Oil roulette

CAP’s Daniel J. Weiss and Valeri Vasquez explain strategies for minimizing speculation in this CAP repost.

The oil shock of 2008 helped drive the U.S. economy into the Great Recession. Oil at that time cost a record $147 per barrel, and gasoline prices surged to $4.11 per gallon in July 2008″”the highest price ever. This squeezed families’ budgets because it is very difficult for most people to significantly reduce driving in the short run when prices rise. And the U.S. Commodity Futures Trading Commission, or CFTC, found that the 2008 oil record was partly driven by speculators driving up prices to make a quick killing.

This year “it’s like d©j  vu all over again.”

Oil prices are rising to heights not seen since 2008. Oil rose from $85 per barrel to $112 per barrel in a little more than two months””a whopping one-third leap. Gasoline prices have followed along, rising by 70 cents per gallon“”or 23 percent””during this same time. As our economy struggles to recover from the Great Recession, Americans are again forced to pinch pennies to afford their commute to work, school, and worship. Meanwhile, oil companies prepare to reap record profits in the first quarter of 2011.

As in 2008, there are serious indications that speculators are driving up oil prices. CFTC Commissioner Bart Chilton released data that found that:

Hedge funds and other speculators have increased their positions in energy markets by 64 percent since June 2008 to the highest level on record.

Similarly, a dozen U.S. senators wrote to CFTC Chairman Gary Gensler that “speculators are seizing on recent political turmoil in North Africa and the Middle East to drive energy prices to unwarranted levels,” citing numbers from the CFTC’s weekly “Commitment of Traders Reports” that indicate since January 25:

Money managers have increased their long positions in NYMEX West Texas Intermediate crude oil futures contracts by more than 35 percent, or the equivalent of 75 million barrels of oil.

According to Investopedia, a long position in a commodity futures contract is made when an investor “enters a contract by agreeing to buy and receive delivery of the underlying [commodity] at a set price – it means that he or she is trying to profit from an anticipated future price increase.” By buying oil futures long, speculators are betting that they expect oil prices will increase over the life of the futures contract so the oil is more expensive at delivery time compared to the original purchase price. Political instability in an oil-producing nation or region often leads end users and speculators to increase their purchase of long oil positions due to the anticipation that future prices will be higher. The fear that prices will continue to rise leads oil end users to pay more now for future delivery of oil to lock in a lower price than the one they expect upon delivery.

Indeed, two weeks ago Goldman Sachs & Co. researchers caused a stir in the commodities trading world when it named “excessive speculation” the culprit for inflating oil prices “$20 higher than supply and demand dictate,” and advised its clients to sell off their oil-related assets because they were being overvalued due to speculation.

Oil market analysts note turmoil in the Persian Gulf as a factor for higher oil prices, beginning with a small price bump around the January democracy protests in Egypt. The uprisings soon spread around the region.

Prices then took another leap up when regional political unrest hit Libya, disrupting its production of 1.8 million barrels per day, or about 2.1 percent of the world’s daily production. A decline in Libya’s prized sweet crude (the best for refining into gasoline) certainly rattled Europe and its market for crude oil. But market fears about potentially declining global oil supplies should have been ameliorated when Saudi Arabia used its vast reserves to fill the supply gap. But as Marcela Donadio, Americas Oil and Gas Leader for Ernst & Young, observes:

When Saudi Arabia increases production, as they just did, it is clear that oil supplies are plentiful and that the current pricing volatility is driven by market psychology and not necessarily real-time fundamentals.

The United States, too, has relatively ample domestic reserves“”enough to reasonably allay fears of an immediate supply disruption. And then there is the question of relatively static demand. Daily energy and environment news service Greenwire noted that:

Current U.S. crude oil inventories are roughly 12.6 million barrels larger than the past five-year average levels. Demand for gasoline from U.S. drivers has barely budged from where it was a year ago.

Although there are ample international and domestic supplies, analyst Donadio notes that “driven by angst over broad geopolitical concerns, markets are proactively reacting to a potential supply problem.” This reaction to Persian Gulf instability makes it relatively easy for speculators to bid up prices because of fear of potential supply disruptions and price increases. Oil end users and other traders buy more future contracts. This, in turn, leads to price increases and the cycle repeats. Indeed, Reuters reported that political unrest in the region drove investors “to accumulate the equivalent of almost 100 million barrels of oil between mid-February and late March on top of their existing positions, adding approximately $10 to the ‘risk premium.'”

