Is oil cheap because of shorters?
Posted by Daniel Hall on December 18, 2008
Joe Weisenthal calls for a ban on shorting oil:
Oil delivered a year from now is selling for so much more than oil is today, that traders are actually buying oil, renting out barges, and then just storing it for a year so they can make a profit. In a rational market, this shouldn’t work. …
Now look, look, don’t get us wrong… we’re all for free markets here. In normal times, the market is the best way to set prices. But in extreme times when the market stops behaving orderly and the prices make no sense, the government must, unfortunately, intervene. The first step is a ban, or at least an uptick rule, on shorting oil.
Count me skeptical that shorting holds much of the blame for the plunge in oil prices. Remember that when both supply and demand for a good is highly inelastic, small shifts in either can produce very large swings in the price. Global demand for oil has certainly shrunk, both in response to the high prices from earlier this year, and now also because of economic recession. Demand was the major reason prices skyrocketed earlier this year, and I suspect demand is now the major reason prices have plunged.
Commodities which cannot be stored are particularly susceptible to these big price swings — think of electricity, where supply and demand must essentially balance in real time, and hence the marginal price of wholesale electricity will fluctuate wildly in a single day. Certainly oil can be stored more easily than electricity, but not as easily as many commodities (particularly compared to the volume of global consumption). And oil is a commodity which can be extremely valuable, right up to the point where you don’t need anymore, at which point the next bit of oil is nearly worthless to you. Just because oil will be worth $60 (or $100, or $200!) per barrel to you next year does not mean that right now it is worth it for you to personally acquire an additional barrel of oil for less than $40 — unless you can cheaply store that extra barrel.
And on that storage question, Geoffrey Styles, while looking at contango in the oil market, suggested last week that general economic conditions may be making storage hard to come by:
At yesterday’s settlement on the New York Mercantile Exchange, oil for delivery in February carried a $2.59/bbl premium over January, and March was another $2.20/bbl higher. Oil for delivery in December 2009 was a whopping $13.81/bbl higher than the January ’09 futures. The fact that sufficient oil is not being bought today and put into storage for future delivery to close the arbitrage opportunity this situation creates is a clear indication of just how tight commercial credit has become, recently. As it is, US oil inventories have climbed by 26 million barrels since the end of September, rising from close to the bottom of their seasonally-adjusted range to near the top. [emphasis added]
In other words, the storage that is out there is filling up, and right now it is damn hard to come by funds to finance new storage.
Update: Geoff Styles comments further at the Energy Collective:
Liam Denning of the Wall St. Journal looked at this in this morning’s “Heard on the Street” column: http://online.wsj.com/article/SB122953721352814785.html He incorporated the floating storage (oil on leased tankers) aspect that I had missed the other day.
I’d suggest thta Mr. Weisenthal has his facts, or at least his perspective on the facts, exactly backwards. The price for long-dated oil futures isn’t so much higher than the front month because traders are driving it up by taking oil off the market. Instead, the super-contango suggests that there is such a glut of oil today that it is driving down the price to the point that it pays traders to buy and hold oil in spite of extraordinarily high interest rates. (If interest rates were lower and credit more available, I’d argue that oil prices would be higher, because the bidding to buy oil for this “carry” play would be more intense, and the price would rise until the arbitrage closed.) He’s also wrong that this reflects a market that has stopped “behaving orderly.” Buying and holding when contango appears is a standard trading strategy. We normally don’t see such a severe contango, because when credit is cheap, the arbitrage is so easy to do.
If this practice were banned, as Mr. Weisenthal suggests, the near-term glut would worsen, causing cargoes to pile up at refineries, crude prices to drop further–perhaps to the point it stimulated demand, even in this weak economy–and more oil wells to shut in, some at a cost to long-term resource recovery. That would only worsen the potential for an even bigger price spike, once the economy recovers.