What Do Futures Markets Tell Us About Long-term Oil Prices?

• The tendency to believe that the prices of oil futures contracts are predicting the future price of oil is understandable but not supported by the track record of such bets.
• The prices of long-dated oil futures merely reflect where buyers and sellers are willing to strike a deal today, for their own, diverse reasons.

A recent article in the Wall Street Journal reminded me of numerous debates about the significance of energy futures prices, when I was a trader and later a trading manager for the former Texaco, Inc.  Do changes in futures contract prices actually predict future oil prices as the Journal's reporter suggests? If so, then it might be reasonable to conclude that today's low oil prices could persist for years. However, from my perspective that over-interprets the market data and ignores some important oil fundamentals.

As tempting as it might be to think so, the futures market for West Texas Intermediate (WTI) crude oil isn't a crystal ball, and neither is the market for UK Brent crude. A futures price is simply the price someone is willing to pay or receive now for oil to be delivered (or settled without delivery) later. It is typically based on business needs, rather than deep analysis.  A concrete example might be helpful.

The parties who on August 11th bought or sold oil for $56 or $57 in December 2017 likely did so, not because they were certain what the price would be then, but because they couldn't be sure and either needed to hedge another transaction or activity, or thought it constituted a reasonable bet. Aggregating a modest number of such transactions--long-dated futures trade much less frequently than those for the near months--doesn't improve the accuracy of these bets on an inherently unpredictable commodity over long intervals. Anyone who thinks it does should examine the track record of oil futures as predictions; it is a sobering exercise, especially for those who have traded this market.

Consider that while the September 2015 WTI contract closed at a little over $43 per barrel that afternoon, traders were buying and selling the same contract for more than twice as much during long stretches of 2012--about as far removed from us as the late-2017 contract prices cited in the Journal article as evidence of a persistent oil-price slump. Prices for the September 2015 contract were even higher in the middle of last year, when traders knew nearly as much about the growth of US tight oil production and its rising productivity as we do today, but crucially didn't know that OPEC would choose not to cut output to alleviate an over-supplied market as they had done in the early 1980s and late 1990s. Similar examples abound.

So how else might one explain the fact that long-dated oil contracts are trading for less today than they were this spring, if not as a prediction of a longer period of low prices ahead? Behavior and learning play key roles. With the  first anniversary of this historic price collapse just a few months off, expectations of a quick rebound in prices have faded. The possibility that the US could produce as much tight oil, for now, with fewer than half as many drilling rigs in operation as a year ago has sunk in. So has the reality that as painful as $50 oil is for some of OPEC's members, cartel leaders like Saudi Arabia show little inclination to blink first.

However, others are blinking, and that's why I'm skeptical that oil prices can remain this low indefinitely. The cuts in staff and investment budgets by major oil companies and their national oil company peers have been breathtaking, totaling $180 billion this year according to one analysis. The cuts suggest that the projects in question require significantly higher oil prices to be profitable, even after recent cost reductions, or have become too risky at current prices.

Few of these companies are big players in shale. Their bread and butter is large, conventional onshore oil fields and enormously expensive deepwater oil projects, the collective output of which is inherently subject to annual declines in output. Decline is the "silent killer" of output, to the tune of 5% or so every year. The only way to offset this trend within the portfolios of these producers is to spend large sums every year on new wells and new projects--projects that according to Rystad Energy, as cited by Bloomberg, have been cut more than at any time since 1986.

We must also put the US shale revolution in its proper context. When added to a global market that was balanced between supply and demand at around $100 per barrel, it was a game-changer, not least because no other producer or group of producers was willing to reduce output enough to accommodate this new source. However, even at today's 5.4 million barrels per day US tight oil represents only about 6% of global supply. The combination of shale plus OPEC covers less than half the world's oil demand.

The remainder must come from onshore and offshore oil fields in non-OPEC countries like Brazil, Canada, Mexico, Norway, and Russia. This non-OPEC supply has grown thanks to  a wave of completions of  large projects begun 5-10 years ago, when prices were rising rapidly. However, reduced investment now surely means lower non-OPEC production within a year or two.

The key question for future oil prices is therefore when demand, which according to the International Energy Agency is growing rapidly under low prices, and supply, for which new investment has suddenly shifted from the accelerator to the brake pedal, will cross over, erasing today's glut. It's hard to infer the answer from the thinly traded market for long-dated oil futures contracts.

Why Haven't Gas Prices Fallen More?

With the US economy stuck in the doldrums, weakening the demand for oil and its products, and with the fall of at least portions of Tripoli foreshadowing the eventual return of Libyan oil exports to the market, it must seem puzzling that US gasoline prices haven't dropped farther in the last few weeks. As of Monday, the national average price for unleaded regular stood at $3.58 per gallon, only 3% lower than a month ago, when crude oil was just shy of $100 per barrel, compared to around $84 today. On Monday's evening news, CBS ran a segment attempting to explain this apparent disconnect. Unfortunately, they over-simplified the main explanation with a graphic showing cheaper domestic crude oil mixing with higher-priced imported oil. The "A" answer to this question is simpler but not well-understood, even though its elements have been fairly widely reported: Americans are simply looking at the wrong crude oil price, out of long habit. When you compare current gasoline prices and more representative crude oil prices, there isn't much of a disconnect about which to grumble.

The source of this confusion is the price of West Texas Intermediate crude oil (WTI), which for three decades has been the most watched and widely traded oil price in the world, and the basis of what most people mean when they talk about the price of "oil." In fact, there are numerous distinct grades of oil, each with its own price reflecting quality, location and availability. However, until recently most of these prices were based on the price of WTI, plus or minus a relatively narrow band of premiums or discounts, so using WTI as a barometer of all oil prices didn't cause much confusion or inaccuracy. The emergence of a pronounced and lengthy supply bottleneck at the Cushing, OK delivery location for the WTI futures contract has exploded this convenient set of relationships and assumptions.

Because more oil has been going into tankage at Cushing than was leaving those tanks over the last year or so, the price of WTI--itself a category, rather than a single stream of oil--has become massively depressed relative other types of crude oil, not just imported oil but also oil in other locations in the US that aren't affected by the bottleneck. Consider some important examples. While oil produced in Kansas, New Mexico and Oklahoma is all cheaper due to the Cushing effect, Louisiana Light Sweet, which historically traded within a dollar of WTI, is now worth nearly $20/bbl more, putting it much closer to the price of UK Brent crude--the best current gauge of global oil prices--than to WTI. Meanwhile, Bloomberg reports Alaskan North Slope crude (ANS) for delivery on the West Coast at nearly $107/bbl, or $24 over WTI. That's surprising, considering that ANS is heavier and higher in sulfur than WTI, and thus requires more processing. Just as remarkably, California heavy crude at Midway-Sunset is quoted at more than $10/bbl above WTI, when based on history and quality I would expect to see a discount of at least that magnitude. In other words, for now at least, the price of WTI is simply no longer representative of the crude that many US refineries are processing, from either foreign or domestic sources.

When you compare the wholesale price of gasoline from US refineries near the East, West and Gulf coasts to the cost of their crude inputs at around $100 or more, the difference of $15-17/bbl isn't historically unusual. Meanwhile, refineries in the middle of the country have recently been experiencing much stronger margins. This disparity is evident in the second quarter earnings reported by various US refining companies. East coast refiner Sunoco, which hasn't benefited much from cheap WTI, reported a net loss for the quarter, while Valero, with a bigger and more geographically dispersed refining system that includes facilities processing large quantities of WTI-related crude, saw refining segment earnings increase by 39% compared to the second quarter of 2010. The Cushing effect was even more pronounced for the recently merged HollyFrontier Corp., which apparently runs little crude that isn't priced near WTI and saw second-quarter net income almost triple versus 2Q2010. Even after that extra profit margin, gas prices in Tulsa, OK are currently as low as $3.30/gal., or about 15 cents per gallon less than the national average after adjusting for differences in state gas taxes.

Gasoline prices are determined by more than just crude oil prices, though in the long run the two must move together, because the latter represents the largest component of the cost of the former. At least until the bottleneck in Cushing is resolved by new pipeline capacity to the Gulf Coast, one option for which was just canceled, we will need to look beyond our old reliable WTI price indicator in order to compare gasoline and crude prices on a representative basis. I've been paying a lot more attention to the Brent market, and the Wall St. Journal still publishes daily prices for Louisiana Light Sweet and ANS. When and if those indices drop significantly, then it will be time to start looking for a commensurate drop in retail gasoline prices at the pump.