Oil speculation has real costs to oil prices and to the overall economy. According to an estimate released by Goldman Sachs, “every million barrels of oil held by speculators contribute[s] to an 8 to 10 cent per barrel rise in the oil price.” Reuters reported:

Using Goldman’s 8- to 10-cent estimates and data on speculators’ positions from the U.S. Commodity Futures Trading Commission, Reuters calculated that as of last Tuesday, the total speculative premium in U.S. crude oil was between $21.40 and $26.75 a barrel, or about a fifth of last Tuesday’s price.

Such an increase would have a real drag on the U.S. economy. Analysts project that a sustained $10 increase in the cost of a barrel of oil can reduce our gross domestic product by up to 0.2 percentage points this year alone. In addition, a sustained $20-per-barrel increase in oil prices could yield at least a 50-cent-per-gallon hike in gasoline costs.

Speculators playing the oil market to make a fast buck are not the only factor contributing to high oil prices. Because oil is priced in dollars, the relatively weak value of the dollar makes oil an attractive purchase for speculators because oil is also priced in dollars but also rising in value. And the greater demand for oil, the higher the price.

What to do about oil-and-gas speculation?

Politico reports that “Republicans are getting ready to capitalize on record prices at the pump with a May focus on oil and gasoline.” But what will they point to? After all, House Republicans voted twice to make it significantly harder for the CFTC to establish and enforce safeguards that reduce speculators’ ability to drive up prices to make quick bucks. In February House Republicans voted nearly unanimously to pass H.R. 1 to fund the government for the remainder of fiscal year 2011. It cut the CFTC budget by nearly one-third.

Fortunately, President Barack Obama and Senate Majority Leader Harry Reid (D-NV) made sure the CFTC received more, not less, money to police commodity markets in the final legislation that funded the government through September of this year. It boosted the CFTC budget by $34 million, a 20 percent increase over FY 2010 levels. The Senate Appropriations Committee says the extra funds will “provide critical funding to better protect the average investor and increase safeguards against excessive speculation.”

But House Republicans came back at the CFTC just weeks later. On April 15 the House passed Budget Committee Chairman Paul Ryan’s (R-WI) budget proposal for FY 2012 that begins October 1, H. Con. Res. 34, by 235-193. All but four Republicans voted for it while all Democrats opposed it. In addition to many other draconian cuts, it chainsawed the CFTC budget by 34 percent, which would compel the agency to cut its staff by two-thirds. This would destroy the CFTC’s ability to police oil markets and would instead let speculators run wild””free to bet with abandon on oil prices, making it impossible for everyday Americans to budget for their driving costs””oftentimes (like now) at a huge cost to their wallets..

So what’s the most effective solution? The CFTC and other federal agencies must promptly develop and enforce safeguards that reduce the impact of speculators on oil prices. Specially, the CFTC should:

