Tuesday, October 03, 2006

Oil Prices...Again

Almost a month ago I raised the possibility that the sharp drop in oil prices in the run-up to the November elections may be the result of manipulation. This has been an easy argument to brush aside, as there are also fundamentals behind the recent drop: this hurricane season hasn't lived up to the hype, causing some speculators to bail out of their oil plays. Also, geopolitical tensions impacting oil supplies have been simmering on low (though some of this--especially the easing of pressure on Iran, may not be entirely innocent). Never the less, the potential for price manipulation has received coverage from most of the mainstream media (though mostly as a preface to dismissing the concern). While I think that I presented several very plausible manipulation scenarios, over the past week there has been one theory (not one of mine) that has cearly risen above the rest: a change in the composition of the Goldman Sachs commodity index led to a massive sell-off in oil-complex futures. The Goldman Sachs commodity index is publicly available, and it acts as the benchmark for the composition of over $100 Billion in commodity funds. Suddenly, and without explanation, Goldman Sachs changed the Unleaded Gasoline component of the index from 8.72% to 2.3%, which sparked a lingering sell-off of over $6 billion dollars in oil-complex futures as funds scrambled to bring their portfolios in line. This was in no way a reflection of the fundamental supply and demand picture, just a quirk of the financial markets. With this theory now out in the open, there is speculation that Goldman's close ties to the Bush administration may be involved, but that is a more of a diversion: this is important not because it may or may not suggest political maneuvering, but because it strengthens the argument that the recent drop in oil prices is not based on fundamentals.

As deconsumption recently pointed out, even the NY Times has picked up on this story.


Anonymous said...

I spoke with Goldman on this one and they claimed (in an muddled way) that it had something to do with the federal legislation mandating replacement of MBTE with ethanol...

Goldman had also recommended an allocation to corn about 18 months ago.

jc said...

This thing, again, if you read about oil and financial market related stuff, then you would know that the financial market future contract buy and sell accelerated the fluctuation of price into an unrealistic level. However, this is part of the market efficiency by discounted the future into the current expectation.

Therefore, the possibility of political maneuvering may exist as it is quite easy to achieve by this mean, but it is probably making sense if Goldman is diverting its attention into corn. It seems developing of ethanol from corn is also a highly important agenda in Bush's agenda, which indeed is the most accessible alternative energy source.

The problem is that up to now, there is no clear record of how much volume of ethanol has already replaced oil. Both China and India are also working hard on ethanol. Ethanol can be produced from root cassava too, which is currently happening in Thailand.

The oil price should fall if the per day consumption is seeming stopping. Would it be much easier to talk about oil price fundamental by tracking global per day consumption.

Marc Fellman said...

I was wondering if part of the acceleration in the price of oil is also due to the effect of its unexpected drop on people that were speculating that oil would continue to go up or at least be stable at a certain price level. Is there a way to measure how many billions of dollars are the result of hedge funds cashing out of bad bets?

My questions is this- was there some initial manipulation that led to a decrease in prices that has become self-perpetuating due to speculators cashing out of their positions and cutting their losses.

I don't know if or how this could be measured. However, once speculators buying energy futures on margin get wiped out as happened recently to the hedge fund Amaranth. From what I read, the decline in natural gas prices was an extremely unlikely event and while the fund's positions were such that it would sink should this highly unlike drop in prices occur, the price drop did occur and Amaranth is out of business having to sell its portfolio for pennies on the dollar.

I think the theory of manipulation will be even more compelling if prices begin to trend upwarwd shortly after the election. The shorter the period after the election and the hirer they align with fundamentals, the more consequences must be explained away.

Who sees these prices as a buyer opportunity? Maybe the price of call options for oil futures that expire in November or December will be a good indicator to follow.

Does anyone know whether USO - the oil ETF is optionable and since I don't think it is, if someone wanted to buy call options on a security that tracked the price of oil futures, are there any?

sventastic said...

There's a good article in the Independent today on the link between global warming and impending desertification of over a third of the earth's landmass:


This makes dependence on industrial agriculture (as completely f***ed as it already is and always has been), especially in growing corn or maize, even more thoroughly futile, short sighted, and self-destructive.

If people think they're going to be saved by ethanol and/or biodiesel, I think they will be in for a very rude awakening. Production of these resources (corn and its oils) is completely unsustainable and causes massive pollution and degredation already. It is also completely dependent on fossil fuels at all stages: fertilizer, pesticides, harvesting, processing, and shipping. I do not see any feasible way of transitioning to a workable, let alone sustainable, addiction to ethanol as opposed to petroleum.
Don't mean to get all apocalyptic on y'all, and despite my short-term pessimism I do remain ultimately optimistic, but there's a heap of trouble brewing, and a lot of suffering will soon hit the fan. Best to be prepared.

Anonymous said...

If the weighting of gasoline was changed in the Index(gsci) would'nt that mean that ,initially , the dollars allocated to said index would flow to those commodities that had an increase in weighting?
When the announcement's were made-if there was 300 billion allocated , and then as the months wore on thru july to september, the money allocated dropped to 260 billion, i'd be willing to agree with the argument. But if the dollars stayed constant, then other commodities would have increased in price-
But this is not what happened-

and a chart-

Jeff Vail said...