Indexing Crude Prices

Although oil trading hasn't been my primary focus for many years, the recent announcement by Saudi Aramco that it is switching its price mechanism for oil delivered to the US caught my attention. Instead of basing its formula for deliveries here on the price of West Texas Intermediate crude oil, it will apparently reference the new Argus Sour Crude Index (ASCI.) While that lends substantial credibility to this new index and may gain Argus more than a few new subscribers, the implications for the widely-traded NYMEX WTI contract and the dynamics of the broader international oil market seem much less clear. In particular, I am skeptical of suggestions that this move could ultimately reduce whatever influence non-commercial financial participants--speculators, in common parlance--have on oil prices.

The question of how best to price crude oil for buyers and sellers is a perennial problem, particularly for oil that differs significantly in quality from the light, sweet grades behind the extremely liquid WTI and ICE Brent futures contracts. US refiners, in particular, have invested many billions of dollars in the hardware required to turn lower-quality oil into high-quality petroleum products. Any time the peculiarities of these contracts drag up the prices of the grades of oil they prefer to run, they grumble about basing deals on WTI. Likewise for sellers of sour crude, foreign and domestic, who suffer when the WTI price moves out of sync with world prices, such as when storage at its nexus at Cushing, OK fills up, as it did earlier this year. However, after listening to the Q&A podcast concerning the ASCI on Argus's website and reading the background document there, I'm skeptical that this index will settle the sour crude market's discontent, because it won't change the way this oil is traded by nearly as much as it might appear.

Without getting into all of its details, as I understand it the ASCI is effectively a composite daily report of the deals done for three specific streams of offshore Gulf of Mexico crude oil, all of which trade at a differential to WTI. In calculating a daily price, Argus will add the average daily discount or premium vs. WTI from the transactions it learns of to the daily price for WTI to come up with a single price in dollars per barrel. The Argus podcast was very clear that NYMEX WTI is still as the heart of the new index, not just because this reflects the way deals are done with reference to WTI, but also because WTI remains the highly-liquid futures contract that the buyers and sellers of the ASCI oil streams use to hedge their market risk. In other words, the new ASCI index is not a substitute for WTI-based pricing, but merely a more transparent gauge of the relationship between WTI and the sour crude market--though an index you have to pay to read falls a bit short of the kind of transparency currently provided by WTI itself.

What would happen if speculators drove up the price of WTI by $30/bbl? In theory, ASCI would reflect any disconnection between the fundamentals-based pricing of its included sour crude streams and the financially-driven WTI market by remaining more or less unchanged, after summing the combination of correspondingly wider discounts for the ASCI grades to the inflated daily WTI prices. Only by looking at the differentials themselves would we see any indication of distortion of the market by non-commercial players. But is that realistic? Consider that between January 2007 and July 2008, when the price of WTI rose more or less steadily from the mid-$50s to nearly $150/bbl, the discount between WTI and the monthly average refiner acquisition price for imported crude only widened from around $4.75/bbl to roughly $9/bbl. If WTI was being driven by speculation in that interval, differentials-based trading of the kind that ASCI will measure hardly insulated refiners from its effects.

That historical result might merely indicate that speculation had little real effect on the market in that period--a view to which I'm sympathetic--but it might just reflect the inertia of negotiated crude differentials. Either way, if you're Saudi Aramco and you're selling crude into the US based on ASCI, I'd conclude that your prices would still go up more or less in tandem with the NYMEX, despite the superficial "arms-length" mechanism flowing through ASCI. Perhaps I've missed some subtlety in the mechanism.

From what I can tell, neither ASCI nor the prospect of new futures contracts based on it addresses the underlying concerns I have had since the industry migrated to pricing based on differentials against the WTI and Brent futures contracts, and away from negotiating actual "fixed and flat" prices for each cargo or pipeline deal, back when I was trading oil in the 1980s and early 1990s. While that shift made life much easier for risk managers and took a lot of heat off traders to strike the best deal on any given day, it also opened the door to a host of other influences on pricing that I still don't think we entirely understand.

The market will pass its own judgment on ASCI and other new tools like it. If it proves useful to traders and risk managers, it could become the new industry standard, as Argus must hope, having made such a big splash over its launch. If it's not useful, it will fade into the background, becoming just another dataset in an already bewildering sea of energy-related information. With Gulf of Mexico output booming and more discoveries yet to be made, it looks like a reasonable bet to join other useful physical crude indices around the world. But anyone hoping it will shine a beacon on speculators in the next oil price spike is likely to be disappointed by the core of a system still rooted in WTI, the speculative influences over which remain uncertain and possibly unprovable.

Speculation Witch Hunt?

This morning's financial press was riveted by the prospect of the Commodity Futures Trading Commission (CFTC) imposing tough new regulations on energy markets. Speculation has been widely blamed for the run-up in oil prices since early spring--as well as for last year's roller-coaster up to $145 per barrel and then down to $34--though in a subtle but important shift the focus seems to be turning to volatility, which is a very different thing than absolute price levels. I don't need to add my voice to the many already warning that limits on speculative positions could hamper the proper functioning of the market by drying up liquidity and depriving "legitimate" participants of the access to hedging they need. Instead, I believe the CFTC and its supporters in Congress and the administration are barking up the wrong tree, altogether, based on a fundamental misunderstanding of the markets.

Let's begin by stipulating that speculation probably has a finite but impossible-to-quantify impact on oil prices. I pointed out this likelihood in mid-2007, when oil prices were at roughly their current level and before they began their wild ride. I've also described the difficulties involved in discerning precisely which trades are speculative and which aren't, based on my own experience trading oil commodities, futures and derivatives over a 10-year span earlier in my career. However, the current determination to clamp down on speculation appears to be based on two hypotheses that are not only unprovable in the real world, but probably entirely false: First, that in the absence of speculation, oil prices would not have spiked to nearly the degree they did last year and would be much lower today than they are, and second, that a market without speculators--or indeed without any futures trading at all--would be inherently less volatile than one in which those factors are present.

The latter proposition is easier to refute, because we've seen ample volatility in markets for which no futures contracts or easily-traded derivatives exist. I experienced this first-hand in the west cost spot gasoline market in the 1980s, a market consisting entirely of the trading representatives of local refiners and a small number of trading companies, some with storage tanks but many with no fixed assets other than a phone and a desk. Every time a refinery experienced a major operational upset, the market would spike by as much as a dime a gallon--a significant fraction of the value of a commodity that was trading well under a buck at the time. I recall one instance when the coking unit of my employer's L.A. refinery had a major fire and was out of commission for several months. Local supplies weren't adequate to cover the shortfall, and the gap had to be filled through imports. I started buying gasoline cargoes at around $0.60/gal., and by the time I had lined up all the supply we needed the price had hit $1.00/gal. before it fell back to more normal levels. That's volatility, and it is a feature of markets in tight balance between supply and demand, whether or not speculators play a role.

The question of where oil prices would have ended up last year absent speculation seems much more complex, until you consider that between 2002 and 2007 global oil demand had been growing steadily at an average rate of more than 1.5 million barrels per day (MBD) per year, outpacing the growth of global supply, and crucially of non-OPEC supply. The latter was essentially flat from 2004-7, when the price of oil roughly tripled from the low-$30s to the low $90s. In effect, the demand curve was marching to the right against a supply curve with a sharply steepening slope, as spare capacity was used up and the long inherent time lags for new oil projects constrained the amount of new production that could be brought on quickly. That path was then quickly reversed in mid-2008, once it became clear just how rapidly demand was falling, both in direct response to the high price of petroleum products--the full manifestation of which in many markets was delayed by government price controls--and by contraction of the global economy due to what we now know was the onset of a recession on a scale not seen in decades. Between February and September of last year, demand in the developed world fell by an astonishing 3.5 MBD. We'll never know whether prices would have fallen sooner if speculation hadn't maintained its momentum during the first half of 2008, but it's borderline delusional to imagine we wouldn't have spiked above $100/bbl without it.

The Wall St. Journal's "Heard on the Street" column on this topic begins with the sage observation that blame is a commodity in infinite supply. To that I would add that we rarely like to apportion that blame on ourselves, though in this case the government would do well to consider how its own actions exacerbated last year's oil price spike and the run-up in prices we've seen this year. The oil markets are mainly driven by supply and demand, and with OPEC maintaining remarkable discipline and cohesion in the face of last year's demand collapse, the supply component that has the most influence in holding down oil prices is non-OPEC production. What has our government done to promote that production? Have we seen our elected officials traveling the world and using their influence and the still-considerable diplomatic and economic leverage of the US to urge producing countries to increase access for foreign firms and investors to new oil exploration and production opportunities, on attractive terms, as the Chinese government has? Have they fast-tracked development in the most promising regions of our own country that were off-limits for drilling, including the eastern Gulf of Mexico, where reserves have already been discovered?

