"Are We in the Peak of an Oil Bubble?"

[Ms. B. Havin]

Since we've had a lot of discussion about real estate bubbles (in the "regional economy"/real estate section), I thought this article about an oil bubble might be an interesting read for people:




This figure shows the total world oil demand and supply (left scale) and the oil price (right scale) from 2004 to the first quarter of 2008. Data from: International Energy Agency and US Energy Information Administration (http://www.eia.doe.gov/ emeu/international/ oilother.html). Image credit: D. Sornette, et al.

Are We in the Peak of an Oil Bubble?
By Lisa Zyga, Physics / Physics

Since 2003, worldwide oil prices have quadrupled. According to a new study, the price of oil is rising at a faster-than-exponential rate, and cannot be sustained. In other words, we’re in the midst of an oil bubble, say researchers Didier Sornette and Ryan Woodard of ETH Zurich in Switzerland and Wei-Xing Zhou of the East China University of Science and Technology in Shanghai, China.

By analyzing oil prices over the past four years, the researchers have demonstrated more support for the hypothesis that the recent oil price run-up has less to do with supply-demand interplay and more to do with speculation.

In their analysis, the team gathered data on oil prices since 2005 in US dollars, euros, and other major currencies (to confirm that the results are not a consequence of the weakening of the US dollar). They also examined worldwide oil supply and demand data, specifically investigating the extent of increased demand from emerging markets such as China and India.

Then, the researchers analyzed this data using a method that Sornette’s group started to develop in 1996 that identifies bubbles as “transient superexponential regimes” – basically, areas of rapid growth that occur due to a source of positive feedback within the system. The scientists looked at the data in the context of three different models, and all three models revealed the existence of a “log-periodic power law,” in mathematical terms – in other words, a bubble. In economic terms, the researchers explain, a bubble refers to a situation in which expectations of future price increases cause prices to temporarily rise without justification from fundamental valuation.

Further, the models showed that the bubble is close to a local peak, and we may have even reached the peak already. On the other hand, the researchers noted, this critical peak may also be embedded in a larger-scale bubble, one that could develop in the coming months and years.

“The most fundamental difficulties [in trying to describe oil prices] lie in the operational definition of a ‘bubble,’” Sornette told PhysOrg.com. “There is no consensus. One standard definition is ‘exponential growth of price.’ But exponential growth of price is normal in economics, because it just corresponds to a constant growth rate. Our definition is ‘faster-than-exponential' growth of the price, which is necessarily unsustainable.”

The team also identified several particular characteristics of oil price dynamics that may help researchers understand the causes of the bubble. First, in the years 2004 and 2005, worldwide supply, demand, and price all increased together. In early 2006, supply started to drop, followed a few months later by a drop in demand, and six months later by a drop in price.

Around this time, from mid-2006 to early 2007, supply and demand fluctuated. Then, supply, demand, and price rose together, and have been continuing to rise through the most recent data point, which was taken in early 2008.

A comparison of supply and demand showed that, most recently, supply has been exceeding demand by more than a half million barrels per day. Meanwhile, the price continues to increase. Since it appears that the supply-demand balance has only a small effect on the price of oil, the researchers suggest that a major effect lies elsewhere. They point out several reasons why speculation, fed on rumors of rising oil scarcity, may be the positive feedback causing high oil prices.

As one motivating factor, investors could be searching for a new high-return investment following the collapse of three recent economic bubbles in the US (communication technology, which peaked in 2000, real-estate in 2006, and sub-prime mortgage lending in 2007). Also, speculation may have increased due to the deregulation of oil futures in the US in early 2006, corresponding to the fluctuations that occurred shortly after that time. Investors may also be concerned about a weakening US dollar, which may encourage protective hedging against future oil price increases.

“I expect rather soon some calming with a correction of the price,” Sornette said when asked about his prediction of future oil prices. “But it seems that, for the medium term, one has to be bullish on oil.”

More information: Sornette, D.; Woodard, R.; and Zhou, W.-X. “The 2006-2008 Oil Bubble and Beyond.” Arxiv:0806.1170v2. 13 Jun 2008. Submitted to Physica A.

[amor de cosmos]

Back in 2006 a US senate committee attributed the high price of oil (~$70/barrel) to speculation. It's basically Enron-style manipulation of the price of oil.