  • Investigate speculative fraud. On April 21 President Obama directed Attorney General Eric Holder to create an Oil and Gas Price Fraud Working Group to “monitor oil and gas markets for potential violations of criminal or civil laws to safeguard against unlawful consumer harm.” The group will function as a subset of the Financial Fraud Enforcement Task Force Working Group and include representatives from the Department of Justice, the Commodity Futures Trading Commission, the Federal Trade Commission, the Department of the Treasury, and other essential federal agencies.
  • Raise margins on speculative oil contracts. Investors who want to buy an individual stock must provide 50 percent of the value of that stock up front. Oil speculators, on the other hand, only have to provide 6 percent for an oil futures contract. In other words, one must provide $500 to buy $1,000 worth of a single stock, while only $60 up front is required to purchase oil futures.
    • The CFTC should heighten margin requirements for speculators to safeguard the market’s financial integrity as authorized by Section 736 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The law’s emphasis on “protect[ing] the financial integrity of derivatives clearing organizations” makes heightened margin requirements permissible for “risk management purposes to protect the financial integrity of transactions.” As recommended by Sens. Bill Nelson (D-FL), Maria Cantwell (D-WA), and 10 other senators in their March 16 letter to the CFTC, these “higher margin levels would reduce incentives for excessive speculation by requiring investors to back their bets with real capital. The margin increase should only apply to speculators, not true hedgers.” Dodd-Frank specifically allows the CFTC to differentiate between speculators and true hedgers (p. 90). This margin increase should apply strictly to speculators, not the actual merchants and producers who are oil end users and are using future contracts to hedge against higher prices.
  • Establish “position limits” to reduce potential for abuse. “Position limits” are an important safeguard that restricts the size of the bets investors can make on commodities. The Dodd-Frank law provides the CFTC with the ability to set such limits but it has not yet acted. Dennis Kelleher, a former securities lawyer who now heads the financial reform advocacy group Better Markets, urges the administration to “impose position limits, which would stop excessive speculation now.” He believes the CFTC has “the power to do this quickly.”
  • Appoint a CFTC commissioner who advocates strong speculator limits. The CFTC’s mission is to protect both “market users and the public from fraud, manipulation, abusive practices and systemic risk.” Five CFTC commissioners fill staggered five-year terms and are central to this mission. One of the commissioner seats expires in June 2011. President Obama should take this opportunity to appoint a new commissioner that is pro-middle class and pro-American family, and supports the aforementioned measures to reduce the impact of speculators on oil prices.
  • Charge a fee for speculator trades. Another way to limit the potential for speculators to manipulate the market would be to charge a small transaction fee for oil speculators. People who oil need must buy it””and hedge it””long term, which is why oil end users, such as airlines, should be exempt. Only serial speculators churn contracts daily, sometimes hourly. The fee per contract should increase as the speculators’ volume of futures contracts increases. The funds levied could pay for more CFTC oil-market cops to police trades and prevent the market manipulation of prices that can devastate middle- and low-income Americans, and oil-dependent businesses.

These solutions will rein in speculators and lessen the high gasoline prices that place a financial burden on American families.

What to do about our oil addiction?

But to ultimately solve the problems the surging cost of oil gives this country, we must make fundamental changes in our energy policies. This means building cars that are able to attain 60-plus miles per gallon by 2025. It means cutting foreign oil use by 5 percent annually in order to reach an end goal of slashing these imports in half by 2022. And it means ending billions of dollars of tax giveaways to Big Oil companies, using those funds to diversify transportation choices and finance advanced vehicle technologies. Only by using less oil, reducing imports, and investing and using clean energy technologies can we diversify our sources of energy and lower the cost of oil and gasoline. We need to start now.

Daniel J. Weiss is a Senior Fellow and Director of Climate Strategy at the Center for American Progress. Valeri Vasquez is a Special Assistant on the Center’s Energy Opportunity policy team. And thanks to David Min, Associate Director for Financial Markets Policy at the Center, for his help on this column.

21 Responses to Oil roulette

  1. PeterM says:

    Gasoline prices have never been higher in Connecticut. I live in the states ‘cheap’ region, east of Hartford- price of regular unleaded is around $4.18 a gallon. I drive a small car, that still costs over $40 dollars to fill up. I would dread having to fill up a truck or larger SUV- $100–

    If we had started to become energy independent 30 years ago, embraced solar and wind power- where would we be tody?

    Ignoring climate change is the flip side. In 2041 what will the world be like…if we fail to reduce C02? I care not to think.

  2. Jeff T says:

    Joe, please get your priorities straight. Do you want cheap gasoline for everybody, or do you want less CO2 in the atmosphere? The correct response to high gasoline prices is to BUY LESS GASOLINE. Not everyone can buy less, of course; but if suburban parents just put their children on the buses instead of driving them to school in SUVs, reduced consumption would drive retail prices down and those nasty speculators would lose their shirts. If commuters started using carpools, they would really destroy the speculators.

    Government efforts to keep prices down, (by subsidizing oil production, for example) just increase consumption. So quit whining and propose government regulation only where it’s needed, such as for environmental protection.

    [JR: I don’t think there is anyone on the blogosphere who has posted more analysis of how to reduce oil consumption. And as I’ve said many times, I don’t think speculation is the major cause of the price run-up. But that doesn’t mean oversight of markets isn’t a good thing.]