Such actions didn't even occur under an administration that was widely viewed as being in the pocket of the oil industry, and they certainly aren't happening now, for reasons I could devote many more paragraphs to dissecting. "Drill, baby, drill" has given way to tax, baby, tax--and I'm not referring to the climate bill, here, but to earlier talk of a windfall profits tax to fund tax relief for the middle class, which has morphed into an effort to close perceived tax loopholes such as the intangible drilling allowance for producers and the manufacturing tax deduction for refiners. None of this is going to add a barrel of real oil to our supply, and it seems likely to eliminate more than a few, while we pin our hopes on corn ethanol that still only supplies 2% of our total liquid fuels demand, after adjusting for its lower energy content. How much of the market's volatility ultimately derives from our own deeply conflicted attitudes towards oil?

Oil prices have fallen by $10/bbl. or around 14% since June 29. This coincides with a general recognition that the economy hasn't yet turned the corner to a real recovery; we've also seen the S&P 500 drop by about 7% since mid-June. Now, you might suggest that this proves that speculators had driven up prices unrealistically, but it makes at least as much sense to suggest that the producers and consumers of physical oil and its products have altered their buying and inventory decisions in light of new information about the likely state of the economy for the rest of the year. No one can win that argument, but we can all lose if regulators impose tough new controls on energy markets based on a misunderstanding of what has occurred. To that end, while I am deeply skeptical of the idea of anyone at the CFTC passing judgment on what is and what is not a proper hedge, I wholeheartedly support Chairman Gensler's call for greater transparency of market reporting, and for a healthy dialog between the industry and its regulators aimed at reining in those practices most likely to add speculative froth to the market without contributing meaningfully to the liquidity required by all participants. Let's get the additional insights that transparency will bring us, before we decide to blunt the tools that actually provide one of the few means by which firms can mitigate the effect of underlying physical market volatility on their activities.

December Surprise

A month ago an old friend--in fact a former boss and mentor--hinted that the recent collapse of oil prices might lead to revisions of the oil & gas reserves that companies carry on their books. I recalled his suggestion a week ago, when the Wall Street Journal published an article on the subject of potential reserve revisions, indicating that "big chunks" of reserves might have be to declared "uneconomic", harming company valuations and potentially their ability to raise capital. This came into even sharper focus last Friday, when the January 2009 crude oil futures contract on the New York Mercantile Exchange (NYMEX) plunged sharply on its last day of trading, ending at $33.87 per barrel--the lowest oil price since February 10, 2004. I can only imagine how intently the reserves accounting groups of oil and gas companies must be scrutinizing the performance of the February contract, wondering how badly it might swoon by December 31, when the price for determining year-end "proved reserves" is established. The comparable price from which the 2007 year-end reserves were calculated was $95.98 per barrel, the highest ever. The subsequent slide puts reserves booked as long ago as 2004 at risk.

My friend knows more about oil & gas reserves and their reporting, from personal experience, than I ever will. It's an arcane subject. Despite the general designation of "reserves accounting", this task is normally carried out not by accountants, but by engineers under the supervision of a very senior and highly-experienced petroleum engineer or geoscientist. Tallying up how much oil and gas a company's leases are likely to produce involves consideration of a large array of technical and economic factors, including the market value of the future production these fields could yield. I'm sure there are other differences between the current SEC regulations, under which these figures are disclosed as part of a company's annual financial statements, and the standard industry approach set by the Society of Petroleum Engineers. The most important for the purposes of this posting is that under the SPE guidelines, the economic viability of the potential production from an oil deposit is assessed against the prevailing prices over the last 12 months, while also taking the firm's forecast of future prices into account. The SEC requires reserves to meet its standards for "proved" status at the price in effect as of the assessment, in this case at year-end.

When the price of oil was relatively stable, there wasn't much difference between these two perspectives, and thus between reserves determined under SEC or SPE guidelines. Even in the last several years, as prices rose dramatically from their roughly $20-25 per barrel range of the previous two decades, the 12-month averages were typically not drastically different from year-end prices, as for example the $66.25/bbl average for 2006, compared to $61.05/bbl on 12/29/06. However, if prices remain where they are today, we could see a $60/bbl difference between these two metrics for 2008, and a year-on-year decline of over $50/bbl. That would require any reserves that were booked at a price above $40 or so--not just this year, but going back as much as four years--to be reevaluated. (Natural gas has fallen, too, though by much less than crude oil.)

This situation is complicated by a bigger underlying question: what is the value of oil likely to be in the future, rather than at a moment in time or over some past interval? Reserves are future production, after all--in some cases extending over 20 or 30 years, or even longer. The market for prompt delivery might be glutted, and the outlook for the next year might appear pretty bleak, but without reading too much into the present steep "contango" in oil prices, there is every reason to believe that when global economic growth resumes, the fundamental conditions that pushed oil prices beyond $100/bbl will reassert themselves.

Before investors panic at the prospect of publicly-traded oil companies writing down hundreds of millions or billions of barrels of "proved reserves" for accounting disclosure purposes next year, they need to consider where the volumes in question will have gone. Were they merely shifted from the "proved" to "probable" category--thus not affecting the amount of oil that would ultimately be produced--by a temporary oil glut arising from a global recession, or did their existence depend on an oil-price bubble that is unlikely to reflate? And even if these conditions do prove to be temporary, there's a good chance that a number of oil and gas projects, including some fairly large ones, will have been deferred in the meantime, if not canceled entirely. That affects reserves in the most fundamental way possible, as well as altering the future global production profile. Since my own portfolio includes oil & gas equities, I face the same uncertainties in this regard as anyone else, as both an investor and a consumer. At the very least, this situation highlights the urgent need for a major revision of the SEC regulations covering the reporting of reserves, along the lines the Commission has already proposed, to put reserve estimates on a more meaningful and less volatile basis.

Energy Outlook will be on holiday break until next week. Merry Christmas, Happy Hanukkah, and Seasons Greetings, as appropriate!

The Baby and the Bath

Over the course of the last year, speculation has become a primary focus of concerns about the rapid increase in oil prices. For a Congress under intense pressure from constituents to address energy prices, regulating speculation in energy commodities could present the best prospect for appearing to deal decisively with the current energy crisis prior to the November election. Nor would I rule out the possibility that it might even provide some genuine price relief, although there are ample fundamental reasons for oil to be much dearer than it was just a few years ago. However, if Congress is going to take on the energy markets, it is imperative that it does so in a measured way, to avoid impeding their legitimate functions--some of which might be considered as speculative as the "commodity index" investment that has come in for the most severe criticism. Overkill could ultimately cost businesses, and eventually consumers, as much as inaction.

There's no shortage of conflicting opinions on this topic. A number of academics and financial experts have dismissed the possibility that speculation in oil futures could have much influence on the price of the physical commodity, pointing instead to the very real contribution of rapid demand growth in the developing world, slower production growth, particularly among non-OPEC producers, and the disappearance of global spare production capacity. Others have highlighted the recent and substantial flow of funds into the market from a new class of commodity investors, including pension funds and other institutions. They spot a cause-and-effect relationship in the accompanying rise in oil prices and find worrying parallels to the high-tech and housing bubbles. For my own part, I worry about the systematic linkages between the impact of this additional demand on futures prices and the mechanisms by which the price of oil purchased by refineries is set. But while I see a connection between speculation and higher fuel prices, I am skeptical of attempts to quantify it.

My background gives me a unique vantage point on this debate. After my graduate training in business and economics, I acquired a hands-on education in markets during a decade spent trading energy commodities for Texaco, Inc. This included a two-year stint trading international petroleum products from London, involving extensive dealings with our futures trading group and external floor broker. When I returned to Los Angeles, I was responsible for managing the commodity risk profile of the company's West Coast refining and marketing operations. Although this experience wasn't recent, I have no conflicts of interest in this area that would constrain my objectivity about the various proposals for regulating oil market speculation.

Some of the recent suggestions for regulating energy futures and derivatives trading might do more good than harm. This includes raising margin requirements, which might decrease liquidity, but also ought to reduce volatility by deterring investors from putting on enormous positions in hopes of turning small per-unit margins into huge aggregate gains, a strategy that hedge funds have employed in many markets. Shrinking volatility would be bad for traders, who thrive on it, but good for the economy. Closing the so-called "Enron Loophole" probably falls into a similar category of positive benefit vs. cost.

