The Bootstrap Theory of the Oil Price

Many strange explanations have been floated to persuade us that the brutal rise in the price of crude is not due to excessive consumption nor sluggish production. An OPEC (Organisation of Petroleum Exporting Countries) minister said recently in all seriousness that because of under-investment in refining, refinery capacity was short, therefore gasoline and diesel prices went up, which pulled up the price of crude. Plain men would think that if refinery capacity was insufficient, it is refining margins that would go up and crude would go down or stay put, but the price of oil today is decidedly not a subject for plain men. Another OPEC minister, in turn, affirmed that oil producers cannot even sell all their current output. He omitted to add that it is Iran that is trying to sell high-sulphur oil at the price of Arab Light, and not succeeding.

All the world hates a speculator and it is deeply satisfying to believe that the rising price of oil (and of wheat, corn and soybeans, not to speak of rice which has no developed futures market) that threatens world prosperity and the very survival of the poor in Asia and Africa, is the fault of heartless profiteers.

George Soros, whose nebulous warnings about the perverse effects of financial markets and speculation enjoy the credibility that people lend to a brilliantly successful practitioner of the art, has recently told a subcommittee of Congress that the large positions taken by pension and other investment funds in commodity indices—of the order of $250 billion—were creating a commodity “bubble”. As three-quarters of the main index is accounted for by oil, most of the effect is exerted on the oil price. He did not explain why there is any effect at all and how it is exerted, but maybe all that went without saying.

Lord Desai, who has taught generations of British students the Marxist economics that had benumbed his native India for half a century, recently went public in the Financial Times, calling on the authorities to “Act Now To Prick The Oil Bubble”. He clearly believes that “pricking” it can substantially reduce the oil price, and he thinks it can be “pricked” by raising futures margin requirements for “speculators” to 50 per cent while leaving them at 7 per cent for “legitimate” users. Doing that may or may not be feasible in a non-regimented economy, but that is not the real problem. The real problem is that much of this talk is based on a fundamental misunderstanding of “speculation”. That “bubble” of confused ideas certainly needs pricking.

For every purchase, there is a sale. When a “speculator” buys 10,000 barrels of Texas Light for delivery in, say, July 2009, because he thinks the price will trend upward between now and then, somebody is selling him 10,000 barrels for the same date. The seller may be a “speculator” who has no oil to deliver, but who thinks the price will trend downward. The buyer who went “long” and the seller who went “short” cancel out and there is no effect on physical stocks of oil. However, if the buyer finds no willing seller at the current futures price, he must bid it up. The futures price must rise above the spot price until the difference is large enough to cover the carrying cost of physical oil for the coming year, namely interest on the capital tied up in it and storage costs. This difference is called in the trade the contango. If more “speculators” tried to buy than to sell future oil, the futures price would tend to rise above the normal contango. It would then be profitable to buy spot oil, store it and sell it for future delivery. The converse would be the case if backwardation occurred. De-stocking would then be profitable.

In a well-functioning market, arbitrageurs, by stocking or de-stocking, see to it that spot and futures prices remain in the normal relation without the future price pulling up the spot price. Indeed, in a speculative equilibrium arbitrage stays on the sidelines, and it pays neither to stock nor to de-stock. “Speculative” buying is matched by “speculative” selling at both the spot and the futures market. Any change in stocks must then be ascribed to refiners’ anticipations of demand (e.g. the spring “driving season” or extreme cold or extreme hot weather forecasts) compared to deliveries they have already arranged for. This both Lord Desai, the politicians and the man in the street would have to regard as “legitimate” (though, for an economist”, such management of refinery stocks of crude is no less “speculative”, i.e. rationally forward-looking, than the reputedly bootstrap-like variety that generates profits at will).

The long and short of it is that if a speculative “bubble” were responsible for a substantial part of the rocketing oil price since February 2008, we should have seen a very large increase in non-governmental stocks, for any speculation that was not reflected in a change in stocks would have been self-cancelling. But there was no massive increase in stocks. In fact, stocks were low throughout, and their ups and downs were minor and not systematic. Speculators may well have swum with the tide, but they did not make the tide so they may swim with it.

In closing, let us recall from elementary economics that speculators only make money if they buy low and sell high, and thus reduce the amplitude of price changes between trough and peak that would otherwise take place. They act as stabilizers. If, on the contrary, they buy high and sell low they magnify the amplitude of the changes that would take place without them, they must lose money and if they lose often enough, they must stop de-stabilizing the markets because they have no money left to “speculate” with. This should suffice to show that “speculators” either stabilize the price or must self-destruct.