/08) to my recent column (BusinessWeek.com, 6/27/08) on the oil futures markets. I would also, humbly, like to thank you for pointing out that I've become something of a hero to the middle class in America for my columns on energy. Obviously, I didn't set out with that particular goal in mind. Nor do I have a problem with futures markets in general; they are responsible for injecting badly needed liquidity into commodities for our future use. From what you have written, I can see numerous areas where we agree completely.
But I don't believe that either one of us has helped our readers grasp one hard reality: By 2015 the world will be faced with a legitimate and serious oil supply-and-demand problem. Many oil insiders have told me that it will be an enduring energy crisis that has the potential to radically reorganize our economic society.
While the International Energy Agency is not usually my favorite source of information, I put great credence in Charley Maxwell of Weeden & Co.; Maxwell was quoted on Energytechstocks.com in February as predicting oil supplies would tighten starting in 2010. He said that peak production would come a few years later and that oil might be priced at $180 a barrel by 2015; and he added that it will take "$12 to $15 a gallon [for gas] to get Americans to let go of their precious freedom of mobility." Scary stuff—and yet, looking at the charts for increased oil production in the future against growing worldwide consumption, I tend to believe Charley's prediction. As I told a group of students at Texas A&M earlier this year at the annual Student Conference on National Affairs, "We are leaving you a far worse world than our parents left us."
On the other hand, in a BusinessWeek.com column (BusinessWeek.com, 8/15/07) I wrote last year, I suggested that, to alleviate our current and future energy problems, Americans should improve our energy efficiency—and was roundly blasted by readers. I wasn't their hero that day.
We also are in agreement as to the profitability of refining diesel. You are exactly right in stating that we are not able to refine enough lower-sulfur diesel. That Middle East refiners find it more profitable to sell their sulfur-laden fuels to Asia, while Europe's product constraints make it incapable of exporting much diesel to the U.S., is also true.
Still, we have a few items on which we disagree.
Traders vs. Speculators vs. Manipulation
First, you mentioned that I have put much of the blame on speculators and manipulators for today's current oil prices, adding something to the effect that I should not put much faith in any statement of fact by a member of Congress. Let me clarify: It wasn't politicians but expert witnesses and their testimony in front of Congress that formed the basis of my articles.
Next, I'm sure you didn't mean to suggest that speculation and manipulation are both acceptable behaviors in tight commodity markets. As we both know, there are three classes of traders in the futures market:
1. Traders—people who are bidding with the intent of actually taking delivery of the goods on the contract's due date;
2. Speculators—those who are simply there for the profits to be made by flipping paper; and
To the best of my knowledge, manipulation of the market is still illegal. In fact, most have forgotten that BP (BP) was caught manipulating the propane market in the winter of 2004 and fined $373 million.
Likewise, you mentioned Amaranth Partners and that company's demise, but left out part of the story: It too was manipulating the market for natural gas futures on Nymex. Amaranth had been told to liquidate its position by the Commodity Futures Trading Commission because it had created "unnecessary price volatility" for natural gas, far beyond what natural supply and demand would cause. Amaranth simply shifted 80% of its holdings into "the dark ICE market," where "Amaranth's traders knew this move would be invisible to regulators," allowing them to "maintain or even increase their overall speculative position." It is believed that Amaranth moves cost "industry, commercial and homeowners as much as $9 billion." All quotes from the House subcommittee on oversight & investigations, Dec. 12, 2007.
Worse, in states such as Texas, where utilities deregulation means rate hikes for electricity can be based on the futures market price for natural gas, we all paid higher electric bills thanks to Amaranth and its manipulation. Let's call it the gift that keeps on giving. I should add that at the time, we were told that natural gas supplies were short; but—shades of Enron—one e-mail from Amaranth's lead trader during this period of manipulation read: "It's a classic pump and dump…boy, I bet you see some CFTC inquiries [concerning] the last two days." Click here for that report.
As we see, it's not hard to find cases of manipulation in the futures market, whether it is for oil, propane, or natural gas. Still, my position is that it is simply the enormous amount of money going into the markets that is distorting the price structure against natural supply and demand. Here I will correct a mistake in my last column. It was a big one, though not entirely mine.
I mentioned that because oil prices are so high, we were witnessing demand destruction of around 525,000 barrels of oil a day in this country. That figure came from the Energy Information Administration. It was wrong; in revising that figure, the EIA now reports U.S. demand for oil has dropped 863,000 barrels per day since April.
Now we can start to get a handle on how oil prices are already drastically reducing demand. We started this year with oil around $100 a barrel and witnessed demand destruction of 2.5%, or approximately 525,000 barrels a day. But, as oil moved past $110 a barrel, demand destruction jumped 60%, to 863,000 barrels per day. This is important; everyone loves to argue that even if our demand is down, China's and India's insatiable quest for ever more oil equals or outstrips our demand reduction, but that's not so. The Oil Daily published an article on July 7, headlined "Data Shows Oil Supply Outrunning Demand." Included in that article is the Asian oil demand charts, which show that from China and India to Bangladesh and Vietnam, this year's entire increase in total Asian oil demand will amount to 582,000 more barrels of oil a day—far less than we've cut our energy consumption. It should also be noted that not all of Asia's oil is imported; much of China's is homegrown. This is why, when OPEC says they would pump more oil if any of their customers demanded it, it's a believable position. Supply outrunning demand? If the markets were operating as they should, the price of oil would be not soaring but plummeting.
I have no problem with real traders in the futures market, whether they be Southwest Airlines (LUV), hedging its energy costs to stay profitable in the future, or a national trucking firm, trying to keep its big rigs moving. But when the amount invested in oil futures rises from $9 billion eight years ago to possibly as much as $280 billion today, that is speculation far beyond what the reality of supply and demand warrants—and that massive new speculation in the market has visibly and seriously been destroying oil demand, while moving the price of oil higher. Moreover, the only constant in the world's economy over the last year has been that it is slowing down—hardly the ideal situation for near-term oil demand growth.
Look to Economics 101
You're not alone; almost everyone apparently missed my column's real point. I'm simply pointing out the poor state of reporting on oil, in which hype passes for news. The dollar has improved on the DX Index by around 5% since Mar. 17, but oil prices have risen sharply. Therefore, any reporting today that oil movements are a response to the weak U.S. dollar has been wrong. America has dropped its oil usage substantially, but that is barely mentioned. Asia turned down 500,000 barrels a day of West African crude in June. And executives with our oil companies go before Congress, and most testify that the supply-and-demand discussion is mostly overblown—and that oil should sell for between $30 to $65 a barrel. I could be wrong, but I'm thinking the oil executives might be on the mark.
And as for the reason that oil supplies are not building right now? Simple enough. Refiners' margins, or crack spreads, are nowhere near as strong as they were this time last year. Economics 101 dictates that when sales and profits are down you don't carry excessively high inventories, particularly when future inventory costs are much higher than they were for the product you purchased just a few months ago (and might still own). If I were a low-margin refiner right now, I'd be burning off old oil inventory, which I might have purchased at $100 a barrel, before I started losing money by stockpiling oil at $140. Car dealers reduce inventories in slow periods. So do department stores. It's the most obvious reason in the world why oil reserves on hand are declining, but everyone seems to have missed that, too.
By 2015, all bets are off the table as to oil. We both should write columns on how America needs to prepare right now for that eventuality. But I'm writing about today's market, not eight years out.
By the way, Peter, I've long been a huge fan of your columns.