Other ideas seem likely to do much more harm to non-financial firms seeking to manage their business risks. For example, one of Senator Obama's recent anti-speculation proposals would force all energy commodities to trade on regulated exchanges. If this shut down the over-the-counter "swap" transactions that are used to bridge the price gaps between the small selection of crude and products traded on the NYMEX and the actual grades that companies buy and sell, it would make it much harder for businesses to hedge their risks. Airlines come to mind, here. Because there is no futures contract for jet fuel, an airline hedging its fuel supplies by buying crude oil or heating oil futures/options often also executes a swap covering the difference in price between jet and crude or jet and diesel. Otherwise, it runs the risk that when it purchase its jet fuel later, the hedge will have only appreciated by a fraction of the increase in the price of the physical product, or worse yet, might have lost money, while jet fuel prices continued to climb due to local or global scarcity. But as important as this transaction has become to airlines, it seems unlikely to generate the scale and liquidity required to merit launching an exchange-traded futures contract to cover it.

An even worse notion making the rounds on Capitol Hill would require anyone buying a futures contract to take physical delivery of the oil or product. As sensible as this might sound to the public, it would be catastrophic for the market and for the vast majority of participants, large and small, who use these markets to manage the enormous price risks associated with real-world energy activities. Even the small minority of players who rely on the NYMEX for physical supply in the New York Harbor would suffer, as liquidity for these contracts dried up. Consumers used to buying heating oil at a fixed-price for the season or year would probably lose this option, as all but the largest suppliers would be unable to offer this service.

Even the basic principle of limiting futures market activity to entities that produce or consume oil or its products is fundamentally flawed. On any given day, the producers and end-users wouldn't be active enough to make a real, liquid market. I experienced this first hand trading refined products on the West Coast. Top management preferred us to deal mainly with other oil companies, but when our own output fell short, the other refiners weren't always in the mood to sell. Without being able to buy from risk-taking independent traders who had previously taken a bet on the market, we would have run out of product on many occasions, and consumers would ultimately have been harmed.

Speculation plays an important role in lubricating the wheels of commerce, although it may also be contributing to higher oil prices, as investors increasingly turn to these markets as an inflation hedge or as another long-term asset class. My advice to Congress is to err on the side of caution in regulating energy commodity trading, and to specify very precisely which activities they want to rein in, rather than designing indirect and intricate rules that would ultimately entangle many participants that are essential to the efficient functioning of these markets. If Congress disrupted the entire energy market, just to constrain speculation by pension funds and other portfolio investors, the resulting chaos would hardly benefit consumers.

Speculation And Crude Oil Differentials

An article in today's Financial Times provides key insights for anyone trying to understand how oil prices reached their current heights, and where they might go from here. This requires more than just an examination of the highly-visible oil futures markets. We need to look at what refiners--who along with a few utilities in Asia are the ultimate customers for all crude oil--are paying for the grades of oil they actually run. Many of these crudes look very different from the West Texas Intermediate and Brent Blend traded on the New York Mercantile Exchange and the Intercontinental Exchange. But while the price relationships among these different grades of oil certainly contain clues about the impact of oil-market speculation, I'm not sure the evidence exonerating speculation is quite as conclusive as the FT suggests.

The growth of the futures exchanges over the last two decades has fundamentally changed oil trading. Most oil is now bought and sold on price formulas pegged to the futures prices, or to published market reports strongly influenced by the futures. What traders are agreeing to when they do a deal is not a fixed price, but a fixed differential above or below a particular futures contract during a set period, usually aligned with the time when the shipment will be loaded or delivered. So while these differentials fluctuate due to a variety of factors, the price that refiners pay for crude oil remains directly tied to the futures price. That means that anything that drives up the futures market, whether a disruption in supply, higher demand, or speculation by a new class of commodity investors, has a direct impact on what we all pay for the products that refineries make.

Crude oil price differentials are determined by several factors. Some of them are fixed, some change gradually, and others shift continuously. A barrel of Saudi Heavy crude (2.8% sulfur, 27 API gravity) is intrinsically worth less than a barrel of Nigerian Bonny Light (0.14% sulfur, 34 API), because the former will yield less high-value gasoline, diesel and jet fuel than the latter without intensive refining. But how much more a barrel of Bonny Light commands in the market depends on the relative prices of all the various petroleum products when it is sold, along with the location and availability of spare capacity in the complex refineries that have the hardware to overcome those intrinsic quality differences. As the chart below shows, the premium for Bonny Light over Arab Heavy is quite volatile, and it does not necessarily depend on the absolute price of crude oil. It was nearly as high in October 2005, when WTI was $62/bbl. as it is with WTI at more than twice that price.

Source: Energy Information Agency
http://tonto.eia.doe.gov/dnav/pet/pet_pri_wco_k_w.htm

As the FT correctly notes, various factors have contributed to make light sweet crudes more valuable and heavy sour crudes less valuable, relative to each other. By itself, though, this does not prove that speculation hasn't driven all of these prices higher than they otherwise would be, because refiners focus mainly on the price relationships among different grades of crude oil, and between crudes and the wholesale prices of the products they yield. Refining is a margin business. Higher absolute prices tend to weaken demand and make it harder to pass on increases in their costs, but refiners have no more control over the market price of oil at $130/bbl than they did at $50/bbl or even $20, so they focus on what they can control: in the short run that means finding the cheapest grades of crude that will yield the products they need to meet their sales commitments, and in the long term it involves investing to enable them to run even cheaper, lower-quality crudes, if increasingly intrusive regulators will allow it.

When we compare the acquisition prices reported by US refiners to the Energy Information Agency for the actual mix of imported and domestic crudes they bought through April 2008, we see that although the discounts to WTI have widened in the last year, they are not unprecedented. As a result, refiners are paying well over $100/bbl for even the least attractive crude oil grades.

Source: Energy Information Agency
http://tonto.eia.doe.gov/dnav/pet/pet_pri_rac2_dcu_nus_m.htm

On balance then, what does all this tell us about the influence of speculation on oil prices? In the view of the Financial Times and others, speculation is unlikely to be the major driver of high oil prices, since the prices for the physical crudes that refiners process have increased more or less in lock-step with the futures prices we observe, rather than disconnecting in the manner that might logically be expected, if the oil futures were experiencing a speculative bubble. However, I would argue that this hypothesis depends on an understanding of the oil markets that is at odds with the actual structure of the market. The manner in which physical oil is traded with reference to the futures price, combined with the reinforcing-loop relationship between crude oil and refined product prices, makes a disconnect between these markets improbable, even if the futures were caught up in a speculative bubble. That's not good news, because it suggests that we might not know whether we're in a bubble until it collapsed, either under its own weight, or through regulatory intervention.

$4 In Sight

As of yesterday's market close, the price of light sweet crude oil on the New York Mercantile Exchange (NYMEX) was up 29% since December 31, 2007. In this environment, prognostications about the market become obsolete almost as fast as they're written, mine included. Ten weeks ago I assessed the prospect of $4 per gallon gasoline this spring and concluded that it would require a combination of unusual circumstances. Instead, after another $20+ increase in oil prices, the average US retail gas price stands at $3.72, with California at $3.92. That means that polesigns showing $4.00 or more for unleaded regular are already a common sight in many communities. In a normal year, I would suggest that we are probably only a few weeks away from the peak price for the year, but this has been anything but a normal year.

Aside from the unprecedented crude oil prices, refining margins have not followed their usual seasonal pattern, in which margins rise as refineries shift out of heating oil production and perform annual maintenance, while gasoline demand builds toward its summer level. But using the difference between NYMEX gasoline and crude oil futures as a proxy for margins, they are running at $0.42/gal. less for April-May than the average of the second quarters of 2006 and 2007. This reflects weak demand, which may now be rebounding. Refineries are operating at somewhat reduced rates, compared to this time last year, and diesel production is a bit higher and gasoline output a bit lower than normal, all driven by weak gasoline margins and the surprising strength of diesel fuel. If normal seasonal factors were superimposed on today's high oil prices, we'd already be paying well over $4/gal. for gas.

I wish I could point out some factor that promised imminent relief. The only candidate I see is the recent decline in the "backwardation" of oil futures. A few weeks ago, the first or "prompt" contract was worth about $2.00/bbl more than the contract for delivery four months out. Today, this premium is around $0.40. That suggests a market in better balance. A further shift into "contango", when prompt oil is worth less than oil farther out, would indicate a surplus and signal refiners and traders to rebuild inventories. Of course, it wouldn't take much in the way of bad news to resume our march toward $130 or higher.