FOR IMMEDIATE RELEASE
June 27, 2006 Contact: Press Office
Phone: 202.228.3685

Levin-Coleman Report Finds Speculation Adding To Oil Prices: Put the Cop Back on the Beat

WASHINGTON – Senators Carl Levin (D-Mich.) and Norm Coleman (R-Minn.), Ranking Minority Member and Chairman of the Senate Permanent Subcommittee on Investigations, today released a Subcommittee staff report [PDF] finding that market speculation has contributed to rising oil and gasoline prices, and that too many energy trades are occurring without regulatory oversight. The report recommends that Congress enact legislation to close a major loophole in federal oversight of oil and gas traders, slipped into law in 2000 at the behest of Enron and other large energy traders.

...

In late April of this year, the price of crude oil on the New York Mercantile Exchange (NYMEX) hit a record of $75.17 per barrel. In mid-May, the average retail price for gasoline reached $2.99 per gallon, just a few cents short of the record set after Hurricane Katrina shut down oil and gasoline production along the Gulf Coast in September 2005.

Although these high prices are often attributed to the forces of supply and demand, the report demonstrates that supplies have been more than adequate to meet demand. Since late 2004, the amount of stored oil in the United States has been increasing. Oil inventories recently reached 347 million barrels – an eight-year high and the largest U.S. inventory since 1998, when oil was $15 per barrel. Similarly, oil inventories in Organisation for Economic Co-operation and Development (OECD) countries recently reached a 20-year high. As the report explains, the traditional factors of “supply and demand” do not tell the whole story on oil and gas prices.

What is new, according to the Levin-Coleman report, is that over the past few years market speculators have poured tens of billions of dollars into the energy commodity markets. For example, the International Monetary Fund reports that over the past three years approximately $100-$120 billion has been invested in energy markets worldwide. Over this same period about $60 billion has been invested in oil futures on the NYMEX.

Many analysts believe these speculative investments have significantly raised the price of oil futures. While it is not possible to determine the precise dollar increase in the price of oil attributable to market speculation, some analysts have estimated that speculation has added as much as $20-$25 to the price of each barrel of oil, thereby pushing up oil from about $50 to around $70 per barrel. As former Federal Reserve Chairman Alan Greenspan recently stated, “with the demand from the investment community, oil prices have moved up sooner than they would have otherwise.”

http://levin.senate.gov/newsroom/release.cfm?id=257862

In a Jun 25 blog update, Export Development Canada vice-president & chief economist Peter Hall more or less agreed:

As with any sustained price rise, it is better for producers to buy additional supplies early, and sell at the latest possible point in time, either marking prices up to reflect rising input costs, undercutting competitors who didn’t pre-buy earlier at lower prices, or a combination of the two. Either way, there is a strong incentive to purchase a lot more than current needs dictate, adding further to the perception of a general supply shortage.

And then there are other market players. These have little or no direct connection to the commodity in question, but see large price increases, and want a piece of the action. They have significant clout, given the sizable liquidity generated by robust global growth in the past four years. And data suggest that they are quite active in current commodity transactions. Their incentive is strong. In the past year, major global stock market indexes have fallen on average by 15%. In the same timeframe, commodities in US dollar terms have jumped by almost 50%. What is more, the incentive has been magnified by crisis in other parts of the economy. This activity is enhancing the perception of shortages, but has little relation to demand and supply fundamentals.

The bottom line? Speculative bubbles are almost impossible to fully identify before they burst, but oddly enough, are always a no-brainer in hindsight. Knowing that the incentives to over-invest in commodities are currently very strong suggests that a near term price correction could well occur.

http://www.edc.ca/english/docs/erepo...ions_14848.htm

[amor de cosmos]

The first firm to be charged with manipulating oil prices:

CFTC Charges Optiver Holding BV, Two Subsidiaries, and High-Ranking Employees with Manipulation of NYMEX Crude Oil, Heating Oil, and Gasoline Futures Contracts

Defendant Caught on Tape and in Email Saying He Would “Bully” the Market

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) announced today its case against Optiver Holding BV, two of its subsidiaries, and three employees, charging them with manipulation and attempted manipulation of New York Mercantile Exchange (NYMEX) Light Sweet Crude Oil, New York Harbor Heating Oil, and New York Harbor Gasoline futures contracts during March 2007.

