The Oil Price — Everybody Has An Axe To Grind

Think of this post as laying the groundwork for tomorrow's Saturday Oil Report. I'm probably going to offend just about everybody today, but recent discussions of the oil markets can only cause a sane man to lose his grip.

The Empire is in decline for a variety of reasons. We have multiple, unsolvable problems. It is a very long list. Considering oil, here are the two most relevant problems—

• Phony markets in which the "price discovery" function has been distorted by unfettered speculation (or outright manipulation) by big financial institutions. Think of the housing market circa 2003-2006, the equities markets in the late 1990s and now, and the commodity markets since about 2006. We live in a Bubble Economy.


• Vulnerability to oil price shocks in the Peak Oil Era

We are now experiencing a "mini-shock" in oil following on the heels of the Egyptian and Libyan revolts. And exactly the same people are putting forward exactly the same arguments they made in 2008 during the much bigger oil price shock—is the oil price based on supply & demand fundamentals? OR, are speculators to blame?

Logically speaking, in the propositional calculus, the statement "P OR Q" is true if either P is true or Q is true. Thus, that statement is true if both the propositions P and Q are true. However, concerning the oil price, the OR just cited is an exclusive OR (XOR). Are people in general really such simpletons as to suppose that the answer to all questions must be Black Or White? That expensive oil is due to fundamentals OR it is due to speculation, but can not be due to both? Apparently so.

Economists say the price is based exclusively on supply and demand. Their elegant theories tell them this must be the case, and since the vast majority of them have no interest in understanding how physical (commercial) or paper (speculative) oil is actually traded in the Real World, they need not go any further toward understanding the problem. These geniuses can not accept the fact that the price discovery function of markets (commodities, equities, etc.) is broken.

In contrast, others say the price is purely a function of speculation in the phony markets. They said this in 2008, and they're saying it again now in 2011. If they are insiders, they know how the markets work and they also know that these same markets have not been re-regulated (e.g. to establish position limits in commodities trading) since the last oil price shock—Gee Whiz! I wonder why not?  In so far as these people have no interest in the physical oil supply, they need not go any further in understanding the problem. These geniuses can not accept the fact that the world's oil supply is not what it used to be.

And then there are the people who for one reason or another come down hard on one side of the peak oil question OR the other. If peak oil is your religion, and the end of the world has arrived once again, speculation can't be driving any part of the oil price—the answer is always insufficient supply. If your religion says we have a boundless supply of everything, including oil, it must be speculation driving the price because shortages don't exist, or if they do, they are only temporary—markets solve all problems. Or we've reached peak demand, or viable substitutes are just around the corner, or some other made-up nonsense.

If you understood and absorbed everything I just said here—everybody has an axe to grind—you are in a position to understand what's going on in the oil markets when I attempt to explain it tomorrow. All such explanations are provisional because we must work off incomplete information. Even in retrospect, as with 2008, nobody can agree on exactly what happened. We have many unsolvable problems which sometimes interact in ways harmful to the American people. This is one of those times, and it won't be the last.

Otherwise, if you prefer to grind your axe, just go to church like everybody else.

Comments

[Kostas Kalevras]

The commodities market is quite different because it deals with contracts. You buy an oil contract that states that you will need *physical* delivery of stated quantity on stated date. In other words, you cannot trade larger quantities than those available on the market and your ultimate loss or gain depends solely on the oil spot price on contract expiration. If the spot price is larger you 'll gain the difference, or you 'll suffer a loss.
Consequently, speculation might accelerate oil price movements but i do not believe that it can drive oil prices to a direction opposite from the one the market is going anyway. Especially since speculators in principle only have access to funds and not actual storage capacity (tankers, land storage etc). Even if they had there would be no point in storing oil unless they expected it to be more expensive in the future.

Just my personal interpretation of the market.