For good or ill, the only element in all of this that consumers control is demand, which is a function of miles driven and fuel efficiency. After falling in the first quarter, it now seems to be running at about the same pace as last year. Americans may be driving less, but the highways speeds I observe others driving imply that for all our complaints about the high price of fuel, we still value our time more. Will the psychological impact of paying $4 per gallon alter that? If a 70% increase in the pump price of gasoline over the last three years hasn't done the job, then I doubt that another $0.30/gallon will.

Bubble or No Bubble

The controversy over the influence of speculation on oil prices is gaining momentum, spurring congressional hearings and a steady patter of op-eds, including Paul Krugman's column in today's New York Times. The idea that oil prices have been artificially elevated beyond a realistic, market-clearing level is of interest to more than just consumers. Biofuel producers have so far failed to reap the bonanza from high oil prices that they must have expected, because of steady increases in the price of grain, oilseeds and other inputs. A sudden oil-price collapse back to $60 or less could do many of them in, particularly with large increments of new capacity coming on later this year. Gauging the future price of their principal competition has become more challenging than ever, when the futures market has proved such an unreliable source of predictions.

Professor Krugman makes a solid argument that today's high oil prices exhibit few of the signs of past speculative bubbles, especially in regard to the level of oil inventories around the world. They don't reflect the degree of hoarding that would be expected, as speculators stored oil in anticipation of selling it at a higher price later. But while I agree with Dr. Krugman that assertions of an oil bubble going back several years owed a lot to wishful thinking, I wonder if he underestimates the influence of an oil futures market that didn't even exist during the energy crisis of the 1970s. This goes beyond the simple notion that a large, liquid market in oil futures allows investors to speculate on the future price of oil without having to take possession of it, and at a much lower carrying cost than if they had to pay for it all and lease a tank in which to store it. The connections between the physical market and futures market have become pervasive, and they tend to reinforce the upward pressure on prices from rising global demand and restrictions on access to resources.

Last December the noted oil expert Philip Verleger testified on oil prices before a joint hearing of two Senate committees. As part of his compelling argument concerning the disproportionate impact of the government's policy of putting additional sweet crude oil into the Strategic Petroleum Reserve, he described how a relatively obscure technique called "delta hedging" could reinforce an upward trend in the futures market. He used the example of Southwest Airlines buying call options on crude oil at a strike price of $51/bbl. through 2009. As the price of oil increased, the financial firms that sold these options to Southwest would have had to purchase increasing quantities of oil futures contracts, in order to manage their exposure, as the options got ever deeper "in the money." The higher the price of oil goes, the more oil futures the call option seller must buy to stay neutral, in a classic positive reinforcing loop pushing up the demand for oil futures, and thus their price. I wish I had noticed his testimony at the time, because Dr. Verleger accurately foresaw the market move past $100 to $120.

This example offers an important insight for those who are focusing on the role of speculation in oil prices. Rather than viewing speculation as the driver of a bubble along the lines of the Dot Com or recent housing bubbles, it makes more sense to view it as an amplifier inserted into the circuit that runs between the energy futures, options and derivatives markets and the markets for physical oil. As long as demand growth continues in spite of high prices--with modest reductions in US demand offset by growth in countries that insulate their consumers from high market prices--speculation will continue to amplify negative supply news and push the market to new heights. However, if new production or conservation suddenly began to overwhelm demand growth, producing a short-term surplus, that signal would be amplified just as effectively, unraveling speculation at a record pace. The "delta hedging" mechanism described above works in reverse, too.

That doesn't mean that alternative energy firms should be overly concerned that oil prices will drop below $60 per barrel and remain there indefinitely. While oil above $100 per barrel has failed to crush global demand, at least so far, oil below $60 would surely stimulate it. The long-term fundamentals remain strong, as oil heads for an effective ultimate limit on global output--whether that limit is 85 million barrels per day, 100 MBD, or even 120 MBD. It does, however, suggest the need for financial flexibility: balance sheets healthy enough to withstand a few quarters of low or negative margins and weak sales. More importantly the possibility of a temporary oil-price dip should not blind the management of these firms to a much larger emerging threat, the prospect that a perceived global food crisis will unravel support for the government subsidies and mandates that have been the principal engines of the industry's growth for the last two decades.

Weak Signals

Today’s posting will be brief, since I’m traveling. An item in this morning’s Wall St. Journal caught my eye. It interpreted some recent oil-related options trading as an indication that some market participants expect a correction in oil prices. While I share the view that oil at $118 per barrel has inflated beyond any realistic interpretation of the supply and demand fundamentals, even with the prospect of a further deterioration of the dollar exchange rate, I wouldn’t make too much of this news. Oil futures have run up by more than $10 in the last two weeks, and it wouldn’t require deep pessimism for traders to want to buy a little insurance. They could pay for it with the profits from just the last day or two.

At the same time, while a correction seems long overdue, I’m concerned that oil has reached its current heights without any major supply crisis, driving the average US retail gasoline price above $3.50/gallon without any serious refining or product distribution problem. An event on either front could send oil prices or refining margins to levels that would quickly translate into another 20-30 cents per gallon at the pump, pushing large parts of the county over the $4.00 mark, which is already appearing at higher-priced retailers in California.

As consumers contemplate that possibility, we should remember that we have more influence over prices than we think. A 0.5 mile-per-gallon improvement in fuel economy from avoiding jackrabbit starts and coasting into stops--rather than accelerating until the last moment—would aggregate to a 6 million barrel per month reduction in demand and ease the pressure on prices, while filling up at ½ instead of ¼ would deplete US gasoline inventories by 10 million barrels, or about 5%. That could make $4 gas a self-fulfilling prophesy.

Calling A Halt

The management of the nation's Strategic Petroleum Reserve has long been a bone of contention between Congressional Republicans and Democrats, with the former tending to support the administration's fill-at-any-price strategy and the latter generally supporting a more interventionist approach. Senator McCain's call yesterday for a halt to SPR additions, until oil prices are lower, signals an important shift. If the government followed his suggestion, the results might be more dramatic than anyone expects, because of the limited size and nearly unlimited leverage of the domestic market for light, sweet crude oil.

Yesterday's posting, which was cited in today's WSJ Environmental Capital blog, looked at how oil trading has changed in the last couple of decades, focusing on the tremendous growth in the influence of the New York Mercantile Exchange's West Texas Intermediate (WTI) crude oil futures contract. Because it is the largest and most transparent oil market in the US, it has provided a handy reference point for traders transacting deals for physical oil, often with very different properties of sulfur, specific gravity, and other characteristics. The typical structure of an oil deal now involves an agreed premium or discount to the prevailing WTI price over an agreed period, often related to the time that a cargo of oil is loaded, or a pipeline shipment delivered. So while the global oil market has expanded to some 85 million barrels per day (MBD), with US refineries consuming on average 16 MBD of that, the price for a surprisingly large proportion of those barrels is set by a domestic light sweet crude futures market that is backed by only a few million barrels per day of physical oil: the domestic oil production and suitable imports connected by pipeline to the Cushing, OK delivery point for WTI.

Since current SPR additions are only 0.07 MBD (70,000 bbl/day), how much effect could foregoing them have on oil prices? Measured against 85 MBD, virtually none, but that's not the relevant comparison. What really counts is the Mid-continent light sweet crude system, consisting of pipelines going into and out of storage at Cushing, serving a number of inland refineries, including five sweet crude refineries in Oklahoma with a combined capacity of 0.5 MBD. Thus, while the volume of "paper barrels" traded on the "Merc" can mount into the hundreds of millions of barrels per day, the physical market underpinning them is orders of magnitude smaller. Anyone doubting the disproportionate impact of that system on crude prices need only look back one year, when Cushing was full and the value of the WTI "marker" was in doubt, with the WTI price consistently below that of its UK Brent cousin.

With its three current royalty-in-kind swaps consisting of 58% sweet crude grades, according to a DOE spokesman I contacted this morning, the government has a 40,000 bbl/day lever with which to nudge the balance point of the physical WTI market by reselling the oil that would otherwise go into the SPR. Because that still only amounts to a few percent of actual WTI deliveries, I wouldn't expect the market to drop by $10/bbl. But when you add the psychological impact of the government shifting its stance from buyer to seller--a net swing of 80,000 bbl/day--I wouldn't be surprised to see a change in the speculative logic driving oil ever higher. That ought to knock off at least a few bucks per barrel, while dampening the market's exuberance going forward.

