Wow, the commods analysts at Dresdner/Commerzbank have taken a rather bold — if slightly self-congratulatory — stand on oil speculators.
In a note published on Thursday, analysts Eugen Weinberg, Barbara Lambrecht and Carsten Fritsch, are very clear: oil speculators have driven up oil prices, and pending an imminent clampdown by the CFTC, those oil prices will now be going down — closer to their fundamentals.
Here’s the start of Dresdner/Commerzbank’s thesis:
In the commodities market it is well worth going against the flow in order to recognise the important turning points. We were virtually alone in our opinion that last year’s oil price rise was mainly due to actions of financial investors. The market, on the other hand, attributed the price rise to structural changes both on the demand side, with the increasing role of emerging countries, and on the supply side with the “peak oil” theory.
Our view that a speculative bubble had formed in the oil market proved correct when it burst with spectacular effect after the price had risen to around USD 150 (chart 1). When the price subsequently nose-dived to around USD 30 per barrel in Q4 2008, we interpreted this as an exaggerated reaction, after many investors simply fled the oil market. This year we anticipated stabilisation of physical demand and normalisation and recovery of equilibrium in the oil futures markets, and were one of the few banks to predict — right at the beginning of the year — that crude oil prices would rise to USD 70-75 per barrel by year-end. This has already come to pass. So why are we now revising our forecasts downwards when the price curve is following our scenario, the economy appears to be recovering and demand from China apparently rises unabated? It is because we have been right for the wrong reasons and prices rose on different factors other than those assumed in our scenario!
Fundamental changes were not so much the cause, rather the rise was due mainly to the greater risk appetite among financial investors, optimistic expectations and increased liquidity. This is also supported by the higher correlation between the oil price and the equity and currency markets.
So how much speculation is in the oil price then?
We are often asked this question and there is no clear answer. Even if we only consider the contracts outstanding on the commodity futures exchanges, it is virtually impossible to say how many of these are held by non-commercial traders. This statistic is hard to pin down in view of the numerous exemption permits for dealers and financial institutions who both handle physical trades and speculate in commodity investments. The so-called COT data of the CFTC, which breaks down traders into speculators and physical traders, is therefore misleading. Statistics concerning the positioning of investors in relation to non-regulated OTC commodities transactions are almost entirely non-existent.
Another method of determining the proportion of speculators in the market, based on comparisons according to the principle of “where would the price be if there were no financial investors in the market?”, is also somewhat wide of the mark. Admittedly the comparison is a legitimate one, and relatively easy to determine if, for example, one compares historic changes in the reach of the world crude inventory in days over time or the free production capacity of OPEC with the corresponding oil price. It is clear that one could explain many past price changes on the basis of these factors. However, the price of a commodity does not always necessarily correspond to the current supply and demand situation. The greatest advantage of exposure of financial players and speculators to the commodity markets that we can see, apart from representative and liquid pricing, is their ability to process and act on available information quickly and efficiently. So ideally, speculators should iron out the hugely exaggerated upward or downward price movements. They should buy when physical demand is very low but about to recover, and sell in the opposite situation. However, the financial markets and financial market players have utterly failed in this role.
Instead, it is our opinion that in recent years, because they drew the wrong conclusions and over-invested, they caused a speculative bubble in commodities, particularly in the oil market. Rather than profiting from existing trends, investors greatly accelerated and to some extent caused those trends. It was precisely their clumsy dealing that, in our view, made the exaggerated upward and downward price swings possible in the first place. The problem is that commodity investors exert far more influence on the market than physical traders. On the one hand, investors exert their influence through regular rolling of commodity futures. On the other hand, one needs to consider the leverage made possible by futures market trading. To purchase a WTI contract on the NYMEX usually requires less than 8% of the value of 1000 barrels of the crude oil which it represents.
But the key thing to understand is that the commodity futures exchanges were not really in a position to absorb investments of billions of dollars. In our opinion these investments damaged the existing pricing system, upset “normal” trading and allowed it to run out of control. The relationship between the physical market and “virtual” stock market trading has gone off the rails. Between the years 2003 and 2008 both WTI oil price and the number of outstanding WTI contracts (futures and options) on the NYMEX have gone up six-fold. This was at least partially responsible for the massive price increase in the last years (chart 6).
When WTI futures were introduced on the NYMEX in the mid-1980s, production of the US domestic crudes which were chosen as a “good delivery” for the benchmark and were available for delivery in Cushing, Oklahoma stood at around 1.5m barrels of crude oil per day. The total trading volume of WTI on the NYMEX averaged the equivalent of about 10m barrels. The relationship was therefore largely satisfactory because WTI was also accepted as the benchmark for all trading both inside and outside the USA, as it still is today. In the 1980s demand for oil in the USA alone stood at 16-17m barrels per day. However, as investors increased their exposure, the relationship changed utterly. Today, on the NYMEX alone, WTI futures worth the equivalent of 600m barrels of crude oil are traded daily, while US production is less than 5m barrels per day. Even compared with global demand for oil, which currently stands at around 83m barrels per day, there is a huge discrepancy. This becomes clearest when we compare the volume of WTI actually produced with market trading volume: WTI oil production has now fallen to just 300,000 barrels per day. So now, each barrel of WTI crude is traded on the futures market nearly 2000 times over (Chart 7). It is no wonder that calls are increasingly heard, especially in political circles, for an end to the current “madness”, “casino system” and “oil bubble”. The US regulatory authority for commodity futures trading, the CFTC, now intends to do something about this.
And what will happen if and when the CFTC cracks down?
The significant rise in the oil price seen in the first half of the year is due in large part to a recovery in investment by financial investors. If their influence is reduced by the CFTC’s actions and sanity prevails, the oil price will fall. We expect some of these measures to be decided very soon, particularly bearing in mind that the political pressure and the desire to combat excessive speculation in the commodities markets, particularly energy markets, is growing strongly not just in the USA but also in government circles in Europe. As most investors bet on rising prices, their departure would undoubtedly tend to depress prices. Therefore we now expect the WTI oil price to fall to USD 50 per barrel in Q4 2009, rather than USD 70 as we previously thought. December WTI futures are currently quoted at around USD 75 per barrel. We have also lowered our forecast of the average WTI oil price in 2010 from USD 75 to just USD 55 per barrel. Besides the reduced contribution from financial market players, the fundamental data also indicate a slower increase in the oil price due to enormous investories worldwide and plenty of production capacity. In the absence of geopolitical tensions, there is little danger of an oil shortage in the foreseeable future. Incidentally, we do not believe that all energy will be adversely affected by the new CFTC rules, and US natural gas prices could even benefit from reduced influence by “speculators”. This question, along with our fundamental assessment of the oil market situation on which our price forecast is based, will be the subject of our next edition of Commodities Spotlight Energy.
Quick! We’re supposed to be regulating this energy stuff – FT Alphaville
In defence of energy speculators – FT Alphaville