  3. Jeff T says:

    Joe, by reposting this hogwash, you endorse it. Please read the “What to do about rising oil-and-gas prices” section. There is nothing about reducing consumption. Speculators (and airlines protecting themselves against possible future price increases) can drive up the price of oil a bit, but they can’t do it for long. (That’s why Goldman Sachs is advising their clients to back off.) When I go to a gas station, I buy gasoline, not crude oil. The price at the gasoline pump is affected much more by the public’s willingness to buy than by speculators’ purchases of oil futures.

    Whether “oversight” is good or bad depends a lot on how broad it is. “Appoint a CFTC commissioner who advocates strong speculator limits” is excessive.

    [JR: Nice try. That section clearly ends, “But to ultimately solve the problems the surging cost of oil gives this country, we must make fundamental changes in our energy policies. This means building cars that are able to attain 60-plus miles per gallon by 2025. It means cutting foreign oil use by 5 percent annually in order to reach an end goal of slashing these imports in half by 2022. And it means ending billions of dollars of tax giveaways to Big Oil companies, using those funds to diversify transportation choices and finance advanced vehicle technologies. Only by using less oil, reducing imports, and investing and using clean energy technologies can we diversify our sources of energy and lower the cost of oil and gasoline. We need to start now.”

    I publish longer blog posts than most websites, but it simply isn’t fair to require the authors of opposed to repeat everything they have ever written on the subject. This is a piece primarily on speculation. As I’ve said countless times, I don’t think it is the major contributor to oil prices, but several credible experts say that it is excessive. If you want to disagree with the post, that’s fine, but they also don’t mention electric vehicles here. Or countless other things that I’ve posted tens of thousands of words on.]

  4. Mike Roddy says:

    The Democrats won in 2008 partly because of gas price spikes. Speculators played a minor but significant role then, as they are now.

    There’s another way to manage prices- restricting actual supply, instead of trading on perceived political problems in the Middle East. There is talk that this is happening now.

    Expect the Kochs and their friends from Exxon and Chevron to suddenly have to schedule refinery and pipeline maintenance in the summer and fall of 2012. A 5% reduction in refined oil availability would be chaotic, and lead to huge windfall profits, a win-win for the oil companies. The media won’t report it much, but even if they do the public will still be in a bad mood over $5 and up gas, and will vote accordingly, giving the Republicans a big edge. I don’t know how you stop it, since the oil companies control supply as well as the media.

  5. Leif says:

    ” (That’s why Goldman Sachs is advising their clients to back off.)” states Jeff T @3:

    I will give you another motivation for GS. They want to cover their A** for future litigation protection while at the same time encouraging bit players to sell at a lower price while they simultaneously BUY. I would love to see their transaction list for the last few weeks.

  6. Barry says:

    I mostly think high oil prices are needed in USA to help us get more efficient with oil — like EU is. Oil will soon be too expensive to maintain our inefficient infrastructure. Plain and simple. A little pain now will save our economy big time.

    But there is one big downside to high oil prices: it makes effective carbon pricing for other fossil very hard to do. And that makes it hard to level the pollution playing field with less-pollution clean energy alternatives.

    Coal and natural gas need carbon pollution pricing…but hard to get anything close to the carbon pollution price needed while oil is off the charts from market pricing already.

    I’m starting to think we might need to shift to a floor pricing policy for carbon pollution pricing. Put a rising floor price on each fossil fuel and only put a carbon pollution price on that fuel when it is below the floor to bring it up to the floor price.

    Biz might be open to this as it provides more certainty around pricing and because it removes carbon pricing when the marketplace is already pushing the pricing above the level needed to get CO2 reductions.

    That would help with carbon pricing backlash on high gas prices where the carbon price isn’t even needed at that point.

    The end of cheap oil during a boom in cheap natural gas and still cheap coal is going to be another thorny issue to navigate.