As with climate change, we now see all three remaining presidential candidates signaling a break with the present SPR strategy, starting next January. Unlike climate change, it wouldn't require a change of heart or ideology on the part of the administration to shift from its policy of continuing to fill the SPR above 700 million barrels to putting the government's royalty oil back into the market. That could be done with the stroke of a pen and would be greeted warmly on both sides of the aisle, and by most Americans, with the possible exception of a few hedge fund or commodity fund managers. If it turned out to have no effect, the government could quietly resume SPR additions once its sales contracts ended. With every dollar increase in WTI adding $4 billion per year to our trade deficit and 2 cents per gallon at the gas pump, that looks like a low-risk, high-reward strategy to me.

Market Memory

Sometimes I wonder if the greatest flaw in the global oil market is that it has such a precise memory. Anyone with an internet connection can see what the price of oil was in New York fifteen minutes ago, and then view another website and track its movements all the way back to a Wednesday in March twenty-five years ago when the NYMEX West Texas Crude Oil (WTI) contract began trading. The problem with this is that, because the market can't forget, and because each moment's price is set with reference to the previous price, there is little opportunity for the market to catch its breath, weigh all of the fundamentals, and arrive at today's price from scratch. As a result, any distortions that creep in take a while to be expunged, if they ever truly are.

Most days I am grateful that I am no longer an oil trader, with one eye always glued to a screen displaying the gyrations of the global energy commodity exchanges. It's not good for one's health, even if you have a calm disposition. That's especially true these days, when a single news item can send the entire market up or down by as much as $4 per barrel from a starting point over $100/bbl. The process was different when I traded crude oil on the West Coast in the late 1980s. Although the NYMEX contract was becoming a bigger factor in the pricing of physical grades of crude oil, such as the cargoes of Alaskan North Slope crude I bought for Texaco's Los Angeles and Anacortes, WA refineries, it was still quite common to buy and sell pipeline quantities of oil at a premium or discount to posted prices--periodically-updated fixed prices at which refiners or traders solicited producers to sell them oil--or as often as not, at a fixed price unique for that deal on that day, e.g., $17.21/bbl for 2,000 bbl/day of Buena Vista Light during April 1987. (It's getting hard to believe oil was ever that cheap.)

Because of the way such deals were struck, a trader and the refinery for which he was buying had to have a very clear sense of the intrinsic value of that oil, either in terms of the products into which it could be refined, or the price at which it could be resold before delivery, if requirements changed. This process involved significant risks that could not easily be hedged, then. The stakes were high enough that, unless the counterparty was a long-term, reliable supplier or customer, deals could fall apart over a difference of 5 cents per bbl. Without suggesting that traders today are any less diligent or astute, I believe a market in which most prices are set with reference to WTI, Brent, or some other ultra-transparent exchange-traded marker entails less accountability for ensuring that the price involved is reasonable, rather than defensible--i.e., "Well, I paid the market price for it."

In a popular film of a few years ago, "Memento," the protagonist had an unusual form of amnesia and woke up each morning without any clear recollection of the previous day. He had to rely on notes he had previously scribbled to himself. What if the oil market worked that way, and each day, traders had to re-establish the price of oil from scratch, relying only on the fundamentals of supply, demand and inventory? A classical economist might suggest that the result would be no different, because the market price is merely the level at which supply and demand are balanced, every day. I'm less sure things are that simple, and I suspect that the practitioners of behavioral economics might be skeptical, as well. For example, yesterday's increase in the price of WTI to $111/bbl in response to an unanticipated 3 million bbl drop in US crude inventories only makes sense if you accept that $108/bbl accurately reflected all of the market factors before that news. However, a similar overall configuration of global inventory and spare production capacity in 2005 yielded prices in the mid-$50s to mid-$60s. $111 makes more sense as the net sum of three years of individual price movements, than as the bottom-up evaluation of all the factors in today's market.

I recently received a copy of an academic paper by a Ph.D. candidate at the University of Michigan and his professor. It tackles the question of whether the oil futures market provides a reliable forecast of future oil prices and finds that it does not. Even my view that it is a good indicator of current expectations of future prices seems shaky, in their analysis. Taken together with my concern that the market may be influenced more by its own price history than it ought to be, I conclude that decision makers, policy makers, and consumers would be well-served to take a somewhat more jaundiced view of that daily WTI settlement price that the media has grown so fond of displaying. Its impact on fuel prices and on our trade deficit is certainly real and tangible, but it might not be telling us as much about the world and the future as we have come to believe.

And One Cent

Oil futures finally closed above $100 per barrel yesterday, yet the context could not have been more different from the first time the market flirted with this level, last November. Then, the global economy was still perceived as growing strongly, albeit overhung with housing and debt troubles, and the US stock market was 7% higher. Now, the world economy is losing momentum, and the push above $100/barrel seems less like a bold move into uncharted territory and more like the late-race effort of a tired marathon runner.

Reading the market has never been easy, and it is even more challenging when the trends and underlying fundamentals shift out of alignment. Although the oil market's $4.50/barrel move yesterday was apparently prompted by several superficially bullish news items, upon further reflection at least two of those look bearish. OPEC's contemplation of a cut in production, which helped push prices higher, must be seen as a purely defensive measure, a tactic to forestall a precipitous drop in oil prices when winter's higher demand abates and economic growth continues to weaken. OPEC learned some bitter lessons in this regard in the late 1990s.

Another event that fueled the market's jitters yesterday was the unfortunate accident at AlON USA's Big Spring, TX oil refinery. But with due deference to the injured workers and their families, it requires a deep-seated bias to view this event as anything but negative for oil, and mildly positive for refining margins. The shutdown of a 70,000 barrel per day refinery, representing less than 0.5% of US refining capacity, will put more oil into a market in which inventories have been growing steadily since the first week of January. Big Spring runs high-sulfur crude oil, so the differential between West Texas Intermediate and West Texas Sour should widen. That seems a poor reason for WTI to spike, unless the market is being driven by investor psychology and technical indicators, not fundamentals.

With the equity markets weak and the debt markets in a funk, there is a lot of money floating around looking for a big return, somewhere. At the same time that forecasts of 2008 oil demand are still being revised downward, investors are piling into oil futures in search of a fast buck, creating a recipe for higher volatility. It's hard to see $100+ oil being sustained, barring some event that actually takes a big slice of production off the market, rather than merely increasing anxiety about such a prospect, a la Venezuela.

As I've noted before, the price of oil is a peculiar indicator. Until it passes through the value chain and emerges as higher prices for petroleum products and the goods and services that require oil as an input, it remains a highly theoretical barometer for most people. Weak refining margins have buffered consumers from the full retail effects of the recent excursions into the high $90s, and with US gasoline inventories well above their seasonal norms, marketers will have a hard time passing on yesterday's uptick, except in the area directly served by the Big Spring refinery. The larger question is whether yesterday's $100 close will affect the behavior of consumers or investors, and if so, how? Perhaps having breached the magic mark, we will tuck it away in the backs of our minds until oil hits the next psychologically-significant milestone, as we seem to have done with $3.00 per gallon gasoline.

The Oil Price Tax

An article in today's Washington Post compared the recent rise in oil prices to a $150 billion dollar-per-year tax on the US economy, enough to negate the various economic stimulus plans being discussed by the Congress and White House. It's a shocking figure, and it helps feed the forecasts of recession, which tend to be at least partially self-fulfilling. But before we accept that $150 million figure at face value--despite its impressive pedigree--it's worth spending a moment on a few ballpark validations. Above all, we should remind ourselves that if high oil prices are a tax, they tax producers, not consumers, who rarely purchase crude oil to use in our homes or vehicles.

The article cites a 2004 comment from Fed Chairman Bernanke noting that firms don't always have the ability to pass on the full effect of a commodity price shock to their customers. At least for oil refineries, now is such a time. Most of last year's oil price appreciation occurred following the end of peak driving season, after Labor Day. Between August and December, the average monthly futures price for West Texas Intermediate crude oil on the New York Mercantile Exchange went up by $19.38 per barrel. The average for January so far would add another $5 to that, so let's call it $25/bbl. With US refineries running at 15.5 million barrels per day, and using the increase in WTI as a proxy for the change in the oil prices actually paid by refiners, their costs have gone up by about $11.5 billion/month. That's close to Professor Nordhaus's $150 billion annualized pseudo-tax.

As I noted above, however, consumers don't buy oil; they buy gasoline, diesel fuel and heating oil. Although the prices of all those products have gone up considerably since Labor Day, only retail heating oil has gone up by as much as crude oil. So far, the average retail price of diesel fuel has risen by about $20/bbl and gasoline by only about $13/bbl. At current consumption rates, the direct impact on consumers is thus around $6.6 billion/month, or $80 billion per year. That ignores increases in the cost of plane tickets, plastics, food and many other things that consumers buy that include a significant energy component, but then, the prices of those goods and services are influenced by many other factors aside from the price of energy. That indirect impact has been further buffered by the relatively low price of natural gas, which supplies a large fraction of the energy and feedstock for the broader manufacturing, chemicals and power sector, and which has been virtually unaffected by the recent change in oil prices.

