The Specs Have It
The debate about the speculative impact on the recent run-up in oil prices continues. Yesterday I was on Cheryl Casone' s program on the Fox Business Network with Oil Price Information Service (OPIS) analyst Tom Kloza. Mr. Kloza is considered to be one of the best retail gas price experts in the country. Now Tom was one of the original founders of OPIS and I used to participate in their price projections survey for oil in their early years, which I think I may have topped their survey at least once or maybe twice.
Yesterday, I was surprised to find out that Tom is blaming speculators for the run up in oil prices! In fact his comments reflected earlier remarks he made to MarketWatch where, "Kloza said the price spike has virtually nothing to do with the supply of oil and everything to do with the perception of the crisis in the Middle East. The spike is a direct consequence of growth in electronic trading of oil futures and options and the fear of those traders manifesting itself in this electronic space."
Now wait a minute. While I agree with Tom that the run up in price has a lot to do with the perception of the crisis in the Middle East and the price is rising on the threat to supply in the future, (it is a futures market you know) what the heck does that have to do with the advent of electronic trading? In fact, as long as I have been in the futures industry, and even back when the commodity markets were traded on blackboards, oil prices rallied on the perceived threat to supply. That's true for all commodities and a simple fact of life. Take grains, for example, that rally on a weather report of no rain and the coming of a potential draught. Or do you remember the oil rally preceding the commencement of the Persian Gulf War when oil prices hit a record high before even a drop of oil was lost. In fact the concept of prices rising before an anticipated disaster happens is so common that it has its own adage "buy the rumor sell the fact."
To blame the run-up in price on electronic trading ignores that fact that when you adjust for inflation, this run-up in price of oil is no greater than similar increases in price we have seen in the past. And this is true since the earliest days of oil prices, even before the computerization of the industry. If you want to see real volatility go back and check oil prices a century or so ago and that activity will make today's moves look like gentle waves.
Rising prices, when there is a threat to supply, serve a valid economic purpose. The market will move to ration supply and decrease demand to try and ensure that we will have enough oil or gas or grain or whatever is being threatened should supply be cutoff. That's what markets do. They become very defensive. If they did not anticipate, order could be removed from the marketplace. It could lead to shortages and disruption of supply and wild price moves.
In fact, we are seeing that today as it is being reported by the Financial Times that, "OPEC is Rushing to Raise Output". The FT says that other influential members of the OPEC Cartel, like Kuwait, the United Arab Emirates and Nigeria, reflect growing unease among OPEC members over the threat to the global economic recovery from crude's runaway rise amid the worsening crisis in Libya."
So in other words, the futures price is inspiring action to their point to bring on more supply. Do you think this would be happening if prices were steady?
Mr. Kloza goes on to say, "the disruption of oil coming from Libya has been largely overblown because Libyan oil is light, sweet crude.” This means it has low sulfur content and is easily refined in unsophisticated refineries in the Mediterranean. The oil replacing it has more sulfur and has created a minor logjam. "If this stops with Libya, then all this is blown out of proportion," Kloza said.
Well yes, I agree Tom, if this all stops in Libya it is being blown out of proportion. If all this unrest blows over then oil prices will plummet. Of course that is a big "if". The changes going on across the Middle East and North Africa are of an unprecedented nature and to think that this is all going to blow over anytime soon is a dangerous bet. One of the ways that many try to prognosticate the future is to look at trends and the trends in North Africa and the Middle East are disturbing to say the least. The market tried to ignore Tunisia and it started to get nervous when the uprisings spread to Egypt, yet it cannot ignore a full blown civil war breaking out in Libya, an OPEC member. Nor can it ignore the very real possibility that this will spread to another OPEC country in the near future.
Even Mr. Kloza, according to MarketWatch, "is nothing but grim about what would happen if the government fell and the flow of Saudi oil became disrupted. ‘It is a true, absolute nightmare scenario,’ he said. ‘It's a complete abstraction to say what the price of fuel would be. It's a silly intellectual exercise to even speculate. But I'd have to guess somewhere between $5 and $10 a gallon.’”
Well thank goodness we don't have to get involved in a silly intellectual exercise to speculate what the price might be because we have the market to do that for us. A free market with hedgers and speculators and enhanced liquidity provided by those wonderful, high frequency traders doing the job the market makers and the scalpers used to do, will do a better job predicting the real risk and real price than me or anyone else.
It becomes a dangerous proposition to try and predict the future, especially when you get caught up into believing that you know better than the market what the price of oil should be. Users of the product get caught up in this game all the time in what is termed 'the fallacy of fair price". If you zero in to a world that you have become accustomed to, you sometimes miss the outside forces that impact price. If you try to convince yourself that you know better than the market what the price should be, you will look for scapegoats and blame speculators or blame computers. This is a common occurrence when prices don't go your way.
I remember back in the eighties when the farmers drove their tractors to the Chicago Board of Trade blaming the speculators for driving down prices in a recession. Or when then Presidential Candidate John Kerry blamed speculators for driving the cost of a barrel of oil to the ridiculously high price of $33 a barrel while being oblivious to the fact that Chinese oil demand and not speculators was driving the price. Blaming the speculators for the price of a commodity is like blaming a thermometer for the weather.
Tom also seems to know better what is good liquidity and bad liquidity. On the air yesterday on the Fox Business Network he seemed to slam high frequency traders and also slam the fact that speculative open interest soared. High frequency traders trade huge quantities for short periods of time providing liquidity for the market and position traders like hedge funds and others are driven to the market because of the historic risks to OPEC countries and other countries around North Africa and the Middle East.
Perhaps Mr. Kloza can tell us why he thinks they are doing something wrong. Does he know what the correct open interest in the market should be? Should he let the world in on what he thinks a fair price for oil should be? Or does he think we should ban futures trading on oil all together? Maybe we should let OPEC set the price?
He argues that the amount of oil contracts that trade far exceed the actual amount of oil available. So what? That is true of any liquid futures markets. Now that might be a problem if all the speculators were doing the same thing. Yet based upon the fact that speculator open interest is rising as is high frequency trading, the fact is that they have very different objectives for trading the market.
It's time we quit blaming the speculators for the prices in the market. This is a dangerous trend that is harmful to the economy. The promise of more oil from OPEC members could ease some concern, yet the risk that unrest will spread will keep the market player anticipating the worst case scenarios. Reports that the West is shunning Libyan crude according to the Financial Times and reports of ongoing fighting will keep the market on edge!
Phil Flynn is senior energy analyst for PFGBest Research and a Fox Business Network contributor. He can be reached at (800) 935-6487 or at firstname.lastname@example.org.