In an unexpected announcement today, President Obama and members of Congress commended oil speculators for driving the price of oil down over the past three weeks. “The men and women who study the oil markets and provide hedging opportunities to energy producers and consumers have also provided a great service to the American people this month by driving down oil prices in front of the summer driving season,” remarked Barry Simpson (D – Kansas). Congress is debating possible tax breaks and transaction credits as a way to reward speculators for their salutory effect on American pocket books.
Ha! Yeah right. It is more likely that the media would report that the Easter Bunny got Osama Bin Laden. When the media or government mentions speculators, it is usually to lambast them for driving oil prices higher, and this always leaves me with a few questions:
- Would the government be interested in implicating speculators in driving oil prices lower? If not, why not? Why, for example, didn’t we hear commendations of the net short positions of speculators in oil during October and November of 2008? Or for that matter, the net selling of oil by speculators from March to July of 2008 as oil went to its all time high?
- If the government would like to limit the roll of speculators, would it also like to set prices? If not, then what happens if there is a significant difference in pricing between what consumers are willing to pay and what producers are willing to receive? And what happens if oil balances are short, but consumers aren’t willing to pay more before an honest-to-God shortage occurs?
Who Are the Market Participants?
To address these questions, it is useful to first examine the market, identify who acts in the market and what motivates these actors. Markets are made up of many types of participants, who can be organized into 2 basic categories – hedgers and speculators. The hedgers, in turn, can be classified into two groups – consumers and producers. Speculators are generally more heterogeneous, but I find it useful to classify them, in turn, into groups with long-term, medium-term, and short-term views. Speculators with short-term views are probably what most people think of when they hear “speculator,” as these are the individuals who are mainly providing liquidity to the market – going in and out of positions based on short term data, price patterns, rumors, and other news.
Producer Hedgers – Every producer is different, and each has their own strategy. Some producers don’t hedge at all, while others hedge up to 100% of their planned production. Generally, even the most conservative producers won’t hedge more than 80% of their planned production to give themselves wiggle room in case the quantity - well production, crop harvest, etc. - is disappointing. There will always be some degree of un-hedged production and this will be sold in the spot market. Producers will sell in both forwards and futures (forwards being the more common method since it can be tailored to the grade and location of each producer). Futures are also used, but often used by the intermediary (usually a large bank) to transfer balance sheet risk.
The fundamental utility of hedging is that it manages risk, as captured in the old saying, “a bird in the hand is worth two in the bush.” If you have a stripper well in Kansas that pumps 1 barrel a day, and will profit from this well if oil is $75/barrel but lose if it’s $50/barrel, then obviously going to the trouble of drilling that well looks much more attractive if you can lock in a price of $80, rather than risk another US recession that drives oil down to $35 and leaves you bankrupt. As in all actions, there is a downside to hedging: in this case, if you lock in $80, and oil goes to $180, you miss out on that extra $100/barrel. But most producers (and most people) want the sure thing. A little thought exercise makes this clear. Which of the following options is more attractive to you?
a) You are given your annual salary free and clear.
b) Flip a coin: heads you are given 2.15 times your annual salary, but tails and you have to pay 5% of your annual salary.
Now even though option (b) gives you the mathematically greater average expectation, 99% of people will pick (a) unless their salary is a small fraction of their net worth. This is because we are risk averse – we’d rather have the bird in the hand then the 2.1 birds in the bush.
The next question that comes to mind is who in the heck is willing to take the other side of that trade? If essentially all of the producers want to hedge their production, then who is willing to take that risk onto their balance sheet, potentially risking the loss of a great deal of money? The answer is not hedgers, either producer or consumers. It is speculators, a group whose explicit job is to back their convictions of where supply and demand will be and take risk.
Consumer Hedgers – Consumer hedgers think much the same way as producer hedgers. They need the product as part of their business expense, but they aren’t interested in speculating on how much it will cost – they merely know that they will make money at price x and lose money at price y. So a consumer hedger is not a natural fit with a producer hedger unless both agree on a price where they make money. A consumer hedger (think airlines, trucking companies, UPS for oil, Starbucks, Dunkin’ Donuts for coffee, etc.) projects the costs of their inputs, and then decides the quantity to produce, projects earnings, etc. based on that. As long as prices stay within their projections, everything works out fine. The problem emerges when prices rise significantly above their projections before they’ve had the opportunity to hedge.
