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Friday, June 27, 2008

Is Oil Speculative

This is a question for which there is a growing debate. Two heavy hitters are on different sides of this debate. Here is how George Soros views the situation.

Soaring oil prices are increasingly the result of speculation, financier George Soros said in an interview published Monday.

The billionaire investor said the money pouring into the oil market increasingly had the look of a bubble, but that it would not burst until both the United States and Britain were knocked into a recession.

"Speculation ... is increasingly affecting the price," Soros was quoted as saying by The Daily Telegraph. "The price has this parabolic shape that is characteristic of bubbles."

But the cost of oil ? which briefly reached new record highs of more than US$135 a barrel in trading Thursday ? was unlikely to fall dramatically until the U.S. and Britain economies began contracting, the paper quoted Soros as saying.

Soros has frequently been a voice of gloom and doom as the U.S. economy

Here is how Warren Buffet sees it.

It's supply and demand. I mean, if somebody buys a thousand forward oil contracts and somebody sells a thousand forward oil contracts, somebody's speculating on the downside and somebody's speculating on the upside. The only way you could have speculators having a big impact is if you had a huge amount of storage where they started actually withdrawing actual, physical oil from the system.

But it's not speculation, it's supply and demand and the situation is that in my adult lifetime, up until the last year or two, there's always been a huge amount of excess supply available. There's been reserve capacity. And that goes back 30 years ago, in this country we produced way more oil than we needed here and we had something called the Texas Railroad Commission that shut down wells. And a matter of fact, we got down to where they would only let wells operate in Texas for eight days, we had so much extra capacity. We don't have excess capacity in the world anymore, and that's what you're seeing in oil prices.

Now, let's take a look at a historical chart of oil.

Now, the last time it had such a dramatic rise, peaking in December of 1979, it crashed. That market was also speculative.

Now, markets work on perception. Markets are never perfect however the closer perception is to reality the closer to perfection the markets are.

I go back to the three speculative markets I know best, 1929, the internet boon, and the mortgage boon. In each of those markets, prices had almost nothing to do with reality. With the internet boon, most folks were buying the concept rather than anything tangible with any particular company. With the real estate boon, folks were buying real estate mostly following the herd. Real estate was literally increasing in value overnight. Now, since the property or location didn't actually change overnight, perception and reality were far apart.

So, what is going on in oil now? Of course, we have heard of greater demand from China and India. We have also heard about the weakening dollar. There is no doubt that all of these are contributing factors, but would these factors contribute to a 150% increase in a year and almost 700% increase in seven years? In my opinion, they wouldn't. I side with Soros on this one (as difficult as that is to admit).

I believe that what's happening now is that speculators are taking issues of supply and demand, big and small, and turning that news into excitement and driving prices far beyond where they should go. Everytime an oil pipeline is blown up or Iran acts up, oil is up five and ten dollars a barrel. A pipeline getting blown up has marginal effect on supply and demand and yet we see far more significant effect on the price of oil.

Earlier this month oil went up ten dollars in one day.

Oil soared after an Israeli politician raised the specter of an Israeli military strike on Iran, the second largest OPEC oil producer. In New York crude oil rose eight percent, or $10.75, to a record over $138 a barrel. The rise followed a five percent gain on Thursday, bringing oil's two-day advance to a stunning $16.

In other words, this market responded acutely to a speculative report. Nothing in the fundamental dynamic of supply and demand changed and yet the price went up nearly 10% in one day. When a market responds to speculation so acutely, in my opinion, that market is itself speculative.

Let's look at what happened when an oil pipeline was blown up.

In an apparent case of politically motivated sabotage, six explosions blew apart oil and natural gas pipelines operated by Mexico’s Pemex state oil and gas monopoly early Monday in Veracruz and Tlaxcala states, causing fires and forcing the evacuation of 15,000 people from surrounding towns.

The blasts forced Pemex to shut down at least four affected pipelines and prompted federal authorities to close two major roads. No injuries were reported.

Mexico is the world’s sixth-largest oil producer and a major supplier of petroleum to the U.S. The outages drove the price of oil above $78 a barrel in futures trading Monday.


The attacks helped push oil prices higher in New York futures trading Monday. Oil for October delivery increased 79 cents to $77.49 a barrel, then rose as high as $78.47 a barrel in late electronic trade, near the record $78.77 reached Aug. 1.

Now, we are talking about pipeline that produces hundreds of thousands of barrels of oil per day when the world produces nearly a hundred million. Yet, the price of oil went up over 1% in one day. Does this sound like a case of supply and demand or merely the perception of supply and demand?

The good news is that ALL speculative markets end bad for the speculators. 1929, the internet boon, and the real estate boon all ended up blowing up for the speculators. The same thing will happen with oil. Speculative markets are built almost exclusively on the emotion, excitement. Excitement is a fickle thing. Anything can swing the excitement back. With the internet stocks it was Greenspan raising interest rates. With real estate, it was the eventual realization that the entire market was built on bad loans. With 1929, it only took one bad day.

So, at some point folks will see relief and great relief at the pump because the oil market will go the way of all speculative markets, with a crash. Unfortunately, no one knows when that will happen, tommorrow, next month, next year, or five years from now. Until then, speculators will drive events. They will take each and every news and blow it up into great excitement and move the market tremendously. That's how speculative markets work. I once witnessed a medical stock go from $7 a share to $70 in one day because their drug passed one of the FDA trials. The drug was still nowhere near being brought to the market let alone making money but this news drove the stock to a 1000% increase in one day. That's what speculative markets are like. Israel indicates that they may attack Iran at an undetermined time in the future and oil blows up $10 a barrel.

The dynamics are always the same, and so is the result. I just hope that folks won't go broke filling up their tanks waiting for the only natural result, the crash. Here is my plan to bring oil to $20 a barrel.

1 comment:

Anonymous said...

Good article, just one typo you may wish to attend to, you said:

"Now, we are talking about pipeline that produces hundreds of thousands of barrels of oil per day when the world produces hundreds of billions."

Actual world daily oil production is about 80 Million barrels.

Truly, as I've posted elsewhere and is now picked up by the MSM;

The price of Crude Oil is no longer reflecting the actual supply and demand of
Crude oil, it reflects the supply and demand of Crude Oil futures contracts.