When we consider the net impact on the entire US economy, we see an increase in the price we pay for imported oil and petroleum products on the order of $9 billion/month since September, or $108 billion/year. Consumers have experienced about three-quarters of that, with businesses absorbing the rest, for now, along with the residual higher cost of domestically-produced oil. If the price of oil remains at this level, more of the increase will flow through to consumers, particularly with the seasonal return of higher gasoline demand in the spring.

$100 billion is not a trivial sum, particularly when it's added to the ongoing expense of two wars and the ultimate cost of repairing the damage caused by the sub-prime debt meltdown. In particular, taking the annualized equivalent of $80 billion out of consumers' disposable income has to worry any business hoping to sell them some product or service this year. But in an economy with nearly $10 trillion of consumer spending, it's the rough equivalent of a 1% tax. Consumers, businesses and policy-makers might want to keep that in perspective, before they panic.

SPR Temptations

Today's Wall Street Journal includes an op-ed advocating the sale of oil from the US Strategic Petroleum Reserve, based on a clever twist on the usual argument about the need to drive down global oil prices. Rather than worrying about the economic burden on low-income Americans, the author sees an opportunity for the federal government to earn an arbitrage profit on the SPR inventory, possibly creating an attractive way to plug the budget gap that will be created by reforming the Alternative Minimum Tax. The problem is not with the author's math, which seems generally correct, but with his assumptions about the nature of the futures market and how it would respond to such a scheme. Nor is his idea of depleting the SPR and ceding its function entirely to the market prudent, given the kind of world we in which we live. This is a classic half-baked idea: it contains the seeds of something interesting, but in its present form it would likely prove disastrous.

Mr. Henderson's idea depends on the shape of the "forward curve", the relationship between the futures market's price for oil delivered promptly, compared with the price for delivery in subsequent months. The market is currently in steep "backwardation," with yesterday's contract for delivery in December 2007 closing at a price $8.59/barrel higher than that for delivery one year later. Mr. Henderson looks at all that oil in the SPR and sees a chance to sell now and buy back later, earning the "front-to-back spread" on every barrel. If you look at the open interest and the daily volume in the Dec'08 contract, you might conclude that a million barrels per day (MBD) would disappear into that vast pool with scarcely a ripple. But with relatively few of those futures contracts ultimately resulting in a physical delivery, an extra MBD or two would change the entire market, not just via arbitrage, but by altering the expectations that set its current shape. In fact, a large portion of the arbitrage opportunity would probably disappear the moment the government announced its decision to sell SPR oil, and before the first SPR barrel was sold. The front-to-back spread would shrink quickly, and the total profit captured by the government might only be a few tens of millions of dollars.

The key to Mr. Henderson's strategy is how large a difference in supply or demand is necessary to flip the market from backwardation to "contango," in which oil for later delivery is worth more than prompt supply, and what would happen next. As the first SPR deliveries eased the current competition for prompt barrels, the market would more towards oversupply, and the basis of his whole proposition would be stood on its head. As long as the government continued to sell, the market would shift towards contango, and Mr. Henderson's front-to-back play would turn negative, with the Dec'08 repurchase costing more than the revenue from Dec'07 sales. The moment the SPR sale stopped, the market would revert to its former shape, though not quite as far, because participants would expect the government to intervene again.

The result of this scheme would be a game driven by expectations of future government intent, and that seems like a very undesirable sort of meddling in a complex market that underpins so much economic activity, globally. Nor is it clear that driving down the global price of oil by this means--the author's larger goal--would create more than a short-lived price holiday, during which demand growth here and in developing countries might accelerate. That would compress the gap between demand and actual global production capacity still further, rendering the market more volatile once the SPR ran out, and leaving us no way to replace the lost inventory without driving prices even higher.

I have long regarded the SPR as an outmoded holdover from a highly-regulated era. Its existence deters companies from holding larger inventories, and it offers minimal protection west of the Rocky Mountains. But simply abolishing the SPR without providing a practical alternative would be irresponsible, given the geopolitical risks we face; an unregulated market won't perform this function without a mandate or carefully-targeted incentives. The goal of any prudent proposal to privatize these stocks must be to position them closer to where they would be needed in an emergency, and to put them in more responsive, market-savvy hands, rather than using them all up in an unsustainable binge.

Regulating Speculation

The front page of the Sunday Washington Post featured an article on the perils of speculation on under-regulated energy futures exchanges. The Post cites the cost to consumers from speculators driving up the cost of these commodities and makes a case for expanding both the powers and budget of the Commodities Futures Trading Commission (CFTC), the federal body established to regulate such transactions. However, the article also describes how further regulation might drive this trade off the regulated exchanges and deeper into the unregulated and much less transparent over-the-counter markets (OTCs.) While all of this is interesting, it reflects the typical shortfalls of coverage that treats futures markets as black boxes. The reality is more complex and less nefarious--and the likely solution much simpler--than the Post suggests.

Futures markets offer important benefits for all participants, particularly for those seeking to manage the price risks of the physical oil positions intrinsic to their operations. That includes oil, gas and electricity producers, refiners and large consumers. The fixed-price heating oil contracts that have become so popular with consumers would not exist without thriving futures markets. Purely financial participants play an essential role in these markets, providing liquidity and taking offsetting positions that the physical players might eschew on any given day. Pegging the price of physical transactions to the settlement prices of these exchanges became popular starting in the late 1980s, because their liquidity and transparency was impossible to match for all but a few high-volume physical trades. The other main benefit for exchange participants is the virtual elimination of counter-party risk, the risk that when the time comes to collect the oil or money owed at the settlement of the transaction, the other party won't be able to make good.

The OTCs serve a different, but complementary role, facilitating transactions that are too specialized or thinly-traded for the established futures exchanges to take on. These can be very lucrative deals for market makers, because transparency is low and transaction costs are often very high. The frontier between the exchanges and OTCs is dynamic, with the former periodically offering new products that encroach on the turf of the latter--sour crude, fuel oil, etc. Anything that made the futures markets less useful or more expensive for their participants would drive trade toward the OTCs, and that's the chief risk of over-regulating these exchanges.

Several months ago I wrote a lengthy posting concluding that it was plausible that speculation had contributed to the dramatic increase in oil prices over the last four years. I took a lot of flak for that suggestion, which I still find eminently defensible on fundamental economic grounds. Notwithstanding expanding global demand for oil and the sharply increased marginal cost of bringing new supplies to market, along with a wide array of "above-ground" risks, financial speculation in oil by non-industry players represents a growing source of demand in the virtual markets that set the price for much of the physical trade in oil and petroleum products. But commodity markets, either regulated formal exchanges or unregulated OTCs, are not responsible for this phenomenon. They are merely the conduit for the impulses of an increasingly securitized financial economy that bets on every aspect of life, down to the weather. The pitfalls of some of these complex bets often don't become apparent until after they go bad, as we are witnessing on a large scale today.

Now factor in the legitimate national interest of the US government and the public it serves to minimize the impact of financial speculation on the final cost of petroleum products and the other forms of energy upon which the real economy depends. There is no corresponding national interest in allowing speculators to profit from these commodities, beyond a practical interest in allowing enough liquidity to ensure that these markets work smoothly for of all participants, especially those with physical exposure to hedge. If speculation in oil commodities drove their price up by $10/barrel, that would cost businesses and consumers $70 billion/year and increase the US trade deficit by about $40 billion. On that basis, I believe there is a solid argument for new regulation. The trick is ensuring that the treatment doesn't kill the patient.

That's where I think the Post and various members of Congress pursuing tighter scrutiny of commodity exchanges are on the wrong track. The issue here is not the exchanges, or even the OTCs, but rather the investors using them. The challenge for an external party trying to piece together all of the market positions taken across various futures exchanges and OTC markets by a party such as Amaranth, the new poster-child for commodities excesses, looks truly daunting, even for auditors examing them after the fact. The most sensible alternative to such a regulatory nightmare would be to require investors themselves to disclose aggregate positions exceeding some threshold to federal regulators, just as the SEC requires the disclosure of any stake over 5% in the equity of a traded company.

