Tuesday, June 30, 2009

Speculating on oil? Go for it.

A nice write-up R S Eckaus discusses the oil price bubble that we've experienced last summer and may be experiencing now. He disputes the argument that we have this tremendous new demand from China as well as some other justifications for oil price being where it is. As we discussed earlier (Oil price will stall on fundamentals), we've had some real demand destruction due to this financial crisis. Some of that destruction is also driven by substantial increases in production and delivery capabilities of liquefied natural gas (LNG) around the world. The Russians wanted to diversify from pumping gas to Europe via the Ukraine (Ukrainians can get a bit "restless" at times) as well as sell their natural gas to other markets. So they are completing some LNG capability, while consumers like China and the US have been building de-liquefaction capacity to diversify from oil. With natural gas prices at current levels, energy users are shifting wherever they can away from oil.

With all this, the IEA finally admitted that the demand will be lower than what thay have been predicting all along. They are now in line with the Credit Suisse forecast of under 90 million barrels per day by 2013.

So why are oil prices on the rise given such demand destruction? Eckaus argues it's speculation. Then what , if anything, can be done about it? Some would argue speculation in oil should be prohibited. Well, that could become a slippery slope. If you buy a piece of land as an investment, that's speculation. Should that be prohibited also? How about buying gold? What about the largest speculative bubble of all, the stock market?

Also, speculating on oil is generally done via futures, unless you own an oil storage facility. That means that eventually you will either have to sell your futures contract or someone will deliver you physical oil in Cushing, Oklahoma and make you pay for it. Plus being long oil futures is expensive because the curve is quite steep, making contracts worth less as time goes on (negative carry). That means that it's not the "fast money" that is doing all the buying but some more strategic players who store oil or hold it in tankers. Controlling or prohibiting that would be ridiculous - we would all be standing in lines to buy government issued gasoline. Socialism anyone?

So oil speculation can definitely hurt the consumer and corporations, but controlling trading is not the answer. It is no more productive than controlling speculation in the housing market that ended up hurting everyone - you just can't legislate whether people can buy or sell homes and at what price. The answer is to prove to the market that diversification away from oil is possible and it works. That will be the most effective way to burst the bubble.

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