Gail the Actuary posted an article by Chris Cook a former compliance and market supervision director of the International Petroleum Exchange.  To say Mr. Cook has an inside view and solid understanding of the oil market and oil prices is an under appraisal.

International Petroleum Exchange Board

The answer to the headline question is – both.  But for nearly everyone the impact of swings in the oil market is serious business.  Cook gives us a very good view of what’s going on inside the market and what drives it.  The short answer from his article is again both, but what is interesting is the prediction of a bust and a recovery – all in the coming eleven and one half months.

Here we’ll summarize the market aspects that Cook outlines for making his case.

Oil is priced in dollars worldwide, so whatever the U.S. government, in particular the Federal Reserve, is doing is going to affect world prices.  Simply put the principle is futures contract traders are electing to choose between owning the dollar as a currency or the oil as an asset.  With that in mind, note that the WTI (West Texas Intermediate) or Brent (actually a combination of oil sourced from the Brent, Forties, Oseberg and Ekofisk fields called BFOE) used by the press and media are minor parts of the world crude market, but the chemistry is used as a benchmark to price the long list of other crude oils.

In the market there are major participants, the sellers and buyers naturally and investors and speculators trying to game the market for safety or profit.  Generally, and so far at least the sovereign oil companies and the Big Oil majors operate at such a scale that they don’t really have to put much money at risk by their standards in order to acquire enough cargoes to move or support the global market price via the BFOE market.

Those big sellers and buyers routinely buy and sell futures contracts in order to insure themselves against a rise or fall in the dollar price.  The market also permits participants to use market contracts for offloading the risk of owning commodities and turn the known to occur future transactions into currency.  It’s a very important part of the market and should work to find the real price, smooth out aberrations and keep the industry finances liquid and able to raise cash or hold oil as an asset.

Here is Cook’s main lesson to folks not inside the industry – in the case of a deliverable exchange futures contract; a price is set for delivery of a standardized quantity of a particular specification of a commodity at a particular location within a specified period of time. If that contract is held open until the expiration date and time then there will indeed be a spot delivery and payment against documents at the original price as set forth by the market exchange’s contractual terms.

This – Almost – never happens, unless the physical market price – which is set by physical supply and demand – is actually at that price at that specific point in time.

Instead when the physical price is lower or higher, then the futures contract will be closed out through a matching purchase or sale of a futures contract to counter the original futures contract and a profit or loss will be taken.  Factually only industry participants can take a supertanker loaded with oil.

The delivery aspect of oil markets is somewhat different than say eggs, corn or lumber.  Those kinds of commodities have found their way to the driveways of inattentive commodities speculators.  But for oil, the broker is responsible to the trading exchange for letting an investor or speculator with no capability of making or taking delivery hold a position into the last month before delivery.  If a broker blows it the exchange officials will ensure such positions are liquidated.

But the industry, investors, and speculators have a new participant – Exchange Traded Funds (ETFs) and structured investment products created to invest in commodities.

Goldman Sachs invented the ETF, whose Goldman Sachs Commodity Index (GSCI), enabled investment in a basket of commodities – of which oil and oil products was the greatest component.  Investors in the new fund were offered the means to exchange the perceived risk of holding dollars with inflation, for taking on the risk of holding commodities. Over the ensuing twenty years the business has boomed, bringing huge amounts of cash worldwide to the oil market and other commodities.

All that money lured in new players and the news making way to park money is to buy a tanker full of oil from a seller and sell it at a future date, while using the market to hedge out any losses.  The main impact is that oil is unseen inventory to the market until someone hedges the risk off.  This isn’t illegal or even a bad idea.  Stocking up is both a smart move for consumers and it’s been a perfectly legitimate financial strategy through history.

The driver for these isn’t greed as regular people expect.  It’s fear, plain and simple.  The U.S. has been busily “printing up” cash since 2008 at incredible rates and the inflation, or more accurately the devaluation of the dollar has been far behind the printing press.  These investors are driven not by making a profit, but by avoiding a loss on the dollars.  There’s lots of oil around, enough to satisfy demand and fill all those tanks and tankers.

Speculators do have a roll, to be sure, but they are most noticeable when they come to the market in a large rush driven by greed and drive a quick price spike.  You can be sure those already in the market are going to cash in and set up for the inevitable price fall.

Commodities markets are driven by expectations, and expectations are heavily influenced by emotions.  It’s often said markets are irrational means to get to a rational end.  Supply, demand and for the past few years the dollar, the medium of the exchange of value, all play major rolls.

The expectation of Mr. Cook, and in part your humble writer, is that supply is more than adequate with little sign of major shocks, consumption demand seems to be declining in the large markets of the U.S. and the EU with some increase in the developing markets.  Little risk here.  The risk lies in the expectations of the dollar and the effect of all that stockpiled oil sitting in tanks and tankers and the cash worried to be in oil or might wish to be back in dollars.  Lots of risk here, and reactions by the market based in reality of producers and consumers will respond.

For consumers, a short price bust might be very good news if a price fall doesn’t trigger a production drop followed by a price boom.

With the market basics covered we’ll link again to Mr. Cook’s article.  The article explains the application of the points raised above, explains how ETFs and other instruments are both consumers in some situations and producers in others. Plus he rolls in some of the expectations, including his own to get to his conclusion.  It a very long read, and there is a long following of entertaining comments.

Lastly, the markets exist to manage risk, not to make sales or buy products.  In a proper operation the price for sales is the last month’s market closing price with a bit of adjustment.  When the sellers and buyers start chasing the price changes they inevitably follow fear and set higher and lower prices, which reduces both production and demand.  Still, over time the market will average out to what the commodity is worth to both buyers and sellers.  Sometimes it just takes a very long time.


3 Comments so far

  1. Matt Musson on January 12, 2012 8:16 AM

    It is important to remember that some of the largest oil hedgers in the USA are the airlines. They ‘buy in’ and lock in a fixed price for their fuel. That way, their ticket prices don’t need to be adjusted every day. A lot of trucking and transport companies are doing the same thing.

    It’s not just greedy ‘speculators’.

  2. Jerry Taylor on January 13, 2012 12:17 AM

    Perhaps all this is about to change with todays NASA announcement and patent application for LENR device…

  3. Matt Musson on January 13, 2012 10:41 AM


    Thanks for that link. WOW! I can’t believe that NASA is actually making such a completely unreserved endorsement of LENR!

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