Consumer hedgers generally face a greater problem when they can’t get the price they want. A very conservative oil producer, for example, simply won’t start drilling a field if they can’t lock in a price that guarantees a profit, in which case the worst case scenario is just being on the sidelines. Consumers are more likely to be dependent on a product and need it, come hell or high water. If you are Starbucks, you can’t very well just sit on the sidelines and say “Well, coffee bean prices are too expensive right now, so I’m just gonna sit this one out and stop serving coffee until they come back down.” No, at some point you are forced into the market, and the same is true for airlines and UPS with respect to oil. As a corollary, when you hear a consumer business (such as Starbucks or Dunkin’ Donuts) complaining in the media about prices and speculators, it’s a pretty good sign that they aren’t hedged, and it is just sour grapes that their price projections were wrong.
Short-term Speculators – Short-term speculators are people who go into and out of contracts on a daily, hourly or more frequent basis. They make their decisions on the basis of news (generally economic data), in response to what other participants are doing, and to patterns that they see in price movements. It is generally these traders who people have in mind when they think of speculators. Yet, when Congress talks about speculators driving up the price of oil, I’m hoping they don’t mean these types of speculators. It’s pretty hard to create an accurate reality where buying oil one second and then turning around and selling it the next second could be responsible for driving up prices, and short-term speculators are just as likely to first sell oil and then buy it. If a market participant is flat by the end of the day, I have a really hard time understanding how someone could even argue they were driving up prices.
Medium-term and Long-term Speculators –Medium term and longer-term speculators in commodities are market participants who generally take a position based on more fundamental factors, such as expected supply and expected demand particular to each market, and macroeconomic factors such as monetary policy. Just for fun, and since everyone seems so focused on how the “evil speculators are driving up the price of oil,” we can try to track how a medium or long-term speculator would fare in trying to hoard oil supplies. Let’s create a fictional hedge fund named “I’m Darn Interested in Oil Too” Capital Management, or IDIOT Cap for short. IDIOT Cap is determined to be an evil speculator and drive up the price of oil to get rich at the expense of the poor American consumer. Let’s watch and see how they do:
The Story of IDIOT Capital Management
In order to actually drive up the price of oil, one needs to affect the supply of oil (by decreasing it) or the demand for oil (by increasing it). Now, it is pretty clear that the impact of speculators on oil demand is limited to the amount they personally use, so that is not a very practical way of driving up the price. Thus, IDIOT Cap is left with trying to reduce supply. How would they reduce supply? Well, in order to reduce supply, it isn’t enough to buy a lot of oil on the NYMEX exchange only to turn around and sell it at the end of the month when the contract expires. This is what most people miss – speculators generally buy or sell lots of oil, and then get out of the lots (or roll to the next contract) before the delivery date. It is the exception to the rule that they would actually take or make delivery. But if IDIOT Cap is going to try to corner the market, they would need to take delivery and then store it somewhere. And to have a noticeable effect, they need to take a significant portion of total world production – let’s say 5% or four million barrels a day, which is approximately the spare capacity of oil production in the world.
Alrighty, so now they’ve got their plan. Form a hedge fund, and hoard four million barrels a day of oil. After thinking about it for a while, IDIOT Cap decides it is going to need assets under management of $100 billion – not an unbelievable number, but still larger than any other Hedge Fund out there. Now let us turn to the matter of how IDIOT Cap is going to perform in its first year given their plan.
Well, first, they’re going to have to think about where to put all of this oil. It is hard to get an exact number for how much bin space is available, but the financial shock of 2008 provides some useful color here; the price of storage rocketed to the sky with an inventory increase of just a couple hundred million barrels. In fact, the marginal price of storage got so high, that people were renting oil tankers as floating storage because it was cheaper than renting on-land storage. Using this example to give us a rough approximation, let us say there are 300 million barrels of empty land storage bins now and another 200 million barrels of floating storage. Well, that would mean it would take exactly 100 days at 4 mbd to fill all of that storage up.