  7. Cinnamon Girl says:

    Thanks Joe for this article, and of course the topic is too complex to exhaust in one post. Jeff’s point that “When I go to a gas station, I buy gasoline, not crude oil. The price at the gasoline pump is affected much more by the public’s willingness to buy than by speculators’ purchases of oil futures.” requires added nuance. Commissioner Chilton’s quote that “Hedge funds and other speculators have increased their positions in energy markets by 64 percent since June 2008 to the highest level on record.” addresses all U.S. exchange-traded energy markets (primarily futures). That includes WTI crude, No. 2 heating oil, natural gas, AND unblended unleaded gasoline. So, the phrase “The price at the gasoline pump is affected much more by the public’s willingness to buy than by speculators’ purchases of oil futures.” ignores speculative activity directly in gasoline futures. Of course, the ethanol component cost is affected by feedstock prices, competing energy sources, and the cost of the substantial petroleum and coal energy component inherent in at least the domestic production of ethanol.

    I have not parsed the precise changes in gasoline speculative positions over the period Comm. Chilton referenced, and this might be a beginning point for those who want to do that:

  8. Barry says:

    Leif (#5) is right. Goldman Sachs got caught during the mortgage bubble betting against the advice and products they were selling publicly.

    Big Money hedges bets and doesn’t reveal their hand. Believing what they say is like taking the table chatter of a skilled poker player at face value.

  9. Barry says:

    Another point I’ve read in a few places recently is that not all “oil” is equal.

    I’ve seen the Saudi oil described as “sour” and high sulphur compared to Libyan oil which is “sweet” and higher grade. There are reports of an imbalance in “sour” and “sweet” on the markets that is obscured by lumping them all together. And one reason Saudi’s aren’t pumping more is that “sour” pipeline is full and it doesn’t really replace Libya oil directly.

    The key point though is that cheap oil is running out and price spikes are going to be with us repeatedly from here on out. The only way to protect yourself is to reduce your need for oil.

    As a simple example, you can cut your oil demand by 66% by trading your SUV, van, pickup for a Prius. Drive a little less and you’ve made an 75% cut in oil demand in your direct personal transportation. That will let you weather a huge oil price spike with extra money in your wallet.

  10. Cinnamon Girl says:

    Piggybacking on Barry’s good post #9, European refineries have been better able to refine sweet/low-sulfur crude, and the U.S. refineries have been better able to handle both sweet and sour product. The Euro refineries reportedly are converting to sour capability, as the feedstock moves toward more sour. Oddly, the Euro market appears to have surpluses of gasoline and heavy fuel oil, but insufficient diesel production. It appears that expansion of Mid-East refining capacity is an ongoing process as well.

  11. Hypnos says:

    Saudi Arabia did not raise production to meet the Libyan shortfall. Saudi Arabia CUT production by 800k barrels per day in March.

    Saudi Arabia does not have, or does not intend to use, spare capacity.

    The oil price is driven by supply and demand.

    The cry of speculators is the last ditch of business as usual defenders to pretend that we are not facing the limits to growth. That oil production has not peaked. But it has, and there is only one thing that will bring the oil price back down: a recession. Which will happen sooner than later.

  12. PeakVT says:

    People who oil need must buy it—and hedge it—long term, which is why oil end users, such as airlines, should be exempt.

    Making certain organizations exempt would add complexity and give them incentive to expand their hedging operations beyond what is strictly need. Any transaction tax should be uniform and the airlines and others can pass the costs on to consumers. The added cost to consumers from a transaction tax will be more than offset by the fall in oil prices – if they really are being run up by speculation.

  13. MiMo says:

    I found these posts about gas prices rather odd. From a point of view of the climate high gas prices are a good thing. If in absence of climate legislation speculators drive up gas prices this blog should applaud it (or at least say nothing), not suggest that speculation should be curbed.

  14. Dan the Man says:

    High prices for petroleum products, if sustained, encourage more crude oil production development. Not good for the climate when prices inevitably fall. The simplest and sanest answer is a carbon tax and dividend, and the sooner the better.

  15. Dean says:

    PeakVT at #12

    Do you have any idea what airlines pay in premiums to hedge their Jet A contracts?

    I know, because I work for a large legacy carrier, and it’s not negligible…There is no way that they would hedge beyond what they need. As it stands now, most only hedge a small percentage of their fuel needs due to the cost of the hedging contracts. The airline that I work for locked in a mere 30% of 2011 fuel needs at $90/bbl.

    Fuel is now an airline’s largest cost on the balance sheet, and the most volatile. The airlines most certainly deserve the right to be able to hedge their fuel costs, without restriction.