Neither of those links show a breakdown in the prices of the commodities that makeup the GSCI. You are correct that the sales of oil-complex futures will generate proceeds that need to go somewhere, and that when those proceeds are invested into other commodities this could upset the supply-demand balance driving up their prices. Corn has been increasing alongside oil's fall, and corn is where the GSCI made its most significant reallocation (under the rationale that future ethanol demand requires a higher percentage allocation to corn). A fair amount of those revenues will, however, go to taxes, and the remainder will experience a lag time before they go into another commodity (assume technicians have any say so). So, while I think your theory holds that the sell off in oil should result in the rising price of another commodity, the chart that you linked to does not provide the information necessary to evaluate this either way. Also, if the funds end up being distributed into all the various other commodities in the GSCI (as they should to reapportion correctly), the impact in these several other commodities would be barely visible--certainly obliterated by any movement on the fundamentals.

theBhc said...

Hi Jeff,

I posted this on your previous item about market manipulation but figured this more recent posting would catch your attention.

I find it amusing that Goldman can rationalise this gas price situation with some post hoc nonsense about MTBE. The MTBE replacement has been a known policy for sometime. This shouldn't have caught anyone by surprise. IN fact, there have been so many different excuses for the oil/gas price drop, it appears that the market "analysts" really have not idea what is actually causing it, other than what is obivous.

The fact is we have had any number of examples of energy market manipulation already. Why is it so hard to believe it is happening now? Enron, anyone? BP recently settled with the NYMERC and, in separate case, Commoidity Futures Trading Commission, for improper trading and manipulating futures markets. But yet, we are told by the poobahs that this cannot be done.

For more on this, see:

Re: Those Darn Gas Prices


theBhc said...
This comment has been removed by a blog administrator.
Jeff Vail said...

Anyone who things that "it cannot be done" needs to 1) look to history (see: copper, silver, etc.), and 2) provide specific analysis of the many plausible theories showing why they will not work.

Of course, we should be careful to remember that proof that it probably CAN be done is not the same as proof that it IS being done. I don't have proof of the latter, just suspicion.

As for the MTBE line, I agree completely that this is not a sufficient explanation. I think that the desire to weight ethanol components such as corn does carry some weight, not because market share for corn is changing dramatically today, but because it may do so if people keep pushing their crazy ethanol-subsidies to make ethanol fuel commercially viable.

As for the knowledge of "market analysts," my early morning entertainment usually consists of a few minutes of CNBC--about all I can handle before I can no longer stand the general ignorance and narrow-mindedness of both the moderators and the guests. "Mad Money" Cramer, for all his faults, at least tends to aknowledge his biases and accept them in the pursuit of near-term profits... mark my words, one of these days you'll hear him say "and a big Peak-Oil Booyah back at yah!"

Laodan said...

What about oil prices falling because demand is actually falling and economies are entering a recession?

That's what some "isolated" economists start to point out. Here is a quote from "Thoughts from the frontline" by John Mauldin about what Professor Nouriel Roubini has to say about falling oil prices:

"Many are suggesting that the recent drop in oil and commodity prices is bullish for the economy. Not so, argues professor Roubini.

The first paragraph is a quote from the Financial Times, and the rest are his comments:

" '...The reduction in prices we see today is the result of expectations of weaker demand rather than of improvements in supply. This makes the fall much more worrying than it may initially seem. If the decline in prices were to continue, it would be an indication of continued weakness in global demand. Worse, it would also undermine the price stability needed for investment in both increased supply and more efficient use of the world's scarce energy resources. Do not cheer too soon. This good news may yet turn out quite bad.'

"In conclusion, the soft-landing bulls are getting it wrong and are altogether confusing cause and effect when they argue that lower oil prices are good news and good signals for future economic activity in the US: oil and commodity prices are exactly falling because we are now experiencing a US and global economic slowdown; so such price action should be interpreted as bad news rather than good news. This is the typical fallacy of non-economists that take a partial equilibrium - rather than a general equilibrium - approach to analyzing data; an economist would ask himself or herself: why are oil and commodity prices falling at the same time? What is the cause of it?

"There is only one clear and consistent explanation of this generalized price fall: the US is sharply slowing down, dragging with itself the global economy. So, paradoxically, falling oil prices are bad news for the economy: they are the proverbial canary in the mine warning us of the recession risks ahead. Indeed, what both the oil and commodity markets and the bond markets and the housing market are telling us - or screaming at us - is: slowdown and recession risks ahead!

"The fact that the stock market is allegedly now providing a signal that is different from the bond market and the oil and commodity markets can be then interpreted - as I have since August - as the typical suckers' rally that accompanies slowdowns where the Fed is expected to come to the rescue of the market and the economy. Remember that in 2001 95% of all economic forecasters predicted in March 2001 no recession that year; too bad that the economy had already entered into a recession by March 2001. The wishful hope of forecasters and markets was that the Fed easing would rescue the economy and that the economy would experience a second-half rebound.

"Indeed, in typical suckers' rally mode the S&P index rallied a whopping 18% in April and May 2001. It was only in June 2001 when even more severe signs of a recession clearly emerged that the stock market started to rapidly tank into a free fall. So, such stock market suckers' rallies are very common at the outset of the recession. The reality is that stock markets are often wrong: sometimes they predict recessions that do not occur but, at times like in 2001, they fail to predict recessions that are already ongoing."

I think less than 5% of economists are predicting a recession today. Take no comfort in the consensus view. "