Now in the process of taking delivery of these 500 million barrels, they would undoubtedly have to bid higher and higher prices to get the oil, so let’s say that they got in at an average of $150/barrel. Well, that means that they just spent $75 billion of their $100 billion buying the oil.
They’d also have to contend with skyrocketing storage costs, as inventory operators would jack up the price of storage as their bins got close to being full. Again, 2008 provides a useful snapshot, as the cost of storing oil got close to $5/barrel per month. This would imply they’d be spending $2.5 billion a month for the privilege of storing their 500 million barrels.
And then…they’d be done or they’d have to start building storage facilities like a madman. How much would it cost to build storage facilities for 4 million barrels a day? I’m sure the permitting and regulatory issues would be a breeze as well, right? The US government would probably look very favorably on the manic construction of 120 million barrels of storage facilities a month for the purpose of speculators cornering the oil market, right?
No, IDIOT Cap would be done. They’d be spending $2.5 billion dollars a month for storing their oil, while praying that there was no hiccup in economic activity or increase in production. But oopsy, they overlooked something. Their capacity to drive the price up by taking oil off the market was dependant on their ability to take delivery and now they would have no more ability to take delivery of oil. At that point, the market clearing price would go right back to where it was before their bout of madness, and the price of oil would go right back to where it otherwise would have been, at roughly $100. Well, now IDIOT Cap is sitting on a huge capital loss of $25 billion as well as laying $1.5 billion a month in storage costs. In conclusion, this would only be a successful scheme if they absolutely hated money - and of all the successful investors and money managers I know, that is a rare trait.
If speculators don’t try to corner markets, what do they do? The answer is that they take risk onto their balance sheets in exchange for a slightly favorable probability of making money. Let us get back to the question of hedging and who takes the other sides of those trades. If the price of oil is $125 and you’ve got a flotilla of producers hedging their forward production, you can be pretty confident that consumer hedgers are not on the other side of that trade. This is because consumer hedgers ordered their traders to lock in a price of $80 or lower, so they’re just going to be sitting on their hands. Another market participant is usually stepping up to the plate and taking the other side of the trade. Now remember, whoever that participant is, they are taking a huge amount of risk because oil supplies could increase or demand decrease to an extent that the price of oil drops to $35. That participant is going to be a speculator, and the only reason they would risk this loss and the wrath of their investor is if they were pretty darn confident in their price projection. And again, the price projection is based on supply and demand, not on a ponzi scheme or some diabolical plan to hoard.
And this is the crux of the issue – prices aren’t determined by any of these participants, but rather by underlying supply and demand. Speculators only make money if they, on average, correctly understand and predict the future price path of whatever they are trading. And speculators who lose money don’t speculate for long.
A final point on this issue is that the idea that speculators hoard supplies couldn’t be further from the truth. For example, most mutual funds and many hedge funds have explicit rules that disallow them from taking delivery! There are well known counter-examples, such as Tiger Management with palladium, and the Hunt brothers tried (unsuccessfully) to do this with silver. However, a number of one-off factors allowed both of these situations. First, in both cases, the speculators were trying to hoard precious metals (which have low storage costs and low annual production/stock numbers). Second, these are relatively small markets in terms of total capital worth. Third, they were hoarding non-perishable goods; hoarding of perishable goods is limited by the amount of time before the product rots. And finally, for all goods except precious metals, storing a significant fraction of the annual production is limited by the need to continuously build and maintain larger and larger storage bins. In a word, it is totally impractical. The only commodities suited to hoarding are precious metals, which is why they have succeeded as money through the ages.
As a post script, I turn to a completely unrelated topic and note that my read of natural gas fundamentals has improved significantly since my last article on this topic. Inventories remain below 5 year averages, S&D ex weather looks neutral to bullish, and market sentiment may finally be turning with the approval of the Sabine Liquefaction terminal. Finally, I note with a certain amount of sheepishness that my last somewhat bearish natural gas article came out at almost the exact same time as the Time Magazine cover cheerleading shale gas as the magical mystery sauce – a bottom indicator if ever there was one. As always, this is not a trading recommendation but nevertheless an interesting development.