The CFTC filed the civil enforcement action in the United States District Court for the Southern District of New York against Optiver Holding BV, a global proprietary trading fund headquartered in the Netherlands, and two subsidiaries – Optiver US, LLC (Optiver), a Chicago-based corporation, and Optiver VOF, a Dutch company. The complaint also names defendants Christopher Dowson (head trader of Optiver), Randal Meijer (head of trading and supervisor of Optiver and Optiver VOF) and Bastiaan van Kempen (Chief Executive Officer of Optiver).

The complaint charges all defendants with 19 separate instances of attempted manipulation involving the aforementioned energy futures contracts on 11 days in March 2007. The complaint further alleges that in at least five of those 19 attempts, defendants successfully manipulated certain of these energy futures contracts, causing artificial prices. In three of those instances, defendants forced futures prices lower, and in two instances, defendants forced futures prices higher. The complaint alleges that defendants profited by approximately $1 million from their manipulative scheme.

According to the complaint, the defendants employed a manipulative scheme commonly known as “banging” or “marking”’ the close. “Banging the close” refers to the practice of acquiring a substantial position leading up to the closing period, followed by offsetting the position before the end of the close of trading for the purpose of attempting to manipulate prices.

The complaint further charges Optiver and van Kempen with concealing the manipulative scheme and making false statements in response to an inquiry from NYMEX.

*snip*

The Energy Futures Contracts Manipulated by Defendants

The defendants’ manipulative trading scheme involved three futures contracts listed for trading on the NYMEX: the Light Sweet Crude Oil futures contract (Crude Oil, also referred to as West Texas Intermediate (WTI)), the New York Harbor Heating Oil futures contract (Heating Oil), and the New York Harbor Reformulated Gasoline Blendstock futures contract (New York Harbor Gasoline). The settlement price for the Crude Oil, New York Gasoline, and Heating Oil futures contracts is derived by calculating the volume weighted average prices of futures trades conducted during the closing period for the contracts (from 2:28 to 2:30 p.m.). The volume weighted average price is referred to commonly as the VWAP.

The defendants’ manipulative scheme involved the Trading at Settlement (or TAS) contracts in Crude Oil, Heating Oil, and New York Harbor Gasoline contracts. TAS contracts are futures contracts, except that the parties determine at the initiation of the contract that the price of the TAS contract will be the day’s settlement price plus or minus an agreed differential. A TAS contract which has been bought or sold can be offset by trading a futures contract in the opposite direction.

The Manipulative Scheme

The manipulative scheme, in defendant Dowson’s words, to “bully the market,” involved trading a significant volume of futures contracts in Crude Oil, Heating Oil, and New York Harbor Gasoline in the opposite direction of the associated TAS position, before and during the close of the contracts. The defendants’ goal in trading the large volume of futures was to improperly influence and affect the price of futures contracts in Crude Oil, Heating Oil, and New York Harbor Gasoline. The defendants’ manipulative scheme was, in the words of defendant Meijer, “built on the idea that we can control the VWAP.”

As alleged in the complaint, the scheme ultimately permitted defendants to profit regardless of the direction of the market move, provided that Optiver’s futures trading in the close and before the close was in the opposite direction of the TAS position it had accumulated during the trading day.

For further detail on the allegations, please see the complaint and background documents found in Related Links.

the whole release is here:
http://www.cftc.gov/newsroom/enforce...pr5521-08.html

[amor de cosmos]

more:

US Senate defeats bill to limit speculation in energy markets

Washington (Platts)--25Jul2008
A vote designed to bring to a close debate on a Democrat-sponsored bill to reduce energy market speculation which sponsors said would bring energy prices down for consumers failed in the US Senate Friday amid an anticipated Republican filibuster.

The move to close debate on Majority Leader Harry Reid's Stop Excessive Energy Speculation Act failed with a vote of 50 in favor and 43 against. It would have needed 60 votes for successful passage.

Following the vote, the Nevada Democrat filed for a motion to reconsider.

Reid's bill, which garnered considerable support among Democrats, would have closed a number of purported loopholes in energy regulation. While Democrats considered the measure a good "first step" in bringing down prices for consumers, Republican opponents wanted to attach several drilling-related amendments to the bill in hopes of addressing broader energy concerns.

http://www.platts.com/Oil/News/6927337.xml