  16. Mulga Mumblebrain says:

    I agree with Leif and Barry above. Goldman Sachs will give ‘advice’ that suits its (ie its owners, partners and functionaries) interests, not those of its sucker ‘clients’, let alone the public as a whole. So long as the plutocrats can skim off billions in profits, ‘bonuses’ and hypertrophied ‘salaries’, (the ‘end’) the means by which it is accomplished are irrelevant. Money justifies any behaviour, no matter how morally repugnant.

  17. Cinnamon Girl says:

    Dean #15 is the way I understand the commercial fuel hedging situation as well. Hedging such a large fuel need is expensive and tricky (I suppose not hedging to some extent also is expensive and tricky). A precisely timed hedge using futures might not be as expensive, but that’s hard to achieve. Anything else requires either a potentially massive margin commitment, often expensive option premiums, or both. Currency values make it more than a computation based on product supply and demand forecasts. There might not even be an adequately liquid vehicle to use directly (there really is no jet fuel instrument for direct hedging), leading buy-hedgers to price based on raw crude or possibly a blend of refined product. (I think railroads have a similar issue with diesel fuel.) That opens considerable risk exposure to refinery schedules and refined product mix. It’s a headache, and as a practical matter I don’t see how or why legitimate buy-hedgers should be or can be restricted. The regulatory problem is identifying and separating true users from faux user-speculators, especially if the faux user-speculators are large and offshore. (I suppose Enron gave us a glimpse of that.) It’s a constant problem to maintain base hedging capability, allow critical liquidity-providing speculation, and restrain speculation from drowning the game all at the same time. I don’t know–maybe it’s a problem of too-large companies swamping finite-product markets. We have that in other commodities as well–two, maybe three, large merchandisers pretty much run the macro wheat, corn, and soybean markets. I suppose at some point the entire mega-industrial complex appears unsustainable.

  18. Chase says:

    I’m not buying any of this. The writing by Ezra Klein and Krugman and analysis by James Hamilton are much more cogent and coherent. The mechanism by which speculation raises commodity prices is highly dubious, and in any case is not explained. If speculation does raise prices, then it will only encourage producers to hold supply off the market, so that the producers take the gains rather than the traders. Saudi has clearly signaled that they will no longer attempt to cover production shortfalls. And the numbers show that they did not cover the production shortfall from Libya, as falsely asserted in this piece. There is no doubt that long traders are making money, as they did last time (until they didn’t), but the traders are following the market rather than leading it. Just look at the numbers.

    I understand this piece is from CAP. They are normally quite accurate, but it appears that anti-corporatist populism may be getting the better of them here.

  19. PeakVT says:

    Dean@15 – First, it’s a bad idea to add exceptions to a tax, because they tend to grow over time. Taxes are best when low and simple, otherwise they hit the groups least able to shield themselves by hiring lobbyists and lawyers. Second, adding exceptions means that a bureaucracy would have to be set up to verify that this or that organization is what it says it is and has a right to the exception, adding costs. Third, most financial transaction taxes don’t have to be high (less than 1%) to discourage speculators. Perhaps it is different in this case, but most likely the tax will constitute a small portion of the final price. Fourth, as I pointed out before, if speculation really is driving up prices, the benefit of the tax will be much greater than it’s cost. Otherwise, the entire discussion is moot. And, finally, the idea that any company “deserves” a tax break is just laughable.

  20. Leif says:

    MiMo @ 13 states that we at CP should applaud speculators because raising fuel costs will lower usage. By the same token we should applaud food speculators as more folks will starve thus lowering fuel usage. Both practices are abhorrent to me and are a clear indication of capitalism structured to help the few at the expense of the many. That our capitalistic system enriches the already rich with total disregard to the suffering below is a clear sign of need for systems change. Humanity first? Earth’s life support systems first? Clearly not money first…

  21. K. Nockels says:

    All the money being spent to make sure that the people believe the only reason for high gas prices is speculators in the oil market is to keep the fact below the public radar that we have in fact passed the cross over point between production and supply. Yes there are market reasons for some of the price increase, but most is the fact that with the global economy beginning to recover and the shut in of production in Lybia we have reached the point of max output that can be maintained over time. If the Saudi’s could flood the market with the amount of oil it would take and that they swear they have to bring prices down and calm the volital price increaces we have now they would.