While journalists and the public may regard such speculators as undisciplined cowboys, every one of them has internal controls that require daily or real-time "mark-to-market" trading reports, tallying the entity's current exposure to each commodity. Reporting that exposure to the CFTC whenever it exceeded 10 million barrels of oil or the equivalent in gas or other energy commodities could be accomplished with minimal new bureaucracy or accounting burden, and without distorting the relationship among the physical, futures and OTC markets. That would provide the over-the-shoulder scrutiny that the Post and others advocate, but at a much lower cost to the economy.

Two Industries

In the first day of the John S. Herold Pacesetters Conference, most of which was focused on the exploration and production portion of the global oil and gas industry, I heard many interesting comments and themes, but I was struck by a contrast between the typical external picture of an industry beset by political and environmental challenges, and the companies on display here, which are working on real growth opportunities and generating real value for their shareholders and the economy as a whole. Anyone expecting this industry to fade quietly and get out of the way of emerging energy sources such as wind, solar and biofuels, is bound to be disappointed. Yet the industry would be equally wrong to ignore the future competition those new sources represent.

In some respects, this contrast arises from something one of yesterday’s panelists observed, that there isn’t one oil & gas industry, but really two. On the one hand, we see the eight or so world-scale companies that are household names across large portions of the globe, while on the other, a constellation of smaller companies that belie the stereotype of an industry that values financial engineering as much as the physical kind. While no one should be surprised to see such companies at an investment conference touting their companies’ stories, the underlying facts are impressive: these smaller companies are generating real production and reserves with the drill-bit-- rather than just buying each other--generating healthy profits along the way.

But as yesterday’s lunch speaker made clear, even the smaller companies don’t necessarily fly under the political radar. The CEO of Chesapeake Energy, one of the largest independent producers of natural gas in the US, shared a remarkable set of correspondence with the audience, in which the Governor of Connecticut accused his company of manipulating the gas market, to the detriment of consumers, by constraining production. She has asked for a Congressional investigation of this practice, and in the current environment she will probably get one.

You don’t have to take Mr. McClendon’s word concerning the inaccuracies contained in Ms. Rell’s allegations; they are easily discernable in the price and inventory storage data maintained by the Energy Information Agency of the Department of Energy. It certainly leaves open the question of how much due diligence the Governor’s office conducted before leveling these charges. More fundamentally, however, it’s not clear why any state government might think it appropriate to criticize a decision by a private company in another state to cut production that has become unprofitable because of falling prices. If natural gas producers can be taken to task for this, can ethanol producers faced with falling margins be far behind?

Finally, I heard some interesting thoughts about what the shape of the current futures markets for oil and natural gas is telling us. When you ignore the fluctuations at the front end of the market and focus on the further-out contracts, the pricing of low $70’s for crude oil and $8 for natural gas are in line with the prices implied by the incremental oil and LNG projects now under development. While that doesn’t preclude the possibility of a collapse back to $50 or $60 oil and $5 natural gas, it does suggest that such drops wouldn’t be permanent—unless producers are forced to produce flat out regardless of price.

Why Is Oil So Pricey?

For the last several months, almost everyone has been asking why gasoline prices are so high. The standard answers often fail to satisfy, and far too many people see signs of a conspiracy. I've devoted a fair amount of space to this issue, but I've largely ignored the more important, fundamental question of why oil prices are so high. Oil prices remain the largest single component of retail gasoline prices, accounting for about 54% of the pump price, and most of those who follow oil are focused on the factors that could move its price up or down, rather than looking at its absolute price level. Why should oil be trading at $70 today, instead of $30 or $40? This question ought to be of great interest to the public and to government officials, and especially to those developing or investing in alternative energy.

Reviewing the long history of oil prices provides some interesting insights. Prior to 1973, oil prices were quite stable, which meant they were trending downward in real terms. From 1985 to 2002, nominal oil prices averaged $21/barrel, and with the exception of a few spikes, such as the Gulf War, real oil prices were generally falling. The overall pattern reflects sharp upward discontinuities, followed by a gradual decay in prices until the next spike. This history includes periods with all sorts of economic, geopolitical, and market conditions. To understand why the oil price is so high, we need to ask what is different today, compared to previous, similar periods when it was lower. Consider some of the factors that are usually trotted out to explain high current oil prices:

Asia's growth - India and China are growing rapidly, straining global oil supplies and pushing prices higher. But is this growth unprecedented? Since 1997 China's oil demand has grown at an average rate of 7% per year, based on US Department of Energy data. Over the last five years, that has added roughly 500,000 barrels per day (bpd) to global oil consumption. But that increment is still only 0.6% of total global consumption of 84 million bpd. From 1960-1970 oil demand in the OECD--essentially the US, Western Europe and Japan--grew by over 8% per year, driving total global demand up by around 6% per year for a decade, during which total consumption more than doubled. Over that entire period, when prices weren't influenced by OPEC, but guided by the Texas Railroad Commission, they were steady in nominal terms and falling when converted to 2005 dollars.

Falling spare capacity - Many analysts suggest that the decade's global economic growth has outpaced the ability of oil producers to expand spare capacity, and the resulting narrowed gap between supply and demand has pushed prices higher. There's no question that global oil capacity has been strained, particularly in 2004 and 2005. It's hard to gauge spare capacity reliably, but it was clear that Saudi Arabia, the world's swing producer, had to dig deeper into less desirable, heavier grades of oil to meet the call on its output. But one of the best proxies for the interaction between supply and demand, inventory, tells a different story. Total OECD oil inventories--which include strategic reserves--have grown by 10% since 2002, with US commercial crude oil inventories currently 9% above their 10-year average. By itself, this fact doesn't suggest that crude is overpriced, but it certainly doesn't justify today's price level, either.

High geopolitical and other risks - Al Qaeda, war in Iraq, unrest in West Africa, climate change, hurricanes: the last six years have been a compendium of nearly every bad thing that can happen to affect the price of oil, and the idea of a high "risk premium" on oil is widely accepted. But how high should it be? What did previous events like this do to the price of oil? Consider the case of the Gulf War, when Iraq invaded Kuwait and threatened Saudi Arabia. From the time Saddam's forces crossed into Kuwait in August 1990 until the coalition air campaign began in January 1991, the price of West Texas Intermediate crude on the NYMEX rose by about 50% from the average of the preceding 12 months. (Once the shooting started, the price plummeted back to the low $20s.) On a comparable percentage basis, the Iraq War, which has had a smaller impact on actual oil production than the Gulf War, might thus account for about $15/barrel of the current price. It's hard to imagine all the other risks doubling that figure.

That brings us at last to the question of whether speculation might account for the remainder of the doubling of oil prices that has occurred since 2002. This is certainly a relatively new factor in the oil markets, compared to the 148-year history of the commodity. The number of players in the futures, options and oil derivatives market, compared to even a decade ago, has exploded. "Open interest" on the New York Mercantile Exchange, a measure of the scale of trading, has more than doubled since 1999, when it stood at 638 million barrels of crude oil. As of Friday's session, aggregate open interest across all crude oil contracts going out to 2012 was just under 1.5 billion barrels. But does that mean that speculators are manipulating the price of oil, as some have alleged? I think there's a different explanation that looks at the nature of these markets, rather than the intentions of their participants.

Oil futures have a basic similarity to equities. Both reflect the underlying value of the thing to which they are linked--barrels of oil in one case, the fortunes of a company in the other--but both also have an independent existence. Oil commodity futures are in demand as financial instruments in a different way than when they were used primarily as a way for refiners and distributors to manage the risk on their physical market activities. As that demand grows--as more individuals, companies, and hedge funds want to participate in the oil market, without a link to any physical supply or demand for the commodity--then the price of these instruments ought to rise, in tandem. But with the price of most physical oil pegged to a futures market, whether for WTI or European Brent crude, that demand can influence the physical market, as well, without changing the real supply or demand by one barrel.

Anyone who has traded oil knows that the physical market needn't move in lock step with the futures market. Differentials for physical oil versus futures wax and wane, depending on a variety of factors, and if the only thing going on were long-term inflation of oil futures by financial demand, you'd expect the discounts for real grades of oil to widen versus the futures to compensate. But those differentials aren't set in a vacuum, without reference to previous prices. You don't wipe out the entire price history of the commodity and arrive at the price from scratch every day.

How much of an influence could the expansion of market participation have? I honestly don't know, but the shortcomings of the other explanations that I discussed above at least suggest that we're missing something important. Frankly, I find this a much more interesting question than many of those that are being asked about gasoline prices in the Congress and elsewhere. Rather than wondering if the market is being manipulated by oil companies or hedge funds, we ought to be analyzing the broader impact of the enormous increase of investor interest in oil price instruments on the cost of real oil to the economy. If anyone has run across a study looking at that, I'd love to see it.